Takeaway: Let’s dig into the TREND factors that could call the ‘dividend cut, then lever up to zero equity value’ call.

My ‘the bears are not bearish enough’ call is predicated on the following…

  • $1.70 per share in ‘at risk’ EPS from credit income that should crack 12 months after peers and partners (ie now).
  • $1.25ps in incremental income from sub-prime consumers over this cycle. Not only 100% linked to credit income, but increasinly at risk given that AMZN just went sub-prime into KSS’ core FICO score base.
  • $1.50-$2.00ps in eggregious lease accounting/structure. In effect, it is paying between $1.50-$2.00 less in rent than retailers leasing the same boxes. The purpose was to push out rent payments – kind of like someone making $60,000 a year that wants to buy a $1,000,000 home and gets an interest only balloon ARM mortgage and has to write a check after it opens up in 7-yrs.

I’ll give KSS the mathematical benefit of the doubt and say this adds up to $5.00 in earnings. So let me get this straight…the company has $5+ per share in earnings that are not ‘real’ or at least sustainable – and yet the Street is modeling that KSS will earn $3.50 in perpituity.

It goes without saying that this is a high conviction short for me, and the bearest of bears are likely not modeling earnings going negative over a TAIL duration with an interim dividend cut, and then the name being valued at 0.25-0.35x sales – or about $4bn enterprise value. That results in equity value of Z-E-R-O, and that’s before the company levers up further. 

So let’s look at the setup – the same one that caused a 15% rally over the past four weeks – and the same one that could cause another 15-20% rally if we’re wrong on the research over a TRADE duration. Let’s look at what could go wrong…

  1. Credit income absolutely has to break this quarter.
    • When looking at the timing of KSS/COF taking up late fees – which prevented income from becoming expense, we should see the initial crack this quarter.
    • I’m 90% certain we see it by the 3Q print. That’s not a ‘positioning hedge’ – to be clear – it’s been part of our thesis..
    • Nonetheless, it is a part of the near-term bear case, and if it fails to play out this quarter, Thusday will be a bad day if you are short (as we clearly are).
  2. Comp… KSS has comped positive only once in the past 6 quarters. Here are some critical factors…
    • There is a very positive Macro setup w the easiest comps of the year in July/Aug.
    • There are no real weather issues to speak of, and the economy is otherwise healthy.
    • ‘The credit card data’ looks good for KSS. At least that’s the buzz. I don’t get that data. And I hate buzz. And I hear that buzz after most funds arguably act on it. That’s the same buzz that was likely planted into the two analysts that turned positive over the past three weeks. But whether I like buzz or not, I have to acknowledge that it exists.
    • At the same time, UnderArmour is on the ropes, and is stuffing KSS with product. There’s no delineation between UA product into KSS and most other wholesale channels – AND our math says that it is – at best a 1.5% comp benefit.
    • But Nike needs KSS more today than it has in about a decade. Nike accounted for over 100% growth in KSS’ athletic business over the past two years – so not much runway left, But still…
  3. GM…inflecting negatively. 1Q inventory position ‘less than good’. Peers ‘investing in price’. And raw materials an issue given the 12-month lag from costs troughing in 1Q last year.  GM should be down (street is flat).
  4. SG&A: the key will be netting out credit vs core sg&a.
    • By our math, core sg&a has been down for 4 out of the last 5 quarters. It’s gone past a level where most of the street that does math is saying ‘it cant go down anymore’. Cutting employees, paying less as the TJ and WMT’s of the world are taking up wages.
    • Credit went from a growth rate of 90% to low teens to mid-single digit and excluding the boost in late fees last year, it grew at only 2% when CFO McDonald prepped to leave. The fact that it has been growing, but at a slower rate, is why the credit call has taken so long to play out when COF, TGT, M, SIG, etc… inflected negatively. Again, credit income needs to go from positive to negative this quarter.

In sum, the ‘earning less than zero with a TAIL roadmap to no equity value’ is a very high conviction call for us. If we’re surprised on the wrong side this quarter – especially given that 19.5% of the float is short – then my team and I will be scouring for puts and takes in the business trajectory that could seriously undermine the structural call here. I’ll literally fall out of my chair (which someone on my team will record and share with you) if we see a thesis changer on Thursday.

-- Brian McGough

McLean’s Model

Macro Set-up. Retail growth in the first half of last year was weak,  and we then saw growth accelerate in 2H. A year ago we saw the worst aggregate retail numbers with July and August growing just 1.4 and 1.3% respectively for retail ex auto.  Discretionary retail (ex auto, gas and food) wasn’t quite as weak, but KSS may have seen an easy comp tailwind in late 2Q into 3Q which could either mean comp upside on the print, or overly bullish guidance with a strong near term sales trend.
KSS | Here’s Your Blow Up Risk     - 8 4 2017 kss chart1 

Revenue
The street is expecting a -1.6% comp number, which would imply a 150bps acceleration on a 2 year basis.
We are modeling a comp number slightly below expectation at -1.7%  with store comp accelerating to -3.5%, and ecommerce growth steady in the mid-teens.

Traffic/Units/AUR
Transactions were down 4.8% in 2Q of last year, a seemingly easy comparison.  However 1Q was facing the same, and KSS still miss comp expectations with traffic down.  AUR last year was essentially  flat, and UPT was up 310bps.  We expect traffic to be down in 2Q, with AUR up and UPT roughly flat.  It is perhaps notable to point out that under new financial leadership (Wes McDonald retired) the company is no longer giving specific numbers for the comp breakdown, but rather up/down commentary.
KSS | Here’s Your Blow Up Risk     - 8 4 2017 kss chart2 

Ecommerce Growth
Ecommerce growth continues to trend lower, 1Q came in at mid teens implying a slowdown on a 2 year basis.  The growth trend has been weak ever since a growth spike in 2014 from a new app launch. With store comps running negative mid single digits, e-commerce is the only growth vehicle, and it continues to trend downward.
KSS | Here’s Your Blow Up Risk     - 8 4 2017 kss chart3B 

New Brands
Under Armour hit KSS stores in mid 1Q.  This was touted as  the "the largest launch in Kohl's history". KSS has guided the brand to add 75-100bps to sales.  Our math puts it closer to 50-70bps of comp benefit.
In 1Q, management said that UA beat expectations, yet is was unable to drive positive traffic or a comp acceleration. Perhaps 2Q will see more impact with some back to school shopping.  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 do have to point out that even with launching in ~1500 new distribution points with KSS and DSW this year, North American revenue still slowed to 0%.  Going into KSS is the move of a brand that is struggling to find quality growth.
Reminder that Apple watches launched in 4Q, so still a couple quarters of potential help there.
KSS | Here’s Your Blow Up Risk     - 8 4 2017 kss chart4B

Nike
Nike is far from new at KSS, but its significance should be top of mind. 
The brand has gone from growing in the low 20s at KSS in 2015, to mid teens in 2016, to high single digits in 1Q and has had its own growth struggles in North America.
Running the math, the comp tailwind from Nike has trended from as high as 100bps to now less than 50bps.  Continued slowing for Nike and the athletic category would mean significant slowing in comps, as this area has been boosting comp growth for several years.
KSS | Here’s Your Blow Up Risk     - 8 4 2017 kss chart5 


Gross Margin
Street is looking for flat gross margins YY.  We are modeling 25bps of contraction. 
The company saw inventories inflect negatively relative to sales in 1Q, and the sequential compare is more difficult as 2Q is facing +50bps vs 1Q that faced -139bps.

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 10-20% 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 both 4Q and 1Q as the inventory spread with sales got worse on the margin.  This may not be the quarter where margins have to take a hit, but building inventory, with positive margins, like we saw in 1Q is a dangerous set-up for the upcoming quarters. 

SG&A

Cost Cutting?
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. Leverage on negative sales has only been done by KSS in 4 quarters in the last 10 years.  However the question remains how much cost can this company cut out of the business?

We don't know for sure how much leverage there is here, but it is a rather lean company. Ultimately if KSS is pulling SG&A without closing stores, we'll simply get more bearish on traffic and comps. As lower SG&A means less marketing, less service employees, worse store experience, which means traffic down, traffic down, traffic down.
KSS | Here’s Your Blow Up Risk     - 8 4 2017 kss chart6

Credit
Credit is the most unappreciated aspect of the KSS thesis for KSS.  EBIT from the credit card portfolio agreement with Capital One now stands at 35% of EBIT, and 46% of EPS.  We think credit will inflect from a tailwind to a headwind in 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 late fee for the card.  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.
After 3 months of slowing, delinquencies at COF accelerated in June.
Meanwhile the Fed's Senior Loan Officer Survey has banks hovering right around the 0 barrier between net easing and net tightening.  If it moves into tightening for a sustained period of time, that would be a very bad macro signal for KSS credit income.
KSS | Here’s Your Blow Up Risk     - 8 4 2017 kss chart7
KSS | Here’s Your Blow Up Risk     - 8 4 2017 kss chart8

Fulfillment Center
KSS's new e-commerce fulfillment center late in 2Q.  Management says the facility will be about 3x the productivity of the fleet.  Perhaps that means some margin tailwind in the long run, but ramping it up could mean margin headwind until its operating at capacity.


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 which is now opened as of late 2Q17.  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.

KSS | Here’s Your Blow Up Risk     - 8 4 2017 kss chart9