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.