Kohl's Finally Succumbs to Industry Headwinds

Kohl's (KSS 4.53%) focus on rotating its products quickly, staying separate from malls with stand-alone stores, and organizing its stores with easy-to-navigate "racetracks" helped it outperform many of its department store peers in the past.

However, Kohl's streak of positive comparable store sales growth ended in the first quarter. Its comps fell 3.4% to start 2019, broadly missing its prior forecast for flat growth, as its total revenue declined 2.9%. Its adjusted earnings fell 5% to $0.61 per share and missed estimates by six cents.

Image source: Kohl's.

Kohl's also reduced its full-year EPS guidance from $5.80-$6.15 to $5.15-$5.45, which implies a 3%-8% decline from 2018. Those dismal numbers caused Kohl's stock to plunge to a fresh 52-week low -- and that pain might not end anytime soon.

What happened to Kohl's?

Kohl's comps growth decelerated over the past year as it faced the same headwinds as other department stores -- sluggish brick-and-mortar traffic, exacerbated by competition from Amazon (AMZN -1.14%), Walmart, and fast fashion retailers.

Source: Kohl's quarterly reports.

Yet Kohl's has partnered with Amazon over the past two years. Kohl's started by accepting Amazon returns at about 100 stores to boost foot traffic. It recently started selling Amazon products at about 200 of its stores, and stated that it would expand Amazon returns to all 1,155 stores by July.

During the conference call, CEO Michelle Gass stated that the nationwide rollout would be a "significant traffic driver" for its stores. But based on Kohl's slumping sales growth -- which compares poorly to Amazon's 17% sales growth in North America last quarter -- that partnership might benefit Amazon more than Kohl's.

Image source: Kohl's.

Kohl's is also splitting up some of its stores to make room for Planet Fitness (PLNT -1.18%) gyms and Aldi grocery stores. That effort will enable Kohl's to cut costs by operating smaller stores, and it might attract a more diverse range of shoppers, but there's no guarantee that they'll buy more products at Kohl's after working out or picking up groceries.

Falling into the trap of using markdowns to drive sales

Gass attributed Kohl's comps decline to unseasonable weather, ineffective promotions, and weaker sales of home goods and footwear. She admitted that the year started off "started off slower," and stated that Kohl's would "be more aggressive in driving top line sales to regain our momentum and grow market share."

That statement is troubling, since it indicates that Kohl's will use aggressive markdowns to boost its sales growth at the expense of its gross margins. Kohl's gross margin already slipped six basis points annually to 36.8% during the quarter due to an unfavorable product mix and higher shipping costs from digital sales.

Kohl's reduced full-year guidance reflects that strategy, and it doesn't include the impact of the recent tariff hike on Chinese goods yet. This means that its full-year earnings could still be too optimistic if the trade war drags on.

CFO Bruce Besanko stated that Kohl's was "working hard to mitigate the impact of the tariffs" while seeking "to remain competitive by putting our customers first." That statement also raises red flags, since it sounds like it will absorb the higher costs instead of passing them onto consumers.

But what about Kohl's low valuation and high dividend?

At $55, Kohl's trades at about 10 times this year's earnings. It also pays a forward dividend yield of nearly 4%, and its dividend will only account for about half its EPS this year. That low valuation and high yield might appeal to value-seeking investors, but the risks are too high.

Kohl's could tumble down a slippery slope if it relies too heavily on markdowns to boost its sales, and its desperate partnerships with Amazon, Planet Fitness, and Aldi probably won't reverse those declines. Investors should steer clear of Kohl's until its comps growth and gross margins stabilize again.