Investors have become very skeptical about department stores' prospects since 2015, because of the rising threat from e-commerce. For example, even after a recent bounce, Macy's (M -0.52%) stock is down more than 60% from its mid-2015 high.
However, investors have fallen back in love with Kohl's (KSS -1.67%) in the past few months. In fact, Kohl's stock has nearly doubled since bottoming out last June and is now within 15% of its all-time high. A big chunk of this increase has come just this month.
There are some good reasons for the recent rally in Kohl's stock. Nevertheless, investors may be getting ahead of themselves. As a result, I am thinking about reducing my exposure to Kohl's by selling a portion of my shares or writing a covered call option against my Kohl's shares.
The bull case for Kohl's
I was fortunate enough to purchase Kohl's stock last June, just as it was bottoming out. At the time, I laid out several reasons I thought the stock would recover.
First, investors seemed to be irrationally punishing Kohl's for margin pressures at Macy's. While margin compression can sometimes spread through the industry, inventory reduction efforts at Kohl's seemed likely to prevent further margin declines -- and perhaps even reverse some of the margin deterioration of the past five years.
Second, free cash flow at Kohl's exceeds its earnings per share by a wide margin. The company's capital spending discipline and inventory reductions are both contributing to this strong free cash flow production. As a result, Kohl's stock carried a dividend yield of more than 6% when I made my investment, and the company still had excess free cash flow to use for share buybacks.
A remarkable holiday-season sales recovery has made Kohl's stock even more attractive today. Earlier this month, Kohl's reported that comp sales surged 6.9% year over year in the combined November-December period, compared with a 1% decline in the first nine months of fiscal 2017.
Euphoria has arrived
Understandably, this improving sales trajectory has helped Kohl's stock snag several upgrades on Wall Street. The most bullish analyst note came last Friday, as Randal Konik of Jefferies raised his price target all the way from $66 to $100, reasoning that Kohl's omnichannel investments will continue to pay off in the next few years, driving sales growth and margin expansion.
This $100 price target isn't as absurd as it might sound. Kohl's will get a big earnings boost from tax reform, while the recent acceleration in sales trends could help the profit margin bounce back. Even without a full margin recovery, EPS could surpass $6 in fiscal 2018.
However, there's no guarantee that the recent sales momentum will continue. Thus far, the hot streak at Kohl's consists of a single quarter, compared with more than five years of stagnant sales before that. If Kohl's encounters a setback in the coming year, Kohl's stock could fall a long way.
The risk-reward balance has shifted
On Tuesday, Kohl's stock reached the $69 mark, nearly 17 times its updated EPS forecast. For comparison, Macy's stock trades for less than 9 times its projected 2017 adjusted EPS.
The company's off-mall store locations do give it an important long-term advantage over Macy's. On the other hand, Macy's has a more developed e-commerce business. Furthermore, its weaker comp sales trajectory may simply reflect that it is at an earlier stage of its turnaround than Kohl's. Finally, Macy's has an important secondary income stream from real estate sales and redevelopment projects.
I'm not planning to sell all of my Kohl's stock in the near future. After all, if Kohl's can post low- to mid-single-digit comp sales growth in 2018, the resulting margin expansion could drive EPS well beyond analysts' current expectations. That said, the stock no longer has a big margin of safety -- unlike Macy's stock, for example. Therefore, I think it is prudent to take some chips off the table at this point.