So Much Potential, So Little Growth

Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

If you try and imagine a great retail concept, it's not hard to picture what you would like to see. You want a store that offers competitively priced merchandise, and is always busy. There is a lot of competition in low-end fashion from companies like Target (NYSE: TGT) and Ross Stores (NASDAQ: ROST), so you would prefer to see a higher-end selection. In addition, it would be nice if the store offered some home furnishings and maybe a small selection of popular toys for the kids. Ideally you would like to see this store stay out of big enclosed malls where rents are high and traffic is down. You also would want to see excitement around new store openings. Where can you find all of these traits? There is such a company that offers everything we have mentioned...Kohl's (NYSE: KSS). So what's the problem? In short, the issue is Kohl's has all the positive traits of a great retailer, but the company can't consistently turn this into good revenue or earnings growth.

Your standard Kohl's store is operated in a strip mall in an area with a decent population. The stores always seem to be busy, and generally everyone I know that has been into Kohl's has been impressed. My family shops at Kohl's from time to time, and we seem to always find what we want. From what I've seen though, Kohl's has trouble selling their merchandise at regular prices. In fact, many people I know say they wait for Kohl's to have a sale before they stop by. This could be a key to their growth conundrum, but first let's look at how the company has been performing recently.

In the last quarter, the company posted sales growth of 2.6% and diluted EPS increased by 14%. On the surface those numbers don't sound too bad. However, as with many companies we have to look beyond just their headline numbers. Kohl's admittedly has a hard challenge trying to fit their pricing in-between the lower priced Target and Ross Stores, and the higher-end chains like Macy's (NYSE: M). In addition, none of these competitors is a slouch as each of these companies is expected to grow EPS by at least 11.7% in the next few years. This is the first disconnect between Kohl's and their competition, the company isn't expected to grow earnings as fast. In fact, analysts are only calling for 7.5% EPS growth from Kohl's in the next five years. Why would Kohl's be able to deliver EPS growth of 14% in the current quarter, and only 7.5% growth in the future?

The bottom line is Kohl's is growing EPS by buying this growth. It's no coincidence that the company has retired 11.3% of their diluted shares in the last year, and that they saw a double-digit increase in EPS. However, if you consider that the company only saw comparable store sales increase by 1.1%, you can see that it would be a huge challenge to grow earnings significantly with low single-digit sales increases. Some investors might point to Kohl's high gross margin as proof that the company can charge premium prices, but I believe this is a big reason that Kohl's isn't doing even better.

Consider this, Kohl's gross margin in the quarter was 38.13% compared to a gross margin of 39.56% at Macy's. The question is, how many people think of Kohl's merchandise as equivalent to Macy's? While Kohl's might not need to lower their margin down to where Target is at 30% or Ross Stores at 27%, somewhere in the middle is probably about right. I honestly believe if Kohl's were to trim their prices enough to bring their margin down to say 34-35% they would be priced more appropriately. Kohl's can afford to charge higher prices than Target or Ross, but to try and charge prices similar to Macy's is a stretch. The fact that many people go to Kohl's more when they have sales is proof that lower prices drive sales. If you figure that Target and Ross can drive EPS growth of 12-13% with their pricing, and Macy's is at the higher-end and expected to grow by 12.7%, Kohl's should be able to fit in the middle and increase their EPS growth. If investors are concerned about what lower margins would do to the stability of the company's dividend, they need not worry.

Kohl's dividend yield of about 3% leads their competition, and is covered by a current quarter free cash flow payout ratio of about 38.6%. They also generate more free cash flow per $1 of sales than their competition at the current time. In fact, Kohl's generates about $0.04 of free cash flow per dollar of sales. By comparison, Ross Stores, Target, and Macy's generate between $0.01 and $0.02 of free cash flow per dollar of sales. As you can see, Kohl's could afford to sacrifice some of their margin to generate better growth. Without better growth, there are just too many other good options available to investors.

How many investors would rather have a 10.5% return instead of a return of 14% or better? In short, no one wants to accept lower returns if they don't have to. Look at the comparison of just EPS growth expectations and yield between the four companies, and tell me which looks the best:

<table> <tbody> <tr> <td> <p><strong>Name</strong></p> </td> <td> <p><strong>EPS Growth</strong></p> </td> <td> <p><strong>Yield</strong></p> </td> <td> <p><strong>Total Expected Return</strong></p> </td> </tr> <tr> <td> <p>Kohl's</p> </td> <td> <p>7.53%</p> </td> <td> <p>3.03%</p> </td> <td> <p>10.53%</p> </td> </tr> <tr> <td> <p>Macy's</p> </td> <td> <p>12.68%</p> </td> <td> <p>2.14%</p> </td> <td> <p>14.82%</p> </td> </tr> <tr> <td> <p>Ross Stores</p> </td> <td> <p>13.02%</p> </td> <td> <p>1.05%</p> </td> <td> <p>14.07%</p> </td> </tr> <tr> <td> <p>Target</p> </td> <td> <p>11.73%</p> </td> <td> <p>2.46%</p> </td> <td> <p>14.19% </p> </td> </tr> </tbody> </table>

I'm sorry for Kohl's investors, but there really is no comparison. If you want a higher-end retail leader, Macy's seems like a good option. If you want a discount retailer, Ross Stores look like a decent bet. If you want a diversified retailer, Target could be a good investment as well. The fact that Kohl's sells for a P/E ratio below their competition is clearly warranted based on their significantly lower total expected return to investors. Until Kohl's management realizes that they need to sacrifice some margin to improve sales growth, investors need to look elsewhere.

MHenage has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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