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A Closer Look at Kohl's


In the wake of JC Penney's problems, will Kohl's benefit, or is it suffering from the same extreme consumer tradedown?

MINYANVILLE ORIGINAL When I saw that JC Penney's (JCP) lost sales from its changeover from couponing to Every Day Low Pricing ("EDLP") had not gone disproportionately to Kohl's (KSS), it's most direct competitor, I was surprised since as a rule, a dissatisfied department store customer would go to another department store. Instead, the JC Penney customer dropped out of the department store category and traded down to discount stores.

But having looked more closely at Kohl's, I believe that it is suffering from the same extreme consumer tradedown as JC Penney.

Kohl's reported a flat comp store sales number in its recent first quarter. Average transaction value was +1.6% with pricing of 4.9%, and units per transaction down 3.3%. Traffic decreased 1.4%. So, Penney's sales shortfall in the past quarter did not help Kohl's, and it seems to have gone disproportionately to discounters Wal-Mart (WMT), Target (TGT) and Costco (COST) in that order. Total inventory was up 7% on a 2% sales increase.

Management had projected gross margin to be down 160 basis points, but it came in down 220. This was against a backdrop of private and exclusive brands being up 50% to 53% last year to this year, and a continuing launch of higher price point exclusive brands rather than new price-oriented private label-type offerings. Management attributed gross margin decline vs. its guidance to the depth of promotional markdowns.

Part of the reason given for the poor total unit sales number was that it needed more inventory at opening price points, which are heavily its private-label offerings. Management said that they were seeing a lot of price elasticity on some items.

Remodelings were cut by 50%. Gross margin guidance was for 200-250 bps of decline in the second quarter.

All of the above leads me to believe that Kohl's is going to continue to suffer from a more economically-strapped consumer. I can only believe that consumers, at the margin, are shifting their purchases out of Kohls' and over to Wal-Mart, Target, and Costco, only at a slower rate than that seen at JC Penney where the exodus was hastened by a disastrous EDLP strategy that failed upon rollout, costing the president his job.

Gross margin has gotten to a historically high level of around 38%, up 200 bps over the past few years, with the addition of many exclusive brands. The pace of these rollouts can probably not be sustained and the consumer looks to be moving more toward value-oriented private labels. Though management is guiding to only a 70 basis point decline in gross margin for the year, the declines seen in the past two quarters (and the bearish-for-pricing comments made by management) point to questions about the company's ability to maintain a department store's typical high operating margin in the 11% range.

So, while the stock looks cheap at $45, discounting essentially no earnings per share ("EPS") growth at all, the stock market does not believe that returns will hold. I do not believe that they will hold either. A 2% decline in operating margin means that the stock discounts a 3% growth rate for EPS over five years. A 3% decline in operating margins implies a 6% growth rate for EPS over the same period to justify $45. My guess is that the average department store over the next five years will have 4-5% growth rate. So, the stock looks to be fairly valued, if you believe the profitability hits of this magnitude.

(See also: Valuing JC Penney After President Michael Francis' Departure.)
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