Kohl's (KSS) reported earnings last week, and even though the company reaffirmed full-year guidance of $4.75 per share, the results disappointed the Street. For the quarter, Kohl's beat street estimates (63 cents vs 61cents), but since earnings were released, Koh'ls stock has fallen over $4 in heavy volume.
What I like most about Kohl's are its shareholder friendly ways. Of the $1.1BB in Free Cash Flow that the company will generate in 2012, Kohl's plans to repurchase $1.0BB of stock, as well as paying a dividend of $0.32 per share. In fact, management is even considering repurchasing an additional $250-300mm of stock by issuing more debt. That is an awful lot of stock, around 10% of the shares outstanding, that the company intends to repurchase just this year.
Koh'ls sells moderately priced clothes, shoes, beauty and home products in 1,134 off-mall department stores across the U.S. in 49 states. Roughly half of its sales are its own in-house or exclusive brands such as Chaps, Elle and its recently added Jennifer Lopez line of sportswear, jewelry and bath products. The other half comes from national brands such as Levi's, Adidas and Dockers. Of the company's $19BB in sales, $1BB was generated online in 2011, up 40% from the year before.
Company: Kohl's Corporation
Market Cap: $11.5BB
Debt (net of cash): $3.1BB
Capitalized Rent: $2.6BB (10x stores leases, 8x equipment leases)
TEV: $17.3BB (Equity + Debt + Capitalized Rent)
EBITDAR (TTM): $3.2BB
TEV / EBITDAR: 5.4x
FCF / Share 2012: $4.50
EPS 2012 (52 weeks end Jan 31, 2013): $4.65
Dividend Yield: 2.7%
The Bad News
Kohl's had a weak holiday season in 2011, lacking inventory in key gift-related items, and reported sales growth for the year of only 2.5%. Comparable store sales in Q4 last year were down 2.1%. To fix this, management plans to make substantial changes to inventory, as well as to lower prices (so-called price investment) during the year 2012. So far, that has meant lower Gross Margins, and 2012 guidance includes an estimated decline of 70bps in GM for the year.
Investors have gotten nervous because in the first quarter, GM fell by 2.2%. So, how can margins only fall 70bps for the year given what happened in Q1?
Put another way, the company did $0.63 in EPS in the first quarter. It guided that EPS would be $0.98 in Q2. That is $1.61 for the first half of 2012. That means to reach the $4.65 (52 week) guidance for the year, EPS will have to be approximately $3.04 in the second half of 2012. ($4.65 less $1.61).
That may be tough to reach. Kohl's did $2.58 in EPS the 2nd half of 2011, which means that it will have to show 18% growth in EPS in the second half of 2012 compared with the year before. For a company with falling Gross Margins and 2% same store sales growth, that is a big hurdle.
Indeed, I would argue that the company's full-year guidance is a tad high. While investing in price may lure back customers, and while more gift-related inventory during the holidays sounds plausible, something along the lines of $4.40 to 4.50 in EPS seems more likely and conservative.
The Good News
Kohl's stock likely already reflects much of the bad news. With KSS off 10% from its highs, the equity has given up almost $1BB in market cap. Management suggested on their recent conference call that they will repurchase at least $250mm of stock the second quarter, and $1.0BB this year. They additionally may repurchase another $250-300mm of stock by issuing debt this summer. In 2011, they bought back a whopping $2.3BB of stock, and by year's end, even flat net income could translate to 8% EPS growth.
You can read the most recent earnings call transcript here.
Given the investment grade rating, Kohl's 5-year bonds trade currently at a 2.1% yield. It clearly makes a lot of sense to sell 2% five year paper, and buy back stock that generates a 10% free cash flow yield. I would do that trade all day long, it's highly accretive to EPS.
To illustrate, $250mm in bonds would cost the company a mere $4mm in additional interest, or a 2 cent hit to EPS (net of the tax benefit). On the flip side, using that $250mm to buy back 5mm shares of stock would add 10 cents to EPS. That is a net benefit of 8 cents.
Doesn't sound like much, but when you can also buy back stock with cash on the books (which is earning less than 50bps), the economics become even more compelling. Management here gets it, and spending FCF on buybacks for a cheap stock at a guaranteed 10% yield is smart.
On the store opening front, management indicated that it intends to open 20 new stores, net of closures in 2012, and likely the same in 2013. That is down from 40 last year, but the good news is that the company spends significant dollars every year maintaining its store base, so that 236 stores have been remodeled in the past 3 years alone. This isn't Sears (SHLD), which is now suffering from years of under-spending on maintenance capex.
Finally, Kohl's began paying a dividend in 2011. Today's 2.7% yield is the best in retail land. Nordstrong (JWN) and Macy's (M) offer 2.2% yields, JC Penney (JCP) pays 2.4%, while Dillard's (DDS) and TJX pay little in the way of dividends. Even Wal-Mart (WMT) only offers a 2.6% dividend yield.
While investors rarely give credit to owned real estate anymore, it's an interesting exercise to value Kohl's owned land and buildings. Of the company's 1,127 stores (from the 10K), 403 are owned. That is 36% of their stores owned outright. TJX for example, owns none of its stores.
Kohl's also owns 11 of their 12 distribution centers, for a total of 7.1mm square feet. Given that many of their owned stores and distributions centers were opened in the 1990s, it's fair to say that book value (PP&E on the balance sheet) is a conservative estimate of fair value. That's $9.0BB of owned real estate, and values the real estate at $300 per square foot. Not a crazy number, some recent comparable transactions suggest a price range of $225 to well over $400 per foot. Commercial retail real estate has not suffered nearly as badly as residential real estate, and many retail REIT's trade at rich 4-5% cap rates today.
While I doubt management would consider a sale leaseback strategy on their owned stores, it is some comfort to know that there is a valuable backstop of owned stores at Kohl's.
TJX, operator of TJ Maxx, Marshalls and Homegoods, is probably the best comp to Kohl's. They have more stores in total, including European and Canadian operations, but offer a similar discounted pricing strategy. EPS at TJX was up 17% last year, exactly the same increase as Kohl's, but its stock trades at a robust 20x 2012 earnings. While Kohl's same store sales are looking less impressive than TJX, the valuation premium seems overdone. If 2012 is a year of only 8% growth at Kohl's, then at 10.2x earnings, that is still far more compelling than TJX.
Other comps to Kohl's also trade at rich multiples: Ross Stores (RSS) at 21x, Nordstrom at 16x, The Gap (GPS) at 18x, and Macy's at 12x to name a few.
Kohl's is a surprisingly stable company from a topline and bottom line perspective. Revenue has grown since 2007 at a 3.4% compounded annual growth rate (CAGR). 2008 was naturally the worst down year, but only showing a 0.50% decline in topline. Kohl's target market below the high end, and above the low end is tailored well for Main Street American value shoppers, year in and year out.
The net income has increased at a slightly lower 2.4% CAGR over that same time frame (2007-2011), and tends to hover in the $1.0BB range. Margins are impressive here, again better than the comps (on an EBIT basis). With some buybacks in place however, EPS has grown by 6.1% per year on average.
Given the likely recession going on in Europe, and the slowdown in Emerging Markets, investing in a U.S.-based company with a healthier consumer makes sense. Especially when it is geared toward the value-conscious consumer.
At $47, Kohl's appears to be attractively priced for an entry position. I recommend keeping some dry powder however, as I am of the belief that full-year 2012 guidance is perhaps a bit out of reach.
That said, at $40-42 this is a pretty compelling buy and is where I double down. The stock over the past decade has only gone below $40 per share on one occasion, briefly during the financial crisis of Q4 2008. In the 2002 to 2007 time frame, the stock also traded at quite a premium multiple to the market, sporting a healthy multiple between 20x and 30x earnings.
Since the real estate crash however, valuations have come back to earth. I don't expect a premium valuation to the market anymore here, but 10x earnings for a stable retailer generating 15% Returns on Equity is too low.
I suggest that a fair valuation of this is at a market multiple of 13x, which is my upside case. The downside case is 9.5x earnings and using $4.40 in EPS, which is well below the company's guided 2012 EPS. It should also be noted that 9.5x is the lowest P/E that Kohl's has traded over the past decade.
Over a two-year time frame I think the upside could be to $65 plus with dividends. I assume that the company will miss guidance for 2012, and then grow EPS by 10% in 2013, to $4.84. The Street's estimates I have seen average around $5.15 to $5.20 per share in earnings for 2013, so I think these numbers are quite conservative.
One final note. While to some extent I think that 2012 guidance will be a stretch, management has over time been quite conservative with forecasting earnings. In fact, to find a quarter where Kohl's disappointed, you would have to go back 7 full years, to Q1 2005. Even then it only missed by 1 cent, reporting 36 cents in EPS vs the street at 37 cents. So, perhaps I will be wrong in my 2012 assessment. I hope so, because that only makes the upside case more compelling.
Disclosure: I am long KSS.