By Damion Rallis, Senior Research AssociateWith the holiday shopping season in full swing we noticed a recent surge in insider sales and a sharp share price drop at department store operator Kohl’s Corporation (NYSE:KSS) and decided to take a deeper look. While the market was clearly reacting swiftly to the retailer’s disappointing earnings results, from our perspective Kohl’s ESG rating and Litigation Model score have been consistently low for some time now.
GMI Ratings’ Litigation Risk model has been flashing warning signs about Kohl’s for several ratings periods. Having been in High Risk territory since the summer of 2011, the company currently has a 4.6% probability of Class Action Litigation occurring within the next 12 months. This places them in the 7th percentile of all companies in North America, indicating higher shareholder class action litigation risk than 93% of all rated companies in this region.
Similarly, the company’s ESG rating has been in steady decline since November 2008 when our assessment of Kohl’s long-term sustainability risk was favourable. Due mainly to KeyMetrics™ red flags in the areas of board and pay, the company’s ESG percentile score has declined over 67% and its overall “C” rating is on the cusp of slipping further to a “D,” an indication of high risk.
Kohl’s most recent stock drop occurred last week when its share price closed on November 28 at $51.15 and then fell to $45.02 the very next day, a significant decline of about 12%. The drop coincided with the company’s poor sales results in which total sales decreased 4.9 per cent and comparable store sales decreased 5.6 per cent from the four-week month ended November 26, 2011. Year to date, total sales increased 0.4 per cent and comparable store sales decreased 1.1 per cent.
In addition, while the company said that the Mid-Atlantic and Northeast were the most challenging regions due to weak sales early in the month following Superstorm Sandy, this assertion was somewhat debunked by the fact that all regions reported negative sales for the month. While weak sales at Kohl’s mirror an overall monthly decline in the retail industry—16 retailers tracked by Thomson Reuters recorded a 1.6 per cent increase in same store sales; analysts expected a 3.3% increase—Kohl’s sales figures are noticeably worse. According to the New York Times, “The company seemed to be the victim of its own ‘showrooming,’ when consumers visit stores to see the merchandise but end up buying online.”
While at GMI Ratings we are not overly reactionary to short-term sales or periodic share price drops, we do feel that that the overall governance structure of a company can be a risk factor that limits its competitiveness in the long term . At Kohl’s several red flags colour the company’s long-term risk profile. First and foremost, there are several issues with the company’s board composition that run counter to what we consider an optimally-structured board. Six directors are long-tenured with over a decade of service, including four board members who have served for about 25 years. Long-tenured directors include Compensation Committee chair Frank V. Sica, five out of six members of the Executive Committee, CEO and Chairman Kevin Mansell, and Lead Director Steven A. Burd. While we recognise the benefits of experience, it becomes increasingly challenging to act independently with such extensive service. Long-tenured directors can often form relationships that may compromise their independence and therefore hinder their ability to provide effective oversight. Additionally, Mr. Sica serves on the board of Jetblue Airways Corporation with Director Peter Boneparth. Intra-board relationships of this kind can compromise directors’ ability to act individually and independently.
Also, Audit Committee chair Stephen Watson has been flagged for his service on the board of Eddie Bauer Holdings, Inc., which filed for Chapter 11 bankruptcy protection in June 2009. While this does not disqualify him for board service, it is interesting to note that Mr. Watson serves on the boards of two other companies that we cover—D-rated Regis Corporation and Chico’s FAS, which receives a “Very Aggressive” AGR® Rating, our lowest rating for short-term negative event risk. Another Audit Committee member, Stephanie Streeter is CEO at Libbey Inc. and is on the board of F-rated Goodyear Tire & Rubber Company. A third Audit Committee member is long-tenured John Herma. The committee as structured may not be up to the task given recent reports that the company was unable to implement and maintain effective internal control over financial reporting as required by Section 404 of Sarbanes-Oxley (SOX). This violation indicates increased risk to shareholders in the form of errors, potential restatements and lack of timeliness related to key financial information. Specifically, the company identified certain errors related to its accounting for leases in August 2011 so that its financial reporting, as of January 2011, was ineffective. Furthermore, as of January 2012, the company reported that it was still unable to implement and maintain effective internal control over financial reporting regarding the accounting for leases. These material weaknesses have led to several financial restatements.
Similarly, regarding the composition of the Compensation Committee, we note that the committee is not only chaired by long-tenured director Frank Sica but he is joined by Steven A. Burd, who notably is CEO at Safeway Inc., a company that is rated “D’ in pay and “Aggressive” in AGR, but also a company whose Say on Pay policies barely passed in 2012 with the approval of only 50.3% of shareholders. Kohl’s executive compensation practice.
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