KSS - So What Makes KSS Finally Go Down?

Takeaway: KSS might never earn over $4 again. SG&A cuts and tax benefits can only obfuscate economic reality for so long. 3/1 downside/upside.

Conclusion: We fully get that KSS is the kind of stock that goes up if the company just hits the quarter – even by accident. So the reaction to today’s headline beat is no surprise, even though the quality of earnings is nothing short of horrible. Comps and Gross Margins were weak, but KSS generated $0.06 (5%) of upside by cutting SG&A, another $0.02 due to a lower tax rate, and changed up its guidance policy in a way that steps up opacity around an already cloudy model. Listening to this conference call solidified our view that KSS is one of the worst run companies in retail. There is a culture of complacency with things going wrong in the business, and a sheer lack of excellence. We hate to poke at one of KSS’ internal battle cries, but the fact management talks of its ‘Agenda of Greatness’ is a head-scratcher.  All that said, we also understand that in order for this short to work, numbers need to come down – a lot. We still believe that this will happen.

The company’s current guidance is $4.05-$4.45. We’re at $4.00 for the year. But the part of this story that we think people are missing is that it is likely to earn about $4.00 for the next five years straight. Consider the following assumptions.

1) Square footage: 0.5%

2) Store comp: -2-3%: That’s a 180bp-270bp hit to consolidated comp w stores at (currently  91% of total)

3) E-com: 15-20%, or 140bps to 180bps in consolidated comp

4) Total Comp: -0.4% to flat

5) Gross Margin: -25bp to -50bp. a) E-commerce is lower margin for KSS. b) needs to step up promotional cadence with JCP back in the game. c) shifts to national brands, and d) dept store industry in year 6 of what is historically a 5-yr margin cycle.

6) Gross Profit: down 1% to 3%

7) SG&A: +2.0% as KSS invests to drive e-commerce business. (incl flat depreciation – co already extended its depreciation rate so D&A = $900mm vs $950mm)

8) EBIT: down 10-12%

9) Share Repurchase: $900mm-$1bn annually, or 21mm-24mm shares on a $40-45 stock (at $56 today). Approx 10% EPS accretion.

10) When all is said and done, we’re looking at LT EPS growth flat at best.

Valuation

We are often hit with the “but it’s so cheap” argument with KSS. In certain respects, we can see that. It’s got a sub-6x EBITDA handle, and a Cash Yield of about 8%. But we think that the thing that’s most wrong is the earnings numbers, not the multiples applied to those numbers. We’re basically making the call that KSS will earn $4 (at best) in perpetuity (or at least the next five years). If we want to get academic (which we don’t) and capitalize that by a 10% cost of equity, then we get to $40. That would equate to 10x earnings, which is not a stretch at all for a department store that can’t grow earnings, and where the consensus numbers are 20% too high. $40 is 30% downside from where we are today. If the Street is right on numbers for the next two years, then we think we’ve got about 13x a $4.75 number, which is about $61 (9% higher from here). That’s about 3/1 downside/upside, which is enough to get excited.

As it relates to events that can steamroll the short side, we think they are extremely limited and unprobable.

1) LBO: We’re heard about this a lot lately. It seems to be the rumor du jour when a retailer gets in trouble. Based on our model, we get to an IRR of less than 10% assuming a 20% premium to the current levels.

2) REIT: KSS has 411 owned stores (35% of portfolio) and 12 DCs. Based on our math, there’s real estate value of about $15/share ($3bn), BUT then KSS would have to incur about $250mm in rent if it wants to stay in those stores.  It also makes the mother of all assumptions, in that there’s someone that wants to pay $3bn for a portfolio of strip-mall real estate. The reality is that if there’s any value it is in mall anchor space, which would accrue to JCP (lease buy-outs) or Dillard’s. But even DDS is encountering the biggest problem with this bull case on department stores – it’s extremely tough to find liquidity for the portfolio. No one wants to buy them.

KSS - So What Makes KSS Finally Go Down? - KSS chart2

A FEW IMPORTANT DETAILS FROM THE QUARTER

 

E-commerce:

1) Dot.com growth rate was up sequentially in the quarter from 12% in 1Q. Though unquantified, we’ll peg it at 15% or 300bps sequentially. That would imply 30% growth in July and 9% in May and June. The key here is that the 9% growth rate in the first two months of the quarter is organic (i.e. uninterrupted by the dot.com re-platform).

2) We’ll give the company the benefit of the doubt on the website re-platform in the third quarter. Taking the dot.com growth rate up a few percentage points in 3Q against easier compares.

3) We have a tough time understanding management's conclusions regarding the negative trends we’ve seen in this business. The re-platform explains the 15% growth rate in 3Q13, but not the 16% and 12% rate we saw in 4Q13 and 1Q14 respectively. The re-platform was at best a four month hiccup.

KSS - So What Makes KSS Finally Go Down? - KSS chart3

SG&A:

1) The one area of our model that was off the mark in the quarter.  This is only the 2nd time in 7 ½ years that the company has leveraged SG&A spend on a negative sales number. Initially the beat was attributed to $13mm in incremental credit revenue, that number came down to a couple million by the end of Q&A, about $0.01 of the EPS beat.

2) In order to get to the low end of guidance (+1.5% to +2.5%) we’d have to assume a 2H growth rate of 3.5%. That’s probably the type of investment this business needs going forward, but not the type of spend this management team is willing to make in light of the fact that it hasn’t taken down its FY EPS numbers despite comp numbers that are running 230bps below plan. We’re taking down our 2H SG&A assumptions from +2% to +1% - giving the company an extra $0.07 of EPS.

KSS - So What Makes KSS Finally Go Down? - KSS chart4

KSS - So What Makes KSS Finally Go Down? - KSS chart1