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Uncovering Value Traps in High Dividend Stocks

Recently one of the members in an investing group posted about this company Chico’s. Chico’s is a retail women’s clothing chain and It had come up in his screenings as supposedly an attractive opportunity with a very high dividend yield. In the same thread another gentleman mentioned about the Kohl’s and wanted my opinion (as I had earlier shared my opinion on Chico’s). Kohl’s is one of the largest departmental store chains in the US.

So in this post I decided to put both these companies through my framework for quick risk check to see if these are actually opportunities worth researching further. 

Sometimes an investing idea may look attractive at cursory glance, but it is important to look deeper before any investment decision is to be made. The detailed analysis of a business idea could take months and that itself is a huge (time) investment. It is not practical to spend months researching every single idea that one comes across… To overcome this I have a 6-step filtering process which I use to filter out the good ideas from the bad ones. This takes me no more than 10-15 minutes, and can save significant amounts of my time. I would only take up a business for a detailed analysis once it clears my quick & dirty evaluation. After a business passes through the quick risk check, I don’t mind investing several months digging into the details.

You can watch the 6 short short videos explaining the quick risk check framework here. (Only for some reason YouTube only allows me to display the playlist in the reverse order and I could not figure out how to change the order. So while watching kindly follow the numbering order of the videos)

Kohl’s Corp (Ticker: KSS)

Here are the steps I follow as part of my Quick Risk Check :

1. How much Debt is there on the Balance Sheet?

Kolh’s does not have any short term debt and they have actually brought down the long term debt as a % of their equity. In this case we also need to consider the capital leases (which are also fixed obligations on which they need to pay interest)

2. How comfortable is their Interest Cover?

I could not for some reason find their interest expenses on MorningStar so had to look up their 10-K. In 2018 their total interest expense was $256M against an Operating Income of $1,361 M…so that translates into an interest cover or 5.3 times. While this is not very high, considering that they are bringing down their long term debt, I would feel ok with their debt/interest cover situation for now.

3. How much capital does the business need to operate?

Kohl’s doesn’t seem to need to invest in too much CapEx.  (compared to the operating cash they generate). They also have been steadily reducing the capital they need to run their business. Their Working capital requirements have actually come down over the years, both in absolute terms and also as a % of the revenues.

They also seem to have steadily brought down their PP&E (property plant and equipment) over the years since 2012 (the below picture is from morningstar…the order of years is from left to right)

And as a result Kohl’s is also being able to return a lot of cash to their owners via dividends and share buybacks (the current dividend + buyback yield put together is very attractive at over 10%)

4. Is the business growing?

When it comes to the revenue growth, the news is not so great. I don’t see Kohl’s being able to grow their revenues at a rate that I would think attractive. Their CAGR revenue growth stands at 1.8%. I was not expecting much more from a department store chain in US… we need to see how well their online business is able to make up for the stagnation in their brick and mortar business. However they are clearly on a capital returning mode as we saw from their dividend and buyback yield above. So this is not surprising.

However they seem to be doing a great job when it comes to maintaining their gross margins over the years. In 2019 they have actually enhanced it a bit which means they are surely being able to fend off competitive pressure on their margins.

Their operating expenses, while being fairly steady over the years, has popped  up over 4% in 2019. A detailed research would be needed to check why this happened. Looking at their long term track record, I would guess this is due to some one-off… but it is not possible for me to know that at this stage… and that is fine.

5.  Are the shareholders getting diluted?

In fact exactly the opposite. They have bought back ~45% of the shares outstanding over the last 9 years . This has been great for the remaining shareholders. So each remaining sahrehold’er share of the business has correspondingly gone up by 45%. However we need to look into the average purchase price to ascertain if the repurchases were done below their intrinsic price (otherwise it will be value destruction).

6. How about the working capital efficiency?

Kohl’s clearly needs less working capital now than what it required 5 years back. So that is great.

Their working capital efficiency has been very stable over the last 10 years. We can see that they understandably do not have any debtors (being a departmental store)… and their cash conversion cycle (Debtors days+Inventory days – Accounts Payable days) has remained fairly stable in the 60-70 range .

So they seem to be running a reasonably tight ship here.

So my conclusion after running through the Quick Risk Framework would be that if someone is interested in a reasonably well run business with a healthy dividend yield (even though this may not be of my interest), then Kohl’s surely qualifies as a business that deserves a closer look. Based on the quick and dirty check, I have not noticed any major issues or red flags, so spending the time to look deeper would be a good idea.


Chico’s (Ticker: CHS)

Chico’s on the other had tells a very different story. There is a good reason why it is available so cheap. Their gross margins, operating margins and net margins are all steadily shrinking. 

It is possible for a business to manage their OpEx and turn around, if you have a management that is cost conscious… but in case of Chicos, you will see they COGS as a % of their revenue is shooting… means that clearly they are being unable to fend off competitive forces… or unable to pass on the (COGS inflation) price increases to their customers, and as a result their gross margins are getting squeezed… so they are definitely NOT going in the right direction.

The picture below in itself is good enough for me to drop Chico’s and move on. However just for the sake of explaining the robustness of the process I decided to look a bit more


They basically have been kind of in the winding down mode as they have been returning cash to shareholders via buybacks and dividends heavily. I can see they have repurchased above 30% of their shares… so it is clear they do not have much ways of investing the cash they are generating… terrible Return on Invested Capital(ROIC) lately. Which clearly shows that the shareholders are better off getting their money back because Chico’s is destroying value.

Also I am not sure even buying back shares is a good idea for Chico’s management. For a business with steadily declining revenues and margins, it is very difficult to calculate the intrinsic value. And any share repurchases that are done above the intrinsic value is essentially destroying value for remaining shareholders.

However to present a comparative picture, in case of Kohl’s (even though Kohl’s is also returning a lot of cash to the shareholders in form of dividends and buybacks) the situation of very different. Kohl’s shows a reasonably steady Returns on Invested capital and ROE. While It is not out of the world… but at least it is not destroying value for shareholders like Chico’s is doing.

In case of Chico’s the Intrinsic value is clearly on the decline. If an investor are banking on a liquidation kind of a scenario..then they need to think again. Most of their assets are their PP&E (~37% of total assets) and inventory(~23% of total assets)… how much of that do you think can be realised in the market? I would have understood if they had huge amounts of marketable securities or land etc… but that does not seem to be the case.

The dividend coverage ratio that initially appeared to be good, has almost vanished in the recent year… Chico’s also has a steadily declining Operating Cash Flows, so their ability to payout cash dividends may not last long, unless they bring down their Capex even lower (which they seem to be doing).

This is not going to be the case for kohl’s, who has maintained their CFO (albeit with the inter-year ups and downs)



So based on the above quick and dirty risk check, while Koh’s can be a candidate for further research, Chico’s is definitely not a business that I would touch with a barge pole.

Disclaimer: I do not own any of the stocks discussed here and neither do I plan to own any of the above in future. The above analysis is not meant to be a recommendation of any sort. It is purely to highlight some risks that often remain hidden behind high Dividend yields, and to demonstrate how we can use this framework to uncover these risks.

 
 
 

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