Description

Position / Ticker: Short / KSS

Price Target: ~$50-55 (Normalized EPS= $4.25 @ P/E= 12x)

Exp. Return: 25-35%

Company Description:

--Department store retailer with 1,160 stores in 49 states (~25% mall-based) across the US selling women's (30%), men's (20%), home goods (20%), children's (10%), accessories (10%), and footwear (10%). ~50% of the brands it sells are cheaper private/exclusive brands (Croft & Barrow, Jumping Beans, and others) and 50% are national brands (Levi's, Nike, etc).

Thesis

KSS’s >40% stock appreciation over the last several months (before reporting Q3 2014) from being a perennial $55 stock to a close to $75-80 stock provides a good opportunity to short a perennial market share donor whose core business continues to decline and will likely continue to do so once one-time tailwinds (from lower gas prices and credit card program penetration) pass. KSS is trading at a multi-year peak valuation and at a ~20% premium to its closest and better performing peer (Macy’s). Coming quarter may show decent same-store sales growth due to easy compares, but the improvement is already priced in and I’d expect the stock to either relatively underperform from here and decline significantly once the tailwinds are lapped. Ultimately, I think KSS is worth ~$50, or down 35% from here.

Here’s the bull case and the reason for the stock’s recent strength:

--Same store sales growth (“comps”) accelerated in latest quarter (Q4 2014) from being perennially flat/negative to positive 3.7%, implying a 500bps sequential improvement in two-year comps. The quarter was the first positive traffic quarter since Q1 2011. Comps are benefitting from a) the company’s initiatives to increase national brand assortment and others which were laid out at an analyst day in October, and b) an improved consumer (lower gas prices). With easier year-over-year compares over the next three quarters, management’s 2-3% comp target laid out at its analyst day looks achievable and possibly conservative. $21bn 2017 sales target implies an achievable 3% comp CAGR.

--The targets KSS laid out at its investor day for 2017 (2-3% comps, $21bn in sales, 9% op margin) look conservative. Bulls view the 2017 operating margin target of 9% (vs. ~9% in 2014) as conservative given potential for higher flow-through if the ~2-3% comp targets are achieved. In the most recent quarter, KSS improved margins by 35bps on a 3.7% comp. Macy’s has ~10.5% operating margins, so there is room for improvement vs. KSS’ closest peer.

--Coupling the above with continued strong share repurchases given strong FCF (~$1bn per year) implies that earnings power could be greater than $6 in EPS.

--KSS is relatively cheap at 15x and 6.8x consensus 2016 EPS and EBITDA, respectively, with a ~8% free cash flow yield (~9% FCF per share).

--KSS owns ~35% of its real estate. Some estimates indicated could be worth ~$4bn, or 25% of market cap. With Hudson’s Bay monetizing its real estate in a high-profile way recently (to strong shareholder reception), focus could turn next on other department stores like KSS that own real estate.

--Short interest is relatively high, continued strong comp performance could cause some short capitulation.

--KSS’s strong FCF and buybacks per year has been enough and should continue to be enough to post solid EPS growth even with comps missing 2-3% target. KSS repurchases $5bn of stock in the last four years and reduces its share count by ~33%.

--Ultimately, 6 in EPS earnings power in 2017. At 15x (vs. 14x historical average), implies at $90 stock in one year (assuming it trades on 2017 estimates one year from now) for a 20% return vs. the current $75 price.

My Thoughts (i.e. Bear Case):

--The Q4 2014 traffic and comp increase is not sustainable. Comps were still negative 0.3% for the full year of 2014. There’s a reason traffic has been averaging negative 0.4% for the last seven years – KSS is the weakest positioned retailer in a secularly declining customer channel (department stores) and as competition increases (from off-price, fast fashion, beauty, and flash sale retailers, Amazon, and a revitalized J.C. Penney). One-time factors – including an incredibly competitive and difficult holiday quarter in 2013 – boosted the Q4 2014 performance. Once those pass, traffic will revert back to negative trend and given the high level of fixed costs of the department store model, margins will continue to decline as they have for years and earnings are in secular decline.

--KSS’s investor day targets will prove optimistic as KSS has not achieved 2-3% comps for a full year since 2010. KSS has comped above 1% only 1 out of the last 7 years – I don’t understand why anybody would believe them when they say they will now comp positively (and at that, 2-3%!) for several years.

-- KSS has been overearning for several years due to the significant contribution from increased credit card penetration at its stores – which will slow. Credit card revenues benefitted EBITDA by $167mm, $41mm, $19mm, and $24m from 2011-2013, or cumulatively boosting EBITDA by $250mm, implying core EBITDA (excluding the benefit from credit card operations) has fallen ~20% since 2010. Given that credit card revenues are recorded as an offset to SG&A (and found only in the notes to filings), many investors/analysts do not account for this. Further, comps have even been overstated as eCommerce is included in the calculation and grew 40% in 2012 and slowed to 20% in 2013 (undisclosed and therefore likely slower in 2014).

--The margin comparison to Macy’s that bulls draw is flawed as Macy’s owns less of its real estate and operating / EBITDA margins are therefore optically lower. On an apples-to-apples EBITDA basis, KSS and M’s margins are actually equal at ~15%.

--Despite growing EPS by 5% in 2014 (and being flattish since 2011), earnings growth is low quality and driven entirely by share repurchases as net income was actually down year-over-year in 2014. With a higher stock price and valuation, share repurchases will be less effective.

--KSS will never monetize its real estate (nor will Macy’s), so that part of the bull case is unlikely to materialize. These are cyclical businesses where selling all of your real estate today might mean bankruptcy come the next recession.

--Overall, earnings power is unlikely to materially move beyond $4 in EPS. For a company that hasn’t grown earnings significantly in years and likely won’t in the future, 15x EPS is expensive and an unwarranted premium to its peer Macy’s, which trades at 12.5x 2016 EPS. At 12x, this implies a ~$50-55 stock and 25-35% downside.

Conclusion

--KSS is a long-term short with a 1.5:1 risk-reward. 

Catalyst

Disappointing traffic trends; diminishing benefit from credit card penetration