4Q Print Overview
The high level view of the KSS 4th quarter was known given the holiday sales announcement. Guidance is perhaps better than feared, but it’s a large range and implied EPS is down YY at both goal posts. Rate of change is weak trend as comps slowed on a 1 and 2 year basis, and gross profit and EBIT slowed. Gross margin was as we expected down 82bps, and SG&A was slightly better up 2.8% slowing from last Q. The interesting point for us was other (Credit) revenue was up 2.4% YY. This presents a large area of risk for 2020 from where we sit. We’ll see what the company has to say on the call and investor day in 2 weeks, but we think there is likely nothing management can do to reverse the long term earnings decline we see in this business.
1Q Outlook
The company didn’t guide the quarter with detail but noted gross margin should be down more than the full year as the company is clearing inventory particularly in Women’s. We suspect that the elevated promotions level will mean decent sales in 1Q especially against an easy compare, and barring a virus outbreak driven by the “nobody going shopping” situation we suspect KSS comps will be positive in 1Q. Still the company is guiding 40 cents in earnings for the quarter, or a 33% decline YY. That number should be achievable.
Full Year Guide
With this full year guide just slightly tempering expectations, let’s remember that last year the company had to guide down 4 times after the March 4Q18 print guide? set the year at $5.80-$6.15. We think hitting guidance is far from a slam dunk again this year.
Comp sales of +1% to -1% seems plausible with the easier compare if we don’t see the US consumer weaken. However, economic pressures from coronavirus concern could easily make KSS miss here.
The company is guiding 10-20bps of gross margin pressure, while seeing 20-25bps of ecommerce/shipping mix dilution. That implies merch margins up YY despite the planned clearance in 1Q. That seems like a stretch if planning for positive comps. The CFO stated that margins were healthy when the company got inventory levels down in ‘17/’18, but we have to raise the fact that the consumer profile in 2020 is going to look very different than the ramp in consumer sentiment/spending we saw from mid 2017 to 2018 when the company was capitalizing on its standard to small initiative to moderate inventory levels and markdowns. Positive merch margins will be a challenge.
Credit Powder Keg
Credit income from KSS’s partnership with Capital One is about half of the KSS EPS, yet credit was not a topic of this earnings event at all. Nothing was guided and the word was only mentioned in Q/A when talking about investor plans to talk loyalty and credit. Again gross credit/other revenue is now about 90% of EBIT, after removing associated SG&A it’s over 45% of EBIT, and about 55% of EPS.
Macy’s on its 4Q call guided credit down due to bad debt and delinquency risks saying, “we expect credit revenue to decline year-over-year. This will result from the combination of our projected decline in top line sales and our expectations that the slight uptick in delinquency and bad debt continue in line with market trends.”
For KSS Recall when credit weakened in 2016, Macy’s was the first to signal it. And suggesting ‘market trends’ implies Macy’s does not think it’s alone in this risk. From a macro perspective jobs data getting worse on the margin, that’s the key catalyst for consumer credit quality. At the same time the market signal seems to be pretty clear that the consumer will be getting worse.
We’ll be closely listening for that incremental color on credit apparently coming on investor day.
Stores
The one element of KSS strategy that is still surprising to us is that it hasn’t outlined a clear store closure plan. Perhaps closing stores is admitting the structural issues of your business, but one would think there is some profit opportunities of tactically closing weak stores. Perhaps this will be a topic of the Investor Day coming up.
Dividend
KSS raised its dividend 5% this Q. I suppose that makes sense as you want to instill confidence in cash flow for investors and reward those that hold onto shares. But now we probably have to start looking at when the dividend might have to be cut. There are no material maturities until 2023, and within our model (which is not our bear case) the cash position gets tight by around the end of 2022. If we are headed into a recession, the dividend cut timeframe is probably trimmed to within 24 months.
What’s It Worth?
Here’s some important math when looking at the KSS value...
By our math over half of EPS is now credit (~55%), so we should be treating about half of KSS as a credit card company in terms of valuation. The relevant card lenders (COF and SYF) are now trading at about 7x EPS. While KSS is trading at ~8.5x, it implies Kohl’s retail is trading closer to 10x.
Now if we back out the credit EPS in both 2018 and 2019, you get to KSS retail earnings down 30% YY in 2019. If we assume credit EBIT flat in 2020, and use the midpoint of guidance for the year, retail is implied to be down about 25% YY in 2020.
Either credit needs to be guided down materially, or the retail side of KSS is likely overvalued, as we would not pay 10x EPS for a business showing 20-30% EPS declines.
With that framework a fair price today for KSS is probably in the area of $30-$35.
Given we see a real risk of a consumer credit rollover, we wouldn’t consider KSS as ‘cheap’ until it’s around the low $20s with a dividend yield resembling something closer to that of Macy’s.
