Kohl's Analysis After the Dip

Over the past couple weeks, I’ve written a set of articles about the retail industry, which has been under immense pressure over the past year. The stocks of Macy’s, Nordstrom, and Tapestry, for example, are all down by about 60% during that timeframe, which has drawn my attention to the space to pick through the rubble for potential bargains over the past month.  

My first retail article from a couple weeks ago was an overview of the retail industry as a whole, touching on several companies. My second article focused on Tapestry, the owner of Coach and other brands, after its stock fell 22% in one day.

This final article about the industry, at least for now, will focus on Kohl’s, which reported earnings today and dropped by about 7% to about $45/share. It is potentially a deep value opportunity, but one that comes with considerable risk.

Kohl’s Overview

While many people would not guess it, Kohl’s is the largest classic department store chain in the United States. They have over 1,100 stores in 49 states.  

The company targets the middle-discount segment, which means their stores are not as cheap and sparse as deep budget players like Ross and T.J. Maxx (which have been doing great), but they are more budget-friendly than solidly middle players like Macy’s (which has been slammed), and far below luxury players like Nordstrom (also in a slump). Kohl’s has good clothes that include a mix of in-house brands and national brands, and their store interiors are a lot more appealing than the super budget players, like a streamlined practical version of Macy's.

Notably, most Kohl’s are not connected to malls, and are instead stand-alone, and tend to be near shopper’s homes. The mall retailers have been the hardest hit lately because mall culture is dying, while Kohl’s is more of the “stop there on the way home from work on Thursday” or “go there Saturday afternoon for some back-to-school shopping on the way to the grocery store” kind of place, which has given them more resiliency than many peers.

The Numbers

Kohl’s reported earnings this morning, and the results were mixed and require nuance to interpret. The market was confused, as the stock went up 4% pre-market, only to fall almost 7% during trading hours.

The company reported mild sales declines and significant earnings declines. However, the company reported that during the second half of the quarter and into August, those declines had reversed and turned into mild growth, thanks to a strong back to school season. 

Furthermore, 2018 comps were difficult. The company grew adjusted EPS by a whopping 34% in 2018 thanks to solid revenue growth and beneficial impacts from the corporate tax cut. So, this quarter’s lower results were still considerably higher than the results from 2 years ago even though they slumped against year-ago comps.

Kohl’s reaffirmed its full year guidance of $5.15-$5.45 in adjusted EPS for the year, which at the midpoint puts its P/E ratio under 10. Kohl’s price to free cash flow ratio is about 7, because the company generates far more free cash flow almost every year compared to net income. A lot of casual investors checking quick stock screener stats won't see that. 

At this low valuation, Kohl’s is paying out roughly half its earnings as dividends, and has grown dividends per share by about 11% per year over the past five years. The current yield after this summer’s big sell off is nearly 6%. In addition, the company is buying back about 5% of its shares each year, for a total shareholder return of about 11%. They can do all of this and still reinvest in the business because their free cash flow yield is so high at this price level. 

While many U.S. corporations have levered up to record debt levels, Kohl’s has strengthened its balance sheet in recent years. Earlier this year, the company paid down over a third of its total debt, leaving the company with a net debt/income ratio of well below 2, which is quite strong. They now have a very flexible balance sheet to work with.

Unfortunately, the stock used to be overvalued, so its stock has gone sideways over the past two decades even as the company substantially grew earnings, dividends, book value, and free cash flow per share. It's a truly bad chart: 

Black line = share price, Orange line = price if at a P/E of 15

At this lower price level, at a single-digit free cash flow multiple for a highly profitable business that returns all of its cash to shareholders, Kohl’s can deliver double-digit total annual returns from dividends and buybacks alone, without growth. The caveat, though, is that they can’t fall apart. All the company has to do is to not shrink too much, and they’ll do fine for shareholders.

However, the next recession will be the test, whenever it comes. Will Kohl’s start to fold like many other retailers, or will they hold strong like they have been in recent years? Historically, the stock has been very recession-resilient, with minimal impact on earnings, because as a budget-friendly retailer, they hold up well during economic weakness. But during a period of mass retail closings and online competition, it could be a different story this time. It will come down to management decisions, and I think the odds are on Kohl’s side.

Management Quality

There are several things I like about Kohl’s at this low price level, but management is near the top of the list, which is not something I could say in my recent analysis of Tapestry.

Kohl’s has been exceptionally well-managed in a very difficult environment. For one, the company has not made any significant acquisitions, so they are one streamlined brand with a unified store experience to focus on, rather than a collection of subsidiaries and other brands. It’s just Kohl’s.

The current CEO, Michelle Gass, has been an executive at Kohl’s since 2013, and has been CEO since early 2018. Prior to that, she was an executive at Starbucks. Under her leadership, the company has expanded its partnership with Amazon, Planet Fitness, and Aldi, increased its allocation towards athletic wear and national brands, strengthened its balance sheet, and increased its focus on attracting younger shoppers.

The company has an extremely strong and straightforward rewards program, called Kohl’s Cash, that has 30 million active members and builds consistent loyalty. When you shop at a Kohl’s during periods where Kohl’s cash is active, you get a big coupon (up to 20% of your purchased goods) that can be used on basically anything next time you come, but the coupon has a limited expiration date, so it incentivizes the customer to keep coming back.

Kohl’s isn’t afraid to experiment on a small scale. The company launched a coffee café in a few of its locations, it didn’t work out, so they removed them and moved on. They partnered with Amazon at select locations, it did work well, so they expanded that program nationwide (more on that below). Currently they are partnering at a few locations with Planet Fitness and the discount grocer Aldi.

Like many retail chains, Kohl’s is slowly downsizing. However, Gass wants the company to maintain its ubiquitous national presence, which means they don’t want to close many stores. Instead, they are shrinking some of their stores and leasing out the extra space for the likes of Planet Fitness, Aldi, and Amazon.

This is part of Kohl’s “stop here after work” sort of focus, where someone can stop by, pick up a couple things at the grocery store, return something from Amazon, buy an item, and hit the gym, thus checking off a bunch of items on the to-do list at once.

So far, it’s working. Although there are a lot of headwinds to growth, Kohl’s has higher operating margins than Macy’s, Nordstrom, Dillard’s, and most other department stores. They’re doing great in a really challenging environment.

The Retail Problem is Not Just Digital

A case I made in my earlier articles is that the idea of online vs physical retailers is somewhat misunderstood, and I want to elaborate more on that here.

When thinking of the retail industry, investors often think of Amazon coming in and taking market share from everyone. They picture leagues of stores going out of business because Amazon and other online retailers took all of their sales.

And yet, over the past two decades, ecommerce has only grown to about 11% of total retail sales in the United States:

The vast majority of retail still takes place physically, not online. And besides Amazon, who are the biggest online retailers? The answer is Walmart, Target, Home Depot, Best Buy, and other leading physical retailers; they are digitizing themselves and are among the top ten online retailers. And Amazon is opening physical stores.

Online retail is just a catalyst for a much larger retail problem. As I described in my first retail article, the United States has way too much retail space per capita. We are vastly oversupplied on retail space compared to every other country.

Mall culture is dying, so we don’t go to malls and spend hours going through stores anymore. We compare prices and reviews online, and then either buy online or physically, and this puts margin pressure on the whole industry. Operating margins have been deteriorating rapidly across retailers everywhere except for super-budget places like Ross.

Even online retailers have trouble making money. Overstock.com loses money, for example, even though it doubled its revenue over the past decade. Amazon mainly makes money because of its cloud business; it cleverly built two halves of a business that work well together so that it can actually produce a profit. Physical retailers that are selling products online are facing lower margins from their online sales. There is brutal competition out there because everyone is fighting to survive.

Instead, it’s a question of strong vs weak, not physical vs online. Which retailers are the best at what they do in an omnichannel environment? Amazon, Walmart, Target, Costco, Ross, T.J. Maxx, Dollar General, Home Depot, and Lowe’s- these retailers have been doing very well. Sears, J.C. Penney, Toys R Us, Payless ShoeSource, Borders, GameStop, and countless others have been failing.

Players like Nordstrom and Kohl’s have been doing okay fundamentally, although their stock price would say otherwise. Nordstrom mildly grew sales in a difficult mall environment because it is doing well on the luxury side and is growing its online platform very well. Kohl’s, thanks to flexibility, good management, and stand-alone locations, has also been doing well in the middle/discount space.

The main thing to ask when analyzing a retailer is whether it’s in the top third of what it does or not. If two thirds of retailers went out of business, would this one still be around among the survivors? For Kohl’s, I think the answer is yes.

The Amazon/Kohl’s Partnership

If you can’t beat them, join them, right?

Stanley Druckenmiller made headlines earlier this year when he said, “We are long the disruptors and short the disrupted”. In other words, he likes tech companies and other blue-chip companies that are benefitting from secular trends and is shorting many of the older industries that they are taking market share from.

There is a third way, however, and that is to evolve and partner with the disruptors. Kohl’s has done remarkably well at not being disrupted too heavily because it has gone with the flow rather than fight the inevitable. Kohl’s has joined the Borg, in other words.

Back in 2017, Kohl’s and Amazon began partnering together. Kohl’s started selling some Amazon products and started accepting Amazon returns (which they then return to Amazon warehouses via their own logistics system), but only in select cities (fewer than 10% of Kohl’s locations).

Earlier this year, they announced that the program went well, so they expanded it nationwide last month. Kohl’s is now part of Amazon’s strategy of having physical locations. You can return items ordered from Amazon, including unpackaged, to Kohl’s for free. Kohl’s packages them up and sends them back to Amazon. Kohl’s gets increased foot traffic and selling opportunities to Amazon’s customer base while they're in the store, and also sells Amazon products in the store.

Amazon owns warrants in Kohl’s stock as part of the deal. The warrants will vest over a multiyear period and give Amazon the option of purchasing 1.75 million Kohl’s shares (at a much higher price of about $70/share, which is what Kohl’s shares were priced at when the deal was made).

This is a small but interesting situation, because Amazon does have a history of about 100 acquisitions. Most of them were for small acquisitions at under $1 billion, but they did buy Whole Foods for $13.7 billion. Even with a hefty premium, it would take less than six months of Amazon’s free cash flow to buy Kohl’s and use it as their physical footprint nationwide. While I’m not saying this will happen, the two are close partners now, and this is a distinct possibility.

Final Thoughts

Most of my portfolio consists of wide-moat companies that benefit from strong trends, but for a small part of my portfolio I like to invest in deep value places that nobody else seems to like, such as Russian equities or department store stocks. The key is to keep these deeper value positions small, so that if they don’t work out as expected, it doesn’t negatively affect the portfolio by a meaningful amount. It’s a series of small bets with good risk/reward expected outcomes.

I initiated a small position in Kohl’s today due to its high dividend, high shareholder yield, low P/E ratio, single digit P/FCF ratio, strong balance sheet, good management, middle/discount non-mall focus, streamlined business model, and Amazon partnership. I consider the stock to be a somewhat risky but appealing value/dividend play at the current price in the $40’s.