2 Retail Stocks to Buy, 1 to Avoid

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With unemployment declining below 8%, the market has reason to be optimistic about retail. In my view, domestic business will struggle in the short-term from consumer uncertainty but still compensate investors for taking on the risk when the economy fully recovers. Accordingly, buying shares in a few select retailers is the key way to play the sector.

Macy's (NYSE: M) & Kohl's (NYSE: KSS): Both Undervalued, But Macy's is Even Better

When it comes to compelling investments in department stores, I believe Macy's edges out Kohl's. At a respective 12.5x and 10.4x past and forward earnings, the former is more expensive the the latter, which trades at corresponding figures of 12x and 9.9x. However, Macy's truly deserves this premium given the better momentum. Over the past five years, Kohl's grew EPS 5.4% annually while Macy's was able to generate double-digit returns.

As good of a brand as Macy's is, it can slip from time to time. September same-store sales went up 2.5% - 80 bps lower than what was expected. This was particularly disappointing in light of strong sales reports from names like Limited Brands and Costco. However, all in all, results have been strong of late. 2Q12 performance was ahead of the Street's expectations, and efficiency has improved, as evidenced by margins and volumes. Spring business was strong despite an uncertain economy, lower spending from international tourists, and disruptions in store remodeling. Kohl's, on the other hand, delivered sluggish results in September.

Kohl's same-store sales fell 2.7% for the month, which was 250 bps below consensus. Shareholders want to see a board and management overhaul; however, in my view, the company is doing just fine. Management's reiteration of Q3 guidance suggests that the business will hold up despite softer-than-expected sales. However, assuming the company merely meets analyst forecasts over the next five years, there is strong room for upside.

If it meets expectations, 2016 EPS will come out to $7.09. At a 15x multiple, this translates to a future stock value of $106.35 - more than double the current valuation. Discounting backwards by 10% yields a present value of $66.03, which is at a more than 30% premium to the current price of $50.60. Thus, I strongly encourage investors to back the business.

JCPenney (NYSE: JCP): Overhaul Not Working

After bringing in new management, overhauling the brand and store layout, and slashing prices, JCPenney has failed to perform. The stock has fallen by a dramatic 30.6% for the year to date and still looks expensive at 17.8x forward earnings. Analysts currently rate the stock a 2.7 out of 5, where "5" is a "sell," and the stock is 83% more volatile than the broader market.

Bear in mind that the analysts are also expecting EPS to grow by 20.3% annually over the next five years despite a 28.6% annual decline over the preceding five. Personally, I do not believe this kind of turnaround is in store for the retailer. Apparently, the company's CEO, Ron Johnson, is also now taking the same attitude after declaring that financial challenges will continue into at least the rest of 2012.

Margins have fallen concurrent with double-digits decline in revenue. With the retail market getting more intense by the day, this strained financial position will cause corporate borrowing expenses to rise and limit growth opportunities during the full recovery. JCPenney has tried superficial ways of adding demand, like the "store within a store" (ie. Sephora) concept, but business has been tougher than anticipated. Mobile and self-checkouts are also not coming out until around 2014, and, by then,  investors will have missed out in the upside from cheaper retailers.

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