Kohl’s Corp. (NYSE: KSS). COVID-19 has been a serious blow to a management team that is working to reverse several years of lackluster earnings as middle-income shoppers struggled following the Great Recession; online competition grew; off-price retailers took market share; shoppers reallocated their spending to cosmetics and purses (where KSS has relatively smaller businesses); and Macy’s became a more aggressive competitor.
This mission, which Kohl’s calls its ‘Greatness Agenda,’ is more important than ever with constrained store traffic, elevated unemployment, customers working at home and allocating more money to cleaning supplies and streaming video, and Amazon poised to gain even more market share.
In short, Kohl’s aims to differentiate itself from its competitors by making it easier for busy, budget-constrained moms to buy products for their homes, themselves and their family members. The company is notably reallocating its advertising dollars and store space, and reducing inventories.
We believe that CEO Michelle Gas is injecting energy into the business but, we were cautious about the department store space before the pandemic because store traffic has been declining. When the virus abates and stores reopen, the competitive environment for KSS could get more difficult with Macy’s, J.C. Penney, T.J. Maxx and other retailers needing to generate cash.
We have been asked about the differences between Kohl’s and Target. The biggest difference is that Target sells food, cleaning supplies and healthcare items, including pharmacy. That gives Target more sales stability in a downturn; sales of ‘essentials’ also allowed Target to remain open while other retailers were forced to close due to pandemic restrictions. It would be hard for KSS to expand to food and consumables because it would require a new distribution system for fresh foods and products, as well as a substantial investment in fixtures and refrigerators. Food and consumables also have substantially lower margins, which would make the capital investments hard to justify. On the bright side, KSS could pick up market share as competitors close locations or go out of business completely.
On December 1, Kohl’s announced a new 10-year partnership to open 200 Sephora locations by the end of calendar 2021 and 850 by 2023. We like the deal. Kohl’s said in its 3Q earnings call that it plans to triple the size of its beauty business. Sephora will be a major component. It has the potential to draw new shoppers and younger shoppers to Kohl’s with Sephora-trained beauty advisors and a wider range of brands. The Sephora ‘shops’ will be 2,500 square feet and be located at the front of Kohl’s stores. The agreement between Kohl’s and Sephora follows the announcement that Ulta will open beauty shops in Target stores.
Sephora has operated shops in J.C. Penney stores for more than a decade. The Wall Street Journal said that the partnership between Sephora and J.C. Penney will wind down in early 2023.
On November 17, Kohl’s reported an adjusted 3Q profit of $0.01 per share for the period ended October 31. The result was better than the $0.38 per share loss we expected and the StreetAccount consensus calling for a loss of $0.45 per share.
Earnings before taxes were negative on an adjusted basis. A big tax benefit pushed adjusted EPS into positive territory. Sales were down 13.3% to $3.78 billion. We were modeling an 11% decline to $3.9 billion. Digital sales picked up some of the slack, rising 25% for the quarter and representing 32% of total sales. Sales of home products and activewear were strong. KSS plans to significantly expand its Active business next year with more floor space and a new private brand called FLX. The company was also happy with the performance of its beauty business and plans to expand it as discussed above. Weak back-to-school sales got the quarter off to a slow start, but business did improve in September and October.
In a previous note, we discussed some of the company’s actions to preserve financial strength. To reduce cash outflow, Kohl’s reduced inventory receipts and extended some payment terms, cut expenses, reduced capital spending, suspended the dividend beginning with the 2Q payment, and suspended share repurchases. In 2Q, the company raised $193 million in a sale-leaseback transaction on two distribution centers. To improve liquidity, the company replaced its revolving credit facility with a new $1.5 billion secured facility and borrowed $600 million in the bond market.
In 3Q, Kohl’s fully repaid an outstanding balance of $1 billion on the revolving credit facility. KSS ended 3Q with $1.9 billion of cash and no borrowing on the revolver. The company plans to In 3Q, Kohl’s fully repaid an outstanding balance of $1 billion on the revolving credit facility. KSS ended 3Q with $1.9 billion of cash and no borrowing on the revolver. The company plans to reinstate the dividend in the first half of 2021.
The gross margin dropped by 48 basis points to 35.8%. The result was a significant improvement from the 569 basis point decline in 2Q. KSS is still seeing a drag from shipping costs as online orders became a bigger portion of the sales mix, but the company saw benefits from inventory management and pricing and promotional strategies. Our estimate was 34.4% and the consensus was 35.2%.
The result was better than the consensus of 34.5%. Interest expense and the share count were both close to our expectations.
Kohl’s generated $910 million in cash from operations in the three quarters despite a net loss of $506 million. One major factor was that inventories were a smaller use of cash. The company generated $1.05 billion.
EARNINGS & GROWTH ANALYSIS
This is in a non-GAAP basis. The 2Q profit was better than the loss we expected. We are making a few very minor changes to our 4Q estimate. We are trimming our sales forecast, but we are also making small reductions to our estimates of depreciation and interest expense. Our 4Q estimate is now $0.86 down from $0.87.
Our sales forecast is unchanged. As context, we expect sales to rebound from FY21 levels, but still remain below FY20 levels. There are three main changes to our model. We are raising our gross margin forecast on the prospect for better inventory management and e-commerce profitability than we had modelled. We will update our estimate when we have more information about the agreement with Sephora.
FINANCIAL STRENGTH & DIVIDEND
This reflects reduced cash flow from the stores being closed, the suspension of the dividend and the buyback plan, the withdrawal of earnings guidance and the potential for significantly weaker operating income in the current year.
To reduce cash outflow, Kohl’s reduced inventory receipts and extended some payment terms, cut expenses, reduced capital spending, suspended the dividend beginning with the 2Q payment, and suspended share repurchases.
To improve liquidity, the company replaced its revolving credit facility with a new $1.5 billion secured facility and borrowed $600 million in the bond market. The company raised $193 million in a sale-leaseback transaction in 2Q. KSS ended 3Q with $1.9 billion of cash and no borrowing on the revolver after repaying $1 billion in 3Q.
Debt declined sequentially to 58% in 3Q, but remained above pre-pandemic levels. The company owns the land and buildings at approximately 35% of its stores. In the remaining locations, the company leases the land and/or the building. This level of ownership doesn’t rank in the top tier of retailers we follow, but it represents a significant asset. It is also encouraging that the company’s book value is tangible. This is largely because the company has mostly grown by opening its own stores rather than through acquisitions, which would put goodwill on the asset side of the balance sheet.
The ratio was slightly weaker at 2.5-times for FY20. We believe this ratio is consistent with credit ratings at the bottom of the investment-grade range and our assessment of Medium financial strength. Before the COVID-19 outbreak, management was targeting a ratio of approximately 2.25-times EBITDAR. The ratio would be above 3-times if we add the new revolving debt and use last year’s adjusted EBITDA. With EBIT likely to be negative in FY21 the ratio could exceed 10-times. The ratio could improve to about 4-times in FY22.
There are no debt maturities in calendar 2020, or 2021. There is $530 million maturing in 2023, and now $1.25 billion maturing in 2025, with the remainder due from 2029 through 2045. The new revolver matures in 2024.
Kohl’s had $723 million in cash at the end of the fourth quarter of fiscal 2020 and a little more than $1.9 billion at the end of 3Q. The company’s operating margin has historically been higher than those of other department stores, including Macy’s and J.C. Penney, and near the top of the range for our retail universe. Kohl’s ended FY20 at an adjusted 6%, down from an adjusted 7.2% a year earlier.
S&P lowered its rating on the company’s debt to BBB from BBB+ in November 2014 based on its assessment of the company’s weaker competitive position and the expectation that sales trends were unlikely to improve meaningfully in the near term. S&P dropped the rating to BBB-, the lowest investment-grade rating, in January of 2017, then raised it back to BBB in April of 2019. The S&P rating is currently BBB-. The outlook from S&P is now Negative.On April 19, 2016, Moody’s lowered its credit rating on Kohl’s to Baa2 from Baa1, citing persistent earnings declines over the previous five years. The outlook from Moody’s is currently Negative.
On April 16, Kohl’s announced a new $1.5 billion revolving credit facility that is backed by the company’s assets. KSS borrowed the maximum amount under the facility and used proceeds to repay the previous $1 billion credit facility which has been terminated. We believe that establishing a new facility was a good idea.
FY19 dividend payments totaled $2.44. In March of 2019, KSS raised its quarterly payout for FY20 by 10%, from $0.61 to $0.67.
The company paid a dividend on April 1. On April 15, 2020, the company suspended the regular quarterly dividend beginning in the second quarter. The company said, at the time that it is committed to paying a dividend over the long term and it will seek to resume paying a dividend when the environment stabilizes. The 8-K announcing the new credit agreement says that the company is restricted from paying a dividend in calendar 2020 if outstanding borrowings on the credit agreement exceed $1 billion. We are raising our dividend estimate for FY22 to $0.70 for the full year. This is about 30% of the consensus EPS for FY22 and would be about a 2% yield on the current share price. We recognize that the dividend is an important signal, but we care more about financial flexibility.
At the time of the fiscal 2Q14 earnings release, KSS raised the authorization under its existing stock buyback plan by $3.2 billion to $3.5 billion.
Kohl’s has a long-term objective of maintaining investment grade credit ratings. Within that construct the company’s objectives are to reinvest in the business, pay a dividend, engage in opportunistic M&A and finally repurchase shares.
MANAGEMENT & RISKS
The company’s annual report cites a risk from epidemics and public health crises such as COVID-19. The company said that these crises could cause customers to avoid public places and could cause temporary or long-term disruptions to the company’s supply chain. Management also said that an epidemic could affect customers’ financial condition resulting in reduced spending. The company said that a crisis, such as COVID-19 could materially and adversely affect the business, financial condition and results of operations. While none of this is a revelation, it is notable that the company said it.
In August 2008, Kevin Mansell replaced Lawrence Montgomery as CEO. He joined the company as a divisional merchandise manager in 1982, and worked in the retail industry for about 40 years.
Michelle Gas, the company’s chief merchant, succeeded Mr. Mansell when he retired in May of calendar 2018. Ms. Gas joined Kohl’s in 2013 and previously served as a regional President for Starbucks for Europe, the Middle East, Russia and Africa.
In calendar 2017, the company hired Bruce Besanko as CFO to replace Wesley McDonald. Mr. Besanko has been CFO of Supervalu and OfficeMax. We met with him on a number of occasions pre-Kohl’s, and we have been impressed with his insights and candor. He is a 26-year veteran of the U.S. Air Force. In October.
In our view, the greatest risk for Kohl’s is maintaining its niche in selling quality merchandise to value-conscious shoppers. The middle market, for apparel in particular, is a highly competitive business. The company must strike the right balance between exclusive brands and national brands, and make sure that it doesn’t abandon its core shoppers (women with household income of about $60,000 who shop for themselves and their families) as it attempts to add new and stylish merchandise. Historically the company has done a good job of giving core shoppers the merchandise they need with just enough sizzle to win additional business. Comps were disappointing for a few years, FY17 comparable sales were down 2.4%, FY16 comps were up 0.7%, FY15 comps were down 0.3% and FY14 comps were down 1.2% and FY13 comps were up 0.3%. FY18 appeared to be an inflection point. FY18 comps were up 1.5% and FY19 comps continued, up 1.7%. Unfortunately FY20 comps were down 1.3%.
Kohl’s faces pressure from full-line department stores (like Macy’s) and specialty retailers (including Dick’s Sporting Goods for the important categories of athletic apparel and the broad category of sneakers) on the high end, J.C. Penney in the middle, and the discounters (Wal-Mart and Target) on the low end. Target is a particularly good competitor for kids, home, seasonal items and we also believe that off-price retailers, such as T.J. Maxx, are a source of competition (although that tends to be a slightly more affluent shopper.) With almost 20% of Kohl’s sales coming from products for the home, the company also faces competition from Bed Bath & Beyond and Pottery Barn, as well as Wayfair, Target, JCP and TJX’s Home Goods. Amazon is an emerging risk for Kohl’s, as it is significantly expanding its offering of clothing, from basic slacks to designer purses and exercise gear. Amazon already has a big offering of toys, small appliances and home goods.
Management also faces execution risk with e-commerce investments and the need to make the right fashion choices. This is increasingly important with retail industry brick-and-mortar traffic declining by about 5% annually in calendar 2019. Sales per square foot declined to $224 in FY17 from $231 in FY13 and from $262 back in FY07. Kohl’s delivered small improvements to $229 in FY18 and $231 in FY19, but dipped back to $229 in FY20.
Another risk is one that every retailer faces: the health of the overall economy and the strength of discretionary consumer spending. In 2006, the company sold its private-label credit accounts to JPMorgan Chase for about $1.6 billion. This probably slightly reduced the company’s overall risk. In August 2010, the company announced a new agreement with Capital One that became effective in 1Q12. In the 1Q15 release, management announced an extension to 2023.
We believe that less affluent customers have, at times, seen their budgets squeezed by higher energy prices, by restricted access to credit, and higher food prices. This is a challenge for Kohl’s which serves a more moderate customer than Macy’s. The business is also somewhat seasonal; about 15% of sales come during the back-to-school season and 30% during the Christmas holiday season. Its monthly sales can also be hurt by the weather. Kohl’s has about half of its stores in the Mid-Atlantic, upper Midwest and Northeast, where year-over-year weather differences be an issue, particularly in the spring and fall. This can create some short-term sales volatility.
The company was not involved in any material legal proceedings at the end of FY20. There is some regulatory risk as described in the annual report. Protection of customer data and credit card numbers is a growing challenge. A data breach could hurt sales if it occurred during a busy shopping period.
Based in Menomonee Falls, Wisconsin, Kohl’s Corp. About 28% of the $18.9 billion in FY20 sales came from women’s clothing. Menswear and products for the home contributed about 20% each. About 40% of sales are from private and exclusive brands that are tailored specifically for Kohl’s. This is up from 25% in FY04, but down from 48% in 2015.
KSS shares have lost about 28% this year. While valuing the shares is very difficult, we will use our FY22 estimate of $2.20 and assume that the shares reach a previous estimate of $3.20 in FY24 (which is close to the current consensus). We then assume that earnings will grow at 6% for the next two years. That would take EPS to $3.60. We are assuming a terminal multiple of 10-times earnings, which includes the assumption of steady-state growth of 2%, a 75% payout, and a 10% cost of equity. Discounting this to the present at 9% puts the value of the shares at about $24. There is obviously greater-than-average uncertainty embedded in this analysis. Our focus is still on stocks with steady earnings, while KSS and other department stores remain under pressure from the COVID epidemic.
The new agreement with Sephora raises our optimism for Kohl’s. If sales come back faster than we are expecting, if e-commerce profitability improves by more than we expect or if the company restores financial strength more quickly it would raise our valuation estimate. We will update our estimates for Sephora in a coming note.
On December 1 at midday, HOLD-rated KSS traded at $36.40, up $4.20.