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Takeaway: Bulls get ~$5 upside if KSS crushes. Underappreciated TAIL risks open up 40-50% downside. Be careful owning this bc the quarter looks good.

Let’s start with the near term. This quarter likely looks solid for KSS. 

  • The CEO has been out at Q end touting the business on multiple media outlets, it’s not likely the company tanks the print on that.
  • Her PR campaign came after weather inflected to cold, whereas the company was “reminding” investors that it’s business is weather sensitive back before the weather changed. We agree that KSS is one of the most weather sensitive seasonal retailers. Which means sales were likely strong in cool October.
  • Macy’s put up a decent sales quarter with 3.3% comps, noting an acceleration late quarter when the weather changed. 
  • And Macy’s saw strong credit card results, we expect KSS to see strength as well and are modeling an acceleration in credit revenue growth in 3Q.
  • We see the 4Q bar as high, yet there is no reason for the company to guide down yet.  It might even bring in the bottom end of the range by the 3Q beat amount (should it beat, which we think it will).

Some things to consider for the next few quarters.

  • The calendar shift will hurt in 2H 2018. Given the shift seen in 1H, and the cadence we saw back in 2013, we see about 140bps hit to comp in 3Q, then 250bps hit in 4Q.  4Q revenue growth has another ~250bps hit from losing the 53rd week.
  • Weather cadence looks different this year.  Last year (at least in the northeast) we didn’t get the stretch of cold days, like we had this mid to late October, until about mid-November.  That means some fall shopping perhaps was pulled into October this year vs November (ie 4Q comp bearish), we think that matters despite Macy’s management comment today of “So we know that our cold weather business in the fourth quarter is not affected by earlier demand, if you will, that's pulled from the fourth quarter.
  • We’re likely to see diminishing returns on “standard to small” as the company has tapped the last 200 of 500 stores it sees as fit for the format.  They appear to have all been in place by end of 2Q.  Interesting that is sounds like Macy’s is going to start mimicking this exact strategy.  It makes sense, but its not a long term sales & margin driver, it’s a 1-time reduction of inventory that people don’t want to buy and saving on some SG&A.
  • We’re lapping a ramp in Active category sales growth at KSS which was aided by year 1 of Under Armour.  It accelerated from mid teens in 2Q17 to 30% in 4Q17.
  • In 4Q we’ll be lapping the only positive traffic quarter for KSS in last 10.

This year the market has been very near term focused in many retail names where we see severe long term risks to the fundamentals. The market is pricing in the rate of change over the next month/quarter, while ignoring the long term earnings power.  KSS in particular has a few quant funds now sitting among its top 20 holders.  To be clear, we think rate of change investing is important, and it’s something we strive to do well, but only in the context of what we see as the real long term outlook and cash generation of a business. What it all means is that we’ll likely have to see a break in comps and/or gross margins (unlikely this quarter) to see a stock price around the level we think is a fair value for this company ($45 or $50).

But we have to point out the tail risks that are completely ignored with a stock at $80…

Tariffs 

  • KSS sells some products made in China that are getting tariffs.  Accessories are 9% of sales, home is 19%.  Probably a little less than half of those categories are goods under the current tariffs, and probably a little less than half of those are from China.
  • Some of the change will be absorbed by suppliers, and Kohl's could maybe pass on a piece of the increase to customers.  So let’s call it about a 5% increase on 4% of COGS (assuming a 10% tariff). That’s in the area of 12-25 cents in EPS or 2%-5%.  That goes up 2.5x assuming tariffs increase to 25%. 
  • If tariffs expand to apparel and footwear, which is more likely than most people think, then it’s game over.

Credit

  • Kohl's has about $500mm in EBIT ($2.30 in EPS) from its credit partnership with Capital One. 60% of sales come through that private label card.  Whenever the credit cycle rolls over, probably in conjunction with the next recession, this $500mm is likely to do down 30-50% from bad debt, lower fees, and lower balances. 
  • The big callout, is we don’t think it will ever recover to the level seen today.  Penetration on the card hasn’t increased since 2014, and there are fewer cardholders than there were 4 years ago.  Growth in income has only come from fees and higher balances to the same people. 
  • When the cycle rolls, customers will default, and they will have little incentive to get the card when the cycle recovers since rewards can be gained with the tender agnostic Yes2You program.

Lease Inflexibility

A retailer operating in strip center anchor boxes like KSS should have a lease duration of about 7 years.  KSS has a duration of 20 years.  This locks KSS into specific leases losing the flexibility to close a store when its materially underperforming.  This is operational risk for KSS over the long term and we think that relative risk absorbed is giving it ~$2.25 in EPS in lower rent today. In other words, KSS is over-earning by over $2 alone from negotiating below-market rents at the expense of extremely high TAIL lease liabilities and minimal flexibility or optionality on property.

Athletic Cycle

  • Active makes up about 20% of the KSS sales.  It’s penetration doubled in 3-4 years.  The company is now exploring taking active to a much larger floor set in various stores.
  • It made sense to take on more athletic product in the wake of bankruptcies of about a half dozen large sporting goods retailers.  Brands were hungry for wholesale distribution, but that hunger won't last forever, and every major athletic brand is investing in ways to sell directly to the customer.  Increasing athletic penetration today, is a good way to weaken comps in the future.
  • In the end, this is a hindsight buying strategy with long term risk as brands increasingly go direct and the athletic cycle weakens on the margin.

Amazon

Amazon is never buying Kohl’s, we think people are starting to accept that.

  • This partnership for shipping doesn’t appear to be making a big difference. It started a year ago (last Oct) and its only gone from 80 to 100 stores (if it's working why not expand to many more?)… the new 20 are in the Wisconsin area (near HQ) which to us says that the company is still trying to assess whether this actually drives traffic and is worth the cost.
  • Traffic did not grow for KSS the last 2 Qs, and we’d argue management's actions demonstrate this is not driving traffic/comp as much as bulls would expect.
  • The Amazon shop in shop is dangerous.  This is putting Amazon devices into the hands of your core customers.  It’s only a matter of time before they shift more spending to Amazon and away from Kohl’s.  Amazon partnerships only make sense if you are brand bringing content to the customer through Amazon and driving sales because of it.  Kohl's is playing with fire here.

Ecommerce (Deferred Capex and Dilution)

  • The most impressive, surprising and confusing thing about Kohl’s recent fundamentals is the relatively good gross margin results.  We know ecommerce is significantly dilutive (the company disclosed it in an old 10-Q), and with competitors moving to total free & fast shipping this holiday, it's not getting much better. All of the sales growth in the last couple years has come from ecommerce.  Yet margins have held up.  Lower markdowns have been the lever to drive margins, eventually that will run out and we’ll see the dilution.
  • Then there’s the underinvestment.  When a retailer starts talking about leveraging stores for ecommerce fulfillment, we simply consider that to be deferred Capex.  In a future world where ecommerce penetration will be higher for the company, store fulfillment will not be fast/efficient enough.
  • I was in a Kohl’s a couple weeks back and I heard an employee in training that was told he should be able to grab 10 e-commerce orders per hour from the shelves.  Google a video of an Amazon Kiva pick and pack operation, and compare that to 10 orders per hour.
  • So when the company says “We're looking at, right now, what the most efficient fulfillment model would be, stores,  direct from the brands, or the -- a central distribution facility. But right now, the majority of it comes from the stores", the answer is a highly efficient DC, whether localized or centralized, but it's not an associate walking around a department store.