The announcement of the Sephora partnership for KSS is certainly a positive on the margin for the company, and it's one of the first ‘traffic driving’ initiatives under CEO Michelle Gass we think will actually have some earnings benefit. With that said, we’re not sure the earnings potential justifies the market reaction today. The deal looks relatively similar to what JCP had in place since 2006 with Sephora. Though, it seems this came together awfully quickly as KSS has been investing in its own beauty business and highlighted its growth plans as recently as the 3Q call a couple weeks ago. It did not appear a Sephora partnership was part of the plan then. But perhaps this is what Gass was referring to when she said “you can expect to hear more from us on the beauty category in the months to come.”
The structure of the deal includes an equal split of the operating profit generated from the partnership. So all expenses including D&A will be taken out and the remainder split down the middle. Kohls will recognize all of the sales, it will own and manage the inventory, and it will put up the capex for the build out. Sephora handles the brand/vendor relationships and assortment, as well as training of KSS employees. Sephora is definitely getting the better end of the deal here, as KSS continues to desperately find ways to drive traffic to the store. The Sephora banner, with a 25mm member loyalty program, definitely helps draw in a younger customer that KSS needs, but we’re not sure the incremental traffic and attachment is what the market might be expecting. We’ve gone through a detailed analysis below to try to estimate the earnings opportunity from the deal, both the direct beauty benefit and the opportunity of new traffic attachment in other categories. We’re getting to an annual 1-3 pts in comp tailwind depending on the number stores changed over in a year. In total about 40 cents in EPS opportunity over 4 years. Our math is focused on the benefit from store roll out process replacing old beauty SQFT at ~$190/sf with Sephora at ~$550/sf, the traffic/conversion help on other goods, and a boost to beauty online sales. Perhaps there is some further comp opportunity from category growth, though it may not be overly large in aggregate with beauty only working its way up to ~10% of KSS sales. And Sephora did not seem to be able to create any consistent comp benefit at JCP, or perhaps it’s just too hard to tell within a brick and mortar store model that is becoming obsolete (Kohl’s is not far from JCP in that sense in our opinion).
One concerning part of the story is the Capex requirements. JCP added 74 Sephoras in 2014/15, and it had $322mm in Store Renewal/Update Capex. There were no major store renovation plans then and commentary seems to imply much of that was for the new Sephoras. If we assume just half of this Capex line went towards Sephora build outs, it still means about $2.2mm per store. That would mean a potential step up of $400-$700mm in Capex a year for KSS to implement this initiative, and KSS is planning store exterior work that JCP didn’t do. Maybe this is why JCP’s Sephora store opening cadence was so measured over a decade. If our numbers on the earnings are correct, that seems like a steep price to pay for the implied return, not counting some likely incremental working capital requirements. Also, it appears that the Sephora loyalty program will remain in place for the Sephora shop, meaning a lower incentive for new KSS visitors to get/use a Kohls Credit Card.
$0.40 in EPS over 4 years doesn’t justify a $4.50 stock increase today, and we are much more bearish than consensus on the earnings power of the rest of the business (credit and prior non-beauty retail) as well. We’re wrong today, but KSS remains a best idea short.
As a reminder, we are hosting a call on KSS this Friday where we will debate the line items of our model. We will definitely spend some time giving further thoughts on this KSS Sephora partnership as well as providing updated earnings estimates after digesting all of the variables at hand.
Call Details
Date/Time: Friday December 4th at 10am EST Add to Calendar: CLICK HERE
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