KSS had a headline EPS beat but overall mixed results on the P&L details. KSS missed comps, down 13.3% vs street at -11.7%. Though that is a notable improvement from -23% last Q. QTD trend was noticeably absent from the commentary, but management cited better store trends in September and October than in August. We think there is risk to B&M trends slowing here in 4Q given rising Covid cases nationwide. Other revenue, which is mainly Credit, was down 25% similar to last quarter. Retail gross margin was better than expected, down only 50bps, the company credited inventory and promotional management offsetting ecom dilution. This drove the majority of upside vs our and street expectations. We’ve been highlighting in our research that for retail in aggregate apparel import trends seemed to imply abnormally low seasonal units, which would be net bullish on margins, but negative on sales. Perhaps that dynamic is at play near term. Can the company deliver strong sales results with inventory down 26% heading into the holiday season? 4Q margins are guided to be under pressure with 100-150bps in incremental shipping/freight charges beyond normal dilution. This quarter had its puts and takes, but management was very bullish on the call. To buy the stock here you really have to be drinking the Kool-Aid that management is serving.
TAIL Targets Are Aggressive
We see big disconnect between the story management is telling and what we think the long term fundamental realities are for the KSS model.
Let’s start with the long term operating margin target of returning to 7-8%. Implied in this number, according to the CFO, is modest sales growth in a normal environment, gross margin improvement and a lower SG&A expense ratio as compared to 2019. We should start by saying that for the last decade the KSS margin has been deteriorating while credit (highly profitable) has been growing. So the underlying retail profit profile was weakening, with the main drivers being ecom mix dilution and store traffic problems. KSS will need to reverse that long term trend to hit the margin targets, we don’t see a clear strategy to address those issues.
Given the big corporate headcount cuts, perhaps a lower SG&A rate is achievable, but the other two assumptions seem aggressive to us.
KSS has really only seen one period of sales growth in the last 6 years, and that was on a big consumer confidence rip aided by tax reform from mid 2017 to mid 2018.
On gross margin, the mix impact of ecommerce is undeniable, and the company actually did a solid job offsetting this with merch margin improvement from its ‘standard to small’ initiative from 2016-2018 which led to less markdowns. The company today is talking about driving value and price investments, yet also expects to have gross margin higher, after a period of driving relatively stable gross margins despite traffic declines and ecom dilution. By our math, the change in digital penetration means ~100bps gross margin hit for 2021 vs 2019. It sounds hard to avoid margin downside, let alone getting upside. Perhaps there is some opportunity on merchandising mix, but keep in mind that Michelle Gass has been with KSS since 2013, and spent the first 5 years as Chief Merchandising Officer. Trying new merchandising strategies now makes sense, but why should we expect the outcome to be materially different? Beauty seems to be a growth/margin strategy, but it comes at the same time that ULTA will be going into TGT. Competitors appear just as motivated in the category.
We believe the long term margin will settle out well below the pre-Covid levels.
Credit Guidance Should Be Ignored
KSS’s comments around credit should be taken with a massive grain of salt. Props to the CFO for providing some credit color in prepared remarks, and it’s great to see an analyst actually ask about it in the Q/A, but we’d caution investors on modeling the guidance implied from the CFO. Her comment was that credit would track with sales (implying a nice recovery on an assumed sales recovery in 2021 lapping Covid). To be clear, KSS management really has no idea what will happen with credit. The recent comments from KSS’s partner, Capital One, imply it doesn't have a read on what will happen to credit card portfolio economics over the next 12 months. If COF doesn't know, KSS management definitely doesn’t know. With such uncertainty around credit quality, perhaps internal modeling of credit in-line with sales is an ok way to go (albeit not conservative), but to think credit income will return to 2019 levels in the near future is something we would strongly caution against believing. Credit profits didn’t correlate with sales through this economic cycle, and given how the portfolio revenue works, there is really no reason to think that should now be the case. In her comments Timm also implied that KSS will convert new loyalty customers into card users, thus growing the portfolio. However the card customer base has shrunk since 2014, despite multiple loyalty tweaks and traffic driving initiatives.
Within our model we are moderating the total impact (2019 peak to 2021 trough) of credit profit degradation from ~$400mm to $350mm. We’re not revising because of KSS’s guidance, but rather because of recent card portfolio results, unemployment trends, and COF commentary on the uncertainty of the future. If there is a credit quality rollover there is also a potential scenario where profits get somewhat better before they get worse as balances rise and late fees return, before charge-offs would occur. Ultimately, we’ll have to see what happens in card trust metrics, the move could be slow, or it could be fast, or could be absent. We’re sticking with what we see as the most probable outcome, that rising underlying unemployment will mean a deterioration in consumer credit quality and card portfolio profits, as has been the case in all past cycles.
