What's Slowing Kohl's: Fast Growth


By Amy Tsao Kohl's (KSS) investors have been perplexed of late. The retailer holds the promise of high-double-digit store growth over the next several years, but existing stores are underperforming. Amid what analysts predict to be a buoyant holiday season, the Menomonee Falls (Wis.) retailer reported a 4.3% drop in sales for stores open for at least year (same-store sales) for November. That same measure at rival chains like Target (TGT) and J.C. Penney (JCP) rose 6.2% and slipped 0.8%, respectively.

Clearly, Kohl's is feeling growing pains. The department store that lured customers with convenient off-mall locations and name brands at lower prices has grown from a regional player with a few dozen stores to more than 500 outlets and $9 billion in sales last year. But costs have been climbing at a faster clip than sales.

"The business model we thought so resilient, now, because of a lack of new brands, tougher competitors, and bad weather, has been thrown off track," says Bill Dreher, analyst at Deutsche Bank. (Dreher doesn't own shares. The firm has no investment-banking relationship with Kohl's but does make a market in the stock.)

"CONTINUED RISK." After two bumpy years, Kohl's is now trading at around $47, near a 52-week low of $45. The stock has lost 15% year-to-date while retailing shares overall have gained 30%. Such a sharp slide may seem an overreaction for a retailer that should remain a fast grower, but many analysts expect more pressure ahead. On Dec. 3, Bank of America Securities analyst Dana Cohen cut her buy rating to hold, writing in her downgrade report: "Given the number of issues facing Kohl's and the time needed to address those that are fixable, we suspect there's likely to be continued risk to earnings."

Despite an economic recovery that's gaining steam, investors need to watch for Kohl's management to prove that its current woes are temporary. The fixes for Kohl's aren't rocket science. It has to improve productivity at older stores, have fewer markdowns, and add new brands.

Many analysts agree that a key first step would be admitting that the expectation of 18% to 20% annual store growth for the next several years is too high. A rate of 15% to 18% in the coming years would be more manageable, argues Dreher.

TOO TRENDY. So far, management has resisted any talk of slower expansion. "For the time being that's our strategy," said chief executive Larry Montgomery during a Nov. 13 third-quarter earnings call. Kohl's declined comment for this story.

Wall Street has some sympathy for the pickle Kohl's is in. "The slowdown is coming faster than management expected," says Heather Brilliant, an analyst at independent research house Morningstar. Kohl's revenue-growth pace over the past five years had been 24.5%, but over the next five she expects it to be closer to 15%. Earnings in that same period had risen a 30%. Something on the order of 15% is more realistic in the next five years, says Brilliant.

That's hardly shabby growth. But slowing the pace of expansion would likely pay off over the long run by getting Kohl's to focus on juicing returns at existing stores, which have diminished, says Dreher. Analysts blame recent attempts to be too trendy for turning off customers, resulting in deep markdowns. That hammered gross margins in the third quarter, and management expects a further decline in the fourth. Kohl's says it has learned from its fashion mistakes and that by early next year, the high levels of clearance merchandise clogging up stores should be greatly reduced.

ENTER WAL-MART. Adding more big brands is also critical to keeping consumers' interested. One big reason for Kohl's success has been its stable of top names like OshKosh (GOSHA) and Nike (NKE). However, it hasn't added a major new brand with wide appeal since Columbia Sportswear (COLM) three years ago. Discounter Wal-Mart (WMT), however, has recently added Levi's, a move that threatens Kohl's name-brand strategy.

A Kohl's cosmetics line in development with makeup outfit Estée Lauder (EL) will provide some benefit -- but not until 2005. And the Lauder line wouldn't be branded as such. What Kohl's badly needs, says Dreher, is a "brand with across-the-board impact."

A more difficult factor to control is the phenomenon of consumers "trading up" -- indulging on some items but spending less on basics (see BW Online, 12/3/03, "The Middle Class's Urge to Splurge"). If it continues, as is likely, Kohl's stands to get lost in the middle. "Distinguishing themselves -- that's the key to long-term survival," says Brilliant. The retailer can't afford to become viewed as "just another department store," she warns.

LIMITED DOWNSIDE? Brilliant is hopeful that Kohl's can improve sales performance at its existing base and manage future growth. For now, however, she gives the stock three stars out of five, a hold rating. While Brilliant calculates its fair value at $49, she recommends investors buy shares at a 40% discount in price -- closer to $29.

Seeing the stock price drop that low, if it happened, would be a real wake-up call for Kohl's management. Yet if it moves quickly now to address recent shortcomings, the stock could hold its own or rise, and 2004 could be stronger. Even Dreher, who remains bearish on the retailer's prospects, is seeing "limited" downside risk. He upgraded the stock to hold, from sell, on Nov. 20.

In the near term, though, Kohl's is more likely to disappoint investors. Its situation is fixable, but Wall Street wants signs that those fixes are in the works. Tsao covers the markets for BusinessWeek Online and writes for the Street Wise column


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