There was no question that Macy's (NYSE:M) second-quarter earnings report was going to be ugly. The department store operator entered the period with all of its stores closed and a glut of unsold spring inventory. And while nearly all of its stores reopened by the end of June, mall traffic has remained weak, as many consumers shy away from brick-and-mortar shopping. Even worse, dressy clothing is typically a source of strength for Macy's, but few people are looking to buy such items right now.

As expected, Macy's reported another steep sales decline and a quarterly loss for its second quarter ended Aug. 1. However, the department store giant performed much better than management and many analysts initially feared. That puts it in a good position to execute its turnaround plan over the next several years.

Sequential improvement

Macy's sales plunged 35.8% year over year to $3.56 billion last quarter on a 35.1% decline in comparable sales. Still, this beat the average analyst estimate of $3.47 billion. In-store sales plummeted 61%, but the weakness in store traffic was partially offset by a 53% sales gain for Macy's e-commerce business.

Meanwhile, gross margin fell to 23.6% from 38.8% a year earlier, and Macy's reduced its selling, general, and administrative expenses by 35.8% year over year (in line with its sales decline). The result was that Macy's posted a Q2 adjusted net loss of $251 million, or $0.81 per share. In the prior-year period, it reported adjusted earnings per share of $0.28.

The exterior of Macy's Manhattan flagship store.

Image source: Macy's.

These results were certainly bad, but considering the effect of temporary store closures and the pandemic's impact on shopping patterns, the outcome could have been far worse. The 35.1% comp sales decline represented a significant improvement over the 45.4% drop logged in the first quarter. Gross margin improved sequentially from 17.1% in Q1. Free cash flow was slightly positive in Q2. Finally, Macy's adjusted net loss of $251 million shrank 60% compared to its first-quarter loss of $630 million. As recently as late May, management was projecting that the company would lose slightly more money in Q2 than it did in Q1.

Macy's adjusted net loss of $0.81 per share was also far more modest than the average analyst estimate of $1.77. All in all, Macy's second quarter marked a big step forward following a disastrous start to the year.

The balance sheet looks fine

The single most important action Macy's took in the second quarter was lining up nearly $4.5 billion of new financing. In early June, the company issued $1.3 billion of secured debt, using the proceeds to pay down its revolving credit line. It also finalized a new $3.15 billion asset-based credit facility, replacing its previous unsecured credit facility, which was simultaneously downsized to $75 million from $1.5 billion.

Thanks to these financing moves, Macy's ended the second quarter with $1.4 billion of cash, compared to $5.4 billion of debt. Its net debt (excluding lease liabilities) of $4 billion is in line with its financial position a year ago. Furthermore, Macy's has about $3 billion of availability on its credit facility.

Macy's certainly needs to return to its previous focus on debt reduction within a couple of years. But for now, it has ample liquidity to meet upcoming debt maturities, buy inventory for future seasons, and make necessary investments in the business.

Planning for the future

While Macy's didn't offer formal guidance for the rest of fiscal 2020, it expects comp sales to decline in the low- to mid-20% range in the back half of the year, roughly speaking. Gross margin should continue to recover while remaining below 2019 levels. These guidelines imply that earnings will continue to improve sequentially in the third and fourth quarters.

With results stabilizing, Macy's can now focus on planning for the post-pandemic environment. It appears that management is doing just that. Even before the pandemic hit, the retailer was planning to implement big expense reductions over the next few years, but it has expanded those cost-cutting plans to deliver $2.1 billion of annualized savings by the end of 2022.

Meanwhile, Macy's plans to expand its freestanding Backstage and Bloomingdale's Outlet concepts and test new off-mall Macy's and Bloomingdale's formats over the next few years. Collectively, these moves will allow the company to offer more convenient shopping options for customers and offset lost sales from mall-based stores that Macy's plans to close.

Macy's has a long way to go to return to health. Still, with the stock trading for less than three times the company's 2019 earnings, investors may be underestimating the company's turnaround potential.