This Low-Cost Retailer Is A Real Bargain
Timothy is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Whenever the stock price of a high-quality company drops by a large amount, it's possible that an overreaction by the market has created a value opportunity.
At the end of November, Kohl's (NYSE: KSS), the chain of value-oriented department stores, reported weak November sales. Same store sales dropped by 6.2% year-on-year while total sales dropped by 5.6% year-on-year. Although this certainly wasn't good news, a single disappointing month isn't the end of the world. The stock plummeted by about 11% on the news and has since fallen even further, currently trading at $42.35 per share, down 23% from its November high of $55 per share.
I don't believe that this single bad month indicates any long-term trend. Let's take a look at Kohl's financial performance and see whether this drop in stock price has opened up an investment opportunity.
* All data from Morningstar
Kohl's has recorded $18.955 billion in revenue in the trailing-12-month period, and net income of $1.065 billion during that same time. This profit margin of 5.61% blows most competitors out of the water. J.C. Penney (NYSE: JCP), the troubled retailer attempting a turnaround, recorded a loss during the TTM period, while larger rival Target (NYSE: TGT) recorded a profit margin of 4.2%. Even the high-end Nordstrom (NYSE: JWN) isn't too far ahead of Kohl's, recording a profit margin of 5.87%.
Kohl's high profit margin is largely due to the low cost structure that the retailer enjoys compared to its peers. Here's how the companies compare on a few important measures:
Kohl's has a similar ROE and ROA to Target, while Nordstrom runs away with both. This is expected given the higher-end nature of Nordstrom's business. In terms of capital structure, Kohl's has a significantly lower Debt/Equity ratio than its competitors. I prefer companies with less debt, so Kohl's is the clear winner there. The drop in stock price Kohl's has suffered has knocked down its P/E ratio to just 9.34, much lower than that of Target and Nordstrom. From this, it looks like the best bet in terms of value is Kohl's. Now let's get into the details.
The Balance Sheet
As of the end of October, Kohl's had $550 million in cash and $90 million in investments. On the liability side, the total debt (in which I include capital leases) was $4.578 billion, leaving a net debt of $3.938 billion, or $16.76 per diluted share. This seems like a lot of debt in absolute terms, but comparatively, it's less than that of Kohl's competitors. On thing to note is that only $100 million of this debt is due within the next year, so liquidity should not be a problem. The total interest paid on this debt in fiscal 2012 was $303 million.
For valuation purposes I like to use Owner Earnings instead of net income or free cash flow. Owner earnings is the net income plus depreciation, amortization, and certain non-cash charges. Added to this is the tax-adjusted interest payments and subtracted from this is the total capital expenditure. I do not include changes in working capital because I don't want fluctuations thereof to affect the calculation. Owner earnings represents the the amount of cash that can be pulled from the company on average each year.
Using the TTM figures from the cash flow statement I arrive at owner earnings of $1,355 million, or $5.77 per share.
I'll use a discounted cash flow analysis to estimate the fair value of a share of Kohl's. I'll use a discount rate of both 12% and 15% and use the results to define a fair value range. Given the pessimism related to the November sales drop I'll assume that owner earnings will grow at just 3% per year in perpetuity. This is almost certainly a drastic underestimate, but if the company is reasonably priced under these parameters than it is most likely a good value. Using the values above and subtracting out the net debt I arrive at a fair value range of $33.20 - $49.70.
So under extremely pessimistic assumptions the stock is well within my fair value range. The average analyst estimate for the 5-year earnings growth rate is 7.53%, so let's try to be a little more realistic and assume that owner earnings will grow by 6% per year for the next 10 years and by 3% per year after that. Using these growth numbers the fair value range for Kohl's is $43.47 - $64.91. This puts Kohl's stock lower than the lower bound of this more realistic fair value range.
The Bottom Line
Kohl's doesn't have to grow by double-digit rates to be a good value. In fact, if Kohl's can grow earnings by just 3% annually, the stock is fairly valued today. Under more realistic assumptions, Kohl's looks like a verifiable bargain after the huge drop in stock price in November. If you ever wanted to open a position in Kohl's, now is the time. Undue pessimism is the long-term investor's best friend.
TheBargainBin has no positions in the stocks mentioned above, but may buy shares of Kohl's within the next month. The Motley Fool has no positions in the stocks mentioned above. 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!