This Discount Department Store Chain May Be the Best in the Industry

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

Mr. Market is known to be especially moody when it comes to discount department store retailers. The market seems to have a singular focus on quarter-over-quarter same-store sales growth; a big miss can send an otherwise great retailer plunging. This happened recently to Kohl's Corp (NYSE: KSS), which just reported weak same-store sales for the month of November. Shares of the middle-market retailer fell 11% on news that same-store sales fell 5.6% for the four weeks ending on Nov. 24.

Great Business Getting Better

A negative trend in one month -- or even one year -- is not enough to offset an entire decade of improving business fundamentals. Ten years ago, Kohl's decided to add more exclusive and private labels to its offering in an effort to increase gross margins; the effort has paid off.

 

A quick glance at this chart will erase investors' concerns over the November disappointment. Kohl's has steadily improved its gross margin over the course of the last decade, besting its rivals in the industry. Only Macy's (NYSE: M), which caters to a more affluent customer, can claim a better gross margin. On the other hand, Target (NYSE: TGT) has endured a precipitous drop-off in profitability due to the consumer recession and J.C. Penney (NYSE: JCP) is undergoing an unprecedented transition that will lead to some short-term volatility in gross margins. Kohl's can continue its upward climb by cutting more of the low-margin brands and adding more private labels to its product mix.

Kohl's also has the highest pre-tax margin among its peers.

 

While J.C. Penney and Macy's took a brutal hit during the recession, Kohl's pre-tax margin hardly budged by comparison. The company was able to raise prices in 2010 and 2011 without affecting sales, indicating that consumers are willing to pay a little more to buy Kohl's brands.

In addition to improving profitability, Kohl's has also started converting more sales into free cash flow. This has allowed the company to renovate existing stores and build new ones while paying down debt.

Valuation

Kohl's has averaged a 10% pre-tax margin over the past decade. If you multiply trailing twelve months sales of $18.9 billion by 10%, you get normalized pre-tax earnings of $1.9 billion. At 7x pre-tax earnings, you get a value of $13.2 billion, or $56 per share.

This assigns no value to growth. But the company's growth is clearly creating value for shareholders; Kohl's is earning mid-teens returns on tangible invested assets, which suggests that future growth will add value rather than squander it.

Final Thoughts

The recent sell-off is nothing more than a jittery Mr. Market ignoring the company's fundamentals. Level-headed investors who take a step back to look at the bigger picture will see a simple company thriving in a highly-competitive industry. At a recent price of $42.34 per share, Kohl's is trading at a significant discount to its no-growth intrinsic value. If the company creates anywhere near as much value for shareholders in the next decade as it did in the last, the stock could easily be a double.


titans8904 has no positions in the stocks mentioned above. 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!

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