Takeaway: The Greatness Agenda is neither investable nor believable. 35% EPS downside. Stock downside/upside is 3 to 1. We’d press this one here.
Conclusion: We went into this meeting expecting to hear at least a few points that would go toe-to-toe with our Short call. But management spent the better part of seven hours articulating (despite its intentions) why it has Zero competitive advantage. We still don't think there's a viable financial plan, and if there is one, we have less confidence today in the company's ability to execute on it. What we do know is that this management team comes across as being extremely comfortable being very mediocre. Guidance implies 2017 EPS of $5.30, which our analysis suggests is a pipe dream. Our math gets us to $3.50. This should be a $35 stock -- a level that does not provide meaningful cash flow yield support relative to where other names in this space have traded. With at least 3 to 1 downside upside, this remains our top short in retail.
Well...if you were wondering why KSS does not regularly host analyst meetings, now you know. While Hedgeye was not physically present at the event (having a short call and 60 page slide deck doesn’t get you a seat in the room with KSS) it was still easy to hear the oxygen get sucked out of the room on a number of occasions via webcast. Yes, it was that bad.
We went into this one looking for areas that could challenge our bear case, but could not find a single one. Though we found a few of the presenters to be high quality (Logistics, Digital, Marketing) the collective message was extremely unconvincing and unimpressive. In fact, we are not really clear as to what the message was. What we do know is that this management team comes across as being extremely comfortable being very mediocre.
We think the company’s financial targets are entirely unbelievable. The company basically guided to about $5.30 in EPS in 2017 ($21bn revs and 9% margins). So you need to believe that KSS can comp nearly 3% for three years. The last time it did this was 13 years ago when it had a base of only 350 stores, had nearly a fifth of its square footage base entering the peak part of the maturation curve, and as a kicker, was bouncing back after a recession. But the company’s targets today assume that the industry goes nine years without a major correction/reset in sales/margins. That’s never happened. Not even close. We’ve never seen a cycle go more than six years (and we’re still in it). We think that’s extremely poor risk management on the part of the team steering this ship. We think earnings will be $3.50 in 2017 – that’s 35% below guidance. And if we had to pick an over/under on our estimate, we’d say closer to $3.
Let’s say – just for a minute – that the company is right. You’re playing for a ‘goal’ of sub-3% growth and $5.30 in earnings in 3.5 years. At best that’s worth a 12x p/e, or $64 – in 3-years. Discount that back by 10% annually, and you get to $48 today – for a best-case scenario. If we’re right, then we’re looking at about 10x $3.50 in EPS. The bulls would point to the company’s cash flow as support, and that’s fair. But as the P&L gets hit, cash flow comes down as well. A $35 stock suggests about a 12% free cash flow yield on our model. That’s high, but far from egregious. Dillard’s, for example, has traded in recent years at a free cash flow yield as high as 25%.
The bottom line is that we think this name is still very shortable today with at least 3 to 1 downside/upside. It remains our top short in retail.
Here are a few things that stood out for us at the meeting (in no particular order).
- Is This Really A Goal. The overreaching goal was “To Become the Most Engaging Retailer in America”. Didn’t Ron Johnson have some iteration of that mantra when he killed JC Penney and replaced it with jcp? We like setting goals that are quantifiably achievable. Nike couldn't even achieve this goal if it tried (which it's not).
- Greatness Redux. Initially we gave Kevin Mansell (CEO) credit as he started off by talking about the challenges they have faced (share too high in categories that consumers are shifting away from, and share too low in categories consumers are embracing, and relevancy of real estate). Then he flashed a slide that said “Time to Evolve” That was pretty exciting, as KSS does not evolve very well. We held our breath and thought we’d get some cool new insightful strategy. But no. We got the good ‘ol “Greatness Agenda”. It’s the same thing we hear about every conference call.
- Numbers are Not Believable. We said this above, but it's worth repeating. In fact, Mansell openly said that he did not want to give financial targets – he wanted to qualitatively show that KSS “has the right team in place to take the company into the new era of retailing”. Wes McDonald (CFO) did the right thing and put his foot down by handing out at least a few numbers, even though there’s no evidence that these targets fully address the substantial risks that KSS will increasingly face.
- Who Were They Talking To? Our sense is that the numbers that KSS targeted -- $21bn in sales in 2017 and flattish margins – represent a statement to employees more than to the financial community. They can’t get up there on stage and tell the rank and file (who are all listening in) that sales and profits will be flat to down over the next few years.
- JCP Won The Battle of the Analyst Meetings. For what it’s worth, last month JCP gave the Street 10x as much information in just three hours (whether you choose to believe it or not), while it took Kohl’s seven hours to say almost nothing.
- Nothing Unique. We can't recall hearing about a single initiative all day – whether it be product, marketing, or customer engagement -- that other retailers are not already doing.
- Stores Too Big? Kevin Mansell actually said something to the tune of “Yeah, many of our stores are probably too big. I wish they were smaller.” We think we got those words right – but if we’re off (transcript not out yet), they’re at least in the ballpark. His somewhat cavalier attitude toward the whole issue was quite offputting.
- Unlikely to Close Stores. The worst performing stores are ‘only losing a few hundred thousand dollars each.’ That’s pretty bearish as it suggests that there’s not exactly a few hundred stores they can close to meaningfully boost profitability.
- Acquisitions. They actually started talking about acquisitions. That’s just baffling. What they’re basically saying is that (and these are our words, not theirs) “we don’t have opportunities to reinvest in our own business, and are less interested in buying our own company (stock repo), so we’ll try buying other business for the first time in our history." People hanging their hat on the free cash flow yield should consider how fast the cash could go away when it’s spent on an off-price apparel chain or luxury flash-sale site.
- Frozen Love. We wish we could make our own word cloud from this analyst day, but unfortunately the transcript isn't out yet. We think the words "Love", and "Frozen" would take center stage (let’s say 24 size font) and the key words like margins, earnings, and cash flow maybe about a 6 font. Seriously, Michelle Gass, the Chief Customer Officer, literally said “Love will drive our business”. We understand that a) it's her job to talk like this, and b) she meant it in the context of caring for customers. But this was over the top.
- JCP/Share. The fact that JC Penney was not uttered all day is bothersome. That’s a consistent miss we see in Kohl’s strategy to deal with a competitor that lost $90/foot in sales over three years, and is clearly on the rebound. All of our research (including several consumer surveys) shows that KSS won (fair and square) about $1bn in revenue from KSS – half of which was online. JCP will take it back. Our surveys suggest that consumers want to go back to JCP with the right product/promotions. JCP will get the sales back, whether it earns it, or buys it. Either way it's bad for KSS.
- E-commerce is not margin accretive on the Gross or EBIT level. Management wouldn't quantify, but did characterize it as worse than in store. Plus it cannibalizes sales from it's brick and mortar business. The company validated our survey research. 96% of shoppers who don't visit the store will not shop online. With a fully extended store base how do they attract new customers? We don’t think the answer is personalization. We did a lot of work on this one in our recent report. Click here for the link.
- Loyalty Math. Initial loyalty sign up numbers are impressive with 5mm added in new markets over the past 21 days. 58% of the now 15.5 million members are non-credit users. But, take into consideration that there are 30mm active credit card members. That implies that 21.7% of active credit card users are now card carrying members of the Y2Y. Credit accounts for 57% of purchases and offset SG&A by $407mm in 2013. Any shift by the customer away from the Credit program to loyalty (they get basically the same deals without a 24% APR) would be a significant margin headwind.
- Two Conflicting Initiatives. ‘Buy-online and pick-up in-store’ and ‘store vs. same day ship’. Our research on buy-online, pick-up in-store (See our Department Store deck from last week) indicates that the #1 reason for choosing this option is free shipping. #2 and #3 on that list, faster fulfillment and convenience, are solved by same day delivery. Shipping costs are already below the rest of the industry average at $75 and we think that goes lower before it goes higher. Which offsets the incentive to pick up items in store.
Takeaway: We remain the “low on the Street” w/ respect to Q3 and Q4 GDP and continue to expect a negative re-rating of consensus growth expectations.
Today at 8:30am EDT, the BEA will release its advance estimate for Q3 GDP. There is a distinct possibility that this pre-midterm election print has the potential to appear optically strong; there is also a distinct possibility that any strength is likely to be conveniently revised down on November 25th (second estimate) and/or on December 23rd (third estimate)...
Ignoring all of that, we remain content to side with our models and the data, which continue to suggest domestic economic growth slowed in the third quarter and is likely to continue slowing here in the fourth quarter.
Our GDP estimates for Q3 and Q4 both have 1-handles; only one of the 84 Bloomberg contributor estimates for Q3 has a 1-handle and only four of the 84 Bloomberg contributor estimates for Q4 have a 1-handle. On a median basis, the Street is expecting +3% QoQ SAAR for both quarters – the same figure consensus is expecting for each of the next six quarters!
The sell-side is forecasting one helluva recovery; hopefully these GDP estimates aren't underpinning bottom-up modelling expectations for metrics such as Facebook's ad revenue growth across the buy-side...
Our GIP Model: Bearish
Like growth, we anticipate that reported inflation will also continue to slow and the confluence of this double-negative from a 2nd derivative perspective puts the U.S. economy squarely in #Quad4 on our GIP Model – which is an expectation we’ve gotten increasingly loud about at every opportunity since early August:
The Data: Bearish
Moving along – if for no other reason than the fact that it’s late on the east coast and I’d like to get some rest – let’s quickly go through a series of the most relevant high-frequency growth indicators as it pertains to our expectations for Q3 GDP and our outlook for the current quarter (and beyond).
Manufacturing PMI (we like to use the Markit data series because it’s both seasonally adjusted and usually released over a full week ahead of its widely-followed ISM counterpart): Decelerating on both a sequential and trending basis.
Services PMI (we like to use the Markit data series because it’s both seasonally adjusted and usually released over a full week ahead of its widely-followed ISM counterpart): Decelerating on both a sequential and trending basis.
Economy-Weighted Composite PMI (we like to use the Markit data series because it’s both seasonally adjusted and usually released over a full week ahead of its lesser-known ISM counterpart): Decelerating on both a sequential and trending basis.
Industrial Production: Accelerating on a sequential basis; decelerating on a trending basis.
Real Wages: Accelerating on both a sequential and trending basis.
Retail Sales: Decelerating on both a sequential and trending basis. So much for the Consensus Macro “gasoline tax cut” narrative…
Consumer Confidence: Accelerating on both a sequential and trending basis. In the context of secular trends, however, this strength is a total head fake and indicative of where we are in the economic cycle (i.e. late).
Business Confidence: Decelerating on both a sequential and trending basis.
Exports: Decelerating on a sequential basis; accelerating on a trending basis. Recent weakness is unlikely to subside with #StrongDollar, #EuropeSlowing, #JapanSlowing and #ChinaSlowing all occurring simultaneously.
Imports: Decelerating on both a sequential and trending basis. With import price growth running at -0.9% YoY, this weakness is not indicative of the “credit-driven resurgence in consumer demand” or the “strong holiday shopping season” Consensus Macro keeps telling bedtime stories about.
Durable Goods: Decelerating on both a sequential and trending basis.
Nonfarm Payrolls: Accelerating on a sequential basis; decelerating on a trending basis.
Jobless Claims (NSA YoY): Decelerating on both a sequential and trending basis. This strength should be tempered by the fact that claims are fast approaching frictional resistance of ~300k on a trending basis, which implies a recession is likely just 2-4 quarters away.
Investment Conclusion: Bearish
After this highly objective look at the data (please email us if you disagree with the methodology and have a better way to analyze it), it’s clear to see that U.S. growth is slowing and the broad-based decline in sequential momentum across a variety of indicators implies further slowing – especially in the context of a more-stringent base effect here in Q4.
Unfortunately for consensus bulls, the Fed just took away its QE drugs, and, in the context of the FOMC’s newfound emphasis on “data dependency”, our analysis suggests it could be at least 2-3 months before they sign off on more easing.
On that note, it’s worth reminding investors that: A) #Bubbles in small-to-mid-cap illiquidity tend to misbehave #Quad4; and B) short-IWM/long-TLT remains our highest conviction macro call of the year – after having made the exact opposite call throughout 2013.
Good morning to our subscribers across Europe. Good night to those still grinding away on the West Coast; we are looking forward to visiting you next week.
Associate: Macro Team
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Consensus estimates, management guidance and commentary, and questions for management in preparation for the earnings release tomorrow.
Please see our note: http://docs.hedgeye.com/MGM_3Q_PREP.pdf
Takeaway: A frightening chart in the context of near-universal bullishness on U.S. equities.
Editor's note: Below is a brief excerpt from a recent research report written by Hedgeye senior macro analyst Darius Dale. You can read the note in its entirety here. On the house. If you would like to learn more about leaving the vulnerable consensus herd once and for all and become a subscriber to the fastest growing independent research firm in America click here.
The current stock market trajectory overlays almost perfectly with its late-2007 analog – which is the last time consensus was as wrong on the outlook for domestic economic growth as they are today.
Takeaway: Should report a decent 3Q. FY 2014 yield guidance range may be narrowed but the focus will be on the undervalued Prestige combo in 2015
Consensus estimates, management guidance and commentary, and questions for management in preparation for the earnings release tonight.
Please see our note: http://docs.hedgeye.com/HE_NCLH_EarningsPrep_10.29.14.pdf