On Wednesday morning, Macy's (M 0.28%) revealed that it achieved its seventh consecutive quarter of comparable-store sales growth in the second quarter of 2019. Unfortunately, that sales volume came at the expense of gross margin, so Macy's posted a sharp drop in its profitability for the quarter. It also reduced its full-year guidance for earnings per share.
Not surprisingly, investors responded to this news by dumping Macy's stock. Indeed, shares of the department store giant plunged below the $16 mark in morning trading for the first time in nearly a decade, before bouncing back a bit by noon EDT. However, investors may be overreacting to this setback.
The second quarter at a glance
Macy's posted a 0.3% comp sales increase last quarter (0.2% excluding licensed departments): its third consecutive quarter of sub-1% comp sales growth. Total sales slipped 0.5% year over year to $5.55 billion, due to the impact of store closures over the past year.
The real problem in Macy's results was that gross margin contracted to 38.8% from 40.4% a year earlier. Management noted that the company entered the quarter with a little too much inventory. As a result, slow sales of warm-weather apparel, a sharp drop in sales to international tourists, and a "fashion miss" in women's sportswear for some of Macy's top private brands forced the retailer to take deep markdowns later in the quarter.
Macy's slow sales growth and its investments to improve customer service also caused operating expenses to increase -- both in absolute terms and as a percentage of sales.
The net result was that adjusted EPS plummeted to $0.28 from $0.70 a year earlier. This fell well short of the average analyst estimate of $0.45. Excluding the benefit from asset sale gains, adjusted earnings per share (EPS) came in at $0.27, compared to $0.59 in the second quarter of fiscal 2018.
Macy's revises its guidance
In light of its solid (but not spectacular) year-to-date sales performance, Macy's is maintaining its forecast for comp sales growth between 0% and 1% in fiscal 2019. However, due to its weaker profitability in the first half of the year, the company cut its full-year EPS guidance by $0.20. It now expects adjusted EPS between $2.85 and $3.05, down from its initial guidance range of $3.05 to $3.25. Both figures include an estimated $0.25 benefit from asset sale gains.
While this guidance reduction is disappointing, it's hardly a devastating cut. In fact, the forecast suggests that Macy's management is fairly optimistic about the second half of the year.
In the first half of fiscal 2019, Macy's adjusted EPS excluding asset sale gains fell to $0.61 from $1.02 a year earlier. The new full-year forecast calls for adjusted EPS between $2.60 and $2.80 before asset sale gains, which implies adjusted EPS of $1.99 to $2.19 in the second half of the year. For comparison, Macy's adjusted EPS (excluding asset sale gains) came in at $2.24 in the second half of fiscal 2018.
Of course, there's no guarantee that Macy's will hit its guidance for the back half of the year. But the midpoint of the current outlook implies a single-digit percentage decline in adjusted EPS for the period. That would represent a big trend improvement compared to the first half of the year.
Still a great stock for patient investors
Macy's inability to return to sustainable earnings growth over the past few years is certainly a major concern. However, investors are vastly underestimating its earnings growth potential -- just as they underestimated its ability to get comp sales growing again a couple of years ago.
First, Macy's is investing in its stores to drive healthier sales trends there. It now has more than 200 Backstage off-price shops within its full-line stores. Additionally, Macy's is upgrading 100 high-performing stores during 2019, following a model it tested in 50 stores last year. The retailer has also added virtual-reality technology to its furniture departments in dozens of stores to drive sales.
Second, Macy's has several important initiatives in the works that could boost its profit margin in the future. Most notably, a new merchandise allocation system called "hold and flow" will allow the company to be nimbler about moving inventory to its stores based on sales trends.
Macy's stock now trades for just six times the company's projected 2019 profit (excluding asset sale gains). Its dividend yield has soared past 9%. Its balance sheet continues to improve, due to management's decision to prioritize debt reduction. And the department store giant's real estate is still worth far more than the company's current enterprise value. All of these factors suggest that investors who buy and hold Macy's stock and ignore all the noise could be rewarded handsomely in the long run.