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1 Underrated Stock to Buy in January

By Adam Levine-Weinberg - Updated Apr 21, 2019 at 11:16PM

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Promising turnaround initiatives, an improving balance sheet, valuable real estate, and a dirt-cheap valuation combine to make the largest U.S. department store operator a compelling investment opportunity.

Macy's (M 9.91%) stock had its worst day ever earlier this month, plunging nearly 18% on Jan. 10 after the department store giant revealed that sales missed expectations during the critical November-December holiday period.

Shares of Macy's had already given up a lot of ground since peaking above $40 over the summer. Due to this latest setback, the stock ended last week below $26 and within striking distance of its 52-week low of $22.47. Many pundits are again treating Macy's as if it is on deathwatch.

M Chart

Macy's Stock Performance. Data by YCharts.

However, investors are overreacting to a relatively small sales miss. The retailer's shares are now cheaper than ever, even though Macy's has dramatically improved its balance sheet in recent years. Furthermore, the company is in the midst of rolling out numerous initiatives that could improve sales and profitability in the years ahead. As a result, Macy's stock looks like a great buy for long-term investors right now.

The holiday results weren't that terrible

During the nine-week holiday period, comparable-store sales rose 1.1% at Macy's. This marked the second consecutive year that the No. 1 department store operator achieved comp sales growth over the holidays. Yet management (and investors) had expected faster growth, particularly after comp sales rose 2.7% during the first three quarters of fiscal 2018.

Macy's indicated that the holiday season started off well but that sales slowed for much of the month of December. The slowdown left the retailer with too much inventory after Christmas, forcing it to take big markdowns. That in turn has negatively impacted its gross margin.

The result is that while annual sales growth will miss Macy's November forecast by no more than 0.5 percentage points, the company had to lower its EPS guidance range by more than 5% at the midpoint. This guidance cut was particularly notable because management raised its outlook for asset sale gains for the year. Excluding asset sales, Macy's new full-year EPS forecast is 10% lower than the guidance provided in November.

The exterior of the Macy's flagship store in Manhattan.

Macy's reduced its fiscal 2018 guidance earlier this month. Image source: Macy's.

Even so, it's important to recognize that Macy's repeatedly raised its guidance over the course of fiscal 2018. Its updated forecast is still significantly better than the expectations laid out by management last February, with or without including asset-sale activity.

Macy's is cleaning up its act

Another key point that investors should keep in mind is that Macy's is still in the early stages of its turnaround effort. It hasn't come close to getting the full benefit of its turnaround initiatives yet. For example, over the past year, the company has begun upgrading its higher-potential stores through its Growth50 program. This effort has shown promising results so far, but it only touched 50 stores last year. Another 100 stores will be renovated this year, with more to come in 2020 and beyond.

Macy's Backstage off-price sections within full-line stores have also contributed to Macy's recent turnaround. Yet there are only Backstage sections in about a quarter of Macy's full-line stores today. There is clearly room to take that percentage much higher.

Additionally, Macy's has made changes to its loyalty program since late 2017 to reward its best customers when they spend more money. These updates are already starting to change customer behavior, but there's more room to go in that respect.

Finally, Macy's has dramatically improved its balance sheet in recent years. It will likely end fiscal 2018 with less than $4.8 billion of debt, down from more than $7.6 billion in 2016. Aside from guaranteeing lower interest expense, this debt reduction also makes the stock less risky than it would be otherwise.

The stock is way too cheap

After reducing its earnings forecast earlier this month, Macy's expects to post full-year adjusted earnings per share between $3.95 and $4.00. That means the stock currently trades for less than seven times earnings.

To be fair, Macy's guidance assumes that the company will book $360 million of asset sale gains this year, adding about $0.90 to its EPS. But even without including any asset sale gains, Macy's is trading for just a little more than eight times its projected 2018 earnings. Furthermore, with a real estate portfolio valued at $15 billion to $20 billion, the company has plenty of potential asset sale gains in the pipeline for future years.

Investors are currently valuing Macy's as if its earnings power is in permanent decline. If any of the company's turnaround strategies succeed, earnings growth could soar far beyond what the market expects, driving Macy's stock higher.

Meanwhile, the company's real estate is worth more than its current enterprise value, providing a nice margin of safety in case the recent return to sales growth doesn't last. This combination of substantial upside if its turnaround succeeds and downside protection is what makes Macy's a great stock to buy this month.

Check out the latest Macy's earnings call transcript.

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