Macy’s (M) shareholders recently rejoiced over the retailer’s rather underwhelming results, which found Macy’s beating on the bottom line and narrowly missing on the top line. Macy’s beat the average analyst EPS estimate by $.04 a share, reporting $.23 per share in earnings. The company missed top-line results by roughly $30mm, which was a net sales decline of 6.2% year-over-year. Total net sales reported were $5.28bn for the Q3 2017 period. The worst part of the reporting metrics for Macy’s was their continued deterioration in comp sales.In the 3rd quarter, the company reported a negative 3.6% same-store sales comp, worse than previous guidance and worse than analysts had expected. But where there is bad news there is also good news in that the company did manage to increase gross margins by roughly 10 basis points to 39.9% in the quarter.  

Macy’s admits that its sales results were worse than expected and blames a portion of the undesirable results on the hurricanes that ravaged Texas and Florida during the quarter, forcing store closures. The retailer offered about 70 total basis points of sales losses due to hurricanes, unseasonably warm weather and international tourist spending during the quarter, which if added back to the sales comp would still find the retailer missing sales estimates by 30 basis points in the quarter. Again where there is bad there is also good and the good sales news continues to come from Macy’s online sales growth. The retailer grew its e-commerce sales by double-digits for a 33^rd consecutive quarter. While that is certainly good news, given the scope of the 3-year long sales decline it also highlights the insignificance of the retailer’s online business when compared to where greater than 85% of its sales are captured, in store. 

When we analyze the decline in the Macy’s retail business over the last 3+ years we continue to look for a bottoming of results.Such a bottom would likely be spirited by previously positioned sales initiatives. But by and large the sales initiatives put forth by Macy’s during this extended decline have been proven of little to no significance. As such it remains illogical to expect future sales growth beyond low bar expectations and momentary growth that only finds additional sales declines thereafter. And what are the positioned sales initiatives Macy’s has in place?

Macy’s Backstage has been a bright spot for the company over the last several quarters, proving to add sales to those 38 plus stores the concept is currently operating.Unfortunately, scaling this merchandise and brand concept takes ample time and comes at a cost.Macy’s has over 700 storefronts for which the cost to implement Backstage across the chain would cost millions of dollars and likely curtail gross margins at the onset.Having said that, Macy’s has offered to scale Backstage at an accelerated pace in 2018. My assessment of the Backstage sales initiative is that the treasure hunt concept of goods is obviously nothing new and while it may provide initial sales lifts within the stores it operates, it will not be able to offset the declines in Macy’s greater category of sales, apparel.Simply put: Backstage has no possibility of proving incremental to the totality of sales. It can help, but it can’t offset!

Another sales initiative put forth by Macy’s is their Loyalty program that launched in the latest quarter. What makes this initiative so unique is… well nothing! Unfortunately, this is Macy’s attempting to play catch up with most of its competitors that already have an established loyalty and rewards program like Kohl’s (KSS), J.C. Penney (JCP), Target (TGT) etc. There is just nothing unique or differentiating about a loyalty program and as such it will prove extremely difficult for Macy’s to gain market share with this initiative. At best Macy’s can possibly extrapolate that much more spending from its already loyal customers.And of course, Macy’s articulated that very assertion on its most recent conference call with regards to its loyalty program. 

And just to remind everybody, our overall goals for the loyalty program: number one, we wanted to strengthen our relationships with our best customers, and that's about 10% of our customer base that currently account for about half of our sales. Second, within our existing customer base, we wanted to migrate customers up to higher spending levels. And third, we wanted to use the loyalty program to attract new customers to Macy's and encourage those infrequent Macy's shoppers to come to us more often.

It’s right there in the verbiage folks. 10% of Macy’s customers account for nearly 50% of its sales. Now management desires investors to assume this means there is a great opportunity given how much market share there is presently to capture, but after oh so many years and oh so many attempts, I would caution investors to align with management assumptions that have consistently failed even their forecasts and objectives. An investor would truly have to believe that the Macy’s loyalty program is unique, is differentiated from its peers and is the “GOLD” the company has been in search of to return to sales growth long-term. An investor would also have to ignore the fact that the existing loyalty programs in place from its peers that have not found long-term sales growth were all anomalies. All of them, they were all anomalies, which is obviously an oxymoron and more obviously illogical. That’s a lot of hope and ignoring of past results that one would have to align for as an investment thesis in Macy’s.  

While the aforementioned initiatives are viable and may provide sales lift in a vacuum, they simply don’t have the ability to be incrementally positive. Macy’s strongest business segments during the latest quarter were fragrances, fine jewelry, dresses, men's tailored clothing, active wear and shoes excluding boots. Beauty is significantly better than it was in the first half of 2017. Macy’s is running about 2.5 points better in the 3^rd quarter than it was running in the first half of the year. Additionally, the retailer has been running positive comps in fragrance. While all of these categories proved to be the strongest business segments for Macy’s they obviously did not prove to be incrementally positive with total net sales declining at an accelerated pace, meaning quarter-over-quarter. That’s right, sales were down 5.5% YOY during the Q2 period and down 6.1% during the Q3 period. Of course the weather impacted results in Q3, but until there is no such thing as weather… well you get the picture.  

Macy’s is witnessing sequential sales improvements in some business segments as they overhaul both the merchandising standards and general product assortment. But as traffic trends prove to decline, the marketing message needs to ramp and improve in order to drive greater sales. It’s one thing to have sales initiatives, but it’s a whole other challenge to get consumers into the store where these initiatives can be realized for their newness and value. As a measure of traffic trends for Macy’s, the company continues to witness accelerations in traffic declines. In the 3^rd quarter, transactions were down 7.3%, average units per transaction were up 1%, and the average unit retail was up 2.9%, in large part due to lower clearance activity. Traffic was obviously hurt by store closures during weather events in the quarter, which can be passed on even as transactions were down only 5.5% during the Q2 period. But then again, transactions were down 7.5% during the 1^st quarter of 2017. How many passes can we really give Macy’s? 

Most of Macy’s EPS and SG&A improvements are coming from the former store closing operation as cost of goods and cost of sales are lesser YOY without the unprofitable stores weighing the company down.Inventory at the end of the 3^rd quarter was down some 7% or 4.2% on a comp basis. That’s a lot less merchandise moving through supply lines and the sales channel. This operation of reducing inventory reduction undoubtedly helped improve margins. A quick note of caution on inventory reductions for those not familiar with such dramatic inventory reduction levels: This operation never works. Essentially it is quite easy to lower inventory levels i.e. turn down or off the hose.It proves extremely difficult should sales improve to increase inventory levels on par with that increase in demand/sales.It’s a virtual “Catch 22”. With that said it is something Macy’s has found itself forced to do, reduce inventory levels in order to align itself with greater profitability. Again folks, this operation rarely if ever proves to work in the long run. 

Income from credit in the 3^rd quarter was approximately $161 million, $4 million below last year. Penetration from proprietary cards in the quarter was 47.4%, down 110 basis points from last year in the 3^rd quarter. I would expect this number to improve based on the launch of the loyalty program, but what Macy’s doesn’t offer is the impact from this business segment on gross margins. Loyalty programs “cut both way” folks, just ask Bed Bath & Beyond (BBBY), which launched its loyalty and rewards program last year only to find its gross margins at financial crisis lows. 

Book gains associated with asset sales were $65 million in the quarter. This compares to $41 million last year. During the quarter, Macy’s completed the transaction to sell two floors of its Downtown Seattle store for approximately $50 million. The Company booked a gain associated with this sale of approximately $40 million. During the quarter, Macy’s also booked $22 million of gain associated with Downtown Brooklyn and closed a few other small asset sales for a total of $3 million of gain. For each asset sale the company has embarked upon and successfully completed, it has proven of no benefit to the share price and its shareholders as the asset sales seemingly highlight the value of the company is aligned with the core business, retailing. 

Cash flow from operating activities was $389 million this year, $81 million above last year. This is due primarily to lower cash outflow for inventory, which offset a few other negative cash flow items.Cash flow from investing activities was an outflow of $346 million, $145 million lower than last year, due both to lower CapEx as well as higher asset sales. Therefore, cash flow before financing activities was an inflow of $43 million. Macy’s ended the quarter with $534 million of cash on the balance sheet, $77 million above last year.

Macy’s expects results to improve in the Q4 period for which they also expected results to improve going into the Q4 period a year ago. I’ll get to that in a moment. But let’s look at what the CFO highlights as the Company’s reasons for Q4 optimism:

We are expecting an improvement in our comp sales trend on an owned plus licensed basis relative to that produced in the third quarter. This expected improvement in trend is primarily due to five factors that Jeff mentioned earlier: the higher digital penetration in the quarter; the launch of our loyalty program; our new marketing strategy; additional post-hurricane recovery; and, hopefully, cold weather.

Well, the company has offered a strong start to the quarter from the post-hurricane recovery, but hoping for cold weather as a means to boost shareholder sentiment? Not something I find a favorable means for producing sales improvement. The sales improvements from the Loyalty program, marketing strategies and digital penetration are largely a given, but also largely found not incremental or able to offset traffic declines and transaction declines. But the bar is set pretty low for Macy’s so the Q4 period may not prove to be a difficult bar to jump over. Having said that, the bar was set pretty low in Q4 2016 only to find the company reeling from a profit warning on January 4^th 2016. And by the way, the company was equally optimistic about its profit picture going into the 4^th quarter of 2016.  

• It might behoove investors to remain cautiously optimistic on Macy’s during the Q4 2017 period when we take a look at what Macy’s offered last year going into its Q4 2016 holiday sales season. 
• We are on track to deliver our annual adjusted earnings per share guidance of $3.15 to $3.40. And we are increasing our sales guidance to an annual decline of 2.5% to 3% on an owned plus licensed basis versus our prior guidance of minus 3% to minus 4%. International tourist sales stabilized during the quarter and were down in line with the rest of our sales.
• This compares to a 1.6% increase in the first half of the year. This helped offset the impact of 6% fewer transactions in the third quarter. This was the same reduction in transactions as we saw in the first half of the year.
• At the end of the quarter, comparable inventory was down approximately 3%. This gives us great liquidity, providing us the flexibility to react to trends during the fourth quarter.
• Proprietary card penetration was still very high in the third quarter, at 48.5%, but it was 80 basis points lower than a year ago. The lower credit sales, combined with slightly lower portfolio yields, continue to negatively impact the income produced relative to a year ago.
• Let's now move on to our outlook for the fourth quarter. The trend improvements relative to the spring season that we saw in the third quarter, combined with a more normal weather pattern, stabilization in international tourist sales and the mix benefit of the higher proportion of digital sales that happened in the holiday season, make us confident that we will be able to deliver an improved comp owned plus licensed sales trend in the fourth quarter. We are expecting comp sales on an owned plus licensed basis to be down approximately 0.5% to down 2% in the quarter, and we are expecting at least a 100 basis point improvement in the gross margin rate this year in the fourth quarter. Given our inventory position and our Last Act strategy, we believe this to be achievable. Remember, last year, our gross margin rate dropped 290 basis points versus 2014, so we do have a lot of room to improve.  

Wow! They actually felt so good about sales that they boosted sales guidance for the full year. Unfortunately, that optimism found Macy’s optimism short-lived and misguided given the fact they failed to achieve their gross margin and quarterly sales forecast. Not much has changed with regards to Macy’s since last year. All investors really have to go on is a continually discounted share price based on continually declining sales and earnings on a year-over-year basis and despite the many sales initiatives. With that, all one can really hope for is a near term bottoming in metrics that finds a meaningful share price appreciation from 52-week low levels. So let’s look at what Macy’s has to offer in the way of its Q4 2017 optimistic view:

So in order to achieve the annual owned plus licensed comp of minus 3%, our fourth quarter comp would need to be minus 1.9%. And on the other side of our guidance, to reach the upper end of our guidance, which is minus 2% for the year, we would need to grow 1.1% in the fourth quarter. We think it likely that we'll be at the lower end of our sales range for the year.We remain confident that our earnings will be within the previously guided range for the year of $3.38 to $3.63.We had guided then to a gross margin decline of 20 to 50 basis points for the last two quarters of the year, which would now imply, given the third quarter performance, that the fourth quarter would be down 30 to 80 basis points.

The CFO is clear that the expectation is to remain within the guided range of the sales forecast, but investors and analysts should expect the retailer to perform to the lower end of the range. That’s a reasonable expectation in my modest opinion and possibly sets the company up for outperforming their own expectation. The 4^th quarter holiday selling season has proven the undoing for retailers over the last several years and as consumers shift their holiday purchases away from brick & mortar storefronts. While brick & mortar retailers maintain a growing portion of e-commerce sales, it has not proven to bridge the gap in sales created from declines in their storefronts. Price competition is fierce during the Q4 period and it will only prove to be equally competitive this year as eBay recently launched its own price match guarantee program for the holiday period.  

Long-term Macy’s has a uniquely problematic business issue related to its consumer demographic or core customer. It is what found the retailer in bankruptcy during the 90’s and what has proven a headwind over the last 3+ years. Macy’s has a middle upper-upper income shopper for which it has scaled the Macy’s brand over decades. The merchandising footprint and general merchandise assortment has proven difficult to amend given this demographic dynamic. Where a retailer like J.C. Penney (JCP), who is performing equally poorly, can amend their merchandising and merchandise given its larger addressable consumer demographic, the Macy’s consumer may not be accepting of such measures. J.C. Penney can add new categories on scale like appliances, flooring, toys and now even HD televisions. Macy’s has recognized its limitations along these lines of product implementations. I mean, can you imagine walking into a Macy’s to find refrigerators and washing machines? As such and given it’s already smaller addressable market where does that leave the company long-term? Most of what Macy’s sells are discretionary and not shielded from weather impact. Appliances and consumer electronics tend to offer retailers that shield if “done right”. And Macy’s has conceded to the impact of weather on its sales, but has yet to do anything to shield itself from the future impacts from weather. Kind of a lost opportunity don’t you think? Time will tell of course and I certainly hope Macy’s has set a low enough bar to produce improving metrics during the 4^th quarter, but investors would be wise to participate with a margin of safety and that’s Macy’s very own historical metric performance speaking. 

However, we were not able to overcome the secular changes in the industry related to shopping habits. These changes appear to have had a bigger impact on our store business than we had expected. We recognize we need to make dramatic changes in how we operate the business. In some cases, we're already executing our strategies, while other strategies are still in development, most notably our marketing strategy. This includes ideas also for testing how we can simplify our pricing and for improving the store shopping experience.