Buy These Retailers Over JCPenny
David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
With the economy in a state of limbo, the last thing investors need is a company that has problems in its own right. JCPenney (NYSE: JCP), in my view, carries significant risks on the bet of a turnaround. The company has been valued at $7.8 billion despite an inability to produce meaningful free cash flow. A peak of nearly $1 billion in 2010 suggested that the company had a strong potential to become a cash cow, but then the company's operating performance started to flounder…
Free cash flow in 2011 dipped to $107 million, and sales barely improved by 1.2%. Next year, free cash flow is expected to be around -$250 billion before hitting just ~350 billion the following year. While the company would certainly be significantly undervalued if it could increase sales per square foot to peer levels, creating demand is easier said than done.
A case in point is JCPenney's attempt to "shuffle the board", if you will, by bringing in Apple retail chief Ron Johnson as CEO. The catalogue business was scrapped, stores were restructured, low pricing strategies were announced, and monthly specials were introduced. The problem for JCPenney is that this strategy may have backfired. Instead of exciting investors, this made the market nervous (especially when strong earnings failed to materialize) that JCPenney was trying to obfuscate its poor operations with gimmicky changes. Certainly, Johnson's adamancy about sticking with the plan has helped to remind investors that he is focused on the long-term.
The problem in sticking with JCPenney's "long-term strategy" is that, by the time it is successful it generates a strong ROI, investors could have gone elsewhere for outperforming. Two excellent retailers are Macy's (NYSE: M) and Kohl's (NYSE: KSS). In terms of risk/reward, both are top notch. The former trades at around 13x past earnings while the latter trades at around 12x past earnings. In addition to being cheaper on a multiples basis, Kohl's is also forecasted for around 60 bps greater annual EPS growth (11.5%) over the next five years.
If Macy's is able to realize analyst expectations, it would be worth $72.62 at a 14x multiple 5 years from now. That translates to a present value of $47.20 in present terms when discounting backwards by 9%. Since all of the last 5 quarters beat consensus, I anticipate Macy's generating high risk-adjusted returns as it performs slightly above Kohl's. Double-digit gains in the online segment also makes the retailer stand out from Kohl's and will help not only with margins but also with penetrating global markets.
Kohl's gross margins fell by 160 bps in the second quarter relative to 2Q11. The decision by management to repurchase $6 billion worth of shares, however, has demonstrated to the market confidence over the fundamentals. My main concern with Kohl's is that it lacks access to many of the strong national brands, like Estee Lauder, Coach, or Uggs. These brands have done well and caused high-end clothing retailers to outperform their counterparts. The lack of them will limit the degree of upside, since Kohl's won't be able to properly target a more affluent population during a full recovery. Even still, I think the company, unlike JCPenney, is taking a strong long-term strategy.
In a late December 2011 equity report by Credit Suisse, which rated the retailer "neutral", the analyst argued that JCPenney should focus more on the product and less on the promotion. I believe that just the opposite is the proper strategy: consumers are price conscious, and the variability in offerings from one retailer is hard to distinguish (at least between Macy's, Kohl's, and JCPenney). While it should introduce more fragrances and designer clothing, the current message towards "this is where you go to save" is compelling. In fact, if you go to a Kohl's store and check out, the cashier will tell you "this is how much you saved" as you get ready to carry the bags to the exit. Sure, it's a little disingenuous, but retail consumers have a history of being fickle. I thus recommend buying shares to supplement an investment in Macy's.
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