Description

Kohl’s has been written up numerous times on VIC and you can read these write-ups for background. 

Today I’m proposing the KSS 5.55 2045 bonds which currently trade at 66 and offer a yield to maturity of 9.1% and a current yield of 7%. 

The reason I like the bonds is because Kohl’s is at the cusp of a turnaround which will improve operating margins and de-lever the balance sheet. A new CEO with a strong background in retail, experience on the Board, and the support of the activist Macellum was recently appointed permanent CEO.

Looking out two years, I anticipate significant credit enhancement by deleveraging, reduced capex and improved operating margins. As a result, I anticipate the KSS ‘45s will trade at a lower spread over treasuries than the current 509bp. In addition, by 2025, my base case is that the Fed will yet again be reversing course which will have the effect of lowering the benchmark rate by 100bp.

At this point in time, if the KSS 5.55’s of 45 trade at a 6.5% yield (a 350 bp spread over a 3% benchmark bond) they’ll be trading at 89.4. Including the 5.55% interest payments earned along the way, this is a 54% return on investment and a 22% annualized return. 

These are equity-like returns for bond-like risk. 

As for our margin of safety, we are buying in at the $1.75B layer in the company's senior unsecured debt priced at 66 on the 45’s, plus 2.8B of capital leases at par, thereby creating the company at $4B. Given that the company has a current market cap of $3.6B on top of the debt and capital leases at par, the $4B valuation through the senior unsecured layer seems attractive.

Kohl’s has executed a standstill agreement with Macellum and does not have any material maturities in the next few years. There’s just a 111M bond due on 12/15/23, and another 465M from two issues coming due in mid 2025. These maturities can be paid out of cash flow from operations, which has typically exceeded 1.5B annually until the recent decline.  

Of course, the investment will not work out so positively if the company does not find a way to improve sales and margins. My recent visit to two stores in Norcal indicate a company with poor inventory and low customer count. It's not a fun place to shop, even if you're a bargain hunter in search of new inexpensive socks.

For now, however, I am willing to give management the benefit of the doubt as the company has faced a number of headwinds in the past year including fending off an activism campaign, high capex from the Sephora rollout, a high priced stock buyback to appease the shareholders, high freight costs and inventory mis-steps. It seems reasonable to think the business can be improved from here.

The company is committed to returning to investment grade which will result in leverage declining from the current 3.8x EBITDA to 2.5x EBITDA. In my latest call with management, they indicated stock repurchases are finished. Furthermore, in the event the economy and/or their results slow dramatically, Kohl’s has the ability to cut capex by stopping/slowing the rollout of Sephora’s store in store and the ability to cut payroll as well.

Earnings come out premarket on 3/1, though I suspect the quarter will be a doozy and the incoming CEO will reset expectations at a very low level.

For background, I recommend reading the details of Macellums campaign at https://macellumcapitalmanagement.com/campaigns/kohls/ including watching their video assessment of Kohl’s operating shortfalls at https://vimeo.com/701078159.

In the downside scenario, it’s possible that interest rates continue to grind higher and we have spread widening due to the economy entering a recession and/or deteriorating performance at Kohl’s in particular. If the long bonds traded to a 12% yield, the price would be 50. Including the 5.55% coupon, this would result in a -16% total return. Ugly, but not the end of the world by any stretch. 

In my upside scenario, if the Fed cuts rates significantly and Kohl’s has successfully deleveraged and implemented a turnaround, it’s quite possible the long bonds return to a price exceeding 100 as investors will once again be in a search for investment grade yield. Note these bonds traded between 100-105 in 2019, when the Fed Funds rate was around 1.5-2.3%, and over 120 for much of 2021 when FF rates were zero.

Catalyst

Operating turnaround

Reduction in capex

Return to investment grade 

Declining benchmark rate

Declining spread over benchmark