Last week, Amazon.com (NASDAQ:AMZN) announced that it will boost its minimum wage in the U.S. to $15 per hour next month. The decision was at least in part a reaction to political pressure on the company, which has been criticized for continuing to pay low wages even as its market cap soared to $1 trillion.
Amazon stock slumped following the announcement, as investors worried about rising costs. Shares of other retailers were hit even harder, due to fears that Amazon's move will force them to raise employees' wages significantly. Top department store chains Macy's (NYSE:M) and Kohl's (NYSE:KSS) were particularly hard-hit. Yet investors have probably overreacted to this news. As a result, Kohl's stock and (especially) Macy's stock look cheap right now.
Rivals won't have to match immediately
It's true that Macy's and Kohl's pay lots of workers less than $15 per hour. In fact, many sales associates at both companies report hourly pay of less than $10 per hour, according to Glassdoor.
However, they are hardly the only employers paying such low wages. Many U.S. mass-market retailers and fast-food restaurants have low hourly pay. The tight labor market is forcing them to raise wages, but the move to $15 per hour is likely to be gradual, allowing companies like Macy's and Kohl's to find offsetting cost savings. While Amazon is hiring rapidly, it will only be able to employ a small fraction of the current retail/restaurant workforce.
Additionally, many longer-tenured Amazon employees claim that they will make less money going forward, because Amazon is eliminating incentive pay and stock compensation as part of the move to a $15-per-hour minimum wage. In other words, labor market competition may not be heating up quite as much as the headlines would seem to indicate.
It's also notable that more than half of Macy's and Kohl's employees said they would recommend working for their company (also according to Glassdoor). This suggests that employees are relatively satisfied with those companies.
Higher pay will drive higher consumer spending
Another factor that investors may be overlooking is that Kohl's and Macy's both have plenty of working-class and middle-class customers. Persistently low wage levels in the U.S. have helped midrange department stores keep costs down, but the same factor has also made it hard for them to increase their sales.
The improving U.S. economy allowed Macy's and Kohl's to get comp sales growing again in late 2017 following a long slump. Both department store giants posted solid comp sales gains in the first half of 2018, allowing them to expand their profit margins.
Department stores inherently have substantial operating leverage in their physical stores -- i.e., relatively small changes in sales have a disproportionate impact on profitability. As a result, the margin benefit of higher sales could potentially allow Macy's and Kohl's to fund significant wage increases for their lowest-paid employees without killing the bottom line.
Stronger than their rivals
Investors should also recognize that Macy's and Kohl's are much stronger than their rivals in the department store industry. Sears Holdings in particular is closing stores at a rapid pace and may be on the verge of bankruptcy. This is adding to the supply of experienced retail workers looking for jobs following the liquidations of Bon-Ton and Toys R Us.
Furthermore, if department stores are forced to raise wages substantially to keep their employees, it would have a much bigger impact on the likes of Sears and J.C. Penney than on Macy's and Kohl's. The greater the pressure from higher wage levels, the greater the likelihood of one or both of those rivals going out of business, leading to a more benign competitive environment for Macy's and Kohl's.
The valuations are too low
Shares of Macy's and Kohl's have both declined by 10% or more since early September. Macy's stock had already plunged about 16% following its Q2 earnings report in August. As a result, both companies appear to be very cheap right now.
Macy's stock trades for just nine times the company's projected 2019 earnings, even though comp sales have increased for three consecutive quarters and are on track to continue rising. Kohl's shares look a little more expensive at 12 times forward earnings. However, free cash flow consistently exceeds reported earnings at Kohl's, making the stock a lot cheaper than it seems at first glance.
Based on these low valuations, investors aren't counting on any earnings growth for Macy's or Kohl's. With such a low bar for success, shareholders shouldn't be overly concerned about rising wages in the U.S. following Amazon's move to a $15-per-hour minimum wage.
John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Adam Levine-Weinberg owns shares of JCP, Kohl's, and Macy's. The Motley Fool owns shares of and recommends Amazon. The Motley Fool has a disclosure policy.