Avoid Nordstrom, Buy These 2 Department Retail Stocks Instead

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

J.C. Penney and its downfall has sucked up all of the attention in the department retail sector over the past year or so. With so much potential missed, investors have had their hopes dashed. However, there are still undervalued investments within this industry. I recommend buying a mixture of cheap momentum plays and beaten-down stocks. Below, I review 3 stocks with this recommendation in mind.

Why You Should Buy Kohl's (NYSE: KSS)

At a respective 10x and 8.9x past and forward earnings, Kohl's is now exceptionally cheap. To put this into perspective, the average industry PE multiple is 18.1x. Not surprisingly, analysts have been trying to communicate this point to the market. In mid-September, Deutsche Bank came out with a "buy" rating and a $62 price target. This is more than a 40% premium to the prevailing price! Analysts forecast 9.3% annual EPS growth over the next 5 years and this comes on top of a 2.9% dividend yield.

Assuming Kohl's meets expectations, 2016 EPS will come out to $6.39. At a multiple of 14x, this translates to a future stock value of $89.46. This means annual average returns of more than 23%--a terrific amount. Discounting backwards by 10% yield a present value of $55.55, which provides a healthy margin of safety should the company fail to generate the kind of growth it is expected for.

No matter how good a company looks in terms of valuation, it's always risky to invest if the underlying business is weak. Fortunately, that is not the case for Kohl's. It has a stellar return on invested capital of 12.1%, and it's high growth rate is not being driven by greater leverage--the long-term debt to equity ratio is around half of peer's. In terms of operations, the company delivers around 200 bps greater operating margins than the industry average and is 30% more efficient in terms of assets per employee. While free cash flow has remained relatively steady over the past two years at around $937 million and November sales were disappointing (comps and online revenues fell a respective 5.6% and 5.9%), the double-digit share drop was way overblown, says a Jefferies sell-side analyst. In fact, it was the firm's worst market day since 2012.

Nordstrom (NYSE: JWN) Vs. Dillard's (NYSE: DDS)

Nordstrom, a higher-end apparel store, trades at 15.9x past earnings. But Dillard's, which is cheaper on a PE multiple of 13.4x, is rated much worse on the Street. Should you ignore the Street's opinion and preferentially buy the latter?

In my view, you should. Though Dillard's has more than doubled (up 110.9%) from the 52-week low and is now at its all-time high, it still pays the cost of buying the shares in just less than 10 years, assuming no growth. What attracts me so much to the company, however, is it's impressive performance. Third quarter comparable stores were up 5%, while expenses were held down to drive a 40 bps expansion in margins. Dillar'ds strategy to target a market between Macy's and Nordstrom has clearly worked out well, to say the least: profit of $0.63 per share is almost double the same quarter last year.

Nordstrom is forecasted for 12.3% annual EPS growth over the next 5 years. Assuming Nordstrom meets expectations, 2016 EPS will come out to $5.62. At a multiple of 14x, this translates to a future stock value of $78.68. Discounting backwards by 10% yields a present value of $48.85. This means the company is around 7% overvalued. With Dillard's delivering strong results and still trading at a multiples discount, I thus strongly encourage buying it over Nordstrom.

TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool owns shares of Dillard's. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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