Last month, Macy's (NYSE: M) reported solid sales and earnings results for the second quarter of fiscal 2018. The results comfortably surpassed management's expectations, as well as analysts' estimates. Nevertheless, Macy's stock plunged 16% on the day of the earnings report. While the stock began to recover in the following days, it has since given back most of those gains.
On Tuesday, Macy's got another negative analyst review. Goldman Sachs analyst Alexandra Walvis initiated coverage of Macy's with a sell rating and a $33 price target, implying roughly 10% downside, while giving three of its competitors buy ratings.
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Walvis and her team believe that Macy's will underperform due to the declining fortunes of malls across America. However, the analysts appear to be overestimating the headwinds Macy's faces -- or underestimating the benefit of its sales growth initiatives.
Macy's is doing fine
It's hard to find much fault with Macy's current performance. After 11 consecutive quarters of comp sales declines, the department store giant returned to comp sales growth in the fourth quarter of fiscal 2017, logging a 1.4% increase (including sales in licensed departments).
Sales trends have improved further this year, with comp sales up 2.3% in the first half of fiscal 2018. The company's forecast calls for similar growth in the back half of the year. But this guidance may be conservative, given that Macy's outpaced management's expectations in the first two quarters.
Meanwhile, adjusted earnings per share surged 65% in the first half of the year and more than doubled excluding real estate gains. EPS growth is set to slow going forward, but Macy's expects full-year adjusted EPS of $3.95-$4.15 -- up from $3.77 a year earlier -- despite a significant decline in real estate gains.
Can Macy's survive the death of the mall?
While Macy's is on track to deliver solid sales and earnings results this year, retail sales growth has been exceptionally strong. Indeed, Macy's is still gradually losing market share. Walvis and her team at Goldman Sachs appear to believe that Macy's recent momentum won't be sustainable in a more normal environment.
Specifically, the Goldman analysts argue that Macy's will be one of the biggest victims of "deterioration in the mall ecosystem" in the coming years. They note that Macy's has stores in many malls that are co-anchored by Sears, which is closing stores at a furious pace. The struggling J.C. Penney chain is another key co-anchor.
In the short run, the closure of other anchors at many malls could further depress mall traffic, undermining Macy's turnaround efforts. (On the other hand, Macy's could gain market share as competitors close stores.) More importantly, in the long run, store closures by department store anchors will allow mall owners to accelerate their efforts to improve their properties and reinvigorate customer traffic.
Along these lines, Brookfield Property (NASDAQ: BPY) closed its acquisition of mall owner GGP last month. Brookfield Property has aggressive plans to reposition some GGP malls while adding additional space to others.
Brookfield has experience with a wide range of real estate types. At some GGP malls, it is likely to add residential, hotel, or office space. At other properties, it may carve up vacant department store space for new tenants in categories like entertainment, fitness, dining, and grocery. Either way, these efforts to bring in new uses should boost traffic by bringing people to the mall who wouldn't have come as often otherwise.
Brookfield's redevelopment efforts are particularly important for Macy's. As of the end of 2017, there were more than 80 Macy's stores (plus four Bloomingdale's stores) in GGP malls. That's more than 10% of the company's store count. However, Brookfield is just one of many mall owners working to reposition properties and replace struggling anchors like Sears with higher-traffic tenants.
Macy's stock is too cheap to ignore
It's fair to say that retailers less exposed to mall traffic trends are likely to have a smoother ride than Macy's. But those companies tend to have significantly higher valuations. Meanwhile, Macy's stock trades for less than nine times its projected 2018 earnings. Even if you exclude real estate gains, the stock still trades for less than 11 times earnings.
At this bargain-basement valuation, investors need not rely on a market share recovery for Macy's. As long as the department store giant's market position doesn't collapse over the next decade, the stock is likely to perform quite well -- particularly considering that Macy's still has a lot of excess real estate to cash in on.
Walvis and her analyst team at Goldman Sachs (and other Macy's bears) are overestimating the threat from declining mall traffic. Macy's self-help initiatives and the gradual redevelopment of malls -- especially the replacement of struggling department stores with new uses -- will likely be sufficient to keep traffic steady. This should allow Macy's to continue pumping out substantial free cash flow for the foreseeable future.
With Macy's stock still trading at a valuation that implies the company is in dire straits, there's plenty of upside for long-term investors.
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