Given the circumstances, Kohl’s (KSS) header results were not so bad in the second quarter. While analysts expected to see a 26% drop in sales YOY, the retailer delivered a less effective drop of 23%. On the earnings side, projected loss of 88 cents per share proved too cautious compared to the 25-cent adjusted loss the company managed to deliver.
But as I explained in my revenue example, “shareholders are likely to pay more attention to the pace of recovery going forward than to the results of the most recent quarter.” As for that, I do not believe that investors have many reasons to be very Bullish about the company and the stock.
Credit: income slides
The good
From the topline, I was under the impression that e-commerce was up almost 60%. Even more impressive were digital sales outlets that accounted for 41% of second-quarter revenue. Compared to peers Macy’s (M) and Nordstrom (JWN), Kohl’s e-commerce as a share of total revenue was a bit on the lighter side pre-pandemic. Therefore, it was good to see that the channel was blooming as much as it did and helped to lift the top line as it was most.
Otherwise, Kohl’s balance sheet looks relatively strong. Despite the pandemic, YOY’s net debt position has improved, as the chart below suggests. While liquidity has skyrocketed due to debt development, cash flow has remained fairly robust due to a combination of factors: from working capital management to asset monetization. As a result, I believe investors should feel comfortable about Kohl’s ability to survive in the short to mid-term future.
Source: DM Martins Research, using earnings release data
The bad and the angry
Unfortunately, there was plenty about Kohl’s earnings results and talks about calls for earnings that I believe investors should care about.
First, the strong results in e-commerce mask the unfortunate performance of the brick and mortar channel. Here’s some quick math: if only 59% of 2Q20 sales came from physical stores compared to 80% this time last year, the YOY revenue cut in the channel should have been 43%. The number is, to my mind, amazing, seeing the stores start up again (albeit slowly) already in the first week of May.
Second, the gross margin fell by more than five percentage points YOY (see table below), which was even worse than the contraction ex-inventory of the first quarter. To make matters worse, I believe a large portion of the margin weakness is likely to last well over the last few months.
For example, about half of the decline in profitability can be attributed to higher shipping costs, which are unlikely to return to a pre-pandemic normal given the popularity of the digital channel. The other half of the dip was represented for soft change to the category at home (not much of me, in my opinion) and promotional activity. The latter suggests a substantially reduced demand for goods, particularly in the important women’s department.
Source: earnings slide
In an environment with lower margins for longer, Kohl’s EPS could suffer greatly. I calculate that, for every 100 bp reduction in gross margin and assumed normalized revenue, the impact on annual net income could be as high as $ 1.00 per share – roughly one-fifth of last year’s underline number . Add to these headwinds a 50% increase in interest expenses caused by new debt issued in 2020 (another $ 0.50 in EPS drag, per my estimate), and one can see how long it can take for Kohl’s return to return to its former glory.
The big reset
For KSS to climb higher and recover some of its losses (shares were still about 50% below the current high before the earnings day), I believe investors heard an optimistic story regarding second-half performance. However, the management did not provide much confidence that trends have improved much in the past few weeks. Instead, investors were greeted with:
- a need for Kohl’s to reinvent product range – further in the direction of casual and atleisure, with fewer SKUs;
- clear indication that the back-to-school season has been badly affected by the COVID-19 crisis;
- management’s approach “to plan the back half of the year conservatively from an inventory position,” chased demand after the opportunity presented itself.
To reiterate, I do not think Kohl’s performance in the second quarter was catastrophic. The company has at least managed to hit water from the perspective of balance sheet and cash generation. As far as the path is concerned, however, it seems that the retailer needs to resume its operations, which probably includes: (1) transferring inventory to adapt to new store trends, (2) adapting to a higher cost environment due to higher digital sales and less scale, and (3) even think about the physical footprint, something I believe the management team needs to address at some point.
Because the light at the end of the tunnel does not yet shine very brightly, and because a return to “business as usual” (certainly from a revenue perspective) is likely to take many quarters, I retain the same bearish position on KSS that I have had since August 2019.
Hit the market by a mile
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Announcement: I / we have no positions in named shares, and no plans to initiate positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I do not receive compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose supply is mentioned in this article.
