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Shares of No-Moat Kohl's Undervalued

No-moat Kohl's KSS reported soft sales and profits in the third quarter of 2019 and provided a disappointing outlook for the critical holiday season. As in the prior two quarters, women's clothing was cited as the weakest category. We believe many of Kohl's competitors are struggling in women's apparel, leading to pricing pressure. Kohl's same-store sales growth of just 0.4% in the quarter missed our forecast of 1.5% even though the firm implemented discounts and promotions to drive traffic. Further, Kohl's guided to fourth-quarter same-store sales growth of flat to 1% (we had forecast 1.5%), suggesting no immediate relief from the competitive pressures. Kohl's lowered its 2019 adjusted EPS target to $4.75-$4.95, well below our previous forecast of $5.21. We expect to reduce our $75 per share fair value estimate by a single-digit percentage. However, we view shares as attractive after they fell by a high-teens percentage on the earnings report. We estimate Kohl's will generate nearly $1 billion in free cash flow to equity in 2019 and return much of it to shareholders.

Kohl's expanded some marketing initiatives and introduced new merchandise in the quarter. While we think these efforts are necessary, they are weighing on margins and are somewhat unproven. Kohl's selling, general, and administrative expenses as a percentage of sales were 30.7%, 50 basis points above our forecast. Among the initiatives, Kohl's introduced a few brands, including 9 West and Elizabeth and James, increased floor space for activewear in 130 stores, and added 100 more Adidas shop-in-shops (now 175 total). We view the increased space for activewear as logical given the ongoing athleisure fashion trend. However, we are uncertain if the new brands will draw much customer interest as Kohl's already has many exclusive brands. We think it is likely that 9 West (which went bankrupt just last year) and Elizabeth and James (a fallen former luxury brand) will just be viewed as two more captive brands.

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