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M: We’re Still Negative on Macy’s

Takeaway: Sales under pressure, margins rolling over, increased SG&A, and higher capex. Sorry, but the ‘cheap valuation’ argument is irrelevant.

Conclusion: Macy’s has been #1 on our list of top three shorts (followed by Gap and Dick’s), and as such, the print today is not a surprise to us. We have no crystal ball as to the comp that Macy’s has been generating, so we’re not claiming to have forecasted the specific sales shortfall in this given 13-week period. But we’ve viewed the triangulation of M’s P&L, Cash Flow Statement and Balance Sheet as being like an increasingly stressed balloon under water. This event does nothing other than strengthen our confidence in our call.

 

DETAILS

Out of any name we cover (and we cover just about all of retail) there is not a single name we find ourselves more fiercely debating than Macy’s. The most common bull arguments we hear are a) the company has been so poorly run for so long, and that investments in Magic Selling, MyMacy’s, Omni-Channel, etc… are making up for years of share loss, and b) the stock is so cheap at just 12x earnings.

 

But we think that valuation is irrelevant, as it is not a catalyst – and never has been – especially with a levered zero-square-footage growth retailer where numbers can change so quickly. 

 

We recognize that there are certainly ways that Macy’s can operate more efficiently and can fine-tune its approach to going after share-of-wallet. But we think that there are too many factors converging on both the P&L and balance sheet that are stacking the odds against a positive change in return on invested capital. When returns are going down, there’s no reason a 12x multiple can’t turn into a 10x multiple – and there’s no rule that says that it needs to stop there.  Factors that specifically concern us are as follows…

1)      Top Line

a) We can’t forget that in 2012, Macy’s grew its top line by $1.5bn, which is the same time that JC Penney lost $4.3bn in sales. Macy’s management completely discounts the idea that any of its sales gain has come at the expense of JCP. If not outright cocky, we think that at a minimum management is being intellectually dishonest.  JCP will start to regain share at some point in 2H --- or lose share at a lesser rate (which is a negative change on the margin for competitors). If JCP fails, it will inflict pain while it tries. The other retailers (including Macy’s) are in denial. 

 

M: We’re Still Negative on Macy’s - midtier

 

b) Macy’s management did a very poor job articulating the source of the 2Q sales miss. Transaction count was down 1.6%, and they noted that consumers are more interested in buying cars, houses and spending on home improvement than they are in spending in department stores.  Seriously? What’s ridiculous is that there’s no way for them to know why consumers are NOT shopping in their stores. This is particularly troubling in light of point A – in that Macy’s is blaming macro factors at the same time we’re seeing sales competition heat up in the mid tier.    

 

c) The company noted that comps had turned up in 3QTD. That’s nice given that we’re just starting back-to-school. But there’s a long way to go in BTS. We give the company credit for trying to keep expectations somewhat grounded that its way too early to declare victory – especially when there so many unknowns as to why sales performance missed like it did throughout 2Q.
 

2)      Gross Margins were down only 10 basis points for the quarter – which is pretty impressive given the magnitude of the sales miss. But keep in mind that the sales/inventory spread eroded by 700bp, as inventories were up 6.4% despite a 0.8% sales decline. Had the company more appropriately cleared out inventory on hand, we’d have seen more Gross Margin pressure. (Notice the swing into the third quadrant of our SIGMA chart below). Either way, management has been vocal about saying that gross margins would be tough to improve from here, and that EBIT margins would need to come from SG&A leverage…

M: We’re Still Negative on Macy’s - sigma

 

3)      …but SG&A is headed higher. In order to kick start the top line and have the proper marketing programs in place for a less-certain 2H, the company is taking up marketing costs. We’re not knocking it, as it’s the right thing to do. But the simple point is that with both the top line and gross margins under pressure, the P&L gets levered in the wrong direction with an uptick in SG&A. Let’s not forget that Macy’s has almost $400mm in interest expense as well – which is another negative leverage kicker.

 

4)      Lastly, capex is running at $925mm this year. There hasn’t been any increase in capex guidance, which is good, but the reality is that it is still up 33% from $698mm last year.

 

The punchline is that we’ve got sales down, gross margins rolling over, increased SG&A spending, and higher capex. In that context, the ‘cheap valuation’ argument is simply irrelevant. We’re modeling flat operating profit over the next four years, with earnings growth only being driven by 3-4% of financial engineering (debt paydown and repo). Our earnings 3-years out are 25% below consensus (see our assumptions in financial summary below). While a 10x p/e and 5x EBITDA multiple only suggests a stock in the low $40s out that far, the reality is that those same multiples could get to a stock with a 3-handle closer in.

 

M: We’re Still Negative on Macy’s - mstats


BYI YOUTUBE

In preparation for BYI's FQ4 2013 earnings release tomorrow, we’ve put together the recent pertinent forward looking company commentary.

 

 

(see our SHFL/BYI CONF CALL NOTES on 07/16/2013)

 

GAMING OPERATIONS

  • "The margin on Gaming Operations was 71%, within our expected range of 68% to 73%."

WAP

  • "All things considered, we expect to see the rate of WAP unit increases to pick up during the upcoming quarters...We expect the flow of WAP and premium game titles to continue in a steady well-planned and controlled fashion."

SHARE BUYBACK/ASR

  • "Just the subject alone that since November 2007, including the ASR we're doing now, we bought back $1 billion. No change in our capital allocation strategy. We think that using an ASR to basically pull in about 7.5% of our total market cap is a pretty efficient means to do that. We do have some additional powder available even during the period of the ASR, should we choose to put that to work." 

NORTH AMERICAN REPLACEMENT VOLUME

  • "When I think about average order size, it's gone up a touch. I would say that's more a result of some corporate buying."

INTERNATIONAL GAME SALES

  • "Because regardless of whether their replacement numbers increase or not, one thing is certain, we are very under-represented in those floors. So we have a lot of market share growth opportunities there, even if the overall replacement trends don't pick up. So we have a long way to go before we are worried about the overall macro (international) trends."
  • "Some of the new game content we've been working on for the past year specifically targeted towards various international regions will be released soon and should help grow this portion of our business during fiscal 2014 and beyond."

SYSTEMS

  • "We are heading towards fiscal 2013 being a record Systems revenue year for us, beating the previous record of $218 million established in fiscal 2010 by a fair amount. We have every reason to believe fiscal 2014 will be even better."
  • [Software/hardware split] "I believe it was somewhere around 36% hardware, so not too dramatically different from the prior quarter and from the year-ago quarter. Looking into Q4, hardware might be a lower, slightly lower percentage of the overall total revenue; software might be a little bit higher...And that is reflected in the normal expectation of gross margin that we say, in the 70%s is the range our gross margin will normally be, give or take a couple of percentage points here and there."

I-GAMING

  • "We also made very good progress on the remote gaming server front, going live with eight Bally titles on multiple European portals this past week. We expect over a dozen such portals to launch Bally's world-class game content by the end of this fiscal year."

NASCAR

  • "And in terms of our expectations of NASCAR, yes, it is along the lines of Michael Jackson and GREASE, if not better."

ASP

  • "If you remove the VGTs and the VLTs our pricing is along the same lines as it has been for the last couple of quarters. In fact, pretty close to the highest levels it's been. We remain very disciplined with pricing."

CANADA & SOUTH AFRICA

  • "Canada and South Africa, I mean, it's a 2014 story. It's a 2015 story. It could even beyond 2015 be a story. There's still more to come on Canada, more jurisdictions that I think ultimately will come to market."

OTHER

  • "We expect that our income tax rate for the fourth quarter will approximate 36.5%."
  • "From a bad debt perspective, we've been relatively consistent."

Slow Growth? Get Out of the Way

Throughout the last 9 months (as US growth went from slowing to stabilizing to accelerating) markets have provided us plenty of opportunity to get into growth related asset classes and out of slow growth ones. August to-date is no different:

 

1.   Utilities (XLU) are the most overvalued slice of the slow-growth equity pie (with hyper-overvalued securities like MLPs within this Sector Style Risk). XLU is down -1.38% for August to-date (versus SPY +0.5%)

 

2.   Tech (XLK) and Basic Materials (XLB) are up the most for August to-date at +2.11% and +2.45% respectively. Both are traditionally considered “growth” sectors but for very different reasons. AAPL is not CAT.

 

Slow Growth? Get Out of the Way - Utilities Yield Spread large

 

Where could we be wrong? Our research on something like Caterpillar (CAT) has been bearish, but now the market signal is stress testing our conviction in maintaining that position. If CAT were to close above my long-term TAIL risk line of $88.67 and hold that level on some real volume, my risk management process stops me out of the position.

 

Do I live my market life from looking inside our portfolio of ideas or from the outside looking in? The truth is that I do both. It’s a learning process. Whenever I ignore the outside, top-down, macro market signals, I will be reminded that volatility lives on the other side of my position’s underlying assumptions. And not in a good way.

 

(Editor's note: This brief excerpt is from Hedgeye's "Morning Newsletter" written by CEO Keith McCullough. Click here for more information.)


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#RatesRising

#RatesRising and #DebDeflation remain two of our Top-3 Global Macro Themes here in the third quarter of 2013.

 

#RatesRising - yoo

 

They are both playing out as a) U.S. economic data delivers sequential #GrowthAccelerating in July and b) Jackson Hole gets discounted as a hawkish event.

 

The 10-Year Treasury is now yielding 2.71%. It's a nice step up of higher-lows and higher-highs. We are now up +14 basis points month over month.

 

Bottom line: #RatesRising has epic reverberations. Epic implications. That is why we are banging this drum so loudly.

 

#RatesRising - 10Y Treasury large


Staples Dodgeball

With a good majority of consumer staples companies having reported their quarterly results, below we give a round-up of our highest conviction ideas on the long and short sides over the intermediate term TREND. As we begin sizing up company performance in the quarter, we note a few key take-away themes that are largely a continuation of last quarter:

  1. Investors chasing yield
  2. M&A speculation (more recently around PEP and MDLZ and in the wake of the HNZ acquisition)
  3. Declining commodity prices and expectations for improvement in gross margins

While we believe points two and three can both help fuel investor appetite, point one remains an area of concern for the broader sector given our macro team’s Q3 theme call of #RatesRising. We see the prospect of rates rising as unfavorable for the XLP (and other sectors that have been targeted for yield). During 2009-2012, the data suggested that many investors sought out staples and other dividend-yielding, stable, sectors for a steady return on investment.  This would suggest that much of the capital flowing into staples may have been more focused on yield than fundamentals, which could result in that same capital exiting the group as expectations increase that the Federal Reserve tapers.

 

With so many factors at play, analyzing names within this space can feel like playing dodgeball. Below, we go through the names we expect to outperform, and those we expect to underperform, over the TREND duration.  Valuations for the sector remain stretched but we still see some opportunities on the long side (valuation charts below, also).

 

 

Long Ideas

  • LO – we expect Lorillard to continue to see outperformance on strong demand for its full-flavored offerings and dominate share of menthol, both contributing to volume outperformance versus the industry (Q2: -1.7% vs -6.1%). We think FDA rulings around menthol will be pushed out to at least the intermediate term. LO’s first-to-market (of big tobacco) e-cig Blu is enjoying top market share, which should help to boost interest in the stock given the excitement around the category.
  • HSY – the company’s portfolio is benefiting from lower input costs and see strong volume gains; we expect strong merchandizing around Halloween and the holidays to further benefit 2H results. The fruits of the Brookside acquisition should continue to pay dividends (expected to contribute 1 pt of growth in 2013).
  • TSN – consumers preferring the value of chicken versus other proteins is a dynamic we expect to continue in 2H. The company has been able to pass on or well manage input costs given its diversity in protein offerings and geographic exposures.  Protein over carbs remains an import component of health and wellness trends that TSN has at its back.
  • SAM – the maker of Boston Lager had surprisingly strong Q2 results and wet investor’s pallets with news that given excessive demand and capacity constraints, the company is increasing its cap-ex guidance to expanding its brewery production. Despite the craft category growing ever more competitive, we like SAM’s positioning in the market and management’s ability to profit from an establish brand as it mixes in new tea and cider offerings.

 

Short Ideas

  • PM – we expect continued FX headwinds given our #StrongDollar call. PM revised down its FY guidance as it forecasts larger volume declines in the year across its geographies, including due to increased excise tax headwinds in key geographies like Russia and the Philippines, and an uptick in illicit trade in Turkey.
  • DPS – the company’s portfolio is ~ 80% carbonated soft drinks (CSD), a category that continues to be challenged as consumers switch to both healthier carbonated and non-carbonated offerings. The company is hopeful around the launch of its 10 calorie DP 10 offering, but we do not expect it to offset the declines across the portfolio.
  • CCE – on-going macro weakness in Europe and the continued impact of the French excise tax, along with competitive pressures, have hampered the company’s results. We do not expect to see an inflection in weak trends as we’re forecasting at best only slow and modest economic improvement in Europe.  
  • K –Kellogg reduced its FY guidance on increased FX headwinds and its results reflect weakness in key categories and geographies that we expect to persist in 2H. The U.S. business remains particularly challenged, especially in cereal. K needs to realign its marketing spend and innovation, which may take at least a couple of quarters to turn around.
  • KMB – Kimberly Clark reported disappointing earnings in July and has underperformed since then. FX and competitive pressures will continue to weigh on earnings growth as inflation sequentially accelerates. We see downside risk to the company’s FY13 estimates, with personal care volumes in the U.S. and other developed markets particularly concerning for shareholders.

 

Our quantitative real-time set-up for consumer staples (etf: XLP) is bullish, trading above its intermediate term TREND line. 

 

Staples Dodgeball - z. xlp

 

Staples Dodgeball - zz. stap pe

 

Staples Dodgeball - consumer staples subsector px

 

 

-Rory Green and Matt Hedrick


Solid: U.S. Macro Growth Data

This note was originally published August 13, 2013 at 15:58 in Macro

Conclusion:  Today’s Retail Sales and Small Business Confidence numbers were solid, extending the trend of broad improvement observed across the balance of the domestic macro over the last two quarters and offering some positive confirmation of the early 3Q13 strength signaled by the Labor Market and ISM figures for July.    

 

------------------------------------------------------

 

 

U.S. MACRO -  Solid Start to 3Q13:   The Labor Market (initial claims) continued to show accelerating improvement in July while the ISM manufacturing and services surveys reflected a broad recovery off the lackluster activity that characterized the April-June period. 

 

As can be seen in the Economic Indicator Summary Table below, 3Q13 has started off solid with the preponderance of growth/activity indicators released thus far showing improvement on both a TRADE & TREND basis.  On balance, the July Macro releases have come in ahead of expectations according the Citi and Bloomberg Economic Surprise Indices.  

 

Solid: U.S. Macro Growth Data - drake1

 

Solid: U.S. Macro Growth Data - Economic Suprise Index 

 

RETAIL SALES:  Monthly Retail sales are volatile, subject to notoriously large revision, and reported in nominal dollars but, still, it’s hard to ignore a component responsible for roughly a third and a quarter of PCE and GDP, respectively.   

 

The first read on consumer spending in 3Q13 came in healthy with July Retail sales ex-Autos accelerating to 0.5% MoM (vs. 0.1% in June) while Sales excluding Autos & Gas accelerated to +0.4% MoM (vs. 0.0% in June).   

 

On a year-over-year basis, growth slowed modestly across each of the primary aggregates with Total Retail Sales, Sales ex-Autos, and Sales ex-Auto’s and Gas slowing 50bps, 30bps, and 40bps, respectively.  On a 2Y basis, however, all three measures accelerated modestly in July. 

 

All in, not a game changer or positioning catalyst, but a positive update for consumer spending to start the third quarter.   

 

We’ll be interested to see the Personal Income data for July (8/30 Release) and the impact of the furloughing of federal workers on aggregate disposable income growth – which has been treading water at a lackluster  ~+2% YoY.   As a reminder, we expect income growth for federal workers (~2% of the total workforce) to grow approx -7% over the balance of the fiscal year due to the combination of  furloughs and employment declines.  The impacts, while moderate, should constrain the upside in disposable income growth and consumer spending in 3Q13.  

 

Solid: U.S. Macro Growth Data - Retail Sales Table July

 

Solid: U.S. Macro Growth Data - Retail Sales

 

NFIB Small Business Optimism:  The NFIB Small Business Optimism Index climbed to 94.1 in July from 93.5 in June.  Under the hood, the outlook for general business conditions deteriorated sequentially although (somewhat incongruously) hiring plans, sales expectations, and job openings all advanced. 

 

The directional TREND in the consumer and business confidence metrics provides a better read on sentiment than any one data point in isolation and the larger trend in small business confidence remains positive and in agreement with the ongoing advance in the lead measures of consumer confidence.  

 

Solid: U.S. Macro Growth Data - NFIB Table

 

Solid: U.S. Macro Growth Data - NFIB Optimism

 

 

With labor, credit, and confidence trends all showing ongoing improvement and with a diminishing fiscal drag and easier comps as we annualize sequestration and the tax law changes into 2014, the growth dynamics for the U.S. economy,  and prospects for the U.S. Dollar and U.S equities remains favorable.  Consumption growth faces some constraints in the near term and congress will likely re-emerge as a negative catalyst in some form in the coming weeks, but, fundamentally the data continues to support a constructive outlook for domestic growth

 

 

Christian B. Drake

Senior Analyst 

 

 


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