Macy's (NYSE:M) has bounced back strongly from the Great Recession, with the share price rising more than sevenfold since bottoming below $6 in late 2008. CEO Terry Lundgren has done a lot of things right as he has turned the company around: customizing store inventories, improving selling techniques, and rapidly growing online sales. Nevertheless, Macy's stock is starting to seem overvalued in light of a few challenges that may hurt its future growth.
As of Friday's close, Macy's stock traded for $43.54, which is 12.6 times last year's adjusted EPS of $3.46. If, as analysts expect, Macy's continues to grow EPS at a double-digit rate, this is a fair price. However, there are a few factors that could cause earnings growth to stall out, leading to a significant correction in the stock.
Consumer spending takes a hit
The biggest headwind for retail stocks in general -- and Macy's stock in particular -- is the sluggish consumer spending environment. The U.S. economy will be pinched this year by the combined effects of higher payroll taxes, higher income taxes on the wealthy, and lower government spending. These headwinds have led to shaky consumer confidence readings in recent months, and may already be impacting retail sales. According to the U.S. Department of Commerce, March retail sales fell 0.4%, following a 1% gain in February.
Discounters such as Wal-Mart (NYSE:WMT) and Target (NYSE:TGT) have reported top-line pressure as consumers cut back on discretionary spending. Target recently announced that same-store sales will be flat in the first quarter and earnings will miss the company's earlier guidance due to unseasonably cold weather in much of the country. To some extent, Wal-Mart and Target are more at risk than Macy's in the current economic environment, because their customers are more likely to live from paycheck to paycheck. However, the effect of bad weather on seasonal merchandise sales could hit Macy's as well. A sales or earnings miss this quarter could cause investors to reevaluate Macy's stock, because the company has consistently beaten estimates in recent quarters.
Moreover, discount retailers have not been the only ones to strike a cautious tone. Upscale department store Nordstrom (NYSE:JWN) provided a 2013 revenue and profit outlook that missed analysts' expectations back in February. In fact, Macy's was one of the few major retail chains to offer a solid 2013 outlook. With other successful retailers above and below Macy's on the price ladder expecting a challenging year, Macy's shareholders may need to rein in their expectations.
J.C. Penney reboot
Macy's also faces some more specific threats. The most important one is the ongoing transition back to a heavily promotional model at struggling competitor J.C. Penney (NYSE:JCP). J.C. Penney's elimination of most coupons and discounts last year led to the loss of more than $4 billion in sales. Macy's management has stated on several occasions that about half of its stores are in malls that also have a J.C. Penney, and that those stores have performed better than the company average. This trend provided a tailwind for Macy's earnings -- and Macy's stock -- throughout 2012.
J.C. Penney is expected to make a strong push to win those customers back this year, starting with the return of "high-low" pricing. This could begin to reverse the trend of J.C. Penney shoppers migrating to Macy's, putting pressure on the latter's revenue growth. If, as I expect, J.C. Penney really ramps up the use of discounts and coupons, this could put pressure on competitors' gross margins. A drop in gross margin could have an even bigger impact on Macy's earnings than a slowdown in revenue growth.
Can Macy's stay strong?
I've been a big fan of Macy's turnaround in the last few years. However, the company benefited significantly from J.C. Penney's woes last year, and J.C. Penney could win back some market share in the second half of 2013 as it returns to a promotional model. This threat is exacerbated by the generally weak consumer spending environment. Moreover, these threats could continue to pressure Macy's beyond 2013. As a result, Macy's stock may be somewhat overvalued at present. Investors should keep a close eye on how well the company's earnings hold up over the next few quarters.
Fool contributor Adam Levine-Weinberg has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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.