Weakness Across The Board, But Kohl's Is Cheap

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About: Kohl's Corporation (KSS), Includes: AMZN
by: Detroit Bear
Summary

Shares of Kohl's tumbled after missing financial estimates.

The company's home business suffered terribly from increased price competition.

Still, H2'19 traffic drivers linger on the horizon.

Shares look cheap in spite of the near-term gross margin headwinds.

Shares of Kohl’s (KSS) have fallen dramatically, dropping over 22% since the company missed Q1 earnings estimates and materially lowered its FY19 EPS and sales forecasts. After reviewing quarterly results and the company’s 10-Q, which provides broad-based insight on Kohl’s many different business lines, I am reiterating my long recommendation, though I am reducing my fair value range to $75-80 per share. Investors who are not overly concerned with short-term swings should be able to capitalize on the multiple upside drivers that Kohl’s develops, and I think the company recover from some short-term headwinds.

Q1 Results in Context

Q1 was undoubtedly a disappointment as total sales fell 2.9% y/y to $4.1 billion with comp store sales down 3.4% y/y. On the positive side, the two-year stack is still positive at 0.2%, and while sales fell by 3%, gross margin fell only 10 basis points y/y to 36.8% of sales. Declining sales are never a positive sign, but I think there is some saving grace in the sense that Kohl’s preserved gross margin.

Category

Q1'19

Q1'18

Y/Y Change

Women's

1,220

1,255

-2.8%

Men's

785

790

-0.6%

Home

629

691

-9.0%

Children's

456

454

0.4%

Footwear

419

439

-4.6%

Accessories

312

324

-3.7%

Net Sales

$3,821

$3,953

-3.3%

Source: KSS Q1’19 10-Q

If we look more closely at the composition of the decline in sales, we can see that while all categories suffered, the Home business was by far the weakest with sales dropping 9% y/y. Management blamed themselves for the poor performance, noting that even though Q1’18 was a tough comparison, the company’s prices were too high for the competitive landscape, allowing competitors to take market share. I anticipate management will “invest” in price for the balance of the year to become more competitive in the category. Unfortunately, Kohl’s will face both a pricing headwind and a China headwind, as much of its product assortment will be subject to increasing tariffs that management did not originally bake into its earnings forecast. China represents over 20% of COGS, and I believe this allocation could be even higher in Home, where Kohl’s vendor partners do not have the ability to freely shift production. As a result, gross margin will likely fall 20-30 basis points compared to an initial forecast of an increase of 10 basis points.

On the expense side, Kohl’s did a fairly reasonable job controlling SG&A, which increased only 1.3% y/y in spite of industry-wide labor headwinds. In fact, most of the increase was driven by a $37 million change in accounting that caused a non-cash charge for operating lease expenses.

In addition to solid expense management, I liked Kohl’s capital allocation in Q1, though I think the company should become a bit more patient with regards to stock repurchases. Capex was up over $100 million y/y to $238 million as the company invests heavily in its 6th e-commerce distribution facility, which should help improve the company’s logistics capabilities and help make the company even more attractive to possible future acquirer, Amazon (AMZN) (more on this later).

Otherwise, the company paid out its regular quarterly dividend of $0.67 per share and repurchased 1.8 million shares for $121 million, equal to an average price of $67.22 per share. This is where the company could learn from another retailer – Foot Locker (FL) – which typically flexes repurchases up and down based on the market price of the stock as well as the insight into the quarter. For instance, Foot Locker barely repurchased stock in Q1, and I am fairly confident the restraint on repurchases was a function of understanding the quarter was likely to come in below expectations, providing a better buying opportunity at a later date. Not every company reads market movements this well, but I think CFOs could take note of Foot Locker’s repurchase strategy.

Traffic Drivers and Value Drivers on the Horizon

One of the reasons why I like Kohl’s management team is because they experiment with concepts to drive traffic. Kohl’s partnership with Planet Fitness (PLNT) where the fitness chain will open 10 stores within Kohl’s stores is one example of unique ideas to drive traffic, and the most prominent idea, is Kohl’s nationwide partnership with Amazon to service returns. Third party research suggests that the returns pilot in Chicago produced a 9% comp growth rate, and I believe the nationwide rollout could be a material catalyst for comp growth in the back half of FY19.

In addition to partnering with Amazon to provide a place for returns in exchange for traffic, Kohl’s issued Amazon warrants to buy 1.7 million shares for $69.68 per share. Though the total investment expenditure would be only 1% of Kohl’s and a paltry $118.5 million for Amazon, I think the warrants underscore Amazon’s underlying interest in increasing its retail presence and nationwide distribution network. Kohl’s also owns proprietary brands that Amazon could leverage through its online presence. In my view, the combination of distribution and brands could eventually make Kohl’s an acquisition target for Amazon.

In addition to the Amazon potential, Kohl’s continues to increase its online capabilities by increase fulfillment resources with its 6th e-commerce distribution facility under construction. Kohl’s also partnered with Fanatics to provide a front-end for licensed sports product, with Fanatics providing back-end fulfillment. I am bullish that Kohl’s will be able to steal some share in the licensed sports area, likely without much of an increase in inventory risk –the plague of the licensed apparel business.

Cash Flow Strong; Shares are Cheap

Ultimately, Kohl’s had a bad quarter, and management did a poor job of adjusting to changes in the marketplace on the fly. The company lowered its earnings guidance to $5.15-5.45 per share from $5.80-6.15 per share, which is a major disappointment. However, the company retains the ability to generate over $1 billion in free cash flow, and the depressed stock price may actually create more shareholder value, as Kohl’s repurchases of $400-500 million will likely retire more shares than previously anticipated at a much more attractive price. Shares trade at less than 8x free cash flow, which looks relatively low considering Kohl's +/- 2% comp recent comp growth history.

That said, I am lowering my fair value slightly to $75-80 from $80-85 to reflect the near-term weakness and lower gross margin dollars over the next two years with the uncertainty to Chinese tariffs. With a dividend yield of 5.6% and comp sales growth drivers on the horizon, I think shares offer excellent return prospects.

Disclosure: I am/we are long KSS, AMZN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.