JCP: Buy The Event

Takeaway: There are many possible outcomes from JCP’s print. But there is virtually nothing JCP can say to suggest that it is not 100% fixable.

Conclusion: One of two things will happen, either we’ll get tangible evidence of the turnaround – which will make JCP worth buying even if it’s up. Or the company will ‘pull a JCP’ and scare the Street with the print, as it has grown so accustomed to. We think that’s unlikely. But we think one thing is clear, there is virtually nothing the company can or will say to suggest that this company is not 100% fixable. We’re buyers on the event.  



First off, let’s be clear about where we stand on JCP. Our positive call is based on our view that not a single thing currently ailing JCP is beyond repair. This company is not broken. Johnson bullied and bruised a few dozen critical functions at the company, and though he may have tried to break them, he failed at that too. We don’t think that Ullman is the right person to rehabilitate JCP, but he is the right guy to take it off life support and administer CPR if necessary. We expect to see a new CEO announced by Spring 2014.


Another important point..we’re not arguing that JCP is a great retailer, a great brand name, or in any way deserving of the right to exist as a go-to source for consumers.


But let’s keep an important factor in mind…it’s operating at $100 per square foot. That’s embarrassing. Kohl’s, which we think has structural issues and has been at the top of our short list – is running close to $210/sq ft. Before Johnson worked his magic, JCP peaked out at $190 per foot.


Our point here is that we don’t have to assume that JCP becomes a great retailer. We don’t have to even believe that it will be an average retailer.  It can remain in the lower quartile – a notch above Sears even – and operate at $140/square foot. And it can get there by simply fixing some of the factors that Johnson damaged during his triumphant reign.


Alongside the $140/ft, our other key assumption is that Gross Margins get back to 37%, which we think is very doable – despite the severe pushback we get on this assumption. Note that Ron Johnson’s decimation of JCP’s private label brands cost the company about $1bn in gross profit – that’s what happens when you remove $2.5bn in sales at a 48% gross margin and substitute with $900mm at a 33% gross margin.  


All in, those assumptions get us to $1.30 per share, which is meaningfully above the high end of where even the most vocal bulls (if there are any) are posting their estimates. Will it get there tomorrow? No. But it’s math that people will begin to run within 12-month’s time. Keep in mind that over the past few years there has always been a debate alive about what the ultimate earnings power of JCP actually is. That debate today is absolutely dead. And we’re not talking about an unachievable Ackmanist-driven Hail Mary $12-EPS power. In all our travels and phone calls, we can’t find anyone that is willing to acknowledge that JCP can actually earn money. That will change, and we think it happens within 12-months.


So, what are we looking for in the quarter?

  1. First off, this is literally a three-year turnaround – it won’t be fixed in a quarter. What we’re looking for this quarter is a mere two or three wins on the road to fixing several dozen problems. That might sound like a shameless hedge – perhaps it is. But there’s going to be a mix of noise and good news in this quarter. That’s upside from the past two years where it’s been all bad news.
  2. We’re looking for about a -5% comp. The company already reported a 0.9% store comp and 38% comp for Oct. Based on commentary by virtually all retailers, October was the best month of the quarter. -5% seems about right, but could be 2-3% +/-.
  3. Gross Margin change is going to move inversely to comp. We have it modeled +100bps vs. last year – which would mark the first GM improvement in about 10 quarters. Our bias is to the downside on that one, as Ullman told the whole world that he’d end the quarter with positive comps, and he did a +0.9% in Oct. Sounds like he stretched. More likely than not, he told his selling and merchandising team to drive a positive comp come hell or high water. That usually does not come alongside a healthy gross margin. Nonetheless, they’re coming off such low numbers that Gross Margins could be down 100bp and still post a 150bp sequential improvement on a 2-year run rate – which is what we’ll really be looking to see.
  4. We’ve got an operating loss of -$292mm, which compares to the Street at -$384mm. Our number might be on the aggressive side due to gross margin, but we’re reasonably confident that JCP won’t miss the consensus.
  5. Usually, we don’t leave EPS for last, but the company’s print relative to expectations will be relatively meaningless due to the timing of the company’s offering and inconsistency in how people are modeling the fully-diluted share count. The Street is at -$1.70 this quarter, but the range is from -$2.36 to -$1.11. We have JCP losing a little over a buck. But again, share count is uncertain. We’ll look at the operating loss delta as the best way to gage our estimates versus consensus. 

Trashing What's Left Of The Dollar

Takeaway: Janet Yellen looks set to launch a new round of aggressive doveishness. We think this risks trashing what’s left of the dollar.

Trashing What's Left Of The Dollar - yello

The Fed’s ongoing policy to trash the dollar has had the effect of inflating prices of things priced in dollars.  This policy has most notably sent the equities markets through the roof.  But remember that actual economic growth is “priced” in real terms.  A factory that increases productivity by 2% a year can not “put it on margin” to turn that into a 4%-10% annual gain.  Indeed, we are suffering the aftermath of an economy whose growth over more than a generation was increasingly driven by borrowing, borrowing, borrowing.


It appears that the Fed really believes it is helping the economy by guaranteeing that the prices of mortgage-backed bonds remain unrealistically high – and using our money to do so.  What is really going on is that asset prices are diverging from fundamental asset values, to the extent that markets risk becoming completely untethered from reality.  Into this morass treads Janet Yellen, who looks set to launch a new round of aggressive doveishness.  We think this risks trashing what’s left of the dollar.


Maybe shutting down the government wasn’t such a bad idea.


This is an excerpt from a Forbes op-ed written by Hedgeye Managing Director Moshe Silver. Click here to read it in its entirety. 




We are adding PBPB to Hedgeye best idea list as a SHORT.


Chipotle redefined the quick-service industry with its innovative operating model, Panera created the bakery café segment and Noodles catapulted into the fragmented Asian fast casual category.  All three are unique concepts that have, in a sense, redefined their respective categories. 


At the heart of it, Potbelly is a single daypart, low margin, low return sub shop with declining traffic and little competitive advantage over its most basic competitors.  Admittedly, these are not quite the qualities we’d expect to find in a company that is trading at a P/E of 84.3x and 21.7x EV/EBITDA on a NTM basis.  But, this is precisely what we have here.  


To be clear, we believe Potbelly is a solid company with a strong management team, but it should not be trading at a premium multiple to its aforementioned peers.


With that being said, we would not be surprised to see PBPB decline by 30-40% over the next twelve months.

As we wrote last week, in aggregate, the current valuations seen across the casual dining sector are shockingly high.  In fact, we have no problem referring to them as bubble-like and we’ve found this extends beyond the depths of casual dining stocks to several newly minted “growth” restaurant stocks.  Our CEO, Keith McCullough, did a nice job contextualizing these bubbles in this brief excerpt from yesterday’s Early Look titled “Weird Bubbles”:



From a US stock market “Style Factor” perspective, check out the score:

  • LOW YIELD (i.e. GROWTH) stocks = +40.4% YTD
  • Top 25% EPS GROWERS (by SP500 quartile) = +37.2% YTD
  • HIGH BETA stocks = +35.8% YTD


From a pure “Style Factor” perspective, PBPB fits the bill of a “growth” restaurant stock.  Let’s consider management’s aggressive guidance:

  • New unit growth of 10%+ for a “long period of time”
  • Low-single digit same-store sales growth
  • At least 20% annual adjusted EBITDA growth
  • At least 20% annual net income growth
  • At least a 25% return on invested capital, as measured by the second full-year profit of new shops
  • Shop margins above 20%

At its core, Potbelly is a local sandwich chain competing in the most competitive segment of the restaurant industry – the sandwich segment.  Although many people like to refer to it as the newest fast casual concept, the reality is it’s only at the “intersection between the fast casual and sandwich categories.”  Needless to say, Potbelly’s operating model, while solid, is nothing close to jaw-dropping.



Peer Group Operating Model Comparison

  • Potbelly’s average unit volumes are low.
  • Food costs are in-line with Panera’s.  There is very little room to move lower without downgrading to lower quality food.
  • The company appears to be very efficient, with labor costs running at 27.96%.
  • Other operating expenses are also very low, which could be the difference-maker in maintaining 20% store-level margins over the long haul.
  • Excluding IPO expenses, Potbelly’s G&A costs are running closer to 8%, which puts it fairly in-line with its competitive set.
  • Even after adjusting for lower G&A costs, operating margins remain low and will require sales leverage for any further upside.




Same-Store Sales

Management’s long-term guidance of “low-single digit same-store sales” implies that they believe, or want us to believe, they have the ability to take price in order to consistently drive average check higher.  In fiscal 2012, Potbelly’s average check was $7, which, on the surface, appears to be in-line with other fast casual operators.  With average check already at this level, relying on price as the primary driver of future profitability is a risky proposition.  Needless to say, we haven’t seen anything recently that would suggest this rate of same-store sales growth will come from traffic gains.  Potbelly has seen traffic decline for at least the past 3 quarters and expectations are for this trend to continue into the first half of 2014.





Average Unit Volumes

The Potbelly mission is to be “the best place for lunch.”  While a strong focus on lunch is important, restaurant companies that generate the best returns operate across multiple dayparts and, in turn, generate higher average unit volumes.  Depicted in the chart below, at $1.1 million, Potbelly’s average unit volumes are below all of its primary public peer competitors.  Given the inherent unit economics of a Potbelly shop, we find the company’s premium multiple very difficult to justify even with the “growth” story as a backdrop.





Restaurant Level Margins

Given the rapid projected growth rate of the company, PBPB will be facing downward pressure on restaurant level margins for the foreseeable future.  On average, new Potbelly shops will open up with shop level profit margins in the high-single digit or low-double digit range.  It will require nearly flawless execution on store openings to avoid being stymied by incremental margin pressure.





Low Returns

Relative to its competitive peer set, PBPB generates a very low return on assets.





Strong Balance Sheet and Cash Flow

PBPB is expected to have $48.87 million of cash and short-term equivalents on its balance sheet at the end of 2013 and is expected to generate approximately $7.8 million in free cash flow after allocating $31.16 million to capital expenditures in 2014.  The company has not formally announced what it will do with its excess cash, but we can safely presume they will use it to fuel their self-funding model and accelerate new unit growth in the second half of 2014 and 2015.




Per our comments earlier and the visuals from the charts below, PBPB is a very expensive stock that we, at the very minimum, find quite unattractive from a valuation standpoint.








As it stands, PBPB’s operating model has little room for error.  To justify the current multiple, it needs to be clear that there is significant upside from current consensus EPS estimates.  We don’t anticipate this coming to fruition and, with short interest comprising 15% of the float, it appears as though we are not the only ones.




Howard Penney

Managing Director



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What's New Today in Retail (11/19)

Takeaway: FW picking up esp VFCs TBL/Vans. ICSC growth above ly 3-wks running. AMZN toys cheaper than WMT – for now. WMT scares factories into action.



DKS - Earnings Call: Tuesday 11/19 10:00 am

TJX - Earnings Call: Tuesday 11/19 11:00 am

JCP - Earnings Call: Wednesday 11/20 8:30 am

LOW - Earnings Call: Wednesday 11/20 9:00 am

COH - Morgan Stanley Retail Conference: Wednesday 11/20 9:45 am

M - Morgan Stanley Retail Conference: Wednesday 11/20 10:55 am




ICSC - Chain Store Sales Index


Takeaway: Chain stores posting sales growth above last year for the third week in a row. This supports the statements by many retailers about how October was the strongest month of the quarter, but has carried into November so far.


What's New Today in Retail (11/19) - chart5 11 19

What's New Today in Retail (11/19) - chart6 11 19


Monthly Athletic Footwear Data


Takeaway: Good month for the industry -- in line with commentary from retailers overall about October being the strongest month. Sales were up 5.7% -- balanced evenly between units and average price. Nike, Jordan and UnderArmour are the clear winners  -- but stating that sounds broken record-ish. One of the real callouts for the week are VFC's footwear brands -- Vans and Timberland, which were up 20% and 16%, respectively.


What's New Today in Retail (11/19) - chart1 11 19

What's New Today in Retail (11/19) - chart2 11 19

What's New Today in Retail (11/19) - chart3 11 19

What's New Today in Retail (11/19) - chart4 11 19




AMZN, WMT, TGT, SHLD - Amazon’s Toys Cheaper Than Wal-Mart Online



  • " Inc.’s toy prices were lower than those available online from Wal-Mart Stores Inc. and Target Corp. last week as retailers seek to attract shoppers heading into the crucial holiday selling season."
  • "Amazon’s prices, excluding those from its third-party sellers, were 3 percent lower on average than Wal-Mart’s on a basket of 87 toys, according to a study conducted by Bloomberg Industries on Nov. 14."
  • "Wal-Mart’s prices were 2.4 percent lower than at Target, 5 percent less than Sears Holdings Corp.’s Kmart and 7.2 percent lower than Toys “R” Us Inc., according to the study."


Takeaway: Not for long.


WMT - Wal-Mart to match competitors’ Black Friday deals a week early



  • "...Wal-Mart said Tuesday it will match competitors’ best Black Friday deals a week early.
  • At 8 a.m. on Friday, Nov. 22, Wal-Mart will cut prices on some of the most popular toys and electronics to match the best Black Friday offers from Target, Toys R’ Us and Best Buy."
  • "Starting Tuesday, Wal-Mart will also extend its Christmas Ad Match to online customers. Shoppers who buy an item online and find a lower in-store competitor price can recoup the difference via a Wal-Mart gift card by emailing That policy has been in place for in-store shoppers, and it runs up to Dec. 24, excluding Thanksgiving Day and Black Friday."


WMT - Bangladesh Factory Audits Stir Calls for More Action



  • "Wal-Mart Stores Inc. became the first major retailer to release a large-scale audit of factories from which it sources in Bangladesh, outlining the failure and improvement rates in fire and building safety at 75 facilities. The company manufactures in more than 200 factories in Bangladesh and said it plans to publicly release results from the audits of all of the factories it uses in the country."
  • "Of the 75 companies in the first round of safety assessment reports made public by Wal-Mart late Sunday night, nearly 10 factories failed the initial audit, according to Wal-Mart executives. However, in a second, follow-up safety audit, 34 factories improved their initial grades from a D (a high safety risk) or C rating to an A (the lowest safety risk) or B rating."


Takeaway: Gotta hand it to WMT, they can scare the pants off of any vendor, manufacturer, or factory with the blink of an eye.


MW - Men's Wearhouse Teams Up With Esquire



  • "In the latest incarnation of editorial merging with e-commerce, Men’s Wearhouse has teamed up with Esquire to launch the Esquire Ultimate Shirt and Tie Collection. The line of men’s dress shirts and ties, which sport the Esquire label, is currently rolling out to Men’s Wearhouse stores and will also be available online. The assortment, which was chosen by the editors of the magazine, retails for $79.50 for shirts and $59.50 for ties."


Takeaway: Another example of where the MW brand is headed -- on its own, without Jos. A. Bank. It's shifting to a higher-end, more aspirational mix of product to attract a better demographic. Admittedly, these changes take a looooong time to impact consumers' shopping patterns, but this strategy is definitely the right move for MW.


COLM - Columbia Unveils New High-Performance Construction Technique



  • "...Columbia Sportswear introduces PED, Performance Enhanced Down, a patent-pending construction technique."
  • "TurboDown is a new technology that leverages the strengths of both science and nature, layering natural down, synthetic Omni-Heat thermal insulation, and Omni-Heat Reflective technology into every baffle. The result is an industry first, a product that has the warmth, look and feel of natural down, and performs in all conditions, wet or dry."
  • "Columbia's...collection will be tiered in three categories, Gold, Platinum and Diamond.  And the jackets and vests will range in price from $130 to $325. TurboDown styles will be available to men and women in September of 2014 and will include 14 pieces in myriad colors and styles."


Takeaway: Let's see how long it takes COLM to sell this technology into Kohl's.




Bangladesh Garment Workers Stage Fresh Protests After Two Deaths



  • "Bangladesh garment workers took to the streets today in the Ashulia industrial zone outside of the capital Dhaka, protesting the second-lowest wages in Asia, after another demonstration yesterday left at least two dead."
  • "Hundreds of workers demanded a higher monthly salary of 8,000 taka ($103) today and the protests forced 50 clothing factories to suspend production, Abdus Sattar Miah, a spokesman of Industrial Police, said over the phone. A group of plant owners held a meeting with the home ministry seeking help to control the labor unrest, said Abdus Salam Murshedy, president of Exporters Association of Bangladesh."
  • “'We are very frustrated,' Murshedy said. 'It seems that we have to fold our business, hand over the factory keys to the government and go home.'”


What's Selling: Men's



NEXT, Cleveland, Ohio

  • Dr. Martens Gideon Fold-Down Lace Boot 
  • Timberland’s 40th anniversary limited collection of heritage-inspired looks
  • Filling Pieces Mountain boot

Top fall trend: “Boots are stronger this year than last,” said co-founder Steve Silver. “The action is in hybrid sneaker-boots. Overall, guys have become very specific about items.” 


  • Florsheim’s Indie military-inspired boot
  • Timberland Earthkeepers zip military boot in tan
  • Cole Haan’s Lunargrand wingtip on colored outsole

Top fall trend: Military-inspired boots take the top spot, said owner Abe Rogowsky, and they include pointy- and round-toe ankle versions. 


  • Gram’s 470G cap-toe sneaker boot in black  
  • WESC Saddle Runar style on running outsole
  • Troop Vibram lace-up boot 

Top fall trend: “We’re seeing a lot of military and black boots,” said owner Scott Starbuck. On the dress side, he noted young consumers gravitate toward cleaner looks. “Classic English brogues and bluchers are really trendy. There’s a [move] to quality and cleaner styling.”      

LOUIE’S SHOES, Portland, Ore.

  • Frye Phillip harness boot
  • Bed Stu oxfords
  • Wolverine 1,000 Mile boots

Top fall trend: “Heritage brands are connecting with our customers,” said owner Pam Coven, noting authentic brands such as Frye and Wolverine. “They’re hipsters in their 30s. Younger guys like the look, too, but can’t afford the prices.”


  • Bed Stu Bryden boot
  • Wolverine 1,000 Mile boot
  • Red Wing Iron Ranger

Top fall trend: “Many of our best-selling brands are made in America,” said Josiane Pilon,social media and marketing manager. “The DNA man is a trendsetter and likes to wear something [he] can dress up and down at the same time, from weekday to weekend casual.”

Polar Perspective

“Difficulties are just things to overcome, after all.”

-Ernest Shackleton


Sir Ernest Shackleton was one of the principal figures of a period known as the Heroic Age of Antarctic Exploration.  Initially, this period was most identified by Roald Amundsen reaching the South Pole in December 1911.  Shackleton decided to try to one up Amundsen and launched an expedition to cross Antarctica from sea-to-sea over the pole.


In 1914, Shackleton began fundraising for this “Imperial Trans-Antarctic Expedition”, which was eventually launched in September 1914 despite the outbreak of World War I.  Misfortune struck Shackleton and his crew early in the trip when their ship, the Endurance, was frozen into an ice flow in the Weddell Sea.  The ship eventually had to be abandoned.


For the next almost 500 days, Shackleton and his men were stranded in Antarctica.  They had no contact to the outside world and routinely faced temperatures that dipped below -50 degrees Celsius.  Eventually after an almost impossible trip to a nearby whaling station, the entire crew was rescued.  While the expedition fell short of its goal, Shackleton and his colleagues certainly gained some polar perspective.


Back to the global macro grind...


Similarly, for many hedge fund managers this has been a year to gain perspective, if not outperformance.   As an example, as of the end of October 2013 the Hennessee Hedge Fund Index was up 9.9%, which paled in comparison to the return of the SP500 of north of 23%.  Now to be fair, returning close to 10% on 2 and 20 money isn’t the worst thing in the world, but undoubtedly for many underperforming a passive strategy by more than 1,000 basis points is frustrating.


Keith touched on this yesterday, but a key reason for the underperformance of hedge funds is the outperformance of heavily shorted stocks.   Specifically, heavily shorted stocks are outperforming the SP500 by some 570 basis points this year.  That’s enough to make any great short seller bi-polar!


Long / short equity managers likely aren’t the only investment managers going a little bi-polar this year. As an example, the PIMCO Total Return Fund has returned a capital eroding -0.87% in the year-to-date.   Clearly, the big bond boys at PIMCO are having some performance issues (not to say that it would at all be easy to steward that much capital!).


The broader issue with bond managers of course is how far afield they eventually have to search for yield.  Just like Shackleton and his crew in Antarctica, who eventually found land, the question for bond managers is ultimately: what is the cost of this search for yield?


As it relates to the PIMCO Total Return Fund, prospective underperformance may even be more concerning given the fund’s holdings and where the managers have gone to find yield.  According to analysis by our Financials Team, almost 34% of PIMCO Total Returns holdings are in agency mortgage backed securities.  In the Chart of the Day, we highlight the spread of agency MBS to the 10-year Treasury Yield.   As the chart highlights, prior to the financial crisis this spread was ~126 basis points, but has now narrowed to ~68 basis points.


The almighty chase for yield has effectively priced mortgage backed securities to one of the lowest levels of risk that we’ve seen in the asset class.  Even if the spread for Agency MBS just normalized by 50 basis points to pre-crisis levels, it would have a meaningful impact on the market.  By our estimation, allowing for modified duration, a 50 basis increase (reversal of tapering for instance) in yield would lead to 5% downside in the Agency MBS market.


The issue for firms like PIMCO is that a 5% correction in one of its more significant asset class exposures is likely to lead to continued underperformance and accelerated outflows.   Outflows and decreased liquidity, of course, are only likely to exacerbate any move in price in the MBS market.


The Financial Times this morning emphasized this point even further in an article looking at managers of collateralized loan obligations.  According to the article, managers of CLOs have increased the proportion of risky loans that their investment vehicles are allowed to buy to the highest level on record.  Currently, 55% of new leveraged loans come in the covenant lite form, which eclipses the 29% reached shortly before the financial crisis. 


Covenant lite loans are fine, in theory, if the economy is stable, but if there is volatility in economic activity, these loans get much more difficult to repay for many corporates.  A good analogy is probably Shackleton and his crew in -50 degrees Celsius weather in Antarctica.  You know weather that cold is dangerous but it is survivable, until the wind starts to blow and wind chill sets in . . .


To dig further into the topics of asset allocation, our Financials Team will be hosting a call his Thursday November 21st at 11am with Carl Hess who is the global head of Towers Watson’s investment advisory services that provides asset allocation recommendations to more than $2 trillion in assets under advisement.  We think this call will provide an interesting perspective on asset allocation and active management, and if you’d like details on how to get access to the call, please email .


Given the challenges faced by large asset allocation funds that rely heavily on yield for performance, going forward it might be prudent that managers of these funds search for analysts for their investment teams with a similar advertisement to what Shackleton used to find his crew:


“Men wanted for hazardous journey. Small wages. Bitter cold. Long months of complete darkness. Constant danger. Safe return doubtful. Honour and recognition in case of success.”




Keep your head up and stick on the polar ice,


Daryl G. Jones

Director of Research



Polar Perspective - chartofday


Polar Perspective - Virtual Portfolio

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