Thesis:

SELL.  Kohl’s (“KSS”), a national family department store, is a sell as it is in a structurally declining segment of retail facing increasing competition from other brick n’ mortar players as well as from online competitors.  Despite having a seasoned management team, KSS has become a retailer growing below GDP and is becoming irrelevant to the consumer at large.   Additionally, KSS’ inability to gain key national brands will further hinder its performance within its retail store and on its website.  Despite its current level of FCF generation, there is a risk (similar to what happened to other formerly cash rich retailers including ARO and COH), that continued poor revenue performance will negatively impact FCF.  From a valuation perspective, KSS is expensive, trading at almost 14x current year P/E when it should trade at a discount to its peers or 10x P/E given its weak revenue and EPS growth outlook.  At that multiple, KSS is worth about $40/share, downside of 30% from today’s price. 

Business Description:

Kohl’s Inc. (“KSS”) is a large national chain of off-mall family-oriented department stores with over 1,100 locations.  Headquartered in Menomonee Falls, WI, KSS merchandise includes men’s, women’s, junior’s apparel and footwear, accessories as well as home. KSS has several well recognized private label brands including Sonoma Life, Jumping Beans, Croft and Barrow and Apt. 9. In addition to private label brands, KSS also has a number of exclusive brands including Jennifer Lopez, Rock & Republic, Derek Lam and Simply Vera Vera Wang 

Why now?:

Over the last three months, despite weakness in the overall markets, KSS has outperformed and is now trading close to its 52 week high of $59. Since hitting a low in early February, KSS is up over 13% while the S&P is up only 7% (so a 600 bps difference.)  KSS’ strength is unwarranted given its significantly slow square footage growth, sensitivity to weather, and increasing competitive environment.  Given the recent run-up as well as the poor results from other retailers, it’s a good time to initiate a short position. 

Additionally, in March 2014, KSS’ Chief Merchant, Donald Brennan, resigned after being with the company since 2001.  His resignation is indicative of the merchandising/sales problems KSS is currently facing.  KSS is looking at internal and external candidates but it will likely be some time before a replacement is found. While KSS is looking for a Chief Merchant, other similar retailers, such as TGT, who recently lost their CEO, are also looking and the pool of potential candidates could be smaller than in years past.

Investment Highlights:

• Overall Business Characteristics Weakening
  • Little to No Square Footage Growth and Weakening SSS

With over 1,100 locations, KSS is already in 49 states and has very little room to grow its square footage. Thus, KSS is particularly dependent on growing its sss to drive revenue growth.  However, store revenues have been flat to down the last three fiscal year and ecommerce revenue is increasing but at a declining rate.  While new initiatives may have some benefit to the top line, they will likely not be enough to offset KSS’ most significant problem of being poorly positioned in a structurally declining segment with increasing competition.   On sss, in particular – sss have been declining and are expected to continue to decline in the near term.  While many retailers had weaker sss during CYQ4’13, KSS was even weaker than its peers. Negative traffic trends as well as AURs/Average transaction value driven by both increased promotions and bad weather continue to hurt sss.  To drive traffic, management is revamping its loyalty program, adding a larger beauty section in remodels and increasing national brand focus. However, those actions have yet to boost the topline, while costing KSS in GM. 

• Declining ROIC

Over the last number of years, the quality of KSS’ business has declined with ROIC down to 15.4% FYE14 from 17.1% FYE13 and a high of 19.5% in FYE12. Other indicators of the health of business are also down including EBIT/EV which is currently at 10.7% from a high of 13.3% FYE11.

• Inability to Gain Key National Brands

In an increasingly online marketplace, one of the biggest differentiators of product, besides price, is brand.  Brands are needed to drive traffic and loyalty.  KSS is now 52%/48% between private/exclusive brands and national brands.  While there is much effort to increase the penetration of national brands, I don’t believe KSS will get the brands that they need.  Most recently, KSS added Juicy Couture as well as IZOD. While those brands are national and well known, they have been poor performers recently and are less desirable than other national brands such as Ralph Lauren, which pulled its Chaps license from KSS a few years ago or Michael Kors.  Recently Juicy Couture was spun off from Kate Spade & Company (KATE) and had total DTC comparable sales down 3% in Q3’13 CY (-6% DTC retail comps).  While IZOD it is a recognizable brand, it doesn’t carry the cache of higher end national brands and is one of the weaker brands in PVH’s portfolio (part of its Heritage brands).

Additionally, while it may be small (~5-10bps for every 100bps shift from private/exclusive to national brand), the strategy to transition from private label to increased national brands will have a negative effect on GM and is actually counter to what the company has been doing over the last few years where it believed that private/exclusive brands would drive traffic. Since that didn’t work in stores, it is even less likely that those brands would drive online traffic, which has prompted KSS management to again focus on national brands. 

• Structurally Weak Segment and Increased Competitive Environment

KSS is an off-mall family department store, a segment that is structurally challenged and increasingly competitive with deep pocketed competitors from Target (“TGT”) and Wal-Mart (“WMT”) to other department stores such as Macy’s (“M”).

• Other Department Store Retailers:
  • Department store players, particularly M, as well as other regional chains including DDS and SSI, are increasingly competitive and promotional. Despite extreme weakness in competitor JCP over the last few years, KSS was unable to capitalize on that and gain traffic and market share.  Newly managed JCP stated in early May 2014 that “slowly but surely, customers are coming back.”  These players, in addition to targeted specialty retailers, are actively marketing and competing w/ the KSS for market share and share of wallet. This often includes steep discounting and markdowns.  US retail has essential “been on sale” for the last several months, making it difficult to maintain/grow merchandise margin and market share. 
  • Fast Fashion:
    • New fast fashion players like H&M, Zara, Forever 21, and Uniqlo are continuing to build out their store bases and able to offer trend-right fashion, particularly for juniors, at entry-level opening price points that both department stores and other specialty retailers cannot match due to their longer lead times. 
    • Off-Pricers:
      • Off-pricers, such as TJX and ROST, are able to sell national name brands at discounted prices.  Since the recession, they have grown their customer bases and consistently outperform other specialty retailers.  Customers have grown accustomed to getting “more for less” so are less likely to switch back to retailers/stores they frequented before the recession.

• Ecommerce
  • Ecommerce is just under 10% of KSS’ business (still less than competitor Macy’s 13% penetration) and has been growing over time. But it has come at a cost to margin (~20bps) due to increased fulfillment and shipping costs. Additionally, one of the keys to a successful ecommerce strategy, in addition to being able to price competitively, is the strength of the brands. As mentioned above, KSS’ lacks the stronger national brands that help to drive traffic to competitors such as M.  While it has many exclusive/private brands, those are not well enough to draw that new incremental customer to the site.  As a result, sss even in the ecommerce business, although growing, are now improving at a slower rate.
  • Outlets
    • Outlets used to be located far away from the cities – maybe 45-60 miles away. Increasingly outlets are moving closer to cities and regional malls, placing increased competition on typical mall and off-mall based retailers who are competing with themselves at the outlet channel as well as high end retailers with stronger brands and steeper discounts to full price.  The outlets have the brands that consumers covet that KSS needs but cannot get.

• Increased Risk of Weakening Balance Sheet/Cash Position Over Time

While a majority of the sell-side has a buy on the name due to its current strong FCF yield, as has been the case in other retail names with declining core fundamentals, cash eventually runs out. Companies in trouble try desperate measures to jumpstart the business including increased marketing and/or change in strategic direction that most often takes time to come to fruition.  Most recently this was seen in teen retailer Aeropostale (“ARO”) and accessories retailer Coach (“COH”).  On its recent earnings conference call, COH announced that it was halting its share buybacks due to declining FCF and increased spend on its brand transformation and capex.  Teen retailer, ARO, after long being debt free, needed to get $150M of financing from Sycamore as inventory and A/P rapidly increased.  Large retailers with extensive inventory and long term operating leases, such as KSS, cannot change their strategy or customer’s perception overnight and those changes come at a heavy cost.  Investors saw this in competitor JCP who burned through cash after seeing significant sales decline when its new strategy was not embraced by its customers.  JCP’s OPM margins dropped from 9.51% in 2006 to -11.9% in 2013.  Should KSS’ EBIT margin experience even a 1/10 of that delta, EPS would drop significantly (over 10%.)

• Valuation

I recommend selling KSS at the current price or better as it is expensive and is trading at a premium to where it should based on its current revenue and EPS growth rates.  Moreover, KSS should trade at a discount to its peers, particularly better run M (which trades at 13.0x FYE’15), who in addition to a GM 400bps higher than KSS’ GM, also has significantly better ROEs (high 20s vs. mid-teens for KSS).  M is also better branded and a stronger, more integrated omnichannel experience.  At 10x P/E current year EPS, KSS is worth $40 per share or 30% downside from current levels.   

Risks:

• One-off improvement in metrics e.g. one qtr. of strong sss could boost the stock
• If KSS is able to sign a key national brand similar to what competitive M has – e.g. RL
• Increased buyback or dividend

• Earnings on May 14^th
• Improvement in competitor topline performance, particularly JCP and M