Fitch affirms Kohl's Issuer Default Rating at BBB+ but revises outlook to negative from stable, citing soft comparable-store sales trend in 2013, including 2% drop in comparable-stores sales in Q4

Cindy Allen

February 17, 2014 (Professional Services Close-Up) – Fitch Ratings has affirmed its ratings on Kohl's Corp., including the Issuer Default Rating (IDR) at 'BBB+', and has revised the Rating Outlook to Negative from Stable.

Key Rating Drivers

In a release on February 10, Fitch noted that the affirmation reflects the company's strong market share position as the third- largest department store retailer in the U.S., industry-leading operating margins, convenient off-mall store format, and high penetration of higher-margined private and exclusive brands.

The Negative Outlook reflects Fitch's concern around Kohl's soft comparable store sales (comps) trend and the resulting pressure on EBITDA since late 2011. Comps for 2013 are down approximately 1.3 percent, with sales trends weak throughout the year, including the 2 percent comps decline during the fourth quarter. Fitch attributes the deceleration to weak store traffic trends given the company's budget-constrained and value-focused customer base; increasing competition from alternative channels; and the slowdown in the growth of private and exclusive brands that have historically supported the company's top-line growth.

Fitch expects investment grade retailers to have strong comps trends and remain market share gainers. Looking at the overall domestic apparel, accessories, and home-related categories, Fitch expects a market consolidator would need to generate top-line growth of 2 percent or above to ward off competition from other channels such as specialty, discount, and online.

Given the modest contribution to sales from store growth expected for 2014/2015 (estimated at 50 bps annually assuming 10 new store openings), Kohl's could achieve 2 percent top-line growth by generating flat-to-modest comps growth at the store level and online sales growth in the mid-teens that would contribute roughly 150 bps to overall comps.

The company's store level comps have been under increasing pressure - declining approximately 1 percent, 1.8 percent and 2.6 percent, respectively, in 2011-2013. This has been somewhat offset by online revenue which has grown from approximately $740 million in 2010 to a projected $1.7 billion in 2013, contributing approximately 150 bps to overall comps annually. The inability to stabilize store- level comps could hinder overall comps from growing at 1.5 percent or better, which could pressure ratings in the next 12-24 months.

Kohl's strong growth in private and exclusive brands (which currently account for 52 percent of sales) had offset the modestly negative growth in national brands. However, growth in private brands has decelerated to the low single digits (from the mid- single-digit range in 2011/2012) while national brands continue to remain under pressure. Given a more competitive market for national brands and the lack of any significant product launches on the exclusive side, overall comps could remain flat in 2014.

Fitch expects Kohl's gross margin to be relatively flat to 2012 levels in the mid-36 percent range in 2013 through 2015. Kohl's EBITDA margin is expected to be around 14 percent in 2013, relative to the 15.8 percent-15.9 percent range in 2010/2011, and be flat to modestly lower over the next two years. The decline reflects Kohl's investment in sharper pricing and inventory repositioning over the last several quarters. However, the current level is still on par with other industry leaders in the department store space such as Macy's Inc. and Nordstrom, Inc.

Fitch expects Kohl's EBITDA to hover around the $2.7 billion level (versus $3 billion in 2011) and adjusted debt/EBITDAR to remain in the 2.3x-2.4x range over the next two to three years, which is in line with Fitch's expectation but modestly above the company's currently stated leverage target of 2.0x-2.25x.

Free cash flow (FCF) generation has typically been strong for Kohl's and is expected to be in the $800 million range annually in 2013 through 2015. This assumes working capital swings are neutral and capital expenditures are in the $700 million-$750 million range to support e-commerce growth, store openings (10 units in 2014) and remodelling program (35-50 expected for 2014 versus 30 in 2013 and 50 in 2012). Fitch expects FCF to be directed toward share buybacks.

Kohl's liquidity is supported by its strong cash balance of around $1 billion and a $1 billion senior unsecured revolving bank credit facility due in June 2018. Kohl's has no debt maturities prior to 2017.

Rating Sensitivities

For a Stable Outlook, the company would need to gain traction on comps growth to a level of 1.5 percent or above and sustain EBITDA margins at current levels.

A negative rating action could result in the event of one or more of the following:

--If retail store comps fail to stabilize and overall comps (including online sales) do not improve to a level of 1.5 percent or better in the next 12-24 months.

--A weakening profitability profile (where EBITDA drops to below $2.6 billion) and/or a more aggressive financial posture that would take leverage above 2.5x.

Fitch has affirmed Kohl's ratings as follows:

--Long-term IDR at 'BBB+';

--$1 billion bank credit facility at 'BBB+;

--Senior unsecured notes and debentures at 'BBB+'.

The Rating Outlook is Negative.

Additional information is available at 'fitchratings.com'.

Applicable Criteria and Related Research:

--'Corporate Rating Methodology' (August 5, 2013);

--'Evaluating Corporate Governance' (December 12, 2012).

Applicable Criteria and Related Research:

Corporate Rating Methodology: Including Short-Term Ratings and Parent and Subsidiary Linkage

http://fitchratings.com/creditdesk/reports/ report_frame.cfm?rpt_id=715139

Evaluating Corporate Governance

http://fitchratings.com/creditdesk/reports/ report_frame.cfm?rpt_id=694649

Additional Disclosure

Solicitation Status

http://fitchratings.com/gws/en/disclosure/ solicitation?pr_id=820152

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