No-moat Macy's (M) announced first quarter comparable sales declines of 5%, an acceleration in decline from 2016’s 3% downtick. Although we have long held that department stores are in secular decline given significant exposure to online threats (with much of the same merchandise found in both channels), we now believe that our estimates did not accurately reflect the speed at which market share losses would occur. Therefore, we expect to lower our $34 fair value estimate by about $2 to $3 and see revenue declining about 2% on average annually over the next five years (versus our prior 1.5% decline estimate). We note that the downside from these new estimates is being offset by a 10 point lower federal tax rate assumption, effective in fiscal 2018 (boosting the fair value estimate by about $4).
In addition to top-line concerns, we also remain worried about the long-term margin trajectory of the company. We acknowledge that, historically, Macy’s has done a notable job controlling expenses, with SG&A expenses (excluding depreciation and amortization) declining 1% on average over the last three years. That said, we believe that there are limited opportunities for additional cuts without risking underinvestment. In the first quarter, gross margin declined 100 basis points to 38.1% and operating margin declined 70 basis points to 4.1%. Although some of the gross margin decline was due to elevated inventory levels that we see correcting (comp inventory was up about 1% at the end of the quarter), it was also pressured by margin declines in beauty, housewares, and the impact of shifts to lower-margin fashion watches, which we see persisting throughout the year. In the long run, we think pricing power will remain limited given intense competition and are modeling gross margin in the 38% range (versus the 39.5% three-year historical average). Our model also continues to incorporate roughly $300 million in announced SG&A savings in 2017 but recognizes limited future upside.
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Bridget Weishaar does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.