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Kohl’s Corporation (NYSE:KSS)

Q2 2008 Earnings Call

August 14, 2008 5:00 pm ET

Executives

Larry Montgomery - CEO

Wesley McDonald – CFO

Kevin Mansell - President

Analysts

Adrianne Shapira – Goldman Sachs

Charles Grom – JP Morgan

Jeffrey Klinefelter – Piper Jaffray

Deborah Weinswig - Citigroup

Robert Drbul – Lehman Brothers

Lorraine Maikis – Merrill Lynch

David Cumberland – Robert W. Baird

Dana Telsey - Telsey Advisory Group

Dana Cohen – Banc of America Securities

Lizabeth Dunn – Thomas Weisel Partners

Richard Jaffe – Stifel, Nicolaus & Co.

Daniel Binder – Jefferies & Co.

David Glick – Buckingham Research

Operator

At this time I would like to welcome everyone to the second quarter2008 Kohl’s 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 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 the replay of this call will be available for 30 days but this recording will not be updated so if you are listening after August 14 it is possible that the information discussed is no longer current.

Mr. McDonald, you may begin your call.

Wesley McDonald

With me today is Larry Montgomery, Chairman and CEO and Kevin Mansell, President. I’ll start off reviewing our financial performance as well as some balance sheet highlights and then I’ll turn it over to Kevin to talk about merchandising and marketing initiatives and then Larry will wrap it up with our store growth plans and our earnings guidance.

Sales for the second quarter were approximately $3.7 billion this year versus $3.6 billion last year, up 3.8%. Year-to-date total sales increased 2.6% to $7.3 billion.

Comp sales for the quarter decreased 4.6% driven largely by lower transactions per store which decreased 4.4%. Average unit retail increased 1.5% but was offset by a 1.7% decline in units per transaction resulting in an overall 0.2% decrease in average transaction value.

Year-to-date comp sales decreased 5.6%. Average unit retail was flat to last year and units per transaction decreased 1% resulting in the same decrease in average transaction value. Transactions per store decreased 4.6%.

From a regional perspective the northeast outperformed the company average for both the quarter and year-to-date periods. The southern regions, south central, southeast and southwest continued to struggle as sales in states most affected by housing; California, Arizona, Nevada, and Florida continue to be soft.

Our credit share was 44.6% for the quarter an increase of approximately 270 basis points over the prior year quarter. Year-to-date credit share increased approximately 250 basis points to 44.6% as well.

Moving on to gross margin, our gross margin rate for the quarter was 39.6%, up 68 basis points from last year. Year-to-date margin increased 30 basis points to 38.2%. The increases reflect strong inventory management, lower clearance level, and higher penetration of both private and exclusive brands.

We would expect gross margin to increase 10 to 20 basis points over last year in the third quarter and 20 to 40 basis points in the fourth quarter.

SG&A increased approximately 11% for the quarter. As expected this was faster then sales but lower then our expectations of approximately 12% to 13% over last year. Year-to-date SG&A increased approximately 9%.

Credit expenses leverage for the quarter and year-to-date, stores advertising corporate and distribution centers expenses did not leverage for either period due to lower then planned sales, our continued desire to maintain a positive customer in-store experience and ongoing efforts to drive additional traffic.

We would expect our SG&A expenses to increase 9% to 10% in the third quarter and 5% to 6% in the fourth quarter. The difference between the quarters is primarily due to having our 95 fall 2007 stores open for the entire third quarter versus one month last year.

Depreciation expense for the quarter was $133 million and $263 million year-to-date, a 25% increase over both prior year periods. The increases are primarily due to new stores.

Depreciation is expected to be approximately $135 million in the third quarter and $140 million in the fourth quarter.

Moving on to preopening expenses, preopening expenses were $6 million for the current year quarter versus $9 million last year. Year-to-date preopening expenses were approximately $17 million in both 2008 and 2007.

The decrease in the quarter reflects the decrease in the number of fall openings; 47 in 2008 compared to 95 in 2007. Preopening expenses are expected to be approximately $23 million in the third quarter and $8 million in the fourth quarter.

Operating income for the quarter declined from $444 million to $406 million this year. Year-to-date operating income was $678 million compared to $790 million last year.

Net interest expense increased to $27 million for the quarter compared to $11 million in the prior year. Year-to-date net interest expense was $53 million compared to $21 million in the prior year. The increases are primarily due to the $1 billion in debt we issued in September of 2007.

Interest expense is expected to be approximately $32 million in the third quarter and $30 million in the fourth quarter. Our income tax rate was 37.9% for both the current year quarter and 37.7% for the year-to-date period. We expect our 2008 tax rate to be approximately 38% for the third quarter and the year.

Net income for the quarter was $236 million compared to $269 million last year and year-to-date net income was $389 million compared to $478 million last year. EPS for the quarter was $0.77 compared to $0.83 last year and year-to-date EPS was $1.26 this year versus $1.48 last year.

Moving on to the balance sheet we currently operate 957 stores compared to 834 stores at this time last year and for your modeling purposes gross square footage 84,942 an increase of 18.4% over last year and selling square footage 74,452, an increase of 17.2% over last year.

We had $461 million short and long-term investments at quarter end of 2008 compared to $36 million last year. As a reminder we reclassified approximately $425 million of auction rate securities from short-term investments to long-term investments during the first quarter.

We’ve also recorded temporary mark-to-market adjustments of $20 million net of tax through equity related to our long-term investments. At the end of the quarter, inventory per store is down 15% per store to $2.7 million.

Our clearance inventory per store is down almost twice this amount on a unit basis. This shows our commitment to being conservative in our sales and receipt planning. Moving on to fixed assets, year-to-date capital expenditures were $558 million, down 30% from last year’s $801 million.

We continue to expect capital expenditures of approximately $1.1 billion for the year. We generated cash from operations of $874 million in 2008 versus $413 million in the first half of 2007 which more than funded our year-to-date capital expenditures.

Our accounts payable percentage as a percent of inventory was 37.7% this year versus 38.4% last year.

During the quarter we repurchased 2.6 million shares at an average price of $42.15. Year-to-date we have repurchased 6 million shares of our stock for $261 million at an average price of $43.19, and for your modeling purposes going forward, I would use 307 million shares for the remainder of the year.

And with that I’ll turn it over to Kevin who is going to talk about our merchandising and marketing initiatives.

Kevin Mansell

Thanks Wesley, let me talk first about sales. As Wesley mentioned comparable sales decreased 4.6% for the quarter and 5.6% year-to-date. All lines of business in all regions reported a decrease in comparable sales in both the quarter and year-to-date.

Accessories and men’s outperformed the company for both the quarter and year-to-date periods. Accessories were led by sterling silver, watches, and beauty. Men’s was led by basics particularly hosiery. Children’s performed with the company average and were driven by infants and toddlers. Women’s, footwear and the home area underperformed the company for both the quarter and year-to-date and women’s missy updated sportswear and basics were the strongest categories.

In footwear children’s shoes reported the strongest performance and home continues to be the most difficult line of business with soft home significantly underperforming the company. Considering the uncertainty in the environment we intend to continue our conservative planning assumptions on both sales and inventory levels going forward.

However, the existing reduction in inventory per store at 15% that we have already achieved puts us in an excellent position to flow fresh receipts as needed throughout the fall season. We are building slight improvement in our expectations for sales in the fall, similar to our improvement in comp for the first quarter to the second quarter.

Our expectations for the fall season are for comparable sales to decrease 2% to 4%. We expect the third quarter to be similar to the fall season in total, down 2% to 4%. By month, August should be worse then the quarter and September should be with the quarter and October should be better then the quarter.

As always in the third quarter weather could be a factor on by-month sales performance particularly in our weather sensitive regions. Moving on to our merchandise initiatives, we continue to be extremely pleased with the performance of brands introduced this spring. Jumping Beans an opening price point children’s private brand targeted to provide value in children’s apparel is driving the infants and toddler business.

The Gold Toe business continues to help men’s, women’s and children’s basics outperform the company. Our new Elle brand has been an overwhelming success. It was part of the reason our missy updated business achieved a positive high single-digit count.

The expansion of our food network brand platform to include Bobby Flay has helped food prep outperform the rest of home.

And finally we’re very pleased with the initial sales of our new Abby Dawn line, a new junior’s brand inspired by Avril Lavigne.

As a reminder our exclusive partnership with Fila is just beginning to hit the stores in men’s, women’s and children’s apparel, footwear and hosiery. We’re planning a very broad September launch.

Our fall 2007 launches Simply Vera Vera Wang, Elle and Food Network also continue to perform extremely well with both our existing and new customers and outperformed their plan for the quarter and year-to-date.

And in addition our exclusive national brands of Chaps and Tony Hawk both had strong double-digit comp growth as did apt. 9 in private brands. As you can see the customer continues to respond well to our new brand launches and their penetration continues to increase with substantial room to grow, particularly on the exclusive national brand front.

Our research continues to show that the acceptance is being driven by the high brand awareness each of these brands has when we launch them. That success is embedded into our thinking for our planning of next year’s launches of Dana Buchman and Hang Ten.

For the quarter our exclusive and private brands were up over 400 basis points in penetration to 42.7% of sales primarily due to our exclusive national brands. As Wesley indicated this had a favorable impact on our merchandise margins and we continue to expect that benefit for the balance of the year given the growth that we plan in these brands.

Moving on to inventory management as we mentioned earlier, average inventory per store is more than 15% lower then last year, stronger then the high single-digit decreases that we had originally guided towards achieving.

We accomplished that through more significant reductions in spring and summer seasonal transitional inventories. As a result some areas like women’s or men’s sportswear are actually down substantially more then the total. Basic areas like men’s, women’s or children’s underwear and hosiery are actually higher then last year on an inventory per store basis.

In addition, our clearance inventories are down approximately twice as much as our total inventory. The team has done this in spite of also delivering a large number of new brands that we just discussed. Looking forward we would expect our inventory per store at the end of the third quarter to be down approximately low double-digit per store.

In addition to carrying overall lower level of inventory we also continue to focus on flowing receipts in season as needed through our cycle time initiatives. This benefited us greatly in achieving both our inventory and our gross margin goals in the second quarter and first half.

Markdown optimization continues to benefit us even with these lower inventory levels. Our size optimization initiatives continue to develop and we expect some benefit in the fourth quarter but certainly more in 2009.

As Wesley indicated for the third quarter we would expect gross margin to be up 10 to 20 basis points over last year with improvement in the fourth quarter of 20 to 40 basis points. We believe this allows us to be flexible in our pricing as we expect the environment will continue to be extremely competitive.

And finally on the marketing, from a marketing standpoint we’re concentrating on four things. First continuing to support and grow our efforts behind our Only at Kohl’s brands, especially our exclusive national brands. These are all clearly and have substantial opportunity to grow.

Second, continue to develop proprietary marketing handled seasonally to differentiate our marketing from the competition. Our current back to school campaign around the connection between music and denim is a great example of that and actually supports our first objective as well.

Third, continue to invest in those marketing vehicles that clearly have higher productivity in a time of increasing media costs. Chief among those are direct mail and online marketing. Print insertion will decline as a percent of our expenditures.

Finally and far most importantly, emphasizing value in all of our advertising. Our inventory management strategies and our proprietary brand mix success have given us a unique position to be able to be aggressive in our promotional efforts compared to competition, and still deliver improved gross margin.

We intend to use that throughout the fall and holiday season to our advantage. From an in-store perspective we’re focusing all of our efforts on supporting our new lifestyle brands and presentation and improving our customer service. Our lower levels of inventory are definitely helping in this regard and our customer service scores are up significant year-over-year across all areas.

With that let me turn it over to Larry.

Larry Montgomery

Thanks Kevin, we expect to open 46 stores in October and one in November. Included in those 47 stores are our 1000th store and seven stores in the Miami, Ft. Lauderdale West Palm market. We also opened a new distribution center in Ottawa, Illinois that’s going to support our store growth there as well as for future transportation and operating expenses.

In 2009 we will utilize our strong financial position to continue to expand in new and existing markets that continue our remodel program in order to grow market share in a difficult environment. We are planning to open approximately 50 stores with 20 opening in the spring and 30 in the fall.

In addition we plan to remodel 60 stores in the spring season, an increase from 36 this year. This allows us to have the flexibility should any real estate become available after the holiday season. As you know we’ve identified over 1,400 trade areas where we believe we can open a Kohl’s store but in the current environment we’re uncertain about the timeline for future store openings beyond 2009.

We continue to expect that 2008 is going to be a challenging year from a macroeconomic perspective. Our second quarter results reflect strong management of inventory levels and expenses in this environment. They also reflect the importance of differentiating our merchandise content and marketing as seen in the impressive growth of our private and exclusive brands.

We remain conservative in our sales expectations for the fall season and we’ll manage our business accordingly. We continue to invest in our long-term growth. We believe it’s extremely important to maintain our existing store base in a tough environment with significant competition for customers whose disposable income is shrinking.

We’re seeing an improvement in our customer service scores in our stores due to 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. Our investment in product development both in talent and technology continues to provide benefits and increases in both private and exclusive brand penetration and gross margins.

You’ve seen the results of our investment in technology around inventory management including assortment planning, cycle time reduction, markdown and size optimization and our inventory per store and gross margin results. We will continue to make investments in our future throughout the year to support our four initiatives; merchandise content, marketing innovation, inventory management, and the in-store experience.

With that let me share with you our updated guidance for fiscal 2008 and our initial guidance for the third and fourth quarters. For the third quarter we would expect total sales to increase 3% to 5%, comp store sales of negative 4% to negative 2%, and gross margin up 10 to 20 basis points.

We expect SG&A to increase 9% to 10%. Wesley already gave you guidance on the other lines on the P&L. This would result in earnings per diluted share of $0.51 to $0.56 for the third quarter. For the fourth quarter we would expect total sales to increase 1.5% to 3.5% and comp store sales to decrease between negative 4% and negative 2%, gross margin increase of 20 to 40 basis points, we would expect SG&A to increase at 5% to 6% over last year. This would result in earnings per diluted share of $1.26 to $1.34 for the fourth quarter.

Achieving these objectives would result in earnings per diluted share for fiscal 2008 of $3.02 per share to $3.18 per share. This guidance does not reflect any additional share repurchases in fiscal 2008.

With that we’d be happy to take some questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Adrianne Shapira – Goldman Sachs

Adrianne Shapira – Goldman Sachs

Pretty impressive on the expense line you were able to come in a little bit lower then the 12% to 13% increase you had planned, we’re just wondering in the back half would you see a similar opportunity.

Wesley McDonald

Well I think we have done a great job of stepping up from when sales are a little bit lighter then we think so I would expect this to be able to react to that but the numbers that we gave you are the numbers that we expect to achieve.

Adrianne Shapira – Goldman Sachs

Maybe you could walk through in terms of where you saw that 100 basis point swing? Where are the buckets that you--?

Wesley McDonald

The biggest areas that contributed were in store payroll, we were able to flex down pretty well as sales started to soften a little bit in July. Also we save a lot of money with inventories being so low we don’t have to mark it down, we don’t have to move it around. There’s not as much replenishment coming in on the seasonal merchandise and then we also performed a little better then we had planned in our credit business as we continue to gain share.

Adrianne Shapira – Goldman Sachs

You talked about the new stores, 70 went to 50, you had mentioned opportunities perhaps if stores become available post holiday, does that suggest that you have the opportunity to perhaps, Mervin’s presents an example, going back up to 70 if that situation presents itself?

Larry Montgomery

I don’t know that we’d go back up to 70, we have flexibility with the 30 that we’re talking about in the fall season so I think we just judge it as those things happened and do what’s best at the time, but basically we’ve built in the flexibility to take advantage of the opportunities as we have several times in the past.

Adrianne Shapira – Goldman Sachs

Pretty impressive gain of the penetration of your exclusive brands, give us a sense, what do you think is driving that?

Kevin Mansell

I think it’s the same as it has been probably for the last three or four quarters, it’s the acceptance of the new brands right away and I think no matter how many times we go back and do the research it all points back to the same thing. When we identify a brand that we can partner with that already has significant consumer awareness and significant consumer acceptance, then the take-off on that brand as we launch it is much faster and much more successful and secondly naturally we’re targeting those brands into areas of our assortments where we think we have voids or gaps so put the two of those things together and I think we’ve had a lot of success, we see that building.

Adrianne Shapira – Goldman Sachs

Can you give us a sense of what you’re seeing from your customer in terms of emphasizing value as we head into the back half? Are you seeing trade down within categories, opening price points mattering more or its still the newness is the more important factor there?

Kevin Mansell

I think newness continues to be the most important factor but there are categories, things like basics that have continued to do really well. In fact maybe even accelerated from a performance perspective and while we did talk a lot about exclusive national brands, our opening price point private brands also increased in penetration about 100 basis points. We had a really good success in apt. 9 in both men’s and women’s and our pipeline on the male side, young men’s and boys. So opening price points is going to continue to be important but I would put most of the focus around newness. Newness is definitely selling.

Operator

Your next question comes from the line of Charles Grom – JP Morgan

Charles Grom – JP Morgan

On your comp expectation for the third quarter beyond the trend that compares from a year ago, can you speak to why you’re expecting to see the month to month fluctuations? Are you going to move some credit events around or could you elaborate on that?

Wesley McDonald

There are not really any major event shifts. A lot of it is just a function of what the comps were last year. Last year our worst comp was in October, our best comp was in August. It’s mostly a function of that.

Charles Grom – JP Morgan

On the gross profit front, clearly 70 bps up in the second quarter up close to 200 in the second quarter, the 10 to 20 and then the 20 to 40 on a one or two year basis suggests a pretty steep fall off. Is that just you being conservative or is there less vendor concessions you’re expecting to receive in the back half?

Kevin Mansell

I tried to address it anticipating there was probably going to be questions about that given the run rate on margin in the marketing section which is, I think what we’ve come to realize is that we do have a couple of things that are really working in our favor and we see them continuing to work in the second half of the year which is our inventory levels have be repositioned, our receipts are flowing much closer to sales and it is clearly driving improved margin and when we combine that with the larger penetration of exclusive and the private brands, we do have a built in margin lift and we are trying to use that lift to be very aggressive promotionally.

So we’re going to try to do that throughout the fall and holiday season and that is built into our thinking on this guidance. So we feel confident about the guidance but built into the thinking is that we’ve got what we think is a big advantage over some of our competition where both of those things are working for us.

Charles Grom – JP Morgan

Lean inventories clearly a good thing today but how do you manage the risk of missed sales opportunities that probably presented itself in July over the next few months?

Kevin Mansell

It’s always a balance. Periods like July which as you well know are really highly driven by clearance and transitional inventories that are moving out are much more vulnerable to a lower inventory level and a pull back in inventory. As you move into more the meat of the season and its forward receipts that becomes obviously a smaller concern and then secondarily in our case, we’ve made the pull back so our inventory is down 15% and the receipts that we’re flowing are going to be right in line with the sales we’re going to be doing. I feel pretty good about that but I understand where you’re coming from. We recognize it and it definitely impacted our July sales.

Operator

Your next question comes from the line of Jeffrey Klinefelter – Piper Jaffray

Jeffrey Klinefelter – Piper Jaffray

On the store openings, you made a comment about post 2009 not a specific timetable for new stores although ultimately still seeing 1,400 potential locations, should we read something into that in terms of how you’re thinking about the sequencing of new stores, has something changed in the environment beyond just this near-term sales slowdown that changes your outlook?

Larry Montgomery

No I don’t think anything has changed and we’ve always given a number of stores about this time of year for the following year and we think that there’s going to be a lot of things going on in the retail community that could afford opportunities that if we don’t keep our powder dry we’re not going to be able to take advantage of them. Its very uncertain times out there and we’re going to run our business conservatively and be able to take advantage of these opportunities.

Jeffrey Klinefelter – Piper Jaffray

Also an update on these southern markets or these housing affected states, could you give us some sense within your comp trends how much of a deterioration basis point wise those maybe four states are causing you and so we can think about what an average run rate is and then what a deterioration those states are?

Wesley McDonald

I don’t want to give specifics, but obviously it’s not performing as we’d like. Normally in those younger stores that have been open two or three or four years they’d be running high single-digit positive comps and in a lot of those cases they’re running fairly significant negative comps. It’s also affecting our new store productivity. Normally with the blend of stores that we’ve opened between small and protos, this quarter we’d be running at about 65% productivity.

Right now we’re closer to about a 61%. That’s because approximately 25% of our new and non-comp stores are in those four states I mentioned. It’s definitely a big headwind and certainly a cause of some of the other retailers that you’ve seen in the news difficulties that are more located in those states then we are.

Jeffrey Klinefelter – Piper Jaffray

Do you have any situations where there are stores that you have to rethink ultimately whether or not you want to keep them open through term? Do you have any of those situations?

Wesley McDonald

No I don’t think people are going to stop moving to California and Florida and Arizona. I think that’s a long-term trend. I think we’re just in a blip right here and it’ll work itself out and developments will continue to grow down there. What we can’t tell you is it going to get better in 2009? Or is it going to take a little while longer?

Jeffrey Klinefelter – Piper Jaffray

On the credit you mentioned 44% of transactions?

Wesley McDonald

Yes, 44.6% for both the quarter and the season.

Jeffrey Klinefelter – Piper Jaffray

Any other details you can give on credit metrics?

Wesley McDonald

I would say it was a big help in terms of the SG&A coming a little bit lower then we thought. Obviously like everybody else we’re seeing bad debt tick up a little bit. We expect it to be up about 100 basis points higher than last year but both finance charge and late fee revenue are also up as well so I expect our yield for the year to be flat to last year or perhaps slightly up.

Operator

Your next question comes from the line of Deborah Weinswig - Citigroup

Deborah Weinswig – Citigroup

You discussed some changes with regards to marketing, can you talk about if there’ll be tweaks in the back half or are those more significant changes?

Kevin Mansell

All we’re trying to do is recognize the positive impact on our margin from our other initiatives and balance that against what’s clearly a need for more value from all consumers. They all want more value regardless of which of our price points they’re interested in buying and use that advantage against that need for value and drive more business. So we definitely are more focused on it naturally in the back half of the year because it’s an important part of our business as we get through September to December.

It’s so critical and as people start thinking about fall apparel and even more importantly holiday gift giving, I truly do believe the advantage that we have there is pretty significantly competitive compared to our competition. It’s definitely a positive no matter how I would look at it and most importantly it’s definitely built into the guidance we’re giving you on our margin rates.

Deborah Weinswig – Citigroup

Any comments in terms of the strength in the beauty business?

Kevin Mansell

Beauty did great, it comped positively. I think roughly low double-digits for the quarter and pretty much the same for the first half of this year. Continued to do very well.

Deborah Weinswig – Citigroup

With regards to home, obviously its challenging for everyone out there but it sounds like soft home is even more challenging. What different initiatives do you have in place from that perspective?

Kevin Mansell

We’re making changes clearly. It definitely was significantly worse then the rest of the store and was significantly worse then home which underperformed the store to begin with. We’re looking harder at value in there for sure. Some of those categories are very basic categories that, new bath towel purchases or new sheet purchases or bedding purchases aren’t going to be heavily driven by strong value offer so we’re definitely looking at that and then secondarily we’re looking to more aggressively apply some of our brand ideas that have been successful elsewhere to a larger part of the soft home business.

Between the two of those things I think we’ve got a couple of good tools but that is definitely a category that is going to probably be difficult throughout the fall.

Operator

Your next question comes from the line of Robert Drbul – Lehman Brothers

Robert Drbul – Lehman Brothers

Can you address the sourcing environment as you look into spring, in the back half of the year, and any sort of challenges you see there and where things are shaking out by category with inflation and any big surprises from that perspective?

Kevin Mansell

From a back half perspective in terms of impacting our receipts sourcing is really not going to play a major role. From the perspective of looking forward into 2009 particularly as we turn the quarter into second quarter purchases of spring of 2009 price inflation looms on the horizon and we’re obviously working really hard with our overseas partners to mitigate what are a lot of the things that are driving that, whether it be raw material pricing, whether its natural raw materials like cotton, our petrochemical based fibers, labor rate, transportation issues, naturally energy issues on the factory base, and there are other things that we’ve been doing that we still think put us in a good place which is we work with the largest overseas agent in the world and they have an incredibly broad based flexible sourcing system in place across many countries in Asia and Central America. And we’ll continue to while working with the key factories, move production where we can get advantageous pricing to help offset some of those other issues.

It’s definitely something we’re all going to face come second quarter and back half 2009 but I do think we’re doing a lot to mitigate the impact.

Robert Drbul – Lehman Brothers

On back to school, have there been any major surprises yet for you on back to school and when you think about the first six months of this fiscal year in terms of channel competition, off mall versus mall, the discounters versus better department stores, can you talk about any surprises you’ve seen in terms of the market share gain that’s going on out there and how you see it playing out the rest of the year?

Kevin Mansell

I wouldn’t characterize anything as a big surprise. When it comes to younger businesses, those are much more heavily penetrated in mass retail in both children’s and even junior’s apparel [are] specialty retail so we’ve tried to attack that with some new opening price point brands, not surprisingly those are working, things like the little size Jumping Beans brand and new brands in junior’s like Abby Dawn is definitely working very successfully.

But I haven’t, I can’t tell you there’s anything unique going on. I think its going to be give the spread of our stores its going to be a late back to school because its later every single year and I don’t think this year is probably going to be any different then that.

Operator

Your next question comes from the line of Lorraine Maikis – Merrill Lynch

Lorraine Maikis – Merrill Lynch

On the second half sales outlook which looks like the comps are getting better sequentially, can you just talk through the reasons for that?

Wesley McDonald

I think part of it we looked at our run rate in the first quarter to the second quarter, we improved. We have, there are a lot of theories out there about the two year, three year stack comp, average comp all that. Sometimes [inaudible] it plays out, its not dramatic improvement. We just ran a negative 4, 6 for the second quarter, negative four is not too far from that. We hope that things improve a little bit but as we mentioned earlier, our inventories are very lean going into the quarter and if we’re incorrect I don’t think we’re going to have any margin rate exposure at all. Just going to be a question of what the top line is going to be.

Lorraine Maikis – Merrill Lynch

Is there a risk that you’ve got some benefit from the stimulus spending in the second quarter and that’s why you saw the sequential improvement?

Wesley McDonald

I think the real reason was it got hot in June. Our business is very weather sensitive. We had poor comps relative to our competition. In May we had better comps then our competition. In June when the weather broke and then in July when we had very low levels of seasonal merchandise, we underperformed a little bit as well. So the weather is very volatile and causes a lot of volatility in our business.

Operator

Your next question comes from the line of David Cumberland – Robert W. Baird

David Cumberland – Robert W. Baird

You upgraded the store prototype last couple of years, wondering if with next year’s openings and remodels are you planning, how much change to the prototype and also if you could comment on why you’re picking up the pace on the remodels?

Larry Montgomery

We’re in our third phase of innovation in our stores and we test them. We’ve got a few stores that are going to be in innovation this fall and we’re going to take the results of those tests and roll it out into the new stores for next year and our remodels. We think it makes it a more productive store. The customers like it better. It’s easier to shop. It’s easier to maintain. It’s lower on energy usage. All of the above. We think that we’re going to continue to spend money to innovate from a store perspective.

And from a remodel perspective as you know we’ve been committed to making sure that we keep our real estate portfolio fresh and competitive. I think it’s a huge mistake not to have that point of view and I think that as you’ll see down the road, it’s going to be a big competitive advantage to us versus the guys that we’ve been talking about as direct competitors.

Operator

Your next question comes from the line of Dana Telsey - Telsey Advisory Group

Dana Telsey - Telsey Advisory Group

You mentioned in your remarks about emphasizing customer service, is there any change in your approach of how you look at it in this environment versus other economic environments whether it’s budgeting for it or just staffing different departments?

Larry Montgomery

We’ve always had the approach of we’re looking at the in-store environment and you see all the new brand launches that we’ve had. You see the new strike points, the way we’re presenting merchandise. We think that has a big affect on customer service. We’re showing them how to put those outfits together. At the same time we’re using technology, back of the house to process freight in a less expensive way and do a lot of the tasks not related to actually doing business or displaying or selling merchandise.

We’ve become much more efficient in that and we’re just redeploying, saving some, but redeploying a lot of those dollars onto the sales floor to make sure the stores are looking sharp and that we’ve got plenty of staff as the people are checking out. It’s not a big difference in terms of the way that we normally look at it but as you go through the three stages of innovation that we’ve gone through, we think that we’re just getting a better looking store and it’s more fun to shop.

Operator

Your next question comes from the line of Dana Cohen – Banc of America Securities

Dana Cohen – Banc of America Securities

On the remodels, is there a material lift to the comp or contribution of those stores or can you give us any sense of the returns now that you’re looking to get more aggressive there? If you look at the gross margin delta between Q1 and Q2 penetration of private and exclusive was up similarly. So is the delta quarter to quarter reduced clearance?

Wesley McDonald

I think we did have a lot of reduce clearance obviously but we also had good benefit from the penetration in private brands. We gave some of that benefit from lower clearance back in the form of more aggressive promotional markdowns. So when you look at it sort of in detail, we got more of a benefit from the increased penetration of private exclusive brands then we did from reduced markdowns over all.

Dana Cohen – Banc of America Securities

And the reason it didn’t show up in the first quarter to the same degree?

Kevin Mansell

We think about the whole thing as kind of inventory management so its just all about where we’re going to put more investment and the selling, the sales sell through and therefore the left over inventory in a lot of those exclusive and private brands was much lower as we transitioned out. So when we talk about clearance that’s kind of one thing but the sell through as we transitioned on these was also much better so the actual absolute merchandise margin on many of these private and exclusive brands was higher then last year. So it wasn’t just about the mix. I think you are thinking about it strictly from the mix standpoint but the absolute margin on the individual brands was also higher.

Larry Montgomery

The comment on the remodels is we look at it as number one, a good business practice and number two, we certainly look at it for the term of the investment. But we’re looking at it from the point of view that if its not maintained and not kept fresh and competitive, it could have huge deterioration in business. So we’re just sort of heading it off at the pass. If it’s worth being open, it’s worth looking sharp and it’s worth being competitive.

Operator

Your next question comes from the line of Lizabeth Dunn – Thomas Weisel Partners

Lizabeth Dunn – Thomas Weisel Partners

Related to weather for fall, I remember last year you were positioned pretty well vis-à-vis the weather was not a lot of inventory and heavy weight product, can you share any plans for this fall and what’s your ability to chase business to the extent that you are light in some of those seasonal categories?

Kevin Mansell

We’ve got flexibility, obviously to move up or to move back as you start a season and the flexibility becomes less on seasonal categories as you get towards the end of the season. If you need more you have great difficulty but earlier in the season I think there’s plenty of opportunity for us to chase business and flow goods more quickly as it sells. Naturally we’ve tried to take into account last year’s experience on some of those categories when we planned this year on a by-week basis through the fall and that’s kind of built into all of our assumptions but high level it still comes back to focus on cycle time initiatives, flow our receipts closer to sales and make adjustments as we see the business or not happen. And I think if we keep focused on that as an organization, you’re going to like the results.

Operator

Your next question comes from the line of Richard Jaffe – Stifel, Nicolaus & Co.

Richard Jaffe – Stifel, Nicolaus & Co.

Regarding a sense of inventories going forward do you have enough control so if sales start to accelerate you can build the inventories or put it another way are you planning inventories in line with the sales trends we’ve seen season to date on a per square foot basis? And is the assortment shifting or consistently shifting to more and more exclusive and private label brands in the second half?

Kevin Mansell

We’re planning, as we said I think the one big positive we have is we’re starting the season with 15% less inventory. We don’t, our forward receipts don’t have to be brought down proportionately. We can now flow receipts forward as sales happen and that’s how they’re planned basically to occur throughout the fall. As a result at the end of the third quarter we’ll be down and we’ll probably be down double-digit, probably won’t be down 15%, it’ll probably be low double-digit decreases.

On a per square foot basis naturally our private and exclusive brands since their penetration has grown so much, they do occupy a larger percent of our total inventory on the floor as well, but big picture, we think we have a lot of opportunity to improve inventory turnover and really open up working capital for the company and we’re focused on doing that. Outside of whether we’re down negative 2% to 4% as we projected or if we do better then that, great. We still can live with less inventory because we know we can turn our inventory faster with these inventory management strategies in place.

Richard Jaffe – Stifel, Nicolaus & Co.

Regarding the auction rate securities and their ability to become more liquid, any changes in the outlook for those?

Wesley McDonald

We sold one for almost $2 million. We sold it at par so obviously it’s been a lot in the news lately the various players making agreements. We’re in conversations with brokers that we’ve used to try to make it more liquid. We were able to get a line against some of the securities to provide more liquidity and that’s not the solution we want obviously. We want to either have people make a mark in these again or refinancing them into other vehicles so we can be taken out at par. Having said that we continue to earn more interest on them then or borrowing cost even though we’re not currently into the line. It’s just a complicated situation we continue to work on.

Operator

Your next question comes from the line of Daniel Binder – Jefferies & Co.

Daniel Binder – Jefferies & Co.

Does your plan for the back half of the year assume that the credit penetration continues at the same pace as the front half of the year?

Wesley McDonald

Well I don’t think it’s going to continue at the same absolute delta because during the back half you get people who don’t shop us as frequently that use bank cards so naturally the penetration drops as we move on into the holiday season. So it won’t be, the delta will not remain at 250 basis points, it will decrease from that.

Daniel Binder – Jefferies & Co.

Year-over-year?

Wesley McDonald

Yes.

Daniel Binder – Jefferies & Co.

With all the credit tightening, are you seeing any limitations in terms of the type of customer you can approve for new accounts?

Wesley McDonald

Well our approval rates are certainly going down compared to previous years. Part of that is a function of areas in the country that we’re going into with our expansion program, part of that is just obviously with people having more economic difficulties, their credit scores are falling across the country.

Daniel Binder – Jefferies & Co.

Are you guiding us towards 307 million shares primarily because you don’t expect to do buyback and keep powder dry for store opportunities, acquisition opportunities, or you just don’t want us to model at this point?

Wesley McDonald

We are [mattingly] consistent in this point; we never give you guidance including share repurchase so we’re just being consistent with our practice.

Daniel Binder – Jefferies & Co.

Is the ad spend as a percentage of sales, do you expect that to continue to deleverage?

Kevin Mansell

Its actually depends mostly on how well we do in sales.

Daniel Binder – Jefferies & Co.

Is the add spend--

Kevin Mansell

We’re planning it pretty much in line with our sales growth.

Daniel Binder – Jefferies & Co.

You touched on the remodel strategy, not sure if you’ve ever given us any specifics on the cost of the remodels and the sales that you typically see to payback--?

Kevin Mansell

The costs have been running around $2.4 million, I think we’ll do a little better then that this year. The payback is we’re trying to earn a return over the course of the nine or 10 years to remodel so we can do it again. I think the bigger thing which we’ve tried to stress both on the call and other places is we know exactly what happens if you don’t remodel. We’ve been the beneficiaries of a lot of that real estate and we’ve refurbished it and been successful in that and it’s not really a sudden acceleration in remodel, it’s just a function of our new store growth. We’ll continue to grow remodels to keep the fleet fresh every nine or 10 years.

Operator

Your final question comes from the line of David Glick – Buckingham Research

David Glick – Buckingham Research

As you look forward to Q4, how are you thinking about the calendar given the one less week between Thanksgiving and Christmas? How significant is that and what kind of an impact is that going to have on the sales flow in the two months and how does that change if any your approach to marketing and sales promotion during the period?

Wesley McDonald

The math is November is going to be tough obviously because of Thanksgiving, shifts a week later and December is going to be much better.

Kevin Mansell

Without going into detail that we wouldn’t want to competitively, I have a feeling that we’ll be approaching it similarly to most people which is going to be how do you drive more business earlier given the later holiday and how do we take advantage of big event marketing earlier in the season pre Thanksgiving in our to offset what’s going to be a tougher month in November given the change in the calendar? Big picture, that’s how we’re looking at it.

David Glick – Buckingham Research

Is this the type of calendar that’s I know historically retailers have hated this calendar. Is this a calendar that has a natural disadvantage going into--?

Kevin Mansell

Nothing has changed about retailers dislike for this calendar.

Operator

We have no more questions at this time.

Kevin Mansell

Thanks very much.

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Source: Kohl’s Corporation F2Q08 (Qtr End 08/02/08) Earnings Call Transcript
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