KSS | …And This Is Only Stage 1 of 3

Takeaway: This is the 1st Stage of KSS EPS permanently being held below $4.00. Stage 2 goes to $3.25. Stage 3 = $2.50 and dividend cut.

All along we’ve been saying that KSS would never earn $4.00 again. While today’s rather dramatic guide-down will make this premise seem a reality for some doubters, what we find most interesting is that this is only midway through Stage 1 of what we think is a Three Stage process to KSS cutting its dividend. Here’s our thinking…

 

Stage 1: Weak sales results as a result of the fact that KSS sells less and less of what consumers want to buy. Sounds overly simple – but it’s reality. That flows through to the gross margin line as online sales cannibalize brick and mortar, and come at a gross margin 1000bps below the company average. True SG&A growth becomes apparent as credit income stops going up as newly emphasized non-credit/loyalty shoppers become a bigger mix of the pie due to launch of Yes2You rewards program.

 

Stage 2: Here’s where credit income (currently about 25% of EBIT) erodes WITHOUT a rollover in the broader credit cycle. The company’s much-touted (but ultimately fatally flawed) Yes2You rewards plan cannibalizes credit income as shoppers can move to a loyalty program that offers similar rewards to the branded credit card but gives the consumers the opportunity to get 2x the points. Once at KSS and once on a National Credit card. That takes SG&A growth, which has been artificially suppressed as credit sales grew from from 50% to 60%+ of total sales over a 5 year time period, from a run rate of 1% to 3%-4%. For a company that comps 1% in a good quarter, this is incredibly meaningful.

 

Stage 3: This is the doomsday scenario, and within the realm of possibility as the credit cycle rolls. On top of the self-inflicted pain we see in Stage 2, we see consumer spending dry up (sales weaken – down 5-10%), gross profit margins are down 2-3 points due to excess inventory, SG&A grows in the high single digits due to credit income (which is booked as an offset to SG&A) eroding, and EPS falls to $2.00-$2.50. Look at any data stream on the credit cycle and you will see that delinquencies and charge-offs are at pre-recession levels. Translate that to KSS, and it means that the credit portfolio is currently at its most profitable rate. Because the company shares in the risk/reward with its partner COF, any weakening in the consumer credit cycle exacerbates the problems brought on by Yes2You cannibalization and puts 25% of EBIT and half of the current FCF at risk. The result, cash flow dries up and by our math, cuts its dividend within 12-months.

 

Other Notables on The Release

The comp in this quarter missed, and believe it or not, the comps from here get much more difficult. This pre-announced $0.30 (7%) earnings miss for a fiscal year is monstrous. The last time a company with the cap and sales base that KSS owned (pre-blowup) missed at this magnitude in a fiscal year was back in 2012 at JCP under RonJon. Prior to that, we have to go all the way back to 2003 when TGT and KSS printed a miss of 11% and 8%, respectively.  

 

This is now the 5th straight quarter of positive SSS comps for a company that hasn’t put a string like this together since 3Q10 – 3Q11. By our math, given that e-commerce sales grew at 30%, brick and mortar comps were down 4% in the quarter. Gross margins were down to the magnitude of 100bps+ assuming SG&A growth of 3-4%.


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