S&P Global Ratings lowered the debt ratings of Kohl’s Corp. as the retailer’s recently reported earnings for fiscal 2022, came in below expectations with lower margins due to heightened clearance activity and muted demand.
S&P said it now projects S&P Global Ratings-adjusted leverage will remain above its previous 3x downgrade threshold in 2023 and 2024. As a result, Kohl’s ratings were downgraded by one notch, including the issuer credit rating on the company to ‘BB’ from ‘BB+’.
S&P also lowered Kohl’s unsecured debt to ‘BB’ from ‘BB+’ and kept a capped ‘3’ recovery rating, which indicates its expectations for meaningful (50 percent-70 percent; 65 percent rounded estimate) recovery in the event of default.
The negative outlook reflects the risk that a challenging macroeconomic environment and execution risks associated with Kohl’s operating initiatives will pressure results. This limits S&P’s view of the business’s long-term prospects, with leverage expected to remain elevated at close to 4x this year.
S&P said in its analysis, “The downgrade reflects the significant deterioration of Kohl’s free operating cash flow and leverage. Kohl’s free operating cash flow (FOCF) saw a steep swing to negative $639 million in fiscal 2022 from positive $591 million in fiscal 2021. Its S&P Global Ratings’ lease-adjusted leverage increased to 5.5x as of year-end 2021 from 1.9x in the prior year. Kohl’s operating performance was particularly weak in the fourth quarter, with revenue declining 7 percent year over year.
“The company employed heavy markdowns to clear inventory, with reported operating margins for the year down more than 700 basis points (bps) compared with our expectations for a 400 bps decline. Its thin operating margin of less than 2 percent in 2022 reflects promotion, inflation, and freight pressure.
“We expect better metrics in 2023 as the company improves merchandising execution, freight costs ease, and it continues the rollout of Sephora shops at its stores. Still, we believe operating margins will remain below historic levels and stay at about 4 percent. We also note macroeconomic risks as the economy slows, which could impair consumer spending and pressure sales more than the low-single-digit percent decline we anticipate in our base case for fiscal 2023.
“We believe inventory levels at the end of 2022 appeared appropriate following clearance activity, up roughly 4 percent compared with the prior year. However, given the mixed recent track record, we see risks of markdowns that could continue to pressure profitability over the coming year. We assume initiatives will gradually improve profitability over the next several years, with revenue declining in 2023 and slowly building back from that point. As a result, S&P lease-adjusted leverage remains above 3x through 2024. Due to the company’s anticipated weaker credit measures and volatile operating results, we revised our financial risk profile assessment to significant from intermediate.
“We believe Kohl’s will benefit from its partnerships and reduced capital spending in the next 12 months. Kohl’s is building its partnership with Sephora and had outsized capital expenditure (CAPEX) in 2022 of more than $800 million, largely associated with establishing 400 Sephora shops in 2022. We expect CAPEX to decrease about $200 million in fiscal 2023 as the company continues the buildout but with only 300 additions this year, 50 of which will be small format shops. We believe this initiative has good prospects given the favorable market trends in beauty products and Sephora’s strong market position.
“The new management team will need to build a track record of favorable execution. We remain cautious on the company’s several management changes over the past 12 months, including the appointment of its new CEO. Considering this turnover and the weaker recent operational execution relative to some apparel peers, we have an incrementally less favorable view of the company’s strategic planning process and its management depth and breadth. As a result, we are revising our management and governance score to fair from satisfactory.
“We believe department stores continue to face mounting competitive pressures and ongoing execution risk to maintain market share. Declining physical store traffic, shifting category preferences, and online price transparency are persistent longer-term risks for Kohl’s business, in our view.
“We believe Kohl’s efforts to leverage partnerships, such as rolling out Sephora to all its stores, could successfully offset some of these pressures.
“Nevertheless, we believe the company still needs to adapt the legacy store footprint with large square footage stores, and we believe there are ongoing execution risks with the evolution of these stores. We view Kohl’s largely off-mall locations (about 95 percent of its total stores) as a benefit as they contribute to the company’s lower cost structure and provide better accessibility and convenience for customers.
“Kohl’s targets a long-term leverage of 2.5x but will not likely achieve it in the near term. We project S&P Global Rating-adjusted leverage (including our adjustment for capital and operating lease liabilities) will improve to about 4x in 2023 and to the mid-3x area in 2024. In addition, we expect FOCF in 2023 of about $620 million as profitability improves, working capital normalizes, and the company reduces its capital spending. While we don’t project leverage to approach the company’s 2.5x target (which includes debt addition of 8x reported rent expense) soon, we expect Kohl’s to navigate the continued macroeconomic uncertainty with expense discipline while suspending its share repurchase activity to drive down leverage.
“The negative outlook reflects the risk of a downgrade if the company does not meaningfully improve its operating performance and cash flow generation in 2023 toward our base case.”
