JC Penney Acquiring Kohl's: A Financial Analysis

Kohl's Financial Overview

Often, a firm that is taken over is struggling financially. One reason is entirely pragmatic: a struggling firm likely has a lower stock price, making the takeover more affordable. Over the past four years, Kohl's has seen its revenues flatline. Revenues were $19.2 billion in FY2016, and the company's cost of goods sold held steady at 63.8%. In that sense, Kohl's is a very stable firm financially. This stability should mean that its stock price fairly accurately reflects the present value of future cash flows, making it difficult for an acquiring firm to earn a profit from the transaction—given that it would need to pay a premium to Kohl's shareholders.

The company has seen its selling, general, and administrative expenses increase gradually over the past couple of years, which has resulted in shrinking operating income. The operating profit margin was 9.8% in FY2013 and had fallen to 8.08% by FY2016, with almost all of the difference attributable to increased operating expenses. Kohl's has seen a corresponding reduction in net income and net margin. Overall, Kohl's has a very stable income statement, and it would be relatively straightforward for JC Penney to price Kohl's based on future cash flows precisely because Kohl's business is so predictable.

Balance Sheet and Cash Flow Analysis

The balance sheet reveals some more interesting issues. The company's cash position has declined over the past four years, coinciding with an increase in inventories. The inventory turnover ratio was 5.14 times in FY2013 and 4.75 times in FY2016. This slight shift indicates that inventory is not moving as quickly. While Kohl's is still doing comparable volumes of business, inflationary price increases are likely allowing the company to hold nominal revenue steady even as it moves inventory more slowly. There is probably a corresponding decrease in foot traffic through its stores.

On the non-current assets side, the property, plant, and equipment line has declined steadily over the past four years. Most of this line item consists of property and improvements, the latter of which can be depreciated. In all likelihood, depreciation accounts for the diminishing book value of this major asset class, but operationally this also confirms that Kohl's is not expanding its footprint.

Kohl's has managed its accounts payable reasonably well. While there is some variability in this line item, it is currently at its lowest level over the past four years. Long-term debt has remained within a fairly consistent range, and there is little indication that the company needs to access debt markets to finance its operations. Total liabilities have crept upward, and while equity is declining, retained earnings are increasing—a pattern explained by the statement of cash flows.

The statement of cash flows has shown some variability in operating cash flows, with the weaker FY2015 year relating to higher inventory levels and higher accounts payable. The company appears to have had a difficult holiday season that year and was left with excess inventory at year-end—though this remains a hypothesis not addressed in the financial statements themselves. Capital expenditures on property and equipment have not been sufficient to offset depreciation and amortization, which explains why PPE is declining on the balance sheet. Cash has also been used in financing activities, particularly Treasury Stock repurchases and a small amount of dividends paid. Stock repurchases are typically a means of returning value to shareholders when operations are not delivering meaningful growth; dividends serve a similar purpose but can have a more pronounced market impact when they are cut. Firms use share buybacks as a way to support share value without altering dividend rates.

Conclusion

Without question, a case could be made for Kohl's to acquire JC Penney. The reverse scenario, however, makes no strategic sense. JC Penney cannot afford Kohl's, has weaker management and a less respected brand, and trades at a far lower value relative to its historical levels. Not to say that Kohl's acquiring JC Penney would be a straightforward decision, but the direction proposed—JC Penney acquiring Kohl's—is a non-starter in every meaningful sense.

References

Kohl's 2015 Form 10-K. Retrieved January 17, 2017, from http://corporate.kohls.com/investors/financial-information

MSN Moneycentral: Kohl's (2017). Retrieved January 17, 2017, from https://www.msn.com/en-us/money/stockdetails/financials/fi-126.1.KSS.NYS

Vasel, K. (2016). JC Penney, Kohl's, Macy's and Sears sued over misleading prices. CNN. Retrieved January 17, 2017, from http://money.cnn.com/2016/12/09/pf/price-scheme-jcpenney-kohls-sears-macys/