Buying great companies can be enormously profitable for investors over time. Even better, when those great companies are selling at attractive valuation levels, you can be facing an exceptional buying opportunity. Our contributors have been looking for high-quality opportunities in undervalued companies, and they believe lululemon athletica (LULU -1.39%), Kohl's Corp (KSS -3.54%), and Macy's (M -1.36%) deserve some serious considerations from investors.
Tim Green (Kohl's): Since the beginning of April, shares of department store Kohl's have declined by more than 40%. The company's results certainly haven't been great, with comparable-store sales rising by just 0.1% and earnings per share, adjusted for a one-time charge, falling 5% during the latest quarter. But the severe negative reaction seems overdone, and Kohl's stock is now in bargain territory.
There isn't that much of a growth story for the company at the moment. Kohl's has almost completely stopped building new stores after years of aggressive expansion, but with 1,164 locations already, it may have reached its limit. Kohl's is making an effort to grow its e-commerce sales, and it's even testing out same-day delivery by partnering with a delivery start-up. But Kohl's was late to the e-commerce party, and its physical stores still generate the vast majority of sales.
Still, even without the potential for rapid growth, Kohl's remains a highly profitable retailer, and it has routinely rated as the top department store by consumers, according to an annual Nielsen poll. The stock trades for about 11 times last year's earnings, but because Kohl's has slowed store growth to a crawl, net income actually understates the company's true earnings power. Kohl's spent $685 million on capital expenditures over the past year, mostly to maintain its stores, while it took a $907 million depreciation charge. Due to this discrepancy, the stock trades for just 9.6 times the trailing 12-month free cash flow.
Kohl's is no longer a growth stock, but the company generates a lot of cash, pays a solid dividend, and has the ability to buy back a significant number of shares without increasing its debt load. Its recent performance hasn't been stellar, but with the stock falling so hard over the past few months, the price looks right.
Steve Symington (Lululemon): Shares of Lululemon are down more than 20% since the yoga apparel specialist reported fiscal second quarter results just over a month ago, despite the fact that it easily beat analysts' expectations on both revenue and earnings per share.
As I pointed out shortly after the report, that decline was primarily caused by Lululemon's guidance for the current quarter, in which revenue again came in ahead of expectations, but earnings fell short. Combined with the fact that inventories skyrocketed 55% year-over-year -- significantly outpacing revenue growth of 16% over the same period -- some investors believe Lululemon's bottom line will continue to suffer if it needs to resort to discounting to bring inventories back in line.
During the subsequent conference call, however, Lululemon CFO Stuart Haselden noted Lululemon maintained its outlook for inventories and "remains on track to meet its goals to sell down late seasonal arrivals with 'little or no markdown risk.'" Haselden further explained that year-over-year inventory growth looked especially high in part, because the company was "significantly under-inventoried" in the same year-ago period.
In addition, Lululemon CEO Laurent Potdevin insisted that gross margin pressure should persist only over the near-term and is "not the result of higher markdowns or quality issues" but rather due to Lululemon investing in its business to foster international growth. Consequently, Lululemon also increased its full-year guidance for both revenue and earnings per share. As a longtime Lululemon investor myself, I'm pleased the company remains on track to meet its goals, and I remain convinced the recent pullback is a great opportunity for patient investors to open or add to their positions.
Andres Cardenal (Macy's): The retail industry has always been quite challenging and competitive, especially among department stores. With the rise of e-commerce, price comparison apps, and similar technologies, the economic environment for companies in the sector is now more demanding than ever.
Macy's is not immune to these difficulties, but the company is staying on the right side of industry trends and making a big effort to adapt to the omnichannel retail paradigm. It's not just about having a big online presence anymore -- the lines between physical stores, online, and mobile shopping are blurring, and Macy's is positioning itself to deliver what customers want across different channels.
Management has been keeping its physical presence in check over the last several years, and it has recently announced it will be closing 35 to 40 underperforming stores in early 2016. All of the company's stores now function as distribution centers for orders made online or via mobile devices, and Macy's is expanding its online footprint in China via a joint venture with local player Fung Retailing. Transformations are never easy, but Macy's seems to be moving in the right direction.
Importantly, Macy's looks attractively valued. The stock carries a price-to-earnings ratio in the neighborhood of 12.5 times earnings over the last year, a big discount versus the average company in the S&P 500 index, with a price-to-earnings ratio around 18 times. At these prices, investors in Macy's are buying a well-managed company for a conveniently low price.
