A potentially undervalued retail game

Kohls Corp. owns and operates large family stores. It offers exclusive brand name clothing, footwear, accessories and home and beauty products in its department stores.

In addition to these deals, its stores offer home products, such as sheets and pillows and housewares aimed at middle-income customers. Kohl’s generally offers a consistent assortment of merchandise with some differences attributable to regional preferences.

Kohl’s has pretty good fundamentals, with improving efficiency metrics and positive free cash flow. Nevertheless, we are neutral on the title.

Measure effectiveness

Kohl’s needs to keep a lot of inventory in order to run the business. Therefore, the speed at which a company can move its inventory and convert it into cash is very important in predicting its success. To measure its effectiveness, we will use the cash conversion cycle, which indicates the number of days it takes to convert inventory into cash. It is calculated as follows:

CCC = Current Inventory Days + Current Sale Days – Current Payment Days

Kohl’s cash conversion cycle is 40 days, meaning it takes the company 40 days to convert inventory to cash. This is above the 32-day Consumer Discretionary sector average. However, in recent years, this number has tended to decline, indicating that the efficiency of the company has improved.

Nevertheless, it is important to note that the number of cash conversion cycles fell by a third in the most recent fiscal year compared to the previous comparable period. This significant drop is likely the result of the intense spending seen in 2021 as the economy reopened and people spent their stimulus checks.

Therefore, investors should probably expect the cash conversion cycle measure to normalize to a figure closer to 60 days going forward, as the positive impact of last year’s stimulus s fades.

In addition to the cash conversion cycle, let’s also look at Kohl’s gross margin trends. Ideally, we would like to see a company’s margins increase every year. If its gross margin is already very high, it is acceptable that it remains flat.

In Kohl’s case, its gross margin has increased over the past few years, from about 36% in fiscal 2013 to 41.1% in the past 12 months. This is ideal because it allows the company to increase its free cash flow or reinvest a larger percentage of its income in growth initiatives.

Does Kohl’s create shareholder value?

To get a good picture of management effectiveness, one can simply look at the numbers. One metric we like to look at is economic spread, which is defined as follows:

Economic distribution = Return on invested capital – Weighted average cost of capital

The idea is very simple; if the return on invested capital is higher than the cost of this same capital, then the company creates value for its shareholders through well thought out projects. Otherwise, the company is destroying value and would be better off just investing the money in risk-free bonds.

For Kohl’s, the economic breakdown is as follows:

Economic spread = 11.1% – 9%
Economic gap = 2.1%

As a result, the company creates value for its shareholders, which requires management to allocate capital efficiently.

Dividend

For dividend-loving investors, Kohl’s currently has a dividend yield of 4.25% when annualized, which is above the industry average of 1.5%. When looking at its $1.7 billion LTM free cash flow, its $147 million dividend payout looks safe.

Looking at its historical dividend payouts, we can see that its 12-month yield range has trended lower over the past few years.

At 4.25%, the company’s dividend is near the middle of its range, implying the stock price is trading at a fair value relative to returns investors have seen in the past.

Evaluation

To value Kohl’s, we will use a one-step DCF model because its free cash flow is volatile and difficult to predict. To demonstrate how undervalued the company is, we’ll use the five-year average of free cash flow and assume no growth.

Our calculation is as follows:

Fair value = Average FCF per share / Discount rate
$73.21 = $7.76 / 0.106

Therefore, we estimate Kohl’s fair value to be approximately $73.21 under current market conditions, which is near the upper range of analyst price targets.

The Taking of Wall Street

On Wall Street, Kohl’s has a moderate buy consensus rating based on five buys, five holds and one sell given over the past three months. Kohl’s average price target of $52.91 implies upside potential of 38.36%.

Final Thoughts

Kohl’s is a solid retailer with pretty good fundamentals. The company consistently produces double-digit returns on invested capital over the teen period and is consistently profitable on a free cash flow basis. This allows the company to deliver a decent dividend yield of 4.25% when annualized.

Investors are currently worried about the risks of high inflation and recession, which is why the stock price has taken a hit. As a retailer, the company’s financial performance is quite sensitive to economic cycles. Accordingly, we are neutral on the stock.

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