KOHLS Corp (KSS) FY 2023 MD&A

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:

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

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

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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.

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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.

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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.

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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:

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

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Operating margin: Approximately 4.0%.

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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.

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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.

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

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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:

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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.

•
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.