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For most US-based readers, Kohl’s is an accepted part of American retail life. Shopping isn’t really my thing, but even I have been to Kohl’s numerous times over the last few years.
However, for the sake of internationally-based readers, Kohl’s operates 1,127 department stores (as of March 2012) in the United States. The stores target middle-income and value focused customers, and offers private, exclusive, and national branded apparel, footwear, accessories, and housewares. In addition to their physical stores, Kohl’s also provides on-line shopping through its website- kohls.com. Kohl’s headquarters are in Wisconsin, but it currently has stores in 49 states. (They haven’t made it to Hawaii quite yet…)
There is a vast amount of information available regarding the department store/apparel industry in the US, and this article isn’t meant to provide a definitive overview. Rather, my goal is to merely share some thoughts of mine on an interesting investment idea.
There are three traits of Kohl’s, that, when combined, demonstrate its leadership in the department store industry. (There is a key fact that can set it apart as an investment idea- regardless of industry-, but I’ll get to that right after the following three traits.)
These three traits are:
1. In 2011, more than 50% of Kohl’s revenues came from exclusive or private Kohl’s brands. That is up from 25% in 2004 and 48% in 2010. Increasing revenues from private or exclusive brands is something that is a major asset to a department store. It improves margins, while also giving Kohl’s more control over production and more price flexibility. Again, more than half of Kohl’s total revenue came from brands that you can ONLY buy at Kohl’s.
2. The e-commerce division at Kohl’s has been experiencing strong growth. This is the revenue from e-commerce (in millions) that Kohl’s has received in the last 6 years:
2011: 1,000+ (more than 5% of total Kohl’s revenues)
In addition to their three e-commerce distribution centers in Ohio, Maryland, and California, Kohl’s is opening up a fourth e-commerce distribution center in Texas in summer 2012.
Currently, Kohl’s margins are lower from e-commerce than from its stores. However, growing its e-commerce division, both in revenues and margins, is a priority with Kohl’s management, and I believe that e-commerce gives Kohl’s growth potential that is not reflected in analyst outlook.
3. Kohl’s has a strong position in the middle-income market.
The more I studied department stores in the US, the more I realized what savvy shoppers probably realize intuitively- that the department store world is fairly differentiated between cheap, middle-of-the-road, and not so cheap.
The economic slowdown has been emphasizing this division. In general, stores branding themselves as off-price have been thriving in the past five years, whereas stores that are middle- to high- income have had a more difficult five years. (There are always exceptions, and along with Kohl’s, Nordstrom is one of them, having experienced good growth as a high-end retailer.)
The recession definitely slowed growth at Kohl’s, but Kohl’s has showed resiliency in the middle-income market in an extremely difficult time. This past year, for example, they were able to pass on price increases to customers (due to higher apparel production costs), and not lose ground in comparable same store sales, despite a tough year for the American middle class as a whole.
Additionally, no major middle-income competitors, such as JCPenney, Dillard’s, and Sears, among others, have been able to keep up with Kohl’s comparable same store sales and margins in the last five years, which demonstrates the strength of Kohl’s in its primary market.
Other companies can rival (or better) Kohl’s in any one or two of the above three areas. For example, Macy’s has about the same level of e-commerce growth in the past year, and JCPenney has 55% of its sales coming from private/exclusive brands. However, I believe that Kohl’s will be able to leverage the combination of its private/exclusive brand strength, e-commerce growth, and market share in the middle-income market to provide decent returns on assets for shareholders.
Many department stores don’t publish all of the above info for their stores, but from what I have read, no department store in the US combines those three elements better than Kohl’s.
The Key Fact
All of that is good, but there is one key fact regarding Kohl’s that is making me take a long, hard look at the company- its share buyback.
A number of buybacks get attention in the financial press, and they are, naturally, buybacks of the larger, more well-known companies, such as Exxon Mobil, IBM (thanks to Warren Buffet’s recent annual letter), and more recently- Apple.
Let’s look at the details of the share buyback at Kohl’s. Here is the exact amount of shares outstanding (not counting options- we’ll get to those later) that Kohl’s had on the below dates:
March 10, 2010- 306,974,796
March 9, 2011- 290,417,880
March 7, 2012- 243,251,944
You read that right. In the past two years, Kohl’s has purchased over 20% of their entire company back.
This year, Kohl’s has allotted $1 billion to share repurchases, and has already purchased some before my March numbers. So, by using $750 million (a conservative guess) remaining for purchases, at an average price of $50, that’d be another 15 million shares purchased this year- another 6% of the company.
Buying back more than 26% of a Fortune 500 company in three years? That allows for some pretty strong EPS growth from buybacks alone!
But wait a minute, you might say, what about options? Are they, like Apple, simply using the buyback to prevent massive dilution from employee stock options?
Let’s find out. Here’s what their shares total would look like if you add in all their options (including options that are antidilutive and aren’t yet exercisable) and all nonvested stock awards:
March 2010- 327,705,796
March 2011- 309,402,880
March 2012- 261,761,944
(Their total options available to employees have actually gone down in the last three years, which I view as a positive. There were 20,731,000 shares available for employee compensation in March 2010, 18,985,000 in March 2011, and 18,510,000 in March 2012.)
As you can see, their buyback isn’t disguising employee option dilution. It’s truly a gift to shareholders, increasing their stake in the company and earnings per share. In addition, their buyback is not saddling Kohl’s with too much debt. They have used some debt to finance the buyback, but their debt position is very manageable
Finally, let’s take a step back and look at the big picture of the share buyback and how it reflects on management’s strategy. Before 2009, Kohl’s was adding roughly 80-90 stores a year, but then the recession hit. In that time, they made two key strategic moves:
1. Slowing massive store expansion, and instead focusing on remodeling and improving their current store base to weather the economic storm, and strengthen their market share.
2. Using the free cash flow that had previously gone to expansion to purchase back shares and begin paying a dividend.
These moves both sound like common sense, and they are. When a recession was in full force, though, knowing that management used common sense is a comforting thought for future investors.
I believe that when the economy begins to strengthen Kohl’s will begin expanding again. In 2007, their plan was to have 1,400 stores in the US by 2012, and were on pace to do so. Economic problems have obviously prevented that, but I believe that as the economy recovers, they will use their cash flow to focus on reaching that goal. However, if the economy weakens again, I think they’ll probably buy back additional shares with their cash.
Management’s past decisions and Kohl’s strong position in its industry give Kohl’s a more defensive position than a lot of department stores, while the share buyback illustrates management’s offensive side, too. It will be interesting to see how things play out.
Financial Strength and Dividends
Kohl’s has a pretty solid balance sheet. Debt levels are fine. This year is the first in several years that they have had their current ratio below 2 (it’s currently around 1.8), but that is only due to the large stock buyback discussed above. The ratio of earnings to interest charges is 4.8, and has been growing steadily the last three years.
Kohl’s paid their first-ever dividend a year ago on March 30, 2011. This year they raised their dividend 28%, and their payout ratio is still fairly low. I believe that their dividend has room to grow beyond the current 2.6% yield.
There are several risks for Kohl’s, and most of them affect all apparel retailers. The big three are: a) macroeconomic struggles, which increase retailer competition for fewer consumer dollars and tighten margins, b) the highly competitive nature of the business, and c) the rise of the price of cotton the past few years.
Two other things for an investor to be cognizant of, while I’m talking about risks:
First, Kohl’s has part of its long-term assets in auction-rate securities, which are fairly uncertain these days. They have marked down a fair amount of their ARS’s value, but it is uncertain that they will get the full par value of their ARS back.
Second, they have had errors in their internal financial reporting framework that have appeared in the last two annual reports. The errors were regarding their accounting for capital leases, and have now been adjusted for, but still, it’s worth keeping an eye on.
Kohl’s is pretty conservatively priced right now. It is trading at or near historical lows with a price/earnings of 11.6, a price/book of 1.9, a price/sales of 0.65, and a price/cash flow of 6.3.
I believe that a conservative valuation for Kohl’s would be in the $59-$65 range, with the median being $62. A 20% margin of safety from $62 would be $49.60. This past year, Kohl’s has traded even as low as the $42-$43 range, where I say it is a buy. I don’t currently own shares in Kohl’s, but will be considering it as an option when the share price is in the $40’s, and probably will be buying if it goes below $45 again.
With a 2.6% dividend yield, a strong share repurchase plan, a reasonable price, a good market position, and plans for further growth, both in e-commerce and in physical stores, I think that investors today could do a lot worse than Kohl’s. At the current S&P 500 price level, I believe that Kohl’s is positioned to outperform the index over a 10-year time horizon.
Guru thoughts on Kohl’s have been mixed. Ray Dalio, Ken Heebner, and Joel Greenblatt have been buying. Chris Davis, Lee Ainslie, Richard Aster, Jr., and PRIME CAP Management have been selling.
The guru with the largest position in Kohl’s is Brian Rogers (2,350,000 shares), and the guru who has KSS as the largest portion of his portfolio is Bill Nygren (1.4%).