The COVID-19 pandemic has hit Kohl's (NYSE:KSS) hard in 2020. Store traffic plunged beginning in March, due to consumers' fears about the virus and the imposition of stay-at-home orders in many regions. E-commerce sales couldn't pick up all of the slack. Moreover, the sudden change in sales trends left retailers with a glut of seasonal inventory that had to be drastically marked down, weighing on gross margin.
That said, Kohl's is in better shape than many other consumer discretionary retailers. And with Kohl's stock plunging 15% on Tuesday despite better-than-feared earnings, the No. 2 U.S. department-store chain looks like an intriguing bargain for risk-tolerant investors.
A better-than-expected earnings report
In the first quarter of fiscal 2020, Kohl's sales plunged 43.5% year over year after sales shriveled up in the back half of the quarter. Making matters worse, gross margin fell by nearly 20 percentage points year over year, as Kohl's wrote down the value of its inventory to account for expected clearance activity. As a result, the retailer reported an adjusted net loss of $495 million ($3.20 per share).
By contrast, the company stabilized its performance in the second quarter. Net sales declined 22.9% year over year, falling to $3.21 billion. This comfortably beat the average analyst estimate of $3.09 billion. Digital sales surged 58% year over year, while in-store sales have stabilized at around 75% of 2019 levels for reopened stores. (Total revenue, which includes credit card income, came in at $3.41 billion.) The greatest sales pressure came in May, when many Kohl's stores were still closed.
On the bright side, solid inventory management enabled strong sequential gross margin improvement. Gross margin came in at a respectable 33.1%, down from 38.8% a year earlier.
Management attributed about half of the margin decline to a combination of greater promotional activity and a shift to lower-margin categories like home, with the other half driven by higher shipping costs, as e-commerce penetration rose.
As a result, Kohl's adjusted net loss for the second quarter was just $39 million ($0.25 per share). Obviously, that's a lot worse than the company's Q2 2019 adjusted earnings per share of $1.55. Yet considering the nature of Kohl's business, it's not a bad result for the middle of a pandemic. It also beat analysts' expectations by a country mile -- on average, analysts expected an adjusted loss of $0.83 per share. And under generally accepted accounting principles (GAAP), Kohl's actually logged a $47 million profit, thanks to asset-sale gains.
Prepared for a choppy recovery
Comments by CEO Michelle Gass indicated that sales trends moderated in July following a rebound in June, which appears to be the main reason Kohl's stock plunged on Tuesday. As COVID-19 case numbers increased in much of the U.S. and the initial surge of pent-up demand petered out, sales momentum slowed. Back-to-school sales also suffered, as many parents still don't know if their kids are going back to school this fall.
Fortunately, Kohl's has been planning conservatively. It exited the second quarter with $2.7 billion of inventory, down 26% year over year. That insulates it from markdown risk. It also helps that many back-to-school staples are year-round items like basics, jeans, and activewear.
Furthermore, Kohl's solidified its balance sheet earlier this year, issuing $600 million of new debt and increasing the size of its credit line. Inventory reductions and lower capital expenditures also enabled Kohl's to generate $108 million of free cash flow in the first half of fiscal 2020. The sale of two distribution facilities last quarter added another $193 million of cash.
That gave Kohl's $2.4 billion of cash as of Aug. 1 (plus $500 million of availability on its credit line), leaving it plenty of flexibility to manage through any short-term headwinds.
Kohl's stock looks very cheap
Kohl's is on track for a full-year loss in fiscal 2020, and looking ahead, it's not clear how quickly results will improve. A full recovery can only happen when people feel comfortable shopping in stores again. That, in turn, almost certainly depends on the availability and effectiveness of coronavirus vaccines.
That said, management has noted that competitors' bankruptcies and store closures create a multibillion-dollar market share opportunity going forward. This sales growth opportunity should offset the headwind from consumers shifting more spending toward e-commerce.
Over the past four fiscal years, Kohl's free cash flow has ranged between $800 million and $1.5 billion, averaging well over $1 billion. Meanwhile, Kohl's stock now trades for around $20, putting the company's market cap at just $3.1 billion.
Uncertainty about the future course of the pandemic certainly creates risk, but Kohl's solid free cash flow, conservative inventory positioning, and big cash cushion put the company in great position to manage future headwinds. And if free cash flow rebounds to even the lower end of the 2016 to 2019 range over the next two to three years, Kohl's stock is a steal at its current price.