In today’s Daily Alert, The Kelly Letter Editor Jason Kelly gives a thorough analysis of a retailer he has personal experience with
“Some of the best consumer stocks I’ve owned were introduced to me by family members. This network of shoppers near and dear to me brought the likes of Abercrombie (ANF), Crocs (CROX) and Deckers (DECK) to our attention, all of which did well for us. ... Last month in Colorado, my mother presented me with a stack of Kohl’s Cash, coupons, and her membership card of the retailer she said is ‘doing everything right,’ and told me to shop there. I went to Kohl’s Corp. (KSS, $43). I loved it, I bought, I saved. I’m not much of a consumer, but even I took note of the store’s excellent decoration scheme, its popularity, the quality of its products and the unbelievable savings that kept mounting as I went.
“I returned several times as a shopper and potential investor. On one of my visits after Christmas, I was able to use the store’s on-shelf discount with a time-sensitive coupon and $30 of Kohl’s Cash to reduce a $120 purchase to $5, no kidding. The clerk said with a straight face, ‘Mr. Kelly, your total is $5. You saved $115.’ ... I handed her a $5 bill for $120 worth of merchandise, muttering, ‘Note to self: Check this place’s margins.’
“I did so the moment I returned home, and was surprised to find that its operating margin has risen from 9.4% in 2009 to 10.4% in 2011 to 11.5% last year. Its net profit margin went from 5.4% to 6.1% to 6.2% in the same years. A company growing profits while delighting customers with discount moments like the kind I experienced at the register is an intriguing find. It seemed then that Mom may have been right about the store ‘doing everything right’ on the consumer front, and that she may have proffered up her next consumer stock winner. Thus, a research quest was launched.
“Based in Wisconsin, Kohl’s operates 1,146 stores in 49 states and sells directly to shoppers at kohls.com. It’s been in business since 1962. Its target market is consumers looking to save money on brand-name goods in an environment that doesn’t feel like the wrong side of town at midnight. Those are my words, not the company’s, to explain an important distinction between Kohl’s and some of its discount rivals. If you’ve stumbled into a typical Wal-Mart (WMT) recently, you probably couldn’t run away quickly enough, and know exactly what I mean. Kohl’s provides good prices on good products in a good atmosphere.
“It creates a better mood than Wal-Mart, offers more brand-name products than Target (TGT), and maintains more convenient locations than JC Penney (JCP). Its store format is cheaper to maintain than most mall-based department stores and it owns 36% of its properties, helping to explain the solid margins despite value pricing. Another reason it’s done well with margins is that management focused over the past decade on introducing many new brands exclusive to Kohl’s, which provides pricing power, and working out good deals with famous brands that lure consumers back. Among the latter: Simply Vera by Vera Wang, Food Network, and Ralph Lauren’s Chaps. Higher-margin and exclusive brands now account for half of total sales.
“Another way this helps Kohl’s save money is by not needing to advertise as much. By carrying brands that consumers already know and have recently heard about again, it does not need to spend its own money touting the appeal of its product lines. The brands are doing it for the store.
“Yet another technique that’s slick for consumers while saving resources for the store was a switch to electronic price displays. This works well for the store’s many changing promotions, even creating the effect of real-time discounting now and then. Rather than requiring employees to run around changing prices every day, stores can just update software instantly.
“The company was affected by Hurricane Sandy when same-store comps for November missed expectations. This came after a series of pricing and merchandising mistakes it made earlier last year. The missteps combined to create an extremely volatile recent period for KSS stock. From $55 in November 2011, it fell to $44 a year ago, rebounded to $51 last February, cratered to $42 in June, shot to $55 in October, then collapsed in the Sandy aftermath to $41 a week ago. It’s at $42 now, just 1.6% above its 52-week low hit Jan 3 — pretty fortuitous timing in the wake of my interest having been piqued over Christmas.
“The low price brings with it a P/E of just 10 and a 3% dividend yield. The P/E has been contracting for years, down from 26 in 2004, 18 in 2009 and 12 in 2011. Its current P/E is 35% lower than the 15 P/E of the S&P 500. Its price/sales of 0.5 is 62% lower than the 1.3 of the S&P 500. As with the merchandise in its stores, Kohl’s stock is a bargain.
“The company plans a modest expansion in the coming year. It will open 20 small stores of 54 thousand to 68 thousand square feet and remodel 50 existing stores. Management says it’s pausing the expansion pace to evaluate merchandising tests intended to improve sales per square foot. The experiment with smaller stores and the slow expansion is also to better assess the growth of kohls.com e-commerce operations, with estimated 2012 sales of $1.4 billion. For investors, the company is buying back shares and reducing debt with operating cash flow. It has reduced the number of shares outstanding by 22% in the past decade.
“To estimate fair value, I used 4% retail space growth and 5% e-commerce growth, projected free cash flow yield of 7%, EPS of $4.62 for fiscal 2013, comp sales growth of 3% for 10 years and 11% operating margins. This gets me a $65 fair value on the stock, which is 55% higher than Friday’s close at $42. However, I expect the P/E multiple to expand as the company improves its product mix and takes market share while recovering from the Sandy setback. Given this, I think it could double from $42 to $84 before we sell. We’re going to jump on this right away. ... Buy Kohl’s (KSS) with a limit order price of $42.”
- Jason Kelly, The Kelly Letter, January 13, 2013