Recent quarterly numbers were not favorable for many retail department stores and Macy's (NYSE:M) was no exception. Its 3rd quarter earnings were expected to be bad, but came in worse than expected. Despite this significant setback, when compared to some of its retail competitors, Macy's seemed to be in a better position than most, and we're here to tell you why.

On today's episode of Industry Focus, The Motley Fool's Sean O'Reilly and Fool contributor Adam Levine-Weinberg take a closer look at the history of Macy's performance in the retail market and how the company's upcoming marketing strategies may help to give it the boost it needs to stand on solid ground again.

A full transcript follows the video.

 

Sean O'Reilly: We're going shopping for consumer goods dividends ... on this CG edition of Industry Focus.

Greetings Fools, I am Sean O'Reilly here in studio at Fool headquarters in Alexandria Virginia. It is Tuesday, November 17th and this week is dividend week on Industry Focus. Vincent Shen is out today and filling in for him and joining us on the phone from the windy city Chicago, Illinois, is Motley Fool contributor Adam Levine-Weinberg.

Morning, Adam and how's it going?

Adam Levine-Weinberg: I'm doing well, how are you Sean?

O'Reilly: Not too shabby. I've got my coffee, got my water, ready to talk some dividends, it's all good.

Levine-Weinberg: That sounds great.

O'Reilly: So Adam I talked to you a few days ago about today's show, and once again thanks for filling in for Vince. And you're willing to dive right into the carnage of the retail sector for some reason I'll never understand.

You picked Macy's for a great consumer sector dividend stock, which I happen to agree with and we'll get into the reasons why in a few. Before we get into the new gritty of Macy's as an income stock, can you just give listeners some perspective as to what's been going on in the retail sector? Because last week alone was a bloodbath.

Levine-Weinberg: Yeah that's right, Sean. Retail stocks really got hit hard last week and Macy's was definitely one of the big reasons for that. Macy's stock peaked in mid-July at $73.61. But since then it's fallen by nearly 50% and as of this morning it's below $39.

So a lot of that drop has happened in just the last week or two after its Q3 earnings; which were already expected to be pretty bad, were even worse than that. And the company is seeing strong, big sales declines. But the result of this is that the quarterly dividend is still $0.36 and so the annual yield which in the middle of July was a little under 2%, is now 3.7%. And that really makes Macy's an intriguing stock at least for dividend investors.

O'Reilly: Yeah that is just crazy. Because that's more than a 30-year treasury right now. I mean these are higher than bonds in the U.S. Government. So what's going on with the business?

Because you and I did a, you were very gracious enough to call in a number of months ago and we talked about Macy's then as well. And we both, I think were, I mean their returns on equity, their shift to doing the online and the stores, it was all just awesome. They were clearly the strongest player especially compared to a JCPenney or a Sears. What's going on with the fundamentals? Because long-term I think the story's intact.

Levine-Weinberg: Yeah so obviously you wouldn't want to invest in Macy's just because of the high dividend yields if you really thought that the business was in grave danger. Because sooner or later if you're not making money, have to cut the dividends and then as income year after year.

O'Reilly: Then game over.

Levine-Weinberg: You're out in the cold. There's no guarantees to dividend. The company can stop it at any time.

Though looking at Macy's, last quarter their comparable store sales, so that's sales in stores that have been open for at least a year, declined 3.6% from the prior year quarter. And Macy's is expecting another decline on comparable sales for about 2% across the full year.

So that's definitely not good and Macy's has definitely seen a trend in the past 2 to 3 years of slowing comparable store sales gains. But this is the first time in quite a while, really since the Great Recession that you've had a year-long [...] decline in comp sales.

On a year-to-date basis, Macy's EPS is $1.56 or $1.76 excluding some asset impairments and that's down year over year. Last year it was $2 and a penny. And Macy's current guidance fiscal year implies that you'll see that some of its decline continued into the 4th quarter. Again excluding any gain from asset sales or special items. But you have to put this in the broader context because Macy's has come out of a six-year streak of double-digit EPS growth.

So it's not like this is a company like you mentioned, Sears, JCPenney, where there's been a lot of struggle. There, a few bad quarters could be a really bad sign. For Macy's, the company's basically been doing well until this year. And so it's worth looking [...] to see why it's not doing well in 2015 and whether it might be able to recover.

O'Reilly: Yeah, so they've got this shift to where they're trying to meet consumers in cyberspace as well. I mean, they built that huge distribution facility which as I understand it and I've talked about it before, they built it in Oklahoma and I'm pretty darn sure it rivals an Amazon warehouse. Like it's top of the line, it cost them $3-4 million and it was it. Is online sales balancing these declines in physical stores at all?

Levine-Weinberg: So Macy's a couple of years ago stopped reporting its online sales separately. And it had for a long time just reported the gross numbers for online sales without necessarily breaking out the exact dollar amounts. But as of a few years ago they were already at $2 billion and rising by at least 20% a year. And a in a lot of years they're rising like 40%. So they're actually growing their online business faster than Amazon for quite some time.

O'Reilly: That's an achievement in itself I would think.

Levine-Weinberg: Yeah, and so that's definitely a big business for them. But it's still smaller than the retail stores and the comp sales figures that I was discussing earlier, that actually includes the online.

So you can, that's if the online is still growing at a healthy clip and if the retail is declining even faster. And so that's creating some need to kind of rebalance and figure out a new strategy to get the most value out of the stores that are in the network right now.

O'Reilly: So comps are dropping, they're projecting decline in earnings for this year. What are they doing to recover?

Levine-Weinberg: So Macy's is basically going after this with a multi-prong strategy. So the first thing is they're trying to explore some new growth avenues beyond the traditional department store and even beyond the online component of its traditional department store business. So one thing that they're doing is they bought the Bluemercury chain which is sort of luxury fashion or beauty stores. More boutique size. So quite small compared to a department store.

And they are building more of those stand-alone Bluemercury stores and at the same time they're putting Bluemercury boutiques into existing Macy's department stores to make better use of space and to boost sales in the beauty department of each Macy's store. They're also testing Macy's Backstage which is a new off-price concept. So it's like a T.J. Maxx or a Nordstrom Rack.

O'Reilly: I was about to say that's reminiscent of Nordstrom's Nordstrom Rack and that's been a huge success.

Levine-Weinberg: Yeah and Macy's has already been in that business to some extent because they also own the Bloomingdale's chain which is upscale relative to Macy's. And Bloomingdale's has a chain of outlet stores. So Macy's is trying to sort of move that more into the mass-market now. And it's just a test at the moment, but they are really talking about rolling that out more broadly over the next few years.

And Macy's is even testing an e-commerce joint venture in China. So they have a bunch of different things that they're trying which will hopefully add more growth. At the same time they also need to focus on getting costs down to be more in line with the sales they're seeing today.

So the company announced last week as part of its earnings report that they're cutting their SG&A spending by about a half billion dollars relative to their prior plan. And that will be implemented by 2018. So you'll see incremental improvements in their selling cost over the next few years. As part of that they're closing 35-40 stores in early 2016 and plan to continue closing stores that are underperforming.

O'Reilly: Now those are essentially, sorry to interrupt, low traffic, unprofitable stores obviously not the big ones in urban areas.

Levine-Weinberg: Right. That's true for the most part. There are some stores in urban areas where they're closing the store not because it's unprofitable, but because the real estate is so valuable that they can make more money by selling the building to someone who wants to redevelop it. But in most cases yeah, the stores that are closing are the ones that are in the lower performing malls where there's just less traffic.

Maybe these are malls where JCPenney's or Sears had a store which closed and so now there's fewer people coming to the mall. And you know there's been a problem in the U.S. for quite some time that there's just too many malls relative to how many people want to go to the mall these days. And so this is just a process that's going to continue for a while with paring down to a number of stores that's more in line with today's reality, where you don't actually need to go to the store for every single purchase. Some things you might just want to buy online.

O'Reilly: Got it. Well before we move on, no go ahead.

Levine-Weinberg: Go ahead.

O'Reilly: Sorry, yeah. Before we move on in going along with this week's income focus theme, I wanted to point our listeners to a special article written by five industry focus contributors detailing their top picks for dividend stocks. Just head to Dividends.Fool.com to learn our picks for the best dividend stocks of 2016. Once again that's Dividends.Fool.com.

So Adam, getting back to Macy's, I was talking a little bit about the dividend sustainability in the context of the cost cuts and everything, and actually their growth potential. Because if they aren't growing that dividend will not last for long.

Levine-Weinberg: Sure. So if you look at the annual payout, it's now $1.44. And that's up from just $0.20 during the Great Recession. So you can see that Macy's really has been increasing its dividends quite rapidly in the past few years. So $1.44 is about 40% of Macy's projected EPS for this year excluding any asset sale gains or special items. So that's a pretty good payout ratio.

It means that you're getting a good proportion of the income but it's not so high that you'd have to worry that a small blip in earnings would make the dividend too high to afford for Macy's.

On a cash basis Macy's has generated operating cash flow of about $2.2 billion over the past 12 months. And the current dividend payout comes to roughly $450 million annually. So this means that Macy's has really plenty of cash to cover its planned capital expenditures which it's reducing to under $1 billion a year going forward. And still have a lot of money left over for dividends and also for some share buybacks.

And just like if it were able to get its profit margins back to last year's model, see who could boost its cash flow, because if you look at its operating cash flow which is $2.2 billion in the past 12 months just a year ago it was $2.7 billion. So there's definitely some opportunity just in doing the retail basis a little bit better. And Macy's is also likely to bring in a lot of cash from selling off real estate. Either real estate in stores where it doesn't want to operate a store anymore, or in some cases it could be really large stores in urban areas like New York, Chicago, and San Francisco where the stores are so massive that you could sell off the upper floors of those stores, bring in a lot of money, and still keep most of the sales because you'd have a lot of space left.

So Macy's is actually working with a real estate company to identify potential deals, both for these flagship stores in those three cities I mentioned, as well as a few other stores. And while those proceeds might get distributed through buybacks rather than dividends, the faster Macy's can reduce its share count the less it has to pay out in dividends for any given dividend rate. Which means it can basically raise its payout faster.

O'Reilly: Yeah, on a per share basis. Yeah.

Levine-Weinberg: Yeah, exactly.

O'Reilly: So for Foolish investors you've made a lot of great points. What's the bottom line, the conclusion that Foolish investors or just our listeners can go to check out, do their own research, but that you want them to know?

Levine-Weinberg: Yeah so I think the main take away here is that Macy's has suddenly become a high-yielding stock with a 3.7% dividend yield. And the payout ratio remains quite modest. And beyond that Macy's profitability should improve going forward due to its cost cuts, attempts to sell off real estate, and that leaves a lot of room for dividend growth in the future.

O'Reilly: Awesome. Well, thank you for your thoughts and I can't thank you enough again for filling in for Vince, Adam.

Levine-Weinberg: You're very welcome.

O'Reilly: Have a great day. That is it for us Fools. If you are a loyal listener and have questions or comments we would love to hear from you. Just email us at IndustryFocus@Fool.com. Again that's IndustryFocus@Fool.com.

As always people in this program may have interests in the stocks they talk about and the Motley Fool may have formal recommendations for or against those stocks. So don't buy or sell anything based solely on what you hear. For Adam Levine-Weinberg, I am Sean O'Reilly. Thanks for listening and Fool on! 

Adam Levine-Weinberg owns shares of Nordstrom. Sean O'Reilly has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Amazon.com. The Motley Fool recommends Nordstrom. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.