Variance And Contentions

“Certainty is the mother of quiet and repose; uncertainty the cause of variance and contentions.”

-Edward Coke


Edward Coke was Chief Justice of the King’s Bench in the early 17th century. His aforementioned quote is dead on when I think about it in the context of modern central planning ideology.


Many want un-elected bureaucrats and benches (like the Federal Reserve) to deliver them the elixir of certainty, quiet, and repose. Unfortunately, markets and economies can’t be centrally planned that way. They are grounded in uncertainty and contention.


“Variance” was a thoughtful word for a judge to be using way back then. It’s too bad that the Fed doesn’t talk in these terms. Variance (how far a set of numbers spread out) and correlation risks are at the heart of what modern Macro Risk Managers think about every day.


Variance And Contentions - EL chart 2


Back to the Global Macro Grind


The variance between how political types talk about market risks and how practitioners on the buy-side explain them continues to widen.

That’s not a good thing. With time, humans aren’t supposed to get dumber.


That said, into both the almighty central planning decision tomorrow (Fed meeting) and Q3 GDP report this week, “should I be turned into a vegetable or a happy imbecile?” (Taleb, pg 61 of Antifragile)


Great question! I actually get asked some version of that question, a lot. Bob Brooke, Darius Dale, and I spent all of yesterday meeting with Institutional Investors in Boston. And one of the underlying questions remains – ‘what if it’s different this time?’


A: It’s not.


What we call #Quad4 deflation is like gravity – it occurs slowly, then all at once.


One of the best ways to observe which “Quad” the market is trending towards is through what modern day risk managers call Sector Style Factors (the variance of the stock market’s sector returns):


  1. When Sector Variance is LOW (like all-time lows in 2013) a monkey can be right on the long side (every sector goes up)
  2. When Sector Variance is RISING (like now), sector returns diverge, and momentum monkeys fall from the trees


Low-variance is the birth-child of compressed (low) volatility. And, to a large extent, that’s what the Fed is trying to promise you, in perpetuity. How else could an un-elected ideology live, unless it delivered political “certainty”, forever!


Then, non-linear market risks do what they do, and volatility rips +160% to the upside in 3-4 months (from the all-time #RussellBubble high of July 7th, 2014 to mid-0ctober) and the Fed needs to “smooth” that with the next central plan.


Or so they think…


And what happens when the next central plan loses credibility in delivering the one thing every political animal who has empowered the Fed is whining about when they stump about “inequality” (with the one thing being inflation)?


Oh, the #deflation.


Look at yesterday’s market action, in Sector Variance terms:


  1. Energy Stocks (XLE) down another -2.1% on the day to -7.53% for OCT to-date
  2. Basic Material Stocks (XLB) down another -2.1% to -4.68% for OCT to-date
  3. Healthcare Stocks (XLV) up another +0.1% to +2.14% for OCT to-date


Yep, since Healthcare (XLV) and Consumer Staples (XLP) are the only Sector Styles you’d be really net long of in Hedgeye #Quad4 terms right now (versus short the commodity #deflation sectors), it looks like Mr. Market is confirming a loss of the Policy To Inflate’s credibility.


And what happens after all 3 of the major central planning committees (Fed, BOJ, and ECB) have already cut to zero? Oh, it looks like Sweden is cutting to 0.00% (from 0.25% prior) this morning. Maybe European stocks can go up for another 4 hours on that.


As both volatility and variance risks are rising, the other big market risk that develops is called mean reversion risk.


In other words, now that Healthcare stocks (XLV) are +17.8% YTD (versus Energy -5.3%), prudent Portfolio Managers starts to ask themselves how much more they can pay up to chase Healthcare stocks.


Unless it’s different this time (it’s not), there are historical precedents for what people are willing to pay for things too. Enter the contentiousness of the “valuation” debate. How much are you willing to pay to not lose money?


Our immediate-term Global Macro Risk Ranges are now:


UST 10yr Yield 2.12-2.31%


RUT 1057-1127

Nikkei 149

VIX 14.34-28.05

WTI Oil 79.79-81.84


Best of luck out there today,



Keith R. McCullough
Chief Executive Officer


Variance And Contentions - Chart of the Day

Hedgeye Statistics

The total percentage of successful long and short trading signals since the inception of Real-Time Alerts in August of 2008.

  • LONG SIGNALS 80.52%
  • SHORT SIGNALS 78.68%

KSS - It'll Miss Again

Takeaway: We'll take 3Q #'s, but this isn't the goal line. KSS won't earn $4/share again until the tail end of the next economic cycle.

We'll definitely take this Kohl's miss, but let's not lose sight of the fact that this miss is not the goal line. KSS will miss again and again and again. The key factor that we think people are missing isn't the level of earnings today, but the duration over which earnings will remain under pressure due to the structural flaws in its business model (outlined below) that are largely beyond repair.


We still think that after 2014 KSS won't earn over $4 per share again until the tail end of the next economic cycle. And even that's questionable. Even with the sell off the stock remains our top short. 


10/27/14 07:25 AM EDT

KSS – Key Questions for Kevin and Wes

Takeaway: Don’t waste time on the CMO or 4Q comp. We’d dig into levers behind whether KSS will ever earn $4.00+ again after ’14


Here are some questions we’d ask at Kohl’s Investor Day on Wednesday. We’re giving these questions to you, because we won’t have the chance to ask them directly. In the spirit of full disclosure we sent management our 61-page slide deck outlining why we think the stock is a short. They didn’t like it very much, apparently. We're fine with that.


We’ll just sit back, listen to the webcast and see how the company’s disclosure about its business challenges or supports our thesis, and will act accordingly. But shy of some massive strategic or financial engineering announcement, we don’t see how the financial community walks away with a whole lot of ammo to think that this company can grow again after 2014 – ever. Our thesis is outlined in the comments below. Also see the link to the replay of our conference call, and the full 60-page slide deck detailing our view.


Here Are A Few Key Questions We’d Have For KSS Management


1. Q: What percent of Kohl’s brands/content do you think the Consumer would be genuinely upset to see go away forever?


Context: No, this question is not a joke. We always ask this of companies that don’t own their own content. Macy’s would probably have a very good answer for this – probably between 80-90%. But its merchants are good enough to fill that void with other content that the consumer wants. For Kohl’s, we have no idea what management would say, but we think it’s as low as 20-30%. That means that 70-80% of its sales could go away forever, and the Consumer would not miss a beat. The irony is that the brands the consumer wants – Nike, Levis, Columbia, Carter’s, Vans – could all be bought at other retailers. Or better yet, online from the brands themselves.


2. Q: Why should the current Kohl’s business model exit?


Context: Maybe you could think of a more articulate way to ask this one, but think about the history here. In the mid-1990s when KSS first roared onto the scene (as THE growth name in Retail), the bankers and analysts all pitched it as ‘an alternative to the mall’. That’s when the concept of mall traffic being in a secular decline found its way into Wall Street Retail lore, and KSS was viewed as the offset. Lower-rent off-mall property that’s much closer to home, providing an extremely attractive alternative to someone that did not want to battle the crowds in overcrowded malls. Back then, even sophisticated consumers did not know about this thing called on-line shopping (KSS IPO was three years before Netscape). Now, the alternative to the mall is something called ‘your living room’ where you shop on your laptop while binge-watching Sons of Anarchy on Netflix.


3. Q: Your e-commerce margins are about 1,200bp below company average. That’s not because you are inefficient, or the model needs to be ‘fixed’, but simply that KSS’ average basket size is too small to accommodate shipping and merchandise handling costs. The real question here is “What happens if your competition moves to free shipping and free returns? If you match that, won’t it crush your margins? If you don’t, won’t it hurt traffic/volume? How is this not lose/lose?”


Context: The evolution toward free shipping is not a function of “If” but “When”. Target is offering free shipping on even the tiniest of basket sizes over the holidays – literally, you can buy a pencil online and TGT ships it for free. AMZN will have to ultimately respond. JWN already offers free shipping both ways. Retailers won’t match each other all at once, but the trend is headed there. In that context – particularly with a weak brand portfolio – how can KSS compete at an acceptable margin?


4. Q: How many square feet of department store square footage exists today? How many should there be?


Context: A seemingly stupid question to ask a CEO. But we’re not so sure that KSS management knows the answer (or many other department store CEOs for that matter). But when 603mm square feet exists today in the department store space – down from 772mm 15 years ago – it’s a perfectly fair question to ask how many the company thinks will exist in another five years. We think we’ll see another 93mm square feet exit the industry. That’s almost as big as KSS is today. We don’t think KSS will be the casualty this time around. But it will hurt – a lot – while it happens.


Q: We’re at the back end of the current industry margin expansion cycle (we’re in year 6). As we transition into the next cycle, whenever that may be, what is the mid-cycle earnings power for this company?


Context: After 2014 passes, we don’t think KSS will ever see $4 in earnings power again. Traffic = down. Basket = deflationary. E-commerce = Up, but at a dilutive margin. No meaningful store closure or cost cutting opportunity. The only growth we see is from stock buyback – at least while the cash flow supports it. We think that KSS EPS eases into an annuity of $3.50 per share over the next five years.  



September 29, 2014



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.

KSS - It'll Miss Again - kss 1


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.

KSS - It'll Miss Again - kss 2


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.  

KSS - It'll Miss Again - kss 3 


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.

KSS - It'll Miss Again - kss 4


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).

 KSS - It'll Miss Again - kss 5


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.

KSS - It'll Miss Again - kss 6 


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.

KSS - It'll Miss Again - kss 7 


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.

KSS - It'll Miss Again - kss 8

TWTR: The Story Has Changed

Takeaway: Not for us, but 3Q14 results/4Q14 guidance raises some red flags that the street wasn’t prepared for. We remain Short.


  1. 3Q14 UPSIDE DRIVEN BY 2Q14 ACQUISITIONS?: TWTR beat consensus expectations for advertising revenues by only 2%; with y/y growth decelerating to 109% vs. 129% in the prior quarter (3Q14 also includes World Cup as well).  Much of its 3Q14 upside came from its Data segment, which grew 171% y/y vs. 91% in 2Q14.  It appears much of its guidance raise in 2Q14 may have been inorganic after all; we suspect this may become a recurring theme.
  2. 4Q14 GUIDANCE SUGGESTS AD LOAD WON’T BE ENOUGH.  4Q guidance suggests ad revenue growth will decelerate sharply from the 129% in 2Q14 to 88% in 4Q14.  There’s nothing wrong with 88% growth, but such a sharp deceleration in such a short period suggests an unraveling of its monetization strategy (rising ad load), which creates a much tougher setup for the company moving forward. 
  3. 2015 WILL BE A STRETCH (ORGANICALLY): We suspect the limitations of its monetization strategy will become more evident in 2015 as management struggles with balancing ad load vs. user growth.  The 67% revenue growth consensus is assuming for 2015 will be a stretch organically. Acquisitions could fill the void, but will the street be willing to pay up for that? This morning's pre-market action suggests that won't be the case.



Advertising revenues grew 109% y/y; yet only beating street estimates by 2%.  Note 3Q14 likely had some lingering benefit from ad campaigns around the World Cup, which essentially straddled 2Q14 and 3Q14 in terms of timing (June 12-July 13).


Still, the quarter was very strong.  Ad engagements were up over 150% y/y; reversing the concerning inflection we saw in 2Q14 when the sequential change in ad engagements lagged that of global timeline views, which suggested users were fading TWTR ads at an increasing rate.  However, that inflection wasn't particularly impressive, and it’s possible this dynamic is still occurring, but we just can’t see it in the data because TWTR may have increased ad load more than its ad engagement metrics suggest.


Data Licensing/Other Revenues accelerated sharply, up 171% y/y vs. 91% in the prior quarter.  We don’t believe the street was prepared for that acceleration, which suggests much of its guidance raise from the prior quarter may have been tied to its recent string of acquisitions.  Given that it just raised an additional $1.7 billion less than a year after its IPO, and now has $3.6B in cash and short-term investments, we suspect acquisitions may become a recurring theme moving forward.  Question is why?


TWTR: The Story Has Changed - TWTR   Ad vs. Data Revenue 3Q14 2 

TWTR: The Story Has Changed - TWTR   Ad vs. user engagement 3Q14



Management suggested that 4Q revenues will be up 28%-30% q/q in a seasonally strong quarter, which at the midpoint implies 88% growth y/y vs. 109% and 129% in 3Q14 and 2Q14, respectively.   There’s nothing wrong with 88% growth, it’s the sharp deceleration from 2Q14 that’s concerning. 


It’s interesting that 2H14 is when we’re seeing the slowdown in revenue growth.  That may have to do with TWTR comping past what we refer to as the 2Q13 supply shock, which we suspect was a colossal surge in ad load given the 124% sequential increase in ad engagements that occurred during the quarter.  Ad price and engagements are near perfectly inversely correlated (-.87 correlation since 2Q12), and we suspect this relationship suggests a supply-demand dynamic (we estimate ad engagements are a proxy for supply).  We don’t believe it’s a coincidence that y/y ad revenue growth is slowing precipitously now that we’re a year past 2Q13.  


If ad load has been the driver of its recent strength, then that puts management in a box.  The street has been punishing the stock whenever its user metrics aren’t accelerating, so the company can’t risk increasing its ad load too much for fear of pushing the casual user away.  Only ~50% of its MAUs use twitter daily, which means much of its user base is on the fringe.  In short, there may be a perverse relationship between revenue and net user growth moving forward…Maybe this is why TWTR is raising capital.


TWTR: The Story Has Changed - TWTR   Ad Engagement vs. Pricing 3Q14

TWTR: The Story Has Changed - TWTR   Ad Load vs. US MAUs 3Q14



We suspect the limitations of TWTR's monetization strategy will become more evident in 2015 as management struggles with balancing ad load vs. user growth.  Further, TWTR will be comping past the World Cup in 2Q15/3Q15, which we believe is an underappreciated headwind.


We believe the 67% revenue growth consensus is assuming for 2015 will be a stretch organically.  User growth will naturally slow from here, while growth in automated accounts should continue to pressure engagement (timeline views/MAU).  So the void must be filled by monetization, which is where we are seeing the most pressure across its model.


Acquisitions could potentially fill the void; we suspect this is why TWTR raised an additional $1.7B in capital when it already had roughly over $2.2B in cash and S/T investments on its balance sheet.  This ads an extra level of risk being short into the 2015 guidance release, but the question is whether the street is willing to pay up for inorganic growth? TWTR's pre-market action this morning suggests that won't be the case.


TWTR: The Story Has Changed - TWTR   HRM vs. Consensus 3Q14


Let us know if you have any questions, or would like to discuss in more detail. For additional detail on our thesis, see the two notes below.  


Hesham Shaaban, CFA




TWTR: Has the Story Changed?

09/17/14 08:51 AM EDT


TWTR: What the Street is Missing

05/19/14 09:09 AM EDT


New Best Idea: Short CHUY (Corrected)

Takeaway: We’re hosting a flash call, Wednesday, Oct. 29th at 11:00am EST. Dial-in details and associated materials to follow.

We’ve covered the majority of our shorts in the casual dining space, but remain bearish on a select few stocks.  Today, we’re adding one of these names, CHUY, to the Hedgeye Best Ideas list as a short.


Three Key Points:

  1. In addition to being phonetically challenging, the Chuy’s brand is having difficult generating awareness is new markets.  The street is assuming that other states will be able to produce the same levels of revenues and returns generated in its core market (Texas) as it pursues its nationwide expansion plans.
  2. The issues associated with a disappointing 2013 class of restaurants are not a one quarter issue.  In fact, AUVs have declined every single quarter since 4Q12, a trend we believe will persist for the balance of 2015.  The concept has already proven it doesn’t travel well, suggesting growth expectations are being overvalued in the marketplace today.  Considering an onslaught of new, underperforming restaurants, the cost structure of the company is deleveraging.  This, coupled with increasing food and labor costs, likely means that more margin deterioration is on the way – precisely what the street is missing.
  3. Trading at 33x consensus NTM EPS, CHUY is currently one of the most expensive publicly traded casual dining stocks.  The company has maintained a premium valuation despite declining AUVs, returns and consensus EPS estimates.  Furthermore, we believe 2014 and 2015 earnings estimates are too high, which would imply this 33x multiple is closer to 39x by our estimates.  We see 30-40% downside in this name and believe 3Q14 earnings will be the catalyst the shorts are looking for.


CHUY has been on our Long Bench for the majority of 2014, until recently when we spotted several disconnects between the street’s expectations and reality.  For this reason, we believe the current issues the company faces will take longer to correct than most are giving them credit for.  At 39x NTM EPS, we believe there are too many risks in the current business, and the future of the business, to support such a multiple.  Importantly, we believe 3Q14 earnings will be the downside catalyst shorts are hoping for.


Our short thesis focuses on the following:

  • Disappointing new unit productivity
  • Cash burn necessitates the current new unit growth rate
  • Rampant support from the biased bulls (read: high expectations, aggressive estimates)
  • Significant insider selling
  • Strong sell-side sentiment and unjustified premium multiple
  • Significant food inflation (dairy, beef, avocados, produce)
  • Overly optimistic consensus food and labor cost assumptions in 2H14
  • A lack of leverage in the business model considering higher year-over-year G&A, D&A and pre-opening spend
  • Aggressive 2H14 and 2015 EPS estimates
  • Approximately 30-40% downside to the name


We’re in the early stages of this earnings season and, so far, we’ve seen bigger casual dining chains posting slightly stronger sales trends than a year ago.  While this trend is important to consider, some of this sales growth is coming at a significant cost to margins.  To that extent, Wyman Roberts, CEO of Brinker, recently said on the company’s earnings call: “If you look at NPD numbers 12 months rolling August, the category hit the highest deal rate that it’s ever hit, and some players in there are reaching some pretty aggressive numbers.”


So while gas prices may be helping the macro picture, it’s undoubtedly difficult to gauge the impact that increased discounting is having on several players in the industry.  What we do know, however, is that discounting is never good for margins.


Chuy’s looks to be one of the promising companies that can beat on the top-line, however, we suspect it will miss on margins and earnings.  The bulls on CHUY will likely point to stronger industry trends and the unexpected price increase management enacted sometime in September (we believe) to help mitigate the margin pressure the company is facing.  While both of these may likely occurred in the quarter, it will not be enough to save it. 


The underperformance of new units, in addition to lower margins, puts the company in a difficult spot, increasing the need for the company to tap the capital market in order to deliver on aggressive unit growth plans.  Over the past 12 months, capital spending has grown by 29%, while the cash burn has more than doubled to $12 million.


From a sentiment standpoint, one issue of concern on the short side is the 18% of short interest.  The average casual dining chain is running closer to 9.8%, so Chuy’s issues are fairly widely known.  Given the massive declines we’ve seen in restaurant stocks this year (with higher short interest) and the fact that insiders have been selling shares faster than gazelles, we believe the short side is a much better place to be.


We look forward to sharing more with you on the call.


Howard Penney

Managing Director


Fred Masotta


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