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JCP: Our Take On The Liquidity Debate

Takeaway: We're weighing in on JCP liquidity -- an issue that's quickly racing to the forefront of key risks, and opportunities.

JCP issued a release this evening vehemently defending against a letter it received suggesting that JCP is in violation of terms on 11% of the company’s debt. The letter came from a firm claiming representation of over 50% of holders of the 7.4% debenture due 2037 (one of 11 tranches of debt).  JCP argues that this is ‘completely without merit and intended to create self-interested trading opportunities in the market’. It’s impossible for us to know one way or another. But right or wrong there’s only one thing that’s certain – liquidity will be talked about more as a key issue with JCP. With that being a near certainty, we thought we’d stress-test our model to see where the risks are to this story.

 

Before going into the model, here's a few thoughts...

  1. First off, the letter was dated on 1/29/13. Based on today’s close, JCP is down 8.0% since the letter was written. That compares to -0.7% for the S&P, and -1.3% for the broader Retail group (RTH). Clearly, this is news to people reading the general tape – but the market has been acting on the event since last Wednesday.
     
  2. The claim is that JCP violated the agreement when it entered into its current inventory-backed $1.5bn revolver (which is expandable to $2.0bn) in Jan 2012 without providing for equal security for the debenture holders.   Why this would come out 13 months after the issuance is questionable – perhaps because liquidity was not a concern back then and now the bond holders are doing whatever is feasible (or unfeasible) to secure their capital if JCP faces a liquidity crunch in 2013.
     
  3. From a risk management perspective, the best we can do is assume that the claim is valid.
    1. In that case, a worst case scenario would be that the other 10 consortiums of JCP’s debt attempt to step forward and stake claim on inventories. But that, quite frankly, seems ridiculous. It would be a first for any retailer we have ever seen. Maybe we’re missing something, but we don’t see how unsecured lenders could think that they could stake claim over a secured asset.
       
    2. Perhaps a slightly more realistic scenario equity holders should keep in mind would be that the holders of $1.1bn in Senior Notes put the debt back to JCP, which could happen in the event of change in control combined with not meeting certain minimum rating standards. That certainly would not be possible based on what we’ve seen transpire thus far. Not even close.

 

We think that the key is to do a simple assessment of JCP’s cash, and cash flow needs under a bear-case scenario, and then do a simple check as to the company’s liquidity. Consider the following as it relates to sources of cash.

  • SOURCES: JCP ended 3Q with $525mm in cash, and the company stands behind its guidance that it will have $1bn in cash by the end of the year. We don’t buy it.
  • Traditionally, 4Q has the biggest cash flow build of the year. There has historically been 12%-17% incremental cash build as a percent of 3Q revenue.
  • That mold was broken last year, when JCP only generated 7.8% -- or $422mm in cash.
  • We assume that 4Q cash build comes in at only 3%, or just $100mm. That leaves JCP with $625mm in cash.
  • JCP has no debt maturities due until 2015 – and even then we’re just looking at $200mm.
  • JCP has $1.5bn in its revolver, and that is expandable to $2.0bn
  • All-in, JCP has between $2.1 and $2.6bn in sources of cash per our estimate.
  • If they miraculously hit their YE estimate of $1bn, then it bolsters the strength in JCP's liquidity materially.

 

USES: Assumptions for uses of cash gets a bit more dicey, but let’s start with our P&L and Cash Flow modeling assumptions…

  • Let’s assume JCP does not earn one red cent until FY16. We’re modeling that it loses $1.0bn in EBIT through 2015. As noted many times, our more constructive view on the stock has been predicated based on the direction of the top line as opposed to profitability, as we think that revenue will pick up on the margin as JCP anniversaries an abysmal 2012 and changes over a third of its store base to a more productive mix by the end of FY13.
  • We assume that sales are down 35% in the upcoming quarter, and remain negative until the back half of 3Q14.
  • We’re modeling Gross Margins just under 35% by the end of 2015 – which is a full 500bp below where JCP is planning its business ‘longer term’.
  • Our SG&A estimate is bottoming out at $4.2bn. Quite frankly, this gives credit for the $900mm in net savings – and if there’s any area where we’re stretching it, this is probably it. JCP needs to invest in its stores.
  • Our EBIT decline estimate is almost evenly offset by $500mm+ in D&A per year.
  • We’re assuming that working capital – both inventories and payables move with the business. On one hand, JCP can’t be a pig and expect vendors to bolster its balance sheet. That jeopardizes its partnerships. On the flip side it’s sitting there with 98 days of inventory on hand – which is a level that can be chopped down. Every day is equal to about $25mm in capital.
  • We tack on about $800mm in cash needed to fund capex and new shops annually. That suggests that JCP will need to use somewhere around $1bn of its revolver ($800mm x 2) = $1.6bn - $625mm in cash on hand.
  • A key consideration is that the company has the option to slow down the cadence of the new store rollout.  Don’t get us wrong…That’s bad. But it is a way to help ward off a liquidity event to the extent that one approaches.
  • When all is said and done, we get to an extra $500mm-$1.0bn in cash available to draw under what we think is a beared-up model.

 

The punchline is that we can absolutely see why there’s all the concern about JCP’s liquidity – a $500mm-$1bn pad is not as much as we’d like to see for a retailer this size. But we don’t think that the concern should be the result of this evening's announced claim.

 

We think we’d need to see a cash balance at year-end below $600-$700mm to get concerned about JCP’s cadence of shop in shop rollouts for 2013. That would lead to either a) a slowdown in the rate of shop-in-shop additions, or b) the need to sell equity to keep the storytelling alive. We’d prefer the former, but due to management’s ego regarding growing the business, we can’t rule out the latter. For now we’re sticking with our modeling assumptions that shouldn’t require either. 

 

As the facts change so will we. For now, we're comfortable with the facts.


YUM GUIDE DOWN A GAME-CHANGER

Yum! Brands announced FY12 EPS and gave game-changing guidance on FY13 that is leading us to capitulate on our long YUM idea. 

 

Stepping Back From YUM

 

In advance of tomorrow’s earnings call, we are stepping back from our long YUM thesis.  While our initial analysis, released in November 2013 as a Black Book, was sound, the chicken supplier issue was clearly unforeseeable.  With hindsight, our mistake was defending the stock at that point, rather than taking a more prudent approach.  The reasoning behind our decision was that the government’s investigation had ceased, the stock price had declined quite dramatically, and sentiment seemed to be setting up for a strong contrarian position on the long side over the long-term TAIL duration.

 

 

Growth Story Intact, Comp Sales the Big Issue in 2013

 

The important component of the YUM press release was the commentary from David Novak, the Chairman and CEO.  Important points regarding China:

  • Due to continued negative same-restaurant sales, mgmt not expecting EPS growth in FY13
  • Growth strategies unchanged, globally.  Still aiming for 700 new units in China this year
  • Same-restaurant sales declined 37%, including 41% at KFC and 15% at Pizza Hut

That the company is not revising its growth targets could mean that management’s confidence in the long-term prospects of its China business is high but, given the data in the press release, we think that the bottoming process could take several quarters. 

 

Our Black Book, which was published the week before YUM’s analyst day, included a sum-of-the-parts-analysis suggested a value of $88 per share.  On December 6th, during the analyst day presentation, management suggested a value of between $80-90.  As of now, it is much more difficult to value this stock.  Following the call tomorrow, we expect to have a better idea of how the business should fare over the coming quarters and years.

 

 

Howard Penney

Managing Director

 

Rory Green

Senior Analyst

 

 


TRADE OF THE DAY: CJES

Today we bought C&J Energy Services (CJES) at $22.72 a share at 3:15 PM EDT in our Real-Time Alerts. C&J Energy Services has been Hedgeye Energy Analyst Kevin Kaiser's Best Idea since his presentation on it on November 16th, 2012. Buying it on red. 

 

TRADE OF THE DAY: CJES - TOTD


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What UK Retail Trends Mean for US Stocks

Takeaway: Hedgeye gets a rare look into the UK retail market and its implications for US companies.

On today’s Retail expert call, we were joined by retail expert Stacey Widlitz, head of SW Retail Advisors.  Stacey is a recognized expert on retail trends with a unique perspective on both the US and the UK markets.  Operating from her base in London, Stacey provided our clients valuable insights on some key retail names last quarter.  In today’s conference call she shared her insights on the Christmas season and the changing face of UK retail.

 

Stacey saw the Christmas season and the fourth quarter generally flat year-over-year in terms of sales.  November was a disappointment in the UK and retailers started discounting both early, and aggressively.  A key takeaway is that the UK consumer has generally been used to much higher price points than we see in the US, and there has not been a broad culture of discounting in the UK.  Stacey believes that is changing and this Christmas season looked a lot like the US season in terms of promotions.  One point that worked in favor of the UK retailers was that they came into the final quarter with tightly controlled inventories.  Nonetheless, what Widlitz calls the “Americanization of the UK consumer” forced many stores to run US-style holiday promotions.

 

Widlitz noted heavy promotions at many leading department stores, with fragrance and cosmetics giveaways, and 20%-50% discounts common across the sector – she says Gap ran their discounts as high as 75%.  Retailers were taken by surprise as customers stayed away from early season discounts, coming back Yankee-style to scoop up bargains, many of them waiting until the day after Christmas – in the UK it’s called “Boxing Day” and is a separate occasion for gift giving.  Widlitz says the UK consumer has figured out the waiting game, and retailers have to play along with the new rules.

Another key theme is the pricing disparity of international brands which often are priced the same in pounds sterling as in US dollars.  Widlitz says Kors handbags are significantly more expensive in the UK – a bag that costs US$ 400 in New York costs 400 pounds sterling in London – equivalent to US$ 630.  UK customers have figured this out and some now buy expensive fashion items on-line in dollars and have them shipped to friends in the US.  London retailers have to figure out how to compete in this environment, and Kors, for example, discounted earlier, and more heavily than in the past.

Widlitz says Hilfiger was among the more successful stores, running “some of the leanest promotions around,” discounting only large sizes and left-over odd pieces.  The higher price point and the cachet appear to still hold appeal for local fashinistas.


Widlitz was most positive on Victoria’s Secret, whose London flagship store appears to be one of the most successful major retail apparel outlets.  Traffic continues strong and with a high conversion rate – folks who come to look, then stay to buy.  Widlitz believes VS is hitting a real void in the retail market, as the only competition for lingerie is either low-market department store lines, or very high-end boutiques.

 

A major theme that will determine the future of retail is the strength of the Asian tourist trade.  High-end accessory retailers look to Chinese consumers to provide demand.  They will need it.  One of the stark differences this year was the lines waiting to get into boutiques such as Prada and Louis Vuitton: there weren’t any.  Last year there were lines out the door at these upscale shops.   Retailers are counting on Asian tourist trade to bolster sales at their highest-end outlets, amidst concerns the domestic accessories market may be close to saturation.  Luxury brands view London as the bridge to bringing Asian tourist demand to the US, so these sales figures will be closely watched.

 

Widlitz believes the biggest new opportunity may be in off-price retailing.  The UK does not have malls, and with the “high street” retail mentality, most operators appear not to be aware of the attraction of this segment.  Widlitz singled out TJX as doing “phenomenally well” with an off-price strategy.  The outlet village concept is catching on, she says, and could be huge.  

We are pleased to have access to Stacey Widlitz’ unique coverage and analysis.  The Hedgeye Retail team will continue to monitor overseas developments for their impact on the domestic market, and for their implications for stock prices in their segment. 


Retail Expert Call Cliffs Notes: Europe Trends Into Earnings

Takeaway: The Americanization of the European consumer is the key trend in Europe today. No promotions = no revenue.

We hosted a call today with Stacey Widlitz from SW Advisors to review the state of retail in the UK heading into earnings. Stacey specializes in monitoring promotional cadence and relative brand positioning for US brands that sell in Europe.  Here’s a brief review of our notes from the call. Please note that while we agree with most of her comments, these thoughts represent her unaltered views. We're simply downloading to you in an easily-digestible format.

For more details, or to connect with Stacey directly, please contact your Hedgeye salesperson.

 

Macro 

Same store sales growth in the UK still running below inflation. Inventories are finally clean (with few exceptions – like GPS) but are squarely driven by increased promotional activity. The ‘Americanization’ of UK retail, where consumers are trained to wait for discounts, seems to be a trend that is more relevant than ever.

 

In 4Q, November was a disappointment and retailers got promotional very early relative to last year. ‘Hitting the panic button too early in the quarter’.

 

Retailers that did not have 20-50% signs up (or ‘free fragrance’ or other promo) by the 1st week of December saw a meaningful slowdown in traffic and/or conversion. Mid-December was ‘eerily quiet’.

 

Majority of retailers noting that consumers are waiting til after the holidays bc they have figured out the markdown game.

 

Here are callouts by company/brand:

 

ANF

After stabilizing in 3Q (something that Stacey had called out when we did this call a quarter ago), ANF got incrementally worse on the margin.

The company did not promote until after holiday, which made it stand out like a sore thumb. Consumers walked into the flagship looking for deals and could not find any overtly stated promos.

The new Hollister store is around the corner from Abercrombie. There is a 35% price discount between the two, but the consumer does not respect it.

The company simply did not pull the pricing lever like it needed to.

 

GPS

Gap and Banana were early with promotions. Perhaps too early.

30% off 1st weekend 

75% off by end of month

Even now stores look heavily clearance. Other retailers are bringing in new product, but GPS seems mired in the excess inventory of holiday.

Gap is competing against Top Shop where conversion rates are double. GPS price points are too high and there’s not enough units. GPS has Fast Fashion at one end, and Primark at the other end (single digit opening price points). Biggest risk to Gap is that Top Shop accelerates expansion.

 

KORS

Went on sale mid Dec this year, which is earlier than last year.

Harrods and dept store discounts were deeper in percentage terms

This weekend the stores are being cleared and freshened up.

KORS' aspirational aspect is much more significant in the UK vs US.

Priced 40-50% higher in UK than US. Kors has the highest price spread out of any brand vs the US.

 

DECK

Retail stores decided to promote, which helped them – as did a blast of snow in Jan.

 

GES

Surprised how long it took to bring out the 50% signs.

After Christmas the 50% off inventory was 2x what it was mid month.

GES seems to be unable to nail down who their consumer really is and what drives shopping behavior.

 

VICTORIA’S SECRET FLAGSHIP

One of SW's favorites.

Very high conversion rate in store.

Lingerie market is very department store focused in the UK.

There is a specialty-store void that is filled by VS.

 

URBN

Opened a 2nd flagship on oxford street. Absolutely amazing environment.

Conversion rates are also some of the highest in the market at first flagship. Very solid brand opportunity.

 

COH

2 flagships in London. There’s quite a bit of promos going on, which is unusual for flagships. Seeing the 30-50% off in bags, trenches, footwear. This is a new phenomena for COH

 

RL

RL had not been getting the boost from Chinese tourism over the past few years like the rest of the luxury market has been.

Part of this is because the tourists have wanted logo product like LV and Coach.

Now those preferences are waning as Chinese consumer wants non-logo product, which opens up a new consumer opportunity for RL.

 

In answer to recent concerns out there about RL, Stacey sees all brands following the promotional cadence set by the department stores, and that RL is not necessarily losing share in that context.

 

Hilfiger is 25% cheaper than RL. Some shirts are 15%. Definitely not enough of a gap to threaten RL.

That said, TH is running some of the most successful promotions, with only discounted odd-sizes left over for sale.

 

LULU

Brand appetite is high. Sweaty Betty is the only athletic game in town outside of the traditional brands (adidas, nike, puma) and they cannot particularly compete with LULU – even at a 30-40% discount. $275 for two tops and a pair of leggings is steep by our standards, but for a UK consumer it works.

 

H&M

H&M was the only fast-fashion retailer to be early in pulling the promotional trigger. The others did not need to. Forever21, Top Shop had extremely strong traffic trends.

 

Pricing Spreads (who are the highest and lowest spreads)

KORS is 40-50% higher priced in the US.

ANF – priced in dollars – paying 50% more. Especially high given that Hollister is a block away at 35% less.

VS is the outlier on the other end. Only 15% premium to the US. Not a surprised that it is performing so well.

 

TJX

The ‘Americanization of the UK’ plays right into TJX’s efforts to grow international presence. They are the only game in town. This is seemingly a great secular opportunity given where the market is headed.

 

 

 

 


#QUADRILL-YEN: IS THIS WHAT TARO ASO REALLY WANTS?

Takeaway: Japanese policymakers’ gross misinterpretation of economic history portends negatively for the ailing yen.

SUMMARY CONCLUSIONS:

 

  • Recent commentary confirms that Japanese policymakers are indeed channeling their inner-Takahashi (Japan’s most infamous money printer).
  • The key question as it relates to any potential Japanese sovereign debt crisis is whether or not this is 2003-06 all over again in Japan, with that occurrence demonstrating that a melt-down in JGB prices could perpetuate a sustained melt-up in Japanese equities.
  • Could, however, this time be different with all three of Japan’s major financial markets (currency, equities and bonds) eventually being lit on fire all at once? That remains the critical tail risk embedded in Japan’s aggressive Policies To Inflate over the long-term TAIL.
  • For now, stay short the yen and long JPY-funded carry trades. Let GPIF President Takahiro Mitani’s P&L woes continue to help get you paid on the long side of emerging market equities and FX.

 

The Japanese yen, which is down roughly -16% since we initially outlined our bearish bias back on 9/27, continues to get Taro Aso’d.

 

The latest developmental jawboning on this front has come in the form of Finance Minster Aso’s recent remarks that the Japanese government is taking a page out of its own historical playbook by pursuing strong anti-deflation policies:

 

“There is no one in the government, the bureaucracy or the BOJ who has experience in anti-deflation policy. We can only learn from history.”

-Taro Aso, 2/3/13

 

The history lesson Mr. Aso is referring to is Depression-era Japanese Finance Minster Korekiyo Takahashi’s mandating of the BOJ to directly monetize Japanese sovereign debt (as opposed to open-market operations), which began in 1932 and continued for the next 14 years.

 

During this era, the ratio of JGB issuance financed directly by the BOJ peaked at 89.6% in 1933 and remained elevated throughout the program. This monetization strategy assisted in doubling JGB issuance and boosting Japanese public expenditures by a whopping +34% in 1932 alone.

 

What is conveniently left out of Aso’s commentary is the fact that Japanese CPI readings peaked at rates north of +40% YoY throughout the 1930s during the aforementioned episode of aggressive sovereign debt monetization.

 

#QUADRILL-YEN: IS THIS WHAT TARO ASO REALLY WANTS? - 1

 

We’re not sure where this fits in the context of this note, but it’s probably worth mentioning that Takahashi was literally assassinated for trying reign in public expenditures in 1936…

 

Phillips curve in hand(s), western economists and those schooled in western academia continue see little-to-no-harm in perpetuating inflation for the sake of achieving nominal GDP growth target(s). We’re not sure how the deflation-addicted JGB market will respond to all of this, but preliminary indications suggests not well:

 

  • Takahiro Mitani, the head of Japan’s public pension fund, said in a recent interview that the fund is considering changes to its asset structure for the first time in seven years amid rising concerns that Japan’s Policies To Inflate will erode the value of its JGB holdings, which currently equate to 64% of the fund’s assets. Emerging market stocks and alternative assets are two asset classes that he suggested GPIF may increase its allocation to in lieu of JGBs.

 

The key question as it relates to any potential Japanese sovereign debt crisis is whether or not this is 2003-06 all over again in Japan, with that occurrence demonstrating that a melt-down in JGB prices could perpetuate a sustained melt-up in Japanese equities.

 

#QUADRILL-YEN: IS THIS WHAT TARO ASO REALLY WANTS? - 2

 

Could, however, this time be different with all three of Japan’s major financial markets (currency, equities and bonds) eventually being lit on fire all at once? That remains the critical tail risk embedded in Japan’s aggressive Policies To Inflate over the long-term TAIL.

 

For now, stay short the yen and long JPY-funded carry trades (email us if you’re interested in specific ideas). Let Mitani’s woes continue to help get you paid on the long side of emerging market equities and FX. Key policy catalysts are outlined in the list below.

 

Darius Dale

Senior Analyst

 

#QUADRILL-YEN: IS THIS WHAT TARO ASO REALLY WANTS? - 3


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