Wisconsin-based retailer Kohl’s (click ticker for report: ) reported second quarter results Thursday morning. Revenue declined 1% year-over-year to $4.2 billion driven by a 2.7% fall in same-store sales, which was approximately in-line with consensus expectations. Earnings fell 7% year-over-year to $1.00 per share, which was slightly better than the Street predicted. The firm cut its full-year earnings forecast to $4.50-$4.65 from $4.75 per share.
The firm has opened 9 stores year-to-date and expects to open 12 more locations. The retail giant is nearing market saturation, with over 1,100 stores, and as a result, seems to be struggling to grow. Although some expected the firm to benefit from JC Penney’s (click ticker for report: ) struggles, it appears the lower-end department store business model is under some serious pressure. The firm remains committed to better (lower) prices, which has resulted in gross margins falling 160 basis points to 39%. Penney’s CEO Ron Johnson hasn’t been taken seriously for his decision to end excessive discounting, but Kohl’s is copying his strategy with lower initial prices.
On a positive note, Kohl’s seems to be investing soundly in technology and other innovations, which have driven operating costs to lower levels. SG&A fell nearly 2% year-over-year to $975 million, even though the firm has 37 more locations. However, the retailer has generated $206 million in free cash flow year-to-date, which is less than half of what it generated last year. We’re worried that the firm has substantially increased its inventory (up 13% year-over-year) and won’t be able to maintain decent gross margins. Management mentioned that stores in “mild” and “hot” markets are carrying too much inventory relative to sales, and that it hopes to change this situation. We’re skeptical in the near-term and think margin compression will occur.
Given its recent challenges and numerous relatively new entrants into the retail market with lower cost structures (think h&m, Zara, Forever 21), we aren’t very excited about shares at this time. Kohl’s has a relatively high dividend for a retailer (2.5%) and potential to grow it, but we are worried about its position in the market over the long term. As a result, we aren’t interested in adding shares of the fairly-valued retailer to our Best Ideas Newsletter portfolio until we see proof that it can return to sustainable sales growth.
Please click the following link to see our Dividend Report for Kohl’s: