The Day Ahead: A Closer Look at a Couple of Dogs

 | May 16, 2013 | 8:00 AM EDT  | Comments
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Stock quotes in this article:

wmt

,

jcp

Every so often, while playing the role of pundit, you have to take a step back and return to where it all began professionally. For me, it's in the rigorous, yet very geeky world of equity research. Keep the skills sharp or risk losing them! Granted, I have refused to dress like a 45-year-old equity researcher at a bulge bracket obsessed with free-cash-flow computations and corporate-owned newspaper subscriptions. Yet, knowledge-wise, I can certainly rumble with the big dogs.

So this is where I found myself Wednesday: researching two stinking dogs named Wal-Mart (WMT) and J.C. Penney (JCP) ahead of their earnings reports. Both have rather interesting stories.

Wal-Mart shares, for instance, managed to outperform the S&P 500 in the first quarter, I believe due more to retail-investor yield-grab than on any euphoria on the future of the company.

Source: Yahoo! Finance

Sure, the company will generate gobs of free cash flow, which jacks up the coverage from longtime bullish analysts. There is also a better-than-average probability that management will announce a major new share-repurchase plan sometime in 2013. But, after cutting through the pomp and circumstance, I went limp at the moment of truth -- and decided not to recommend the stock into earnings for a quick portfolio score. Here is why.

• Wal-Mart shares trade at a forward price-to-earnings multiple of 13.35x vs. the S&P 500, which trades at an average of 14.65x. I would prefer to roll with an S&P ETF, as the embedded companies are likely to offer stronger earnings growth via pricing power and real traction overseas. Wal-Mart, on the other hand, is eroding its gross margin by investing in lower prices, and it continues to produce subpar international returns.

• Wal-Mart shares trade on a 10% premium to their historical P/E multiple. Are you going to pay up to own Wal-Mart amid earnings-per-share growth that is slower than normal? Come on, get with the program.

• I have concerns on the very structure of Wal-Mart that prevent me from making robust future projections on earnings before interest and taxes. Specifically, I think the company is missing opportunities in food and consumer staples because it can't manage itself properly. In addition, rent expenses are ballooning, a function of rising land values and the company's push into urban markets. These issues are coming in tandem with higher costs to manufacturer goods in areas that include China and Bangladesh.

Then there is J.C. Penney, which has suddenly become a turnaround delight for those lovers of "value" hunting.  Look, the stock has dusted the S&P 500 in the past month!

Source: Yahoo! Finance

The bottom line on this company is that I would be willing to miss upside in order to wait for clear evidence that the business has reached lasting stabilization. In that case, believe me, the bulls will stampede back into J.C. Penney. The thesis here would take into account a significantly reduced expense base (thanks to former CEO Ron Johnson) and renewed customer loyalty, with the argument that this means margins are on track to surpass levels seen during Mike Ullman's prior tenure.

In the meantime, keep these things in mind on J.C. Penney:

• The company recently won a $1.75 billion loan, but only $1.3 billion of it will hit the cash-and-equivalents account on the balance sheet. The rest is destined to pay off debt and various banker fees. Liquidity remains a material issue.

• The company has a whopping 10 million square feet under construction. That means continued store disruption, which leads to operational inefficiencies -- as well as risks to increased Street bullishness.

As for the Broad Market

No news is good news. I say this tongue in cheek, of course -- I was definitely was no fan of the Empire State survey or industrial-production reports.

Now go obsess over Tesla (TSLA).

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