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My investing philosophy mostly centers around the Value discipline and GARP- Growth at a Reasonable Price. This blog includes commentary on market conditions as well as fundamental analysis of specific companies. Graduated from Rhodes College with a degree in Business with concentration in Finance & Marketing. Currently working on obtaining the CFA designation. Previously worked in Mortgage Trading for a major bank. Use MS Excel extensively for developing investment models, notably valuation models based on DCF methods.

Saturday, August 25, 2007

Kohl’s (KSS): Most Attractive Relative to Retailers: Costco (COST), Target (TGT) & Wal-Mart (WMT)

In looking at a few names: Kohl’s (NYSE:KSS), Wal-Mart (NYSE:WMT), Costco (Nasdaq:COST) and Target (NYSE:TGT), I find Kohl’s to be the most compelling. Costco appears to be rich, and Target and Wal-Mart look fairly valued. Kohl’s offers best growth potential at lower multiples, as well as the highest margins and return on assets.

Concerns over consumer stamina have raised caution among investors regarding names in the retail space. Most retailers have sharp declines in their stock price in the last couple of months. The primary factor responsible for the retail weakness stems from expectations of a pullback in consumer spending. Slower economic growth, higher energy/food prices, and tighter credit all point to less robust consumer spending.

I think that we are overdue for below-trend consumer spending, thus in the near-term investors’ concerns are probably justified. Yet, equity values are based on very long time horizons. A few years are only a minute fraction of total value. Stock prices falling due to a weak near-term outlook can provide opportunities if their long-term prospects remain attractive. I like to use industry sell-offs to boost long-run returns by acquiring solid companies trading at relatively cheap prices.

If you have noticed, most of my recent commentary has been on retail companies. On a relative basis, the long-term outlook is easier to predict for established names thus making them attractive when trading at low multiples.

Valuation- P/E & Expected Growth:

KSS ($58.92): According to Yahoo Finance, KSS trades at 15.3x this year’s estimated EPS and 13.0x next year’s. That represents annual growth of 16.3% and 17.7%. Analysts project 17.4% annual growth for the next 5 years, slightly less than the 18.5% average growth for the last 5 years. Using next year’s P/E, Kohl’s possesses a very attractive PEG ratio is 0.75. My personal calculation for Kohl’s projected 5-year growth rate is only slightly lower at 17.3% (based on next two EPS estimates and Value Line’s 3-5 year EPS estimate).

WMT ($43.74): In comparison, WMT trades at 14.3x and 12.8x current/next years’ EPS estimates. That translates into annual growth of 5.5% and 11.5% growth for the current year and next year, respectively. Expected 5-year growth is 12.2% giving WMT a 1.05 PEG. My calculated 5-year growth estimate is a bit lower at 10.4%.

COST ($61.68): Costco shares are expensive trading at 24.3x and 21.2x current/next years’ EPS estimates. EPS will increase 10.4% this year, 14.6% next year, and average 12.7% annually for the next 5 years. Costco’s PEG is a lofty 1.67. My estimated growth rate is 11.7%, which makes COST even more expensive. Costco’s ROE is rather week, averaging less that 12% the past 5 years.

TGT ($63.09): Target’s P/E multiples are 17.5x and 15.4x for current & next years EPS estimates, respectively. That equates to 13% average growth for next two fiscal years reported, and analysts are estimating annual growth of 14.8% for the next 5 years. Target’s PEG ratio calculates to about 1.04. I am projecting annual growth of 13.5% for the next 5 years.

Discounted Cash Flow Valuation:
I employ a 3 DCF stage model- 1) 5yr revenue constant growth phase 2) 10yr transition phase-input assumptions converge to long-run average 3) Normal growth- sales grow @ inflation and capex = depreciation

The assumptions that drive the valuation process are sales growth, margins, net investment, and working capital requirements.
I expect Kohl’s revenues to grow at 11% annually for the next 5 years versus 9% for Target and Costco, and 7% for Wal-Mart.

Based on my model, intrinsic value for Kohl’s falls in the mid 70’s, roughly 25% higher than the current $60 share price. Wal-Mart’s DCF intrinsic value is above $50 suggesting shares are a good buy at current price of $43.74. DCF valuations for COST and TGT suggests fair value roughly in-line with current market. Costco’s capital spending and working capital requirements are very low which may possibly explain why it trades at a much higher multiple relative to other retailers.

This final measure that I examine is ROA (Income/Sales x Sales/Assets), or otherwise stated: Net Margin x Asset Utilization. For a low margin firm to be attractive, asset utilization must be high- relatively assets are needed to generate sales, thus the return on sales (profit margin) can “turnover” more frequently with regards to assets invested. ROA is a great tool in comparing similar businesses.

On a ROA basis, Kohl’s 12.3% (lfy) is the most attractive of the four. ROA for the other 3 firms: WMT-7.8%, TGT- 7.7%, and COST- 6.5%.
Competition among WMT, COST, and TGT is driven mainly on price. The manner by which these competitors can offer unique and attractive product assortments gives slight pricing power ability.

Kohl’s offers a very unique apparel selection as well as its “off-mall” store location strategy results in lower operating costs. Kohl’s high profit margins could serve as a deterrent for price wars since it could lower prices more than competitors could and still be profitable. Closer competitors such as Macy’s and JC Penny have margins of about 5%

In summary, KSS looks to be the most undervalued relative to other retailers. KSS is trading at lower multiples and has the highest expected growth rate. Even if Kohl’s actual growth is lower, shares would still be a decent value. Costco appears to be the least attractive investment given its high PEG and low margins and ROA.

Disclosure: I do not have a position in any of the stocks mentioned.


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