TODAY’S S&P 500 SET-UP – September 30, 2014
As we look at today's setup for the S&P 500, the range is 25 points or 0.80% downside to 1962 and 0.47% upside to 1987.
CREDIT/ECONOMIC MARKET LOOK:
MACRO DATA POINTS (Bloomberg Estimates):
WHAT TO WATCH:
COMMODITY/GROWTH EXPECTATION (HEADLINES FROM BLOOMBERG)
The Hedgeye Macro Team
Takeaway: Consistent w/ our outlook for EM asset prices, we see 15-20% downside in the EZA amid a myriad of idiosyncratic structural & cyclical risks.
Our Dour Outlook for EM Asset Prices Remains Firmly Intact
At Hedgeye, we like to go both ways – particularly when it comes to emerging markets. Recall that we authored the 2013 bear thesis back in April of last year, as well as the 2014 bull thesis in February/March of this year.
We are now overtly negative on the EM space going forward, a research view we outlined in great detail in our September 23rd note titled, “EMERGING MARKETS: THE EM RELIEF RALLY IS LIKELY OVER”. In that note, we closed all of our active long ideas across EM, as well as introduced the Vanguard FTSE Emerging Market ETF (VWO) on the short side. We highly encourage you to review that note to the extent you haven’t already.
Those equity ETF declines compare to a -1.3% decline in the MSCI All-Country World Index over that time frame and the near one percent drop in the EMB ETF compares to a +0.1% increase in the Barclays Aggregate Bond Index since then.
As you can probably tell, booking gains at the appropriate juncture and minimizing losses remains a core focus of our fundamental research efforts, as most recently highlighted by our decision to book gains on the long side of Brazil (EWZ), which has dropped -5.6% since we booked an +11.2% gain in this bullish research recommendation on June 3rd and on the short side of Japan (DXJ), which has risen +10.9% since we booked a +0.1% gain in this bearish research recommendation on May 28th. Moreover, we’ve been implicitly negative on the former since our July 14th note titled, “SELL BRAZIL?”; the EWZ ETF has plunged -12.2% since then.
As part of our nascent quest to populate our idea list with emerging market short ideas, we walk through why we think South Africa is a prime candidate in the sections below.
Our Model Suggests South Africa Has the Greatest Degree of Structural Economic Risk Among Emerging Market Economies
Unfortunately, we continue to lack a crystal ball, magic wand or rabbit’s foot with respect to making calls on emerging markets. That being said, however, we do possess what we continue to believe is the most robust model for quantifying risk across emerging market economies (i.e. our EM Crisis Risk Index).
And on this model, South Africa scores most poorly at the current juncture:
South Africa’s key risks are concentrated in Pillar I (i.e. external sector risks) and Pillar IV (i.e. political and regulatory risks):
One of South Africa’s key issues is the fact that policymakers have failed to respond to ~18M of consensus expectations for [and actual] US monetary and fiscal policy tightening with credible tightening of their own. The current account deficit is actually wider now as a percentage of GDP versus its TTM average (-6.2% and -5.6%, respectively), while the sovereign budget deficit is little changed as a percentage of GDP versus its TTM average (-4.9% and -5.1%, respectively).
Now, the country is at risk of meaningful capital outflows, while at the same time seeing reduced current account inflows from falling commodity prices. It’s worth noting that raw materials account for over half of South African exports (55%), with the slowing Chinese economy being its key export market at 14% of the total.
In light of the aforementioned dynamics, it’s no surprise to see the South African rand (ZAR) has dropped -5.2% vs. the USD over the past month; that’s the third worst spot return of the 24 EM currencies tracked by Bloomberg. We anticipate further downside over the intermediate term.
Our Model Suggests Cyclical Risks Are Mounting As Well In South Africa
The South African Reserve Bank (SARB) finds itself in quite the policy conundrum. On one hand, the Monetary Policy Committee (MPC) is projecting full-year growth in a range of +1.5-1.7%, which would be the slowest pace since 2009. On the other hand, inflation has exceed their +3-6% target for the past five months.
Layer on the fact that the SARB needs to find a replacement for Governor Gill Marcus who is stepping down from her post in November after just one term, and we clearly have a central bank that is squarely under pressure from both an economic and political standpoint. Pressure bursts pipes in emerging markets.
One key overhang on South African growth specifically are “managed” blackouts that are weighing heavily upon Industrial Production growth and Business Confidence trends. The state-owned Eskom Holdings SOC Ltd, which provides 95% of the country’s electricity, is facing a 225B ZAR ($20B) funding shortfall through 2018, which is forcing it to ration power during peak periods. Its 33.2 gigawatts of daily available capacity in the YTD is a mere 4% above estimated peak demand of 31.8 gigawatts, which is well shy of the 15% international norm. The current blackouts are eerily reminiscent of the 2008 blackouts that forced mine closures and were declared a national emergency.
This net result of these economic factors is that we see the South African economy mired in the stagflationary scenario that is Quad #3 on our GIP model for the balance of the year.
Investment Conclusion: Short the EZA
Our Tactical Asset Class Rotation Model (TACRM) is generating a “SELL” signal for the iShares MSCI South Africa ETF (EZA). Moreover, TACRM is also generating “high-conviction SELL” signals for both EM Equities and Commodities, as well as a “low-conviction SELL” signal for Foreign Exchange. All three of these primary asset class signals corroborate the aforementioned “SELL” signal being generated for South African equities.
In the context of these quantitative signals and the fundamental risks highlighted above, we believe South African equities are great short opportunity at current prices. We see probable downside to at least the 2013 lows of $53.61 (-16.2%) over the intermediate term.
Have a great night,
Associate: Macro Team
This indispensable trading tool is based on a risk management signaling process Hedgeye CEO Keith McCullough developed during his years as a hedge fund manager and continues to refine. Nearly every trading day, you’ll receive Keith’s latest signals - buy, sell, short or cover.
Takeaway: Here are some of the more controversial slides from our 60-slide deck from last week on why we think KSS is a structural short.
Last week we hosted a conference call to review our 60-page slide deck as to why we think KSS is a short. If you’d like to listen to a replay of the call and download the full materials, please click the link below. We picked out eight slides below that are among the more controversial.
Replay Link: CLICK HERE
Materials: CLICK HERE
Point #1: Expectations Too High
Yes, near-term numbers look doable given several tailwinds facing all retailers. But one we get past this year (only four months away) we think KSS numbers will start to come down materially. The consensus has earnings growing 10% next year, while we think they will be down nearly 10%. Then they’ll be down again, and again, and again. Ultimately, once we’re past 2014, we don’t think that KSS will earn $4 again until the tail end of the next economic cycle.
Point 2: Losing Share At A Faster Rate
It’s no secret that department stores are losing share of wallet (3.5% of Retail Sales vs 10% a decade ago), but KSS is losing share within that context. The blue line in the chart below shows KSS’ share gain of the department store space. The first big bubble – from 1Q09 to 4Q10 – came about 3-years after a meaningful square footage growth spurt. That’s when the stores began to hit the sweet spot of the maturation curve. Then the next bubble came a little over a year later when KSS gained what we think (based on our surveys) is $1bn in share from JCP. Our latest survey shows that about $150mm has shifted back to JCP – but that still leaves $850mm at risk for KSS. The punchline is that after gaining share of this space every single quarter since its inception, KSS is now a net share loser.
Point 3: This Model Is Broken
There’s no square footage growth – at all. Productivity of $210/ft in brick and mortar stores is trending down. E-commerce is the only growth engine, but unfortunately it is the lowest margin business at KSS by a country mile. As such, gross margins are structurally headed lower. SG&A can’t be cut in line with the gross profit erosion. D&A was just lowered from $950mm to $900mm – which is stunning in itself. That’s not likely to go down much further. Cash flow still remains healthy enough to buy back 7% of the stock this year. Buy with lower net income, we think that repo/financial engineering gets cut by better than 50% for the duration of the model. EBIT should be down 5-8% each year, with share count making up about 3% of the gap. Net/net = EPS declining every year.
Point 4: Store Productivity Bifurcation
Sales per square foot have been flat for the past four years, but that is only if you include e-commerce. Brick & Mortar productivity is $210, and is at the lowest rate we have ever seen it. There is absolutely no valid argument we can find that this turns around – particularly given that JCP is sitting at just $108 in productivity and has KSS right in its sights. We think those two will converge over time.
Point 5: New Brands – Juicy and Izod
This topic absolutely dominates the information flow around KSS. We all know that Juicy Couture and Izod are now available at KSS. That said, our consumer survey shows Kohl’s purchase intent is down year/year, while retailers like JC Penney and Macy’s are up meaningfully. So we know about the brands – but consumers might not know, or might not care. Nonetheless, let’s keep in mind that there’s noise around new brands EVERY year at Kohl’s. Take a look at the graphic below. Could this years’ additions be better than last years? Possibly. But keep in mind that Izod and Juicy are not exclusive. Izod is all over Macy’s and JC Penney’s. Juicy is in the process of growing distribution through new owner Authentic Brands. To get a good read you need to quantify the impact (see next exhibit).
Point 5b: Quantifying Juicy and Izod
We know that these brands occupy 525 sq ft and 700 sq ft, respectively, inside the average KSS box. That’s 1.42% of KSS’ total square footage. Now…it can’t just create space out of nowhere, which means that it needs to take out product that is underperforming – but is still productive. Assuming that these brands generate $225/ft in productivity, and that it is replacing private label brands that are doing $110 per foot in the same space, we build up to about $250mm in incremental sales in another two years. That’s about 1.3% accretion to sales, but it comes at a lower margin as these national brands carry lower profitability than the portfolio as a whole. The bottom line = it’s going to take a lot more than a couple of mediocre brands to salvage KSS’ top line.
Point 6: Structural Margin Decline
Gross margins on KSS’ e-commerce business run about 1,200bp below the store-level margins. Some people are hoping/banking on a margin rebound as KSS did not seemingly benefit from the same tailwind the rest of the group has over the past five years. The truth is that it has. Without that tailwind we’d be looking at KSS with margins near 5-6% today. The industry tailwind was masked by the massive growth in KSS’ e-commerce business. In fact, from ’05-’13 KSS put up the highest growth rate of any ecommerce business in the US throughout all of retail. But as this business continues to grow 15-20% annually (the only line item to grow aside from SG&A) it naturally depresses aggregate GM% by 30bps per year. Those are margin points that this model can’t afford to lose.
Point 7: Keep An Eye On KSS Credit
Many retailers have, or maintain, credit cards. It’s a solid tool to keep customers and incentivize them to spend more. But our consumer survey suggests that 18% of KSS shoppers have a rewards card. But more importantly, we know that 57% of purchases are made by that card. That is a simply staggering figure from where we sit. Three years ago KSS shifted its partnership from Chase to Capital One. But median credit scores for Chase customers range between 700-750, which are optimal for a mid-tier retailer. But the 700bps in card penetration that KSS saw under Capital One came at a median credit score of 600-650. Basically, this tells us that incremental sales growth is likely coming from more marginal consumers. This is not exactly a smoking gun on the short side, but taken in context with the other pressures we see to the model, it certainly does not bode well.
Earlier we conducted a Flash Call on the European risks facing RCL and CCL. The link below is the replay of our call.
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