Stinky Cheese

This note was originally published at 8am on May 02, 2012. INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK (published by 8am every trading day) and PORTFOLIO IDEAS in real-time.

“For every complex problem there is an answer that is clear, simple, and wrong.”

- H.L. Mencken


While they’re not the only ones in the business, the French are rightfully proud of their “stinky” cheeses.  Yet stinky is for the consumer to judge and when it comes to pungent cheese, aroma and taste can run the spectrum from intense pleasure to pain, or alternatively as a pleasure from the pain.


A similar broad spectrum on the handling of the Eurozone’s sovereign debt and banking “crisis” is enjoyed by investors, strategists, journalists, and European citizens alike: abolish it, rescue it, or structure some hybrid of the two.  So what’s the update on the region as we find ourselves in May with the stink currently in Spain?


We continue to throw the abolishment camp out the window on four main factors:

  1. Eurocrats will tote the line to save their job
  2. Fear of the contagion effect from the default of countries and banks on the rest of the continent
  3. Belief in the Union’s economic benefit (namely through open trade and travel)
  4. Belief in the formation of a European identity (including the continental strength to balance the closest geographic spheres of influence in the U.S. and Russia)

While we could argue until we’re blue in the face that Europe needs its own Lehman-like event, to let weaker countries default and/or exit the Union, and that one monetary policy for a collection of joined states growing at uneven rates will continue to compromise the Union because it handcuffs nations from manipulating currencies and interest rates to encourage competitiveness, we think the above factors will justify the maintenance of the existing Eurozone fabric over at least the next 12 months.


So the task is to play an incredibly-challenged environment ahead as Eurocrats try to find a balance between fiscal consolidation, while not obliterating future growth in the process. One key factor to monitor, which we’ll hit on later in the note, is the deterioration of Merkozy, or relations between Germany and France on Eurozone policy.


So what’s so wrong with Europe?

The existing rub in directing European policy to improve the fiscal health of countries is that European leadership is inherently compromised: on one hand they have to answer to their citizenry that is largely voting against fiscal consolidation (and rioting on the street to bout), yet on the other they must answer to the markets, and a larger Brussels “authority”. Given that the markets are pricing in slow growth across Europe in 2012 and such threats as the inability of governments to meets consolidation targets, sovereign yields should remain elevated, which in turn increases the cost to raise capital and sets the “non-virtuous” cycle of raising debt and deficits levels. 


With 10YR yields trading at 20.4% in Greece; 10.5% in Portugal; 5.8% in Spain; and 5.6% in Italy; vs 1.6% in Germany, it comes with no great surprise that Germany is not interested in issuing Eurobonds.


But now the stakes in reducing risk have elevated, as Spain has taken the sovereign spotlight after a lengthy focus on Greece!  (Note: Spain’s economy = 5x Greece’s.)


And while Eurocrats have set up a number of firewalls to ease investor concern that the Eurozone is going away—including funding programs such as the EFSF, ESM, and enhanced commitments to the IMF earmarked for Europe, to liquidity programs such as the two 36M- LTROs and the SMP—these programs do little to bind Europe under a growth strategy.  As of recent weeks, it’s growth that has been given more attention by Eurocrats.


More Conflicts Ahead

But how do you manufacture growth? Simply by setting up more funding through the European Investment Bank or earmarking more lending from the IMF?  But who’s paying for it? Importantly, Germany hasn’t put up her hand, and who’s left?


Again, the uneven and compromised nature of Europe (and the Eurozone specifically) cannot be overlooked.  Simply throwing money at “problems” won’t cure structural drags like high unemployment rates, low labor productivity, vulnerable banks, and further risks from declines in housing and property prices ahead.


To highlight a few imbalances: Spain’s unemployment rate is 24.4% vs Germany’s at 6.8%, or Spain has a monster deficit reduction target of 5.3% (of GDP) for 2012 versus 8.5% last year vs the German deficit forecast to fall to 0.6%.  Or consider Portugal’s average annual growth rate over the last 10 years of 0.03% vs 1.07% for Germany, or recall that we forecast house and property prices could fall another 30% from here in Spain! 


It’s such structural mismatches (to name a few) that suggest that even if Europe finds a united path, it won’t come next week, next month, or next year. Uncompetitive countries like a Portugal or a Greece are going to stay uncompetitive. Europe’s stronger nations will simply have to decide how long they want to subsidize them.  Is this a realistic long-term strategy? We think not, but we still must play the likelihood that Eurocrats fight to support the whole.


Of note is that in some cases expectation are just grossly misaligned. For example, the European Commission targeted all member nations to have deficits at or below 3% by 2013. That’s surely not realistic for Portugal, Ireland, Spain, or Greece! Further, the Fiscal Compact, which is really an amended version of the Stability and Growth Pact (aimed at deficit reduction to 3% and debt reduction to 60%), stands to fall short as Brussels wrongly assumes members will give up their fiscal sovereignty.


French Inflections

Returning to stinky cheese, the likely victory of the Socialist candidate Francois Hollande in this Sunday’s presidential elections spells the likely end of a strong working relationship between France’s Sarkozy and Germany’s Merkel. Hollande’s very socialist agenda (increase spending by €20 MM over five years, reduce the retirement age from 62 to 60, raise income tax on earners over €1 MM to 75%, capping gasoline prices for a number of months and a pledge to block corporate job cuts) along with such positions as pro Eurobonds (which Germany vehemently opposes) and opposition to the Fiscal Compact, portend great disunity at a time when the Eurozone needs its two largest economies to pull jointly on the loose strings and direct solutions to its sovereign and banking ills.


Returning to H.L. Mencken’s quote that started the note, it’s clear Europe has a very complex suite of problems. And if expectations are the root of all heartache, it’s the market’s expectation that Europe will be “fixed” tomorrow that needs amendment.   While there is no simple solution, without better coordination through both appropriate targets for fiscal consolidation alongside strategies for growth, we do not see any hope for material improvement across the region over the next 12 months.


The immediate-term support and resistance ranges for Gold, Oil (Brent), US Dollar Index, and the SP500 are now $1630-1656, $119.07-121.06, $78.55-79.32, and 1391-1415, respectively.


Matthew Hedrick

Senior Analyst


Stinky Cheese - EL CHART


Stinky Cheese - el VP

Proactively Prepared

“Most people have the will to win, few have the will to prepare to win.”

-Bobby Knight


We don’t have to apologize, fear-monger, or point fingers while everyone is reacting to the news again this morning. This has been going on for 5 years. Get both the Slope of Global Growth (slowing) and the direction of the US Dollar right, and you’ll get a lot of other things right.


Winning in this country (or being right in this business) should be celebrated instead of shunned. It’s not easy out there – and it’s not going to get any easier any time soon. Life is hard.


Repeatable risk management processes trump pundits. Either our profession’s broken sources go away, or whatever is left of the trust, inflows, and volumes in our markets will.


Back to the Global Macro Grind


From a Global Macro perspective (currencies, countries, commodities, etc.) I am finally seeing the early signs of capitulation (immediate-term TRADE oversold) on the downside as the US Dollar approaches immediate-term TRADE overbought.


That’s what happens when The Correlation Risk goes “on.” Policy (or in this case the lack thereof in expectations of an iQe4 upgrade) drives the US Dollar; and the US Dollar drives mostly everything else (USD up for the 11th consecutive day today).


Correlation Risk has a reflexive impact on demand (markets that go straight down scare people), but it is not traditional demand in terms of how we measure it – it’s behavioral. Our Leading Indicators on Global Demand (Growth) have been slowing since February-March.


Commodities and Asian Equities stopped going up in February; most other major Global Equity markets stopped going up throughout March; and US Treasury bond yields stopped going up in March as well.


In other words, if you have a Globally Interconnected Risk Management Process (or just a Twitter feed with credible sources), why people are freaking out right now (instead of when they should have), should at least give you a chuckle.


People freak-out (buy high, sell low) because we have institutionalized asset management into a very short-term game of performance chasing. Sadly, gaming the game of the next policy move is paramount on people’s minds – and the intermediate-term draw-downs (from peak-to-trough) for the last 5 years have been epic.


Here’s how the draw-downs (losses of your capital from the YTD tops) look in some of the majors:

  1. Japanese stocks (Nikkei) = down -14.2%
  2. Hong Kong stocks (Hang Seng) = down -11.2%
  3. Indian stocks (Sensex) = down -13.0%
  4. German stocks (DAX) = down -11.3%
  5. Spanish stocks (IBEX) = down -25.1% (crashing)
  6. Russian stocks (RTSI) = down -22.3% (crashing)
  7. CRB Commodities Index = down -11.3%
  8. Gold = down -14.2%
  9. Oil = down -11.8%
  10. Treasury Yields (US 10yr) = down -24.8%

Bullish, right?


Right, right. And all of this, including JPM’s news is all about Greece, right?


C’mon. Let’s get real here before whatever is left of the world’s investors yank all their capital from our fee based businesses. Ben Bernanke may very well have dared you to chase yield on January 25th, but that doesn’t mean you should have taken on the dare. You have seen this Qe expectations game before. You should have sold into it.


US Equities, which I didn’t list in the top 10 draw-downs, have done a complete round trip from where we were banging the risk management drums here in New Haven. While the Russell2000’s draw-down is about the same as the Hang Sang’s (-8.2%), the SP500’s is just -6.3%. So, if you bought the April 2ndtop, you only have to be up about 7% (from here) to get back to break-even.


Break-even? Yes. That matters. And so does timing – that’s why we are so focused on both.


Check out the timing of this trifecta:

  1. Russell 2000 peaks on March 26that 846
  2. US Equity Volatility (VIX) bottoms on March 26that 14.26
  3. Obama’s probability of winning the US Election peaks on – yep, March 26th

Political pundits probably don’t read this Newsletter. But if they did, they’d think that last point can’t be true. After all,  it doesn’t come from Washington or the accepted wisdoms of partisan paralysis.


We call it objective analysis. That’s all the Hedgeye Election Indicator is, math.


So, as US Equity markets draw-down from their March/April peaks (as they have from Q1 to Q3 in every year of the last 5 other than in 2009 when we were the most bullish firm on Wall Street 2.0), that’s obviously going to be a headwind for Obama.


It’s also going to be a headwind for Ben Bernanke.


Don’t forget that any headwind for Obama is, on the margin, a tailwind for Romney. Anything compression in the spread between Obama versus Romney (Obama had a huge lead in March), puts Bernanke’s career risk in play.


That, dear friends of the risk management gridiron, is US Dollar bullish.


And, with the US Dollar Index breaking out across all 3 of our core risk management durations (TRADE, TREND, and TAIL), you want to continue to be Proactively Prepared for what may very well be the most epic economic debate of our generation.


My immediate-term support and resistance ranges for Gold, Oil (Brent), US Dollar Index, EUR/USD, and the SP500 are now $1, $110.27-112.99, $80.04-81.22, $1.27-1.29, 1, respectively.


Best of luck out there today,



Keith R. McCullough
Chief Executive Officer


Proactively Prepared - Chart of the Day


Proactively Prepared - Virtual Portfolio

Hedgeye Statistics

The total percentage of successful long and short trading signals since the inception of Real-Time Alerts in August of 2008.

  • LONG SIGNALS 80.47%
  • SHORT SIGNALS 78.71%

DKS: 1Q12 Report Card


Conclusion: As we expected, DKS is firing on all cylinders (FW, Apparel, Team Sports & Golf) for the first time in a long while. Improvement in hardlines were driven by baseball bats and golf equipment as expected with the later coming in even more robust than even we expected. While some of the outperformance can be attributed to a pull forward in sales, the product cycle continues to improve while DKS’ compares are relatively easy. In addition, there were several developments during the quarter (Top-Flight acquisition, JJB stake, Bubba’s Pink Ping Driver in June, etc.) that represent a series of positive intermediate-term drivers. Expectations for the balance of the year continue to look flat out conservative to us.

What Drove the Beat?

Solid quarter from DKS coming in $0.07 above the top end of its range and consensus expectations driven by higher sales and gross margins. Revenues came in strong up +15% a little better than our expectation for +14%E and the consensus of +10.5%E, but the real callout in the quarter is inventory management reflected in better than expected gross margins, which were up +112bps on stronger sales despite clearance activity and higher equipment sales mix.


DKS: 1Q12 Report Card - DKS S

Deltas in Forward Looking Commentary?


In order to properly measure performance relative to original expectations, we look at management’s first quarter results relative to management guidance as well as any updates to previously provided full year 2013 outlook:


DKS: 1Q12 Report Card - DKS Delta


Highlights from the Call:


  • Aggregate comps up +8.4%
  • Comps at Dicks up +7.3%
    • FW, App, and hardlines all positive
    • +4% sales per transaction
    • +3.3% in traffic
  • GolfGalaxy +12.6%
  • E-Commerce +33.4% (~3% of total sales)
  • Expect to open 38-40 stores in 2012; 50/50 new vs. existing markets
  • Continue to shift product mix to higher margin private label (acq. Top-Flight) and key brands via shop-in-shops (NKE, UA, The North Face)
  • Price, size, and packaging optimization starting to bear fruit
  • New store productivity up +105.8%
  • Opening 4th DC in Jan ’13, 600k sq. ft. facility in AZ; w/DC in DC can support 750 stores
  • Targeting ship-from-store capability in 2012

Q2 Outlook:

  • Comps up +2-3%
  • GM: modest increase
  • SG&A: modest leverage
  • EPS $0.62-$0.63

GM: +112bps due to:

  • Occupancy leverage (+120bps)
  • Merch margin down modestly (-8bps)
  • Cold weather apparel inventory clearance now complete
  • Some due to clearance of fitness equipment

SG&A: up +12%; -58bps due to:

  • Payroll leverage
  • Lower advertising


  • Cash = $521mm
  • Share repo = 2.1mm shares at $49.39/sh = $104mm
  • Completed SRA yesterday purchased total 4.1mm shares
  • Purchased store-support center for $133mm


Bat replacement cycle contribution:

  • Less than 1pt to comp
  • Isolated benefit to Q1

Occupancy Leverage:

  • Need +3% to lever

Lease Duration:

  • 10yr term lease structure preferred going forward

Private label

  • Top-Flight margins 2bps higher than other brands

Competitive Pricing Environment

  • Seeing rational pricing in the space
  • 'think we did better than most'

Cold Weather Overhang Impact:

  • Primary impact on merch margin in Q1
  • NFL jerseys for Q4 should be very helpful to margin rate

Store Opportunities:

  • Cont to look at big box opportunities - ex BBY, KMart, SHLD, Linens space
  • Planning on ~40 stores/yr, maybe 45


  • One of better performing categories in the qtr
  • New product expectations positive
  • Expect positive momentum to continue

JJB Investment:

  • 'this is a high risk, very high reward investment'
  • JJB has only 6%-7% of ~$9.5Bn UK market - 'see a big opportunity' for share gain


  • NKE ~50 this year
  • UA ~80 add'n stores
  • Adding North Face shops as well


TODAY’S S&P 500 SET-UP – May 16, 2012

As we look at today’s set up for the S&P 500, the range is 34 points or -0.50% downside to 1324 and 2.05% upside to 1358. 












    • Up from the prior day’s trading of -2114
  • VOLUME: on 5/15 NYSE 868.62
    • Increase versus prior day’s trading of 8.20%
  • VIX:  as of 5/15 was at 21.97
    • Increase versus most recent day’s trading of 0.46%
    • Year-to-date decrease of -6.11%
  • SPX PUT/CALL RATIO: as of 05/15 closed at 2.35
    • Down from the day prior at 2.50 


  • TED SPREAD: as of this morning 38
  • 3-MONTH T-BILL YIELD: as of this morning 0.09%
  • 10-Year: as of this morning 1.77
    • Unchanged from prior day’s trading
  • YIELD CURVE: as of this morning 1.50
    • Unchanged from prior day’s trading 

MACRO DATA POINTS (Bloomberg Estimates):

  • 7am: MBA Mortgage Apps., week of May 11 (prior 1.7%)
  • 8:30am: Housing Starts, Apr., est. 685k (prior 654k)
  • 8:30am: Housing Starts (M/m) Apr., est. 4.7% (prior -5.8%)
  • 8:30am: Building Permits, Apr., est. 730k (prior 764k, revised)
  • 8:30am: Building Permits (M/m) Apr., est. -4.5% (prior 4.5%)
  • 8:30am: ECB monetary policy conference; participants include President Mario Draghi
  • 9:15am: Industrial Prod., Apr., est. 0.6% (prior 0.0%)
  • 9:15am: Capacity Util., Apr., est. 79.0% (prior 78.6%)
  • 9:15am: Manufacturing (SIC) Production, Apr
  • 10:30am: DOE Inventories
  • 12:30pm: Fed’s Bullard speaks on economy in Kentucky
  • 2pm: Minutes of April FOMC Meeting 


    • House, Senate in session:
    • Senate Health holds hearing on health care delivery systems, with Coastal Medical, Humana officials, 10am
    • Senate Commerce holds oversight hearing on FCC, with Chairman Julius Genachowski, 2:30pm
    • House Financial Services subcommittee holds hearing on effects of Dodd-Frank Act, 10am
    • House Ways and Means panel holds hearing on tax-exempt organizations, 10am
    • House Financial Services subcommittee holds hearing on market access for U.S. financial firms in China, 2pm
    • House Financial Services panel holds hearing on FDIC oversight with Lennar Corp. CEO Stuart Miller, 2pm
    • House Small Business holds hearing on U.S. trade agenda, 1pm
    • World Bank President Robert Zoellick speaks at Economic Club of Washington, 12pm 


  • FOMC releases minutes of April 24-25 meeting
  • Facebook said to increase size of IPO to 421m shrs
  • Housing starts in U.S. probably rebounded from five-month low
  • Euro-region inflation slowed in April, March exports dropped
  • U.K. unemployment unexpectedly falls in sign of stabilization
  • Greek leaders meet on new election after European stocks fall
  • Carlyle said to seek $3.5 billion for fourth Asia buyout fund
  • Berkshire Hathaway took new stakes in Viacom, General Motors
  • Verizon in $63 billion faceoff with AT&T over family plans
  • Investor Whitworth holds $610m PepsiCo stake, meets w/ co.
  • GE to buy U.S., Australian mining-equipment cos.
  • Australian consumer confidence stagnates near year’s lows
  • Soros, Eton Park raised gold ETP holdings before price drops
  • House Financial Services subcommittee holds hearing on effects of Dodd-Frank Act
  • NYSE Euronext removed from bidding for London Metals Exchange
  • EADS 1Q profit misses est.; raises 2012 EPS outlook 


    • Staples (SPLS) 6am, $0.30
    • ValueVision (VVTV) 6:30am, ($0.19)
    • Chico’s FAS (CHS) 6:55am, $0.30
    • Deere & Co (DE) 7am, $2.53
    • Abercrombie & Fitch Co (ANF) 7am, $0.01
    • Sears Canada (SCC CN) 7am, C$0.03
    • Target (TGT) 7:30, $1.01
    • Brady (BRC) 8am, $0.57
    • Eagle Materials (EXP) 8:30am, $0.24
    • Hot Topic (HOTT) 4pm, $0.08
    • Ltd Brands (LTD) 4:30pm, $0.40
    • (CTRP) 5pm, $0.17
    • (NTES) 6pm, $1.01 



COMMODITIES – definitely seeing some capitulation in Bernanke’s Bubbles (our Top Macro Theme issued in April) – Gold finally oversold at -14% from its YTD high; Copper getting spanked -1.7% to immediate-term oversold (-12% from its Feb Growth Slowing high). 

  • Commodities Drop Near Five-Month Low on Greek Euro Exit Concern
  • Gold Eclipsed by Dollar Haven as Goldman Sees Rally: Commodities
  • Palm Oil Slumps Most in 14 Months in Record Volume on Euro Debt
  • BHP Won’t Meet $80 Billion Spending Target as Minerals Fall
  • Gold Tumbles Into Bear Market on Concern Greece May Leave Euro
  • Copper Drops for Fourth Day as Greece Remains Without Government
  • Corn Declines as U.S. Planting Nears Completion, Lowering Risks
  • Sugar Falls as Brazil’s Weaker Currency May Accelerate Exports
  • NYSE Euronexit Is Removed From Bidding for London Metal Exchange
  • Crude Palm-Oil Futures Volume Reaches Record 63,019 Contracts
  • Soros, Eton Park Raised Gold ETP Holdings Before Price Drop
  • Seaway No Guarantee for Goldman’s WTI-Brent Bet: Energy Markets
  • Eni Follows BG, Anadarko With More Gas Finds off Eastern Africa
  • Inmet Capitalizes on Junk Demand for Copper Mine: Canada Credit
  • GSCI Index Decline to Near Five-Month Low
  • Oil Drops to Six-Month Low on Rising Stockpiles, Greek Crisis
  • Rubber Falls to Four-Month Low as Greek Woes May Cut Demand









EUROPE – we don’t see Greece “leaving the Euro” anytime soon (pundits might, but the market doesn’t either or the Euro would catch a bid – weakest stores (countries) stay in the currency base and Euro goes to $1.22); what we do see is capitulation (immediate-term) to oversold lows in Spain and Russia this morning (crashing markets, down -26% and -22% from their YTD tops).






JAPAN – probably the most misunderstood and under-reported situation in the world right now is Japan (Nikkei down 21 of the last 28 days = -14.2% draw-down) and the BOJ just saw the lowest demand (1st shortfall vs the 600B they wanted to issue) for JGBs since Oct 2010. Greece is nothing compared to this.









The Hedgeye Macro Team


JCP: Making the Call on Air

Conclusion: This story is playing out like it should fundamentally. That’s no surprise to us. What did come as a shocker was how management approached the quality of its results, and seemed to add every bit of opacity within its grasp. Is Ullman still there? There’s a long time to wait for any signs of momentum (on the upside) here. In the meantime you’re paying 15.2x a made-up non-GAAP EPS number that might or might not materialize before 2014.



As big as this event seems to be for JCP, it was really written in the cosmos. We didn’t exactly have a soft stance on this one.


June 11, 2011: HedgeyeRetail on The Closing Bell with Maria Bartiromo “The Street is at $2.77 [in 2013]. I think they’ll be lucky to earn a buck.”


June 11, 2011 Interview on "The Closing Bell" 


What are we looking at today? After assuring the investment community that JCP would earn adjusted EPS of $2.16 (estimates had been coming down from $2.77), and GAAP EPS of $1.59, today he pulled the GAAP number. Earnings are going to come in closer to a buck.


The message he left us with is “We’ll still get to adjusted earnings of $2.16 – which is excluding all restructuring charges – but we’re not going to tell you what our GAAP target is. We’ll include restructuring benefits in our results, but not the costs associated with those benefits. As our results change each quarter, we’ll call the delta between what we report and the $2.16 a ‘restructuring charge’."


Seriously Ron…we’d expect this from your predecessor’s administration. But you? With your high-class pedigree? Someone is giving you bad advice.


Let us hit on a couple of items we liked in the quarter.

1) The dividend cut: The reality is that JCP has no business paying a dividend. 1Q Cash from Operations was –($577mm). Last year it was +$52mm. That's a $629mm hole. Its cash balance was down $928mm yy. JCP HAD to cut the dividend. In fact, we’d be concerned had they not.

2) It would be disingenuous for us not to state – flat out – that the store concept sounds very exciting. With dedicated shops from brands like Nike, Liz Claiborne, Tourneau, Levi’s, DC Shoes and about 95 other ‘higher-end-than-KSS and even Macy’s brands, this concept has teeth. We still don’t think that the goal of ‘a store for everybody’ is achievable in any way, shape or form. But the store as it is described today certainly has mid-upper mass appeal.

3) We still like the bargaining power JCP will have with vendors as it goes about its strategy. Johnson at one point made a comment like “even Gold Toe (Gildan) wants a shop in shop.” They also noted that there will be a very large Levi’s presence, indicating that VFC’s Lee and Wrangler did not make the cut, or play the price cut game required to secure the business. In the end, this is good for JCP. (We still think that the supply chain implications for the rest of the industry are extremely negative).


What we did not like…

1) From the very start of the presentation, management’s attitude was surprisingly cagey. They took the few statistics they they were willing to share , such as average spend and conversion, and attempted to twist them around to suggest that comping down 18.9% had some kind of positive read through. Let’s face some facts, comping down 20% and putting up a 28% decline in internet sales when Macy’s reported 33% growth in e-tail is just flat-out embarrassing.

2) It would have been so much better for them if he stood up and said “Hey everybody. Let’s get right to the heart of the matter. I realized this quarter that the forecastability of near-term customer behavior and competitive response in this business is much harder than what I am accustomed to. I’m pulling guidance accordingly because I don’t want our team focused on the wrong metrics. I’m going to quantify for you what deviated from my expectations, what I learned, and how I’m changing it.” For a guy with Johnson’s level of integrity, this could have taken an otherwise awful quarter and flipped it 180.

3) Though we like the concept in theory as noted above, we have major concerns about execution, capital investment needed to achieve the goals, and the duration mismatch between Johnson and investors (he gets paid in 6 ½ years when his warrants vest – few investors have that luxury).

4) The company identified additional cost saves – we’re guessing about another $50mm above the previously stated $900mm run rate JCP should achieve by year end (they indicated north of just $10-$20mm). Mind you, this means that it could get to this run rate on Jan 31, and would be a FY14 earnings event. Nonetheless, when a company puts up one of the most miserable top lines in recent memory, we rarely want to see Retail Austerity to sustain earnings. Management probably reads a statement like this and says ‘c’mon Wall Street…you want earnings and now you tell me not to cut costs?’  Our answer is “Yes. Some people want earnings via cost-cuts today, and they could care less about tomorrow. We’d rather you invest today and crush Kohl’s and Macy’s tomorrow.”

5) We have to point out the irony of management’s statement about employee morale, and how “it has never been better” since they switched from a commission to a salaried workforce. So let me get this straight, the employees are happy with sales down 21%? Wow…  Johnson’s point is a good one. A salaried workforce leads to happier workers, which leads to better service, more customers, and perhaps better conversion (though we could argue against that one). In the end he thinks it is a big positive. He’s probably right. But again, we’d note that it is a positive within his 7-year duration – not the 2-3 year horizon by the average long-term investor.

6)      The shop in shop rollout will take time. Johnson is planning on rolling out 2-3 shops per month through December 2015 until JCP has reached 100 overall. Right now, we know ~30 of these shops (see matrix below). Additionally, there seems to be no shortage of applicants as JCP received 110 applications from brands interested in partaking in the new concept. Though the actual rollout may consist of 2-3 brands per month, our sense is we will be introduced to those participating in the "shops" in larger groups well ahead of their actual rollout not unlike we were yesterday. Assuming JCP maintains the 2-3 shop schedule, the rollout and ensuing change to the merchandise assortment could looking something like the roadmap below with 100% of the assortment refreshed come 2015 (47% will be changed by this August). 


JCP: Making the Call on Air - Shops cube


JCP: Making the Call on Air - Merchandising Roadmap


We’re at $1.00 for the year, and $1.75 in 2014. Timing is a very important consideration. If the company gets closer to $2.16 in 2014, then people will look towards a number above $3 another year out as the excitement around a big comp rebound and associated leverage ensues. That would, in fact, be an exciting story. But the absolute earliest there will be any form of visibility into any such rebound happens well into 2013. In the meantime you’re paying 15.2x a made-up non-GAAP EPS number that might or might not materialize before 2014. We can think of dozens of other places we’d rather be.



Brian P. McGough
Managing Director





Below are the highlights from managements presentation last evening:


"If I were to write the headlines for today, here is what I’d say. Our first 90 days are a little tougher than we expected. We expected the sales to be down, double-digit. They at the low end to that range, of our expectation, but the good news is, the transformation from my perspective is way ahead of schedule." - Ron Johnson, CEO


Progress to Date

  • 2012 is the year of transformation; 2013 to be the year when takeoff starts, currently on day 105
  • Expect to earn "good money" this year



First Quarter Results


"This has been a very tough quarter for us, but not necessarily unanticipated." - Michael Kramer, COO


  • Revenues down 20%, comps down 18.9%
  • GAAP EPS loss of $0.75
  • Adjusted EPS of -$0.25
  • Feb sales down 21%, saw 300 bps improvement in back half of the Q
  • Continue to expect the back half of the year to be better
  • Traffic down 10%
  • Traffic down 6% Monday-Thursday
  • Traffic down 12% on the weekends
    • Conversion: 21% this year vs. 22% last year
    • Average spend per visit $46 this year vs. $48 LY
    • Primary issue is traffic due to like of couponing- 40% of last years transactions not only included a product on sales but had an additional coupon


Gross Margin -290 bps (270 bps due to selling margin reduction)


 JCP: Making the Call on Air - GM chart 1


JCP: Making the Call on Air - GM chart 2



Expense Savings:

  • Incurred $76mm in restructuring charges in Q1


 JCP: Making the Call on Air - restructuring charges

  • For the quarter, saved $121mm of SG&A YoY
  • Now Committed to more than $900mm run rate of savings in 2013


3 opportunities to reduce costs


Inventory management: moving more to chase mode allowing merchants to really go after hits and misses

  • Uncovered 17 weeks of inventory
  • Department stores typically operate 15-18 weeks of inventory
  • Some hard goods operate closer to 10-13 weeks (WSM)
  • Feel JCP can get this to 13 weeks of inventory
  • Had way to many skus with excessive weeks of supply
  • By the end of 2012, this will free up $500mm of working capital


Legacy Systems: Streamlining internal systems

  • 492 unique applications
  • JCP should be operating around roughly 100 systems
  • 88% of the applications were customized
  • Translates to 90% of IT spend goes to maintenance
  • 10% goes to strategic initiatives


Simplify Processes: Eliminating false sense of precision

  • Extra processes create false precision
  • Of the $900mm, have already identified and are executing on $650mm of it


Progress Update:

  • Starting to act like a startup- need to be nimble and fast
  • Marketing is gaining a lot of mindshare but is not communicating the pricing message and driving traffic
  • Marketing is entertaining but not doing the hard work
  • Now running the "Do the Math" advertising

 JCP: Making the Call on Air - do the math

  • Need to convey JCP still has promotions, just not 500
  • Started doing ROPs in major publications last week highlighting month long values
  • Will be running ads like this every Thursday or Friday going forward
  • Changed marketing to the "Big Deal" starts today
  • Working harder from moving marketing from building a brand to convey pricing
  • Did not have enough impact in the store for pricing


Strengthened the team:

  • Added 41 people at the VP, SVP, EVP team level
  • 20 internal promotions
  • 6 new EVPs
  • Team is dramatically different

Simplified the structure

  • Had 92 buying teams to start the year, now 60
  • Have eliminated commissions


  • Customers love what they see when they come to the store
  • Customer Survey Improvements:

 JCP: Making the Call on Air - customer survey

  • Changes in brand perception:

 JCP: Making the Call on Air - brand perception

  • Love the everyday price (67% product bought at highest point price)
  • Best price purchases representing 15% of sales


 JCP: Making the Call on Air - pricing breakdown

  • Have established a Predictable sales pattern
  • Doing this with pricing strategy as the customer shops on their terms
  • Only had 1 week with sales more than 10% outside of the range

 JCP: Making the Call on Air - predictable sales pattern


Fashion Apparel Performing:

  • Problems selling basics
  • Home/basics men women kids remain weak
  • On fashion, customers want better merchandise- Best performing retailers have fashion with credibility for great product

New Store design ahead of schedule:

  • Have a 60,000 square foot warehouse, working on new store design which will be discussed in August

Shop strategy:

  • March 15th, posted application for shops, got 110 shop applications excluding those already in discussion
  • Now in a position for more choices in content than space

Product Update:

  • Beginning in august, will have transformed 47% of content through new brand launches and improving current brands

New Brands launching the Fall

  • JCP brand rolled out in August to both men's and women's
  • Dream Pop for ages 7-14
  • Betsyville by Betsy Johnson- handbags and accessories in 4Q
  • LULU Guinness
  • Vivienne Tam debuting in the Fall
  • Royal Velvet- heritage brand for bed and bath, expanding exclusive license into furniture window and tabletop
  • DC will be a foundational element of young mens
  • Monet- categories like handbags and footwear

Powering up existing brands:

  • Liz Claiborne, goal is to return LIZ to its heritage of well designed collection for working women
  • Puma- athletic footwear and active wear, growing assortment dramatically in the back half of the year
  • Xersion- Americas favorite active wear brand for the family
  • Nike- have had partnership in footwear- introducing broader assortment of men's and women's
  • St John's Bay- restoring the brand to it's roots, outdoor brand
  • Worthington- one of the top 10 women's brands in America focusing on the modern career women
  • Stafford- improving design, styling and fabrication

10 new shops announced in January

  • Arizona Jeans- creating assortment of fashion denim for men's and women's in all new shop
  • IZOD
  • Liz Claiborne- honoring the customers ability to pull together a look with ease
  • JCP brand- in addition to having fashion basics, will have a men's/women's shop rolling out in September of this year in all stores
  • Levis- opening shops for both men and women for BTS season but will represent the most innovative  Levi experience in the US

Spring Update:

  • Corner stone of home will be Martha Stewart by March 1st, 2013

 JCP: Making the Call on Air - home shop

  • Partnerhsip with Jonathan Adler called "Happy Chic"
  • Michal Graves Design
  • Bodum
  • Design by Conran
  • Lamour by nanette lepore (13-19 year old crowd)
  • Georgina Chapmen expected to be in stores by Feb 2013
  • Licensing agreement with William Rast- premium denim and sportswear apparel beginning in the Spring
  • Nike- Building out men's/women's Nike Shops, most inspiring collection outside of Nike Freestanding stores
  • Watchgear by Torneau for JC Penney

 JCP: Making the Call on Air - watch shop



  • Adjusted EPS of $2.16
  • Taking off $1.59 GAAP guidance due to additional restructuring expenses
  • Increased Marketing and 47% change in merchandise expected to drive traffic
  • Shops will have a big impact on the business going forward
  • Discontinuing dividend
  • Will generate over a $1bn in cash before capex- plan to invest cash in the business which will be a better return than a dividend


August Meeting Agenda:

2Q results

Merchandise strategy

New technology platform

New store design






  • Have done best valuation on aged inventory
  • Have removed aged inventory
  • Goal is to get inventory turning faster which will generate a profound amount of cash
  • Reduced inventories will help push margins over 40%

Cost Savings

  • $900m net run rate by year end
  • Do anticipate increased investing

Merchandise priorities

  • Those introductions shared today reflect gaps that JCP has had in the past
  • Expect to see a thoughtful review of legacy and heritage brands that will be restored in shop environment as well as newness in all categories within the store
  • Have had the goal to reach younger customers without sacrificing heritage customers

Shops in Stores

  • Goal is to get shops in as many stores
  • At launch, shops will go into A, B, C stores (about 700) with sizing varying
  • Largest stores are called stores (2000 square feet) done selectively
  • Shops minimum 500 square feet
  • 3rd is boutique, 300 square feet which may not have all the walls

Store performance:

  • Best performance was in the smallest small town stores
  • Took the time to really understand the pricing strategy
  • Performance across all other markets was virtually identical within 1%
  • Continue to expect to operate all stores vs. any closures
  • A new priority is to work and reevaluate the store portfolio but this hasn’t been focused on early on

Customer Demographic

  • Are seeing that JCP has been engaging a younger customer
  • Hard to say with precision how the mix is changing this early
  • Will provide greater detail in August through enhance analytics

Merchandise Selection

  • With all of the shops, engineering all of the shops to be in line with expectations of the consumer
  • Torneau will help open the doors to all of the brands like Sephora did for makeup
  • Can do large brands like Nike, Levis, etc.
  • Have yet to enter certain categories, food, beverage, hardlines, etc.

$1bn in cash flow

  • This is before capex
  • During the transformation will still generate cash


  • No Comp guidance
  • Expect sales to improve throughout the year
  • Half of the assortment will be new
  • Changes in content will update the fashion with fewer key items
  • Inserting freestanding shops will help drive volume

Employee Morale

  • Difficult to know customer morale from the top
  • Store employees have embraced the change, easier to take care of customers, stores are cleaner, less recovery
  • Most employees were thrilled with commission changes
  • Non commission force will create a better customer service experience overall

Market Share

  • Keeping the customer is job number 1
  • Currently losing customers
  • Customer has not gone to primary long term competitors, i.e KSS comping essentially flat
  • M said in some markets against JCP have gained share but comps have slowed
  • Believe a great deal of the slowdown is lack of refilling basics
  • Customer is clearly buying less- want to earn him/her back


  • Plan on winning in basics
  • Configured basics for a promotion strategy (bulk)
  • Dinnerwear- JCP selling 72 piece innerwear sets- need to reconfigure the basics
  • Working to get merchandise aligned with new strategy
  • Gold Toe wanted to put in a Gold Toe shop


  • No major competitive response to changes at JCP
  • TGT had better performing spring apparel
  • TJX had strong results
  • Old Navy improving
  • Those succeeding are using an EDLP strategy vs. the promotional strategy

Category issues

  • Overall, opportunity to better communicate value proposition
  • 3 categories: fine jewelry, home, basics (towels, underwear, socks)
  • Fine jewelry: lowered in March all of fine jewelry prices
  • In April, made jewelry pricing better everyday


  • Will learn more in August about new store design that is about creating traffic outside of the product
  • The old way of driving traffic was a coupon or a sale

Impact of SG&A savings on sales

  • Have to take a look at the base
  • Historically over the past 5 years of sales decline JCP has not been reducing labor force in stores
  • Have had an over managed over processed labor force in stores- working to simplify that base
  • Want to develop a high service model
  • Conversion was hardly effected thus far


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