After J.C. Penney Rally, Buy Macy's, Kohl's Instead

By David Gould - September 8, 2012 | Tickers: AAPL, JCP, KSS, M | 0 Comments

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As J.C. Penney (NYSE: JCP) desperately tries to update its brand image to bring back investors, other undervalued competitors, like Kohl's (NYSE: KSS) and Macy's (NYSE: M), are remaining more focused on the fundamentals. I find that, while J.C. Penney is a potentially attractive turnaround play, Kohl's and Macy's have more favorable risk/reward comparisons. Below, I review the fundamentals of each stock.

J.C. Penney

When J.C. Penney first brought in ex-Apple executive Ron Johnson, they thought it would be enough to induce investors to put aside reservations and focus on the promises. While the stock has rallied by a tremendous ~25% over just the last month, the stock is still down by nearly a third from six months ago while the S&P 500 is up slightly.

Although it's far too soon to make any judgment on Johnson, part of the reason why he has failed to create value stems from the obvious obfuscation of poor performance with tacky cosmetic changes, like logo changes, nonsense price cutting, hype-ish store redesigns, and so forth. At the end of the day, J.C. Penney's free cash flow has fallen from $539 million for the TTM ending July 31, 2009 to -$529 million for 2012. That's a $1.1 billion "backflip." Average annual FCF over the last 5 years has been less than $250 million, which implies that the yield is a dismal 4.4%. I thus strongly recommend investing in more promising retailers.

Macy's

Macy's is one such department store with a lucrative risk/reward. It trades at just a respective 12.8x and 10.6x past and forward earnings with a dividend yield of 2%. Analysts forecast 10.9% annual EPS growth over the next 5 years.

Assuming that Macy's merely meets expectations (it has delivered terrific double-digit ROE), the stock would theoretically be worth $72.62 at a 14x multiple by 2016. Discounting backwards by 9% yields a present value of $47.20. This provides a decent, although not incredible, margin of safety. The upside is nevertheless huge, and it requires in-line performance to the broader market - not too hard of a feat to achieve given excellent past execution.

All of the 5 last quarters have beaten expectations by an average of more than 25%. Macy's had a 37% gain in online sales from macys.com and bloomingdales.com. This demonstrates one of the company's core catalysts going forward: online and mobile mediums. It has been able to realize meaningfully cross-selling opportunities from diversification - as evidenced by unusually high same-store sales of 5.1%.

Kohl's

Kohl's is another undervalued department store that is worth buying over J.C. Penney. It trades even cheaper than Macy's at a respective 12.3x and 10.2x past and forward earnings. Moreover, the dividend yield of 2.5% and forecasted annual earnings growth of 11.5% also bests Macy's.

Fee cash flow generation is fairly strong with around $1.2 billion generated for the 52 weeks ending Jan 28, 2012. The firm recently reported stronger-than-expected same-store sales growth as a result of better marketing and merchandise. Same-store sales were up 3.4% while sales grew 4.3% to $1.5 billion.

During the second quarter, Kohl's charges sales penetration grew by 160 bps to 57% of total sales. While gross margins fell by 160 bps below the same quarter last year, SG&A, taxes, and capex are all trending downwards and may dominate the cost savings story the years ahead. Furthermore, management has showcased confidence over free cash flow by repurchasing 6 million shares of common stock for the quarter. Accordingly, I recommend buying shares in this well-managed business.

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