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Review: UBS Initiates Coverage On Department Stores

|Includes: J. C. Penney Company, Inc. (JCP), JWN, KSS, M, SKS, UBS

Recently, UBS (UBS) the Swiss investment bank initiated coverage on department stores J.C. Penney Company, Inc. (JCP), Kohl's (KSS), Macy's (M), Nordstrom (JWN), & Saks (SKS). The investment bank rated shares of the department stores "Neutral" with the exception of Nordstrom which is rated "Buy." These firms operate in a monopolistic competitive industry and don't earn an economic profit. We'll take a look at the department stores and see if we agree with UBS's analysts.

J.C. Penney Company

J. C. Penney Company, Inc., through its subsidiary, J. C. Penney Corporation, Inc., operates department stores in the United States and Puerto Rico. The enterprise in the process of transforming the way they do business in an attempt to get customers back in the doors and spending money in J.C. Penney stores.

The sales number shows the deterioration in the business the past five years as sales have declined at an annual pace of 2.8 percent. Earning the past five years declined 32.1 percent annually. This year earnings shrank by 144 percent; next year they are forecasted to rebound 86.5 percent. The earnings projection for the next five years is for an increase in earnings of 16.6 percent annually.

The sales and earnings numbers aren't growing thus profit margin is negative, the operating margin too; gross margin is 36 percent. Return-on-equity, a measure of the effectiveness and efficiency of management is also negative.

Debt is 77 percent of equity and the most liquid current assets are 79 percent of current liabilities. The forward P/E is 11.83 and price-to-book 1.85. The dividend yield is 2.3 percent.

Shares are trading below the rising 50-day simple moving average and above the 45 degree rising trendline on the 3-box reversal point and figure chart.

J.C. Penney is trying to transform the brand. The firm isn't growing sales or earnings and the market doesn't think the firm has good growth prospects based on its relative price-to-book. The negative earnings should weigh on cash and that could mean a decline in the dividend. The debt level isn't attractive. J.C. Penney deserves its "Neutral" rating.

Kohl's Corp.

Kohl's Corporation operates department stores in the United States. Its stores offer private, exclusive, and national branded apparel, footwear, and accessories for women, men, and children; soft home products, such as sheets and pillows; and housewares targeted to middle-income customers. As of March 1, 2012, it operated 1,127 stores in 49 states.

Kohl's reported single digit growth in sales and earnings the past five years. Sales increased at an annual pace of 3.8 percent while earnings increased 5.4 percent. Notwithstanding, the forecast for Kohl's is brighter than the reported past. Earnings this year grew 17.7 percent and are projected to grow 11.8 percent next year. Earnings are expected to grow 13.4 percent the next five years.

The gross, operating, and profit margins are 38.2, 11.5, and 6.2 respectively. Return-on-equity is 16.2 percent. Institutions own roughly 90 percent of shares.

Debt is 65 percent of equity and current assets are 84 percent greater than current liabilities. The quick ratio is 0.61. Price-to-earnings per share is 11.3 & forward price-to-earnings is 9.3. The shares trade at an 87 percent premium to book value. The dividend yield is 2.6 percent.

Shares are trading at the flat 50-day simple moving average and are down 7.2 percent over the previous year.

Kohl's does have some things going for it, positive earnings and sales growth. The firm also generates cash which means it can continue to pay dividends and repurchase its shares. The shares haven't done much during the current bull market; the company is a laggard. The market isn't paying much more for its growth prospects than J.C. Penney. The "Neutral" rating is the correct rating; the shares could be an "accumulate" on significant weakness in the broader market (a bear market).

Macy's, Inc.

Macy's, Inc., together with its subsidiaries, operates stores and Internet Websites in the United States. Its retail stores and Internet Web sites sell a range of merchandise, including apparel and accessories for men, women, and children; cosmetics; home furnishings; and other consumer goods.

Management does an excellent job of running the company; sales the past five years declined at an annual pace of almost half of a percent while earnings increased 10.1 percent. Earnings this year increased 47 percent and are projected to increase 13.8 percent next year. Long-term earnings growth is projected to be 10.6 percent.

Gross, operating, and profit margins are 40.4, 9.1 and 4.8 percent. Return-on-equity, a measure of the effectiveness and efficiency of management is 21.9 percent. Institutions own 91.3 percent of shares.

Debt is 131 percent of equity and the quick ratio is 0.58. Price-to-earnings per share is 13.5 and forward P/E is 10.4. The market is paying 2.75 times book value and the dividend yield is 2.03 percent.

Shares are trading above the rising 50-day simple moving average and above the 45 degree long-term trendline.

The market is paying a higher premium for shares relative to book value a sign that investors are encouraged by the long-term growth prospects relative to Kohl's and J.C. Penney. The firm generates cash and should be able to repay its debt. Notwithstanding, the debt level will impact the pace of dividend growth and share repurchases. Thus while Macy's is a solid investment, the shares have increased in value significantly and the cost of equity capital could exceed investors required return. We agree with UBS, Macy's should be rated "Neutral" and share could possibly be accumulated on significant weakness.

Nordstrom Inc.

Nordstrom, Inc., a fashion specialty retailer, offers apparel, shoes, cosmetics, and accessories for women, men, and children in the United States. It operates in two segments, Retail and Credit.

The enterprise grew in the single digits the past five years. Sales grew at an annual rate of 4.7 percent while earnings grew at 4.2 percent. Earnings this year grew above trend at 13.9 percent and earnings the next year are expected to grow at 13.5 percent. Earnings growth the next five years is dependent on cyclical tailwind or economic expansion in the United States. The projection is for earnings to grow above trend the next five years at a pace of 11.6 percent.

Gross margin is just below 40 percent of net sales. Operating and profit margins are 11.5 and 6.3 percent respectively. Management has been effective and efficient recently as return-on-equity is 34.4 percent. Institutions own 61 percent of shares.

Debt is 186 percent of equity and the company is relatively liquid with a quick ratio of 1.71 percent. The market is paying almost 18 times earnings and almost 14 times forward earnings. Price-to-book value is 5.80. The dividend yield is 1.98 percent.

Shares are trading above the 50-day simple moving average and above the long-term 45 degree trendline.

The company has generated cash flow in recent years and should have the ability to increase the dividend and repurchase shares. The firm issued $788 million of debt last year, which may limit the ability of the company to increase the dividend. The market is paying a larger premium over book value for shares of Nordstrom relative to peer companies. Nordstrom should be rated "Neutral" and may potentially be rated "Accumulate" at a lower cost of equity.

Saks Incorporated

Saks Incorporated operates retail stores in the United States. Its stores offer an assortment of fashion apparel, shoes, accessories, jewelry, cosmetics, and gifts. The company operates stores under the brand name of Saks Fifth Avenue (SFA) that are principally free-standing stores in shopping destinations or anchor stores in upscale regional malls.

Growth at Saks has been stagnant in recent years. Sales the past five years increased slightly less than 1 percent as earnings declined at an annual pace of almost 10 percent. This year earnings grew above trend at a 51.9 percent pace and are forecasted to grow 16 percent next year. The next five years are expected to be better than the past five as earnings increase 15.5 percent annually.

Gross, operating, and profit margin are 40.8, 4.9 & 2.5 respectively. Management hasn't been very effective and efficient recently as return-on-equity is 6.3 percent. Institutions own 68.5 percent of shares.

Debt is 30 percent of equity and the firm is liquid. Investors are paying the highest premium for earnings relative to the peer companies reviewed at 24.5 times earnings. Forward price-to-earnings is 18.2. The price/book value is 1.4. Saks doesn't pay a dividend, it does repurchase shares.

Common shares are trading below the rising 50-day simple moving average and above the 45-degree trendline going back to 2009.

Saks has been retiring debt which could allow the company to pay a dividend at some point. The market isn't enthusiastic about the firm's growth prospects. Return-on-equity could increase as debt has been retired. The firm is cyclical and has been growing cash flow from operating activities. We agree with the "Neutral" rating and will revisit this issue at a later date to see if management has increased efficiency and effectiveness.

Dow Theory

According to the rules of Dow Theory, we are in a bull market. Notwithstanding, the Transportation Average has failed to reaffirm the bull market. Since the low of the previous bear market we have seen two intermediate reactions. In a typical bull market, there are two intermediate reactions and the third intermediate reaction is the start of a bear market.

You can't do finance without economics; in the next section we will show that the economic data has improved recently and may be peaking. We would look to add to positions after a correction in the economy.

Macro Picture

Consumer Confidence is rising is above the 3 and 6-month simple moving averages.

ISM Non-manufacturing PMI is below the rising 3-month simple moving average. The decline below the 3-month simple moving average could be a warning of a slow down to come in the pace of growth in non-manufacturing.

Unemployment claims had been in a range the past few weeks. Claims are above the rising 3 and 6-week simple moving averages; that could mean that claims will rise in the weeks to come.

Nordstrom, Macy's & Kohl's

Overall, we agree with the rating coverage initiated by UBS analysts. However, we don't agree with the "Buy" rating on Nordstrom. The difference is that we would rate Nordstrom "Neutral" and probably "Accumulate" on significant weakness. We also feel that Kohl's and Macy's shares could potentially be an "Accumulate" on significant weakness.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.