Kohl’s: Why I Sold Their High Yield Bond Last Week (NYSE:KSS)

When concern amongst the bondholders of Kohl’s (NYSE:KSS) sent the company’s 2037 maturing debt to below 70 cents on the dollar and above 10% yield to maturity back in September, I jumped in with both feet, purchasing those bonds. Over the last few months, I have steadily watched the company’s financial reporting and last week, I sold my holdings. Kohl’s debt has rallied since September, but four different maturities still offer greater than 9% yields, but I believe the risks have become too great.

In the company’s most recent financial filing in November, Kohl’s covered the third quarter of its fiscal year. The income statement highlighted the challenges facing the company. Sales had declined year to date by nearly $900 million compared to the same period a year ago. What’s more concerning is that the cost of merchandise only declined by $250 million, leading to an approximately $650 million decline in gross profit. Operating income declined by more than half, with the increase in SG&A being a contributing factor. Overall, in just one year, Kohl’s profitability has significantly eroded.

Kohl’s balance sheet highlighted additional concerns. First, the company has burned nearly all of its $1.8 billion cash hoard on merchandise inventory and borrowed an additional $668 million. Investing in merchandise is usually not a bad thing, but when it comes during a period of significant gross margin erosion, investors will lose confidence in the company’s ability to sell the merchandise at the appropriate profitability levels. A portion of long-term debt coming due in the next year combined with higher accounts payable puts additional pressure on the company.

Kohl’s cash flow statement was even more concerning. The purchase of inventories and increase in capital expenditures led to a free cash flow deficit of more than $1.1 billion in nine months. This deficit clearly calls into question Kohl’s ability to continue paying dividends, which it has expended to the tune of $184 million in the same time period. While Kohl’s was making a big bet on the addition of its Sephora line, it picked an awful time to do it.

Now, with lower sales and little cash, Kohl’s faces $275 million in debt maturities between now and the end of 2023. The company does have a little over $300 million left in its revolving credit facility maturing in 2026, but that leaves little wiggle room to operate at a loss. The company admitted in November that continued credit downgrades could impact its access to credit markets. I was willing to hold on until March when the company would report full year earnings to see if everything was turning around, until last week.

With no updates or press releases regarding the company’s performance during the holiday season, Kohl’s filed an 8-K last Thursday, entering into a new credit agreement and upsizing its borrowing capacity from $1 billion to $1.5 billion. The agreement did not specify what the starting balance would be or if there are any restrictions to the dividend, but it left me uncomfortable. Clearly, the holiday season did not go well if Kohl’s had to refinance a credit agreement that was negotiated under a lower interest rate environment in 2021 with a 2026 maturity. The need for the additional $500 million appears to have superseded any benefits that the old loan had.

Based on this newest information, I believe that Kohl’s will continue to struggle to generate free cash flow, likely borrow beyond $1 billion under its new credit agreement, and likely eliminate its dividend to preserve what cash it has left. Debtholders may believe that they have good value compared to other BB rated corporate notes, but for every additional dollar Kohl’s borrows from its credit agreements, the further subordinated bondholders become. In the current interest rate and economic environment, I believe that further downside is ahead for Kohl’s.