Kohls (KSS) is not an exciting stock, and department stores are not an exciting investment category, but the current valuation of Kohls and the company's unusually good financial track record make Kohls a very attractive investment opportunity. In the last year, most of the media's attention on the department store category has been focused on Bill Ackman and Ron Johnson's attempt to turnaround JC Penney and on Eddie Lampert's efforts to build shareholder value at Sears. The poor operating performance of these companies has contributed to the perceived riskiness of the department store sector. The struggling stalwarts, along with stretched middle class consumers that are shopping more and more at places like Wal-Mart (WMT) and Marshalls, has caused prices of the entire department store category to fall to unusually low multiples of earnings, revenues and book value. Kohls has survived the worst of the recession and has continued to produce excellent cash flows as its mall-bound counterparts struggle. In this article I outline the current valuation of Kohls, examine why the shareholder friendly management will help Kohls achieve attractive returns, discuss some of Kohls competitive advantages that distinguish it from its competitors, and point out a potential catalyst that might cause the stock to trade higher.
Valuation and Multiple Contraction
Kohls current valuation is near its 10 year lows. Kohls currently trades at a trailing P/E ratio of 10.8, and a forward P/E ratio of 10.1. Over the last decade, Kohls has seen its P/E ratio contract from 42 (the high reached in 2003) to the current ratio of 10.8. Similar to many excellent growth companies that had nose-bleed valuations at the beginning of the 2000s, Kohls has continued to grow its business earnings and cash flows, but its stock price has remained stagnant due to the earnings multiple contraction. Kohls increased its earnings per share between 2003 and 2012 from $1.87 to $4.30, an increase of 130% over the last ten years while the stock price remained flat. Additionally, Kohls book value per share has compressed from 3.9 in 2003 to 1.7 in 2012, resulting from a declining perception of the value of Kohls' assets. Once investors realize that Kohls is not destined to be another Sears (SHLD) or J.C. Penney (JCP), the valuation should increase to at least a market multiple. This could be a bump of 40% or more in valuation alone once perception shifts.
Experienced, Shareholder Friendly Management
One of my favorite things about Kohls is the ownership mentality of management. As of the company's proxy statement dated January 28, 2012, the Board of Directors and Executive Management collectively owned 8.8% of the company (21,404,296 shares worth $989,948,690). This management team has a lot of faith in the Kohls' franchise. Kevin Mansell, the current CEO, has been with Kohls for 29 (president for the last 12 years). The former CEO, William Kellogg, retired in 2000 after 34 years of service and still serves on the board of directors and holds a large number of shares. The interesting back-story here is that William Kellogg led a leveraged buy-out to buy Kohls in 1986 from British American Tobacco, grew the store under private ownership, went public in 1992, and has grown Kohls into what it is today. Thanks to Kohls, Kellogg is now on the Forbes list of richest people. Some have recently been concerned by large insider sales by some of Kohls' executives, but I believe these sales (which were a small portion of overall holdings) were just part of a plan to avoid larger capital gains taxes before the fiscal cliff.
The capital allocation strategy of management is impressive. Over the last two decades, Kohls was growing its store base quickly and profitably. Now that Kohls has such a large store base in the United States, and given the low valuation of Kohls stock, management has been decreasing capital expenditures on new store openings and aggressively buying back Kohls stock. Kohls currently has $3.5 billion dollars approved for share repurchases, and management expects to use this repurchase authority over the next three years. Considering the market cap of Kohls is $10.6 Billion, this would reduce the number of shares outstanding by 33% at current market prices. If Kohls stocks languishes over the next three years at current prices, but maintains its earnings, Kohls' earnings per share would increase substantially. In addition to the share repurchases, Kohls' initiated a dividend in 2011 and increased the dividend in 2012 by 28%. The current yield is 2.76%.
Kohls' Competitive Advantages Distinguish it from Peers
It is difficult to create a competitive advantage in retail stores. The odds are that by the time a company has a formula that works, the formula will be ripped off and copied by someone else. In spite of the difficulty in creating a competitive advantage in retail, I believe Kohls has managed to carve out a niche in the department store space that allows it to continue to increase profitability while competitors struggle.
The first competitive advantage is that Kohls' management operates the business for the benefit of shareholders and focuses on cost-control (since they are large shareholders themselves). In the retail business, having a low cost of operations is the key to long term sustainable operations (just ask Sam Walton's kids or James Sinegal of Costco (COST)). Kevin Mansell, the CEO of Kohls, continues to focus on cost savings as a key priority for the company, and said the following on Kohl's latest quarterly call: "As I mentioned just a moment ago, our teams again delivered solid expense results in the second quarter. Our operational process changes and technology-driven productivity changes are generating sustainable expense savings. But we will not become complacent. We will actively pursue opportunities to generate additional savings in the future to allow us to operate most efficiently and pass the greatest value onto our customer."
The second competitive advantage is Kohls' increasing focus on exclusive brands. In 2004, only 25% of Kohls merchandise was exclusive. Kohls' CEO Kevin Mansell recently said that 53% of Kohls third quarter sales were private and exclusive Only-at-Kohl's Brands. He explained, "This increase was the result of our new exclusive brands, Jennifer Lopez, Marc Anthony, Rock and Republic and Princess Vera Wang, as well as strong sales in Chaps, LC Lauren Conrad and FILA SPORT." These brands cannot be bought at JC Penney or Sears or Wal-Mart or Amazon.com (AMZN). This means that half of the brands (and growing) are "Only at Kohls." In a world where most department stores seem to have the same items, this is a point of differentiation that seems to be drawing in customers.
The third competitive advantage for Kohls is its strategy to be located in convenient off-mall locations. There are several benefits to the off-mall strategy. First, the convenient off-mall locations allow busy working parents to shop for affordable clothing for their family after their regular run for supplies at Target (TGT), Wal-Mart, Costco or the local supermarket. It is much easier for most people in America to run into Kohls after their grocery shopping than to go to the mall for everyday clothing items. Second, pursuing off-mall locations has allowed Kohls to own a large chunk of its real estate -- as of the end of 2011, Kohls owned 403 of its 1127 locations. This real estate holding is a significant value for shareholders and provides an additional margin of safety in the purchase of Kohls stock.
Potential Catalyst - LBO speculation
There has been some recent buzz that Kohls might be a leveraged buy-out target. I could understand why given the low valuation. A buy-out would need to be management-led considering management's large shareholdings, but this may not be out of the question since management has taken Kohls private before! The large stock buy-backs over the next three years might be designed to increase the shareholdings of management before a going-private transaction is consummated. But even if an LBO does not happen, the speculation might get more institutional shareholders to see the value embedded in Kohls' stock. Buy the stock before this happens, and you should be rewarded over the next few years.
Additional disclosure: Long KSS at $43.62/share