Macy's (NYSE:M) has posted volatile results recently. Between 2015 and 2017, it suffered 11 consecutive quarterly declines in comparable store sales, causing profitability to tumble. It then returned to comp sales growth for seven quarters, with particularly strong results for the four quarters beginning with the 2017 holiday season. That enabled the retailer to begin rebuilding its profit margin.

More recently, sales trends have turned negative again. The company expects to report adjusted EPS between $2.72 and $2.77 for fiscal 2019, down from $4.18 a year earlier. Management doesn't expect much improvement in the near term.

This profit erosion and gloomy outlook cost Macy's its investment-grade credit rating from S&P last week. However, the company's new "junk" rating from the credit rating agency overestimates the long-term risk for Macy's bondholders and shareholders, mainly by overlooking the massive value of the retailer's real estate.

Why Macy's was downgraded

S&P's ratings downgrade came in the wake of the company's recent investor day event, at which management presented a new three-year plan and turnaround strategy. The biggest headline from the event was that Macy's will close roughly 125 low-volume full-line stores over the next three years, beginning with more than two dozen store closures revealed last month.

The exterior of a Macy's store

Macy's will shrink its store base significantly over the next three years. Image source: Macy's.

Macy's also plans to upgrade all of its remaining stores with new technology, fixtures, and other enhancements. Meanwhile, gross annual cost reductions of $1.5 billion will help fund these investments and offset competitive pressures.

Nevertheless, management made it clear that there will be bumps along the way. During fiscal 2020, Macy's expects disruption related to some of its cost-cutting moves to drive a 1.5% to 2.5% decline in comparable store sales. Moreover, management projects that adjusted EPS will come in between $2.50 and $3.00 in fiscal 2022, after most of its turnaround initiatives have been implemented. That would be roughly in line with the company's 2019 performance.

As a result, S&P's credit analysts reduced their expectations for near-term results and see more execution risk over the next few years. "While we believe management's strategic plan is a necessary step toward rightsizing the enterprise, it demonstrates to us that the company's competitive advantage has diminished more than we expected, and to a point that we no longer believe is consistent with an investment-grade rating," the analysts wrote.

Macy's still has investment-grade ratings from Fitch and Moody's, so getting downgraded to junk status at S&P won't have any immediate impact on the company. Furthermore, the retailer has plenty of levers to pull to meet its future financial obligations.

Plenty of pathways to create value

While there isn't much earnings growth included in the multiyear outlook, management did project that free cash flow will rebound to $1 billion by fiscal 2022. That's a substantial sum for a company with a $5.1 billion market cap. Macy's hasn't achieved that level of free cash flow over the course of a full fiscal year since 2017.

M Free Cash Flow Chart

Macy's free cash flow data by YCharts.

With annual free cash flow of $1 billion, Macy's would be able to fund its generous dividend, which currently yields about 9% and costs just over $460 million a year, while paying down debt and buying back some stock. This would be a very favorable scenario for shareholders.

Moreover, Macy's 2022 projections may have been conservative. In the first year and a half or so after Jeff Gennette became CEO of Macy's in 2017, the company generally beat its guidance, suggesting that its initial forecasts were conservative. That track record didn't hold up in fiscal 2019. However, management may have learned its lesson and -- recognizing the amount of disruption in the retail industry -- built more of a margin for error into its 2022 targets. The projection of flattish EPS despite $1.5 billion of gross cost savings certainly seems conservative.

If stabilizing the retail business proves harder than expected, Macy's can still fall back on the value of its real estate. During the recent investor day presentation, management highlighted a slew of ways that Macy's can profit from its real estate, ranging from selling properties outright to forming joint ventures to build new buildings on Macy's-owned parking lots.

Across the company's entire real estate portfolio, the value-creation opportunities probably total in the billions of dollars, even if the company doesn't close many stores in high-end malls. (The more stores it is willing to give up, the more real estate value Macy's could harvest.) Importantly, most of this real estate potential relates to building office, hotel, restaurant, and apartment buildings, so the opportunity does not depend much on the health of the retail industry.

Macy's is still following a cautious financial policy

Over the past several years, Macy's has moved aggressively to reduce its debt. Just four years ago, Macy's had more than $7.6 billion of debt on its books. By the end of Q3 2019, it had cut that to $4.7 billion. It reduced its debt by another $525 million late last year.

This focus on debt reduction has dramatically improved Macy's balance sheet. Of course, there's still room for improvement. Over the next three years, the department store operator expects to reduce its debt by another $700 million to $1 billion.

The value of flagship stores alone probably exceeds the company's remaining debt. Beyond that, Macy's has a business that still generates ample free cash flow and hundreds of stores in high-performing malls, many of which occupy desirable locations for mixed-use development. Notwithstanding last week's debt downgrade, Macy's appears well positioned to meet all of its obligations while delivering tremendous value for shareholders in the years ahead.