KOHLS Corp (KSS)

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Executive Summary

Kohl's is a leading omnichannel retailer operating 1,175 stores and a website (www.Kohls.com) as of February 1, 2025. Our Kohl's stores and website sell moderately-priced private and national brand apparel, footwear, accessories, beauty, and home products. Our Kohl's stores generally carry a consistent merchandise assortment with some differences attributable to local preferences, store size, and Sephora shops. Our website includes merchandise which is available in our stores, as well as merchandise that is available only online.

Key financial results for 2024 as compared to 2023 include:

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Net sales decreased 7.2%, to $15.4 billion. 2023 net sales included approximately $164 million from the 53rd week.

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Comparable sales, which compares the 52-week period ending February 1, 2025 versus the 52-week period ended January 27, 2024, decreased 6.5%.

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Gross margin as a percent of net sales was 37.2%, an increase of 50 basis points.

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Selling, general & administration ("SG&A") expenses decreased 3.7%, to $5.3 billion. As a percentage of total revenue, SG&A expenses were 32.7%, an increase of 118 basis points year-over-year.

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Operating income was $433 million compared to $717 million in the prior year. As a percentage of total revenue, operating income was 2.7%, a decrease of 143 basis points year-over-year.

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Net income was $109 million, or $0.98 per diluted share. This compares to net income of $317 million, or $2.85 per diluted share in the prior year.

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On an adjusted non-GAAP basis, our adjusted net income was $167 million, or $1.50 per adjusted diluted share.(a)

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Operating cash flow was $648 million.

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Long-term debt was reduced by $113 million through the voluntary redemption of the remaining 9.50% notes due May 15, 2025.

(a)
Non-GAAP financial measures. Please see the “GAAP to Non-GAAP Reconciliation” for a reconciliation of net income to adjusted net income and diluted earnings per share to adjusted diluted earnings per share.

Our Strategy

Kohl's remains committed to driving long-term shareholder value by providing our customers with great product, great value, and a great experience. To achieve this, we will offer a curated balanced assortment, reestablish Kohl’s to be a leader in value and quality, and enhance our omnichannel platform to deliver a frictionless experience to customers.

Financial and Capital Outlook

For fiscal year 2025, the Company currently expects the following:

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Net sales: A decrease of (5%) to a decrease of (7%)

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Comparable sales: A decrease of (4%) to a decrease of (6%)

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Operating margin: In the range of 2.2% to 2.6%

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Diluted EPS: In the range of $0.10 to $0.60

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Capital Expenditures: In the range of $400 to $425 million

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Dividend: On March 11, 2025, Kohl’s Board of Directors declared a quarterly cash dividend on the Company’s common stock of $0.125 per share. The dividend is payable April 2, 2025 to shareholders of record at the close of business on March 21, 2025.

Results of Operations

For our comparison and discussion of 2023 and 2022, see Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations in Part II of our 2023 Form 10-K.

53rd Week

The retail calendar for fiscal January 2023 included a fifth week, resulting in a 14-week fiscal fourth quarter and a 53-week year. Our comparable sales in 2024 exclude the impact of the 53rd week in 2023 and compare the 52 weeks ended February 1, 2025 and January 27, 2024.

Net Sales

Net sales includes revenue from the sale of merchandise, net of expected returns and deferrals due to future performance obligations, and shipping revenue.

Comparable sales is a measure that highlights the performance of our stores and digital channel by measuring the change in sales for a period over the comparable, prior-year period of equivalent length. Comparable sales includes all store and digital sales, except sales from stores open less than 12 months, stores that have been closed, and stores that have been relocated where square footage has changed by more than 10%.

The following graph summarizes net sales dollars and the change in comparable sales over the prior year.

Digital sales decreased 9% in 2024. Digital penetration represented 28% of net sales in 2024 and 29% of net sales in 2023. We measure the change in digital sales by including all sales initiated online or through mobile applications, including omnichannel transactions which are fulfilled through our stores. We measure digital penetration as digital sales over net sales. These amounts do not take into consideration fulfillment node or digital returns processed in stores.

Comparable sales and digital penetration measures vary across the retail industry. As a result, our comparable sales calculation and digital penetration may not be consistent with the similarly titled measures reported by other companies.

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2024 compared to 2023

Net sales decreased $1.2 billion, or (7.2%), to $15.4 billion for 2024.

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The decrease was driven by an approximately 3% decrease in average transaction value as well as a decrease of approximately 4% in transaction volume.

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Sales decreased across all lines of business, except for Accessories. Accessories increased approximately 9% during 2024 driven by Sephora sales increasing over 25%. Sephora sales exceeded $1.8 billion in 2024.

Other Revenue

Other revenue includes revenue from credit card operations, third-party advertising on our website, unused gift cards and merchandise return cards (breakage), and other non-merchandise revenue.

The following graph summarizes other revenue:

Other revenue decreased $54 million in 2024 due to lower credit revenue, driven by a decrease in net sales, lower revolving credit balances, and an increase in loss rates.

As it relates to our credit business and recent regulatory developments, on March 5, 2024, the Consumer Financial Protection Bureau (CFPB) released a final rule reducing the safe harbor dollar amount for credit card late fees and eliminating the automatic annual inflation adjustment to such safe harbor dollar amount. The rule is subject to legal challenge, and the United States District Court for the Northern District of Texas granted a preliminary injunction, staying implementation of the rule, on May 10, 2024. As of February 1, 2025, this injunction remains in effect. The ultimate outcome of this legal challenge, along with the rule’s effectiveness and implementation under the new presidential administration, remains uncertain. If implemented, this rule could adversely impact Kohl’s credit card revenues; however, we are actively pursuing various mitigation strategies should the rule become effective.

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Cost of Merchandise Sold and Gross Margin

Cost of merchandise sold includes the total cost of products sold, including product development costs, net of vendor payments other than reimbursement of specific, incremental, and identifiable costs; inventory shrink; markdowns; freight expenses associated with moving merchandise from our vendors to our distribution centers; shipping expenses for digital sales; and terms cash discount. Our cost of merchandise sold may not be comparable with that of other retailers because we include distribution center and buying costs in selling, general, and administrative expenses while other retailers may include these expenses in cost of merchandise sold.

The following graph summarizes cost of merchandise sold and gross margin as a percent of net sales:

Gross margin is calculated as net sales less cost of merchandise sold. Gross margin in 2024 was 37.2% of net sales, an increase of 50 basis points to last year. The increase in gross margin was driven by lower freight costs and strong inventory management as our receipts were down 5% to last year as we continue to benefit from operating with greater flexibility. This was partially offset by elevated shrink levels.

Selling, General, and Administrative Expenses

SG&A includes compensation and benefit costs (including stores, corporate, buying, and distribution centers); occupancy and operating costs of our retail, distribution, and corporate facilities; freight expenses associated with moving merchandise from our distribution centers to our retail stores and among distribution and retail facilities other than expenses to fulfill digital sales; marketing expenses, offset by vendor payments for reimbursement of specific, incremental, and identifiable costs; expenses related to our credit card operations; and other administrative revenues and expenses. We do not include depreciation and amortization in SG&A. The classification of these expenses varies across the retail industry.

Many of our expenses, including store payroll and distribution costs, are variable in nature. These costs generally increase as sales increase, and decrease as sales decrease. We measure our expenses as a percentage of revenue and changes in this percentage compared to the prior year. If the expense as a percent of revenue decreased from the prior year, the expense "leveraged". If the expense as a percent of revenue increased over the prior year, the expense "deleveraged".

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The following graph summarizes the changes in SG&A by expense type between 2023 and 2024:

SG&A decreased $204 million, or 3.7%, to $5.3 billion in 2024. As a percentage of revenue, SG&A deleveraged by 118 basis points.

The decrease in SG&A expenses was driven by strong cost discipline across the organization. In addition, as sales declined, expenses were further reduced across stores and distribution centers. Distribution costs, which exclude payroll related to online originated orders that were shipped from our stores, were $378 million for 2024 compared to $406 million for 2023.

Other Expenses

Depreciation and amortization decreased in 2024, primarily driven by reduced capital spending in technology. This was partially offset by increased store investments, including Sephora shops and queuing lines.

We recognized $76 million in Impairments, store closing, and other costs related to the closure of our San Bernardino E-commerce Fulfillment Center and 27 underperforming stores in 2024. Included in this amount was $43 million of fixed asset impairments, $11 million of lease Right of Use (“ROU”) asset impairments, $14 million of severance, and $26 million in other costs relating to the closure of these locations. The $26 million in other costs includes $32 million of costs offset by $6 million in cash proceeds related to lease termination agreements. Offsetting these costs were $18 million in non-cash lease gains, where upon the remeasurement, the reduction recorded to the lease liability was greater than the remaining value of the related ROU asset.

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Net interest expense decreased in 2024 compared to 2023 due to reduced outstanding unsecured senior debt and a lower average outstanding balance on the revolving credit facility throughout the year. Decreases in interest expense were partially offset by a $5 million loss on extinguishment of debt recognized in connection with a voluntary redemption of the remaining $113 million of outstanding 9.50% notes due May 15, 2025 completed in June 2024.

Income Taxes

The effective tax rate for 2024 was lower than the effective tax rate for 2023 because of the impact of favorable results from uncertain tax positions and federal tax credits relative to consolidated book net income.

GAAP to Non-GAAP Reconciliation

In addition to reporting our financial results in accordance with generally accepted accounting principles (GAAP) for fiscal 2024, this Annual Report on Form 10-K contains certain non-GAAP financial results, including adjusted net income and adjusted diluted earnings per share. These adjusted results exclude the gains, impairments, and other costs associated with the closing of 27 underperforming stores and our San Bernardino, California E-commerce Fulfillment Center, as we believe such costs and charges are not representative of our normal business activity. We believe these non-GAAP measures are useful, as they are more representative of our core business, enhance comparability across reporting periods and to industry peers, and align with the measures used by management to evaluate the Company’s performance. The adjusted, non-GAAP results are provided and should be evaluated in addition to, and not as an alternative for, our results reported in accordance with GAAP. Shown below is a reconciliation of each non-GAAP measure referenced throughout this report to the most comparable GAAP measure. No adjustments were made to our results for fiscal years 2023 and 2022 and therefore these results are not included in the table below. Net income was $317 million, or $2.85 per diluted share, in 2023, and a net loss of $19 million, or ($0.15) per diluted share, in 2022.

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Inflation

We expect that our operations will continue to be influenced by general economic conditions, including food, fuel, and energy prices, higher unemployment, wage inflation, and costs to source our merchandise, including tariffs. There can be no assurances that such factors will not impact our business in the future.

Liquidity and Capital Resources

Capital Allocation

Our capital allocation strategy is to invest to maximize our overall long-term return and maintain a strong balance sheet. We follow a disciplined approach to capital allocation based on the following priorities: first we invest in our business to drive long-term profitable growth; second we pay a quarterly dividend; third we will complete debt reduction transactions, when appropriate; and fourth, when appropriate, we return excess cash to shareholders through our share repurchase program.

We will continue to invest in the business, as we plan to invest approximately $400 to $425 million in 2025, which includes the investments to complete the roll out of Sephora, expansion of impulse queuing lines, omnichannel enhancements, and two new store openings. On March 11, 2025, our Board of Directors declared a quarterly cash dividend of $0.125 per share. The dividend will be paid on April 2, 2025 to all shareholders of record at the close of business on March 21, 2025. Although we remain committed to returning capital to shareholders, this reduction in the quarterly dividend allows for greater balance sheet flexibility. In June 2024, we completed a voluntary redemption of the remaining $113 million of outstanding 9.50% notes due May 15, 2025. We did not complete any share repurchases during fiscal 2024.

Our period-end cash and cash equivalents balance decreased to $134 million from $183 million in 2023. Our cash and cash equivalents balance includes short-term investments of $9 million and $15 million as of February 1, 2025, and February 3, 2024, respectively. Our investment policy is designed to preserve principal and liquidity of our short-term investments. This policy allows investments in large money market funds or in highly rated direct short-term instruments. We also place dollar limits on our investments in individual funds or instruments.

The following table presents our primary uses and sources of cash:

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The following table includes cash balances and changes:

(a)
Non-GAAP financial measure. Please see the “Adjusted Free Cash Flow (Non-GAAP measure)” for a reconciliation of net cash provided by operating activities to adjusted free cash flow.

Operating Activities

Our operating cash outflows generally consist of payments to our employees for wages, salaries and other employee benefits, payments to our merchandise vendors for inventory (net of vendor allowances), payments to our shipping carriers, and payments to our landlords for rent. Operating cash outflows also include payments for income taxes and interest payments on our debt borrowings.

Operating activities generated cash of $648 million in 2024 compared to $1.2 billion in 2023. Operating cash flow decreased due to a lower net income and inventory increasing 2% to last year as we invested into private brand inventory. Receipts decreased 5% in 2024 compared to a decrease of 9% in 2023 due to the private brand investment.

Investing Activities

Our investing cash outflows include payments for capital expenditures, including investments in new and existing stores, improvements to supply chain, and technology costs. Our investing cash inflows are generally from proceeds from sales of property and real estate.

Net cash used in investing activities decreased $95 million to $467 million in 2024. The decrease was primarily driven by fewer Sephora shop openings and other investments, consistent with our reduced capital expenditure plans for fiscal 2024.

The following chart summarizes capital expenditures by major category:

At the end of 2024, we had a Sephora presence in over 1,000 of our stores, including 861 full size 2,500 square foot shops and 190 small format Sephora shops. We also had 350 locations with impulse queuing lines, launched 200 Babies "R" Us shops, and had six new store openings, including one relocation. In 2025, we anticipate capital expenditures of approximately $400 to $425 million, which includes the investments to complete the roll out of

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Sephora, expansion of impulse queuing lines, omnichannel enhancements, and two new store openings. We will continue to invest in enhancing our omnichannel capabilities.

Financing Activities

Our financing strategy is to ensure adequate liquidity and access to capital markets. We also strive to maintain a balanced portfolio of debt maturities, while minimizing our borrowing costs. Our ability to access the public debt market has provided us with adequate sources of liquidity. Our continued access to these markets depends on multiple factors, including the condition of debt capital markets, our operating performance, and our credit ratings.

During 2024, S&P downgraded our senior unsecured credit rating from BB to BB-, Moody's downgraded our rating from Ba3 to B1, and Fitch downgraded our rating from BBB- to BB. Fitch revised their outlook to stable while S&P and Moody's reaffirmed their outlook at negative.

As of February 1, 2025, our credit ratings and outlook were as follows:

As a result of the downgrades, the interest rate on our 3.375% notes due May 2031 will increase an additional 50 basis points in May 2025 due to the coupon adjustment provision within the note. Our credit rating was also downgraded in 2023 and 2022. This resulted in the interest rates on our 3.375% notes due May 2031 and 9.50% notes due May 2025 increasing 100 basis points in 2023 and 25 basis points in 2022. In total, the interest rates on the notes due May 2031 have increased 175 basis points since their issuance, of which 50 basis points becomes effective in May 2025, and the rates on the notes due May 2025 increased 125 basis points from their issuance to their redemption in June 2024. Each of the credit rating agencies reviews its rating periodically and there is no guarantee our current credit ratings will remain the same.

The majority of our financing activities generally include proceeds and/or repayments of borrowings under our revolving credit facility and long-term debt, dividend payments, and repurchases of common stock. Financing cash outflows also include payments to our landlords for leases classified as financing leases and financing obligations.

Financing activities used $230 million in 2024 compared to $576 million in 2023.

In 2024, we had net borrowings of $198 million on our $1.5 billion credit facility compared to net borrowings of $7 million in 2023. Borrowings under the revolving credit facility, recorded as short-term debt, had $290 million outstanding as of February 1, 2025, and had $92 million as of February 3, 2024.

In the second quarter of 2024, we completed a voluntary redemption of the remaining $113 million of outstanding 9.50% notes due May 15, 2025. In February 2023, $164 million in aggregate principal amount of our 3.25% notes matured and was repaid, and in December 2023, $111 million in aggregate principal amount of our 4.75% notes matured and was repaid.

There was no cash used for treasury stock purchases in 2024 or 2023. Share repurchases are discretionary in nature. The timing and amount of repurchases are based upon available cash balances, our stock price, and other factors. While we are not currently planning for share repurchases, we expect to resume share repurchases over the long-term following improvement in overall leverage.

Cash dividend payments were $222 million ($2.00 per share) in 2024 and $220 million ($2.00 per share) in 2023.

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Adjusted Free Cash Flow (Non-GAAP measure)

We generated $104 million of adjusted free cash flow for 2024 compared to $519 million in 2023. The decrease was primarily driven by less cash provided by operating activities due to a lower net income and inventory increasing 2% to last year as we invested into private brand inventory. Receipts decreased 5% in 2024 compared to a decrease of 9% in 2023 due to the private brand investment. Partially offsetting this was a decrease in capital expenditures related to fewer Sephora shop openings and other investments.

In addition to net cash provided by operating activities, we provide Adjusted Free Cash Flow as a useful measure of our financial performance and position and our ability to generate additional cash flow from our business operations. We believe the presentation of Adjusted Free Cash Flow is relevant and useful for investors to evaluate the cash generated from operations consistent with the method used by management. Adjusted free cash flow is a non-GAAP financial measure which we define as net cash provided by operating activities and proceeds from financing obligations (which generally represent landlord reimbursements of construction costs) less capital expenditures and finance lease and financing obligation payments. Adjusted free cash flow is provided and should be evaluated in addition to, and not as an alternative to our other financial GAAP measures such as net cash provided by operating activities or net income.

The following table reconciles net cash provided by operating activities (a GAAP measure) to adjusted free cash flow (a non-GAAP measure):

Key Financial Ratios

Key financial ratios that provide certain measures of our liquidity are as follows:

Our working capital and inventory levels typically build throughout the fall, peaking during the November and December holiday selling season.

The decrease in our working capital and current ratio are driven by increased borrowings under the revolving credit facility and additional long-term debt due within the next year.

Debt Covenant Compliance

Our senior secured, asset based revolving credit facility contains customary events of default and financial, affirmative and negative covenants, including but not limited to, a springing financial covenant relating to our fixed charge coverage ratio and restrictions on indebtedness, liens, investments, asset dispositions, and restricted payments. As of February 1, 2025, we were in compliance with all covenants.

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Contractual Obligations

Material contractual obligations arising in the normal course of business primarily consist of long-term debt and related interest payments, principal and interest payments for leases, and other purchase obligations. See Notes 2 and 3 to the Consolidated Financial Statements for amounts outstanding on February 1, 2025 related to debt and leases.

Other purchase obligations primarily include royalties, legally binding minimum lease and interest payments for stores opening in 2025 or later, as well as payments associated with technology, marketing, and donation agreements. The obligations were $599 million as of February 1, 2025.

Off-Balance Sheet Arrangements

We have not provided any financial guarantees as of year-end fiscal 2024.

We have not created, and are not party to, any special-purpose or off-balance sheet entities for the purpose of raising capital, incurring debt, or operating our business. We do not have any arrangements or relationships with entities that are not consolidated into the financial statements that are reasonably likely to materially affect our financial condition, liquidity, results of operations, or capital resources.

Critical Accounting Policies and Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires us to make estimates and assumptions that affect reported amounts. Management has discussed the development, selection, and disclosure of these estimates and assumptions with the Audit Committee of our Board of Directors.

Retail Inventory Method and Inventory Valuation

The majority of our merchandise inventories are valued at the lower of cost or market using the retail inventory method (“RIM”). Under RIM, the valuation of inventory at cost and the resulting gross margins are calculated by applying a cost-to-retail ratio to the retail value of inventory. RIM is an averaging method that has been widely used in the retail industry due to its practicality. The use of RIM will result in inventory being valued at the lower of cost or market since permanent markdowns are taken as a reduction of the retail value of inventories. A reserve is recorded if the future estimated selling price is less than cost.

RIM inherently requires management judgment and estimates, such as the amount and timing of permanent markdowns to clear unproductive or slow-moving inventory, which may impact the ending inventory valuation as well as gross margin. Factors considered in the determination of permanent markdowns include current and anticipated demand, customer preferences, age of the merchandise, fashion trends, and weather conditions.

Inventory shrinkage is estimated as a percent of sales for the period between the last physical inventory count and the balance sheet date. Shrink is the difference between the recorded amount of inventory and the physical inventory. We perform an annual physical inventory count at the majority of our stores, E-Commerce fulfillment centers, and distribution centers. The shrinkage rate from the most recent physical inventory, in combination with current events and historical experience, is used as the standard for the shrinkage accrual rate for the next inventory cycle. Historically, our actual physical inventory count results have shown our estimates to be reliable.

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Vendor Allowances

We frequently receive allowances from our vendors for markdowns that we have taken in order to sell the vendors' merchandise and/or to support gross margins earned on those sales. This markdown support generally relates to sold inventory or permanent markdowns and, accordingly, is reflected as a reduction to cost of merchandise sold. Markdown support related to merchandise that has not yet been sold is recorded in inventory.

We also receive support from vendors for marketing and other costs that we have incurred to sell the vendors’ merchandise. To the extent the reimbursements are for specific, incremental, and identifiable costs incurred to sell the vendor's products and do not exceed the costs incurred, they are recognized as a reduction of Selling, General, and Administrative Expenses. If these criteria are not met, the support is recorded in inventory and reflected as a reduction of costs of merchandise sold when the related merchandise is sold.

Insurance Reserve Estimates

We are primarily self-insured for costs related to workers’ compensation, general liability, and employee-related health care benefits. We use a third-party actuary to estimate the liabilities associated with these risks. The actuary considers historical claims experience, demographic and severity factors, health care trends, and actuarial assumptions to estimate the liabilities associated with these risks. Historically, our actuarial estimates have not been materially different from actual results.

Impairment of Long-Lived Assets

We review our long-lived assets for impairment when events or changes in circumstances, such as decisions to close a store or significant cash flow losses, indicate the carrying value of the asset may not be recoverable. All long-lived assets are reviewed for impairment at least annually.

If our evaluations, which are performed on an undiscounted cash flow basis, indicate that the carrying amount of the asset may not be recoverable, the potential impairment is measured as the excess of carrying value over the fair value of the impaired asset.

Identifying impaired assets and quantifying the related impairment loss, if any, requires significant estimates by management. The most significant of these estimates is the cash flow expected to result from the use and eventual disposition of the asset. When determining the stream of projected future cash flows associated with an individual store, management estimates future store performance including sales, gross margin, and controllable expenses, such as store payroll and occupancy expense. Projected cash flows must be estimated for future periods throughout the remaining life of the property, which may be as many as 40 years in the future. The accuracy of these estimates will be impacted by a number of factors including general economic conditions, changes in competitive landscape, and our ability to effectively manage the operations of the store.

Income Taxes

We regularly evaluate the likelihood of realizing the benefit for income tax positions we have taken in various federal and state filings by considering all relevant facts, circumstances, and information available to us. If we believe it is more likely than not that our position will be sustained, we recognize a benefit at the largest amount which we believe is cumulatively greater than 50% likely to be realized.

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Unrecognized tax benefits require significant management judgment regarding applicable statutes and their related interpretation, the status of various income tax audits, and our particular facts and circumstances. Also, as audits are completed or statutes of limitations lapse, it may be necessary to record adjustments to our taxes payable, deferred tax assets, tax reserves, or income tax expense. Although we believe we have adequately reserved for our uncertain tax positions, no assurance can be given that the final tax outcome of these matters will not be different. Income taxes are further described in Note 5 of the Consolidated Financial Statements.

Leases

Accounting for leased properties requires compliance with technical accounting rules and judgment by management. Application of these accounting rules and assumptions made by management will determine if the lease is accounted for as a finance lease, an operating lease, or a financing obligation.

The following are estimates used by management in accounting for real estate and other leases:

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Accounting lease term—Our accounting lease term includes all noncancelable periods and renewal periods that are reasonably assured of being exercised. Typically, renewal options are considered reasonably assured of being exercised if we have made significant leasehold improvements that would exceed the initial or renewal lease term and the cash flow performance of the store remains strong. The expected lease term is used in determining whether the lease is accounted for as an operating lease or a finance lease.

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Incremental borrowing rate—The incremental borrowing rate is the rate of interest that the lessee would have to pay to borrow on a collateralized basis over a similar term for an amount equal to the lease payments in a similar economic environment. The incremental borrowing rate is used in determining whether the lease is accounted for as an operating lease or a finance lease.

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Fair market value of leased asset—The fair market value of leased retail property is generally estimated based on comparable market data as provided by third-party appraisers or consideration received from the landlord. Fair market value is used in determining whether the lease is accounted for as an operating lease or a finance lease.

Leases are further described in Note 3 of the Consolidated Financial Statements.

Sephora Arrangement

In 2020, we entered into an arrangement with Sephora to be the exclusive beauty offering at Kohl's and bring a transformational, elevated beauty experience to Kohl’s. We sell prestige beauty products through Sephora-branded retail shops in certain Kohl’s stores and through a Sephora-branded offering on Kohls.com. We have opened 861 full size 2,500 square foot Sephora shops and 190 small format Sephora shops to date.

Both parties to the arrangement are active participants and are exposed to significant risks and rewards dependent on the success of the activities of the arrangement. The arrangement involves various activities including the merchandising, marketing, and operations of the shops and Kohls.com. Kohl’s is the principal on sales transactions with our customers and we recognize sales, cost of merchandise sold, and operating expenses in the respective lines on our consolidated statements of operations. Kohl’s owns and manages the inventory and funds capital expenditures for the arrangement. The parties share equally in the operating profit of the arrangement which incorporates all expenses to run the arrangement including depreciation expense related to the assets. Amounts due to Sephora for their share of the operating profits are recorded in cost of merchandise sold.

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Executive Summary

Kohl's is a leading omnichannel retailer operating 1,174 stores and a website (www.Kohls.com) as of February 3, 2024. Our Kohl's stores and website sell moderately-priced private and national brand apparel, footwear, accessories, beauty, and home products. Our Kohl's stores generally carry a consistent merchandise assortment with some differences attributable to local preferences, store size, and Sephora shops. Our website includes merchandise which is available in our stores, as well as merchandise that is available only online.

Key financial results for 2023 as compared to 2022 include:

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Net sales decreased 3.4%, to $16.6 billion. 2023 net sales included approximately $164 million from the 53rd week.

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Comparable sales, which compares the 52-week period ending January 27, 2024 versus the 52-week period ended January 28, 2023, decreased 4.7%.

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Gross margin as a percent of net sales was 36.7%, an increase of 347 basis points.

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Selling, general & administration ("SG&A") expenses decreased 1.3%, to $5.5 billion. As a percentage of total revenue, SG&A expense was 31.5%, an increase of 67 basis points.

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Operating income was $717 million compared to $246 million in the prior year. As a percentage of total revenue, operating income was 4.1%, an increase of 274 basis points.

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Net income of $317 million, or $2.85 per diluted share. This compares to net loss of $19 million, or ($0.15) per diluted share, in the prior year.

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Inventory was $2.9 billion, a decrease of 10% to last year, driven by managing receipts down 9% versus last year.

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Operating cash flow was $1.2 billion.

Our Strategy

Kohl's strategy is focused on delivering long-term shareholder value. To achieve this, the Company has established four overarching priorities to drive improved sales and profitability. These priorities include enhancing the customer experience, accelerating and simplifying its value strategies, managing inventory and expenses with discipline, and strengthening the balance sheet.

Financial and Capital Outlook

For fiscal year 2024, the Company currently expects the following:

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Net sales: A decrease of (1%) to an increase of 1%

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Comparable sales: In the range of 0% to 2%

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Operating margin: In the range of 3.6% to 4.1%

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Diluted EPS: In the range of $2.10 to $2.70, excluding any non-recurring charges.

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Capital Expenditures: Approximately $500 million, including expansion of Sephora arrangement and other store-related investments

The Company’s guidance includes the potential impact from credit card late fee regulatory changes in the second half of 2024.

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Results of Operations

For our comparison and discussion of 2022 and 2021, see Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations in Part II of our 2022 Form 10-K.

53rd Week

The retail calendar for fiscal January 2023 included a fifth week, resulting in a 14-week fiscal fourth quarter and a 53-week year. Our comparable sales in 2023 exclude the impact of the 53rd week and compare the 52 weeks ended January 27, 2024 to the 52 weeks ended January 28, 2023.

Net Sales

Net sales includes revenue from the sale of merchandise, net of expected returns and deferrals due to future performance obligations, and shipping revenue.

Comparable sales is a measure that highlights the performance of our stores and digital channel by measuring the change in sales for a period over the comparable, prior-year period of equivalent length. Comparable sales includes all store and digital sales, except sales from stores open less than 12 months, stores that have been closed, and stores that have been relocated where square footage has changed by more than 10%. We measure the change in digital sales by including all sales initiated online or through mobile applications, including omnichannel transactions which are fulfilled through our stores.

We measure digital penetration as digital sales over net sales. These amounts do not take into consideration fulfillment node, digital returns processed in stores, and coupon behaviors.

Comparable sales and digital penetration measures vary across the retail industry. As a result, our comparable sales calculation and digital penetration may not be consistent with the similarly titled measures reported by other companies.

The following graph summarizes net sales dollars and the change in comparable sales over the prior year. As our stores were closed for a period during 2020, we have not included a measure of 2021 comparable sales as we do not believe it is a meaningful metric over this period of time.

2023 compared to 2022

Net sales decreased $575 million, or (3.4%), to $16.6 billion for 2023.

•
The decrease was driven by transaction volume down approximately 4% partially offset by an approximately 1% increase in average transaction value.

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•
The sales decrease was seen across all lines of business except for Accessories, as they underperformed the Company average. Partially offsetting this decrease was a 23% increase in Accessories driven by over a 90% increase in Sephora compared to the prior year. Sephora sales exceeded $1.4 billion in 2023.

•
Digital sales decreased 14% for the year as sales were impacted by the elimination of online-only promotions as we worked to simplify our value strategies. Digital penetration represented 29% of net sales in 2023.

Other Revenue

Other revenue includes revenue from credit card operations, third-party advertising on our website, unused gift cards and merchandise return cards (breakage), and other non-merchandise revenue.

The following graph summarizes other revenue:

Other revenue decreased $47 million in 2023 driven by a decline in credit revenue due to increasing credit loss rates.

In addition, as it relates to our credit business and recent regulatory developments, the CFPB has finalized a rule that will lower the late fees credit card companies can charge. The final rule will have a negative impact on our credit card revenues if unmitigated. We are actively pursuing various initiatives to mitigate the effects of this ruling including scaling our recently launched co-brand card and other various initiatives with Capital One, our credit partner. We are closely monitoring developments on this ruling, specifically as it relates to the timing of implementation.

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Cost of Merchandise Sold and Gross Margin

Cost of merchandise sold includes the total cost of products sold, including product development costs, net of vendor payments other than reimbursement of specific, incremental, and identifiable costs; inventory shrink; markdowns; freight expenses associated with moving merchandise from our vendors to our distribution centers; shipping expenses for digital sales; and terms cash discount. Our cost of merchandise sold may not be comparable with that of other retailers because we include distribution center and buying costs in selling, general, and administrative expenses while other retailers may include these expenses in cost of merchandise sold.

The following graph summarizes cost of merchandise sold and gross margin as a percent of net sales:

Gross margin is calculated as net sales less cost of merchandise sold. Gross margin as a percent of net sales increased 347 basis points in 2023 compared to 2022. The increase in gross margin was driven by lower clearance markdowns, lower freight costs, reduced digital-related cost of shipping, and the simplification of our value strategies.

We expect gross margin to expand 40 to 50 basis points in 2024, driven by strong inventory management, lower freight expense, and continued benefits from the simplification of our value strategies.

Selling, General, and Administrative Expenses

SG&A includes compensation and benefit costs (including stores, corporate, buying, and distribution centers); occupancy and operating costs of our retail, distribution, and corporate facilities; freight expenses associated with moving merchandise from our distribution centers to our retail stores and among distribution and retail facilities other than expenses to fulfill digital sales; marketing expenses, offset by vendor payments for reimbursement of specific, incremental, and identifiable costs; expenses related to our credit card operations; and other administrative revenues and expenses. We do not include depreciation and amortization in SG&A. The classification of these expenses varies across the retail industry.

Many of our expenses, including store payroll and distribution costs, are variable in nature. These costs generally increase as sales increase, and decrease as sales decrease. We measure our expenses as a percentage of revenue and changes in this percentage compared to the prior year. If the expense as a percent of revenue decreased from the prior year, the expense "leveraged". If the expense as a percent of revenue increased over the prior year, the expense "deleveraged".

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The following graph summarizes the changes in SG&A by expense type between 2022 and 2023:

SG&A decreased $75 million, or 1.3%, to $5.5 billion in 2023. As a percentage of revenue, SG&A deleveraged by (67) basis points.

The decrease was primarily driven by decreased marketing investments across all channels and decreased distribution costs due to lower receipts and increased productivity. Distribution costs, which exclude payroll related to online originated orders that were shipped from our stores, were $406 million for 2023 compared to $457 million for 2022. Partially offsetting the decreases were increased store costs. Store expenses were driven by increased wages, continued investments in Sephora openings, and other store-related expenses.

In 2024, SG&A dollars are expected to be flat to slightly down with wage inflation being offset by labor productivity improvements and marketing efficiency.

Other Expenses

Depreciation and amortization decreased in 2023, primarily driven by reduced capital spending in technology.

Net interest expense increased in 2023 compared to 2022 due to borrowings under the revolving credit facility as well as Sephora related lease amendments.

In 2021, we completed a cash tender offer and recognized a loss of $201 million from the extinguishment of debt.

Income Taxes

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Fiscal year 2023 resulted in an income tax provision compared to an income tax benefit in fiscal year 2022 due to the pre-tax book income in fiscal year 2023 compared to the pre-tax book loss in 2022.

GAAP to Non-GAAP Reconciliation

(1) Amounts shown for 2023 and 2022 are GAAP as there are no adjustments to Non-GAAP. These amounts are shown for comparability purposes.

We believe the adjusted results in the GAAP to Non-GAAP table are useful because they provide enhanced visibility into our results for the periods excluding the impact of certain items such as those included in the table. However, these non-GAAP financial measures are not intended to replace the comparable GAAP measures.

Inflation

We expect that our operations will continue to be influenced by general economic conditions, including food, fuel, and energy prices, higher unemployment, wage inflation, and costs to source our merchandise, including tariffs. There can be no assurances that such factors will not impact our business in the future.

Liquidity and Capital Resources

Capital Allocation

Our capital allocation strategy is to invest to maximize our overall long-term return and maintain a strong balance sheet, with a long-term objective of achieving an investment grade rating. We follow a disciplined approach to capital allocation based on the following priorities: first we invest in our business to drive long-term profitable growth; second we pay a quarterly dividend; third we will complete debt reduction transactions, when appropriate; and fourth we return excess cash to shareholders through our share repurchase program.

We will continue to invest in the business, as we plan to invest approximately $500 million in 2024, including the expansion of Sephora shops, the launch of Babies "R" Us, and the expansion of queuing lines to 350 stores. We remain committed to the dividend, and on February 28, 2024, our Board of Directors declared a quarterly cash dividend of $0.50 per share. The dividend will be paid on April 3, 2024 to all shareholders of record at the close of business on March 20, 2024. Last, we retired $164 million of notes due in February 2023 and $111 million of notes due December 2023. We are not planning any share repurchases until our balance sheet is strengthened on a path towards the long term target leverage ratio of 2.5 times adjusted earnings before interest, taxes, depreciation, amortization, and rent ("EBITDAR") (utilizing an eight times cash rent calculation for lease obligations) as calculated in our capital structure ratio below.

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Our period-end cash and cash equivalents balance increased to $183 million from $153 million in 2022. Our cash and cash equivalents balance includes short-term investments of $15 million and $10 million as of February 3, 2024, and January 28, 2023, respectively. Our investment policy is designed to preserve principal and liquidity of our short-term investments. This policy allows investments in large money market funds or in highly rated direct short-term instruments. We also place dollar limits on our investments in individual funds or instruments.

The following table presents our primary uses and sources of cash:

The following table includes cash balances and changes:

(a)
Non-GAAP financial measure. Please see the “GAAP to Non-GAAP Reconciliation” for a reconciliation of adjusted free cash flow to net cash provided by operating activities.

Operating Activities

Our operating cash outflows generally consist of payments to our employees for wages, salaries and other employee benefits, payments to our merchandise vendors for inventory (net of vendor allowances), payments to our shipping carriers, and payments to our landlords for rent. Operating cash outflows also include payments for income taxes and interest payments on our debt borrowings.

Operating activities generated cash of $1.2 billion in 2023 compared to $282 million in 2022. Operating cash flow increased primarily due to higher net income and strong inventory management in 2023. Inventory management resulted in managing receipts, down 9% versus last year. We placed a lower percentage of our overall receipts in the early part of the buying cycle to allow for additional flexibility to chase receipts based on trending sales, establish a better flow of goods to our stores and maintain better in-stock positions, with the goal of minimizing the risk of future markdowns and out-of-stock positions.

Investing Activities

Our investing cash outflows include payments for capital expenditures, including investments in new and existing stores, improvements to supply chain, and technology costs. Our investing cash inflows are generally from proceeds from sales of property and equipment.

Net cash used in investing activities decreased $221 million to $562 million in 2023. The decrease was primarily driven by fewer rollouts of Sephora shop build-outs and store refreshes undertaken in 2023, consistent with our capital expenditure plans for fiscal 2023.

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The following chart summarizes capital expenditures by major category:

In 2023, we opened 254 full size Sephora shops and 45 small format shops. We now have a Sephora presence in over 900 of our stores, including 860 full size 2,500 square foot Sephora shops and 50 small format Sephora shops. In 2024, we are planning to open approximately 140 small format Sephora shops, and plan on opening the remaining Sephora shops in 2025 which will bring a Sephora presence to the entire Kohl's chain. In 2024, we anticipate capital expenditures of approximately $500 million, including the expansion of Sephora shops, the launch of Babies "R" Us, and the expansion of queuing lines to 350 stores. We will continue to invest in enhancing our omnichannel capabilities.

Financing Activities

Our financing strategy is to ensure adequate liquidity and access to capital markets. We also strive to maintain a balanced portfolio of debt maturities, while minimizing our borrowing costs. Our ability to access the public debt market has provided us with adequate sources of liquidity. Our continued access to these markets depends on multiple factors, including the condition of debt capital markets, our operating performance, and maintaining strong credit ratings.

During the first quarter of 2023, S&P downgraded our senior unsecured credit rating from BB+ to BB and Moody's downgraded our rating from Ba2 to Ba3 while both also revised their outlook to negative. While Fitch reaffirmed our credit rating, they also revised their outlook to negative.

As of February 3, 2024, our credit ratings and outlook were as follows:

As a result of the downgrades, the interest rate on our 3.375% notes due May 2031 and 9.50% notes due May 2025 increased 50 basis points in May 2023 due to the coupon adjustment provisions within these notes. In 2022, our credit rating was also downgraded which resulted in the interest rates increasing 75 basis points, of which 25 basis points was effective in 2022 and the remaining 50 basis points became effective in May 2023. In total, the interest rate of both these notes have increased 125 basis points since their issuance. If our credit ratings are lowered further, our ability to access the public debt markets, our cost of funds, and other terms for new debt issuances could be adversely impacted. Each of the credit rating agencies reviews its rating periodically and there is no guarantee our current credit ratings will remain the same.

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The majority of our financing activities generally include proceeds and/or repayments of long-term debt, dividend payments, and in 2022 and 2021 repurchases of common stock. Financing cash outflows also include payments to our landlords for leases classified as financing leases and financing obligations.

Financing activities used $576 million in 2023 compared to $933 million in 2022. The decrease is driven by no treasury stock purchases occurring in 2023 partially offset by repayment of long-term borrowings.

In January 2023, we entered into a Credit Agreement with various lenders which provides for a $1.5 billion senior secured, asset based revolving credit facility that will mature in January 2028 and replaced our existing senior unsecured revolving credit facility. The revolver is secured by substantially all of our assets other than real estate, and contains customary events of default and financial, affirmative, and negative covenants, including but not limited to, a springing financial covenant related to our fixed charge coverage ratio and restrictions on indebtedness, liens, investments, asset dispositions, and restricted payments. Outstanding borrowings under the credit facility bear interest at a variable rate based on SOFR plus the applicable margin. Borrowings under the revolving credit facility, recorded as short-term debt, had $92 million outstanding as of February 3, 2024, and had $85 million as of January 28, 2023.

In February 2023, $164 million in aggregate principal amount of our 3.25% notes matured and were repaid, and in December 2023, $111 million in aggregate principal amount of our 4.75% notes matured and were repaid.

There was no cash used for treasury stock purchases in 2023 compared to $658 million used in 2022. Share repurchases are discretionary in nature. The timing and amount of repurchases are based upon available cash balances, our stock price, and other factors. As previously noted, we are not planning any share repurchases until our balance sheet is strengthened on a path towards the long term target leverage ratio of 2.5 times adjusted EBITDAR (utilizing an eight times cash rent calculation for lease obligations).

Cash dividend payments were $220 million ($2.00 per share) in 2023 and $239 million ($2.00 per share) in 2022.

Adjusted Free Cash Flow

We generated $519 million of adjusted free cash flow for 2023 compared to a negative adjusted free cash flow of $639 million in 2022. The increase is primarily driven by more cash provided by operating activities due to a higher net income and a reduction in inventory purchases of 9%, and a decrease in capital expenditures related to less Sephora shop build-outs and store refreshes in 2023. Adjusted free cash flow is a non-GAAP financial measure which we define as net cash provided by operating activities and proceeds from financing obligations (which generally represent landlord reimbursements of construction costs) less capital expenditures and finance lease and financing obligation payments. Adjusted free cash flow should be evaluated in addition to, and not considered a substitute for, other financial measures such as net income and net cash provided by operating activities. We believe that adjusted free cash flow represents our ability to generate additional cash flow from our business operations.

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The following table reconciles net cash provided by operating activities (a GAAP measure) to adjusted free cash flow (a non-GAAP measure):

Key Financial Ratios

Key financial ratios that provide certain measures of our liquidity are as follows:

Our working capital and inventory levels typically build throughout the fall, peaking during the November and December holiday selling season.

The increase in our working capital and current ratio are primarily due to a reduction in our short-term debt as we repaid $275 million in short-term notes that matured as well as a reduction in accounts payable offset by a decrease in inventory due to strong inventory management.

Capital Structure Ratio

The following table shows our capital structure ratio (non-GAAP financial measure):

Adjusted debt to EBITDAR is a non-GAAP financial measure which we define as our adjusted outstanding debt balance divided by EBITDAR. The decrease in our adjusted debt to EBITDAR ratio is driven by higher operating income as well as repayment of long-term debt. We provide our adjusted debt to EBITDAR ratio to our ratings agencies and our current goal is to achieve a ratio of 2.5 which demonstrates our commitment to an investment grade rating and allows us to operate with an efficient capital structure for our size, growth plans, and industry. Adjusted debt to EBITDAR is a liquidity measure and not a measure of financial performance under GAAP and should be considered in addition to, and not as a substitute for debt or other GAAP financial measures of liquidity. Our adjusted debt to EBITDAR calculation may not be comparable to similarly-titled measures reported by other companies.

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The following table includes our adjusted debt to EBITDAR calculation:

(a)
Lease obligations presented under US GAAP are replaced with eight times cash rent for operating leases, finance leases, and financial obligations. A summary of cash rent can be found in Note 3 of the Consolidated Financial Statements. Management believes this normalizes for timing within the lease term and the impact of lease amendments triggered by our investment in the Sephora shops.

(b)
The EBITDAR component of the adjusted debt to EBITDAR ratio excludes costs (i.e., rent) that are essential to the operation of our leased stores.

Debt Covenant Compliance

Our senior secured, asset based revolving credit facility contains customary events of default and financial, affirmative and negative covenants, including but not limited to, a springing financial covenant relating to our fixed charge coverage ratio and restrictions on indebtedness, liens, investments, asset dispositions, and restricted payments. As of February 3, 2024, we were in compliance with all covenants.

Contractual Obligations

Material contractual obligations arising in the normal course of business primarily consist of long-term debt and related interest payments, principal and interest payments for leases, and other purchase obligations. See Notes 2 and 3 to the Consolidated Financial Statements for amounts outstanding on February 3, 2024 related to debt and leases.

Other purchase obligations primarily include royalties, legally binding minimum lease and interest payments for stores opening in 2024 or later, as well as payments associated with technology, marketing, and donation agreements. The obligations were $540 million as of February 3, 2024.

Off-Balance Sheet Arrangements

We have not provided any financial guarantees as of year-end fiscal 2023.

We have not created, and are not party to, any special-purpose or off-balance sheet entities for the purpose of raising capital, incurring debt, or operating our business. We do not have any arrangements or relationships with entities that are not consolidated into the financial statements that are reasonably likely to materially affect our financial condition, liquidity, results of operations, or capital resources.

Critical Accounting Policies and Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires us to make estimates and assumptions that affect reported amounts. Management has discussed the development, selection, and disclosure of these estimates and assumptions with the Audit Committee of our Board of Directors.

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Retail Inventory Method and Inventory Valuation

The majority of our merchandise inventories are valued at the lower of cost or market using the retail inventory method (“RIM”). Under RIM, the valuation of inventory at cost and the resulting gross margins are calculated by applying a cost-to-retail ratio to the retail value of inventory. RIM is an averaging method that has been widely used in the retail industry due to its practicality. The use of RIM will result in inventory being valued at the lower of cost or market since permanent markdowns are taken as a reduction of the retail value of inventories. A reserve is recorded if the future estimated selling price is less than cost.

RIM inherently requires management judgment and estimates, such as the amount and timing of permanent markdowns to clear unproductive or slow-moving inventory, which may impact the ending inventory valuation as well as gross margin. Factors considered in the determination of permanent markdowns include current and anticipated demand, customer preferences, age of the merchandise, fashion trends, and weather conditions.

Inventory shrinkage is estimated as a percent of sales for the period between the last physical inventory count and the balance sheet date. Shrink is the difference between the recorded amount of inventory and the physical inventory. We perform an annual physical inventory count at the majority of our stores, E-Commerce fulfillment centers, and distribution centers. The shrinkage rate from the most recent physical inventory, in combination with current events and historical experience, is used as the standard for the shrinkage accrual rate for the next inventory cycle. Historically, our actual physical inventory count results have shown our estimates to be reliable.

Vendor Allowances

We frequently receive allowances from our vendors for markdowns that we have taken in order to sell the vendors' merchandise and/or to support gross margins earned on those sales. This markdown support generally relates to sold inventory or permanent markdowns and, accordingly, is reflected as a reduction to cost of merchandise sold. Markdown support related to merchandise that has not yet been sold is recorded in inventory.

We also receive support from vendors for marketing and other costs that we have incurred to sell the vendors’ merchandise. To the extent the reimbursements are for specific, incremental, and identifiable costs incurred to sell the vendor's products and do not exceed the costs incurred, they are recognized as a reduction of Selling, General, and Administrative Expenses. If these criteria are not met, the support is recorded in inventory and reflected as a reduction of costs of merchandise sold when the related merchandise is sold.

Insurance Reserve Estimates

We are primarily self-insured for costs related to workers’ compensation, general liability, and employee-related health care benefits. We use a third-party actuary to estimate the liabilities associated with these risks. The actuary considers historical claims experience, demographic and severity factors, health care trends, and actuarial assumptions to estimate the liabilities associated with these risks. Historically, our actuarial estimates have not been materially different from actual results.

Impairment of Long-Lived Assets

We review our long-lived assets for impairment when events or changes in circumstances, such as decisions to close a store or significant cash flow losses, indicate the carrying value of the asset may not be recoverable. All long-lived assets are reviewed for impairment at least annually.

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If our evaluations, which are performed on an undiscounted cash flow basis, indicate that the carrying amount of the asset may not be recoverable, the potential impairment is measured as the excess of carrying value over the fair value of the impaired asset.

Identifying impaired assets and quantifying the related impairment loss, if any, requires significant estimates by management. The most significant of these estimates is the cash flow expected to result from the use and eventual disposition of the asset. When determining the stream of projected future cash flows associated with an individual store, management estimates future store performance including sales, gross margin, and controllable expenses, such as store payroll and occupancy expense. Projected cash flows must be estimated for future periods throughout the remaining life of the property, which may be as many as 40 years in the future. The accuracy of these estimates will be impacted by a number of factors including general economic conditions, changes in competitive landscape, and our ability to effectively manage the operations of the store.

Income Taxes

We regularly evaluate the likelihood of realizing the benefit for income tax positions we have taken in various federal and state filings by considering all relevant facts, circumstances, and information available to us. If we believe it is more likely than not that our position will be sustained, we recognize a benefit at the largest amount which we believe is cumulatively greater than 50% likely to be realized.

Unrecognized tax benefits require significant management judgment regarding applicable statutes and their related interpretation, the status of various income tax audits, and our particular facts and circumstances. Also, as audits are completed or statutes of limitations lapse, it may be necessary to record adjustments to our taxes payable, deferred tax assets, tax reserves, or income tax expense. Although we believe we have adequately reserved for our uncertain tax positions, no assurance can be given that the final tax outcome of these matters will not be different. Income taxes are further described in Note 5 of the Consolidated Financial Statements.

Leases

Accounting for leased properties requires compliance with technical accounting rules and significant judgment by management. Application of these accounting rules and assumptions made by management will determine if the lease is accounted for as a finance lease, an operating lease, or a financing obligation.

The following are significant estimates used by management in accounting for real estate and other leases:

•
Accounting lease term—Our accounting lease term includes all noncancelable periods and renewal periods that are reasonably assured of being exercised. Typically, renewal options are considered reasonably assured of being exercised if we have made significant leasehold improvements that would exceed the initial or renewal lease term and the cash flow performance of the store remains strong. The expected lease term is used in determining whether the lease is accounted for as an operating lease or a finance lease.

•
Incremental borrowing rate—The incremental borrowing rate is the rate of interest that the lessee would have to pay to borrow on a collateralized basis over a similar term an amount equal to the lease payments in a similar economic environment. The incremental borrowing rate is used in determining whether the lease is accounted for as an operating lease or a finance lease.

•
Fair market value of leased asset—The fair market value of leased retail property is generally estimated based on comparable market data as provided by third-party appraisers or consideration received from the landlord. Fair market value is used in determining whether the lease is accounted for as an operating lease or a finance lease.

Leases are further described in Note 3 of the Consolidated Financial Statements.

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Sephora Arrangement

In 2020, we entered into an arrangement with Sephora to be the exclusive beauty offering at Kohl's and bring a transformational, elevated beauty experience to Kohl’s. We sell prestige beauty products through Sephora-branded retail shops in certain Kohl’s stores and through a Sephora-branded offering on Kohls.com. We have opened 860 full size 2,500 square foot Sephora shops and 50 small format Sephora shops to date, and are planning to have a presence in all Kohl's stores by 2025.

Both parties to the arrangement are active participants and are exposed to significant risks and rewards dependent on the success of the activities of the arrangement. The arrangement involves various activities including the merchandising, marketing, and operations of the shops and Kohls.com. Kohl’s is the principal on sales transactions with our customers and we recognize sales, cost of merchandise sold, and operating expenses in the respective lines on our consolidated statements of operations. Kohl’s owns and manages the inventory and funds capital expenditures for the arrangement. The parties share equally in the operating profit of the arrangement which incorporates all expenses to run the arrangement including depreciation expense related to the assets. Amounts due to Sephora for their share of the operating profits are recorded in cost of merchandise sold.

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Executive Summary

Kohl's is a leading omnichannel retailer operating 1,170 stores and a website (www.Kohls.com) as of January 28, 2023. Our Kohl's stores and website sell moderately-priced private and national brand apparel, footwear, accessories, beauty, and home products. Our Kohl's stores generally carry a consistent merchandise assortment with some differences attributable to local preferences, store size, and Sephora. Our website includes merchandise which is available in our stores, as well as merchandise that is available only online.

Key financial results for 2022 as compared to 2021 include:

•
Net sales decreased 7.1%, to $17.2 billion, with comparable sales down 6.6%.

•
Gross margin as a percent of net sales was 33.2%, a decrease of 485 basis points.

•
SG&A expenses increased 2.0%, to $5.6 billion. As a percentage of total revenue, SG&A expense was 30.9%, an increase of 268 basis points.

•
Operating income was $246 million compared to $1.7 billion in the prior year. As a percentage of total revenue, operating income was 1.4%, a decrease of 729 basis points.

•
Net loss of $19 million, or ($0.15) per diluted share. This compares to net income of $938 million, or $6.32 per diluted share, and adjusted net income of $1.1 billion, or $7.33 per diluted share, in the prior year.

•
Operating cash flow was $282 million.

Our Strategy

Kohl's strategy is focused on delivering long-term shareholder value through driving improved sales and profitability. Key strategic focus areas for the Company include: driving top line growth, delivering a long-term operating margin of 7% to 8%, maintaining disciplined capital management, and sustaining an agile, accountable, and inclusive culture. In the context of these strategic focus areas, the Company outlined the following priorities for 2023: enhancing the customer experience, accelerating and simplifying its value strategies, managing inventory and expenses with discipline, and strengthening the balance sheet.

Financial and Capital Outlook

For fiscal year 2023, the Company currently expects the following:

•
Net sales: A decrease (2%) to (4%), including the impact of the 53rd week which is worth approximately 1%.

•
Operating margin: Approximately 4.0%.

•
Diluted earnings per share: In the range of $2.10 to $2.70, excluding any non-recurring charges.

•
Capital expenditures: $600 million to $650 million, including the expansion of the Sephora arrangement and store refresh activity.

Results of Operations

For our comparison and discussion of 2021 and 2020, see Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations in Part II of our 2021 Form 10-K.

Net Sales

Net sales includes revenue from the sale of merchandise, net of expected returns, and shipping revenue.

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Comparable sales is a measure that highlights the performance of our stores and digital channel by measuring the change in sales for a period over the comparable, prior-year period of equivalent length. Comparable sales includes all store and digital sales, except sales from stores open less than 12 months, stores that have been closed, and stores that have been relocated where square footage has changed by more than 10%. We measure the change in digital sales by including all sales initiated online or through mobile applications, including omnichannel transactions which are fulfilled through our stores.

We measure digital penetration as digital sales over net sales. These amounts do not take into consideration fulfillment node, digital returns processed in stores, and coupon behaviors.

Comparable sales and digital penetration measures vary across the retail industry. As a result, our comparable sales calculation and digital penetration are non-GAAP measures that may not be consistent with the similarly titled measures reported by other companies.

The following graph summarizes net sales dollars and comparable sales over the prior year. As our stores were closed for a period during 2020, we have not included a discussion of 2020 or 2021 comparable sales as we do not believe it is a meaningful metric over this period of time.

2022 compared to 2021

Net sales decreased $1.3 billion, or (7.1%), to $17.2 billion for 2022.

•
The decrease in net sales was driven by lower sales in both stores and digital as a result of lower traffic. The impact of a higher average ticket was offset by lower units per transaction.

•
Digital sales decreased 7% for the year. Digital penetration represented 32% of net sales in 2022.

•
Men's, Women's, and Accessories, which includes Sephora, outperformed the Company average.

Other Revenue

Other revenue includes revenue from credit card operations, third-party advertising on our website, unused gift cards and merchandise return cards (breakage), and other non-merchandise revenue.

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The following graph summarizes other revenue:

Other revenue decreased $25 million in 2022. The decrease in 2022 was driven by a decrease in credit revenue due to lower overall accounts receivable balances and a normalizing loss rate.

On March 14, 2022, we amended and restated our private label credit card program agreement with Capital One. The agreement ends on March 31, 2030. The agreement will operate in substantially the same manner as it currently operates, and with planned modernization of technology and processes.

Cost of Merchandise Sold and Gross Margin

Cost of merchandise sold includes the total cost of products sold, including product development costs, net of vendor payments other than reimbursement of specific, incremental, and identifiable costs; inventory shrink; markdowns; freight expenses associated with moving merchandise from our vendors to our distribution centers; shipping expenses for digital sales; and terms cash discount. Our cost of merchandise sold may not be comparable with that of other retailers because we include distribution center and buying costs in selling, general, and administrative (SG&A) expenses while other retailers may include these expenses in cost of merchandise sold.

The following graph summarizes cost of merchandise sold and gross margin as a percent of net sales:

Gross margin is calculated as net sales less cost of merchandise sold. Gross margin as a percent of net sales decreased 485 basis points in 2022 compared to 2021. The decrease in gross margin was driven by increased permanent markdowns taken to address inventory levels, elevated freight, and headwinds from product cost inflation and higher shrink.

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We expect gross margin to stabilize in 2023 and to be in the 36.0% to 36.5% range. We expect the promotional environment to remain competitive, but expect progressive benefits as freight and product cost inflation moderate in the second half of the year.

Selling, General, and Administrative Expenses

SG&A includes compensation and benefit costs (including stores, corporate, buying, and distribution centers); occupancy and operating costs of our retail, distribution, and corporate facilities; freight expenses associated with moving merchandise from our distribution centers to our retail stores and among distribution and retail facilities other than expenses to fulfill digital sales; marketing expenses, offset by vendor payments for reimbursement of specific, incremental, and identifiable costs; expenses related to our credit card operations; and other administrative revenues and expenses. We do not include depreciation and amortization in SG&A. The classification of these expenses varies across the retail industry.

Many of our expenses, including store payroll and distribution costs, are variable in nature. These costs generally increase as sales increase, and decrease as sales decrease. We measure both the change in these variable expenses and the expense as a percent of revenue. If the expense as a percent of revenue decreased from the prior year, the expense "leveraged". If the expense as a percent of revenue increased over the prior year, the expense "deleveraged".

The following graph summarizes the changes in SG&A by expense type between 2021 and 2022:

SG&A increased $109 million, or 2.0%, to $5.6 billion for 2022. As a percentage of revenue, SG&A deleveraged by (268) basis points.

The increase was primarily driven by an increase in stores as we made strategic investments in our stores to support the approximately 400 Sephora shop-in-shop openings this year compared to the 200 openings last year as well as increased wages. Technology was driven by higher investment in new technology initiatives. Distribution costs, which exclude payroll related to online originated orders that were shipped from our stores, were $457 million for 2022 compared to $449 million for 2021. Partially offsetting the increases were savings across our credit, marketing, and corporate areas.

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In 2023, SG&A dollars are expected to deleverage slightly, with wage inflation continuing to be a headwind, offset by benefits from a more efficient organization structure, and fewer Sephora openings in 2023.

Other Expenses

Depreciation and amortization decreased in 2022, driven by reduced capital spending in technology.

Net interest expense increased in 2022 compared to 2021 due to more financing leases as well as borrowings under the revolving credit facility. This was partially offset by less interest expense in the first quarter of 2022 due to the debt reductions in 2021.

In 2021, we completed a cash tender offer and recognized a loss of $201 million from the extinguishment of debt.

Income Taxes

The effective tax rate for 2022 was higher than the effective tax rate for 2021 because of the impact of favorable results from uncertain tax positions as well as federal tax credits relative to consolidated book net income (loss).

GAAP to Non-GAAP Reconciliation

(1) Amounts shown for 2022 are GAAP as there are no adjustments to Non-GAAP. These amounts are shown for comparability purposes.

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We believe the adjusted results in the GAAP to Non-GAAP table are useful because they provide enhanced visibility into our results for the periods excluding the impact of certain items such as those included in the table. However, these non-GAAP financial measures are not intended to replace the comparable GAAP measures.

Inflation

We expect that our operations will continue to be influenced by general economic conditions, including food, fuel, and energy prices, higher unemployment, wage inflation, and costs to source our merchandise, including tariffs. There can be no assurances that such factors will not impact our business in the future.

Liquidity and Capital Resources

Capital Allocation

Our capital allocation strategy is to invest to maximize our overall long-term return, maintain a strong balance sheet, and achieve an investment grade rating. We follow a disciplined approach to capital allocation based on the following priorities: first we invest in our business to drive long-term profitable growth; second we pay a quarterly dividend; and third we return excess cash to shareholders through our share repurchase program. In addition, when appropriate, we will complete debt reduction transactions.

We are committed to rebuilding our cash balances and reducing leverage to our long term target of 2.5 times utilizing an eight times cash rent calculation for lease obligations. We will continue to invest in the business, as we plan to invest $600 to $650 million in 2023, including the expansion of the Sephora arrangement and store refresh activity, and we remain committed to the dividend. On February 21, 2023, our Board of Directors of Kohl's Corporation declared a quarterly cash dividend of $0.50 per share. The dividend will be paid on March 29, 2023 to all shareholders of record at the close of business on March 15, 2023. We replaced and upsized the revolver in January 2023 to enhance our liquidity and flexibility and will utilize it to fund working capital as well as retire bonds as they become due, with the goal of reducing the debt portfolio. We retired the $164 million of notes due in February 2023, and plan on retiring the $111 million of notes due December 2023 when they mature. We are not planning any share repurchases until our balance sheet is strengthened on a path towards the long term target leverage ratio of 2.5 times.

Our period-end cash and cash equivalents balance decreased to $153 million from $1.6 billion in 2021. Our cash and cash equivalents balance includes short-term investments of $10 million and $1.5 billion as of January 28, 2023, and January 29, 2022, respectively. Our investment policy is designed to preserve principal and liquidity of our short-term investments. This policy allows investments in large money market funds or in highly rated direct short-term instruments. We also place dollar limits on our investments in individual funds or instruments.

The following table presents our primary uses and sources of cash:

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The following table includes cash balances and changes:

(a)
Non-GAAP financial measure. Please see the “GAAP to Non-GAAP Reconciliation” for a reconciliation of free cash flow to net cash provided by operating activities.

Operating Activities

Our operating cash outflows generally consist of payments to our employees for wages, salaries and other employee benefits, payments to our merchandise vendors for inventory (net of vendor allowances), payments to our shipping carriers, and payments to our landlords for rent. Operating cash outflows also include payments for income taxes and interest payments on our debt borrowings.

Operating activities generated cash of $282 million in 2022 compared to $2.3 billion in 2021. Operating cash flow decreased primarily due to lower net income and a decrease in accounts payable due to late arriving receipts in 2021. Additionally in 2021 we received a tax refund related to the net loss we incurred in 2020 and the carryback provision under the Coronavirus Aid, Relief, and Economic Security ("CARES") Act.

Investing Activities

Our investing cash outflows include payments for capital expenditures, including investments in new and existing stores, improvements to supply chain, and technology costs. Our investing cash inflows are generally from proceeds from sales of property and equipment.

Net cash used in investing activities increased $213 million to $783 million in 2022. The increase was primarily driven by in-store investments related to Sephora shop-in-shop build-outs, store refreshes, and other customer experience and sales driving enhancements.

The following chart summarizes capital expenditures by major category:

In 2022, we opened 406 full size Sephora-branded retail shop-in-shops and now have a total of 606 full size Sephora shop-in-shops open. In 2023, we are planning to open at least 250 full size and 50 small format Sephora

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shop-in-shops. In 2023, we anticipate capital expenditures of approximately $600 to $650 million to support the Sephora shop-in-shops and store refresh activity. We will continue to invest in enhancing our omni-channel capabilities.

Financing Activities

Our financing strategy is to ensure liquidity and access to capital markets. We also strive to maintain a balanced portfolio of debt maturities, while minimizing our borrowing costs. Our ability to access the public debt market has provided us with adequate sources of liquidity. Our continued access to these markets depends on multiple factors, including the condition of debt capital markets, our operating performance, and maintaining strong credit ratings.

In September 2022, Standard & Poor's downgraded our credit rating from BBB- to BB+. Additionally, in December 2022, Moody's downgraded our credit rating from Baa2 to Ba2.

As of January 28, 2023, our credit ratings and outlook were as follows:

As a result of Standard & Poor's downgrade, the interest rate on our 3.375% notes and 9.50% notes increased 25 bps due to the coupon adjustment provisions within these notes. Additionally, Moody's downgrade will increase the interest rate on these two notes an additional 50 bps in May 2023 due to the coupon adjustment provisions within these notes. If our credit ratings are lowered further, our ability to access the public debt markets, our cost of funds, and other terms for new debt issuances could be adversely impacted. Each of the credit rating agencies reviews its rating periodically and there is no guarantee our current credit ratings will remain the same.

The majority of our financing activities include repurchases of common stock, proceeds and/or repayments of long-term debt, and dividend payments. Financing cash outflows also include payments to our landlords for leases classified as financing leases and financing obligations.

Financing activities used $933 million in 2022 compared to $2.4 billion in 2021. The decrease is driven by a reduction of treasury stock purchases in 2022 compared to 2021 as well as debt reduction activities in 2021 as discussed below.

In March 2021, we issued $500 million in aggregate principal amount of 3.375% notes with semi-annual interest payments beginning in November 2021. The notes include coupon rate step ups if our long-term debt is downgraded to below a BBB- credit rating by S&P Global Ratings or Baa3 by Moody’s Investors Service, Inc, both of which occurred in 2022. The notes mature in May 2031.

In April 2021, we completed a cash tender offer for $1.0 billion of senior unsecured debt. We recognized a $201 million loss on extinguishment of debt in the first quarter of 2021, which includes the $192 million tender premium paid to tendering note holders in accordance with the terms of the tender offer, a $6 million non-cash write-off of deferred financing costs and original issue discounts associated with the extinguished debt, and $3 million in other fees.

In January 2023, we entered into a Credit Agreement with various lenders which provides for a $1.5 billion senior secured, asset based revolving credit facility that will mature in January 2028 and replaced our existing senior unsecured revolving credit facility. The revolver is secured by substantially all of our assets other than real estate, and contains customary events of default and financial, affirmative, and negative covenants, including but not limited to, a springing financial covenant related to our fixed charge coverage ratio and restrictions on indebtedness, liens, investments, asset dispositions, and restricted payments. Outstanding borrowings under the credit facility bear interest at a variable rate based on SOFR plus the applicable margin. Borrowings under the revolving credit facility, recorded as short-term debt, has $85 million outstanding as of January 28, 2023, and approximately $1.4 billion

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remains available under the revolver. No amounts were outstanding at January 29, 2022 under our previous credit agreement.

We purchased treasury stock of $658 million in 2022 compared to $1.4 billion in 2021. $158 million of the 2022 purchases were made pursuant to a Rule 10b5-1 plan adopted in November 2021. Share repurchases are discretionary in nature. The timing and amount of repurchases are based upon available cash balances, our stock price, and other factors. On August 18, 2022, we entered into an accelerated share repurchase ("ASR") pursuant to the previously announced share repurchase program, with Goldman Sachs & Co. LLC ("Goldman Sachs") to repurchase $500 million of the Company's common stock. On August 22, 2022, we received an initial delivery of 11.8 million shares of common stock, representing 80% of the total shares expected to be repurchased under the ASR. Final settlement occurred on November 7, 2022 with an additional 6.1 million shares of common stock being delivered, resulting in a total of 17.9 million shares with an average price of approximately $28 per share.

Cash dividend payments were $239 million ($2.00 per share) in 2022 and $147 million ($1.00 per share) in 2021.

Free Cash Flow

We had negative free cash flow of $639 million for 2022 compared to $1.6 billion free cash flow generated in 2021. The decrease is primarily due to less operating cash flow due to a net loss as well as increased capital expenditures to support the investments related to Sephora shop-in-shop build-outs, store refreshes, and other customer experience and sales driving enhancements. Free cash flow is a non-GAAP financial measure which we define as net cash provided by operating activities and proceeds from financing obligations (which generally represent landlord reimbursements of construction costs) less capital expenditures and finance lease and financing obligation payments. Free cash flow should be evaluated in addition to, and not considered a substitute for, other financial measures such as net income and net cash provided by operating activities. We believe that free cash flow represents our ability to generate additional cash flow from our business operations.

The following table reconciles net cash provided by operating activities (a GAAP measure) to free cash flow (a non-GAAP measure):

Key Financial Ratios

Key financial ratios that provide certain measures of our liquidity are as follows:

Our working capital and inventory levels typically build throughout the fall, peaking during the November and December holiday selling season.

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The decrease in our working capital and current ratio are primarily due to lower cash balances as a result of a decrease in cash provided by operating activities and higher capital expenditures.

Return on Investment Ratio

The following table shows our return on investment ratio (a non-GAAP financial measure):

Changes in earnings drove changes in our return on investment ratio.

We believe that Adjusted ROI is a useful financial measure in evaluating our operating performance. When analyzed in conjunction with our net earnings and total assets, it provides investors with a useful tool to evaluate our ongoing operations and our management of assets from period to period. Adjusted ROI is a non-GAAP financial measure which we define as earnings before interest, taxes, depreciation, amortization, and rent (“EBITDAR”) adjusted for certain one-time items divided by adjusted average gross investment. Adjusted EBITDAR is a useful non-GAAP measure that excludes items that are non-operating in nature and focuses on items that are key to our operating performance. Our Adjusted ROI calculation may not be comparable to similarly titled measures reported by other companies. Adjusted ROI should be evaluated in addition to, and not considered a substitute for, other GAAP financial measures. See the key financial ratio calculations below for our Adjusted ROI calculation.

Capital Structure Ratio

The following table shows our capital structure ratio (a non-GAAP financial measure):

Adjusted debt to EBITDAR is a non-GAAP financial measure which we define as our adjusted outstanding debt balance divided by EBITDAR. The increase in our adjusted debt to EBITDAR ratio is primarily due to lower operating income. Our current goal is to achieve a ratio that demonstrates our commitment to an investment grade rating and allows us to operate with an efficient capital structure for our size, growth plans, and industry. Our adjusted debt to EBITDAR calculation may not be comparable to similarly-titled measures reported by other companies. Adjusted debt to EBITDAR should be evaluated in addition to, and not considered a substitute for, other GAAP financial measures. See the key financial ratio calculations section below for our adjusted debt to EBITDAR calculation.

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Key Financial Ratio Calculations

The following table includes our ROI calculation. All ratios are non-GAAP financial measures:

(a)
Represents average of five most recent quarter-end balances.

(b)
Represents excess cash not required for operations.

(c)
Lease assets presented under US GAAP are replaced with eight times cash rent for operating leases, finance leases, and financial obligations. A summary of cash rent can be found in Note 3 of the Consolidated Financial Statements. Management believes this normalizes for timing within the lease term and the impact of lease amendments triggered by our investment in the Sephora shop-in-shops.

(d)
Adjusted EBITDAR divided by adjusted gross investment.

The following table includes our adjusted debt to EBITDAR calculation:

(a)
Lease obligations presented under US GAAP are replaced with eight times cash rent for operating leases, finance leases, and financial obligations. A summary of cash rent can be found in Note 3 of the Consolidated Financial Statements. Management believes this normalizes for timing within the lease term and the impact of lease amendments triggered by our investment in the Sephora shop-in-shops.

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Debt Covenant Compliance

Our senior secured, asset based revolving credit facility contains customary events of default and financial, affirmative and negative covenants, including but not limited to, a springing financial covenant relating to our fixed charge coverage ratio and restrictions on indebtedness, liens, investments, asset dispositions, and restricted payments. As of January 28, 2023, we were in compliance with all covenants and expect to remain in compliance during 2023.

Contractual Obligations

Material contractual obligations arising in the normal course of business primarily consist of long-term debt and related interest payments, principal and interest payments for leases, and other purchase obligations. See Notes 2 and 3 to the Consolidated Financial Statements for amounts outstanding on January 28, 2023 related to debt and leases.

Other purchase obligations primarily include royalties, legally binding minimum lease and interest payments for stores opening in 2023 or later, as well as payments associated with technology, marketing, and donation agreements. The obligations were $608 million as of January 28, 2023.

Off-Balance Sheet Arrangements

We have not provided any financial guarantees as of year-end fiscal 2022.

We have not created, and are not party to, any special-purpose or off-balance sheet entities for the purpose of raising capital, incurring debt, or operating our business. We do not have any arrangements or relationships with entities that are not consolidated into the financial statements that are reasonably likely to materially affect our financial condition, liquidity, results of operations, or capital resources.

Critical Accounting Policies and Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires us to make estimates and assumptions that affect reported amounts. Management has discussed the development, selection, and disclosure of these estimates and assumptions with the Audit Committee of our Board of Directors.

Retail Inventory Method and Inventory Valuation

The majority of our merchandise inventories are valued at the lower of cost or market using the retail inventory method (“RIM”). Under RIM, the valuation of inventory at cost and the resulting gross margins are calculated by applying a cost-to-retail ratio to the retail value of inventory. RIM is an averaging method that has been widely used in the retail industry due to its practicality. The use of RIM will result in inventory being valued at the lower of cost or market since permanent markdowns are taken as a reduction of the retail value of inventories. A reserve is recorded if the future estimated selling price is less than cost.

RIM inherently requires management judgment and estimates, such as the amount and timing of permanent markdowns to clear unproductive or slow-moving inventory, which may impact the ending inventory valuation as well as gross margin. Factors considered in the determination of permanent markdowns include current and anticipated demand, customer preferences, age of the merchandise, fashion trends, and weather conditions.

Inventory shrinkage is estimated as a percent of sales for the period between the last physical inventory count and the balance sheet date. Shrink is the difference between the recorded amount of inventory and the physical inventory. We perform an annual physical inventory count at the majority of our stores, E-Commerce fulfillment centers, and distribution centers. The shrinkage rate from the most recent physical inventory, in combination with current events and historical experience, is used as the standard for the shrinkage accrual rate for the next inventory cycle. Historically, our actual physical inventory count results have shown our estimates to be reliable.

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Vendor Allowances

We frequently receive allowances from our vendors for markdowns that we have taken in order to sell the vendors' merchandise and/or to support gross margins earned on those sales. This markdown support generally relates to sold inventory or permanent markdowns and, accordingly, is reflected as a reduction to cost of merchandise sold. Markdown support related to merchandise that has not yet been sold is recorded in inventory.

We also receive support from vendors for marketing and other costs that we have incurred to sell the vendors’ merchandise. To the extent the reimbursements are for specific, incremental, and identifiable costs incurred to sell the vendor's products and do not exceed the costs incurred, they are recognized as a reduction of Selling, General, and Administrative Expenses. If these criteria are not met, the support is recorded in inventory and reflected as a reduction of costs of merchandise sold when the related merchandise is sold.

Insurance Reserve Estimates

We are primarily self-insured for costs related to workers’ compensation, general liability, and employee-related health care benefits. We use a third-party actuary to estimate the liabilities associated with these risks. The actuary considers historical claims experience, demographic and severity factors, health care trends, and actuarial assumptions to estimate the liabilities associated with these risks. Historically, our actuarial estimates have not been materially different from actual results.

Impairment of Long-Lived Assets

We review our long-lived assets for impairment when events or changes in circumstances, such as decisions to close a store or significant cash flow losses, indicate the carrying value of the asset may not be recoverable. All long-lived assets are reviewed for impairment at least annually.

If our evaluations, which are performed on an undiscounted cash flow basis, indicate that the carrying amount of the asset may not be recoverable, the potential impairment is measured as the excess of carrying value over the fair value of the impaired asset.

Identifying impaired assets and quantifying the related impairment loss, if any, requires significant estimates by management. The most significant of these estimates is the cash flow expected to result from the use and eventual disposition of the asset. When determining the stream of projected future cash flows associated with an individual store, management estimates future store performance including sales, gross margin, and controllable expenses, such as store payroll and occupancy expense. Projected cash flows must be estimated for future periods throughout the remaining life of the property, which may be as many as 40 years in the future. The accuracy of these estimates will be impacted by a number of factors including general economic conditions, changes in competitive landscape, and our ability to effectively manage the operations of the store.

Income Taxes

We regularly evaluate the likelihood of realizing the benefit for income tax positions we have taken in various federal and state filings by considering all relevant facts, circumstances, and information available to us. If we believe it is more likely than not that our position will be sustained, we recognize a benefit at the largest amount which we believe is cumulatively greater than 50% likely to be realized.

Unrecognized tax benefits require significant management judgment regarding applicable statutes and their related interpretation, the status of various income tax audits, and our particular facts and circumstances. Also, as audits are completed or statutes of limitations lapse, it may be necessary to record adjustments to our taxes payable, deferred tax assets, tax reserves, or income tax expense. Although we believe we have adequately reserved for our uncertain

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tax positions, no assurance can be given that the final tax outcome of these matters will not be different. Income taxes are further described in Note 5 of the Consolidated Financial Statements.

Leases

Accounting for leased properties requires compliance with technical accounting rules and significant judgment by management. Application of these accounting rules and assumptions made by management will determine if the lease is accounted for as a finance lease, an operating lease, or a financing obligation.

The following are significant estimates used by management in accounting for real estate and other leases:

•
Accounting lease term—Our accounting lease term includes all noncancelable periods and renewal periods that are reasonably assured of being exercised. Typically, renewal options are considered reasonably assured of being exercised if we have made significant leasehold improvements that would exceed the initial or renewal lease term and the cash flow performance of the store remains strong. The expected lease term is used in determining whether the lease is accounted for as an operating lease or a finance lease.

•
Incremental borrowing rate—The incremental borrowing rate is the rate of interest that the lessee would have to pay to borrow on a collateralized basis over a similar term an amount equal to the lease payments in a similar economic environment. The incremental borrowing rate is used in determining whether the lease is accounted for as an operating lease or a finance lease.

•
Fair market value of leased asset—The fair market value of leased retail property is generally estimated based on comparable market data as provided by third-party appraisers or consideration received from the landlord. Fair market value is used in determining whether the lease is accounted for as an operating lease or a finance lease.

Leases are further described in Note 3 of the Consolidated Financial Statements.

Sephora Arrangement

In 2020, we entered into an arrangement with Sephora to be the exclusive beauty offering at Kohl's and bring a transformational, elevated beauty experience to Kohl’s. We sell prestige beauty products through Sephora-branded retail shop-in-shops in certain Kohl’s stores and through a Sephora-branded offering on Kohls.com. We have opened 606 full size shop-in shops to date and are planning to open at least 250 full size and 50 small format Sephora shop-in-shops in 2023.

Both parties to the arrangement are active participants and are exposed to significant risks and rewards dependent on the success of the activities of the arrangement. The arrangement involves various activities including the merchandising, marketing, and operations of the shops and Kohls.com. Kohl’s is the principal on sales transactions with our customers and we recognize sales, cost of merchandise sold, and operating expenses in the respective lines on our consolidated statements of operations. Kohl’s owns and manages the inventory and funds capital expenditures for the arrangement. The parties share equally in the operating profit of the arrangement which incorporates all expenses to run the arrangement including depreciation expense related to the assets. Amounts due to Sephora for their share of the operating profits are recorded in cost of merchandise sold.

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Executive Summary

Kohl's is a leading omnichannel retailer operating 1,165 stores and a website (www.Kohls.com) as of January 29, 2022. Our Kohl's stores and website sell moderately-priced private and national brand apparel, footwear, accessories, beauty, and home products. Our Kohl's stores generally carry a consistent merchandise assortment with some differences attributable to local preferences, store size, and Sephora. Our website includes merchandise which is available in our stores, as well as merchandise that is available only online.

Key financial results for 2021 included:

•
Record earnings of $6.32 per diluted share on a GAAP basis and $7.33 per diluted share on an adjusted non-GAAP basis*

•
Strong financial position, ending the year with $1.6 billion in cash

•
Repurchased $1.4 billion of shares

•
Net sales increased 22.9% to last year

•
Gross margin was 38.1% of net sales, a 700 basis point increase from last year

•
SG&A increased 9.1% and leveraged as a percent of total revenue by 328 basis points to last year

•
Achieved a 8.6% operating margin

*Please see the “GAAP to Non-GAAP Reconciliation” for a reconciliation of earnings per diluted share to adjusted earnings per diluted share.

COVID-19

As discussed in our 2020 Form 10-K, the COVID-19 pandemic has had significant adverse effects on our business. We are closely monitoring the effects of the ongoing COVID-19 pandemic and its continued impact on our business. We cannot estimate with certainty the length or severity of this pandemic, or the extent to which the disruption may materially impact our Consolidated Financial Statements. In 2021, we saw momentum in our business which allowed us to resume our capital allocation strategy including reinstating dividends, resuming our share repurchase program, and employing liability management strategies.

Comparison of Financial Results to 2019

Due to the significant impact of COVID-19 on 2020 operating results, we are providing the below comparisons to 2019 to provide additional context.

•
Net sales decreased 2.2% with digital sales increasing 30%.

•
Gross margin as a percent of net sales increased 237 basis points driven by strong inventory management and our pricing and promotion optimization strategies, partially offset by higher freight costs.

•
SG&A decreased 4.0% and leveraged as a percent of total revenue by 37 basis points driven by marketing and technology efficiencies.

Our Vision and Strategy

The Company’s vision is to be “the most trusted retailer of choice for the active and casual lifestyle” and its strategy is focused on delivering long-term shareholder value. Key strategic focus areas for the Company include: driving top line growth, delivering a 7% to 8% operating margin, maintaining disciplined capital management, and sustaining an agile, accountable, and inclusive culture.

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Driving Top Line Growth

Our initiatives include building a sizable beauty business with Sephora, driving continued growth in our active and outdoor business, reigniting growth in the women’s business, enhancing our brand portfolio, opening new stores, leading with loyalty and value, and further growing digital. We have already taken significant steps in many of these areas, such as successfully launching our strategic partnership with Sephora in 2021 by opening the first 200 shop-in-shops and offering a comprehensive digital experience, driving strong sales growth of more than 40% in our active and outdoor business, and introducing new brands including Tommy Hilfiger, Calvin Klein, and Eddie Bauer.

Delivering a 7% to 8% Operating Margin

The Company is committed to delivering an operating margin of 7% to 8%. Our gross margin initiatives include disciplined inventory management and increased inventory turn, efficient sourcing, and optimized pricing and promotion strategies. Our initiatives to drive selling, general, and administrative expense efficiency are focused on labor productivity, across our stores and fulfillment centers, marketing, and technology expenses.

Maintaining Disciplined Capital Management

We are committed to prudent balance sheet management with the long-term objective of sustaining Kohl’s Investment Grade credit rating. The Company has a long history of strong cash flow generation, investing in the business, and returning significant capital to shareholders—all of which will remain important in the future.

Sustaining an Agile, Accountable, and Inclusive Culture

Fostering a diverse, equitable, and inclusive environment for Kohl’s associates, customers, and suppliers is an important focus of ours. We have a diversity and inclusion framework that includes a number of key initiatives across three pillars: Our People, Our Customers, and Our Communities. In addition, we continue to build on the Company’s commitment to Environmental, Social, and Corporate Governance (“ESG”). We have established 2025 goals related to climate change, waste and recycling, and sustainable sourcing, and Kohl’s has earned many ESG-related awards.

2022 Outlook

Our current expectations for 2022 are as follows:

Results of Operations

For our comparison and discussion of 2020 and 2019, see Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations in Part II of our 2020 Form 10-K.

Net Sales

Net sales includes revenue from the sale of merchandise, net of expected returns, and shipping revenue.

Comparable sales is a measure that highlights the performance of our stores and digital channel by measuring the change in sales for a period over the comparable, prior-year period of equivalent length. Comparable sales includes all store and digital sales, except sales from stores open less than 12 months, stores that have been closed, and stores where square footage has changed by more than 10%. We measure the change in digital sales by including

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all sales initiated online or through mobile applications, including omnichannel transactions which are fulfilled through our stores.

As our stores were closed for a period during 2020, we have not included a discussion of 2020 or 2021 comparable sales as we do not believe it is a meaningful metric over this period of time.

We measure digital penetration as digital sales over net sales. These amounts do not take into consideration fulfillment node, digital returns processed in stores, and coupon behaviors.

Comparable sales and digital penetration measures vary across the retail industry. As a result, our comparable sales calculation and digital penetration are non-GAAP measures that may not be consistent with the similarly titled measures reported by other companies.

The following graph summarizes net sales dollars and comparable sales over the prior year:

2021 compared to 2020

Net sales increased $3.4 billion, or 22.9%, to $18.5 billion for 2021.

•
The increase in net sales was driven by higher sales in our stores.

•
Digital sales were flat to 2020. Digital penetration represented 32% of net sales in 2021.

•
Men's, Footwear, Women's, and Accessories outperformed the Company average.

•
Active outperformed the Company average increasing more than 40% to 2020. Active represented 24% of sales in 2021.

Other Revenue

Other revenue includes revenue from credit card operations, third-party advertising on our website, unused gift cards and merchandise return cards (breakage), and other non-merchandise revenue.

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The following graph summarizes other revenue:

Other revenue increased $38 million in 2021. The increase in 2021 was driven by an increase in credit revenue due to lower write-off activity partially offset by lower accounts receivable balances associated with decreased sales in 2020 and higher payment rates in 2021.

Cost of Merchandise Sold and Gross Margin

Cost of merchandise sold includes the total cost of products sold, including product development costs, net of vendor payments other than reimbursement of specific, incremental, and identifiable costs; inventory shrink; markdowns; freight expenses associated with moving merchandise from our vendors to our distribution centers; shipping expenses for digital sales; terms cash discount; and depreciation of product development facilities and equipment. Our cost of merchandise sold may not be comparable with that of other retailers because we include distribution center and buying costs in selling, general, and administrative expenses while other retailers may include these expenses in cost of merchandise sold.

The following graph summarizes cost of merchandise sold and gross margin as a percent of net sales:

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Gross margin is calculated as net sales less cost of merchandise sold. Gross margin as a percent of net sales increased 700 basis points in 2021. In 2021, gross margin benefited from strong inventory management driven by inventory turnover of 4.1 times for the year and further scaling our pricing and promotion optimization strategies, partially offset by incremental transportation costs related to the constrained global supply chain. In executing against our strategy, we have structurally improved our margin efficiency and are confident in our ability to sustain the recent improvement, while we are also monitoring industry-wide supply chain uncertainties and cost inflation.

Selling, General, and Administrative Expenses

SG&A includes compensation and benefit costs (including stores, corporate, buying, and distribution centers); occupancy and operating costs of our retail, distribution, and corporate facilities; freight expenses associated with moving merchandise from our distribution centers to our retail stores and among distribution and retail facilities other than expenses to fulfill digital sales; marketing expenses, offset by vendor payments for reimbursement of specific, incremental, and identifiable costs; expenses related to our credit card operations; and other administrative revenues and expenses. We do not include depreciation and amortization in SG&A. The classification of these expenses varies across the retail industry.

Many of our expenses, including store payroll and distribution costs, are variable in nature. These costs generally increase as sales increase, and decrease as sales decrease. We measure both the change in these variable expenses and the expense as a percent of revenue. If the expense as a percent of revenue decreased from the prior year, the expense "leveraged". If the expense as a percent of revenue increased over the prior year, the expense "deleveraged".

The following graph summarizes the changes in SG&A by expense type between 2020 and 2021:

SG&A increased $457 million, or 9.1%, to $5.5 billion for 2021. As a percentage of revenue, SG&A leveraged by 328 basis points as we continue to deliver against our efforts to drive marketing and technology efficiency and improve store productivity, which more than offset increased wage pressure across our stores and distribution centers.

The increase was primarily driven by increases in store, marketing, distribution, and credit expenses as sales recovered and expenses normalized after our store closures last year due to COVID-19. Distribution costs, which exclude payroll related to online originated orders that were shipped from our stores, were $449 million for 2021 compared to $346 million for 2020. Corporate expenses also increased due to the retention credit benefit we were eligible for under The Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”) in 2020. Partially offsetting the increase in SG&A expense was a decrease in technology expense driven by a more balanced staffing model.

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Wage inflation remained a headwind as the employment market remained very tight. We will continue to monitor our positioning in the market to ensure that we remain competitive. We will look to mitigate the higher costs through increased store productivity and efficiency across other areas of the business.

Other Expenses

Depreciation and amortization decreases in 2021 were driven by reduced capital spending in 2020 due to COVID-19.

Impairments, store closing, and other costs in 2020 included total asset impairments of $68 million, which consisted of $51 million related to capital reductions and strategy changes due to COVID-19 and $17 million related to impairments of corporate facilities and lease assets. It also included a $21 million corporate restructuring charge, $15 million in brand exit costs, and a $2 million contract termination fee due to COVID-19, offset by a $13 million gain on an investment previously impaired and $4 million gain on lease termination.

In 2020, we recognized a gain of $127 million from the sale leaseback transaction of our San Bernardino E-commerce fulfillment and distribution centers.

Net interest expense decreased in 2021 compared to 2020 due to the benefit of debt reductions as a result of our liability management strategies employed during 2021 and because no amounts were outstanding during 2021 on the revolving credit facility. Offsetting this decrease was an increase in interest expense related to more financing leases.

In 2021, we completed a cash tender offer and recognized a loss of $201 million from the extinguishment of debt.

Income Taxes

Our effective tax rate in 2021 is less than the effective tax rate in 2020 primarily due to the 2020 rate including the benefit for the net operating loss carryback provision from the CARES Act enacted on March 27, 2020. This provision allows losses generated in 2020 to be carried back to the five preceding years, which include years in which the statutory tax rate was 35%.

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GAAP to Non-GAAP Reconciliation

We believe the adjusted results in the table above are useful because they provide enhanced visibility into our results for the periods excluding the impact of certain items such as those included in the table above. However, these non-GAAP financial measures are not intended to replace the comparable GAAP measures.

Inflation

In addition to COVID-19, we expect that our operations will continue to be influenced by general economic conditions, including food, fuel, and energy prices, higher unemployment, wage inflation, and costs to source our merchandise, including tariffs. There can be no assurances that such factors will not impact our business in the future.

Liquidity and Capital Resources

Capital Allocation

Our capital allocation strategy is to invest to maximize our overall long-term return, maintain a strong balance sheet, and maintain our investment grade rating. We follow a disciplined approach to capital allocation based on the following priorities: first we invest in opportunities to drive long-term profitability in our business as well as maintain our current operations; second we pay a quarterly dividend with a goal to increase it annually; and third we return excess cash to shareholders through our share repurchase program. In addition, when appropriate, we will complete liability management transactions, and look for profitable mergers and acquisitions opportunities.

Our period-end cash and cash equivalents balance decreased to $1.6 billion from $2.3 billion in 2020. Our cash and cash equivalents balance includes short-term investments of $1.5 billion and $2.1 billion as of January 29, 2022, and January 30, 2021, respectively. Our investment policy is designed to preserve principal and liquidity of our short-term investments. This policy allows investments in large money market funds or in highly rated direct short-term instruments. We also place dollar limits on our investments in individual funds or instruments.

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The following table presents our primary uses and sources of cash:

The following table includes cash balances and changes:

(a)
Non-GAAP financial measure. Please see the “GAAP to Non-GAAP Reconciliation” for a reconciliation of free cash flow to net cash provided by operating activities.

Operating Activities

Our operating cash outflows generally consist of payments to our employees for wages, salaries and other employee benefits, payments to our merchandise vendors for inventory (net of vendor allowances), payments to our shipping carriers, and payments to our landlords for rent. Operating cash outflows also include payments for income taxes and interest payments on our debt borrowings.

Operating activities generated cash of $2.3 billion in 2021 compared to $1.3 billion in 2020. The increase was primarily due to an increase in net income resulting from increased sales due to the impact of COVID-19 last year and a tax refund received in 2021 related to the net loss we incurred in 2020 and the carryback provision under the CARES Act. Partially offsetting this was increased inventory purchases in 2021 due to reduced inventory receipts in 2020 in response to COVID-19.

Investing Activities

Our investing cash outflows include payments for capital expenditures, including investments in new and existing stores, improvements to supply chain, and technology costs. Our investing cash inflows are generally from proceeds from sales of property and equipment.

Net cash used in Investing activities increased $433 million to $570 million in 2021. The increase was driven by in-store investments related to Sephora buildouts, refreshes, and other customer experience and sales driving enhancements; our new e-commerce fulfillment center that opened in 2021. In addition, 2020 included proceeds from the sale of our San Bernardino E-commerce fulfillment and distribution centers.

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The following chart summarizes capital expenditures by major category:

We launched 200 Sephora shop-in-shops in 2021 with plans for 400 additional shop-in-shops in 2022, and reaching at least 850 total shop-in-shops by 2023. In 2022, we anticipate capital expenditures of approximately $850 million to support the expansion our Sephora shop-in-shops, new stores and improvements to existing stores, and technology investment. We will continue to invest in a differentiated omni-channel experience to modernize the store experience, continue digital growth, and further enhance our omni-channel capabilities.

Financing Activities

Our financing strategy is to ensure liquidity and access to capital markets. We also strive to maintain a balanced portfolio of debt maturities, while minimizing our borrowing costs. Our ability to access the public debt market has provided us with adequate sources of liquidity. Our continued access to these markets depends on multiple factors, including the condition of debt capital markets, our operating performance, and maintaining strong credit ratings.

If our credit ratings were lowered, our ability to access the public debt markets, our cost of funds, and other terms for new debt issuances could be adversely impacted. Each of the credit rating agencies reviews its rating periodically and there is no guarantee our current credit ratings will remain the same.

The majority of our financing activities include repurchases of common stock, proceeds and/or repayments of long-term debt, and dividend payments.

Financing activities used $2.4 billion in 2021 compared to generating cash of $347 million 2020.

In March 2021, we issued $500 million in aggregate principal amount of 3.375% notes with semi-annual interest payments beginning in November 2021. The notes include coupon rate step ups if our long-term debt is downgraded to below a BBB- credit rating by S&P Global Ratings or Baa3 by Moody’s Investors Service, Inc. The notes mature in May 2031.

In April 2021, we completed a cash tender offer for $1.0 billion of senior unsecured debt. We recognized a $201 million loss on extinguishment of debt in the first quarter of 2021, which includes the $192 million tender premium paid to tendering note holders in accordance with the terms of the tender offer, a $6 million non-cash write-off of deferred financing costs and original issue discounts associated with the extinguished debt, and $3 million in other fees.

In October 2021, we entered into a Credit Agreement with various lenders which provides for a $1.0 billion senior unsecured five-year revolving credit facility that will mature in October 2026 and replaced our existing senior secured revolving credit facility. Among other things, the agreement includes a maximum leverage ratio financial covenant

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and restrictions on liens and subsidiary indebtedness, all of which are generally consistent with the prior 2019 senior unsecured five-year revolving credit facility. We may request an increase in revolving credit commitments under the facility of up to $500 million in certain circumstances. Events of default under the Credit Agreement include, among other things, a change of control of the Company and the Company’s default on other debt exceeding $75 million. No borrowings were outstanding on the credit facility in place as of January 29, 2022 or January 30, 2021.

In March 2020, we fully drew down our $1.0 billion senior unsecured revolver. In April 2020, we replaced and upsized the unsecured credit facility with a $1.5 billion senior secured, asset based revolving credit facility maturing in July 2024.

In April 2020, we issued $600 million in aggregate principal amount of 9.50% notes with semi-annual interest payments beginning in November 2020. The notes include coupon rate step ups if our long-term debt is downgraded to below a BBB- credit rating by S&P Global Ratings or Baa3 by Moody's Investors Service, Inc. The notes mature in May 2025. We used part of the net proceeds from this offering to repay $500 million of the borrowings under our senior secured, asset based revolving credit facility with the remainder for general corporate purposes.

In October 2020, we fully repaid $1.0 billion outstanding on the revolver and had $1.5 billion available for utilization.

We paid cash for treasury stock purchases of $1.4 billion in 2021 compared to $8 million in 2020. During the first quarter of 2021, we reinstated our share repurchase program which had been suspended in the first quarter of 2020 in response to COVID-19. Share repurchases are discretionary in nature. The timing and amount of repurchases are based upon available cash balances, our stock price, and other factors.

Cash dividend payments were $147 million ($1.00 per share) in 2021 and $108 million ($0.704 per share) in 2020. During the first quarter of 2021, we reinstated our dividend program which had been suspended beginning in the second quarter of 2020 in response to COVID-19. On February 28, 2022, our Board of Directors declared a quarterly cash dividend on our common stock of $0.50 per share. The dividend is payable March 30, 2022 to shareholders of record at the close of business on March 16, 2022.

As of January 29, 2022, our credit ratings and outlook were as follows:

Free Cash Flow

We generated $1.6 billion of free cash flow for 2021 compared to $908 million in 2020. The increase is primarily due to strong earnings resulting in an increase in net cash provided by operating activities, and an IRS refund related to the 2020 loss carryback, partially offset by an increase in capital spending from 2020 levels that were impacted by our response to COVID-19. Free cash flow is a non-GAAP financial measure which we define as net cash provided by operating activities and proceeds from financing obligations (which generally represent landlord reimbursements of construction costs) less capital expenditures and finance lease and financing obligation payments. Free cash flow should be evaluated in addition to, and not considered a substitute for, other financial measures such as net income and net cash provided by operating activities. We believe that free cash flow represents our ability to generate additional cash flow from our business operations.

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The following table reconciles net cash provided by operating activities (a GAAP measure) to free cash flow (a non-GAAP measure):

Key Financial Ratios

Key financial ratios that provide certain measures of our liquidity are as follows:

Our working capital and inventory levels typically build throughout the fall, peaking during the November and December holiday selling season. Due to COVID-19, typical working capital and inventory patterns did not occur in 2021.

The decrease in our working capital and current ratio are primarily due to lower cash balances as a result of higher share repurchases, higher capital expenditures, the cash tender offer, and fewer proceeds from the sale of real estate, partially offset by an increase in cash provided by operating activities.

Return on Investment Ratio

The following table shows our return on investment ratio (a non-GAAP financial measure):

Changes in earnings drove changes in our return on investment ratio. The prior year calculations have been revised to be consistent with our current year presentation. We have revised our calculation of Adjusted Gross Investment in the Adjusted ROI calculation to replace the lease assets presented under US GAAP with eight times cash rent for operating leases, finance leases, and financial obligations. Management believes this normalizes for timing within the lease term and the impact of lease amendments triggered by our investment in the Sephora shop-in-shops. The impact to prior years were reductions of 20 bps and 70 bps in 2020 and 2019 respectively.

We believe that Adjusted ROI is a useful financial measure in evaluating our operating performance. When analyzed in conjunction with our net earnings and total assets, it provides investors with a useful tool to evaluate our ongoing operations and our management of assets from period to period. Adjusted ROI is a non-GAAP financial measure which we define as earnings before interest, taxes, depreciation, amortization, and rent (“EBITDAR”) adjusted for certain one-time items divided by adjusted average gross investment. Adjusted EBITDAR is a useful non-GAAP measure that excludes items that are non-operating in nature and focuses on items that are key to our operating performance. Our Adjusted ROI calculation may not be comparable to similarly titled measures reported by other companies. Adjusted ROI should be evaluated in addition to, and not considered a substitute for, other GAAP financial measures. See the key financial ratio calculations below for our Adjusted ROI calculation.

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Capital Structure Ratio

The following table shows our capital structure ratio (a non-GAAP financial measure):

The decrease in our Adjusted debt to adjusted EBITDAR ratio is primarily due to higher operating income. The prior year calculation has been revised to be consistent with our current year presentation. We have revised our calculation of Adjusted Debt in our Adjusted debt to adjusted EBITDAR calculation to replace the lease obligations presented under US GAAP with eight times cash rent for operating leases, finance leases, and financial obligations. Management believes this normalizes for timing within the lease term and the impact of lease amendments triggered by our investment in the Sephora shop-in-shops. This results in a 2020 adjusted debt to adjusted EBITDAR of 7.70 versus the previous reported 7.59.

Adjusted debt to adjusted EBITDAR is a non-GAAP financial measure which we define as our adjusted outstanding debt balance divided by adjusted EBITDAR. We believe that our debt levels are best analyzed using this measure. Our current goals are to maintain a ratio that demonstrates our commitment to an investment grade rating and allows us to operate with an efficient capital structure for our size, growth plans, and industry. Our adjusted debt to adjusted EBITDAR calculation may not be comparable to similarly-titled measures reported by other companies. Adjusted debt to adjusted EBITDAR should be evaluated in addition to, and not considered a substitute for, other GAAP financial measures. See the key financial ratio calculations section below for our adjusted debt to adjusted EBITDAR calculation.

Our senior unsecured five-year revolving credit facility includes a maximum leverage ratio financial covenant and restrictions on liens and subsidiary indebtedness, all of which are generally consistent with the prior 2019 senior unsecured five-year revolving credit facility. As of January 29, 2022, we were in compliance with all covenants and expect to remain in compliance during 2022. The calculation represented above is generally consistent with the language in our credit facility.

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Key Financial Ratio Calculations

The following table includes our ROI calculation. All ratios are non-GAAP financial measures:

(a)
Represents average of five most recent quarter-end balances. For 2019, fourth quarter 2018 balances were adjusted to reflect the impact of the new lease accounting standard.

(b)
Represents excess cash not required for operations.

(c)
Represents eight times cash rent for operating leases, finance leases, and financial obligations. A calculation of cash rent can be found in Note 3 of the Consolidated Financial Statements.

(d)
Adjusted EBITDAR divided by adjusted gross investment.

The following table includes our adjusted debt to adjusted EBITDAR calculation:

(a)
Represents eight times cash rent for operating leases, finance leases, and financial obligations. A calculation of cash rent can be found in Note 3 of the Consolidated Financial Statements

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Contractual Obligations

Material contractual obligations arising in the normal course of business primarily consist of long-term debt and related interest payments, principal and interest payments for leases, and other purchase obligations. See Notes 2 and 3 to the Consolidated Financial Statements for amounts outstanding on January 29, 2022 related to debt and leases.

Other purchase obligations primarily include royalties, legally binding minimum lease and interest payments for stores opening in 2022 or later, as well as payments associated with technology, marketing, and donation agreements. The obligations were $582 million as of January 29, 2022.

Off-Balance Sheet Arrangements

We have not provided any financial guarantees as of year-end 2021.

We have not created, and are not party to, any special-purpose or off-balance sheet entities for the purpose of raising capital, incurring debt, or operating our business. We do not have any arrangements or relationships with entities that are not consolidated into the financial statements that are reasonably likely to materially affect our financial condition, liquidity, results of operations, or capital resources.

Critical Accounting Policies and Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires us to make estimates and assumptions that affect reported amounts. Management has discussed the development, selection, and disclosure of these estimates and assumptions with the Audit Committee of our Board of Directors.

Retail Inventory Method and Inventory Valuation

Merchandise inventories are valued at the lower of cost or market using the retail inventory method (“RIM”). Under RIM, the valuation of inventory at cost and the resulting gross margins are calculated by applying a cost-to-retail ratio to the retail value of inventory. RIM is an averaging method that has been widely used in the retail industry due to its practicality. The use of RIM will result in inventory being valued at the lower of cost or market since permanent markdowns are taken as a reduction of the retail value of inventories. A reserve is recorded if the future estimated selling price is less than cost.

RIM inherently requires management judgment and estimates, such as the amount and timing of permanent markdowns to clear unproductive or slow-moving inventory, which may impact the ending inventory valuation as well as gross margin. Factors considered in the determination of permanent markdowns include current and anticipated demand, customer preferences, age of the merchandise, fashion trends, and weather conditions.

Inventory shrinkage is estimated as a percent of sales for the period between the last physical inventory count and the balance sheet date. Shrink is the difference between the recorded amount of inventory and the physical inventory. We perform an annual physical inventory count at the majority of our stores, E-Commerce fulfillment centers, and distribution centers. The shrinkage rate from the most recent physical inventory, in combination with current events and historical experience, is used as the standard for the shrinkage accrual rate for the next inventory cycle. Historically, our actual physical inventory count results have shown our estimates to be reliable.

Vendor Allowances

We frequently receive allowances from our vendors for markdowns that we have taken in order to sell the vendor’s merchandise and/or to support gross margins earned on those sales. This markdown support generally relates to sold inventory or permanent markdowns and, accordingly, is reflected as a reduction to cost of merchandise sold. Markdown support related to merchandise that has not yet been sold is recorded in inventory.

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We also receive support from vendors for marketing and other costs that we have incurred to sell the vendors’ merchandise. To the extent the reimbursements are for specific, incremental, and identifiable costs incurred to sell the vendor's products and do not exceed the costs incurred, they are recognized as a reduction of selling, general, and administrative expenses. If these criteria are not met, the support is recorded in inventory and reflected as a reduction of costs of merchandise sold when the related merchandise is sold.

Insurance Reserve Estimates

We are primarily self-insured for costs related to workers’ compensation, general liability, and employee-related health care benefits. We use a third-party actuary to estimate the liabilities associated with these risks. The actuary considers historical claims experience, demographic and severity factors, health care trends, and actuarial assumptions to estimate the liabilities associated with these risks. Historically, our actuarial estimates have not been materially different from actual results.

Impairment of Long-Lived Assets

We review our long-lived assets for impairment when events or changes in circumstances, such as decisions to close a store or significant cash flow losses, indicate the carrying value of the asset may not be recoverable. All long-lived assets are reviewed for impairment at least annually.

If our evaluations, which are performed on an undiscounted cash flow basis, indicate that the carrying amount of the asset may not be recoverable, the potential impairment is measured as the excess of carrying value over the fair value of the impaired asset.

Identifying impaired assets and quantifying the related impairment loss, if any, requires significant estimates by management. The most significant of these estimates is the cash flow expected to result from the use and eventual disposition of the asset. When determining the stream of projected future cash flows associated with an individual store, management estimates future store performance including sales, gross margin, and controllable expenses, such as store payroll and occupancy expense. Projected cash flows must be estimated for future periods throughout the remaining life of the property, which may be as many as 40 years in the future. The accuracy of these estimates will be impacted by a number of factors including general economic conditions, changes in competitive landscape, and our ability to effectively manage the operations of the store.

Income Taxes

We regularly evaluate the likelihood of realizing the benefit for income tax positions we have taken in various federal and state filings by considering all relevant facts, circumstances, and information available to us. If we believe it is more likely than not that our position will be sustained, we recognize a benefit at the largest amount which we believe is cumulatively greater than 50% likely to be realized.

Unrecognized tax benefits require significant management judgment regarding applicable statutes and their related interpretation, the status of various income tax audits, and our particular facts and circumstances. Also, as audits are completed or statutes of limitations lapse, it may be necessary to record adjustments to our taxes payable, deferred tax assets, tax reserves, or income tax expense. Although we believe we have adequately reserved for our uncertain tax positions, no assurance can be given that the final tax outcome of these matters will not be different. Income taxes are further described in Note 5 of the Consolidated Financial Statements.

Leases

Accounting for leased properties requires compliance with technical accounting rules and significant judgment by management. Application of these accounting rules and assumptions made by management will determine if the lease is accounted for as a finance lease, an operating lease, or a financing obligation.

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The following are significant estimates used by management in accounting for real estate and other leases:

•
Accounting lease term—Our accounting lease term includes all noncancelable periods and renewal periods that are reasonably assured of being exercised. Typically, renewal options are considered reasonably assured of being exercised if we have made significant leasehold improvements that would exceed the initial or renewal lease term and the cash flow performance of the store remains strong. The expected lease term is used in determining whether the lease is accounted for as an operating lease or a finance lease.

•
Incremental borrowing rate—The incremental borrowing rate is the rate of interest that the lessee would have to pay to borrow on a collateralized basis over a similar term an amount equal to the lease payments in a similar economic environment. The incremental borrowing rate is used in determining whether the lease is accounted for as an operating lease or a finance lease.

•
Fair market value of leased asset—The fair market value of leased retail property is generally estimated based on comparable market data as provided by third-party appraisers or consideration received from the landlord. Fair market value is used in determining whether the lease is accounted for as an operating lease or a finance lease.

Leases are further described in Note 3 of the Consolidated Financial Statements.

Sephora Arrangement

In 2020, we entered into an arrangement with Sephora to be the exclusive beauty offering and bring a transformational, elevated beauty experience to Kohl’s. We sell prestige beauty products through Sephora-branded retail shop-in-shops in certain Kohl’s stores and through a Sephora-branded offering on Kohls.com. We opened 200 shop-in shops in 2021 and are planning to open another 400 stores in 2022 and 250 in 2023.

Both parties to the arrangement are active participants and are exposed to significant risks and rewards dependent on the success of the activities of the arrangement. The arrangement involves various activities including the merchandising, marketing, and operations of the shops and Kohls.com. Kohl’s is the principal on sales transactions with our customers and we recognize sales, cost of merchandise sold, and operating expenses in the respective lines on our consolidated statements of income. Kohl’s owns and manages the inventory and funds capital expenditures for the arrangement. The parties share equally in the operating profit of the partnership which incorporates all expenses to run the partnership including depreciation expense related to the assets. Amounts due to Sephora for their share of the operating profits are recorded in Cost of merchandise sold.