With the Federal Reserve raising interest rates and the prospect of a possible recession on the horizon, the S&P 500 has dropped by 21% since the start of the year. When stocks have a broad sell-off, you might view this situation from a value perspective.

Kohl's (KSS -0.47%) has fallen by an even bigger 41% during this span. Let's dive in to see if the market has overreacted, creating a buying opportunity, or if the sharp downturn signals further trouble.

A man and woman looking at a piece of paper and laptop.

Image source: Getty Images.

Easy comparison

Kohl's rebounded strongly last year, but it was facing easy comparisons due to the pandemic's effects on 2020 results. For fiscal 2021, which ended on Jan. 29, sales grew by 22.9% to $19.4 billion. This came after sales fell by 20.4% in the previous year.

The company flipped to a $1.7 billion operating income from a $262 million loss. And its operating margin was 8.6%.

Despite these seemingly strong results, management in March issued lukewarm guidance for the year. It expected sales to increase 2% to 3% and operating margin to contract to 7.2% to 7.5%.

Challenges ahead

Since then, economic conditions have worsened as inflation has led to higher costs for many retailers, including Kohl's. As a result, consumers, particularly the company's targeted middle-income customers, have pulled back.

Kohl's sales have fallen for the first two quarters of the fiscal year. In the latest period, ended on July 30, sales declined by 8.5% to $3.9 billion. And its gross margin contracted by 2.9 percentage points. These factors helped drive operating income down to $266 million from $570 million.

This doesn't look likely to reverse anytime soon. Management now expects this year's sales to drop by 5% to 6% and the operating margin to contract by roughly half to 4.2% to 4.5%. The lower sales mean inventory remains elevated, and gross margin will remain under pressure as Kohl's discounts the goods to clear the shelves.

Longer-term issues

Operating about 1,100 department stores, Kohl's offers a broad range of moderately priced goods. However, over the years the retailer has lost out to online competitors like Amazon (NASDAQ: AMZN) and discounters such as TJX Companies' (NYSE: TJX) brands.

In fairness, management has attempted to boost traffic through its partnerships with Amazon and Sephora. Kohl's is attempting to make its stores an attractive destination where shoppers can find differentiated goods.

However, I think it needs to concentrate on its own offerings to boost traffic. It's also worth remembering that J.C. Penney tried this exact same thing, and it wasn't enough to save the retailer from bankruptcy. In fact, the retailer's precarious financial position led Sephora to leave J.C. Penney for Kohl's, and it's possible that could happen here.

While the stock has dropped quite a bit, I would hold off on making purchases until there's evidence that Kohl's has moved beyond its department store roots. Right now, investors would be better served to shop for other stocks that offer stronger prospects.