JC Penney (JCP) has lost sales in its changeover to an everyday low-pricing strategy, but those customers haven't moved disproportionately to Kohl's (KSS), its most direct competitor.

I was surprised since, as a rule, dissatisfied department store customers generally switch to another department store. Instead, JC Penney customers have dropped out of the category altogether and traded down to discount stores.

Having looked more closely at Kohl's, I believe the retailer is suffering from the same extreme consumer trade-down as J.C. Penney.

Kohl's reported flat comparable-store sales in its recent quarter. Average transaction value was up 1.6%, with pricing up 4.9%, and units per transaction were down 3.3%. Traffic decreased 1.4%. So Penney's sales shortfall in the past quarter did not help Kohl's but seems to have gone disproportionately to discounters Wal-Mart (WMT), Target (TGT) and Costco (COST), in that order. Total inventory was up 7% on a 2% sales increase.

Management had projected gross margin to be down 160 basis points but dropped 220. This was against a backdrop of private and exclusive brands being up 50% to 53% last year to this year and a continuing launch of higher-priced exclusive brands rather than less expensive private-label offerings. Management attributed the additional gross-margin decline to the depth of promotional markdowns.

Part of the reason given for the poor total unit sales number was that the company needed more inventory at opening price points, which are heavily private-label offerings. Executives said they were seeing a lot of price elasticity on some items.

Remodelings were cut by 50%. Gross-margin guidance was for 200-250 bps of decline in the second quarter.

All of the above leads me to believe that Kohl's is going to continue to suffer from more economically strapped consumers. I can only believe consumers are shifting purchases out of Kohl's to Wal-Mart, Target and Costco, only at a slower rate than than seen at Penney, where the exodus was hastened by a disastrous pricing strategy that failed upon roll-out, costing the president his job.

Gross margin has reached a historical high of around 38%, up 200 bps over the past few years, with the addition of many exclusive brands. The pace of these roll-outs can probably not be sustained, as consumers look to be moving more to less expensive private labels. Though management is guiding to only a 70-basis-point decline in gross margin for the year, the declines seen in the past two quarters (and the bearish pricing comments made by management) point to questions about the company's ability to maintain a department store's typical high operating margin in the 11% range.

So while the stock looks cheap at $45, discounting essentially no earnings-per-share growth at all, the stock market does not believe returns will hold. I do not believe they will hold either. 

A 2% decline in operating margin means that the stock discounts a 3% growth rate for per-share earnings over five years. A 3% decline in operating margins implies a 6% growth rate for EPS over the same period to justify $45. My guess is that the average department store over the next five years will have a 4% to 5% growth rate. So the stock looks to be fairly valued, if you believe the profitability hits of this magnitude.

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