It's been a fun year for Kohl's (NYSE:KSS) investors. Shareholders have enjoyed gains of more than 60% over the past year, as the department store chain has proven that it can successfully compete in an increasingly competitive retail environment.
And shareholders may be in store for even more rewards in the year ahead. Here are three reasons why Kohl's stock can continue to head higher.
An opportunity in activewear
CEO Michelle Gass highlighted Kohl's strong performance in active apparel during the company's second-quarter earnings call:
National brand sales increased 4%, driven by strength in apparel and footwear, which is largely due to our continued growth in the active category ... Looking more closely at our active brands, Nike, our largest national brand, continues to outperform the company through its core and new offerings, which included launching Golf this quarter. Under Armour has delivered very strong growth in its second year and accelerated from its first-quarter sales performance. Adidas had another outstanding quarter, as our customers continued to react favorably to our expanded and elevated assortment.
As an apparel retailer, it's paramount that Kohl's offers a selection of popular brands in its stores. Kohl's knows this and has worked diligently to strike partnerships with the likes of Under Armour, Nike, and Adidas in recent years. In the process, these sports apparel titans have secured a valuable distribution partner in Kohl's. In return, Kohl's has received popular product lines that are boosting sales at its stores.
Moreover, Kohl's has gained market share in activewear after the bankruptcies of sporting goods retailers such as Sports Authority in recent years. To further capitalize on this opportunity, Kohl's is increasing the square footage devoted to active and wellness-related items in 30 of its stores. If this test program goes well -- and all signs suggest it will -- Kohl's could roll out this new format to more of its stores in the quarters ahead.
Store optimization initiatives are driving margin expansion
In 500 of its 1,158 stores, Kohl's is reducing its square footage in order to rent space to other businesses, such as Aldi supermarkets. This should help to increase vital foot traffic at these locations.
This smaller store format is also helping Kohl's scale back its inventory levels, which is leading to lower clearance-related markdowns and, by extension, improved profitability. On an overall basis, Kohl's reduced its inventory per store by 8% year over year in the second quarter, which helped drive a 42 basis point improvement in gross margin.
Gass declined to name other prospective tenants, but said that Kohl's is building a "robust pipeline of interested parties." Investors can expect to hear more news regarding this initiative in the coming quarters.
Sweet, beautiful cash
As Kohl's profit margins have improved, so too has its cash production. Operating cash flow rose to more than $1 billion in the first two quarters of 2018, up from $376 million in 2017. And free cash flow increased to $735 million, up from negative $23 million in the year-ago period.
This bountiful free cash flow generation is helping Kohl's strengthen its balance sheet by paying down debt and increasing its cash reserves. It's also allowing the company to reward shareholders with stock buybacks and a hefty 3.4% dividend.
Better still, Kohl's cash dividend payout currently accounts for less than 30% of its free cash flow. Investors can therefore rest easy knowing that their dividends are well secured. And with Kohl's profits set to climb higher in the coming years, more dividend increases likely lie ahead for long-term shareholders.
Joe Tenebruso has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Under Armour (A Shares) and Under Armour (C Shares). The Motley Fool recommends Nike. The Motley Fool has a disclosure policy.