This article was co-produced with Christopher Volk.
On November 8, along with a rare lunar eclipse, Kohls Corporation’s (NYSE: KSS) CEO Michelle Gass has announced she will step down as CEO after four years, choosing to accept a management position at Levi Strauss. She and Kohl have been under pressure from analysts and activist investors to boost the company’s beleaguered share price.
This event raises an obvious question: what should the new CEO do differently?
A short story
Twenty years ago, Kohl’s was primarily a regional powerhouse retailer, operating just over 450 locations from its perch in Menomonee Falls, Milwaukee.
Each year, the company could be counted on to increase its store count by nearly 20% as it set out to expand nationwide, resulting in earnings growth that, unsurprisingly, s averaged around 20% between 2002 and 2007.
Given this rate of growth, the company’s P/E ratio stood at approximately 46X at the end of January 2002, generating a market capitalization of over $22 billion. The company’s highest price/earnings multiple was more than 70x about a year ago.
Kohl’s Equity Capitalization, Price, and P/E Ratio
All multi-unit retailers eventually run out of revenue growth gas. By 2009, with fewer markets left to enter, Kohl’s store expansion rate had fallen to less than 10%.
At the same time, earnings have become more volatile and average earnings growth has halved. With competitive pressures high, the company’s vaunted 6% net income margins have shown increasing volatility and have also gradually shrunk by a third.
With such volatility and headwinds, the company’s price earnings multiple would unsurprisingly fall to the teen lows, with its stock valuation halving by 2010. Stock capitalization would also show volatility but would remain in this zip code for the next decade.
Operate the financial levers
All business leaders have three business efficiencies at their fingertips:
- Operational efficiency
- Asset efficiency
- Capital efficiency.
Their favorite is the former, which Kohl has skillfully used to increase sales through new store development, while maintaining an enviable level of profitability compared to other major discount retailers.
But, as companies mature, so does leadership.
In 2007, the company turned to Asset Efficiency, significantly lightening its balance sheet by selling its $1.6 billion in credit card receivables.
That year, they began buying stocks, using most of that money to acquire over $1.5 billion worth of stock. The share price thus jumped by nearly 60%, but the rise was short-lived. You can only do this trick once.
With its stock buyback in 2007, Kohl’s embarked on capital efficiency strategies.
Between the start of its 2007 fiscal year and the end of its fiscal year ending January 31, 2022, the company would buy back nearly two-thirds of its shares. It would also start paying dividends from 2012, further reducing its capitalization.
Buying stock and paying dividends isn’t enough to tell Kohl’s success story with the capital efficiency leverage. There is the important issue of free cash flow investing. Over the twenty-year period ending January 31, 2022, the company’s invested free cash flow looked like this:
Over 20 years, Kohl’s has purchased nearly $12 billion in stock, while reinvesting more than $17 billion in equity back into the business in the form of store expansions, other capital purchases and a net reduction in borrowings.
Ultimately, the company invested approximately $5.5 billion in net equity in the company. With a current market capitalization of less than $4 billion, it’s safe to say that shareholders have not been rewarded for his investment.
Kohl’s equity at cost at the start of its 2003 fiscal year was approximately $13 billion, meaning that the company has cumulatively destroyed about 70% of every dollar of stock it has ever investedD.
He set shareholders’ money on fire.
The erosion of shareholder value results from business models that provide shareholders with returns that fall below their requirements. The three business efficiencies work together to make this happen.
When it comes to Kohl’s inefficiencies, there’s a singular glaring anchor: At the start of its 2023 fiscal year, the company owned 410, or 35%, of its 1,165 locations. It also owned seven of its nine distribution centers (it sensibly and profitably sold-leased its California location in 2020), offices, and 6 e-commerce distribution centers.
In choosing this real estate ownership route, Kohl’s has chosen to have a combination of conservative capital and highly equity ownership that has resulted in superior corporate ratings.
In September 2022, Moody’s placed the company’s Baa2 under review for possible downgrade. Standard and Poor’s beat them. Around the same time, they downgraded the company to BB+, or the first stop of junk/high yield status.
Anyone who knows me knows what I think of high-volume, low-margin retailers and service companies that own significant amounts of real estate. Generally speaking, high-volume, low-margin businesses have no reason to live up to investment ratings thanks to the ownership of such large amounts of real estate.
In perhaps his biggest mistake, Kohl also owns 238 buildings that are on land leases. Here they have the opportunity to pay rent to their landowners while occupying buildings they have paid for but will never own.
The seeds of Kohl’s capital inefficiency were laid long before Michelle Gass took office, although she did nothing to change the company’s debt/equity mix. The company had a bias towards real estate ownership and land lease ownership from its early days.
In the absence of rents and debt payments, rapidly expanding retailers are often drawn to the faster profit growth that comes from owning real estate. And, if they are trading at high multiples, as Kohl had been, the immediate costs of equity may seem cheaper than debt or leases.
For a time, shareholders may be caught up in growth and unaware of the inefficiency of the debt mix and its impact on the inefficiency of the business model. But, over time, the economic model will reveal itself and shareholders will be able to pay a high price.
The upshot of all of this is that, for over twenty years, Kohl’s has been a miserable stock to own for the long term. Investors who have made money have done so by making calculated short-term, event-driven bets on stocks, most recently in 2021 given the company’s privatization prospects. Unsurprisingly, the privatization thesis was primarily centered on reversing inefficient corporate capitalization.
What to do?
There is good news for the future CEO of Kohl’s. While the company’s former margins of 6% have given way to net income margins of 4% and below, it is holding its own against major discount retailers.
Additionally, its current pre-tax return on equity, calculated using the value equation, or V-formula, was around 13% for its most recent fiscal year.
Rescaling Kohl’s capital efficiency leverage by selling much of its real estate would increase returns and hopefully recoup some of the lost equity value. One of the hurdles here will be the degree of tax leakage resulting from asset sales.
An opportunity cost of owning corporate real estate is that depreciation makes it commercially more difficult to implement real estate recapitalization strategies due to the gain on tax costs of sale.
The timing is also less than ideal, given the higher interest rates, wider borrowing spreads and resulting higher real estate capitalization rates. Nonetheless, it will end up being something incoming leaders will have to recognize.
Improved margins would also be attractive, but shareholders would likely opt for a strategy to ensure more consistent margins. Firms with greater consistency and reliability of performance can improve their cost of equity and reduce the cost of current required returns on equity.
In the case of Kohl’s, the pandemic has demanded a significant cost, while giving a boost to margins at discount retailers selling essentials. Post-pandemic, the company’s margins are showing signs of life, but performance volatility is hurting investors’ yield demands.
Kohl’s Net Profit Margin vs. Walmart (WMT) and target (TGT)
Growth, which is what shareholders have historically rewarded Kohl’s the most for, will likely be elusive. This will depend on the company’s ability to achieve real inflation-adjusted same-store growth.
Over the past ten years, the company has built 67 stores and closed 21, averaging less than four new units per year. This net new store development within its heavily penetrated markets is a meaningless number on its broad base of 1,165 locations.
A lesser ability to reinvest free cash flow accretively (and the company has always been a poor free cash flow investor) suggests the need to pursue a “cash cow” strategy, providing shareholders with a trajectory of yield more focused on dividends.
Ultimately, it is this dilemma that could determine whether Kohl’s can be properly assessed as a public company.