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Cartoon of the Day: Muscle vs. Russell

Takeaway: The 2014 Macro Score: Long Bond $TLT +14% vs Russell 2000 -2%

Cartoon of the Day: Muscle vs. Russell - Russell 2000 cartoon 08.14.2014


ICI Fund Flow Survey - Taxable Tantrum with Domestic Equity Funds Continuing to Struggle

Takeaway: In the most recent ICI survey, taxable bond funds experienced a substantial snap outflow joining domestic stock funds with dour trends

Investment Company Institute Mutual Fund Data and ETF Money Flow:

 

In the most recent 5 day period ending August 6th, taxable bond funds snapped 2 months of consecutive weekly inflows with a substantial $8.6 billion redemption driven by geopolitical fears and mixed domestic economic signals. The snap outflow in the category was the biggest redemption since the week of June 26th, 2013 during the Taper Tantrum where $20.4 billion in a single week was called in by investors. Despite the panic in taxable fixed income last week, the category has had inflows in 24 of the past 26 weeks, so we will be monitoring if this about face has longer standing implications. Domestic stock fund flows also continued to struggle in the most recent survey with another $3.0 billion withdrawal by investors last week, much worse than the running 2014 weekly average of a $652 million redemption, making it 15 consecutive weeks of outflows in domestic stock funds. Janus Capital (JNS) and T Rowe Price (TROW) have the most exposure to negative retail equity fund trends with 60% and 40% of assets-under-management respectively in domestic stock funds.

 

Total equity mutual funds put up a slight outflow in the most recent 5 day period ending August 6th with $422 million being redeemed from the all stock category as reported by the Investment Company Institute. The composition of the outflow continued to be weighted towards domestic stock funds with $3.0 billion being withdrawal from the category in now the 15th consecutive week of outflows. These withdrawals were again cushioned by a $2.6 billion inflow into international equity funds which have experienced subscriptions (inflows) in every week of 2014. The running year-to-date weekly average for combined equity fund flow is now a $1.5 billion inflow, which is well below the $3.0 billion weekly average inflow from 2013. 

 

Fixed income mutual funds experienced mixed trends last week with the aforementioned taxable redemption of $8.6 billion offset by a slight inflow into municipal or tax-free products of $454 million. Intermediate term bond momentum continues despite the dramatic outflow last week with inflow in 24 of the past 26 weeks in taxable bonds and municipals tallying 29 of the past 30 weeks with positive subscriptions. The 2014 weekly average for fixed income mutual funds now stands at a $1.8 billion weekly inflow, an improvement from 2013's weekly average outflow of $1.5 billion, but still a far cry from the $5.8 billion weekly average inflow from 2012 (our view of the blow off top in bond fund inflow). 

 

ETF results were volatile during the week with inflows into bond funds and substantial outflows in stock funds. Equity ETFs lost a massive $15.5 billion last week, the biggest outflow since the week of February 5th where $27.4 billion was redeemed in stock ETFs. Fixed income ETFs conversely put up a decent sized inflow with $2.7 billion flowing into bond products. The 2014 weekly averages are now a $1.2 billion weekly inflow for equity ETFs and a $883 million weekly inflow for fixed income ETFs. 

 

The net of total equity mutual fund and ETF trends against total bond mutual fund and ETF flows totaled a negative $10.4 billion spread for the week ($15.9 billion of total equity outflow versus the $5.4 billion outflow within fixed income; positive numbers imply greater money flow to stocks; negative numbers imply greater money flow to bonds). The 52 week moving average has been $4.3 billion (more positive money flow to equities), with a 52 week high of $31.0 billion (more positive money flow to equities) and a 52 week low of -$37.5 billion (negative numbers imply more positive money flow to bonds for the week). 

 

Mutual fund flow data is collected weekly from the Investment Company Institute (ICI) and represents a survey of 95% of the investment management industry's mutual fund assets. Mutual fund data largely reflects the actions of retail investors. Exchange traded fund (ETF) information is extracted from Bloomberg and is matched to the same weekly reporting schedule as the ICI mutual fund data. According to industry leader Blackrock (BLK), U.S. ETF participation is 60% institutional investors and 40% retail investors.   

 

ICI Fund Flow Survey - Taxable Tantrum with Domestic Equity Funds Continuing to Struggle - chart1

ICI Fund Flow Survey - Taxable Tantrum with Domestic Equity Funds Continuing to Struggle - chart2

 

 

 

Most Recent 12 Week Flow in Millions by Mutual Fund Product:

 

ICI Fund Flow Survey - Taxable Tantrum with Domestic Equity Funds Continuing to Struggle - chart3

 

ICI Fund Flow Survey - Taxable Tantrum with Domestic Equity Funds Continuing to Struggle - chart4

 

ICI Fund Flow Survey - Taxable Tantrum with Domestic Equity Funds Continuing to Struggle - chart5

 

ICI Fund Flow Survey - Taxable Tantrum with Domestic Equity Funds Continuing to Struggle - chart6

 

ICI Fund Flow Survey - Taxable Tantrum with Domestic Equity Funds Continuing to Struggle - chart7

 

 

Most Recent 12 Week Flow Within Equity and Fixed Income Exchange Traded Funds:

 

ICI Fund Flow Survey - Taxable Tantrum with Domestic Equity Funds Continuing to Struggle - chart8

 

ICI Fund Flow Survey - Taxable Tantrum with Domestic Equity Funds Continuing to Struggle - chart9

 

 

Net Results:

 

The net of total equity mutual fund and ETF trends against total bond mutual fund and ETF flows totaled a negative $10.4 billion spread for the week ($15.9 billion of total equity outflow versus the $5.4 billion outflow within fixed income; positive numbers imply greater money flow to stocks; negative numbers imply greater money flow to bonds). The 52 week moving average has been $4.3 billion (more positive money flow to equities), with a 52 week high of $31.0 billion (more positive money flow to equities) and a 52 week low of -$37.5 billion (negative numbers imply more positive money flow to bonds for the week). 

 

ICI Fund Flow Survey - Taxable Tantrum with Domestic Equity Funds Continuing to Struggle - chart10 

 

 

 

Jonathan Casteleyn, CFA, CMT 

 

 

 

Joshua Steiner, CFA


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


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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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