Kohl's Is a Rare Value in a Booming Stock Market

Department-store operator Kohl's (KSS 3.41%), like many retailers, has been struggling to attract shoppers to its stores. During the first quarter, comparable-store sales declined by 3.4%, a deterioration from the 2% decline suffered by the company during the holiday quarter. Results like this aren't unique to Kohl's, with Macy's (M -0.63%) also seeing its comparable-store sales decline during the first quarter, and J.C. Penney (JCPN.Q), while posting growth during the past two quarters, still about 30% below its annual revenue from 2011.

But Kohl's has some important advantages, and the problems that it's facing can be fixed. In a market that seems to be hitting new highs every day, Kohl's offers a rare value opportunity.

What makes Kohl's different?
Compared to Macy's and J.C. Penney, Kohl's has two significant advantages. First, Kohl's operates with a lower cost structure, and that makes it easier for the company to remain profitable during difficult times. Here is how much each company spent on operating expenses as a percentage of revenue during 2013:

Source: Morningstar. 

Of the three companies, Kohl's manages to spend the least on operating and maintaining its stores. Macy's achieves a higher gross margin, being a higher-end retailer, which justifies this extra expense, but Kohl's is significantly more efficient than J.C. Penney. To be fair, J.C. Penney's numbers are skewed by the massive revenue collapse it suffered a few years ago, but even in its best year in terms of profitability during the past decade, J.C. Penney still spent 29.6% of revenue on operating expenses.

Beyond operational efficiency, Kohl's is also far less dependent on malls compared to Macy's or J.C. Penney. Only 7.4% of Kohl's 1,160 stores are located within malls, with the rest being either freestanding or in strip centers. Both Macy's and J.C. Penney are more heavily mall-based, and this gives Kohl's an advantage as mall traffic continues to decline. Over the past decade, 400 of America's 1,110 malls have been either closed or repurposed, and the number of mall visits during the crucial holiday period has been declining in the double-digit percentages for the past few years. Kohl's focus on non-mall locations appears to have been a prescient strategy.

The problems facing Kohl's
Kohl's net income has been declining for the past few years, dragged down by both a decline in gross margin and the recent weakness in sales. Earnings per share peaked at $4.30 in 2011, falling to $4.05 in 2013 due to these issues, although share buybacks have helped prop up per-share numbers a bit. Beyond the current retail environment, there are two main factors that have led to this decline, and both are completely fixable.

First, Kohl's continued to rapidly expand following the financial crisis, only recently slowing store growth to better reflect reality:

Source: Kohl's.

This slowdown in store growth has caused Kohl's annual depreciation charge and annual capital expenditures to diverge. Since year-end 2009, depreciation has risen by about 50%, while capital expenditures in 2013 were the lowest they've been in the past five years. In 2013, depreciation came to $889 million compared to capital expenditures of $643 million, and this difference means that the net income actually understates the real cash earnings. This is one reason that the free cash flow can be so different from the net income.

The second reason behind Kohl's profit decline is that the company became overly dependent on its private-label brands. In 2007, about 30% of Kohl's sales were private label. This number rose to 54% in 2012, and the lack of national brands caused consumers to lose confidence in Kohl's. According to one survey, the percentage of consumers who think that Kohl's has the brands that they prefer fell from 10.8% in 2007 to 7.8% in 2011. While private-label merchandise typically carries higher gross margins, the lack of national brands began to drive shoppers away.

Kohl's has started to fix this problem by refocusing on national brands, but winning back consumers will take time.

Why Kohl's is a value
Kohl's currently trades at a P/E ratio of about 13, lower than the 15.4 P/E ratio of Macy's, but the difference between depreciation and capital expenditures actually makes the stock appear more expensive than it really is. If we use free cash flow instead of net income, taking the average value over the past five years to minimize the effects of year-to-year fluctuations, the P/FCF ratio is a bit below 11. For a company like Kohl's, that seems inexpensive to me.

The bottom line
Kohl's is undervalued if you believe the story that its current problems are temporary. The company has a cost structure that is more efficient than its competition, and while its focus on private-label brands has backfired, the company has already taken steps to correct this problem. Kohl's is a rare undervalued stock within a booming stock market where nearly everything seems expensive, and it should be on the watchlist of every value investor.