Keep an Eye on Kohl's

 | Aug 27, 2013 | 10:00 AM EDT
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It's been a brutal second fiscal quarter (ending July 31) for most retailers, and investors have consequently taken these stocks to the woodshed. One of the few companies that reported a decent quarter was Kohl's (KSS), the moderately priced department-store chain headquartered in Wisconsin. Not surprisingly, its stock has recently held up better than most of its peers.

Kohl's is a full-line department store chain with nearly 1,200 locations in 49 states. Its core target is the "Mom" demographic -- married women ages 29-54 with household income close to the $100,000 range. Its stores are on the newer side, generally free-standing or in power strips, not as mall anchors. Management has done a good job of implementing an "omnichannel" (integrated store plus Internet) strategy, resulting in a redeployment of capital spending from new store development to IT and distribution center investment.

A key merchandising tactic has been the deliberate emphasis on private-label and exclusive brands at the expense of national brands. This strategy should generate higher margins, but it has also recently weighed on comp-store sales.

Kohl's has an adequate balance sheet, and it has used its sizable free cash flow to initiate and to rapidly increase its dividend (it's now a 2.7% yield) and to markedly reduce its share count through a repurchase program (outstanding shares are down by 26% in the last three years). The company plans to reduce its outstanding shares by roughly 10% annually for the next few years, while maintaining its aggregate dividend payout. The result will be a per-share dividend increase of the same 10% per year.

Management has faced some criticism, mainly because of a poorly placed bet on merchandise and a related inventory build during last year's holiday season. CEO Kevin Mansell acknowledged the failure at the beginning of this year and said that management knew how to fix it.

The company's operating performance in the fiscal second quarter demonstrated progress and surprised many observers by coming in as expected on both the top and bottom lines. The company slightly trimmed forward guidance, even though management has demonstrated progress on inventories, merchandising and gross margin. The back-to-school season has gotten off to a good start, and testing of a customer loyalty program looks to be successful. Importantly, Kohl's has improved its sales of national brands such as Nike and Keurig, in response to concerns that emphasis on exclusive and private labels such as Rock & Republic and Croft & Barrow had become too dominant in the store.

Expectations for Kohl's earnings per share are $4.26 for this year ending January and $4.68 for the following year; we believe both figures are reasonable. On that basis, Kohl's stock would trade at around 12x earnings and then 11x. This undervalues the company in our opinion, given our estimate of intrinsic value in the low to mid $60s.

We like the investment case for Kohl's, but we are not ready to buy at the current price. Kohl's has a solid business, good locations, a distinct strategy, stable financials and an interest in doing well by shareholders. Despite these favorable attributes, we feel no great urgency to buy it right here. There is a definite headwind among retailers, and despite Kohl's recent results and the prospects for substantial growth in its already attractive dividend, we believe that the industry's negativity could affect Kohl's stock price as well. Indeed Kohl's stock price movement last week reflected that sympathetic negativity.

In light of that, we would wait and watch. Right now we would be buyers at $46 or lower. Kohl's might not get to that level, but at this moment we think it's worth holding out for that price. We will keep readers posted if and when our thinking on the entry point changes.



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