Kohl's ($KSS) at a Crossroads: Bargain Bond Buy at 9% or Value Trap?
Kohl's ($KSS) at a Crossroads: Bargain Bond Buy at 9% or Value Trap?
Analyzing the Retail Giant's Turnaround Efforts and Opportunities Across its Capital Structure
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This week, I’ll be looking into Kohl’s in light of the recent acquisition announcement of Neiman Marcus by Saks. The parallels are interesting: both Kohl’s and Neiman Marcus previously rebuffed takeover bids, with Neiman rejecting a $3 billion offer late last year. This scenario also echoes the recent buyout drama surrounding Macy’s, another department store retailer with valuable real estate assets similar to Kohl’s (see my write-up from December here). Given Kohl’s recent share price underperformance (-25% YTD), it wouldn’t be surprising to see M&A rumors resurface in the near future. The retail landscape is clearly in flux, and Kohl’s position in this evolving market merits a closer look.
Separately, to those that are celebrating, happy July 4th! Remember folks, you need fingers for this job so be safe and don’t do anything stupid!
Situation Overview:
Kohl’s Corporation (“Kohl’s” or “KSS”) is a U.S. omnichannel retailer operating 1,176 department stores across 49 states. Founded in 1962 and headquartered in Wisconsin, Kohl’s has grown to become the 2nd largest department store chain in the country with $17bn+ of sales and 30+ million loyalty members.
Despite the company’s massive size, KSS has struggled to adapt its business model to changing consumer preferences and an increasingly competitive retail environment. Even with efforts to modernize its offerings through partnerships like Sephora shop-in-shops and a focus on key categories such as home decor and gifting, Kohl’s has been unable to drive consistent top-line growth and profitability.
Market and Business Challenges
Kohl’s mounting challenges over the past decade have been driven primarily by changing market dynamics (i.e., market share erosion) and consumer preferences (i.e., online shopping). The company has steadily lost market share to a trifecta of competitors: off-price retailers, e-commerce giants like Amazon, and fast-fashion brands. This erosion has been magnified by the broader consumer shift towards online shopping and value-oriented channels, putting significant pressure on the traditional department store model.
Compounding these issues has been Kohl’s heavy reliance on its private label credit card program, which has been a double-edged sword for the company. While historically a significant profit driver, this program now poses a substantial risk due to recent regulatory changes. In March 2024, the Consumer Financial Protection Bureau (CFPB) capped credit card late fees to $8, a dramatic reduction from the historical $30-$40 range. With credit income accounting for a significant portion of the company’s operating income, this regulatory shift might have a severe impact on the company’s overall profitability.
Despite these overall headwinds, Kohl’s does maintain some unique strengths. The company owns approximately 55% of its store locations (including ground leased properties), with 95% situated in off-mall locations. This valuable, largely unencumbered real estate portfolio has made Kohl’s an attractive acquisition target in the past, with multiple suitors expressing interest in 2022 at prices in the mid-to-high $60s per share range. While these attempts did not materialize, they did underscore the inherent value in Kohl’s assets and business model.
Turnaround Efforts Stall
In response to these market/company challenges, Kohl’s has undergone several leadership changes. In February 2023, Tom Kingsbury was appointed as CEO after serving as interim CEO since December 2022, following the departure of former CEO Michelle Gass. The new management team has been tasked with turning around the business, focusing on inventory management, category expansion, and digital transformation.
Despite these efforts, Kohl’s continues to face operational difficulties. In 1Q’24, the company reported disappointing results with net sales declining -5.3% y/y (SSS falling -4.4%) as the company’s middle-income customer base ($50,000 to $100,000 annual income) continues to be squeezed by inflation and rising interest rates. This weak start to the year marks an acceleration in underperformance, following a -3.4% y/y decline in revenues in FY’23. While 1Q’24 gross margins expanded ~50bps due to improved inventory management and lower freight costs, this was more than offset by SG&A deleverage. As a result, reported EBITDA fell 19% to $231 million, well below consensus expectations of $278 million (~17% miss).
In light of the weak quarter, management lowered its FY’24 guidance, now expecting net sales to decline -2-4% (vs. previous guidance of -1% to +1%) and operating margins of 3.0-3.5% (vs. 3.6-4.1% prior). This implies FY’24 Adj. EBITDA could decline by ~14% year-over-year to $1.2 billion, leaving leverage elevated at 3.5x by year-end.
Amid deteriorating fundamentals and rising leverage, the company’s unsecured notes, including the 4.625% Notes due 2031 and the 5.55% Notes due 2045, have come under pressure. The company’s liquid, longer-dated bond maturities last traded in the high 60s, implying a YTW of approximately 9%, despite their Ba3/BB credit rating.
While Kohl’s maintains adequate liquidity with $228 million of cash and ~$1.1 billion available on its ABL facility, there are growing concerns about the company’s ability to navigate its current challenges without impairing recovery values for creditors. The company’s bond indentures are investment-grade in nature and provide significant flexibility for potential liability management exercises (LME), including unrestricted subsidiary transfers and incremental debt issuances. Moreover, the company’s owned real estate not only provides a strong asset base but also offers potential flexibility for sale-leaseback transactions or other strategic alternatives that could unlock shareholder value at the detriment of creditors.
Uncertain Outlook
In the face of these headwinds, management has expressed confidence in their turnaround strategy, citing positive results from initiatives like the Sephora partnership, which is driving younger customer traffic, and growth in categories such as home decor, gifting, and impulse purchases. Additionally, the company is seeing improved inventory management, with turns increasing and margins slightly improving. However, given the uncertain industry backdrop and Kohl’s track record of underperformance, credit and equity investors alike remain cautious until there are clearer signs of a sustained turnaround. In the next section, I’ll review the company’s capital structure, financials, and key considerations as well as provide my view on whether I find the best value in the company’s capital structure, if at all.
Disclosure: The information provided is for informational purposes only and should not be considered as investment advice. Any investment decisions made based on the information provided are at your own risk. It is essential to conduct your own research and consult a qualified financial advisor before making any investment decisions. Investing involves risks, and past performance is not indicative of future results. By using this information, you acknowledge that you are responsible for your own decisions and release me from any liability. Seek professional advice tailored to your financial situation and objectives.