Why I'm Avoiding This Stagnant Department Store Stock

Another day, another weak retail forecast.

Last Thursday, Kohl's (NYSE: KSS  ) fit right into the trend seen at some of the larger brick-and-mortar retailers, with unimpressive earnings and weak guidance for 2013. While the company's fourth-quarter EPS of $1.66 beat its most recent guidance, that figure fell significantly short of the company's original EPS estimate of $2.00 to $2.08, and was lower than last year's fourth-quarter EPS of $1.81. Kohl's had a very disappointing 2012, with comparable-store sales up just 0.3% for the year. The company now expects another small comparable-store sales increase of 0% to 2% for 2013. In light of this mediocre performance, Kohl's seems like a stock to avoid.

2012: Missed opportunities
Kohl's minuscule 2012 sales gain was particularly unsatisfactory because of the missed opportunity it represented. J.C. Penney (NYSE: JCP  ) , which is probably the closest direct competitor for Kohl's, had a disastrous year due to a poorly executed strategy change, with sales down roughly 25%. J.C. Penney had eliminated the use of promotions and coupons, driving away customers who were "addicted" to discounts. Kohl's, as a highly promotional department store, ought to have been able to attract many of these shoppers, but instead the company appears to have lost market share in 2012.

Poor execution was largely to blame for this missed opportunity. The company did not have sufficient inventory to meet demand during the first half of the year, particularly in popular seasonal categories. This miscue was bizarre insofar as management had come into the year planning to compete aggressively on price to gain market share. Even more troubling, when the inventory situation improved in the second half of the year, there was insufficient demand. Kohl's was forced to ramp up discounting and sell more merchandise on clearance, which led to a 290-basis-point decrease in fourth-quarter gross margin year over year (from 36.2% to 33.3%).

2013: No improvement expected
Management's guidance for sales to be flat to up 2% in 2013, and EPS to be $4.15 to $4.45 (compared to $4.18 in 2012) does not inspire very much confidence. Kohl's plans to repurchase $1 billion of shares in 2013, bringing the average share count down to 216 million. This implies net income of $896 million to $961 million, compared to net income of $986 million in 2012. In other words, Kohl's is only preventing an EPS decline by repurchasing shares to shrink the share count.

There is nothing wrong with repurchasing shares if they are trading at an attractive valuation and the business is generating ample free cash flow. However, Kohl's has been repurchasing shares at an unsustainable rate during the past two years while the business has struggled. Share repurchases and dividends combined exceeded free cash flow by more than $1 billion in each of the past two years. Kohl's balance sheet cannot support such heavy repurchase activity if revenue remains flat. If net income continues to drop, Kohl's will not be able to maintain EPS at its current level by buying back more shares.

What's in store
Kohl's saw EPS shrink this year despite heavy share repurchases and a major stumble at its top competitor. While the company is continuing to buy back shares to support EPS, this strategy cannot serve as a long-term substitute for organic earnings growth. Management expects yet another net income decline in 2013, which leaves little reason for shareholders to stick around.

Kohl's is already under pressure, and if J.C. Penney can finally stage a comeback, that would put even more pressure on this stagnant department store. However, investors are beginning to doubt if J.C. Penney CEO Ron Johnson can weave the same magic that he did at Apple. If you're wondering whether J.C. Penney is a buy today, you're invited to claim a copy of The Motley Fool's must-read report on the company. Learn everything you need to know about JCP's turnaround -- or lack thereof -- and as a bonus, you'll receive a full year of expert guidance and updates as key news develops. Simply click here now for instant access.


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