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TIF | Bad Cocktail

Takeaway: 2nd worst comp in retail. No strategic plan to win back the customer. We’d short on strength.

This quarter had all the makings of a bad cocktail. The garnish was pretty – demonstrated by the 17% headline EPS beat, 12% sequential improvement in the EPS growth rate, and maintained guidance for the year. But the event itself lacked any substance that would shake us from our bear case. Heck, the comp itself was just shy of toxic, and at -9% in constant currency is good for the second worst comp in all of retail behind only Stage Stores – consistent with what we saw in 1Q16 when TIF ranked 2nd on the list of worst performing retailers behind Lumber Liquidators. That’s not an enviable list.

 

We get that the stock is hated, but we still think there is a lot of hope embedded in this name at current levels. Here’s what’s currently assumed in Street expectations and our pushback…

  • Comps will inflect to positive in 4Q and beyond. Comps do get sequentially easier throughout the year, but if you’re looking for a way to play the ‘easy weather compares’ this isn’t the story. That is unless TIF has a Flagship in Arendelle that we're not aware of (Arendelle = the magical land of Frozen fame). Plus, the macro backdrop from a demand perspective continues to erode – that’s confirmed by every metric we track including US Luxury Spend, high-end watch exports, and foreign tourism flow.
  • Margins will stabilize. TIF has some positive benefits working in its favor on the gross margin side from input costs, and the company won’t compete on price keeping merch margins relatively stable. That’s the positive. On the negative side, the company pulled the SG&A parachute this quarter and continues to operate in the status quo. That means no tangible investment plan to invest in all the right places to make the ‘Little Blue Box’ cool again in the eyes of the core consumer. The lack of that investment, we think will translate to a sluggish top-line in the near and long-term and margin deleverage.

That gets us to a -2% EPS CAGR over the next three years vs. the street at 10%. Even if we’re wrong, and the Street’s numbers prove out, we think you’re looking at a best case 20x multiple on $4 bucks next year, good for 10% upside. If this call plays out the way that way think it will, we’re looking at 40% downside or stock in the mid-40s (mid-teens multiple on $3.20 in EPS). We’d short on strength.

 

TIF | Bad Cocktail - 8 25 2016 tif earn table

 

 

Additional Callouts From The Quarter

 

Comps Weak, US Slowing

Comps missed for the 4th straight quarter coming in about 100bps below the street.  As expected, soft demand and macro headwinds continue to pressure the US as the Americas C$ comp slowed on a 2 year basis, now running at a negative MSD rate.  We expect comps to continue to be soft as the issues of tourist traffic and luxury demand, which we highlighted in our previous note (below), show no signs of abating.

TIF | Bad Cocktail - 8 25 2016 TIF Am Comp

 

Gross Margins Beat as Expected

About 1/3 of the EPS beat came from gross margin outperformance, though they were actually in line with our expectations.  TIF continues to benefit from lower product costs as commodity price drops flow to the P&L from inventory, and TIF is seeing a bump from international price increases last year which were implemented in order to offset Fx presssure.  Product costs should continue to be a tailwind with cheaper diamond prices hitting the income statement in 2017, however in the back half TIF will lap last year’s price increases meaning gross margin expansion should be much more muted than 1H.

 

Pulling SG&A

2/3 of the 17% headline EPS came from lower SG&A spend in the quarter, as TTM SG&A per store hit the lowest levels we have seen in over 5 years. Lower investment today = lower demand in the future.   If TIF wants to meaningfully accelerate the top line it needs a significant capital spending plan to reinvigorate the brand, which would ultimately mean a reset to margins and lower returns on capital. 

Look to the near-term, FX is inflecting to an SG&A headwind in the back half while also working against tough compares, so even if TIF continues to underspend, we expect SG&A growth to meaningfully accelerate into year end.

TIF | Bad Cocktail - 8 25 2016 TIF SG A

 

Below is our prior note from 8/24/16

 

We’re comfortable with the TIF short headed into earnings on Thursday. To be clear, we wouldn’t press it, as the name has a lot of the style factors that we tend not to like into a newsy event. Namely peaky short interest at 13% of the float, hittable expectations with the street looking for a -8% comp deleveraging into -16% earnings growth, and management’s penchant for beating low-bar guidance. Despite 2016 EPS expectations coming down by $1.50 to $3.59 the company has a 67% batting average when it comes to manufacturing beats.

 

Over a slightly longer duration, we think expectations for the current year still need to come down by at least another 5%, as all the work we’ve done suggests that the tourism/luxury headwind and simply weak demand for TIF products hasn’t improved – at all, really – which is an absolute must if the company wants to hit the positive comp bogey currently embedded in street models for 4Q. Then we fast forward to 2017, and we’re looking at $3 in earnings power vs. the street close to $4.

 

If we’re right on the model, we think that $3 in earnings power will translate to a mid-teens earnings multiple which gets us to a stock in the low $40s good for 35%-40% downside from current levels. If we’re wrong and TIF recognizes the benefit from 2yrs of easy compares, a better luxury demand equation than we currently see shaping up, and finds some way to become ‘cool’ again with a younger demographic, then we think we are looking at best-case a 20x P/E on $4 in EPS = $80 stock. That’s $11 upside, and $27 down. We like the risk reward on a tail duration, with the macro back-drop not doing TIF any favors.

 

Additional Considerations:

 

Luxury Bucket Just Went Negative

Real luxury spending, as we measure it (Pleasure Vehicles and Watches & Jewelry PCE), went negative in May for the first time in 5 years and the June number continued the downward slide. Historically, comp sales for TIF have generally followed this luxury bucket directionally. But we’ve seen a meaningful bifurcation in the trend starting 18 months ago. We think that speaks to the company’s competitive positioning and general lack of demand for the product offering. With luxury demand headed into negative town, we think it adds an additional kicker to the TIF demand equation.

TIF | Bad Cocktail - 8 24 2016 TIF chart2B

 

Swiss Watch Trends Signaling Weakness

The Swiss Watch Exports numbers are the best indicator that we can find to gauge the global demand for luxury items – particularly jewelry. Of course, watches have their very own demand constraints and TIF is underexposed to the category – but we'd argue that the iWatch, FitBit, and other connected fitness wrist wear don't compete with items priced above $3,000. That price range posted a -17% growth rate in 2Q, good for a 550bps deceleration on a 2yr basis.

Looking at the trend in TIF comp sales vs. the global Swiss Watch exports numbers paints a pretty tight correlation between the two metrics. Watch exports slowed significantly in 2Q, while the current comp expectation for Tiffany is looking for a slight inflection.

TIF | Bad Cocktail - 8 24 2016 TIF chart3

 

Tourism Has Not Hit Bottom

When things started to turn south for Tiffany, management quickly pointed to the weak international consumer demand that was inflicting a great deal of hurt to companies with high US tourism exposure. The general sentiment seems to be that the tourism headwind is starting to roll off. However, if we look at the actual trends in international visitation and commentary by companies during this earnings season, we can see that international tourism visitation to the US is hitting new lows at 1.3%. That’s off from 5.2% last year. The punchline is that the tourism headwind isn’t going away anytime soon – during the last notable deflationary period (08/09) visitation slowed from +13% to -7%.

TIF | Bad Cocktail - 8 24 2016 TIF chart4

 

In addition, beyond the slowing US visitation trend is the total spending impact that visits and FX fluctuations have on the spending power of international tourists. The chart below shows the YY change in spending power on a TTM basis. For this analysis, we assumed a value of spending per visit that varied based on where the visitor was traveling from, and adjusted this value based on YY changes in FX rates with the dollar. Spending power remains negative at -2.7%, with the 2 year average hitting new lows. Keep in mind that any discretionary portion of spending is being compressed significantly more. By that we mean, assuming a visitor uses a constant trip budget year over year, the change in currency conversion flows predominantly to the discretionary spend, since the fixed pieces (hotel, ground transport, food, etc) will not get cheaper in USD. Retailers annualized the start of the 2015 FX tourist issues about 6 months ago, but tourist spending power shows no signs of rebounding both in our math nor in retailer commentary. For TIF – who has global exposure, the "easy" tourism compares in the US don’t mean the same thing that it does for a company like M, as we think TIF has benefited from shifting travel patterns in some of its international markets.

TIF | Bad Cocktail - 8 24 2016 TIF chart5

 

FX Inflecting to Topline Tailwind

FX should be an ever so slight drag on revenue in 2Q. However, on the positive side, after 7 quarters of FX hurting the revenue line, this quarter marked the inflection point where currency could start to aid growth in USD (assuming constant FX rates from now). This is mostly due to the 12% rally in the Japanese Yen over the last 6 months, while the Pound and Yuan continue to be a drag. Yet with C$ comps currently running in the negative high single digit range, a couple point bump from currency will likely not be enough to put reported comps into the black.

TIF | Bad Cocktail - 8 24 2016 TIF chart6B

 

Margins:

TIF had one of the worst SIGMA moves in retail in 1Q, and a bearish set-up for 2Q. For the average retailer, this is very negative for margins, but due to the nature of luxury jewelry production and sales, TIF historically has had no problem holding extra working capital with inventory days at 612 – the highest in all of retail. As a luxury brand Tiffany also does not compete on price to boost the top-line nor will it compete away margin benefits resulting from lower product costs.  As cheaper metals continue to flow through to the P&L, we expect gross margins to surprise to the upside. And 2017 margins will continue to see product cost benefits as diamond price decreases start to flow through as well.

Marketing spend was high in 2Q of last year with capital deployed backing Tiffany's "Will You" campaign. Tiffany now gets to lap that so we are expecting SG&A growth to be muted in 2Q.  Lastly, since FX is no longer a revenue headwind, so goes the SG&A tailwind that was once as much as a 5% offset to reported SG&A in mid 2015.

TIF | Bad Cocktail - 8 24 2016 TIF chart7


TIF | Far Too Shiny

Takeaway: Story still has too much luster. 2017 #'s too high by as much as $1. Macro backdrop not doing TIF any favors.

We’re comfortable with the TIF short headed into earnings on Thursday. To be clear, we wouldn’t press it, as the name has a lot of the style factors that we tend not to like into a newsy event. Namely peaky short interest at 13% of the float, hittable expectations with the street looking for a -8% comp deleveraging into -16% earnings growth, and management’s penchant for beating low-bar guidance. Despite 2016 EPS expectations coming down by $1.50 to $3.59 the company has a 67% batting average when it comes to manufacturing beats.

 

Over a slightly longer duration, we think expectations for the current year still need to come down by at least another 5%, as all the work we’ve done suggests that the tourism/luxury headwind and simply weak demand for TIF products hasn’t improved – at all, really – which is an absolute must if the company wants to hit the positive comp bogey currently embedded in street models for 4Q. Then we fast forward to 2017, and we’re looking at $3 in earnings power vs. the street close to $4.

 

If we’re right on the model, we think that $3 in earnings power will translate to a mid-teens earnings multiple which gets us to a stock in the low $40s good for 35%-40% downside from current levels. If we’re wrong and TIF recognizes the benefit from 2yrs of easy compares, a better luxury demand equation than we currently see shaping up, and finds some way to become ‘cool’ again with a younger demographic, then we think we are looking at best-case a 20x P/E on $4 in EPS = $80 stock. That’s $11 upside, and $27 down. We like the risk reward on a tail duration, with the macro back-drop not doing TIF any favors.

TIF | Far Too Shiny - 8 24 2016 TIF chart1B 

 

Additional Considerations:

 

Luxury Bucket Just Went Negative

Real luxury spending, as we measure it (Pleasure Vehicles and Watches & Jewelry PCE), went negative in May for the first time in 5 years and the June number continued the downward slide. Historically, comp sales for TIF have generally followed this luxury bucket directionally. But we’ve seen a meaningful bifurcation in the trend starting 18 months ago. We think that speaks to the company’s competitive positioning and general lack of demand for the product offering. With luxury demand headed into negative town, we think it adds an additional kicker to the TIF demand equation.

TIF | Far Too Shiny - 8 24 2016 TIF chart2B

 

Swiss Watch Trends Signaling Weakness

The Swiss Watch Exports numbers are the best indicator that we can find to gauge the global demand for luxury items – particularly jewelry. Of course, watches have their very own demand constraints and TIF is underexposed to the category – but we'd argue that the iWatch, FitBit, and other connected fitness wrist wear don't compete with items priced above $3,000. That price range posted a -17% growth rate in 2Q, good for a 550bps deceleration on a 2yr basis.

Looking at the trend in TIF comp sales vs. the global Swiss Watch exports numbers paints a pretty tight correlation between the two metrics. Watch exports slowed significantly in 2Q, while the current comp expectation for Tiffany is looking for a slight inflection.

TIF | Far Too Shiny - 8 24 2016 TIF chart3

 

Tourism Has Not Hit Bottom

When things started to turn south for Tiffany, management quickly pointed to the weak international consumer demand that was inflicting a great deal of hurt to companies with high US tourism exposure. The general sentiment seems to be that the tourism headwind is starting to roll off. However, if we look at the actual trends in international visitation and commentary by companies during this earnings season, we can see that international tourism visitation to the US is hitting new lows at 1.3%. That’s off from 5.2% last year. The punchline is that the tourism headwind isn’t going away anytime soon – during the last notable deflationary period (08/09) visitation slowed from +13% to -7%.

TIF | Far Too Shiny - 8 24 2016 TIF chart4

 

In addition, beyond the slowing US visitation trend is the total spending impact that visits and FX fluctuations have on the spending power of international tourists. The chart below shows the YY change in spending power on a TTM basis. For this analysis, we assumed a value of spending per visit that varied based on where the visitor was traveling from, and adjusted this value based on YY changes in FX rates with the dollar. Spending power remains negative at -2.7%, with the 2 year average hitting new lows. Keep in mind that any discretionary portion of spending is being compressed significantly more. By that we mean, assuming a visitor uses a constant trip budget year over year, the change in currency conversion flows predominantly to the discretionary spend, since the fixed pieces (hotel, ground transport, food, etc) will not get cheaper in USD. Retailers annualized the start of the 2015 FX tourist issues about 6 months ago, but tourist spending power shows no signs of rebounding both in our math nor in retailer commentary. For TIF – who has global exposure, the "easy" tourism compares in the US don’t mean the same thing that it does for a company like M, as we think TIF has benefited from shifting travel patterns in some of its international markets.

TIF | Far Too Shiny - 8 24 2016 TIF chart5

 

FX Inflecting to Topline Tailwind

FX should be an ever so slight drag on revenue in 2Q. However, on the positive side, after 7 quarters of FX hurting the revenue line, this quarter marked the inflection point where currency could start to aid growth in USD (assuming constant FX rates from now). This is mostly due to the 12% rally in the Japanese Yen over the last 6 months, while the Pound and Yuan continue to be a drag. Yet with C$ comps currently running in the negative high single digit range, a couple point bump from currency will likely not be enough to put reported comps into the black.

TIF | Far Too Shiny - 8 24 2016 TIF chart6B

 

Margins:

TIF had one of the worst SIGMA moves in retail in 1Q, and a bearish set-up for 2Q. For the average retailer, this is very negative for margins, but due to the nature of luxury jewelry production and sales, TIF historically has had no problem holding extra working capital with inventory days at 612 – the highest in all of retail. As a luxury brand Tiffany also does not compete on price to boost the top-line nor will it compete away margin benefits resulting from lower product costs.  As cheaper metals continue to flow through to the P&L, we expect gross margins to surprise to the upside. And 2017 margins will continue to see product cost benefits as diamond price decreases start to flow through as well.

Marketing spend was high in 2Q of last year with capital deployed backing Tiffany's "Will You" campaign. Tiffany now gets to lap that so we are expecting SG&A growth to be muted in 2Q.  Lastly, since FX is no longer a revenue headwind, so goes the SG&A tailwind that was once as much as a 5% offset to reported SG&A in mid 2015.

TIF | Far Too Shiny - 8 24 2016 TIF chart7


FL | STICKING TO OUR GUNS, SHORT MORE

Takeaway: Solid effort by mgmt to torpedo our Short call. But beneath the surface, the warning signs are there. This pop is a great oppty to press.

INVESTMENT CONCLUSION 

The long-term short call is one of the more powerful ones in retail, though such TAIL calls are far from linear. This will be a ’three steps forward, one step back’ call for 1-2 years, as the natural ebbs and flows of even the best/worst retailers offer temporary windows challenging conventional wisdom — we’ve said this all along. That said, we still take very seriously our fiduciary responsibility to Hedgeye customers to navigate the TRADES and TRENDS that build to the TAIL duration. Did we think they’d beat this quarter and we’d take a step back? Definitely not. We thought the opposite — so at a minimum we need to drill down on what changed and why. The comp was strong, and it warrants some serious thought on our part as to where we could be wrong. So that’s what our team did over the past two days. 

 

We’ll outline the ‘what’s changed’, 'where we were wrong last week', and ‘what’s not fully appreciated’ part of this call later in this note. But to be crystal clear, when all is said and done, we still think the TAIL call here should result in close to $3 in earnings power (Street is at $5.22 in 2-years) and financial returns being cut in half from 28% today to the low-mid teens over 2-years. How does that happen?

1. Nike and Foot Locker play nice in public, but behind the scenes things are getting fierce. FL is not getting the incremental growth in allocations it once did. Foot Locker Nike sales ratio peaked at 73% in 2014, went to 72% last year, and we think is trending closer to 70% today, That’s manageable…

2. ...but the problem is that said ratio is headed to 60% — a level it saw just 2-3 years ago. Regardless of what Nike and FL say on conference calls, Nike is growing around FL, and the numbers are indisputable. More Nike for FL equals greater traffic, higher ASP, better conversion, and huge incremental margin. That should start going the other way. 

3. FL has among the lowest SG&A ratios in all of retail. Why? because 3/4 of sales come from the mother of all brands that serves as its own traffic driver. FL is shifting incrementally to Adidas and UA, both of which are lower ticket and less profitable. And importantly, with such a huge Nike presence, FL needs to spend close to nothing on advertising relative to the financial impact of having such great product. That is changing. A 19% SG&A ratio is targeted to 18%, but it could (and should) just as easily go to 22-23%, which cuts margins by more than a third — not including the e-commerce investment. 

4. FL needs to hire a world-class e-commerce organization to prevent itself from being disintermediated. That is very very expensive. Same goes for fulfillment ops, and having the content to back up such an investment. 

5. As Nike moves forward with full-scale US-made customization of product, FL will want a piece of the action. It will have to front the capital cost to get Nike manufacturing technology, and will still only get the technology in question in at best 5% of its stores. But still, that will solidify Nike’s position in this relationship (even with a lower FL/Nike sales ratio) by keeping FL right where it needs it to extract more of the consumer margin to its own P&L, not FL’s.

6. But McGough, how could you say that? Nike NEEDS FL to sustain its wholesale model. Yes, that’s right. But Nike does not need FL to be at 72%. 50-60% is fine — and arguably still too much for a healthy relationship.

7. Working capital should bloat as FL carries more brands. More SKUs to manage. More closeouts to manage. Less buying power from being in bed with one vendor. GM under pressure as well.

Capex should grind much higher than we’re seeing today. Without it, FL can’t sustain a dramatically better growth rate in e-commerce.

8. Oh, and by the way, there’s zero square footage growth, and international growth efforts are sputtering at best. 

9. So the only sustained growth here is if the cycle does not roll, people start buying more pairs per capita per year (which has been between 0.8x-1.2x per cap per year since 1988 — so lets not bank on that changing). We basically need higher ASPs — again — without the benefit accruing to the content owner. Good luck with that for FL and anyone else that sells shoes. 

 

We challenge anyone to find us a fully valued stock (17x earnings and 7.1x EBITDA) that did not go down precipitously when returns were cut in half, and consensus estimates prove aggressive by as much as 30% for next year. The only stocks that would prove us wrong are take-out candidates. And mark my words, no strategic buyer or private equity investor that can even spell ‘due diligence’ would take a look at buying this outright. If anyone is reckless enough to buy it, then we'd love nothing more than to debate the pathetic merits of such a transaction in any public forum with the moderator of their choice. I don’t mean to sound arrogant there, but taking-out Foot Locker is as absurd as the occasional rumor of Nike buying UnderArmour. 

 

The TREND call should definitely support that premise/math directionally, particularly with ERODING incremental margins with greater capital intensity (i.e. lower returns). As a kicker, we’re looking at no more QTD guidance from the company (a wise move by management, we think) at a time when the Street is largely playing a wicked game of ‘extend the trend’ in its financial models and that the strength we’re seeing today remains in place — or stronger — pretty much in perpetuity. We’re probably looking at Short Interest at about 5% after last week’s rally, and everyone we talked with who buys into the disintermediation theme largely ran for cover on this print.  

 

We think this story will mutate into a full-on Bear within two quarters, and more likely by the end of the year. Here’s your chance to short more of one of the most structurally-flawed names we can find — but one that is temporarily suggesting, to skittish/scared investors, otherwise. We think that if RNOA goes from 28% to 14% in 2-years and EPS loses $1.50 instead of gaining $1.00 over 2 years (a massive $2.50 delta) then we’re looking at something closer to a good ol' zero square footage growth retailer with eroding comps, peak margins, meaningfully higher SG&A and working capital requirements, that has 72% of its product coming from one vendor that says all the ‘pro-Foot Locker' things in public, but truly does not care if its FL business shrinks by 2,000bps over 3 years (or sooner). When a 40+ year paradigm of designing, sourcing, manufacturing, distributing, selling and marketing shoes is being turned on its head — there is absolutely no way Foot Locker, Finish Line, Hibbett and any retailer other than Dick’s (a temporary winner) will come out in its happy place.

 

If we’re right on the model, we’re looking at nearly 50% to be made on the short side — 9-11x a $3 EPS number, which assumes 4x EBITDA and an 8% FCF yield which given the downside to earnings we see from here is the most important metric. That’s about $35 downside. If we’re wrong, and the economic cycle does not roll, the brands don’t disintermediate traditional/dinosaur distribution, and we don’t see any channel conflict between Nike and FL, then the best we get to is an irrational mid-teens multiple on $5.00 in EPS, or about an $80 stock.  That’d hurt…but we don’t think we’ll see it. All in, we got $13 up, and about $35 down. We usually like 3 to 1 for the optical margin of error on a bold call like this. But that’s close enough.   

 

BOTH SIDES OF THE ARGUMENT 

So let’s pick apart the bull and bear arguments — at least how we see ‘em. The punchline for us is that the fundamental fat-tailed short call is very much in tact. The stock rallied 11% on the day after a 5% run the week into the print. That’s $1.1bn in added market value for an improved TRADE duration, which is far too much given our certainty that the financial return metrics in this model — more capital for lower incremental EBIT — and long-term earnings power is 35% below what the street is modeling. When a stock rallies on a good print that otherwise does not change the underlying short thesis, we’ll begrudgingly pay the price on that day (as we did last week) but we will not count the cost. This call will turn out to be a winner — far more than the mediocre 12% decline relative to the market since we made it a Best Idea almost exactly 1yr ago. 

 

HERE’S WHAT HAPPENED IN THE QTR THAT HIT OUR THESIS WHERE IT HURTS

1. Ok…time to get real. This print was one heck of an effort by the company to torpedo our FL Short Thesis. As fundamentally flawed as this business model is, we have always thought the post-Hicks legacy management was very good at managing this model. This quarter they did that. Golf clap — a big one. Score one for a very good management team on this print. We hate shorting stocks of good management teams. But good management teams in flawed business models usually lose out in the end.

2. The top line was killer. A +5% comp — when even decent retailers are selling their soul just to put up a +1% in this environment makes it very tough for a lot of shorter-duration funds to stay negative on this —and we completely understand why. It’s equally frustrating and perplexing.  Here’s an interesting way to look at it: When we look at the actual comp vs the QTD comp reported on the conference call two months earlier, this quarter showed the biggest positive inflection this decade. Now…keep in mind that the delta was negative in 2Q last year. 1Q of this year was a mere 1% positive delta. 

FL | STICKING TO OUR GUNS, SHORT MORE - 8 21 2016 FL chart1

The confusing (or important) data point for us is 1Q —  why was it so weak?  It basically means that either 1Q or 2Q was anomalous, or it tells us that this rate of strength we saw this summer is simply not sustainable.  One thing we’ve learned is that when there are extremely volatile swings like this relative to plan — good or bad — it is almost always a negative event. Consistency and predictability are great; that allows retailers to manage the business well on a consistent basis. We’re seeing increased volatility. Which is bad any way we cut it.

 

3. E-Commerce Was Relatively Weak.  Our traffic indicators showed weakness for FL domains, and on a relative basis the muted 7.1% growth and 2 year slowdown underperformed the rest of the industry while it was dwarfed by NKE. FL B&M stores therefore accelerated and did so with the benefit of positive traffic company wide. Positive traffic is not something we'll bank on in the long term for a retailer that has a significant majority of stores within malls posting negative traffic.

FL | STICKING TO OUR GUNS, SHORT MORE - 8 22 16 E comm FL

 

4. Leverage Works Both Ways. The biggest validator of our thesis is that the 5% comp actually resulted in SG&A DE-leverage to the tune of 13bps — and that’s despite the fact that gross profit grew at 110bps better than sales. So we ask…how can a company comp so strong, but fail to leverage SG&A and have it result in a positive delta as it relates to margins? Simple. It doesn’t. By our math, FL would have needed a 5.5% comp to leverage SG&A. What would have happened if it only comped 3%? How about flat? How about -5%? It’s happened before, and mark my words, it will happen again. We think that people too easily forget that the tremendous leverage on the upside to EBIT growth, as FL has routinely put up 30-40% EPS growth on a 10% comp, has been cut dramatically. Run the math…all it takes is a down comp 1 or 2 quarters in a row and EBIT will contract by just as much as people were so surprised to see it expand over the past economic cycle.

FL | STICKING TO OUR GUNS, SHORT MORE - FL SG A

 

FL | STICKING TO OUR GUNS, SHORT MORE - 8 22 2016 FL Fin Table


TGT/WMT | Backyard Brawl

Takeaway: WMT investing as TGT sits on the sidelines. Competitive dynamics continue to intensify, TGT the clear loser.

This evolving TGT/WMT relationship has all the makings of a backyard brawl. The only problem is…it’s not a fair fight. Don’t get us wrong – it could be, but as highlighted in our note following the TGT print (full note: TGT | Losing at Defense), we think the management team at Target is playing defense – badly. Think the ‘rope-a-dope’ without the Ali endurance or uppercut. That’s at the same time that the competitive dynamics around the retailer are evolving faster than at any point we can remember in large-cap retail.

 

In one corner you have AMZN scooping up 25% of the incremental dollars up for grabs in US retail – that’s 2x the rate we saw at the same time in 2015. In another corner is WMT, who saw a meaningful traffic inflection starting in 1Q14 and has been able to hold the upward trajectory for 2+ years as it invests its way to a flat earnings CAGR over the next 4 years. And in the 3rd corner there’s TGT, who has effectively managed expenses to hit near term expectations at the expense of long-term share, with no clearly articulated plan to win in any environment and a stunning lack of insight as to why the business is struggling in the face of otherwise solid prints by its two closest competitors.  

 

In the series of charts below, we walk through what we think are the key callouts from the evolving TGT/WMT relationship and why we think TGT is the ultimate loser in this royal rumble. That will ultimately manifest itself in either a) lost market share and pressured margins taking earnings into the mid-$4s, or b) a meaningful reset in expectations as the company doubles down on the investment line to compete with its peer group.

 

WMT Out-Trafficking TGT

We positioned this chart first in the queue because we think it clearly demonstrates that WMT is winning what we coined the ‘backyard brawl’. To be clear, this is the effect and not the cause of the broader strategic decisions each team is making in order to ultimately drive traffic and win market share. There has been a clear deviation in the trend, with the spread between the two opening up to 1.2% in 1Q and 3.4% in 2Q, both in favor of Walmart. The most recent metric is good for the biggest spread we’ve seen since the TGT data breach in 4Q13, and the widest gap over the past 5 years in a normal environment. Most importantly, we don’t think this a near term statistical aberration, as WMT is putting the dollars behind the up-tick in traffic which will continue to propel outperformance while TGT sits on the sidelines.

TGT/WMT | Backyard Brawl - 8 18 2016 WMT TGT Traffic

 

Two Different Investment Cycles

This is the cause we referred to earlier, as we’ve seen a huge investment spread open up between TGT and WMT. It started back in mid-2014 around the same time Cornell started his tenure in Minneapolis, and has held steady at nine-points over the past two quarters. That’s important given that Cornell is now two years into his tenure at TGT, and now has his team and strategy in place. Based on what we’ve seen to date, it can be characterized by prudent decision making when it comes to cutting Canada/Rx biz and a reluctance to spend in order to keep pace with the competition. Ultimately, we think the spread between the two needs to change dramatically – and that’s not going to be gifted to TGT from WMT as the latter company has a free pass to invest after it lowered expectations 10 months ago. That means either TGT needs to open its pockets or be content with taking what comes its way.

TGT/WMT | Backyard Brawl - wmt tgt sga

 

WMT Lean, TGT Bloated

The SIGMA trajectory for each company couldn’t be more different. For WMT: we are looking at a sales/inventory spread of 5% in the US which is a positive set-up for GM going forward and this leverage should continue to offset some of the SG&A pressure felt from investments. For TGT: inventories are building into a slowing sales guide, which we think could add additional pressure on GM in addition to the e-commerce headwind and promotional pressure already being felt.

TGT/WMT | Backyard Brawl - 8 18 2016 WMT TGT SIGMA

 

Win For TGT

This is the one metric where we will declare victory for TGT in 2Q. Though at 16% growth it’s not going to win a medal. There have been flashes of brilliance over the past 18 months for TGT, but not the sustained growth at a 40% CAGR that management thought was achievable 18 months ago. The key here is that while TGT continues to pull back on capital outlays to fund its e-commerce growth both on the P&L and the balance sheet, WMT went out and spent $3.3bn to acquire talent and technology in the form of Jet.com. The ante chip to compete for brick and mortar retail just went up tremendously.

TGT/WMT | Backyard Brawl - 8 18 2016 WMT TGT Ecomm Spread


FL | Confident in Short Across Durations

Takeaway: This short call has legs as returns get cut in half over 2 years. If FL manufactures EPS tomorrow, short more.

For over a year we have been vocal on how the changing paradigm in how shoes are designed, sourced, manufactured, and sold is radically changing up the Athletic Footwear industry as we have known it for 40+ years. To be clear, this goes far beyond the simple 'content owners (NIke, UA, Adidas, etc...)' win, and traditional distribution loses. Everyone has a license to win, or lose. All it takes is a vision, talent, a boatload of capital, and the mandate to deploy it.

 

In that context, Nike is the clear winner, which is no surprise. But we think that people grossly underestimate both the depth and duration of its share gain and boost in profitability. Foot Locker is nearly the exact inverse, characterized by declining sales, weaker margins, higher SG&A, more working capital, Capex grinding higher (but not high enough to win strategically), and RNOA going from 28% (where it is today) to something in the low-mid teens. Stocks don't go up when RNOA gets cut in half -- even if they 'look so darn cheap on consensus earnings and trailing cash flow'.

 

To be clear, this kind of call does not play out in a single quarter. That is not a 'weak conviction hedge' into tomorrow's FL print. Not by a long shot. We fully expect the print to reinforce our 'declining return' theme -- with better than 90% confidence. Could the company find a way to make the stock go up on the day? Of course. Companies always can. But either way, every bit of research in our arsenal says that this is a name we want to be short right here, and right now. 

 

DETAILS

We’ve seen some of of our call play out to date – but only some. Mostly in the stock price…off 7% YTD vs. the XRT +5%, rather than the reported earnings numbers. The call has worked, but not for all the right reasons, yet. We’ve seen multiple compression and now we think it’s time to start seeing it in the form of earnings revisions. Maybe not tomorrow, but certainly before the year is out. This is a 3 steps forward and one step back kind of short – and one that will ultimately lead to earnings closer to $3, which is significantly below where just about anyone thinks they could go.

 

Thinking about the near-term considerations, we saw the first hiccup from this company three months back in the form of a comp number that slowed by 400bps sequentially on a 2yr run rate and EPS growth of 7%, good for the lowest rate we’ve seen since 2009. It was also a watershed moment in the FL/NKE relationship as management at the former was as bearish on its key partner as we can ever remember. It hasn’t quite been a soap opera since, but there is a slew of data points that we think are particularly bearish for FL. Including…

 

a) Nike basketball growth went negative for Nike in FY16, though with Jordan the growth rate for the year was 11% down from 19% in 2015.

b) Nike readjusted the price/valuation equation at the tippity top of the pricing spectrum for its KD and Lebron shoes, taking the new model price points down 17% and 13%, respectively. That’s key given that much of the comp number is driven by ASP growth given that FL is smack dab in the middle of the negative traffic mall.

c) Nike wholesale growth went from a pretty consistent run rate between 10-15% to flat in the quarter the company closed in May.

d) Nike incremental wholesale dollars slowed to $431mm in the company’s FY16, 40% the average rate we’ve seen over the past 4 years. Assuming a 20% DTC growth rate for Nike in FY17, which we think could prove to be on the low end, means the wholesale dollars up for grabs are set to be cut in half again.

 

None of the above is a good barometer for FL. We’re short it. There’s no way FL comes out of this smelling better than it does today. Sales should weaken, gross margins should decline, SG&A and capex will BOTH head higher as FL tries to build up a more successful e-comm business to compete with its existing partners. Management is good at FL, and it will spend where it needs to – and after its Nike business went from 50% to 73% of revs over six years it really did not have to invest at all (hence unsustainably low SG&A). Now that changes.

FL | Confident in Short Across Durations - 8 18 2016 FL earn table B 

 

Near Term Considerations:

 

After 3 years of nearly bulletproof earnings prints (FL has gone 11 straight quarters meeting or exceeding street numbers), we believe FL will be hard pressed to hit current 2016 estimates. Here’s why:

 

Revenue

1. Jordan launch timing was the signaled to be the key perpetrator for the negative comp trend QTD and while we aren’t blind to the factor launch timing can have on the weekly cadence of comps, but we think the softness in Nike basketball is a bigger headwind to overcome. The latter part we think helps explain the 500bps deceleration in comps from 4Q15 to 1Q16.

2. In this last fiscal year, NKE reported Nike Basketball and the total Jordan Brand separately for the first time. Jordan Brand grew 18% for FY16 on top of +20% in 2015, while Nike Basketball was DOWN 1% on top of +18%. While we think there is some obvious shift in demand from Nike to Brand Jordan, it’s the aggregate basketball business that really matters for FL. Basketball slowed to negative mid-single digits in 1Q16 vs a tough low double digit compare, and it doesn’t get any easier up against DD growth again back in 2Q15.

3. Comps were negative QTD as of the FL call on May 20th with street expectations for a 3.8% comp in the quarter. That means we would need to see a of 500bps+ intra-quarter acceleration in the trend in order for FL to hit current estimates. If history is any indication, FL has a pretty big mountain to climb. In order to hit a 4% comp this quarter, FL would have to see the biggest acceleration in… well, ever (or at least during this economic cycle). Then, from here, comps don’t get easier.

4. Don’t be fooled by positive QTD sales commentary on the call. August of 2015 was a relatively easy compare at mid-single digits, while September and October compares jump to double digits.

FL | Confident in Short Across Durations - 8 18 2016 NKE Bball

 

Margin Considerations

Merchandise margin compares get tougher sequentially from 1Q when the company missed comp by 160bps and gross margin by 30bps. ASP resistance has been well documented, and compares aren’t getting any easier from here. That’s an important point, as FL needs a low mid-single digit comp to leverage occupancy and about the same on SG&A. The FX SG&A tailwind is now completely gone with certain investment buckets weighing on 2Q in particular. Rounding it all out, the 1Q sales to inventory spread, though still positive, hit its worst level in 9 quarters. Throw in the liquidation of ~3mm pairs of athletic footwear between TSA and Sport Chalet in 2Q, and we think margins are more likely to surprise to the downside than the up.

FL | Confident in Short Across Durations - 8 18 2016 FL Sigma


TGT | Losing at Defense

Takeaway: Winners find a way to win. But TGT points fingers while #failing to reinvest for growth.

The obvious place to start the conversation on TGT would be on the numbers, and the company gave us plenty of ammo to poke holes in the print this morning. But we think the far greater concern for the long-term health of this company is the lack of definable plan or any clear insight by the management team as to what actually caused the worst quarterly comp number since the data breach and subsequent guide down for 2H16. We heard a lot of excuses, everything from Apple products losing their cache, to deflation, e-commerce pressure, and soft Rx traffic. Which all may be legitimate in their own right – but we have a NEWSFLASH for Cornell and team...

 

This is something we like to call RETAIL. The environment/consumer isn’t going to throw anyone a bone, especially at the tail end of a seven year economic expansion. In this sport, only losers point fingers. Stocks that make investors money on the long side find a way to win. Target is doing the opposite.

 

All in, we think this is all very characteristic of a management team playing defense instead of offense. Need further evidence? How about 2 consecutive quarters of earnings beats generated by cost cuts and share buy-backs with the stock at or near all-time highs. We’d argue that the team in Minneapolis would be better served missing expectations and taking down numbers by 2x the rate we saw today in order to build a superior platform from which to grow.

 

That may sound harsh, but after running through the numbers and sitting through the 60-minute conference call, we were still left asking what actually happened? In the absence of a clearly articulated answer from the TGT C-Suite, here’s what we think is playing out…

1) Competitive dynamics evolving: TGT has one of the least enviable competitive sets in all of retail stuck, right smack dab in the middle of four unique competitors – 1) WalMart, 2) Department Stores, 3) Dollar Stores, and 4) Supermarkets. As a bonus, it has Amazon.com hovering over its head plucking away every last sales dollar it can. The bookends of that are the real callouts, with WMT investing its way to flat earnings growth over the next 4yrs and AMZN taking 25% of the incremental sales dollars spent by the consumer. Both have huge implications for TGT, who clearly isn’t winning or investing.

2) TGT underinvesting: That’s on a relative and absolute basis. SG&A per square foot was down 0.7% in the quarter, and that’s in the face of WMT taking SG&A/sq. ft. up 9% as it spends on e-comm/stores/labor in order to propagate positive store traffic. TGT is content with managing expenses to free up $2bn in cost savings in order to invest at a measured pace. Without a considerable step up in the investment line, we have a hard time seeing how TGT wins as the competitive dynamics continue to evolve in favor of the other guys.

3) Market share loser: Retail has been a bit fickle over the past 6 months to say the least. But we think that given the prior two points, TGT is facing the brunt of that tough environment to a greater degree than its most immediate peer group. And that’s because there isn’t a clearly articulated strategic or capital investment plan in place in order to win in any environment. We saw the company lose share for the first time since the data breach hangover, and we expect that to continue as the two points cited above compound to make TGT a net loser.

 

So what does that mean in dollars and cents? We get to $4.60 in 2018 vs. the street at $6.25. The components of that number are a 1% comp (20% e-commerce growth and flattish store comps) and margin contraction to the tune of 20-30bps per year driven by both GM deleverage and an uptick in SG&A. On that, we’d argue a generous low double digit earnings multiple for a zero square footage growth retailer positioned as a market share loser. That’s a stock in the low-50’s, good for 25%-30% downside from current levels.

 

 

Additional Details On The Quarter:

 

A Lot Promised, But No $ Allotted

We heard about a dozen or so initiatives the company is working on internally as part of the long-term plan, and the projects run the gamut from investing in people, self-checkout lanes, digital assets, to back end infrastructure. Those all fall under the overarching theme which is boiled down into the phrase, ‘initiatives to drive future growth’, that TGT management throws out when it communicates with the Street. The only problem is that there is a considerable mismatch between the number of projects the company speaks to on any given conference call and the actual dollars allocated to those projects.

 

For TGT, the numbers speak for themselves, with SG&A/Sq. Ft. still in negative town down 0.7% in the quarter on TTM basis. The company can tout its $2bn cost savings plan all it wants (we thought it was particularly strange to see that as the number two bullet point in this morning’s earnings release) but the fact of the matter is that a cost savings plan isn’t going to support top-line acceleration. Not when WMT is investing a boat load to eat TGT’s lunch supported by SG&A/sq. ft. up 9% in 1Q (a number we expect to stay elevated when we see numbers out of the company tomorrow). At the same time, AMZN steps up its marketing and fulfillment spend in order to continue to take share. For AMZN, the numbers work out to an incremental $5bn in marketing/fulfillment expense over the past 12 months to support an incremental $20.5bn in revenue, with the expense rate up 90bps.

Bottom line, TGT is not getting it done.

TGT | Losing at Defense - TGT SGA

 

Traffic Slowing, Why?

That’s a fair question, and one that we don’t think was answered during the duration of the 60 minute conference call today. We heard a lot about a tough consumer environment, weekly/regional volatility, and apples of multiple varieties (tech and food), but very little concrete detail on what the company actually has in the works to stop the bleeding. This is an important point on the TGT story from here. The benefit from the data breach is now in the rearview, much of the improvement in the ‘signature categories’ has been recognized over the past two years, 20% of its revenue base is broken and that’s food, and we think most importantly, the company is being bombarded from all sides from the competitive set which includes, WMT, AMZN, dollar stores, grocery stores, and department stores.

From here (outside of price, which has its own margin implications) we can’t point to any material initiatives the company has in the pipeline to offset a decelerating comp trend. There are a few private brands (Cat & Jack, Pillowfort), continued investment in out-of-stocks, duct-tape work on the grocery division, regionalization, and digital spend. But none of the efforts are being allocated the capital needed or the marketing dollars behind them in order for the company to play offense and take market share.

TGT | Losing at Defense - 8 17 2016 growth slowing

 

Losing Share Like Never Before

Pre-data breach, TGT was good for 2-3% points of the incremental consumer outlays in retail category per quarter. It took an obvious step back in wake of the data breach, and recognized a snap back in demand as the company restored consumer confidence and recognized part of the Cornell plan. Fast forward to where we are today and TGT in this quarter just posted its biggest market share decline we’ve seen over the past 6yrs. Some of that is due to the sale of the $4.2bn Rx business, which we don’t adjust for in the chart below. The biggest callout from where sit is the bifurcation between a relatively healthy retail sales figures (ex Auto/Food Service/Gas) which has been in the 3.5% on a TTM basis and TGT’s decelerating comp store sales into negative territory for the first time since 1Q14. We think that’s due in large part to the following…

1) AMZN: If you run the same math on AMZN as we did with TGT, you’ll see the guy’s in Seattle carving out a bigger and bigger part of the incremental retail dollars. 2x the rate from a year ago and good for 25% of the incremental retail dollars. Compare that to TGT at -1.8%. That pressure isn’t going away unless TGT implements a material capital investment plan to beef up its e-commerce operation.

2) Stores: TGT no longer has the benefit of sq. ft. growth. Not that it had a big tailwind back in 2011-12, but it’s now in sq. ft. consolidation mode with smaller format store growth offsetting some of the big box closings. That means that traffic needs to be earned organically or online. Which brings us to point 3...

3) Digital: TGT owns one of the most underfunded and underdeveloped e-commerce operations in retail. The company took the operation in house from AMZN in 2011 and since that time, sales have grown to ~4% of total. Sales in the channel grew just 16% in the quarter, 40% the rate the company promised two years ago when it spoke to a 40% e-commerce growth CAGR (the company has since talked down expectations). There is a clear divide between the e-commerce winners and TGT. Unfortunately for them, the ante chip to play the game just went up with WMT’s $3.3bn acquisition of Jet.com.

TGT | Losing at Defense - 8 17 2016 TGT   of US retail


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