Department Stores: Finding Value in a Declining Sector
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Creative Destruction is elegant in theory but ugly and brutal in practice. Companies, Industries and Business Models / Strategies rise to prominence, and sometimes dominance, only to be supplanted. Change is constant, and there will always be losers.
The question that investors must ask themselves when considering the sector is this: do Sears Holdings (NASDAQ: SHLD) and J.C. Penney (NYSE: JCP) offer upside to savvy investors, or is the sector represented by these three bound for the dustbin of history?
Department Stores, especially those catering to middle and low-end consumers, are increasingly at odds with the needs of their customer base. With both median disposable income down and labor force participation down in the U.S. over the past several years, price and convenience are the key factors for an increasing number of U.S. consumers.
The department store model may once have offered advantages to consumers on both price and convenience, but today that advantage has at a minimum severely eroded, and is more likely non-existent. Big-box retailers, in particular Wal-Mart (NYSE: WMT) and Target (NYSE: TGT), with a broader assortment of goods (including groceries), and in many cases the ability to leverage superior purchasing power in order to offer lower costs to consumers, have shifted consumer shopping patterns by winning on the key factors of price and convenience.
Comparisons against the winners of big-box retail are tough:
- Wal-Mart: The law of large numbers may slow down growth, but in given market conditions of the past few years, and given the sheer nominal increase, Wal-Mart’s 9.5% increase in revenue from FY09 to FY11 is remarkable. The company succeeded in adding nearly $39 billion of sales in the period, and sacrificed only half a percentage point in gross margin (down to 25.0%, from 25.5%) in doing so.
- Target: Sales increased 6.9%, from $65.4 billion to $69.9 billion from FY09 to FY11. During this period gross margins did slip, from 32.6% to 31.5%, but this could be due to the company’s push to carry more fruits and vegetables.
Given these trends, a review of three of the largest mid-tier department store companies is instructive:
Sears Holdings came about through the combination of what may have been one of the better trades of the 2000’s and one of the worst operating strategies for a mature business in the past 20 years. Chairman Edward Lampert acquired a position in the subordinated debt of Kmart during that company’s bankruptcy. He was then able to convert that position into a majority ownership stake. At the time, Lampert was hailed as a Warren Buffett-esque figure, and Kmart was seen as a nascent platform akin to what Berkshire Hathaway (BRK) has become. Under Lampert’s leadership Kmart was aggressively selling real estate and looked to be positioning itself to sell even more. Then Lampert acquired Sears (the buyer in some of those real estate transactions), and the long slow nightmare of a financier running a retailer into the ground began.
- Sales Trends: Persistent negative sales growth is a considerable challenge for management. Sales are down nearly $1.8 billion (approximately 4.1%) over the past three years.
- Profitability: Management must take steps to halt the erosion in profitability. Gross margin pressure is also a matter of concern, with gross margins having declined by more than two percentage points, to 25.5% down from 27.6% two years earlier. Operating income has declined nearly $2.2 billion over three years.
- Cash Flow: Cash flow is horrendous, with operating cash flow having declined by approximately $1.8 billion over the past three years. A mature company such as this has no excuse for such cash flow characteristics, and more than anything else the decline in this fundamental measure highlights the underlying weakness of the company. Over the past three fiscal years, depreciation has outpaced capex by a cumulative $1.4 billion. This under-investment is leading to shoddy looking stores and is degrading the value of Sears Holdings for anyone else. The savings here do not justify the erosion of the consumer shopping experience.
- Thesis: Sears Holdings is a company struggling to find and execute a coherent strategy while wrestling with declining sales and weakening fundamentals. It is easy to see why this company has lost favor with investors. However, this company is very cheap, with a Price/Book of 1.5 and an Enterprise Value / Sales of 0.25, investors buying in have considerable downside protection.
- Recommendation: Hold your nose and buy, there should be 20-40% upside in this deep-value play for patient investors.
CEO Ron Johnson is pushing forward with an aggressive strategy to remake this century-old retailer. Johnson, widely regarded as a retail guru who oversaw Target’s retail push and then led the development of Apple Stores, is now in his first CEO role, and at a company with a considerably less affluent customer base. The trouble with Johnson’s approach is that this might very well be a case of the right strategy for the wrong customer. I expect to see Nordstrom (JWN) or a similarly up-market department store copy Johnson’s store within a store concept to considerable success.
Due to the recent appointment of Ron Johnson as CEO, and the company’s acknowledgement that this is a turnaround situation, looking at the past few years is not instructive. But the Q2 numbers were ugly.
- Sales: Same store sales were down 21.7% YoY, and internet sales were down 32.6%. True, the SSS number was brought down by the outlet business, but these are horrifying numbers. Particularly worrisome is the trend in internet sales. It is difficult to see how a turnaround of J.C. Penney can succeed without a strong web presence.
- Profitability: If sales are going to plummet due to a turnaround, investors should at least have the comfort of seeing profitability measures moving in a more promising direction. Not so here. Gross margins were down 5.1 percentage points from the year ago period (33.2% vs. 38.3%). Adjusting for management’s claim that 340 basis points of that reduction was due to markdowns still yields a Proforma gross margin decline of 1.7 percentage points, which seems particularly worrisome in the face of collapsing sales.
- Cash Flow: While down nearly 50% from two years ago, operating cash flow ($820 million for the last fiscal year) remains positive and substantial. The challenge will be maintaining discipline with dividends and share repurchases (the two combined for over $1 billion in the last fiscal year). Redemption of REIT units yielded $248 million in Q2, a one-time gain without which the YoY cash flow comparison would have been particularly ugly. Capex has outpaced depreciation over the past three years, but the store remodeling necessary for a company-wide implementation of Ron Johnson’s s store within a store concept will not be cheap. Although Q2 capex was down YoY ($132 million vs. $178 million), this number is undoubtedly heading higher.
- Thesis: This company is another deep value play. Like Sears Holdings, it is showing weak financial performance but it currently underpriced. With a Price/Book ratio of 1.5 and a Price/Sales ratio of 0.35, investors have considerable downside protection.
- Recommendation: Under current management this company is a value trap. It is cheap now, but I expect to see it get even cheaper. The components are there for a turnaround, but the strategy is wrong, and the implementation of Ron Johnson’s retail concept will prove to be a very expensive strategic cul-de-sac. Avoid long positions at the current price level.
Both Sears Holdings and J.C. Penney are troubled companies in a troubled sector. Neither is pursuing a strategy that seems well-suited to its situation, and fundamentals for both are poor. But there is value in both companies for investors willing to be patient and look beyond the short-term frustration to a longer-term payoff. There is nothing wrong with winning ugly, and that is exactly the prospect that both companies offer to savvy investors.
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