Don't Jump Into Department Retail Stocks Too Fast...

David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

If you are looking to buy retail stocks during the holiday season, I recommend looking beyond November sales reports and December news flow to make an investment decision. Corporate strategy, expansion towards positive secular trends, and growth prospects need to be considered. Below, I review three retail stocks with these variables in mind.

Why Macy's (NYSE: M) Is Undervalued

At a respective 12.1x and 10.2x past and forward earnings, Macy's is one of the cheaper department stores. To put this into perspective, the PE multiples of some of the top 20 industry peers range from 14.2x to 22.6x with an average of around 18x. This discount is particularly odd in that Macy's ranks 4th out of 20 in terms of growth prospects (a rate of 24.8% annually over the next 5 years.) P/B ratio of 2.8x is also well below the 3% average. ROIC, while nearly 100 bps below the industry average, is still strong at 11.6%. 10 of 15 analysts rate the stock a "buy" or better and none rate it a "sell".

The one factor that really concerns me is limited free cash flow momentum and the subsequent investor fatigue. Over the last two and a half year, free cash flow has gone nowhere--hovering around $1.7 billion. The current yield is still strong at 11.7%, and this is well above industry equilibrium levels. Moreover, Macy's has beaten analyst expectations for 15 consecutive quarters and is expected to see a 5-year EPS growth rate that beats the broadline retail line industry by 1460 bps. Fundamentally, however, the stock needs a catalyst to unlock that value.

Though early holiday sales were weak with same-store revenue declining by 0.7%, management has guided for market share gains. Particularly, the company is very competitive in online retail, which has seen record Black Friday trends. The company has a unique strategy among retail where it has set up some of its stores as dedicated "fulfillment stores" that handle holiday season. 292 were planned by November 1st, and I believe it will be a major catalyst going forward by creating an early-mover advantage among time-stressed consumers. This is a large perception that online purchases are cheaper, quicker, and less troublesome. Consumer interests have been historically fickle, in my view, but this appeal is built to last for a good amount of time.

Avoid J.C. Penney (NYSE: JCP), Buy Kohl's (NYSE: KSS)

When it comes to complementary stocks, J.C. Penney isn't one of them. The company has badly underperformed--dropping 58.8% from the 52-week high--and for good reason. The last four quarters have missed expectations several miles over. In the January quarter, EPS of $0.67 was expected--management yielded $0.21. In the April quarter, EPS of -$0.11 was expected--management provided -$0.25. In the July quarter, -$0.24 was expected--management provided -$0.37. In the October quarter, -$0.08 was expected--management provided -$0.93. This performance was so lousy that even some of the most long-term focused investors, like Bill Ackman, had to acknowledge poor same-store sales on a consolidated business.

Ackman has argued that investors should look at J.C. Penney as two companies. One of the companies, "New JCP" started August 1, which has gone from nothing to 7 million square feet in just one month--much faster than the pace at Apple stores. 11% of J.C. Penney stores have been renovated with the "New JCP" and are yielding $269 per square foot--the rest are only making $134 per square foot. But there was no concept of the "New JCP" when Ackman first made his investment. Many were looking at as a possible real estate spin off play that Ackman has earlier pushed other retailers, like Target, to pursue. Investors feel as though this is a desperate move by J.C. Penney to save itself as sales plunge. It's very easy to just wave your hands with something new--maybe update a logo and claim innovation through price cutting (a popular, now ubiquitous to the point of meaningless, retail strategy)--and expect the market to be cajoled. But results speak louder than words, and J.C. Penney's trajectory has been quite weak. Perhaps the "New JCP", however different that may be from the core department layouts, may come to represent the entire company, but that won't happen until several years from now. At this point, it's worthwhile avoiding the business.

Retailers like Kohl's can provide nice upside in the meanwhile. This department store trades at only 10.4x past earnings and is forecasted for 11% annual EPS growth over the next 5 years. Assuming expectations are met, 2016 EPS will come out to $6.92. At a multiple of 15x, this translates to a future stock value of $103.80. Discounting backwards by 10% yields a present value of $64.45. This is at a 50% premium to the prevailing price and easily warrants buying shares. Deutsche Bank recently upgraded the stock from a "hold" to a "buy" and puts the price target at $62. ROIC, moreover, is strong at 12.1%, so the business is creating value in the process.

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