While you might have treated your friends to a bottle of champagne on New Year's, your stock portfolio could probably use a lump of Kohl's ( KSS). In 2005, the retail picture is divided into two camps. In one, you've got your department store old-timers, facing an uphill battle against a new generation of powerhouses like Wal-Mart ( WMT) and Target ( TGT). In the other, discount superstores are approaching a saturation point for growth in the U.S., forcing them to look overseas for new opportunities that tend to present their own set of problems. In the middle sits Kohl's -- a discount department store chain whose smaller, stand-alone stores offer a nice option for consumers looking for convenience and low prices. Its attractive growth prospects earn the company a premium valuation, but the price is probably worth it. "Kohl's is in the enviable position of being able to expand its retail footprint substantially over the next several years," wrote Sanford Bernstein analyst Emme Kozloff in a recent report. "Our analysis shows that the company should comfortably be able to grow its square footage at a rate of approximately 15% for the next five years." Over the past decade, Kohl's averaged sales growth at 23% annually, dwarfing the low-single-digit growth logged by many traditional department stores, like Federated ( FD) and May Department Stores ( MAY), over the same period. Much of this success is owed to rapid store expansion, but the company's same-store sales, those at stores open at least a year, have increased consistently as well. Thanks to an unexpected drop-off in demand in 2003, Kohl's got caught with excess inventories and was forced to take deep discounts that year. Lower pricing whittled away at its margins, making for a disappointing year. Margins recovered in 2004.
After watching its shares lose roughly 20% in 2003, Kohl's has enjoyed a 9.2% gain in 2004. For its third quarter, the company posted a 19% jump in profits, rolled out several new clothing brands and reported a drop in markdowns. Some analysts hold great expectations for the company in the new year. "In part due to its organic growth, we estimate Kohl's can grow earnings 20% in 2005 compared to 17% for retail stocks and 6% for the overall market," Kozloff said. She rates the stock an outperformer with a target price of $60, a 22% premium to its current price of $49. Also, she reports no position in shares of Kohl's or banking relationships between the company and her firm. The biggest threat to the retailer's prospects is increasing competition. Both Wal-Mart and Target have increased their apparel offerings of late, and Allen Questrom's turnaround at J.C. Penney ( JCP) has made it a formidable threat. "With management expecting free cash flows to turn positive in 2005, the next few years are going to be very important for Kohl's," wrote Morningstar analyst Kim Picciola in a research note. "In order to hold our enthusiasm for its stock, the company must continue to execute its expansion strategy and stave off competitors looking to recapture market share." The company offers a nice mix of branded and private-label merchandise at moderate prices. Its off-mall real estate strategy allows it to keep rent costs low and create attractive store layouts with wide aisles, shopping carts, centralized checkouts and fewer employees per store. It also frees it from the slowing pace of mall development that hampers many department stores and allows it to seek out attractive sites in populated, growing communities, often years before a regional shopping center is built. When Kohl's expands into a new area, it often launches a large number of stores in the same geographic region on the same day, allowing it to spread distribution and marketing costs over the group. This strategy gives it an operating-cost advantage over a number of its competitors.
On its third-quarter conference call, Kohl's said it was planning to open stores in Florida in 2005 as part of its 95-store expansion for the year. Details on the expansion are hazy, but The Orlando Sentinel reported recently that developers in Central Florida said the company had plans for at least five or six new stores in the area. It also has expansion plans for other new markets, such as Northern California and the Pacific Northwest, and analysts say it has more room to grow in existing markets, such as Southern California. From a financial perspective, Kohl's returns on invested capital exceed its cost of capital. With over $1 billion in long-term debt on its balance sheet, the company is leveraged, but its earnings before interest and taxes are a comfortable 14 times interest expense. If it achieves positive free cash flow in 2005, it can start funding its expansion without increasing its debt load. At $49 a share, Kohl's trades over 19 times its earnings estimates for 2005. That's a steep price compared with competitors, such as J.C. Penney at just 14 times its estimates. But Wall Street expects Kohl's sales to grow at an average 15% over the next five years, while sales estimates for J.C. Penney forecast growth of less than 3% in 2005 followed by 4% in 2006. Wall Street estimates Kohl's will post an 18% jump in earnings for the year, to $2.55 a share from $2.15 a share, according to consensus estimates reported by Thomson First Call. In 2006, analysts expect a 20% gain. Kohl's prospects should offer investors a better-than-average return in the new year, as long as the company manages to avoid strategic missteps like the one that tarnished its performance in 2003. The company's management, headed by Chief Executive R. Lawrence Montgomery, appears to have the proper incentives in place to maintain its competitive edge. "Given the firm's disappointing performance in 2003, it was refreshing to see that bonuses weren't paid to senior management," said Picciola.