Department stores are struggling to attract shoppers, and Kohl's ( KSS -2.89% ) is no exception. Kohl's posted a 1.7% decline in comparable sales and a 5.7% decline in transactions per store during the third quarter, numbers that are hard to like. The company is now reducing its store count and focusing on smaller formats for new stores, an abrupt change of pace from just a few years ago.
Despite the top-line troubles facing Kohl's, there are plenty of positives that make the stock a compelling investment. Here are four reasons to buy Kohl's stock now.
Doing better than the rest
Kohl's is operating in a difficult environment. Department store sales have been weak all year, and unseasonable weather in September contributed to lackluster performance. Kohl's management sees the trends improving going into the holiday season, but there's still a lot of uncertainty.
Two of Kohl's competitors, Macy's ( M -3.25% ) and J.C. Penney ( JCPN.Q ), are also facing challenges. Macy's reported a 2.7% decline in comparable sales during the third quarter, a steeper decline than Kohl's. The company is being far more aggressive with store closings, aiming to shutter about 15% of its locations by early 2017. The hope is that closing underperforming stores will improve profitability at the expense of sales. Macy's definitely needs an earnings boost -- adjusted EPS dropped 70% during the third quarter.
On the surface, it looks like J.C. Penney is doing better. Comparable sales declined by just 0.8% during the third quarter, and J.C. Penney expects comps to improve by 1% to 2% for the full year. But J.C. Penney's sales are still so depressed from its near-collapse a few years ago that slumping comparable sales is a disaster. The company needs to post robust growth for years in order to get back to where it was. That doesn't appear to be happening.
Profits holding up
Despite a decline in sales during the third quarter, Kohl's managed to keep adjusted net income roughly flat compared to the prior-year period. A slight increase in gross margin and a slight decrease in operating expenses helped to offset the lower revenue. On a per-share basis, the company grew adjusted earnings by 7%, driven by share buybacks.
Kohl's has been successful in keeping its costs down and its inventory in check during this period of soft sales. Selling, general, and administrative expenses are down 1.5% through the first nine months of the year, and inventory at the end of the third quarter was down 10% compared to the same time last year. Keeping inventories lean has saved Kohl's from needing to be aggressive with markdowns, allowing gross margin to be maintained despite weak sales.
A deceptively cheap valuation
Kohl's expects to produce between $3.80 and $4.00 in adjusted EPS this year, which puts the PE ratio at roughly 13.5. But Kohl's will produce substantially more free cash flow this year due in part to its inventory reduction efforts. Free cash flow has already reached $689 million through the first nine months of the year, or about $3.90 per share.
This inventory-related boost can't be repeated every year, so free cash flow may not be the best valuation metric. But Kohl's is producing a lot more cash than its earnings suggest, which can be used to fuel buybacks that knock down the share count and drive per-share earnings higher.
Speaking of buybacks, Kohl's has been aggressively buying back its own stock for the past few years. The company's share count fell to 177 million at the end of the third quarter, down from 306 million at the beginning of 2011.
Kohl's spent $441 million on share buybacks during the first nine months of this year, and the company boosted its buyback authorization to $2 billion, with that total expected to be used over the next three years. With a market capitalization of about $9.5 billion, Kohl's has the ability to reduce its share count by another 20%. Cash flow should fund much of this buyback spending, and the net result will be higher per-share earnings, even without much growth.