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The Call @ Hedgeye | March 28, 2024

Takeaway: Missing 2H & '19 is written in the cosmos; the market is putting a peak multiple on undoable EPS. 33% downside, then 10%+ EPS decline by yr.

Seriously…find me a worse one. New CEO flowed the entire 1Q beat to FY guide in anticipation of traffic pick-up that will likely never come – at a time when KSS faces the toughest compares in 5 years. Rookie mistake built on hope that cost 7% in a day after +7% pre-market. New CEO sounded terrible on the call, and did not answer questions with any degree of coherence. In order to own this name, you have to believe that it is a growth stock. Period. We’re $0.05 below for the upcoming quarter, 8% below for the year. And 20% below next year. Out to 2020 the consensus is at $5.23, and we’re at $3.85 – comfortably so. There are always spikes on this name around the quarters, but if KSS could not win in this one – then it likely never will come.  Key drivers to our model downside are a) comp erosion – in part to going overweight athletic (now 20% of store) when the cycle is on its last legs. b) weak gross margins due to switch to national brands and dilutive e-comm growth, and c) SG&A growth due to credit income breaking bad.  The Street thinks this is a $5.25-$5.50 earnings annuity – while we have earnings down 10%-20 per year with high confidence. KSS is likely to never to see $5 per share again. Only thing that could help will be JCP going bust, but that’s likely 3-5 years out – and at best 10% recapture. Trading at peak multiple on our number, which is likely to be revalued downward when the company misses later this year. 9-10x a 20% miss into FY19 gets is to a $40 stock – 33% downside – setting up for another 20-30% downside per year thereafter. My confidence in shorting KSS into the summer when retail sales comps get ridiculously tough rivals that of HBI – which says a lot.

Updated model based on new credit and revenue breakout. McLean’s callouts on the quarter below.
KSS | Worst 2H Setup in Retail - 5 22 2018 KSS Earn Table


What Happened:

KSS smoked EPS $0.64 vs $0.50 on GM upside and lower than expected SG&A.  Company guided up full year by about half the 1Q EPS beat. Higher guide is essentially reflective of interest savings.

This is the first time I can recall a full year revision on a 1Q print.  KSS doesn't usually change FY guidance this early in the year, perhaps that's new leadership influence.

Stock down 7.4% on the day on weak comp results (when adjusting for calendar shift).


Revenue:

  • Comp of 3.6%, decelerating 270bps vs 4Q, a 160bps slowdown on the 2 year rate. 
  • This seemed like a decent result relative to the 2.6% street number. Then on the call, management notified us that the 3.6% comp was aided by 320bps of help from the 53rd week calendar shift, bringing May promotions into 1Q.
  • So the real comp was barely positive (+0.4%) while comping against a down 2.7% last year and coming off a +6.3% last Q.
  • Active was up 10%, slowing from +30% last Q... That’s about 2pts of comp by our math.  The company is looking to capitalize in hindsight by testing active expansion in 30 stores, increasing square footage by 40% in the doors.
  • Looking forward you now have to believe in a very material 2 year comp acceleration for the model to work throughout the rest of the year.  We don’t think that happens. 
  • Note that 2Q will see help from the calendar shift as well, from gaining back to school sales/promotions. That’s likely 200-300bps. Then the company gives it back in 2H.
  • Keep in mind KSS is lapping the Under Armour launch last year, which got progressively better as the year went on.  That’s 100 to 150bps of headwind.
  • Management is sticking to its 0-2% guide, the problem with that is a 2% comp probably means a stock around $70, a 0% comp means a stock around $45. Negative = $40.

 
Gross Margin:

  • Gross margin was up 48bps higher than guided and expected taking advantage of the inventory position.  See SIGMA below.
  • Merch margin upside has clearly been offsetting other margin pressures (ecom dilution, private label vs national mix, and freight) in recent quarters.
  • The lack of gross margin weakness over a longer duration despite known headwinds leads us to wonder if there is some benefit to merch margin we have been missing.  One possibility is the Nike/athletic penetration.  Recall FL as it took up Nike penetration saw bad initial mark ups, but then saw much lower markdowns (higher full price selling), and leverage fixed margin costs with high GP dollars.  KSS does not have much fixed costs in COGS, but less markdowns has definitely been a driver of margin. Perhaps persistent athletic growth helps the mix that ends up having to be marked down.
  • Going forward inventory position is still a tailwind to gross margin tailwind.
  • It may be enough to keep GM flattish for the remainder of the year offsetting the other headwinds:
    • Secular pressures of higher ecom/shipping
    • Lower IMUs from growing national brands.
    • Short term freight cost increase.
    • Rising raw material costs hitting the supply chain.


SG&A:

  • SG&A (which now includes SG&A associated with credit operations) was up 3.7%, slowing from the 5% rate seen last Q (adjusting for 53rd week) on the old reporting style.
  • On credit, revenue appears to be up (given that other income was up 2%), and credit SG&A was down ("leveraged" per management commentary on call), so definitely an EBIT help in 1Q at about half point or so of SG&A growth.
  • Management noted the wage rate pressures, but stated payroll management and operational excellence more than offset that.
  • Looking forward wages will still be a pressure, technology investment continues, and credit is likely to get worse as the year goes on.  Credit portfolio growth is tapped, cost pressure from bad debt remains.  We don’t expect a real reversal here unless the credit cycle sees a significant reset (ie big charge off increase).
  • A 3-4% SG&A growth rate is likely the right range for 2Q and 3Q, with 4Q about flat to slightly down lapping the 53rd week.


Cash Flow:

  • CFFO up $341mm, and capex down $83mm were both significantly better than last year. 
  • Accounts payable was a $183mm benefit in working capital.
  • Capex will accelerate into the rest of the year as guidance for $700mm was reiterated, representing a 4% increase YY, despite the lower 1Q number.

What’s Changed:

  • Getting more negative on revenue via comps (better 2Q, much worse 2H as calendar shift helps 1H, robbing 2H).  The 1Q comp was not great given the compare, and that’s before the 320bps help from calendar shift.  Now modeling flat comp vs up 0.9% for the year.
  • More bullish on gross margin. Great results in 1Q with good inventory position, and inventory remains clean.  It appears merch margin upside is able to offset the secular pressures in the near term.  Going from about flat GM for the year to +20bps.
  • SG&A same so the deleverage on revenue hurts. 
  • Interest expense lowered by ~$19mm from notes tender offer outcome.
  • Tax rate taken down to bottom end of guide since 1Q came in below that goal post.
  • At $4.88 vs guidance for $5.05 to $5.50 for the year.  2Q went up to $1.57 vs $1.45 prior and street at $1.66 (before estimate revisions, not sure if that goes up or down)


KSS | Worst 2H Setup in Retail - 5 22 2018 KSS SIGMA

KSS | Worst 2H Setup in Retail - 5 22 2018 KSS Algo