Can Kohl's Stock Keep Rallying in 2018?

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Back in June, shares of department-store giant Kohl's (NYSE: KSS) fell to around $35, near the stock's multiyear low. Investors were extremely worried that the rapid growth of off-price and e-commerce retailers would undermine Kohl's revenue and its gross margin.

At the time, I saw these fears as overblown and recommended buying Kohl's stock. Since then, the stock has come roaring back, rising by about 50%. Nevertheless, there could be plenty of additional upside for Kohl's stock, because of improving sales trends and the impact of tax reform. The apparent rebound in retail sales trends could also create plenty of upside for weaker department store chains such as J.C. Penney (NYSE: JCP).

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A lower tax rate will lift earnings

Like most domestic retailers, Kohl's currently pays close to the full statutory corporate tax rate of 35%. It now seems likely that the statutory rate will fall all the way to 21%.

The impact on Kohl's will depend on its capex plans. If the company continues to keep a tight lid on capital spending, it might have to pay somewhat more in federal taxes. Even so, the tax reform package will probably boost annual earnings per share by about 20%.

This reduction in the book tax rate will filter through to cash flow fairly quickly. In recent years, Kohl's has only been able to defer a small fraction of its tax liabilities.

Sales trends appear to be very strong

While a lower tax rate will lift profit, it wouldn't matter much if the company's underlying pre-tax profitability were about to plunge. However, Kohl's may be on the verge of breaking out of a years-long sales slump that has weighed on its profitability. A return to consistent comp sales growth could drive the stock much higher.

Last quarter, Kohl's surprised investors by eking out a 0.1% comp sales gain. Management noted that sales trends were particularly strong near the end of the quarter, and that momentum continued into November. Later in the month, CEO Kevin Mansell indicated that Kohl's saw a big uptick in sales on Thanksgiving and Black Friday relative to 2016.

Other retailers also seem to be capitalizing on strong demand. J.C. Penney posted solid comp sales growth last quarter, albeit at the expense of its profit margin. J.C. Penney also put out a statement on Black Friday saying that it was "encouraged by store and jcpenney.com traffic," although it was still early in the holiday shopping season.

That said, other retailers also experienced solid Black Friday weekend sales last year. The problem was that there was a big lull during the first half of December.

That doesn't seem to have been the case in 2017. Growth in chain store sales slowed from 4.8% on Thanksgiving week to 3% the following week, according to Redbook -- but it rebounded to 4.4% last week. By contrast, chain store sales growth didn't exceed 2.2% in any week of the 2016 holiday season, based on Redbook's data.

Kohl's will have lots of cash to reward shareholders

Analysts' current earnings estimates for Kohl's imply that its operating margin for this year and next year will be around 7%. That's down by almost two percentage points from 2014. A return to a stronger sales growth trajectory should help profit margin recover, at least partially. J.C. Penney is even more desperate for the margin tailwind that would come from a strong sales recovery, as it has been running around breakeven recently.

The combination of margin expansion and a lower tax rate would cause EPS to spike at Kohl's -- perhaps to more than $5. That makes the recent Kohl's stock price of about $53 look fairly attractive.

Furthermore, Kohl's has been steadily reducing its inventory in recent years, while holding capex well below the level of its depreciation and amortization expense. Both moves serve to boost free cash flow relative to net income.

As a result, Kohl's should have plenty of cash to ramp up its share buybacks beginning next year, while maintaining or even increasing its generous dividend. This scenario should keep the stock moving higher in 2018.

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