KSS - Kohl's Debt And Lack Of Growth Make It A Sell

2023-12-19 10:20:13 ET

Summary

• Kohl's stock has been beaten down, and its dividend yield is around 8%.
• The company has made bad financial decisions, resulting in flat sales, negative cash flow, and high levels of long-term debt.
• Kohl's is facing challenges from e-commerce and lacks a growth strategy, making it an unattractive long-term investment.

Many are familiar with the department store, Kohl's ( KSS ). Some may have gotten some nice merchandise there before, myself included. Yet, the stock has been beaten down in recent years. An acquaintance asked me about it recently because its dividend yield has been around 8%. Having first looked at it in 2020 and not bought, I decided to take another look.

I see problems with this company, most of which come down to (in my view) bad financial decisions. I'll review the reasons why Kohl's is a Sell and why long-term investors should not be tempted by its seemingly high dividend.

Financial History

Let's take a look at how the company has done financially over the last decade, including the YTD data for 2023.

Here we can see that, as a nationwide department store, Kohl's had flat sales, typically around $19 billion. As COVID, supply chain disruptions, and inflation hit, we even see total revenues starting to sag as we reach the present.

The cash flow situation shows more volatility, with the current challenges creating negative free cash flow for the company over the last two years. Consequently, the company has had to reduce its dividend payments.

Long-term debt has been around $1.8b in recent years and sits at $1.6b as of the latest quarterly results. Their Form 10-Q for the Q3 2023 showed the following breakdown of that long-term debt:

This table indicates that much of the debt is due years into the future, but the upcoming portions are in a struggle against current cash flows.

These notes have poor credit ratings and provisions that raise their interest in the event of a downgrade, which the company notes ( in their 10-Q ) has occurred a few times:

During the first quarter of 2023, S&P downgraded our senior unsecured credit rating from BB+ to BB and Moody's downgraded our rating from Ba2 to Ba3. As a result of the downgrades, the interest rate on our 3.375% notes due May 2031 and 9.50% notes due May 2025 increased 50 basis points in May 2023 due to the coupon adjustment provisions within these notes. In 2022, our credit rating was also downgraded which resulted in the interest rates increasing 75 basis points, of which 25 basis points was effective in 2022 and the remaining 50 basis points became effective in May 2023. In total, the interest rate of both these notes have increased 125 basis points since their issuance.

This all becomes additionally puzzling when, on top of dividends that appear to be unsustainable, the company spent over $2 billion in share repurchases from 2021 to 2022, instead of simply paying down the debt. Given how retailers operate on thin margins and require a high volume of sales to be successful, managing their debt when they have the cash to repay it is crucial.

The distressed company received offers for acquisitions, the most prominent of which was made by Franchise Group in the summer of 2022 for $53 per share. Kohl's ultimately declined any offer for what seemed like a safe exit for shareholders at the time.

A Look to the Future

If we look at where shares of KSS currently stand in price over the last decade, they are on the low side:

Is this the same as a discount, however? This works out to a market cap of about $3b as I write this. The company has negative cash flows currently, but given the average of the last decade, that works out to a multiple of about three. Of course, this relies on the assumption that the company will resolve its current issues and return to its levels of cash flow.

Why should we assume a happy ending for Kohl's? As we can see, the last decade has been marked by a boom of e-commerce , while American retail at-large has only plugged along in volume of sales. The events of the last three years, the very kind that I described, have accelerated this trend. It was kicked off by COVID, but we see that consumers have largely stuck with e-commerce, even though the lockdowns and quarantines that drove them there have subsided.

An old-school retailer like Kohl's can coast on the niche customer base that may be attached to their brands and deals, but this isn't attractive for long-term investors who may want to hold KSS for the next decade or so, particularly when the near-term is looking at dividend cuts to pay the upcoming debt and more repayments that will persist in the years to follow.

Looking at its investor presentation, it's not clear to me that management is accepting these trends:

Kohl's already has 900 stores across 49 states and within reasonable driving distance of most of the country. Even if it didn't have to worry about the e-commerce players gobbling up retail, where's the growth for its store-driven business model?

Don't get me wrong. If physical stores are the pieces in your set, then that's what you play. Kohl's should not operate under any illusion that being really good at an ephemeral model with almost nowhere else in the nation to saturate is a foundation for growth. It certainly should not be painting a vision of that future to shareholders.

In my opinion, this is the kind of mindset that leads companies to avoid paying off long-term debt or even taking on more, only to get wiped out later on down the road.

We might wonder what it was that Franchise Group saw in Kohl's that it was willing to pay almost double the current price to acquire it. Their takeover would have given them control of the company and thus more options. As the name implies and their website shows , they would have tried to convert Kohl's stores into a franchise operation, allowing them to impart a lot of the headache and risk onto the franchisees that acquire the stores. Selling franchises would have given them their capital back in a relatively short time, while also giving them easy cash flow from the franchise fees.

You, as an individual shareholder, don't have that option. You can only hold the bag.

Conclusion

Kohl's is an established department store with a corps of loyal customers who appreciate its brands and deals. That said, I believe it's an elder who doesn't seem aware of their age. Sales have plateaued and appear to be on the decline as it lacks new territory to penetrate and as e-commerce has become a new norm in the past decade, at the expense of retailers like Kohl's.

Like a tobacco company, it can continue on for years for as long as its loyal customers survive, but nothing about this company indicates that it's an industry leader or poised for growth. The debt on its balance sheet has strained the company, and I don't see enough commitment to paying it down and keeping cash flows smooth. Management that is aware of this could still generate good returns through buybacks and dividends after debt is managed, but recent announcements about the company's strategy indicate otherwise.

For those reasons, I haven't bothered with my usual valuation, and I consider KSS to be a Sell for anyone seeking a good long-term investment.

For further details see: