As investors work to identify the winners and losers of the recent tax bill, it's clear that one of the biggest beneficiaries of the new corporate tax rate will be the retail sector.
In this episode of Industry Focus: Consumer Goods, Vincent Shen recruits senior Motley Fool contributor Adam Levine-Weinberg to break down why the news is so good for retailers and its likely effect on companies, including TJX Companies (NYSE:TJX), Target (NYSE:TGT), and Macy's (NYSE:M).
The hosts also look at Bon-Ton's (NASDAQ:BONT) recent bankruptcy filing and its grim prospects even if management is able to avoid a liquidation.
A full transcript follows the video.
This video was recorded on Feb. 13, 2018.
Vincent Shen: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Tuesday, Feb. 13th, and I'm your host, Vincent Shen. Joining me via Skype for today's show is senior Fool.com contributor, Adam Levine-Weinberg. Hey, Adam! Thanks for being here!
Adam Levine-Weinberg: Thanks for having me on the show! Always great to be here!
Shen: You've been busy on a few different segments for Industry Focus lately.
Levine-Weinberg: Yeah, this is my fourth of 2018.
Shen: Very nice. I'm glad that you're here with us. Fools, today we're going to start our discussion with news that broke earlier this month, before turning our attention to the new tax plan and the implications it has for some of our favorite retailers.
First up, we're going to spend a couple of minutes talking about the major retail bankruptcy, the first one of 2018, and that's for Bon-Ton Stores. They have over 250 store locations spread across 26 states. Bon-Ton is one of the larger regional department store chains in the U.S. The company filed for Chapter 11 protection on Feb. 4th.
Adam, when we actually covered department stores and their holiday results last month, you spoke briefly about Bon-Ton and how this outcome seemed pretty much inevitable at that point. How did Bon-Ton end up in this position?
Levine-Weinberg: From a high-level perspective, Bon-Ton's historical strength was being in these rural markets, primarily smaller towns where there wasn't a lot of competition, and there weren't a lot of options for consumers to get high-quality, branded department store goods. This was great until the internet came about. All of the sudden, after you had Amazon in particular moving into the fashion market, now people can get the same kinds of goods that they had to go to Bon-Ton for previously. Now, they can get the same thing at a lower price, at least a more competitive price, from Amazon and from the retail websites of companies like Macy's. That's the big picture of what has happened.
Bon-Ton is a lot smaller than most of its competitors, it has about $2.5 billion annual revenue. That makes it about a tenth of the size of Macy's, for example. And it just hasn't been profitable in many, many years at this point. A lot of people have talked about, "Oh, it had to file for bankruptcy, because it had too much debt." And it's true that it does have too much debt. It has roughly $1 billion of debt as of November. And for a company with $2.5 billion of sales, that's a pretty tough burden. That said, the reason why the debt piled up was because it couldn't pay the bills in the first place and had to borrow year after year. So the underlying cause of the bankruptcy is just that Bon-Ton is not profitable. They've been putting together annual losses of about $60 million in 2015 and 2016 -- 2017 hasn't been reported yet but it was probably even worse. Comp sales declined about 6% for the full year. Because the primary issue here is unprofitability as opposed to high debt, it's hard to see how Chapter 11 can really fix things.
Bon-Ton has already taken a hatchet to its cost structure. It's going to close some more stores, some of which aren't profitable. But given that the company has been losing so much money up until now, it's hard to see how, even with less debt, it's going to be a sustainable company. It has less than half of the online sales penetration of its larger rivals. And it's not that surprising. Bon-Ton, last year, planned to invest about $30 million in capital spending. Macy's plan was for about $900 million in capital spending. So Macy's has more money to invest in its stores, more money to invest in its e-commerce operations to try to keep up, at least somewhat, with Amazon. Bon-Ton is running on a shoestring budget, and it's really hard to see how a Chapter 11 restructuring would do anything more than string out the pain for another few years. A lot of Bon-Ton's creditors just want the company to liquidate. The company is fighting back. So we'll just have to see what happens. But the chances for long-term survival definitely don't look good.
Shen: Sure. Thanks, Adam. I'll add that, even for this most recent holiday shopping season, a pretty strong one for retailers across the board. In that episode from mid-January where you and I talked about the holiday results for a lot of department stores, in November to December, revenue for Bon-Ton was down about 4% year over year, while others were seeing pretty strong gains. And before this bankruptcy news even, you mentioned some store closures, the company had already announced plans to close over 40 stores. I'm on the same page as you in terms of the company's prospects. Even with a potential reorganization, it's looking rather grim. With that in mind, I'll ask you this: Are there any competing department stores or retailers that you think might stand to benefit the most from these store closures and what might fall out with the bankruptcy filing?
Levine-Weinberg: I think the biggest beneficiary is most likely to be Kohl's (NYSE:KSS). Kohl's has the broadest retail footprint among the department stores, because it has smaller stores than a chain like Macy's, for example, and it tends to have strip mall and stand-alone stores as opposed to being in malls. Kohl's has a bigger presence in the smaller markets where Bon-Ton has a stronger presence as well, so that definitely puts it in a good position to win some of that business. I think Macy's will also get some, but there's relatively limited overlap at this point in terms of malls where there's both a Macy's store and one of Bon-Ton's retail chains. So there's definitely some upside there for Macy's, definitely a little more upside on the e-commerce side, potentially, for Macy's. But in e-commerce, you're fighting with everybody, so it's kind of a jump ball. And given the way things are going, you'd expect Amazon to come up with a big chunk of that revenue.
So I would say that the most interesting thing that we're going to have to see about is whether any competitor tries to scoop up part or all of the company in a bankruptcy sale. You could imagine, even if Bon-Ton as a whole isn't profitable, you could plug in certain stores into a different company. And those particular locations actually might be pretty good department stores still. So we'll just have to see if anybody is willing to take that risk and try to integrate some of Bon-Ton's stores into their own store portfolios.
Shen: Alright, let's move on, then, to our main topic for today. Fools, Adam originally approached me last month, and he pitched the idea of covering the new tax plan, specifically the changes to the corporate tax rate. For the major retailers that we often discuss here on the show, the sector has been cited by many publications and analysts as a space that will benefit more than others from the new tax rate. Adam, since you pitched the idea to me from the get-go, I'll let you take it away. Can you give our listeners a rundown of some of the reforms that went into effect last month, and also why there is an outsized impact for retailers?
Levine-Weinberg: Absolutely. The big headline of the corporate tax reform that went into effect at the beginning of 2018 is that the statutory federal tax rate, so the base tax rate, was reduced from 35% previously to 21% going forward. That's a pretty significant decline there. However, a lot of companies weren't actually paying a 35% effective tax rate. There's a whole host of tax credits that existed under the previous tax law, and some of those still exist.
Companies that have a lot of international sales and earnings have been able previously to shelter that money by keeping it overseas and reinvesting it there. That's why you've seen companies like Apple keep so much cash abroad. So some tech firms have had very low effective tax rates in the past. By contrast, retailers really haven't been able to take advantage of any of these tax benefits under the old law. If you look at most retailers, they're very heavily concentrated in the U.S. for sales and especially for their earnings, and they don't have many tax breaks, so they're paying effective tax rates, when you include state taxes as well, of 37% and 38%. Those are typical numbers there.
Shen: I'll jump in there with some examples. You combine the fact that retailers, most of their operations are based in the U.S., so they generate the bulk of their revenue here, with that income being largely subject to the higher U.S. tax rates. And also, they just don't get access to as many of those tax credits and deductions that you mentioned, Adam. I have some specific examples that generally highlight what we've described so far. These are the effective rates for some of the bigger retailers out there.
Starting with Wal-Mart, they generate about 70% or so of their revenue in the U.S. Their effective tax rate for the trailing 12-month period came out to 31.8%. Its rival, Target, they note in their 10-K that virtually all of their revenue is generated within the United States. Its effective tax rate was 31%. And then, for the department stores, Nordstrom, Macy's and Kohl's are also all predominantly U.S.-based businesses, and their effective tax rates all came out in the range of 36% to 40%. Even TJX Companies, which has Canadian and international segments that they break out that account for about 25% of sales, that company is still reporting an effective rate of 37.2%.
So you compare those rates that I just mentioned with the broad U.S. effective tax rate from the Congressional Budget Office, that came out to 18.6%. So you can see that retailers are, indeed, paying higher rates, and thus in a position to benefit from this new tax plan. With some of those broader details in mind, Adam, I know you wanted to focus on how different companies might take advantage of their cost savings specifically. What did you have in mind?
Levine-Weinberg: I basically would group it into, there's two different categories here of retailers that will do well. The first are retailers that have very high cash flow already relative to their market cap. And then the other would be retailers that have relatively high capital spending budgets. We'll go through both of those in order.
On the cash flow side, when you look at retailers that have low price to free cash flow ratios, basically the tax cuts made a lot of these stocks, which were already pretty cheap, even cheaper. The typical benefit for a company that was paying a 37% to 39% effective tax rate previously, the benefit of moving to this new tax structure is probably worth about 20% more earnings per share on an after-tax basis. So even if their pre-tax earnings stay exactly the same in 2018 compared to 2017, you're going to see really strong earnings growth. So a company that might have been trading for 10x earnings before is now at something like 8x earnings. That makes these cheap stocks even cheaper. And to the extent that they haven't yet corrected, there's definitely some upside for investors there. And I would put a lot of department store companies into that category.
On top of the valuation aspect, companies with a high free cash flow are now going to have extra firepower because of the lower tax bill, to pay more dividends, to buy back more stock, or to reduce their debt. So Kohl's is a really great example of this. As we talked about on our last show last month, Kohl's reported 6.9% comp sales growth during the holiday period, which was its strongest result in over a decade. It's already doing really well -- it's already making the investments that are necessary to transform the business. The extra cash that it's now going to bring in from paying a lower tax rate, there's not much that it should do with it other than start returning it to shareholders. So I think you could see either a nice dividend increase this year or higher share buybacks, or potentially both.
Shen: And I just wanted to quantify the potential windfall that Kohl's will enjoy. Assuming its effective tax rate falls from 37%, which was the latest I could find for the trailing 12-month period, to about 23%, that's an additional $144 million in earnings that can potentially flow to the bottom line, so it's pretty significant, as you mentioned, in terms of giving them that additional firepower to, for example, pay dividends or buy back stock.
And if we categorize that as the more shareholder-focused benefits of the new tax rate, I think there's also, the other category you mentioned, in terms of the spending, the capital spending. With the traditional brick-and-mortar retail space, there's a lot of trends that are changing the sector, whether it's omnichannel, new store formats, experiential retail, among others. So for the companies that end up putting the savings back into their businesses and operations, what does that potentially look like?
Levine-Weinberg: There's an extra benefit for companies that want to reinvest the tax law savings. One of the interesting things in this tax law is, it implements a temporary cut in the cash tax rate for companies that are investing in the business. Instead of having to depreciate investments over a period of, it could be five, 10, or even 20 years, between now and 2022, companies will be allowed to expense 100% of their capital spending, which means that they can write it off all in the first year. That's an immediate tax deduction for them. That creates a lot of additional cash flow, because theoretically, a company that's reinvesting all of its cash flow could actually pay no taxes, even if it's posting pretty high profits, because it's getting all of these write-offs from its capital spending.
Among the retailers we've been looking at, none of them are investing quite that heavily, but there are definitely some that are putting more money into the business right now. TJX, which is the parent company that runs the popular TJ Maxx and Marshalls and HomeGoods chains in the U.S., that's definitely a company that's been spending at a pretty high rate to expand. It's adding square footage of about 5% a year in recent years. It could potentially even speed up its expansion even more going forward. Just in the past few years, it started to test out some new store formats for the United States to potentially give it even greater growth opportunities.
The first one that came about was Sierra Trading Post, which was a mainly online off-price retailer that it had acquired a few years ago, and it started opening some Sierra Trading Post retail stores. It's learned a lot from that. It seems to be figuring out how to make those work. And now it's started to ramp up that expansion. With the new tax law benefits, it's possible you'll see that expansion move even faster. A second area where it's experimenting is in the home market, because the HomeGoods chain has been by far the most successful in terms of comp sales growth and total sales growth in recent years. Now, TJX is testing a second home store format called HomeSense in the United States. It sees that as a way to tap into some different segments of that home market and further expand its growth. The idea is that, kind of like TJ Maxx and Marshalls have some overlap but also some differences, by offering two different home store concepts, TJX could significantly expand its long-term growth potential.
Those are two areas where you could definitely see TJX ramping up investment because of the benefits of this tax law. Then, aside from that, TJX will have more cash flow that it can return to shareholders. It's been raising its dividend at a pretty healthy rate in recent years, and it's also been buying back a lot of stock, so I'd expect to see more of the same in 2018 and beyond.
Shen: Another company that you pointed out before the show, too, that has announced recently some pretty big plans to up their spending, try and claim more market share, do some store remodeling, things along those lines, is Target. How much of a beneficiary do you think the company could be from these new rules that we've talked about so far?
Levine-Weinberg: Target isn't growing as quickly as TJX, but it is opening up some more small-format stores in the United States. This is its best way now to penetrate the markets it hasn't been able to get into up until now. Beyond that, it's investing really heavily in remodeling the stores, improving its technology and fulfillment so that it can capture a bigger share of online stores.
Really, if you look at the last 10 years of Target, the company made two really, really big mistakes that have held it back from its full potential. The first was, it got caught up in trying to expand into Canada, and that was just a complete disaster. It had to write off billions of dollars when it pulled out. And that also obviously diverted a lot of management attention. The second one was, years and years ago, it outsourced all of its e-commerce to Amazon, which gave Amazon a huge amount of data and meant that Amazon could run Target's business to not compete very much with Amazon's online business.
So Target has taken control of its own e-commerce operations again, but it still has a long way to go to improve its ability to serve that e-commerce market and try to gain some market share there, because right now, it's growing quickly but still quite small compared to the total company. So those are definitely areas where Target needs to invest, so the tax law is really convenient, because it will reduce the pain from those investments by creating some offsetting tax breaks.
Shen: I'm looking at Target's income statement here, and it's interesting. The tax savings, again, with the reduced rate for this company, the savings could come out to about half a billion dollars. If we keep in mind that, this time last year, that was when management announced they'd be doing the big push on their investment, spending $7 billion to gain market share, to develop that e-commerce platform, like you mentioned. So those investments, they said, would be spread out over three years. That's about $2.3 billion per year. If these recent tax savings come out to over half a billion dollars, they can make up almost a quarter of the annual spending that the company has planned, so pretty significant.
Our last part of the discussion, I want to focus on one last company that could really change over the next few years given some unique aspects of its asset base and the long-term vision that management seems to be pursuing for the company. How did the cards fall, then, as a result of the tax reform for Macy's?
Levine-Weinberg: Macy's is definitely a unique case here, and it could be, possibly, the biggest beneficiary in the retail sector from this change in the tax law. Similar to Kohl's, Macy's stock trades at a very low price to free cash flow ratio. In a scenario where nothing really major changes, you're going to have more cash flow, which Macy's can use to pay down debt, continue paying its really high dividend -- it has one of the highest dividend yields out there right now -- and it can also eventually, maybe later in 2018 or if not, in 2019, it could start buying back stock again. In the past year or so, it's been focusing on paying down debt rather than trying to buy back stock.
But outside of its core retail business, Macy's has also been starting to sell excess real estate. And the idea is, Macy's, over its more than 100-year history, has built stores all over the country. And some of them are actually in extremely valuable locations. And some of those stores, while they're profitable, they're not really making enough money to pay for the opportunity cost of what the real estate would be worth if it were to be sold. So sometimes, that's because the Macy's store is in a really great mall, where the mall owner wants to redevelop that Macy's store to put in luxury stores or restaurants or entertainment spaces that can generate higher rents. In other cases, Macy's has these downtown stores in really hot real estate markets like New York, San Francisco, even Chicago might fit into that.
The problem for Macy's is, when it sells these assets, if it's built a store 50 years ago or even 100 years ago, it built that store at a much lower cost than what the sale price would be. So every time it sells one of these stores to another investor, it has to pay a pretty big tax bill because of that asset sale gain. So with a high corporate tax rate where the taxes might take up 40% of the sale price, or close to that, it definitely would give Macy's pause as to whether it should sell the store or keep operating it, because obviously, the longer you operate the store, you're just paying taxes as you go, as opposed to paying a giant tax bill all at once. With this tax reform bill, now you have a lower rate, so that might encourage Macy's to start selling off properties at a faster rate, because now there's a lower tax penalty to doing that. And it's actually particularly good timing, because Macy's, as I mentioned, has been ramping up this strategy. They have a strategic partnership with Brookfield Asset Management, a huge firm in private equity and real estate management that's looking into several dozen Macy's store sites and ways to either redevelop the store or do additional real estate development on the parking lots or things of that nature. So that's definitely a project that could lead to substantial proceeds for Macy's.
Beyond that, it's looking into ways to monetize the upper floors of its humongous stores, both in Chicago and New York. So as these projects eventually turn into deals that bring in cash for Macy's, now it's not going to be paying as much tax, so it may have an incentive to speed up this movement. And that's pretty important, because most people who have analyzed this think that Macy's real estate is worth more than the entire company's valuation right now. So being able to sell off that real estate, bring in cash, pay down debt, and return cash to shareholders, could be really transformative for Macy's share price performance.
Shen: Absolutely. It sounds like, when it comes down to it, this tax change becomes another incentive for the company to right-size the store footprint, think of other uses for that valuable real estate. And just like a bunch of competitors have done recently with all the store closures that we've discussed in 2017 alone, that's going to be a push from the industry overall.
Final comments from me, I wanted to mention a couple of other potential benefits that we haven't covered yet today. First, there have also been some calls for companies to use their tax savings to increase wages and benefits for workers. In retail, Wal-Mart announced raises to hourly pay, in addition to one-time bonuses for its employees. Home Depot and Starbucks also made pretty similar moves, and that's a trend I hope to see across the industry, because employee turnover for retail positions is notoriously high, and better pay for workers often leads to better service. So the more companies experiment with things like e-commerce, in-store pickup, stores as fulfillment centers, these various initiatives that have come up in the past few years, the more they will end up leaning on their employees to adapt and execute well so that these initiatives are successful.
If we look at Amazon as this industry's boogeyman, so to speak, I think a lot of companies could take a cue from Amazon, considering how often it leads, for example, customer satisfaction surveys. With good service being closely tied with convenience, and convenience often being the differentiating factor for a lot of consumers, hopefully investments in higher pay for workers, higher wages, that could prove to be a worthwhile investment for a lot of companies in the sector.
And then, for consumers themselves, I've seen analysts generally agree that in the near-term, U.S. families will see higher take-home pay thanks to the tax bill. Consumer confidence is already really high, but you can bet that retailers are hoping to claim a chunk of that extra discretionary spending. Where that spending ultimately goes, whether that's to tangible goods that would benefit department stores, for example, or to experiences, whether that's electronics or smartphones, or clothing, we'll see. But I wanted to leave a minute here for you, Adam. Any final thoughts on your end before we wrap?
Levine-Weinberg: I would just echo the last thing you said. It's going to be very interesting over the next six months to a year to see how the individual component of the tax reform bill impacts spending at a lot of these retailers. It's definitely been a pretty weak market recently for apparel retail. It's a question of whether, if people now have a little more discretionary income, do you see, finally, an uptick in retail sales growth? And who's going to capture most of that incremental revenue? Because this retail sales model, the change in profit from a relatively small increase in sales growth is pretty significant. So that could have a pretty big impact on one or more of these retailers. We'll just have to see how it works out.
Shen: Alright. I'm sure we'll follow up on that, Adam. Thank you for joining us!
Levine-Weinberg: Thanks for having me on the show!
Shen: Thanks for listening, Fools! Anne Henry today is our woman behind the glass. 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 during the program. Fool on!
John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Adam Levine-Weinberg owns shares of Apple, Kohl's, Macy's, Nordstrom, and The TJX Companies and has the following options: short February 2018 $160 calls on Apple. Vincent Shen has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Amazon, Apple, and Starbucks. The Motley Fool has the following options: long January 2020 $150 calls on Apple, short January 2020 $155 calls on Apple, short May 2018 $175 calls on Home Depot, and long January 2020 $110 calls on Home Depot. The Motley Fool recommends Home Depot, Nordstrom, and The TJX Companies. The Motley Fool has a disclosure policy.