Kohl's Long-Term Strategies Are Making Progress
New merchandise from national brands and focus on customers are gaining traction with consumers.
We still believe Kohl's (KSS) has a narrow economic moat, and although comparable-store sales in the first quarter were mildly below management's full-year guidance midpoint of 2%, we see no reason to materially change our $68 fair value estimate. Our long-run operating forecast also remains virtually unchanged. Positive movement on gross margins and proprietary work on customized marketing and loyalty are in the early stages but showing traction already. The less promotional stance and focus on loyalty and increasing gross margins--including national brands selling at full price and consumer engagement and customization initiatives--give us more confidence that Kohl's can maintain double-digit operating margins and peer-beating returns on capital for the long run.
In the first quarter, sales increased to $4.123 billion on a 1.4% increase in same-store sales. Since the first quarter of 2014, Kohl's has opened just four stores (two in the recent quarter), bringing the total count to 1,164, and modest store openings have been widely communicated. With last year's first-quarter comparable-sales increase a negative 3.4% and annual guidance for a 1.5%-2.5% increase, some investors may be disappointed, but merchandise and departments affected by strategic initiatives such as marketing and national brands appear to be outperforming. Although Kohl's management did not hide behind bad weather and West Coast port strikes, we note that a number of retailers believe such factors had a negative impact on first-quarter sales. Gross margins in the quarter increased 17 basis points to 36.9%; management said this has been the first time in a number of years that the merchant organization exceeded margin plans. Selling, general, and administrative expense held steady at 24.6% of sales year over year, and while new marketing and loyalty programs are creating additional touch points with customers, there are early signs that the efficiency of marketing can continue to increase.
Kohl's Has Found an Attractive Niche
Kohl's operates in a competitive environment with department, specialty, and general merchandise stores aggressively vying for share of consumer discretionary spending. We like the niche Kohl's has created by providing a wider selection of national brands than discounters such as Target (TGT), an excellent price/value equation, and more convenient off-mall locations than some competitors.
Kohl's stores are predominantly newer (75% are less than 15 years old and 50% are new or remodeled in the past six years) and located off-mall where they are the anchor tenant (roughly 80 stores are mall-based), giving the firm cost advantages and access to better and improving customer demographics. Kohl's also has lower SG&A ratios (22.9% in 2014) in part due to buying efficiencies. Combined with high gross margins from exclusive brands, Kohl's generates near-double-digit operating margins, above most department store rivals. We think these advantages are sustainable, and we assign Kohl's a narrow economic moat, with its solid returns on invested capital supporting our view.
Another key to Kohl's success has been its ongoing merchandise efforts focused on earning high gross margins. Kohl's has expanded private and exclusive labels to over 50% of total sales, but is now initiating strategies to highlight merchandise from national brands. We think continually updating the product offering is key to driving repeat business, and we also think Kohl's store environment can offer a better presentation that national brands will find attractive. While some investors may believe gross margins have now peaked, we think long-run improvement is still possible, but we have conservatively modeled no growth in gross margins to arrive at our fair value estimate.
Kohl's has been able to buy back shares and maintain dividend growth with its operating cash flow while opening stores, remodeling others, and maintaining target debt levels, incrementally boosting shareholder returns in the process. Now, as store openings have slowed, Kohl's has been able to focus more on remodels. IT spending is boosting capital expenditures, but we expect this to stabilize.
Low-Cost Structure, Solid Merchandising
We think Kohl's narrow economic moat stems from its low-cost structure and merchandising efficiency. The company has a combination of private and exclusive brands and national brands that often are not offered anywhere else. In addition, national brands that have minimum price requirements from vendors can be used toward Kohl's loyalty and cashback programs. Kohl's has a younger store base with more stores in strip centers, which lowers costs and increases flexibility, in our view. The retailer's store format, with its centralized checkout area, allows more efficient staffing levels than mall-based peers.
Additionally, Kohl's has a centralized buying, advertising, and distribution model while using buying agents overseas, which results in a very cost-efficient operation. We think the firm's private- and exclusive-label offerings, which account for roughly more than 50% of sales, help differentiate it from peers, in that the quality of Kohl's exclusive offerings often leads consumers to believe that they are true national brands. The chain's low-cost structure coupled with solid merchandising capabilities allows Kohl's to generate operating margins in the low double digits to high single digits, surpassing the mid-single-digit margins of close peers. Returns on invested capital also exceed our estimate of the firm's cost of capital, providing further support for a narrow economic moat.
Retail Competition Always Intense
We rate Kohl's as having medium fair value uncertainty. Although there are risks to achieving our forecast, including competition and macroeconomic considerations, we believe the outcomes for the company are reasonably narrow on both the upside and downside.
Kohl's may be overestimating the number of stores the domestic market can support, which could reduce our estimates of long-term cash flow growth. Competition in retail is always intense. J.C. Penney (JCP) could emerge from its turnaround and begin opening off-mall stores, and discounters such as Target and Wal-Mart (WMT) are expected to continue efforts to enhance their apparel offerings. All of these general merchandise stores compete for consumer discretionary spending.
If Kohl's experiences greater-than-anticipated competitive pressure or curtails expansion, its growth prospects could slow. Same-store sales could be weak for an extended period if economic pressures continue to affect consumer spending for Kohl's more moderate-income customers. The firm has exposure to fashion risk, with roughly a third of sales coming from women's apparel.
As Kohl's continues to strive to improve gross margin, it must balance national brands with private- and exclusive-label offerings. The risk exists that consumers may one day prefer a competitor that has a different assortment of brands or better fashions, and there is also the risk that national brands will refuse to sell at Kohl's.
Because Kohl's develops and imports many private- and exclusive-label products, the business environment and costs of operating in developing economies where most soft goods are made is a risk. Business disruptions, increased labor costs, or increased costs or problems during transportation could cause Kohl's to have delays in merchandise receipts or to raise prices, both of which could hurt demand.
Paul Swinand does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.