Retail details Kohl's addresses problems and pursues expansion.

A full three years before Kohl's Corp. flooded into the Southern California market by launching 28 stores on a single day in March 2003, company executives were meticulously plotting strategy.

Los Angeles and the four surrounding counties seemed ripe: nearly half of the population had an annual income of between $35,000 and $100,000, and there were ample suburban areas with populations between 200,000 and 400,000.

For all the planning, however, the Menomonee Falls, Wis.-based retailer has been performing at the lower end of expectations. The company does not break out sales figures for particular geographic regions, but during a conference call last week Chairman and Chief Executive Larry Montgomery said single-store volume in the Los Angeles area--covering Los Angeles, Ventura, Orange, Riverside and San Bernardino counties--is 70-75 percent of a mature Kohl's store. That lags year-old stores in New York, which were at 90 percent of mature sales volume.

Analysts say a lot has gone wrong: Kohl's merchandise didn't take off with California shoppers, the stores are not located in the most optimal locations, and there's stiff competition from Target Corp.'s Mervyn's, a highly entrenched retailer based in Hayward that Kohl's used as a model.

Some also theorized that Kohl's hadn't properly considered Southern

California's two-season climate and its impact on clothing sales. "Two-season regions don't have the same catalyst to drive sales," said Bill Dreher, an analyst with Deutsche Bank AG, which holds 1.4 percent of the outstanding shares. "It's basically warm and damp or just plain hot, so in those areas it's more difficult for them to keep their top line strong."

Within six months of its massive, highly promoted openings on March 3, 2003, Kohl's stores were heavily overstocked. "I think they had fairly high expectations, but they came at a bad time, the economy wasn't the best and you've got a lot of competition out here already," said Richard Giss, a partner with the retail service group of Deloitte & Touche LLP."

Several analysts say Kohl's has had to rely on deep discounts--some as much as 70 percent--to clear merchandise. "It is not just too many units," writes ThinkEquity Partners LLC analyst Ed Weller. "It is also too many units of too many styles and too many colors."

Disappointing earnings

Kohl's malaise wasn't confined to the local market. In 2003, company-wide same-store sales fell 1.6 percent from the year earlier, compared with projections of 5 percent growth, according to Value Line analyst Paul Debbas. In the all-important fourth quarter, same-store sales were down 2.1 percent. Markdowns were a big problem, he said; in December the number of transactions rose 3 percent but the dollar value per transaction fell 4.2 percent.

"Our earnings performance was a disappointment," said Montgomery in reporting a drop in fourth-quarter net income to $246.8 million from $279 million for the like period a year earlier.

Until now, Kohl's has had success targeting the middle-range shopper in search of fashion able brand names at competitive prices. But it's a tricky strategy, with price competition coming from both the higher and lower ends. Any misstep in merchandise selection and pricing could easily result in costly inventory clearances.

Even for an experienced retailer, entering a new market is fraught with risk.

"We believe the Southern California consumer has a style quotient, an awareness of fashion that extends further down the spectrum than other parts of the country, even by New York standards," said Dreher.

"The combination of this fashion miss, combined with inadequate inventory controls and the reluctance to clear merchandise through the gray market, such as liquidators, compounded to a very challenging first year," he said.

As for competition from Mervyn's, "they did have a good toe-hold in the moderate apparel segment in Los Angeles," said Gary J. Holdsworth, an analyst for Wedbush Morgan Securities Inc. "For Kohl's to come in and convince people they have a fundamentally better store is difficult."

Growing pains notwithstanding, Kohl's has not pulled back from its aggressive expansion plans.

In the next year, the retailer has scheduled opening two stores in the San Gabriel Valley, one in Newbury Park and another in Palmdale, bringing its total number of locations in the region to 32.

That would put it in the same league as Macy's, with 33 stores; J.C. Penney, 32; Robinsons--May, 35; and Wal-Mart, 34. Mervyn's--Kohl's closest competitor--has 48 stores in the region, and Target has 84.

Giss said the tactic of opening a large number of stores at one time has paid off for the company.

"They have had an immediate impact out here and established a big presence. They were able to get their brand known fairly quickly," he said. "It's a big gamble, a huge risk, but the reward is being able to spread your advertising dollars over a lot of locations and have a presence that's immediate."

Focus inland

Holdsworth said Kohl's was smart to open stores on the fringes of Los Angeles County, where much of the region's population growth is taking place.

"The majority of the stores are in less populated inland areas but the stores are positioned in areas where growth is headed," he said. "It was strategically important to place those stores in the inland areas. The fact they have real estate where houses are going to be built means they will be around for many years in those locations."

Analysts point out that the company is aggressively reducing its inventory and bringing in new apparel lines to appeal to the Los Angeles market. In January, for example, Kohl's announced it was launching a new line named for Latina fashion model Daisy Fuentes.

"Kohl's is still adjusting to the Los Angeles market," Holdsworth said. "They're adding merchandise targeted to a more urban or ethnic market in the L.A.-based stores compared to rest of country."

But by discounting merchandise early on, customers have come to expect that if they hold off long enough they'll be able to pick up items at a steep discount, said Dreher.

"I think the Southern California consumers are aware Kohl's will discount items," he said. "They know if they see something they like not to buy it then and come back later and they know it will be on sale. We don't know how consumers will react when they are asked to pay full price."

That could cost Kohl's down the line, according to Weller. To regain L.A. customers initially turned off to the stores, Kohl's will have to spend more on advertising, he wrote in a Feb 6 report.

However, Weller also believes Kohl's stock is undervalued and presents a good buy. The company was trading last week at just under $50 per share, well off its 52-week high of $65.44.

Dreher remains unconvinced.

"Traffic has been there, which speaks well to their aggressive promotional posture," he said. "They do a good job of getting people into the stores, but once they are there they are not compelled to buy merchandise at full price. Until that changes it won't make any difference in the world."

Catching Up

Kohl's has become one of the largest
regional retail players.

Retailer          Stores *

Target              83
Mervyn's            48
Robinsons-May       35
Wal-Mart            34
Macy's              33
J.C. Penny          32
Kohl's              28

* In L.A., Ventura, Orange, Riverside and
San Bernardino counties

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