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TGT – This Narrative Will Change Dramatically

Takeaway: Less talk about tactical patches. More action about expensive strategic solutions to 5-years worth of poor decisions. Flat EPS for 3-yrs?

Conclusion: Though the fundamental call is playing out as expected, we still think TGT is a ‘Best Idea’ short. The reality is that the narrative on this name will change dramatically over the next 12 months after a real CEO is hired, major strategic decisions are made and we get away from the tactical discussion about whether traffic is up or down by 50bps or how many Frozen DVDs Target sold.  We’ll be talking about a new CEO’s vision to both transform the company, and fix all the mistakes made over the past 5 years. That might sound like great news, but it will be expensive news. You don’t build a world-class e-commerce platform without investing a few billion on the balance sheet and P&L. You also don’t change the make-up of your customers and product offerings and brand image without some painful organizational changes and operational expenses that hurt over a multi-year time period before they ultimately help grow market share, margins, and returns. Our point is that the bar has been reset for this FY closer to a level that we think is doable. But this company might not earn anything higher than $4.00 for another 3-years. We won’t wait a day for mediocrity – nevermind 3 years.  This stock should have a 4-handle.

 

DETAILS

 

We added TGT to our Best Ideas list as a Short on 4/24, and there it will stay. The quarter played out exactly as planned; the company traded margin for comp (which was still negative) in the US, and meaningfully underperformed in Canada. But our call went far beyond the quarter. It is based on the premise that five years ago Target set out on a path to dramatically alter its persona. Mind you, in the mid-2000s Target was the anti-Wal-Mart, and was viewed as a fashion leader for a younger demographic (i.e. Tar-Jay). At that point, it was clearly worth a higher multiple, which it consistently commanded.  But then three things happened that would ultimately cost Sheinhafel his job – and No, one of them was NOT the data breach.

 

1) TGT converted 65% of stores to P-Fresh – which mirrored WMT’s supercenters (ie sell people milk and eggs so they stick around and buy diapers, sweaters and lipstick).

2) TGT pushed the Red Card, which offered 5% off on all purchases. This went from 6.5% of sales to 20% of sales over 5 years.

3) The company was spending on the above initiatives while the rest of retail was investing in e-commerce, something TGT is severely deficient in.

 

Maybe all these things seemed a good idea to TGT at the time. But it fundamentally changed the makeup of the company.

 

1) That old cool Tar-Jay is not just dormant, but it is officially dead. Now TGT competes in the US more closely with WMT than it ever has before. So it’s got WMT on one end, supermarkets on another, department stores on another, and even dollar stores to a certain extent. This is one of the least appealing competitive sets we can think of. And that’s not even mentioning AMZN, which is emerging as one of its biggest competitors whether Target likes it or not.

 

TGT – This Narrative Will Change Dramatically - TGT chart1

 

2) The Red Card might have seemed like a good idea as well. After all, some retailers have had great success with similar reward cards. It’s not the 100bps in margin that TGT gives back to consumers that we have a problem with. But rather, we think that the mix of customers changes meaningfully when you start incentivizing them with price.  To be clear, we understand the nature of US retail, and price discounting can be a great weapon. But when TGT was more of a cool-ish fashion-leading department store, it did not have to incentivize people with a Red Card to be loyal. Now it is a different animal altogether. Our point is that we encounter many people who think that historical peak margins could someday be doable. We think it’s close to impossible.

 

TGT – This Narrative Will Change Dramatically - TGT chart2

 

3) Lastly, the dot.com element is pathetic. Every statistic we track shows that target.com is near the bottom of the pack when compared to other retailers’ online business. We hear Mulligan say on the conference call that they are ‘channel agnostic’, and that they don’t care if a person buys online or in the store. Seriously? 46% of what your store sells is Food and Home Essentials – these are things that you need people to come into the store to buy repeatedly at lower margin so they buy high margin seasonal goods. This company needs people in its stores, period.

 

TGT – This Narrative Will Change Dramatically - chart3 tgt

 

SO WHAT HAPPEN’S NOW

 

We think that today’s conference call was so bad yet so enlightening. We walked away with the firm view that both the company and the Street are hyperfocused on issues that are impacting the next 2-3 quarters of earnings. Those things are important as it relates to near-term trading. We respect that. But the reality is that there were some people who are interviewing for the CEO job who were listening in to the call. Others will read the transcript. Those people could care less about a couple points in traffic growth, or weakness in gross margin, or whether Target sold a million Frozen DVDs (still in disbelief that they talked about this). They’re going to have to make a handful of strategic decisions when they start their new job if they want to get paid 3-5 years down the road -- because status-quo is not acceptable. If it is, then the Board will be hiring the wrong person, and they should probably hand in their own resignations while they’re at it.

 

Our point here is that what we heard on today’s call is a narrative that will be a distant memory in 9-12 months’ time. We’ll be talking about a new CEO’s vision to both transform the company, and fix all the mistakes made over the past 5 years. That might sound like great news, but it will be expensive news. You don’t build a world-class e-commerce platform without investing a few billion on the balance sheet and P&L. You also don’t change the make-up of your customers and product offerings and brand image without some painful organizational changes and operational expenses that hurt over a multi-year time period before they ultimately help grow market share, margins, and returns.

 

The bar has been reset for this FY closer to a level that we think is doable. But this company might not earn anything higher than $4.00 for another 3-years. We won’t wait a day for mediocrity – nevermind 3 years.  

 

TGT – This Narrative Will Change Dramatically - tgt financials 1



DRI: Simply Egregious

I’m still stunned by the sheer arrogance of Darden management.  It’s been rumored that, shortly following the emergence of activist shareholders, Matt Stroud (VP: Investor Relations) said shareholders had no say in the running of the company.  I laughed when I heard that comment, but the truth is he’s right.

 

The message from Darden management and the Board is fairly straightforward: “As long as we are in office, we get to run the show.”  All the activists can do now is turn up the heat and try to replace directors at the upcoming annual meeting.  To that end, the deadline for nominating board candidates for this meeting is today.  The ultimate outcome, however, will likely not be known until sometime later this year.  Until then, we are confident that management will continue to destroy shareholder value under its current operating plan.

 

Moving forward, management has introduced two or three initiatives that could appease shareholders, but we believe the core value destructive initiatives remain in place:

 

  1. The current management team has proven they are incapable of fixing broken brands.
  2. Carrying on with excessive unit growth – growing the Specialty Restaurant Group is not a value creating strategy.

 

To be clear, increasing market share in an industry in secular decline by growing new units is a value destructive strategy.  According to NPD, visits to casual dining restaurants were at a six year low in the twelve months ending February 2014.  Since 2009, casual dining traffic has declined nearly 2% each year, totaling a loss of 7.1 million visits.  Meanwhile, Darden's CEO Clarence Otis has been excessively compensated to open 417 net new stores since the end of FY09. 

 

As we see it, the investment case for the new Darden is centered on fixing Olive Garden.  According to management, they plan to “continue to execute our comprehensive Brand Renaissance Plan at Olive Garden, building on progress simplifying operations to enhance food quality and taste to improve the guest experience.”

 

We have major concerns with the lack of visibility around this plan and believe management is in “trust us” mode – a truly scary thought.  Given their track record, we have little reason to believe this plan will be successful and won’t see any evidence of this, supportive or not, for at least another 12-18 months.

 

All told, the sale of Red Lobster does very little to change our view of the company.  We firmly believe that the only legitimate way to create shareholder value will come from a shakeup of senior management.  At this point in time, significant changes (e.g. Starboard gets controls of the board) are not likely to have any significant impact until late in FY15, if at all.  Absent this, the earnings power of the company will continue to deteriorate.

 

On a pro-forma basis, we are currently projecting FY15 EPS of $2.20 versus street estimates of $2.72.  This puts the fair value of DRI, under the current management team, in the low $40s.

 

Absent any significant changes to the Board, this stock is headed lower! 

 

DRI: Simply Egregious - 1111

 

DRI: Simply Egregious - 22

 

Howard Penney

Managing Director

 

Fred Masotta

Analyst


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YELP: Chat with the CFO (Recap)

Takeaway: We had a good conversation with YELP’s CFO…We are reiterating the Short

NOTE SUMMARY

  1. INCREMENTAL COMPANY DETAILS: We have included some notes below to assist you with your models.
  2. ATTRITION ISSUES?: We are now more confident that the attrition issues we have been highlighting are occurring.
  3. TOTAL ADDRESSABLE MARKET: We suspect that the company sincerely believes its TAM is as large as it has publicly stated.  We have previously detailed why this isn't the case, and we'll have follow-up note on this topic shortly. 

 

We spoke with Rob Krolik of YELP yesterday.  We believe he was very honest and forthcoming with us.  He answered pretty much all of our questions with the exception of one very important one, which we will get to below.  

INCREMENTAL COMPANY DETAILS

  1. Salesforce: YELP’s salesforce has been rising 50% y/y for about the past 8 quarters.  They now represent a little less than 60% of its total employee count of 2,156 (as of 1Q14).  Most of those reps focus on the Local Advertising Segment (Brand Advertising salesforce is fairly small).  The breakeven on those Local Ad reps is roughly 6-9 months (on a cash basis).
  2. Customers: Most customers sign 12 month contracts.  There is 2-3 month penalty for cancellation, but YELP doesn’t always enforce (e.g. client has financial problems or goes under).  The Active Local Business accounts reported by the company are essentially all of its customers excluding Brand Advertising; specifically all Local Advertising customers (which includes SeatMe as of 2014) and Other Services customers (Gift Certificates and Deals)

ATTRITION ISSUES?

Where we didn’t get a tremendous amount of detail was when we delved into its customer repeat rate, which is how we are backing into its attrition rate.  We did spend some time discussing this topic, and while he wouldn’t explicitly verify or refute our attrition thesis, he did say that YELP has never said that they are not losing customers after we delved into its reported numbers.

 

The question he wouldn’t answer, which is a spin off of its customer repeat rate metric: “How many of your current customers have been generating revenue for YELP for over a year?”

 

This is the most important question because it drives at the heart of the retention issue we have been highlighting.  We estimate that in any given period that the overwhelming majority of YELP’s reported Local Business Accounts are accounts the company has signed within the LTM (meaning YELP is losing the majority of its accounts after the first year).    

ADDRESSABLE MARKET

He did point out that total accounts continue to grow on a quarterly basis at a strong rate (there’s no denying that), and he reiterated YELP’s strategy of focusing on acquisition vs. retention given its large addressable market; highlighting YP.com as a reasonable opportunity (575K customers).

 

To be explicitly clear on this front, we believe Rob (and the company) sincerely believes that YELP’s TAM is as large as they have publicly stated.  We do not; we have gone into detail on why this isn’t the case in our original YELP Short Best Ideas note (with much greater detail in the deck). 

 

We will be publishing another note shortly with incremental detail on YELP’s TAM to emphasize this point. 

 

 

If you have any questions, or would like to discuss in more detail, let us know.

 

Hesham Shaaban, CFA

@HedgeyeInternet

 


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