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Summary

  • Kohl’s screens as undervalued according to our quantitative valuation metric, the Value Score.
  • Two factors - overaggressive geographical expansion and changing dynamics in its target demographic - represent headwinds to Kohl’s.
  • We review why this retailer will be more valuable if there is another construction or manufacturing boom.

Kohl's Headwinds

Kohl's (NYSE:KSS) has faced some commercial headwinds due to two factors: 1) too much expansion into the wrong geographical regions just before the housing market fell off a cliff and 2) changing dynamics in its target demographic. As mentioned above this article is just a part of the analysis conducted on our Focus Report on Kohl's (email sign up required).

First, let's look at the geographical expansion issue.

(click to enlarge)

Source: Company Statements, YCharts Research Analysis

In the chart above, the total number of retail locations for each region (West, South, Midwest and East Coast) are displayed as shaded areas with the aggregate quantity of each shown on the left-hand axis. The total number of retail locations in California (West) and Florida (South) are displayed by green and black lines, respectively, with their quantities shown on the right-hand axis.

While the bump in FY 2007-2008 in Florida is not as visually startling as the 2008-2009 jump in California, note that in percentage terms, Kohl's Florida operations nearly doubled, while Californian growth "only" increased by about one-third.

The other headwind is changing dynamics in Kohl's target demographic: suburban soccer moms.

The Great Recession affected all middle-income families, but there is evidence that the impact on middle-income male wage earners was particularly severe. The collapse in the housing market, combined with fairly high levels of housing inventory, has meant that construction employment - traditionally dominated by men - has remained moribund. Another bastion of male middle-income employment - manufacturing jobs - has also remained weak. This weakness in male employment has meant that more of the responsibility for meeting day-to-day expenses has fallen on female spouses.

(click to enlarge)

Source: Bureau of Labor Statistics, NBER, YCharts Research Analysis

Kristin Smith, a demographer at the University of Vermont's Carsey Institute, published a revealing study in fall 2012 looking at the impact of the Great Recession on the income source of families. Her research (a lay-focused summary of which can be found here) showed that women's wages as a percentage of the total household wages jumped during this period and have remained elevated even after the official end to the recession.

It makes sense that if middle-income families are relying more upon the salaries of female wage-earners, female wage earners will be less able to spend on self-indulgences or will do so less frequently.

These headwinds have clearly affected Kohl's main valuation drivers: revenue growth, profitability and investment level. Let's take a look at each driver in turn.

Revenue Growth

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Source: Company Statements, YCharts Research Analysis

Growth rates at Kohl's were quick as it expanded out of its Midwestern heartland starting in the mid-1990s. While over expansion into Sunbelt states mentioned in the Focus Section led to slow revenue growth in the post-bubble period the firm still has room to grow in Western states. The 121 stores in California make up fully half of all of Kohl's presence in the West, and the firm had begun expanding into the Pacific Northwest just as the housing crisis took hold.

The change in five-year rolling aggregate sales slowed to an average of 5% over the last five years, but expansion into the Pacific Northwest when the economy improves might tack on a few more percentage points worth of revenue growth. A worst-case scenario would be further stagnation and a continued flattening of revenue growth as we have seen since 2012.

Profitability

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Source: Company Statements, YCharts Research Analysis

The most notable feature of this chart is the saw tooth pattern in margins after 2007. This is an artifact two things: 1) the company's sale of its store-branded credit card business in 2007 and 2) our use of cash-based profitability measures. The sale of the credit business (made with excellent timing, in hindsight) meant greater volatility in the year-to-year difference in working capital, but we believe this volatility mainly represents timing issues and does not represent a material change in the business risk of this firm. The notable drop in profitability two years ago is caused by a larger than normal purchase of inventories that year.

In general, a good retailer should be like a machine. A given square footage of selling space in a geographical area with a given demographic profile should reliably churn out fairly stable profits. Indeed, Kohl's profit margins are consistently in the mid-single digit percent range.

When a management team fails to keep the stores in good condition (e.g., Sears Holdings (NASDAQ:SHLD)) or attempts to use the selling space to sell to a different demographic (e.g., JC Penny (NYSE:JCP)), the machine breaks down.

Investment Level

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Source: Company Statements, YCharts Research Analysis

This chart is striking in the difference between investment levels pre-Boom and post-Bust. The company was spending nearly half of its Owners' Cash Profits to expand its geographical footprint before the year ending in 2008 and only about a tenth of it on average since then. The present investment level is extremely low and can be expected to increase as the chain resumes its expansion. This expansion will likely not occur until the purchasing power and disposable income of the middle class improves.

These three factors - revenue growth, profitability and investment level - all drive the amount of free cash flows available to owners.

Free Cash Flow to Owners

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Source: Company Statements, YCharts Research Analysis

A lack of expansionary cash outflows meant that its FCFO has ballooned since the Great Recession - a fact evident by looking at the pattern of light blue columns on the above chart. Pre-recession FCFO averaged -5% as the company built out its presence in the East, the South, then the West. This compares to a post-recession margin of 4% during which time its square footage of selling space has flattened out.

Conclusion

Kohl's has a good business strategy, a strong brand image and high customer loyalty - everything that a retailer could want. However, excess capacity from its Sunbelt expansion during the mid-aughts and its reliance on a target demographic that remains under economic pressure is weighing on its ability to create cash flows on behalf of its owners.

In our opinion, the company will muddle through this rough patch of high long-term unemployment rates and lowered middle-income purchasing power. Management has sensibly ceased expansionary spending and refocused strategy on conserving cash rather than building new stores to boost top-line growth. However, to get the engine of this women's fashion outlet really running again, we need a nice old-fashioned housing bubble and/or a manufacturing renaissance.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Source: Man Trouble At Kohl's