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Summary

  • Kohl's has had some operational issues this year but shares have moved to multi-year highs recently.
  • Waning demand and compressing margins have weighed on operating results, making shares a bit expensive here.
  • KSS' dividend yield is attractive and will likely buoy shares on a pullback.

After a rocky 2012, shares in discount retailer Kohl's (NYSE:KSS) rebounded nicely and recently, are trading at multi-year highs. The retailer has had some false starts in 2014 as well with some well publicized issues making shares volatile so far this year. After stagnating for years now, is there any value in KSS around $57? In this article we'll attempt to answer that question and take a look at KSS going forward.

(click to enlarge)

To do this I'll use a DCF-type model that you can read more about here. Basically, the model uses inputs such as earnings estimates, which I've sourced from Yahoo!, dividends, which I've set at 6% growth per year, and a discount rate, which I've set at the 10 Year Treasury rate plus a risk premium of 6.5%, reflecting the relative stability and nature of KSS' business but allowing for the operational issues that Kohl's has experienced as well. Applying a discount rate is more art than science so yours may not be the same as mine.

 

2013

2014

2015

2016

2017

2018

2019

Earnings Forecast

       

Prior Year earnings per share

 

$4.05

$4.27

$4.70

$4.94

$5.20

$5.47

x(1+Forecasted earnings growth)

 

5.40%

10.10%

5.20%

5.20%

5.20%

5.20%

=Forecasted earnings per share

 

$4.27

$4.70

$4.94

$5.20

$5.47

$5.76

        

Equity Book Value Forecasts

       

Equity book value at beginning of year

 

$28.48

$31.19

$34.23

$37.43

$40.77

$44.27

Earnings per share

 

$4.27

$4.70

$4.94

$5.20

$5.47

$5.76

-Dividends per share

 

$1.56

$1.65

$1.75

$1.86

$1.97

$2.09

=Equity book value at EOY

$28.48

$31.19

$34.23

$37.43

$40.77

$44.27

$47.94

        

Abnormal earnings

       

Equity book value at begin of year

 

$28.48

$31.19

$34.23

$37.43

$40.77

$44.27

x Equity cost of capital

9.00%

9.00%

9.00%

9.00%

9.00%

9.00%

9.00%

=Normal earnings

 

$2.56

$2.81

$3.08

$3.37

$3.67

$3.98

        

Forecasted EPS

 

$4.27

$4.70

$4.94

$5.20

$5.47

$5.76

-Normal earnings

 

$2.56

$2.81

$3.08

$3.37

$3.67

$3.98

=Abnormal earnings

 

$1.71

$1.89

$1.86

$1.83

$1.80

$1.77

        

Valuation

       

Future abnormal earnings

 

$1.71

$1.89

$1.86

$1.83

$1.80

$1.77

x discount factor(0.09)

 

0.917

0.842

0.772

0.708

0.650

0.596

=Abnormal earnings disc to present

 

$1.56

$1.59

$1.44

$1.30

$1.17

$1.06

        

Abnormal earnings in year +6

      

$1.77

Assumed long-term growth rate

      

3.00%

Value of terminal year

      

$29.53

        

Estimated share price

       

Sum of discounted AE over horizon

 

$7.07

     

+PV of terminal year AE

 

$17.61

     

=PV of all AE

 

$24.67

     

+Current equity book value

 

$28.48

     

=Estimated current share price

 

$53.15

     

As you can see the model produces a fair value for shares of around $53, or just under $4 below where shares trade as I write this. That isn't a huge discrepancy but it's certainly worth mentioning so the question becomes, is KSS to expensive right now?

Maybe. But first we need to understand what we're looking at. The model produces a fair value for shares as of right now, given the inputs I described above. That means the model is saying that KSS shares are worth $53 based upon the present value of its discounted earnings stream, adjusted for dividends. In other words, shares are a buy at any price below $53.15 today.

This is not to be confused with a price target, which is forward looking. A price target would be somewhat higher as you would take, say, 2015's earnings estimate and multiple it by your earnings multiple estimate to get price target for KSS. I prefer the fair value method as it affords a reference point for today's price and not simply some point in the future.

Now that we have that out of the way, we can see that the fair value of KSS is around 8% less than shares trade at today, indicating that KSS is overvalued. In short, I tend to agree with this conclusion but in order to make a case for such a statement, let's dig a bit deeper.

To begin, Kohl's had a rough first quarter; missing both revenue and EPS estimates by decent margins. The company struggled with traffic and pricing power, along with many other retailers, and the effects were felt in the company's earnings statement. Comp sales fell a whopping 3.6% and margins also fell 40 bps over the previous year to 36.8%. Anytime a retailer reports comp sales fell it's never good but when you're talking about a nearly 4% drop, that is downright ugly. Losing that much in comp sales revenue is never acceptable or excusable and what made it worse was the compression in margins as well.

The second quarter was better as Kohl's bested beaten down expectations of $1.07 in EPS but still had a slight miss on revenue. Comp sales still fell a bit, 1.3%, but this was a vast improvement over the first quarter's much larger loss. And while margins ticked lower on a YoY basis, they were sequentially higher, bringing a bright spot to a mixed report.

So what is KSS' issue? Discount retailing has been a tough business in 2014 with retailers in all sorts of niches struggling to get traffic and retain pricing power. Kohl's falls into that same boat as it fell victim to over-promotion, losing pricing power and compressing margins in the process. We all know that KSS' business model is to promote and offer "sales" on everything in the store but discounts must have been a little deeper this year as sales lagged and margins ticked lower.

On the bright side, Kohl's is still adding store count, up to 1,160 as of the most recent quarter, a good sign that the company feels it hasn't yet reached saturation with its footprint. Around where I live there are several Kohl's stores and they are usually reasonably busy. However, I wonder how many consumers do what I do which is to walk in, look for something, and leave without buying. I would guess roughly half of my trips to Kohl's look like this and Kohl's over-promotes so much that if my family is going to buy something from Kohl's we simply wait for the huge coupon to come in the mail. This is a basic problem for margins with Kohl's that it has created for itself; it has willingly given up pricing power by offering so many promotions so improvements in margins will be hard to come by. Couple that with still-falling comp sales and you've got a recipe for an expensive stock.

Still, shares are trading for only 12 times next year's earnings estimate so it isn't as though shares appear that expensive on a forward basis but I would caution that 12 times is probably too much for Kohl's. The company has experienced waning demand for its products, as indicated by falling comp sales, and margins are also lower on promotional activity. In addition, we saw inventory move up during the second quarter, although by a small amount. The point is that all indicators for Kohl's right now are pointing the wrong direction and the company's momentum has yet to turn around. I think Kohl's is a decent retailer but it doesn't deserve the multiple it's receiving.

I think a more appropriate multiple for a company with these characteristics is more like 10 or 11 as we need to see some positive results from Kohl's and some indication that things are getting better. We haven't seen that yet and so for now, I think shares should trade down into the low $50s. This represents a modest drop from where shares trade now and around $50, I'd be interested in Kohl's on a value and yield basis. The company pays a nice dividend and for those investors looking for income, Kohl's could be a good choice if we see a pullback. I don't want to chase shares higher as they ramp into the back-to-school season as I think you'll be able to get a lower price in a couple of months, if so inclined.

Source: Kohl's Worth A Look On A Pullback