Kohl's (KSS -0.95%) recovery from the depths of the COVID-19 pandemic continued in the final quarter of its fiscal 2020. Last week, the department store giant officially reported that sales and earnings trends both improved significantly in its fiscal fourth quarter compared to the rest of the year.

To be sure, Kohl's key business metrics remain well below their pre-pandemic levels. However, this sequential progress -- and some promising initiatives in the pipeline -- have put the company on track to make a full recovery and potentially even surpass its pre-pandemic earnings power within a few years.

The fourth quarter in brief

For the period that ended Jan. 20, Kohl's revenue declined 10.1% year over year to $6.14 billion. This marked a solid improvement compared to the company's 14% revenue decline in its fiscal third quarter, not to mention the 31.5% plunge in its revenue during the first half of its fiscal year.

This sequential sales improvement was noteworthy in that the pandemic grew significantly worse during the fourth quarter. Nonetheless, strong demand for home goods, e-commerce growth, and greater consumer comfort with in-store shopping all contributed to Kohl's better-than-expected top-line performance.

The exterior of a Kohl's store

Image source: Kohl's.

Kohl's reported a 12% year-over-year increase in adjusted earnings per share for the fiscal fourth quarter. A little more than half of its quarterly EPS came from tax benefits, though. Excluding those items, adjusted EPS fell to $1.07 from $1.99 a year earlier. Still, considering that the pandemic continued to limit store traffic -- while the company incurred incremental costs related to coronavirus safety protocols and holiday shipping surcharges -- this result was encouraging.

Recovery begins in 2021

In conjunction with last week's earnings report, Kohl's said that it expects a mid-teens percentage increase in sales during fiscal 2021. That would allow it to recover a little more than half of the roughly $4 billion revenue decline it suffered in fiscal 2020. Meanwhile, it expects EPS to rebound to between $2.45 and $2.95.

The activist investors who have been calling for a board shakeup at Kohl's weren't impressed with this outlook. After all, adjusted EPS totaled $4.86 in fiscal 2019 and $5.60 in fiscal 2018. That said, management may be providing a conservative forecast given how uncertain near-term business trends are. Moreover, Kohl's clearly won't get back to "normal" this year.

First, the COVID-19 crisis isn't over yet. Store traffic may approach what will be a post-pandemic new normal by the summer, but for now, some consumers are still avoiding trips to consumer discretionary retailers like Kohl's.

Second, Kohl's temporarily faces elevated financing costs. It issued $600 million of high-yield debt last spring to shore up its liquidity. It also sold and leased back two distribution centers. However, Kohl's ultimately generated about $1 billion of free cash flow in fiscal 2020, ending the year with $2.3 billion of cash. It will start repaying debt with some of that cash during 2021, reducing future interest expenses.

KSS Cash and Equivalents (Quarterly) Chart

Data source: YCharts.

Third, due to the steep decline in sales during fiscal 2020, customers are (on average) carrying lower balances on their Kohl's Charge accounts, which will cut into Kohl's high-margin credit card revenue in fiscal 2021. This temporary headwind should abate over the next few years, though, assuming sales recover.

Momentum will grow

While Kohl's earnings power will remain depressed in fiscal 2021, the department store chain has substantial long-term earnings growth potential. Indeed, based on its 7% to 8% operating margin target, Kohl's could be earning $6 to $7 per share or more by fiscal 2023.

Skeptics may wonder whether the retailer could really hit that level of earnings. Nothing is guaranteed, but Kohl's could exit the pandemic stronger than it was at the beginning of 2020. Due to its fellow department stores' woes, Kohl's has become a preferred partner for brands looking for broad distribution. Just in the last 12 months, it has signed distribution partnerships with key brands like Lands' End, Eddie Bauer, and Calvin Klein. Most notably, it struck a deal to open at least 850 Sephora shops within Kohl's stores by 2023.

Between its improved brand portfolio, an enhanced focus on inventory management and cost discipline, and an expected rebound in retail traffic, Kohl's sales and earnings trends will likely gain momentum over the next three years or so. While Kohl's stock price has quintupled since bottoming out around $11 last spring, there could be more upside ahead if the company's post-pandemic recovery goes as planned.