These Are Not The “Great Things” We Were Expecting
Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
When a company's slogan is “expect great things", as a customer you hope to see a good product lineup, clean stores, and reasonable prices. Kohl's (NYSE: KSS) stores seem to meet all of those criteria. However, as an investor you want to see good revenue growth, good EPS growth, and a reasonable expansion plan. Unfortunately for investors, the company's most recent earnings release did not contain the great things the company promises.
Kohl's operates 1,134 stores that it refers to as specialty department stores. We have a store just minutes from my home and generally speaking people go there for the clothing and they might pick up other things while they are in the store. The company competes with multiple retailers in my immediate area and across the country. Companies that range from the clothing selection at Target (NYSE: TGT) to closeout retailers like Ross Stores (NASDAQ: ROST). In addition, diversified retailers like TJX (NYSE: TJX) operates the Marshall's and TJ Maxx chains. While each of these companies has a different price point, consumers have become more price sensitive and Kohl's is in danger of missing this point. In the company's most recent quarter, sales were down 1%, and comparable sales were down an even worse 2.7%. This drop in sales caused EPS to decline by over 7% to complete the trifecta of disappointing numbers for investors. What is really interesting is these disappointing numbers don't really explain what's going on as well as the company's financials do.
When it comes to Kohl's recent financial statements, it's almost as though investors are dealing with the tale of two companies. On a positive note, the company's diluted share count has decreased an astounding 14.03% from last year. In addition, the company's dividend is well covered with a free cash flow payout ratio of just 40.69%. The rest of the numbers are just ugly. With the huge share repurchases, the company's balance sheet has taken a major hit. Kohl's cash balance has been cut almost in half in the last year, and long-term debt has increased by 43.31%. The company's adjusted operating cash flow decreased 8.73% on a year-over-year basis as well. In a strange twist, the company noted that its gross margin held up very well at 39.05%, but this was down from 40.68% last year. Primarily due to this disappointing quarter, the company lowered their guidance for the third quarter and the full year.
Kohl's now expects third quarter sales growth to come in at 1% to 3%, with comparable sales flat to up 2%. Earnings per share for the quarter are expected to come in between $0.83 and $0.89. Considering that analysts were predicting $0.89 as an average, an earnings miss is possible. For the full year, the company now expects earnings to come in at $4.50 to $4.65 versus prior guidance of $4.75. It's never a good thing when a company gives guidance and then after one quarter has to lower their earnings expectations. The issue that Kohl's management is in danger of missing is the company's pricing doesn't match well to their targeted consumer.
Many people know I like Kohl's, but not at this everyday price. Shoppers like the store and wait for sales, or they mainly check the clearance racks for deals. This has become the nature of consumers in the last few years. With relatively high unemployment and so much uncertainty in the economy over the last few years, customers don't just go into a store and buy without checking prices carefully. This is a message that Target, Ross, and The TJX Companies have heard loud and clear. Ross and The TJX chains TJ Maxx and Marshall's regularly attract shoppers looking for bargains. They don't have sales because their regular prices are already very low. Target, on the other hand has low prices on a regular basis, and when items go on clearance it's not an everyday occurrence. Kohl's on the other hand, seems to operate under the old idea of price items at a high price and then regularly have sales and make use of Kohl's cash to drive shoppers back into the store. The problem is shoppers don't like not knowing if they will get a good deal that day or not. If they can go into these other stores and consistently get a bargain, than Kohl's is likely to lose some customers, and this already seems to be happening.
When you consider that analysts are calling for just 2.5% average revenue growth at Kohl's over the next couple of years, you can see that this anemic sales growth is expected to continue. While the company's balance sheet has allowed them to retire a ton of shares in the last two years, this can't continue. Two years ago Kohl's had over $2 billion in cash and about $1.4 billion in debt. Today, the company has about $600 million in cash and over $2 billion in debt. The company needs to realize that cutting prices to a more reasonable everyday level should allow the company to avoid so many sales and drive more consistent traffic. This is what's already happening at their three competitors and analyst’s expectations for revenue growth show the difference. Target is expected to see about 5% revenue growth, The TJX companies are expecting 7.5% revenue growth, and Ross Stores leads the way with 9% expected growth. While Ross and TJX can't match Kohl's dividend and growth rate combination, Target could serve as a good alternative. Target's dividend is only slightly less than Kohl's, and the company's earnings growth at 12.13% is expected to beat Kohl's at 10.84%. I would suggest investors look to replace Kohl's with the dividend aristocrat Target, due to the latter's higher expected revenue and earnings growth. Kohl's management needs to wise up and realize that better growth at a lower margin beats non-existent growth at a higher margin every time.
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