Should Investors Expect Great Things from Kohl’s in 2014?

Kohl's (NYSE: KSS  ) was once a marquee retail stock, renowned for rewarding investors with great and consistent returns. More recently, the stock has mostly sat on the sidelines while its retail counterparts, including Macy's (NYSE: M  ) , Target (NYSE: TGT  ) , and Nordstrom (NYSE: JWN  ) , have soared. The retail giant, which operates 1,158 stores across 49 states, has largely been hampered by inventory imbalances and lackluster merchandising, as well as thinning profit margins.

However, the specialty retailer might just live up to its motto "Expect Great Things" in 2014. It recently moved to revamp its merchandising assortment and its national brands, instituted a host of deep-running cost-cutting measures, and reinvigorated its online business. These measures are likely to lead to modest revenue growth at the very least, as well as a significantly improved operating margin. This could, in turn, lift shares in 2014. Kohl's current trailing-twelve-month P/E ratio of 13.5 is below its peers' average of 16, and also well below the P/E of 30+ that Kohl's sported back in the early 2000's when it was a darling of the stock market.

Aggressive share buybacks
Kohl's went out on a limb to repurchase its own shares in an aggressive share buyback program running from 2010 through 2012. The company managed to buy back shares worth $4.6 billion during this period, which effectively reduced the number of outstanding shares by a whopping 30%. Kohl's plans to continue shopping to bring down the numbers even further.

The retailer initiated a dividend in 2011 and has steadily increased it to $1.40 per share. The stock currently yields 2.6%. These moves provide a considerable amount of valuation support for Kohl's shares.

Inventory markdowns and squeezed margins
Kohl's has been on the receiving end of intense flak for several quarters following its apparent inability to match its inventory to customers' demands. The retailer has consequently been turning to inventory markdowns in a bid to get its snafu-laden merchandise out the door. In fiscal 2012, the company's sales grew marginally by 0.3% from the previous year, but this happened at the expense of profitability. Kohl's gross margin contracted by 290 basis points from the previous year, from 36.2% to 33.3%, as it was pressured by extensive product markdowns. The gross margin has, however, been improving this year. In the third quarter, the gross margin stood at 37.5%.

Reinvigorating national brands
Although private brands are preferred by retailers since they usually sport higher gross margins than national brands, sometimes to the tune of 500 basis points or more, national brands are better at driving store traffic. One thing working against Kohl's has been its inability to attract and retain large national brands. Kohl's product portfolio has of late been leaning more toward private brands, with these making up 56% of sales, a sharp rise from 2007 when they accounted for just 37% of sales.

Kohl's management has learned from its mistakes. In a bid to induce more national brands to sign on, the company has been paying more attention to these brands in its ads and improving its store presentation.

The retailer is also working feverishly to reinvigorate its national-brands portfolio with new additions to the line such as Juicy Couture and IZOD. After a troubling period of misjudging demand, the company is also showing marked signs of improvement in inventory management. The inventory level rose just 6% in the third quarter, which was a huge improvement over the second quarter when it spiked in the double-digits. As the company continues to remove the overhang of undesirable inventory and goes easier on markdowns, we can expect a natural forward progression in its gross margins.

How's the competition doing?
For comparison's sake, Kohl's huge competitor Macy's enjoys an industry-leading gross margin close to 40%. The company has been busy retooling its merchandising strategy for the last few years, which includes creating a more localized and personal experience across its 800 stores throughout the country.

Target had been doing quite well this year, with 2013 being touted as Target's year in Canada, after the retailer opened 124 stores across The Great White North. In Dec.15, 2013, however, disaster struck when the company announced that it had suffered a massive information-security breach. About 40 million card accounts are feared to have been compromised by the heist. Encrypted debit card PIN numbers are also believed to have been stolen. However, as I pointed out in this article, investors should not panic over the unfortunate incident. The TJX Companies suffered a similar hack in 2007, yet store sales continued to grow at a healthy pace in the quarters following the incident.

Meanwhile, Nordstrom is looking to follow in Target's footsteps by opening five full-price department stores in Canada starting in 2014. The specialty fashion retailer is no doubt hoping to profit from Canada's underserved retail space. According to Colliers International Consulting, a Vancouver-based consultancy, Canada has just 14.6 square feet of retail space per capita, way lower than U.S.' 23.8 square feet per capita.

The bottom line
Spiffing up Kohl's will not be an easy task. Maybe the retailer should borrow a page from J.C. Penney, the ailing retailer whose turnaround seems to be on course after it focused on a more favorable product mix. Meanwhile, Kohl's own improving product mix, better inventory management, and sweet dividend might be reasons enough to expect great things from the company in 2014.

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