What You Need to Know About the State of Department Stores

By Adam Levine-Weinberg Markets Fool.com

Many major department stores reported quarterly earnings in the past week, and most of their stocks have since taken a beating.

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In this episode of Industry Focus: Consumer Goods, Vincent Shen enlists senior Fool.com contributor Adam Levine-Weinberg to share his thoughts on results from these brick-and-mortar chains. Find out how companies like Kohl's (NYSE: KSS), J.C. Penney (NYSE: JCP), Nordstrom (NYSE: JWN), and Macy's (NYSE: M) fared, the biggest headwinds for the industry, and more.

A full transcript follows the video.

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This video was recorded on May 16, 2017.

Vincent Shen:Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. I'm your host, Vincent Shen. It'sTuesday, May 16th, and I'm pleased to welcome senior Fool.com contributor Adam Levine-Weinberg to the show.Adam, I'm really excited to have you in studio today. Thanks for being here.

Adam Levine-Weinberg:Yeah, thanks for having me, and I'm really looking forward to the show today.

Shen:Adam, you've been covering department stores for some time now.

Levine-Weinberg:I have.

Shen:With so many of them reporting earnings in the past week, I wanted to welcome you, our resident expert in the space, to share your thoughts on some of the specific company results, and also the broad trends that seem to be playing out for this beaten-up corner of the retail world. Case in point among the major companies reporting, the market reaction to the results has been pretty ugly so far, I see hereMacy'sdown about 21% since the results came out,Kohl's8% for theirs,J.C. Penney18%,Nordstrom10%,Dillard's18%, and just this morning, the latest results fromTJXCompanies(NYSE: TJX) were greeted by a 5% decline so far in just the first couple hours of trading. So, to kick things off, I asked this to Asit, too, based on theCoach-Kate Spadedeal, what his first impressions were, in terms of some of your big-picture takeaways, your first impressions of this flurry of results that we've seen from these various competitors in the space. What are your thoughts?

Levine-Weinberg:What I would say is, this was definitely a bad quarter for department stores and retailers, especially in the fashion space in general. Some of that has to do with some long-running trends, secular decline in the department store space, and obviously the one that people talk about the most is Amazon. Amazon is still growing at a really rapid rate. They're really just scratching the surface at this point in terms of apparel sales and other categories that are important to department stores. So, as Amazon continues to grow, improve its offerings in that area, there's definitely more trouble to come for department stores. On the other hand, they were also someshort-term factors that were particularly making it hard for department stores to generate decent sales performances this quarter. What's really important is to try to tease out how much of this is an issue of long-term decline and how much of it is actually just short-term problems that, within a quarter or a year, are going to go away or at least become much less of an issue.

Shen:Sure thing. One short-termfactor that's played into this recent quarter's results that I thought was kind of amusing, I've seen a few different companies and some analysts bring it up, was the idea of the tax returns this year and some of the late payments. Some companies actually saw, on a month-to-month basis, February results being weaker, but going later into the season, more people have their refunds, and March and April numbers seem to have recovered from that. A really interesting look. Sometimes, I think a lot of companies in this space, we'll talk about, whether we had a few years where the winter weather was unseasonably warm and that affected them. So, it's always interesting to watch how these factors can impact their short-term one-quarter performance, maybe two quarters of performance, as they work through inventory and things like that. But I think toward the end of the show, we'll really hone in on some of the longer-term takeaways that you've seen, and maybe some of the companies that you think are positioned best to come away from this shake-up that's happening in this space.

Levine-Weinberg:Yeah.

Shen:Moving on to some of the specifics, a lot of these companies have seen comparable sales declines,revenue declines, some cost-cutting measures, store closings, and other reorganizations, and asset sales have helped them boost their bottom lines. But what are we seeing for these companies, in terms of their core key headline results?

Levine-Weinberg:Across the sector, if you look at the major department store chains, last quarter, low- to mid-single-digit comparable-store sales declines were pretty much the norm across the board. You look at Macy's: Comp sales were down 4.6%. Kohl's, it was down 2.7%. You had down 3.5% at J.C. Penney, down 4% at Dillard's, and then at Nordstrom, if you slice out the Rack, which is their off-price chain, and just look at their full-line comp store sales, they were down 2.3% in that part of their business. So, all in, that's down in the 2-5% range. The only real exception so far isSears, which hasn't officially reported their results yet. But Sears has really been struggling mightily and losing its relevance pretty quickly. Through late April, they had already seen an 11.9% year-over-year decline in their comp sales. Barring a huge changein the last week of April, they're going to have a double-digit decline. So, pretty bad results on the sales front. In many cases, these companies are closing stores, so total sales are declining at an even faster rate than the comp sales declines.

On the other hand, if you actually look at the earnings results, surprisingly good for many of these companies.Macy's is the only one where you really saw an earnings wipeout last quarter. Macy's reported that its adjusted earnings per share was down about 40% year over year. So, clearly, that was a big miss, and that's why Macy's was one of the hardest-hit companies after the earnings reports last week. On, the other hand, if you look at Nordstrom, Nordstrom reported EPS up 19% year over year. You look at Dillard's, it was down 2% year over year, so down but not disastrous in any way, shape or form. Kohl's was up 26%, that was actually the biggest gain, and that's why Kohl's stock only declined about 8-10%, as opposed to 20% for a lot of these other companies. J.C. Penney, its numbers weren't very easy to compare. They had a big asset sales gain last quarter. If you include the asset sale gain, they actually posted positive adjusted earnings per share compared to a big loss a year ago. If you take out that gain, they still were a little bit better on a year over year basis in terms of their core profitability.

So, overall, what you see is these department stores have huge sales problems, and at Macy's, that did translate into a big earnings decline. But many of these companies actually improved their earnings results, or basically held the line. There's a few reasons for that. First of all, last year in the first quarter was just as bad, in terms of bad weather, in terms of the timing of when it got warm and when it was cold, inventory mismatches, a lot of these stores weren't expecting sales to be so bad a year ago, so they got caught with too much inventory and had to take a lot of markdowns. If you look at the results this year, you both saw a cost-cutting where they were taking operating expenses out in many of these companies. Then, also, gross margin improvements, which really speaks to the improved Inventory management. For a department store, you would obviously love to have sales growing, but at least if you expect sales to be declining, you can take the proactive inventory management steps in advance so you're not stuck with too much on your shelves, and you can at least get a better margin on what you are selling.

Shen:Yeah, in turn,obviously, the things that you have a hard time moving through, getting out of your inventory, you have to sell at a discount or through promotions, and that hurts your profitability and your margins.

Levine-Weinberg:Yeah, it's really the clearance part. All these department stores have some amount of promotionality to their business models. They're used to marking things down 50-60%. That's OK. It's when they get into clearance, and they have to start marking stuff down 70-80% because they just need to get rid of it right away, if it's part of the collection of winter clothing and now it's getting into late March, then they just have to sell it for however low they have to go to get rid of that merchandise, because they just can't afford to hold on to it for another year.

Shen:If it's OK with you, I would like to hone in on Macy's a little bit. It seems, like you mentioned, they had their earnings wipeout hit particularly hard. But I also think they are in a really dynamic situation in that a lot of people talk about, and it was a similar story with Sears for some time before things started really spiraling down the drain, into that real estate, really valuable, company is undervalued just on that basis alone. What are some of the things that Macy's is doing to try to address this weakness? In general, what are you seeing on that side in terms of what they're doing with the real estate? How are they utilizing it? How are they approaching the sales and things on those lines?

Levine-Weinberg:I guess I'll start with the real estate, and then I'll look at some of the other things that they're doing to try to rebuild their core business. On the real estate specifically, about a year or two ago, they were in a bit of a fight with an activist investor that has since sold out and decided to pursue other prospects. Anyway, these activist investors wanted Macy's to spin off their real estate. They estimated the value of their real estate was more than $20 billion, and thought that Macy's should try to put it into a real estate investment trust, somehow split up the company where you would have a real estate company on the one hand and a retail company on the other hand, and that would make the company's valuation go up. Macy's didn't agree, they thought there would be tax problems, and also didn't agree with the logic of how this would create value for shareholders. What they decided to do instead is, they're really focusing on, where do we have real estate where we're not utilizing it effectively and actually getting value out of it? Andthat's where they're looking to either sell off or in some other way monetize real estate. I'll just give a few examples of things that they're doing.

One thing that they have been trying to do is take stores where they're not necessarily losing money, but they're not making a lot of money, and they sit on very valuable real estate, and just selling those store properties and closing the store. Some places where they've done that recently are in downtown Portland, in downtown Minneapolis, big flagship store buildings that they decided the stores aren't profitable enough anymore -- these aren't vibrant shopping environments -- we're going to close the store. Those two combined brought in more than $100 million. They're also selling off some mall-based stores to the mall owners.General Growth Propertieshas bought several Macy's stores. Including all of those together, that's brought in more than $100 million. In San Francisco, Macy's, for many years, has operated a very large flagship store that's close to a million square feet, but then also a separate men's store, which is a quarter of a million square feet. They sold that men's building for $250 million, and over the next two to three years, they're going to take all that inventory, move it into the main store, which is still a very large store,one of the biggest in its system, and they think they will be able to capture most of the sales, maybe even do better, because everyone will be in the same building. But they've also just gotten a windfall of $250 million. That's one aspect of what they're doing.

Shen:Yeah. I'm really glad that you brought up that example in San Francisco. I was there a few weeks ago in Union Square, a huge shopping area, very attractive, tons of traffic in general, because that's the shoppingcentral area of the city, and I couldn't believe the size of these Macy's stores that they had --

Levine-Weinberg:Yeah, they're massive.

Shen:-- separately, right next to each other. You could see the men's store was closed. There was construction around it as they're starting to move things in, as you mentioned. But I couldn't believe they were operating these separately. It makes a lot of sense to bring them under one roof. And it's hard to argue with the $250million in proceeds that they get from selling that space.

Levine-Weinberg:And if you look, another thing they're doing in San Francisco in particular is they're working on a plan to carve out about 10,000 square feet of space on one side of the first floor in that main building and renting it out to luxury retailers that maybe wouldn't sell their products in Macy's, but they'll take space on one of the biggest shopping streets in the city. Some of the retail rents there have been astronomically high, so just carving out this 10,000 square feet of space, that could bring in something like $6 million of annual rent, for years on end. So, that's a really nice way to, one, you get the rent, which is nice -- it boosts the bottom line. But, hopefully, it also gets people in who might not otherwise come to Macy's, and once they're in these little shops in the front of Macy's, they'll walk under the bigger store and maybe they'll see a purchase that they otherwise wouldn't have made.

Shen:And lift their general foot traffic overall.

Levine-Weinberg:Another thing that Macy's has been doing on the real estate front is they're working on a plan withBrookfield Asset Managementto redevelop in some way about 50 store sites. In many cases, they keep the store that's already there. But oftentimes, Macy's owns not only the store but a large parking lot area or just vacant space that's not being used. So, it's possible to densify development on these parcels. So, maybe they'll put a restaurant in an outparcel in what's currently a parking lot. In some cases, they could build a mid-rise condo development. There's a lot of options. Real estate where the Macy's store would probably benefit if you brought residents in. That's been a really big trend recently, to have these towncenter environments where you have mixed use developments, retail, commercial, office space, and residential all in one place --

Shen:A town center model.

Levine-Weinberg:It could not only give Macy's the proceeds up front from selling off this land, or building a building and then selling it, but then you also have a more vibrant shopping environment, which helps the store for many years to come. So, there's a lot of things that Macy's is doing in terms of its real estate. The one last thing I'll mention is, they have a couple of big flagship stores in Chicago and New York. The Chicago flagship is worth hundreds of millions of dollars at least. The New York one has been valued at billions of dollars. These are really valuable properties.

Shen:Really massive space, and in that neighborhood, too, I can imagine they're really valuable.

Levine-Weinberg:Yeah. They're not closing those stores, but they're probably going to lop off a bunch of space at the top and redevelop it in some ways, either office space or maybe even residential or hotel, in some cases. So, that's another thing that could bring in a lot of money over the next two or three years, probably.

Shen:Sure. Let's move on to some of the things that are driving some of those top-line declines and weaker comparable-store sales that you were talking about previously. The ultimate question for people who are investing in these companies -- who are seeing these low prices and trying to better understand what the headwinds are -- why are the sales falling so much and what's the outlook for that?

Levine-Weinberg:As I mentioned before Amazon.com and other e-commerce retailers are definitely taking a bite out of department stores' space. That's something that has gotten a lot of press attention, and rightfully so. And that's something that's not going away. You've also seen off-price retailers -- and TJX in particular is the big one -- but you will have places likeRoss Stores, and I should also mention for our listeners and viewers, TJX is the parent company that owns brands like T.J. Maxx, Marshalls, and HomeGoods. Acouple years ago, it surpassed Macy's as the biggest apparel retail chain in the country. Those definitely are serious, long-termchallenges, andthey're going to create some top-linechallenges for department stores for the foreseeable future. It's hard to know just how much that'shurting department store sales, though. Ifyou think the economy is growing at2%, you would expect department stores togrow at 2%. Are they taking 2% off thatand making it so that department stores can be flat or are they taking 4%. It's hard to really be sure.

Shen:Toquantify exactly.

Levine-Weinberg:Yeah,to quantify exactly how much you should expect that share shiftfor department stores. But what we can be pretty sure of is,there are certain temporary factors that arealso impacting department stores, andthose factors are going to change,dissipate, at least to some extent. Theone that you mentioned before was the tax refunds. To be fair, I'm not surewhether that's a good excuse, becauseif people didn't get their tax returns in February, thatexplains why sales were downso much in February. Butwhy didn't you get those sales back in March,when the tax refunds did come out? It doesn't entirely make sense,because most of those refunds that got lost in February still cameduring that first-quarter period. You could say, maybe,if you get a tax refund on February 10th, you'regoing to go out and get a nice Valentine's Day presentfor your significant other, andif you get one on March 10th, you'renot going to go get a nice St. Patrick's Day gift. So,you're missing a big holiday event where,if you get the refund in March, maybe that means people save it. It's possible,but it's definitely not a very good explanation for whyFebruary was so bad.

Another issue that'sdefinitely a problem is the particular categories that aren't doing well. One of those that'sreally been a problem for quite a while now is handbags. A few years ago, brands like Michael Kors werereally popular. And you've seen these brands,because they become so popular,so many people bought their products, they'vebecomecommoditized, and now nobody wants them -- or,at least, people aren't willing to pay a premium,and you either have to mark it down to aridiculous price or you can't sell it at all. So, now these brands that weredriving huge growth a couple years ago are seeing huge sales declines,and it's really hard to overcome that.

Shen:We talked about that last week in terms of the Coach-Kate Spade's deal. One of thebig challenges that Coach ran into,and this applies to Michael Kors as well and the other competitors in the mid-rangeluxurycategory,is the fact that they become so commonplace,commoditized, thatthey lose some of that aspirational value thatconsumers often want,stepping up a tier to that level of luxury goods. So,not surprised at all. All these companies, it seems, aretaking steps to reduce discounts, to up the price ranges, torestore some of that brand value that they lost inthe years of growth they were pursuing.

Levine-Weinberg:Yeah.I think it will be good for these companies in the long run, butin the short term, it meansyou have to give up sales. Because you need to raise the prices and give up sales frompeople who only want to buy the bagif it's really discounted. Oneother tidbit I'll mention is, Macy's said that women's apparel was actually its strongest product category last quarter. Andthey said the same thing a quarter earlier. That cuts against thisnarrative that apparel sales are allmoving online, andit's going to go to Amazon and kill department stores. It's actually not really been the apparel at a lot ofthese companies. We might talk a little bit later about J.C. Penney. They arehaving some apparel issues there. Butfor most of these companies,apparel is not actually the biggest problem. It'ssome of these other bigimportantcategories like accessories,cosmetics, where they've been having more salespressure recently.

The one other temporary factor thatreally impacted department stores last quarter was all of these store closures. In the long run, store closures aredefinitely a positive for the sector,because everybody recognizes right now that there'stoo much retail space in the U.S. It'svastly more per capita than any other country in the world. Quitefrankly, stores need to close,especially when you have more and more business moving online. However, in the short-term, storeclosures are not good for department store results, becauseyou end up competing with clearance sales. IfMacy's has 700 stores in aparticular market in a metro area,it has 10 stores and it's closing two of them, you're going to see sales trends decline at the other eight because you can go and get great deals at the two that are closing. So,now that the stores are closed,I think we'll see better results going forward,starting in the second quarter.

Shen:They've gone through the pain of closing the stores. Hopefully, in the longer term, they'llsee the benefits.

Levine-Weinberg:Now,to be fair,there probably will be more store closuresin the future, but this was a particularly big quarter for store closures. So, yousaw a particularly big impact from thatjust in the past three months.

Shen:We have a few moreminutes here, and I want tolook at this and provide some final takeaways for the listeners who are looking at these companies, whether theyhold them in their portfolio or seethe potential bargains there. We've heard a lot of the negative aspect or the bearish tune ofwhat'saffecting these department stores. In your view, you mentioned how the store closures aregood for the long term. Are there other tailwinds thatinvestors in these companies or these management teams canlook forward to that might at least give some people who are following the space, like, "Oh,that's something to be positive or optimistic about"?

Levine-Weinberg:There'sa few things that I would mentionin this respect. The first is,department stores are actually prettyearly in the process of responding to the recent change in their sales trends. On the one hand, department stores are veryslow-moving,historically, and that's definitely a bad thing. This is not the first time they've been caught flat-footed by some change inindustry sales trends. Onthe other hand, what that also means is they'reworking on it now, sothere's a chance that things will get better. So,just a few of the major things they've been doing recently, big trends, are atMacy's and J.C. Penney, they're moving to open-sellenvironments for shoes. Rather than having to go get a salesperson togo in the back, get you a shoe box with the size that you want, youtry it on, it doesn't fit, they have to go back again andget a different size or different color, they'll haveall the shoe boxes out on the floor, you can try it on yourself. It's cheaper for thembecause they don't need as much staff. It's a much easier, fasterexperience for you. People are used to this now. If you're going toDSW,nobody is going to the back to get you a pair of shoes.

Shen:No,absolutely not.

Levine-Weinberg:So,it's just one of those things where,20 years ago, this would have been unthinkable for adepartment store to make you get your own shoes. Now,that's what customers want,in many cases, so that's what they're going to do. There's anincreasing focus on uniqueness across the board. Macy's has talked about thisa lot in the last couple of quarters. Theysigned an exclusive deal withDKNYforwomen's apparelstarting next February.Kohl's just started a big partnership withUnder Armoura few months ago,bringing in Under Armour apparel. You'reseeing the same things at pretty much everydepartment store. They're trying to find a few things that areunique about themthat will drive traffic. J.C. Penney has itsSephorashops for cosmetics that have been doingextremely well.

Shen:WithJ.C. Penney,I'm glad you brought that upso we can dive in. They're reallymaking some big changes jumping and expandinginto other product categories. And this may be something thatpresents a big opportunity for them going forwardas they test this.Tell us a little bit about theappliances and these other shop-in-shops that they're expanding into.

Levine-Weinberg:Yeah. I think,what you're saying for J.C. Penney is, one, they are beingvery strategic in looking at whereSears gets a lot of revenue and wherethey can take revenue away from Sears. Because Sears is closing tons of stores. They'redefinitely at a risk for bankruptcyin the nextseveral years, so there are definitely sales that are being donated to other companies. Appliances is one area whereJ.C. Penney said, "Look,we have a lot of people actuallygoing on to our websitesearching for a refrigerator and we don't sellrefrigerators, so maybe we should. Peoplewant to buy a refrigerator, apparently, from us." So, they've putappliance shops up. Last year, they put it into about half of their stores. Bythe end of this year, it's going to be in at least two-thirds, if not more, of their stores. Theysee this as being a really big sale driver going forward. They've got other categories where they're doing similar things. They'retesting out new furniture and mattress displays. Theystarted a partnership withAshley Furniture,which is a really big furniture manufacturer. They're testingflooring, in-home custom windows,all kinds of different areas where they thinkthey can get some sales share,particularly in the home section of the store, where theyactually used to be really goodand struggled a little bit whenRon Johnson came in as CEO about five years ago. So,they're trying to rebuild that strength,especially because a lot of consumer dollars aregoing to home improvement right now. They see that as being areally big sales driver, andyou have this secondary benefit of,if Sears goes bust, there'spotentially a lot of sales on the table in this area.

Shen:OK. Lastcouple minutes here,I want to touch on some numbersin terms of valuation andother things that I think doultimately, despite some of the headwinds that they face, make thesecompanies pretty attractive. In terms of valuations, with the way these stocks haveperformed, they'regetting into what I would considerbargain territory, andcombine that with the yields thatsome of them pay, Nordstrom,Macy's,Kohl's, their yields range from about 3.5 to 6.5%. It'spretty impressive. Is there an issue, though,in that regard,in terms of whether those payments are sustainable? Are theygetting stretched thin as their businesses,at least currently, are weaker,in terms of being able to maintain those payouts?

Levine-Weinberg:Macy's as you mentioned, is up at the top of that list, with a6.5% yield. That's a stock that I own. It's a stock thatI think has been understandably punished, butI do think investors are kind of missing the point somewhat. Thecompany is not really getting credit yet for its real estate moves. It's beenreally transparent thatthis is going to take some time. You could sellall the real estate in a yearif you wanted to. You would just have to take a big discount for it. So, that doesn't make sense. Itmakes sense to take the time, work through some plans, and in thenext two or three years, you're going to see a lot more value from the real estate. At the same time, they areworking on a lot of differentinitiatives to improve their sales results.I don't expect them to ever return to strong sales growth,but I think they will be able to stabilize their salesin the next year or two. And when that happens,you could see the stock really improve. Even with the yieldup at 6.5%, theirfree cash flow is quite strong. It's about two times thedividend payments. So, there's a pretty big cushion there to support the dividend. AndMacy's is also investing quite heavily. They're spending about$900 million a year on capex, which is 3-4%of their annual revenue. More thansome of their competitors. They'reinvesting in things that,if it turns out these investments aren't working,they could definitely cut back there, and that would be another way to free up more cash flow tosupport this dividend. So,I see that dividend at Macy's,and you could say the same thingabout Kohl's, Nordstrom, they're allpretty sustainable.

That's definitely an opportunity for investors going forward, because I think, if youlook out a few years,department stores aren't going to be healthy, per say, but they're more stable thanpeople seem to realize right now, sothere's actually some really big opportunities right now, if you're patient, to pick updepartment store stocksat a discount,collect the dividend, and as things settle downin the next couple years, these valuations could improve to a more normalized level that they were six months to a year ago.

Shen:Last point,do you have a favorite?

Levine-Weinberg:I would say that Macy's actually is my favorite,because if you look at the real estate value, it'spretty much, after the recent stockdecline, enough to cover the value of all of the company's debt, all of the company's stock. Even if the retailbusiness gets worse over time, thatreal estate is a realfloor value for the stock. Now,obviously, that could change. Thereal estate value could change based on economic conditions,things like that. But, itdefinitely gives you some risk protection. I also think the company's scale,as the biggest department store out there, will help it in the long run to survive. If industry conditions do get worse,I think they could actually benefit from some bankruptciesamong other retailers that aren'tin as good of shape as Macy's.

Shen:Andthey should be best able to weather that storm, right?

Levine-Weinberg:Yeah,that's what I think.

Shen:OK. Thanks again,Adam, for joining us. Thank you, Fools, for tuning in. You canreach out to the entire Industry Focus team via Twitter @MFIndustryFocus, or send any questions to industryfocus@fool.com. Don'tforget to check out podcasts.fool.com to hear all The Motley Fool'sdifferent shows. People on the program may owncompanies discussed on the show, andThe Motley Fool may have formal recommendations for or against stocks mentioned, sodon't buy or sell anything based solely on what you hear during theprogram. Fool on!

Adam Levine-Weinberg owns shares of J.C. Penney, Macy's, Nordstrom, and Under Armour (C Shares). Adam Levine-Weinberg has the following options: long January 2018 $60 calls on The TJX Companies and short January 2018 $90 calls on The TJX Companies. Vincent Shen has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Amazon, Coach, Under Armour (A Shares), and Under Armour (C Shares). The Motley Fool recommends DSW and Nordstrom. The Motley Fool has a disclosure policy.