We’ve been wrong being short KSS over the last couple quarters, but we still think the market is over estimating the relative opportunity in 2021 reopening vs other retail players, and is too bullish the long term EPS potential here by far. Given the market bullishness on reopening, positive rate of change on business trends, and the US still sitting in Macro Quad2, we’ll be patient before pounding the table short side here.
For KSS management, this quarter was all about the messaging addressing the criticisms of the activist investors. CEO Michelle Gass and CFO Jill Timm spent gave a significant amount of time and attention to highlighting the initiatives that the company has been executing and new plans to drive new customers, higher spending, and better margins. The execs wanted to clearly demonstrate that they are far from sitting on their hands as it relates to actions to improve the business. We tend to agree management is trying many things and being innovative, but we just don’t think the profit opportunity is there via better management to justify being long this stock at over 21x the EPS number just guided for fiscal 2021. The most notable new info provided was details around the Amazon Returns partnership, which is something both we and the activists group were critical of given the lack of transparency. Management stated “In 2020, we can attribute at least 2 million new unique customers shopping at Kohl's as a result of the Amazon Returns program, 1/3 of which are millennials. And while the details of the partnership are confidential, we continue to see that this is accretive to both sales and profit.” So the team reiterated the contribution, and noted new customers created from the partnership. The problem then becomes the lack of total customer growth, lack of traffic growth, and lack of profit growth despite Amazon driving new customers. This generally highlights the risk around bullishness on the Sephora partnership. We can reasonably assume it will drive some new customers and incremental traffic and beauty sales, the problem is will that be enough to offset the general customer and share losses. We think this business model just isn’t right for the next megacycle of consumer shopping in #Retail5.0. The extra risk for Sephora vs Amazon is that Sephora will require real capital investment. With the capex step up (above street expectations), dividends and buyback will likely be depressed until the buildouts are near complete. This quarter the dividend has been reinstated, but at less than half the rate of pre-covid. 2022 should require significantly more Capex than the starting Sephora stores in 2021.
Given the quarter was preannounced, the most notable new info was guidance. The guided range $2.45-2.95 vs $2.65 looks reasonable to us given we now currently expect credit to improve YY. We’re coming out around the top end of that EPS range. Another consideration for guidance is that the activist group was rightly critical of the 2019 guidance management, the company was far too bullish having to revise down 4 or 5 times that year, and that CFO is no longer with the company. So keep in mind the company should be setting a bar it thinks it can easily beat. Modeling each line item at what we think is reasonable we’re coming out at $2.99 for 2021. Within guidance, management specifically tempered credit card revenue expectations. Last call the CFO noted it would recover in-line with sales. This call it was changed to less than sales, which makes more sense to us given stimulus is likely keep a relatively 'status quo' environment in 1H21 as it relates to card balances and late fees (reduced levels, meaning less revenue for the portfolio). We’ll have to see whether bad debt risk will play a role in 2021, we certainly don’t expect it in 1H given forbearance and stimulus, but Macy’s signaled that it expected some pressure at some point during the year. We don’t mean to spend so much time on KSS credit, but credit revenue is probably accounting for somewhere between 70% and 100% of 2021 EBIT, so it's an awfully sensitive line item within the model. Given what we know about the KSS credit partnership, the cadence management implied makes more sense to us vs last Q. Credit down YY in early 2021, then as receivable balances grow and late fees return in mid-year we should see growth vs last year’s easy compares, then growth moderating in 4Q as compares steepen and bad debt potentially creates some pressure YY. All in we’re coming in at $975mm in other revenue for 2021, though there is still a high level uncertainty within the consumer credit environment looking out more than about 6 months.
Other fundamental considerations we’d flag include the category mix, and wage pressure. On the former, we continue to think from a wallet share/spending opportunity KSS has a significantly weaker tailwind compared to other apparel focused retailers given where it’s taking its category merchandising. Home is now about 25% of the mix, Active is 20%+, and other comfy basic apparel items are probably another 10%. All of these categories were in demand during the pandemic, and we think they will see less aggregate demand upon reopening vs other apparel categories. KSS’s CEO highlighted the opportunity in an enhanced assortment of outdoor and loungewear, again both categories that many people just stocked up on in 2020. So less than half the assortment will have the reopening consumption tailwind of people buying the apparel items they avoided for over a year. That means lower relative sales performance, and less relative merch margin opportunity vs many other B&M apparel retailers.
As for wage pressure, management tried to downplay the risk, saying “we're above $15 in our fulfillment centers. And second, we actually have an average hourly rate for our full timers in those stores that averages $15.” Unless management can explicitly say all employees are above at least $12 an hour, or KSS quantifies the percentage of work hours paid at wage rates $14 and below, wage inflation both from market forces and regulatory pressure remains a big earnings risk.
The rate of change is bullish for KSS given the coming easy compares, and catalysts on the downside of earnings likely won't be evident for at least a couple quarters. We think the market is over estimating the long term EPS potential here by far, but given the market bullishness on reopening, positive rate of change on business trends, and the US still sitting Macro Quad2, we’ll be patient before pounding the table short side here.
