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KSS - So What Makes KSS Finally Go Down?

Takeaway: KSS might never earn over $4 again. SG&A cuts and tax benefits can only obfuscate economic reality for so long. 3/1 downside/upside.

Conclusion: We fully get that KSS is the kind of stock that goes up if the company just hits the quarter – even by accident. So the reaction to today’s headline beat is no surprise, even though the quality of earnings is nothing short of horrible. Comps and Gross Margins were weak, but KSS generated $0.06 (5%) of upside by cutting SG&A, another $0.02 due to a lower tax rate, and changed up its guidance policy in a way that steps up opacity around an already cloudy model. Listening to this conference call solidified our view that KSS is one of the worst run companies in retail. There is a culture of complacency with things going wrong in the business, and a sheer lack of excellence. We hate to poke at one of KSS’ internal battle cries, but the fact management talks of its ‘Agenda of Greatness’ is a head-scratcher.  All that said, we also understand that in order for this short to work, numbers need to come down – a lot. We still believe that this will happen.

 

The company’s current guidance is $4.05-$4.45. We’re at $4.00 for the year. But the part of this story that we think people are missing is that it is likely to earn about $4.00 for the next five years straight. Consider the following assumptions.

1) Square footage: 0.5%

2) Store comp: -2-3%: That’s a 180bp-270bp hit to consolidated comp w stores at (currently  91% of total)

3) E-com: 15-20%, or 140bps to 180bps in consolidated comp

4) Total Comp: -0.4% to flat

5) Gross Margin: -25bp to -50bp. a) E-commerce is lower margin for KSS. b) needs to step up promotional cadence with JCP back in the game. c) shifts to national brands, and d) dept store industry in year 6 of what is historically a 5-yr margin cycle.

6) Gross Profit: down 1% to 3%

7) SG&A: +2.0% as KSS invests to drive e-commerce business. (incl flat depreciation – co already extended its depreciation rate so D&A = $900mm vs $950mm)

8) EBIT: down 10-12%

9) Share Repurchase: $900mm-$1bn annually, or 21mm-24mm shares on a $40-45 stock (at $56 today). Approx 10% EPS accretion.

10) When all is said and done, we’re looking at LT EPS growth flat at best.

 

 

Valuation

We are often hit with the “but it’s so cheap” argument with KSS. In certain respects, we can see that. It’s got a sub-6x EBITDA handle, and a Cash Yield of about 8%. But we think that the thing that’s most wrong is the earnings numbers, not the multiples applied to those numbers. We’re basically making the call that KSS will earn $4 (at best) in perpetuity (or at least the next five years). If we want to get academic (which we don’t) and capitalize that by a 10% cost of equity, then we get to $40. That would equate to 10x earnings, which is not a stretch at all for a department store that can’t grow earnings, and where the consensus numbers are 20% too high. $40 is 30% downside from where we are today. If the Street is right on numbers for the next two years, then we think we’ve got about 13x a $4.75 number, which is about $61 (9% higher from here). That’s about 3/1 downside/upside, which is enough to get excited.

 

 

As it relates to events that can steamroll the short side, we think they are extremely limited and unprobable.

 

1) LBO: We’re heard about this a lot lately. It seems to be the rumor du jour when a retailer gets in trouble. Based on our model, we get to an IRR of less than 10% assuming a 20% premium to the current levels.

 

2) REIT: KSS has 411 owned stores (35% of portfolio) and 12 DCs. Based on our math, there’s real estate value of about $15/share ($3bn), BUT then KSS would have to incur about $250mm in rent if it wants to stay in those stores.  It also makes the mother of all assumptions, in that there’s someone that wants to pay $3bn for a portfolio of strip-mall real estate. The reality is that if there’s any value it is in mall anchor space, which would accrue to JCP (lease buy-outs) or Dillard’s. But even DDS is encountering the biggest problem with this bull case on department stores – it’s extremely tough to find liquidity for the portfolio. No one wants to buy them.

KSS - So What Makes KSS Finally Go Down? - KSS chart2

 

A FEW IMPORTANT DETAILS FROM THE QUARTER

 

E-commerce:

1) Dot.com growth rate was up sequentially in the quarter from 12% in 1Q. Though unquantified, we’ll peg it at 15% or 300bps sequentially. That would imply 30% growth in July and 9% in May and June. The key here is that the 9% growth rate in the first two months of the quarter is organic (i.e. uninterrupted by the dot.com re-platform).

2) We’ll give the company the benefit of the doubt on the website re-platform in the third quarter. Taking the dot.com growth rate up a few percentage points in 3Q against easier compares.

3) We have a tough time understanding management's conclusions regarding the negative trends we’ve seen in this business. The re-platform explains the 15% growth rate in 3Q13, but not the 16% and 12% rate we saw in 4Q13 and 1Q14 respectively. The re-platform was at best a four month hiccup.

KSS - So What Makes KSS Finally Go Down? - KSS chart3

 

SG&A:

1) The one area of our model that was off the mark in the quarter.  This is only the 2nd time in 7 ½ years that the company has leveraged SG&A spend on a negative sales number. Initially the beat was attributed to $13mm in incremental credit revenue, that number came down to a couple million by the end of Q&A, about $0.01 of the EPS beat.

2) In order to get to the low end of guidance (+1.5% to +2.5%) we’d have to assume a 2H growth rate of 3.5%. That’s probably the type of investment this business needs going forward, but not the type of spend this management team is willing to make in light of the fact that it hasn’t taken down its FY EPS numbers despite comp numbers that are running 230bps below plan. We’re taking down our 2H SG&A assumptions from +2% to +1% - giving the company an extra $0.07 of EPS.

KSS - So What Makes KSS Finally Go Down? - KSS chart4

 

KSS - So What Makes KSS Finally Go Down? - KSS chart1


The Scoreboard Doesn’t Lie on #Q3Slowing

Takeaway: Don't let the consensus macro herd lead you astray.

As you can see in the chart below, the 2014 Macro Scoreboard has the Long Bond (TLT) up +14% vs. the Russell 2000 which is down -2%. Front-running a compressing yield curve (LONG U.S. TREASURIES) as growth continues to slow continues to do the job for us on the long side, despite continuous head scratching from consensus who totally missed the call. 

 

The scoreboard doesn’t lie.

 

The Scoreboard Doesn’t Lie on #Q3Slowing - SCOREBOARD


Ouch! Eurozone, Germany and France GDP Fall in Q2

Investment Recommendations:  short Eurozone equities (EZU) and EUR/USD (FXE)

 

Europe has been on the sell side in our current macro themes deck and that position is seeing the benefit of more slowing economic data from Europe this morning. Beyond the EU region stalling to 0.0% sequentially and +0.7% Y/Y, Germany saw a significant drop Q/Q (from +0.8% to -0.2%) and France’s slowing led the government to cut its GDP forecast in half (again) to 0.5% for 2014 (and it will likely cause the country to miss its deficit target of 4%). Ouch!

 

This is also the first time both the USA and Europe have slowed (in rate of change terms) at the same time since 2011. German GDP has now fallen to the annualized rate of change the USA had in 1H of 2014 (+0.8-0.9%).

 

Our quantitative lines of support have been broken across European equities for 1.5 months (the DAX, CAC, and MIB index all remain bearish TREND signals) and our propriety GIP model (growth, inflation and policy) for assessing economies suggests the Eurozone economy will land in the ugly quad #3 in 2H, representing growth slowing as inflation accelerates.

Ouch!  Eurozone, Germany and France GDP Fall in Q2 - z. gip eurozone

 

Beyond the economic growth signals, our outlook for asset classes in the Eurozone remains focused on the actions of ECB President Mario Draghi. While Final CPI for July (released today) was unchanged at 0.4% Y/Y, we believe there’s a risk to the downside that we expect will force Draghi’s hand and accelerate expectations that the Bank launches a full scale QE program into year-end. 

 

Currently we see the Bank on hold (it’s August and vacation time after all), however come Fall he may begin QE-lite purchases (via ABS), and as expectations mount of a recession in the Eurozone, full blown QE could be the last saving grace to stoke growth and inflation.   

 

Should expectations heighten around a QE program while economic data continues to slow, we may well be altering our view across the region.  For now, we recommend short Eurozone equities (EZU) and EUR/USD (FXE).

 

Here are the preliminary Q2 GDP results for the Eurozone, Germany, and France:


Eurozone  0.0% Q/Q (0.1% est.) vs. 0.2% prior

Eurozone  0.7% Y/Y  (0.7% est.) vs. 0.9% prior

 

Germany  -0.2% Q/Q (-0.1% est.) vs. 0.8% prior

Germany  1.3% Y/Y (1.4% est.) vs. 2.2% prior

 

France  0.0% Q/Q (0.1% est.) vs. 0.0% prior

France  0.1% Y/Y (0.3% est.) vs. 0.7% prior (0.8% revised)

 

For Germany, this is the first sequential contraction since 2012, and comes as no great surprise given the downturn in German Industrial production, Factory Orders, and ZEW expectation numbers released over the last two weeks.

 

As my colleague Daryl Jones wrote in today's Early Look, "given this, it’s no surprise then that the German Bund hit a record low of 1.0% this morning and has been front running this slow down.  Clearly, low reported inflation is leaving the door open (some might say wide open!) for incremental easing in Europe (a point the German bund market is front running)."  Indeed.

Ouch!  Eurozone, Germany and France GDP Fall in Q2 - z. 10 yr yields

 

Here are the region’s Q2 GDP results according to Eurostat:

Ouch!  Eurozone, Germany and France GDP Fall in Q2 - z. eurostat

 

Matthew Hedrick
Associate


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INITIAL CLAIMS DATA SOFTENS BUT THE TREND REMAINS INTACT

Takeaway: Claims data continues to augur well for unsecured lenders like Capital One (COF).

Claims Data Softens a Bit 

Initial claims data softened a bit on the week. On a single week basis the rate of year-over-year improvement in NSA claims slipped to -4.9% from -14.2%. On a rolling 4-wk basis, however, NSA claims remained lower year-over-year by -11.1% vs -12.0% in the previous week and are still in-line with the trend line rate of improvement over the past six weeks.

 

Meanwhile, SA rolling initial claims are now running at sub-300k on a rolling SA basis for the third week in a row. In the past two instances (1 & 2006-2007) the market advanced for 12-18 months after rolling initial claims first dropped below 300k.  

 

The Data

Prior to revision, initial jobless claims rose 22k to 311k from 289k WoW, as the prior week's number was revised up by 1k to 290k.

 

The headline (unrevised) number shows claims were higher by 21k WoW. Meanwhile, the 4-week rolling average of seasonally-adjusted claims rose 2k WoW to 295.75k.

 

The 4-week rolling average of NSA claims, which we consider a more accurate representation of the underlying labor market trend, was -11.1% lower YoY, which is a sequential deterioration versus the previous week's YoY change of -12.0%

 

INITIAL CLAIMS DATA SOFTENS BUT THE TREND REMAINS INTACT - 1

 

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INITIAL CLAIMS DATA SOFTENS BUT THE TREND REMAINS INTACT - 19

 

Yield Spreads

The 2-10 spread fell -1 basis points WoW to 201 bps. 3Q14TD, the 2-10 spread is averaging 203 bps, which is lower by -18 bps relative to 2Q14.

 

INITIAL CLAIMS DATA SOFTENS BUT THE TREND REMAINS INTACT - 15

 

INITIAL CLAIMS DATA SOFTENS BUT THE TREND REMAINS INTACT - 16

 

Joshua Steiner, CFA

 

Jonathan Casteleyn, CFA, CMT


THOUGHT PIECE: CALLING UP “MANAGEMENT” ON RATES

Takeaway: Recent commentary out of Federal Reserve policymakers solidifies our expectations that the Fed will surprise investors to the dovish side.

This note was originally published August 13, 2014 at 23:43 in Macro by Hedgeye Macro analyst Darius Dale. For more information on our services click here.

When I started as a junior analyst in this business, I had the fortunate experience from learning from one of the best Retail & Apparel analysts in the world, Hedgeye Sector Head Brian McGough. One of my primary responsibilities on Brian’s team was to update models during earnings season and take notes on conference calls. 

 

It didn’t take long for me to realize that “management” knew little more about the future than even I did. In fact, listening to how bearish many of those executives sounded during what was a generational opportunity to buy domestic consumer discretionary stocks (i.e. mid-2009) sounded increasingly at odds with the Hedgeye Macro Team’s almost-giddy bullish view on the US consumer.

 

THOUGHT PIECE: CALLING UP “MANAGEMENT” ON RATES - future

 

I learned three valuable lessons from that experience that have shaped, if not defined my analytical career:

 

  1. No one knows anything about the future. We’re all getting paid handsomely to bet on what we view as the most probable outcome (i.e. “guess”).
  2. While relative levels of compensation would indicate otherwise, corporate executives are not any better than you or I at predicting the future state of their own operating performance – let alone the broader economy. The best they can do for you in a 1x1 meeting is provide you with details that may border on material nonpublic information – something we vehemently shun at Hedgeye. 
  3. There is no “management” to call in macro.

 

Regarding that last point, we often joke in meetings with prospective customers that “God called us” whenever we’re asked to describe the research process that has allowed us to stay on the opposite side of both buy-side and sell-side consensus on the direction of interest rates in both 2013 and 2014 (i.e. accurate).

 

In reality, our process is a combination of rigorous quantitative methods, meticulous study of economic history and a willingness to incorporate relatively newer disciplines such as behavioral finance and complexity theory into our analysis. We’re certainly not always right, but over the years we’ve found that combination to be the most successful at generating a high probability of accuracy on a consistent basis.

 

If, however, there was a management team to call in macro, it would most likely be the Federal Reserve. Their incessant and growing interference with financial markets has certainly amplified their role in both the price discovery process and the pace of economic activity. 

 

While we don’t have Janet Yellen’s phone number, or the numbers of any of her minions among the Federal Reserve Board of Governors, or their minions at CNBC or the WSJ, we can at least pretend to engage in a 1x1 dialogue with them by asking and responding to commentary from their recent statements.  We do this below with a satirical interview that incorporates sound bites from Federal Reserve Vice Chairman Stanley Fischer’s 8/11 speech at the Swedish Ministry of Finance:

 

  • Q: Hedgeye: Tell us about the Fed’s track record on growth.
  • A: Fischer: “Year after year we have had to explain from mid-year on why the global growth rate has been lower than predicted as little as two quarters back. Indeed, research done by my colleagues at the Federal Reserve comparing previous cases of severe recessions suggests that, even conditional on the depth and duration of the Great Recession and its association with a banking and financial crisis, the recoveries in the advanced economies have been well below average... These disappointments in output performance have not only led to repeated downward revisions of forecasts for short-term growth, but also to a general reassessment of longer-run growth. From the perspective of the FOMC, even in the heart of the crisis, in January 2009, the central tendency of the Committee members' projections for longer-run U.S. growth was between 2-1/2and 3 percent. At our June meeting this year, these projections had fallen to between roughly 2 and 2-1/4 percent.”

 

  • Q: Hedgeye: Interesting. Why do you think growth has been so slow in the post-crisis era?
  • A: Fischer: “As Cerra and Saxena and Reinhart and Rogoff, among others, have documented, it takes a long time for output in the wake of banking and financial crises to return to pre-crisis levels. Possibly we are simply seeing a prolonged Reinhart-Rogoff cyclical episode, typical of the aftermath of deep financial crises, and compounded by other temporary headwinds. But it is also possible that the underperformance reflects a more structural, longer-term, shift in the global economy, with less growth in underlying supply factors… In the United States, three major aggregate demand headwinds appear to have kept a more vigorous recovery from taking hold. The unusual weakness of the housing sector during the recovery period, the significant drag--now waning--from fiscal policy, and the negative impact from the growth slowdown abroad--particularly in Europe--are all prominent factors that have constrained the pace of economic activity.”

 

  • Q: Hedgeye: So, to be clear, you do not think your Policies To Inflate have had anything to do with the fits and starts in growth we’ve seen over the past several years?
  • A: Fischer: [no comment]

 

  • Q: Hedgeye: Moving along, what do you make of claims that ZIRP and quantitative easing after quantitative easing are effectively holding back the recovery by depressing the “animal spirits” needed for a true economic cycle?
  • A: Fischer: “… turning to the aggregate supply side, we are also seeing important signs of a slowdown of growth in the productive capacity of the economy--in the growth in labor supply, capital investment, and productivity. This may well reflect factors related to or predating the recession that are also holding down growth. How much of this weakness on the supply side will turn out to be structural--perhaps contributing to a secular slowdown--and how much is temporary but longer-than-usual-lasting remains a crucial and open question.”

 

  • Q: Hedgeye: Interesting that you mention labor supply. Can you talk a little bit about “slack”, which has been a hot topic amongst monetary policymakers in recent weeks?
  • A: Fischer: “There has been a steady decrease in the labor force participation rate since 2000. Although this reduction in labor supply largely reflects demographic factors--such as the aging of the population--participation has fallen more than many observers expected and the interpretation of these movements remains subject to considerable uncertainty. For instance, there are good reasons to believe that some of the surprising weakness in labor force participation reflects still poor cyclical conditions. Many of those who dropped out of the labor force may be discouraged workers.”

 

  • Q: Hedgeye: Lastly, can you share with us any insights you guys may have that we may not yet be aware of as it relates to your “data dependent” guidance on policy normalization?
  • A: Fischer: “At the end of the day, it remains difficult to disentangle the cyclical from the structural slowdowns in labor force, investment, and productivity. Adding to this uncertainty, as research done at the Fed and elsewhere highlights, the distinction between cyclical and structural is not always clear cut and there are real risks that cyclical slumps can become structural; it may also be possible to reverse or prevent declines from becoming permanent through expansive macroeconomic policies.”

 

  • Q: Hedgeye: So basically what you’re saying is, “We really have no clue what we’re doing or where we’re headed, but we’re going to attack every problem as if it were a nail and we’re the hammer.” Is that more-or-less accurate?
  • A: Fischer: [no comment]

 

Moving along, if you aren’t yet familiar with the debate surrounding the outlook for US monetary policy we’ve been attempting to prepare investors for since JAN, we highly encourage you to review the following Reuters article: "Yellen Resolved to Avoid Raising Rates Too Soon; Fearing Downturn" (7/12).

 

All told, we remain the bears on US interest rates/bulls on long-term Treasuries as growth is likely to slow throughout 2H14.

 

THOUGHT PIECE: CALLING UP “MANAGEMENT” ON RATES - dd1

 

Meanwhile, Consensus Macro remains out to lunch with their expectations of perpetually compounding +3% QoQ SAAR GDP growth – expectations that don’t even align with their full year view of +1.7%. Specifically, if GDP compounds at +3.1% in Q3 and Q4, full year GDP will equate to +2.1%, not the +1.7% currently expected by Bloomberg Consensus. I know it’s August, but c’mon, that’s just analytically lazy. Update those forecasts!

 

THOUGHT PIECE: CALLING UP “MANAGEMENT” ON RATES - Conensus GDP Estimates

 

For those of you who are still grinding away with us, we wish you a restful night’s sleep and a very productive morning.

 

DD

 

Darius Dale

Associate: Macro Team


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