Kohl’s: Best of a bad bunch

At the recent Ira Sohn Conference, Stephen Mandel, of Lone Pine Capital, highlighted Kohl’s (NYSE: KSS) as one of his favorite stocks right now. Kohl’s is a national chain of 1,100+ department stores with a moderate focus toward the Midwest/West regions of the US. Department stores generally got very hard hit by the market decline in 2008 and they have slumped since the end of 2009 so valuations are quite reasonable with Kohl’s trading at roughly 10x trailing earnings.

If we first look to Kohl’s operating performance we find that this it is an able competitor. The competitors I have chosen to focus on are those in the Department Store Index apart from SearsNordstrom (NYSE: JWN), Macy’s (NYSE: M), Dillard’s (NYSE: DDS), and J.C. Penney (NYSE: JCP). On the basis of these comparisons Kohl’s should be trading at a slightly more ambitious multiple.

The core of this advantage appears to be structural — Kohl’s stores are on average far smaller than competitors. For example, Nordstrom’s average store is 211,000 square feet, Dillard’s is 174,000 but Kohl’s is only 87,000. As a result, Kohl’s SGA (selling, general, and administrative) costs are the lowest in the industry at the per store level. Coping with pressure on the top-line is far easier with this kind of advantage.

Another advantage from smaller stores is high sales per square foot. Nordstrom is way in the lead here with $400 of sales per square foot but Kohl’s with $190 per square foot is way above everyone else. Again, it appears that that these smaller stores allow Kohl’s some protection against changes in the top line and allow it to use its space more effectively.

 

Sales/Sqft SGA/Sqft Sales/Store SGA/Store
Nordstrom 424.21 113.44 89.72 23.99
Macy’s 173.38 54.37 31.36 9.83
Dillard’s 118.00 30.22 20.60 5.28
J.C. Penney 155.22 45.94 15.66 4.64
Kohl’s 190.98 43.09 16.69 3.76

 

Kohl’s historicals are just as strong. Over the past five years, Kohl’s has continued to expand adding 198 stores and nearly 16,000,000 square feet of capacity whilst the rest of the sector, except Nordstrom, has stood still. More surprisingly, whilst this expansion has led to declining sales figures at a per store and per square foot level, the pace of decline is comparable to that experienced  by the sector as a whole. It has outpaced Dillard’s, the clear laggard, and only Macy’s managed to prevent declines in sales per store and per square foot over the past five years.

 

Kohl’s Historicals 2011 2010 2009 2008 2007 CAGR
Avg Store Sqft 87.37 87.99 88.17 88.62 88.85 -0.34%
Sales/Store 16.69 16.89 16.24 16.32 17.73 -1.21%
SGA/Store 3.76 3.85 3.73 3.75 3.98 -1.10%
Sales/Sqft 190.98 191.93 184.14 184.19 199.59 -0.88%
SGA/Sqft 43.09 43.73 42.35 42.36 44.79 -0.77%

 

At an operating level, it is difficult to understand the discount that the market has attached to Kohl’s. On the basis of trailing P/Es, Kohl’s trades at a 30% discount to Nordstrom and a 14% discount to Macy’s. On an EV/store basis, this gap is even larger although this is surely complicated by accounting for leases. Considering the fact that Kohl’s has the second highest pre-tax margins in the industry, a structurally lower cost base, and more potential for expansion we may argue that this discount is unwarranted.

 

EV/Store P/E Pre-tax PM
Nordstrom 98.80 14.71 10.3%
Macy’s 22.54 11.99 7.5%
Dillard’s 12.27 7.16 6.3%
J.C. Penney 6.56 -1.3%
Kohl’s 12.67 10.27 9.9%

 

The company is also attractive at a financial level, which seemed to be the focus of Stephen Mandel’s decision. Kohl’s has just begun paying dividends but it is the share buyback program that is most interesting. In 2010, the company bought back just under 19m shares worth $1bn and in 2011, Kohl’s bought back just under 46m shares worth $2.3bn. In the first quarter of 2012, $325m worth of shares were bought back. This program is being achieved through drawing down the company’s cash balance, which amounts to a modest re-leveraging. However, despite the substantial repurchases already made, EBIT/Interest Expense (inc. rental expenses) was 7.2x at the end of January 2012. The company expects to return another $1bn through 2012.

On both a financial and operating basis, the case for Kohl’s looks strong. However, in this sector one always has to consider the effect of broader movements in consumer spendings. Pundits are widely divided on where the economy is going although, as might be expected, the recent decline in broad market indexes has led to a wave of negativity.

For this sector, one should bear in mind that over the last five years (the longest period for which results are comparable) there was very little to choose between the companies in terms of sales growth. Certainly, Kohl’s and Nordstrom were boosted by continued store expansion but the standard deviation of sales growth for the group was steady around 5.7%. Kohl’s definitely stands out in the sector, but the investor must feel comfortable with taking the risk of investing in the department store sector as a whole.

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