We believe no-moat Macy’s is struggling to stay relevant, as consumers have many choices. Moreover, its problems have been exacerbated by the coronavirus crisis, which caused a 29% drop in its revenue in 2020 and a nearly $1 billion adjusted operating loss. Unfortunately, we think Macy’s large fleet of more than 500 full-line stores limits its options. While Macy’s operates stores in most top-tier U.S. malls, it also operates scores of stores in weaker malls, some of which may not fully recover from shutdowns and the economic fallout of the pandemic. Macy’s 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 may cause this trend to accelerate. As evidence of its struggles, there have been reports that wide-moat Nike will drop Macy’s as a wholesale customer. We forecast Macy’s operating margins (excluding real estate gains and charges) will average just 4.6% over the next decade. Further, due to store closures and a lack of consistent organic growth, we forecast Macy's revenue will remain below the $25 billion achieved in 2019.

We think Macy’s response to market changes is insufficient. Macy’s is trying to leverage its strengths with its Polaris plan, which includes store remodeling, store closures, improved e-commerce, and expansion of its Backstage concept. While the initiatives may be sound, we don’t 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 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 (more than 250 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, Ross Stores, and Burlington have already built bases of freestanding stores. We do not think Macy’s can regain sales lost to these and other retail outlets.

We assign a no-moat rating to Macy’s, as we do not believe it has established a sustainable 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 closed (net) 78 stores in 2019 and 2020. 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 the virus.

As evidence of its inability to carve out a competitive edge, Macy’s annual adjusted ROICs, including goodwill, averaged just 9% over the past five years, down from an average of 14% between 2010 and 2015. We forecast Macy’s will report negative ROIC in 2021 as it recovers from the pandemic, and we do not expect it will generate economic profit in at least the next decade. We forecast that its annual adjusted ROIC, including goodwill, will average just 7% in 2022-30, below our WACC estimate for the company of 9%. This supports our view that it has no moat.

We believe Macy’s lack of an intangible-asset-sourced moat 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 the May Company 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 80 or so stores in 2019 and 2020, and (we estimate) will close about 75 more over the next three years. 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 about 100 full-price stores, 95% of which are in more productive Class A malls. The U.S., by some estimates, has 2 to 8 times as much retail square footage as other industrialized nations, and we believe the COVID-19 crisis will accelerate necessary downsizing. We view Macy’s excessively large footprint as a competitive disadvantage.

Macy’s is a familiar brand, but is not viewed as aligned with consumer trends, further supporting our contention that it lacks a moat based on an intangible brand asset. In a 2017 survey commissioned by the company, 70% of consumers aged 18-35 and 68% of consumers aged 36-65 claimed to “love” or “feel good” about Macy’s, allegedly putting the brand on par with such companies as Apple, Google, and Target. However, the same survey revealed only 45% of people aged 18-35 and 37% of people aged 36-65 viewed Macy’s as a “favorite” or “preferred” shopping destination. It appears that many people know about Macy’s but prefer to shop elsewhere. Indeed, the company has admitted that the average age of its customers is increasing. It has also admitted that many customers do not buy much or visit often. In 2017, Macy’s revealed that just 9% of its customers generate 46% of its sales on an average of 18 visits per year. Macy’s also revealed that 40% of these top customers drop down into lower segments on an annual basis, suggesting its most important customers are not particularly loyal. Moreover, Macy’s revealed statistics that suggest the bottom 40% of its customers visit fewer than three times per year and account for just 12% of sales. These numbers suggest Macy’s is a well-known brand but not a particularly powerful one.

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 about 250 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 revenue today 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 250 Backstage stores, all but six 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. 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. According to Digital Commerce 360, Macy’s was the 14th-largest online retailer in the U.S. with $7.7 billion in online sales in 2020. 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.

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.

We are raising our fair value estimate for Macy’s to $18.70 from $17.40, which implies a fiscal 2021 adjusted P/E of about 9 times. We have lifted our revenue expectations for 2021 and beyond due to the expected passing of the pandemic, the positive effects of some of the Polaris initiatives (such as greater e-commerce and faster production), and less impact from store closures than originally expected. Specifically, we have raised our 2021 comparable sales estimate to 34% from 22%. While Macy’s recorded a 29% revenue decline and large operating loss in 2020 due to store closures and economic fallout from the COVID-19 crisis, we now we expect it to be profitable throughout 2021, resulting in adjusted EPS for the year of $1.99 (up from our prior estimate of $0.72).

In the long term, we are not confident that Macy’s growth plans, such as building Backstage stores within Macy’s stores, improving merchandising, a new loyalty program, and digital capabilities, will overcome weakness in mall-based retail. While we acknowledge Macy’s has a large customer base and millions of credit card holders (42% of 2021 first-quarter transactions were conducted with its proprietary credit cards), evidence suggests many Macy’s customers shop there infrequently. We do not think Macy’s can gain market share as online and offline competition will intensify despite some store closures by rivals. Overall, after 2023, we forecast yearly comparable sales growth of just 0.25% on owned retail.

After a sharp increase due to sales lost during the pandemic, we anticipate Macy’s selling, general, and administrative expenses as a percentage of revenue in 2022-30 to remain around the 35% of recent years (excluding 2020) as we believe the firm will have to spend heavily on marketing, e-commerce, and other initiatives to stay competitive.

We expect Macy’s total gross margins to stabilize around 40%, in line with the prepandemic levels. Excluding credit card operations, we forecast its gross margins around 38% in the long term. Macy’s may maintain gross margins if it increases sales of its private-label and exclusive brands.

We assign a high uncertainty rating to Macy’s, which was struggling with high debt and inconsistent results even before COVID-19 crisis. Its operating income (excluding charges) dropped more than $1.5 billion between 2014 and 2019 (to $1.2 billion from $2.8 billion) on store closures, declining sales, and increased expenses. Macy’s reported negative same-store sales in five of the past six years. Meanwhile, competition from traditional retailers (Kohl’s, Walmart), e-commerce (Amazon), and discounters (Ross, T.J. Maxx) remains fierce. While Macy’s is investing in its Polaris and omnichannel plans to stay relevant, there is scant evidence these efforts can bring in new customers or encourage existing customers to spend more. The Backstage stores may allow Macy’s to be more competitive with discounters, but they are mainly in Macy’s stores and thus dependent on customer traffic.

Macy’s, like other apparel and home-goods retailers, is affected by the business cycle. In the last recession, its total revenue dropped from $26.3 billion in 2007 to $23.5 billion in 2009. Same-store sales declined 4.6% in 2008 and another 5.3% in 2009. Due to the COVID-19 store closures and recession, it suffered a 28% decline in comparable sales in 2020.

Macy’s could suffer in a trade war with China. Clothing makes up around 70%-80% of Macy’s sales. As China accounts for 35% of worldwide apparel exports, according to the World Trade Organization, trade barriers (legal or logistical) between the U.S. and China would affect Macy’s private-label and third-party apparel businesses. Tariffs on imports from China could increase Macy’s costs.

We do not think Macy’s faces material environmental, social, and governance, or ESG, risks. However, it does face exposure to controversies related to the treatment of laborers in the global supply chain for apparel.

We assign a Standard capital allocation to Macy’s. Jeff Gennette, a Macy's lifer, assumed the CEO role at Macy’s after Terry Lundgren retired in March 2017. However, there has been considerable recent turnover at other key positions, including at CFO.

Macy's has operated with significant debt for many, but we do not foresee any distress. At the end of 2021's first quarter, the firm had nearly $4.9 billion in total debt, but this was partially offset by $1.8 billion in cash. Using this cash and anticiapted free cash flow, we forecast Macy's will reduce its total debt to less than $3.5 billion by the end of 2024. We project its debt/adjusted EBITDA will drop from 2.4 times at the end of 2021 to 1.8 times at the end of 2024, in line with 2019's level (before the pandemic). While Macy's also has more than $3 billion in long-term lease liabilities, we do we do not view this as a concern.

We think Macy’s has a fair record of returning cash to shareholders in stable times but has recently prioritized debt reduction and has paused buybacks and dividends during the COVID-19 crisis. We view this as a prudent strategy as its high debt load has been a concern for investors. Macy’s stock repurchases totaled $1.9 billion in 2014, $2 billion in 2015, and $316 million in 2016 until it halted repurchases in 2016 to use cash for debt reduction instead. Macy’s repaid about $3.5 billion in debt over 2016-19, which brought it below its target debt/adjusted EBITDA of 2.5 to 2.8 times. However, as Macy’s has taken on new debt during the pandemic, we do not think it will resume share repurchases until 2025. Macy’s had been paying an annual dividend of $1.51 before the pandemic. We expect dividends to resume in 2022, and we forecast its dividend payout ratio will average 41% in 2022-30. While we expect Macy’s free cash flow to equity will be only $200 million or so in 2021, we forecast the firm will generate an average of about $630 million per year in free cash flow to equity in 2022-30 and return an annual average of more than $500 million to shareholders.

Macy’s has reduced capital expenditures as its fortunes have declined. The firm averaged about $1 billion in yearly capital expenditures between 2014 and 2019 but spent less than $500 million during the pandemic in 2020. Now, we forecast annual capital expenditures at about $830 million over the next five years as the firm scales back its store remodeling program and closes stores but invests in other initiatives. Under the Polaris plan, Macy’s intends to invest more than 50% of its capital expenditures over the next three years into its e-commerce capabilities and supply chain. We view this shift in investment as prudent given that Macy’s store productivity has dropped while its e-commerce has continued to expand.