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Kohl's Turns Cold

Last week, retailers started reporting first quarter earnings and several had disappointing results. Not only have sales been below plan, but a large number ended the quarter with bloated inventory levels. Retailers will have to resort to heavy promotional activity this summer in order to trim the excess inventory before the important back to school season. Because of the large number of retailers that have high inventory levels, even those that have properly managed their inventory are likely to get caught up in the promotional activity in order to compete with the other retailers. This will lead to lower margins throughout the retail sector.

Target said it fell short of its profit plan. Total sales were up 7.6% with EPS flat with last year. Same store sales increased 1.1%, driven more from increased traffic than an increase in the average ticket. Target's credit card operations saved the day. Backing out the contribution to pre-tax income derived from the credit card operations, pre-tax income would have dropped 6.6% instead of the 1.2% gain recorded. Credit quality might be starting to slip. Target announced its net write-offs increased sequentially at an 8.4% annualized rate and mentioned that is saw a higher than expected uptick in bankruptcies.

Some of the specialty retailers are having a more difficult time. Children's Place saw comparable store sales drop 13% on top of an 11% decline last year. The decline in comparable store sales was driven by a 14% decline in average transaction size, which pushed gross margin down over 700 basis points to 38.6%. The retailer said it was encouraged by the 2% increase in the number of transactions. I think after dropping prices by 14%, a 2% pick up in transactions does not quite add up. Inventories on a per stores basis jumped 16%

American Eagle Outfitters detailed how comparable sales did based on weather. I seldom let companies off the hook when they blame weather for their troubles, but the first quarter did have some severe weather. It does appear there is a good correlation between weather and comparable store sales.

Hot stores: Up mid-single digits

Warm stores: down low-single digits

Moderate stores: down high-single digits

Cold stores: down low-double digits.

Overall, comparable store sales declined 6.5% with total sales advancing 5.0%. American Eagle is one of the retailers that mentioned having too much inventory at the end of the quarter. Excluding some early receipts, inventory increased 7% on a per foot basis

Department stores have been the worse sector in retail for quite a while. The tide certainly has not changed. Dillard's same store sales fell 5% in the first quarter along with total sales. It's March same store sales dropped 12% due to a combination of Easter being three weeks later this year and the war. Dillard's was one of the few retailers that mentioned the war as a reason for the weakness. Sales failed to bounce back in April and were down 2% compared to last year. While sales fell 5%, inventory rose 5%. The company stated that they have been "very aggressive in attempting to deal with the inventory levels." Dillard's echoes Target's concern over bankruptcies, saying they, "continue to be outrageously high."

Perhaps the most surprising results come from Kohl's. Over the past several years, Kohl's has exemplified the aggressive, expanding retailer. It has doubled its store base during the past four years, and anticipates growing at a 20% clip in the future. The tide might be starting to turn on this once invincible retailer.

Kohl's reported total sales increased 13.2% during the first quarter, but same store sales fell 2.4%. This was the first quarter that Kohl's experienced a decline in same store sales. Comparable sales for the first half of this year are up against very strong year ago periods. During the February to July period last year, monthly same store sales growth averaged almost 10%. However, Kohl's has had several difficult comparisons in the past that it managed to exceed. Additionally, this was only the fifth time since 1994 that Kohl's didn't grow EPS by double digits. With Wall Street analysts calling for a meager 11% growth for the quarter ending July 2003, any slip in operations would mean the first sequential back-to-back quarter with sub-10% EPS growth.

Prudential Securities issued a research report last week detailing some of the problems Kohl's is experiencing. One of the most notable points Prudential makes is after leading the industry in same store sales growth, Kohl's now is performing much closer to its peers. During the first quarter last year, Kohl's same store sales grew on average 10% faster then Prudential's department store index.& This year, it grew same store sales only 2.7% faster than Prudential's index.

The decline in same store sales must have caught Kohl's off guard as inventory increased 27% from the year ago period. Coming into the quarter, Kohl's inventory level was a little higher than normal, but the company was, "very comfortable with constant over-inventory." The company's tone sure has changed. This quarter the company stated during its conference call, "From a pricing standpoint, we will become much more aggressive to ensure we drive the top line." Kohl's goal is to have inventory levels 20% above last year's level at the end of the quarter. Even if Kohl's is able to reduce its inventory to 20% above last year's level, inventory will still be growing faster than total sales. Wall Street analysts expect total sales to increase about 17%. The table below details how historically Kohl's has been able to control inventory growth below total sales growth.

  1997 1998 1999 2000 2001 2002 1Q03
Sales Growth 28.1% 20.3% 23.8% 35.0% 21.7% 21.8% 13.2%
Inventory Growth 21.9% 19.7% 28.7% 26.3% 19.4% 35.8% 27.6%
Difference 6.3% 0.6% -4.9% 8.7% 2.3% -14.0% -14.4%

Since Kohl's has been growing its store base aggressively, analyzing inventory on a per store basis is a better way to gauge inventory growth.    Not only has Kohl's been able to keep inventory growth comparable to total sales, it has been able grow same store sales faster than inventory per store.  But this engine of its growth started to sputter last year and has continued do to so this year. 

  FY 98 FY 99 FY 00 FY 01 FY 02 1Q03
Same Store Sales Growth 7.9% 7.9% 9.0% 6.8% 5.3% -2.4%
Inventory per Store Growth 0.6% 7.7% 3.0% -1.7% 13.8% 8.9%
Difference 7.3% 0.2% 6.0% 8.5% -8.5% -11.3%

Another way to analyze inventory is to compare inventory on hand at the beginning of the quarter to inventory actually sold during the quarter. This is especially useful when analyzing a rapidly expanding company. For the current quarter, the cost of good sold can be estimated by using the mean analysts' estimate for sales ($2.24 billion) and using an appropriate gross margin. The gross margin for the first quarter was 35% and is a little lower than analysts' estimates for the second quarter, but with the heavy amount of discounting that Kohl's admits will be done this quarter, it could prove conservative. This yields a cost of goods sold of $1.46 billion. Inventory going into the quarter is $1.81 billion. Days of sales is calculated by taking the inventory level divided by cost of goods sold divided by 365 to get the number of days. Since this calculation uses just one quarter of sales, it needs to be divided by 4. This works out to be:

$1.81 / $1.46 / (365/4) = 113 days of inventory.

The following table shows this calculation historically. It uses actual sales for each period except for the current quarter.

Jul01 Oct01 Jan02 Apr02 Jul02 Oct02 Jan03 Apr03 Jul03
106 92 85 90 105 95 89 108 113

No wonder management is concerned. Not only is the days of sales highest in the past two years, but it is also the highest going back at least another two years. The July period does consistently have the highest inventory level going in, but this year it is 7% and 8% above the past two years.

Almost all the retailers are expecting results to be better in the second half of the year driven by an economic rebound. It appears that conditions will be good for consumers this summer to get good deals. If retailers are unable to trim their bloated inventories this summer, the back to school season could bring disappointment throughout the retail sector.

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