Earnings Call Transcript - KSS Q4 2022

Operator, Operator

Good morning. My name is Audra, and I will be your conference operator today. I would like to welcome everyone to the Kohl’s Corporation Q4 2022 Earnings Conference Call. Today’s conference is being recorded. All lines have been muted to prevent background noise. After the speakers’ remarks, there will be a question-and-answer session. I will now turn the conference over to Mark Rupe, Senior Vice President of IR. Please go ahead.

Mark Rupe, Senior Vice President of Investor Relations

Thank you. Certain statements made on this call, including projected financial results and the Company’s future initiatives, are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Kohl’s intends forward-looking terminology such as believes, expects, may, will, should, anticipates, plans or similar expressions to identify forward-looking statements. Such statements are subject to certain risks and uncertainties, which could cause Kohl’s actual results to differ materially from those projected in such forward-looking statements. Such risks and uncertainties include, but are not limited to, those that are described in Item 1A in Kohl’s most recent annual report on Form 10-K and Item 1A of Part 2 of the Company’s quarterly report on Form 10-Q for the first quarter of fiscal ‘22 and as may be supplemented from time to time in Kohl’s other filings with the SEC, all of which are expressly incorporated herein by reference. Forward-looking statements relate to the date initially made, and Kohl’s undertakes no obligation to update them. In addition, during this call, we will make reference to non-GAAP financial measures. Information necessary to reconcile these non-GAAP financial measures can be found in the investor presentation filed as an exhibit to our Form 8-K filed with the SEC and is available on the Company’s Investor Relations website. Please note that this call will be recorded. However, replays of this call will not be updated. So, if you’re listening to a replay of this call, it is possible that the information discussed is no longer current, and Kohl’s undertakes no obligation to update such information. With me this morning are Tom Kingsbury, our CEO, and Jill Timm, our CFO. I will now turn the call over to Tom.

Tom Kingsbury, CEO

Thank you, Mark. Thanks to all for joining us this morning. I want to start by saying that I’m excited to be leading Kohl’s during this pivotal time. Kohl’s is a solid company. We have a substantial opportunity to make a difference in the retail landscape. As you will hear today, we have a solid foundation and a highly motivated team with a set of priorities to drive Kohl’s sales and earnings growth. During the past three months, I have had the opportunity to assess our go-to-market strategies, our operational capabilities and processes in our organizational structure. I have also visited a number of our stores across the country and engaged with many of our brand partners. It is clear to me that Kohl’s fills an important need in the market offering highly relevant products at a great value to millions of customers in conveniently located stores across the U.S. and online. We are making great strides in beauty through our Sephora partnership. However, we have lost some ground in other key categories. Candidly, I know we can do better. To reach our full potential, we will refine our strategy and reestablish merchandise disciplines with a customer-centered focus across the organization. This will sharpen our positioning with customers, allow us to capitalize on new opportunities, and drive greater efficiency. Our efforts have already begun. We took a number of proactive measures in the fourth quarter to clear our inventories, and we will seek to maintain the discipline by planning inventory down mid-single digits percent going forward. We also implemented several growth initiatives in Q4 that will begin to benefit our results in 2023 and structure the organization to run more efficiently. One of the early messages I shared with our leadership team was that we must simplify how we work to drive efficiency, which in turn will allow for greater time to be spent on executing and driving our strategy. In late January, we realigned parts of the merchandising and marketing departments with the objective of driving efficiency in our operations. This included consolidating the number of general merchandise managers to four from seven, a structure that we had prior to the pandemic, as well as transitioning, planning and allocation to report directly to me. And more recently, I am pleased with the appointment of two key executive leadership positions. Yesterday, we announced the hiring of Dave Alves as our new President and Chief Operating Officer. Dave is a 30-year retail veteran and will lead our enterprise operations including our nearly 1,200 stores, global supply chain and distribution center network, real estate portfolio, among other functions. In addition, we appointed Nick Jones as our new Chief Merchandising and Digital Officer. Nick has great experience across many of our categories, including apparel, home and gifting, and will be instrumental in leading our merchandising strategy and functions. Both Dave and Nick will join us in the coming weeks, and I look forward to our partnership. Through these important actions, I am confident that we have the right plans, organizational structure, and team in place to drive improved and more consistent sales and earnings performance over the long term. That said, I want to be realistic in setting expectations. The full impact of our efforts will take some time. It won’t happen overnight. And we must acknowledge that we are implementing these actions in a challenging macroeconomic backdrop. As Jill will discuss in more detail, our actions against this backdrop form the basis of our prudent guidance for 2023. With that context, I will now discuss our path to improve performance and the key priorities that will guide our forward action. We are focused on four overarching priorities in 2023 that will drive overall sales and profitability. They are: enhance the customer experience, accelerate and simplify our value strategies, manage inventory and expenses with discipline, and strengthen the balance sheet. Successful execution across these priorities will unlock considerable long-term shareholder value. Let me walk you through each of these priorities discussing the actions and intended outcomes we are driving towards. The first priority is enhancing the customer experience. It is imperative that we continue to provide the best experience for our customers when they shop at our stores and online. We are focused on ensuring that our customers are finding the product assortment they are looking for tailored to the way they shop. Our partnership with Sephora is an excellent example of how we are enhancing the customer experience. Nearly 8 million of our customers purchased beauty products at Sephora at Kohl’s last year, and this will continue to grow in the coming years as we further expand our store presence. In the fourth quarter, our total beauty sales increased 90%. We achieved high-single-digits percent comparable beauty sales growth in the 200 Sephora shops that opened in 2021 and better-than-expected sales in the 400 shops opened in 2022. We also continue to see strong digital sales growth. Our Q4 performance in many ways cemented our positioning as a major player in the beauty industry based on our notable market share gains. I want to commend the team for successfully capitalizing on the holiday selling period. We drove value through our expansion and gift sets, merchandise both in the shop and in the aisle with fragrance being a key category. I am confident that we can build on this momentum in the months and years to come. I recently met with Sephora leadership, and what I can tell you is that, one, we both are pleased with the partnership we’ve built and what has been accomplished in such a short period; and two, we both see immense opportunities to continue to drive sales and profitability in the future. This summer, we’ll open another 250 Sephora shops, bringing our total to more than 850 stores, featuring the standard 2,500 square foot space. In addition, we are opening 50 smaller formats Sephora shops by the end of this year with a plan to roll out to the remainder of the chain by 2025. Moving beyond beauty, let me now touch on efforts we have underway in our product and merchandising. As it relates to our product assortment, we remain highly committed to the active business supporting our key brands, though we’ll recenter our focus on our customers’ needs by capitalizing on multiple lifestyles. We will rebalance portions of our assortment to capture our customers’ return to more normal purchasing behavior for their wardrobes. Additionally, we’ll add more offerings across casual and career wear, including, for example, further expanding our women’s dress business following last year’s success. We also see clear tangible opportunities in other categories in which we are underpenetrated. Home and gifting are two areas that our customers expect more from us. I believe Kohl’s can increase its penetration in areas like home décor and become a destination for gifting. To capitalize on this, we are rethinking how we source portions of our assortment, recognizing that we can find great values, increase our speed, and broaden our offerings by going into the domestic marketplace regularly. I now want to highlight the importance of our stores. We have an incredibly strong physical presence across the U.S. They continue to represent nearly 70% of our annual sales and are critically important to how we engage with our customers. I have worked with our real estate team in reviewing our portfolio and remain very comfortable that our stores are healthy. Frankly though, we have to do a better job of driving greater in-store productivity, and I am confident that we can. In the fourth quarter, some of our early efforts began to bear fruit. Looking ahead, we are rethinking how we merchandise stores to deliver a better experience for customers to drive greater frequency of visits and capture more share of their wallet. Let me share a few early examples of actions we are taking in areas that simply weren’t up to standard. In early December, we moved our gifting assortment to the front of the store from the back to better capitalize on peak holiday traffic. This proved highly effective, resulting in sell-through significantly higher than the prior year. We will also showcase more products, including home and gifting, near the front of the store to inspire our customers as well as feature more impulse products, which is a largely untapped opportunity for Kohl’s. In addition to our stores, we are also highly committed to our digital business, which represents over 30% of our sales. Two of our key digital growth initiatives include expanding Kohl’s Marketplace and Kohl’s Media Network. Kohl’s Marketplace is broadening our product offering online to capture incremental sales opportunities and Kohl’s Media Network is leveraging our digital platform and site traffic to partner with more of our key brands and capture more advertising dollars. As you just heard, we have a lot of initiatives and actions underway to enhance the customer experience. This will be a continuous focus of ours. The retail industry is ever evolving, and we must ensure that our positioning consistently meets the needs of our customers. Now, let me transition to our second priority, which is accelerating and simplifying our value strategies. In today’s inflationary environment, it is very important that Kohl’s stands for value, both in our pricing and in our messaging. We provide great value to our customers through Kohl’s Cash, our rewards loyalty program, and our Kohl’s Card. That said, we know that our promotional strategy at times can be a disadvantage to Kohl’s when compared to our competitors’ price-focused strategies. We have made progress over the past couple of years in our pricing and promotional optimization efforts. We will build on this progress in 2023, accelerating our efforts to reduce our reliance on general promotions. We will test everyday value pricing with a small percentage of our product assortment, and if successful, grow it appropriately in subsequent years. We fully recognize the sensitivities around pricing with our customers, and we’ll approach this with great measure and flexibility. A part of this will enhance consistency in our marketing messaging to improve the customer experience, drive increased customer engagement, and make our pricing less complex. When we stand for something with greater clarity and value, our customers do respond. This is evident in the customer response we have experienced in recent weeks related to our clearance effort. Another way we will enhance the value we are providing our customers is through our industry-leading loyalty program. In 2023, we’ll broaden the reach of our credit opportunities through the launch of a co-brand card with Capital One. We already have a strong private label Kohl’s credit card, so we recognize that today’s younger customers want greater flexibility in their payment options. Let me now turn to our third priority for 2023, which is managing inventory and expenses with discipline. As I mentioned earlier, we took proactive actions during the fourth quarter to clear out excess inventory and slow-selling goods. This is best seen through our inventory progression over the past few quarters. Inventory was up 48% year-over-year at the end of Q2, up 34% at the end of Q3, and up just 4% at year-end, despite a tougher sales environment. Inventory is now generally back in line with our sales performance when compared to 2019. We took markdowns following Christmas, which benefited our sales performance in the quarter. Q4 comparable sales down 6.6% improved through the quarter with November down low-double-digits percent, December down mid-single-digits percent, followed by up high-single-digit percent in January with a positive trend continuing into February. Jill will discuss the related impact to margin in more detail in a moment, but it was important that we took these actions in Q4 to best position the Company for 2023. During the past three months, I have spent a significant amount of time focused on merchandising, including establishing stronger inventory control processes. We are putting a spotlight on fresh receipts and on driving turnover. We will operate so that we have plenty of room to chase receipts, enabling better management of receipt flow. As part of this, we are committing to planning inventory down mid-single digits percent going forward. We will also adjust how we mark our goods, getting rid of excess inventory or slow-selling items on a more even flow throughout the year instead of waiting until the end of a season. In terms of spring 2023, we feel good about our Q1 inventory position with a steady flow of transitional receipts that arrived during January and February. And considering there are still a lot of macro headwinds for Q2, we have left even greater liquidity and our open-to-buy with lots of room to chase. I am optimistic that through our new inventory control processes we will be able to increase our sales productivity and inventory efficiency. Now, let me address our focus on expense management. This has been a core strength of Kohl’s over time, but given the ongoing inflationary environment, it must be an even greater priority for the organization. In 2022, our SG&A expense ratio drifted higher on lower sales, increased strategic investments, and wage inflation. Growing sales is paramount to easing the expense pressure. However, we must proactively capitalize on other opportunities such as increasing self-service capabilities in our stores, driving improved marketing efficiency, and reducing spend across all areas of the company. And lastly, our fourth priority for 2023 is strengthening our balance sheet. Our focus remains on returning our balance sheet to its historical strength after a challenging 2022. Our long-term objective remains to manage our business at 2.5 times leverage. In January, we replaced and upsized our revolver to a $1.5 billion secured facility, which enhanced our liquidity and flexibility. This was the right move given the ongoing macro uncertainty and the actions we are taking to drive Kohl’s sales and earnings growth. While we were only partially utilized at the end of the year, we will increase our borrowings in the first quarter to fund working capital and the recently completed retirement of our February 2023 bond maturities. However, we will work our revolver balance down throughout the year with no borrowings planned at year-end. Jill will discuss our other capital allocation priorities in more detail, including our commitment to the dividend, which represents a healthy yield at the current share price. So to summarize, enhancing the customer experience, accelerating and simplifying our value strategies, managing inventory and expenses with discipline, and strengthening the balance sheet are four overarching priorities for 2023. And the broader Kohl’s organization is aligned and focused on executing against each of them. Now, let me frame up how we are thinking about 2023 in the context of the priorities and actions I just discussed as well as the anticipated soft consumer demand outlook. We are prudently planning the year with sales down 2% to 4% and our operating margin and earnings pressured largely as a result. I want to be realistic in setting expectations. The benefits from our actions will take time. However, I am confident that successful execution against our priorities will produce the intended improvement in sales and earnings growth over the long term. While 2023 may be viewed as a transitional year, it is our objective to show progressive improvement against our priorities and actions as we move through the year. We look forward to providing updates on future quarterly calls. In closing, I want to reiterate that Kohl’s has a solid foundation in place. I am excited to lead this company and see immense opportunity to unlock value. I want to thank our loyal associates who are serving our customers every day. I will now turn over the call to Jill to discuss our fourth quarter results and 2023 outlook.

Jill Timm, CFO

Thank you, Tom, and good morning, everyone. I will review our fourth quarter results and then discuss our guidance outlook for 2023, highlighting the key takeaways from our Q4 performance. We implemented significant proactive measures to better position the business for 2023, although our sales continued to be impacted by the ongoing inflationary environment. Net sales declined by 7%, mainly due to reduced customer traffic, while higher average transaction values and lower unit sales per transaction balanced each other out. Our middle-income customers remain under pressure and are increasingly opting for our value-oriented private brands. As Tom mentioned, our sales trends improved throughout the quarter, particularly as we focused on clearance in late December and January, a trend that carried into February. From a channel perspective, store sales improved sequentially during the quarter, although they were down 3% compared to the previous year. This improved performance was attributed to having more Sephora shops open and heightened clearance demand in stores late in the quarter. Digital sales fell by 12% compared to last year and represented 37% of total sales. In terms of product performance, sales of our private brands remained relatively stable in the quarter, with strong contributions from top brands like Sonoma, Croft & Barrow, Tek Gear, and Lauren Conrad. Conversely, sales of our national brands dropped by high-single-digits, largely due to weaker performance in active home and denim categories. Accessories showed strong sales growth, up by mid-single digits compared to last year. While beauty experienced strong sales growth, this was partly offset by lower jewelry sales, primarily due to in-store displacement caused by removing the fine jewelry counter to accommodate Sephora shops. We see opportunities to recover lost sales in this category. In other categories, men’s and women’s apparel outperformed the overall company average. Men’s saw solid results in tailored dress, young men’s, and outdoor segments, while women’s apparel benefited from higher demand for elevated casual and dress wear, along with sequential improvement in intimates. Juniors posed a challenge within women’s, and active categories faced difficulties across all business lines. Home, footwear, and children's categories underperformed relative to the company average. Other revenue, primarily from our credit business, declined by 13% in the fourth quarter, continuing to be affected by a lower overall accounts receivable balance and normalizing loss rates. Moving on to the income statement details, the gross margin for Q4 was 23%, down from 33.2% last year. This decline was mainly due to clearance markdowns of approximately 750 basis points and product cost inflation of around 200 basis points. Additionally, we faced challenges from higher shrinkage and unexpected freight expenses during the quarter. SG&A expenses decreased by 0.6% to $1.7 billion, with lower spending on marketing and distribution mostly offset by increased operational costs driven by wage pressures. Depreciation was $200 million, a decrease of $7 million compared to last year due to reduced technology capital expenditures. Interest expenses increased to $78 million, up by $13 million from last year because of Sephora-related lease amendments and higher revolver borrowings. The net loss for the quarter was $273 million, equating to a loss per share of $2.49. Regarding the balance sheet and cash flow, our inventory at the end of the quarter rose by 4% compared to last year but was down by 10% compared to the fourth quarter of 2019, aligning with the sales decline over this period. As stated by Tom, we are committed to reducing inventory by mid-single digits in the future. Operating cash flow for the fourth quarter stood at $707 million. Capital expenditures for the quarter were unspecified, totaling $826 million for the year. Notably, CapEx in 2022 was primarily driven by the opening of 400 Sephora locations, store refreshes, and the introduction of 5 new stores and 4 relocations. For 2023, we plan to invest between $600 million and $650 million, which includes opening 250 Sephora shops, adding another 50 small format Sephora locations, refreshing stores, and opening 7 new stores, one of which will be a relocation. Now, I'll present an update on our capital structure and capital allocation priorities. Strengthening our balance sheet is a top priority for 2023. It is crucial that we rebuild our cash position, and we aim to manage this business with a leverage target of 2.5 times in the long term. We are making progress on both cash and leverage as we move through the year. We will utilize the revolver to fund working capital and a $164 million bond retirement in the first quarter, and we plan to reduce it sequentially throughout the year, with no anticipated borrowings by year-end. In addition to the bond retirement in February, we will also retire $111 million in bonds in December 2023. Regarding our return of capital to shareholders, we will prioritize our current dividend, offering a robust yield to our shareholders. During Q4, we distributed $55 million, or $0.50 per share, in dividends. Also, as previously announced, our Board declared a quarterly cash dividend of $0.50 per share payable on March 29th. Concerning share repurchases, we will not initiate additional activities until we have improved our balance sheet. Now, let’s discuss our outlook for 2023. We are concentrating on four key priorities to enhance sales and earnings performance. Despite the challenging macroeconomic environment, this focus allows us to plan judiciously for the upcoming year. As Tom highlighted, establishing realistic performance expectations is essential, as it provides us with the flexibility to take further actions if needed while also building on our progress throughout the year. For the entire year, we currently anticipate net sales to decrease by 2% to 4% compared to 2022, including a contribution of about 1 percentage point of growth from the 53rd week. We expect the operating margin to be around 4%, with EPS projected to range from $2.10 to $2.70, excluding any nonrecurring charges. I’d like to provide some additional guidance. We plan for other revenue to decline in line with our overall net sales in 2023. We estimate depreciation and amortization to be approximately $770 million, interest expenses around $350 million, and a tax rate of approximately 23%. From a margin and cost perspective, we foresee gross margin stabilizing in 2023 within the range of 36% to 36.5%. We expect freight expenses to provide a tailwind with progressive benefits throughout the year, while product cost inflation will continue to be a headwind in the first half. We anticipate a competitive promotional environment. SG&A dollars are expected to decrease slightly, with wage inflation posing a challenge, countered by benefits from a more efficient organizational structure and fewer Sephora openings this year. Finally, I want to emphasize a few points regarding our outlook for the year. In Q1, we have experienced sales trends above our annual guidance so far. However, much of this positive trend has been due to increased clearance activities that are associated with lower margins. As we work through clearance inventory, we expect sales trends to moderate. We anticipate both sales and earnings to improve throughout the year. Our guidance suggests that EPS will be lower in the first half compared to last year, with the second half benefiting from easing freight and product cost inflation and from the inventory actions we took in Q4. With that, Tom and I are ready to take your questions.

Operator, Operator

We'll go first to Bob Drbul at Guggenheim Securities.

Bob Drbul, Analyst

Hi. Good morning. And Tom, welcome. I guess just two questions that I have. The first one really for Tom, can you elaborate some more just on the opportunities that you do see now at Kohl’s and what excites you about the opportunities? And the second question is really for Jill. When you look at the guidance that you’ve given us, can you just elaborate a little more as how you have approached the guidance and how you think about it? Just how we should be expecting things to play a little more, that would be great. Thanks.

Tom Kingsbury, CEO

I believe Kohl’s has numerous opportunities ahead. It's a strong company with solid foundations already established. Kohl’s has successfully set up initiatives like the Sephora partnership, which I see as a significant chance for growth. It attracts a different demographic—specifically younger and more diverse consumers—which is very promising. However, we need to enhance certain operational aspects, particularly inventory management. Our inventory levels got out of control in 2022 after performing well in 2021, resulting in a substantial spike. Improving our inventory practices and being more agile in managing our buy-in each quarter will allow us to respond better to customer demands rather than making upfront purchases with the hope of selling them. We've already implemented substantial changes in the fourth quarter, as both Jill and I mentioned. Additionally, we’re examining our store operations, which we view as a critical opportunity. We aim to adjust how we display products slightly to increase gifting options at the beginning of key seasons. This strategy proved effective during the fourth quarter, so we replicated it for Valentine’s Day and plan to continue it for Mother’s Day. We are also working on refining store aesthetics by minimizing the number of graphics and signs to create a more modern ambiance. Our goal is to boost in-store productivity while also expanding our digital presence. Overall, I see tremendous opportunities at Kohl's, which is why I returned—I believe we can capitalize on these prospects in the future.

Jill Timm, CFO

And then, Bob, in regards to our guidance, I think what we did is we took a cautious plan as we look to the year. We wanted to be appropriate with our guide given the environment, it’s high inflation, interest rates are rising, and we know that has a large impact to particularly our middle income customer. So, as we are navigating them in certain times, we have a lot of change that Tom had outlined not only in the script, but obviously just in his remarks as well in terms of what we see ahead of us. So, we do expect the sales to build throughout the year. Particularly as these initiatives roll out, we’re going to have more Sephora stores open. We’re going to work more on the gifting, impulse, and home décor really seeing that build throughout the year. And then I think as well with gross margin, we’ll see that build throughout the year as well with the freight moderating. We’re going to see commodity costs come down, starting with our back-to-school receipts. And then we’re going to start taking more timely clearance markdowns throughout the year. And this will actually have a bigger impact to Q2 margin because we’ve typically taken these seasonally. You’ll see a negative impact in Q2, but a positive impact in Q3 as we move those marks up and take them much more timely, particularly on our spring and summer goods from that perspective. And then, in SG&A, we’ll expect Q2 and Q3 to have more costs associated with them just due to the timing of when we’re opening up our Sephora shops. Last year, we started that construction earlier in the year and this year, you’ll see it more in Q2 and Q3 with the 250 stores and then those 50 new shop stores. So, that’s kind of how I would make the model work and your build work from a guidance perspective.

Gaby Carbone, Analyst

Tom, so previously, Kohl’s targeted a 7% to 8% long-term operating margin. You’re guiding to 4% for FY23. I was wondering if your confidence still in that 7% to 8% goal over time. And what does the bridge look like to get there? Thank you.

Tom Kingsbury, CEO

Well, I’ll talk for a few minutes, and then I’ll have Jill. Overall, we’re still confident in the 7% to 8% target that we have. A lot has to do with rebuilding our sales to obviously get to those levels again. But we’re not changing. We’re not changing our long-term guide at all because we feel we can get there. But I’ll let Jill talk about it.

Jill Timm, CFO

Yes. I think the framework that we gave you with the 7% to 8% still exists today. And as Tom mentioned, it really starts with sales growth. And if you recall in that framework, it was a low-single-digit sales growth that was the beginning of that framework. So I think we feel confident in the initiatives that we’ve outlined today, like I mentioned, that we’re going to get back to that growth pattern. But as Tom suggested, it takes time to do this. So, we’re moving things in the right direction. So, we look at this as a long-term framework that still exists. You go into the margin side of things, our guide this year is at the low end of that, it’s a 36% to 36.5%. But we do think we’re going to continue to see benefits, particularly around the strong inventory management that Tom spoke about. We’re going to have better inventory control processes, this will drive turn, we’ll have better reg selling. So, we do see that we can continue to get to that higher end there. And then from expenses, we’ve always had a very strong focus on expense discipline at Kohl’s. We know we can leverage at about a 1.5 comp. This continues to be a focus for us. We’re looking for efficiencies across the business. But particularly, you’re going to see that around like automation, the self-service in our stores, automation in our distribution centers. We’ve done a lot of organizational optimization. We’re looking at marketing efficiencies, all places that we can continue to lean into to bring down our SG&A run rate as well. So I think overall, hopefully, you heard from both Tom and I, we’re very confident in the long-term framework for op margin, getting back to 7% to 8%.

Gaby Carbone, Analyst

And just a quick follow-up. So you mentioned your private brands are flat for the quarter, which is encouraging. Just curious how you’re thinking about leveraging your private brands portfolio moving ahead, especially as consumers are continuously seeking more value.

Jill Timm, CFO

Yes. I think value is crucial in this environment, and customers are actively looking for it. In recent quarters, we’ve noticed that they have increasingly turned to our proprietary brand portfolio because it offers them that value. Additionally, we've seen strong performance from Sephora and some of our new brands like Tommy Hilfiger and Eddie Bauer in the outdoor category. Value spans across our offerings, providing customers with a quality product at a price they find reasonable. This is evident in the trade-offs they make, especially as the financial situation for middle-income customers becomes tighter. As we primarily sell discretionary items, having a mix of private brands and national brands has benefited our customers, allowing them to adapt to their budget constraints. We are capitalizing on this and will continue to focus on a more agile approach, as Tom mentioned, to enhance our proprietary brands. We have a dedicated team working on this by partnering with more West Coast suppliers and engaging directly with vendors. You'll see us continue to strengthen our private brand portfolio while adhering to the inventory discipline that Tom discussed.

Tom Kingsbury, CEO

Yes, I believe that private brands are a crucial aspect of our business. However, we will also focus significantly on improving our performance in national brands throughout 2023. It is essential that we excel in both areas. We faced some challenges with national brands in 2022, but our objective is to ensure that both national and private brands perform strongly.

Mark Altschwager, Analyst

Tom, your thoughts on leveraging the domestic marketplace are intriguing. Is this strategy mainly aimed at home décor and gifting, or do you see potential in apparel and other categories too? I'm also interested to know if you anticipate needing to invest more in merchandising or expanding the buying teams to strengthen that capability within the organization.

Tom Kingsbury, CEO

We’re really looking at chasing goods across all categories of business, to be honest with you. There’s always ample product that we can chase. I’ve experienced that before in another place where I work that you can do that pretty readily. We do have the right structure in place to do that. We have the right buying teams, the right GMM structure to do that. There’s nothing really, I think, that could prevent us from doing that. But managing our inventories, that’s the key. I mean, we have to make sure that we have open to spend. That’s the only thing that could hurt us in that pursuit. But in general, I think it’s across the board that we can do it.

Mark Altschwager, Analyst

Thank you. A quick follow-up for Jill. Just with gross margin, any more color you can give us on the first quarter? I guess, specifically, the clearance headwind was obviously very large for the fourth quarter. It sounds like that activity continued into the early first quarter. So just relative to that 750 basis points, how should we be thinking about the headwind early in the year here? Thank you.

Jill Timm, CFO

Yes. I think what we’re seeing is freight is moderating. That’s going to happen throughout the year. We’re going to get some product cost benefits starting with our back-to-school. Obviously, we took a lot of clearance into Q4. The selling is continuing to benefit us into February, like I had indicated, but the marks happened in the fourth quarter. So it’s not as punitive into Q1. I think the thing with the clearance markdowns that we’re looking for is just taking them much more timely when they’re more relevant to get better sell-throughs. And so the one quarter that I would say will look different will be Q2 because we typically haven’t done clearance in Q2. We waited till Q3. So, we’re going to move those up. So you’ll see Q2 be a little more margin pressured because of that change, and then that will offset into Q3. And of course, Q4, we don’t expect to have a repeat of this year. So, you’ll see a large benefit into Q4.

Matthew Boss, Analyst

Tom, could you assist us in understanding the timeline for the release and your thoughts on refining the strategy and reestablishing the merchandise disciplines? In a broader sense, how do you view this turnaround opportunity in light of your past retail experience? Additionally, on a more detailed level, how should we consider the market share opportunity regarding spending from existing customers compared to the new customer acquisition that may be necessary?

Tom Kingsbury, CEO

The timeline does not unfold quickly. We are making progress, and our inventories are now where they should be. We are also planning our inventory for the first and second quarters accordingly. We expect advancements in 2023, but as with any business, it takes time to gain real traction. We have made significant strides already. In my previous experiences, it also took time to get things moving in the right direction, so I want to emphasize that this is not something that can happen instantly. It's important to note that Kohl’s is a different company from my previous one. We already have many solid elements in our strategy, so it is not a complete overhaul. There are areas where improvements are needed, and we have started addressing those, but it is not a total redesign. I want to clarify that there are many positive aspects already in place. Regarding market share, if we execute effectively, we have the potential to capture market share from various sources.

Dana Telsey, Analyst

As you think about the merchandise mix, Tom of Kohl’s, active has always been a big portion of where they were driving to. What is your ultimate goal in the merchandise mix? And what do you think would be most effective? And then also, Jill, in terms of omnichannel and delivery expense and some of the headwinds there, how do you see that impact on margin in 2023 and the framework of whatever is happening with freight expense and supply chain? Thank you.

Tom Kingsbury, CEO

We will let our customers guide us on their preferences. Establishing specific business targets isn’t in the best interest of our customers, so our product mix will evolve to align with what they want. Currently, we believe the active business is significant, but outdoor products are also important. We'll incorporate some outdoor items into our presentations, and we've already started doing that. However, I won't set general targets because we need to remain flexible. Our assortments must reflect customer desires rather than predefined goals. Moving forward, you will see more gifting and impulse products in our home store, as this is a direction I strongly support. Our customers have shown us through their purchases, notably in the fourth quarter gifting sales and successful Valentine’s displays, what they want. We will continue to follow their preferences.

Jill Timm, CFO

In terms of omnichannel, digital consistently adds pressure to shipping costs. However, we are observing a moderation in costs, and the increase is not as significant as it has been previously. Even so, as digital penetration rises, it remains a challenge. We believe there are considerable opportunities to improve store productivity, which can help counterbalance these challenges since digital growth won’t be as pronounced if we can enhance both channels. Our main focus is on revitalizing productivity in our stores through various strategies, including changes in presentation and the introduction of new categories, as well as attracting new customers with initiatives like Sephora. While digital remains a challenge, it isn't as significant as in the past. Additionally, we are witnessing greater efficiency from our new fulfillment centers, which allow us to process more products efficiently and deliver them to customers quicker. Utilizing our stores also helps us maintain close proximity to our customers. This approach improves our inventory management and supports disciplined inventory practices. Overall, we see a significant opportunity to expand our store presence, which will help alleviate some of the shipping cost pressures we've experienced.

Oliver Chen, Analyst

Regarding the new strategy, I have a broader question about attracting younger customers, particularly in women's apparel, as this presents an opportunity. I would appreciate your thoughts on the potential mix for home and gifting as you consider this. Additionally, how do you see gross margin and inventory returns being affected? I believe the potential benefits will surpass any challenges in this area. Jill, I’d like to hear your views on inventory control processes and what you believe are the easy wins. Also, considering the current inflation situation, what does your forecast look like in terms of average unit retail? Thank you.

Tom Kingsbury, CEO

I'll address the first part, and then Jill can take over. Adding Sephora has already attracted a younger demographic. Additionally, we are focusing on complementary products like women's apparel, accessories, and footwear so that when younger customers visit for Sephora, they can also shop for these items. We believe this initiative is a positive start in attracting younger consumers, and our goal is to broaden it across other categories in the store. Regarding the product mix, as I mentioned earlier, we’ll let customer demand guide how we approach the mix for home décor and gifting. Jill?

Jill Timm, CFO

And I think from an inventory control perspective, I just think the processes and the disciplines we have in place in terms of the chase model and really letting ourselves have some liquidity and not making all the buys upfront, like Tom has mentioned is a core fundamental that we just really need to reinstate, instead of allocating all our goods ahead of time. I think this way, we can chase them to the right items. It helps the sell-throughs. It helps the margins because you’re buying the right goods, so you don’t have to take as many marks at the end of the season. So I think that’s just really a core discipline that really needs to get reinstilled into the organization. And then quite honestly, the liquidity is going to go where the demand is. So, even though bustle plants at the beginning of the year, we need to be agile in moving through those based on what the consumer is looking for and then giving that open to buy to the right areas. So I think that’s fundamental I’ve always been really focused, as you know, on inventory control. So I love the new disciplines that Tom has brought to the organization. And then in terms of...

Tom Kingsbury, CEO

We’re going to spend a lot of time on inventory. That area will report directly to me due to the importance of inventory control in achieving our goals for 2023 and beyond.

Jill Timm, CFO

No problem. Regarding inflation and deflation from an AUR perspective, we didn’t experience significant inflation in our AURs this year even though we operate in discretionary spending. This situation differs from buying or selling essential items, so we haven't managed to significantly increase our AUR. The growth in our AUR has primarily come from the mix of products we offer. We always view this through the lens of value. For example, Sephora offers higher ticket items, which have consistently performed well for us despite fluctuations in the inflationary environment. We’ve also introduced products from brands like Tommy Hilfiger and Calvin Klein at higher price points. We expect to manage this situation smoothly since we didn’t raise prices significantly. Additionally, 65% of our sales come from national brands, so our pricing will align with their trends in the market, and we will adapt accordingly. Importantly, we haven’t increased prices due to inflation, which also means there is limited need to decrease them.

Oliver Chen, Analyst

Okay. And Tom, one follow-up on making pricing less complex. What’s the timing at which you’ll execute on that? And Kohl’s Cash is pretty iconic and the Company has been on a journey to simplify and amplify, less can be more. So, what’s different about what you think needs to be done? And what kind of guardrails might be good ideas around making these kinds of changes?

Tom Kingsbury, CEO

We will be very careful and proceed at the right pace with our plans. Starting around the back-to-school season, we will introduce some products with everyday low prices. This will represent a small portion of our total, and we’ll learn from this experience to decide whether it should grow or not. Currently, we are testing this approach. We have multiple promotions and we aim to simplify them significantly. We will maintain Kohl’s Cash, as it is a crucial part of our value proposition, but we also want to explore other options. We intend to focus on increasing markdowns on clearance items, as timing is essential for that. Monthly allocations of markdowns will be directed toward addressing our clearance inventory, which is very important. We plan to be more strategic with our promotions. At the moment, we have a lot of broad audience promotions that we will evaluate, and we have already analyzed the first and second quarters to identify areas for improvement and where targeted markdowns could be effective. Everything we implement will be at the appropriate pace.

Operator, Operator

And we’ll take our final question from Paul Lejuez at Citi.

Tracy Kogan, Analyst

Thank, guys. It’s Tracy Kogan filling in for Paul. Just two questions. On CapEx, it looks like you’re reducing your CapEx this year, which is understandable, but just wondering if that’s a good run rate and you’re no longer expecting the $2.5 billion over three years? And then secondly, I was hoping you could update us on the Amazon partnership and how do you assess the traffic driving results of the Amazon Returns in stores and how you’re doing converting as you look back at this year overall? Thanks.

Jill Timm, CFO

Sure. I think for CapEx, obviously, Tracy, we’ve talked about one of our core strategies being to strengthen back to the balance sheet. So, we did make that reduction this year in terms of really focusing on the return projects. So, of course, still going to invest back in Sephora and then adding those 50 small stores now that we have a solution to hit all of our stores from a Sephora perspective, but really being able to pull back into those more meaningful areas just given the fact that we are trying to build back our cash. So given what we spent this year and next year is obviously hitting $2.5 billion is probably not where we’re going to be at this point. But we’ll continue to assess what that CapEx needs to be really based on a return model. But just to get to the math, we won’t be making up that difference over the next couple of years. I think we’re really thoughtful. And as we’ve said through this whole call, it’s just going to be long term. So we’re going to build back to that position of strength from a balance sheet perspective, but that’s going to also take some time because we need to make the right investments for growth for our business as well. And then, in terms of Amazon, I think Amazon is one of many, hopefully, you’ve heard today, initiatives that we’re looking to drive traffic with. So along with Sephora and even home décor, gifting, impulse, all things that will have customers coming in more to see the changes, it’s more impulse-driven. So, we’re really going to just continue to be focused on all of our initiatives to drive traffic, and Amazon is obviously one of those key items, Sephora being another one in terms of driving new customers and traffic into the store from a replenishment perspective, and then just really the whole store experience to drive more newness or exploration. So I think Amazon is just a key to that strategy in total.

Tom Kingsbury, CEO

Thanks for joining us today.

Operator, Operator

And this concludes today’s conference call. You may now disconnect.