Description

Along the lines of the best investment ideas embodying obvious decisions, I’d like to direct your attention to KSS.  What you’ll see is an exceptionally well run company that while susceptible to short term earnings pressure, should over the long run continue growing earnings at a double digit rate while sustaining returns well in excess of its cost of capital.  Trading at 13x this year’s consensus estimate KSS conservatively offers 60% upside with 10-20% downside.

With KSS representing a well known and widely followed company, I will keep my business description short.  With over 900 locations, KSS is a well established off-mall department store with significant growth opportunities.  KSS primarily differentiates itself versus other retailers with a strong collection of national, exclusive, and private brands that combine to deliver a unique combination of value and satisfaction relative to traditional department stores or discount retailers.  As a result, KSS’s has successfully tripled its store count over the last eight years while earning double digit returns on capital despite operating in a mature and saturated market.

Why So Cheap?

Since hitting a high on 4/20/07 KSS has declined more than 40% while the market as a whole has fallen 1.8%.  The reasons are straight forward.

1.       Fear of a consumer slowdown

2.       Lowered 4Q guidance

3.       2008 estimates have been reduced 11%

With the current macro-backdrop, a near term earnings miss is a definite possibility.  However, unless the state of the world has changed so dramatically that the next 5 years look very different than KSS’s recent past this differentiated retailer looks to be building value at a rapid pace.  At the very least, the multiple has contracted from over 20x this year’s earnings to 13x, heavily implying the market is already pricing in a decline in this year’s earnings, and lackluster growth over the next several years.

In trying to place a conservative price target on KSS’s shares, we have looked at a scenario analysis for earnings and multiples over the next several years.  While preferring a free cash flow model, it is roughly guesswork to determine when the business will slow growth investments thus rendering a dcf value lacking a whole lot of confidence.

Kohl’s issued the following long term guidance in October:

• Total sales increases of 9% - 11% CAGR
• Comparable store sales increases of 2% - 4% per year
• Operating Margin of 13% - 13.5% by 2012
• EPS Growth – CAGR of 15% - 17%
• Targeting over 1,400 stores by 2012 (8.5% cagr)
• Mix of prototype (88K sq. ft.) and small (68K sq. ft.) and urban stores (130K sq. ft.)
• Split by year dependent upon timing of real estate opportunities

Unless you want to bet against KSS’s ability to continue executing along the lines of its recent past, the real question becomes what will earnings look like next year and how long-lasting will the economic headwinds prove to be. 

Catalyst