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. Personal Finance

    A Day in the Life of an Equity Research Analyst

    What does an equity research analyst do on an everyday basis?
  5. Mutual Funds & ETFs

    ETF Analysis: PowerShares S&P 500 Downside Hedged

    Find out about the PowerShares S&P 500 Downside Hedged ETF, and learn detailed information about characteristics, suitability and recommendations of it.
  6. Mutual Funds & ETFs

    ETF Analysis: iShares Morningstar Small-Cap Value

    Find out about the Shares Morningstar Small-Cap Value ETF, and learn detailed information about this exchange-traded fund that focuses on small-cap equities.
  7. Mutual Funds & ETFs

    ETF Analysis: ProShares Large Cap Core Plus

    Learn information about the ProShares Large Cap Core Plus ETF, and explore detailed analysis of its characteristics, suitability and recommendations.
  8. Mutual Funds & ETFs

    ETF Analysis: iShares Core Growth Allocation

    Find out about the iShares Core Growth Allocation Fund, and learn detailed information about its characteristics, suitability and recommendations.
  9. Mutual Funds & ETFs

    ETF Analysis: iShares MSCI USA Minimum Volatility

    Learn about the iShares MSCI USA Minimum Volatility exchange-traded fund, which invests in low-volatility equities traded on the U.S. stock market.
  10. Stock Analysis

    Should You Follow Millionaires into This Sector?

    Millionaire investors—and those who follow them—should take another look at the current economic situation before making any more investment decisions.
RELATED TERMS
  1. Equity

    The value of an asset less the value of all liabilities on that ...
  2. Profit Margin

    A category of ratios measuring profitability calculated as net ...
  3. Quarter - Q1, Q2, Q3, Q4

    A three-month period on a financial calendar that acts as a basis ...
  4. Debt Ratio

    A financial ratio that measures the extent of a company’s or ...
  5. Middle Market

    Definition of middle market
  6. Fast Fashion

    Definition of "fast fashion."
RELATED FAQS
  1. 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 >>
  2. 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 >>
  3. 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 >>
  4. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  5. What is the difference between the return on total assets and an interest rate?

    Return on total assets (ROTA) represents one of the profitability metrics. It is calculated by taking a company's earnings ... Read Full Answer >>
  6. How can a company execute a tax-free spin-off?

    The two commonly used methods for doing a tax-free spinoff are either to distribute shares of the spinoff company to existing ... Read Full Answer >>

You May Also Like

COMPANIES IN THIS ARTICLE
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!