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Short-Term Gain, Long-Term Strain at Kohl's

The discounter faces easy comps in 2004, but nagging issues such as inventory could weigh on the stock.

After a poor performance in 2003,


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is poised for much better results this year. But questions remain over the discount department store chain's long-term prospects.

Kohl's should be able to take advantage of easy comparisons in 2004, making its shares a short-term favorite of many investors. Kohl's shares have gained 10% year to date, albeit following about a 20% decline in 2003. (Kohl's shares rose 16 cents, or 0.3%, to $49.56 on Wednesday.)

Kohl's stock has risen this year due to investors essentially "gaming" the stock by projecting better-than-expected results or a short squeeze, said Gary Farber, a partner with hedge fund Nightingale & Farber. The firm has no position in Kohl's.

But whether the company's stock will be a good investment in the long term depends on whether its business is really back on track, Farber said.

"The key to the whole story is getting their inventory under control," he said. "I don't care what their

fourth-quarter earnings number is. I want to see what their comment is about their inventory."

At the end of the third quarter, the company's inventories were up 16.7% over the same period a year earlier -- a rate exceeding the company's sales growth. Meanwhile, through the first nine months of 2003, Kohl's gross margin declined by more than 1 percentage point as a portion of sales and its operating costs were up 16 basis points as a portion of sales.

Impressive Streak Ends

Farber may not care about the quarterly results, but consensus estimates are for fourth-quarter earnings of 69 cents a share, compared with 81 cents a share in the year-ago period, according to Thomson First Call.

Even if net earnings dropped less than analysts expect, the decline is a sharp contrast from the company's track record. For seven straight years before 2003, Kohl's posted annual net earnings growth of at least 30%.

Likewise, the company's sales have slowed. Kohl's has already reported fourth-quarter sales of $3.56 billion. Overall, sales were up 11.9% from the year-ago period. But on a same-store basis, which compares like results at outlets open for more than a year, sales fell 2.1%.

For all of last year, the company's overall sales grew 12.7% from 2002 to $10.28 billion. But in each of the previous four years, Kohl's had posted sales growth of at least 21%.

Wall Street expects the company's growth to get back on track in 2004. Analysts project earnings per share will grow 25.4% to $2.12 a share this year, according to Thomson First Call. Analysts forecast sales of $12.12 billion, a 17.9% jump from 2003.

Of course, much of that growth will be the result of easy comparisons with last year. For the short term, those easy comparisons could be a boon to the company. But over the longer haul, the company's prospects -- and its stock's -- may be more up in the air.

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Deutsche Bank analyst Bill Dreher is skeptical about Kohl's ability to return to previous growth levels. Kohl's struggled with inventory all year, despite repeated assurances from management that it was dealing with the problem, Dreher wrote in a report Wednesday. Meanwhile, the company has limited opportunities to grow its women's apparel business or to add new brands to attract customers.

"We don't believe the negative results flow has ended, despite hearing some positive comments," Dreher said in his report. "The worst is unlikely over and we recommend investors refrain from purchase."

Deutsche Bank does not have any investment banking business withKohl's, and Dreher does not own the stock.

In addition to overbought inventory, Kohl's officials blamed the company's poor 2003 performance on slow apparel sales and rising expenses.

"Kohl's was stuck at this point where they were still managing their business as if it were still performing as it was in the late '90s or 2000," said one long-term Kohl's investor, who requested anonymity. "They needed to rethink how they manage their inventory."

In the past, the company benefited from weak competition. Department store chains such as Montgomery Ward and Bradlees shut down while


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J.C. Penney

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suffered through their own sales declines.

But the competition is getting tougher, analysts say. J.C. Penney seems to have turned its operations around, as has Gap. After buying Lands' End, Sears is becoming a formidable competitor for Kohl's core apparel customers.

Meanwhile, Kohl's poor 2003 may haunt its future. To clear out excess inventory, the company had to resort to deep discounts repeatedly, and observers worry how consumers will react if the promotions subside.

Back to the Future

In the past, Kohl's has been able to focus investor attention on its fast-paced growth. In addition to its sales and earnings surge, the company averaged annual square footage growth of about 22% from 1992 through 2002.

But with sales and earnings slowing, analysts expect the company to curtail its square footage growth as well. That could actually be a good thing for the company long term and for its stock, said the Kohl's investor, whose firm manages more than $4 billion.

"I think it's wise that they take the square footage growth down," he said. "It's a bigger company. It will be easier to manage growthat this point that's slower than what they've done historically."

If the company does end up cutting its growth rate, its attraction to investors may well come back to simple execution. That's something the company appeared to do well until last year.

"To own Kohl's, you have to believe that this is not a broken growth story, that this is a management team that's doing everything they need to to right the ship," said the Kohl's investor.

Assuming that the company is able to get back to even modestly positive same-store sales growth and 15% square footage growth, the investor projects that Kohl's could post earnings growth of 20% to 25% a year.

"There's not a lot of

companies like that out there in retail land," the investor said.

That said, Kohl's stock is trading at a 23.4 times projected 2004 earnings, which is relatively rich by retail standards. Given the pricey multiple and the stock's recent surge, Kohl's investors may soon get antsy without some evidence of improvement in the retailer's long-term prospects.