The Long and Short
Kohl’s Inc. has further spread upside as leverage declines
Meredith Contente | June 4, 2021
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.
After posting first quarter results that exceeded expectations and repaying approximately $540 million of debt, Kohl’s Inc. (KSS) is moving much closer to hitting its leverage target of 3.0x. While not the widest trading credit in the investment grade retail space – as Nordstrom (JWN) has captured that spot – it has the greatest potential to trade closer to pre-pandemic spreads by year-end 2021, with the company’s 10-year bonds offering significant upside for investors.
Focus on debt reduction has brought KSS’ total debt (excluding leases) to its lowest level in over 10 years. Leverage should improve as EBITDA returns closer to $2.0 billion on an annual basis. The company’s 3.375% 2031 bonds offer the best potential value: they are currently trading at +143 bp (+146 bp g-spread – 3.05% yield) and have recently traded as tight at +135 bp. These spreads could tighten to the +120 bp area if results continue to outpace expectations and the company’s leverage target is achieved before year-end.
Exhibit 1. 10-year BBB Retail Curve
Long History of Prudent Capital Management
KSS has long maintained a conservative balance sheet as management values its IG credit ratings, and the pandemic was no exception. In fact, we note that KSS has maintained an IG rating for over two decades. While the pandemic hit all retail peers exceptionally hard, KSS quickly shifted focus to debt reduction in an effort to help limit the deterioration of its credit metrics. We note that KSS ended the most recent quarter with total debt (excluding leases) of $1.9 billion, which is down from $3.5 billion in the year-ago period. Adjusted leverage now stands at 4.2x and should get to the 3.0x area by year end, as EBITDA returns to more normalized levels. Additionally, while supply chain disruptions have plagued the retail sector, KSS navigated the headwinds quite well and moved to bring inventory levels closer to the buying environment. As such, inventory is down 25% year-over-year. Management plans to monitor inventory levels quite closely to better match buying patterns and reduce its level of clearance promotional strategies, which should help support margins. KSS believes that its prudent to not build inventory levels too quickly but has increased the frequency of store deliveries to make sure that it is prioritizing inventory levels in growth areas (namely the women’s business line).
Liquidity Remains Strong
Even as the pandemic winds down, there is likely to be some disruptions along the way. That said, we believe KSS remains in a strong liquidity position to fuel its growth strategy and manage any further headwinds. KSS ended the quarter with cash on hand of $1.6 billion and also maintains an untapped $1.5 billion revolver. The cash position is supported by solid free cash flow generation, which totaled $1.3 billion on an LTM basis. KSS is returning to shareholder rewards, but we note that they are expected to remain within the confines of free cash flow. The board recently approved a $0.25 common dividend, after suspending the dividend for nearly a year. The new dividend is approximately one third of what the company was paying pre-pandemic. KSS also plans to repurchase between $200 million-$300 million of shares in 2021. We note that KSS spent $46 million on buybacks in 1Q and we expect that pace to continue per quarter. That said, shareholder rewards will likely total between $350 million-$450 million for the year. We estimate that KSS will generate at least $500 million of free cash flow in fiscal 2021, with potential for upside to that number should results continue to exceed expectations.
Exhibit 2. KSS Key Balance Sheet & Cash Flow Items 1Q21
New Year New Outlook
Given the strong start to the fiscal year, management raised full year guidance. Management chose to approach its updated outlook prudently given the uncertainty to how the recovery unfolds. That said, there is potential for further upside should the pace of recovery continue. Net sales are now expected to grow in the mid-high teens area, up from previous guidance of mid-teens. The operating margin is now expected to be in the 5.7%-6.1% range, which is up from original expectations of 4.5%-5.0%. Lastly, EPS was raised from the $2.45-$2.95 range to a range of $3.80-$4.20. The guidance now assumes interest expense of $270 million which is lower than previous expectations given the recent debt reduction. While management has been managing costs conservatively, they expect SG&A expense in 2Q to be higher than the rate witnessed in 1Q as the company invests in its partnership launch with Sephora (expected this fall).
Managing Activist Investors
As if the pandemic was not hard enough, KSS management felt the heat of a group of four activist investors (Macellum Advisors, Legion Partners Holdings, Ancora Advisors and 4010 Capital) earlier this year. The group, which took a 9.5% equity stake, proposed nine directors to be elected to KSS’ board after citing equity underperformance which they believe is the result of operating mishaps. The activist investor group believes that KSS can benefit from improvements in merchandise mix (branded versus private label), as well as better inventory management and a focus on e-commerce fulfillment. Furthermore, the activist group is in support of KSS liquidating real estate holdings via sale lease-back transactions. KSS management was able to appease the activist group with a settlement agreement that included two seats on the board and an additional independent board member that both parties agree upon. While KSS kept its share buyback expectation in the $200 million-$300 million range for the year, it did increase its repurchase authorization to $2.0 billion. We note that as of 4/9/21, KSS had $697 million of authorization remaining under its existing program. Given management’s commitment to IG ratings, we do not expect share repurchases to increase until management achieves is leverage target.