Kohl’s: The Digital Operations Could Deliver Again (NYSE:KSS)


(Source: Barron’s)

Kohl’s (KSS) reports quarterly earnings on November 17th. Analysts expect revenue of $3.84 billion and EPS of -$0.45. The revenue estimate implies a 17% decline Y/Y. Investors should focus on the following key items.

Will Digital Deliver Again?

The coronavirus brought business activity to a standstill in March. Kohl’s and several other retailers temporarily closed stores in order to help stem the spread of the pandemic; the company also furloughed employees in order to save money. In May, it began reopening closed locations. For the August quarter, stores operated about one-fourth fewer days than the year-earlier period. It weighed as Kohl’s reported revenue of $3.4 billion, down 23% Y/Y.

Last quarter, the company had to rely heavily on digital sales to offset any diminution of sales through physical locations. Unlike Walmart (WMT) and Target (TGT), Kohl’s was not necessarily known for its digital prowess. However, the company’s digital platform delivered big, growing revenue 58% Y/Y:

May was the most challenging period in the quarter as a majority of our stores were closed for most of the month. We saw a strong rebound in June with the vast majority of our stores reopened and digital’s momentum remaining. However in July, we did experience some sales deceleration from June strength, as COVID concerns heightened in areas of the country where cases have been escalating. We also saw a softer start to the back-to-school selling season, given increased uncertainty around kids returning to school. So, all in for the quarter, store productivity for reopened stores was approximately 75%. We are pleased that digital sales remains strong in the quarter, increasing at 58%.

Kohl’s proved it could rely on its digital operations to help offset loss of revenue through its physical stores if need be. In my opinion, the company passed a key test last quarter.

The back-to-school season and the holiday season are typically important periods for retailers. They get a large percentage of sales during these periods. With students engaging in virtual learning, back-to-school sales will likely be dismal. There is also no guarantee that sales over Thanksgiving or Christmas holidays will be as robust as previous years. That portends that sales for Kohl’s could be dismal for the rest of 2020. However, the prospects of a vaccine from Pfizer (PFE) to treat the pandemic could brighten the outlook for the economy and Kohl’s.

Margins Could Remain Depressed

Traditional retailers were struggling with falling margins prior to the pandemic. Declining scale has hurt even more. Last quarter, Kohl’s reported gross margin of 33.1%, down over 550 basis points versus the year-earlier period. The higher mix of digital sales also hurt margins. Gross profit on a dollar basis was $1.1 billion, down 34% Y/Y. SG&A expense was $1.1 billion, down 17% Y/Y. Lower marketing costs and reduced store expenses due to store closures drove down SG&A last quarter. I expect more of the same this quarter. SG&A was 31% of revenue, up from 29% in the year-earlier period.

The fallout was that EBITDA declined 45% to $335 million. EBITDA margin was 10%, down 400 basis points versus the year-earlier period. A few retailers suffered an EBITDA loss last quarter, so positive EBITDA could be considered a victory for Kohl’s. Falling scale could cause EBITDA margin to remain depressed this quarter as well.

Solid Liquidity

Maintaining liquidity is paramount for retailers in this environment. Kohl’s has cash of $2.4 billion, up from $625 million in the year-earlier period. The company had to raise debt to shore up liquidity. Working capital was $3.1 billion, up from $1.8 billion in the year-earlier period. Kohl’s reduced inventory to $2.7 billion, about $1.0 billion less than last year. It is imperative for the company to pare inventory to keep product from getting stale and to drive free cash flow (“FCF”).

FCF for the first six months of the year was $108 million, versus $237 million in the year-earlier period. The company hived off real estate totaling $193 million and suspended dividend payments. These were smart moves, in my opinion. How long the economy will remain in recession territory is still uncertain. Kohl’s has $3.5 billion in debt, up from $1.9 billion in November. Debt is less than 2x last 12 months (“LTM”) EBITDA. Debt appears manageable for now. If EBITDA remains depressed, then its credit metrics could become cause for concern.

Conclusion

KSS is down over 50% Y/Y. Its prospects are improving, so I rate the stock a Hold.

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