S&P Global Ratings revised its ratings on Kohl’s to negative on softening consumer spending.
S&P noted that Kohl’s Corp. cited obstacles in the financing and retail environment that terminated its exclusive negotiations for a sale to Franchise Group Inc. In addition, the company is seeing weaker demand in its most recent quarters and has lowered its sales guidance for the second quarter of fiscal 2022.
S&P said, “We believe Kohl’s low leverage and off-mall, value-oriented positioning are offsets to secular headwinds facing department stores, a more-promotional environment, and a softening U.S. economy that will continue to challenge business prospects.”
S&P affirmed its ‘BBB-‘ issuer credit rating on the company and removed the rating from CreditWatch, where it was placed with negative implications on June 7, 2022.
The negative outlook reflects the risk that Kohl’s performance may not stabilize and that there is limited capacity for a less conservative financial policy at the current rating barring a return to meaningful profit growth.
S&P wrote in its analysis, “Kohl’s has seen swings in performance amid the pandemic since 2020. The company cut its guidance for the remainder of fiscal 2022 in May because high inflation continues to crimp consumer demand and complexities in managing inventory levels across the sector due to the shift away from active and casual lifestyles affects operating margins. Most recently, the company updated its guidance for the second quarter ending July 30, expecting sales to be down in the high-single-digit percentage area for the quarter versus in the low single digits previously. Kohl’s operating performance rebounded well in fiscal 2021, with the company’s S&P Global Ratings-adjusted EBITDA margin rising sharply to 14.7 percent from 5.7 percent in 2020, reflecting significant sales leverage and a less-promotional environment. Still, we expect margin trends to reverse in 2022 as the general retail environment returns to more promotions. Since the company is in the early stages of taking actions to navigate this difficult environment, we believe there are execution risks involved with the company’s key operating initiatives to drive traffic and increase margins, such as its inventory optimization, enhanced digital capability, and merchandise offering.
“Kohl’s has indicated it will explore shareholder-friendly actions following the termination of its sale to Franchise Group. Kohl’s board recently reaffirmed its commitment to a $500 million accelerated share repurchase program and is also currently reviewing other opportunities to unlock shareholder value, including reevaluating selling portions of the company’s real estate portfolio. We will closely monitor shifts in financial policy and expect shareholder returns to be balanced against the prudent approach to debt to maintain the investment-grade ratings. The company exited 2021 with solid credit protection measures, but we expect the weakening environment and cash outflows in the form of dividends and share repurchases will move adjusted leverage to the mid-2x level this year, aligned with our expectations for the ratings.
“In recent months, Kohl’s has been the subject of a proxy battle with activist investors Macellum Advisors. The activists have been pushing for Kohl’s to increase sales and cut costs through a sale-leaseback, a spin-off the e-commerce business, or exploring selling itself. On May 11, Kohl’s announced that based on the preliminary result of the vote count, Kohl’s shareholders have voted to re-elect its entire existing board. As such, we do not expect an immediate departure from the company’s operating strategy and financial policy based on the continuity of the board and the management team.
“We believe competitive pressures in the evolving and highly competitive department store segment remain significant. Apparel purchases are highly discretionary, and performance remains vulnerable to economic conditions, such as the recent macroeconomic slowdown. In addition, our longer-term view is that changing consumer preferences will be difficult to navigate, which increases the potential for operational missteps. Declining physical store traffic, shifting category preferences, and online price transparency are persistent longer-term risks for Kohl’s business. We think a continued shift to online shopping and competition from off-price e-players could pressure both traffic at brick-and-mortar locations and margin challenges, but Kohl’s efforts to leverage partnerships, such as those with Sephora and Amazon, may prove successful in offsetting some of these pressures. As a result of this challenging backdrop, we have revised our business risk assessment to fair from satisfactory, which is comparable with Kohl’s closest peers, Nordstrom and Macy’s.
“Still, we think Kohl’s is relatively well-positioned as a mid-tier department store with customer-centric merchandise and mostly off-mall locations against many other mall-based competitors. While we anticipate customers will remain focused on value and accessibility, we think Kohl’s merchandise mix, with accessible prices and a concentration on active and casual lifestyles, resonates well with today’s evolving consumer preferences. We also view Kohl’s largely off-mall locations (about 95 percent of its total stores) as a benefit. It contributes to the company’s lower cost structure and provides better accessibility and convenience for customers and contributed to the company’s less volatile operating performance over the past few years relative to its peers. These favorable elements lead us to view the company’s business risk at the better end of the fair category and we, therefore, have revised the comparable ratings adjustment to positive from neutral.
“Good cash flow generation and flexibility to manage shareholder returns are positive rating considerations. Kohl’s continues to have the ability to manage credit metrics through its ample cash flow generation and potential for additional monetization of its real estate. Kohl’s has demonstrated a track record of a conservative financial policy and its profitability managed to hold up better through the pandemic period than other department store peers. The company’s leverage improved to below 2x in fiscal 2021 from 5.1x in fiscal 2020, during the peak of the pandemic.
“Our base case reflects our assumption that Kohl’s will sustain its financial policy and remain focused on executing key strategies, maintaining leverage in the mid-2x area. We also forecast Kohl’s will continue to generate good free operating cash flow (FOCF) of about $500 million in fiscal 2022 and $700 million in fiscal 2023. The company ended fiscal 2021 with a healthy $1.6 billion cash on the balance sheet. Although we anticipate it will allocate part of cash and FOCF for dividends and its accelerated share repurchases, we believe Kohl’s will maintain substantial cash on the balance sheet, which provides additional support to weather potential economic or industry uncertainties.
“The negative outlook reflects the risk of a downgrade over the next 24 months if Kohl’s does not stabilize its performance with prospects for sustainable growth in 2023 and beyond. Our base case assumes the company balances shareholder returns and executes operational initiatives to maintain leverage at about the mid-2x area while returning to growth.”
