October 28, 2014

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Equity Market Bounce

Client Talking Points


The sector variance in the U.S. stock market has completely blown out – yesterday’s -2.1% drop in Energy (XLE) to -5.3% year-to-date vs. Healthcare (XLV) hanging out at the rafters +0.1% to +17.8% year-to-date has a lot to do with #Quad4 deflation.


Copper is bouncing to lower-highs this morning as Chinese stocks had their 1st up day in 6; looks like a selling opportunity anywhere north of $3.09/lb – which is consistent with our SELL Old China (buy New China) theme + commodity deflation.


After opening “up” yesterday, then getting smoked into the close, they bounce them again as Sweden cuts rates to 0.00% - yet everyone knows that isn’t going to do a darn thing for the economy; keep selling European equities on green.

Asset Allocation


Top Long Ideas

Company Ticker Sector Duration

The Vanguard Extended Duration Treasury (EDV) is an extended duration ETF (20-30yr). U.S. real GDP growth is unlikely to come in anywhere in the area code of consensus projections of 3-plus percent. And it is becoming clear to us that market participants are interpreting the Fed’s dovish shift as signaling cause for concern with respect to the growth outlook. We remain on other side of Consensus Macro positions (bearish on Oil, bullish on Treasuries, bearish on SPX) and still have high conviction in our biggest macro call of 2014 - that U.S. growth would slow and bond yields fall in kind.


We continue to think long-term interest rates are headed in the direction of both reported growth and growth expectations – i.e. lower. In light of that, we encourage you to remain long of the long bond. The performance divergence between Treasuries, stocks and commodities should continue to widen over the next two to three months. As it’s done for multiple generations, the 10Y Treasury Yield continues to track the slope of domestic economic growth like a glove. We certainly hope you had the Long Bond (TLT) on versus the Russell 2000 (short side) as the performance divergence in being long #GrowthSlowing hit its widest for 2014 YTD (ex-reinvesting interest).


Restoration Hardware remains our Retail Team’s highest-conviction long idea. We think that most parts of the thesis are at least acknowledged by the market (category growth, real estate expansion), but people are absolutely missing how all the pieces are coming together to drive such outsized earnings growth over an extremely long duration. The punchline of our real estate analysis is that a) RH stores could get far bigger than even the RH bulls seem to think, b) Aside from reconfiguring 66 existing markets, there’s another 19 markets we identified where the spending rate on home furnishings by people making over $100k in income suggests that RH should expand to these markets with Design Galleries, and c) the availability and economics on large properties for all these markets are far better than people think. The consensus is looking for long-term earnings growth of 28% -- we’re looking for 45%.  

Three for the Road


TREASURIES: 10yr = 2.25%, remains in crash mode, -26% YTD (long $TLT)



Sometimes it's just enough to smile sincerely.

-Mike Dolan


66%, the percentage of teams to win the World Series after winning Game 5 and breaking a 2-2 tie. The San Francisco Giants did just that Sunday night, and they play the Kansas City Royals tonight in Game 6.

CHART OF THE DAY: Variance And Contentions


CHART OF THE DAY: Variance And Contentions - Chart of the Day

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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

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