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Kohl's Stock Upgraded: What You Need to Know

Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...

"Big One" bath towels for only $1.79? $4 for a Crock-Pot? Less than $12 for a queen-size mattress pad and pillow -- combined!?

Sometimes, the bargains at Kohl's (NYSE: KSS) seem too great to resist, and according to the analysts at R.W. Baird, the same might be true of Kohl's stock. This morning, Baird announced it is upgrading shares of Kohl's stock to outperform despite the company's disappointing earnings announcement yesterday. As the analyst explains, there comes a point when Kohl's stock gets too cheap to resist -- and that point is getting closer by the day.

Here are three things you need to know about that.

Christmas is coming. Are you ready to shop at Kohl's (stock?) Image source: Getty Images.

1. What Kohl's said Thursday

Kohl's earnings report Thursday was...not good. Although Kohl's reported slightly better revenue than Wall Street had expected, its gross margin declined, while its general and administrative costs rose. As a result, net profits declined 16% to $0.70 per diluted share -- missing analyst estimates. On top of all that, Kohl's issued new guidance calling for full-year earnings ranging between $3.60 and $3.80 per share. At the midpoint, it would be short of Wall Street's expected $3.76.

Kohl's stock initially plunged on the news, but rebounded later in the day, and ended up closing higher than it had begun. And it's rising again this morning -- up 4.5% from its pre-earnings price already -- on the back of an endorsement from Baird.

2. What Baird said about Kohl's

Why the sudden rethink? As Baird explains in a note covered on StreetInsider.com (requires subscription), Kohl's margins were "pressured" in Q3 by rewards accruals, which should abate in Q4, and perhaps even drive incremental sales as customers cash in those rewards. (In a similar vein, analysts at Gordon Haskett observed yesterday that Kohl's same-store sales seem to be trending back up. Same-store sales grew 0.1% in Q3. After last year's 2.4% same-store sales decline, this year's sales should look better by comparison.)

Additionally, Baird thinks that Kohl's efforts to cut costs and reduce inventory will result in better free cash flow "visibility" in the near term.

3. What Baird really thinks about Kohl's

Perhaps most important of all, even if Baird's high hopes for a resumption of sales growth at Kohl's fall through, and Kohl's stock falls with them, there's only so much farther that it can go down before it hits the bottom. After all, Kohl's stock has already lost 19% of its value over the past year, versus a 19% gain for the S&P 500. There will come a point, says Baird, when Kohl's stock gets so cheap that investors will buy it through pure "takeout speculation."

This hope that a white knight will come riding in to save Kohl's, says Baird, "will provide a good floor for the equity."

The most important thing: How cheap is Kohl's stock?

So, how close are we to the price point at which would-be Kohl's buyers will emerge? I can't say for sure, but we sure look close. Kohl's stock currently costs just 10.8 times trailing earnings -- and just 6.9 times its trailing free cash flow of $1 billion. Granted, the stock is more expensive once debt is factored into the equation. Kohl's carries about $3.8 billion in net debt, raising its enterprise value to $10.7 billion, and its enterprise value-to-free-cash-flow ratio likewise -- to 10.7.

Still, with Kohl's paying a 5.3% dividend yield and pegged for 7% annualized long-term growth on Wall Street, Kohl's stock is looking remarkably cheap right now. Even if no other company has expressed an interest in buying it just yet, maybe you should.

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Rich Smith has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.