How American Companies Get Dividends Wrong

In this episode of Market Foolery, Chris Hill chats with Motley Fool analyst Brian Feroldi about some retail stocks making headlines today. They've got some rough reports and news about store closures and job cuts. They talk about how a Dividend Aristocrat retained its title and a major retailer posting strong year-on-year growth. Finally, they take some listeners' questions and much more.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.

This video was recorded on July 9, 2020.

Chris Hill: It's Thursday, July 9. Welcome to Market Foolery. I'm Chris Hill. With me today: the pride of Rhode Island, it's Brian Feroldi. Good to see you.

Brian Feroldi: Chris, it is awesome to be back.

Hill: We're going to dip into the Fool mailbag. We have a lot of retail to get to, including Costco (COST -0.55%). We're going to start with the stock of the day. And sometimes when I say stock of the day, that means really good things for what's happening with that stock; and sometimes it's what's happening today with Bed Bath & Beyond (BBBY), because first-quarter sales [laughs] for Bed Bath & Beyond fell nearly 50%. On yesterday's show, we talked about the number of store closings so far in 2020; we can add Bed Bath & Beyond to the list, because they're going to be closing 200 locations over the next few years; and they should, Brian.

Feroldi: Yes, they should. This was a pretty rough report; although to be fair, it was over March, April, and May, so it's kind of [laughs] hard for a retailer to report good results during that period, but it's hard to find, really, any good news in this report. Chris, as you noted, sales fell 49% to $1.3 billion; that's quite the drop. When you dig into that a little bit more, you see that store sales dropped 77%. On the plus side, digital sales actually grew 82%, and this actually blew me away. Digital sales of this company represent two-thirds of sales this quarter; that's far higher than I thought it was going to be, Chris.

Hill: Me as well. And we've been saying this for months with all kinds of retailers, you know, you look at the results for the quarter, not surprising to see digital sales skyrocketing to try and counterbalance the store closings. Unfortunately, that's not the case here with Bed Bath & Beyond. When you talk about, sort of like, where is the silver lining, if there is one, I think it's actually in the announcement of the store closings. Mark Tritton who really made his bones at Target as an executive vice president, Target's move into private-label brands, Tritton was the guy behind that. So there was a lot of enthusiasm at the end of 2019 when he took over this company. And he made some pretty swift moves in the C suite. He basically cut most of the executives. And it's clear that, for whatever was happening with the company today and the stock today, and it's down about 20% today, [laughs] Tritton is a guy who has a clear vision. He knows what he wants to accomplish. He cleaned house at the end of 2019. And they've got 950 Bed Bath & Beyond locations. They're going to be closing 200 of them over the next two years. Just on a percentage basis that's -- you know, we've seen retailers nibble around the edges with store closings before, and so, as someone who actually owns a few shares of Bed Bath & Beyond, like, that's the silver lining [laughs] to me, is that Tritton is doing with the store closings what he did with the executive ranks.

Feroldi: Yeah. He's pulling every lever that he can. And when you dig into the rest of the numbers for the quarter, it becomes pretty clear that he has to. So again, on the upside, digital sales grew pretty strongly, 82%, and represent two-thirds of sales. The trouble is, those digital orders are actually more costly to fulfill than fulfilling them in stores. So we actually saw gross margin decline 780 basis points, down to 26.7%. Now, that's quite the drop, considering that you would -- I would naturally assume that fulfilling orders online would be higher margin.

And to dig into more, that kind of trickled down to make some very ugly results in the bottom line. Net loss for the quarter was $300 million; that included $85 million in impairments and severance costs. If you pull those out, it's not as bad as it seems. But if you look at the free cash flow, the story actually gets worse. The company reported  negative $450 million in free cash flow for the period; and they funded those losses by piling on another $236 million in long-term debt. Now, you did bring up that they plan to close 200 stores in the next two years to save themselves somewhere between $250 million and $350 million annually, but let's put that in perspective: That doesn't even cover the loss of this quarter. So that's a whole lot of store closures that probably should have happened a long time ago. But, to me, there's no doubt that this company is in trouble.

Now, the CEO did state that they have over $1.1 billion in cash on their books, $850 million in asset-backed revolving credit lines, so that does give them almost $2 billion in liquidity. But this company still has $1.7 billion in long-term debt; a number that just went up. It's still losing money, and it's really losing relevance. So the CEO has a huge task ahead of him to turn this company around.

Hill: He does. And, you know, normally this quarter for Bed Bath & Beyond, for Target, for any number of large retailers, one of the things we would be talking about, as we look to the near future, is back-to-school. And in the case of Bed Bath & Beyond, it's like, oh, my goodness! All these kids [laughs] going off to college, they're going to go get new bedding, you know, all types of things for their dorm room, that sort of thing. They don't even have that. Like, [laughs] that's one more challenge thrown at Mark Tritton's feet in terms of the pandemic. So as you said, he's got his work cut out for him.

Feroldi: Chris, I'll throw one more at you there: How about wedding season? I don't know about you, but when I got married, one of the things we were forced to do is go to Bed Bath & Beyond with a scanner and go and create a whole bunch of different price points for people to buy us stuff. Not a lot of weddings happening these days, and definitely not in the traditional manner that they've been happening before. So another potential near-term headwind.

Hill: You were forced, like, your fiancée put a gun to your head, that's how you were forced?

Feroldi: It wasn't my fiancée; we'll just say that. [laughs]

Hill: Let's move on to Walgreens Boots Alliance (WBA -0.23%). The rough third-quarter results, a lot of this for the Boots division in the U.K. The stock is down about 8%. And, look, I know the pandemic is affecting all bricks-and-mortar retailers. [laughs] But you look at this business, and even before that, just go back 12 months, I mean, Walgreens has been steadily challenged, and the steadily declining stock price reflects that.

Feroldi: Yes. And, really, retailers, pharmacy retailers like this, have been hugely under pressure ever since Amazon announced a couple of years ago that it had taken an interest in the space. So that is really when Walgreens' troubles are really started in earnest. And you can say the exact same thing for CVS. But no surprise to see what happened here; they reported some pretty abysmal results. They did say that they are going to end their stock buybacks, that's definitely a good thing in the near term to husband some cash. They are cutting some jobs, specifically in their U.K. offices following the trouble that they're undergoing there.

But they do say that they're still going to be profitable for the full year on an adjusted basis, just nowhere near close to what they were predicting before. So as you said, Chris, this company had some troubles prior to this, and COVID-19 is just making things worse. In the long term, though, I think that Walgreens will probably be just fine as a company, whether or not it works out as an investment, different story.

Hill: They're cutting jobs, they are suspending buybacks; they are, however, increasing the dividend. And for anyone who wonders for the Dividend Aristocrats, and Walgreens is one of them, they've been increasing their dividend for more than 40 years in a row now, for anyone who ever wonders, boy! I wonder, once you get that Dividend Aristocrat title, how badly do you want to hold on to it? I would submit to you as evidence Walgreens in this quarter. That's how badly they want to hold on to this title, like, yes, we're a Dividend Aristocrat. I kind of get it, but if you're one of the people who is losing their job, you can't help but be even more bitter as you look at Walgreens making the capital allocation decision to raise their dividend, even the 2% that they're doing it.

Feroldi: And that just shows you, kind of, the problem with a lot of American companies: dividend policies. They set a fixed rate and then they, as you said, tend to increase it every single year, and they'll do almost anything to defend the dividend. This is why some companies, especially in European markets, have a dividend policy that's based on earnings. So the dividend fluctuates from quarter to quarter and year to year based on how the company is doing. That policy might make a little bit more sense in today's world.

Hill: It's not all bad news out there in the retail landscape, because if people are not shopping at Bed Bath & Beyond or Walgreens, in the month of June, they were shopping at Costco, because same-store sales for Costco were 11% higher than a year ago. And this is welcome relief for anyone who was stunned in April when Costco reported their first monthly same-store sales decline in over a decade. This helps those people [laughs] breathe a sigh of relief.

Feroldi: Yeah, I like to think that this report made Mac Greer and Ron Gross do a little happy dance somewhere. But to your point, yeah, same-store sales were up 11% in the month to $16.2 billion. Total companywide sales were up 11.5%. That's a very strong number given Costco's size. And if you break them down a little further, comps in the U.S. were up 11%, up 8% in Canada, and up 18% in international markets. E-commerce remains strong: 86% growth, although, off of a very small base. And, Chris, those numbers are even more impressive if you strip out the effects of gasoline, which is definitely down, and foreign exchange movements. And as you said, a sharp reversal or a sharp increase over May, when total companywide sales were up 5.4%; and April, when they were down 4.7%. So anybody that was calling Costco out in April, you got served some humble pie today, but no surprise to see this. Costco is a beast of a company; people love shopping there, and they could really continue to do so.

Hill: One programming note, David Henkes, one of, if not the best analysts in America when it comes to restaurants and the food service industry, David Henkes is going to be our guest on Motley Fool Money this weekend, so we'll have a deep-dive into restaurants there. Our email address is [email protected].

Question from Todd, who asked, "What role should options play in a buy-and-hold portfolio? I understand that you can generate income for retirement, but I'm interested more in your thoughts on how options are best used in a Foolish portfolio."

Feroldi: Well, let's just back up, so we're on the same page and just define what is an option. So an option is a financial derivative that gives the buyer the rights to buy or sell a stock at an agreed-upon price for a certain period of time. And there's two types of options. So there are call options, call options give the buyer the right to buy a stock at a set price. So let's say $100, you would have the option to buy that stock at $100 for a certain period of time. Usually a couple of months or even a couple of years. And then there's a put option, and the put option gives the buyer the right to sell a stock at a certain price for a certain period of time.

And one thing to keep in mind with options, Chris, is that they are derivatives that are leveraged. So every one contract that you have represents 100 shares [laughs] of the underlying stock. Now, if a stock trades for $10/share, that's not that big of a deal, but keep that in mind when you're thinking about trading options on Amazon, because one share of Amazon costs $3,000. So one option [laughs] on Amazon stock represents $300,000 in value.

Now, to answer this question, should they be a part of The Foolish portfolio? That depends on who you ask. We have certainly our resident option experts at The Fool, Jim Mueller, Jim Gillies, Jeff Fischer. They're all big believers in using options to supplement their buy-and-hold portfolio. And they mostly use them defensively as a way to generate income. So largely Foolish option users sell options, they sell calls, and they sell puts in order to buy stocks cheaper or sell stocks at a higher price to generate income in the short term.

So options are a tool, a financial tool like any other, and when used certain ways, they can actually be used to generate consistent income and reduce portfolio volatility. But when used incorrectly, they can greatly magnify risk. And I could tell you that, I've used options in the past, I no longer use them; they're a bit too complex for me, and I think you can generate just fine returns without them. But whether or not they're right for you totally depends on your specific situation.

Hill: Brian Feroldi, good talking to you; thanks for being here.

Feroldi: Always great being here, Chris.

Hill: As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear.

That's going to do it for this edition of Market Foolery. The show is mixed by Dan Boyd. I'm Chris Hill. Thanks for listening. We'll see you on Monday.