Is Macy's (M -2.53%) hot or not? Once a thriving department store chain selling everything from baby clothes to mattresses, its sales dropped more than 45% at the beginning of the pandemic. It's been plagued by all sorts of problems, but after hitting what appears to be the nadir of its challenges, things are actually looking up. 

Why Macy's lost its luster

Macy's is the second-largest apparel-focused retailer in the U.S., and it made its big bucks through its huge department stores. But what was once a major asset is now weighing the company down. Department stores are out of fashion, and the malls they typically anchor were seeing less foot traffic even before the pandemic hit and people had to stay home. 

Cheaper stores with competitive digital options, such as Target, with its private-label apparel brands, were succeeding in the digital era. Macy's launched a digital program as well, but the business initially lacked the nimble features that made Target, Nike, and other retailers stars on the e-commerce landscape.

The front of a Macy's department store in the evening

Image source: Macy's.

Before the coronavirus hit, Macy's was toying with various solutions to its woes, such as closing down offices, shuttering stores, shrinking store size, and changing store formats. But the foundational changes brought out by the pandemic are what can truly turn around the company's prospects.

COVID-19 and the digital revolution

Second-quarter earnings, which covered the period ended Aug.1, were 35% lower than the same time in the prior year, but marked improvement from the first-quarter decline. As with pretty much every retailer these days, sales were powered by digital, which rose 53% to partially compensate for a 61% decrease in in-store sales. But that number lags behind most retailers' year-over-year digital sales growth during a similar time period. For example: 

  • Target: +195%
  • Walmart: +97%
  • Costco: +90%
  • Gap: +95%
  • American Eagle Outfitters: +74%

Digital momentum is also winding down, with July digital sales coming in at a low 25% year-over-year growth as stores reopened, although the company expects that number to grow in the current quarter.

Macy's is shifting its focus to succeed in e-commerce, offering all sorts of options such as in-store pickup of online purchases, curbside pickup, and same-day delivery. It will also close two stores to shoppers in Delaware and Colorado, and turn them into fulfilment centers to meet e-commerce demand. 

Where Macy's can grow

During Macy's' second-quarter earnings conference call, management said that luxury goods, particularly at Bloomingdale's stores, were selling well. Wealthy customers who can't travel are indulging in apparel, accessories, and home products instead. With Barneys closed, Neiman Marcus recently filing for Chapter 11 bankruptcy protection, and Lord & Taylor going out of business, this is an opportunity for the company to sink its teeth into. 

It's also seeing more action in home-based categories like housewares, textiles, activewear, and sleepwear, as people are staying indoors more. Interim CFO Felicia Williams said that the company will lean into these categories.

Finally, Macy's is also seeing greater strength in its mall-based, off-price Backstage stores, which performed better than the full-price stores. In the next two years, it plans to open several free-standing Backstage stores, as well as Bloomingdale's off-price stores.

With retail sales continuing to climb, the department store retailer may get a chunk of that spending as it revamps its omnichannel strategy and focuses on its strengths. The company is expecting sales to keep climbing, especially now that we're approaching the holiday season. In last quarter's earnings call, CEO Jeff Gennette said, "The holidays are when Macy's shines and this year will be no exception."

Gross margin was still 15 points lower than in the past year during the second quarter, but increased to 23.6% from 17.1% in the first quarter. Macy's sold assets and offered debt to enhance its liquidity and ended the quarter with a solid $1.4 billion in cash plus $3 billion untapped credit. 

Macy's stock has lost more than 60% of its value year to date. Shares are trading at a supercheap three times trailing-12-month earnings, which makes it a steal for investors who see the upside. But it's still in a precarious situation, and until sales and earnings become more stable, I'd stay away.