Kohl's (KSS) Q3 2016 Results - Earnings Call Transcript

Nov. 10, 2016 1:51 PM ETKohl's Corporation (KSS)
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Kohl's Corp. (NYSE:KSS) Q3 2016 Earnings Call November 10, 2016 8:30 AM ET

Executives

Wesley S. McDonald - Kohl's Corp.

Kevin Mansell - Kohl's Corp.

Analysts

Mark R. Altschwager - Robert W. Baird & Co., Inc. (Broker)

Paul Lejuez - Citigroup Global Markets, Inc. (Broker)

Lorraine Maikis Hutchinson - Bank of America Merrill Lynch Research

Lindsay Drucker Mann - Goldman Sachs & Co.

Daniel Thomas Binder - Jefferies LLC

Oliver Chen - Cowen & Co. LLC

Paul Trussell - Deutsche Bank Securities, Inc.

Neely J. N. Tamminga - Piper Jaffray & Co.

Brian Jay Tunick - RBC Capital Markets LLC

Robert Drbul - Guggenheim Securities LLC

Richard Jaffe - Stifel, Nicolaus & Co., Inc.

Bernard Sosnick - Madison Global Partners

David J. Glick - The Buckingham Research Group, Inc.

Dana Lauren Telsey - Telsey Advisory Group LLC

Operator

Ladies and gentlemen, thank you for standing by. Welcome to Kohl's Q3 2016 Earnings Release Conference Call. Certain statements made on this call, including projected financial results, are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Kohl's intends forward-looking terminology, such as believes, expects, may, will, should, anticipates, plans or similar expressions, to identify forward-looking statements.

Such statements are subject to certain risks and uncertainties, which could cause Kohl's actual results to differ materially from those projected in such forward-looking statements. Such risks and uncertainties include, but are not limited to, those that are described in Item 1A in Kohl's most recent Annual Report on Form 10-K, and this 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 recording will not be updated. So if you are listening after November 10, 2016, it's possible that the information discussed is no longer current.

At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. As a reminder, today's conference is being recorded.

I would now like to turn the conference over to our host, Mr. Wes McDonald, Chief Financial Officer of Kohl's Department Stores. Please go ahead, sir.

Wesley S. McDonald - Kohl's Corp.

Thank you. Good morning. With me today is Kevin Mansell, our Chairman, CEO and President. I'll start today's call by walking through our operational results. Kevin will then provide some more details on our results and our thoughts on the upcoming holiday season. We will then open up the call to your questions.

Comp sales decreased 1.7% for the quarter, slightly better than the second quarter. Transactions per store were down 5.7% for the quarter. Average transaction value increased 400 basis points, comprised of a 210 basis point increase in units per transaction and 190 basis point increase in average unit retail.

From a line of business perspective, Men's was the strongest category for the third consecutive quarter. Footwear also outperformed the company average. Children's and accessories were the weakest. On a regional basis, the West was the strongest region with a low single-digit increase in comp store sales. The South Central outperformed the company this quarter as well. The Mid-Atlantic and Northeast were the most challenging. Kevin will provide additional details on sales in his prepared remarks.

Gross margin was up 2 basis points to last year. Merchandise margin increased 30 basis points but was offset primarily by shipping cost. SG&A decreased $19 million to $1.1 billion for the quarter and deleveraged by about 12 basis points. About half the favorability to SG&A is related to timing of expenses and will hit the fourth quarter. Though our teams did a fantastic job of managing their expenses against our internal plans, most were unable to leverage on the lower sales. Our credit distribution center and IT teams were able to leverage but our store fixed payroll – and payroll expenses, corporate and e-commerce fulfillment center expenses, did not leverage during the quarter.

Headwinds in the fourth quarter continue to be as expected around store payroll due to wage inflation and continued use of store associates to fill digital demand as well as a timing difference in incentive compensation versus last year. We continue to believe that our fall season SG&A will be up 50 basis points to 200 basis points higher than last year.

Depreciation expense decreased $4 million to $232 million. Most of the decrease is due to last quarter's stores closures. Interest expense decreased $5 million to $76 million for the quarter. The decrease is primarily due to lower interest on cap leases as the portfolio matures as well as the store closures.

Our income tax rate was 35%, approximately 150 basis points lower than last year. Most of the decrease is due to changes in nontaxable trust income.

Net income on a reported GAAP basis for the quarter was $146 million, and diluted earnings per share were $0.83. During the quarter, we reversed $6 million of store closing and restructuring costs that were reported (5:18) earlier in the year. This reversal includes severance for corporate associates that have found reemployment elsewhere as well as lease liabilities for a Milwaukee area store that will be used for corporate purposes.

Excluding the positive effects of store closure and restructuring items this year and $38 million of debt refinance costs last year, net income was $142 million, comparable to the $144 million reported last year. Adjusted diluted earnings per share increased 7% to $0.80 per share.

We currently operate 1,155 Kohl's stores with gross footage of 99.2 million square feet and selling footage of 82.8 million square feet. During the quarter, we opened six Kohl's stores and closed one store. All of our new stores are in our new small store format. We also operate 12 FILA Outlets and three Off/Aisle centers.

We ended the quarter with $597 million of cash and cash equivalents, an increase of $96 million over last year, reflecting improved working capital especially on the inventory side. Year-to-date we, generated $599 million in free cash flow, an $825 million (6:31) improvement over the first nine months of last year.

We've made incredible progress on our inventory reduction initiatives during the quarter, reducing inventory per store by more than 9%. As a result, our AP to inventory ratio increased almost 370 basis points to 44.4%.

Capital expenditures were $591 million, $40 million higher than last year. Most of the increase is due to spending for our fifth e-commerce fulfillment center, which is scheduled to open next year.

Weighted average diluted shares were 177 million for the quarter. During the quarter, we repurchased 4 million shares of our stock. We ended the quarter with 177 million shares of stock outstanding. On Wednesday, our board declared a quarterly cash dividend of $0.50 per share. The dividend is payable on December 21 to shareholders of record on December 7. Our board also increased the outstanding share repurchase authorization under our existing program to $2 billion.

Based on our year-to-date results and our expectations for the fourth quarter, we are reaffirming our fiscal 2016 diluted earnings per share guidance of $3.12 to $3.32 per share. Excluding impairments, store closing and other costs, we continue to expect diluted earnings per share of $3.80 to $4.00.

I'll now turn it over to Kevin who will provide some additional insights on our results.

Kevin Mansell - Kohl's Corp.

Thanks, Wes. We're pleased to see continued though modest improvement in our year-to-date comp sales trends for the third quarter in total. The period included a strong back-to-school selling season, with sales up 5% in key back-to-school categories, but that was followed by a very weak month of September selling period.

I'm happy to say we ended the quarter strongly in October and saw progressive sequential improvement throughout the month as we moved some of our key marketing to better coincide with colder weather. The month of October ended basically flat to last year, which is encouraging as we enter the holiday season.

Looking at our sales by business, Men's was the strongest business with strength in active and tailored dress clothing. Footwear outperformed the company with strength in athletic. Home was consistent with the company. However, Home reported the most significant improvement of any business over the spring trend, which is a great sign, as Home becomes much more important in penetration to our overall sales in the upcoming holiday season.

Women's was slightly below the company, but had continued strength in juniors, driven by our speed initiative, as well as strength in SONOMA and other key proprietary brands. Children's continues to be challenging. Strength in Carter's was offset by declines in Jumping Beans; and Accessories underperformed the company. Double-digit increases in bath and beauty and fine jewelry were more than offset by declines in other categories. Overall, our Women's business is beginning to get traction from our speed initiative in several of our key proprietary brands. I would expect this to grow in impact as we move through the holiday and into the spring season.

The active and wellness category also remains very strong. We've expanded assortments and introduced newness with key suppliers such as Nike, New Balance and Fitbit, and that's continuing to drive sales.

Unseasonable weather, as we experienced in September, will always be a challenge for us. It's a reason why localization is increasingly important to our success, and we're seeing growing traction in our localization initiatives. We continue to see slightly better sales results, 50 basis points to 100 basis points, in localized categories, on less inventory versus nonlocalized categories.

I'm extremely pleased with the freshness and the levels of our inventory. This is year one of a three-year initiative in inventory reduction, and we're managing it well across all areas of our business. While sales were down 2% for the quarter, we ended the period with 9% less inventory and, as a result, had significantly improved sell-throughs.

Localization is helping, as it's flowing receipts closer to need. This has in turn freed up open to buy, which has allowed us to invest in stronger trending areas of the business. It's also provided flexibility to address seasonal differences across the chain. And as a result, about one third of our fourth quarter receipts will be spring transitional merchandise, which should help our business in our mild and hot stores, and keep our assortments fresh.

I'm also very excited about the exciting new brands that we're introducing. You already know about next spring's Under Armour launch, which will be the largest launch in Kohl's history. This holiday, though, we're also excited to offer the American Girl Doll of the Year, Koolaburra by UGG, and our most recent announcement, the Apple Watch. These highly recognized brands are sure to drive traffic to our stores and online.

From a marketing perspective, we see our positioning on loyalty as the most important differentiator for us in the marketplace. With the ability to use new technology enablers to personalize our offers and therefore grow usage and adoption over time, we believe loyalty has the potential to be a driver of visits and transaction size in a significant way over a long period of time. On a more near-term basis for holiday, we'll be driving hard on all of our loyalty programs, including our credit card program, Kohl's Cash, and Yes2You rewards program, by making changes in execution to heighten and strengthen the effectiveness of the programs and improve our value proposition.

In conclusion, we feel we're very well positioned for the upcoming holiday season. We have momentum coming out of October. We have considerable newness in our stores and online assortments. Given our much lower inventory position, we've created a more appealing selling environment in our stores, and we can deliver a substantial amount of new transitional product across the company as we move through the holiday season. Whether she shops in one of our stores or online, whether she chooses to have her merchandise delivered or pick it up herself, we're committed to providing our customer with a convenient and value-driven experience.

And with that, we'll be happy to take your questions at this time.

Question-and-Answer Session

Operator

Thank you. One moment, please, for the first question. And introducing Mark Altschwager with Robert W. Baird. Please go ahead.

Mark R. Altschwager - Robert W. Baird & Co., Inc. (Broker)

Good morning. Thanks for taking the question. And first off, Wes, congratulations on your impending retirement. You're going to be missed.

Wesley S. McDonald - Kohl's Corp.

Thanks a lot.

Mark R. Altschwager - Robert W. Baird & Co., Inc. (Broker)

I wanted to start off and ask about gross margin. The rate of improvement pulled back a bit from what we saw in Q2. Just hoping to get a better sense of some of the puts and takes there. And then, as we look into Q4 and even Q1, comparison's obviously quite a bit easier from a merch margin perspective, and inventory's down 10%. So I guess the bull case on gross margin could be quite strong, but what other factors should we be taking into consideration as we model that for the next couple of quarters, and any notable pressures we should be thinking about, beyond e-commerce?

Wesley S. McDonald - Kohl's Corp.

Yeah, we certainly think that we'll have opportunity to improve more in the fourth quarter and, as you mentioned, especially in the first quarter next year. I think for this particular quarter, we obviously didn't plan to run down 3% roughly in the spring. So we did have to take some additional perm markdowns in the third quarter more than we planned to get rid of the spring merchandise. So that was part of the merchandise margins only being up 33 basis points.

Shipping costs continue to be in that sort of 20 basis points to 30 basis points range on a per quarter basis, due to mix of business and then the actual shipping costs themselves. As we get into fourth quarter, how well we do on gross margin is really going to be dependent on the mix of business between digital and brick and mortar. If our digital business continues to accelerate in the fourth quarter as it did last year, that will put some pressure on shipping cost and we might not be able to achieve the gross margin that you guys might expect off of an 80 basis point drop last year. But I still think we'll be able to be in that range of 20 basis points to 40 basis points for the season.

Kevin Mansell - Kohl's Corp.

Hey. And, Mark, the other thing is looking forward, the biggest single thing – and I think Wes would agree with this – on our margin opportunity will be our ability to change the process on how we manage receipts. And that includes both the massive new speed initiative that Michelle is driving, as well as localization as a key enabler, because both of those things allow us to bring receipts closer to need, and they also allow us to bring receipts that are more localized to the individual stores. So if you look at it on a long-term basis, I think those are really the big drivers. They're more permanent, I would say...

Wesley S. McDonald - Kohl's Corp.

Yeah.

Kevin Mansell - Kohl's Corp.

Than sort of the temporary things that you're focused on, which is, hey, you had poor gross margin last year in quarter four, quarter one last year, therefore, you should have got big opportunity. Yeah, we agree, but it's these longer term things that I think you want to focus on.

Mark R. Altschwager - Robert W. Baird & Co., Inc. (Broker)

That's very helpful. Thank you. And maybe more of a macro question, if I may. Just a lot of noise out there regarding whether the consumer was holding back ahead of the election and encouragingly, your sales improved in October versus September, which may suggest otherwise. So just hoping get your broad views on where the consumer is as we approach the holiday season and whether there's anything you're seeing in your own sales data that would suggest demand has been held back and could potentially accelerate now that we're past the election. Thanks.

Kevin Mansell - Kohl's Corp.

I mean, I don't think either Wes or I have a good sense of that. The cyclical nature of our sales in the third quarter, which was really basically really strong back-to-school, really poor September, and then very solid October were probably mostly driven by demand based on weather. And yeah, I think it's positive that it improved, but overall, I think our experience over a long period of time is things that are distracting like the election, once there's an outcome, certainty is a good thing. So from a positive perspective, having certainty on that is probably a good thing looking into the holiday.

Wesley S. McDonald - Kohl's Corp.

Yeah, I mean, also, the fact that weather wasn't very favorable not only affects the selling of cold weather merchandise, but we lose the trip to the store as well.

Mark R. Altschwager - Robert W. Baird & Co., Inc. (Broker)

Great. Best of luck this holiday season.

Kevin Mansell - Kohl's Corp.

Thanks.

Wesley S. McDonald - Kohl's Corp.

Thanks.

Operator

Thank you. For our next question, introducing Paul Lejuez with Citi. Please go ahead.

Paul Lejuez - Citigroup Global Markets, Inc. (Broker)

Hey. Thanks, guys. First time in a while that you've managed inventory levels down as much as you are. I'm just curious, what has the exercise taught you thus far? Are you happy what it's done for the business? I'm curious if there are any places, categories in your assortment where pulling back on inventory maybe constrained your sales to some degree. Thanks.

Kevin Mansell - Kohl's Corp.

This is Kevin, Paul, and I can probably take the first part and I think Wes actually has a perspective on it as well. But I think the main thing we're focused on is not making inventory management a point in time exercise. So it's not about pulling our inventories down, we did 9% at a point in time, it's about a permanent change to the way we approach delivering receipts over a long period of time.

So the speed initiative is a key enabler of that because it affects our proprietary brands, which is 50% of our business. Localization's a key enabler because it gets the assortments that need to be in the right store in the right store, and those are the more permanent things. I think everything we're seeing, which is there are plenty of examples in the company where receipts and inventory were pulled way back and sales are actually up, gives us sort of the sample size in the examples to point other areas to say to them, hey, this works, as long as it's a permanent process change. Wes?

Wesley S. McDonald - Kohl's Corp.

Yeah, I mean, I think we're pulling down private and exclusive more than national because that's where the sales are going. We're also giving up space in private to make room for some of our new brands. We did have a pretty decent quarter last quarter, Paul, but – you're going to win your steak dinner, I know, but that's okay. But no, like Kevin said, it's a multiyear plan. I expect us to be down 5% next year and then 5% in 2018, too. So it's a combination of absolutely reducing the receipts and then how we flow the merchandise, as Kevin mentioned, that speed initiative is going to be a big factor and we're going to look to turn our inventory a lot faster than we have in the last few years.

Paul Lejuez - Citigroup Global Markets, Inc. (Broker)

Thanks. Good luck. And best to you, Wes.

Wesley S. McDonald - Kohl's Corp.

Thanks.

Operator

Thank you. And for our next question, introducing Lorraine Hutchinson with Bank of America. Go ahead, please.

Lorraine Maikis Hutchinson - Bank of America Merrill Lynch Research

Thank you. Good morning. Just wondering how much of your assortment is currently on the speed pipeline at this point? And where will we see that go over time?

Kevin Mansell - Kohl's Corp.

Well, it's basically affecting, I would say, the Women's part of our proprietary brands. So Women's penetrates, in proprietary brands, much higher than the 50% for the company. And there are – without getting into a lot of detail, Lorraine, I think the way you think about it is it's been launched aggressively in certain areas, juniors, for example, and then it's scaling up in other areas, Women's sportswear, for example. And we would expect that 2017 is kind of the year, would have a major impact on the 50% of our business that's proprietary brands. I don't know if you've got anything to add on that, Wes.

Wesley S. McDonald - Kohl's Corp.

No, I think, in general, Women's, I think, by the end of the fourth quarter, we'll have 50% of the business on speed. And we're seeing a big comp difference between what's on the speed brand and what's not. Some of the successes, I'd say we've got a much better comp on the speed brands. We've been up sort of mid single-digits with inventory being down 8%. So that's a CFO's dream. So we continue to do that. That's going to enable us to do what we addressed in Paul's question.

Lorraine Maikis Hutchinson - Bank of America Merrill Lynch Research

Great. And then as you think about the athletic business and prepare for Under Armour, are you thinking about this as just growing your overall active business? Or do you think it will potentially cannibalize from other brands as you add Under Armour into the assortment?

Kevin Mansell - Kohl's Corp.

Well, we're definitely thinking that this is going to grow our overall active business, and that's how we managed it from both an inventory allocation standpoint, a space allocation and a floor standpoint, a fixture allocation, a marketing allocation, we just see active and wellness, and not just in a traditional sense of active, but also the wellness aspects of the business that include technology, things like Apple Watch or Fitbit, but they also include sleep health and eat healthy initiatives. It's a permanent lifestyle change and we don't see it slowing down.

More specifically to Under Armour, I think our expectations are that the active business, footwear and athletic, is going to grow substantially and it's not going to pull back the rest of our other active brands substantially. It's going to be incremental.

Wesley S. McDonald - Kohl's Corp.

Yeah, I expect to get extra trips. That's the whole key to this thing, is to get more people to come to our store for more things, and they buy Under Armour and they buy our other things as well.

Lorraine Maikis Hutchinson - Bank of America Merrill Lynch Research

Great. Thank you.

Operator

Thank you. For our next question, introducing Lindsay Drucker Mann with Goldman Sachs. Please go ahead.

Lindsay Drucker Mann - Goldman Sachs & Co.

Thanks. Good morning, everyone.

Wesley S. McDonald - Kohl's Corp.

Good morning.

Lindsay Drucker Mann - Goldman Sachs & Co.

I wanted ask about the transaction number per store in the third quarter, which slowed versus the second quarter. But I was wondering if you attributed that most to weather, whether you saw sort of regional differences in that trend, and if the overall trend kind of mirrored the progression of comps across the quarter.

Wesley S. McDonald - Kohl's Corp.

I mean, the short answer is yes, I think weather did affect it. It was different by region. I think I mentioned that the West region had a positive single-digit comp, and we definitely had better transactions as we entered October.

Lindsay Drucker Mann - Goldman Sachs & Co.

Great. And on the price per unit, the nice sequential improvement there, was curious if there were any specific drivers. You mentioned you had to take some permanent markdowns given the unplanned weakness in the second quarter. So just was hoping to get a little more detail on that.

Wesley S. McDonald - Kohl's Corp.

Well, the AUR was up about 2%, so the perm certainly didn't help it, it would have been higher without that. But I think it's continued strength with our national brands and the content's getting better. I went back and looked through the board meeting, (24:58) it's the first time since 2004 that we've had both AUR and UPT up in the same quarter more than 1%. So we're getting the customer to pay more for it, and they're liking what they pay. We just got to get more people into the store. That's the key.

Lindsay Drucker Mann - Goldman Sachs & Co.

Yeah, on the merchandise initiatives you talked about, specifically for holiday, where the big focus is for traffic?

Kevin Mansell - Kohl's Corp.

Yeah, both the merchandising initiatives but also the marketing initiatives, and we sort of alluded to that, that we're really leaning on loyalty in the long term for driving our business. We're moving more and more of our efforts to our loyalty platforms, whether they're the credit card or Kohl's Cash or Yes2You rewards. But I think some of the reasons why our October moved more positively was that we better effectively landed loyalty offers, including the credit card offer, including some Yes2You reward offers, into timing where customers are more naturally shopping. And I think that was a big positive for us. And I think Michelle has those planned pretty aggressively to do the same thing in the fourth quarter.

Wesley S. McDonald - Kohl's Corp.

Yeah, I also think the fact that we talked about Men's being better than the company for three straight quarters and Home showing the biggest improvement, both those businesses over-indexed in the fourth quarter. So that gives us some confidence that the sales will continue to improve.

Lindsay Drucker Mann - Goldman Sachs & Co.

Great. Thanks so much.

Wesley S. McDonald - Kohl's Corp.

Thanks.

Operator

Thank you. And for our next question, introducing Dan Binder with Jefferies. Please go ahead.

Daniel Thomas Binder - Jefferies LLC

Hi. It's Dan Binder. You mentioned that there was a retiming of SG&A into Q4. I'm assuming that was the marketing that you mentioned. I was just wondering if you can quantify it and tell us a little bit about what type of marketing. You're obviously very promotional already, and in the fourth quarter, just kind of curious where you plan to spend that money.

Wesley S. McDonald - Kohl's Corp.

Well, I said about half of our favorability, or about $8 million or $9 million, is going to shift into the fourth quarter. It wasn't just in marketing, it was in other areas, too. Don't really want to tip our hand on what we're doing from a marketing perspective, but we're definitely, as Kevin mentioned, focusing on loyalty and focusing on Kohl's Cash, those are things that differentiate us versus our competition.

Our Thanksgiving Black Friday event is the only time of the year we do $15 off $50 Kohl's Cash, and that's a really big driver to get people into our store versus other stores, and so we'll definitely play that up as we move through the month.

Daniel Thomas Binder - Jefferies LLC

And then I was wondering if you could comment – I may have missed it. If I did, I can go back – just the national brand performance versus private label and exclusive.

Wesley S. McDonald - Kohl's Corp.

National brands continue to be positive low single-digits, and private and exclusive combined were down about mid single-digit. Private is doing better as things like SONOMA get more back on track.

Daniel Thomas Binder - Jefferies LLC

The SONOMA relaunch generally, I think, was well received. Is that comping positive yet or no?

Wesley S. McDonald - Kohl's Corp.

Yeah, on the Women's side, which is the biggest part of the business. It's up mid-single digits in the third quarter.

Daniel Thomas Binder - Jefferies LLC

And then the last question...

Wesley S. McDonald - Kohl's Corp.

On 19% less inventory.

Daniel Thomas Binder - Jefferies LLC

Got you. Last question was on the comparisons. You had a choppy fourth quarter last year as I recall. Started off really soft, then got strong in the core of the holiday season. Just curious from a promotional standpoint, as you go up against those tougher compares in the heart of the season, should we expect promotions to be heavier or more or less in line with what we saw last year?

Kevin Mansell - Kohl's Corp.

Well, again, I think, Dan, first of all, as Wes said, I don't think we want to get into the specific activities we have planned in marketing. But just in general, I think when you think about Kohl's from a marketing perspective, it's natural, based on our history, that you think a lot about big events, about pricing efforts, about couponing. And more and more, you're going to see more dependence on product being important to the overall effort, and loyalty, which includes our credit card and our Kohl's Cash efforts and our Yes2You rewards effort, to be more and more important. And so that does allow us to time and, as I said, personalize many of those efforts more effectively.

So, it's going to be an intense holiday season. I don't think there's anything new about that, and there's nothing special about that from a year-over-year standpoint. But I suspect, when you look back at the end, you'll see a noticeable effort to better time our marketing, particularly around how we pull all of our loyalty components together.

Daniel Thomas Binder - Jefferies LLC

Great. Thanks.

Operator

Thank you. And for our next question, introducing Oliver Chen with Cowen and Company. Go ahead, please.

Oliver Chen - Cowen & Co. LLC

Thank you. When you do look at your month-to-month regarding September, was there anything that could've taken place, in terms of trying to reduce that volatility? And as you do look forward to a lot of these structural positive changes you're making, is your expectation that we could see less volatility, hopefully, in month-to-month as it relates to weather?

And another topic we were curious about, inventory has been a great theme for you. Previously, which inventories were elevated? It sounded like you had too much and it was harder for the consumer to shop. So I'm just trying to understand what edit was critical, in terms of doing better with less stuff. Thanks.

Kevin Mansell - Kohl's Corp.

I'll take the first part of it. It's Kevin, Oliver. I mean, from a volatility perspective, looking backwards to the weak September, there's always things, when you look in hindsight, that you can say, had we done this differently from a marketing standpoint, we might have done better overall. And certainly there were a couple things, particularly around the Labor Day holiday, that we look back at and say, we probably would have done them differently had we known. But they were informed based on testing and piloting we had done, so I don't second guess it. And I think, over time, we'll continue to make improvements on that.

We're always going to be affected by the seasonality of weather at a point in time. We just are. I mean, we're heavily penetrated in apparel. We have a customer who shops on a wear-now basis for that clothing and accessories. And so we're more vulnerable than some of our competition, both negatively but also positively, when it's good.

I do think Michelle's made, with her merchandising team, some big changes to lessen the dependence on cold weather as a driver. And, as I said, both the localization initiative and the speed initiative are key components of that, because they put us in a position to better depend upon other classifications within the apparel business to drive our overall business over time. But we're still going to always be vulnerable, as I said, both on the negative side and on the positive side, on weather. I do think, though, it's going to lessen, and we see it lessening, actually.

Wesley S. McDonald - Kohl's Corp.

Yeah. I think we did make a good calendar shift with our Lowest Prices of the Season event. We moved from August to September, where the weather was a little cooler, and drove a nice double-digit comp during that event, so that was a smart move.

And then the other thing I think is, we – and you can ask anybody in the company this now, I think they know the number – in 2011-2015, we grew sales 2% and we grew inventory 29%. That's not sustainable, and we're making progress on doing that, and it's a multi-year effort because we want to do it smartly.

Oliver Chen - Cowen & Co. LLC

Okay. And you may not have an answer for this, but as we think about Trump, there's still a lot of unknowns in the marketplace. Is this something that you think will still kind of be in the minds of your consumer? I'm just curious about your thoughts from a senior level as we dissect how this may impact shopping and sentiment, and how consumers think about what they may want to spend in such a time of change?

Kevin Mansell - Kohl's Corp.

I mean, overall, I think, Oliver, you can only – as business people, we can only manage what we can manage. So, there are plenty of things, though, that we can manage better. Inventory is a big aspect, but that's driven by receipt flow. And I think we're managing it much more effectively than we did in the past, and it's giving us a lot more flexibility. So if, for instance, you feel there's uncertainty due to continued fallover from the election, I think more flexibility in a business plan is a good thing.

From a marketing standpoint, we're trying to do the thing that gives us the maximum flexibility as well, and that's to be less dependent on the big event and be more dependent on tying all of our strong loyalty components together over time. So, I feel like we're doing things with an eye to the long term and that it's benefiting us, and it'll continue to benefit us, regardless of whether or not you think the consumer's in a buying mood for holiday or is still not so much. I don't know if you've got anything to add, Wes, on that?

Wesley S. McDonald - Kohl's Corp.

Yeah, I'm not touching that one.

Oliver Chen - Cowen & Co. LLC

Thanks for answering that. I appreciate it. And congrats on all the initiatives. Best regards.

Wesley S. McDonald - Kohl's Corp.

Thanks.

Operator

Thank you. And for our next question, introducing Paul Trussell with Deutsche Bank. Please go ahead.

Paul Trussell - Deutsche Bank Securities, Inc.

Good morning. Congrats, Wes. My first question is, what will you be doing this time next year? And then I have a follow-up.

Wesley S. McDonald - Kohl's Corp.

Think I'll be on a pontoon – well not this – yeah, yeah, I can still be on a pontoon boat next year, so we'll see. If the weather never changes in October, I could be on one, so we'll see.

Paul Trussell - Deutsche Bank Securities, Inc.

Sounds good. Sounds good. Congrats on that.

Wesley S. McDonald - Kohl's Corp.

Thanks.

Paul Trussell - Deutsche Bank Securities, Inc.

Just from a digital standpoint, has e-commerce continued to have the strong gains that you've been posting for the last few years? Just wondering if there's anything different from recent trends or your set of expectations? And then also, on the door fleet. I know it's a bit early to comment on this, but just wanted to inquire on what you've maybe learned in these very few short months since you've done the store closings as well as open the FILA doors.

Kevin Mansell - Kohl's Corp.

On the digital side, I mean I think that trends are similar to what they've been. People continue to shop and explore and search more online increasingly, obviously, more with their smartphone than anything else. And we see that in all of our metrics and all of our trends. I would say we are seeing, increasingly, a trend towards customers using that information to transact in our stores, which I think would – if that were to continue over a long period of time and grow, that would be a really good thing for us, because as you know, one of our key initiatives is to amplify the importance of our store base, and we have a substantial store base. So that would be a great trend if it continued. But I think overall, people continue to use the digital devices that they have to do all the things that make their shopping easier for them.

From a door fleet perspective, I think there's two things that happened in the third quarter. One I think you're alluding to, which was the small number of stores we closed. It's way too early I think for us to draw any conclusions on that. But I do think by the time we get to February, we definitely will owe you and give you some indication of what we're seeing from a holding (37:38) the trade area sales in other stores, and whether or not it was a positive thing or not from a market share perspective. So too early. I wouldn't want to share it, but I promise you that when we get to February, we'll give some indication of the impact of that.

The other thing that happened in the third quarter was that we opened up six new small 35,000 square-foot stores. And the more of those that we open, the more confident we're getting that those are long-term pluses for us, both to get us into trade areas where we can't make the economics of a larger store work but also just, in the long term, looking at larger stores that we have that have been more impacted by digital sales and are doing a little less volume than they used to do, there's the opportunity for us to scale down the size of the store, because we do think that that's, long term, a big positive for us.

You know we've said – and I think Wes agrees – having stores is a critical component of our success. So I think the small store initiative – and it's early – could be very good for us, and certainly the early indications are positive.

Wesley S. McDonald - Kohl's Corp.

And you asked about FILA, I would say we've had a lot of learnings from that since we opened those in May, and we've made some changes for the holiday season. And we'll be in a better place to tell you more details after holiday.

Paul Trussell - Deutsche Bank Securities, Inc.

I appreciate the color, guys.

Wesley S. McDonald - Kohl's Corp.

All right. Thanks.

Operator

Thank you. In for next question, introducing Neely Tamminga with Piper Jaffray. Please go ahead.

Neely J. N. Tamminga - Piper Jaffray & Co.

Great. Good morning. Hey. So question here on Home for you, Kevin, if you can. It sounds like Home had this nice improvement. As you alluded, Q4, it over-indexes, but Home is comprised of a lot of different types of trends and categories, so can you give us a sense of what started to work in Q3 and whether or not that has legs for holiday, or some other insights you can give us for holiday (39:53)?

Kevin Mansell - Kohl's Corp.

Wes can (39:54)

Wesley S. McDonald - Kohl's Corp.

I actually know this one, Neely. Kevin's surprised. But no, I think bed and bath have been the strongest categories all year, and they accelerated in the third quarter. We also saw some nice improvement in the premium electronics area as we got some of the new versions of things like Fitbit out there. What continues to be a little softer is the hard home areas in home decor, tabletop and cookware.

Neely J. N. Tamminga - Piper Jaffray & Co.

Okay. Thanks, Wes. And you probably won't be on a pontoon if it's up here in the (40:32)

Wesley S. McDonald - Kohl's Corp.

I'm optimistic.

Neely J. N. Tamminga - Piper Jaffray & Co.

All right. Best wishes to you. Cheers.

Wesley S. McDonald - Kohl's Corp.

All right. Thanks.

Operator

Thank you. For our next question, introducing Brian Tunick with Royal Bank of Canada. Please go ahead.

Brian Jay Tunick - RBC Capital Markets LLC

Thanks. Good morning, guys.

Wesley S. McDonald - Kohl's Corp.

Good morning.

Brian Jay Tunick - RBC Capital Markets LLC

Curious about two things. I guess one, on Under Armour, I guess you guys said being the largest launch in the company's history. So just curious about the overall brand portfolio, are you guys thinking about other national brands? Or are there specific categories in which you think you're still missing a big national brand or really could be impactful to your customer? So just curious about that in the same vein of Under Armour.

And then I guess, Wes, when you think about potentially rebuilding, I don't know, to a 37% gross margin over time, can you maybe talk about those positives and negatives, including the Buy Online, Pick Up In Store, the digital, things like that, offsetting potentially the merchandise margin recapture?

Kevin Mansell - Kohl's Corp.

I can take the first part. I think Wes can take the other. On the brand aspect of our strategy, I think Michelle would tell you that she is continuing to push hard and explore new additions. She's had some great success. We alluded to a couple of the recent really important ones, which include the partnership with Apple and the launch of the Apple Watch uniquely as a component of our overall active and wellness initiative, which I think is something that will be very positive.

I would say any brands in which we can provide additional help in distribution against the core categories that we think are so important to our business. So naturally, the apparel business is our biggest business, and we're looking hard for expansions in apparel. And then categories that we really believe in, active and wellness is obviously the most obvious one right now, are ones in which we're exploring more aggressively.

Wesley S. McDonald - Kohl's Corp.

I think we have opportunities in Footwear and Accessories, but the Accessories ones are a little more difficult, I'd say. From a gross margin perspective, very simply, we're trying to get back 50 basis points a year of merchandise margin improvement through inventory initiatives. And I'm especially excited about the speed initiative because that should be incremental to the 50 basis points which should just be able to occur from getting our inventories to the right level.

But that's going to be offset by about 30 basis points of pressure from e-commerce, assuming that it continues to grow at the kind of the rate that we think it is in that mid-teens kind of a range. So from a modeling perspective, if you're looking at a multiyear model or thinking about how we're going to do 20 basis points a year improvement is probably the best, I think, that we'll be able to accomplish, absent improvement in comps from where we're running today. If we can improve in comps, then that could provide us some margin upside over and above that.

Brian Jay Tunick - RBC Capital Markets LLC

Super. Thanks for the color. Good luck.

Wesley S. McDonald - Kohl's Corp.

Thanks.

Operator

Thank you. And for our next question, introducing Bob Drbul with Guggenheim Securities. Please go ahead.

Robert Drbul - Guggenheim Securities LLC

Hi. Good morning. And Wes, congratulations.

Wesley S. McDonald - Kohl's Corp.

Thank you.

Robert Drbul - Guggenheim Securities LLC

I got a couple of questions. In the store, did you give Buy Online, Pick Up In Store penetration in the trends that you're seeing this quarter?

Wesley S. McDonald - Kohl's Corp.

Buy Online, Pick Up In Store?

Kevin Mansell - Kohl's Corp.

The (44:27) business (44:28)

Wesley S. McDonald - Kohl's Corp.

I mean, last quarter it was about 5% or 6% of the digital demand. We would expect it to go up during holiday. We're making it more prominent in the stores. We're making it easier. There'll be a line that you can go in to pick up your order versus waiting in a general customer service line. I think we've put a lot more efficient tools in the stores to help our associates pick it in a smaller amount of time. We're doing a little from a marketing perspective to make people realize, especially when they're on the website, that it's available. I expect that we'll get up to that sort of high single-digit range as we get into the fourth quarter.

Robert Drbul - Guggenheim Securities LLC

Great. And on the capital structure, I think the new buyback program, can you just update us how to think about the trends in buybacks over the next couple of years, and sort of share repurchase versus dividend, updated thoughts?

Wesley S. McDonald - Kohl's Corp.

Well, we'll go through a really detailed discussion with the board in February on that. We had a preliminary discussion yesterday, but obviously, with the increase in the authorization, we think we can accomplish that over a three-year period, roughly. So that'd be about $600 million or so a year for share repurchase.

And I would intend to increase the dividend at what level. I'm not sure we've targeted 10%. I think it would be dependent on what net income payout ratio that we're comfortable with. But I actually think the better metric to look at is the percentage of cash flow. We've done a really good job this year and I expect us to be able to generate about $1 billion in free cash flow after CapEx expenditures. So I think we could be able to continue to do a 10%, but whether or not that's the right use for the excess cash, we'll have that discussion with the board in February.

Robert Drbul - Guggenheim Securities LLC

Got it. And you talked about some strength continuing in active. Has the NIKE business continued to comp? Can you give us some updates on how NIKE's performing for you?

Kevin Mansell - Kohl's Corp.

I think NIKE was up mid double-digit for the third quarter.

Robert Drbul - Guggenheim Securities LLC

Great.

Wesley S. McDonald - Kohl's Corp.

Yes.

Robert Drbul - Guggenheim Securities LLC

Okay. And then one last question. You talked about Women's, you talked about Men's doing well. And in the Women's business, Kevin, the cold-shoulder style offerings in blouses and tops, there's some offerings on the floor and online, and I just wondered if you think that's a trend that can help turn and improve the Women's business.

Kevin Mansell - Kohl's Corp.

Tell you what, Bob, I'll answer that question if you can describe for everybody what a cold-shoulder top is?

Robert Drbul - Guggenheim Securities LLC

So it has the – the shoulders are cut out and you have some various smock ones that are there. You have some J.Lo offerings. You've got Apt. 9, so I don't know if that's part of the speed initiative, but there's definitely some good trends and styles in those stores, Kevin.

Kevin Mansell - Kohl's Corp.

Well, you sort of stumbled through that answer but you did a decent job, I would say. So yeah. No, it's good, Bob. Thanks for the color for everybody.

Robert Drbul - Guggenheim Securities LLC

Thanks, Kevin.

Operator

Thank you. And then for our next question, introducing Richard Jaffe with Stifel. Please go ahead.

Richard Jaffe - Stifel, Nicolaus & Co., Inc.

Thanks very much. And first my congratulations to Wes as well. Wish you well and keep in touch. You can be an all these calls. We'd love to have you.

Kevin Mansell - Kohl's Corp.

Let me tell you, no, he won't be on these calls.

Richard Jaffe - Stifel, Nicolaus & Co., Inc.

Wes, inventory decline, obviously, is very impressive this quarter and there's more runway ahead. Do you think this rate of change in your inventory could continue for the next four quarters? For the next 12 quarters? (48:15)

Wesley S. McDonald - Kohl's Corp.

Yeah, absolutely. I think one of the big initiatives that we're going to in the fall is some of our lower volume 88,000 square feet stores, we're going to fixture like they're a 64,000 square foot store. So that will eliminate the need to just buy product to fill fixtures.

We've done it in over 100 stores already and it's proven to be – not affect any of the sales results and driven pretty nice gross margin improvement to the tune of, depending on the vintage, it was 25 basis points to about 100 basis points of improvement. So we have another chunk of about 100 stores that we're going to have in place for back-to-school, and I think that will allow us to continue to reduce inventory without hurting sales very easily.

Richard Jaffe - Stifel, Nicolaus & Co., Inc.

And if you could just comment on the smaller stores. I think early in the presentation, you talked about smaller mall stores. Are you finding that the attached mall opportunity is attractive to you, that that's working, with a smaller box?

Kevin Mansell - Kohl's Corp.

Well, I mean some of the stores that we just opened in the third quarter, actually, are what you're describing. I definitely don't want to get ahead of myself in the 35,000 square-foot stores. We've been open for now, I guess, six weeks or seven weeks. But you know that the strategy there had two prongs to it. One was pretty straightforward, which is, it gives us new points of distribution in smaller markets where we can't make the economics of a larger store work, and makes our ability to reach customers more effective. You know that we've put a stake in the ground, that brick and mortar is really important as an omnichannel retailer, both to have a place in the customer's mind, but also as a point of distribution. So that's one.

And then the second one is just this, probably longer term aspect which is, if you believe that digital sales are going to continue to grow as a percentage of the total, then we ought to be able to operate stores in existing areas where we have stores that are simply smaller because they're more efficient. And it's all positive right now, Richard. I just – I think we just need a little more time to give you quality.

Richard Jaffe - Stifel, Nicolaus & Co., Inc.

Yeah, no, that makes sense. And just a final thought on marketing and more traditional advertising in the fourth quarter. Sounds like that accelerated towards the end of the third quarter and had some positive results. Could you talk about, year-over-year, what advertising will look like in 4Q?

Wesley S. McDonald - Kohl's Corp.

Year-over-year, it's going to be up slightly, $4 million or $5 million, not materially. And it's going to be more shifted into paid search. As Kevin mentioned earlier, two or three years ago, when you did search, it drove a lot of traffic to the site. With the increased use of mobile devices and the ease of use that our app and our wallet has proven to be effective with our customers, they're using it more to pre-shop. So we're having to spend more money on paid search to drive people both into the store as well as the website, because we're finding that effective use of the marketing dollars, but so is everybody else, so the cost to do that is getting more expensive.

Richard Jaffe - Stifel, Nicolaus & Co., Inc.

Understood. Thank you very much.

Wesley S. McDonald - Kohl's Corp.

Thanks.

Operator

Thank you. And for our next question, introducing Bernard Sosnick with Madison Global. Please go ahead.

Bernard Sosnick - Madison Global Partners

Good morning.

Kevin Mansell - Kohl's Corp.

Good morning.

Bernard Sosnick - Madison Global Partners

With regard to Children's wear, a price-sensitive category, you've had some difficulty, and particularly with Jumping Beans. What are the reasons there, and what does it say about the level of competition that you're facing?

Kevin Mansell - Kohl's Corp.

Well, I mean, I think you know, Bernie, that Children's wear is a particularly and acutely competitive category, because price is such an important aspect of the buying decision. It's also uniquely different for us in terms of the competitive set, where the share sits. So unlike, let's say, Women's apparel, in Children's wear, we compete much more aggressively against retailers like Walmart and like Target. So I mean, I think our judgment is that it always comes back to product. Our prices are great in Children's wear; in particular, they're great in Jumping Beans. And you're right, Jumping Beans as a brand has been far short of our expectation.

Everything always comes back to product, and I think Michelle would tell you that that's where we need to put our effort, is to give customers better choices in product, to time them from a speed perspective more effectively, so they flow more evenly into the store, and more localized, so they're more appropriate based on where the store is. I think those are the three big things.

Bernard Sosnick - Madison Global Partners

The other part that was lagging is Accessories where, if I remember correctly, you made a significant effort to improve your offering. What's happening there?

Kevin Mansell - Kohl's Corp.

Similar. I mean I think on the call, in the prepared remarks, we alluded to the fact that there were a couple categories actually that performed exceptionally well. One of them is really encouraging, which is fine jewelry. And as you know, the fourth quarter, fine jewelry's a more important category. We haven't had a lot of success in fine jewelry. The other one's been a more consistent performer for us, which is bath and beauty. That did well, and I would expect that to continue.

Our categories that are dragging on sales in Accessories are categories like handbags, where we haven't had success. And very similarly to Children's wear and the conversation we just had, often these things come back to product. And we just have to make better buying decisions, and we have to give customers better choices. So it goes without saying, of course, that that's a high priority for us right now.

Bernard Sosnick - Madison Global Partners

Well thank you. I focused on a couple of the weaknesses, but I don't want to leave without saying, you're doing an impressive job overall, especially with inventories. So thank you.

Kevin Mansell - Kohl's Corp.

Thanks, Bernie.

Wesley S. McDonald - Kohl's Corp.

Thanks, Bernie.

Operator

Thank you. And for our next question, introducing David Glick with Buckingham Research. Please go ahead.

David J. Glick - The Buckingham Research Group, Inc.

Thank you. Good morning, and Wes, best wishes and good luck.

Wesley S. McDonald - Kohl's Corp.

Thank you very much.

David J. Glick - The Buckingham Research Group, Inc.

Just want to follow up on Buy Online, Pick Up In Store, as you alluded to earlier, it was not as efficient at holiday last year. You were just rolling it out. I'm just curious, how big of an opportunity you see that from a sales-driving perspective? And then secondly, given that it's your most profitable sale, how are you strategizing to build that business? Are you considering giving customers an incentive – a cash incentive, a Kohl's Cash incentive, for example, to come in and execute an order that way? Thanks.

Kevin Mansell - Kohl's Corp.

Well, I think right now, to be honest with you, we're actually pretty pleased with Buy Online, Pick Up In Store. To be totally honest, if you just did the calculation for the third quarter, Buy Online, Pick Up In Store as a percent of our total digital demand was not as high as we had hoped for. So we're not trying to dodge that. That's a fact. But we've been focused all year on the fourth quarter, because we know that's actually when the big opportunity presents itself.

And the way we're looking at it first is really to have provided sort of best-in-class experience, and that starts with the enablers on customers' devices, in particular their mobile phone device, to make the experience of buying and picking up in store really, really easy. And Wes alluded to some of that. There's all kinds of operational changes that we've made. I think our sense is that will actually drive the percentage to where we need it to be. I don't think we need to get at this point at all into more specific incentives for customers to consider to drive them to use Buy Online, Pick Up In Store. I think if we make the experience phenomenal, I think it's going to be really, really good.

And we seem to be overlooking, in some of the questions, the positive impact I think also of ship from store because, again, we've put a stake in the ground to say our store portfolio is really important, and we believe in it, and we're going to amplify it. And the way we're going to amplify it is use our stores for all aspects of customer experience, which include not just Buy Online, Pick Up In Store but also our ability to ship from store.

And so I think both of those for the fourth quarter are going to be phenomenal. I think we'll be talking this February about really good indices on both of those strategies.

Wesley S. McDonald - Kohl's Corp.

Yeah, I think the key is going to be we have to execute after shipping cutoff because that's the key to get that last trip for the shopper to come in our store. Because with the 28% I think this quarter attachment rate, that helps drive additional sales. We got to just get them into the store.

David J. Glick - The Buckingham Research Group, Inc.

Great. Thank you very much. Good luck in the fourth quarter.

Wesley S. McDonald - Kohl's Corp.

Thank you.

Operator

Thank you. And for our final question, introducing Dana Telsey with the Telsey Advisory. Please go ahead.

Dana Lauren Telsey - Telsey Advisory Group LLC

Good morning, everyone, and congratulations, Wes.

Wesley S. McDonald - Kohl's Corp.

Thank you.

Dana Lauren Telsey - Telsey Advisory Group LLC

I know this isn't the end. We'll be seeing more of you on these calls or at least hearing from you from time to time.

Wesley S. McDonald - Kohl's Corp.

Thank you.

Dana Lauren Telsey - Telsey Advisory Group LLC

As you think about the online and omnichannel efforts, what are you seeing in terms of expenses, ability to reach profitability, anything with shipping that we should be mindful of as we're going into 2017 and managing it? Thank you.

Wesley S. McDonald - Kohl's Corp.

Yeah, (58:35) we continue to improve on digital profitability. So my comments on shipping costs is just it's a fact, it's not increasing. It's just as the percentage of the business goes forward, our costs per package are actually doing a little bit better. The key for us to continue to improve profitability is to reduce the amount of split shipments. That's the key for probably most retailers. It's especially for important for us, given our relatively low average transaction value online, which is around $75.

So we have a lot of IT initiatives to do that. Kevin mentioned ship from store. That's helped from a speed and capacity perspective, but we have to continue to help give the associates the tools to find all the items in that order so we don't end up having to send a partial order to another store. That's critical. So if we can continue to make progress there, I think you'll see the profitability improve.

Our overall inventories were down about 9% per store. In e-comm they were flat, so that continues to – and obviously, their sales are much better than brick and mortar. So we continue to get a turn (59:47) improvement from that perspective, so I think we'll be able to grow our merchandise margins on the e-comm side as well. And the SG&A expenses continue to come down. The EFC-5 that we're opening next year is going to be three times as productive as our existing EFCs. So we've got a lot of things in the hopper that are going to help us improve that profitability.

Dana Lauren Telsey - Telsey Advisory Group LLC

Thank you.

Kevin Mansell - Kohl's Corp.

Thanks, Dana.

Wesley S. McDonald - Kohl's Corp.

Thanks, everybody. Appreciate it. I'll be available for calls a little bit later. Thanks.

Operator

Thank you. And, ladies and gentlemen, this conference will be available for replay after 11:00 AM Eastern Time today through December 10 at midnight Eastern Time. You may access the AT&T TeleConference replay system at any time by dialing 1-800-475-6701 and entering the access code 386530. International participants dial 320-365-3844. Those numbers again are 1-800-475-6701 and 320-365-3844, access code 386530.

That does conclude our conference for today. Thank you for your participation and for using AT&T Executive TeleConference. You may now disconnect.

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