Is It Time to Buy Kohl's Stock?

Kohl's third quarter wasn't a particularly good one, with comparable-store sales growth being not only negative, but degrading compared to both last quarter and the same quarter last year. Profits declined as costs rose despite sagging revenue, and store traffic continued to be weak.

The best time to buy a stock is often when the company appears to be at its worst, although the success of this strategy requires the company to eventually recover. Kohl's certainly isn't standing still, launching various initiatives in an effort to boost sales, but it faces an extremely competitive landscape. Is it time to buy shares of Kohl's in the hopes that the company can return to growth? Or should the struggling company be avoided?

Kohl's biggest problemThe main issue facing Kohl's is the struggle to get customers to visit its stores. Store traffic has been declining, and in fact retail store traffic in general has weakened over the past few years. Kohl's is attempting to drive repeat visits to its stores in two ways, and so far both have shown progress.

First, Kohl's in October rolled out nationwide the new loyalty program which it had been testing, and in the test markets the program drove an average of two extra store trips per year. Getting customers to the stores in the first place is important, but getting them to come back over and over again is the key for Kohl's to return to comparable-store sales growth.

A second initiative, also aimed at driving repeat sales, is the company's new beauty department. The idea behind the initiative is that beauty products are the closest thing to consumables that Kohl's sells, and as customers run out of various beauty products they'll return to the stores and hopefully buy other products. So far, this has worked well in high-volume stores, and Kohl's will be rolling it out to hundreds of additional stores next year.

Whether these initiatives will continue to work at the national level remains to be seen. Kohl's has guided for comparable-store sales growth of between 2% and 3% during the holiday quarter, which would be a vast improvement over the 2% decline during the fourth quarter of 2013, but the real test will be 2015.

Still a very profitable retailerDespite the issues that Kohl's is having, the company still generates plenty of profits. During the last 12 months, Kohl's managed an operating margin of 8.75%, leading to a net income of $832 million. This is well below peak levels; the operating margin reached 11.5% in 2011 and Kohl's generated net income of $1.17 billion. Per-share earnings have been helped by share buybacks, so the trailing-12-month EPS of $4 is only slightly below the peak value of $4.30 from 2011.

Shares of Kohl's currently trade around $58, putting the P/E ratio based on TTM earnings at 14.5. There's the potential for these earnings to weaken further if Kohl's initiatives to boost store traffic don't pan out, but there's also the potential for earnings to expand if Kohl's can raise margins closer to historical levels. If Kohl's can get back to a 10% operating margin based on current revenue, EPS would rise to somewhere around $4.70, putting the P/E ratio at roughly 12.3.

It's possible, though, that Kohl's may never return to the same level of profitability. The continuing shift from in-store to online may mean that Kohl's best days are behind it. The decision to buy the stock shouldn't be based on the best-case scenario, which may not pan out, but a more realistic scenario. Paying 14.5 times the current, seemingly depressed earnings, isn't a bad deal, given Kohl's history of reliable earnings. But I'd probably like to pay less, because there is a chance that the situation gets worse from here, or that margins never get back to historical levels.

A P/E ratio of around 12 would put the stock price at a little less than $50 per share, and at that price I think Kohl's is a solid buy. At the current price, it's not necessarily a bad idea, but there's not quite a large enough margin of safety for my tastes.

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Timothy Green has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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