Department Stores Surge on Latest Earnings Results -- Is the Rally Sustainable?

Last week, most department store chains reported that sales declined once again in the second quarter. Yet shares of Macy's (M 0.53%), Kohl's (KSS -0.95%), J.C. Penney (JCPN.Q), and Nordstrom (JWN -0.34%) all surged by roughly 20% within a few days of their earnings reports.

In this episode of Industry Focus: Consumer Goods, senior consumer goods specialist Adam Levine-Weinberg joins Vincent Shen as they discuss why investors are flocking back to department store stocks, despite the weak sales results. Then, they dive into the investments and strategic shifts department stores are employing in reaction to changing consumer habits. Adam also reveals his top pick in the department store sector.

A full transcript follows the podcast.

This podcast was recorded on Aug. 16, 2016.

Vincent Shen: Welcome! This is Industry Focus, the podcast that dives into a different sector of the stock market each day. I'm your host Vincent Shen. It is Tuesday, Aug. 16. For my guest today I am really excited to welcome Fool.com contributor and senior consumer and retail specialist Adam Levine-Weinberg, who is joining us from Chicago via Skype, but not for long because he's actually coming to Fool HQ's home, here, in Alexandria next week. I just found that out. How's everything going, Adam?

Adam Levine-Weinberg: Great!

Shen: I'm really happy to have you here. I know it's been a little bit of time since we last had you on Industry Focus. I have taken over more of the hosting role from Sean, I think a month or two now. I'm really glad to have you on, hope you can be a regular contributor, especially with the news that we are covering for our listeners this week. We have a spate of earnings reported by major department store chains last week, including Nordstrom, J.C. Penney, Kohl's, and Macy's. TJX (TJX 0.43%) actually just reported this morning before market open. These companies have been facing some pretty significant headwinds. I think we agree, in a weak retail environment, reduced share of consumer spend, e-commerce competition. Otherwise, since the earnings -- and I noted this when you sent me your notes, too -- they've enjoyed a huge surge in the past few days all for the stocks I mentioned. Again, that's Macy's, Kohl's, Nordstrom, and J.C. Penney are up around 20% or more since reporting their earnings. Adam, could you give us a rundown of the results and just some insight into what's driving this bullish run for the companies?

Levine-Weinberg: Yeah. The department stores, they're definitely still under pressure, but the trends are improving and that is what really drove these rallies. Just since the market opened on Thursday, you had J.C. Penney up 23% in the last three days, that's Thursday, Friday, and Monday. Macy's up 19%, Kohl's up 21%, and Nordstrom up 20%. Pretty similar moves in all four stocks showing that their trends are moving in the same direction. If you look at Macy's, for instance -- comparable-store sales, that's sales in stores that have been open for more than a year, are still declining, which is not good. Comp sales were down 2% in the second quarter compared to down 5.6% in the first quarter. While it wasn't good, it was better than a lot of people had feared. That was part of the reason why the stock started to rally on Thursday.

Similar situation at Kohl's, where you had comp sales down 1.8% in the second quarter, compared to being down 3.9% in the first quarter. At Nordstrom you had similar kind of improvement with their full-line comparable-store sales down 2.8%, compared to down 5.4% in the previous quarter. At Nordstrom you actually even had an even bigger underlying improvement, because they run a very big sale called the Anniversary Sale, which always happens in the middle of the summer. Usually it's all within their second quarter, but just based on the timing this year, a week of the sale moved into the third quarter, and that's one of their highest-volume periods of the year. It's right up there with Christmas, and so because of that you didn't have as good sales numbers in the second quarter, because a lot of those sales got shifted out into the third quarter. The company estimated that they actually would have posted a comp sales increase excluding that factor, which is really pretty impressive because Nordstrom had a really good performance in the second quarter last year.

Shen: Yeah, that's a tough comparison for them already. The fact they would've been able to post that gain had the timing worked out on the sale, and especially the sequential improvement that we're seeing for the companies that you've mentioned so far. That's pretty impressive.

Levine-Weinberg: Yeah, the one among these four retailers that did manage to get a comp sales increase last quarter was J.C. Penney. Comp sales increased 2.2%, which was another sequential improvement. They were down 0.4% in Q1.

Shen: Okay. What about on the bottom line?

Levine-Weinberg: The difference here is that J.C. Penney is still unprofitable. They expect to make a full-year profit, but during the first three quarters where you have lower sales volumes, they're still losing a little bit of money. They are improving, but off of a smaller sales base. They're still not really recovered from the problems they had a few years ago. Just for some context, even in a best-case scenario J.C. Penney is going to end this year with about $13 billion of sales, and 10 years ago, they were at $20 billion. They're still well below their peak and really a few years away at best from recovering to be sustainably profitable.

Shen: Okay. Looking at the numbers and just based on this quick rundown that you provided for these four companies, it seems like they are moving in the right direction now, but I noticed just one thing is I mentioned TJX reported this morning. Keep in mind the TJX Companies is definitely considered more of an off-price discount retailer, at least relative to a Macy's and Nordstrom. A really quick take from their fiscal second-quarter earnings was that their net sales growth was up 7% and their earnings were up about 5% to $0.84 per share. What really stood out to me was their comparable-sales growth was 4%. The stock's actually trading down slightly as of early morning trading, but that's due to guidance for the coming quarter coming in weaker than expected. TJX is more of a discount competitor, and I noted that at Nordstrom, their Rack brand segment actually delivered 5.3% comparable-sales growth compared to the core flagship Nordstrom line. Do you feel like these off-price chains are going to be able to continue grabbing market share and doing a little bit better than the core department stores that we're talking about today?

Levine-Weinberg: Yeah, absolutely. I think that's definitely true. You've seen a really strong run at TJX, which is by far the biggest of these off-price chains. I think people were a little bit disappointed by the 4% comp-sales growth because they were at 7% in the first quarter. It seemed to some extent that they go a little bit opposite the department stores. When the department stores are really struggling, the department stores cut back on their inventory orders, and so all of the sudden, all of their suppliers are desperate to move product at really low prices, and TJX can step in. That's the benefit of the off-priced business model: They can step in, take those goods at really low prices, get it into stores quickly. A lot of times it's good merchandise, it's just the department stores aren't seeing the customer traffic that they need to be able to sell that much. I expect to see companies like TJX, Ross Stores, and also the Nordstrom Rack brand, which you mentioned is an off-price version of Nordstrom. I think they're going to continue to gain market share pretty quickly in the coming years and post pretty steady sales growth just on a brick-and-mortar basis. Some of them are getting a little bit into e-commerce, but that's one of the few retail business models that seems to be difficult to disrupt from an online standpoint.

Shen: Absolutely. Just for that Nordstrom Rack segment again, something else I just wanted to highlight is if you look at a press release in terms of store counts for Nordstrom's different brands, of their 25 stores that they've opened since a year-ago quarter to now, 22 of them have been Rack brand stores. Obviously they're seeing a lot of strength and success there, and they're really focused on that. When it comes to store counts, and openings, and closings, I know Macy's, with their earnings, they released a separate release about closings. For quite a few of their stores -- 100 of its 675 full-line stores, I think they have around 730 total stores. That's still 15% of the base. Those are happening, I think, in early 2017. What's the story there?

Levine-Weinberg: Macy's did announce that they are planning to close about 100 stores, and this is after they already closed 36 just this spring. They are really moving very aggressively to reduce the store count. From closing about 100 of their full-line Macy's stores, they do expect to lose about $1 billion in annual sales, and that's net of sales that they can recapture in other nearby stores and also through their online business. They company's incoming CEO stated that a lot of the stores that they're closing are still profitable, but they've been facing long-term declines in sales productivity and in earnings, so they can see where things are going.

Oftentimes for a department store you get to a point where you really need to decide if you're going to invest a lot of money to freshen the stores, make them look better, bring in new merchandise, maybe reconfigure the space, and that's pretty expensive. Or just give up and put your money somewhere else, and that's kind of what Macy's has decided to do. In some cases, they are closing stores where the real estate is really valuable, so there are some stores that are actually preforming very well, but they're just too good as a redevelopment opportunity.

One really great example of this is Macy's men's store in San Francisco, downtown. Right now they have a massive flagship store in San Francisco that's over 900,000 square feet, and right across the street they have a smaller men's store, which is about 250,000 square feet. An article that I saw recently said that selling prices for buildings in the Union Square area have been around $1,000 to $2,000 per square foot recently. If that holds, then Macy's men's store could be worth anywhere from $250 million up to as much as $500 million. While it's making a lot of money, it's not enough to justify that opportunity cost. Macy's is in the middle of negotiations to sell that store, and they're just going to move the men's business into the main store. The fact of the matter is when you have a store that big, then you're still going to be over 900,000 square feet, you can downsize without losing a lot of sales volume, because you can just take away the least productive space in the store and still do really well.

Shen: Yeah. I think that makes a lot of sense, especially for that specific location you mentioned with the real estate prices. That's incredible for that space, for them to potentially be able to get $250 [million] or $500 million based on where the real estate market ends up going there. San Francisco is still very strong. Overall, there's 100 stores, the press release mentioned as well that in the past six years they've closed 90. This is obviously a very aggressive transition for the company, but do you have any concerns at all that this is maybe short-sighted or that the substantial proceeds that even Macy's can generate here from real estate sales, freeing up capital ... do you think that that flexibility I guess they're getting is the right move?

Levine-Weinberg: Yes, I think so. There's definitely a risk in that these stores are still making money, so when you close them, they're expecting to have some pressure on the bottom line next year. However, that will be offset by the proceeds they get from selling a lot of the real estate that they own, that are related to these stores, which they won't need anymore. I think that, over time, their capital could be better spent on their top-performing stores. They've mentioned that they have stores right now in 49 of the top 50 markets in the United States. After all of these store closures, they're still going to have a presence in 49 of the top 50 markets, so mainly they're closing stores in regions where they have multiple. Given that you've seen a very long-term decline in mall traffic, very significant decline, it's probably worthwhile to concentrate in those top malls, the top-performing stores, and really invest in them to have the best retail experience that can really compel consumers to come out and shop in a world where going to the mall is just not automatic anymore.

Shen: Yeah. Okay. With Macy's, they're kind of moving in that direction. It doesn't seem though for the other three companies that we're covering -- Nordstrom, Kohl's, J.C. Penney -- does not seem that they're necessarily following the same strategy, or at least as aggressively. Can you give us a rundown of what the strategy that these companies are taking?

Levine-Weinberg: Yeah. I definitely agree. You're not going to see these kind of massive store closures at the other three chains. Kohl's is closing a handful of stores this year, but it's a much different retailer in terms of its real estate positioning. Most of its stores are either in strip malls, or they're stand-alone locations in the suburbs, so their real estate isn't that valuable. It doesn't have much in the way of alternative uses, and it's pretty cheap. Stores don't have to do that well to justify their performance in staying in the store fleet. Kohl's is also very focused on using their stores as hubs for shipping online orders and also for picking up online orders. Kohl's management has made it very clear that they want to keep a big store fleet so that they have that convenience for customers.

If you look at J.C. Penney, they're not opening stores, but they're also not really closing stores right now. They've taken a different approach. The management team at J.C. Penney really thinks that they can gain market share over the next few years, because Macy's is closing so many stores, and also because Sears -- which is another one of their big competitors -- is really pulling back, in some cases even more so than Macy's. Given the fact that J.C. Penney is the only one of these four chains where comparable-store sales are rising, it probably doesn't make sense to get rid of stores right now. You want to see how long you can keep that sales growth going. Then, maybe at some point in the future, if the sales growth tails off, then at that point you have to decide whether there's too many stores.

One of the things that you're seeing at J.C. Penney is they're putting in some new categories, particularly in the home department, which they hope can drive continued sales momentum in the next few years. Then lastly, at Nordstrom they've announced one store closure this year, it's a store in downtown San Diego. They've said that they might close a couple more, but Nordstrom is a much smaller chain than these other retailers in terms of full-line stores. J.C. Penney and Kohl's are both up around 1,000, Macy's is a little bit below that, Nordstrom has 121 full-line stores. They can't close that many without losing their positioning and key markets. In fact, they're actually planning to open some stores in the next few years to take advantage of favorable markets where they have minimal or no presence right now.

Shen: Okay, that makes sense. I've followed Nordstrom for a little bit and known generally their smaller size changes that dynamic for them. The fact that Macy's is coming off base of 750 locations gives them a little bit more flexibility. I wanted to take a step back a little bit. We touched on their recent earnings, we've touched on some of the recent news with the closures and that dynamic, but you've mentioned a few times I guess more of the big picture and the higher context in terms of the headwinds that these stores are facing. What do you think that a Macy's or a Kohl's or J.C. Penney can do to position itself going forward, or what are they doing to position themselves to fight off some of the headwinds or to fight off some of the challenges and return themselves to a stronger growth and a stronger position overall?

Levine-Weinberg: Sure. There's three things that are challenges right now for department stores. The first is just the shift in consumer buying habits, where it's e-commerce. The second is declining mall traffic, and the third is lower spending on apparel and related categories. People seem to be spending more money on things like home renovations, buying new cars, and dining out. Those things don't help department stores as much. The e-commerce growth is a positive and a negative. It's good in that all four companies are investing a lot in e-commerce and seeing a lot of growth there. If you look at Macy's and Nordstrom they're much further ahead, they're getting 20%, in some cases even closer to 25%, of their sales online right now. That's really a major part of the business, and it's a key growth driver.

They've gotten to that because it's a successful focus on what in this business is called omnichannel initiatives, and that's basically ... it means they are trying to make it seamless for customers to shop both in-store and online, having the same item assortments and using the two parts of their business to work together. Key initiatives around that are being able to ship online orders from stores, being able to ship online orders to stores, and keeping good inventory management so that you can allow people to buy online and then pick up their order in the store the same day if the goods are already there. J.C. Penney and Kohl's, they've seen how successful Macy's and Nordstrom have been, and they are later in the process, but they are catching up and they've implemented all these key features. They expect that to help them grow their online sales in the coming years.

The problem for all of these companies is that nobody's really figured out how to make online sales as profitable as the in-store sales. Nordstrom has had a lot of trouble in that in particular, and they've talked about actually cutting some items out of their online assortment. They realized they just couldn't make any money selling these things online, and they were in some cases cannibalizing their in-store business in order to build up online sales that ultimately weren't profitable.

If you look at some of the other companies, Kohl's has some advantages in that, like I said before, it's stores are not really in malls. They tend to be stand-alone or in strip malls, and for that reason, it's a little bit protected from some of these trends toward online sales. People still have to go shopping for groceries, and a Kohl's store is more likely to be near the grocery store just based on their real estate positioning, so it's a little bit more convenient for customers. As you mentioned before, the off-price business is doing really well. So that's helped Nordstrom, because the Nordstrom Rack chain they've invested a lot in in the past few years. They've roughly doubled the Nordstrom Rack store count in the past five years or so, and they have plans for a continued growth in the near future.

In terms of the merchandise selection where you have people spending less on apparel, that's still a problem for all four chains. They're heavily focused on apparel, beauty, shoes, accessories, things like that. J.C. Penney, among the four, is being the most aggressive in trying to broaden its appeal and move its merchandise assortment away from categories that it thinks are not doing as well. The biggest thing that you've seen there is appliances. J.C. Penney is in the middle of rolling out appliance sales, refrigerators, dish washers, washers and dryers. They're going to put that into about half of their stores. They're really trying to steal market share from Sears in particular. They share a lot of mall space with Sears; Sears is downsizing, people aren't going to Sears anymore, but the appliance business has really been one of the hallmarks of Sears over the years.

J.C. Penney sees an opportunity to move into a new category that could drive a lot of sales. It's a category where sales have been rising, not falling, in the past few years. Even Macy's you've seen some tweaks. They put a few Best Buy branded consumer electronics shops into a handful of stores last fall; they haven't really talked about how that test went. It's not clear if they're going to try to roll it out more broadly this year, but they're definitely interested in bringing some new merchandise categories in to try to cushion themselves if apparel sales continues to decline.

Shen: Okay. Sorry, I just wanted to jump in there really quick, because there's two things you mentioned that really stood out to me. Of course, there's the e-commerce side. That's a theme or topic that we've touched on here on consumer goods Industry Focus quite a few times. Even last week, we were just talking about Wal-Mart making its transition, trying to pivot its strategy with its Jet.com acquisition for $3.3 billion. In this case, obviously, these department stores are still looking in that direction hoping to bleed some of their declining mall traffic, like you mentioned, things along those lines.

Also, the diversification is interesting to me. With TJX Companies, again, reporting some pretty strong numbers relative to the four core department store chains that we're talking about today. The fact is they are an off-price apparel retailer, but also they have a lot of home goods. Seeing J.C. Penney branching out with appliances and things beyond what might be considered their core apparel offering, and then Macy's having some of these Best Buy store-within-a-store concepts, and the fact that I think in the press release Macy's mentions that a lot of the proceeds from the store closings, the real estate sales, will be used to test the optimization of the extensive real estate and space that they have within their store. It's just really interesting to see that dynamic.

Closing out here, I wanted to give you a chance to wrap it up with any final thoughts, but also I'd love to get your opinion on who you think is the best positioned among these four, basically with the strongest prospects for maybe midterm or even long term, if you have a take on that?

Levine-Weinberg: Yeah, absolutely. Just to wrap up quickly, you're seeing sales declines in a lot of the department stores, with J.C. Penney being the lone outlier here. The way you're seeing them react is Macy's, as we said, is going to be closing a lot of stores. They're trying to focus on their top-performing stores and really reinvesting in the stores that are doing well, instead of trying to save the ones that have been going down the tubes. J.C. Penney is trying to add these new product categories, especially in the home department around appliances. They're also adding some flooring, new window treatment sections, furniture, etc.

Kohl's is probably making the fewest changes, they're trying to get some better brands in. One thing that we heard about recently was Kohl's struck a deal with Under Armor for their new leisure line. Kohl's has also updated its loyalty program to try to bring more customers in and get them to keep coming back, and it's also trying to catch up in digital. Lastly, Nordstrom is focusing on building out its off-price brand with Nordstrom Rack stores. It's also recently introduced an updated loyalty program. For the first time you don't need to have a Nordstrom credit card to participate in their loyalty program. I think this will bring in both a lot of new customers, make them more loyal, and also provide a lot of data that will help Nordstrom better understand its customers and buy them with targeted offers.

I think that of these four companies, in the long term, Nordstrom is going to be the best positioned. The Nordstrom Rack chain helps enormously, I think that's a business that's going to continue to grow for a very long time. They have toned back their expectations a bit. They had been saying up until recently that they were going to get to 300 stores by 2020, up from a little over 200 now. They're pushing that back a little bit. They said that they'll have a little fewer than 300 come by 2020, but I think that there will ultimately be a lot more store growth after that.

Aside from that, they have a really strong dot-com business in e-commerce, and they're still working their way through it philosophically, trying to figure out how it works with their in-store business. I do think they'll be able to improve their profitability there. This is a company that's really investing the most in itself, and I think that those investments will pay off over time. It's been a little slower than a lot of investors had hoped, but I think that some of their new store investments in Canada ... an upcoming new store they have in Manhattan, in the long term are going to be huge sales and earnings drivers for them. Right now, they're actually creating a bit of a drag on earnings. Over the next few years, as those investments start to mature, I think that you'll see better financial results coming out of Nordstrom, and that trend is sustainable for a long time.

Shen: Okay. Thank you very much, Adam! That's all the time we have for today, but I really appreciate you joining us. I really look forward to the fact that hopefully you can actually be in studio with me for some of the future Industry Focus episodes.

Levine-Weinberg: Yeah, that would be great.

Shen: All right. That's a wrap for us today, but you can continue the conversation via Twitter @MFIndustryFocus, or send us any questions via email to [email protected]. You can also enjoy the other great podcasts from The Motley Fool by checking out Fool.com/podcasts. People on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear on the program. Thanks for listening, and Fool on!