There was an unusually large number of statements from KSS management during the conference call that stood out to us as being in stark contrast to the bullish financial guidance provided. Despite guidance, we’re not making any changes to our model, which assumes that last year’s EPS proves in hindsight to be the highest number KSS ever earned.
Here Are Some Of The Standouts From Where We Sit
- Wage Increases. In commenting on KSS stance on the impact of WMT’s 25% wage increase, Kevin Mansell noted that employees at KSS are not monetarily driven. We understand the sensitivity of making comments about wages to anyone other than the employees themselves – especially the financial community. But he averted the fact that KSS faces the biggest wage risk out of any major retailer (even more than Target) . The fact is that KSS pays its floor associates and cashiers about 6% less than the TGT/WMT average. It even characterizes itself as ‘best in class’ when it comes to payroll optimization, i.e. not paying its employees. We aren’t making a moral judgment, simply following the laws of supply and demand. When we extrapolated the wage increases from WMT ($1850 per employee) to the 106,000 part time employees at KSS, we get to 104bps in margin pressure and $0.62 in earnings. Are we modeling all of that? No. But when the 900 pound gorilla in the US employment market makes sweeping changes to its hiring and payment practices, it’s hard to imagine that KSS won’t feel the impact. No doubt that the company will try to hold off as long as it can, but eventually it will be forced to follow suit.
- Shipping Costs. Kohl’s currently has a $50 threshold for free shipping. In answer to a question about Target’s reduction of its shipping minimum to $25, management said “…free shipping at $25 – that’s something that I don’t think will work for us long-term from a profitability perspective.” They’re right. The irony is that even $50 doesn’t work for Kohl’s either as DTC margins are already 1000bps below B&M sales. The reality is, KSS was forced to drop the free shipping minimum because it needed to incentive shoppers to protect its market share. As KSS commoditizes its merchandise (more National brands) it will have to fight tooth and nail for every point share. TGT’s move is the first domino to fall on the shipping size, but the bottom is not $25, it’s $0 – which is where we think all the major retailers, including KSS, will be within 24 months.
Gross Margin
- The company admitted to the fact that it will face a 30bps-40bps head wind per year from e-commerce. 10bps-15bps come from mix alone, and the other 20-25bps is due to shipping expenses.
- That’s not new to us, and it’s something we already have factored into our model. For the year we are modeling GM down 40bps. How we get there…
- For 2014 we estimate that the -9bps move in gross margin was a function of B&M margins up 45bps and DTC down 50bps. Store level margins are now at 37.9%, 100bps off 2011 peaks. We don’t see it going any higher from there as the company mix moves towards National brands and the Yes2You rewards increases as a % of sales giving consumers who previously didn’t qualify for a 5% rebate.
- In 2015 - we’re modeling B&M margins down 25bps due to the aforementioned headwinds, and DTC margins up 100bps as ship from store helps offset some of the negative shipping impact. DTC moving from 11% of sales to 13.5% equates to GM down 40bps for the year
SG&A
- Rewards Members – Since the analyst day in late Oct. Kohl’s has added 10mm new members to its Yes2You platform. That’s positive momentum in the program for sure, but the most troubling aspect of the increase is that almost 60% of the newest additions are existing credit card holders. Those credit card holders already account for about ~60% of sales and the fees generated from those sales account for about 25% of operating profit.
- Of the 30mm credit users, 40% are now enrolled in the Yes2You program.
- Credit Income. On the call McDonald guided to credit income being up for the year. We’re highly skeptical on that front for a couple of reasons.
- We think that KSS was playing defense when it rolled out the Yes2You program. The company is already tops in the industry in terms of credit penetration at 60% (M is only at 47%), and it got the last bps by switching its partner to COF from JPM. COF has a much lower credit threshold and allowed KSS to scrape the bottom of the credit eligibility barrel.
- Now COF is pulling back the reins – so reaching new consumers is extremely difficult for KSS. Hence the Y2Y. The problem is that you now have 40% of a consumer group who accounted for 25% of operating profit enrolled in a program that lets consumers get double points. Once at KSS and once on a national credit program.
- The manifestation of that will most likely flatten out the curve in penetration (and SG&A offset) until it rolls all together. By our math, $62mm in operating profit is at stake.
