The Long and Short

Kohl’s Potential Sale Likely to Trigger COC Language

| June 10, 2022

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.

Kohl’s Corporation (KSS) has entered exclusive talks with Franchise Group Inc. (FRG – B1/B+) for a potential sale of the company. Although the current offer of $60/share is less than one rejected from Acacia Research Group of $64/share earlier this year, KSS’ shares have since slumped after disappointing first quarter results, and lowered full year sales and earnings guidance. FRG’s initial funding proposal includes raising $7 billion of secured financing backed by KSS’ real estate assets. This would subordinate KSS’ existing unsecured bonds and likely push lease-adjusted leverage above the threshold for investment grade ratings, potentially triggering change of control language in the bonds.

The companies are currently in a three-week exclusivity period to review FRG’s offer of $60/share, valuing KSS at roughly $8 billion. This potential offer from FRG seems to have legs given that they entered the exclusivity period. Numerous activist investors have tried to overhaul KSS’ board, with Macellum Capital Management being the latest activist to be rejected by investors. KSS has been pressured to unlock value from their sizeable real estate portfolio or pursue a transaction similar to the one made by Saks Inc. last year, where they split off the e-commerce business into a separate entity.  While a deal with FRG may not come to fruition, there could be substantial impact to KSS’ bonds should the transaction occur.

Who is Franchise Group Inc.?

As their name suggests, FRG is an owner and operator of franchised and franchisable businesses with a diverse portfolio of both leading and emerging brands.  Their comprehensive partnership offering provides infrastructure and support in the areas of franchise strategy and development, operations, marketing, digital strategy, IT, real estate, training and tuck-in acquisitions. The company looks to diversify their portfolio of brands via acquisitions as well as organic development.  If a company is new to franchising, they help to ensure that the business has the capabilities and resources to integrate a franchising strategy into the existing organization.  Their investment criteria includes both franchise and non-franchise businesses that tend to be economically resilient and require minimal maintenance capex.  Furthermore, they look for businesses that cannot be commoditized in the e-commerce space.  They tend to look for companies that have a long-term investment horizon.  Franchise Group’s brands currently include: The Vitamin Shoppe, Sylvan Learning, Pet Supplies Plus, American Freight, Buddy’s Home Furnishings, and Badcock Furniture (Exhibit 1).  On a combined basis, Franchise Group operates over 3,000 locations that are either company-run or operated via franchising and dealer agreements.  For fiscal 2021, FRG generated over $4 billion in revenues with an EBITDA margin of roughly 10%. FRG targets net leverage in the 2x-3x range through cycles, but will stretch to 4x or above opportunistically when pursuing an acquisition that provides for rapid deleveraging through refranchising, non-core asset sales or enhanced cash flows.

Exhibit 1. Franchise Group Subsidiary Breakdown

Source: Company Reports; APS

Initial Terms of the Deal

According to statements from both companies, its FRG’s intention to contribute $1 billion of capital towards the deal, which they expect to fund via their secured credit facilities.  FRG plans to finance the remaining $7 billion through financing backed by KSS’ real-estate assets.  This $7 billion of financing is expected to be non-recourse to FRG.  The three-week exclusivity period allows for FRG to work with its financing partners in completing its due diligence and lining up financing. Whether FRG plans to use the real estate as collateral or pursue sale lease-back transactions, the outcome of the deal translates to higher adjusted leverage for KSS, which posted lease adjusted leverage of 2.5x for the LTM period ended 4/30/22.  FRG’s net leverage is currently slightly higher at 2.6x. KSS’ capital structure is unsecured so any secured debt used to finance the deal will subordinate KSS’ existing bonds.  Layering on an additional $7 billion of debt or leases would push lease-adjusted leverage above 5.0x, which is well above the threshold for IG ratings.

Should Moody’s and S&P downgrade KSS’ ratings below IG due to the transaction and its structured as an acquisition and not a merger, that would constitute a ratings event, which would trigger the change of control (COC) language that is contained in most of KSS’ bonds.  The COC language allows holders to put the bonds back at $101 when both a COC and ratings event occurs.  We note that only the 7.25% 2029 and 6% 2033 bonds do not contain COC language (Exhibit 2) and could be left outstanding if a transaction occurs. We expect these bonds, if left outstanding, to witness multiple notch downgrades given the increase in leverage and potential subordination.

Exhibit 2. KSS Capital Structure

Source: Bloomberg; APS

S&P Places KSS on CreditWatch Negative

Shortly after the announcement, S&P placed KSS’ BBB- rating on CreditWatch Negative noting that if the transaction were to proceed, adjusted leverage would likely increase to levels that are no longer commensurate with IG ratings.  S&P indicated that KSS’ rating could be lowered “several notches” if the acquisition were to be consummated.  While the agency noted that the likelihood of the deal closing is uncertain at this time, they believe that if it were not to occur, it could prompt KSS management to reconsider previous bids that will likely prove to be leveraging events.   While there is no guarantee that bids made prior to FRG’s are still on the table, given that KSS’ equity dropped considerably post 1Q results and guidance reduction, S&P will evaluate management’s business prospects and financial policies moving forward, if no deal materializes, before resolving the CreditWatch.

Meredith Contente
meredith.contente@santander.us
1 (646) 776-7753

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