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Kohl's Gets It Right

Marc Lichtenfeld

There are a couple sweet spots in retail: Catering to high-end customers with expensive goods and excellent service, like Nordstrom (JWN Quote); or offering appealing brands and a pleasant customer experience at lower price points, like Target (TGT Quote).

Kohl's (KSS Quote) has embraced the latter recipe for success.

We often buy stocks because of what we believe a company will achieve in the future. But what I like about Kohl's is it's not just a tomorrow play. They're getting it right today.

The company's expansion plans, cost controls and fashion sense make Kohl's one of the most enticing retailers in the department store space.

Getting It Right Today

According to a survey by advisory firm Retail Intelligence Group, Kohl's, along with Nordstrom and Federated Department Stores'(FD Quote) Macy's, are taking market share in the women's apparel space from Chico's FAS (CHS Quote).

"Macy's and Kohl's are the big winners in this marketplace, given their superior values and solid mix of merchandising, store atmosphere and inventory management," says Retail Intelligence Group's Derek Noce.

Of the women who responded to the survey that they were shopping at Chico's less, they said Macy's, Kohl's and Nordstrom were the top three stores that they were shopping at instead.

What's interesting is that Macy's and Nordstrom are generally considered to be in a higher-end category than Kohl's. So it can be inferred from this survey that Kohl's is starting to see a higher-income buyer.

The company's stores also came out near the top in questions asking which stores the women shopped at most recently, as well as which ones the women expected to shop at in the near future.

Kohl's inventory management also is winning rave reviews on Wall Street and should continue to boost profits and cash flow.

The company is implementing a markdown optimization system that is credited with helping boost gross margin by 90 basis points in 2006. Lehman Brothers analyst Robert Drbul believes the company is well ahead of its 2010 operating margin goal of 12.5%, considering the 11.7% figure posted for 2006. Lehman has a non-investment banking business relationship with Kohl's.

Don't look around your local mall for Kohl's. The company typically is located in its own big box store, where rents are cheaper. This lower expense gives the company a leg up on competition in regards to margin and ability to pass savings on to the customer.

Getting It Right Tomorrow

If the women in Retail Intelligence Group's survey liked what they've seen recently at Kohl's, they'll probably have even more reason to return to the stores in the coming year.

Kohl's is bringing in several exclusive brands in 2007. In women's apparel, the company will have brands from designer Vera Wang and Elle magazine. The retailer also will introduce Polo Ralph Lauren's (RL Quote) Chaps brand in several categories, including girl's apparel and home goods.

According to Bank of America, Kohl's has increased its percentage of private or exclusive-brand goods from 24% to 35% over the past several years. This growth helps the company in several ways. The exclusive brands give shoppers a reason to return to the stores, as they won't be able to find the Elle brand and others anywhere else. Moreover, private-label goods usually carry higher margins, improving profitability.

$100 Stock?

While Kohl's might pride itself on low prices, its stock isn't cheap. Trading at over 19 times this year's projected $3.85 earnings per share, the stock is near the top in valuation in several metrics when compared to its department store peers.

While I always look for a bargain, sometimes in life you get what you pay for. While Kohl's is valued at a bigger premium than most of its peers, it's deservedly so.

Despite the higher valuation, the stock's 17.7% projected long-term growth rate is second only to Bon-Ton Stores (BONT Quote), which has less than half the number of locations. Kohl's trades at a measly 1.1 times growth on a forward basis, far below the group average of 1.5 times growth.

Kohl's plans to add roughly 400 more stores in the coming years. Its already-efficient systems should enable the company to grow profits faster than sales, according to Morningstar.

I believe Kohl's share price, right now hovering around $75, can hit $100 in the next 12 to 18 months. That assumes there is no major fashion miss, which is always a risk with any retailer.

At $100, the stock would be trading at less than 26 times this year's expected earnings. Lehman's Drbul notes that over the past five years Kohl's stock has traded at an average of 30.9 times forward growth.

A 26 multiple would still have the stock in line with its peers on a price-earnings-to-growth basis. Both this year's expected profit as well as next year's projected EPS of $4.53 could prove conservative if Kohl's manages to continue to grow sales and improve margins.

Lastly, there is still room on board the bandwagon. Wall Street is divided on the name; 14 analysts rate the stock a buy, while 11 have a hold rating. If my prognosis proves true, some of those 11 likely will upgrade the stock, which could give shares an additional lift.

With a healthy balance sheet, talented management and a flourishing brand, Kohl's has emerged from a sleepy Midwest retailer to a big-time national player. While that's not exactly a secret on Wall Street, investors have not yet fully appreciated the potential in the stock.