The COVID-19 pandemic continues to weigh on department stores' sales results, but the worst of the storm seems to have passed. That's particularly true for Kohl's (KSS -0.76%). On Thursday, the retailer told investors that its profitability improved much more than expected in the final quarter of its 2020 fiscal year. This news triggered a rally in Kohl's stock, which jumped 6% on Thursday.
A better-than-expected end to 2020
In the third quarter, Kohl's sales fell 13% year over year, which marked a big improvement over the second quarter, when sales plunged by 23%. Kohl's also returned to profitability -- albeit just barely -- posting an adjusted profit of $2 million ($0.01 per share).
Kohl's didn't share specific guidance for the fourth quarter. However, in a preliminary update on the company's Q4 performance this week, CEO Michelle Gass stated, "Our fourth quarter performance exceeded our expectations across all key metrics with sales strengthening as we moved through the period." Total sales fell about 10% on an 11% decrease in comparable sales.
While that sales result marks another quarter of sequential improvement, the analyst consensus had called for a sales decline of around 9%. Kohl's really shined with respect to profitability, though. The company now projects that adjusted earnings per share will land between $1 and $1.05 for the fourth quarter -- down from $1.99 a year ago but well ahead of the analyst consensus of $0.70.
This earnings forecast implies that Kohl's adjusted net margin declined by less than 2 percentage points last quarter, compared to a 2.5 percentage-point drop in the third quarter. Management attributed this improvement to disciplined cost control and effective inventory management, which more than offset the negative impact of holiday shipping surcharges.
A sign of good things to come
Kohl's fourth-quarter results certainly don't measure up to the company's usual standards. However, the department-store chain continued to face substantial -- but temporary -- headwinds last quarter, including stay-at-home restrictions that weighed on store traffic and weak apparel demand. (Kohl's usually gets over half of its sales from apparel.)
As the pandemic fades during 2021, store traffic trends will likely improve. And as people start to congregate publicly again, apparel demand could bounce back, too. Furthermore, many of Kohl's rivals are closing stores -- and some apparel retailers have gone out of business entirely -- creating huge market-share opportunities. These factors pave the way for a full sales recovery by 2022.
Moreover, Kohl's hasn't been standing still during the pandemic. Late last year, it announced a game-changing partnership to add highly visible Sephora mini-shops to most of its store fleet over the next few years. The first 200 Sephora shops will open this fall, and that figure will grow to at least 850 by 2023. This relationship will drive incremental traffic and instantly turn Kohl's into a major player in the beauty business.
Cash deployment in focus
Like many retailers, Kohl's typically generates strong free cash flow in the fourth quarter. In fiscal 2019, the retailer brought in $435 million of free cash flow in Q4, more than half of its full-year total.
Kohl's probably produced less free cash flow last quarter because it entered the period with low inventory. Still, given that Kohl's ended the third quarter with $1.94 billion of cash and cash equivalents on its balance sheet, the company's cash balance likely surpassed $2 billion by year-end -- up from $723 million a year ago.
Kohl's may want to keep some extra cash on hand until sales and earnings trends stabilize again. It also plans to resume paying dividends this year. Nevertheless, it has plenty of excess cash to deploy.
When Kohl's releases its full earnings report next month, management may provide more clarity about how and when it will deploy this extra cash. Kohl's has $534 million of debt maturing in 2023 and another $1.25 billion that matures in 2025. Repurchasing some of this debt would make sense, even though Kohl's would have to pay a premium to do so. The cash on Kohl's balance sheet is earning virtually no interest, so retiring bonds early would reduce future net interest expense.
If Kohl's can get its debt back to pre-pandemic levels this year, it will be well-positioned to return more cash to shareholders starting in 2022 -- particularly if its profitability bounces back quickly.