Avoid J. C. Penney, Buy These 2 Retailers Instead
David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Though many investors are still uncertain about the sluggishly growing economy, retailers have held up fairly well in recent months. While some are just starting to recover, others are continuing dramatic earnings growth from the depths of the recession...
J. C. Penney (NYSE: JCP) is Still a Loser...
At a forward multiple of 18.6x, J. C. Penney looks expensive. This is because it is expensive. Having seen 28.6% annual EPS declines over the past five years, the stock is now in the negative territory in terms of earnings. Over the twelve trailing months, it has lost $2.50 per share, and while the company is valued at less than 0.4x sales, sales per square footage still lags well behind industry levels. While value investors, like Bill Ackman (a large shareholder of the company), would normally think that this leaves large room for improvement, in J. C. Penney's case, it's an indication of weak fundamentals.
Analysts currently rate the stock closer to a "sell" than a "buy" for several reasons. Though the company has tried to invest in premium brands for higher margins, this is being compromised by the firm's aggressive price cutting strategy. Moreover, these price cuts are ill timed under the context of an improving economy. In terms of innovation, when was the last time you haven't heard of a retailer "cutting prices" and "passing savings" onto consumers? Kohl's is particularly notorious for this with its cashier registers that indicate how much money you saved on clothes. Who would guess that shopping could be so economical?!
Deutsche Bank forecasts shopping performance from 2012 to 2013. Free cash flow for 2011 amounted to just $107 million. This year, they forecast -$269 million in free cash flow; next year, $336 million. During the same time, net debt is projected to surge from $477 million last year to north of $2 billion by 2013. As a $5.6 billion company, this is way too much debt for so little free cash flow generation.
… So Go With Macy's (NYSE: M) and Kohl's (NYSE: KSS) Instead
I thus recommend buying shares of a peer that has actually delivered strong momentum. Macy's trades at a compelling 12.2x and 10.1x past and forward earnings, respectively, despite strong 10.1% 5-year annual EPS growth. This compares to corresponding figures of 12.4x and 10.2x for Kohl's, which has seen even stronger 11.5% 5-year annual EPS growth. Over the next five years, Kohl's is expected to continue its lead with slightly greater than 11% annual EPS growth.
The good news is that both of these earnings curves will be enough to more than catalyze valuation. With multiples below peer levels and business tracking well, it will be hard to justify any price decline even with earnings misses. In terms of which stock I believe is more undervalued, I would say the odds are with Kohl's. With gross margins of 37.3% (310 bps below Macy's), there is potential for improvement. If earnings are slightly greater and complemented by margin expansion, operational outperformance should technically drive a greater multiples premium. Accordingly, I recommend buying now to capitalize on this outlook.
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