Earlier this year, it seemed like smooth sailing for the top two U.S. department store chains: Macy's (NYSE:M) and Kohl's (NYSE:KSS). Macy's had finally reached its margin target after six years of double-digit EPS growth, while Kohl's was on the mend following a few rough years.
However, both companies have reported disappointing earnings results in 2015 and investors have quickly bailed on the stocks. Macy's and Kohl's both had share prices above $70 earlier this year -- now each one trades for well under $50.
Macy's and Kohl's certainly face competitive pressure, particularly from online retailers. But the ongoing rout in retail stocks has driven shares of both retailers down to the point where they trade for about 10 times earnings. At these low prices, Macy's and Kohl's offer a lot of upside for investors relative to the remaining downside risk.
Death by a thousand cuts
Shares of Macy's and Kohl's have declined almost in lockstep with earnings expectations for the two department store operators. Both companies had to slash their 2015 EPS guidance due to weak results during the year. As the charts below show, analysts have sharply reduced their earnings estimates for Macy's and Kohl's for 2015 and also for 2016.
The two retailers have offered a wide range of explanations for their weaker-than-expected sales and earnings. In August, Kohl's CEO Kevin Mansell noted that lower seasonal demand, a change in the timing of some tax-free weeks, and a later start to the back-to-school shopping season negatively affected Q2 sales.
Macy's CEO Terry Lundgren pointed to some similar headwinds. He blamed Macy's poor Q2 sales performance on weak consumer demand for fashion and home items, disruptions caused by the West Coast port slowdown in late 2014 and early 2015, the removal of a major promotional event during the quarter, and the strong dollar. CFO Karen Hoguet added that the transition to a new organizational structure continued to dent Macy's performance in Q2.
Clearly, midpriced department stores like Macy's and Kohl's have had some bad luck in 2015. They may be about to face some more bad luck, as several analysts believe that unseasonably warm fall weather is leaving them with a glut of cold-weather merchandise.
However, the scale of the problems is too big to attribute to luck alone. Department stores will continue to face a tough environment as online and off-price retailers grow rapidly. Another challenge is the shift in consumer spending priorities toward tech products.
Macy's and Kohl's are making smart moves
Despite the pressure both companies are facing, they also have significant opportunities to improve their results. For example, in the past year or so, Kohl's has started to implement some sensible strategy improvements. These include catching up on "omnichannel" capabilities -- i.e., creating a seamless experience between in-store and online shopping -- and localizing product assortments at each store.
Macy's mastered both of these things years ago. This has helped it dramatically increase its operating margin over the past five years. Meanwhile, Kohl's profit margin has suffered. As Kohl's improves its execution on retail basics, its operating margin could expand to the higher levels it achieved just a few years ago.
Macy's is already pretty good at the retail basics, although as noted above, an organizational restructuring caused some problems earlier this year. However, it has a potentially significant opportunity to extract value from its vast real estate holdings.
A few months ago, Macy's took one step in this direction. It agreed to sell the upper floors of its Brooklyn store and an attached parking garage to a real estate company. Macy's will get $170 million in cash, plus another $100 million toward the renovation of the remaining store -- which will still be quite large at 310,000 square feet.
However, some investors think Macy's can go even further. Jeffrey Smith, CEO of activist investment firm Starboard Value, claimed earlier this year that Macy's real estate is worth a whopping $21 billion. He has urged Macy's to spin off its real estate assets as a separate publicly traded REIT in order to maximize shareholder value.
If Smith's estimate is even remotely accurate, then Macy's is sitting on a gold mine. After its recent stock slide, Macy's market cap is just $15.3 billion and its enterprise value (including debt) is $22.6 billion. That's not much more than the value of its real estate alone.
The sky isn't falling
Macy's and Kohl's are in the midst of a rough year, but investors seem to have become overly pessimistic about both retailers. Kohl's earnings could bounce back in the next few years as the company improves its "omnichannel" capabilities and starts offering localized product assortments in each store.
Meanwhile, Macy's is likely to continue monetizing underutilized real estate, at the very least. It could also potentially take the much bolder step of spinning off its real estate as a separate REIT.
Finally, Macy's and Kohl's are likely to return a lot of cash to shareholders. Macy's shares now offer a dividend yield above 3% -- for Kohl's, the yield surpassed 4% this week. With the stocks trading for about 10 times earnings, both companies are also likely to buy back more shares, providing one more lever for future EPS growth.
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.