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Bargain or Bust for Department Stores?

Many question whether beaten-down retailers like Macy's and Kohl's can overcome the e-commerce threat.

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January is always a tough month for retailers, as consumers hold back on spending after blowing the bank on holiday shopping. But it's been an especially difficult few weeks for department stores. While we're only a few weeks into a new year, stores like  Macy's (M),  Kohl's (KSS), and  Nordstrom (JWN) have seen their stock prices drop significantly. The former two, which are the third- and fourth-worst performing stocks on the S&P 500 year-to-date as of this writing, have fallen by 17%.

The sector has been on a downward spiral for a while, with the S&P 500 Department Store subindex plummeting by about 45% since peaking in August 2015. While it did climb by 52% between May and December last year, those gains, which were the result of these companies beating ultralow expectations during one quarter, have mostly been given back. The index is down 30% since Dec. 8.

Despite the poor performance, many investors and mutual funds still own department store companies. Yet, the outlook for these stocks remains mixed, with many analysts and fund managers trying to determine whether it's a sector that should be abandoned or if it's filled with potentially attractive value plays.

Online Shopping Soars
It's no secret why department store stocks are in trouble: More people are shopping online. Forrester Research says online sales will exceed $500 billion in sales in the next five years, up 34% from 2016--and that's impacting department store sales. On Jan. 4, Macy's reported store sales declined by 2.1% in the last two months of the year compared with the same time the year prior. It also reduced full-year 2016 earnings estimates by between 6% and 9%. Kohl's has seen similar declines, with third-quarter sales falling 2.6% through the first nine months of 2016.

While department store stocks have seen a steep decline since January--and part of that has been due to companies revising estimates downward--in general this is a reflection of the continuing move from brick and mortar stores to online, says Bridget Weishaar, a senior equity analyst with Morningstar.

"A lot of people thought for a while that department stores still had a place," she says. "But we're still seeing massive traffic losses."

On the surface, the decline may seem trivial--losing 3% of sales year-over-year still means that 97% of sales returned. But big department stores have huge overhead, so even marginal sales losses can hurt, says Jim Morrow, a portfolio manager with Fidelity Investments, which holds department store stocks in several funds, including in  Fidelity Small Cap Value (FCPVX), which is rated Bronze by Morningstar.

Operating margin, in particular, is a sensitive metric in this business and many firms have seen declines. Macy's, for instance, has seen its operating margin compress from about 14% to 12%, which doesn't sound significant, but it is a 14% reduction.

"It doesn't have the top-line sales growth to offset that," says Morrow. "A little bit of sales degradation, coupled with margin degradation, has an impact."

Another factor contributing to declining sales is the growing popularity of off-price retailers, like  TJX (TJX) stores T.J. Maxx and Marshalls, says Weishaar. These places sell the same brands as the department stores do, but at 20% to 60% discount. If it's the same merchandise only cheaper, then people will naturally buy the items that are on sale, she says.

More Store Closings
It's not clear what the sector needs to do to turn itself around, but companies aren't standing still. Macy's is closing 100 stores and laying off 10,000 people this year; Sears is shutting down 30 stores by April; and Kohl's closed 18 stores in 2016. Store closures are the primary way to stop the bleeding--they're shutting the least profitable stores and keeping the best ones.

"Maybe, if enough capacity shuts down, it can catch up to demand and the remaining department stores can stabilize their businesses," says Morrow. It doesn't always work, though; Sears has been shutting stores for about 15 years yet it continues to struggle.

Companies may also have to give even steeper discounts than they already do to compete. While convenience is contributing to online shopping growth, many web-based companies are also selling goods closer to cost.  Amazon (AMZN), for instance, is barely turning a profit and any money it is making is coming from other services, like its cloud offerings, says Morrow. Despite that, online shopping stocks are still climbing.

"Online companies don't seem to have a desire or need to make money," he says. "So it's difficult to compete against someone who doesn't care (about profit)."

If there's one company that can give investors hope that a turnaround is possible, it's  Best Buy (BBY). While it's not a department store per se, it had gone through many of the same challenges that the department stores are going through now, says Morrow. A number of electronics companies were decimated by online shopping--the sales declines were even worse than what's happening with department stores, he says--and Best Buy in particular was hit hard, with its stock price declining by about 77% in two years. However, since its 2012 trough, Best Buy stock has risen by 300%.

How did it turn itself around? By shutting stores, cutting staff, and slashing prices to Amazon-like levels. Its earnings have fallen--EBITDA is down 29% since 2011--but it's certainly doing better than it was, and investors have rewarded the stock with higher valuations. Best Buy will always get foot traffic, since buying a $1,000 computer is not the same as $50 shirt--but Morrow nevertheless thinks department stores could use it as a model.

Deals Abound?
If there's one potentially positive takeaway from the department store downturn, it's that many of these stocks are trading at historically low prices. In the past, these retailers have traded at 20 times earnings, and now they're trading at close to 10 times. And, with many other sectors pushing their historical highs, these stocks are some of the cheapest around. Still, that doesn't mean jump in--they're trading that cheaply for a reason. Investors need to ask themselves whether these companies can turn themselves around.

Weishaar isn't sure. She does think that there will always be a place for these kinds of stores, as some people like shopping, or need things at the last minute, but traffic continues to decline every year, she says. She does say Nordstrom is better positioned than others, in part because it also runs discount retailer Nordstrom Rack. She's more partial to brands, such as  Ralph Lauren (RL) and  Hanesbrand (HBI), which can be sold in many retailers, rather than one department store.

Morrow is also unsure of where things will go, but he's not giving up on the space. People still like to shop, and if a company can pull off a Best Buy-like turnaround, then its stock price could soar. The best bets are the companies that have brand equity, are diversifying their product lineup, have a strong customer loyalty program, and that own their own real estate. If they own their own buildings they could potentially sell them and get cash influx or spin them off into a Real Estate Investment Trust.

There will be more volatility ahead for the sector, but the stores that can figure out how to operate in today's world--and some will--should see returns rise again.

"You can look at the pressure that online retailers are putting on these companies and you can write off the stocks," says Morrow. "But you can also make a lot of money if a business can stabilize and restore margins. "

As of this writing, here's Morningstar's take on the three department stores.

Kohl’s
Rating: 3 stars
Uncertainty: High
Economic Moat: None
Fair Value Estimate: $41
Weishaar"We think that over time, Kohl's will lose market share to Internet competitors and be forced to compete on price to maintain volume. Therefore, we stand by our long-term model assumption calling for slight average annual top-line declines over the next five years."

Macy's
Rating: 4 stars
Uncertainty: High
Economic Moat: None
Fair Value Estimate: $37
Weishaar: "In the long term, we believe that monetization of real estate, store closures, and cost cuts will provide some margin support, but we fear that regaining market share in a highly competitive space is difficult to achieve."

Nordstrom
Rating: 3 stars
Uncertainty: High
Economic Moat: Narrow
Fair Value Estimate: $48
Weishaar: "In our opinion, Nordstrom has managed to build a brand worthy of significant pricing power through a best-in-class service model, a localized curated product selection, and advanced omnichannel capabilities."

Bryan Borzykowski is a freelance columnist for Morningstar.com. The views expressed in this article do not necessarily reflect the views of Morningstar.com.

Bryan Borzykowski does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.