Here’s an overview of incremental thoughts on our Retail Best ideas.
The Retail Group Call: The out-of-consensus call here is to be bullish on retail. But with margins at peak, capex up by 30-40%, and SG&A up by 30-50bp the rate of sales, we need confidence in a given company’s ability to drive top line growth through its model to keep returns headed higher. We think that Retail will increasingly be a game of haves and have not’s in 2013 – and capital efficiency/deployment will be the biggest theme.
LONGS
Nike (NKE): The consensus view is that the company just put up a great quarter, and now the story is over. But the reality is that it proved that it can continue to drive results in its core US market, while we’re now seeing a recovery in China, Europe and Emerging Markets. Also don’t forget that Gross Margins, which have been an Achilles Heel for over two years, are improving sequentially. Inventories look cleaner than they have in 10 quarters. It is doing this with a disproportionately small amount of working capital and capex, which carries big weight with us. Consensus estimates are still too low.
Restoration Hardware (RH): The Street has left this one for dead. But the reality is that RH is seeing an inflection point in its square footage growth by way of rolling out its new Design Galleries – which are 3x the size of its current stores. While bigger stores is usually the swan song for a retailer, in the furniture space is critical. RH has only been able to showcase 25% of its product, and now it is changing its model to show the consumer a dramatically greater portion of its product line, as well as launch new categories like kitchen, bath, flooring, kids, art, etc…. The punchline is that this is a volatile name, but you’ve got square footage growth, productivity improvement from new categories, and a call option on a sustained recovery in housing.
Fifth & Pacific (FNP): The stock is hitting multi-year highs, but that doesn’t mean that it can’t hit new multi-year highs. The new wrinkle of a likely sale of Lucky along with Juicy Coture is a big positive – as much as we a) like the current momentum at Lucky and b) cringe at selling Juicy at t he bottom. FNP has already gone from being a debt-laden, low margin, low asset turning portfolio of bad brands to being one of the best growth stories in retail. Getting rid of these brands would strip FNP of its debt, which would only make the story that much more attractive. We’re modeling Kate EBITDA to nearly triple to $300mm by 2015. That more than 50% ahead of consensus. Until that’s recognized, the ‘FNP is too expensive’ argument holds little water with us.
Michael Kors (KORS): Yet another expensive stock, but one where we think we’re looking at 40-50% earnings growth – and expectations that are about 20% too low through 2015. In short, we think that KORS and COH will flip flop as it relates to margins, with KORS accelerating to the low 30s and COH slipping to the mid-20s. We’re modeling another 175 stores added globally on top of 30% wholesale growth. Both of those are very realistic. As it relates to comps, we concede that the productivity numbers are getting stratospheric -- $1,700 today on a trajectory to $2,400 over three years. Though we’ll be looking at moderating growth thereafter, we’ll also be looking at a company that turns its assets 12x annually on top of 22% tax-adjusted EBIT margins. That would make it one of the highest retailers in retail – ever. 25x a $4.00 EPS number in 2015 is hardly a stretch in that scenario. At a minimum, shorts beware.
JC Penney (JCP): Ok…here comes the accountability thunder.
After being short JCP from the Ackman/Johnson $40 ‘$9-$12 in earnings power’ hype, we pulled a 180 at $19 earlier this year. To say that our ‘about-face‘ was the wrong call would be an understatement.
While it’s very tempting to support it here, we simply can’t for anyone with a near-term horizon. We have three primary concerns. 1) First off, we’re at a loss of ($0.91) for the quarter, versus the Street at a loss of ($0.68). We were below-consensus last quarter too, and made the mistake in thinking that it was ‘in the stock’. The timing of the Vornado sale did not help, but clearly, it’s tough to be bullish on a name like this ahead of a miss. 2) The Martha Stewart trial is coming to a head and we’ll see fireworks on or around April 8. It is near impossible to get an edge on which way this will go. 3) The calls for Ron Johnson to be fired scare us. For most companies, we could see how this would make sense. But the company can’t financially afford to change direction under anyone else, and if RJ is out of the equation there’s the risk of major vendors backing out. If the lobbying for him being fired is successful, we’d short every share we could find. The punchline here is that there’s no reason this stock can’t drift lower near-term.
While it’s obvious that a lot of this uncertainty is what’s driving the stock down so hard, the reality is that the better risk-management call would be to support it once a) 1H earnings is past, and b) we have clarity that RJ is keeping his job – even if it means getting involved at a higher price.
If this story is really going to work, getting back in at $19 as opposed to $14/$15 won’t make much of a difference for someone with a 1+year duration. But if the company misses even our bearish estimate in 1Q and/or the research call changes (its ability to roll-out higher productivity shops), we’ll cut bait…fast.
SHORT
Dick’s (DKS): DKS might be a best in breed, but it’s a bad breed. DKS is low margin, low asset-turning, and subsequently low return. We only like to get involved with DKS on the long side as a rental, and that’s when we can bank on comps in the 5% range or better. Today, we’ve got 1-2% comps, and the only safety there is that the golf business (Golf Galaxy – about 22% of total) is doing well because Tiger is back. The current run rate is not enough to leverage occupancy, which is not comforting given that a) margins are at peak and b) management admitted that it has underspent in its omni-channel growth strategy and needs to play catch up (#$$$). We might be ok with that for an above average retailer, but keep in mind that this is a company that faces stiff web competition from other retailers and even the brands that sell in its stores. The companies that are winning today are the ones that spent on ‘omni-channel’ way back when no one even knew what the heck ‘omni-channel’ was. Too little, too late. We think that DKS is a value trap.
Guess? (GES): The Guess? brand is stalling globally, the executive suite has a revolving door, and the only real bull case revolves around this being cheap on a more ‘normal’ earnings base of $3+ that it earned over each of the past two years. That’s a pipe dream. Even management’s guidance of $1.70-$1.90 is optimistic at best, and if it gets there it will be through cutting costs that arguably be reallocated to other areas of the business. One thing that’s important to consider is that 2/3 of GES’ business is causing the problem – and that’s North America Retail, and Europe. The company is blaming the economy – again. The company needs to understand – as we do – that investors absolutely have zero tolerance for a management team that does not have a process to drive its business in the face of a downturn in the economy. In the end, we think we’ll need to see new blood in the executive rank at GES who will then need to fight for – and win – the right to reinvest capital into the business to better stratify the brand and build an omnichannel strategy accordingly. We’d definitely put GES in the bottom quartile with its abilities in those areas. Until then, it too, is a value-trap in the mid-$20s.
UnderArmour (UA): We continue to think that UA will join the band of companies in the retail supply chain that is stepping up capital investment this year – both in capex and in SG&A. Growth in Footwear and International are both absolutely critical to UA’s aggregate top line. When that happens, we think that revenue and EBIT growth will diverge. If we’re wrong, then we think it is a matter of time until the top line slows, which would be even more damaging to UA’s multiple. We still think that this is an exceptional brand, but simply think that it belongs to a company that needs to go through some growing pains before it could deliver upon the expectations currently embedded in the stock. We think it’s more likely than not that earnings growth gets pushed out by a year sometime in 2H, and that investors should take advantage of this on or just after the 1Q print.
Lululemon (LULU): We rarely make a multiple call, but this is about as close as we get. LULU owns one of the most powerful brands in apparel, and few would debate that. That’s implicit in the company’s sales trajectory, 27% margins, 125% ROIC, and ultimately, its 30x multiple. Unfortunately, its ‘wardrobe malfunction’ that threatened one of its most important products, it begs the question as to whether there’s enough infrastructure at LULU to ensure quality control at a level that is consistent with a company that is going to double in size to $3bn over 3-years. Keep in mind – in order of magnitude of this blunder is like Nike finding out that all its Jordan’s are defective. We know that costs are going up to some extent. But will they only impact margins by 1%, or take them to 25%, 20%, 15%? We can speculate, but the reality is that we simply don’t know, and the market won’t know either for a 1 to 2-year time period. This kind of uncertainty does not give us confidence that a multiple starting with a 3 – or perhaps even a 2, is bankable until sales and margins reaccelerate.
Macy’s (M): We simply don’t like how this story is packaged. Macy’s is a lousy secular story with no unit growth that is at peak margins and just had a breakout year that temporarily pushed returns above its cost of capital. It has a major competitor that is coming back online after a disastrous year, and it will impact the competitive landscape whether JCP succeeds or fails in hitting its own goals. By saying ‘a major competitor coming back online’ we mean that JCP probably won’t comp down another 30% this year (even if you’re a JCP bear you probably agree with this). That’s the magnitude Macy’s needs to see in order to face a similar competitive set as last year. On the margin front, management already noted that additional gross margin improvement is unlikely, and that we’ll need to see future margin growth coming from SG&A leverage. We’d be much more comfortable paying up for M if we could bank on Gross Margins. But banking on sales and SG&A leverage for a department store? Not quite. And let’s not forget that it’s got financial leverage. We think the downside/upside here is 2 to 1.
Carter’s (CRI): CRI has been an outstanding story, and it’s one where we’ve gotten the research call wrong on the short side. That said, we’re keeping it on this list because it fits so well with our capital allocation theme as we struggle to find another company that is spending more capital for an incremental return that is already embedded in consensus estimates. In other words, there’s extremely little room for error. We started to see product pricing show slight signs of weakness two quarters ago. Then last quarter comps weakened in US Carter’s stores. At the same time SG&A was up 40%, and the company noted that capex was going up from $85mm in 2012 to $200mm in 2013. The Street is modeling margins of 14.4% 3-years out, and we’re hard-pressed to think that we see anything higher (in fact we can’t find comparable businesses that do much better). With the stock at $59, we’re looking at 17.8x, 15.5x, and 12.4x earnings using 2013, 14 and 15 consensus estimates, which assume that CRI grows margins by 330bps over that time period. If we’re wrong on this one, we think it will be the time period over which CRI hits these goals – not that it will surpass the absolute margin levels.
