Better Buy: J. C. Penney Company, Inc. vs. Kohl's

By Markets Fool.com

Department stores are having a tough time adapting to changing consumer habits. Macy's, the largest department store chain, is taking the dramatic step of closing around 15% of its stores in an effort to boost profitability amid slumping sales. Neither J.C. Penney (NYSE: JCP) nor Kohl's (NYSE: KSS) are faring quite as badly as Macy's, but both will face challenges in the years ahead.

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With J.C. Penney aiming to return to profitability in the next few years, and with Kohl's trying to simply prevent earnings from declining, which stock is the better buy?

The case for J.C. Penney

Image source: Mike Mozart via Flickr.

J.C. Penney, which looked as though it could fail a few years ago after a disastrous drop in sales, has been slowly clawing its way back. Comparable sales have been increasing, albeit from a low base, and the company now has a long-term plan to return to meaningful profitability. While J.C. Penney posted a net loss of $513 million in fiscal 2016, the company expects to produce as much as $500 million in net income by 2019.

The potential for a $1 billion swing in profit means J.C. Penney stock could have some serious upside if the company can follow through. The stock currently sports a market capitalization of just $2.9 billion. If J.C. Penney actually manages to produce $500 million in profit by 2019, the stock could easily double. However, the stock could also decline if the company comes up well short.

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J.C. Penney's plan involves a renewed focus on home goods, including major appliances, beauty products, and special sizes, all in an effort to bring in new customers. E-commerce is getting some love as well, with the company planning to reduce its standard delivery turnaround to two business days next year for 95% of the U.S. population. These are all good ideas that should help J.C. Penney continue to grow sales.

J.C. Penney also plans to boost its private-label business, bringing private and exclusive brand penetration up to 70% of sales by 2019. While private-label merchandise carries higher gross margins, the move has the potential to backfire. Kohl's tried a similar move a few years ago, only to backtrack when customers unable to find their preferred national brands began shopping elsewhere.

J.C. Penney is a high-risk, high-reward investment at this point. The company has successfully stabilized itself and is no longer in immediate danger of failing, but it still has a lot of work to do before it can return to profitability.

The case for Kohl's

Image source: Kohl's.

Kohl's spent much of the past decade rapidly expanding its store count, but the company halted that effort in recent years as sales began to weaken. Comparable sales growth has been inconsistent in recent quarters, slumping 1.8% during the second quarter of 2016 after rising by 0.1% during the prior-year period. Profits have been falling as well as the company attempts to maintain its gross margin and cut costs amid weak sales.

Kohl's expects to produce between $3.80 and $4.00 per share in earnings this year, excluding a few one-time charges. Buybacks are helping boost per-share numbers, but Kohl's EPS has gone nowhere for years because of slumping net income. Sales in fiscal 2016 were essentially the same as in fiscal 2013, but operating expenses rose by nearly $300 million, knocking down profitability.

The market has become pessimistic on Kohl's, pushing the stock price down to less than 11 times the midpoint of the company's full-year earnings guidance. The company has made some progress; during the second quarter, Kohl's managed to boost adjusted per-share earnings by 14% through inventory and cost management. Still, in the long run, Kohl's will need to halt the ongoing comparable-sales decline in order to return to earnings growth.

The verdict

I'm a fan of turnaround stocks that the market has given up on, but my preference is for companies that remain profitable. The market is pricing J.C. Penney at 6 times its expected net income in 2019 because it doesn't believe the company will hit its target, and I tend to agree. If the company fails to return to profitability in the next few years, the stock could tumble.

I own shares of Kohl's because I think the market has become too pessimistic. The company still generates plenty of profit, enough to pay a 4.6% dividend and fund significant share buybacks. It needs to figure out how to return to growth, but unlike J.C. Penney, investors in Kohl's get paid to wait.

For investors willing to take a gamble on a potential double, J.C. Penney is the way to go, but I'll take Kohl's any day.

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Timothy Green owns shares of Kohl's. 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.