Better Buy: Macys, Inc. vs. J C Penney Company Inc.

By Markets Fool.com

Will these popular retailers see their stocks move up or down in the coming years?

Continue Reading Below

J.C. Penney and Macy's represent the "old guard" of fashion retailers. The two have been in operation for a combined 272 years. It's tough to find that type of longevity in today's business world.

But this belies the challenges the entire retail industry has faced since the Great Recession. Coming out of 2009, malls have fallen out of favor, and e-commerce has exploded -- rendering a number of brick-and-mortar chains obsolete. Both J.C. Penney and Macy's have managed to survive the first wave of e-commerce migration, and with shares trading significantly lower than all-time highs, the individual investor might ask: Which is the better buy today?

Here's how I think we should measure that question.

Financial fortitude
One of the reasons Penney and Macy's are still around is that each company had the financial fortitude to weather a downturn in sales. While smaller players were forced to close up shop, accept a buyout, or declare bankruptcy, both companies had a level of flexibility that allowed them to survive.

But that flexibility has largely been spent. That's why it's crucial for investors to keep an eye on both cash and debt levels moving forward. Here's a look at those metrics, along with how much net income and free cash flow (FCF) each company produced over the past 12 months.

Continue Reading Below

Company

Cash

Debt

Net Income

Free Cash Flow

J.C. Penney

$900M

$4.7B

($513M)

$120M

Macy's

$1.1B

$7.0B

$1.1B

$1.2B

Source: SEC filings.

This ends up being a game of "pick your poison." On one hand, Penney has just under $1 billion in cash on hand, and $4.7 billion in long-term debt. While that sounds like a hefty mismatch, Macy's has about the same level of cash, but a debt burden that's 50% higher than Penney's. That would make Penney seem like the clear winner.

But when we look at how each company is operating right now, Macy's is the clear winner -- even after Penney recently saw its stock jump on a positive earnings report.

Macy's is profitable on paper and produces 10 times the FCF that Penney does. Given that Macy's is only valued at five times the market cap of Penney, it's clear that Macy's is doing a better job running its business profitably right now.

Winner = both.

Valuation
There are several ways to value retail companies. Three popular metrics are price-to-earnings (P/E), price-to-free-cash-flow (P/FCF), and price-to-sales (P/S). Here's how Macy's and Penney stack up.

Company

P/E

P/FCF

P/S

J.C. Penney

N/A

25

0.2

Macy's

11

11

0.5

Sources: SEC filings, Yahoo! Finance.

While it's true that Penney does sell at a discount to Macy's on a P/S-basis, Macy's is the clear winner here. As I stated, Macy's is turning a profit on paper and has been doing a better job at putting actual money in its bank account (FCF) than Penney. Trading at less than half what Penney is on a FCF basis, Macy's almost looks like a steal at today's levels.

Winner = Macy's.

Sustainable competitive advantages
I saved the most important aspect for last. The most difficult thing for retail stores is that there are fairly low barriers to entry. Anyone can open up shop and start selling clothes and accessories. And while it takes decades to build a brand that people can trust, it only takes a few scandals for that trust to evaporate.

Add in the high overhead costs associated with operating brick-and-mortar stores, and you can see why a sustainable competitive advantage is tough to come by in this industry.

Currently, Penney is in turnaround mode. Management has teamed up with Sephora -- a French cosmetic brand -- to help draw customers into their stores. Once in, the thinking goes, those customers are then ripe to make other purchases within the store.

Macy's, on the other hand, has been working very hard to make itself into the strongest e-commerce player in the industry. The company has been building out a small infrastructure of fulfillment centers to shorten delivery times and convince customers to frequent its site -- over bigger names such as Amazon.com -- to meet their apparel and accessory needs.

Long-term, it's tough to say which approach will work better. Macy's could be a big winner, but only if it can continue to succeed as an e-commerce player. Penney is playing it safer: taking on less debt and counting on a slow and steady recovery.

To help me decide, I investigated same-store sales (which include e-commerce) to see which approach has been paying off.

Same Stores Retail Sales
Create column charts

Here again it is very difficult to discern a winner. Penney has had some awful years lately, but seems to have steadied its ship. Macy's, on the other hand, is currently riding a downward trend.

Winner = both

At the end of the day, I'm not convinced either of these retailers is particularly worthy of your investment dollars. If forced to choose, however, I'd go with Macy's. I like management's bold vision for e-commerce, and I haven't yet mentioned that the company currently offers a 3.5% dividend yield -- while J.C. Penney offers none.

That's enough to give my (cautious) nod to Macy's.

The article Better Buy: Macys, Inc. vs. J C Penney Company Inc. originally appeared on Fool.com.

Brian Stoffel owns shares of Amazon.com. The Motley Fool owns shares of and recommends Amazon.com. 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.