Takeaway: Positive print? Yes. But lighting needs to hit 2x for upside from here. Fundamentals of biz model continue to soften. Short it on strength.

This was the superfecta for KSS. In that a) expectations for the company on this print were at all-time lows, b) the comp came in in-line at -1.8%, c) the company executed exceptionally well on its inventory plan hence the GM benefit, and d) leveraged SG&A on a negative comp for only the 3rd time in a decade. That translated into $1.22 in EPS good for an 18% bottom line beat and algorithm not typical of a company like KSS with a -2% topline leveraging into 14% EPS growth, and cash from ops up 180%.

Those are the positives, but while doing the "short squeeze victory dance", remember that this retailer is unlikely to exist in another 10 years. Until then, the incremental shopper will go here because she has to, not because she wants to. Across an intermediate and long term duration, all of those metrics will go and stay negative, and the dividend is likely to go bye bye.

Here are factors that the market looked right through today, which we don't think you should.

  • Traffic decline of 5% for a two year stack of -6% weakening sequentially by 120bps into 2Q16. And no clear catalyst to change the direction of that trend outside of a material strengthening consumer picture.
  • Mid-teens e-commerce growth, down from 20% in 2015, and no longer the buffer to a store business that hasn’t comped positive more than 1 time in 5 years.
  • Secular gross margin pressure as the company shifts more of it’s i) sales online, which come at a GM 1000bps below a B&M sale, and ii) sales towards national brands, NKE, UA, NewBalance, you name it, which come at lower gross margin than the private/exclusive brands.
  • Unsustainably low SG&A, as the company pulls back on the ‘Greatness Agenda’ investment buckets to manage near-term costs at the expense of market share in a shrinking category.
  • Significant credit exposure, with 30% of EBIT coming from credit income which serves as a net SG&A offset with the portfolio at peak profitability.
  • 60%+ of sales linked to the KSS card users after 5 years of credit expansion to lower quality consumers as industry consumer credit metrics show clear signs of weakening as signaled by CapOne and Synchrony Financial.

There wasn’t one thing we heard on today’s call that changed our conviction level on any of the six points cited above. If anything, the lack of investment in order to prop up the top-line makes us even more convinced that the management doesn’t have a plan in order to re-accelerate growth. We can criticize Macy’s all day long for its current state of business, but at least the company is taking strategic action in order to attempt to remedy the issues. That’s not the case in Menomonee Falls. We still think that KSS has one of the most complacent management teams in retail.

What we’re left with is a stock trading at 11.5x 2016 numbers, which should again prove to be the high water mark for KSS. The bulls might point to the 4.5% dividend or the 11.5% cash yield for valuation support. But we think those numbers look a lot different on an earnings number starting with a $2 handle. So, what’s the upside from here assuming KSS can reverse the current trend, manufacture some top-line growth and margin stability – we think you’re playing for $4.50 in earnings power in 2.5 years. At best that’s worth a 12x p/e, or $54 for a best-case scenario. Discount that back by 10% annually, and you get to $44 right where the stock closed today. If we’re right, then we’re looking at a 10x multiple on $3.40 in earnings next year good for 25% downside from here, and that’s without a material change in the credit cycle. We’d short this on strength.

KSS | Lightning Needs To Strike Twice - kss financials

Full Details…

 

E-Comm Not Providing The Lift

-3% to -5% store comps aren’t new to the KSS story, but the biggest change between what we saw play out this quarter and the historically underperforming store base is the lack of an e-commerce offset to help soften the blow. Some of that may be due in part to the law of large numbers, as of the end of 2Q16 the company had a $2.8bn e-commerce business good for 15% of total sales. Regardless of the explanation for the trajectory on the topline, the fact remains that for this model to work the company needs in excess of a 20% e-comm comp in order to more than offset a store base that has only comped positive 1 time in 20 quarters. One could argue, that the two go hand in hand, but we’d counter by saying that e-commerce across the industry has outperformed KSS current run rate leading us to believe that the company is losing both market share in its stores and online (a channel where the company has actually performed particularly well over the past decade). So it comes down to can KSS generate store traffic, and we think the answer there is definitively no. 

KSS | Lightning Needs To Strike Twice - KSS ecomm

SG&A Leverage Not Sustainable: Let’s put the SG&A cost savings into the context of the longer-term history at KSS. Over the course of a decade KSS has leveraged SG&A on a negative comp just twice. This quarter doesn’t quite qualify as the -1.8% comp translated to 2bps of deleverage, but that’s a technicality. The point here is that the cost savings we saw this quarter are not sustainable over the long term as the company even pointed out today by re-iterating the leverage point on SG&A at 1.5%-2%. Where did the dollar decline come from? From the sound of it, it was primarily on the payroll side with a slight benefit from marketing and a slight increase in credit income. That’s troubling for a KSS who just rolled out BOPIS and ship from store across its portfolio, which require a well-staffed store. There may be a little more wiggle room on the staffing side – but KSS by its own admission is ‘world-class’ in store payroll and is facing ‘significant wage pressure’.

Outside of that there is maybe a couple bps, and we are talking 10s, to whack off the marketing budget, but at 5.3% of sales we think any material step back from here puts the already dwindling market share position, in a category that’s been in a 20yr secular decline, at risk.

That leaves credit left holding the bag. We think there is minimal growth left in the portfolio as the company recognized much of the benefit in credit portfolio growth when it took sales on the card from 50%-60% over a 5yr time period during the company’s partnership with CapOne. That didn’t happen because of sq. ft. growth instead, the two in conjunction loosened credit requirements in order to attract new entrants into the program. Fast forward to 2014, when the company launched its Y2Y credit program which was intended to help curb the traffic problems. Why traffic problems you ask...no new credit customers.

We thought originally that the introduction of the Y2Y program would put the credit income which accounts for 30%+ of EBIT at risk, as credit customers used a 3rd party tender in order to capitalize on double points – once from KSS and once from a 3rd party credit card program. That to date hasn’t proven to be the case – as the credit income has continued to churn higher, not at an accelerating rate by any means, but enough to offset true SG&A growth by about a half a point a quarter. Absent an acceleration in the credit program, which we don’t think is likely given a) KSS has already attracted 75% of the total population who could possibly shop at a KSS store, and b) sales on the credit card already are tops in the sector at 60%, KSS will have to continue to cut costs across the organizations to suppress the true SG&A run rate. We think this benefit heads towards zero.

The BIG risk for KSS is in 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 delinquencies, and a significant hit to the KSS core profit center. We’re just starting to see the rise in charge offs/delinquencies which we think is the first crack in the larger credit issue for KSS specifically, and the department space more broadly.

KSS | Lightning Needs To Strike Twice - kss sga

What Bullets Does The Company Have Left In The Chamber

Transactions declined 4.8% in the quarter on par sequentially with what we saw printed in 1Q, but amounted to a 120bps deceleration in the two year stack to -6%. That’s not a sustainable model, and since any Bullish thesis on KSS has to be predicated on a return or at least reversion towards a positive traffic number, we need to examine the possible tailwinds that could take comps higher. We examine two possible scenarios below, but opposite an improving consumer environment and general sentiment around the department store space which would raise all boats, we are hard pressed to identify any possible fixes over the near term for the company.

  1. The obvious would be new brands. The company has that in spades in Under Armour, but that’s more for headlines than it is for actual results. All in we think it’s good at best for 0.5% benefit to comps in FY17.
  2. More rewards? The company already exhausted the Y2Y rewards program which helped the company towards 5 consecutive quarters of positive comps (the first since 2010-11). That benefit has all but evaporated with the core consumer (i.e. the KSS charge card holder) tripling down on credit, Y2Y, and Kohl’s Cash. The problem is that KSS only incentivized its core customer to get better discounts. Yea, that may have benefitted the company a little bit (it hasn’t been reflected in numbers), but it failed at the main objective which was driving loyalty (and traffic) from a new wave of KSS shoppers. That we think is due in large part to the fact that KSS is 75% penetrated in its current TAM. 

KSS | Lightning Needs To Strike Twice - kss traffic