Kohl's Reports Second Quarter Earnings

Tuesday morning, before the opening bell, Kohl's (KSS) reported a top and bottom line beat with its FY2Q19 earnings results. On the top line, sales of $4.43 billion (-3.1% YoY) outpaced the $4.31 billion consensus. On the bottom line, adjusted earnings per share of $1.55 (-12% YoY) exceeded expectations of $1.53 per share.

In addition to the headline results, while the company's gross margin declined 70 bps from the year ago period at 38.8%, it was largely in line with expectations. We remind members that the contracted year on year margin in the quarter should not come as a surprise as, on the first-quarter conference call, management called out expectations for a full year contraction due to tariffs and promotional efforts "with the second quarter modestly lagging the year." On the second-quarter call, CFO Bruce Besanko noted that the annual decline "was largely driven off of the higher penetration of our digital demand, as we spoke to, that accelerated from the first quarter. That as well as our increasing pricing and promotional activity to defend our market share were really the key drivers. As we look ahead, we do expect that our cost of shipping impact will normalize in the second half. While we expect our digital business to continue to perform at that level, we do anticipate that our stores business to improve. And we did see that in the back half of Q2. So getting that mix more normalized will definitely help us get to the more typical values that we've seen on the headwind from shipping. I would say in addition, as we referenced earlier, operational excellence is a key focus of the company, and shipping in particular is a very big focus of our logistics organization."

With the in-store and shipping dynamics expected to improve, we believe any additional pressure from the digital push to be more than acceptable as we again reiterate that a digital presence is absolutely critical for any department store that plans to contend with ongoing shift toward e-Commerce.

Looking to the all-important retail metric, same store sales (a.k.a. comps), while the headline numbers came in above estimates, same store sales were somewhat disappointing at -2.9% versus the -2.4% analysts were looking for. While this is certainly not what it was in the year-ago period when same store sales advanced 3.1%, it is a sequential improvement versus the FY1Q19's 3.4% decline and in line with Besanko commentary on the first-quarter conference call, where he stated, "We expect Q2 comps to remain soft but show relative improvement to Q1."

Given CEO Michelle Gass's commentary on the release, we believe this to still be the case as she noted, "we are pleased to report that our business strengthened as we progressed through the second quarter. Comparable sales were better than the first quarter and improved during the period, turning positive during the last six weeks of the second quarter with 1% growth. This positive trend has continued into August driven by a successful start to the back-to-school season. We are confident that our upcoming brand launches, program expansions, and increased traffic from the Amazon returns program will incrementally contribute to our performance during the balance of the year and beyond."

Furthermore, breaking the comps improvement throughout the quarter down a bit further, Gass stated on the call, "the business strengthened as the quarter progressed driven by active, swim, key national brands, including Levis, Lee, Madden for Bali and strengthened our private brands, SONOMA, Apartment 9 and SO. Of note, our accessories, Children's, Men's and Women's businesses each had positive comps during the combined June and July period." We believe the comps inflection in the quarter (which as noted above "continued into August") to be a key factor for members to keep in mind that speaks to why you can't trade simply on macroeconomic reports as the University of Michigan Consumer Sentiment survey (here) that so many look to as a read on the consumer and as a result consumer discretionary sector in general, actually showed a downtick during this period from 100.0 in May to just over 98 in June and July, and move down to 92.1 in August.

Additionally, despite the second-quarter comps miss, it is important to remember that sentiment was about as bad as it could have been coming into the release and as a result, in our view, the same store sales miss is forgivable given the simple fact that despite all the pressures facing retail such as trade, a tight labor market and fears of a recession on the horizon, the company managed to reaffirm its adjusted annual earnings guidance (which management reiterated does take into account tariff concerns) of $5.15 to $5.45 per diluted share, which at the midpoint ($5.30 per share) exceeds the $5.23 per share consensus.

Taking the results into account, we believe there is an important dynamic at play that members must understand and keep in mind both today (as we view this selloff to be unwarranted) and for the future. We have often spoke about the "good house, bad neighborhood" set up, in which an entire sector becomes so hated that even those stocks that actually are managing to perform (even if not at peak levels) are viewed terribly and taken down as collateral damage. That's exactly what we believe to be happening here as a result of an poor release from Macy's (M) last week, a somewhat disappointing 3Q19 guide from TJX Companies (TJX) this morning (though full-year guidance remained intact) and the noted decline in consumer sentiment. Once Macy's hit, the big money decided the sector as a whole must be suffering the same fate - and they wouldn't be wrong if we went strictly off the consumer sentiment number without accounting for any other company-specific initiatives happening at Kohl's that we've been monitoring (more below) - and as a result, all retail stocks regardless of their individual underlying fundamentals became simply untouchable.

On that note, we feel it important to also remind members that unlike many of the others in the sector currently feeling the pressure (think Macy's, J.C. Penny (JCP) , Sears, etc.), Kohl's is not a mall-based name. It stands alone, which is in part what allows it to be such a good partner for the Amazon (AMZN) Returns initiative, and keeps it insulated from the ongoing, secular decline of mall-based shopping.

Now to be clear, we're not sounding the alarm to signal the all clear and we're certainly not out of the woods, yet given the macroeconomic backdrop, what we're saying is that the research matters, execution at the company-specific level matters and of course fundamentals matters, which is why we have not closed out our position despite the awful pin action in the sector (though we did trim a bit on strength ahead of the print, here). As painful as it's been and continues to be, with the stock trading at ~9x forward earnings with a dividend yield nearing 6%, KSS is the poster-child for a value stock and as members know, rule #20 of the 25 Rules For Investing (here), is that "Giving Up on Value is a Sin."

Speaking to those macroeconomic headwinds, Gass stated on the conference call, "Now I want to address the recent tariff news. We recognize there are uncertainties in the market given the impending tariff on apparel and footwear. We will approach our path forward thoughtfully with a focus on doing what's right, not only for our business but also what's right for our customers over the long term. We know that our customers are driven by our value proposition, so we will ensure that our customers continue to receive the value they expect from Kohl's. We've been executing against a sourcing diversification strategy for quite some time. And this year, our team has been working closely with our vendors to ensure that we are prepared for any potential tariff escalation."

Moving to operational initiatives, starting with the omnichannel strategy, which as members know is absolutely crucial in a world that continues to shift toward digital, Gass stated, "we are very pleased with the positive momentum we are seeing in our digital channel. Our investments in personalization, Your Price, Smart Cart, BOPUS [Buy Online, Pick Up in Store], BOSS [where items are shipped from the warehouse, reducing the need for inventory on hand] and the Kohl's mobile app have improved the overall customer experience and continue to drive positive customer engagement. As Bruce noted, in the second quarter, digital demand accelerated to mid-teens growth from high single digits in the first quarter. Mobile continues to drive the majority of our digital traffic with particularly strong growth from the Kohl's app. In fact, during the second quarter, our app visits and conversion grew at nearly double the rate of digital overall. In addition, our efforts to increase our customers' adoption of BOPUS and BOSS are working. Combined, BOPUS and BOSS in-store pickup is approaching 20% of all digital units. This is a key part of our overall omnichannel strategy, getting customers to engage across stores and digital and to leverage the inventory of our stores. During the second quarter, 40% of our digital orders were fulfilled by stores."

We believe the digital push (more below) to be an important factor in not only maintaining current relationship but also generating new ones as younger shoppers have shown a clear preference for both e-Commerce and m-Commerce (mobile commerce, which members know we believe to be a secular trend given our positions in Twilio (TWLO) , Shopify (SHOP) and previously, PayPal (PYPL) ).

As for management's in-store initiatives, which are expected to be a material catalyst for that second-half inflection we're looking for, Gass provided upbeat commentary on both trends in the second quarter and expectations going forward. On the Amazon Returns program, which was rolled out nationwide on July 8th, Gass stated, "While it's only been in place for 6 weeks, we are highly encouraged with the initial results. Traffic coming into our stores is meeting our expectations and skewing towards off-peak times. We are seeing a mixture of existing customers and new younger customers using the service. We began supporting the program in mid-July with a robust marketing plan, including print, digital and national broadcast TV. We are focused on optimizing sales and driving conversion to ensure that we fully capitalize on the traffic coming into our stores. To date, we're seeing conversion consistent with our pilot stores and are particularly encouraged with how our customers are engaging with our proprietary brand. So while it's early, we are pleased with the initial results and remain confident in our ability to drive the intended benefit of this program over the long term."

However, while positive trends are nice, we believe the real takeaway here is that management expects the program "to have a positive contribution to operating income in 2019." Remember the way this initiative plays to the benefit of Kohl's is that more returns (which come with Amazon's own growth) the more foot traffic and therefore the greater the opportunity for Kohl's to convert Amazon returns into Kohl's purchases.

As for product initiatives, Gass noted a strong start to the back-to-school selling season, the company's second largest selling season, and looking ahead called out the upcoming Nine West launch as a key factor that will aid momentum in the company's Woman's footwear and apparel segments, stating, "Nine West is an iconic, sought-after brand that will be a great addition to our portfolio. It will further raise Kohl's relevancy as a fashion destination, and we expect it to positively impact not only our Footwear business but also our Women's apparel business. The launch of Nine West footwear will be our largest ever in the dress casual category and will position Kohl's with the largest ownership and footprint of the Nine West brand in the market. This is a key growth opportunity as we currently under-index from a market share perspective in women's dress casual footwear. We're also excited about the significant opportunity we have in introducing the Nine West brand into women's apparel. Designed in-house, our Nine West collection will include an expanded wear-to-work offering and feature an elevated aesthetic and a more contemporary look, which we believe will attract new millennial customers into Kohl's as well as engage our already loyal shoppers."

Other upcoming initiatives to look forward to include a partnership with "highly decorated fashion designers," Ashley and Mary-Kate Olsen, and Jason Wu, which launch in time for the holiday season, and in November, Gass noted that Kohl's "will become the exclusive retailer of Elizabeth and James-branded apparel, handbags and accessories."

We should also note that within the quarter, a dynamic that should aid the back half of the year, management saw positive trends in Active with Gass stating, "Active apparel remain solid with mid-single-digit growth driven by Nike, Under Armour and Adidas." as for Active footwear, improvements were also seen versus the first quarter with Gass noting during the Q&A section that Adidas (ADDYY) momentum is tracking well, the Vans (VFC) business is "really, really strong," and Nike (NKE) , which saw some pressure in the first quarter, "improved in the second quarter." Gass also noted, "Accessories led the company driven by positive growth in beauty and fashion accessories," and "children's once again outperformed the company driven by growth in active, licensed characters, Carter's and in toys driven by LEGO."

As for the Home category, which had been under pressure sector wide in the prior quarter, Johl's is looking to turn things around as Gass noted that the company will "introduce a new line of soft home goods by Koolaburra by UGG as well as expand the distribution of Amazon-branded smart electronics" in September; and in October, will introduce Scott Living at Kohl's the company's "collaboration with the Property Brothers, Jonathan and Drew Scott, featuring an exclusive line of home decor, which fills an important whitespace opportunity and offering modern lifestyle products."

Lastly, management will also seek to drum up excitement via it's new platform, "Curated by Kohl's," which will showcase emerging, digitally native bands starting in approximately 50 Kohl's stores and online beginning in October. "We will begin by offering 6 brands and then rotate brands in and out to create a constant will of newness and sense of discovery for current and new Kohl's customers."

On the marketing and loyalty front, Gass noted that the Kohl's Rewards pilot, which is now available in 175 stores across 13 markets and has 30 million active members, provides the company a "significant opportunity to improve customer acquisition and retention." Looking ahead Gass noted, "during the second phase of the pilot, we are simplifying the marketing around earning more Kohl's Cash and deploying more targeted and personalized offers to members. We look forward to updating you on our loyalty progress later this year."

Management is also planning to reinvigorate its online experience, Gass telling investors "From a digital perspective, this fall, we will begin testing a new site redesign to a small subset of our traffic with the objective of improving the overall customer experience and driving even better conversion. Our new site will feature enhanced imagery, navigation and filtering. It will also encourage more product discovery and inspiration while maintaining our value messaging. We're also continuing to focus on driving BOPUS and BOSS penetration, as I mentioned earlier. And we are investing in our sixth e-commerce fulfillment center to support future digital growth." Again, we can't stress the importance of an up-to-date online strategy enough as we have clearly seen that those who do not invest in online (think Toys R Us, Sears or Bed Bath and Beyond (BBBY) ) simply cannot compete in today's digital world.

All in, we believe the combination of these initiatives bodes well for the back half of the year and believe today's move to represent somewhat of a disconnect from the better-than-feared results.

On the capital allocation front, the Board of Directors declared a quarterly cash dividend of $0.67 per share, payable on September 25 to shareholders of record at the close of business on September 11, 2019. Additionally, the team repurchased 2.6 million shares during the quarter with CFO Bruce Besanko reiterating on the call that full year guidance assumes share repurchases of $400 million to $500 million and that management now expects, based on year-to-date repurchases of $254 million, to be at the high end of this range.

Bottom line, while there is no avoiding the fact that this has been a painful position and today's action offers no respite, we believe shares to be disconnected from the underlying fundamentals and that today's move is overdone. That said, there is no denying that the sector dynamics have and will likely continue to weigh on shares until management can prove that their initiatives are working and that the dynamics impacting others in the space (such as stale heavily brick-and-mortar based business models and mall-based locations) are not hitting Kohl's in the same way. As a result, this remains a show me story and we must remain patient as shares look to bottom before buying back those shares sold in the $50s. In accordance with this line of reasoning, while we would normally believe a ~9x P/E multiple with a nearly 6% dividend to represent a low point for shares, we must acknowledge and accept that Macy's (regardless of our own view that using it as a comp is wrong) trades at a multiple of less than 6x forward earnings with a dividend yield nearing 10% and as a result will weigh on all names in the sector - despite Macy's being mall-based, with less of an omni-channel strategy and no accretive Amazon partnership to speak of. As Jim put it on the Daily Rundown, the Kohl's story (again, in large part thanks to what's happening elsewhere in the sector) is disliked, we're just going to have to take the pain because, going back to rule #20, "patience is a virtue, but giving up on value is a sin."

Action Alerts PLUS, which Cramer co-manages as a charitable trust, is long KSS, AMZN, TWLO, SHOP.