Hottest Trend in Retailing: Department Stores?

Group 1: Best Buy, Walmart, Target, Home Depot, Lowes.

Group 2: Federated, May, Kmart, Sears, JC Penney.

Rewind the investment landscape a year and see which retailers Wall Street was talking about. It was the first group of companies listed above. However, nowadays it’s the second group that is getting all of the attention.

First it was Kmart buying Sears. That was supposed to be a unique situation. Kmart had come out of bankruptcy. Eddie Lambert already owned a chunk of Sears, so it made sense to buy the rest with the fortune he was making on his contrarian purchase of Kmart. Kmart owns most of its locations and has cheap lease agreements dating back decades for the rest of its attractive off-mall locations. However, once the real estate strategy was uncovered by Kmart, Wall Street analysts turned their attention to every other major retailer to try and quantify how much hidden value was there.

Federated recently announced they were buying fellow mall-based department store giant May. The stock have been on fire ever since. JC Penney has jumped 25% since rumors of that deal heated up. All of the sudden, department stores in malls across the country are the hottest investment idea in retail. But does this make any sense? Will every retail merger result in a Kmart-like jump in shareholder value?

Not likely. Merging two poorly-run retailers does not create a larger better-run, more profitable company. Shoppers have abandoned mall department stores over the years for good reason. And they’re not coming back. The attractiveness of the Kmart/Sears deal is less about improved operations as it is about creating shareholder value via other means. This will be done by selling real estate and other non-core assets. Sears can sell its stake in Sears Canada and its Lands End subsidiary. Kmart can sell more store locations since there is usually a Sears within a few miles of Kmart. The cash flow is not going to come from an influx of new customers beating down the doors of the recently renovated Kmart store that now is called Sears and carries Craftsman tools.

Why then, are the share prices of Federated, May, and Penney through the roof? It’s a valid question. A lot of people think every retailer can harness the Sears/Kmart model. If that was the case, wouldn’t they all have done it long ago? To show how speculative some investors have gotten, you only need to look at rumors that helped Circuit City stock rally. They were rumored to be looking at selling some of their real estate, given their dismal track record competing with Best Buy. Only one problem, though. Circuit City doesn’t own any real estate, they lease their stores.

I would be leary of the rallies in Federated/May and JC Penney. I hope they can get their acts together and increase profitability. It just seems unlikely that the people that have driven customers away and created an abundance of poorly-run and unappealing department stores would all of the sudden be able to turn their companies into gold, simply by merging and trying to duplicate someone else’s strategy.