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The Good, the Bad, and the Ugly: Macy’s, Kohl’s and J.C. Penney

Saturday - 3/2/2013, 2:29pm  ET

The fourth quarter is easily the most important quarter for retailers, and we at Valuentum saw winners and losers surface. The fortunes couldn’t have been more different, so let’s take a look at the results of the department stores.

The Good: Macy’s

Macy’s fourth quarter was among the best of the department stores, if we exclude performance from higher-end Nordstrom. Macy’s took advantage of J.C. Penney's movement away from discounting to run several promotional sales, which drove revenue growth of 7% year-over-year to $9.4 billion during the quarter (with one extra week of sales). Earnings, net of one-time expenses, increased 21% year-over-year to $2.05 per share, easily beating consensus estimates.

Same-store sales were up 3.9% year-over-year, mostly driven, in our view, by the 48% increase in online sales. In fact, the firm noted that online sales accounted for 3.3 percentage points of the same-store sales growth rate in the fourth quarter, meaning actual in-store shopping rose 0.6%. For the full-year, online sales accounted for 2.2 percentage points of the 3.5% of same-store sales growth, underscoring the basic secular trend toward online purchasing.

Though we aren’t too worried, we do fear that online selling can have a negative impact on the firm’s operating margin during the holiday season. In the latest holiday season, for example, we noticed such guarantees as free 2-day shipping by Christmas. In instances when the company did not successfully deliver on its guarantee, it ended up compensating consumers with gift cards. We’re not saying operating margins will crumble as a result of such tactical moves, but it certainly can put downward pressure on earnings.

Nevertheless, the firm leveraged fixed costs in the fourth quarter, as SG&A fell 90 basis points to 25.9% of sales (though we believe it benefited greatly from the extra selling week). The company’s gross margin was 40 basis points lower than the year-ago period at 40.6% of sales. Overall, its operating margin increased 20 basis points to 14.9%, showing the firm’s strong ability to contain costs in a difficult retail environment. Still, Macy’s looks fairly valued at this time, so we won’t be looking to add it to portfolio of Valuentum's Best Ideas Newsletter.

The Bad: Kohl’s

Although Kohl’s valuation has looked compelling at times during 2012, we’ve seen the brand lose some momentum to fast-fashion retailers. During the fourth quarter, sales increased 5% year-over-year to $6.3 billion, largely benefiting from an extra week of sales. If we exclude this extra week, sales advanced just 2.5%, which was not satisfactory considering rival J.C. Penney was leaving its customers open for the taking during the period. Same-store sales were 1.9% higher than a year ago—better than no growth, but still not great considering the temporarily weakened competitive landscape (J.C. Penney).

Earnings per share fell 8% during the quarter to $1.66, while full-year earnings declined 3% year-over-year to $4.17. Earnings weakness occurred even though the company had an extra week to sell goods during fiscal year 2012. In the fourth quarter, the firm experienced modest sales leverage, with SG&A declining 50 basis points to 19.1% of sales. Still, gross margins felt some pain, falling 290 basis points to 33.3% of sales.

Though the Kohl’s customer is in a slightly lower income bracket than the Macy’s customer, we don’t think the gross margin divergence should be so dramatic. Kohl’s simply isn’t getting the right fashion to market, and its customers love huge discounts. Still, the company believes gross margins will recover in 2013 as a result of lower input costs and (hopefully) the right merchandise. On the bright side, we were pleased to see Kohl’s e-commerce sales jump 43% during the quarter, but when we exclude the online same-store sales growth rate, sales at stores fell 1.3%.

Going forward, Kohl’s has essentially replaced its existing merchandising team, leading us to believe the inventory mix in stores could improve. Sales at same-store sales are expected to be flat to up 2% in 2013, and earnings are expected to come in between $4.15-$4.45 per share, including the impact of $1 billion in share repurchases. The firm thinks its gross margin will increase 15 to 30 basis points; SG&A is expected to grow 1.5%-3% on an absolute basis.

Though guidance was mediocre, in our view, Kohl’s raised its quarterly dividend 9% to $0.35 per share—representing an annual yield of 3% at current levels. Free cash flow was still positive at $480 million, but that was a sharp decrease from free cash flow of $1.2 billion in 2011. It’s quite possible that 2012 was an aberration, but management’s poor guidance leads us to believe 2013 will also be fairly weak. We don’t think shares of Kohl’s look expensive, so we’ll continue to monitor the situation to see if it can improve its brand image and regain traction with its core consumer base. Valuentum places a strong emphasis on valuation, but recent results suggest fundamentals could be declining.

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