After stepping back and picking apart our short thesis on KSS to see where we could be wrong, we’re sticking to our guns on this one. The reality is that we thought KSS was a great short at $63, and we think it’s even a better one at $67. Was the 3.7% comp better than we expected? Yes. Would we rather have been better positioned heading into today? Absolutely. But we’re sticking by our statement that the year KSS just preannounced is likely the last time the company will ever print EPS starting with a $4. We think that the Street’s 3-year earnings ramp to nearly $6/share ($5.76) is an absolute pipe dream. Over that same time period, we have earnings hitting $3 even (and $2.75 the year after). With a -48% earnings delta, we’re willing to take the beating on a sales comp. If our numbers prove right, which we obviously think will be the case, then we’re probably looking at about an 11-12 multiple on $3 in earnings – or about $35.
We get the whole ‘it’s got good cash flow’ argument. But even at a price in the mid-$30s, the stock would be at a 12% free cash yield. Yes, that borders on cheap, but names like Dillard’s have traded as high as 20%+. Furthermore, we’ll worry about that when the stock is in the $40s. With the stock at $67 today, that’s about $30 downside and maybe $5 upside if KSS pulls one out of the hat this coming year and earns $4.75 ($0.25 above the consensus). To be clear, KSS hasn’t traded at this multiple since March of 2007. It’s already trading at 15x the consensus numbers. To own KSS here you NEED to believe that the company is going to crush numbers. We don’t see how anyone could argue that with any fundamental analytical support.
There are two big points we’d hit on…one short term, and the other long term.
As it relates to shorter term considerations, we think the comparison between Macy’s and Kohl’s is overblown – or at a minimum lacks context. True, the number of times that the perennially-hated KSS puts up better numbers that the perennially-loved Macy’s are few and far between. The quick and easy conclusion on the open that all the hype around new brands (Izod, Juicy), initiatives like Beauty, and the company’s new Yes2You Rewards program have turned this company around. Could they have helped on the margin? They probably did. But consider the following…
a) This is retail, and the best companies occasionally have a bad quarter, and the worst always have their moment in the sun. Just because the numbers were higher by 2% does not mean that earnings are going up by a dollar next year.
b) One X factor this quarter is last year's January washout. KSS comps were -8%, assuming a 14% weight for the month. To be fair, we completely knew about this, and thought we modeled it appropriately. And Macy's had an even greater impact with -10% last Jan, and it put up a 2% owned comp for the quarter which implies a 1.5% comp for January. KSS is the rare standout. But modeling the holiday hangover this year for department stores is particularly tough.
c) People are only looking at Macy’s as a comp here. But consider similarly poor quality retailers like Belk and Bon-Ton (and even Old Navy – which is in KSS comp basket) comped negative all year, and then gave holiday updates that were 500-600bp higher. When you look at KSS’ numbers relative to those companies, it is hardly a stand out at all.
d) By our read, KSS had a killer January in its e-commerce business. This is in large part as it comped last year’s delivery issues, which benefitted it this year. The results mirror the comp differential with Macy’s well.
We think that KSS’ target market is far more tapped than most people think. We think KSS knows this, which is why it changed up its rewards program. But how we’re doing the math, it simply will not work over the long term – and perhaps the shorter term. It offers up meaningful risk on the SG&A line of the P&L.
Keep in mind that KSS is one of the last remaining retailers that links its rewards program to the loyalty program. Or at least it did. The company decoupled late last year. Everyone knows that, but few people talk of the risks. They should given that 57% of KSS sales flow through the card.
Last year – according to Capital One – it booked $805mm in income related to the KSS Card, and then rebated $405mm to KSS (a standard practice in such partnerships). Though this is not unusual, keep in mind that it served as a 9.5% counter-expense to SG&A.
Now with the new Yes2You rewards program, KSS decoupled that card from the rewards program. As such, a customer could shop in a KSS, get full rewards, and then use Amex, Discover, or whatever card, and get those rewards too. In effect, the customer can get similar rewards but double the benefits if they DON’T use the KSS card. So…KSS might still get the sales, but then we’d see SG&A rise simply as the counter-cost begins to deflate.
We analyzed the number of customers that KSS would need to win in order to offset this risk. The bottom line is that for every 5% of the 57% of sales that shifts to the new rewards program, the company has to find about 395,000 new customers to fill the void. In the table below, we built up to the customer count based on KSS’ average basket and visitation statistics. So if the credit card ratio decreases by 10% (very plausible), we need about 800k people in order to offset the $0.12 per share hit in EBIT from lost credit income.
800k customers might not sound like a big deal for a company as big as KSS, but consider the share it currently has of it’s target market. We calculate it two ways, and the results are very similar (scary).
1) Household Share: There are 79,000 households within a 15 minute driving distance of the average KSS store. The company has about 58,800 customers in each market. That tells us that the company has 74% share of relevant households.
2) Customer Share: The core demo for KSS is a 30-60 year old woman, and secondly is a 61-80 year old woman. When we look at this core, we get to a total market size of 73.2mm consumers (assuming that 75% of women in the age group are potential KSS customers, and 5% of males are prospects). Today KSS has about 64.3mm customers. In other words, it has about 88% share according to this metric.
So with extremely high consumer share penetration, KSS will largely be attracting new customers from either a) a less desirable age demo, b) a greater driving distance, or c) they’ll be looking to attract more men. We don’t want to bank on any of those. It’s no wonder that KSS has store productivity that is ahead of Macy’s. It’s not going to get much higher.