When it comes to purchasing retail stocks, I believe a significant margin of safety is necessary, particularly if you aren't overly optimistic on consumer spending in the face of high unemployment. One retail operation that I've been following for some time in the hopes of finding a good entry-point is Kohl's Corp. (KSS). The company operates 1,146 stores in 49 states and has a focus on providing excellent value to customers through offering moderately priced, exclusive and national brand apparel. Most stores are at conveniently located, off-mall locations. I've long admired the fact that Kohl's is one of the lowest cost operators in the retail industry and the company's capital allocation is excellent. The stock has sold off significantly of late based on the November 29th announcement that same store sales for November were down 5.6% YoY, and 4.9% total. This sell-off marks the buying opportunity that we have been looking for, and at current prices Kohl's offers excellent long-term value for the patient investor.
One of the first things that caught my attention when I began looking at Kohl's a while back was the prudent capital allocation strategy employed by management. In 2003, the company had 347MM diluted shares outstanding, and as of October 2012 that number has dwindled down to 235MM diluted shares. This 32% reduction in the share count increases the long-term investor's ownership stake in the business. In addition, most of these buybacks were done at excellent prices, which increases the intrinsic value of the business. Many market participants laugh at Sears Holdings (SHLD) due to its contraction in sales and profits over the years, but Edward Lampert has been enormously successful investing in retailers Sears, Autozone (AZO), and Autonation (AN) largely because of his prowess in capital allocation. As opposed to growing the store footprints for the sake of growing, these companies focused on buying back stock at discounts to intrinsic value. When these companies have leveraged technology to improve their operating efficiencies and same-store sales, the result on earnings has been exceptional. If Sears would have expanded its footprint like Best Buy (BBY) tried to do for many years, the company would likely have gone bankrupt through over-leveraging itself on a declining retail concept. Sears has been the laggard of the three, but Kohl's reminds me a lot more of the other two due to its current standing as one of the most efficient retail operators in the industry.
Kohl's operating margins have been in excess of 11%, which is better than many of its peers including Macy's (M), and is far better than J.C. Penney (JCP). A big reason for this is that Kohl's is notoriously good at keeping its SG&A expenses low, and all of this leads to solid profit margins around 6%. That compares to less than 5% for the well-run Macy's franchise. Kohl's return on assets has averaged better than 8% over the last decade, while ROE and ROIC have been around 15% and 10% respectively over the last 5 years. Kohl's clearly is earning returns in excess of its cost of capital, and because the company is prudent with its capital management Kohl's has done right for its shareholders.
Source Kohl's 10-K and Real Estate Presentation on IR Site
Kohl's owns about 36% of its real estate and generally has long-term operating leases on the other locations. When I buy large retail operations, I like feeling a sense of security by knowing that it is possible to unlock additional value through the real estate. Most Kohl's real estate is in very convenient locations with easy to access parking. The company has slowed down on its growth plans, which I believe is prudent based on my conservative long-term outlook for consumer spending. Kohl's tries to remodel each of its stores once a decade and I like that the company is very careful in monitoring its return on investment on these remodels.
Kohl's is really a family oriented store and offers a convenient choice for budget conscious consumers. Over the last several years the company has improved its private label and exclusive national brands. This was reflected in 3rd quarter sales where private and exclusive Only-at-Kohl's brands represented 53% of sales, up 150 bps YoY. Some of their new exclusive brands include Jennifer Lopez, Marc Anthony, Rock and Republic and Princess Vera Wang. The company also pointed to strong sales in Chaps, LC Lauren Conrad and FILA SPORT. These different brands allow Kohl's to reach all points of the value chain and maximize store traffic. The company has also invested a great deal in its eCommerce site, which has been bearing fruit. These sales have lower gross margins than in-store sales, but obviously eCommerce is very scalable, therefore the company is making the right investments in right sizing its distribution.
At a current price of $43.88 and on 235MM shares, the company has a market capitalization of roughly $10.3 billion. The company does carry $2.492 billion in long-term debt and $1.986 billion in capital leases, so I don't think the company should use too much more leverage moving forward. Over the last 5 years, the company has averaged in excess of $1 billion in net income while free cash flow ebbs and flows with capital spending. Earnings per share have increased far faster than revenue or net income due to the aggressive share buybacks. Over the last twelve months the company has earned $4.39 per diluted share, and the company guided in October for $4.52-$.4.60 in fiscal year 2012 EPS. I'd expect to see management increasing the rate of share buybacks due to the roughly 20% decline in the stock price, which could actually cause EPS to hit the high end of the range, assuming a good Christmas. Last year the company was able to pass on higher costs of goods sold to customers, but the company was light on inventory in the 4th quarter, which hurt sales. The situation seems to be rectified this year so I'm optimistic that the company should do pretty well. Earnings are likely to increase at a low double-digit pace over the next 2-3 years factoring in buybacks, so the current valuation of less than 10 times 2012 EPS is really attractive. Factoring in the dividend yield that is right around 3% makes the opportunity even better, and I believe that a good holiday season and 2013 outlook could have the stock trading above $55 per share before long.