M and KSS with big 3Q headline beats and guide ups. The upside to 2H earnings while we sit in Macro Quad2 is what has kept these names off our Best Idea short list. The sales trends put both companies roughly around 2019 levels, with M seeing an acceleration on a 2 year basis, and KSS seeing a slowdown. Gross margins remain elevated as has been seen across the industry, SG&A for both companies was very lean especially in the context of wage inflation and tight labor supply. Guidance for both companies implies similar sales rate of change trends, but slowing margin expansion. A quick side note on the M ecom separation narrative, management announced that the board is doing its diligence to look into it, hiring Alix Partners to assess it. However we think this is just appeasing the activist in terms of process. The management message was pretty clear on the call with the team saying “Omnichannel” at about 10x the normal conference call rate. The separation won’t happen, for more details on why see our note: M | What’s Zero Plus Zero?.
The recovery to 2019 sales levels actually presents a very real problem. Let’s take a quick look at core KSS/M categories in the context of US retail in 3Q (retailer fiscal). Census data has Clothing stores (this is just the B&M stores, excluding online) about 16% ahead of 2019. Home furnishings stores about 20% ahead of 2019. Meanwhile Target apparel grew low double digits this Q, on top of +10% last year… ie about 25% ahead of 2019. The takeaway, department stores are losing significant amounts of share, likely in the form of net customer losses. It has been happening for years slowly, but in this Covid shakeup it appears to be losing big chunks. Given the value proposition of the store and the preference of the incremental consumer, its unlikely we see reversion in those share trends. Then on gross margins, its clear that the supply/demand environment and consumer strength is driving unprecedented merch margin expansion across all of apparel retail. This will revert, and probably revert faster than consensus thinks. SG&A is a bit more puzzling, both companies are seeing solid leverage vs 2019 levels despite serious labor rate inflation in retail. Both cut a lot of costs out in peak Covid when the companies could, maybe the leverage can last, but given inflation trends these SG&A rates are probably at risk on a go forward basis as well.
So that brings in the question of timing to get heavy on these shorts. We think we are in the later innings on EPS upside vs the street, probably at the 7th inning stretch. Though you probably want these shorts on before the bottom of the 9th. We expect holiday to be strong for retail in total, the consumer is flush with cash, lean inventories will keep margins up. M and KSS will likely beat again, though we think much lower beats than seen the last couple quarters. Holiday release in Jan might mark the peak, management teams should guide conservatively for 2022, but that doesn’t mean they will. By 1Q results we think earnings reversion is in full swing. At the same time cashflow will be further at risk as working capital builds back up and the companies get back to normal investment rates after Covid cutbacks. We could say the time to short these is now because any more upside in EPS is already priced in, but the reality is in Macro Quad2 nothing is fully priced in to the upside in consumer discretionary for bullish Trend names. We still have another month and a half of Quad2 in Q4, and current outlook for Quad1 in 1Q. So we remain patient, but M and KSS are VERY close to being added to our Best Ideas on the short side.
