Kohl's: The Ugly Path To The Inevitable Dividend Cut

Takeaway: In the path to the inevitable dividend cut, all that concerns us is an activist that does not know how to do research.

Editor's Note: Today's lackluster earnings release from Kohl's (KSS) sent the shares tumbling -9%, as the company missed on just about every important metric. The stock is off almost -15% on the week, handicapped by the broader economic malaise that hit other retailers like Macy's (M).


Meanwhile, Retail analysts Brian McGough and Alexander Richards have been bearish on the stock for some time now. In a note to clients today, McGough and Richards wrote:


"One thing we want to remind everybody of, however, is our thesis that the erosion in Credit income at KSS (30% of EBIT) will take up SG&A, pressure cash flow, and cause KSS to cut its dividend.”


In other words, the worst is yet to come.


Below is an excerpt from a research note published on February 3, 2016, in which they detail the troubles ahead for KSS. To read our Retail team's institutional research email 


Kohl's: The Ugly Path To The Inevitable Dividend Cut - kss images

KSS | …And This Is Only Stage 1 of 3


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 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.

Cartoon of the Day: The Spin Cycle

Cartoon of the Day: The Spin Cycle - The Cycle cartoon 05.12.2016


"While it should surprise no one who has been on the right side of the US economic, profit, and credit cycle call that the #LateCycle Sectors of the US Economy (Financials, Consumer Discretionary, Tech, Healthcare) are the biggest dogs for the YTD, the pace of the decline in the US Retail (XRT) sub-sector of consumer has caught many off-side this week," Hedgeye CEO Keith McCullough wrote in the Early Look this morning.


Takeaway: In the path to the inevitable dividend cut, all that concerns us is an activist that does not know how to do research.


With KSS trading down nearly 20% over two days, it’d be a waste of time to dwell too much on its worst comp since the Great Recession, its worst gross profit growth – EVER, or beat management up on its gross inability to come anywhere close to achieving goals set out by its ‘Greatness Agenda’.  While those punches have become central to the narrative for most bears, it won’t necessarily help us decide which way the stock is headed after today. We’d argue that estimates need to be cut in half by year three – that probably matters too.


One thing we want to remind everybody of, however, is our thesis that the erosion in Credit income at KSS (30% of EBIT) will take up SG&A, pressure cash flow, and cause KSS to cut its dividend. The point here is that we often get the argument about these zero square footage growth retailers like KSS (and FL, and GPS) that ‘the cash flow is just too good’. Well, we agree that the cash flow is great, until it’s not. And it can change very quickly in this business – especially when you have no other asset like real estate to buffer your cash position.


The progression of the thesis is in three stages, as follows…

1) General erosion in the business, simply due to poor positioning in a bad sector. We’re seeing this today.

2) Erosion of Credit Income as its efforts to attract new customers no longer require the Kohl’s Credit Card to qualify for discounts and promotions. This would boost KSS SG&A by 1-3% annually, which is a lot of KSS. We think this will be a key theme in 2016.

3) A turn in the broader credit cycle. This means fewer shoppers, smaller baskets, less credit revenue into the KSS/COF partnership, higher charge-offs, more delinquincies, and a significant hit to KSS core profit center. This is on top of Stage 1 and Stage 2, which are still likely to hurt along the way. This is at the end of the economic cycle, be it now, later this year, or whenever.


One other point worth mentioning that could presumably ‘blow us up’ in staying short KSS is an activist investor. We put a lot of thought into this, and are 100% convinced that the only kind of activist that could be attracted to KSS would be somebody who does not know how to do research. That sounds like a jab to an imaginary activist, but it’s true.  Consider the following…

1) We have to start with management. This is hardly an all-star management team, but they’re probably as good or better than what a company this size probably deserves. Management has missed some major financial targets, behaved in a puzzling way as it relates to its dealings with the Street, and can’t seem to financially plan its way out of a ditch. But for most of the major brand and store initiatives, KSS management has done what it set forth to do. In reality, we think that if Alan Questrom (the grand poo-bah of Retail CEOs) was put in charge here, KSS would still be terminal.

2) There are no asset sales worth considering. No brands. No manufacturing assets. KSS owns 414 stores, but most of these are in the 7,250 strip centers in the US, which have minimal value to anyone other than one-off developers.

3) The Board is very complacent, and could be changed up, but really has not done anything flat-out wrong.


This is not about the people, it’s not about the brands, it’s not about the physical assets, it’s that KSS was built up 25 years ago for the consumer that existed at that time. That consumer no longer exists. As such Kohl’s stores attract a much lower-end customer, who spends less, but gives up financing income due to their inability to pay for what they’re buying in real-time. This is a structurally impaired strategy and is riddled with risk. But to management’s credit, it’s the only choice it has.  


If someone steps in to go Activist on Kohl’s, someone will need to Activist on the Activist. We’d take that challenge anyday.




Additional Details on the quarter…

Comps: The five quarter string of positive comps came to a dramatic end today with KSS posting a -3.9%, its worst comp since 1Q09 (a la M yesterday), missing consensus expectations by 410bps. More importantly a lot of the value creating tenants of the ‘Greatness Agenda’ are now in year two of implementation, that means comp in national brands, beauty, Y2Y continue to be tough for at least the next two quarters. Management justified its comp performance by a weak consumer environment demonstrated by the Macy’s print yesterday. Yea, the company maintained its comp advantage over M, but the gap tightened. And, more importantly the bifurcation between retail sales growth and department store performance is blowing out.




Traffic: The key measuring stick for the efficacy of the ‘Greatness Agenda’ was traffic. Since its inception, results have been mixed with the most recent data point equal to the worst traffic number we’ve seen posted in the past 5 years. The concept thrived in the early 2000’s because of the convenience factor associated with side-stepping a regional mall. Now there is a new convenient channel…it’s called the internet (actually not so new). But, the point that we think gets lost in the lack of traffic conversation is the fact that KSS has attracted 75% of the potential consumers who could actually shop in a KSS store. That incremental customer won’t be easy to get, and the company will have to spend up meaningfully to get it – something KSS has proven it isn’t willing to do as it looks to take its expensive rate leverage ratio down.




Brick and Mortar Cannibalization: Store comps decelerated to -5%/-6%, the lowest store comp reported since the company started to speak to e-commerce growth back in 2009. E-commerce growth slowed on the margin to 16% from mid-20% in 2015, but a surprisingly good rate in light of the reported comp. That has extremely negative repercussion on the P&L, with e-commerce gross margins and EBIT margins 1000bps and 600bps, respectively, below a brick and mortar sale. It’s scary to us when a CFO steps in front of Wall Street and emphatically states that e-commerce is ‘not as profitable’ when a disproportionate amount of sales are bleeding from the more profitable channel. To help mitigate the margin hit, the company has invested heavily to rollout BOPIS and fulfill from store across the retail portfolio, which amounted for just 2.5% of total sales in the quarter. That won’t help close the margin gap anytime soon.


Gross Margins: On the positive side, the sales to inventory spread improved sequentially coming out of the quarter, as the company cleaned up its seasonal inventory overhang from the 4th quarter. That’s well and good, but as noted above, there are still negative headwinds that persist as the company moves more of its business online and continues to shift its mix to National brands (penetration up 200bps in the quarter). A lot of real estate on the call was dedicated to improved inventory management, but let’s be clear…the same people are still in charge inside the company, and inventory management has always been an issue. We’re not inclined to give the team internally at KSS the benefit of the doubt on this line in 2016 – were modeling ~30bps of GM pressure.




Credit Income Up: There was no more detail given on the amount of credit income growth (we’ll have to wait for the Q), but credit income was up in the quarter. Credit transactions as a percent of sales was up almost 100bps to 59%, in line with what Macy’s reported yesterday. Unlike M, KSS said nothing on its call about potential headwinds from increased charge-offs on this line item for the year. But as we’ve talked about in the past, we think there is material risk to the credit line for KSS (33% of operating profit), as the company continues to push its Y2Y program, now 40mm strong, on the customer. The company is waiting until 2H and its new POS system rollout to fish from its Y2Y ranks in an attempt to add new credit members. We think those attempts will be futile as KSS has already scrapped the bottom of the credit eligible barrel as it took sales from the credit up 1000bps during its time with CapOne.


SG&A Leverage Point Needs to Come Down: Management talked to the need to take down the SG&A leverage point from what has been historically a 2% comp to a 1%-1.5% comp despite ‘significant wage pressure’, the need to continue to invest in omni-channel, and stagnant credit income. The levers in this model are all but dried up, demonstrated by the -4% comp deleveraging into -50% EPS growth. The marketing silver bullet, digital ad spend which was supposed to create personalized interactions with consumers, has been a failure today as management touched on the need for higher cost mailers. All in, we’re near the high end of previous guidance of 1%-2%.


No Guidance Update: Despite the miss and additional commentary on the call suggesting it would be hard to hit the sales and earnings targets, management clearly stated on the call that it was not taking down FY16 guidance, which calls for flat sales growth and 0%-5% EPS growth. No question that Street models are coming down after this print, but this is as clear a statement as any that the management team has very little grasp on the business model or the reasons for its underperformance over the past 15 months. 

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Retail Flirts With Crash Mode | $XRT

Takeaway: The Retail Sector (XRT) is down more than -18% since July 2015.

Retail Flirts With Crash Mode | $XRT - consumer slowing


As U.S. consumer spending mirrors the broader malaise of the U.S. economy, now is not the time to bet on Retailers.


Since the July 2015 peak, the retail sector has continued its slow slide and is now flirting with full-blown crash mode. Here's analysis via Hedgeye CEO Keith McCullough in a note sent to subscribers this morning:


"Not surprisingly, the US Consumer gets that they get the bill when US Growth Slows (Down Dollar = Tax on Real Consumption) and now the US Retail Sector (XRT) which has been a Best Idea in our Macro Themes since Q3 of 2015 is moving toward #crash mode at -18.3% since July 2015."


Retail Flirts With Crash Mode | $XRT - xrt 5 12

(In case you missed it, click here for our current big Macro theme investment conclusions referenced by McCullough.)


Leading the losers today is Kohl's (KSS).


(Note: KSS happens to be on Retail analyst Brian McGough's Best Ideas Short list.)


As McCullough wrote in today's Early Look:


"Not to pick on Kohl’s (KSS), but now that LINE is a bagel, I have to pick on something with market cap. KSS missed the top-line (same store sales were DOWN -4% year-over-year) and EPS came in at $0.31 vs. an Old Wall “expectation” of $0.37/share."



... He continued with this final cautionary note on KSS:


"Ah, but 'it’s cheap.' Yep. Getting cheaper.”


Heads up!

Trump Towers Over Divided GOP

Editor's Note: Below is a brief excerpt from Hedgeye Potomac Chief Political Strategist JT Taylor's Morning Bullets sent to institutional clients each morning. For more information on how you can access our institutional research please email


Trump Towers Over Divided GOP - trump tower


Donald Trump's schedule will be the focus of everyone in Washington today and, for the first time, the presumptive nominee will meet with Speaker Paul Ryan, Majority Leader Mitch McConnell and RNC Chairman Reince Priebus as well as other member of the Republican leadership team. Trump's last meeting with Priebus at the end of March was billed as a unity meeting and ended up being anything but...


Still, we see these meetings as serving multiple purposes for all parties involved:

  1. With Trump now the Party's standard-bearer, today will serve as the first phase of getting the entire team to unify, privately first if nowhere else;
  2. For Ryan and McConnell - both of whom fear down-ticket trouble with Trump at the top of the ballot - the meetings will serve to calm nerves (or ring the alarm) and outline their concerns for holding onto the majority;
  3. This is Trump's opportunity, if we wants it, to claim the Party's mantle and megaphone; doing so, however, carries risk to the brand he's carefully built as an outsider who does not play the Washington game.


With Ryan and Trump publicly trading jabs and efforts building around finding another choice for conservatives, the only thing certain about today is that Trump will be sure to tweet about it.


Trump Towers Over Divided GOP - polling station


Throughout the presidential primary, voter turnout/enthusiasm was at an all-time high, with Republicans eager to move on from a two-term Democrat in the Oval Office. As Trump's ascent became inevitable, the Republican establishment feared his record unfavorability would tamp that enthusiasm and the ensuing turnout gap would siphon Republican votes from candidates down ballot.


Hardly scientific, but as figures roll in from the WVA and NE primaries - the only two held since Trump's had the race to himself - the data suggest those fears may be unfounded. In 2012, primary turnout in NE was a paltry 26.1 percent; this past Tuesday, 26.5 percent. WVA turnout in 2012 was the worst in the nation, both in the primary and general; just four years later, more people returned absentee ballots than voted in 2012!


A Quinnipiac poll this week placed Trump and Hillary Clinton in a dead heat in the three key swing states of FL, OH and PA. While this may appear concerning for both sides, there are a few things to keep in mind.


For one, FiveThirtyEight has awarded Quinnipiac a "B+" in polling accuracy. For another, FiveThirtyEight founder and election-poll-guru Nate Silver tore into the media for making a big deal of the polls so far from Election Day. Taking to 2016's favorite soapbox (Twitter) for an 8-tweet rant on the inaccuracies of such "snapshot" polls six months out.  Of course for his part, Silver held firm from last November through late January that Trump had no chance of securing the nomination. Beware the potholes of political portending.

Dissecting Today's Jobless Claims: How Many Points Make A Trend?

Editor's Note: Below is an excerpt from a research note dissecting today's Jobless Claims data and written by our Financials team. To access our institutional research email


Dissecting Today's Jobless Claims: How Many Points Make A Trend? - jobslatecycle


How many data points does it take to make a trend? That's a question worth asking, in light of the fact that the last three weekly initial claims prints have been sequentially higher. At the low end of the spectrum, some argue that a simple plurality (two) of datapoints constitute a trend. Most seem to think it takes three data points (i.e. 2,4,6) to conclude a trend is occurring. At the other end of the spectrum there are those who argue it takes at least four data points to have the requisite conviction needed for forecasting/extrapolating recent data into the future.


Three weeks ago, claims rose by 9k. Two weeks ago, they increased by 17k, and last week they rose by a further 20k. There are no holidays or distortions in the last few weeks of data that could account for the rise and we're not yet into the automotive furlough season. 


Dissecting Today's Jobless Claims: How Many Points Make A Trend? - jobless claims 5 12


I would suggest that the last 2-3 weeks of data are significant; the last two weeks especially, as they've shown the largest back-to-back weekly increases in initial claims YTD, and they've come consecutively (+17k, +20k). Moreover, they come directly on the heels of the weaker-than-expected April NFP report, which was measured in the week prior to the most recent 3 weeks of rising claims. In other words, taking the April NPF in conjunction with the last 3 weeks of claims data, you have ~7 weeks of weakening labor market data.


We'll see what the next few weeks bring, but I would argue that if the "trend" in initial claims continues higher over the next two weeks, the early innings of a labor recession trend are afoot. 

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