Fitch Downgrades Kohl's Corporation to 'BBB'; Outlook Stable

NEW YORK--()--Fitch Ratings has downgraded the Long-term Issuer Default Rating (IDR) for Kohl's Corporation (Kohl's) to 'BBB' from 'BBB+'. The Rating Outlook is Stable. A full list of ratings is provided at the end of this release.

The downgrade reflects the expectation that recent weakness in the mid-market apparel sector and online migration of sales will continue, limiting Kohl's comp growth to flat to positive 1% over the next 24 - 36 months, with lower margined online sales essentially offsetting declines to in-store sales. As a result EBITDA could decline another 10% - 15% over the next 24 - 36 months from 2015 levels of $2.5 billion and adjusted leverage is expected to be in the high 2x range.

The rating continues to reflect the company's strong market share position as the third-largest department store retailer in the U.S., convenient off-mall store format, low double digit EBITDA margins and strong free cash flow generation.

KEY RATING DRIVERS

CONTINUED MID-MARKET APPAREL WEAKNESS

Mid-market apparel sales have been weak due to a number of factors, including lack of compelling fashion trends and share loss to lower-priced competitors such as fast-fashion and off-price players. In-store apparel sales have been further pressured by share migration online. Kohl's comparable store sales (comps) have essentially been flat over the last five years, with online growth estimated to contribute an average of 2% to comps annually. Fitch estimates that in-store level comps have been running in the negative 2.5% - 3% range over the last three years.

Compared to other department store chains, Kohl's benefits from its off-mall real estate base and its value-oriented positioning. However, Fitch believes Kohl's will need to continue investing significantly in omni-channel capabilities, store remodels, and national brand presence to avoid negative sales growth and compete more effectively against the growth in off-price retailers.

Fitch expects store closures at 20 units annually (on a base of 1,164 stores in 2015) are possible to preserve the long-term financial health of the brand, albeit at the expense of near-term sales growth. Kohl's announced 18 store closures in 2016 which account for less than 1% of sales, with half the store closings in California.

Looking at the overall domestic apparel, accessories, and home-related categories, Kohl's would have to generate top-line growth 2% or above to prevent share loss to other channels such as specialty, discount, and online. This could be achieved by relatively flat to modestly negative comps growth at the store level and low-to-mid-teens growth from online sales.

EBITDA COULD DECLINE TO LOW $2 BILLION BY 2018

As a result of continued investments to preserve the top line, EBITDA is expected to maintain the negative growth track it began following its peak $3 billion level in 2011. Sales growth has averaged almost 1% over the last five years, driven by modest unit expansion.

EBITDA margins fell from 15.9% in 2011 to 13.2% in 2015, due to increased online penetration, promotional activity to clear excess merchandise, SG&A investments and expense deleverage on flat comps. As a result, EBITDA declined from $3 billion in 2011 to $2.5 billion in 2015.

Given sector challenges, Fitch expects the above P&L dynamics to continue. Sales are expected to be flattish over the next 24-36 months with flat to modest comp growth and 60-70 bps hit to top line from an assumed 20 store closings annually. Gross margin is expected to decline 10 bps to 15 bps annually given the migration of sales online, relative to Kohl's projection flat to up 20 bps per year which it expects to achieve through better inventory management, localization and its speed initiatives. Fitch expects SG&A to grow 1% annually.

EBITDA, therefore, is likely to trend toward $2.1 - $2.2 billion by 2018, with EBITDA margin declining to 11% - 11.5%.

LEVERAGE TO REMAIN ELEVATED

Kohl's adjusted leverage has moved from the low-2.0x range in 2012 to 2.5x primarily on EBITDA declines. Kohl's continues to generate good free cash flow after dividends (FCF) which is expected to be $750 million to $800 million in 2016 and $400 million to $450 million annually in 2017/2018. FCF is expected to be used for share repurchases rather than debt paydown. As a result, adjusted leverage is expected to trend towards the high-2.0x.

KEY ASSUMPTIONS

--Fitch expects overall top-line growth to be flattish, driven by low-double digit e-commerce growth and negative low-single digit in-store comps.

--Annual EBITDA is expected to decline from $2.5 billion in 2015 to the $2.1 - $2.2 billion level as EBITDA margin declines from 13.2% to 11 - 12% on modest gross margin contraction, continued SG&A investments and fixed-cost pressures.

-- FCF after dividends of $750 million to $800 million in 2016 due to positive working capital contribution of $200 million and $400 million to $450 million annually in 2017/2018. Fitch expects FCF to be used towards share buybacks.

--As a result of negative EBITDA growth and flattish debt levels, adjusted debt/EBITDAR is expected to trend toward the high-2.0x range.

RATING SENSITIVITIES

A positive rating action would occur if a reacceleration of comps drove EBITDA above $2.6 billion, yielding adjusted leverage in the low-2.0x.

A negative rating action could result if EBITDA margin declined below 11% on low-single digit sales declines, resulting in EBITDA below $2.0 billion and adjusted leverage above 3.0x.

LIQUIDITY

Kohl's liquidity is supported by its strong cash balance of $700 million as of January 30, 2016, and a $1 billion senior unsecured revolving bank credit facility due in July 2020. Kohl's has no debt maturities prior to 2021.

Fitch projects free cash flow after dividends (FCF) of $750 million to $800 million in 2016 due to positive working capital contribution of $200 million (versus a drain of $400 million in 2015) and FCF of $400 million to $450 million annually in 2017/2018 assuming modest working capital improvement.

FULL LIST OF RATING ACTIONS

Fitch has downgraded the following ratings:

Kohl's Corporation

--Long-term IDR to 'BBB' from 'BBB+';

--$1 billion bank credit facility to 'BBB' from 'BBB+;

--Senior unsecured notes and debentures to 'BBB' from 'BBB+'.

The Rating Outlook is Stable.

Additional information is available on www.fitchratings.com

Summary of Financial Statement Adjustments - Financial statement adjustments that depart materially from those contained in the published financial statements of the relevant rated entity or obligor are disclosed below:

--Historical and projected EBITDA is adjusted to add back non-cash stock based compensation and exclude restructuring charges. In 2015, Fitch added back $48 million in noncash stock based compensation to its EBITDA calculation and excluded $169 million loss on extinguishment of debt. Forecasted 2016 EBITDA excludes $150 - $170 million in announced charges related to store closures and organizational realignment.

--Fitch has adjusted the historical and projected debt by adding 8x annual gross rent expense.

Applicable Criteria

Corporate Rating Methodology - Including Short-Term Ratings and Parent and Subsidiary Linkage (pub. 17 Aug 2015)

https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=869362

Additional Disclosures

Dodd-Frank Rating Information Disclosure Form

https://www.fitchratings.com/creditdesk/press_releases/content/ridf_frame.cfm?pr_id=1002574

Solicitation Status

https://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=1002574

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Contacts

Fitch Ratings
Primary Analyst
Monica Aggarwal, CFA
Managing Director
+1-212-908-0282
Fitch Ratings, Inc.
33 Whitehall Street
New York, NY 10004
or
Secondary Analyst
David Silverman, CFA
Senior Director
+1-212-908-0840
or
Committee Chairperson
Steven Marks
Managing Director
+1-212-908-9161
or
Media Relations:
Alyssa Castelli, +1 212-908-0540
alyssa.castelli@fitchratings.com

Contacts

Fitch Ratings
Primary Analyst
Monica Aggarwal, CFA
Managing Director
+1-212-908-0282
Fitch Ratings, Inc.
33 Whitehall Street
New York, NY 10004
or
Secondary Analyst
David Silverman, CFA
Senior Director
+1-212-908-0840
or
Committee Chairperson
Steven Marks
Managing Director
+1-212-908-9161
or
Media Relations:
Alyssa Castelli, +1 212-908-0540
alyssa.castelli@fitchratings.com