3 Highlights From Kohl's 2018 Annual Report

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In early March, Kohl's (NYSE: KSS) reported another quarter of solid profit growth, capping off a strong 2018 fiscal year. For the full year, adjusted earnings per share soared 34% to $5.60. While much of the increase was driven by a lower tax rate, Kohl's also made progress on initiatives to grow its sales and improve its profit margin last year.

Kohl's recently filed its annual report for fiscal 2018, which provides more detail on the company's results for the past year and its plans for 2019. Here are three important details investors might have missed.

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Gross margin growth -- despite pivot to national brands

In recent years, Kohl's has been reducing its inventory steadily in order to avoid margin-killing clearance markdowns. This effort is working, as gross margin reached 36.4% in fiscal 2018, up from 36% a year earlier and 35.9% in fiscal 2016.

This gross margin improvement is particularly notable because it comes in the face of two major headwinds. First, Kohl's is posting steady double-digit growth in digital sales, and gross margin tends to be lower for e-commerce transactions due to shipping costs.

Second, gross margin tends to be lower for national brands than for private-label brands, and Kohl's has been making a big push to grow its sales of national brands recently. A key deal to begin selling Under Armour gear went into effect two years ago. As a result, Kohl's derived 61% of its sales from national brands last year, up from 54% in fiscal 2016. Yet Kohl's was able to more than offset the impact of this shift in its merchandise mix and continue expanding its gross margin.

Kohl's plans to continue its focus on growing sales of national brands in 2019. That will include the launch of the Nine West brand at Kohl's this summer. Nevertheless, management expects gross margin to increase slightly once again this year.

Free cash flow soared last year, but it may dip in fiscal 2019

One of the most impressive aspects of Kohl's financial performance last year was its cash-flow production. Free cash flow surged 59% year over year to $1.4 billion: the company's highest full-year total in nearly a decade. Working capital gains and a decline in capex to $578 million -- compared to $768 million just two years earlier -- contributed to this strong result.

Looking ahead to fiscal 2019, free cash flow is likely to recede again, due to higher planned capital spending. Kohl's expects capex to jump to around $850 million this year, mainly thanks to costs associated with building its sixth e-commerce fulfillment center. Omnichannel capex will nearly triple year over year to $280 million.

Kohl's is also planning a substantial year-over-year increase in capex for its "store strategies" in fiscal 2019: from $152 million to $240 million. This increase likely relates to the decision to open four more small-format stores this year and an ongoing initiative to subdivide several stores in order to lease excess space to other retail tenants, including Aldi and Planet Fitness.

However, capex is likely to moderate in fiscal 2020, driving a rebound in free cash flow. First, e-commerce fulfillment center spending tends to be heavily concentrated in certain years, depending on the timing of construction. Second, technology capex is likely to decline over time, as Kohl's is shifting spending toward cloud services, which have a pay-as-you-go business model.

The balance sheet is in excellent shape

Kohl's annual report also confirmed that the company's balance sheet is in better shape than it has been since at least 2011. That's because Kohl's used a substantial proportion of its free cash flow last year to pay down debt.

By the end of fiscal 2018, Kohl's had $3.5 billion of debt and capital leases on its balance sheet, down from $4.5 billion at the beginning of the year. Meanwhile, the company posted a modest increase in its adjusted earnings last year. This enabled it to reduce its leverage ratio -- adjusted debt divided by adjusted earnings before interest, taxes, depreciation, amortization, and rent -- from 2.54 to 2.16.

Kohl's current leverage ratio puts it well within investment-grade territory. That means it will be able to return more of its free cash flow to shareholders in the future.

Indeed, Kohl's raised its dividend by 10% this year. It also expects to buy back more stock, even though free cash flow will probably be lower in fiscal 2019 than it was last year. And with free cash flow likely to rebound after this year, Kohl's shareholders could benefit from even higher capital returns in fiscal 2020 and beyond.

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Adam Levine-Weinberg owns shares of Kohl's. The Motley Fool owns shares of and recommends Under Armour (A and C shares). The Motley Fool recommends Planet Fitness. The Motley Fool has a disclosure policy.