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Executives

Wesley S. McDonald - Chief Financial Officer

Kevin Mansell – President and Chief Executive Officer

R. Lawrence Montgomery - Chairman of the Board

Analysts

Jeffrey P. Klinefelter - Piper Jaffray

Robert Drbul – Barclays Capital

Lorraine Hutchison – BAS-ML

Adrianne Shapira – Goldman Sachs

Michelle Clark - Morgan Stanley

Charles Grom – JP Morgan

Lizabeth Dunn – Thomas Weisel Partners

Deborah Weinswig – Citigroup

Mark Miller - William Blair & Company

Kohl’s Corp. (KSS) Q1 2009 Earnings Call May 14, 2009 8:30 AM ET

Operator

At this time I would like to welcome everyone to the Kohl's Corporation first quarter 2009 earnings release conference call. (Operator Instructions)

Statements made on this call including projected financial results are forward-looking statements that are subject to certain risks and uncertainties that could cause actual results to differ materially from those projected in such forward-looking statements. Such risks and uncertainties include those that are described in the Item 1(a) in Kohl’s annual report on Form 10-K and as may be supplemented from time to time in Kohl’s other filings with the SEC, all of which are expressly incorporated herein by reference.

Also, please note that replays of this call will be available for 30 days but this recording will not be updated so if you are listening after June 14, 2009, it is possible that the information discussed is no longer current. I would now like to turn the call over to Wes McDonald.

Wesley S. McDonald

With me today are Larry Montgomery, Chairman, and Kevin Mansell, President and CEO. I will start off by reviewing our financial performance. Kevin will talk about our merchandising and marketing plans. Larry will discuss our store experience and expansion plans and Kevin will close and give guidance for second quarter and the year.

Total sales for the first quarter were approximately $3.6 billion this year and last year, an increase of 0.4%. Comp sales for the quarter decreased 4.2%, driven by a 2.6% decrease in transactions per store. Average unit retail increased 5.8% but was offset by a 7.4% decrease in units per transaction resulting in a 1.6% decrease in average transaction value.

The Southwest region generated the strongest comp sales for the quarter and from a line of business perspective, footwear led the company for the quarter.

Our credit share was 45% for the quarter, an increase of approximately 160 basis points over the prior-year quarter.

Moving on to gross margin, our gross margin rate for the quarter was 37.6%, up almost 80 basis points from last year. The increase reflects continued inventory management, lower clearance levels, and higher penetration of exclusive brands. We would expect gross margin to increase 20 basis points to 30 basis points over last year in the second quarter.

SG&A for the quarter, $961.0 million versus $923.0 million last year, an increase of 4.1%, reflecting our ongoing efforts to control costs in the current economic environment. As expected, SG&A increased more than sales but less than new store growth of 6.8%.

Credit expenses leveraged for the quarter. As you know, we have a revenue sharing agreement with Chase relative to our Kohl's credit card accounts. Even though we continue to see an increase in the number of accounts which carry balances and ultimately charge off, these increases are more than offset by increases in finance charges and late fees, so this business continues to produce positive year-over-year results.

Our advertising and distribution centers and IT organization expenses also leveraged for the quarter.

We would expect SG&A expenses to increase 3% to 4% in the second quarter, less than our store growth of 6.8%.

Depreciation expense for the quarter was $141.0 million versus $130.0 million last year, an increase of approximately 8.5%. The increase is primarily due to new stores. For second quarter 2009, depreciation is expected to be $147.0 million.

Pre-opening expenses were $15.0 million for the quarter, $4.0 million higher than the prior-year quarter. We opened 19 stores in the first quarter of 2009 compared to 28 stores in 2008. Even though we opened fewer stores in 2009, pre-opening expenses increased because a larger percentage of our fall 2009 new stores are treated as ground leases.

Under GAAP we are required rent expense when we take possession of the property. As a result, we must recognize rental expense for ground lease properties several months prior to the actual opening of the store and in most cases, before rental payments are due.

Pre-opening expenses are expected to be $14.0 million for the second quarter.

Operating income for the quarter declined from $271.0 million last year to $251.0 million this year.

Net interest expense increased to $32.0 million for the quarter, compared to $26.0 million in the prior year, primarily due to lower interest rates on our long-term investments and reductions in capitalized interest due to lower capital expenditures.

Interest expense is expected to be approximately $30.0 million for the second quarter.

Our income tax rate was 37.5% for both the current and last year quarter. We expect our tax rate to be approximately 37.8% for the second quarter and the year.

Net income for the quarter was $137.0 million, compared to $153.0 million last year, a decrease of approximately 10% and EPS for the quarter was $0.45, compared to $0.49 last year.

Moving on to the balance sheet, the square footage we grossed for 2009, 9554, a change of 6.6%, and selling of 76,273, a change of 6.3%.

We currently operate 1,022 stores compared to 957 at this time last year, and we closed one store in Pontiac, Michigan, during the quarter.

On the investment line, we had $981.0 million in short- and long-term investments at quarter end, compared to $429.0 million last year. The majority of our $655.0 million of short-term investments are in money market funds.

We have also recorded temporary mark-to-market adjustments of $46.0 million, net of tax, through equity related to our long-term investments, but made no change to that valuation in the first quarter.

Moving on to inventory, inventory levels, basically flat to last year, down about 0.5% at $2.8 billion, and inventory per stores are down approximately 7.0%. This reflects our continued commitment to conservative sales and receipt planning.

Our clearance inventory per store is significantly lower than our total inventory per store.

Moving on to fixed assets, year-to-date capital expenditures were $186.0 million, down 32% from $273.0 million last year. We generated cash from operations of almost $400.0 million during the first quarter and free cash flow was $213.0 million, $133.0 million better than the first quarter of 2008, or 2.5x last year's free cash flow.

Moving on to accounts payable, AP as a percent of inventory was 35.8% versus 33.5% last year and weighted average number of shares, basic for Q1, 304.7 million and diluted 305.5 million.

We have not repurchased any of our stock since July of 2008. We will continue to evaluate market conditions but do not currently expect to repurchase any shares in 2009.

And for your modeling purposes, I would 307.0 million shares for the year.

And with that, I will turn it over to Kevin to talk about our merchandising and marketing initiatives.

Kevin Mansell

As Wes mentioned, comparable sales decreased 4.2% for the quarter with all lines of business and regions reporting a decrease in comparable sales. By line of business, footwear reported the strongest performance, led by children's and athletic shoes. Accessories was led during the quarter by sterling silver, handbags, and fashion jewelry. Men's was led by basics and casual sportswear. In our home are bedding and small appliances performed best. Children's was driven by infants and toddlers and boys and in women's updated sportswear and intimate were the strongest categories.

By region, the Southwest was the strongest region with the Southeast remaining the most difficult. The remainder of the regions performed closely to the overall company comp. We are planning comps down 5% to 8% in the second quarter, similar to our guidance for the year. By month, May should be toward the high end of the quarter, June should be toward the low end of the quarter, and July should be similar to the quarter. Those expectations are primarily driven by last year comparison levels.

From a merchandise standpoint, we are very excited about our recent merchandise initiatives. The Dana Buchman line was launched in February. This classic lifestyle brand spans several categories, including women's apparel, intimate apparel, accessories, and footwear, and ultimately the brand may extend into home, beauty, and fragrance.

Sales have significantly exceeded our plans and we have also seen lift in our Chaps line since the Dana Buchman launch.

April saw the launch of Hang Ten in nearly 240 Kohl's stores and on Kohls.com. Hang Ten is a California lifestyle collection for young shoppers, which we hope to expand to all stores nationwide.

We are also excited about Mudd becoming exclusive to Kohl's in July, just in time for back to school. This partnership expands Kohl's current Mudd merchandise assortment in Kohl's stores nationwide and online.

And finally, in April, we announced an exclusive partnership with Lauren Conrad for LC Lauren Conrad, a contemporary lifestyle brand that will launch in the women's department in approximately 300 Kohl's stores and on Kohls.com this October. The brand is ultimately planned to expand to all stores nationwide.

The success of these recent launches, as well as our other exclusive and private brands, continue to drive increased penetration in these brands to our sales. Exclusive and private brand sales as a percentage of total sales increased 200 basis points to 44% for the quarter.

The consumer continues to recognize our private brands as the absolute best value in our stores, offering quality and style at a competitive price. The credibility of our exclusive brands with consumers has insured that there is immediate acceptance and awareness with our customer at the launch and has been a major reason why each has had so much immediate success.

Moving on to inventory management, as we mentioned earlier, average inventory per store is approximately 7% lower than last year, in line with the mid-single-digit decreases that we had originally guided toward achieving. The level of reduction in clearance inventories is substantially larger, approximately 30% less than last year on a per-store basis.

Within our regular priced inventories, the actual changes by area year-over-year vary widely based on how we have positioned inventories and receipt plans for each area. Some areas, like women's sportswear, are down more than the total store. We have been able to chase sales where appropriate, with our focus on replenishment and shorter lead times and we would expect our inventory per store at the end of the second quarter to be down mid-single digits per store as we continue additional investment in basics and in the Southwest region.

As Wes mentioned, for the second quarter we would expect gross margin to be up 20 basis points to 30 basis points over last year. We believe this allows us to be aggressive in our pricing as we expect the consumer to continue to be very focused on getting the best value and making our budget stretch further.

In marketing, in light of the current economic environment, our marketing efforts will be even more focused than in prior periods. Our campaign, The More You Know, The More You Kohl's, seems to have resonated with our customer. We will continue to highlight the many ways that she can save while shopping at Kohl's: Bonus Buys, Kohl's Cash, Early Birds, and Power Hours. Buy-more-save-more promotions will position us as the smartest customer choice by helping her stretch her budget.

We will also increase awareness and understanding the Kohl's charge benefits, such as Secret Sale and Pick-a-Day savings events. Our Kohl's cardholders are our most loyal customers. They spend significantly more per year than non-Kohl's charge customers and this spending difference is even more dramatic for our best MVC customers. Clearly, our customers realize the value of being a Kohl's charge customer.

Finally, we will take credit for our liberal, no-hassle exchange policy to ensure she shops with confidence every time she comes in.

With that I will turn it over to Larry to discuss the store experience and our expansion strategies.

R. Lawrence Montgomery

We opened 19 stores this quarter, 8 in March and 11 in April, including our entry into Alaska, our 49th state. We plan to open the remainder of approximately 56 new stores in the fall. The vast majority of those fall openers will be former Mervyns' sites.

Many of these sites are irreplaceable where there were no ground-up opportunities or alternatives in those densely populated areas and they are going to provide 100% incremental sales. The acquisition puts us in a strong position to be the retailer of choice in California.

We have made significant progress in that regard, as California posted a positive mid-single-digit comp for the first quarter.

We will maintain flexibility in our real estate pipeline to take advantage of any opportunities that may arise as other chains continue to rationalize their real estate.

We completed 20 remodels during March and we plan to remodel an additional 31 stores this year, with 12 in May and 19 in August, for a total of 51 remodels. This is an increase from 36 remodels last year.

We have been able to compress the remodel duration from 16 to 9 weeks over the past two years in order to minimize the disruption and cost to our stores.

In our first wave of remodels, this shorter duration provided a benefit to our sales and customer service. Remodels remain a critical part of our long-term strategy and we believe it's extremely important to maintain our existing store base, even in a tough environment.

First quarter overall, we saw an 8.4% improvement in our customer service scores over last year due to the improvements made in the physical environment in all stores and a focus on engaging our customers on the sales floor and at point of sale. Customer service will be a point of differentiation in where the customer decides to shop.

With that I will turn it back to Kevin who will give you our earnings guidance for the second quarter and year.

Kevin Mansell

We have outperformed our competitors on a number of metrics during the first quarter and exceeded our earnings expectations. At the beginning of this year we were focused on starting to improve our trend in sales and take market share from our competitors. We feel we've made progress on both points. Sales were better than our plan and guidance, spread across most of our merchandise areas and territories.

Gross margin was the biggest area of out-performance versus our expectations, up 80 basis points for the quarter. The gross margin results were aided by the investments we had made previously in technology, including assortment planning, mark-down optimization, and size optimization.

As a result, we have moved well beyond just cutting overall inventories but are increasing inventory effectiveness by flowing receipts closer to sales, aided by cycle-time initiatives. The results can be seen in the significant reduction in our clearance levels as well as the freshness of our inventories.

As a result, we feel we have increasing confidence in our ability to manage inventories going forward. The reduction in inventories also has had the added benefit of improving our cash flow, which has clearly been a focus for us.

Additionally, our efforts to create a differentiated brand portfolio around exclusive brands that have strong existing equity, have led to a significant increase in penetration of these brands to our total sales. This mix improvement has continued to benefit gross margin results and position us for future new brands, as well as creating a marketing platform for us to create separation from our competitors.

Last year we had indicated we expected further consolidation and rationalization in real estate would open up opportunities for us. The late year acquisition of the Mervyns stores was an indication of that opportunity coming to fruition and we expect those stores to fuel our market share gains on the West Coast and strengthen our existing store base as well.

We believe there will continue to be more consolidation, which may open up more real estate opportunities and our balance sheet and cash flow will allow us to act aggressively if that happens.

We have built more flexibility into our pipeline for 2010, allowing us more time to understand the macro environment, as well as be very selective about the stores we chose to open next year.

Our expense performance matched our expectations even with slightly better sales results. We continue to look for ways to become more efficient throughout the company but will keep as a high priority the customer experience in order to continually improve our results with her and provide consistency across all of our stores.

With that, let me share with you our updated guidance for fiscal 2009 and our initial guidance for the second quarter. We do recognize that our first quarter results overachieved our expectations on several lines, including sales assumptions, gross margin assumptions, and the resulting EPS.

Implied in our guidance, however, is the fact that we don't feel one quarter's results are enough to change our generally conservative view of the remainder of the year. We expect the consumer to continue to be reluctant to spend and demand to continue to be weak.

We use the advantages I described earlier to drive our value position to maximize our sales and expect to continue to outperform our competitors in sales and gain market share during the remainder of 2009 just as we did in the first quarter.

For the second quarter we would expect a total sales decrease of negative 1 to negative 4. Comp sales of negative 5 to negative 8, and gross margin up 20 basis points to 30 basis points over last year. We expect SG&A to increase 3% to 4%. This would result in earnings per diluted share of $0.56 to $0.64 for the second quarter.

Our updated guidance for the year is $2.19 to $2.42 per diluted share, reflecting sales and SG&A expectations similar to those in the second quarter for the fall season and gross margins flat to 10 basis points higher than last year for the fall season.

This guidance does not reflect any additional share repurchases in fiscal 2009.

With that, we would be happy to take some questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Jeffrey P. Klinefelter - Piper Jaffray.

Jeffrey P. Klinefelter - Piper Jaffray

My question is really focused on guidance for the year and what you are incorporating into that outlook for the second half, appreciating that visibility is pretty low that far out, but given your performance in Q1 and even your guidance in Q2, it seems that on a year-over-year basis you would actually be looking at comp deterioration in the fourth quarter versus the relatively negative comps the last two years.

Can you give us a sense, are you basing that on anything that you are seeing in the current sales trends or is simply just a conservative outlook?

Kevin Mansell

No, there's nothing about the current sales trends that impacts our view of the year. I think we started with a generally conservative view, which is specifically based on the economic conditions our customer is facing and the research we've done around her having to really stretch dollars further, and we just kind of feel that one quarter of our-performance to that expectation doesn't make for a good reason to change the view.

So there is nothing particularly unique about how we're coming to that conclusion, we just think we would need a longer time of out-performance in a clear direction that is different than we one we set at the beginning of the year.

Jeffrey P. Klinefelter - Piper Jaffray

In terms of your first quarter and the gains you made in the Southwest and then the comment I think Larry made about California comping positive, all very encouraging and points to share gains from urbans and probably others. Do you feel confident that those were consistent gains throughout the quarter? Any changes on your gains throughout those three months of the first quarter?

And then in Q2, any anticipated shifts in promotions that you had last year that moved around your comps between the months?

Kevin Mansell

From a Southwest and California perspective, we had consistent positive performance. I would say if anything there was increasing momentum during the course of the quarter. You know, April was probably the biggest month of out-performance so I think that felt pretty good.

Wesley S. McDonald

There is not real calendar—there's calendar shifts within the month but as we report the month there won't be anything that really crosses months so it should be relatively straight forward.

Operator

Your next question comes from Robert Drbul – Barclays Capital.

Robert Drbul – Barclays Capital

On the gross margin, so in the first quarter you guided flat to up 10, you did 80. I just wondered if you can elaborate a little more on color around exactly how you did such number.

And when I look at the second quarter gross margin, your guidance is for up 20 to 30 but you have more difficult compares, so what really changed from your original outlook from gross margin expansion?

Kevin Mansell

Well, I think nothing really changed. What really happened is that the combination of really strong inventory management, which together with the technology improvements we made our size and mark-down optimization, drove clearance levels down very quickly and sell-throughs at a higher rate than last year, produce higher average unit retails. That was a positive.

I think overall inventory management by greatest store was definitely a big positive for us that continues to exceed our expectations.

And then naturally, the increased level of private and exclusive brand penetration is always going to be a tailwind as long as we can continue to execute that.

So I guess the simple answer would be execution. The execution was very strong around all three of those things.

The second quarter view is, I think to be fair, we looked at the margin guidance we gave at the beginning of the year and felt that it was only reasonable to raise it slightly, given the out-performance in the first quarter. And without any further visibility into the fall season it didn't make sense to do that for the fall season.

Wesley S. McDonald

The only other thing I would add is last year in the first quarter we still had a little bit of hangover from clearance inventory from fourth quarter of 2007, which was kind of the real beginning of the downturn. So I think our results in first quarter were probably aided by a little bit easier comparison from the first quarter of 2008 and we had significant reductions last year, starting the second quarter and beyond, so the compares are a little tougher.

Robert Drbul – Barclays Capital

And a question on the inventory, can you discuss the initiatives around managing inventories between like the low-, mid-, and high-volume stores. Where are we on this initiative?

Wesley S. McDonald

I think we've made a lot of progress. As you guys probably know, we've done a good job, probably over the last 18 months in our lower-volume stores. As Kevin kind of alluded to in his comments, we made significant progress in the middle-volume stores this year, where in the first quarter their increases were basically the same as the company and we haven't seen that in the last 18 months.

And because our stores are on a bell curve, that's really the big bang for the buck when you can start getting those stores in the middle to have the same margin improvement as the company.

Operator

Your next question comes from Lorraine Hutchison – BAS-ML.

Lorraine Hutchison – BAS-ML

I was hoping that you could update us on your expectations for free cash flow this year and given that you're not planning to buy back stock this year, should we just expect that to build on the balance sheet?

Wesley S. McDonald

Well our expectations, I think, remain to be similar to last year so roughly $700.0 million. As we get through the year it's possible we could raise that if we continue to perform the way the way we have. And our expectations would be to just let the cash build. The banking environment is still a little uncertain. We have $400.0 million coming due in early 2011 so I would like to keep the cash cushion there so if we had to pay it off we could do that without going back to refinance it.

Operator

Your next question comes from Adrianne Shapira – Goldman Sachs.

Adrianne Shapira – Goldman Sachs

On the SG&A it looks like you obviously [inaudible] on the sales line and yet the SG&A spend was at the higher end of the 3% to 4% range. Could you talk about why we didn't see a little bit better leverage there.

Wesley S. McDonald

What we normally do is if we were to run a down 8 we would have been closer to the 3%, if we would have run a down 5 we would have been closer to the 4%. Since we ran a down 4.2 we were slightly over that. I think in Kevin's comments he alluded to we're trying to be more conservative in our store payroll but we're not going to cut it back barebones to destroy customer service. And as evidenced by our score increase of 8.4% I think we've done a pretty decent job of managing store payroll with sales but not hurting customer service.

Adrianne Shapira – Goldman Sachs

And going forward, as Kevin mentioned, aggressive on the messaging. Talk about the marketing spend, what should we expect in terms of as we head into the back half, the back to school. Should we see increases in that year-over-year?

Kevin Mansell

No, we're planning, I think what we said at the beginning of the year we still believe, which is we will spend in marketing in line with sales and if productivity turns out to be better, if we're better at executing then we'll get leverage. And otherwise you would expect to maintain that percent of sales.

Adrianne Shapira – Goldman Sachs

And on the traffic, we're seeing traffic declines are trending about 5 to 6 last year, so meaningful improvement down 2.6. Perhaps this aggregates the difference in terms of what you're seeing in lift in the Southwest as you are clearly picking up from Mervyns. You know, how that compares to those regions in terms of traffic lift versus the rest of the region. Is it pretty comparable or is it a pretty wide range in terms of traffic performance?

Kevin Mansell

Traffic is basically driving comps, so the improvement in comp performance was because traffic improved and the positive comp performance in California and the West Coast was because traffic was very much in line with those comp numbers. And I think our traffic counts for last quarter were down between 4.5% and like 8% for the year. So that the middle 2s is quite a bit of improvement in that trend.

Wesley S. McDonald

The traffic number is the best number I think we have had in six quarters so that's very encouraging. And to Kevin's point, there's not a wide variance in average transaction value across the regions. It's really all about transactions per store that differentiates the comp.

Adrianne Shapira – Goldman Sachs

And tying back, I think the gross margin improvement is obviously very impressive in the fact that you're seeing better traffic. Are you surprised perhaps, you were expecting—we were all expecting—as you point out, a very value-conscious consumer. The fact that you're seeing gross margin improve, do you not have to be as aggressive on pricing and still able to see traffic lifting. Would you have expected to have to be sharper at this point and how you think what that means in terms of as we head through the year.

Kevin Mansell

We consciously were very aggressive in pricing and we definitely offered great value during the course of the quarter and I don’t see any reason why we're going to have to be able to let up on that. We are going to have to be very focused on giving great value. I mean, honestly, simply it was just the combination of the three factors we talked about earlier and I think the team did a strong job at executing flow and receipts and improving our private and exclusive brands.

And as Wes mentioned, the really critical factor was our planning area doing a better job of allocating our inventory across our store base so that our mid-volume stores really had a nice pickup in margin.

But value is going to be really important. That's not going to change.

Operator

Your next question comes from Michelle Clark - Morgan Stanley.

Michelle Clark - Morgan Stanley

Wes, can you remind us what your leverage point is for fiscal year 2009 and what the sensitivity is around that for every 1% of comp.

Wesley S. McDonald

It's basically flat so if we achieve between the 3% and 4% we guided to for the year, that will be what we achieve. Below a flat it's 15 basis points to 20 basis points on the down side, above the flat it's probably 8 basis points to 10 basis points.

Michelle Clark - Morgan Stanley

Are you seeing any negative impact in doors that have a Macy's located within a five-mile radius, given the fact that they're boosting up their localization initiatives.

Wesley S. McDonald

Since we ran a down 4 comp and they ran a down 9 comp I think we haven't seen that big of an effect.

Michelle Clark - Morgan Stanley

On apparel deflation, what are you seeing in terms of cost? What are you seeing today and what do you expect to see in the back half of the year?

Kevin Mansell

I think for fall we're seeing a range of probably 3% or 4%, up to 7% or 8%, so maybe in the 5% range or so, from a cost perspective. And we expect that would impact essentially all of our fall and holiday shippings at this point. We don't have any visibility beyond that but for fall and holiday that's what we're seeing.

Operator

Your next question comes from Charles Grom – JP Morgan.

Charles Grom – JP Morgan

Just to that last point, Wes, just as you guys see the lower sourcing cost as your plan just to decrease pricing or keep where you are, flat. Just how you're factoring that into the flat to up 10 basis points for GPM he second half.

Wesley S. McDonald

Well, I think we're going to try to improve the quality. That's been something we've traditionally done. We have no intention of either raising the ticket or really lowering the ticket. Whether or not we have to promote more will be a function of the competitive environment.

Charles Grom – JP Morgan

And in the past you've talked about how the day-to-day volatility in sales has been real extreme. Have you seen that calm down a little bit over the past month?

Wesley S. McDonald

It's getting better. I still wouldn't say it's perfect but we are not driving the store people as crazy as we were earlier in the quarter.

Charles Grom – JP Morgan

Exclusive brands have done very well, private disappointed a little bit in 2008. Just wondering if you could comment on some of the trends in the first quarter on the private brand front and how much of the 200 basis point increase in mix is from private versus exclusive?

Kevin Mansell

Basically almost all of the 200 basis point improvement is from exclusive, which is probably not surprising, given the number of new brands that we've launched that entered the sales stream.

On the private brand perspective, we essentially held our share, which I think on the positive side, given our sales performance, was better than competition. I think that's positive. We had a positive influence. But to be perfectly frank, I think we expected the private brands would actually probably increase in penetration, just given the environment and the customer looking for better value. So it's an area we're focused on.

I think we've got growth opportunity there and we think we can turn that around. I'm not distressed about holding our penetration in private brands, given our over overall performance, but I would like to see it increase.

Operator

Your next question comes from Lizabeth Dunn – Thomas Weisel Partners.

Lizabeth Dunn – Thomas Weisel Partners

Just a little bit more on the Mervyns stores that you have acquired. Will they be prototypical? I mean will they look just like a Greenfield store? Is there anything different about the size or the specs of those stores?

And as you open those stores, I guess right now you're seeing a lift because there has been obviously sort of a vacuum in the market. Is there anything different that you expect once you open those stores about the other comp stores in that region?

And then how many stores do you think you can ultimately have in California?

R. Lawrence Montgomery

A number of these stores are a different size than our prototypes. But that's not unusual in our history as we have taken on people's distressed real estate and enfolded it into our store base.

But when you walk into the store, you're definitely going to know that you're in a Kohl's store. All of our merchandising initiatives will be in place and the number of the stores will have work done over the period of time to make them look on the outside just like a Kohl's store.

And a number of these stores, talking about the performance of those stores, a number of these stores, as I mentioned in my comments, are in areas where it's going to be 100% incremental sales, where we are actually doing no business now, so we think that that's going to be a positive and we're going to have a fairly significant re-grand opening when those stores open at the end of September.

We're going to see what happens with the economy but we think we still have opportunity to have a number of more stores in California.

Lizabeth Dunn – Thomas Weisel Partners

Are you seeing anything else with any of the other retailers that have gone by the wayside, any other places that you're picking up business?

Wesley S. McDonald

Not really. I mean, the ones of note, Linens and Things, obviously I think people's home business is strengthening, I think partly because of that but partly just because after 18 months of fairly dismal home performance across the industry it's just time to replenish some of the basic items.

And then some of the Goodies was too small for us to really measure a big effect in the Southeast. Gottschalks I think will help us, once they go out. I think it's at the end of July, in the inland areas of California. But I think they only have 50-something stores, so it's not going to help us a whole bunch. But Mervyns has obviously been the biggest help to the comps out there.

Operator

Your next question comes from Deborah Weinswig – Citigroup.

Deborah Weinswig – Citigroup

As we think about the comp guidance for the second quarter, how should we think about how you incorporate the tax holiday shift and also any benefit from the tax rebates a year ago?

Kevin Mansell

The comp guidance by month is really predicated on last year's comparisons, that's the best way I would say it. We had strongest performance in June and then frankly, if you rewound that to our June sales release, we were hard pressed to say how much of that was potential stimulus and how much of that was an improved weather environment in June, because we did get a lot of seasonal lift.

So overall though, we had a positive comp so our view was that June could be the toughest month. It wouldn't be a surprise.

Other factors were not significant enough to affect one month versus another. I would probably just call June out of the three months, and it was strictly based on last year.

Deborah Weinswig – Citigroup

And can you talk about any changes in place to spend less on payroll and obviously there's less inventory in the store, that should theoretically help as well.

Wesley S. McDonald

I think in general what we've tried to do is focus on where work load has been taken out and not just do random cuts. We have been trying to have people remain on the sales floor and staff the POS appropriately. But you're right, with 30% less clearance units, we don't have to spend as much money taking mark-downs and reduction in receipts, we're being able to take out replenishment hours.

And we're trying to match sales floor hours to the traffic in the store as well as fitting room hours. So I think the store guys have done a great job with that. We almost leveraged hourly payroll for the quarter. The de-leverage really came in fixed and controllable. So for us to do that and get that increase in customer service scores indicates to me that the guys in the field are doing a great job.

Deborah Weinswig – Citigroup

Can you talk about remodel costs and are there opportunities in this environment to bring those down, or is there anything with reverse auction technology that you're doing.

Wesley S. McDonald

We have reversed auctioned almost everything we can do on fixtures. As you can imagine, the contractors are pretty hungry for work right now. So our remodel cost projections were $2.4 million a store for the year. We are going to probably come in at $2.2 million a store. So that's a pretty significant savings from where we thought. It's going to save us roughly a little over $10.0 million.

And that's really a function of both reversed auctioning on the fixtures and then just labor rates coming down.

Operator

Your final question comes from Mark Miller - William Blair & Company.

Mark Miller - William Blair & Company

The company has had fabulous gross margin performance, I was hoping you could speak to the range of initiatives here that are driving that and how far you are along on specifically mark-down optimization, size optimization, shortening of cycle times and then private label and exclusives, however you would size that for us.

Kevin Mansell

I think the way we would try to describe the margin is just it's driven by the following factors, probably in order of priority:

Number one is just overall better inventory management so flowing receipts close to the sales has got the biggest positive impact and allows us to allocate the inventory more effectively across 1,000 stores and you're seeing lifts in that in that our margin performance in our mid-range stores are coming up to equal the company, which was not the case last year.

Technology, whether it be size optimization or mark-down optimization is still fueling both better averaging retail on clearance and a better balance in inventory when we take our mark-downs, so mark-downs are less in units but they're also less in dollars;

And then the overall improvement in private and exclusive brands is definitely a positive because our margins on those two categories of merchandise are higher than the overall margin for the stores. So I think everything seems to be working together on that front and that's probably why we out-performed on that line to a greater degree than others.

And I don't think there is a good way of saying where we're at in the progress. I don't know if you feel any differently, Wes, but we've got a lot of opportunity on all those things still.

Wesley S. McDonald

If I had to rank them, mark-down optimization is probably just more incremental and not transformational, but we're just starting to see benefits on size optimization. And we continue to learn more about how to manage inventory overall, as evidenced by, we mentioned the middle stores getting better. If we can get the same kind of increases in the middle stores as we have gotten in the small stores, we have a lot more opportunity.

Mark Miller - William Blair & Company

The analysts' estimates assume about a 3% or 4% decline from the prior peak in the company's operating margins and I notice at the same time gross margins have gone up. How does management think about the prior margin structure of the business given that it occurred during a period of the housing boom and decline in savings rate. Given that you now seeing the fall in advertising expenses and rent, do you think you can get back to that same level of profitability and what might that take in terms of sales per square foot, to get back to where you were.

Wesley S. McDonald

I think if we can lower our leverage point to a flat comp that's going to certainly help. We talked about the last time that we had a analyst day when we gave our last five-year guidance of gross margin improvement of 120 basis points to 150 basis points over a five-year period, there's nothing we've experienced so far that would indicate we can't do that. But we're going to have to get sales per square foot towards that 240 range again. I think at the end of the year we ended at 222 so at some point it's going to require a return to positive comps.

Wesley S. McDonald

Thanks everybody.

Operator

This concludes today’s conference call.

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