Shares of Kohl's (KSS 2.17%) have risen about 50% over the past year as investors rewarded the department store giant for improving sales trends. However, Kohl's stock has fallen by about 15% since peaking earlier this year.
Meanwhile, industry conditions are set to become more favorable, mainly due to the pending liquidation of Bon-Ton Stores. Kohl's stock is also quite cheap, particularly when valued based on its free cash flow. That makes the No. 2 U.S. department store chain a compelling long-term investment opportunity.
Sales growth rebounded during 2017
Up until about a year ago, Kohl's was struggling just like most of its peers in the department store sector. Comp sales fell 2.4% year over year in fiscal 2016 and 2.7% in the first quarter of fiscal 2017. That's a big reason why Kohl's stock lost more than half of its value between early 2015 and mid-2017.
Fortunately, sales trends started to improve in the middle of last year. Comp sales slipped just 0.4% year over year in the second quarter and inched up 0.1% in the third quarter.
Kohl's sales trajectory then accelerated dramatically during the holiday season. In the combined November-December period, comp sales surged 6.9%. For the full fourth quarter, comp sales rose 6.3%. This stellar performance allowed Kohl's to post full-year adjusted earnings per share of $4.31-- far ahead of its initial guidance of $3.50 to $3.80.
The sales opportunity just got bigger
For fiscal 2018, which began in February, Kohl's projects that comp sales will rise 0% to 2%. Comp sales growth is expected to exceed the high end of that full-year forecast in the first half of the fiscal year before slowing in the second half of the year.
This guidance may be overly conservative. Kohl's experienced a sharp change in its sales trend last year, and management probably doesn't want to overpromise, particularly when the company will face a tough year-over-year comparison in the fourth quarter. Overall industry conditions remain very favorable, though, with GDP likely to grow at a robust pace and consumers benefiting from tax cuts.
Furthermore, Kohl's could be a big beneficiary of Bon-Ton's demise. There is significant geographic overlap between the two: 35% of Bon-Ton's store base is within one mile of a Kohl's location, and 71% of its stores are within five miles of a Kohl's, according to a recent Morgan Stanley analysis. This represents a valuable opportunity to increase sales and earnings, which would give Kohl's stock a boost.
The only department store operator that has more overlap with Bon-Ton is Sears Holdings, which is rapidly losing market share itself. Meanwhile, TJX Companies is the only other fashion retailer with comparable exposure to Bon-Ton's local markets.
TJX and Kohl's are both likely to achieve substantial sales gains after Bon-Ton closes the remainder of its stores this summer. TJX probably has more merchandise overlap with Bon-Ton, but it doesn't carry full collections, so it takes more effort to find the hidden gems in its stores. By contrast, Kohl's merchandise assortment tends toward more moderately-priced brands, but it will be one of the few department stores left in many of Bon-Ton's smaller markets.
The timing of Bon-Ton's liquidation means that most of the incremental sales will come in the second half of fiscal 2018. That should help Kohl's continue posting solid comp sales growth even as the year-over-year comparisons become tougher.
Kohl's stock looks like a bargain
Kohl's initial forecast for fiscal 2018 calls for EPS of $4.95-$5.45. Based on the midpoint of this guidance range, Kohl's stock currently trades for about 11 times forward earnings.
That's not as cheap as some other department store stocks. However, as noted above, Kohl's may be underestimating its sales potential, particularly in light of the Bon-Ton liquidation. Kohl's surpassed the high end of its initial 2017 EPS forecast by more than 10%, and it's certainly possible that it could achieve a similar earnings beat this year.
Additionally, Kohl's has a much better balance sheet than most of its peers. It ended fiscal 2017 with $2.8 billion of long-term debt and $1.7 billion of capital-lease obligations. Just last week, Kohl's paid down about $500 million of its debt, giving it an even cleaner balance sheet.
Finally, free cash flow has routinely exceeded net income at Kohl's in recent years. This trend is set to continue in 2018. Based on Kohl's plans to limit capital expenditures to $700 million and reduce its inventory, free cash flow could be as high as $8 per share this year.
That makes Kohl's stock look like a bargain at its recent trading price below $60. If the company can continue gaining market share from weaker competitors while executing its plan to sublease excess retail space to high-traffic grocery and convenience stores, Kohl's stock could potentially reach triple-digit territory in the next few years.