S&P Global Ratings downgraded the debt ratings of Kohl’s Corp. following the retailer’s update on its sales and earnings guidance for the full year. S&P said it expects Kohl’s medium to long-term business prospects will continue to be challenged by department stores’ secular headwinds.
The rating agency expects that over the next 12 months, economic headwinds and a promotional environment will pressure profitability and result in weak credit metrics, including leverage remaining above S&P’s mid-2x downgrade threshold for a ‘BBB-‘ rating.
As a result, S&P lowered its issuer credit rating on Kohl’s to ‘BB+’ from ‘BBB-‘. S&P also lowered its rating on Kohl’s secured, unsecured debt to ‘BB+’ from ‘BBB-‘, and assigned it a capped ‘3’ recovery rating, which indicates its expectations for meaningful (50 percent to 70 percent; 65 percent rounded estimate) recovery in the event of default. The stable outlook reflects S&P’s view that although sales and profitability will likely stay pressured over the next year, the company will continue to balance shareholder returns and execute operational initiatives while sustaining leverage around 3x on an S&P Global Ratings lease-adjusted basis in 2023.
S&P said in its analysis, “The downgrade reflects the secular headwinds we continue to associate with the highly competitive department store sector and our expectation that Kohl’s operating performance will be weaker than our prior forecast with S&P Global Ratings lease-adjusted leverage at about 3.5x in 2022 before improving to around 3x in 2023. Kohl’s operating momentum continued to slow in the second quarter of 2022, with sales declining by 8.5 percent as the company continued to face the weakening macroeconomic environment, high inflation, and dampened consumer spending. Operating margins for the quarter declined by more than 600 basis points. We expect weak prospects over the next year, with the company’s S&P Global Ratings-adjusted EBITDA margins decreasing to below 11 percent in 2022 from 14.7 percent in 2021, reflecting higher input costs, ongoing investments in-store initiatives, and a more promotional environment. So far this year, Kohl’s performance has been more volatile than its peers due to inflationary pressure on its middle-income customers and the nature of its merchandise mix, which is concentrated in the active and casual lifestyle categories.
“Despite clearance activity during the second quarter, inventory levels continued to increase materially, particularly in the women’s casual and activewear categories, where we believe promotions will likely intensify throughout the industry. S&P Global Rating-adjusted leverage, including our adjustment for capital and operating lease liabilities) was 3.2x for the 12 months through second quarter 2022. In addition, we project leverage will be around 3.5x for the fiscal year ended 2022, which is above our prior expectation and the downgrade threshold of mid-2x for a ‘BBB-‘ rating. In addition, we expect free operating cash flow to remain pressured in 2022 due to lower sales and higher inventory levels while the company continues to sustain high capital expenditures for its Sephora buildouts and related store refurbishments.
“Kohl’s has indicated it will explore shareholder-friendly actions, as it reaffirmed its commitment to returning capital to shareholders, including approximately $900 million through dividends and share repurchases this year. It is also currently reviewing other opportunities to unlock shareholder value, including reevaluating selling portions of the company’s real estate portfolio. In 2023, we expect free cash flow to improve to about $900 million and for the company to repay its $275 million senior unsecured notes, thereby improving its leverage to around 3x. At this time, we do not factor in future potential sale-leaseback transactions, given the uncertainty of the timing and amounts.
“We believe competitive pressures in the evolving and highly competitive department store segment remain significant. Apparel purchases are highly discretionary, and retailer performance remains vulnerable to economic conditions such as the recent macroeconomic slowdown. In addition, our longer-term view is that changing consumer apparel buying habits 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 believe Kohl’s efforts to leverage partnerships, such as with Sephora, which will be rolled out to all its stores, could prove successful in offsetting some of these pressures. Nevertheless, this partnership also highlights the need to adapt the business model to secular trends and a legacy store footprint with large square footage stores, and we believe there are ongoing execution risks with the evolution of these stores. We think a continued shift to online shopping and competition from off-price e-players could pressure traffic at brick-and-mortar locations and margins. We believe this relative underperformance highlights some of the challenges Kohl’s will need to overcome to strengthen its competitive standing, and as such, we revised our comparable rating analysis modifier for the company to neutral from positive. Kohl’s closest rated peers are department store operators Nordstrom (BB+/Stable/B) and Macy’s Inc. (BB/Positive/B). We view Kohl’s largely off-mall locations (about 95 percent of its total stores) as a benefit as it contributes to the company’s lower cost structure and provides better accessibility and convenience for customers. Still, Kohl’s credit measures lag its peers year-to-date, and we believe performance trends across the three companies have converged over time due to the challenging backdrop they are facing.
“The stable outlook reflects our view that sales and profitability will likely stay pressured over the next year amid the intensely challenging operating environment. Nevertheless, we believe the company will continue to balance shareholder returns and execute operational initiatives.”
