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JCP: Reasons To Reconsider Your Short

Takeaway: While we're not pounding the table on $JCP, we think there's serious risk to being short headed into 2013. Don't ignore them.

We’ve thought from Day 1 that there’s no shortage of reasons to be bearish on JCP. Structurally, we still think that’s the case. But stocks don’t trade in a vacuum, and on the short side, we would not touch this one with a 20-foot pole in the high teens. Our purpose here is not to convince anyone to buy JCP. But rather to explore as many factors as possible that could prove a short position painfully wrong.

 

Details

We recently spent two weeks on the road, and JCP name was a topic of discussion in 8 out of 10 meetings. The only one that rivals it in terms of controversy is Nike. The irony here is that despite the overwhelming bearishness – 40% of float short and bulls capitulating with less than 30% recommending JCP as a Buy – the topic we encountered most on the road was “why not buy JCP here, as it seemingly has all the bad news we’re likely to see in the stock, and is discounting zero positive developments?”. Out of all the people who raised that question, we could find maybe one who followed through and actually bought the stock here.

 

We think the reason is that if you buy it here and you’re wrong, it’s an offense that probably poses career risk for some. Buying JCP here is really taking a flier on Johnson getting ANYTHING right next year – even if by accident. Let’s face it, after so many self inflicted black eyes, the guy is due for a win. That blind assumption is hardly a sound investment process in our book.  But if you want  to stay bearish in the high teens, you should remember the following.

 

1)      The ‘JCP is a Zero’ argument has been made about SHLD since that marriage was formed in the fall of 2004. And since then, the stock has underperformed with a -10% CAGR, but it has been flat for the better part of five years, and has been far from insolvent. We could make a good TAIL call about how JCP will prove to be a failure in 8 years – even sooner than that. But it has no bearing on how the stock trades next year. Initially we feel short sighted in saying that, but the facts are what they are, and we won’t ignore them.

 

2)      Let’s look at the specific stock trading patterns from the week before the Sears/K-Mart deal was announced vs the week before Ron Johnson’s appointment as JCP CEO. They’re different types of events, but we put them both in the ‘hail Mary’ category and therefore comparable. For 10 months, the stocks followed almost the same EXACT trading pattern, until JCP’s egregiously low comp level pushed it down to new cyclical lows. JCP is now down 45% from the announcement, while SHLD was UP 45% at the same corresponding point in time (ie 1.5 yrs after announcement). The point is that there was ‘reason to believe’ 2-3 years into the SHLD story. It turned out to be unjustified, as SHLD is sitting at a mere $42 today, down 56% from the announcement of the deal. But if you were a ‘perma-short’ throughout the past 8 years, the early part of it was probably less than comforting. The chart below is self explanatory.

 

JCP: Reasons To Reconsider Your Short - jcp1

 

3)      Why does this ultra-long duration matter? Because that’s how Ron Johnson gets paid. Keep in mind that his warrants don’t vest until 2017. We can’t imagine that he did not get the Board’s full support before accepting the job to live through major jolts to the company’s financial nerve center. Without that, there’s no way he’d have taken the risk. Currently, his 50mm warrants are worthless. Above $29, he starts to see the fruits of his labor. His big mistake was not in trying to radically change the store. It was bowing to storytellers in the investment community and issuing near-term guidance around a story that would not play out until the intermediate-term had long passed.

 

4)      One thing to keep in mind is that Johnson is not afraid to miss near-term targets for long-term value creation. That’s painfully apparent to the bulls who suffered through the past three quarters of financial results. But his investments ultimately paid off. We’re the first to highlight how his toolbox at JCP pales in comparison to what he had at Apple. But the guy is not used to losing, and likely won’t go another year wearing that tattoo.  Check out his performance at Apple.  The retail business missed its guidance to hit break-even target twice in the early days. We’re currently seeing the miss, though obviously on a much greater scale. But he will likely tweak the equation in whatever way he needs in order to keep morale heading higher and fend off share loss.

JCP: Reasons To Reconsider Your Short - jcp2

 

5)      Speaking of share loss, we don’t think its clear exactly how much share JCP has hemorrhaged in year 1. For the first three quarters of this year we’re talking over $2.7bn in share. When 4Q – the seasonally strongest quarter – comes out, we’ll be looking at something closer to $4bn in annual share. This is coming off a base of only $17bn in revenue.  Our sense is that the M’s, GPS’, KSS’ and TJX’s of the world are underestimating how much share JCP is handing them. This is not a permanent share shift by any stretch. And given that these other retailers pretty much don’t have a clue as to how much share they are gaining, it’s tough for them to have a clear plan as to how to avoid giving it back.

JCP: Reasons To Reconsider Your Short - jcp3

 

6)      The argument for comp improvement is tough to refute mathematically. Not only is JCP coming off –mid20% comp declines, but it is happening at the same time that an incremental 2-3% of its store base is being remodeled every month. With current sales per square foot sitting at a paltry $112 – yes, you read that right, $112 – and the new stores likely to clock in 30-40% above that level, it is tough for us to not get to a 20%+ positive swing in comps next year. One may wonder (as we do) how much the comp will cost them in terms of higher technology and deferred maintenance costs, we think that it will trade with the comp, not necessarily with profitability. We don’t think that’s appropriate, but we think it’s reality.

JCP: Reasons To Reconsider Your Short - jcp4

 

7)      We think that the big risk here on the long side is simply cash flow. In other words, to be short the stock here, we think that you have to prove the company will run out of cash to fund its growth. That might happen, but not until 2-3 years down the road at the earliest. Before that, we’ll see the comp delta improve.

In the event that cash runs dry the company can follow in the footsteps of Dillards and most recently Loblaw, a Canadian food retailer that is spinning-out 80% its of its property assets and reinvesting the $7bn into its operating business. Yes, JCP would have to pay market rent on this property that is currently largely fully amortized. But again, for the first few years this would not matter. It would have the liquidity for Johnson to evolve the store base according to his plan.

With cash flow from operations YTD down -$655mm and net debt-to-equity at historical highs at 0.67x, the probability of JCP pursuing this option is still low, but increasing on the margin, and most importantly, the optionality is there.  

JCP currently owns approximately 39% of its real estate, or 44.6 million sq. ft. Based on current rent and cap rates, we estimate JCP’s potential REIT value at $1.85Bn-$2.55Bn, or $8.25-$11.50 per share. Since the formation of a REIT provides the greatest benefit for retailers that own a substantial percent of their real estate, we’ve looked at the likely candidates (see chart below).  Both Macy’s (55%) and Nordstrom (46%) own a greater portion of their store base compared to JCP, but even with 39% of its real estate owned, this is an option for Penney’s to consider. 

While forming a REIT is not likely, one thing to keep in mind that Steven Roth is on JCP’s board. While Loblaw’s announcement may have roused speculation in the start of a potential trend, recall that Roth was one of the first to execute such a strategy when he bought Alexander’s out of bankruptcy in 1993 and converted it to a REIT. Roth has “been there and done that” before.

JCP: Reasons To Reconsider Your Short - jcp5

 

JCP: Reasons To Reconsider Your Short - jcp6


Bullish TREND: SP500 Levels, Refreshed

Takeaway: This US stock market is back in a Bullish Formation for the right fundamental economic reasons.

POSITION: Short Commodities, Long Consumer

 

This US stock market is back in a Bullish Formation for the right fundamental economic reasons. Deflating commodity inflation is one of the very few policies the government has tried yet. That, of course, is because it would require them to get out of the way.

 

Across our core risk management durations, here are the lines that matter to me most:

 

  1. Immediate-term TRADE resistance = 1435
  2. Intermediate-term TREND support = 1419
  3. Long-term TAIL support = 1366

 

In other words, bullish is as bullish does until it doesn’t. The volume signals in this market are beyond alarming at this point. I get that, but also get that consensus hedge funds tend to capitulate and cover at no-volume lower-highs when the VIX hits 14.

 

So there’s plenty to consider as you risk manage this very manageable Risk Range (1). What was TREND resistance (1419) is still confirming itself as newfound support.

 

If it doesn’t hold, we’ll change our position.

KM 

 

Keith R. McCullough
Chief Executive Officer

 

Bullish TREND: SP500 Levels, Refreshed - SPX


RH: Idea Alert. Buying the Freak-Out

Takeaway: $RH should be up 9%, not down 9%. It's off for all the wrong reasons -- giving a great opportunity to invest in a solid double.

We're adding RH to the long side of the ledger in the Hedgeye Virtual Portfolio. With the stock down 9% on an otherwise great quarter, it's a great time for us to get involved on a high conviction research call. The Street does not like the lack of guidance -- particularly given the bumps and bruises around short term events like Sandy and the West Coast Port Strike. Based on what we see, the company is executing on its its growth strategy. We have that confidence, plus our own research -- and that's all we need. We'll let the Street stress about not being spoon-fed. We'll buy on the down days.

 

We were asked this morning what we thought a fair value for RH was. Our response sounded something like this.

"I rarely like to ‘pick a multiple out of nowhere’, but the way I look at the earnings power, we’re coming off $0.57 last year headed to $3.00 in 4-years. I’m ahead of the consensus by 40% next year alone. With a 30% earnings CAGR could I justify a 25x earnings multiple? I think so. Apply that to $3.00 in calendar 2015 and I get a $75 stock. I discount that back at a hefty 20% discount rate and I get a $62 stock in 2 years, and $52 1-year out." 

 

RH: Idea Alert. Buying the Freak-Out - 1111

 

Here's our Thoughts on the Print

This story is still full steam ahead, which is notable given that investor interest around the name has been paltry at best since the day after IPO. Comps are crushing it at +29%, the new Design Gallery in Scottsdale opened at or ahead of plan, and the company announced two new catalog businesses to launch this Spring – RH Tableware and RH Objects of Curiosity. It also announced RH Fine Art, which is likely an ASP-lifter. There’s usually not this much new info out of a recent IPO, but we definitely liked what we heard. There's noise around 4Q-to-date trends given the port stroke and lingering impact of Sandy, but that's hardly a sign of real underlying trends.

 

We’re taking up our Direct Numbers my next year about 4k catalogs without any degradation in revenue per page. This takes up our total Direct revs by about 800-900bp, and total RH sales by about 400bp.

 

There seemed to be some concern on the call about the Gross Margin. That shouldn’t be the case. The company went up against up a +450bp gross margin in this quarter last year. On a 2-year run rate, the gross margin was up 200bp despite an incremental shift to furniture which is lower GM (COGS includes shipping costs). This not a Gross Margin story on a longer term basis. It is about sheer top-line growth leveraging SG&A (which only  grew 12.9% vs 22% sales growth).

 

We still like this one a lot. The key rationale is that…

1)      We think that the company can leverage mid single digit square footage growth into double digit growth, and 20% top line. The company can then leverage fixed costs and grow EBIT by 30%, and EPS approaching 40% while it pays down debt. It is not without its volatility – especially on a quarter to quarter basis, but the growth algorithm works.

 

2)      Scale is critical in this business. That’s not a problem for RH if you measure by number of stores given that it has 73 locations as it can leverage a national distribution platform. Unfortunately, store count is a pretty useless metric when your average store is so small that it can only show 25% of the assortment. Categories like apparel might be ok in showing a prospective customer an item in an iPad 'lookbook' in hopes of placing an order. But when buying a sofa, desk, or bunk beds, people need to touch and feel. The shift to the company’s Design Galleries allow the ENTIRE assortment to be visible in the appropriate places.

 

3)      With the larger (25,000 square foot) Galleries, the company can also get into new categories like we’re seeing it do in the Spring of 2013. These will allow the company to cherry pick the best and most appropriate mix of product in each region and for each store to maximize sales productivity.

 

4)      While it opens Design Galleries, the existing base of stores allows the company to backfill existing markets with the new categories that are being tested in its new concepts.

 

5) It has only scratched the surface with its design services offering. Ever try to furnish a home with the help of a designer? Plan on spending 2x your budget.

 

6)      In the end, the Home category is one of the most fragmented in retail. Though people are quick to complain that prices are too high, we'd be quick to answer that there's a difference between high price and expensive. RH’s existing prices on like-for-like items are very competitive, and there are no other retailers that are doing what RH is trying to do with the same scale. It has had ‘defacto SKU proliferation’ in the past that held back profitability – which was only the case because it did not have the real estate to show 75% of its product in the way it needs to be presented to consumers. 

 

RH remains one of our top picks for those with a higher risk tolerance.

 


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JOSHUA STEINER: JOBLESS CLAIMS: LABOR TAILWINDS BACK IN FULL FORCE THROUGH FEBRUARY

Takeaway: Initial claims were impressively low last week. The tailwinds of the last 3 years are returning again this year and will last through Feb.

Labor Market: Surprisingly Strong

Last week was another surprisingly strong week of improvement for initial jobless claims. As we've been doing the last few weeks, we again ran the analysis to see whether over-representation by NY, NJ and PA is distorting the numbers. As a reminder, state-level data is released on a one-week lag vs. national data. As of two weeks ago, when national claims were 370k, NY, NJ and PA were still being over-represented in the series by 7.1% vs their normal proportional weightings. This suggests that the normalized run-rate in claims is actually 370 / 1.071 = 345k. Interestingly, that's almost exactly what we saw this week: 343k. 

 

This week's claims print of 343k is significant for a few reasons. Foremost, it matters because it represents a new low in claims post the crisis. Second, it matters because it returns claims to the seasonal trajectory we've seen over the last three years. In other words, the seasonality mal-adjustment tailwind we've often called out is back in full effect, and will continue, as a reminder, through February. So, to reiterate, the jobs data is improving, but the perception of the rate of improvement will be stronger than the underlying reality for the next two and a half months. This, coupled with momentum in the housing market, will provide a strong, ongoing tailwind to the sector.

 

Jobless Claims - The Numbers

This week initial jobless claims fell 27k to 343k from 370k. The prior week's number was revised up by 2k to 372k. Incorporating this upward revision, claims were lower by 29k. Rolling claims, meanwhile, fell 27k WoW to 381.5k and non-seasonally adjusted claims fell 72k to 429k. Additionally, the NSA rolling year-over-year change, which we monitor because it excludes the effects of seasonality, was -4.9% YoY, down from +2.1% in the prior week.

 

JOSHUA STEINER: JOBLESS CLAIMS: LABOR TAILWINDS BACK IN FULL FORCE THROUGH FEBRUARY - 1

 

JOSHUA STEINER: JOBLESS CLAIMS: LABOR TAILWINDS BACK IN FULL FORCE THROUGH FEBRUARY - 2

 

JOSHUA STEINER: JOBLESS CLAIMS: LABOR TAILWINDS BACK IN FULL FORCE THROUGH FEBRUARY - 3

 

JOSHUA STEINER: JOBLESS CLAIMS: LABOR TAILWINDS BACK IN FULL FORCE THROUGH FEBRUARY - 4

 

JOSHUA STEINER: JOBLESS CLAIMS: LABOR TAILWINDS BACK IN FULL FORCE THROUGH FEBRUARY - 5

 

JOSHUA STEINER: JOBLESS CLAIMS: LABOR TAILWINDS BACK IN FULL FORCE THROUGH FEBRUARY - 6

 

JOSHUA STEINER: JOBLESS CLAIMS: LABOR TAILWINDS BACK IN FULL FORCE THROUGH FEBRUARY - 7

 

JOSHUA STEINER: JOBLESS CLAIMS: LABOR TAILWINDS BACK IN FULL FORCE THROUGH FEBRUARY - 8
 

JOSHUA STEINER: JOBLESS CLAIMS: LABOR TAILWINDS BACK IN FULL FORCE THROUGH FEBRUARY - 9

 

JOSHUA STEINER: JOBLESS CLAIMS: LABOR TAILWINDS BACK IN FULL FORCE THROUGH FEBRUARY - 10

 

JOSHUA STEINER: JOBLESS CLAIMS: LABOR TAILWINDS BACK IN FULL FORCE THROUGH FEBRUARY - 11

 

JOSHUA STEINER: JOBLESS CLAIMS: LABOR TAILWINDS BACK IN FULL FORCE THROUGH FEBRUARY - 12 

 

September SNAP: Another 608k People on Food Stamps

While the trend in joblessness is improving, the number of people receiving government assistance to buy food in the U.S. continues to rise. In September, SNAP participation reached 47,7101,324, or 15.3% of the population. In terms of households, there are roughly 23 million households receiving assistance, or about 20% of all U.S households. In September, an additional 608k people joined the program. The number of people on food stamps has risen 79% since June of 2007. 

 

If there's any silver lining here its that the rate of growth in the program has been slowing. In the first chart below, we show the total number of participants in the blue grey columns and the year-over-year rate of change in the black line. The current growth rate is 3.1% year-over-year. which is down from the 5.1% year-over-year growth rate we were seeing at the beginning of this year. 

 

JOSHUA STEINER: JOBLESS CLAIMS: LABOR TAILWINDS BACK IN FULL FORCE THROUGH FEBRUARY - 13

 

Joshua Steiner, CFA

 

Robert Belsky


Jobless Claims: Happy Endings

Today’s Jobless Claims numbers came in at 343,000, another strong showing on a week-over-week basis that suggests Hurricane Sandy is no longer affecting the data. The 343k print is significant because it represents a new low in claims post-financial crisis. It also returns claims to the seasonal trajectory we’ve seen in the last three years (i.e. the seasonality mal-adjustment tailwind is back in full effect). 

 

 

Jobless Claims: Happy Endings - Katrina normal

 

 

Jobs data continues to improve but more importantly, the perception is even more positive than reality and perception is everything. The rate of improvement will continue to be strong through February of 2013. Between jobless claims and the recovery in the housing market, there’s a lot to be excited about here.

 

Jobless Claims: Happy Endings - NSA YoY linear normal

 

Jobless Claims: Happy Endings - S P normal


JOBLESS CLAIMS: LABOR TAILWINDS BACK IN FULL FORCE THROUGH FEBRUARY

Takeaway: Initial claims were impressively low last week. The tailwinds of the last 3 years are returning again this year and will last through Feb.

Labor Market: Surprisingly Strong

Last week was another surprisingly strong week of improvement for initial jobless claims. As we've been doing the last few weeks, we again ran the analysis to see whether over-representation by NY, NJ and PA is distorting the numbers. As a reminder, state-level data is released on a one-week lag vs. national data. As of two weeks ago, when national claims were 370k, NY, NJ and PA were still being over-represented in the series by 7.1% vs their normal proportional weightings. This suggests that the normalized run-rate in claims is actually 370 / 1.071 = 345k. Interestingly, that's almost exactly what we saw this week: 343k. 

 

This week's claims print of 343k is significant for a few reasons. Foremost, it matters because it represents a new low in claims post the crisis. Second, it matters because it returns claims to the seasonal trajectory we've seen over the last three years. In other words, the seasonality mal-adjustment tailwind we've often called out is back in full effect, and will continue, as a reminder, through February. So, to reiterate, the jobs data is improving, but the perception of the rate of improvement will be stronger than the underlying reality for the next two and a half months. This, coupled with momentum in the housing market, will provide a strong, ongoing tailwind to the sector.

 

Jobless Claims - The Numbers

This week initial jobless claims fell 27k to 343k from 370k. The prior week's number was revised up by 2k to 372k. Incorporating this upward revision, claims were lower by 29k. Rolling claims, meanwhile, fell 27k WoW to 381.5k and non-seasonally adjusted claims fell 72k to 429k. Additionally, the NSA rolling year-over-year change, which we monitor because it excludes the effects of seasonality, was -4.9% YoY, down from +2.1% in the prior week.

 

JOBLESS CLAIMS: LABOR TAILWINDS BACK IN FULL FORCE THROUGH FEBRUARY - Katrina

 

JOBLESS CLAIMS: LABOR TAILWINDS BACK IN FULL FORCE THROUGH FEBRUARY - NSA YoY linear

 

JOBLESS CLAIMS: LABOR TAILWINDS BACK IN FULL FORCE THROUGH FEBRUARY - State Level Data

 

JOBLESS CLAIMS: LABOR TAILWINDS BACK IN FULL FORCE THROUGH FEBRUARY - raw 2

 

JOBLESS CLAIMS: LABOR TAILWINDS BACK IN FULL FORCE THROUGH FEBRUARY - rolling

 

JOBLESS CLAIMS: LABOR TAILWINDS BACK IN FULL FORCE THROUGH FEBRUARY - NSA

 

JOBLESS CLAIMS: LABOR TAILWINDS BACK IN FULL FORCE THROUGH FEBRUARY - Rolling NSA

 

JOBLESS CLAIMS: LABOR TAILWINDS BACK IN FULL FORCE THROUGH FEBRUARY - S P

 

JOBLESS CLAIMS: LABOR TAILWINDS BACK IN FULL FORCE THROUGH FEBRUARY - Fed

 

JOBLESS CLAIMS: LABOR TAILWINDS BACK IN FULL FORCE THROUGH FEBRUARY - recession

 

JOBLESS CLAIMS: LABOR TAILWINDS BACK IN FULL FORCE THROUGH FEBRUARY - rolling linear

 

JOBLESS CLAIMS: LABOR TAILWINDS BACK IN FULL FORCE THROUGH FEBRUARY - YoY NSA

 

September SNAP: Another 608k People on Food Stamps

While the trend in joblessness is improving, the number of people receiving government assistance to buy food in the U.S. continues to rise. In September, SNAP participation reached 47,7101,324, or 15.3% of the population. In terms of households, there are roughly 23 million households receiving assistance, or about 20% of all U.S households. In September, an additional 608k people joined the program. The number of people on food stamps has risen 79% since June of 2007. 

 

If there's any silver lining here its that the rate of growth in the program has been slowing. In the first chart below, we show the total number of participants in the blue grey columns and the year-over-year rate of change in the black line. The current growth rate is 3.1% year-over-year. which is down from the 5.1% year-over-year growth rate we were seeing at the beginning of this year. 

 

JOBLESS CLAIMS: LABOR TAILWINDS BACK IN FULL FORCE THROUGH FEBRUARY - SMAP

 

Yield Spreads

The 2-10 spread rose 10 basis points WoW to 145 bps. 4QTD, the 2-10 spread is averaging 141 bps, which is higher by 4 bps relative to 3Q12.

 

JOBLESS CLAIMS: LABOR TAILWINDS BACK IN FULL FORCE THROUGH FEBRUARY - 2 10

 

JOBLESS CLAIMS: LABOR TAILWINDS BACK IN FULL FORCE THROUGH FEBRUARY - 2 10 Spread

 

Financial Subsector Performance

The table below shows the stock performance of each Financial subsector over multiple durations.

 

JOBLESS CLAIMS: LABOR TAILWINDS BACK IN FULL FORCE THROUGH FEBRUARY - Subsector Performance

 

JOBLESS CLAIMS: LABOR TAILWINDS BACK IN FULL FORCE THROUGH FEBRUARY - Companies

 

Joshua Steiner, CFA

 

Robert Belsky

 


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