Can These Retailers Provide an Upside Surprise in 2014?

The past holiday shopping season wasn't what retailers were hoping for. Sales rose a sluggish 2.7% and in-store traffic declined 14.6%, providing the weakest growth in four years according to industry monitor ShopperTrak. The disappointing result sparked worries about a consumer-spending slump that pressured retailers' shares. Amid the malaise, some store operators such as Macy's (NYSE: M  ) , Nordstrom (NYSE: JWN  ) , and J.C. Penney (NYSE: JCP  )  look like they could have a surprisingly good 2014. Here's why.

A great strategy produces great results
Macy's is a retail operating leader. Earnings per share climbed 31% year-over-year while total sales grew 3.3% in its latest quarter. On a comparable-store basis, a key retail metric, sales were up 4.6% with the inclusion of departments licensed to third parties, and comp sales rose a good 4.3% in the generally lackluster holiday time period.

Underpinning the current excellent result is Macy's brilliant three-pronged business strategy. Its "My Macy's" initiative concentrates on store localization, or matching the mix of sizes, colors, and brands in a store with the unique needs of that site's customer base. With the "Omnichannel" program, Macy's attempts to make online and in-store shopping  equally easy. It also acquaints online customers with the benefits only a store can provide, while offering store customers the added convenience of buying online. The company's "MAGIC Selling" process focuses on building true relationships with each customer. This is the often-overlooked essence of good retail practice.

Macy's is attempting to improve future results through a reorganization. By opening new stores in major metropolitan areas like Las Vegas and Miami, while simultaneously closing stores in smaller markets, the company hopes to boost earnings. To make sure these profit gains are sustainable, Macy's has also initiated a proactive cost reduction plan. 

Trading around 11 times an expected $1.88 billion of cash earnings, which is basically net income plus non-cash charges such as depreciation and amortization adjusted for expected capital expenditures,  Macy's shares look reasonably priced. Given management's successful track record, the company may be ripe for a positive revaluation on any top-line or profit beat.

A case of successful sales channel diversification
Nordstrom was another retailer whose capabilities were confirmed by good results. The company's earnings for the first nine months of 2013 were up 3.3% year-over-year as same-store sales increased 2.5% and total sales jumped 4.7%. While the overall performance was excellent, Nordstrom's online and off-price sales channel achievements were the most impressive.

The store operator's online sales jumped a stunning 29% year-over-year in the first nine months of 2013 helped by better merchandise selection and website improvements. Its HauteLook business also delivered significant gains. This savvy online endeavor, which offers designer fashion "flash" sales, saw quarterly revenue increase 22% year-over-year.

Nordstrom's off-price Rack stores concept looks to be another winner. Selling high-quality name brands and Nordstrom clearance inventory at discount prices has made the stores very popular. Rack sales increased 16% year-over-year in the last quarter thanks to a combination of new store openings and a 3.7% same-store sales increase. A growth vehicle, Nordstrom plans on boosting its Rack store footprint from the current 141 sites to over 230 locations by the end of 2016.

Nordstrom shares currently appear fairly valued. Based on the low end of 2013 guidance, with revenue of $12.60 billion and cash earnings around $1.08 billion, the company is trading at a reasonable 11 times cash earnings. Continued success in alternative selling channels with some stabilization in lagging full-line store results might indicate a higher earnings multiple is warranted, however.

Buying enough time to deliver good news
While not Macy's or Nordstrom's operational equal, J.C. Penney could produce a greater upside surprise. The company's troubles are so well known that even something as simple as an improved survival outlook might significantly increase investor enthusiasm.

J.C. Penney has already shown some signs of improvement. Comparable-store sales and gross margins were up sequentially in the latest quarter and October comp-store sales actually increased. Online sales also came in better with an impressive 24.5% year-over-year gain. Though comparable sales still dropped year-over-year and gross margin continued to fall, there seemed to be some progress in getting customers to consider returning to J.C. Penney.

Recent guidance also suggests there may be time to make further headway. J.C. Penney's reaffirmation of year-end quarter targets was constructive. Comparable-store sales and gross margins are expected to improve sequentially and year-over-year, while administrative expenses are believed to be lower than 2012 levels. While admittedly not a high hurdle given last year's dismal fourth quarter, this is still encouraging.

The company's cash flow outlook is even more hopeful. With total available liquidity expected to be more than $2 billion at the end of the fiscal year and capital outlays envisioned at a moderate $300 million for fiscal 2014, J.C. Penney may have adequate funds to survive well into 2015. This could possibly be long enough for the company to produce better-than-expected sales figures, which is obligatory for a meaningful and sustained rise in share price.

Summary
Though we may be entering a period of sluggish consumer spending, some store operators might still deliver unexpected share-boosting news. Successful initiatives from Nordstrom or Macy's could lead to higher valuations. J.C. Penney, more of a speculative play than an investment, might see its shares advance simply on any report that is "not bad." In 2014, the retailers that have the best chances of supplying positive surprises may end up being the best sector stock performers.

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