What's in Store for Retail?
Later-economic-cycle department stores still have upside despite low growth.
Our current outlook for the department store industry is mildly positive, based on our opinion that the early stages of an economic recovery are among the few times in the retail landscape where competition is more rational and expansion is more controlled. Current valuations are mostly in line with our fair value estimates, with high-end stores slightly above fair value and stores serving more economically sensitive customers trading at small discounts.
Department stores are currently benefiting from a rebound off 2009 lows in the general economy and from consumers' realization that they needed to return to shopping, despite worrisome macro conditions such as stubbornly high unemployment. While retail remains a highly competitive business, we are still in the stages of the economic cycle where competition remains more subdued. We believe weak commercial real estate trends are still creating a positive environment for larger retail industry competitors, with many smaller boutique stores continuing to close up shop--meaning myriad small competitors have exited the market.
Since June 30th, department stores' equities have generally outpaced the broader market, with stocks such as J.C.Penney (JCP) and Saks (SKS) (that were the most depressed due to dim, recession-driven earnings outlooks) appreciating more than 60% and 50%, respectively, compared to around a 20% gain for the S&P 500.
Higher-end retailers such as Nordstrom (JWN)also have fared well, as many wealthy consumers did not experience as deep of a financial crisis as the rest of the country. Now it is also our view that the higher end already has played a number of its cards in this economic cycle, with stocks already accounting for the future earnings power of these retailers. Thus far in 2011, Nordstrom is down slightly about 2%, while stores such as Sears and J.C.Penney, which cater to a lower-end consumer and thus would also benefit from a later stage in the economic cycle, have appreciated 8% and 10%, respectively. On a price to fair value basis, we see both Macy's (M) and Nordstrom as trading right around fair value, but we view the more middle- and working-class-customer-focused Kohl's (KSS) and Sears Holdings (SHLD) as undervalued.
Long-Term Investors Beware: Department Stores Don't Exhibit Superior Returns on Capital
If investors are considering department stores for their portfolios, we'd advise them to look at long-run returns on invested capital. By our analysis, when all sources of capital (including store leases) are considered, returns are mediocre at best for department stores. Complicating the analysis are cyclical shocks and downturns (where returns are negative) and the fact that there is "survivorship bias" in the results, in that we are looking at returns on capital only for the companies that have survived and not the entire department store universe. Over time, some competitors have exited the market through both mergers and liquidation. Macy's, for example, exhibits long-run returns on capital just breaking into the double digits, roughly just a few percentage points over its long-run cost of capital. J.C. Penney averages about the same low-double-digit returns, but with more volatility historically. Put in perspective, J.C. Penney's returns have been above 20% for three of the last 12 years, but there were also three negative years (including one year with returns in the negative high double digits). Given such statistics, it is not surprising that industry participants often increase leverage to grow. From an investment standpoint, department store retail is so sufficiently competitive that investors cannot count on compounding return on investment to ensure that a buy-and-hold strategy will be a winner in the long run.
Stores That Have Survived 100 Years Must Be Earning Their Cost of Capital, Right?
Given that many of the surviving department stores such as Sears, J.C. Penney, and Macy's have been around for 100 years or more, one might assume that department store retailing cannot be so competitive that companies are only earning a few percentage points over their cost of capital. The answer, in our opinion, lies in the retail business cycle. Stores earn above average returns on incremental stores added when competition is lowest (both for customers and for real estate), which is at the end of a recession, in our opinion. Recessions test the marginal productivity of stores while recoveries offer opportunities that weaker competitors are reluctant to take, as the effects of prior investment decisions may impact returns for years. In the early stages of a recovery, it is our experience that department store operators also are careful to focus on just a few store openings, and are more likely to create a customer experience that is consistent with the brand and the rest of the chain and at productivity levels that are likely to be profitable.
During an economic downturn investment is reduced, debt is paid down, and surviving stores come out more profitable. Consistent with this notion, most all of the department stores on our coverage list have reduced capital expenditures, store growth in particular, preferring instead to focus on the profitability of existing stores and the balance sheet. Some examples include Macy's, which reduced debt by $1.2 billion to $6.9 billion, and J.C. Penney, which paid down debt by $700 million to $3.1 billion.
The slowdown in store openings is pronounced, with only Kohl's and Nordstrom currently making any significant expansion plans and Sears and J.C.Penney still closing stores. J.C. Penney ended the year with a net closing of one store, while Macy's went from three store openings and $1.4 billion in capital expenditures on $27 billion in revenue and 156 million square feet, to $505 million in capital expenditures in 2010 on 154 million square feet and $25 billion in revenue. Some other stores such as Sears have cut capital expenditures even more drastically. In 2003, Sears spent $925 million on capital expenditures, compared to $441 million today, or $2 per square foot, significantly lower than the $4 per square foot J.C. Penney invests and in a different league than the $17 per square foot Nordstrom spends. That translates to Sears spending just $.01 of every dollar of revenue to maintain its stores.
Slow growth might sadden investors used to square footage growth and comp-store sales gains as new stores mature, but it is this unique event that will drive less competition and higher profits--until balance sheets are built up to a level that stores begin expanding again. From Morningstar's perspective, where long-run returns on capital are key drivers of value, we are still mildly positive on the outlook for department stores; most stocks are trading right at or just below our fair value estimates, but with minimal growth expectations and judicious attention to use of capita--at least in the medium term. We will become more cautious later in the economic cycle when both growth and valuations pick up, along with the investment needed to fuel such growth. If historic trends hold, growth in later stages of the cycle will rely on increasing use of leverage through leasing and debt, providing a boost to earnings but ultimately setting the stage for the next round of industry overexpansion and lower returns on capital.
Department Stores Must Differentiate to Succeed
We are often asked the question of whether department stores are a thing of the past. We are firmly of the opinion that they are not. Department stores will play an important role in retail well into the future.
Nordstrom, through unwavering attention to customer service and fast-turning high-end fashion, has been able to average returns on capital in the mid to high teens, better than the competition. Even in the last two cyclical downturns, Nordstrom earned returns in the neighborhood of 8% to 9%, not out of line with its theoretical cost of capital. During the last 10 years, Nordstrom has averaged inventory turns almost twice the rate of Macy's and more than double Saks.
After many years of mergers and restructurings at what was once Federated and May department stores, we believe Macy's may still have more innings to play in what has been a steady turnaround based on a "Retailing 101" strategy (internally dubbed "My Macy's"), which is still cycling through the chain. Initiatives include sales associate training and the ability of local and regional store managers to make decisions based on what's popular and selling well on a more localized level. We also are encouraged by management's understanding of destination department store shopping and brand heritage. Macy's still operates many stores in landmark real estate districts of major city centers, such as its original flagship in New York City and the former Marshall Field's site in Chicago. In our opinion, such stores create shopping experiences that are hard for competitors to copy, and stand in stark contrast to many of Macy's more generic store formats found in older malls around the country.
Beware Unbridled Expansion
During the economic cycle, it is our view that department stores tend to push expansion too far. And toward the end of the cycle, the stores incrementally added are less and less exciting, and thus less productive/differentiated when compared to low-cost retail competitors such as Wal-Mart (WMT) and Target (TGT). In our view, successful department stores will continue to create customer experiences that are different from generic big box retailers that simply compete on price.
Malls Are Challenging in the Long Run
During the last two economic expansions, malls and overall retail space have expanded faster than the broader economy. According to the International Council of Shopping Centers, total retail shopping space stood at an all-time high of 47 square feet per capita in the United States in 2009. Statistics on mall spending have been soft for several years now and, despite improvement in 2010, it would not be impossible to see additional mall consolidation take place, as malls continue to compete for tight consumer discretionary spending dollars. In our opinion, the ability of older malls to make a return on capital while maintaining the customer experience has been lagging, as older malls visibly deteriorate and will continue to do so. Statistics from the SEC filings of regional mall REITs suggest that 2010 sales per square foot have rebounded, but only to 2008 levels. Anecdotal evidence from retailers on our coverage list suggests older malls continue to struggle--all stores are reporting similar trends in on-mall stores compared with off-mall. Chains such as J.C.Penney are facing more challenging same-store sales gains compared to competitors such as Kohl's, which has a higher percentage of off-mall stores at 94% compared to J.C. Penney's 52%. Conversely, retailers such as Nordstrom that are opening stores in newer, higher-end malls have maintained strong comparable store sales and profits. Yet new malls seem to offer compelling growth opportunities to retailers. Developers offer very attractive lease rates to get high-volume anchor stores at each end of the mall. For example, J.C. Penney and Macy's, pay on average only $7 and $5 per leased square foot, respectively. But this seemingly low-cost growth is available to all competitors, and in our opinion, is one of the drivers of the lack of differentiation among retailers.
Investors Must Focus on the Future
We believe companies that continue to differentiate themselves will be successful, but investors need to look beyond current reported earnings in their valuation assessments. We encourage investors to focus on long-run returns on capital and the price paid for future earnings.
Kohl's, for example, has a differentiated merchandise mix and produces higher-than-peer average returns on invested capital, averaging midteens ROICs. We currently rate Kohl's as mildly undervalued on a price to fair value basis. Nordstrom is also one of the firms that we view as differentiated, and with defendable competitive advantages exhibited by its high-teens returns on capital. Unfortunately for investors, the value of these advantages is well appreciated by the market. Nordstrom, in our analysis, is trading at a slight premium to our current fair value estimate, but is a name worth holding for the longer term at the right entry price. J.C.Penney also is trading right around fair value, and we are encouraged by its focus on fast fashion at great prices; a plan not without complication, but at least the company has direction.
Without a doubt, the most controversial department store under our coverage is Sears Holdings, owner of both the Sears and Kmart brands. Sears has been underinvesting in its stores and it is becoming more and more visible to customers. Yet, in our opinion, Sears knows it must differentiate itself to compete longer term. But beyond investment in digital tools and the testing of retail partnerships and alternative retail formats, we are not sure if we see a clear, winning differentiation strategy emerging. Sears' exposure to hard goods and appliances should get a later-cycle economic boost. If a cyclical boost could propel Sears even close to prior productivity levels, Sears' shares also should prove to be currently undervalued.
Paul Swinand does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.