Macy’s Is Making Necessary Enhancements but Still Lacks an Edge in Tough Environment

Senior Equity Analyst

David Swartz

We believe no-moat Macy’s is struggling to stay relevant as consumers have many choices. While revenue has recovered from the virus-related 29% drop in 2020, we think the company's fleet of more than 500 full-line stores limits its options. Macy’s operates stores in most top-tier U.S. malls, but it also operates scores of stores in weaker malls, some of which are probably not viable in the long run. The company does not need its vast selling space, as department stores have been losing market share to e-commerce and other retailers (outlets, branded stores, specialty stores, discounters) for years, and we think the virus caused this trend to accelerate. Further, although it spiked to 9% in 2021, we forecast Macy’s operating margin (excluding real estate gains and charges) will average just above 6% over the next decade. Due to store closures and a lack of consistent organic growth, we forecast revenue will stay below prepandemic levels.

We think Macy’s response to market changes is insufficient. The firm is trying to leverage its strengths with its Polaris plan, which includes store remodeling and closures, improved e-commerce, and expansion of its Backstage concept. While the initiatives may be sound, we do not expect them to bring in large numbers of new shoppers. As evidence, Macy’s same-store sales have been weak over the past few years (excluding 2021) even as its e-commerce has grown. We think Macy’s has been too slow to respond to competitive threats and lacks the efficiency of fast fashion, the customer service of luxury retailers, or the low prices of discounters. While Backstage (nine freestanding stores and just over 300 locations within Macy's stores) provides a presence in the off-price space, we view it as mainly defensive as narrow-moat discount apparel retailers like TJX and Ross Stores have already built bases of freestanding stores. We do not think Macy’s can regain sales lost to these and other retail outlets.

Business Strategy & Outlook

We assign a no-moat rating to Macy’s, as we do not believe the company has established a durable intangible asset or cost-based advantage over competitors. While its Macy’s and Bloomingdale’s brands are very well-known in the U.S., intense competition from both e-commerce and discount retailers has reduced mall traffic and eroded profit margins on many products sold in department stores. Macy’s has struggled over the past few years and has reduced its number of stores by about 10% since the beginning of 2019. Its total revenue peaked at $28 billion in 2014 and was steadily declining even before the pandemic. Macy's average annual operating margins (excluding real estate gains and charges) have been weak as well, coming in at just 5.6% in the four years before COVID-19.

As evidence of its inability to carve out a competitive edge, Macy’s annual adjusted return on invested capital, including goodwill, averaged just 9% in the four years before the pandemic (down from an average of 14% between 2010 and 2015) and then turned negative in 2020 before rebounding over the past two years. We forecast that annual adjusted ROIC, including goodwill, will average just 9% over the next 10 years, below our 10% weighted average cost of capital estimate. This supports our view that Macy's has no moat.

We believe Macy’s lack of an intangible asset moat source is reflected in the fact that it has been downsizing and plans further reductions in its store base and retail square footage. In 2005, Macy’s (then known as Federated Department Stores) acquired May for approximately $17 billion. The deal nearly doubled the number of stores operated by Macy’s, including bringing new stores in smaller markets. However, despite its added scale, the subsequent growth of e-commerce and changes in the U.S. apparel retailing (the growth of outlet malls, for example) reduced the need for such a huge number of stores. Macy’s closed at least 124 stores between 2015 and 2018, closed an additional 84 stores (net) in 2019, 2020, 2021, and 2022, and (we estimate) will close a total of five more (net) in 2023. Despite the closures, Macy’s still operates more than 500 Bloomingdale’s and Macy’s stores, many of which are in middle-class malls. In contrast, narrow-moat-rated competitor Nordstrom operates 94 full-price stores, about 95% of which are in more productive Class A malls. The U.S., by some estimates, has 2-8 times as much retail square footage as other industrialized nations, and we believe the COVID-19 crisis has accelerated necessary downsizing. We view Macy’s excessively large footprint as a competitive disadvantage.

Macy’s is building an off-price business within its full-price stores to compete with discounters. One of the big changes since the Federated-May merger has been the growth of discount fashion through outlet stores, fast fashion retailers, and clearance stores. Narrow-moat fashion discounters TJX and Ross Stores, for example, have roughly doubled their revenue over the past decade. Thousands of fashion outlet stores have also opened in recent years. Some of these stores have been opened by direct competitors of Macy’s. Nordstrom, for example, has grown its chain of Rack outlet stores from 50 in 2007 to more than 240 today. Competition has also increased from international fast fashion firms such as no-moat H&M and narrow-moat Inditex (parent of Zara), both of which have greatly expanded in the U.S. since 2010. H&M operates more than 500 stores in the U.S., up from 208 U.S. stores at the end of 2010, while Zara operates about 100. Macy’s, meanwhile, reports lower annual revenue now than it did in 2007. It is attempting to fight the discounters by opening its own outlet stores under its Backstage label. Macy’s operates more than 300 Backstage stores, all but nine of which are located within existing Macy’s locations. Macy’s reports Backstage stores open more than 12 months have mid-single-digit comparable sales growth and contribute positively to overall gross margin and inventory turnover. While the firm views Backstage as a major strategic initiative, we consider it mostly defensive. Macy’s knows that it is losing customers to discounters and is desperate to bring them back. Despite its claims, we are uncertain if Backstage is additive, as weak sales numbers have coincided with growth of the brand. It is possible that Backstage is cannibalizing full-price apparel sales. Also, we do not believe Backstage is bringing new customers to Macy’s stores. Backstage, unlike off-price stores located in strip centers, is as dependent on mall traffic as Macy’s itself. Thus, we do not believe Backstage will be significant enough to compete with discounters and strengthen Macy’s brand.

Macy’s sizable e-commerce business may also be taking sales from its physical stores. In 2022, digital sales accounted for 33% of the firm’s retail sales, or about $8.1 billion. The firm has invested heavily in e-commerce, with an emphasis on mobile, same-day delivery in major markets, and buy online/pick up in store. Macy’s, though, has been reporting poor same-store sales numbers even as its e-commerce business has grown, suggesting that e-commerce is cannibalizing its physical store sales. Macy’s reported negative same-store sales in 2015 (negative 3.1%), 2016 (negative 3.6%), 2017 (negative 2.2%), 2019 (negative 0.8%), and 2020 (negative 27.9%) despite consistent double-digit percentage annual e-commerce growth. We do not believe Macy’s e-commerce contributes to the strength of its brand, as we do not view it as additive to sales.

We do not believe Macy’s growth strategies will overcome areas of weakness in its business and, unfortunately, its efforts were interrupted by COVID-19. Macy’s turnaround strategy, known as Polaris, consists of five major categories of improvements, some of which have already been implemented under its prior North Star plan. The Polaris plan includes changes to Macy’s loyalty program, expansion of its online capabilities, growth of its Backstage store footprint, cost reductions, and real estate optimization. Parts of the plan will require new promotion and marketing expenses, offsetting Macy’s efforts to reduce operating expenses. In early 2016, Macy’s announced efforts to reduce expenses by $400 million per year to improve its EBITDA as a percentage of revenue to 14%, from about 12% in 2015. However, its adjusted EBITDA margin did not reach this level, and we forecast its EBITDA as a percentage of revenue around 10% in the long run, well below its stated goal. We view Polaris as defensive and expensive and do not believe it improves Macy’s position enough to offset competitive pressures.

One of Macy’s key merchandising efforts is to improve its private-label offerings. Macy’s private-label brands, such as Alfani, INC, and Hotel Collection, account for about 20% of total sales and likely have better gross margins than some third-party merchandise. Macy’s intends to prioritize these brands to improve margins. It has reduced the design and production time on some types of apparel in its private-label group to improve sales and compete with fast-fashion rivals. Rival Kohl’s, in contrast, has been actively reducing its large (36% of its 2022 sales) private-label business because it has found that national brands bring in more customers. While private-label apparel may be profitable, it may not drive store traffic. Macy’s biggest problem is the lack of customer traffic in malls and its stores. It remains dependent on popular, third-party brands like no-moat PVH’s Tommy Hilfiger, narrow-moat Ralph Lauren, and many others to attract customers, and we expect it will continue to do so. We do not think private-label apparel will be significantly additive to Macy’s sales.

Macy’s is attempting to defend its cosmetics business with its Bluemercury subsidiary, but we think it will continue to lose share in the category. Macy’s large cosmetics business, led by brands such as Estee Lauder, Clinique, and Lancome, has been challenged by the introduction of many specialty brands and the growth of cosmetics stores like Sephora (owned by wide-moat LVMH) and narrow-moat Ulta, both of which are continuing to expand. Macy’s bought its own specialty beauty business when it acquired cosmetics and spa retailer Bluemercury for $210 million in 2015. Macy’s paid approximately 2 times sales and 21 times EBITDA for Bluemercury’s proprietary brands and 62 stores. We view the price as relatively high (Macy’s itself has historically traded around 6 times EBITDA), especially as Bluemercury’s growth has stalled at about 160 freestanding stores and the co-founders have left the company. We believe Bluemercury does not contribute to the strength of Macy’s brand, as most customers are likely unaware that Macy’s even owns it. Moreover, Bluemercury is presently too small to be material to Macy's, a business with about $25 billion in annual revenue.

Bloomingdale’s is a premium brand, but it is not large enough to contribute to a brand intangible asset for Macy’s. Bloomingdale’s competes with high-end fashion retailers like Nordstrom, Saks Fifth Avenue, and Neiman Marcus. However, we think Bloomingdale’s attracts a somewhat less affluent customer than Neiman Marcus or Saks Fifth Avenue. While Bloomingdale’s carries some luxury apparel brands with premium price points, it also sells many of the same fashion brands (Ralph Lauren, Calvin Klein, Tommy Hilfiger) that are available at Macy’s and other middle-market stores. While Bloomingdale’s competes directly with Nordstrom, we do not believe it has the devoted customer base that Nordstrom has. As evidence, Nordstrom has a far greater number of followers on social media platforms than Bloomingdale’s (Nordstrom has 8 times as many followers on Facebook, for example). Bloomingdale’s, like Bluemercury, is more of a separate, niche brand for Macy’s and not large enough to add to its brand. Bloomingdale’s produces about $3 billion in annual sales, which is roughly one eighth of Macy’s total.

Beyond intangibles, we do not believe any other moat sources can be applied to Macy’s. The company has no production cost advantage, as it sources its apparel from many of the same manufacturers as other fashion retailers. We do not believe it has the power to negotiate lower prices from producers. Macy’s does not have efficient scale, either, as its distribution system is like that of competitors. There is no network effect in the apparel retailing business, and switching costs are nonexistent. While the Macy’s brand is widely known in the U.S., we do not believe it contributes to an economic moat and believe it stands to be challenged by the intense competitive landscape.

None

Economic Moat

Macy's

Macy's, Inc. engages in the retail of apparel, accessories, cosmetics, home furnishings, and other consumer goods. The firm's brands include Macy's, Bloomingdale's, and Bluemercury. It offers men's, women's, and children's apparel, women's accessories, intimate apparel, shoes, cosmetics, fragrances, as well as home and miscellaneous products. The company was founded by Rowland Hussey Macy Sr. on March 6, 1929 and is headquartered in New York, NY.

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Macy's, Inc. engages in the retail of apparel, accessories, cosmetics, home furnishings, and other consumer goods. The firm's brands include Macy's, Bloomingdale's, and Bluemercury. It offers men's, women's, and children's apparel, women's accessories, intimate apparel, shoes, cosmetics, fragrances, as well as home and miscellaneous products. The company was founded by Rowland H. Macy in 1858 and is headquartered in New York, NY.