Kohl's: Many Happy Returns?

Kohl's (KSS 3.12%) has launched several initiatives this year that are aimed at driving traffic to its stores. This includes a much-heralded partnership with Amazon.com that permits people to return goods they bought on Amazon to Kohl's stores. There were also other deals inked earlier this year, such as the one with Planet Fitness whereby Kohl's leases space next to its stores to the gym operator.

The Amazon deal has been the one that grabbed headlines. Kohl's makes it very convenient to return Amazon goods. Customers do not need to do anything like pack the items or put a label on the returned merchandise.

On the company's third-quarter earnings call, CEO Michelle Gass said of the returns program:

We continue to be very pleased with its overall performance, and based on the results we are seeing, we remain confident that it will have a positive contribution to operating income in 2019. With the expansion of the program, consumer research indicates that customers are very satisfied with the service. They find it simple and easy to use and they intend to use it again. The program is driving incremental traffic into our stores and we are particularly encouraged by the disproportionate amount of new customers, which on average are also younger than the typical Kohl's customer.

While the returns program is a valuable service to Amazon's customers, investors should not confuse this with higher profitability for Kohl's.

While customer traffic did improve in the third quarter, helping to increase Kohl's comparable-store sales 0.4%, the company discounted merchandise (including as part of its Amazon program; the company provides a 25% off coupon with a return) , which squeezed its gross margin from 37% to 36.3%. The company also boosted selling, general, and administrative (SG&A) costs for a host of items, including store expenses, marketing, and technology. CFO Jill Timm noted on the earnings call that the Amazon initiative was one factor that raised the quarter's expenses, although she did not provide a specific figure.

Lower gross profitability and higher expenses drove Kohl's profit markedly lower. In fact, management sharply lowered its fiscal 2019 diluted earnings per share guidance from a range of $5.15 to $5.45 to a range of $4.75 to $4.95. I am skeptical management can drive enough traffic to increase sales by an amount sufficient to offset the higher costs needed to get these customers into the stores. While the CEO noted on the earnings call that the Amazon program is part of management's plan to drive traffic, the company is also discounting merchandise and that may prove difficult to stop. So, while shoppers can enjoy the convenient return process investors should be wary. 

Here's a look at key figures from the quarter.

DATA SOURCE: KOHL'S. YOY=YEAR-OVER-YEAR. DOLLARS (except earnings per share) IN MILLIONS. *FOR NET INCOME AND DILUTED EPS, THE 2019 PERIOD ADDS BACK IMPAIRMENT/STORE CLOSING COSTS AND SUBTRACTS THE GAIN ON THE EXTINGUISHMENT OF DEBT. FOR THE 2018 PERIOD, THERE WAS A LOSS ON THE EXTINGUISHMENT OF DEBT THAT WAS ADDED BACK.

Behind the numbers

Kohl's eeked out a comparable sales increase in the third quarter. On the positive front, customers were attracted to the stores, with the number of transactions increasing, reversing a trend from the first half of this year. But, the customers spent less. So, the customers were not necessarily attracted to Kohl's merchandise. Rather, they liked the promotional activity.

The higher SG&A was mostly caused by a $43 million increase in "store expenses." Management did not provide a breakdown, but attributed part of this cost to the Amazon initiative as well as higher wages, costs from brand launches, and increased rent, although the last item was primarily due to a change in lease accounting. Management also increased marketing spending by $6 million in an attempt to win customers.

The company is hoping these expenditures result in higher sales down the line, of course. With the Amazon partnership started in April and expanded in July, thus far, the effect on sales has been minimal. While Gass is optimistic that the initiative will become profitable as soon as the fourth quarter, investors would need to take a leap of faith that Kohl's continues to garner and convert returns foot traffic.

A moderately priced department store, customers have been attracted to Kohl's for its merchandise, coupons, and, with the Amazon partnership, increased convenience. In the latest quarter, management said that the company's three key national brands -- Nike, Under Armour, and adidas -- have attracted customers. The question is, with the company increasingly stocking its shelves with lower-margin national brands over proprietary brands -- exclusive brands sold only at Kohl's contracted from 46% of 2016's sales to 39% in 2018 -- will this differentiate Kohl's offerings enough to gain shoppers over its competitors? 

A tough fourth quarter

In the near term, management is not expecting profitability to get better. While the CEO spoke about the positive impact of the Amazon program on store traffic, management lowered its yearly earnings guidance and said "we expect the heightened promotional environment to continue through the balance of the year. For the top line, we now expect comp sales of down 1.5% to down 1% for the year, which implies Q4 comparable sales in the range of flat to up 1%."

The talk about continuing to spend more to gain market share and discount merchandise to remain competitive should give investors pause and warrant a cautious approach until management proves its Amazon program and other partnerships can boost sales sufficiently to grow profitability.