Overall the print much as we expected, and this selloff is well deserved. We’d press it…there’s more downside to come. Fair value on this stock is $8-$12 range, bear case would put $0 equity as a possibility. As expected, KSS put up a headline beat, -25 cents vs consensus at -88 cents… we were at -6 cents. Ugly quarter from absolute basis – especially on a day where names like HD and WMT put up killer growth algorithms. In line with our call heading into this event, the recovery in sales has stalled out and the company comments suggest it will struggle to meet sales expectations in 2H. Credit income was weak this quarter, but we think the weakness materially accelerates in 2H as lower credit balances being experienced today turn into an actual spike in delinquencies due to lower levels of stimulus and no increased forbearance. We expect fundamental performance vs expectations here in 2H is likely to be the negative catalyst for the KSS stock, so far given today’s print and trading, that looks to be the case. KSS remains a Best Idea Short for us as we don’t think EPS will bounce back above $1 over a TAIL duration, nor will the company restart the dividend accordingly. Even with today’s selloff, the stock remains downright expensive. For our note from last week see KSS | Thoughts Into the Print
Comps
As we expected commentary indicates that the recovery in comps stalled out this summer, as management noted that July actually softened due to stores near virus spikes. It seems stores have remained around down 25% since late June. Management noted back to school started soft, we don’t think that will change as we’re within about a couple weeks from school starting (where there will actually be school). If we look at the mix, for the quarter digital was up 58%, with total sales down 23%, that means stores on average were down about 42%. Ecommerce in May was up 90%, when open stores were comping down 55%, so that means stores have ramped, and ecommerce has slowed rather materially. So we think that means 3Q is running something like stores down 25% and ecom up 25% or comps of ~-14%. Given the stimulus/government benefit tailwind is waning, and there is no signal of store improvement recently, we think the quarter finishes around that down mid-teens level. The shift to digital of course means sales come at a lower margin. Our current outlook on 4Q is stores improve to down mid teens, and ecom slows to up mid teens, meaning negative mid to high single digit comps.
When talking about holiday the company noted it intends to be lean on inventory going into the season, something we expected to hear. Inventory was down 26% at Q end, though as we have visited local stores in recent weeks, there appears to be plenty of product present, and lots of spring clearance, which we think means a lot of inventory reductions are on what has been ordered and in the DCs/supply chain. That means limited/reduced assortment and likely weak sales for 2H, and the company expects a continued promotional environment and margin pressure potential.
Credit
Other revenue, where credit is booked, was down 26% this Q. The company cited lower receivable balances from lower sales as the driver. That means credit income is down materially with seemingly no real negative impact from bad debt yet. The dynamic that is driving lower delinquencies (paying down balances on time) is currently driving lower portfolio revenue generation. We think in the coming months as borrowers lost the discretionary help of government benefits, and assuming we see lower levels of stimulus continue and no increased forbearance, bad debt will start to spike given the US unemployment situation. So the credit gross revenue will be down, and the shared expense will be up, and net credit revenue for KSS will fall dramatically. We also think the timing of this impact is being shifted and spread out over a longer time period, so 2021 is looking less likely to see a snap back in credit profits.
Lastly, in talking SG&A benefits the company mentioned less credit expenses. KSS does the servicing and marketing of the credit card, so reduced card marketing expense makes some sense. If the company is cutting more than temporary marketing, then it might be a sign it doesn’t think the portfolio will be recovering anytime soon, and/or an expense that would have to return and offset future credit upside.
Margins
As noted above, the sales penetration shift to online will continue to be margin dilutive. Mix is also a drag as home (outperforming) is lower margin while apparel (lagging) is higher margin. That trend likely continues for several more quarters. The company is still using reduced salaries and cost cuts that cant be sustained over the long term should business recover. Meanwhile WMT and other retailers are paying employees higher wages for their efforts during the pandemic, that means wage inflation for KSS or at a minimum weaker relative labor quality. Covid procedural expenses remain, and then as we look our farther, we think inflation is starting to take place within the Macro Quad3 environment which could mean COGS inflation and further margin pressure as the consumer will likely not be willing or able to endure higher prices.
Cash/Leverage
Given the trend of business and the leverage situation, it seems it will be a long time (12 months+) before a dividend returns for KSS. The business is being managed to preserve cash and keep some equity value longer term. Leverage is currently over 3x Net Debt(incl leases) to our 2021 EBITDAR.
The market appears to be realizing that recovery earnings (or at least 2021) is likely to be below $1.00. With how we see the model playing out, we think fair value on this stock is $8-$12 range. Though with the current state of business, if we don’t see notable improvements over the next 12 months $0 equity value is very much a possibility.
