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Kohl’s Stock: A Potentially Undervalued Retail Play

Kohl's Corp. (KSS) owns and operates family-oriented department stores. It offers exclusive brand apparel, shoes, accessories, and home & beauty products through its department stores.

In addition to these offerings, its stores provide soft home products, such as sheets and pillows and housewares targeted to middle-income customers. Kohl's generally carries a consistent merchandise assortment 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 stock.

Measuring Efficiency

Kohl's needs to hold onto a lot of inventory in order to keep the business running. Therefore, the speed at which a company can move inventory and convert it into cash is very important in predicting its success. To measure its efficiency, we will use the cash conversion cycle, which shows how many days it takes to convert inventory into cash. It is calculated as follows:

CCC = Days Inventory Outstanding + Days Sales Outstanding – Days Payables Outstanding

Kohl's cash conversion cycle is 40 days, meaning it takes the company 40 days for it to convert its inventory into cash. This is above the consumer discretionary sector average of 32 days. However, in the past several years, this number has trended downwards, indicating that the company's efficiency has improved.

Nevertheless, it's important to note that the cash conversion cycle number dropped by one-third in the most recent fiscal year when compared to the prior comparable period. This significant drop is likely the result of the intense spending witnessed in 2021 as the economy reopened and people spent their stimulus checks.

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

In addition to the cash conversion cycle, let's also take a look at Kohl's' gross margin trends. Ideally, we would like to see a company's margins expand each year. If its gross margin is already very high, it is acceptable for it to remain flat.

In Kohl's' case, its gross margin has increased in the past several years, rising from around 36% in fiscal 2013 to 41.1% in the past 12 months. This is ideal because it allows the company the opportunity to increase free cash flow or reinvest a larger percentage of its revenue into growth initiatives.

Does Kohl's Create Value for Shareholders?

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

Economic Spread = Return on Invested Capital - Weighted Average Cost of Capital

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

For Kohl's, the economic spread is as follows:

Economic Spread = 11.1% - 9%
Economic Spread = 2.1%

As a result, the company is creating value for its shareholders, implying that management is efficiently allocating capital.

Dividend

For investors that like dividends, Kohl's currently has a 4.25% dividend yield when annualized, which is above the sector average of 1.5%. When taking a look at its LTM free cash flow figure of $1.7 billion, its $147 million dividend payment looks safe.

Taking a look at its historical dividend payments, we can see that its trailing 12-month yield range has trended downwards in the past several years.

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

Valuation

To value Kohl's, we will use a single-stage DCF model because its free cash flows are volatile and difficult to predict. To demonstrate how undervalued the company is, we will use the five-year average for 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

As a result, we estimate that the fair value of Kohl's is approximately $73.21 under current market conditions, which is close to the upper range of analysts' price targets.

Wall Street's Take

Turning to Wall Street, Kohl's has a Moderate Buy consensus rating based on five Buys, five Holds, and one Sells assigned in the past three months. The average Kohl's price target of $52.91 implies 38.36% upside potential.

Final Thoughts

Kohl's is a solid retailer that has pretty good fundamentals. The company consistently produces double-digit returns on invested capital in the low teens, and is consistently profitable on a free cash flow basis. This allows the company to provide a decent dividend yield of 4.25% when annualized.

Investors are currently worried about high inflation and recession risks, which is why the stock price has taken a beating. As a retailer, the company's financial performance is quite sensitive to business cycles. As a result, we are neutral on the stock.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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