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Shares of department store chain Kohl's (NYSE:KSS) surged Thursday after the company reported better-than-anticipated earnings for its first quarter. Revenue at the retailer fell 1% year-over-year to $4.2 billion as same-store sales declined 1.9%. Earnings per share increased 5% year-over-year to $0.66, exceeding consensus estimates as the share count shrunk. Conversely, free cash flow declined 29% year-over-year to $170 million as the company did not increase its accounts payable as aggressively as it did in the first quarter of the prior year.

We suspect some of the optimism surrounding Kohl's first quarter centers around a slight improvement in gross margins, which increased 50 basis points year-over-year to 36.4%. Management pointed to lower sourcing costs and fewer markdowns as the key drivers, though the firm has yet to see much benefit from improving its inventory mix. Management continues to identify better inventory as a positive driver for gross margin and sales going forward, but we need to see improvements materialize before buying into this notion.

Also on the cost side of the equation, the firm did a decent job of containing SG&A, which only increased 10 basis points as a percentage of sales to 23.7%, even with a larger store base. Management cited payroll control at the individual store level as a key component of cost savings, though it appears the company may ramp its advertising spend in order to drive sales traffic in the second quarter and beyond.

As for sales weakness, the company noted that:

"…we saw significant comp improvements in our weather-sensitive markets, including the Midwest, Mid-Atlantic and Northeast."

Management didn't hammer home excuses about weather as sometimes is the case, but did note there may be some degree of pent-up demand for seasonal items since weather during the first quarter was so much colder than normal. Nevertheless, we think sales should have been stronger, especially since its prime competitor, J.C. Penney (click ticker for report: JCP), saw its same-store sales decline 16.6% during the quarter. In our view, it makes sense for Penney's customers to flock to Kohl's, which we think provides a very similar experience to the pre-Ron Johnson Penney's. We don't know where these customers are going, but it's safe to say Kohl's hasn't jumped on the opportunity.

Overall, we aren't crazy about Kohl's recent performance. Although guidance was decent, as the company conservatively predicted earnings per share of $1.00-$1.08 (which would be flat from the year prior even though the company anticipates $250 million in share repurchases), we simply aren't sure if 2013 will be the year for Kohl's to turn around. Same-store sales growth of 0-2% for the second quarter is relatively unexciting, and we need to see the company improve its cash-generating abilities for its shares to warrant a higher valuation. We remain on the sidelines in the portfolio of our Best Ideas Newsletter at this time.

Source: Don't Be Fooled By Kohl's Earnings 'Beat'