By Eli Inkrot
Kohl’s (KSS) is what I would classify as a “second tier” type of investment.
It doesn’t have that quality aspect of your typical well-known dividend growth company. It’s not like a Coca-Cola (KO) or PepsiCo (PEP). Those companies can charge 40% as much as the generic product sitting right next to it on the shelf, and yet over and over again people go home with the brand name.
The name isn’t really a strong draw for consumers – you buy a Nike (NKE) tennis shoe because you like the brand. You go to Kohl’s to buy a pair, not the other way around.
Granted there is certainly some loyalty associated with the business, but if you want Nike shoes and Kohl’s doesn’t have them, your purchasing dollars are likely to be loyal to the shoes, not the store. It’s not even like a Wal-Mart (WMT), where you have massive scale or consistency lower prices.
The economics are good – it makes money every year – but it doesn’t necessarily have the staying power of some of the best companies out there.
As Warren Buffett might suggest, there are only so many “inevitables” – companies you know that will be around say 40 years later.
So before we get into anything about the security, I want to make that point clear. If you only want to partner with the very best companies, a security like Kohl’s probably wouldn’t hit your radar screen.
So you have to consider your comfort zone. If you’re fine with holding some “good” and “very good” firms, instead of (or I suppose in conjunction with) the “best” companies it expands your possibilities, but it also opens you up to accepting potentially lower quality businesses into your portfolio.
To continue with this article, let’s suppose that you’re comfortable owning some “good” or “very good” companies.
The second thing that you ought to consider is whether or not the valuation reflects this sentiment. You want to be compensated for agreeing to take a step back from the “inevitables.”
It’s sort of like if your favorite ice cream flavor is chocolate and the ice cream stand happens to be having a sale of vanilla. If they were both selling for the same price (or value), you’d pick chocolate every single time; no question about it. But if vanilla is noticeably cheaper, this could make the decision a bit more difficult. The value proposition is harder to calculate.
If you hate vanilla, then obviously you’re going to pay up for chocolate; but really, who hates vanilla?
If you think chocolate is only slightly better, then you may very well go with vanilla for the better perceived value. For instance, if during the next month you could have say 5 vanilla ice cream cones for the same price as 4 chocolate ones.
Incidentally, this is basically how the investing world works as well.
If Visa (V) sold at the same valuation as say Viacom (VIA), it’d be easy to suggest that Visa ought to be selected. Yet that’s not how it works with securities. Instead, you have a company with exceptional prospects trading near 30 times earnings against another trading under 10 times earnings.
Making investment decisions is harder than simply selecting the best businesses, because everyone tends to know what a good business looks like and value the shares accordingly. It’s a lot harder than looking at chocolate or vanilla, but the concept is quite similar.
So how does this apply to Kohl’s?
Great question. What you want to find out is whether or not the current valuation reflects an opportunity. If it trades in line with say Colgate-Palmolive (CL), you’d likely have no interest.
Colgate-Palmolive is more “inevitable” than Kohl’s. Yet if it trades at half the value, things become more interesting.
So let’s see if we can get a handle on what the security might be offering.
Earnings Are Down…
If you were to look up the recent “bottom line” results of Kohl’s, you might be a bit alarmed.
In 2014 the company earned around $4.24 per share. Last year Kohl’s reported diluted earnings-per-share of $3.46 – or an 18% decrease. That doesn’t exactly give you a warm and fuzzy feeling. However, I would like to make a couple of points.
First, a portion of that decrease resulted from a loss incurred from the extinguishment of debt. It doesn’t make up the whole difference, but without this aspect the company’s earnings-per-share would have been closer to $4.01. Moreover, Kohl’s sold more stuff, had a higher level of sales per square foot and increased its store count during the year. So not all was bad.
The second item to consider is that the share price has certainly reflected the business uncertainties as of late.
…But So Is The Share Price
After reaching a peak of around $78 in the first quarter of 2015, Kohl’s shares are now trading around $43. That’s a 45% decrease in just over a year.
So sure, the underlying earnings power of the company decreased for the year – anywhere from 5% to 18% depending upon how you look at it. Yet the share price has gone way beyond this by nearly halving.
So the question becomes, which we’ll attempt to address shortly, whether or not the long-term business of Kohl’s is now half of what it was just a year ago or if the new share price could be offering something interesting.
In any event, even using the lower earnings-per-share figure, you had a company that went from trading around 18 times trailing earnings all the way down to just 12 times earnings.
With that in mind, let’s think about the potential for the company and security moving forward. For this illustration I’ll use a construct quite similar to the one used to outline the potential prospects of JPMorgan (JPM).
Before looking ahead, it can be helpful to see what has transpired in the past. This doesn’t dictate the future, but it can give you a reasonable prospective as far as what might be “within the realm of reason.”
Here’s a look at Kohl’s business and investment history from 2005 through 2015:
This is a rather interesting history, in my view. On the top line the business saw reasonable growth, coming in at just under 4% per year.
However, the quality of those sales have diminished – with Kohl’s profit margin dropping from 6.3% to 4.1% – and in turn, providing negative company-wide earnings growth. In 2005 the company made $842 million. Even using the adjusted figure for last year, the profits stood at just $781 million.
This is the sort of thing that I mean by a “second tier” type of investment. The company makes money every year, but it’s not a straight march upward like the Johnson & Johnson’s (JNJ) of the world.
Perhaps equally noteworthy is the idea that just because the company does not become more profitable, this does simultaneously indicate that a shareholder’s ownership claim cannot be increasing. Over the last decade Kohl’s has significantly reduced its share count – from around 345 million in 2005 down to under 200 million last year. As such, negative company-wide earnings growth turned into 5% annual earnings-per-share growth.
The roller coaster ride continued as we move down the components, as the valuation that investors were willing to pay went from around 20 times earnings down to 12. While earnings-per-share increased by roughly 65% over the last ten years, the share price did basically nothing. Which, incidentally is the reason that shares look more attractive today – you have the same price, but a much lower share count and thus higher earnings claim.
Finally, Kohl’s initiated a dividend in 2011 and has been increasing this payout nicely in the year’s since. All told investors would have only seen total gains of about 1% per annum – certainly nothing to text home about.
When I review the history of Kohl’s I’m reminded of a few things. First, just because the business isn’t earning more this does not mean that a shareholder’s earnings claim cannot be improving. As seen above, the significant reduction in share count has allowed earnings-per-share to grow steadily.
Next, it places a vital importance on the valuation paid. It shows you the finicky nature of stock prices. A share of Kohl’s today has a 65% higher underlying earnings claim and yet it trades at the same price as it did a decade ago. That’s why it’s important to demand a reasonable (or better) valuation.
Finally, I’m reminded that past history does not dictate the future. It can give you clues, and certainly there is a “carry through effect,” but poor performance in the past does not necessitate that a security will always do poorly. Indeed, given a lower valuation and higher dividend yield, it could very well indicate the opposite.
So let’s move on to thinking about the future, using the above information as a teaching lesson rather than an absolute.
For 2016 the company has told you to expect earnings in the $4.05 to $4.25 range, which presumes roughly $600 million used to repurchase shares at an average price of $50. That means that Kohl’s is anticipating the share count to be reduced from ~195 million down to ~183 million for the year. It also implies that future earnings could be in the $740 million to $780 million.
Analysts are presently expecting intermediate-term growth to be in the 6% to 9% range. I’m going to scale that back quite a bit, call it 2% business growth over the next decade. If you’re using a $760 million starting point, that equates to a future earnings value of about $900 million after a decade. As a point of reference, Kohl’s has earned over $1 billion many times in its history – so this assumption isn’t exactly shooting for the moon. We’ll leave it there for the moment to move on to the next aspect.
Kohl’s started out paying a $0.25 quarterly dividend in 2011. The current mark is now double that, sitting at $0.50 per quarter. That leads to an annual commitment of just under $400 million. While it’s conceivable that the payout could continue to grow at a quick rate, the idea here is to keep things conservative as a means to reflect the uncertainty and inherent quality (or questions) about the business.
If the per share dividend payment were to grow by say 5% per year, you’d anticipate Kohl’s to pay a $3.25 dividend or thereabouts after 10 years. In total you might anticipate collecting $27 of so in per share dividend payments. Growing the dividend faster than company-wide earnings may give you pause, but it’s important to remember that we haven’t yet talked about share repurchases.
As we saw above, Kohl’s had an exceptional share repurchase program over the past decade – decreasing the share count from about 325 million to below 200 million, or a compound decrease of over 5% per annum. This program was effective for three basic reasons.
Capacity: for the first half of that period no dividends were being paid, leaving more room for buybacks.
Willingness: Kohl’s has been putting very large amounts of capital towards this effort, sometimes upwards of a billion dollars a year.
Valuation: A good chuck of those share repurchases were accomplished when shares were trading with P/E ratios in the mid-to-low teens. When buying out past partners it’s much better to do so at a discount rather than a premium.
These three factors allowed Kohl’s to materially reduce the number of common shares outstanding. For every five shareholders that existed in 2005, just three remain today; Kohl’s bought out two out of every five shareholders during the last decade on your behalf.
Moving forward you may not anticipate that the share repurchase program can be quite as effective. For one thing, the dividend component now takes up a decent chunk of “organic” funds. Moreover, we’ve already presumed that the profitability of the company will be subdued.
Yet the other two factors remain. You still have the willingness to use funds toward this endeavor and the lower valuation makes buying out partners more effective.
To continue with the example, I presumed that 80% of total profits would be utilized for share repurchases and dividends. Using the 2% company-wide growth rate assumption, that worked out to an average of roughly $240 million a year going toward share repurchases. Just to give you some context, over the past five years the company has averaged closer to $1.2 billion annually going toward repurchases, so once again I don’t think that this is an especially far leap.
Yet even in this scenario, depending on the average price paid, Kohl’s could retire perhaps 40 or 50 million shares over the next decade. This would mean that the share count could decrease by just under 3% annually, moving from around 195 million down to perhaps 145 million.
Valuation can be a tricky thing – naturally we don’t know the price that other people may or may not be willing to pay for shares 10 years down the line. And as illustrated above, even if your underlying earnings claim is increasing, this doesn’t mean that the share price has to as well. (To be sure the chances are better when this happens, but there’s nothing stopping a security from going from 20 times earnings down to 12.)
Over the past decade shares of Kohl’s have traded with an average earnings multiple of about 13. It’s certainly possible that shares follow a similar path as they had in the past and go down to say 7 times earnings in the future. However, I think it’s important to remain cognizant of the idea that this would simultaneously imply a future dividend yield of around 7%. Let’s stick near the historical average (actually just below) and use 12 times earnings.
Putting it All Together
Now we’re ready to put it all together. There have been hints as we’ve gone along, but the actual value of these assumptions has not been revealed. If Kohl’s were to make $900 million in profits 10 years from now and have 145 million shares outstanding, you’d anticipate an earnings-per-share number of about $6.20. At 12 times earnings, that equates to a future price of roughly $75. If we add in the cumulative dividends of $27 per share that comes to a total expected value of about $102. On an annualized basis, based on a share price around $43, that equates to a total annualized gain of about 9%.
Although it doesn’t perfectly match up to the description above, here’s a basic construct of what that might look like (keeping in mind that this is merely a baseline and ought to be adjusted according to one’s own expectations):
I won’t go through the whole table, but I would like to make a couple of points.
The middle column is presented for reference, showing the history of Kohl’s as detailed above. The right-hand column presents a hypothetical scenario based on the assumptions that we worked through.
First note that the earnings-per-share growth is actually lower than what was achieved in the past decade. Yet the Kohl’s security of today has a couple of things working for it that were not present with the Kohl’s of 2005.
First, you have a valuation closer to 11 times earnings instead of 20. This allows for a much greater likelihood of the share price performance matching (or besting) the business performance. The possibility of P/E compression is still present, but I would contend less likely.
Furthermore, you now have a dividend yield sitting around 4.7%. You don’t need much (or any) payout growth in order for the dividend to contribute meaningfully to the bottom line.
Combined, these two factors could very well be the difference between the lackluster past and potentially solid future. It’s not that the business is that much better or worse, it’s just that the valuation gives you a healthy starting yield and a better chance at capturing business performance.
I find the 9% annualized return assumption interesting for a couple of reasons. First, that represents a solid return. As a point of reference, that’s the sort of thing that could turn a $10,000 starting investment into $24,000 after a decade. If you could achieve a 9% average compound return for an investing lifetime, you’ll be in the driver’s seat as far as long-term wealth creation goes.
Beyond that aspect, I don’t think that my assumptions are that large of a stretch. You have analysts anticipating 6% to 9% growth. In comparison, I talked about 2% business growth, using way less funds for share repurchases, thinking about an earnings multiple under 13 and a company paying out around half of its earnings in the form of dividends. Those assumptions aren’t exactly shooting for the moon, and yet the results could still be quite solid.
Naturally if the company starts to decline the results could be much worse, but it works the other way as well.
If shares of Kohl’s later trade at say 15 times earnings or the company grows by 6%, suddenly you have the opportunity for a “bonanza” of a return in relation to today’s valuation proposition.
In short, if you’re only looking to partner with the very best firms then Kohl’s will probably not be on your list.
And to be frank, this is a perfectly legitimate stance to take – your capital is limited so you want to make sure that you’re comfortable with all of your partnership decisions. Yet if you would like to partner with, or at least learn more about, a “second tier” type of investment I think something like Kohl’s fits that bill. The company is one of the best retail stocks around when factoring in its yield, growth, competitive advantage, and valuation.
In doing so you want to make sure that you’re compensated in the way of a compelling valuation. If things go well, you don’t just want to see returns on par with your typical high-quality mega-firms. If you’re going to be taking on additional risk in the way of looking beyond the Johnson & Johnson’s of the world, the return proposition ought to be more compelling. For Kohl’s I think that fits – if things go marginally you could do well, but if things go better than expected you could very well expect great things.