KOHLS Corp: Form 10-Q for the period ended Oct 28, 2023

For purposes of the following discussion, unless noted, all references to "the quarter” and “the third quarter” are for the three fiscal months (13 weeks) ended October 28, 2023 or October 29, 2022. References to "year to date" are for the nine fiscal months (39 weeks) ended October 28, 2023 or October 29, 2022. References to "the first quarter" are for the three fiscal months (13 weeks) ended April 29, 2023 or April 30, 2022. References to "the second quarter" are for the three fiscal months (13 weeks) ended July 29, 2023 or July 30, 2022.

This Form 10-Q contains “forward-looking statements” made within the meaning of the Private Securities Litigation Reform Act of 1995. Words such as "believes," "anticipates," "plans," "may," "intends," "will," "should," "expects," and similar expressions are intended to identify forward-looking statements. Forward-looking statements include the information under “2023 Financial and Capital Allocation Outlook,” as well as statements about our future sales or financial performance and our plans, performance, and other objectives, expectations, or intentions, such as statements regarding our liquidity, debt service requirements, planned capital expenditures, future store initiatives, and adequacy of capital resources and reserves. Forward-looking statements are based on management’s then-current views and assumptions and, as a result, are subject to certain risks and uncertainties that could cause actual results to differ materially from those projected. Any such forward-looking statements are qualified by the important risk factors, described in Part I Item 1A of our 2022 Form 10-K, or disclosed from time to time in our filings with the SEC, that could cause actual results to differ materially from those predicted by the forward-looking statements. Forward-looking statements relate to the date initially made and we undertake no obligation to update them.

Executive Summary

Kohl's is a leading omnichannel retailer operating 1,170 stores and a website (www.Kohls.com (http://www.Kohls.com)) as of October 28, 2023. Our Kohl's stores and website sell moderately-priced private and national brand apparel, footwear, accessories, beauty, and home products. Our Kohl's stores generally carry a consistent merchandise assortment with some differences attributable to local preferences and store size, as well as Sephora shops. Our website includes merchandise which is available in our stores, as well as merchandise that is available only online.

Key financial results for the quarter included:

• Net sales decreased 5.2%, to $3.8 billion, with comparable sales down 5.5%.
• Gross margin as a percentage of net sales was 38.9%, an increase of 158 basis points to last year.
• Selling, general & administration ("SG&A") expenses increased 1.9%, to $1.4 billion. As a percentage of total revenue, SG&A expenses were 33.5%, an increase of 235 basis points to last year.
• Operating income was $157 million compared to $200 million in the prior year. As a percentage of total revenue, operating income was 3.9%, a decrease of 82 basis points to last year.
• Net income was $59 million, or $0.53 per diluted share. This compares to net income of $97 million, or $0.82 per diluted share in the prior year.
• Inventory was $4.2 billion, a decrease of 13% to last year.
• Operating cash flow was $151 million.

Our Strategy

Kohl's is focused on delivering long-term shareholder value by driving improved sales and profitability through four key strategies: driving top line growth, delivering a long-term operating margin of 7% to 8%, maintaining disciplined capital management, and sustaining an agile, accountable, and inclusive culture. In 2023, the Company outlined the following priorities to drive this strategy: enhancing the customer experience, accelerating and simplifying our value strategies, managing inventory and expenses with discipline, and strengthening the balance sheet.

2023 Financial and Capital Allocation Outlook

For the full year 2023, the Company updates its financial outlook and currently expects the following:

• Net sales: A decrease of (2.8%) to (4%), including the impact of the 53rd week which is worth approximately 1%. This compares to the Company's prior guidance of a decrease of (2%) to (4%).
• Operating margin: Approximately 4.0%, which is consistent with the Company’s prior guidance.
• Diluted earnings per share: In the range of $2.30 to $2.70, excluding any non-recurring charges. This compares to the Company’s prior guidance range of $2.10 to $2.70.
• Capital expenditures: Towards the lower end of $600 million to $650 million, including expansion of its Sephora partnership and store refresh activity.

Results of Operations

Total Revenue

(Dollars in Millions)

Net sales decreased 5.2% in the third quarter of 2023 and 4.5% year to date 2023.

• Comparable sales decreased 5.5% in the third quarter of 2023 and 5.0% year to date 2023 driven by lower digital sales. Digital sales decreased 16.5% in the third quarter of 2023 and 18% year to date 2023. Digital sales continue to be impacted by the elimination of online-only promotions as we worked to simplify our value strategies. Digital penetration represented 26% of net sales in the third quarter and 25% year to date 2023. Store sales in the third quarter of 2023 decreased 1% and were slightly positive year to date 2023.
• From a line of business perspective, Accessories, which includes Sephora, outperformed the Company average for the third quarter and year to date 2023. Total beauty sales increased more than 70 percent in the third quarter.

Net sales includes revenue from the sale of merchandise, net of expected returns and deferrals due to future performance obligations, and shipping revenue.

Comparable sales is a measure that highlights the performance of our stores and digital channel by measuring the change in sales for a period over the comparable, prior-year period of equivalent length. Comparable sales includes all store and digital sales, except sales from stores open less than 12 months, stores that have been closed, and stores that have been relocated where square footage has changed by more than 10%. We measure the change in digital sales by including all sales initiated online or through mobile applications, including omnichannel transactions which are fulfilled through our stores.

We measure digital penetration as digital sales over net sales. These amounts do not take into consideration fulfillment node, digital returns processed in stores, and coupon behaviors.

Comparable sales and digital penetration measures vary across the retail industry. As a result, our comparable sales calculation and digital penetration may not be consistent with the similarly-titled measures reported by other companies.

Other revenue, which is primarily our credit business, decreased $14 million in the third quarter and $49 million year to date 2023. The decrease is driven by payment trend declines and increasing credit loss rates.

As it relates to our credit business and recent regulatory developments, the Consumer Financial Protection Bureau ("CFPB") has proposed lowering the late fees credit card companies can charge. If enacted as proposed, it would have an impact on our credit card revenues if unmitigated. We are actively pursuing various initiatives to mitigate the effects of this potential ruling including scaling our recently launched co-brand card and other various initiatives with Capital One, our credit partner. We are closely monitoring developments on the issue.

Cost of Merchandise Sold and Gross Margin

(Dollars in Millions)

Cost of merchandise sold includes the total cost of products sold, including product development costs, net of vendor payments other than reimbursement of specific, incremental, and identifiable costs; inventory shrink; markdowns; freight expenses associated with moving merchandise from our vendors to our distribution centers; shipping expenses for digital sales; and terms cash discount. Our cost of merchandise sold may not be comparable with that of other retailers because we include distribution center and buying costs in selling, general, and administrative expenses while other retailers may include these expenses in cost of merchandise sold.

Gross margin is calculated as net sales less cost of merchandise sold. For the third quarter of 2023, gross margin was 38.9% of net sales, an increase of 158 basis points to last year. Year to date 2023, gross margin was 39.0% of net sales, an increase of 56 basis points to last year. The increase in both the third quarter and year to date 2023 was driven by lower freight costs, reduced digital-related cost of shipping, and the simplification of our value strategies, partially offset by higher product costs. Additionally, year to date 2023 we continue to experience higher shrink.

Selling, General, and Administrative Expense (“SG&A”)

(Dollars in Millions)

SG&A includes compensation and benefit costs (including stores, corporate, buying, and distribution centers); occupancy and operating costs of our retail, distribution, and corporate facilities; freight expenses associated with moving merchandise from our distribution centers to our retail stores and among distribution and retail facilities other than expenses to fulfill digital sales; marketing expenses, offset by vendor payments for reimbursement of specific, incremental, and identifiable costs; expenses related to our credit card operations; and other administrative revenues and expenses. We do not include depreciation and amortization in SG&A. The classification of these expenses varies across the retail industry.

Many of our expenses, including store payroll and distribution costs, are variable in nature. These costs generally increase as sales increase and decrease as sales decrease. We measure both the change in these variable expenses and the expense as a percent of revenue. If the expense as a percent of revenue decreased from the prior year, the expense "leveraged". If the expense as a percent of revenue increased over the prior year, the expense "deleveraged".

The following table summarizes the changes in SG&A by expense type:

(Dollars in Millions)

SG&A expenses increased $26 million, or 1.9%, to $1.4 billion in the third quarter of 2023. As a percentage of revenue, SG&A deleveraged by 235 basis points. Year to date 2023, SG&A expenses decreased $8 million, or 0.2%, to $3.9 billion. As a percentage of revenue, SG&A deleveraged by 150 basis points. During the quarter and year to date 2023 increases in store expenses was driven by continued investments in Sephora openings, increased wages, and other store-related expenses. Additionally, general corporate costs increased for both the third quarter and year to date 2023. Year to date 2023, the increase in corporate costs was partially offset by expenses related to the proxy contest and sale process that occurred in the first half of last year. Partially offsetting these SG&A increases were lower marketing and distribution costs. For both the third quarter and year to date 2023, marketing investments were down across all channels and distribution costs decreased due to lower receipts, sales declines, and increased productivity.

Other Expenses

(Dollars in Millions)

The decrease in depreciation and amortization in the third quarter and year to date 2023 was primarily driven by reduced capital spending in technology.

Net interest expense increased in the third quarter and year to date 2023 due to borrowing under the revolving credit facility and Sephora related lease amendments.

Income Taxes

(Dollars in Millions)

The third quarter and year to date rates reflect the recognition of favorable tax items in both 2023 and 2022. Due to lower pre-tax income in 2023, the favorable discrete items will have greater impact in 2023.

Seasonality and Inflation

Our business, like that of other retailers, is subject to seasonal influences. Sales and income are typically higher during the back-to-school and holiday seasons. Because of the seasonality of our business, results for any quarter are not necessarily indicative of the results that may be achieved for a full fiscal year.

We expect that our operations will continue to be influenced by general economic conditions, including food, fuel and energy prices, employment rates, wage inflation, and costs to source our merchandise, including tariffs. There can be no assurances that such factors will not impact our business in the future.

Liquidity and Capital Resources

Capital Allocation

Our capital allocation strategy is to invest to maximize our overall long-term return and maintain a strong balance sheet, with a long-term objective of achieving an investment grade rating. We follow a disciplined approach to capital allocation based on the following priorities: first we invest in our business to drive long-term profitable growth; second we pay a quarterly dividend; and third we return excess cash to shareholders through our share repurchase program. In addition, when appropriate, we will complete debt reduction transactions.

We will continue to invest in the business, as we plan to invest towards the lower end of $600 to $650 million in 2023, including the expansion of the Sephora shops and store refresh activity. We remain committed to the dividend, and on November 7, 2023, our Board of Directors declared a quarterly cash dividend of $0.50 per share. The dividend will be paid on December 20, 2023 to all shareholders of record at the close of business on December 6, 2023. Last, we retired $164 million of notes due in February 2023, and plan on retiring $111 million of notes due December 2023 when they mature. We are not planning any share repurchases until our balance sheet is strengthened on a path towards the long term target leverage ratio of 2.5 times adjusted earnings before interest, taxes, depreciation, amortization, and rent ("EBITDAR") (utilizing an eight times cash rent calculation for lease obligations).

Our period-end cash and cash equivalents balance decreased to $190 million from $194 million in the third quarter of 2022. Our cash and cash equivalents balance includes short-term investments of $11 million and $8 million as of October 28, 2023, and October 29, 2022, respectively. Our investment policy is designed to preserve principal and liquidity of our short-term investments. This policy allows investments in large money market funds or in highly rated direct short-term instruments. We also place dollar limits on our investments in individual funds or instruments.

The following table presents our primary uses and sources of cash:

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(Dollars in Millions)

Operating Activities

Our operating cash outflows generally consist of payments to our employees for wages, salaries and other employee benefits, payments to our merchandise vendors for inventory (net of vendor allowances), payments to our shipping carriers, and payments to our landlords for rent. Operating cash outflows also include payments for income taxes and interest payments on our debt borrowings.

Operating activities generated $379 million of cash year to date 2023 compared to $425 million of cash used year to date 2022. Operating cash flow increased year over year due to strong inventory management in 2023.

Investing Activities

Our investing cash outflows include payments for capital expenditures, including investments in new and existing stores, improvements to supply chain, and technology costs. Our investing cash inflows are generally from proceeds from sales of property and equipment.

Investing activities used $491 million of cash year to date 2023 and $702 million year to date 2022. The decrease was primarily driven by fewer rollouts of Sephora shop build-outs and store refreshes undertaken year to date 2023, consistent with our capital expenditure plans for fiscal 2023.

Year to date 2023, we opened 251 full size Sephora shops and 41 small format shops. At the end of the quarter, we had a Sephora presence in over 900 of our stores, including 857 full size 2,500 square foot shops and 46 small format Sephora shops.

Financing Activities

Our financing strategy is to ensure adequate liquidity and access to capital markets. We also strive to maintain a balanced portfolio of debt maturities, while minimizing our borrowing costs. Our ability to access the public debt market has provided us with adequate sources of liquidity. Our continued access to these markets depends on multiple factors, including the condition of debt capital markets, our operating performance, and maintaining strong credit ratings.

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 while both also revised their outlook to negative. While Fitch reaffirmed our credit rating, they also revised their outlook to negative.

As of October 28, 2023, our senior unsecured credit ratings and outlook were as follows:

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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. If our credit ratings are lowered further, our ability to access the public debt markets, our cost of funds, and other terms for new debt issuances could be adversely impacted. Each of the credit rating agencies reviews its rating periodically and there is no guarantee our current credit ratings will remain the same.

The majority of our financing activities generally include proceeds and/or repayments of long-term debt, dividend payments, and repurchases of common stock. Financing cash outflows also include payments to our landlords for leases classified as financing leases and financing obligations.

Financing activities generated $149 million of cash year to date 2023 and used $266 million of cash year to date 2022.

During the year, we drew $540 million on our credit facility. As of October 28, 2023, outstanding borrowings under the revolving credit facility were $625 million and were recorded as short-term debt. As of October 29, 2022, outstanding borrowings under our previous credit agreement were $668 million.

In February 2023, $164 million in aggregate principal amount of our 3.25% notes matured and was repaid.

There was no cash used for treasury stock purchases year to date 2023 compared to $658 million used year to date 2022. Share repurchases are discretionary in nature. The timing and amount of repurchases are based upon available cash balances, our stock price, and other factors. As previously noted, we are not planning any share repurchases until our balance sheet is strengthened on a path towards the long term target leverage ratio of 2.5 times adjusted EBITDAR (utilizing an eight times cash rent calculation for lease obligations).

Cash dividend payments were $165 million ($1.50 per share) year to date 2023 compared to $184 million ($1.50 per share) year to date 2022.

Key Financial Ratios

Key financial ratios that provide certain measures of our liquidity are as follows:

(Dollars in Millions)

Our working capital and inventory levels typically build throughout the fall, peaking during the November and December holiday selling season.

The decrease in our working capital and current ratio is primarily due to a decrease in inventory.

Debt Covenant Compliance

Our senior secured, asset based revolving credit facility contains customary events of default and financial, affirmative and negative covenants, including but not limited to, a springing financial covenant relating to our fixed charge coverage ratio and restrictions on indebtedness, liens, investments, asset dispositions, and restricted payments. As of October 28, 2023, we were in compliance with all covenants and expect to remain in compliance during the remainder of 2023.

Contractual Obligations

There have been no significant changes in the contractual obligations disclosed in our 2022 Form 10-K other than borrowings under our revolving credit facility, which have been disclosed in Note 3 of the Consolidated Financial Statements and discussed under "Liquidity and Capital Resources - Financing Activities."

Off-Balance Sheet Arrangements

We have not provided any financial guarantees arising from arrangements with unconsolidated entities or persons as of October 28, 2023.

We have not created, and are not a party to, any special-purpose or off-balance sheet entities for the purpose of raising capital, incurring debt, or operating our business. We do not have any arrangements or relationships with entities that are not consolidated into our financial statements that are reasonably likely to materially affect our financial condition, liquidity, results of operations, or capital resources.

Critical Accounting Policies and Estimates

The preparation of financial statements in conformity with U.S. GAAP requires us to make estimates and assumptions that affect reported amounts. Management has discussed the development, selection, and disclosure of its estimates and assumptions with the Audit Committee of our Board of Directors. There have been no significant changes in the critical accounting policies and estimates discussed in our 2022 Form 10-K.

Evaluation of Disclosure Controls and Procedures

Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we carried out an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures (the “Evaluation”) at a reasonable assurance level as of the last day of the period covered by this report.

Based upon the Evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures are effective at the reasonable assurance level. Disclosure controls and procedures are defined by Rule 13a-15(e) of the Securities Exchange Act of 1934 (the "Exchange Act") as controls and other procedures that are designed to ensure that information required to be disclosed in the reports that we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified by the SEC's rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed in the reports that we file or submit under the Exchange Act is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosures.

It should be noted that the design of any system of controls is based in part upon certain assumptions about the likelihood of future events and there can be no assurance that any design will succeed in achieving our stated goals under all potential future conditions, regardless of how remote.

Changes in Internal Control over Financial Reporting

There were no changes in our internal control over financial reporting during the quarter ended October 28, 2023 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.