When Macy's (M) reports its first-quarter results on Wednesday, May 11, look for a swing and a miss. But it might not matter. I believe the company could be positioned for a dramatic recovery later in the year.
Back in February, when Macy's reported its fourth-quarter results, management told investors to expect a negative same-store sales number for the next three quarters. For the year, the company guided to a -1.5% comps figure. But the stock rose on the belief that management had the situation under control and the future wasn't as bleak as some had thought. Over the next few weeks, the shares advanced 15% and almost made their way back to $45. However, by the middle of last month, investor optimism began to wane as analysts began to worry about unseasonably cool weather in most parts of the country.
That's right. The winter was unseasonably warm, which destroyed winter clothing sales and forced Macy's to take aggressive markdowns in 4Q. Now spring has been unseasonable cool and is wreaking havoc on margins going into summer. These guys can't catch a break. But I think it's even worse than that because Macy's is still stuck with winter gear it couldn't sell in January and December. The company has been marking down winter gear as recently as March, which is sure to pressure margins in the first quarter.
Macy's ended the fourth quarter with a gross margin of 37.4%, a decline of 290 basis points. Two hundred ninety basis points was the steepest margin decline ever for the company. For the entire year, gross margins narrowed 90 basis points to 39.1%. But that's not all. Operating margins have been doing even worse, since the company took a charge of $177 million associated with asset impairments and store closings. Fourth-quarter operating margins fell to a dismal 10.6%, and the company finished out the year with an operating margin of just 7.5%.
Beside the weather and excess inventory, the dramatic growth of e-commerce is also pressuring Macy's margins. As the ratio between in-store sales and e-commerce sales changes, the lower margin e-commerce business has been weighing on margins across all retailers.
Macy's total sales for the first quarter are expected to decline 4% to $5.9 billion. Because of lower margins and higher expenses, operating profit could fall 45% to $224 million. Macy's is aggressively spending to improve offerings in its jewelry business, opening more Backstage discount outlets, spending more on service, products and presentation at its top 150 stores and expanding its Bluemercury beauty business.
Add it up and 1Q gross margins should be down to 38%, expenses up nearly 200 basis points and operating margins off 290 points to 3.6%. If that model is right, that means Macy's would post net income of only $75 million (on $5.9 billion of revenue) and earnings per share of just $0.25 (vs. $0.56 a year earlier). And that's on an 11% reduction in shares outstanding. How the mighty have fallen.
Nevertheless, the stock could be poised for a dramatic turnaround later in the year.
Management has promised to cut $400 million in costs this year and investors will be listening carefully for an update on those cuts. The timing will be critical. If the cuts are heavily weighted toward the back half of the year, and if Macy's can get to a positive same-store figure by the fourth quarter, the stock could rocket higher since those cuts would fall directly to the bottom line and Macy's will be facing easy comparisons with 2015.
It's unlikely that gross margins will decline as much as they did in the fourth quarter of 2016 as they did in 2015. If the company's heavy investment begins to pay off in better sales, and the share count continues to drop, Macy's will probably beat fourth-quarter estimates pretty handily.
Last year, operating income fell 19%, but with some luck, operating margins will only be down 5% to 6%. On a share count that will be less than 290 million (from 330 million last year), EPS would be up vs. down 14% last year. Sales don't even have to grow for Macy's to beat last year.
I believe the first quarter could be the trough quarter for Macy's. If management can wring out some savings, beef up the top line and stabilize margins, Macy's could post blow out numbers by the fourth quarter.