Kohl’s Corp (KSS) Q3 2020 Earnings Call Transcript

Kohl’s Corp  (NYSE: KSS) Q3 2020 earnings call dated Nov. 17, 2020

Corporate Participants:

Mark Rupe — Investor Relations

Michelle Gass — Chief Executive Officer

Jill Timm — Senior Executive Vice President, Chief Financial Officer

Analysts:

Robert Drbul — Guggenheim — Analyst

Lorraine Hutchinson — Bank of America Merrill Lynch — Analyst

Mark Altschwager — Robert W. Baird — Analyst

Oliver Chen — Cowen and Company — Analyst

Matthew Boss — J.P. Morgan — Analyst

Dana Telsey — Telsey Advisory Group — Analyst

Presentation:

Operator

Ladies and gentlemen, thank you for standing by and welcome to the Q3 2020 Kohl’s Corporation Earnings Conference Call. [Operator Instructions]. After the speakers’ presentation, there will be a question-and-answer session. [Operator Instructions]. I would now like to hand the conference over to your speaker today, Mark Rupe. You may begin.

Mark Rupe — Investor Relations

Thank you, operator. Certain statements made on this call, including projected financial results and the Company’s future initiatives are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Kohl’s intends forward-looking terminology such as believes, expects, may, will, should, anticipates, plans, or similar expressions to identify forward-looking statements.

Such statements are subject to certain risks and uncertainties, which could cause Kohl’s actual results to differ materially from those projected in such forward-looking statements. Such risks and uncertainties include but are not limited to those that are described in Item 1A in Kohl’s most recent Annual Report on Form 10-K and most recent quarterly report on Form 10-Q and as may be supplemented from time to time in Kohl’s other filings with the SEC, all of which are expressly incorporated herein by reference. Forward-looking statements relate to the date initially made and Kohl’s undertakes no obligation to update them.

In addition, during this call we will make reference to non-GAAP measures including adjusted net income, adjusted EBITDA, adjusted earnings per share, and free cash flow. Information necessary to reconcile these non-GAAP measures can be found in the investor presentation filed as an exhibit to our Form 8-K with the SEC and is available on the Company’s Investor Relations website.

Please note that this call will be recorded. However, replays of this call will not be updated. So if you’re listening to a replay of this call, it is possible that the information discussed is no longer current, and Kohl’s undertakes no obligation to update such information. With me today are Michelle Gass, our Chief Executive Officer, and Jill Timm, our Chief Financial Officer.

I will now turn the call over to Michelle.

Michelle Gass — Chief Executive Officer

Thank you, Mark. Good morning and welcome to Kohl’s third quarter earnings conference call. I sincerely hope you and your families are safe and healthy. The COVID-19 pandemic has continued to remain a global health and economic challenge. As cases have risen to record levels here in the U.S., I want to extend our sincere gratitude once again to all of those working tirelessly across the country for the greater good. While we don’t know how long the pandemic will persist, I am pleased with our team’s efforts to navigate through this crisis and create more stabilization in our business.

We are successfully executing against our short-term priorities to protect the health and safety of our associates and customers and preserve the financial position of the Company. As you saw in this morning’s release, our business is strengthening. Our third quarter results exceeded our expectations with significant sequential sales and profitability improvement.

We also further enhanced our financial position during the quarter, driven by solid operating cash flow. We ended the quarter with more than $1.9 billion in cash and no amount outstanding on our revolver. Based on the progress we are making and through disciplined capital management, we are pleased to share that we plan to reinstate a dividend during the first half of 2021.

For today’s call, I’m going to provide a high level overview of our third quarter performance, touch on how we are approaching the holiday season, and spend most of my time discussing our new strategic framework for the years ahead. Jill will then review our financial results and capital structure and discuss our key initiatives to drive improved profitability. Let me start by recapping the third quarter. As I said a moment ago, our third quarter results exceeded our expectation despite a very challenging start to the quarter. As we indicated on our Q2 earnings call, the pandemic significantly impacted back-to-school sales and this weighed heavily on our sales performance in August.

However, our sales trend nicely rebounded in September and October. For the quarter, we were particularly pleased with the continued strong positive growth in our home and toys businesses as well as our performance in active and beauty. We are encouraged by these trends given that these categories grow in importance over the holiday season and they are a key part of our strategy going forward.

In addition to an improved topline trend, I am especially pleased with how the team managed the business with discipline. As you will hear from Jill, we made tremendous progress in gross margin resulting from efforts in inventory management and the acceleration of our value strategy. Importantly, we were able to fully repay our revolver this quarter due to our robust cash flow generation.

Now let me touch on how we are approaching the holiday season. Kohl’s has always been known as a holiday destination, and this year will be no different, despite COVID-19 altering all aspects of customer expectations. We entered the holiday season well positioned and prepared, amplifying our omnichannel capabilities to serve and support our customers. Given the heightened role of digital this year, it will be more important for us to further drive awareness of our store and curbside pickup services. Ship from store will also continue to be critical in supporting our omni channel network. And we are more than doubling the number of stores carrying incremental inventory to fulfill digital orders during peak.

While we feel good about our inventory position, we are actively monitoring the supply chain. We are operating very safely and we expect many customers will shop in our stores. We implemented extensive health and safety measures earlier this year and have put in place additional precautions to ensure store cleanliness, and to support social distancing during this busy time of year. From a product perspective, we’ve entered the season with a compelling assortment based on what customers want and in areas of strength for Kohl’s, where we already have momentum. We are emphasizing Active, Home, Cozy and Comfort, and Toys.

These areas become even more important in the fourth quarter, which positions us well. We also expect to see more practical gifting and a continued focus on value this holiday, which Kohl’s is known for. This holiday period is going to be unique, and we are prepared and confident that we will deliver the great experience that our customers always expect from Kohl’s. Let me now transition to how we are planning the business beyond this year and discuss our new strategic framework.

Last month we shared an updated investor presentation introducing this new framework. We are excited to share more color on this new strategy with all of you today. Our vision is to be the most trusted retailer of choice for the active and casual lifestyle. We are uniquely positioned to deliver against this vision. We serve the entire family, we offer an accessible an aspirational brand portfolio, we provide a seamless omni-channel experience and we have a leading loyalty program.

To bring this vision to life and create long-term shareholder value, we have four key areas of focus: Driving top line growth; expanding operating margin; disciplined capital management and; an agile accountable and inclusive culture. I am confident in our organization’s ability to deliver on these four focus areas. With respect to our stated operating margin goal of 7% to 8%, it’s important to remember that we delivered this margin in 2017 and 2018.

With a modest level of growth, our transformational margin initiatives already underway, and our continued focus on operational excellence, we are confident that we can return to this level.

So back to our strategic framework. I will kick off the discussion by sharing more depth around the strategies we are deploying to drive top line growth. And I’ll also touch on the organizational changes we are making to be a more agile and diverse culture. Jill will follow with the initiatives we have in place to expand our operating margin and fulfill our commitment of disciplined capital management.

Now, let me go into more detail around our key initiatives to drive top line growth beginning with products. As I referenced earlier, our vision is to be the most trusted retailer of choice for the active and casual lifestyle. Against this objective, we intend to further build on our position as a leading destination for active and outdoor. Next, we must reignite growth in our Women’s business. And third, we have a tremendous opportunity to build a significant beauty business.

Let’s start with Active. We plan to expand Active from 20% to at least 30% of our business. As we think about Active, we think of it in the broader sense covering multiple categories including Active apparel and footwear, accessories, athleisure and outdoor. Our insight show that more people are focusing on health and wellness, whether it’s working out or spending time outdoors. In addition, their active and athleisure wardrobe is expanding into many new occasions and we expect this trend to continue.

As you know, Active has already been a key growth driver of our business in recent years and doubling in penetration since 2013. Clearly, the customer is giving us permission to play here. In Q3, Active once again outperformed the Company with notable positive apparel sales growth driven by our key national brands. We’ll look to further accelerate our Active sales in 2021 through the following initiatives: First, we’ll be increasing our space dedicated to Active in our stores by nearly 20%. The outperformance of our existing 160 Active expansion stores gives us confidence that as we grow space across the fleet, we will drive incremental sales and productivity.

Next, we are introducing FLX, our new athleisure private brand in March 2021. FLX filled a white space in our current men’s and women’s assortment featuring a modern and elevated esthetic made with performance fabrics and sustainable materials. In 2021, we are also looking forward to amplifying the success we are seeing with the Champion brand, which grew 95% in the third quarter.

We see great runway ahead and we’ll further expand placement in men’s, women’s and kids. Consumers have also shown growing interest in the outdoor lifestyle. Kohl’s is uniquely positioned to serve the entire family with great brands like Columbia and our newly introduced Lands’ End offering.

Given the early success we are seeing with Lands’ End, we will continue to offer their full catalog online and we will be doubling the number of stores offering Lands’ End in 2021. Next, let me tell you about our initiatives underway to improve our Women’s business, which as you know has been under some pressure in recent years.

We have already made several bold moves earlier this year to reposition the business, starting with putting a new leadership team and structure in place. This team has been hard at work increasing the relevancy of the brand portfolio by exiting eight downtrending brands and focusing on improving clarity by significantly reducing choice counts and building depth. While this is a long-term strategy, we are beginning to see some early wins.

Consistent with where customer trends are going, we are leaning into categories like athleisure, lounge and sleepwear and intimates, which performed very well in Q3. We also saw some of our casual brands like SO and Nine West deliver strong growth during the quarter. Looking ahead, we feel good about our ability to show continued progress. In 2021, we will further iterate and evolve the portfolio to drive even more relevancy. This will include moving away from the Apartment 9 brand in Women’s as we shift our focus to Nine West, and exiting the Chaps brand altogether.

We are going to tightly manage the brand portfolio and will exit additional downtrending brands to make room for new relevant brand introductions. Third, we continue to see beauty as a significant incremental opportunity for us and have our sights set on at least tripling our sales in this category.

While only a modest low single digit penetration of our business today, we’ve driven steady growth of nearly 40% over the past five years. We know customers want a bigger and bolder beauty experience at Kohl’s. We are seeing meaningful outperformance in our elevated beauty shops that we’ve just recently expanded to 62 stores. We are pleased with the response we are seeing with the newness we’ve introduced to customers as well, including our recent launch of Lauren Conrad Beauty.

In addition to these, we remain committed to driving newness and discovery with our customers. We’ve seen great response to our introductions of Toms shoes and Lands’ End earlier this year with both exceeding our expectations. And in 2021, we will look to build on the success with the introduction of Cole Haan and several more new brands in the pipeline that we look forward to discussing with you in the future.

With the clarity of our new strategy in serving the active, casual and wellness needs of the family, we will be innovating and experimenting in new ways to serve our customers. One example of this is our Curated by Kohl’s platform that we are expanding this holiday to 300 stores.

And we recently began piloting a new concept called the Wellness Market in 50 stores and online. The wellness market is a way for us to introduce new categories to see how they come to life. It includes everyday products across home, beauty, personal wellness, baby and pet care with an emphasis on sustainable attributes. This umbrella of wellness affords us the opportunity to experiment with many different products and we are already getting good initial insight into areas like baby, pet and household supplies.

Our strategy gives us a clear lane to experiment, and we are excited to pursue many new opportunities. Now let me shift our strategic effort around loyalty and value. As a leader in the loyalty and value space, the current environment presents an opportunity to further separate ourselves and drive greater clarity and innovation in how we deliver value to our customers.

We are approaching the strategy on two levels. First, let me start with our core value equation. This is the combination of how we competitively price our goods, while we offer relevant promotions that resonate with both new and existing customers. Our customers give us very high marks in delivering great value, but we know that expectations are evolving and we need to evolve too.

One of the insights we have is that customers want to understand the end price they are paying more quickly. While promotions will continue to be important, we are balancing this out by investing more in price. What this means in practice is you’ll see us shift even more into price led events, while still maintaining the promotions that matter the most.

We’ve been testing and evolving into this model over the last year and we scaled it more aggressively in Q3. This approach resonated with our customers and we saw a gross margin benefit as well, as Joe will discuss later. To be clear, value is part of the core DNA of Kohl’s. We know where the customer is going and we are evolving thoughtfully. I’m encouraged by the results we are seeing. And second, a critical and highly differentiated part of the value equation for Kohl’s is our loyalty program delivered through our Kohl’s Cash, our recently updated Kohl’s Rewards program and of course, our leading private label Kohl’s Charge card.

Let me just spend a minute on our new Kohl’s Rewards program. As I’ve shared with you before, Kohl’s Rewards is based on our iconic Kohl’s Cash and now more fully integrates our digital, omnichannel and store capabilities. We have a great program, and now we’ve made it even easier. Even seemingly small things like customers always knowing the total balance of their Kohl’s Cash and reminders we send them when their Kohl’s Cash is expiring are delivering a better and more seamless experience.

We launched the new program in September, and we’ve seen increased engagement with significant growth in sign ups and higher redemption rates. Now, let me shift to our third focus area in driving growth; delivering a differentiated omnichannel experience. The COVID-19 pandemic has no doubt accelerated the shift towards digital, and we’ve seen this in our business. Digital sales represented 32% of our total sales this quarter, increasing 25%.

Our stores supported much of this growth fulfilling nearly 40% of the digital sales. Kohl’s is positioned to continue benefiting from this shift. We have an extremely healthy and flexible off-mall store base, a large and growing digital platform and compelling and differentiated omni capabilities which reach our base of 65 million customers.

Our omnichannel customer is six times more productive than a digital only customer and four times more productive than a store-only customer. We were pleased to see a number of our store only customers become omnichannel customers during this time and we expect this to continue as they enjoy the convenience of shopping digitally in addition to our stores. We are incredibly focused on evolving and elevating the customer experience across our store and digital assets.

We are modernizing the total store experience by refreshing the look and feel of the environment and improving overall clarity through our inventory management initiatives. We also continue to build on our new digital experience launched in January of this year by delivering more personalization that are filtering and tailoring our messages with great agility as customer needs shift.

We will continue to invest in our omnichannel capabilities as this truly leverages our advantageous off-mall presence. We are focused on driving further adoption on our pickup offerings and especially Store Drive Up. And we continue to be pleased with Amazon Returns, both from a customer experience and economic standpoint.

We are also experimenting with new services such as self-service returns, which provide both an easy experience to customers and an expense benefit as well. Now, let me touch on how we are evolving our organization to become even more agile and diverse. We are fortunate to have an outstanding culture here at Kohl’s, driven by our passionate and talented associates. The team is innovative, agile and accountable, and we will continue to evolve how we work to accelerate our progress against our strategy.

Even during this unprecedented time with all of our people working in new ways, whether that’s in our stores, fulfillment centers or corporate offices, I’ve never seen the level of innovation and creativity that I am seeing today. We are deeply committed to fostering a diverse, equitable and inclusive environment for our associates and customers and we recently established a diversity and inclusion framework to accelerate our progress. This effort is being driven by a diversity task force with leaders from across the Company. And we are focused on a number of key initiatives across the three pillars of our D&I framework: Our people; our customers and; our communities. I look forward to sharing our progress with you in this important focus area of the Company.

We have made great progress in the area of ESG, a journey that began more than a decade ago. We have established 2025 goals related to climate change, waste and recycling and sustainable sourcing. Our efforts received frequent recognition including the Dow Jones Sustainability Index and Barron’s most sustainable companies. Maintaining our strong culture while driving progress against our operational excellence efforts requires difficult actions at times.

In September, we reduced our corporate positions by approximately 15% to align our cost base in response to the business impact resulting from the pandemic. As difficult of a decision this was, it was an important step to set us up to deliver against our strategic framework. Before I hand it off to Jill, let me summarize my comments today.

I continue to be very proud of how our organization is navigating through the COVID-19 pandemic. Our third quarter results exceeded our expectations with significant sequential sales and profitability improvement. Our performance also showcased the power of our business model, specifically, our cash flow generating capabilities, despite facing pandemic driven headwinds. We’ve also learnt to run the business with greater speed, agility and creativity during this pandemic which will continue to benefit us going forward.

The ongoing disruption in the retail industry presents significant market share opportunities and we are aggressively taking advantage of that. We began to redeploy our competitive store closure strategies during Q3 and we are pleased with the initial traction we are seeing. We’ve said this before, but it’s worth saying again, Kohl’s is a well-disciplined operator with a strong foundation.

We have a new strategic framework in place that will enable an even more compelling customer proposition and we are working hard to create significant long-term shareholder value. In closing, I want to recognize all of our associates around the country and across the business for their incredible resilience and commitment to Kohl’s in what has been a challenging and ever-changing year. Your perseverance is a testament to the strength of this organization.

With that, I will now turn the call over to Jill who will provide details on our third quarter results and financial position.

Jill Timm — Senior Executive Vice President, Chief Financial Officer

Thank you, Michelle and good morning everyone. Before reviewing our third quarter results, I want to provide some additional color on our initiatives to expand operating margin and fulfill our commitment to disciplined capital management. As Michelle indicated, returning to a 7% to 8% operating margin level will require modest sales growth in a normal environment, gross margin improvement, and a lower SG&A expense ratio as compared to 2019.

Let me discuss how we plan to get there starting with gross margin. First, we are focused on inventory management and increasing our inventory turns. Our efforts on this front include a focus on fewer choices with greater depth for choice. In addition, we will shift towards more productive categories like Active, while streamlining less productive categories like dress apparel in men’s and women’s and fine jewelry.

We’ve already begun to make progress as shown in our Q3 margin performance and increased inventory turns. Second, as Michelle discussed, we are encouraged by the progress we are making to simplify our core value equation. We are in the beginning of this journey, but the early results are encouraging. During Q3, we optimized our promotional strategies focusing on the most productive offers and we invested into price to drive a clear, compelling value to our customers. We see further opportunity going forward.

And third, we have a supply chain transformation underway, where we are focused on optimal deployment of inventory to increased service levels, reduced clearance and shipping costs while improving churn. This includes increased precision of inventory placement by channel, informed by demand forecasting and expanding our sourcing engine capabilities to avoid future markdown risk. Now turning to SG&A expense opportunities, we have managed SG&A to 1.5% CAGR over the past few years, but we plan to manage this more tightly moving forward.

We will continue to leverage our operational excellence initiatives and focus on expenses across stores, marketing, technology and corporate. As it relates to store expenses, we continue to learn from our actions taken through the crisis. We’ve operated with fewer store hours and with just one entrance open which has helped to reduce payroll costs.

In addition, we are going to increasingly leverage technology to streamline and automate task based work. We are currently testing both self checkout and self returns which we plan to scale to more stores in 2021. We’ve also learned a lot this year in our ability to be more efficient in our marketing spend. During Q3, marketing spend was down 18%, improving our advertising to sales ratio. We are investing in the most efficient media such as digital while reducing less productive areas such as print advertising.

We also leveraged our technology spend in Q3. As we pulled back on capital spend, we are afforded the opportunity to rebalance our internal versus external model. In addition, we have embedded greater discipline in where we invest and have adopted a new, more agile methodology, enabling us to deliver more value with less resources.

And lastly, we will continue to seek out efficiencies across corporate and other areas leveraging our core discipline of operational excellence. Our corporate restructuring actions in 2020 are expected to deliver expense savings of more than $100 million on an annualized basis.

Going forward, we will continue to look for cost savings opportunities. And, we are also committed to disciplined capital management. This is a hallmark of ours and we remain focused on managing the business to sustain our investment grade ratings. We showcased this in the third quarter through significant cash flow generation, debt reduction and now disclosing our plan to reinstate a dividend in the first half of 2021.

We’ll be thoughtful on how we reinstate a dividend, taking into account the payout ratio and yield as well as our intent to sustain and grow it over time. We also see opportunities to do some liability management in 2021 to further improve our leverage profile.

Now let me review our third quarter results. We made significant progress in Q3. While sales and earnings remain down versus last year, they improved substantially relative to the second quarter. Net sales declined 13% driven in part by challenging back-to-school sales in August. We saw a nice rebound in sales in September and October. Digital sales increased 25% for the quarter and accounted for 32% of total sales, up from 22% last year.

Other revenue declined 25% driven primarily by credit revenue. This decline was due to lower accounts receivable balances associated with lower sales. In addition, we saw an increase in payment rates resulting in less interest, late fees and write-off activity as compared to last year. From the line of business perspective, as Michelle indicated, we saw strong results in areas like home, active, beauty and toys, while dress apparel and footwear were soft due to the crisis.

Our home business remained strong during the third quarter with sales up 10% overall, and up over 50% digitally. Our customers continue to show interest in the kitchen with solid demand for cookware, food preparation and kitchen electrics as well as their living spaces where sales increased in floor care and bedding. Our active offering also outperformed in the quarter. We saw positive apparel sales growth driven by both our key national and private brands. And we continue to see growth in our assortments of inconclusive sizes.

Children’s outperformed the Company with double-digit growth in toys and successful new brand introductions of Lands’ End and Little Co. by Lauren Conrad. This was offset by some softness in back-to-school categories such as uniforms, backpacks and denim.

Turning to gross margin, Q3 gross margin was down 48 basis points to last year, which showed significant sequential improvement from Q2. While we continue to face headwinds from shipping cost to deal with increase in digital sales penetration, we are pleased with our ability to offset a majority of the pressure through our intense focus on inventory management and pricing and promotion optimization. Looking ahead to Q4, gross margin will continue to benefit from these efforts and will help offset some of the shipping cost headwinds from increased digital penetration and incremental freight surcharges over the holiday period.

We estimate the freight surcharge impact to be 100 basis points to 150 basis points of margin pressure. Now let me discuss SG&A. In Q3, SG&A expenses decreased 8% to $1.3 billion driven primarily by lower store payroll, marketing and credit expenses. Of note, SG&A would have been down 10% excluding expenses related to COVID-19.

Last, let me touch on some additional financial items. Depreciation was $17 million lower than last year and we expect this to continue due to the reduced capital spend of this year. Non-recurring charges of $21 million relate to the corporate restructuring activities incurred during the quarter. Interest expense increased $26 million versus last year due to higher debt outstanding during the quarter. For Q4, we expect interest expense to remain higher than last year as a result of the April bond issuance, but lower relative to the third quarter as we fully repaid our revolver in October.

Our tax rate in Q3 was elevated, primarily due to tax benefits from losses eligible for carryback under the CARES act. We expect to continue to see this elevated rate in Q4. On a GAAP basis for the quarter, our net loss was $12 million and net loss per share was $0.08. Excluding non-recurring items for the quarter, adjusted net income was $2 million, or adjusted earnings per share of $0.01.

Turning to the balance sheet, we ended the quarter with more than $1.9 billion of cash and cash equivalents, a $1.4 billion increase from last year. Our strong cash flow generation during the quarter allowed us to fully repay our revolver which had previously had $1 billion outstanding. We are really pleased with our tightly remanaged inventory during the third quarter. Inventory decreased 26% to last year and we increased return to a five-year high.

We also improved the health of our inventory with aged inventory down significantly from the second quarter. We will continue to manage inventory tightly with the opportunity to chase into demand in Q4 and beyond. Turning to cash flow, we generated positive operating cash flow of $910 million year-to-date including $606 million in the third quarter driven by our actions to reduce both inventory and expenses.

Capital expenditures were $264 million year-to-date, including $68 million in the third quarter. This is significantly below last year as we reduced spending across technologies, omni-channel and our store strategies due to COVID. However, we have resumed capital spending related to our sixth e-commerce fulfillment center which will open in 2021.

We now expect capital expenditures for the full year to be closer to $300 million. In summary, we further strengthened our financial position in this quarter. Sales and gross margin showed significant improvement from the second quarter. We continued to deliver positive operating cash flow, paid off our revolver and ended the quarter with over $1.9 billion of cash and cash equivalents.

Although the pandemic will continue to create uncertainty this holiday season, we will put our best foot forward, leveraging our strong financial position and the agility of the organization. We are focused on maximizing our sales opportunities across all channels. We will benefit from our margin driving initiatives and we remain focused on managing our expenses tightly.

Given this uncertainty and to align more directly with our peers, we are not planning on providing a holiday sales update this year. Therefore, we look forward to discussing our holiday performance and providing an update on our strategic progress on our Q4 call in early March. This has been an extraordinary year on every level and we are proud of the way we have managed through this time. We have shown progressive improvement and stability in the business and are focused on executing against our new strategic framework to drive long-term shareholder value.

We are happy to take your questions at this time.

Questions and Answers:

Operator

[Operator Instructions]. Your first question comes from the line of Bob Drbul from Guggenheim. Your line is open.

Robert Drbul — Guggenheim — Analyst

Hi, good morning.

Michelle Gass — Chief Executive Officer

Good morning, Bob.

Robert Drbul — Guggenheim — Analyst

I guess — the question I have really is, can you talk a little bit just about the expectation that you have for holiday with respect to sort of like the sales mix of stores versus digital and maybe just talk about overall traffic that you’ve seen so far and your expectations for the coming weeks. That will be very helpful. Thanks Michelle.

Michelle Gass — Chief Executive Officer

Yeah. You bet, Bob. Thanks for the question. So first to set a little context, I mean clearly it’s a very important quarter for us and the industry, and as you know, Kohl’s has always been known as a holiday destination, and we are putting our best foot forward this holiday like we always do. We are planful and prepared and this quarter we’re ready to adapt as needed as the customer adapts.

That being said, we are pleased with how the holiday has kicked off. Let me remind you, we’re still in a pandemic and there’s a lot of uncertainty ahead. But the customer response so far has been positive. And like I said, we’re pleased with the early results. We made a lot of adjustments to adapt to what we knew was going to require changes given the pandemic. I’d say really hitting all elements of the holiday season from timing, product, value and the experience.

From a timing standpoint, we have put more emphasis on the early part of the season so, we kicked off with great energy an early Black Friday campaign, like I said, we are pleased with that. And from a product standpoint, we are leaning into categories that have been performing for us, categories like home and active and even toys that become even more important during the holiday season.

Value is always important, this time of year and ever — ever more so this holiday season pleased that we just launched our new Rewards program that’s off to a good start. And I think, Bob, we have a really good balance of price led events and also promotions that we’re quite famous for.

And lastly, getting specifically to your question on the channels is around the experience. I think we really benefit from having such a strong omnichannel presence. First, start with our stores, as you know 95% off-mall, clearly it has been very important during the pandemic, and will continue to be so during the holiday season. And then, digital, we like — like all are seeing digital acceleration, we made a lot of investments the last couple of years and the customer is responding. We’re pleased with the strength we saw in Q3. We expect that to continue into Q4. And as you know, typically Q4 for us digital does penetrate even higher.

So we are prepared for that. You’ll see us amplify our pickup options and really leverage the store footprints. Again, we’re pleased with the customer adoption of buy online pickup in store and then curbside, which now represents a third of all the pickups that we’re seeing from customers. And then just specifically on traffic trends, the only thing I would comment is as we think about Q3 and how we entered and exited the quarter, the beginning of Q3 was tougher given back to school, but the back half of the quarter call it September-October was stronger and we specifically saw the store traffic pick up once we got — once we got past that back to school season and so the improvement we saw in September, October, really was all driven by improvement in the store performance.

Robert Drbul — Guggenheim — Analyst

Got it. Okay. And Michelle, just one question on the Women’s business generally, like, do you feel like you’re making some progress in women’s yet, and I was just wondering things like layered trends are actually starting to work a little bit in Women’s. I was wondering if that was impacting your business at all sort of Q3 and the Q4? Thanks.

Michelle Gass — Chief Executive Officer

Yeah. No, great question. So I’d say like across all of our businesses we did see improvement from Q2 into Q3 and we have a lot of focus happening in Women’s. We’ve already made a lot of moves that we’ve talked to you about. So, including putting a new leadership team and a new structure in place, we are really focused on the brand portfolio, so we exited a, downtrending brands, we just announced more on the call today. And we’re seeing some early wins. We’re seeing wins in categories like of course active, but athleisure, lounge, sleepwear, intimates and more casual brands like SO and Nine West.

So specifically to your comment or question on trends, we are seeing that in our business and we’ve been deliberate to bring in a lot more layering pieces into the assortment. We have personalization capabilities, so you’ll see that in our communication, our emails to customers. So we are really balancing out our assortments and offering more — more jackets and layering pieces to where the customer and how they’re dressing today, which is definitely more comfortably and more casually.

Robert Drbul — Guggenheim — Analyst

Great. Thank you very much. Happy holidays, Michelle.

Michelle Gass — Chief Executive Officer

Thanks Bob.

Operator

Lorraine Hutchinson from Bank of America. Your line is open.

Lorraine Hutchinson — Bank of America Merrill Lynch — Analyst

Thank you. Good morning. Can you comment on the health of the credit portfolio, and then maybe just give us some indication of what kind of performance is baked into your 7% to 8% margin target for credit specifically?

Jill Timm — Senior Executive Vice President, Chief Financial Officer

Sure, good morning Lorraine, it’s Jill. So for credit, obviously it was down in the quarter, really two key components there. One was the sales performance and the second was actually driven by an acceleration in the payment rates. So as the quarter progressed, we saw our payment rates actually hit all time highs in terms of how the customer responded, which then results in less late fees and interest charges. The good news is, it means our customer is incredibly healthy. They have more opened up aisles moving into the holiday period and it definitely derisks us as we move into 2021.

I think going forward, what we’re modeling from a credit perspective is really for it to stay back in line with sales. I think we’re in some unique times right now based on how the customer and the economy is moving, especially with and without the stimulus. So this is definitely, I think an anomaly, not how I would expect it to continue moving forward.

Lorraine Hutchinson — Bank of America Merrill Lynch — Analyst

And so when you say get back in line with the sales, that implies that your 2021 credit income will grow back towards 2019 levels?

Jill Timm — Senior Executive Vice President, Chief Financial Officer

Yeah. We will definitely follow that. So obviously a key component is our Kohl’s Charge Card, you know, it’s our most loyal customer. We get the most spend from that customer. So as we continue to move forward, we would expect that to move back in line with sales and the health of the customer obviously would afford that spending as well.

I think the other note is, we are seeing new customer acquisitions through our market share disruption strategies that we started deploying this quarter. Those new customers move in and then we have the ability over the long term to continue to move them up the loyalty ladder as you know into the Kohl’s charge, which will help to continue to perform as well.

And then I think if we step back and your other question was how we get to the operating margin levels, and you know, we tried to outline that this will definitely be requiring some modest growth on the top line, the expansion of margin from a gross margin perspective, what you’ve seen us do in the past and this will really be enabled through our inventory management initiatives, our simplified value equation as well as our supply chain transformation.

And then, we will continue to manage our expenses. It’s been a core discipline of Kohl’s. But you’ll see us tighten on those expenses through some of the actions that we talked about automation and use of technology in the stores. Continuing to focus on our productivity and marketing and tightening that [Indecipherable] as well as being much more efficient in our technology spend.

And then you saw us do some unique actions this year for corporate, but we’ll continue to leverage our operational excellence across the organization to continue to drive down expenses, all of which will then lead to the increase in the operating margin level. What I will say is, I know we haven’t given you a time frame. A lot of that is due to the continued uncertainty that we see in the environment today. But we do look at this as more of a near-term goal. So I would say we expect to do this in the next two to four years versus over the long term, it’s really just dependent on when we see some stabilization in the market.

Lorraine Hutchinson — Bank of America Merrill Lynch — Analyst

Thank you.

Operator

Mark Altschwager from Baird. Your line is open.

Mark Altschwager — Robert W. Baird — Analyst

Good morning. Thanks for taking my question. Specific to gross margin, can you talk about some of the puts and takes over the holiday period? To what extent do you think benefits from inventory management and pricing can offset the shipping and the surcharge that you talked about? And bigger picture gross margin was just under 36% this quarter. As we think about the new algorithm as you manage inventory more aggressively, is 35% to 36% gross margin level you think is achievable in fiscal 2021 or should we be thinking more kind of a multi-year build to get back to that level?

Jill Timm — Senior Executive Vice President, Chief Financial Officer

So Mark, I can definitely start here. I think, obviously trying to get to the end goal of the 7% to 8% operating margin is the goal we’re going to focus you on. We will look to expand margin over that time. As we look at Q3, we are down about 50 basis points and a lot of that was driven off of two key strategies, first inventory management. You saw inventory was down 26%. We had a five-year high from an inventory turn. And over history, you’ve seen when we’ve managed our inventory tighter we turn faster, we not only benefit for sales because we’re chasing the right goods, we benefit on margins as we don’t have to take the markdowns. So it’s much more productive for us.

That benefit will continue to persist into Q4 or managing tightly or chasing into the areas that are trending, so that will continue. The core value equation that Michelle had talked about during her script as well, we know we’re known for great value and promotions. That is definitely not going away. But you also know we’re known for testing. And we have tested a lot over the past year to focus on the most productive offers. You’re going to see us moving to pricing, instead of having as many promotions really getting the customer to the end price much more quickly, and we’re going to leverage our personalization efforts to target offers.

So the offers are going to drive behavior, be much more targeted and help us expand margin in the same timeframe as well. Those two things will continue into Q4. Q4 as you know, digital always outsize us. And in addition, this year, we do have during that holiday peak a short-term headwind with surcharges, which we indicated in the call, which will end to about 100 basis points to 150 basis points of headwind this year.

As we move forward long term, we’re accelerating our supply chain transformation and that’s really an end-to-end supply chain. We’re going after COGS, so we’re looking at sourcing work to bring down those expenses. But we’re also looking at how to optimally deploy our inventory, and this is going to help us mitigate our cost of shipping. We’re going to have much more real-time inventory allocation, much more dynamic allocation to react to how the demand is coming in, so we can best place that inventory to optimize our shipping costs and bring down those levels, which is the pressure obviously that you’ve seen with digital over the last several years.

So that will be more over the long term, but those three key initiatives Mark is what’s going to grow our gross margin and really contribute to that 7% to 8% operating margin goal that we’ve set.

Mark Altschwager — Robert W. Baird — Analyst

It’s very helpful. Thank you. And if I could also follow up on marketing, just wanted to maybe you could speak about how you’re thinking about marketing investment over holiday and into early 2021. You know, a lot has changed in terms of the assortment, or it still is changing, yet happening at a time when many consumers happened to visit the stores as much and apparel hasn’t been as top of mind. So I guess I’m wondering, how are you thinking about balancing marketing efficiency and margins with the need to maybe invest more aggressively in marketing to drive customer acquisition in this type of environment.

Michelle Gass — Chief Executive Officer

Yeah, Mark. So it’s Michelle here, I’ll take your question. So we feel really, really good about our marketing strategy. You know, we’ve used this opportunity to really kind of tighten our marketing strategy, drive greater impact, and as a result, drive greater efficiencies.

So, good example is how we have evolved our mix, our media mix, driving a lot more towards digital and moving out of some of the less productive elements of our marketing mix like say traditional newspaper inserts, etc. We will still use those surgically, but certainly what we’re learning and where the customer is going is, they’re highly responding to the capabilities that we’ve built on the digital marketing side. And we expect this to continue. So we have, as we’ve commented, we have reduced our overall marketing spend, just given the dynamics of the pandemic. But we will always prioritize driving the top line, but driving it now in a much more impactful and efficient way.

The other big benefit we get with being so much more digitally driven is that we have great flexibility and agility. So as the consumer trends have evolved over the time of that pandemic, we have been able to quickly adapt on our messaging and our mix even within digital to go where the customer is going and what’s resonating with them and we’re able to see real-time what they’re responding to. And day by day we’re flexing that marketing muscle to chase the demand, but do it in a more efficient and impactful way.

But that is over time, as Jill was just talking about our targets around overall margin expansion, driving marketing efficiency is a key lever, but like we often talk about many things we’re testing our way into it and we’re very confident in the results we’re having that we can drive better impact in reaching customers and driving traffic and new customer acquisition, but do that in a more efficient way.

Mark Altschwager — Robert W. Baird — Analyst

Thank you for that and best of luck for the holiday.

Michelle Gass — Chief Executive Officer

Thanks, Mark.

Jill Timm — Senior Executive Vice President, Chief Financial Officer

Thanks, Mark.

Operator

Oliver Chen from Cowen. Your line is open.

Oliver Chen — Cowen and Company — Analyst

Hi, thank you. Regarding reigniting Women’s, what will be earlier versus later in your thoughts on timing and mix over time from the Women’s part of the business? Bigger picture would also love your view of your longer-term strategic goals in terms of speed, reducing weather sensitivity and also thinking about a month-to-month volatility. Will we continue to see that for the foreseeable future and longer term? Thank you.

Michelle Gass — Chief Executive Officer

Yes. So Oliver, Michelle here, thanks for the question. So specifically to Women’s, as you know, that’s a key plank in our new strategic blueprint to really reignite growth in Women’s. And it is amongst the top priorities to the Company. We have a great team and a great leader who is driving this change. And as I mentioned earlier in my remarks, we’re already starting to see the benefit of that. What I would say first of all is getting a really good sense of what the customer wants from us and so we have been using insights to drive the changes we’re making around our brand portfolio. We are exiting, we have exited, and we’re continuing to optimize the portfolio over the brands to make sure that those are the ones that are most relevant to a broad base of women, because we serve on broad demographic. So we want to make sure that we’re hitting it across both our core customer and new customer.

And the customer is telling us they want — they want greater clarity, they want fewer choices and what we do put in front of them has to be more meaningful and I’m really encouraged by the progress. I think we’ll really see that into 2021. As we drive the new brand portfolio, did mentioned that we’re seeing great results in younger brands like SO, Nine West with a greater casual focused lands and which cuts across the family, but it’s resonating with our female customer. We have more in the pipeline as we look ahead into 2021 and beyond.

So it’s the product that we offer, it’s how we merchandise and doing a lot more storytelling. But with reduced inventory and choice counts, we have more space in the store to make a greater shopping experience, and we’re seeing that resonate with our customers. And this is both in stores and its digital and our personalization engine is also really important to make sure that we can target customers with the right message.

As it relates to call it early wins that we’re seeing now will carry into us in 2021, it’s the active category clearly, but athleisure and athleisure is an extension of some of our core brands today, as well as our new brand FLX, that we’re very excited about in terms of a white space for serving our female customer, cozy, comfortable, lounge sleepwear as well as more kind of top to bottom casual dressing.

So you know, one of the top retailers of — Levi’s is an example, which fits squarely into our new strategy. So I think the combination of that, the portfolio, the value we offer, the store experience, the digital experience, I think we’re really set up to pivot this business in 2021 and beyond. And then, your second question around speed, weather sensitivity, etc. Let me take weather first, I mean I think we’re making tons of moves as we’re driving our new strategy to have fewer less weather headwinds as we look to 2021 and beyond. We’ve talked about the momentum in categories like home and as we think about our new strategy and being that destination for the active and casual lifestyle, that includes home.

And so, that has a nice benefit of reducing weather sensitivity. And then categories like active tend to be less weather-sensitive. So I think we’re making all those right moves to give us that insulation. And then our supply chain, our product development process, speed is paramount. We’re — as we sit here today, our inventory turn is at a five-year high. That will only continue as we look forward and speed to market is a critical part of that.

Oliver Chen — Cowen and Company — Analyst

Thanks a lot. Just one follow-up on beauty. There is an exciting opportunity ahead. What will be your approach to the brand matrix? And as you think about masks and versus prestige [Phonetic], as well as category highlights and what’s different this time versus prior efforts many years ago. Thank you.

Michelle Gass — Chief Executive Officer

Yeah. You bet, Oliver. So we’re really excited about the beauty opportunity. It’s a large attractive market for us. There is a lot of disruption happening and transformation in the industry. It is a small business for us today, but we’ve made steady progress over the last five years. We — our growth is up nearly 40%. So the customer is giving us permission here and we have scale, right, we serve 65 million customers, 70% are women and they’re looking for a bigger and bolder beauty solution for us — from us, I should say. And so we see a lot of upside, as you might imagine we’re having lots of great conversations with brands given the disruption that’s happening in the industry.

I’d say our customer is looking for an elevated experience. They are looking for those higher end brands as we’ve offered them that customer is responding. And the investments we’re making was different, is working. So building out, we have a little over 50 stores now where we’ve built out a much more premium experience that has dedicated associates to it and it’s an opportunity for the customer to really explore and discover what’s there, that’s working.

So you can expect to hear more from us on the beauty category in the months to come.

Oliver Chen — Cowen and Company — Analyst

Best regards. Happy holidays.

Michelle Gass — Chief Executive Officer

Thanks, Oliver.

Operator

Matthew Boss from J.P. Morgan. Your line is open.

Matthew Boss — J.P. Morgan — Analyst

Great. Thanks. Michelle, maybe relative to home and active, which I think accounted for roughly 40% of sales pre-pandemic where do you see this mix strategically moving and you mentioned some of your tests, I think particularly on the active. Any key proof points that give you confidence that Kohl’s will be the primary customer destination for these two categories?

Michelle Gass — Chief Executive Officer

Yes. Thanks, Matt for the question. So in terms of mix, what I’d point to you say, for in roughly the 40% territory today, active alone we see growing to over 30%. So that takes you north of 50% right there. So it will be a very, they’re very important businesses for us today and they’ll become even more important as we look forward.

I would say we have a lot of proof points that this is where the customer wants us to go. If I look at active, as you know we’ve more than doubled the business, it’s 20% of our business today like I said, growing to 30% or more. We’ll take the customer’s lead on that. But I think importantly, the active productivity is significantly higher than the overall productivity in our store.

So even by dedicating more space, which we’ve done over time, and we’re going to increase the space dedicated to active by another 20% this coming year. We know that that’s going to give us greater productivity in the box. So that gives me great confidence. The growth gives me confidence, the active expansion stores that we’ve been testing and iterating 160 of them have had great results, they outperformed the chain.

And I just think, Matt, we are so uniquely positioned to deliver against this vision, while clearly active and athleisure has been a trend, we really feel like we can own delivering active, casual wellness beauty for the entire family across so many categories. And also, the unique brand portfolio we have really stretching from accessibility and great value to great aspiration with our national brand partners. So I think those things, and then just to finish off the power of our omni-channel platform, off-mall reach, our digital platform, all those things give me a great confidence that we can win in this space.

Matthew Boss — J.P. Morgan — Analyst

Great. And then to follow up Jill on gross margin, what was the headwind from cost of shipping in the third quarter, and then on the composition of the fourth quarter gross margin, so the 100 basis points to 150 basis points freight surcharge that you cited, is that incremental to underlying digital fulfillment headwinds that we would normally see in the fourth quarter? And what’s your assumption for pricing and promotional activity year-over-year, this holiday or fourth quarter maybe based on what you’re seeing so far.

Jill Timm — Senior Executive Vice President, Chief Financial Officer

Sure. So in Q3, what I would tell you is our cost of shipping headwinds were pretty normalized to the stats that we had given you the 20 basis points to 30 basis points or 200 basis points to 300 basis points of penetration increase. So we are back into that norm. We are a little elevated in Q2 due to the store closures and the inventory not being absently placed. So as we were able to move back into normalization, get our inventory fresh, we ended up seeing that right in that normal.

As we move into Q4, I expect, you know, the promotional environment, we’re actually going to carry through a lot of what we’ve tested and learned and saw a success in Q3. So you’re going to see us with pricing events, you’re going to see us with more targeted offers, but obviously holiday is about value. It’s what Kohl’s stands for. So we’re going to continue to drive that through our promotional activity.

I just think it’s going to be more moderated or normalized versus elevated based on what we’re seeing. And if it is elevated, we can leverage our targeted personalized offers to really drive behavior, which will help margin. So that will continue to persist as a benefit, as well, our inventory management. We are down 26% in inventory. It was — the aging was down substantially from Q2. We have a lot more clarity on the floor.

So we feel very well positioned as we move into Q4 with our inventory. And we’re going to continue to manage that down. So we will exit the year very clean from an inventory perspective. The freight numbers, it is a short-term one-time charge and it is on top of what we would normally see as our digital headwinds. So you know, in Q4 digital typically out penetrates. So we will continue to see those same cost of shipping headwinds that we’ve seen in all year, it will normalize again like it did in Q3. And then on top of that, we’ll see about 100 basis points to 150 basis points of headwinds.

But I don’t want to leave without saying that the efforts that we have on the value equation and the inventory management will benefit us and will help offset some of those headwinds.

Matthew Boss — J.P. Morgan — Analyst

Great. Best of luck.

Michelle Gass — Chief Executive Officer

Thank you.

Operator

Dana Telsey from Telsey Advisory Group. Your line is open.

Dana Telsey — Telsey Advisory Group — Analyst

Good morning, everyone, and nice to see the sequential improvement. Michelle, if you think about the market share opportunities that are out there that only seem to be growing, where do you see the most abundant share opportunities come? Is it from a category? Is it from distinct retailers? And as you’ve looked at your store formats and whether it was the other ancillary tenants as you’re subdividing some space, how do you think about that going into 2021 and beyond? And Jill just on the investing in price, what does that mean for gross margin overall? And does it differ in store versus online? Thank you.

Michelle Gass — Chief Executive Officer

Thanks Dana for the question. So I’ll kick it off and then I’ll hand over to Jill here. So we think there is a lot of market share opportunity for Kohl’s as we look forward. As you well know, if you just take brick and mortar alone, there are thousands of stores that are closing over this year and going into next year.

I would — I think about market share on two levels, both in terms of our short-term opportunity and then our long-term opportunity. So short-term, as we sit here today, headed into the fourth quarter at the beginning of next year and beyond, it’s how can we capture that dislocated market share and capture those customers in a particular area, neighborhood, etc. And we’ve had this playbook in the past Dana, if you might remember, as we’ve seen either chains or stores close down and it’s worked for us quite successfully. It did benefit us in the 2018 timeframe, let’s say.

And that’s everything about identifying those customers, I mean, we can geo-target them. We can look at what the categories of product that they’ve been buying. So for example, if a retailer had been selling some of the national brands that we’ve been selling, we can market those things directly.

So I do think it’s a combination to your question about category and store specifically. So I believe we’re well-prepared and we’re going to maximize that share gain opportunity. And then over the long-term, it’s really capturing share by having an even more relevant proposition to the customer, which is around the new strategic framework that we just shared with you.

And Dana can you — can you add a little more context to your second question on the consumer side you just asked?

Dana Telsey — Telsey Advisory Group — Analyst

On the subdividing of the stores, how you’re adding the growth [Phonetic] or the Planet Fitness, how’s that going and where do you see those opportunities?

Michelle Gass — Chief Executive Officer

Yeah. So I would say on that one, that is still an experiment for us, Dana. We have roughly 20 stores. Given the COVID pandemic disruption over the last year, we’ve put a little pause to that. We still look at our stores as a big asset for us. You know, they’re cash generating 90% over $1 million in cash were invested in our fleet. We see a lot of possibilities and whether that is the right sizing or subdividing, as you said, or frankly doing different things and experiments within the four walls our self. We mentioned that we have this 50 door wellness market that we’re trying. So — and one of the best things coming out of COVID, I mean, there’s been lots of really negative things about COVID, but it has amplified the teams, we’ve always been an experimenter and a tester and an innovator. We’re taking that even further.

So you can see a lot of experiments happening both digitally and in our stores in the months to come. So more to come on that.

Jill Timm — Senior Executive Vice President, Chief Financial Officer

And then in terms of the margin and price, first, if we stand back, I just want to remind you in the supply chain transformation, I just said that we’re accelerating, part of that through COGS work as well. So we are really going after ways to reduce our cost of goods sold through our sourcing efforts, without taking away any value from the customer. So we’re going to still invest in quality, but we’re also going to invest in price. And I think pricing for us doesn’t mean we’re not going to be on sale. It just means that we’re trying to have more transparency with our pricing. So the customer can see the price more quickly and make it much more competitive.

I think home is a prime example here. It’s been a category that’s clearly been outperforming in the industry and at Kohl’s and it’s very price sensitive. So how do we bring that slide quicker so the customer sees what value that Kohl’s has versus making them work through some of the math we’ve done in the past?

So you’re going to see we introduced a new pricing event in Q3. It was called Love Deal [Phonetic], it’s really focusing on sharp pricing versus more on the promotional activity that you have seen in the past. And we’re going to leverage that as a new muscle which will help us, I think as part of the effort to get to an expansion of ops margin, really optimize that. And then use more targeted offers to drive consumer behavior versus blanket them across the whole population of our customer base.

So it will be a key enabler as we continue to move forward on our journey to get to the operating margin of 7% to 8%.

Dana Telsey — Telsey Advisory Group — Analyst

And will there be a difference in stores versus online, Jill? Or does it hold similar?

Jill Timm — Senior Executive Vice President, Chief Financial Officer

And — You know, at this point we have same pricing on stores and online, I would definitely say it’s something that we continue to look at and understand. Is there an opportunity to do more dynamic pricing in the future? But at this point it’s not something that has been encompassed in what we’ve tested.

Dana Telsey — Telsey Advisory Group — Analyst

Thank you.

Michelle Gass — Chief Executive Officer

Thanks, Dana.

Thank you to everyone listening on the call today. Please stay well and have a wonderful holiday season. We look forward to speaking with you in early March.

Operator

[Operator Closing Remarks].