Nearly all the factors that kept this stock grinding higher while estimates came down last year are either slowing, or flat-out reversing, on the margin. We really like the 3/1 odds on the short side.
We think Carter’s is shaping up as a short again. After nearly a year of perceived positive factors at its back, we think that opacity related to organic earnings power will be gone, and competitive challenges will emerge at a time when it is shifting away from harvesting its prior investments, and will need to put capital in to its model that will put a ceiling on margin improvement at a minimum, and likely create meaningful downside if our industry call for increased competition and margin pressure comes to fruition. With that, sales deceleration is a near certainty barring another acquisition, and valuation is sitting near the seven-year peak.
We say ‘shaping up as a short again’ with full awareness that it did not do what we thought it should have done in 2011. In fact, we went into 2011 with estimates for the year at $1.75 and the consensus at $2.40. By year’s end, the Street came down, and down and down by 21%, and CRI earned an adjusted $1.94 (before $0.15 Bonnie Togs accretion). Yet the stock literally defied gravity and went the exact opposite direction – gaining 35% for the year (vs. virtually flat performance for S&P, RTH and the MVRX).
If there’s one rule of retail investing that we’ve learned over time, it’s that earnings revision is the key factor in determining the direction of a stock. Pull up the <EEG> function on your bloomberg. With 9 stocks out of 10, you’re going to see that the stock price tracks (or leads) earnings in a very tight band. Take a look at NKE, AAPL, GIL earnings revisions vs. the stock (all courtesy of Bloomberg).
Now look at CRI. HUH?
Whenever we talked to people about this name, we were given the same bull factors ad nauseam:
1) The company had the toughest COGS comps in 2H11, in advance of which it took up prices by 10%. In doing the math, a 10% increase on a $10 product at retail almost entirely outweighs a 25% increase in a $3-4 product cost.
2) At the same time, CRI was boosting its off-price sales from 1% of total in 2010 to 4% in 2011, and while this would ordinarily be dilutive to margins, it was enough to help leverage SG&A.
3) While both of these two factors played out, CRI benefitted from the addition of the Bonnie Togs acquisition, which boosted sales by an average of 6% per quarter – again, a factor that (with some minor cuts to acquired SG&A) helped leverage SG&A at the greatest rate in nearly a decade.
4) And how could we forget the ultimate response? “The market is flat, I’m clawing to hang on to my return/loss for the year, and you expect me to short the stock of a company that Berkshire Partners is not-so-slowly taking private?
Now what have we got?
1) The good news is that CRI starts to anniversary its higher product costs (that’s the bull case), but unfortunately, it starts to anniversary its pricing initiatives as well. It’s all too often that people adjust one without the other. There are, after all, two components to gross margin. Costs are forecastable. But prices to consumers – especially for a company where 40% of sales come from vertically-owned-retail – are DEFINITELY not.
2) Off price sales should come down from 4% of sales last year, to about 2% this year. Yes, that’s good for gross margin. But on top of other factors impacting top line, it will make any form of SG&A leverage very difficult.
3) Bonnie Togs is still there. But it is officially anniversaried. Now it and Carter’s each need to grow on their own without the benefit of basic acquisition accounting helping the situation.
4) Expectations are lofty – at or above company guidance for sales and EPS.
- Revenue: Consensus at $2,370mm – ABOVE guidance of $2,300mm – $2,342mm.
- EPS: 2012 Consensus at $2.61 – ABOVE guidance of $2.51-$2.61
- Consensus EPS of $3.28 for 2013, and $3.63 for 2014. We’re at $2.70 and $3.00, respectively.
- With all these other factors no longer in CRI’s favor, we have a tough time stomaching the premise that the <EEG> chart on bloomberg maintains its scant correlation under these circumstances with a 20% earnings reduction.
- If our estimates prove right, there’s no reason this stock can’t see the low-mid $30s. But under the most bullish consensus expectations, we still have a tough time getting this name in the upper $50s. We like the 3/1 odds of a short here.
5) And lastly…the “Berkshire is Buying” argument is pretty much dead in the water. Yes, they’re selling on the margin.
Historical context is important here...
We were asked a couple of weeks ago by a top client as to why CRI traded at such a high EV/Sales ratio (2.1x) circa 2005. Our answer sounded something like this:
This was when CRI achieved cult stock status. There were several factors, all related to post IPO action.
The pitch on the IPO was…
a) Shift away from basics into playwear
b) Shift from traditional dept store biz to serving 1) mass channels, and 2) company-owned retail.
c) CRI had new arrangements with Li&Fung – through which it cut its sourcing costs by nearly 1/3 and passed right through to consumers in the form of lower prices to gain share.
d) Remember that this period (ending April 2007 when LIZ went Ka-Boom) was easy for apparel retail. You could be an average brand and run at peak margins without much effort. The environment allowed CRI to sell into three completely distinct channels with like product without stepping on each other’s toes – and the Street was not only oblivious, but it also gave CRI’s multiple credit for this as a big positive.
e) Then in 2005 CRI bought Osh Kosh. In the ensuing 2-years, they cut employee count from 400 to less than 100. Margins went up temporarily, before growth slowed and the story became outwardly and visibly broken.
f) Pretty soon thereafter, people realized that this name was not infallible – that it can’t sell the same stuff through Target, Kohl’s, Macy’s and its own stores -- and that it can’t cut costs to keep margins high in the face of slowing growth.
g) Fred Rowan (CEO) got fired in 2008, and since then, the Mike Casey era has taken hold. Definitely a better regime. But there was just as much financial engineering as anything else (he was former CFO). CRI had to button up policies due to a markdown irregularity accounting issue w KSS, as well as an exec being charged with fraud and insider trading by SEC in 2010. Nonetheless, it’s got a long way to go before it’s worthy of ‘cult stock’ status again. Our point is that today it is sitting at 1.25x EV/Sales. That’s well below the prior peak of 2.1x, but the old peak is just that…the OLD peak. It need not apply any more.
Playwear has nearly doubled as a percent of CRI’s total over the past ten years. ‘Baby’ is a very defendable business – the Carter’s brand goes a long way with a new Mom swaddling her newborn. But in the Playwear category, it competes with everything from Children’s place, to Old Navy, to JC Penney and Wal-Mart private label. Not a place to hang your hat on.
Just listening to the Arcos Dorados call last week, it was clear that Brazil was the topic du jour. The country was referenced 36 times during the 1Q11 conference call versus 13 times in the 1Q10 earnings call. We think that two key risks exist for ARCO (with repercussions for MCD); in the near term, management may need to bring its same-restaurant sales guidance lower while in the longer term, we believe that unit growth may be overly aggressive. In that case, margins and returns will deteriorate.
Brazil is a very meaningful market for Arcos Dorados, representing 67% of the company’s EBITDA and 35% of its total units. Same-store sales are running at 1% in April versus 9.2% in posted for 1Q. As the chart below indicates, the top-line trend does not look positive for Arcos Dorados.
So what is it that ails McDonald’s in Brazil? Management pointed out that “we experienced a noticeable slowdown at the end of 2011 which continued into the month of January.” The company attributed this to “a temporary low in Brazilian consumer spending, which picked up in February and is expected to accelerate through the remaining quarters.” What’s confusing to us is that government data detailing consumer spending during the same quarter showed a significant acceleration in 1Q.
Not only did consumer spending rise, but the services sector expanding in April also. Moshe Silver, our Portuguese-speaking Chief Compliance Officer and Managing Director, recently informed us that Brazil’s services sector PMI advanced to 54.4 in April, up from 53.8 in March, seasonally adjusted. This compares to the industrial sector PMI, which declined from 51.1 in March to 49.3 in April, even as the government implemented stimulus programs.
With all of this in mind, taking into account what other consumer companies are seeing, McDonald’s recent fortunes in Brazil are all-the-more perplexing. Lapping last year’s highly successful Big Mac promotion of last year is a big difficulty for Arcos Dorados but this slow down seems to be reflective of more than tough comps. On a year-over-year basis, the company is emphasizing its “value platform” much more, which has been a tried-and-tested strategy of McDonald’s when trends slow. With same-store sales trending at 1%, traffic does not seem to be booming for ARCO. Current guidance is still calling for high-single digit comps this year; this seems like a stretch to us.
Below we have provided a selection of quotes from consumer-facing businesses in Brazil. The commentary from each of these companies does not rhyme with the weakness that ARCO is highlighting. The corollary from this is that the pain McDonald’s is feeling in Brazil could be self-inflicted. It is difficult to prove, but the first factor that springs to mind as a possible driver of this is the overbuilding of stores. As the chart below illustrates, Arcos Dorados have been aggressively growing its unit count over the past three years. The boom in building came at a time when the Brazilian economy was very strong and, if there is now an oversupply of McDonald’s restaurants, it could be a problem for ARCO’s return on its investment. If an oversupply of units is not behind the slowdown in McDonald’s business in Brazil at the moment then it likely will be if the trajectory of new unit openings continues with comps in low-single digit territory.
While this is a difficult thesis to prove, we think it is likely that slowing new unit growth could be a tactic pursued by management if comps fail to pick up next quarter.
WHAT ARE OTHER CONSUMER COMPANIES SAYING ABOUT BUSINESS TRENDS IN BRAZIL:
As the commentary, below, states, consumer-facing companies in Brazil did not highlight any macro weakness as a reason for softness in business trends. The only factor that was offered by way of an excuse was the unseasonably wet weather in January.
Starbucks: I think we're quite encouraged with what's going on in the Americas on a macro level in markets like Brazil. And in Latin America, markets continue to perform well with strong comp growth and a long runway for additional stores. In fact, our comp growth in Brazil is outpacing our expectations, which is evidence that our stores and brand continues to be well-received.
Starwood Hotels & Resorts Worldwide, Inc.: Latin America continues to be our fastest-growing region with RevPAR up 14% in Q1. Brazil and Chile were both up over 20% with double-digit rate growth. Business and leisure travelers are returning to Mexico where RevPAR grew 17%. Occupancies at our resorts were up almost 1,000 basis points. U.S. groups are once again looking at Mexico as an attractive destination. Argentina lags and we are monitoring the situation closely. At this point, all indications are that Latin America will remain our fastest growing region.
Fidelity National Information Services, Inc.: Brazil was very strong. We're continuing to see nice growth in both not only accounts but also transactions. We're also seeing nice growth in our EBITDA margins.
Marriott International, Inc.: Over the last 12 months, international arrivals to our hotels in the U.S. increased 7%, arrivals from Brazil were up 16%, and arrivals from China were up 32%.
Kraft Foods, Inc.: Developing markets posted a double-digit increase, led by strong growth in Latin America. Brazil was up nearly 30%, driven by strong Easter shipments and leveraging marketing campaigns supporting (03:55) 100th anniversary.
Avon Products, Inc.: Our largest market, Brazil, was us 2% in constant dollars, driven by 6% growth in Beauty, which was partially offset by double-digit decline in Fashion & Home. In Brazil, our new general manager and his team have been focused on understanding the drivers of recent performance and identifying the required steps to win competitively while delivering profitable growth.
Stoneridge, Inc.: Brazil's GNP growth has declined to an annualized rate of 2.8%, which is starting to impact the Brazilian consumer market. PST distributors and retailers are experiencing less demand for aftermarket products as the overall economy softens and they are making adjustments to their inventory positions to reflect the current market demand.
Anheuser-Busch InBev SA: Turning now to Brazil, despite, cooler and rainier weather than normal in January and helped by positive impacts from the increase in minimum wage, industry volumes grew by 3% in the quarter. We outperformed the market with our beer volumes growing by 4%; results in a market share of 69% for the quarter which represents a gain of 70 basis points versus the same period last year.
Procter & Gamble Co.: A few highlights include India delivering a 39th consecutive quarter of double-digit sales growth, Brazil growing sales over 30% and building share for the 25th consecutive period and Russia growing value share for the tenth month in a row.
Coca-Cola FEMSA SAB de CV: Our South America division delivered solid top line results in the first quarter of 2012, despite bad weather conditions in Brazil and Columbia.
Owens-Illinois, Inc.: Overall, Brazil has gone through a little bit of a coaster ride over the last couple of months. The government is clearly opening the faucet at this point in time to drive economic activity again. And certainly in the projections that we're getting from our customer base, that's clearly reflected for the latter part of the year.
PepsiCo, Inc.: Emerging markets revenue growth was particularly strong, up 13% on a constant currency basis, led by strong double digit organic revenue growth of 21% in India, 13% in Brazil, 33% in Saudi Arabia, and 26% in Egypt just to name a few.
Whirlpool Corp.: As we discussed on the last call, the Brazilian government declared an appliance sales tax holiday in December. The program originally set to expire on March 31 was extended for an additional 90 days through June 30, 2012 as expected. Irrespective, however, of the stimulus program, we continue to be very positive about the prospects for our Brazil and Latin American international business.
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April gross gaming revenues (GGR) were flat MoM and increased 22% YoY to $3.13BN
April gross gaming revenues (GGR) were flat MoM and increased 22% YoY to $3.13BN. The early start of Golden Week likely helped boost the numbers in the tail end of the month and slightly better YoY hold also contributed to the strong results this month. We estimate that total direct play this month accounted for 6.4% of the market, same as in April 2011. The total VIP market held at 3.01% vs. 2.94% in April 2011. Accounting for direct play and theoretical hold of 2.85% in both months, April revenues would have increased 20% YoY.
Encouragingly, Mass drove most of the growth as this higher margin segment increased over 41%. VIP Rolling Chip only increased 13.5% YoY. The last 3 months have been the slowest growing RC months since mid-2009.
The details are written in the section below but here are some company market share highlights:
- Wynn slot share is getting hammered: roughly 15.5% the last two months versus 19.4% for all of 2011
- Wynn Mass share lowest since Feb 2010
- Wynn Mass share 2012 ytd is 10.7%, down 140bps from 2011
- Wynn VIP Rolling Chip share holding its own
- MPEL hits all-time high in Mass share – consistent up trend all year
- MPEL Rolling Chip share stabilizing following Sands China’s junket push that began in Q4
- MGM getting beat up on Mass and Rolling Chip but slots have been surging
- Galaxy held its own despite the opening of Sands Cotai Central
Sands China (LVS)
- LVS share was disappointing: only 60bps above the average for the 5 months since they began the junket push
- LVS Mass share up 190bps over TTM – should’ve been better since SCC added 4% to Mass table supply in Macau and was open for 2/3 of the month
- Rolling Chip share was only up 40bps from the average since the junket push was instituted in November
Y-o-Y Table Revenue Observations
Total table revenue grew 22% YoY this month. The slightly higher YoY hold helped contribute 2% of the growth in the month. We also suspect that the earlier start to Golden Week this year helped the tail end of the month, but that’s harder to quantify. Mass revenue growth of 41% was in-line with the 40+% growth rate we’ve seen in the market over the last 6 months. VIP revenues grew 16%, while Junket RC increased 13%, both continuing the ‘slowing trend’ that we began to see in October.
Table revenues grew 29% YoY, outpacing the market due to the opening of SCC and high hold at Four Seasons. We estimate that LVS’s properties held at 2.9% in April. At 21%, LVS had the best VIP growth after Galaxy and ranked #3 behind Galaxy and MPEL for Mass table growth at 46%.
- Sands generated a 32% YoY decline mostly due to low hold and a difficult hold comparison coupled with VIP volume declines. This should be no surprise given the ‘cannibalization’/reallocation of tables to SCC. The good news is that the entire YoY decline came out of the lower yielding VIP segment.
- Mass was up 2%
- VIP saw a huge 48% YoY decline. We estimate that Sands held at 2.2% in April compared to 3.3% in the same period last year. We assume $230MM/month of direct play or 11% (in-line with what we saw in 1Q12)
- Junket RC was down 17%. This was the 5th consecutive month of YoY declines in VIP RC at the property
- Venetian table revenues decreased 2% YoY, driven by a big drop in VIP revenue which was offset by stellar growth on the Mass side
- Mass had a great month, increasing 55%
- VIP decreased 32% and junket VIP RC decreased 34%
- Again the declines on the VIP side should be no surprise given the reallocation of tables to SCC / cannibalization. Luckily Mass is doing great which will boost margins due to mix shift and soften the blow from losses on the VIP side. That said, we may see a greater impact once the second Mass casino opens in 3Q this year.
- Assuming 27% direct play in the quarter (in-line with 1Q12), hold was 2.73% compared to 2.76% in April 2011, assuming 22% direct play (in-line with 2Q11)
- Four Seasons grew 347% YoY, driven by a huge Junket RC growth, high hold and an easy hold comparison
- After 9 consecutive months of double digit growth, mass revenues decreased 11%
- Junket VIP RC increased 4.24x YoY and VIP revenues soared 590%
- Four Seasons is clearly seeing a benefit from LVS’s recent initiatives. If we assume that monthly direct play volume of ~$660MM is in-line with 1Q12 absolute levels, that implies a direct play percentage of 23% and a hold rate of 3.62%. In comparison, if April 2011 direct play was around 41% then hold is approximately 2.2%.
- Sands Cotai Central opened on April 12th and during the first 18 days of operation, produced table revenue of $48MM. Given the partial opening of the property and poor luck in the few weeks of operating, it’s too early to draw many conclusions on the property’s performance.
- Mass revenue of $19MM
- VIP revenue of $29MM
- Junket RC volume of $1,064MM
- If we assume that direct play was 15%, hold would have been just 2.3%
Wynn table revenues fell 7% in April, exhibiting the worst table decline of all 6 concessionaires. Wynn’s hold was normal but last year’s comparison was difficult so that didn’t help. Wynn’s average growth table growth over the last 6 months has slowed to an average of 5%.
- Mass was up 15% offset by an 11% drop in VIP
- Junket RC increased 3%
- Assuming 10% of total VIP play was direct (in-line with 1Q12), we estimate that hold was 2.95% compared to 3.43% last year (assuming 8% direct play – in-line with 2Q11)
MPEL table revenue fell 4%, driven by a drop off in Altira revenues driven by a drop in junket volume, low hold and a difficult hold comparison. On MPEL’s earnings call earlier today, the company did point out that they had moved some tables out of Altira and into CoD’s new junket rooms. On the bright side, Mass continued to be very strong, growing 65% YoY and exhibiting growth second to only Galaxy in this segment.
- Altira revenues fell 29%, due to a 35% decrease in VIP that was slightly offset by strong Mass growth. Altira revenues have declined 4 of the last 6 months, averaging a YoY decline of 7%.
- Mass revenues increased 56%
- VIP RC decreased 35%; over the last 6 months, VIP revenues have averaged a 10% YoY decrease
- We estimate that hold was 2.8%, compared to 3.3% in the prior year
- CoD table revenue was up 10%, driven by 67% growth in Mass, offset by a 5% decline in VIP
- Junket VIP RC fell 11% despite the addition of 3 junkets and 23 new tables in the month of April
- Assuming a 16% direct play level, hold was 3.2% in April compared to 3.1% last year (assuming 13% direct play levels in-line with 2Q11)
Table revenue grew 5%
- Mass was up 12% and VIP eked out an 1% of growth
- Junket RC was down 1.9%, implying 2.72% hold across the company’s properties. Last April’s hold rate was also low at just 2.63%. May has a much tougher comp to 3.2% last year.
For the 11th month in a row, Galaxy posted table revenues growth north of 100% - at 175%. Mass soared 333%, while VIP grew 155%.
- StarWorld table revenues grew 27%
- Mass grew 37% and VIP revenue grew 26%
- Junket RC grew 7%
- Hold was high at 3.1% and had an easy comp of just 2.6% last April
- Galaxy Macau's total table revenues were $329MM – coming close to the property’s high set during October 2011’s Golden week of $339MM. Revenues were up 5% sequentially.
- Mass table declined 8% MoM to $71MM, which was still the property’s second best month
- VIP table revenue grew 9% MoM to $258MM, the second best month since October 2011
- Hold was 3.44% - the property’s 3rd highest since opening
- RC volume of $7.5BN was down 5% MoM and compares to a peak of $8.3BN in October
Table revenues grew 12%
- Mass revenue growth was 12%
- VIP revenue grew 11%
- Junket RC increased 7%
- If direct play was in-line with 1Q12 levels of 6%, then hold in April was 3.2% compared to 3.1% in April 2011
Sequential Market Share
LVS was the largest share gainer in April, closing the month with 17.8% share vs. 16.5% in March. This compares to a 6 month trailing market share of 17.3% and 2011 average share of 15.7%.
- Sands' share dropped 120bps to 3.2%, marking an all-time low for the property. For comparison purposes, April share was below 2011's share of 4.6% and 6M trailing average share of 4.2%.
- Mass share fell 90 bps to an all-time low of 5.7%
- VIP rev share decreased 1.4% to an all-time low of just 2.2%
- RC share decreased 20bps to just 2.8%, above the all-time low of 2.4% set in Feb 2012
- Venetian’s share dropped 20bps to 7.4% - the lowest market share in 8 months. 2011 share was 8.4% and 6 month trailing share was 8.2%.
- VIP share decreased 40bps to 4.6% - only 10bps above the all-time low set in August 2011
- Mass share increased 30bps to 15.2% - the property’s best share in 6 months and nicely above their 6 month average of 14.4%
- Junket RC fell 20bps to 3.9% setting an all-time property low
- FS gained 1% share to 5.1%. This compares to 2011 share of 2.2% and 6M trailing average share of 4.2%.
- VIP share increased 1.3% to 6.4%. This marks the 3rd consecutive month where FS VIP revenues exceeded those of Venetian and the 4th month in a row where they exceed Sands’ revenue.
- Mass share increased 10bps to 1.6%
- Junket RC improved 10bps to 4.2%. April marked the 3rd month where RC share at Four Seasons exceeded that of Venetians’ and 5th month where volumes exceeds those of Sands Macau.
- Sands Cotai Central achieved table market share of 1.6% during their first 18 days of operation
- Mass share of 2.5%
- VIP share of 1.3%
- Junket RC share of 1.6%
Wynn was the second largest share gainer in a month that saw relatively little movement. Wynn’s share increased 60bps to 12.9%, which was in-line with its 6 month trailing average share of 12.9% and well below its 2011 average share of 14.1%. We expect Wynn’s share to continue to struggle in the face of a ramping Sands Cotai Central.
- Mass market share fell 20bps to 8.9%; just 10 bps better than the property’s all-time low
- VIP market share improved 90bps to 14.1%
- Junket RC share fell to 13.9%, a 1.4% MoM decline
MPEL lost 60bps of share in April to 13.7% which was in-line with their 6 month trailing share of 13.7% but below their 2011 share of 14.8%. Interestingly, this was the 3rd month in a row where MPEL’s Junket RC share exceeded that of Sands.
- Altira share fell 1.1% to 3.5%, which was below the property’s 2011 share of 5.3% and 6M trailing share of 4.1%
- Mass share ticked up 10bps to 1.7%
- VIP declined 1.6% to 4.2%, the properties’ lowest level since July 2007
- CoD’s share improved 50bps to 9.9%; above its 2011 share of 9.3% and 6M trailing share of 9.4%
- Mass market share increased 50bps to 11.5% hitting an all-time property high
- VIP share increased 60bps to 9.4%
- Junket RC increased 40bps to 7.9%
SJM was the biggest share loser in April. SJM’s share fell 1.3% to 25.3%, well below their 6-month trailing average of 26.8% and 2011 average of 29.2%. SJM is likely to continue to be in a position of a share donor as SCC ramps up.
- Mass market share fell 50bps to an all-time low of 31.8%
- VIP share fell 1.3% to 24.0%
- Junket RC share was flat at 28.4%
Galaxy’s share ticked up 20bps in April to 20.5%, which was above their 6-month trailing average of 19.2%
- Galaxy Macau share increased 50bps to 11%, above its 6-month trailing average of 10.1%
- Mass share fell 60bps to 9.0%
- VIP share increased 90bps to 11.8%, marking an all-time property high
- RC share increased 20bps to 11.0%, in-line with its all-time high set in October
- Starworld share fell 40bps to 8.6% but was still above its TTM average share of 8.2%
- Mass share fell 20bps to 2.7%
- VIP share fell 50bps to 10.7%
- RC share was flat at 11.0%
MGM share ticked down 10bps to 9.9%. April share sits a little below MGM’s 2011 and 6-month trailing average share of 9.9%. We expect that MGM’s share will continue to be under pressure for the balance of the year and the first half of 2012
- Mass share fell 1% to 7.0%
- VIP share ticked up 10bps to 10.4%
- Junket RC ticked down 20bps to 9.4%
Slot revenue totaled $142MM in April, with growth accelerating to just 32% YoY. Two concessionaires hit records this month.
- As expected, GALAXY slot revenues grew the most with 393% YoY to $14MM
- MGM slot revenues had the second best growth at 68% YoY to $25MM; a record for the property
- LVS slot revenues grew 22% YoY to $39MM
- MPEL slot revenues grew 15% YoY to $27M; a new record for the company
- WYNN slot revenues grew 9% YoY to $22MM
- SJM came in last with growth of just 1% to $15MM
Conclusion: Further Deflating the Inflation will make us bullish on growth-oriented equities from a price. We, of course, need to actually see that occur – which ultimately means the Fed must remain on hold long enough for market prices to “clear”. If the Fed is unable to resist the urge to ease, we’ll happily play the long side of the Inflation Trade up to another long-term lower-high in US equities – just as we did from JAN 25th though mid-MAR.
Hedgeye Macro Active Themes: Growth Slowing, Deflating the Inflation, The Last War: Fed Fighting, Bernanke’s Bubbles, Asymmetric Risks and Sovereign Debt Dichotomy.
Hedgeye Asset Allocation: ZERO percent exposure to commodities (since APR 5th) and international currencies (since APR 23rd).
This we know – on every down tick in crude oil prices, a legion of pundits will tell you to buy [US] stocks because of “declining energy prices”. This we also know – many of these are the same perma bulls who told you buy stocks with crude oil prices +10% higher because: A) “US growth was decoupling from the rest of the earth”; B) “QE_ would propel the rally higher”; or C) “high energy prices were merely a function of accelerating demand” (in spite of global growth data sequentially decelerating since FEB – but who’s counting?).
Given such obvious discrepancies, we find it useful to incorporate a consistent and repeatable research process to help navigate the thick haze of Old Wall Storytelling around expectations for growth, inflation and/or policy. Regarding the latter, our quantitative analysis of key market prices suggests that, while some noteworthy participants are already out begging for more QE, the Global Macro universe generally does not view incremental easing out of the Federal Reserve as a near-term event (USD breaking out; Oil and Gold breaking down).
Looking to the Fed’s own index of “medium term inflation expectations”, there’s still quite a bit of Deflating the Inflation that must occur in the TIPS market relative to current levels to justify pursuing further easing. The 5yr breakeven inflation rate according to the Fed is 2.76%; this is substantially higher than the 2-2.2% range when the Fed announced QE1, QE2 and Operation Twist. Interestingly, the strike price on the “Bernanke Put” has increased from 750 on the S&P 500 in ’08, to 1050 on the S&P 500 in ’10 and 1150 on the S&P 500 in ’11. Is 1250 the next logical step in this progression? Call us chaos theorists, but that roughly jives with Keith’s 1281 TAIL line of S&P 500 support.
As we penned in our MAY 4th research note titled, “Analyzing the Jobs Report Through the Lens of the General Election: April 2012 Edition”, we continue to view the general election debate as supportive of intermediate-term USD strength from a rhetorical perspective as both Bernanke and Obama are forced into an increasingly smaller box for the time being. If events ultimately play out according to our expectations, you’ll hear us get very loud about being bullish on the US/global economy and US/global equities – from a price. In our view, Bernanke packing up his moral hazard and getting completely out of the way will allow both the US economy and US equities to rally to new highs vs. the latter simply bouncing to another long-term lower-high on waning volume.
The phrase: “from a price” is paramount. As alluded to previously, you actually need to see a clearing of commodity market prices for Deflating the Inflation to occur and have a positive impact on growth. That roughly equates to more pain across the commodity complex over the intermediate-term in the name of reflating economic growth – an occurrence we saw in both 1H09 and 2H11. Without that pain, the disinflationary tailwind of falling commodity prices will peak here in MAY and decline through year-end (holding prices flat at current levels). For disinflation to continue being incrementally supportive, we need to actually see it show up via continued declines in commodity prices – not just consensus storytelling on the first leg down in crude oil!
All told, further Deflating the Inflation will make us bullish on growth-oriented equities from a price. We, of course, need to actually see that occur – which ultimately means the Fed must remain on hold long enough for market prices to “clear”. If the Fed is unable to resist the urge to ease, we’ll happily play the long side of the Inflation Trade up to another long-term lower-high in US equities – just as we did from JAN 25th though mid-MAR.
Conclusion: Macy’s 2H guidance supports our concern about the stepped-up competitive pressure in the mid-tier later this year. Yeah, we know, Bloomies is high end, and much of Macy’s is not exactly KSS-competitive. But they definitely compete on the fringe. Mgmt went as far as to say that they are seeing definite strength in areas where they compete w JCP. One other interesting dynamic we see is analysts are asking Macy’s management about input costs. We think that’s actually a very relevant question, but probably for a different reason. The reality is that input costs don’t really matter much anymore. They are known. They are built into the plan – for the vendors, at least. And those prices are tentatively set with retailers. But ultimately, we’re going up against significantly higher AUR’s vs 2H11, and we absolutely NEED to maintain pricing integrity in 2H for margin integrity to hold. People forget that there are two elements to the gross margin equation – and only one of them is cost.
While playing the guidance game is not our forte, the reality is that this is the first quarter in 5 where Macy’s did not increase its outlook. With the stock up 23% YTD and short interest as a percent of float testing historical lows of 2.1%, we absolutely need to see positive earnings revisions to move this stock higher. Our thesis regarding stepped up competition in the mid-tier in 2H will need to be dead-wrong in order for that to happen (or JC Penney will need to fall flat on its face and cede share increasingly to M).
What Drove the Beat?
The $0.03 beat in 1Q12 was a result of operating expense leverage in light of 2 new store openings in Salt Lake City, UT, and Greendale, WI. The operating expense leverage of 110bps was primarily due to improved profitability in the credit portfolio which is expected to increase $15-$20mm this year. Additionally, M benefitted from reduced D&A though partially offset by increased investment spend in OMNI Channel (My Macy’s, MAGIC selling, etc.) as well as higher pension expense. Inventory growth improved 2 points sequentially in Q1 +6% though the sales to inventory spread remained unchanged -2%.
Deltas in Forward Looking Commentary?
In order to properly measure performance relative to original expectations, we look at management’s 2012 guidance headed into the quarter as well as the key deltas in Q1 results vs. expectations :
Store And Sales Growth
- For planning purposes, we are assuming a comp store increase of approximately 3.5% on a 52-week basis UNCHANGED- continue to expect 3.5% for the remainder of the year and now expect 3.7% for the full year
- Our total sales, including this extra week, are expected to be up approximately one point over our comp store sales increase UNCHANGED
- Now, obviously, in Q4, given that extra week, we’re expecting a much bigger gap – in fact, 3.5 points higher total store growth than comp UNCHANGED
- However, in the first three quarters of the year, total sales growth is expected to be slightly below our comp store growth due to the locations that we closed at the end of 2011 UNCHANGED- revenues +4.3% on +4.4% comp
New Store Openings
- We are planning to open two new stores in 2012 – both, in fact, next month – one in Milwaukee and one in Salt Lake City COMPLETE
- We are also opening five new Bloomingdale’s outlets during 2012, bringing the total number to 12 UNCHANGED
Gross Margins, Income And Credit
- We are assuming a flattish gross margin rate for the year, although we could have continued pressure from free shipping, given the sales growth expected in the omnichannel business UNCHANGED- GM was down 30bps in Q1
- On the SG&A front, we expect to be able to continue to improve our expense rate as a percent of sales UNCHANGED- SG&A leveraged 100bps in Q1
- We expect our income from the credit portfolio to increase approximately $15mm to $20mm during 2012 UNCHANGED- credit contributed to expense leverage in Q1
- But we are expecting big variances when we look at the comparison to last year in each quarter UNCHANGED- 3Q expecting unfavorable impact
Expenses, Depreciation, Tax Rate And CapEx
- For the year, we’re expecting retirement expense – pension plus SERP – to increase by approximately $65mm UNCHANGED
- While depreciation is expected to decline approximately $25mm for the year UNCHANGED
- For interest expense, we’re assuming approximately $435mm to $440mm for the year UNCHANGED
- And we’re assuming an effective tax rate of 36.95% for 2012, although it will vary by quarter UNCHANGED
- And our CapEx budget for 2012 is $850mm INCREASED: now $950mm but will return to $900 level in 2013
EPS And Costs
- So, net-net, we are assuming EPS on a diluted basis of $3.25 to $3.30 for 2012 UNCHANGED0 $0.09 below consensus at the high end of range
Highlights from the Call:
- Sales continued to be strong at Macy's and Bloomingdales both in-store and online (online +34%)
- Sales performance broad based
- Men's, center core (watches jewelry handbags cosmetics shoes etc.) and home strong
- Feminine apparel stronger in Feb and March than in April but feeling better particularly in classic
- Saw strength in impulse apparel (women's age 22-30)
- Junior business continued to be weak
- Private brands continued to perform well (charter club, bar 3 strongest, new ideology brand launched recently doing well)
- Geographic: southern markets continue to outperform (FL, TX, Hawaii)
- Strength in other markets demonstrate the power of My Macys and more localized assortments
- AUR +8% with units down 4%
Gross Margin: 38.8%, down (-30bps)
- Merchandise margin flat in the first quarter
- Rounded the impact of free shipping but growth of Omni channel continue to put pressure on GM
- Inventory +6% (increase in in-transit merchandise, inventory +3% net payables)
- More opportunity to satisfy demand with inventory from other stores and DTC as well as online demand from in store
- Now have over 80 stores equipped to drop ship and expect over 290 store fulfillment locations by Holiday
- Drop shipping Should enable more productive inventory and store square footage
Operating expenses: +1%; 110bps of leverage
- Credit was the biggest factor favorably impacting expenses
- Expect credit profitability to increase by $15-$20mm for the full year (1Q consistent with higher end of annual guidance)
- Benefitted from lower D&A
- Offsetting: higher expense related to Omni channel investments, higher pension expense
EBIT +80bps YoY
Cash Flow $265mm vs. $67mm LY
5 primary drivers:
- Higher net income
- Last year, pension contribution of 225mm in quarter
- Tax payments and reductions in deferred taxes last year (246mm unfavorable last year)
- Inventory net of payables was $118mm favorable vs. last year
- Reduction in prepaid expenses due to Lord and Taylor proceeds that had been put in escrow were used to purchase 2 key parcels of flagship in Union Square Can Francisco.
- Sales growth to be consistent with +3.5% with May higher and June/July lower
- GM expected to be flattish
- SG&A expected to increase more in 2Q relative to last year than it did in the first Q primarily because credit profitability is only expected to be up slightly
- In 3Q, credit profitability is expected to be lower than last year by 40-50mm but still expect 15-20mm increase in full year credit profitability
- Guidance is unchanged at +3.5% comp for the remainder of the year or 3.7% for the full year
- EPS also remains at $3.25-$3.30
- Capex now expected to be $950mm although next year it will return to $900 level as previously discussed
- Plan to continue to focus on OMNI Channel and better tailor assortment to localized needs.
- Enhanced MAGIC Selling expected to continue to differentiate Macy's from competitors
- Have seen an uptick in business in markets where they compete against JCP
- Marketing strategy has been unchanged since the announcement of JCP's new strategy
- There are strategies in place to maintain the customers coming over from JCP
Renovation at Herald Square:
- Will have an impact on the comp
- Will have some effect on the total but not material
- Are expecting to see some relief in 2H
- Don’t expect an impact until later in 3Q
- 1.1bn remaining in the authorization
- Have not quantified exact amount but idea is to use excess cash to buy back stock
- Net of payables up 3% so below 2Q sales expectations
- Will take longer to figure out optimal place by cetegory for inventory levels
- Expect to see this in 2013 and beyond
- With more categories online that can be fulfilled from store better able to satisfy demand
- Big chunks of inventory available in store but not yet online
- Will be testing putting inventory up online that will be 100% fulfilled from in-store
- Site to store to door rolling out by category- accelerating rollout because it has been so successful
- Not giving guidance but quarter but 40-50mm credit profit compare will put a lot of pressure on earnings
- Committing to reaching 14-15% EBITDA rate
- Current game plan in place to reach 14%; getting to 15% will require new thinking
- While investing in growth, doing so while keeping in mind bottom line improvement
- Think there is huge opportunity to improve inventory productivity that will help gross margin
- Plan to pull inventory from locations where they would be sold for less to preserve margins
- Expect gross margin to be flattish for the year
- Did not increase promotions in the quarter
- Clearing the cold weather goods when the weather was hot
- Feel very good about regular priced selling of the new goods
Millennial Customer Initiatives:
- Spending a lot of time rethinking how product is selected for stores
- Launched Bar 3 last year as a way to use private label market to help (bar 3 geared toward older customer)
- Reviewing marketing to be sure reach out is working; digital, social media, etc.
- Juniors doing less well due in part to market overall, M needed to reload the strategy and restart overall- feel it will be much better a year from now
- Will continue to improve and add new components to MAGIC selling
Brazil Brazil Brazil Campaign
- Very early to tell but product from Brazil doing very well in store
- Doing some tailoring by market mostly in terms of size of the Brazil campaign
- Sticking to overall marketing program
- Continues to be very strong, no major callout there
- Big ticket has been unbelievably strong- think the trend will continue
- As much a competitor as JCP, KSS, etc.
- In most of the businesses, the in store experience is still very important to the consumer
- Expect it to be very challenging for an internet pure play to compete
- In fashion business, having stores is still a competitive advantage
Potential for short term borrowing:
- Not something that would be done this year given cash position but have started to test the opportunity
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