Description

Description

Kohl’s (“KSS” or the “Company”) is one of the largest department stores in the U.S. with 1,100 locations in 49 states and online offerings. Like many of its department store peers, KSS owns a significant amount of its real estate. KSS has been in a seemingly constant “turnaround” mode over the last number of years, including the period in which its current CEO, Michelle Gass, has been leading the Company (CEO since 2018). Her latest plan involves putting Sephora mini-stores within Kohl’s locations to drive store traffic and a younger demographic. 

Background to Strategic Review

Many of you are likely familiar with the Kohl’s drama that has unfolded over the last number of months, but I will provide a brief refresher:

• In January 2022, it was reported by Bloomberg that Sycamore Partners reached out to KSS about a potential acquisition at $65/share. This was a few days after it was reported that a suitor backed by Starboard Value LP (Acacia) bid $64/share, which equated to a high 30% premium (and ~$9 billion equity value). The occurred in the midst of an activist hedge fund, Macellum, which had been pushing for board changes and a sale of the Company.
  
• A few weeks later in early February, KSS issued a press release rejecting the unsolicited expressions of interest saying that the bid “[did] not adequately reflect the Company’s value in light of its future growth and cash flow generation.” KSS also implemented a poison pill and announced that they had hired Goldman Sachs and PJT Partners to engage with the interested parties.
  
  
• Reuters reported in mid-March that HBC was planning a bid in the “high $60s per share.”
  
  
• A week later, Macellum nominated 10 individuals to replace the entire KSS board at the meeting in May. Up until the vote in May, there were numerous letters and presentations sent out by KSS and Macellum.
  
  
• In mid-April, Reuters reported that Franchise Group (“FRG”) was preparing a $69/share bid for KSS.
  
  
• In late April, the New York Post reported (click here) that Simon Property and Brookfield Asset Management (who collectively own JC Penney) offered to acquire KSS for $68/share.
  
  
• On May 11, Macellum lost its proxy fight with KSS as shareholders voted to retain all existing KSS  board members.
  
  
• A week later, Kohl’s announces absolutely disastrous Q1/22 earnings along disastrous guidance. As well, the Chief Marketing Officer and Chief Merchandising offer stepped down the night prior to earnings being released.
  
  
• In the weeks following, it was reported Simon Property and HBC were no longer interested in the pursuing KSS and that the remaining parties were interested at lower prices.
  
  
• On June 6, KSS and Franchise Group each put out a press release (KSS release and FRG release) stating that they have entered into a three week exclusive negotiation period whereby FRG would acquire KSS for $60/share. FRG also stated in their press release that they intended to “contribute approximately $1 billion of capital to the transaction, all of which is expected to be funded through a corresponding increase in the size of its secured debt facilities.”
  
  
• Three days later, the New York Post reported (click here) that Apollo (who has provided financing to challenged situations recently including Carvana) will be providing more than $2 billion in financing to FRG for the acquisition. CNBC also reported that financing was almost in place.

So, what do we have here in summation:

1. A terribly run strategic review with a management team that have effectively been kicking and screaming to remain independent because they believe their Sephora expansion plan will work (history with JC Penny and others would indicate otherwise). 

    

2. An underlying business that is deteriorating rapidly along with a U.S. economy that could be heading into a recession. 

    

3. A number of interested parties that were initially bidding in the mid-to-high $60s that have largely walked away.

    

4. One bidder left with seemingly no synergies (unlike JC Penny or HBC) that is attempting to pull off a public LBO.

    

5. A buyer and a seller who seemingly have agreed to a $60/share price. 

    

6. A buyer who seems to have secured financing in the form of a $1 billion credit facility, $2 billion from Apollo and the approximate $5 billion balance from Oak Street who will be financing against KSS’s real estate (CNBC article). 

    

7. A buyer whose stock traded +17% in the following days after announcing it was in exclusive negotiations with KSS.

What Is the Trade?

Even without a definitive deal signed, all the elements seem to be in place. Yet, Kohl’s stock is trading at $46.60 or a full 28% below the potential $60/share deal price. Even if a deal gets signed, KSS stock will likely trade at a wide spread until close – perhaps $56 or $57 to adjust for all the risks until close. Even then, upside from here seems attractive. So why it is trading at such a wide spread?

1. Arbs are skeptical that management, after rejecting a $64/share bid earlier in the year, will accept a lower bid.

2. Credit markets are wobbly at the moment so even with all the reports, many are (and should be) skeptical about financing being in place.

3. If there’s no deal, what is the break price on Kohl’s? Your guess is as good as mine. Maybe $35 where it was trading a few weeks ago after earnings (and the recession and retail earnings picture has only gotten worse since so maybe $35 is too high)? I simply don’t know. 

If I assume a $35 break price and $56 definitive deal spread price, I have approx. $9 upside and approx. $12 downside on the stock at current levels. Do I think a definitive deal has a higher probability than is being priced into the stock? The answer is yes. Do I think playing this through the stock is the best trade? No. There is too much downside for my liking.

I think the much better risk/reward trade comes in the form of Kohl’s unsecured bonds. Specifically, the 3.375% 2031 notes. These bonds have $101 change of control (“CoC”) language and are currently priced in the $91 area.

Source: KSS 3.375% 2031 Prospectus Supplement to Prospectus dated March 29, 2021

The CoC language is pretty standard here for an investment grade issuer. If there is a change of control event and each of the ratings agencies who currently rate the bonds lower the rating below investment grade, then holders have the right to put the bonds back to the Company at $101 + accrued interest. 

We know the FRG acquisition would constitute a change of control event – so the first part of the language is triggered. The next part has to do with the ratings agencies downgrading below investment grade. 

The current bond ratings are shown below. Moody’s would need to downgrade by two notches, S&P by one notch and Fitch by one notch to fully trigger the $101 change of control put.

Source: Bloomberg

Given the amount of proforma leverage that will be on this entity (FRG is effectively executing a public LBO and is contributing no equity), it is a near certainty that proforma KSS will be rated well below investment grade (likely in the CCC area). In fact, one day after the press releases from KSS and FRG on the exclusive negotiations, S&P placed KSS on creditwatch negative, which is the agency gearing up for a downgrade if the deal transpires.

Source: Bloomberg

At $91.00, the yield and spread on the 31s is 4.62% and 156 basis points, respectively. The average BBB- 10-year bond (this is a 9-year bond, but the curve is relatively flat), yields 5.276% according to Bloomberg. 

Source: Bloomberg

If I assume the 31s trade at the average BBB- 10-year yield of 5.276% in a no deal scenario, then the downside price is $86.65. The downside price equates to a 223 basis point spread which is higher than where the bonds have traded historically (most of the rise in corporate yields YTD is a result of underlying rates as opposed to spreads blowing out). Therefore, I think the $86.65 downside price is fairly conservative. 

Source: Bloomberg

Source: Bloomberg

Even though the bonds don’t have as much upside in a definitive deal announcement, I think they have much better downside protection. The stock effectively gives you a 1:1 upside/downside payoff versus the KSS 3.375% 2031 bonds which give you a 2:1 upside/downside payoff. Plus you get a little bit of accrued interest while you wait (for the next week or two). 

Conclusion

Despite the Kohl’s saga being one of the poorest executed strategic reviews I have seen, I think there is a reasonably good probability that a definitive deal in announced in the coming week or two. Kohl’s stock is the best way to play this outcome if you are only focused on maximum upside. If you are focused on downside protection, then the KSS 3.375% 2031 bonds have a much more attractive upside/downside ratio due to the $101 change of control language in the bond prospectus. 

Recommendation: BUY KSS 3.375% 2031 bonds. 

Risks

• Kohl’s and Franchise Group end up terminating the negotiations for a variety of reasons (unable to lock in financing, political pressure from state of Wisconsin who has been against a transaction, change of heart from Kohl’s or Franchise Group on price, etc.).
• Despite being a $500 million issue, trading the bonds is not easy and they are fairly illiquid. 

Catalyst

Announcement of a definitive transaction between Kohl’s and Franchise Group.