U.S. Markets open in 55 mins

Kohl's Newest Real Estate Partner: Planet Fitness

Adam Levine-Weinberg, The Motley Fool

A few years ago, Kohl's (NYSE: KSS) management determined that many of the department store chain's stores were too big. In many cases, Kohl's was filling these stores with more inventory than was necessary to meet demand, just so the stores wouldn't look empty. That excess inventory led to margin-sapping clearance discounts at the end of each season.

To address this problem, Kohl's has changed the layouts and fixtures of about 500 stores in the past few years, in order to make them act like smaller stores. The strategy has been quite successful, allowing Kohl's to steadily reduce its inventory and improve its gross margin.

Kohl's has proven that it's better to have underutilized space than to fill stores up with too much inventory. Of course, it would be better to find something productive to do with the extra square footage. This has led Kohl's to find strategic partners that can take over space that it doesn't need. Fast-growing gym chain Planet Fitness (NYSE: PLNT) is its newest partner in this effort.

Gradually repurposing space

A typical full-size Kohl's store is about 85,000 square feet, but management believes that lower-volume stores could downsize to 60,000 to 65,000 square feet with no meaningful impact on sales.

A little over a year ago, Kohl's announced a pilot program to downsize 10 stores and lease the extra space to discount grocer Aldi. The first of these new Aldi stores opened last month in Waukesha, Wisconsin. From Kohl's perspective, the goal is not just to get some rental income, but also to benefit from the additional traffic that Aldi will bring to the shopping center. Some shoppers might stop at Kohl's to buy something before or after picking up groceries.

The exterior of a Kohl's store

Kohl's is leasing excess space at some of its stores to high-traffic tenants. Image source: Kohl's.

Kohl's recently announced partnership with Planet Fitness has the same goals. Planet Fitness will lease 20,000 to 25,000 square feet of space next to a different set of 10 Kohl's stores, with the gyms set to open later this year.

A great partner for Kohl's

Working with Aldi made a lot of sense for Kohl's. Aldi stores generate lots of customer traffic, and the grocer is less than halfway into a five-year plan to add 800 stores to its U.S. footprint.

That said, Planet Fitness is an even more natural partner for Kohl's -- and not just because its gyms have high traffic. The No. 2 department store has made the "active" category one of the centerpieces of its strategy. Activewear, athletic shoes, and accessories like Fitbit devices now account for nearly 20% of Kohl's sales, a percentage that is rising quickly. Kohl's is also trying to boost its wellness credentials through a partnership with WW (formerly known as Weight Watchers) announced earlier this year.

Kohl's hopes that many Planet Fitness customers will stop by its stores to buy workout gear (and perhaps other items). The two companies are exploring the possibility of "co-marketing" to potential customers.

Like Aldi, Planet Fitness is in the midst of an ambitious expansion plan, with a goal of more than doubling the chain to about 4,000 U.S. locations over time. As a result, there's a good chance that Planet Fitness will become a tenant next door to many other Kohl's stores in future years.

Patience is required

Kohl's management team is diligent about testing new initiatives on a small scale before rolling them out broadly. In this case, the key question is which type of next-door tenant will drive the most incremental sales for a Kohl's store. Leasing space to several different companies across a handful of stores in various markets will give Kohl's valuable data about which tenants it should seek out for the rest of its excess space.

For investors, that means the downsizing initiative will have very little impact on Kohl's finances this year. Based on the company's current plans, no more than 2% of Kohl's stores will have active tenants by the end of 2019.

However, once Kohl's gets more data on which tenants are driving the most incremental traffic to its stores, the company could accelerate the process of signing leases for excess space at its stores. With at least 500 of its 1,159 stores having more space than they need, there's a huge long-term opportunity for Kohl's to build up a rental income stream while also improving the productivity and profitability of its stores.

More From The Motley Fool

Adam Levine-Weinberg owns shares of Kohl's. The Motley Fool recommends Planet Fitness. The Motley Fool has a disclosure policy.