This story is riddled with $4.00ps in ‘uninvestables’ when it will be lucky to earn $3.50 ever again. Credit needs to crack for a sell-off. By mid-year? Yes. By Thurs on CFO’s last conf call? No.
Here’s the setup into Thursday’s print.
- Macro better on the margin vs last year and 4Q.
- Biggest ‘squeeze event’ is that KSS is comping against the first of four straight quarters of the biggest contraction in ‘transactions’ its seen this cycle.
- Transactions were down 4.8% in 1Q of last year. Last time KSS comped against a traffic number that bad was 4Q14, when KSS put up a 3.7%, best comp the company has seen since coming out have the recession.
- Ecommerce growth is approaching new lows, which is a major #fail. But e-comm is 800-1,000bps GM dilutive. Weaker e-comm growth helps margins, perversely.
- Also on GM, inventory position good headed out of 4Q = GM bullish
- People are talking UnderArmour KSS launch. Why? At best it’s 2-3 cents on an earnings base of $3.50. People should be talking credit, which is the equivalent of 68 UnderArmours (no joke).
- All in, we need credit to crack this quarter. We think it cracks in 2Q. But will Wes McDonald guide as such on his last conference call as KSS CFO? Doubtful.
All in, this story is absolutely riddled with risk.
- It’s got $1.70 in credit income, which looks like it’s about to turn from a 9-year tailwind to a headwind.
- It’s got $1.25 in EPS due to egregious lease terms – a weighted 23-year average which is more than 3x ‘property peers like DKS and BBBY’. There’s no way out and no ‘dirt sale’ optionality.
- It generated an incremental $1.00 per share in sub-prime customer earnings, IN ADDITION to the $1.70 it earns by allowing them to borrow at 24% via CapitalOne. #risk
That’s about $4.00 in ‘uninvestables’ for a company that is unlikely to ever earn more than $3.50.
Let’s be clear about this…the call I HATE making (aside from ones that end up being wrong) are the good ‘ol “I like the idea, just not this week” call. But I’m gonna say that today. The risk is to the upside on this print – even if KSS gets something right by accident.
Here’s McLean’s modeling assumptions…from Macro to revs, credit, etc…
Macro Set-up
At this point in time last year, Retail Sales accelerated as department stores slowed on the margin. Now we see department stores improving on the margin in the context of healthy overall growth in the economy. There’s no reason to assume that share loss is not accelerating, but at face value it’s a more positive macro set-up for KSS than last year.
Recall that last year, the 1Q print was a major negative catalyst for KSS. The company missed EPS by 16% and missed comps by 410bps after stepping up the non-deal Roadshow schedule. Not exactly a ‘HBI 4Q cash flow event’, but it was close. Management also guided down, to at or below its prior full year range. The stock completed a 3 day drop of 17%, having already started a downward move after a M comp miss two days earlier.
Revenue
Transactions per Store is getting ready to comp against a major downdraft exactly four quarters ago. That’s probably the most bullish factor in this quarter for KSS. KSS is never immune from missing an ‘easy’ comp. But if there was ever a time to surprise on the upside, now is it.
The Street is expecting a -0.9% comp number, which would imply a 150bps slowdown on a 2 year basis.
We are modeling a +0.9% comp with a 90bps underlying comp improvement at the store level, and a low teens ecommerce growth rate.
Traffic/Units/AUR
Transactions were down 4.8% in 1Q of last year. Last time KSS comped against a traffic number that bad was 4Q14, when KSS put up a 3.7%, the best comp the company has seen since coming out have the recession. Units per transaction were up 1.9% last year, while AUR was down 1%.
Ecommerce Growth
Ecommerce growth is approaching new lows, growing just low teens in 4Q, the worst since the new app launch in Fall 2014. With store comps running negative mid single digits, e-commerce is the only growth vehicle, and it continues to trend downward.
New Brands
Under Armour is the headline brand debut this year, with management touting it as the "the largest launch in Kohl's history". KSS is guiding the brand to add 75-100bps to sales. Our math puts it closer to 50-70bps of comp benefit. After reviewing the product in a couple KSS stores (an admittedly small sample) the Under Armour displays seem to be focused on selling kids clothes/shoes. We think the comp benefit is likely to come more from incremental traffic shopping that brand, rather than higher conversion from shoppers already in the store. With that set-up, a comp boost is probably more heavily 1H weighted with the buzz around the launch.
The other brand addition is Apple watches which were launched in 4Q.
Gross Margin
Street is looking for 60bps of gross margin expansion in 1Q. We are modeling 75bps of expansion, with the company in a much better inventory position than it had last year, while being mindful of the following margin pressures...
E-commerce Dilution
With online sales at about 1000bps below stores, the gross margin headwind remains. Though ecommerce is growing as a portion of sales, the fact that growth is slowing puts the negative margin impact about inline with last year, which we estimate at 15-20bps yy.
Price/Cost
With two large competitors (TGT and WMT) noting that they are investing in price, AUR could see pressure at KSS.
At the same time we see cotton prices up 30% yy. Vendors will likely be trying to pass that cost off to KSS, probably unsuccessfully. But either way there is margin compression pressure from both price and cost.
SIGMA
The SIMGA move was negative back in 4Q as the inventory spread with sales got worse on the margin, at the same time margins weakened. This signal is bad for the trend set-up, however with a very easy compare in 1Q, if the company doesn’t reverse the SIGMA move, it would be a VERY bad read on 2Q and 3Q gross margins.
SG&A
Credit
Credit is the most unappreciated aspect of the KSS thesis. EBIT from the credit card portfolio agreement with Capital One now stands at 35% of EBIT, and 46% of EPS. We think credit inflects from a tailwind to a headwind in FY 2017, which manifests itself in higher SG&A. 2015 saw charge-off rates at all-time lows, 2016 saw a benefit from an increase in the card late fee. Now as Capital One continues to see delinquencies accelerating YY, we think Kohl's is out of credit levers to pull, and this shared default risk will flow through to the KSS P&L. In 2016, after acknowledging that the Yes-2-You program seemed to be a 1 time comp help, the company also described an initiative to convert Y2Y to credit saying “use the loyalty information that they've completed with their profile to do a prescreen on them for our credit card and try to get people to move along the value path”. That means the credit customer keg is kicked.
Macy's signaled increasing delinquencies in early 2016, in 4Q16 it reported credit EBIT down 26%. We know the Cap One delinquency trend, and now COF is raising its provision for loan losses above expectations.
Last year credit was an $8mm EBIT benefit in 1Q, or 3 cents in EPS. If that inflects to an $8mm drag it’s a 9% EPS hit.
Beyond 1Q, KSS nearly leveraged SG&A in 2Q and 3Q on negative comps in 2016, with gross margins positive. That is an incredibly difficult process to repeat.
New Fulfillment Center
KSS opens its new e-commerce fulfillment center late in 2Q. The company will be rolling back capex and ramping up SG&A for that facility. Though, management notes it will be highly productive given the amount of automation used.
Capex/Cash Flow
Capex is guided to be down 9% for 2017, mainly due to lapping of investment in the new fulfillment center in 2016. That's bullish for free cash flow, however we have operating cash getting cut in half vs last year with an earnings miss and working capital reversing a portion of the cleanup in 2016 on both the inventory and payables lines.
Management - CFO Departing
As a reminder, this should be the last conference call for Wes McDonald who announced in November that he intends to retire this spring. The company has not yet announced a new CFO.
