Why You Should Sell J.C.Penney and Buy Macy's, Kohl's
David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
As the political season gets hot towards the November presidential election, we can expect increasing commentary on jobs, jobs, and jobs. This focus will cause stronger speculation in the retail sector, which is arguably the most direct beneficiary of lower unemployment. Should a demand-side stimulus package or tax cut initiative receive support from both houses of Congress, the resulting increase in consumer expenditures will give firms like JCPenney (NYSE: JCP), Macy's (NYSE: M), and Kohl's (NYSE: KSS) a nice boost. Even still, I recommend only buying shares in Macy's and Kohl's given J.C. Penney's struggling business model.
J.C. Penney is currently rated a "hold" on the Street, which is fairly reserved. Perhaps more importantly, all but one of the last 17 revisions to EPS estimates have gone down for a net change -48.4%. EPS is expected to go down to $0.64 and takeoff thereafter, hitting $2.69 by 2015. In my view, this is an aggressive assumption and will cause shares to underperform when expectations are not met.
Indeed, the company reported a lousy second quarter with a 21.7% decline in the top-line - 430 bps more than what analysts forecasted. eCommerce - which is supposed to be a major catalyst towards margins - collapsed 32.6% to $220M. Earnings for the quarter ending June 30, 2012 was -$0.37, or 54.2% below consensus. Despite the disappointment, CEO Ron Johnson explained that the company will continue its strategy of offering "everyday low prices" and monthly specials.
What concerns me most about J.C. Penney is that they appear to be in that stage where they are acting more out of desperation than building off of fundamentals. Discounts have begun to get so ridiculous at retail stores that many consumers, ironically, have discounted them. 50% off this, 50% off that, Buy 1 Get 2 Free. Worse yet, some consumers are starting to get the sense that the pricing is actually misleading… Ever felt that the 50% off was applied after they marked the price up 2x? I know I have. In the end, this effort is nothing special in retail and comes across as an effort to get the market's attention.
While JCPenney may be attractive in three years's time, why wait when the upside from a full recovery will already be felt at peers? Macy's is an attractive pick to capitalize on strong momentum. The company has beaten expectations solidly over the last five quarters. 2Q12 EPS of $0.67 was 4.7% above consensus and followed a 7.5% beat in the preceding quarter. Free cash flow generation, on the other hand, has not been so favorable. FCF for the TTM ending 2Q12 was $1.6 billion. This compares to $1.4 billion in reference to 2Q11 and 2Q10. While it's up substantially from $1.1 billion in 2Q09, it's less than the recessionary 2Q08.
On a more value-related note, the company is still cheap. It trades at only 12.1x past earnings versus a 13.7x historical 5-year average. Assuming the company grows EPS annually by 10.9% as expected, 2016 EPS will come out to $5.17. At a 13.7x multiple, that translates to a future stock value of $70.82. Discounting backwards by 10% yields a present value of $43.97. Thus, while Macy's does not offer the most attractive margin of safety, it has meaningful growth potential and room for margin expansion.
Note that Kohl's is even cheaper than Macy's at 12x past earnings and 9.9x forward earnings. Its free cash flow generation has also been more solid. Over the TTM ending April 30, 2012, FCF came out to $1.3 billion versus $1 billion in 2011, $1.5 billion in 2010, $812 million in 2009, and -$63.7 million in 2008. Even still, analysts prefer Macy's over Kohl's, according to data sourced from FINVIZ.com. I believe that the market has myopically focused on weakness from the 2010-2011 period and a correction is in order. Should the economy head towards full employment faster than expected, buying shares now will enable you to profit off of margins becoming more in-line with peers.
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