The retail apocalypse has finally caught up to the weakest department stores in 2018. Bon-Ton filed for bankruptcy protection early in the year and was forced to liquidate. Last month, Sears Holdings entered bankruptcy . It is fighting to avoid the same outcome.
In this context, it's not too surprising that top department store chains Macy's (NYSE: M) and Kohl's (NYSE: KSS) have been working hard to reduce their debt loads. After all, a strong balance sheet is a great way to hedge against the risk of a profit downturn.
However, the focus on debt reduction has left less cash available for share repurchases. Given how much their balance sheets have improved already, Macy's and Kohl's don't necessarily need to keep debt reduction as their top priority for much longer. That could pave the way for greater buybacks in the near future, which could drive the stocks even higher.
Debt is shrinking quickly at Kohl's
For most of the past few years, the debt load was relatively stable at Kohl's. However, the company has aggressively paid down debt this year.
During the first quarter, Kohl's completed a tender offer for $500 million of its debt . It continued down the same path in the second quarter by repurchasing some of its debt in the open market.
Kohl's has reduced its debt by more than $500 million in 2018. Image source: Kohl's.
The net result is that Kohl's reduced its long-term debt by 19% in the first half of fiscal 2018, from $2.8 billion to less than $2.3 billion. Furthermore, the company ended the second quarter with more than $500 million of extra cash on its balance sheet compared with a year earlier. Over the same period, net debt -- including capital leases, but adjusted for its cash balance -- fell from $4 billion to less than $2.9 billion.
In short, Kohl's has dramatically reduced its debt just in the past few quarters -- and it is about to see another surge in its free cash flow, thanks to the upcoming 2018 holiday season.
Macy's has made a lot of progress, too
Macy's began its debt-reduction journey about a year before Kohl's, but it was starting from a much deeper hole. Two years ago, Macy's had $7.5 billion of debt on its balance sheet -- and more than $7 billion of net debt after deducting its cash.
Since the beginning of fiscal 2017, Macy's has used all of its free cash flow after dividend payments for paying down debt. Most recently, this has included a $400 million tender offer last December and $347 million of debt repurchases in the first half of 2018. By early August, Macy's had just $5.5 billion of debt, offset by a little over $1 billion of cash and equivalents.
Given that Macy's typically generates more than 100% of its free cash flow in the fourth quarter -- and also expects a major asset sale to close near the end of the year -- the company should have ample cash available to continue its debt reduction over the next few months.
The recent pace of debt reduction isn't likely to continue
In theory, Kohl's and Macy's could continue paying down debt at the rapid rate seen over the past year. However, it doesn't make sense for either company to reduce its debt all the way to zero, given that the cost of capital is significantly lower for debt compared with equity.
Indeed, Kohl's has a fairly conservative balance sheet today. If it uses a substantial portion of its holiday-quarter free cash flow for debt reduction, its balance sheet will be in even stronger position by the end of the year. This move could pave the way for upgrades to its credit rating, as the company's profitability has stabilized and should improve further as Kohl's capitalizes on its rivals' woes.
Meanwhile, Macy's has already achieved its official leverage target. It's likely to bring in more than $1 billion of additional cash during the second half of fiscal 2018. Even if Macy's wants to reduce its debt further, there's no reason it needs to continue to devote 100% of its free cash flow after dividends to debt repayments.
Macy's will generate a lot of free cash flow in the next few months. Image source: Macy's.
More share buybacks could boost these stocks
Fiscal 2018 guidance at Kohl's calls for $300 million to $400 million in share repurchases. Hitting that forecast would put its total cash return to shareholders at around $700 million to $800 million, including dividends. But its free cash flow is likely to be twice that level.
As for Macy's, the company suspended its share repurchase program at the beginning of fiscal 2017. Its dividend currently costs $464 million a year, but it's generating more than $1 billion of annual free cash flow, with asset sale proceeds providing substantial cash above and beyond that level.
Kohl's and Macy's could soon decide that they have paid down enough of their debt. If so, the amount of cash flow that could be redeployed toward share repurchases is substantial relative to market caps of $13.4 billion and $11.4 billion for Kohl's and Macy's, respectively. Thus, renewed buyback activity could power the next move higher for shares of these two department store giants.
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Adam Levine-Weinberg owns shares of Kohl's and Macy's. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy .