KSS Kohls Corporation

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

For purposes of the following discussion, unless noted, all references to "the third quarter" are for the three fiscal months (13 weeks) ended November 2, 2019 or November 3, 2018.  References to “year to date” are for the nine fiscal months (39 weeks) ended November 2, 2019 or November 3, 2018.

This Form 10-Q contains "forward-looking statements" made within the meaning of the Private Securities Litigation Reform Act of 1995.  Words such as "believes," “anticipates,” “plans,” "may," "intends," "will," "should," “expects” and similar expressions are intended to identify forward-looking statements.  Forward-looking statements may include comments about our future sales or financial performance and our plans, performance and other objectives, expectations or intentions, such as statements regarding our liquidity, debt service requirements, planned capital expenditures, future store initiatives and adequacy of capital resources and reserves. Forward-looking statements are based on our management’s then current views and assumptions and, as a result, are subject to certain risks and uncertainties that could cause actual results to differ materially from those projected. Any such forward-looking statements are qualified by the important risk factors described in Part I, Item 1A of our 2018 Form 10-K or disclosed from time to time in our filings with the SEC, that could cause actual results to differ materially from those predicted by the forward-looking statements. Forward-looking statements relate to the date initially made and we undertake no obligation to update them.

Executive Summary

As of November 2, 2019, we operated 1,159 Kohl's stores, a website (www.Kohls.com) and 12 FILA outlets. Our Kohl's stores and website sell moderately-priced proprietary and national brand apparel, footwear, accessories, beauty and home products. Our Kohl's stores generally carry a consistent merchandise assortment with some differences attributable to local preferences. Our website includes merchandise which is available in our stores, as well as merchandise that is available only online.

In the third quarter of 2019, we delivered positive comparable sales growth driven by an acceleration in our Active business, continued strength in Digital and improved performance in our stores and across all of our lines of business versus the first half.  During the quarter, we invested in pricing and enhanced our marketing offers to respond to a heightened competitive environment and to drive sales following modest disruption in stores related to a record number of brand launches.

Key financial results for the third quarter of 2019 include:

We adopted the new lease accounting standard in the first quarter of 2019 and prior periods were not restated.  

See "Results of Operations" and "Liquidity and Capital Resources" for additional details about our financial results.

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Comparable sales increased 0.4% for the third quarter and decreased 1.9% year to date 2019. 

Comparable sales is a measure that highlights the performance of our stores and digital channel by measuring the change in sales for a period over the comparable, prior-year period of equivalent length. Comparable sales includes all store and digital sales, except sales from stores open less than 12 months, stores that have been closed and stores where square footage has changed by more than 10%. We measure the change in digital sales by including all sales initiated online or through mobile applications, including omnichannel transactions which are fulfilled through our stores.

We measure digital penetration as digital sales over net sales.  These amounts do not take into consideration fulfillment node, digital returns processed in stores and coupon behaviors.

Comparable sales and digital penetration measures vary across the retail industry.  As a result, our comparable sales calculation and digital penetration are non-GAAP measures that may not be consistent with the similarly titled measures reported by other companies.

Increases in Other revenue of $8 million for the third quarter and $20 million year to date 2019 were driven by higher credit revenue.

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Cost of merchandise sold includes the total cost of products sold, including product development costs, net of vendor payments other than reimbursement of specific, incremental and identifiable costs; inventory shrink; markdowns; freight expenses associated with moving merchandise from our vendors to our distribution centers; shipping expenses for digital sales; and terms cash discount. Our Cost of merchandise sold may not be comparable with that of other retailers because we include distribution center and buying costs in Selling, general and administrative expenses while other retailers may include these expenses in Cost of merchandise sold.  

The decreases in gross margin as a percent of net sales were driven by higher promotional markdowns due to a heightened competitive environment, product mix and higher shipping costs due to increases in digital penetration for both the third quarter and year to date 2019.

Selling, General and Administrative Expenses ("SG&A")

SG&A expenses include compensation and benefit costs (including stores, headquarters, buying and distribution centers); occupancy and operating costs of our retail, distribution and corporate facilities; freight expenses associated with moving merchandise from our distribution centers to our retail stores and among distribution and retail facilities; marketing expenses, offset by vendor payments for reimbursement of specific, incremental and identifiable costs; expenses related to our credit card operations; and other administrative revenues and expenses.  We do not include depreciation and amortization in SG&A. The classification of these expenses varies across the retail industry.  

Many of our expenses, including store payroll and distribution costs, are variable in nature. These costs generally increase as sales increase and decrease as sales decrease. We measure both the change in these variable expenses and the expense as a percent of sales. If the expense as a percent of sales decreased from the prior year, the expense "leveraged". If the expense as a percent of sales increased over the prior year, the expense "deleveraged".

The following table summarizes the increases and (decreases) in SG&A by expense type:

SG&A expenses increased 3.2% deleveraging 96 basis points in the third quarter and increased 1.4% deleveraging 101 basis points year to date 2019, compared to the same periods in 2018.  The changes were driven by an increase in store expenses which reflect higher rent expense, primarily due to the new lease accounting standard, costs related to brand launches, the Amazon return initiative and wage pressure in the third quarter and year to date 2019.  Marketing expense increases were driven by continued investments to target market share gains over the long-term. Corporate and other expenses decreased due to lower general corporate costs in 2019 and expenses associated with leadership changes in 2018.

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Depreciation and amortization decreases were driven by the maturity of our store portfolio, as well as the adoption of the new lease accounting standard.

Interest expense, net decreased in the third quarter and year to date 2019 due primarily to the benefits of debt reductions in 2018 and adoption of the new lease accounting standard in the first quarter of 2019.

In the third quarter 2019, we purchased leased equipment that was accounted for as a financing obligation and resulted in the recognition of a $9 million gain on extinguishment of debt.

Year to date 2019, we incurred $55 million of Impairments, store closing and other costs; we incurred $49 million in lease asset impairment charges related to the closure of four Kohl’s stores and $6 million in costs related to the closure of our four Off-Aisle clearance centers and the execution of a voluntary role reduction program.

In the first quarter 2018, we recognized a $42 million loss on extinguishment of debt related to our $500 million cash tender offer.

The increase in the Provision for income taxes in the third quarter was driven by a higher effective tax rate due to favorable items in the third quarter 2018 not repeating in the third quarter 2019, including positive audit results, tax accounting method changes and a higher stock price for share-based compensation.  The decrease in the Provision for income taxes for year to date 2019 was driven by lower taxable income.

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Income before Income Taxes, Net Income and Earnings Per Diluted Share

We believe the adjusted results in the table above are useful because they provide enhanced visibility into our results on a non-GAAP basis.  However, these non-GAAP financial measures are not intended to replace the comparable GAAP measures.

Seasonality and Inflation

Our business, like that of most retailers, is subject to seasonal influences, with the majority of sales and income typically realized during the second half of each fiscal year, which includes the back-to-school and holiday seasons. Approximately 15% of annual sales typically occur during the back-to-school season and 30% during the holiday season. Because of the seasonality of our business, results for any quarter are not necessarily indicative of the results that may be achieved for a full fiscal year.

We expect that our operations will continue to be influenced by general economic conditions, including food, fuel and energy prices, higher wages and by costs to source our merchandise, including tariffs. There can be no assurances that such factors will not impact our business in the future.  

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Our working capital and inventory levels typically build throughout the fall, peaking during the November and December holiday selling season.