Retailers have to try to pick winners, and whenever a company builds its model upon picking winners it's just a matter of “when” (not “if”) the company stumbles. Kohl's (NYSE:KSS) did a lot of things right in building up its 1,150-store chain of value-oriented specialty department stores, but execution has been more problematic recently. Conventional valuation metrics suggest Kohl's could have further to run if/when the reported numbers improve, but investors thinking long term should be wary of the cash flow model and the ability of any company to establish long-term competitive edges in retailing.

Discount Brokers Comparison: Your one-stop shop for finding the perfect broker for your investments.

Good Margins Save An Otherwise Unpromising Quarter
Kohl's reported good bottom-line results for the first quarter, but I struggle to call this an especially good quarter for this retailer.

Revenue fell 1% as reported, as comps declined 1.9%. Within those comps, transactions (volume) were down more than 3% and price was down more than 1%, while a larger number of units per transaction offset this partially. E-commerce revenue rose 31%, adding more than two points to the comp total. Management also claimed that cold weather hurt comps to the extent of over three points, but I always take these “weather adjustments” with a grain of salt as you seldom see retail management teams talk down the numbers by pointing to perfect weather.

While Kohl's comp number was a disappointment for a Street looking for roughly flat results, margins were much more promising. Gross margin improved half a point from last year, beating the average Wall Street estimate by 60bp (and adding about six cents to the EPS number). Management also managed to pick up a little more through the operating items – operating income fell 1%, but the operating margin beat expectations by about 80bp.

SEE: Understanding The Income Statement

Can Kohl's Regain Its Merchandising Mojo?
As I said in the intro, every retailer sooner or later screws up with its merchandising and alienates its customer base. It happens with teen retailers like Abercrombie & Fitch (NYSE:ANF) and American Eagle (NYSE:AEO), it happens with adult retailers like Gap (NYSE:GPS) and Chicos (NYSE:CHS), and it happens with department store retailers like Kohl's.

Given that Kohl's is not seeing a JC Penney-style (NYSE:JCP) meltdown, I don't want to blow this out of proportion. Still, this marks the sixth straight quarter where inventories outgrew sales, and that's not a good thing. What's more, Macy's (NYSE: M) and Saks (NYSE:SKS) have been executing better, and other value-priced retailers like Gordmans Stores (Nasdaq:GMAN) are looking to be “the next Kohl's”.

Kohl's now gets about half of its revenue from proprietary merchandise – merchandise that company either produces or sells on an exclusive basis. While that's great if and when the shopping public likes it, it can also crowd out non-exclusive brands and send shoppers to other stores when that's what they want. Hopefully Kohl's will get its merchandising sorted out, or rising inventories could lead to uncomfortable margin consequences.

I also think Kohl's cannot afford to drop the ball on execution. Having recently been in a Kohl's with the intention of buying, I was disappointed to see multiple products that lacked any pricing information. While I suppose I could have asked a sales rep, I could also do what I did – walk out, go across the street, and buy from another retailer. Now this was just one Kohl's in one town (and with one particular collection of merchandise), but it does seem to fit within the overall sense I get that Kohl's has started to let things slip on a store-level execution basis.

The Bottom Line
As a stock, Kohl's is an interesting proposition. For a retailer, the short interest in Kohl's is a little on the high side (though certainly nowhere near as high as for Saks or JC Penney). What's more, conventional ratios like price/book, EV/EBITDA, EV/revenue and so on appear to be on the lower end of the range. That would argue for some solid upside potential if/when the company delivers a couple of solid quarters (particularly with respect to sales, inventories, and margins).

SEE: 5 Must-Have Metrics For Value Investors

Looking at the cash flow, though, it appears that Kohl's may be better as a short-term engagement. Unless Kohl's can grow its top-line significantly faster than the retail environment and/or post some pretty spectacular free cash flow margins (for a retailer), it's hard to see that these shares are worth much past the mid-$50s. That makes Kohl's an interesting candidate as a soft turnaround (meaning, it hasn't gotten so bad as to be a real turnaround like JCP), but maybe not such a great buy-and-hold idea.

At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.

Related Articles
  1. Investing Basics

    Ostrich Effect And Passive Investing

    Learn how to take a hands-off approach to your portfolio without sticking your head in the sand.
  2. Mutual Funds & ETFs

    Learn The Lingo Of Private Equity Investing

    Because of the non-public nature of private equity, it can be difficult to the learn the lingo. We break it down here.
  3. Personal Finance

    Go Green With Socially Responsible Investing

    Find out how morals and ethics can bring you a surprising return.
  4. Investing

    Time to Bring Active Back into a Portfolio?

    While stocks have rallied since the economic recovery in 2009, many active portfolio managers have struggled to deliver investor returns in excess.
  5. Professionals

    The Best Financial Modeling Courses for Investment Bankers

    Obtain information, both general and comparative, about the best available financial modeling courses for individuals pursuing a career in investment banking.
  6. Investing

    Where the Price is Right for Dividends

    There are two broad schools of thought for equity income investing: The first pays the highest dividend yields and the second focuses on healthy yields.
  7. Economics

    Investing Opportunities as Central Banks Diverge

    After the Paris attacks investors are focusing on central bank policy and its potential for divergence: tightened by the Fed while the ECB pursues easing.
  8. Stock Analysis

    The Biggest Risks of Investing in Pfizer Stock

    Learn the biggest potential risks that may affect the price of Pfizer's stock, complete with a fundamental analysis and review of other external factors.
  9. Stock Analysis

    Why did Wal-Mart's Stock Take a Fall in 2015?

    Wal-Mart is the largest company in the world, with a sterling track-record of profits and dividends. So why has its stock fallen sharply in 2015?
  10. Stock Analysis

    Allstate: How Being Boring Earns it Billions (ALL)

    A summary of what Allstate Insurance sells and whom it sells it to including recent mergers and acquisitions that have helped boost its bottom line.
  1. What does low working capital say about a company's financial prospects?

    When a company has low working capital, it can mean one of two things. In most cases, low working capital means the business ... Read Full Answer >>
  2. Do nonprofit organizations have working capital?

    Nonprofit organizations continuously face debate over how much money they bring in that is kept in reserve. These financial ... Read Full Answer >>
  3. Can a company's working capital turnover ratio be negative?

    A company's working capital turnover ratio can be negative when a company's current liabilities exceed its current assets. ... Read Full Answer >>
  4. Does working capital measure liquidity?

    Working capital is a commonly used metric, not only for a company’s liquidity but also for its operational efficiency and ... Read Full Answer >>
  5. How do I read and analyze an income statement?

    The income statement, also known as the profit and loss (P&L) statement, is the financial statement that depicts the ... Read Full Answer >>
  6. Can working capital be too high?

    A company's working capital ratio can be too high in the sense that an excessively high ratio is generally considered an ... Read Full Answer >>

You May Also Like

Trading Center