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On Jan 28, we downgraded specialty departmental store Kohl’s Corporation (KSS - Analyst Report) to Underperform due to weaker-than-expected holiday season sales, which also forced the company to reduce its earnings expectation for the fourth quarter and fiscal year 2012.

Why the Downgrade?

Kohl’s performance during the holiday season was impacted by unfavorable weather conditions and lower consumer confidence, which forced Kohl’s to give more than expected discounts to its customers. This was reflected in Dec comparable store sales, which were lower than the company’s expectations. Notably, the company’s Nov sales were also below expectations.

The sluggish sales also prompted the company to slash its expectations for the fourth quarter and fiscal year 2012. The company has reduced its earnings expectation to a range of $1.60 to $1.62 for the fourth quarter and $4.11 to $4.13 for fiscal 2012 versus its previous guidance of $2.00 to $2.08 for the fourth quarter and $4.52 to $4.60 for fiscal 2012.

Estimates for Kohl’s have been declining ever since it reported its Dec comparable sales. The Zacks Consensus Estimate for fiscal 2012 has gone down 7.0% to $4.13 per share over the last 30 days, while the Zacks Consensus Estimate for fiscal 2013 declined 6.1% to $4.58 per share over the same timeframe. With the Zacks Consensus Estimates for both fiscal 2012 and 2013 going down, the company now has a Zacks Rank #5 (Strong Sell).

Cause for Concern

Other than weak holiday season, Kohl’s has been facing the burden of increasing cost of raw materials, especially cotton in the last two years. Apart from cotton price hike, the company has also been facing a 10 – 15% increase in other apparel costs.

Crop yields, weather conditions, transportation costs, energy prices, work stoppages and government regulations mainly lead to such cost escalations. In addition, any decrease in the availability of raw materials increases its cost and thereby lowers the sales volume of the company. Often this leads to passing off the higher costs to customers.

In addition, Kohl’s doesn’t have access to the leading accessories brands trending at other department stores, even though it focuses on introducing new brands. Rather, new private and exclusive brand introductions appear to be cannibalizing existing brands.

Also, Kohl’s absence of international exposure makes it vulnerable to a weak U.S. economy and declining consumer spending in the U.S. markets. Besides, Kohl’s discounted pricing does not allow it to overcome the tough economic times.

Stocks That Warrant a Look

While we prefer to avoid Kohl’s until we see signs of improvement in the company's performance, other retail stocks worth a look are Big Lots Inc. (BIG - Analyst Report), Ross Stores Inc. (ROST - Analyst Report) and TJX Companies, Inc. (TJX - Analyst Report). All of them carry Zacks Rank #2 (Buy).

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