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.

This note was originally published August 14, 2013 at 19:11 in Retail

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.

M: We’re Still Negative on Macy’s - macy1 


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 - mcgough1


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


We’re bearish on MCD, so one could argue we have a bearish bias, but we remain present and well-grounded in reality.  Make no mistake, MCD has a top line issue and not a cyclical one.  That said, we don’t believe management is willing to acknowledge the secular issues the company faces and new products like Mighty Wings seem like a desperate attempt to hide from reality.


We think MCD’s decision to sell its Mighty Wings this fall could potentially be disastrous for the company.  We have three main issues with the current MCD menu strategy:

  1. Mighty Wings will not enhance the McDonald’s brand (Premium Wraps have not helped either)!
  2. Both new products (Mighty Wings and Premium Wraps) have slow service times.
  3. Adding new products to an already complex menu is the wrong direction for the company to go.

Selling chicken wings may temporarily boost sales during the LTO, but it could end up doing more harm than good.  Asking the currently disgruntled franchisee community to prepare yet another new product, with a slower than normal preparation time, will only add to the service issues the company is already experiencing.  In our view, this is likely to lead to the further deterioration of the MCD brand.


McDonald’s franchisees that sold wings in the test markets have suggested that the above average cooking time for the new menu item was an impediment to their service times.  If this is indeed true, we expect drive through times to slow significantly.  What it ultimately comes down to is the margin on Mighty Wings relative to other products on the menu.  If wings generate a lower margin than a core sandwich and slow service time, then MCD could be headed for a 4Q13 disaster.


This is all too reminiscent of the period from 1, when we witnessed the sad decline of a mismanaged McDonald’s brand.  During that time, the company was focused on unit growth and cost reduction rather than driving high margin, top line sales.  As the image of the brand began deteriorating, management failed to invest in the brand and customer experience.  Rather, they turned to monthly promotional tactics to in order to drive short-term sales at the expense of brand equity and margins.  This strategy did not end well for either the company or investors and we’d be surprised if this time was any different.







Howard Penney

Managing Director


HEI vs. HEI/A: Pair Opportunity?

HEI vs. HEI/A: Pair Opportunity?



HEI vs. HEI/A: Pair Opportunity? - hei2





Heico is an interesting, family dominated industrial with a dual class structure (Common and Class A).  Heico’s best business is the manufacture of FAA certified, slightly-lower-priced replacement parts for aircraft (Flight Support, ~57% of 2012 operating income).  By undercutting OEMs like GE and Pratt, HEI has built a high margin business with plenty of runway for growth.  Heico also has what could broadly be described as a successful aerospace/defense electronics business (Electronic Technologies, ~43% of 2012 operating income).


For the purposes if this discussion, what Heico does is not as important as the relative characteristics of the Class A (HEI/A) and Common (HEI) shares.  The spread between the two share classes appears abnormally wide at current levels, as shown in the chart above, having reached this level of divergence only a handful of times in the past dozen years.  Shorting the common and buying the Class A is worth considering, if it matches the reader's style,, even though it is not a position that could be all that large (HEI trades about 40k shares a day with 42.16 close yesterday).  Positions like long HEI/A vs. short HEI can be useful at extremes.  Reversals can be fairly quick once started, but timing the inflection is, of course, very challenging.  It is also noteworthy that HEI options have recently displayed elevated implied volatility, although we are not entirely certain as to why, and may be a point for further research.  




  • Key Differences:  The HEI Class A shares offer 1/10th of vote while the common HEI shares offer 1 full vote.  The common shares are more liquid, with about 3x more volume over the past few months.  Both classes of shares have been repurchase targets, with the HEI common shares more favored in 2011.
  • What a Full Vote Buys:  Heico insiders exert significant influence over the company, collectively holding about 6% of Class A shares and 21% of the common.  Three members of the Mendelson family sit on the Board of Directors and are in senior management.  While insider may not have a lock on corporate control, it appears to us that current management exerts significant control over the company.  Anti-takeover provisions may leave a would-be activist challenged to acquire meaningful influence.  For most shareholders, the extra votes do not appear to add much value.
  • Liquidity Better in HEI/A:  Better liquidity certainly matters, in so far as it persists.  The HEI common shares likely deserve a liquidity premium to the Class A shares, but the >40% magnitude appears abnormally large.
  • No Arbitrage: There is no mechanism that forces these two share classes to match, except in the case of a few specific events.  The Common premium could theoretically go anywhere. Historically, the current premium is at the high-end of the range - even relative to stressed equity markets.  That said, positions like these can be slow to work out and can diverge further.  The two securities are economically pretty close to identical, by our assessment, but do not have to trade that way.
  • Events That Could Collapse Premium:  Many companies have eliminated dual class structures, but that seems an unlikely short-run outcome at Heico.  A sale of the company or MLBO would also likely eliminate the premium.  The Chairman, CEO and elder Mendelson, Laurans, is 74, so the company may well be preparing for an eventual change at the top.
  • What Insiders Prefer:  Since January 2012, insiders have only made one small purchase of HEI common.  On balance, insiders have sold nearly 50,000 HEI common share. At the same time, there have been many HEI/A purchases (net addition of over 4,000 shares) with Victor, Eric and Laurans Mendelson choosing the Class A shares.  We assume that they know which share class offers the best value. 
  • Even For Longs:  A long-term investor interested in HEI should look at buying the Class A instead of the common at present levels.  Long-term holders also may benefit from a swap, liquidity permitting.


Early Look

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The fundamental outlook for Estée Lauder remains favorable versus its Personal Care peers. For a candidate to short against an EL long position, we would look no further than KMB.


Estée Lauder surprised the Street to the upside on 8/15 with 8% organic sales growth in 4QFY13 and strong operating leverage. Subdued guidance for FY14 was largely shrugged off by the market since, with the stock outperforming the S&P 500 and peer consumer staples stocks by 14 bps and 182 bps, respectively, since the earnings release. We believe that EL is likely to raise its conservative guidance as accelerating sales and margin growth drives shareholder returns. At 22x earnings, the stock is valued roughly at the mid-point of its historical range and in line with slower-growth, higher-yielding stocks like PG that are more susceptible to the downside of rates rising.


Kimberly Clark disappointed investors with its 7/22 earnings release as soft volumes in the U.S. and FX headwinds in emerging markets combined to disappoint investors. We believe the possibility of a guide-down increased since the last earnings release, with management stating that share repurchases and cost cutting measures would fill the void left by slower-than-expected revenue growth in FY13. As a result, the company reiterated its FY13 earnings growth guidance of 8%. In light of inflation costs accelerating, we believe a guide-down is likely in 2H13. See charts below for more details.



Revenue: EL, in our view, has the more favorable revenue growth outlook with management expecting 6-8% organic sales growth for FY14. Exposure to the high end consumer remains a strong point, with premium brands’ sales growing much more rapidly (~20%) than the overall portfolio (6%) in 4QFY13. Earnings across retail have continued to suggest a bifurcation among consumers that is leading the high end to outperform the mid- and low-tier concepts.


KMB is seeing weakness in developed markets like the U.S., Australia, and South Korea. U.S. Personal Care volumes declining despite negative product mix was a concern. For household product makers like KMB, growing volumes in the U.S. could remain challenging with disposable incomes in the U.S. stagnating. Emerging markets continued to be pressured by unfavorable currency rates of ~3%.



Margin Outlook: EL continues to drive margin expansion through its long-term strategies aimed at increasing efficiency in its business model. Over the past four years, sales have grown by 40% and operating margins have doubled. Management is confident that the FY16 operating margin target of 16.5% is achievable.


KMB faces several headwinds, with respect to its operating margin, in 2H13, as commodity inflation has been accelerating during 3Q to-date. We believe this heightens the likelihood of a guide-down from KMB during 2H13.


EL – A CUT ABOVE THE REST - kmb inflation chart1


EL – A CUT ABOVE THE REST - kmb cost savings



Quantitative View: Our macro team’s quantitative view of EL and KMB corroborates our fundamental view of the respective stocks. EL needs to hold above its intermediate-term TREND line of $66.68. KMB has broken its intermediate-term TREND line of $97.96.


EL – A CUT ABOVE THE REST - el levels 8.27


EL – A CUT ABOVE THE REST - kmb levels 8.27



Rory Green

Senior Analyst



Patience: SP500 Levels, Refreshed

Takeaway: It’s a range bound bullish TREND in SPY with immediate-term TRADE resistance, for now. Growth stocks still look great.



I didn’t play the 1st correction as well as I would have liked, but I’m happy with how we faded the bounce. Now I need to make decisions on not only buying this dip, but selling this rip (in Gold, Treasuries, etc.). There’s plenty to do out there today,


Across our core risk management durations in the SP500, here are the lines that matter to me most:


  1. Immediate-term TRADE resistance = 1670
  2. Immediate-term TRADE support = 1637
  3. Intermediate-term TREND support = 1631


In other words, its game time. The US stock market either holds here or it does not. Same thing with both Gold and Treasuries – they either fade at lower-highs (again), or they do not.


Have some patience – this isn’t the all-or-none market people want it to be. It’s a range bound bullish TREND in SPY with immediate-term TRADE resistance, for now. Growth stocks still look great.



Patience: SP500 Levels, Refreshed - SPX

[VIDEO] FLASHBACK: JCPenney Wise, Pound Foolish


A little over two years ago, the market went bananas over news J.C. Penney hired Ron Johnson away from Apple to lead the struggling retailer as its new CEO. While consensus celebrated the announcement, sending the stock up almost 20%, Hedgeye Retail Sector Head Brian McGough didn’t budge on his bearish forecast for the company.


As this interview with CNBC’s Maria Bartiromo shows, McGough unequivocally told investors to get out of JC Penney and that Wall Street got it wrong. If Bill Ackman had listened, he could have saved himself about $500 million.