Kohl’s: Mediocre Times Ahead, But Hidden Assets Are Key (NYSE:KSS)

Who is Kohl’s

Kohl’s Corporation (NYSE:KSS) is a retail company operating in the United States. The company offers a wide range of products including apparel, footwear, accessories, beauty products, and household items through its brick-and-mortar stores and online platform.

These products are primarily sold under well-known brand names such as Apt. 9, Croft & Barrow, and Vera Wang, among others.

Kohl’s has had a difficult decade as online retailers have aggressively gained market share through attractive pricing and taking advantage of changes in consumer behaviors.

This is reflected in the company’s share price, which has gradually declined over the last decade.

Investment thesis

Brick-and-mortar is not necessarily dead, however. The industry is showing signs of life and industry trends are once again shifting. Our view is that retail is showing signs of attractiveness, with upside potential for fundamentally strong businesses. We intend to analyze Kohl’s with the view to assessing if the business has the characteristics necessary to outperform in the coming years or if other options for value could generate alpha. This will involve considerations of its financial profile, and how the business is being impacted by economic conditions, alongside the aforementioned industry trends we have identified.

E-commerce and brick-and-mortar

E-commerce retailers have found success by offering affordable prices, plenty of options, and convenient delivery options. These online businesses have lower overhead costs due to the lack of storefronts, with resources instead diverted to marketing efforts. This has made it incredibly difficult for storefront retailers to compete.

Kohl’s has faced challenges in adapting to the trend of increased online shopping, which contributed to the business struggling during COVID-19. The business experienced a 20.1% decline in sales during FY21, with a bounce back of only 21.8%. The business has yet to return to its pre-COVID level (Source: CapIQ). As of FY21, only 32% of sales were through online channels, which is up 11% from 2019. Given that the period in-between was completely lockdown due to COVID, our expectation would be for the business to achieve closer to 40%.

We place significant importance on this ratio because e-commerce continues to grow at an impressive rate compared to traditional brick-and-mortar establishments. According to Statista, this trend is expected to persist and maintain its remarkable growth trajectory.

Further, it is important to identify that the younger generation is those driving e-commerce growth. They are the future and so the retailers they associate with are far more likely to succeed long-term as long as they can maintain their relevancy. This is one of the big reasons why retailers that fall out of favor with the trend-driving generation usually struggle to regain a footing in the market.

Despite the growth of e-commerce, brick-and-mortar retail continues to offer benefits. The return to physical stores has been impressive, with 94% of customers returning following lockdowns. Additionally, many consumers choose to shop both online and in-store, with 29% opting for online purchases with in-store pick-up. This demonstrates that brick-and-mortar is not becoming obsolete and can actually complement online shopping. This presents a positive outlook for Kohl’s, as its extensive brick-and-mortar presence allows for greater accessibility and convenience. Currently, Kohl’s is ranked as the 27th largest retailer in the US, including both online and physical retailers, with over 1,000 stores nationwide.

Sephora x Kohl’s

Kohl’s has consistently increased the presence of Sephora retail services within its stores. Sephora, a French personal care and beauty product company owned by LVMHF, has seen impressive growth as consumers become more fashion-conscious. This growth has propelled LVMH to record-breaking results in 2022, showing the significance of this brand to LVMH. By having Sephora services within its stores, Kohl’s increases its chances of selling its own merchandise to customers searching for Sephora products. Further, it brings young (and influential) people into their stores. This is a perfect cross-selling opportunity. Data suggests that this move has been highly accretive for Kohl’s, with store contribution being significantly higher at locations with a Sephora presence. Furthermore, management is planning to open an impressive 600+ Sephora locations this year, compared to 200 last year, according to the Q4-22 press release.

Brick-and-mortar is clearly showing opportunities for growth through innovation and strategic decision-making. Consumers have shown that they will come to stores if given a compelling reason to, which is why this move from Kohl’s is genius.

The loss of the CEO

Kohl’s has appointed Tom Kingsbury as permanent CEO following the departure of Michelle Gass, who left to take over at Levi Strauss. This comes as activist investor Macellum Advisors has been pressuring the board for reform, with Tom being a nominee of theirs.

With the appointment taking place in the last few weeks, we have yet to see the strategic direction Tom has for the business and further details about how the board convinced Macellum to sign a Cooperation agreement.

This was an unplanned departure, suggesting Michelle either had an issue with the current situation at Kohl’s or saw a better opportunity with Levi. We are not in the business of speculating and so will purely state that this is a problem for Kohl’s.

Activist investors can have both positive and negative impacts, but given the prolonged period of underperformance, we believe that fresh perspectives can be beneficial. Kohl’s has a strong foundation with its partnership with Sephora and can leverage this to expand its reach toward its target audience.

Kohl’s assets

Historically, many large businesses with substantial physical assets preferred to own their properties outright. However, in recent decades, there has been a shift towards leasing and alternative financing methods as interest rates have trended down, freeing up capital for growth. Kohl’s has a substantial amount of PPE worth over $8 billion, much of which are prime assets in the United States. This provides investors with the opportunity to own these valuable assets, which a potential acquirer of Kohl’s may value at a premium. For example, a sale-and-leaseback scenario could free up billions of dollars. Kohl’s has an equity value of $4 billion and a market capitalization of c.$3.6 billion, offering investors potential returns through liquidation alone.

A similar situation occurred in the UK, where Morrisons supermarket caused a bidding war between many of the leading PE firms, all of whom attributed significant value to the company’s extensive portfolio of physical assets. CD&R won, paying £7BN (compared to a £4.2BN market cap before the first offer, £4.2BN equity value, and £8.2BN net PPE). They have already engaged in asset selling and S&LB transactions. Using this as a comp, Kohl’s has significant upside and is positioned well as a buy-out target.

Management did turn down a $53 takeover bid from Franchise Group in mid-2022, suggesting they believe there to be greater value in the business. With interest rates remaining elevated, it could be difficult to finance such a deal currently but our view is that this is a fantastic opportunity for someone when rates normalize.

Kohl’s financials

Kohl’s has seen a prolonged decrease in sales over time, due in part to the difficulty in competing with other retailers. Upon examining the third quarter of 2022 results, both comparable and net sales have dropped. Although the company faces intense competition, the weakened economic conditions have also played a role. With interest rates and inflation being significantly higher than the average of the past decade, consumers are facing financial pressures, causing demand to decrease as they seek to cut back on spending. As a result, retail sales have begun to drop.

Additionally, GPM has seen a slight decrease over the past 12 months, but more significantly in Q3-22, due to higher freight and the inability to raise prices. heightened costs are a result of the current inflationary pressures, with persistent inflation caused by supply-side problems. Our outlook is that inflation will remain persistent for the majority of 2023, with a decline only towards the end of the year. We are unsure how much further rates will need to rise to achieve this, but realistically 50bps more looks appropriate currently. As a result, margins will probably experience a further decline in the coming quarters. We would be very concerned if GPM falls below 38 in any one quarter. The company cannot raise retail prices to counteract this, which is unsurprising given how competitive retail is. This has translated to a decline in bottom-line margins, as the business has been unable to achieve the S&A efficiencies sufficient to offset the increases in costs.

Kohl’s debt balance has gradually increased in recent years, with a large uptick in the LTM period. This has contributed to a decline in its credit ratios, with only a 3.4x coverage of interest and a net debt / EBITDA ratio of 3.8x. Our targets for these ratios would be 8x and 3x, respectively, which suggests the business has drifted far from a comfortable financial position. Management intends to begin a period of deleveraging, with all buybacks paused until the net debt ratio reaches 2.5x. This has resulted in a BB+ rating from S&P, which indicates a significant degree of risk and a high coupon rate for much of its debt. With FCF yield turning negative in the LTM period, we are slightly concerned as to how this will be funded in the immediate term.

Interestingly, the inventory turnover rate has significantly decreased, contributing to the negative free cash flow that has been observed. This indicates that the stores are having difficulty selling inventory, possibly due to a decline in demand. Only 5% of the 34% increase from the previous year is related to Sephora, which confirms this as a build-up of core stock. This will likely lead to lower margins in the coming year as discounts are offered to sell the items. We would be remiss not to mention that Management believes that OPM will return to 8%, which implies a margin expansion of c.2.5% from LTM levels.

Peer group analysis

Kohl’s is currently underperforming a cohort of similar businesses, with a slightly lower EBITDA margin and very poor FCF yield. This is all while using significantly more leverage to generate returns. This said, the company’s normalized level of EBITDA margin is closer to 12%, and its FCF yield is closer to 5%, suggesting the company does have the ability to perform at this level. If Management’s execution is in line with their forecast, Kohl’s can return to this level this year. Nonetheless, our view is that they are a weaker member of the retail community.

Kohl’s valuation

Kohl’s is trading at a discount to its counterparts while paying a significantly larger dividend. This reflects the clear inferiority of the business, with investors pricing weaker profitability and declining growth.

Kohl’s has historically traded at a 6x NTM EBITDA multiple, suggesting the business is slightly overvalued. This said we have conducted a DCF valuation of the business which implies an upside of 12%. This is based on the assumption that FCF will remain within $550-800M, below its historical average. Further, we assume an exit multiple of 6x and perpetual growth of 2%.

Final thoughts:

Kohl’s has shown hints of opportunity going forward, with e-commerce sales improving, B-A-M remaining robust, and the expansion of its Sephora partnership. Currently, however, this has not translated into improving financials. We could see a scenario when retail demand continues to decline but improved economics through the Sephora expansion acts as a buffer.

Further, the business can be comparable to its peers, yet currently is performing poorly and is priced as such. Our outlook is that financials will continue to worsen and so a normalization to its historical financial profile could take 12-24 months.

So, why did we give a “buy” rating to this stock? The answer is not based on our discounted cash flow valuation. It’s because the value of its assets is too attractive to overlook at its current share price. We are confident that potential acquires are currently evaluating Kohl’s, with the only significant hindrance being the cost of borrowing, which is likely to stay elevated for a few more quarters. However, we don’t focus on timing the market, so see value in starting a small position now.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.