INVESTMENT THESIS

Kohl’s experienced rapid growth in the 1990s and the first half of the 2000s, following which growth in sales and profitability slowed significantly.  Kohl’s was previously posted on VIC in December 2007, when the stock price was $47.31.  At that time the company had 313.7 million shares outstanding and a market cap of $14.8 billion (vs. 230 million shares and $10.6 billion today).  The author described it as an exceptionally well-run company which could be expected to grow earnings at a double-digit rate over the long run, while sustaining returns well in excess of its cost of capital.  The author argued that the stock, then trading for 13x that year’s estimated earnings, offered 60% upside and 10-20% downside.  All of these conclusions seemed reasonable at the time based on the historical performance.

What a difference five years can make.  The fundamental nature of the business has not changed meaningfully, but Kohl’s has evolved from being a relatively high-growth retailer to acknowledging that growth prospects have hit a wall, and that the best use of profits is to return capital to shareholders.  And the company has done that in spades: buybacks have shrunk the shares outstanding by fully one-third between early 2006 and the present, from 345 million shares then to 230 million in November 2012.  The number is possibly lower by another 5 million at this writing due to additional buybacks, and the company recently announced an increased buyback authorization of $3.5 billion, which could shrink the share count by another 30% at today’s price.  In addition, management started paying quarterly dividends for the first time two years ago, with an initial rate of $1.00 annually, which was increased to $1.28 in February 2012.  I expect the dividend to be increase to $1.40+ later this month.

My fundamental thesis is that this is a company and a management team that has been willing to face the hard reality of its growth limitations, and is willing to focus its energies on ensuring that they make the most of their existing operations, and to return all excess capital (and it generates huge amounts of free cash flow) to its shareholders in the form of dividends and stock buybacks.  If the business can generate very modest top-line growth (through a combination of low same-store sales growth and some new store openings), and can maintain its operating margins, the combination of the dividends and the growing EPS (resulting primarily from buybacks) should result in a decent and relatively low-risk return to shareholders from the current stock price.

The stock closed at $46.01 last week, and management recently projected that EPS for the year just ended will be $4.11 to $4.13 (down from $4.30 in 2011, and from an initially projected $4.75), for a current P/E multiple of 11.2.  Analysts estimate $4.60 in EPS for the fiscal year which started this month.

BACKGROUND

Kohl’s is ubiquitous in the U.S., so I won’t dwell too much on the business, and will only provide some summary background information.  Kohl’s Corporation, founded 50 years ago, is a large, national, well-established department store chain, with 1,146 stores in 49 states.  (By comparison, there were 79 stores in 1992, 457 in 2002, and 1,004 in 2008.)  The net store count only grew by 19 (or 1.7%) over the last year, and by 38 (3.5%) the prior year.  (It sells moderately-priced apparel, footwear and accessories for men, women and children.  It also carries housewares and soft home products such as sheets and pillows.  The product mix in 2011 is provided below; this mix has changed very little in recent years:

Over time the company has gone to great lengths to develop its own private and exclusive brands, which it believes gives it an edge over other retailers.  In 2004, the company’s sales mix of private/exclusive brands to national brands was 25% to 75%; by 2011 it had shifted to 50%/50%.  These brands include names such as Jennifer Lopez, LC Lauren Conrad, Simply Vera Vera Wang for women’s fashion; Rock & Republic for premium denim, and Food Network for kitchen/entertaining.  (They have dozens of such brands; these seem to sell well and generate decent margins.)

Kohl’s is different from most of its competitors in that very few of its stores (less than 8%) are in malls, while two-thirds are in strip centers and about 25% are free-standing.  This appeals to those shoppers (like myself) who prefer to avoid malls, and apparently appeals to many other shoppers too.  Being a reluctant shopper, I would not dare to generalize that this is a major positive for the company.  The company owns 36% of its stores and leases the other 64%.

I am not a big shopper, but I have patronized Kohl’s stores periodically over the years, and have visited a few recently while mulling over this idea.  I am also clueless about fashion, and have very little to say on that score, but I have generally found Kohl’s stores to be clean, pleasant, and well-maintained, with no indications that management is skimping on maintenance.  (The company says that some 50% of its stores are either new or were remodeled in the last five years.)  And in the few categories of products that I have looked to buy there (jeans, khakis, casual shoes, sneakers), I have generally found products that meet my undemanding tastes, at prices that seem fair.

RECENT PERFORMANCE

Fiscal Years Ended approx. January 31

Fiscal 2012 (which ended January 31, 2013) sales performance has been weak, with same store sales gains of just 0.3%.  This is actually worse than it sounds; for the first eleven months of the fiscal year SSS were down 0.3%, and the company ended December with bloated inventories.  But management took steps to rid the company of excess stocks, resulting in January SSS growth of 13.3%.  These sales would have been at large markdowns, and lower gross margins, but management states that it is happy with the state of inventories as the new fiscal year begins.  And operating margins have shrunk, so that EPS is expected to come in at just over $4.10 for the year.

SHARE BUYBACKS

Since the start of 2006, i.e. over the last seven years, the company has bought back 130 million shares, reducing the share count by 115 million (employee stock plans account for the difference), or one-third of the starting shares.  The total cost of the buybacks was $6.8 billion.

In November 2012 the company approved an additional $3.2 billion of stock buybacks, increasing the outstanding capacity to $3.5 billion.  (They had spent roughly $3.2 billion in buybacks over less than two years.)  In the company’s words in the most recent 10-Q, “We expect to repurchase shares in open market transactions, subject to market conditions, over the next three years.”  Prior to that, in February 2011 the Board approved $2.6 billion for share repurchases, in addition to the $900 million then outstanding, increasing the capacity to $3.5 billion.

DIVIDENDS

No dividends were paid prior to 2011.  In February 2011, the first quarterly dividend of $0.25 per share was declared ($1.00 annually).  A total of $271 million in dividends was paid that year.  In February 2012 the dividend was increased by 28% to $0.32 per quarter ($1.28 per year).  For the year that just ended in January 2013, approximately $300 million in dividends has been paid.  Management has indicated that maintaining the combination of share buybacks and total dividend payments of $300 million per year would permit roughly double-digit increases in the dividend rate each year.  This suggests to me that the dividend rate will likely be increased to perhaps $1.40 annually later this month, which would result in a 3% yield based on the current price.

PROJECTIONS

What kind of financial performance is plausible in the future?  Looking out over the next two years, my model assumes growth in total stores of 1% to 2% per year, annual same-store sales growth of 1%, and operating margins returning to between 11% and 11.5%, resulting in operating income of $2.2 to $2.3 billion.  Assuming a share count of between 200 and 210 million shares, EPS works out to between $5.60 and $6.19 in 2014.  The key assumption, in my opinion, is the operating margin.

This is my best guess projection, a reasonable estimate of things to come, and the real numbers will very likely be somewhat higher or lower than my projections.  The important points on which my thesis rests are that the underlying business remains fairly stable in sales and profitability, with modest growth, and that management continues to actively manage its capital structure: spending enough on capex to maintain its existing stores in good condition; continuing to pay out about $300 million in dividends annually; and proactively reducing the share count by buying shares in the open market, particularly when the stock price is weak.

The market cap of the equity today is $10.6 billion, and the company has “returned” $6.82 billion to shareholders in the past seven years (2006 – 2012) via share repurchases, plus dividends of $571 million over the last two years.  The current buyback authorization is for an additional $3.5 billion, expected over the next three years, and we can expect perhaps $900 million in dividends over this period.  This company is serious about creating value through buybacks and dividends – no empire-building for them.

The key unknown for us as investors is whether Kohl’s can maintain its prodigious cash-generating ability going forward.  Management may be serious about doing the right thing for shareholders in their capital allocation strategy, but if they cannot keep the ship on course, all their good intentions will come to naught.

An analyst recently provided his fantasy scenario for the near future (say 2014): Sales of $20 billion (or about 5-6% above current levels), operating margins of 12% (which is higher than the peak level of about 11.5% of recent years), EPS of about $7.00 (benefiting from a lower share count), and a multiple of 12x, implying a price of $84 for the stock.  I think that this is a bit of a stretch, particularly on the operating margins, but the general idea fits my thesis: very modest top-line growth, operating margin improvement to previous levels (say 11.5%), and a shrinking number of shares outstanding, resulting in meaningfully higher EPS.

There have recently been rumors of the possibility of a Kohl’s LBO.  As far as I can tell there is no basis to these rumors, and this factor plays no role in my recommendation.

RISKS

(1) Further decline in operating margins.

(2) Weak consumer spending due to a weak economy.