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Takeaway: After 3-yrs of bullet proof margins, KSS is starting to show its true less-profitable colors. It’s just beginning.

Bad quarter for KSS. Deleveraged a 2.9% comp decline (missed 50 bps) to declines of 16% in EBIT and 18% in CFFO (-35% ytd). Importantly, gross margins – which have been rock solid at KSS for 3-years – finally started to crack, while credit income stopped growing. The company beat EPS by 2 cents by pulling back on SG&A which seems bearish for go forward revenue.  Management put a lot of focus on improving trends and positive June/July results.  That is putting a lot of pressure on 2H results, and a high bar for a company showing weak fundamentals. What really will matter for this stock is can Amazon returns actually add material earnings to KSS. Our math says No, and yet costs are already ramping to support the initiative that Amazon will eventually be rolling out with other retailers (ie the biggest flaw in this deal is that it's non-exclusive). For details see our black book from April, KSS Sleeping With the Enemy, Link: CLICK HERE. Ultimately our estimates are 5% below the mid-point of guidance for the back half of the year, which should mark the last year that KSS prints EPS starting with a 5 ever again. Best Idea Short.

KSS | The Model Is Cracking - 8 20 2019 KSS Fin Table 2


Comp Trend and Amazon

The company was very clear about the improving trend for sales throughout the quarter, with the press release seeming to imply that Amazon returns aided that.  CEO Gass rightfully downplayed Amazon’s impact on the comp trend noting in Q/A that the improvement started before the Amazon nationwide ramp. We would argue that the improving trend could have simply been due to the comparison set-up last year. May was strong in retail in 2018, June and July were less strong.  We expected improvement throughout the quarter.  Meanwhile the company is clearly guiding increased expenses around the Amazon initiative, after we heard from bulls previously that they wouldn’t need extra labor and the reverse logistics cost would be negligible.  By our math, the 1H store comps were down just over 6%, hence the company’s focus on trying to get more traffic to the store.

All the commentary about improving trends is raising comp expectations, though the market doesn’t believe it or doesn’t care given the margin risk.  What matters from here is whether Amazon returns can drive real incremental comp, and that the sales come with an accretive margin profile given incremental SG&A and 25% off coupons handed to package returners (we don’t think so).  The problem doesn’t end there though, as it is important to remember that any real success will mean copycats start popping up diluting the traffic benefit. Don’t forget Amazon announced a new service called Counter, where you will be able to go to a store to pick up Amazon packages. Rite Aid is the first partner Amazon is launching this with over a hundred stores, but Amazon plans to scale to thousands of location with multiple partners. It you can handle package pick-up, you can probably quickly add on returns.


Gross Margins Crack, SG&A Down?

Gross margins down 72bps, the worst quarter in over 3 years.  Gross margins for KSS have somehow been bucking the secular pressures seen by other retailers, but not anymore. We think the biggest driver of previous margin strength was KSS’s ‘standard to small’ initiative, which should see notable diminishing returns as the company hit its 500 store target by end of 2Q last year.  This quarter’s sales/promotion cadence definitely had an impact (Macy’s saw big spring clearance pressure), but KSS is flagging ecommerce dilution on margins, that wont be going away for a long time.  Inventories remain high, so expect some continued merch margin pressure.

Remember that on the 4Q call the company guided gross margin to be up ~10bps for the year. On the 1Q call it was down 20 to 30bps for the year, now down 35 to 45bps for the year.  That’s 50bps different in just 5.5 months.  That gives some context about the actual visibility and control that KSS has over GM% (we acknowledge tariffs are having an impact, but the company was not crediting the changes to tariffs, and wouldn’t quantify the tariff portion).

With retail market wages up mid to high single digits it is surprising and perhaps concerning that SG&A is actually down.  The company is citing expense control, and we think they are removing people/SG&A from the credit card operations, but it’s hard to think there are many levers left in op ex.  Spending is heading higher in 2H according to guidance, but we think the pullback in 1H could be incrementally bearish for comps.  


Ecommerce and Store Fulfillment

Ecommerce accelerated this quarter to mid-teens from high single digits.  Management noted the continued growth/success of BOPIS and BOSS noting 40% of digital orders were fulfilled in stores.  We have to ask the strategic question, is high store fulfillment rates a good thing, or a bad thing?  Store pick-up saves money and drives a store trip, but ship from store is inefficient and low margin, as retailers think it saves money due to bad cost allocation.  Perhaps the bigger question is should you rely on stores to fulfill online orders?  Think about it, KSS has admitted it probably has too many stores and that they are too big.  So why would you want to have more of your total company sales relying on stores for fulfillment when you know you will have to close them down at some point?  We already know closing a store hurts online sales in a given market (out of sight, out of mind), but what about that store being lost as a mini-fulfillment center to the a market of customers.  We stand by the conclusion that store fulfillment of ecom orders in US retail basically equates to delayed capex.


Kitchen Sink on 2H, Yet Only Amazon Matters

There are a lot of initiatives hitting in 2H. Amazon returns, Nine West, Elizabeth and James, expanded Active, expanded Adidas shops, Jason Woo collection, Curated by Kohl's… we’re probably missing something there too.  With all of those coming, the company is guiding to positive 2H comps.  We commend management for trying some unique ideas, but what happens to investor confidence if the company can’t comp even with all of those traffic/comp drivers, and margin pressure from investments that should aid sales growth? Ultimately we think the only piece that matters is can Amazon really drive accretive traffic. These initiatives might get bulls excited, but it’s not a lasting solution to the greater structural headwinds KSS sees.


Don’t Ignore Credit

Other revenue (credit sharing) slowed to 0.4% growth, up just $1mm YY.  With credit revenue at about 80% of EBIT, net credit EBIT (after associated SG&A) is likely in the area of 40% of company total.  There is lot of EPS at risk if we see weakening credit quality.  60% of sales are through the private label card, that means comp risk in addition to the lost revenue/EBIT from the credit card portfolio risk.