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I was reading the latest 10-Q for Kohl's, trying to start getting info about the company and decide whether I want to put money with them or Bed Bath and Beyond.

I saw that in the quarter ended October, 2000 they acquired a huge amount of short-term debt (as well as increasing their long-term debt). Reading further down in the report, I found a statement that the company "issued $554.4 million aggregate principal amount of Liquid Yield Option Subordinated Notes (LYONs) due June 12, 2020. The zero coupon LYONs were issued at a discount to yield an effective interest rate of 2.75% per year."

These can be converted to common stock by the holder at any time, and the debt is "callable by the Company beginning June 12, 2003 for cash (issue price and all original issue discount)."

So is this debt the company owes someone, or is this debt they've incurred by loaning money to other people (which I'm assuming is still a liability because the holder could default)?
Such a huge increase in debt makes me worry about the future long-term performance of the company, especially as their cash reserves shrank over the last year. This is about the only thing worrying me about investing in this company, mainly because I don't understand whether this is "good" or "bad" debt. All other indications suggest this is a good stock, but I want to understand this piece before making a decision (rather than just diving in and having it come back to bite me in the rear, as some earlier investments have done).

Any information you can give me on LYONs and what they're used for, and their likely impact on Kohl's long-term prospects, would be appreciated.
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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...

Best,

Lleweilun Smith
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Definition:
Liquid yield option note (LYON)
Zero-coupon, callable, putable, convertible bond developed by Merrill Lynch & Co.

See ML's website for more info on these securities at :


http://askmerrill.ml.com/products/details/0,,132_ask0000,00.html
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