Last month, Macy's (NYSE:M) released another disappointing earnings report. Comparable-store sales inched up 0.3% in the second quarter, but that included a big tailwind from online sales, which continued to rise at a double-digit rate. Clearly, in-store sales are declining -- with some stores experiencing severe revenue declines. Meanwhile, profitability plunged.

Nevertheless, CEO Jeff Gennette has said that Macy's doesn't plan another big round of store closures. Gennette has argued repeatedly that closing stores is equivalent to "firing" customers, because the loss of visibility hurts online sales in the market where a store is closed. As a result, Macy's has focused on cutting costs, so that it can keep as many stores open as possible.

However, if Macy's current turnaround plan doesn't succeed, "firing" customers may be the best way for the department store giant to improve its profitability and boost shareholder value.

The current situation is unsustainable

Gennette and his management team have noted in recent years that despite comp sales declines, nearly all of Macy's stores generate positive cash flow. In fact, by introducing more self-service options in lower-volume stores and having them double as fulfillment hubs, Macy's hopes to make these locations more profitable.

That said, this strategy of keeping underperforming stores open to boost online sales doesn't seem to be good for Macy's profitability. Five years ago -- when sales peaked -- Macy's adjusted operating income reached $2.9 billion. By contrast, adjusted operating income fell to just $1.5 billion last year (excluding asset sale gains) and is on track to decline significantly again in fiscal 2019.

The exterior of a Macy's full-line store

Macy's profitability has plunged over the past five years. Image source: Macy's.

Even more alarmingly, Gennette stated on the earnings call last month that customers had "very little appetite" for price increases. (Macy's had been testing price increases on certain items that were hit with tariffs this year.) If it isn't possible to pass rising costs through to customers, it's no wonder that profitability has been plunging. This also suggests that it may not be worth trying to hang on to every existing Macy's customer -- some are not willing to pay prices that would make sense for Macy's in the long run.

Cost cuts are a step in the right direction

Earlier this month, Macy's provided more details on a cost-cutting plan it had teased earlier this year. The company hopes to generate annual savings of $400 million to $550 million by using data and technology to become more efficient. It hopes to realize most of the savings by fiscal 2021.

Several of the changes relate to pricing and merchandise allocation algorithms. These initiatives could potentially improve the profitability of Macy's neighborhood stores, mainly by reducing markdown risk.

That said, this may only be a stopgap solution. Gennette expects sales to continue declining in the neighborhood stores, which will steadily erode the profit gains from cost cuts and improved pricing algorithms. Sooner or later, stores with consistently declining sales are bound to become unprofitable.

Furthermore, the only way to keep low-volume stores cash-positive is to minimize capex investments in those locations. That makes it harder to keep them up to the Macy's brand's standards. Over time, these stores could detract from the chain's image in a meaningful way. In addition, low-volume locations probably turn inventory at a slower pace than the corporate average, weighing on cash flow.

Macy's may need to completely reinvent itself

In short, low-volume Macy's "neighborhood stores" may be profitable in an abstract sense, but they tie up a significant amount of capital, drag down the chain's image, and don't have a long-term future. Closing those stores could lead to missing out on e-commerce sales, but a lot of the customer relationships that would be lost appear to be marginally profitable today, at best.

On the flip side, closing these stores would allow Macy's to reduce its inventory investments. For stores that it owns, it would also have the opportunity to monetize the underlying real estate. Macy's could use the extra cash to pay down more debt or to reward shareholders.

Just as importantly, by eliminating its weaker stores and driving more traffic to its higher-performing stores, Macy's would be putting its best foot forward with customers. Over time, this could improve the chain's image, helping it appeal to wealthier consumers who may be less price-sensitive. Macy's could also consider adding freestanding Backstage off-price stores in markets where it closes underperforming full-line stores, in order to hold on to more price-sensitive customers in a less costly store format.

Macy's would almost certainly lose some customers if it closed hundreds of underperforming stores in the years ahead. However, that may be a price worth paying if it allows the chain to improve its cash flow, burnish its image with wealthier consumers, and establish a more defensible business that would be a solid foundation for profitable long-term growth.