Sales plunged approximately 45% year over year at Macy's (NYSE:M) last quarter, according to preliminary estimates the company released on Thursday. As a result, the iconic department store operator expects to report an operating loss of around $1 billion for the first quarter of fiscal 2020. Management also warned that earnings trends could get worse before they get better, as many of the company's stores have been closed for two months and counting.

Despite this ugly earnings pre-announcement, Macy's stock rose 6% on Thursday. While this might seem bizarre, a lot of damage had already been priced into the stock. Macy's shares have lost more than two-thirds of their value since early 2020, reducing the company's market cap by nearly $4 billion.

M Chart

Macy's stock performance and market cap data by YCharts.

Moreover, Macy's management provided more tidbits on recent sales and earnings trends, some of which were quite encouraging, during a "fireside chat" with a J.P. Morgan analyst on Thursday. This highlighted the company's turnaround potential. Indeed, while Macy's remains a risky stock to own, it has substantial upside if the retailer can make a full recovery from COVID-19.

COVID-19 crushes Macy's

Department stores have been some of the hardest-hit retailers during the COVID-19 pandemic. Since they were classified as nonessential businesses, most were forced to close their stores in mid-March. Macy's did so at the end of the day on March 17. Meanwhile, competitors like Target that also sell essential goods were -- for the most part, anyway -- allowed to continue selling apparel, accessories, housewares, and beauty products in their stores.

While department stores were able to continue their e-commerce operations, they typically get the vast majority of sales from physical stores. Macy's is one of the biggest e-commerce companies in the U.S., but digital sales still make up just a quarter of its business. Making matters worse, Macy's and its peers carry a lot of seasonal merchandise that loses value if it can't be sold at the right time. Finally, with most people working from home right now, sales of dressy work clothing, a key merchandise category, have plunged.

As a result, following a solid start to the quarter in February, sales fell off a cliff in March because of the store closures and as consumers prioritized essential purchases. Digital sales trends did improve dramatically in April, but it wasn't enough to offset the loss of in-store sales. For the full quarter, Macy's expects to report sales between $3 billion and $3.03 billion, down from $5.5 billion a year ago.

The exterior of the Macy's flagship store in Manhattan

Image source: Macy's.

Meanwhile, Macy's expects to report an operating loss between $905 million and $1.11 billion for the quarter, compared with a $203 million operating profit in the prior-year period.

Gross margin erosion probably accounted for the vast majority of this profit pressure. In addition to absorbing higher shipping costs, Macy's had to take big markdowns to try to sell seasonal inventory before it went stale. In addition, outgoing CFO Paula Price revealed that Macy's took a roughly $300 million inventory writedown at the end of the quarter, reflecting the impaired value of unsold seasonal merchandise. Credit card revenue, which totaled $172 million in Q1 2019, also fell, as store closures negatively affected credit card signups and rising unemployment led to higher expected credit losses.

Some green shoots

As bad as the first quarter was, Macy's management is planning for a slightly worse earnings performance in the second quarter. Yet management also pointed to a number of developments that should make investors at least somewhat optimistic.

First, Macy's has been able to reopen stores at a steady pace this month. The first set of stores reopened on May 4. As of this weekend, more than half of its stores are fully open, and nearly 80% are at least offering curbside pickup. Macy's hopes to reopen the rest of its stores over the next month or so.

The exterior of a Macy's store

More Macy's stores are reopening each week. Image source: Macy's.

Just as importantly, sales volumes have exceeded expectations at reopened stores. In late April, CEO Jeff Gennette estimated that reopened stores would do less than a fifth of their normal sales volume. Instead, they have been doing about half their normal sales, with little regional variation in that figure.

Second, e-commerce sales trends have remained extremely strong even as stores have started to reopen. Digital sales are up 80% year over year so far in May. While it's still early in the quarter, which began on May 3, these two data points suggest that Macy's may post a smaller sales decline in Q2 than it did last quarter.

Third, CFO Paula Price said that Macy's is on track to exit Q2 with a clean inventory position. This is significant for two reasons. First, it implies that Macy's will convert a lot of inventory to cash this quarter, relieving some of the pressure on its balance sheet. Second, it suggests that there is an end in sight for Macy's massive losses; big markdowns this quarter will allow the retailer to bring in fresh merchandise next quarter, driving substantial margin improvements.

A business under pressure, but with big opportunities ahead

Of course, nothing that Macy's management said on Thursday guarantees that the retailer will experience a smooth recovery. The biggest risk is that stay-at-home restrictions are reinstated at some point, causing another batch of inventory to go stale, leading to further writedowns. Weak consumer spending and permanent declines in mall traffic are other notable risks.

That said, Macy's also has a big opportunity to regain market share in the years ahead. Several major retailers are already planning to shut down permanently because of the impact of COVID-19, including Lord & Taylor, a moderate-upscale department store chain that has lots of overlap with Macy's. J.C. Penney also declared bankruptcy recently and expects to close more than a quarter of its stores, assuming it survives at all. Gennette sees a $10 billion sales opportunity from competitors' store closures, and he hinted that Macy's might add new merchandise categories to capitalize on changes in the competitive landscape.

Macy's also may be able to reverse the balance-sheet damage of COVID-19 faster than investors expect. It continues to own a vast trove of valuable real estate, some of which it is likely to sell to pay off debt it takes on in 2020. In addition, it has paid over $2 billion of cash taxes over the past five years, mainly at the pre-2018 statutory rate of 35%. Under the CARES Act stimulus bill, it will be able to carry back its 2020 losses to claim substantial tax refunds next year.

Before COVID-19, Macy's expected to produce adjusted earnings per share between $2.45 and $2.65 this year. Instead, it will report a hefty loss -- and profitability won't recover immediately in 2021. But with shares trading for just 2 times the company's original EPS estimate for fiscal 2020, Macy's stock has a ton of upside even if it takes three or four years to fully recover from COVID-19. For investors with high risk tolerance, betting on a gradual recovery at Macy's could lead to big rewards over the next several years.