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No. of Recommendations: 1
Dear JLMoran,

First, I know zippo about Kohl's; all of my comments are from a very cursory glance through their latest 10Q.

Here's my read on LYONs.

They are debt that Kohl's owes someone. They are callable (redeemable) by the company after three years, or any time later in the future. They are convertible at any time into 7.156 shares of Kohl stock. They are "putable" (i.e. can be redeemed) at certain times after 3 years and 10 years for a combination of cash and stock. They are "zeros", i.e. the company pays no interest except at the end (or unless these are redeemed early by either the company or the bond holders). They are subordinated (i.e. junior claim to the company).

What does this mean?

1) If Kohl's goes bankrupt, these notes are junior, likely not worth much.

2) If Kohl's share price tanks over the next few years, but Kohl's doesn't go bankrupt, there seems to be a good chance that bondholders will "put" (redeem) their shares. They will essentially get the 2.75% interest over the 3 years (or whenever they redeem it), i.e. not much interest at all, but will keep their principal. Kohl's has the right to pay cash or pay stock; if Kohl's performance is lousy and isn't that solvent, likely Kohl's would redeem in stock.

3) If Kohl's share price zooms big-time, bondholders will likely convert the bonds to cash.

Bonds are usually issued at a par ("face" value) of $1,000. Zeros are issued at a discount to the face value; and the footnotes say that for par of $554.4 million, proceeds were $319.4 million. This means that a bond with par of $1,000 was issued for roughly $576.00 (= $1,000 * 319.4/554.4). (Actually the price would be slightly higher, there would be some transaction costs, underwriting costs etc.)

Well, if we take $576.00 and convert to 7.156 shares, this is a roughly $80.49 share price. Today the share price is $62.00.

4) If Kohl's financial condition improves greatly over the next few years, Kohl's will likely redeem the debt in cash. If things go quite well, it would be better to pay in cash than pay in stock (and in principle Kohl's could issue new shares to buy out the rest of the convertible debt). Kohl's can't do that though for three years.

Well... These are kind of complicated debt instruments! It seems to me there is very little chance that this debt will be outstanding until maturity (either Kohl's or the bondholders will redeem the shares at some point).

My feeling is that this should be considered almost like equity. There is an awfully good chance that this will be redeemed for stock in some fashion; and even if redeemed for cash, the company may issue more stock to pay the cash.

My first concern isn't so much that Kohl's is taking out debt, but why. In particular, I see that inventories are increasing big-time, faster than revenues are increasing. Cash from operations is negative mostly due to the build up of inventories. Is there a change in business plan which is causing this? I'd be concerned...


Lleweilun Smith
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