Kohl's (KSS 3.18%) served up another big earnings beat on Thursday. While the company has lagged many of its peers on revenue growth this year, it continued a streak of impressive margin expansion.
Investors initially rewarded the company for its strong third-quarter margin performance, sending Kohl's stock up more than 10% on Thursday. However, the shares subsequently fell 9% on Friday, forfeiting nearly all of those gains. That makes Kohl's stock an absolute steal for long-term investors.
Another quarter of stellar profitability
In the second quarter, Kohl's reported record earnings per share (EPS) of $2.48, even though revenue barely increased compared to the same period two years ago. Exceptionally strong gross margin and tight expense control enabled the company to post its highest second-quarter operating margin in a decade.
Similar trends played out in the third quarter. Net sales rose 15.5% year over year to $4.37 billion but inched up just 0.2% relative to Q3 2019. Total revenue actually decreased slightly over that period, due to lower credit card revenue (which is excluded from net sales).
For the second consecutive quarter, supply chain challenges weighed on sales. Kohl's ended the period with inventory down 25% from two years earlier. Moreover, a higher-than-normal proportion of that inventory is still in transit (i.e., not available for sale) due to port delays and other supply chain constraints. Management indicated that inventory is especially tight in the women's apparel category, which typically accounts for at least 25% of sales.
On the flip side, Kohl's capitalized on the combination of strong demand and tight inventory by cutting back on discounts. Gross margin reached 39.9% -- up from 36.3% two years earlier -- despite higher freight costs. Meanwhile, operating expenses declined slightly compared to Q3 2019. As a result, adjusted EPS more than doubled from $0.74 two years ago to $1.65 last quarter. This crushed the average analyst estimate of $0.64.
The full-year outlook rises again
Following its latest earnings beat, Kohl's raised its full-year adjusted EPS guidance by more than $1 to a new range of $7.10 to $7.30. At the beginning of 2021, it estimated that full-year EPS would range between $2.45 and $2.95.
Kohl's has a good chance of beating this updated outlook. Whereas consumer discretionary retailers typically post their highest margins in the fourth quarter, Kohl's full-year forecast implies a sequential margin decline this quarter. Elevated freight costs and sky-high holiday shipping surcharges do represent meaningful headwinds, but management appears to have built a lot of room for error into its guidance.
Ramping up buyback activity
Kohl's stock currently trades for just eight times the company's projected 2021 adjusted EPS. Moreover, the company has a rock-solid balance sheet and generated $1 billion of free cash flow in fiscal 2020 (despite the pandemic) plus another $1.3 billion in the first nine months of fiscal 2021.
As the company's performance has improved -- while its share price has languished -- Kohl's has ramped up its share buyback program. After repurchasing just $46 million of Kohl's stock in the first quarter, the company spent $255 million on buybacks in the second quarter and a whopping $506 million last quarter. In the first nine months of the year, it bought back roughly 10% of its outstanding shares.
Despite its aggressive buyback activity, Kohl's ended last quarter with nearly $1.9 billion of cash. As a result, it plans to repurchase another $500 million of stock in the fourth quarter (approximately). Thanks to its strong cash generation, Kohl's could continue buying back about $1 billion of stock annually over the next few years, driving further share count reductions.
Kohl's stock is set to soar
Strong consumer demand and an unusually tame promotional environment have undoubtedly boosted Kohl's profitability this year. Nevertheless, the company is well positioned to grow its earnings further in the years ahead.
First, improved inventory levels -- particularly for women's apparel -- will enable Kohl's to make sales that it is missing out on right now. Second, Kohl's game-changing partnership with Sephora is just beginning. The retailer opened its initial batch of 200 Sephora shops within its stores last quarter -- with early results exceeding expectations -- but it will grow that number to at least 850 by 2023. Third, Kohl's continues to enhance its brand portfolio, adding Calvin Klein, Tommy Hilfiger, and Eddie Bauer to its merchandise mix in recent months.
If Kohl's can capitalize on these tailwinds to accelerate its sales growth while maintaining its profit margin near current levels and aggressively buying back stock, EPS could easily reach $10 within a few years. That makes Kohl's stock a stunning bargain today.