Reiterating what we published two weeks ago…as we get more retail datapoints, it holds true with increasing confidence.
Critical Bearish Retail Theme: Guidance – It’s Simply Not Believable. I (McGough) have been doing this job for 29-years. I’ve seen my fair share of economic, market, Quad, and most importantly RETAIL cycles. By my math, I’ve been through ~15,000 earnings reports, and management guiding throughout those reports. I can say with 100% confidence that the guidance I’m seeing out of management teams – over the past reporting/conference season, in particular – is the least believable of any time in my career. The Pods and The Quads were built to front-run management team guidance -- to predict today what they’ll be telling us in another 3, 6, 9 months down the road. We seen some realistic cuts for 2H of this year – which might be good for an occasional bear-market bounce on a given reporting day or as the real time credit card data shows trends better than management guided. Other companies are ‘extending the trend’ and just because things are stable today, they will not remain that way. Good luck with that strategy. But no one, and I mean NO ONE is talking about 2023 – and the consensus is looking for massive ramps in earnings in ’23 thinking that the margin hit we’re seeing today is ‘transitory’. Well guess what…it’s not ‘transitory’ if it happens four quarters in a row. My prediction… retailers will have an absolutely abysmal holiday season as consumer confidence crashes, inflation soars (boosting the price of necessities – like at WMT), the personal saving rate tests new troughs, and consumers lever up at generationally high interest rates. Holiday is going to be a dog fight, and we’re just getting a taste of this during back-to-school. After getting their teeth kicked in in 4Q, I think retail management teams will actually take an overly cautious approach to guiding FY23 by the end of 1Q, and come April/May, we’ll likely begin to see beatable numbers out there – on much lower stock prices. Remember that spending could fall off a cliff in 1Q23 -- we still face tough compares and the consumer will just have stretched to spend around holiday. Don't be tempted to be long retail before then. But after the April/May time frame that’s approaching the point where we get out of Quad 4, which is a double whammy to the upside. I currently have 44 shorts, and 21 longs (some with waning conviction), which is as short as I’ve been in the 15 years since we started Hedgeye. Recall that Retail EBIT ran +/- 3% of $150bn for seven years in a row this cycle (see table below), and now the consensus is closer to $200bn in 2022, and has that growing to $230bn in 2023. If we’re in fact in a recession (which, let’s face it – we are), there’s no reason we can’t see $100bn in EBIT. That’s a LONG way from current estimates. That is beyond unreasonable given the current economic climate, with top and bottom-line pressures on cycle-high inventory levels. Needless to say, I remain short retail. Sell the lower highs, and buy the quality businesses with asymmetric growth drivers on the red days (see Position Monitor at the bottom of this note for idea ranking). I KNOW you all want juicy long calls. They will come. I’m HUGELY bullish about the Retail setup in 2H23 – not just 20-30% moves, but doubles+ in Retail. Let’s give time time, and be on the right side of a red retail tape until then.
Two companies, we think, that will buck the ‘punk guidance’, negative revision and multiple compression risk are Driven Brands and Valvoline. Both Best Idea longs.
Target (TGT) | Moving higher on Best Ideas Short list. The market thinks TGT EPS revisions are done, yet we see US Macro getting worse. The 2-3 quarter outlook on Retail is ugly, yet TGT expectations suggest a rapid recovery in margins with sales growth remaining positive in perpetuity. That is unlikely to happen in a recession. Get ready for a promotional holiday dogfight and a consumer that will be fully tapped out come 1Q23. Consensus has a rapid recovery in margins mid recession baked into expectations. The gross margin estimates look plausible, what doesn’t look right is revenue and SG&A in the context of revenue. Gross margins were high heading into the pandemic, all of the upside in operating margin has been on SG&A leverage, yet the street has SG&A rate going to new all time lows in 2023, and sales continuing to growth despite the rising pressure on discretionary spending for the US consumer. At ~16x earnings, TGT is far from cheap, and it’s multiple relative to the XRT is not far off all time highs. We see further risk to 2022 earnings and 2023 earnings 23% below consensus. On the downward earnings revisions the multiple heads into the low double digits meaning a stock around $100 or 40% downside from current levels.
Valvoline (VVV) | Taking VVV Higher on Best Ideas Long list. Stock has been weak with some investors disappointed in the sale price of Global Products. We weren’t, and partly because when Core NA had issues in 2018/19, nobody wanted to put more than ~6x EBITDA on the business. Also, VIOC will need some time executing as a standalone entity before the market realizes it deserves a big premium to peers in the Auto Aftermarket space. The separation has been official for a bit over a month, closing to come around year-end or early 2023. At that time there will be debt reduction and share buyback to drive the stock up. We think VIOC is one of the best growth assets in all of retail and deserving of a 20x+ EBITDA multiple as a standalone business. We’ve been making the case for unlocking value with a business separation since mid-2019. VIOC is a growth asset that when separated should get strong interest from growth investors that had little interest in owning the “CPG” type Global Products asset. We see a fair price today in the low to mid-30s, as we exit Quad4 and the business model shows its growth power and defendability we see upside to $50.
Driven Brands (DRVN) | Taking DRVN Higher on Best Ideas Long list. DRVN did another auto glass repair acquisition in Auto Glass Fitters a couple weeks back. It looks to be decent sized, but the company didn’t disclose many specifics of the deal. The model is growing organically, and the company keeps layering on accretive M&A on top. Scale drives a competitive advantage in the auto service space. There is definitely some conservatism in the guidance. This is a new public company that wants to easily beat the street bar, management is wise to keep expectations grounded. We think the company is likely to beat in 2H. Looking out farther this model is juiced for top line and profit growth over a TAIL duration, and we think DRVN should do its long term $850mm EBITDA targets two years early. The leverage is high at ~4.7x as the company has levered up to accelerate growth, but cash flow growth will mean deleveraging and enhanced equity value appreciation over time. We see DRVN as a double or $60+ over a TAIL duration.
Adidas (ADS-DE/ADDYY) | New Best Idea short. We added this name to our short list just three weeks ago, and though it’s traded down, the reality is that this company has a major China problem, and it’s going up against Nike on one end – which is investing a ton of capital to regain share – and increasingly competitive local brands Li Ning, Anta and xStep on the other end. It’s getting squeezed and it’s not improving. Bigger picture, the CEO got ‘fired’ though will stay on for much of 2023 – so we’ve got a lame duck CEO with likely material turnover in the executive ranks to boot. Then the new CEO will need a year to figure out a strategy as to how the company can regain brand heat. Then we’re looking at another 1-2 years until that strategy can be implemented. Punchline – the stock looks ‘cheapish’ at 17x earnings, but both the multiple and earnings revision are likely to head lower over a TREND and TAIL duration. This is literally a dead stock for 2-3 years.
TJX, Inc (TJX) | Still a Best Idea Long, but our near-term conviction is waning. Apparel inventories are simply not improving, and in fact are getting worse. Fall product resets across the board are 2-4 weeks late while retailers struggle to clear summer inventory. To be clear, this allows TJX to buy inventory on the cheap, pack it away, and bring it back next year to drive comp at an outsized margin, hence our above-consensus estimates for the next two years. But while other retailers are getting so competitive on pricing, it pinches TJX as well. Home Goods also accounts for ~25% of cash flow, and that category is under increased pressure over a TREND duration. We like this stock in the $60s (currently at $65), but we think we’ll be able to like it more in the $50s sometime over the next 3-6 months.
Amazon (AMZN) | Lower conviction on our Long Bias list. Yeah, we get it, the stock is down 15% since August (when we kicked this down from our Best Idea Longs to Long Bias), but we care about where stocks are going, not where they’ve been. The Retail Sales numbers reported last week showed notable weakness in e-commerce. And while the company likely has 3Q ‘in the bag’, we think the competition for AMZN this 4Q will be unusually fierce, leading to a deceleration in growth – which should slow further in 1Q when a levered and tapped out consumer simply fails to show up to spend. Despite our bullish longer-term TAIL view on Amazon and all the ways it’s driving value and dominance through its impenetrable ecosystem, the rate of change is likely to work against the stock once through 3Q22 – like so many of its peers. We think we’ll get the chance to make a ‘pound the table’ call on AMZN (likely a Best Idea Long) at a better price over 12 months.
Canadian Tire (CTC.A-CA) | Moving higher on our Best Idea Short list. Canadian housing data, consumer credit, and the general intensity of Quad4 is mirroring the US, but this name has fallen beneath the radar. We got an initial crack in the company’s credit book in the latest quarter, and the stock hardly sold off. It’s ~25% of cash flow, and poses a meaningful risk to the earnings and cash flow stream (note delinquency statistics from the Capital Ones and Synchronys of the world are getting worse). The elephant in the room is that the Canadian Tire concept is still ‘over-productive’ with sales per square foot near C$410 vs C$305 pre-pandemic. The potential for MAJOR mean-reversion is being completely overlooked by the Canadian analysts that cover the stock. The company earned C$13 pre-pandemic – and the Street has C$19 straightlined in perpetuity. That’s simply not gonna happen. The multiple here is not egregious at 8.3x EPS and 6.5x EBITDA. But this company has a massive debt burden, and was built to be cheap. We think you get paid here on a big downward earnings revision sometime over the next 12 months, with new trough multiples in play given that the credit cycle on such a highly levered retailer is going the wrong way.
FIGS, Inc (FIGS) | Moving meaningfully higher on Short Bias list. We think this company has materially overstated its TAM, understated its competitive set, and is overestimating demand for its product when the consumer hits a wall around holiday, and then ‘evaporates’ in 1Q23.This should be a $5 stock – currently trades at $10 and at 46x earnings. That multiple simply won’t hold in multiple Quad4s.
PLBY Group (PLBY) | No change as Best Idea Long on our Position monitor…but want to reiterate what we said last week that we walked away meaningfully more bullish (with much of our concerns about liquidity put to rest) after meeting with the full management team at HQ in LA. This one is going to be a grind and you need patience around the volatility, but we think that the fundamental story will be gaining traction just as we’re exiting Quad 4 in 2023. An added plus is that we’ve done checks with the creators for CENTERFOLD in the wake of the redesign launched last week, and they definitely like the added control this launch gives them as it relates to pricing and engaging with subscribers. We expect to see more CENTERFOLD enhancements in the coming weeks by the internal team hired to turbo-charge the initiative. Again, not for the faint of heart – but we think this $4 stock starts to gain institutional traction over 12 months as it passes $10.
