One of the benefits of closely monitoring stocks month after month is that you get to identify great companies to put on your watch list. And when these companies temporarily fall out of favor, you can take advantage. During the past decade, I have always been very impressed with the consistent sales execution and profit growth from Kohl’s (NYSE: KSS). The retailer has clearly replaced Macy’s (NYSE: M) as the most effective department store operator, and always seems poised for steady further growth. Yet shares have never quite seemed like a bargain. Until now.

Kohl’s shares have fallen for five straight sessions (through Monday) and, even though they have bounced about +2.5% in Tuesday trading, the shares are still near 52-week lows, thanks to recent conservative management guidance. They caution that sales and profits may be constrained in the next few quarters as consumers hit the pause button and one-time issues hit the income statement. But looking into 2011 and 2012, Kohl’s winning formula of appealing merchandise and very judicious use of working capital should enable the retailer to once again boast the best metrics in the business.

Cautious or realistic?
When Kohl’s reported fiscal second quarter results last Thursday evening, the retailer delivered its typical set of solid financial barometers. Same stores sales rose +4.6% in the quarter (which is no easy feat in the face of a depressed consumer), gross margins continued their steady upward march, and per-share profits came in slightly ahead of forecasts.

Yet management cautioned that same store sales in the current quarter may only rise in the +2% to +4% range, slightly below analysts’ forecasts. That partially led to a profit forecast that was also below estimates. The main culprit for expected near-term profit weakness: uncertainty, over newly-established credit card rules, that has led management to freeze new credit card openings until they can ascertain the new rules’ impact along with financial advisor JP Morgan (NYSE: JPM). Kohl’s expects this issue to only last for a quarter or two.

But it’s important to know that any near-term sales and profit weakness is not a function of toughening competition or a misguided merchandising strategy. Instead, it is simply a function of weak consumer spending. On a full-year basis, profits are only expected to rise +10% to +12%, which again, has to be applauded at a time when consumers are loathe to spend.

A stealth private label play
As the economy rebounds, investors are likely to notice a subtle shift taking place at Kohl’s. The retailer has been steadily expanding its private label offerings, and consumers seem to have really warmed up to the company’s internal brands. Sales of these private label clothes and shoes rose +20% in the most recent quarter and now account for a company-record 49% of sales.

As is the case with supermarkets, clothing retailers love private label merchandise, thanks to superior profit margins. It’s why analysts think sales will not only rise +5% in fiscal (January) 2012, but per share profits should rise by about +15% to around $4.20. Analysts at Smith Barney think the combination of rebounding consumer spending along with steady margin gains should take earnings per share (EPS) to nearly $5 by fiscal 2013.

This is why shares of Kohl’s have suddenly become so compelling. They trade for less than nine times that 2013 profit view. It’s the first time in the retailer’s history that it has sported a single-digit forward multiple.

Most importantly, the consumer will eventually spring back to life. Footwear and apparel tend to wear out and need to be replaced. And Kohl’s has already won the hearts of minds of many consumers by stealing their allegiance away from retailers like Macy’s, JC Penney (NYSE: JCP) and Nordstrom’s (NYSE: JWN).

Kohl’s management insists there is still ample room to expand the company’s base of stores. Expect a combination of modest same store sales increases and annual +3% to +4% expansions in the number of stores to yield sales growth in the +7% to +9% range. And with ongoing gross margin gains and better leverage on fixed costs, profits can grow at twice that rate. Of course once those trends are in evidence again, shares will no longer be this cheap.

Action to Take –> The best time to buy solid companies is when they have moved out of the spotlight. The consumer may remain weak into 2011, so Kohl’s shares may not rebound quickly. But investors can feel very comfortable owning the stock at these levels.