Kohl's Is on Sale

We believe the coronavirus crisis and the resulting turmoil in clothing retail have created an opportunity to invest in Kohl’s KSS at a price well below our fair value estimate. We do not believe the company has an economic moat, and we share widespread concerns about the future of traditional retailers in the age of apparel discounters and Amazon AMZN. Indeed, we do not expect Kohl’s to approach peak sales growth or profit margins. However, it was not in financial distress before the pandemic, and we believe its large base of customers keeps it viable.

Kohl’s served 65 million individual shoppers in 2019 and is one of America’s largest online retailers at about $4.5 billion in 2019 digital sales. While many of its rivals are downsizing or disappearing, we do not think Kohl’s will have to shutter a significant number of its 1,150-plus stores. The company is a consistent generator of cash under normal market conditions and allocated more than $4 billion of its cash to dividends and share and debt repurchases over the past four years. We forecast that Kohl’s will produce about $700 million in annual free cash flow after 2020 and use most of it to pay dividends, reduce debt, and retire its own shares, which we view as an attractive use of cash, given the stock’s current discount to our valuation.

Retail Apocalypse Is Real, but Kohl's Remains Standing Kohl's was the second-largest department store company by sales in the United States in 2019, behind only Macy's/Bloomingdale's M. This is not necessarily an enviable position, as changes in retail and consumer behavior over the past 35 years have impaired the department store model. During 1970-90, department stores greatly expanded their presence in suburban shopping malls and became dominant places for families to shop. By the 1990s, though, they had begun to lose customers and sales to big-box stores, discount stores, and specialty stores that offered quality products at generally lower prices. Then, e-commerce and discount stores expanded and changed the retail landscape yet again. It has become apparent that department stores will never return to their former glory, and many locations and even entire chains have gone away. A July 2020 report estimated that about 800 large, mall-based department stores in the U.S. (roughly 22% of the total) have closed since the beginning of 2017 or will do so by the end of this year.

Some of the struggles of department stores reflect changes in the U.S. economy. Department stores like Kohl’s are designed to serve the middle class, but the U.S. middle class has been shrinking and is relatively small compared with other industrialized economies. Of primary concern to department stores, as the middle class has struggled, consumers are spending less money on clothes. Between 1987 and 2019, U.S. consumer spending on apparel as a percentage of total spending fell to 3.1% from 5.9% as persistent inflation in areas like housing, education, and healthcare has effectively crowded out spending on clothes. There has been practically no inflation in U.S. apparel in the past 30 years. There was a big increase in low-cost offshore apparel production in 1995-2005, but much of the savings was ultimately passed on to consumers as lower prices.

The impact of these forces on apparel retail has been severe. Despite a generally good economy, more than 10 U.S. retailers of apparel or footwear went bankrupt in 2019. Then department and clothing stores were crushed by the coronavirus pandemic and resulting recession in 2020. Approximately 15 U.S. apparel retailers have already filed for bankruptcy in 2020, and many chains that are not in bankruptcy have announced permanent downsizing.

Kohl’s stands out in that it has not shuttered stores recently, and we do not expect it will need to do so in any significant way. We believe its status as an off-mall retailer with a reputation for reasonable prices provides an advantage over others.

Kohl's Will Endure Industry Turmoil and Current Crisis We think the main difference between Kohl's and many other department stores is that it has very limited exposure to malls. Only about 5% of Kohl's stores are in enclosed malls. Consequently, Kohl's share of U.S. mall square footage is relatively small.

Shoppers increasingly prefer off-mall chains, and it has been a real challenge for department stores to generate sales consistently in this environment. However, Kohl’s status as an off-mall retailer does not automatically make it immune from the woes of department stores. Many off-mall clothing retailers have failed or are in distress. To be successful in an ultracompetitive space, Kohl’s must offer products and values that draw shoppers, but we do believe that the makeup of its store footprint affords it a modest leg up on peers.

Kohl’s has a large customer base to go along with its nationwide fleet of more than 1,150 stores. Despite declining customer traffic, the company sold products to an all-time high 65 million individual customers last year, well above the approximately 40 million customers served by Macy’s. Kohl’s large customer database allows for insights into its customers’ preferences that it can use for merchandising and marketing. Kohl’s has stores in every U.S. state except Hawaii, and about 80% of Americans live within 15 miles of a store. In the U.S. mass apparel sector, Kohl’s had the second-highest sales per store in 2019, behind only Nordstrom Rack JWN.

Kohl’s spends heavily on advertising to attract new customers and increase sales to existing ones. It spends about $1 billion (more than 5% of sales) per year on advertising, a level that has changed little over the past few years. Many major competitors spend significantly less and have been shedding customers as a result.

Greatness Agenda Has Not Been That Great, but It Is Important In an effort to mitigate the competitive threats to its business model, Kohl's created the Greatness Agenda in 2014. The strategic plan includes initiatives to improve product selection, personal connections, savings, ease of shopping for customers, and management talent. Six years later, successes under the Greatness Agenda include expansion of e-commerce, increasing sales of national brands, the introduction of many new brands, a unified loyalty program with 30 million members, and some efficiency improvements. But total sales have not grown, and e-commerce growth has been largely offset by lost sales in physical stores. Kohl's has been unable to counteract the negative trends of lower store visitation and apparel price deflation in its industry. Its customers remain dependent on its coupons and other discount programs, and there is no obvious way that it can change this.

The company deserves credit for not standing still, though. It has learned to operate its stores with less staff and no apparent decline in the customer experience. As fewer people shop in stores, there is less need for employees to wait on them, and store inventory needs should be lower. The savings are important, as we estimate wages make up 35%-40% of Kohl’s selling, general, and administrative expenses. Roughly 70% of the company’s 120,000-plus employees are part-time store workers.

Also, Kohl’s has kept its inventories under control despite disappointing sales and turns its inventory faster than some rivals. Improved inventory management is crucial, as excess inventory increases staffing needs, ties up cash, and leads to discounting of old and out-of-season merchandise. Kohl’s reduced its inventory by 26% in the first half of 2020 despite store closures and other pandemic-related disruptions that caused a 33% drop in net sales.

We think Kohl’s ability to retain customers and provide new services under the Greatness Agenda will pay off in the long run. Still, operating margins have been declining, and we do not think they will return to previous levels. We think competition, especially from Amazon, has permanently reduced operating margins across the industry. We forecast Kohl’s operating margins will remain in the midsingle digits over the next decade, down from high single to low double digits for the better part of the past 10-15 years.

We think Kohl’s has adapted reasonably well to the rise of e-commerce. Between 2014 and 2019, Kohl’s e-commerce as a percentage of total sales steadily increased to 24% from 11%. Then, in the first half of 2020, Kohl’s e-commerce jumped to more than 40% of sales as online operations picked up some of the slack from pandemic-related store closures. According to Digital Commerce 360, Kohl’s was the 21st-largest e-commerce retailer in the U.S. in 2019.

Kohl’s e-commerce investments have kept it competitive as store visitation has lagged. It now has one of the largest digital sales operations among traditional apparel retailers. We view this as particularly important, given the lagging store traffic. We see no realistic way to operate a U.S. department store chain without a large online presence. In fact, many of the apparel retailers that have disappeared had little or no e-commerce.

In 2017, Kohl’s invested $105 million (15.6% of total capital expenditures) on its omnichannel efforts. Just two years later, in 2019, its omnichannel investments more than doubled to $253 million (29.6% of the total). Kohl’s capital expenditures were focused more on omnichannel operations than on physical store improvement projects in 2019, and we think this will largely persist.

The company’s efforts have paid off in high digital sales; we forecast its 2020 e-commerce at nearly $6 billion, or about 39% of net sales. Ten years ago, in 2010, e-commerce was only about 4% of Kohl’s net sales. However, physical store productivity has suffered. This is a major problem, as Kohl’s is still a primarily store-based business. We estimate its offline sales declined to $14.4 billion in 2019 from $16.9 billion in 2014, even though its total selling square footage only shrank about 2% in the period. We calculate Kohl’s sales per square foot excluding e-commerce declined about 13% between 2014 and 2019. The company needs to find a way to hold its in-store sales while expanding its e-commerce.

Building While Shrinking: The Department Store Dilemma We think Kohl's assortment is underappreciated. Kohl's offers a very large selection of private-label brands, two of which produce more than $1 billion in annual sales. Private-label products have generally lower prices than national brands but better profit margins because there are no wholesale markups. Four of Kohl's five best-selling brands are captive brands, and they accounted for 37% of its 2019 total sales. For comparison, Macy's generated just under 20% of its sales from private-label products in 2019.

Kohl’s largest customer demographic group is women aged 35-54. The company’s private-label offerings are mainly geared to serving this demographic, and its own brands account for as much as 70% of its women’s apparel sales. However, few people would classify Kohl’s as a fashion-forward retailer, and its private brands have failed to meet fashion trends. Between 2013 and 2019, its annual women’s clothing sales dropped to $5.3 billion from about $5.9 billion and the category’s share of Kohl’s total sales dropped to 28% from 31%.

Kohl’s is in the process of improving its women’s offerings. The company replaced its women’s apparel leadership team at the end of 2019 and is remaking the category. It recently announced the elimination of eight declining private-label women’s brands to focus on expanding its more popular brands while introducing some new ones. While it makes sense for to drop declining labels and try something new, we are uncertain of the prospects for these added brands, as some of them were something less than healthy before they came to Kohl’s. The company appears to be betting that some faded fashion brands still have life in them. This is a bit of an odd strategy, but it does attest to Kohl’s attractiveness to brands looking for a large customer base. Also, as the new brands are replacing declining brands, they do not have to be wildly successful to generate incremental sales. Mostly, Kohl’s just wants to advertise something new to keep shoppers interested.

Kohl’s also hopes to increase its women’s sales by selling more units. Its new Outfit Bar concept is a curated space that combines multiple products from multiple brands to entice women to buy a group of products. This is different than the typical setup of a department store, as shoes are sold alongside apparel and brands and styles are mixed and matched. It seems like an innovative concept, but it will take time to prove itself.

In addition, Kohl’s has an opportunity to build its beauty category. It has never devoted significant floor space or staff to beauty, which accounts for only 2%-3% of total sales by our estimates. The company cannot expect to compete effectively without better products and increased customer service. Knowing this, it rolled out a larger beauty department with advisors in 12 stores in 2019 and plans to introduce the concept in another 50 stores this year. We think Kohl’s has a long way to go to be a legitimate beauty retailer. For one thing, it does not have access to the high-margin prestige products that help Ulta ULTA achieve double-digit operating margins. Yet, with J.C. Penney bankrupt (Sephora has already threatened to leave) and many other department stores closing, we think there is an opportunity for Kohl’s to pick up customers.

When taken together, Kohl’s only has single-digit share in some of these key categories, representing an opportunity. Last year, the company produced women’s apparel and home sales of about $5.3 billion and $3.2 billion, respectively. Its beauty sales, meanwhile, were approximately $500 million. In 2019, according to Euromonitor, womenswear was a $143 billion retail market in the U.S., homewares and home furnishing stores generated $108 billion in sales, and beauty and personal care totaled $93 billion. Kohl’s private-label sales in all categories were about $7.0 billion last year, down from about $9.5 billion five years prior. If the company can recover part of those lost sales through better merchandising, it can generate sales growth again.

Kohl’s struggles with women’s apparel have overshadowed its success on the men’s side and with athletic apparel and footwear. One of the few bright spots in apparel retail for both men and women over the past few years has been athletic apparel and "athleisure." The size of the retail U.S. sportswear market grew nearly 40% over the past five years (Euromonitor). Athletic apparel has continued to outshine other categories during the pandemic as many people have begun to exercise regularly at home and/or have embraced casual dress while working remotely, and we believe the fashion trend will continue.

Thus far, on the women’s side, Kohl’s success with activewear has not been enough to overcome negative trends in other areas of women’s apparel. However, its efforts to upgrade its private-label offerings while emphasizing national brands provides it with opportunities. Given that Euromonitor estimated the size of the U.S. retail sportswear market at $127 billion in 2019, even small share gains would be material for Kohl’s.

We also believe that the woes of many competitors present an opportunity for Kohl’s. Just two of the bankrupt retailers that compete with Kohl’s and Macy’s, J.C. Penney and Ascena Retail, combined for over $16 billion in sales in 2019. And Macy’s has its own store closures to worry about and has already reduced its direct competition with J.C. Penney and others in past downsizing.

Moreover, Macy’s may not be able to capitalize on the problems of J.C. Penney and others if malls themselves become unviable. There are roughly 1,100 enclosed malls in the U.S., and it is widely believed that hundreds of them will close in the next few years. Kohl’s, though, appears to be in good position, as the closure of J.C. Penney stores and other mall-based stores could drive more traffic to off-mall strip centers. Hundreds of Kohl’s stores are near J.C. Penney stores, and both target the same low- to middle-income demographic and carry many of the same brands. Indeed, Kohl’s rise is probably one of the reasons J.C. Penney ended up in bankruptcy court.

Real Estate Strategy Could Unlock Value and Attract Buyer Kohl's ownership of many of its stores gives it options as it deals with changes in American retail. Kohl's full-size stores are unnecessarily large. As store traffic has waned, it is inefficient to carry the volume of inventory needed to fill such big stores. Aware of the problem, Kohl's has opened some smaller stores; in many stores, it has widened the aisles and made other changes to reduce their effective sizes. In others, Kohl's has walled off about half the space and brought in tenants. Thus far, it has agreements with German grocer Aldi and gym chain Planet Fitness to open about 10 locations apiece in unneeded Kohl's space. This strategy could draw more visits if people drop by the neighboring Kohl's when they make their regular visits to grocery shop or work out.

We think the value of Kohl’s substantial real estate holdings has been overlooked. At the end of 2019, the company owned 412 stores (35.3% of its total base) and 13 of its 14 distribution centers. Its net property, plant, and equipment was $7.4 billion, including substantial buildings and land. Some of Kohl’s real estate was acquired decades ago and is likely worth more than stated book value. Its real estate could be monetized through sale-lease back transactions or disposals if stores close. We estimate that if Kohl’s could produce annual real estate gains over the next decade similar to those realized by Macy’s, it could increase its annual operating income by about 30% and provide an even greater lift to our fair value estimate. Even if its fixtures, equipment, and IT are valued at zero, the value of its real estate assets likely exceeds Kohl’s current market capitalization of about $3 billion.

We think there is a legitimate possibility that Kohl’s could be acquired. According to media reports, in 2016 the company explored the possibility of going private through a sale to private equity or a management-led leveraged buyout. At the time, Kohl’s share price was around double the current price. There has been significant interest in retail acquisitions by private equity. A company like Sycamore Partners (which recently backed out of a deal to buy troubled retailer Victoria’s Secret) could be attracted to Kohl’s real estate value and consistent cash flow.

We view Amazon as another possible acquirer. It and Kohl’s already have a relationship due to the Amazon returns program. In much the same way that it bought Whole Foods in 2017 to boost its grocery operations, Amazon could buy Kohl’s to expand its apparel, home, and consumer electronics operations and to better serve Prime and non-Prime customers. Amazon has a very large number of private-label products that could be sold alongside some of Kohl’s popular existing brands, and we think there are still possibilities for incremental sales through physical stores.

Despite potential interest, we think Kohl’s is unlikely to sell itself at the current valuation. As its share price has fallen about 75% over the past two years, Kohl’s trades at much lower multiples on projected earnings and cash flow than in the past. If it does pursue a sale, it makes sense to wait until the pandemic has passed and business has returned to normal levels. Also, Kohl’s continues to implement changes under the Greatness Agenda, which could bring better results in time.

Cash Flow Generation Is Key Consideration We think investors are overlooking Kohl's consistent cash generation. Our long-term estimates are not aggressive. Our 10-year financial model assumes no sales growth for the company, declining gross margins, and no leverage on operating expenses. We assume long-term annual operating margins of only about 4%-5%, well below the five-year historical average (excluding restructuring costs) of 7.1%. We think Kohl's pricing power and productivity have eroded, which is why we believe it has no moat and a negative moat trend. Still, we see real value in the business due to its cash generation. Kohl's produced more than $1.5 billion in free cash flow in a year as recently as 2018, and we forecast that it will produce annual cash flow/equity of about $700 million after the pandemic has passed.

An important consideration is how Kohl’s uses its cash. The company is not expanding its store base and does not make acquisitions, so internal investment needs are limited. We estimate that Kohl’s returns on invested capital declined to 10% from 15% between 2010 and 2019. In the long term, we forecast ROICs of around 8%, below our estimated weighted average cost of capital of 10%. Given this low internal return and our view that it is a no-moat business, it makes sense for Kohl’s to return available cash to shareholders. Before the crisis, the company was generating cash and paying down its debt while returning capital to shareholders through dividends and stock buybacks. It used more than $4 billion in cash on dividends and stock and debt buybacks in 2016-19.

Kohl’s instituted a dividend of $1 per share in 2011 and raised it annually thereafter. Between 2011 and 2019, its dividend increased at a compound average annual rate of 13%. By 2019, its yearly dividend was $2.68 per share and its dividend payout ratio was over 60%. It suspended dividends and buybacks when it bolstered its liquidity during the pandemic. The company raised $1 billion through its revolving credit facility (matures 2024) and completed a $600 million bond offering in April at an interest rate of 9.5% (matures 2025). After these financings, we believe Kohl’s will not fall into financial distress even if the virus persists. The company generated about $300 million in operating cash flow in the first half of 2020, and at the end of July, it had $2.4 billion in cash and $500 million in remaining borrowing capacity. While Kohl’s now has $3.5 billion in debt, it has no maturities until 2023. We forecast it will generate significant cash flow after the crisis has passed and can begin to pay down its debt in a significant way by 2022, before resuming dividends and share buybacks. We expect Kohl’s will return to precrisis dividend and share-repurchase levels by the middle of this decade.