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. Mutual Funds & ETFs

    What Exactly Are Arbitrage Mutual Funds?

    Learn about arbitrage funds and how this type of investment generates profits by taking advantage of price differentials between the cash and futures markets.
  5. Investing News

    Ferrari’s IPO: Ready to Roll or Poor Timing?

    Will Ferrari's shares move fast off the line only to sputter later?
  6. Stock Analysis

    5 Cheap Dividend Stocks for a Bear Market

    Here are five stocks that pay safe dividends and should be at least somewhat resilient to a bear market.
  7. Stock Analysis

    The Biggest Risks of Investing in Amazon Stock

    Find out which risks are most important to Amazon's shareholders. Learn which operational risks impact share prices and which financial risks affect investors.
  8. Investing

    How to Win More by Losing Less in Today’s Markets

    The further you fall, the harder it is to climb back up. It’s a universal truth that is painfully apparent in the investing world.
  9. Fundamental Analysis

    Use Options Data To Predict Stock Market Direction

    Options market trading data can provide important insights about the direction of stocks and the overall market. Here’s how to track it.
  10. Stock Analysis

    2 Oil Stocks to Buy Right Now (PSX,TSO)

    Can these two oil stocks buck the trend?
  1. 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 >>
  2. How do I use discounted cash flow (DCF) to value stock?

    Discounted cash flow (DCF) analysis can be a very helpful tool for analysts and investors in equity valuation. It provides ... Read Full Answer >>
  3. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  4. What is the formula for calculating compound annual growth rate (CAGR) in Excel?

    The compound annual growth rate, or CAGR for short, measures the return on an investment over a certain period of time. Below ... Read Full Answer >>
  5. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  6. When does the fixed charge coverage ratio suggest that a company should stop borrowing ...

    Since the fixed charge coverage ratio indicates the number of times a company is capable of making its fixed charge payments ... Read Full Answer >>

You May Also Like

Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!