Kohl's Continues Its Brilliant Downsizing Initiative

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Kohl's (NYSE: KSS) has been one of the best-performing department store companies in the U.S. during 2017. That's not to say it has been immune from the sales challenges pressuring the rest of the industry. Indeed, comparable-store sales fell 2.7% in the first quarter and 0.4% in the second quarter. Nevertheless, earnings per share increased on a year-over-year basis in both quarters, including a 26% jump in Q1.

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A big reason for Kohl's profit turnaround is an initiative to redesign many of its stores to better match demand in its markets. On Tuesday, the company updated investors on how this extremely important project is progressing.

Moving beyond a single store format

Historically, nearly all of Kohl's stores were designed in line with a single store prototype. The typical Kohl's store was about 88,000 square feet. It was located in a strip mall on a busy street. It had two entryways in the front and a "racetrack" design: i.e. a wide aisle loops around the store's circumference. Merchandise was arranged in a similar way in each store, too.

There are clearly advantages to having a single store format. It reduces design costs for new stores and limits operational complexity. However, as sales have stagnated in the past few years, Kohl's has started to realize that a one-size-fits-all philosophy carries some very real costs.

Most notably, Kohl's has historically stocked all of its prototype stores with a similar amount of inventory, regardless of those stores' sales volumes. This meant that lower-volume stores often ended up with tons of unwanted merchandise at the end of each season, forcing Kohl's to offer margin-sapping clearance discounts. The excess space also results in a waste of resources.

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Kohl's is taking a two-pronged approach to address these issues. First, it is redesigning full-size stores with lower sales volumes so that they can carry a more appropriate amount of inventory. Second, it is looking to physically shrink the size of some stores.

Downsizing without less space

The easiest fix for low-volume stores is a program that Kohl's calls "standard-to-small." By installing new fixtures, Kohl's can set up full-size stores with less inventory without making them seem empty (which would presumably drive away potential customers). The reduction in inventory boosts gross margin by cutting down on clearance merchandise. It also frees up working capital and leads to lower store operating costs.

As of the beginning of 2017, Kohl's had already converted about 115 of its nearly 1,000 full-size stores to the new "standard-to-small" format. By the end of this year, Kohl's will have converted another 200 stores to this more efficient format.

Shifting to smaller stores

Of course, if Kohl's is going to operate many full-size stores as if they were smaller, it would be logical to downsize to smaller spaces when that's possible. Downsizing can allow Kohl's to save money on rent and utilities. (Alternatively, in cases where Kohl's owns its store, it could sell or rent out a portion of the building.)

Indeed, Kohl's already has about 185 smaller stores. Most of these range from 55,000 square feet to 68,000 square feet in size. Kohl's even started testing a 35,000 square foot format last year. So far, it has opened eight of these stores, which feature an open floor plan -- similar to what you would expect at an off-price store.

On Tuesday, Kohl's announced that it will open another four 35,000-square-foot stores in October. The company has previously stated that it sees these small-format stores as a way to penetrate urban areas where space is at a premium, as well as lower-density suburban areas that can't support a full-size store -- all while supporting its e-commerce business.

Kohl's also highlighted that it recently relocated an 80,000-square-foot store in Charlotte to a new 55,000-square-foot location nearby. It plans to downsize another two full-size stores to 62,000 square feet later this year and relocate an 85,000-square-foot Kohl's in a Milwaukee-area mall to a 55,000-square-foot space nearby in 2018.

A gem for patient investors

I invested in Kohl's stock recently. The company's initiatives to carry less merchandise in low-volume stores while physically downsizing others are a big reason for my optimism.

While sales growth is proving elusive for Kohl's, revenue isn't cratering. (Going forward, share gains from rivals that are closing stores should help keep sales stable at the very least.) Thus, the main thing investors have to worry about is margin pressure.

The downsizing initiatives should allow Kohl's to keep its profit margin stable or even growing. Meanwhile, its steady inventory reductions and lower capital spending will boost free cash flow. This is allowing Kohl's to return lots of cash to shareholders. With Kohl's shares currently trading at a steep discount to the market, this could be a great stock for patient investors to own for the next five years or more.

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Adam Levine-Weinberg owns shares of Kohl's. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.