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Macy’s should continue to outperform Kohl’s

| April 26, 2019

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

Following positive ratings actions by S&P, both Kohl’s and Macy’s are trading about 20 bp tighter. The M 2.875% 2023 bonds now trade roughly 40 bp behind KSS 3.25% 2023 bonds, and the relationship could collapse another 10 bp as Macy’s looks to repay more debt this year. In 5-year CDS, M trades roughly 90 bp behind KSS, which is the more attractive trading opportunity.

S&P takes positive ratings actions on Kohl’s and Macy’s

Despite its view that the department store space continues to be challenged, S&P upgraded Kohl’s Corporation (KSS) to BBB with a stable outlook and revised its outlook on Macy’s Inc. (M) from negative to stable. According to the agency, the timing of the rating actions for the aforementioned credits reflects both improved performance and initiatives taken to shore up the balance sheets.  Both names have returned to positive same store sales (SSS) growth, while reducing adjusted leverage metrics to levels more commensurate with their ratings. S&P estimates that KSS ended the year with adjusted leverage of 1.9x, while M has brought adjusted leverage down to the 2.3x level.

Kohl’s is a step above peers

The underlying factor that is separating KSS from its peers is margin growth. The company posted gross margin growth of 330 bp and 30 bp, in 2017 and 2018, respectively. Management’s strict inventory control, which has declined on a year-over-year basis for 12 consecutive quarters, has led to less markdowns associated with clearing out inventory. In turn, less clearance has helped to offset higher shipping costs as online sales increase. Their omnichannel efforts, particularly BOPUS (buy online, pick up in store) helps to drive store traffic while saving on shipping costs. S&P expects KSS’ gross margin to continue to improve in 2019.

Additionally, KSS has been successful with its partnerships and recently announced that it would be expanding its Amazon Returns program to its entire store base in July.  The pilot program, which launched in 2017, was accepting Amazon returns across 100 stores in the Los Angeles, Chicago and Milwaukee markets.  The program is just another component in delivering on management’s priority of driving traffic.  KSS hopes to achieve the same success with its partnerships with Planet Fitness and ALDI.  KSS will lease store space – approximately 20,000-25,000 square feet per store – at 10 locations to Planet Fitness.  KSS structured a similar partnership with ALDI last year.  If the programs are successful they plan to roll it out to more stores in the future.

Debt reduction to continue at Macy’s 

 After posting five consecutive quarters of SSS growth, it appears that M has stabilized operations.  Furthermore the company has reduced adjusted debt by $2.4 billion over the past three years, which has helped to somewhat offset EBITDA declines. In 2018, M repurchased $1.1 billion of debt using asset sale proceeds and free cash flow, bringing leverage to 2.5x (2.3x using S&P’s adjustments). While management is now comfortably at the low end of their leverage target range of 2.5x-2.8x, management would like to be within that range, excluding asset sales.  That said, management estimates that leverage is closer to 2.9x (excluding asset sales) and plans to deploy excess cash in 2019 to reduce debt further.  M has drastically reduced its debt maturity profile with $35 million maturing in 2019 and nothing maturing in 2020.

Real estate ownership has proved beneficial to the department store in helping to provide financial flexibility, and the quality of those assets exceeds its peers.  Speculation hit the market this week that the company may be looking to build an office tower on top of its Herald Square property in Manhattan. The potential plans could add 1.2 million of square feet to be leased out to tenants, providing for rental income as management looks to unlock additional real estate value.

Relative Value

Following S&P’s actions, both KSS and M are trading about 20 bp tighter.  M 2.875% 2023 bonds now trade roughly 40 bp behind KSS 3.25% 2023 bonds, the spread 10 bp tighter than previous levels, and the relationship could collapse another 10 bp as M looks to repay more debt this year. In 5-year CDS, M trades roughly 90 bp behind KSS, which is the more attractive trading opportunity.

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