Shares of Kohl's (NYSE:KSS) lost about three-quarters of their value in the first three months of 2020, as investors panicked due to the COVID-19 pandemic's onset. However, Kohl's quickly stabilized its finances, enabling a partial recovery for the stock. More recently, Kohl's stock has rallied on growing optimism that highly effective COVID-19 vaccines will become widely available next year.

Kohl's earnings report on Tuesday showed that the retailer didn't need to wait for the pandemic to end to improve its operating performance. Kohl's shares surged more than 11% after the company easily surpassed analysts' expectations for a significant quarterly loss.

KSS Chart

Kohl's stock performance. Data by YCharts.

Indeed, the encouraging third-quarter earnings report suggests that Kohl's stock has plenty of room to rise, with the retailer likely to fully recover from the 2020 downturn.

Another quarter of sequential improvement

After posting an ugly $495 million adjusted net loss in the first quarter of fiscal 2020, Kohl's managed to stabilize its profitability in the second quarter. Kohl's adjusted net loss improved sequentially to a relatively manageable $39 million. Nevertheless, many investors were concerned by a deceleration in sales momentum that began in July and continued into August. Management attributed the slowdown in part to weak back-to-school sales.

Investors need not have worried. The sales recovery accelerated again in September and October, leading to a net sales decline of 13.3% for the quarter. That represented a big improvement compared to Kohl's 22.9% sales decline a quarter earlier. Total revenue came in at $3.98 billion, roughly in line with analysts' estimates.

Even more impressively, Kohl's gross margin recovered to 35.8% last quarter: down just 0.5 percentage points year over year. By contrast, gross margin had fallen by 5.7 percentage points year over year in the second quarter, landing at 33.1%. (Margin erosion was even worse in the first quarter.) Careful inventory management was the biggest driver of this sequential growth in gross margin.

The exterior of a Kohl's store.

Image source: Kohl's.

Kohl's also reduced its operating expenses by 8% last quarter, despite modest cost headwinds from pandemic-related safety measures. The net result was adjusted net income of $2 million, or $0.01 per share. While that was down considerably from the company's adjusted earnings per share of $0.74 a year earlier, analysts had expected a loss of about $0.43 per share.

Finally, Kohl's generated $511 million of free cash flow in the third quarter, bringing its year-to-date total to $578 million. That enabled it to repay its revolving credit line and still end the quarter with over $1.9 billion of cash. In fact, tight inventory management and reduced capital spending have put Kohl's on pace to generate more free cash flow in fiscal 2020 than it did last year.

A bright post-pandemic future

The rapid improvement in Kohl's sales trends despite the ongoing pandemic (which is clearly weighing on store traffic) suggests that the No. 2 U.S. department store chain is well positioned to return to growth in the years ahead. Management sees a big opportunity from rivals' store closures. Kohl's is also expanding its emphasis on activewear, beauty, home, and toys: categories where it is already succeeding. It is phasing out underperforming brands to make room for new brand launches like FLX (a new private-label athleisure brand) and Cole Haan. It's even testing a curated collection of consumer staples in 50 stores.

Management thinks the combination of modest sales growth, better inventory management, and various cost cuts will enable it to boost its operating margin to between 7% and 8% in the coming years. That would be consistent with annual net income of around $1 billion. Meanwhile, Kohl's buoyant cash position will allow it to start paying a dividend again next year while also reducing its debt load.

Even after the recent rally in Kohl's stock, the company's market cap is just $4.5 billion. If Kohl's can succeed in driving its operating margin back above 7% -- which seems very achievable -- the stock could easily double again over the next few years.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.