A big KSS headline EPS miss at $0.74 vs $0.86, the biggest miss in 3.5 years. The rate of change improved at the top end of the P&L as comp was exactly as we expected and accelerated 330bps to +0.4%, but gross margin was a little worse than we expected (continuing to crack) down 69bps, vs -72bps last Q, on an easier compare. SG&A growth ramped higher to +3.2% from -0.2% last Q. The market won’t pay for that top line improvement when it sends EBIT down 21% YY. The company is guiding down the year by about 3x the headline miss, implying we were right to think 4Q expectations were too high. After seeing the results this quarter, one has to wonder why did the stock go back to the high 50s? The top line accelerated, but that should have been expected with the Amazon rollout. KSS may have downplayed the Amazon return margin impact for investors, or perhaps there was too much focus on high frequency sales data vs the underlying fundamental opportunity.
As we’ve been saying, KSS will never earn over $5 again, and the way the P&L is heading we see significant downside to EPS over the next 12 months. This year’s revisions are just the start. We’d put a fair value today around $35-$40 (9x our 2020 EPS estimate). If we start to see a real weakening of the consumer and weakening credit quality, we see downside to $20.
KSS remains a Best Idea short.
Amazon Returns
There are still few specifics given on the impact of Amazon returns. KSS did state that “based on the results we are seeing, we remain confident that it will have a positive contribution to operating income in 2019.”
There are 2 things to note there. One is that it the commentary implies it hasn’t contributed to EBIT yet. Second, if Amazon returns is driving EBIT contribution, how bad is everything else to be driving EPS down ~12%+ for the year.
Management also stated that the program is driving incremental traffic into the stores, with disproportionate new customers, and they intend to use it again. However according our math, with digital up mid-teens, stores did not got better on a 2 year basis despite the Amazon Returns ramp.
Given the margin performance relative to sales, the numbers seem to imply that the incremental traffic/sales that Amazon returns is driving is margin dilutive, which we detailed in our presentation in April (KSS Sleeping With the Enemy, Link: CLICK HERE). KSS hopes to leverage the new visitors into long term retained customers. We don’t think that happens, as the customers view the store as a return hub, and the overall shopping value proposition is not great enough to drive repeat customers.
Gross Margin
We outlined prior to the quarter that gross margin has no longer been able to buck the industry trend of dilution from ecommerce given the standard to small tailwind is gone. That remains the case this quarter and this line is driving the greatest variance vs earnings expectations at the start of the year. We suspect Amazon returns are dilutive, as well as the competitive environment creating pressure, alongside the ever-present ecommerce dilution. Going forward we expect retail gross margin weakness to continue in the coming quarters, especially considering that tariffs are an incremental risk that the company is citing no impact from so far. In 3Q KSS offset any tariff risk with supplier concessions, 4Q was not detailed except to say it is in guidance. If tariffs remain, 2020 should see incremental margin risk.
Women’s Still Weak
Last Q management stated, “Our Women's business was positive in June and July combined, and we are confident that Nine West will further strengthen our positioning headed into the fall and holiday time period and beyond.” This quarter Women's was again outlined as a drag, down 1% and the only business to decline this Q. One would think the core user of Amazon returns would be Women who might go shopping online for themselves and family. So shouldn’t we expect traffic strength within Women’s given the storewide rollout of Amazon returns? This suggests to us a value proposition problem in the category for the desired new customer when compared to other apparel shopping options in greater retail. We admit women’s apparel has been challenging industry wide, but with all of these initiatives and investments that should drive greater women’s comp sales, it is concerning to see it still negative and underperforming.
Credit
Other income was up 3.1% this quarter. That adds ~$8mm in revenue that flows in at nearly 100% margin, keep that in mind with EBIT down 21% this Q.
We’re not surprised to see the improvement on the margin as COF's (KSS card partner) delinquency data has signaled a net positive trend in the last few months. However, the inherent risk for credit is building as it becomes a great part of EBIT this quarter.
We think when we see a real consumer slowdown/recession (which our Macro team is noting has a rapidly rising probability over the next 6-12 months) the impact on credit quality will be disastrous for the KSS earnings and cash flow as credit revenue accounts for about 83% of EBIT, net credit EBIT (after associated SG&A) is likely in the area of 40% of company total, or ~50% of EPS. 60% of sales are through the private label card (ie big comp risk in a credit slowdown).
Revisions Upon Revisions
This is now the 3rd EPS guide down of the full year in as many quarters since the March 4Q print set the year at $5.80-$6.15... it's now at $4.75-$4.95. That poor forecasting accuracy, along with the fact that Besanko was out at Q end, and didn’t join the call makes you wonder if the former CFO’s retirement wasn’t voluntary. We think we haven’t seen the last of these downward earnings revisions.
When talking about 2020, Gass mentioned continued excitement around the top line (ie comp growth) and expecting to get back to margin expansion. We think the former is not easy, but possible. The latter seems very unlikely from where we sit. Regardless, the street will likely grab onto those comments when modeling 2020, which will keep the bar higher than it should be on street numbers.
4Q looks doable now with the big guide down, but lets keep in mind, the new CFO Jill Timm was likely a catalyst for the guide down this quarter. She doesn’t want to miss a quarter yet again. And looking to 2020, unless Gass forces her hand, she won’t make the same mistake Besanko did this year. Expect a notable guide down on 4Q print as the street won’t come down enough.
