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Deflated Disputants

This note was originally published at 8am on October 30, 2014 for Hedgeye subscribers.

“How many a dispute could have been deflated into a single paragraph if the disputants had dared to define their terms?”

-Aristotle

 

Are you a central planning disputant? I am, big time. So, please, allow me to define my terms:

 

  1. The Fed’s QE was a Policy To Inflate asset prices
  2. After that inflation, you get the #deflation

 

That is all.

 

Deflated Disputants - EL chart 2

 

Back to the Global Macro Grind

 

I know. So easy a Mucker can explain it.

 

If you’d like to have a dispute with me on these terms (or change the M in my nickname to an F like the 1997 Princeton Hockey Team did), I’m happy to have it as long as you define yours. Mr. Market has been pricing them in all year long.

 

When our #process signals #Quad4 deflation (growth and inflation slowing, at the same time) here’s our asset allocation:

 

  1. Cash
  2. Long Term Treasuries (TLT, EDV, etc.)
  3. Municipal Bonds (MUB)
  4. Healthcare Stocks (XLV)
  5. Consumer Staple Stocks (XLP)

 

We #timestamped that in our Q4 Macro Themes deck on October 1st (pre-Oct 14th fetal position for the levered long beta portfolios) and we’ll reiterate that again, now that the Fed has done precisely what they said they’d do (ending the Policy To Inflate).

 

Now that that’s over, what I think happens next is where I’ll have many disputes. Here’s what I’m thinking:

 

  1. As both US and Global growth slows, the Fed will be under pressure to say that they can provide moarrr #cowbell
  2. Mean Reversions: classic late-cycle indicators (like employment and “confidence”) should roll over; Fed will freak out on that
  3. Long-term rates will continue to make a series of lower-highs and lower-lows, tracking lower growth and inflation expectations

 

Again, think like a Fed head. Define their terms – then front-run their proactively predictable behavior.

 

The main problem my disputants have with me is that I don’t think like they do. I am a dynamic counter-cyclical strategist and they are pro-cyclical linear economists. The economy is non-linear. It’s also one massive cyclical. You don’t buy a cyclical at the top of a cycle – you sell it.

 

The #1 question you should be asking Ed & Nancy (linear economists) has two parts:

 

A)     After 65 straight months of US economic expansion, isn’t this an early-cycle slowdown, and

B)      Now that everyone has cut to zero, where are we in the worldwide easing-cycle?

 

We know how they think about this. They’re making the same calls that they made at the top of prior cycles (that the cycle wasn’t slowing in 2H of 2007). They have defined their surveys and their terms. Those are pro-cyclical too.

 

What does being pro-cyclical mean?

 

  1. That you think late-cycle indicators being good is good
  2. That you don’t think in 2nd derivative terms (going from great to good is bad)
  3. And that once things are actually bad, you’re both late and getting bearish a lot lower

 

No,  I’m not calling anyone names. I am not being “mean” either. Rather than drifting from bullish to bullish thesis on the economy (at the beginning of the year they said inflation and capex would drive the economy; now they are saying global slowing and deflation will), I am being a consistent disputant.

 

This morning I’ll list the Top 12 Big Macro Risk Ranges (and our TREND views in brackets) – they are in our Daily Trading Ranges product too:

 

UST 10yr yield 2.16-2.35% (bearish)

SPX 1871-2007 (neutral)

RUT 1071-1157 (bearish)

DAX 8709-9340 (bearish)

VIX 12.89-22.25 (bullish)

USD 85.34-86.24 (bullish)

EUR/USD 1.25-1.27 (bearish)

Yen 107.11-109.77 (bearish)

WTI Oil 79.98-83.05 (bearish)
Natural Gas 3.57-3.82 (bearish)

Gold 1194-1231 (neutral)

Copper 2.96-3.09 (bearish)

 

Best of luck out there today,

KM

 

Keith R. McCullough
Chief Executive Officer

 

Deflated Disputants - Chart of the Day


JCP - Taking Off Our Long Bench

Takeaway: After having a long bias on JCP, we now think the upside/downside is symmetric - from $15 to $0. Not the risk/reward we like on either side.

Conclusion: We’re taking JCP off of our ‘Long Bench’ and are making some meaningful downward revisions to our model. This is not all about the 3Q print, but rather our confidence in the company’s ability to drive its top line in conditions that are anything other than optimal. Modeling ‘optimal’ conditions for the next four years hardly seems realistic, and irresponsible considering JCP’s debt maturity schedule. To be clear, we’re not making a short call. But now, we think that the likelihood of the stock going to $15 is equally offset by the chance of it going to zero (something we previously assigned a very low probability). That’s hardly a palatable risk/reward with the stock at $7.50.

 

FULL DETAILS

It’s extremely rare that a quarterly earnings print will sway our opinion meaningfully on a stock. But this is definitely one of those times. While we did not have JCP on our list of top longs we definitely had a positive bias in our view on the company’s recovery and earnings potential.  Based on our view of where the department store space is headed, and where JCP’s market share and cost structure are both likely to shake out – we now don’t have JCP turning a profit on the P&L until 2019 vs our previous model of break-even by 2016. If our numbers are right, that means that JCP will have to go through another economic cycle losing money, which matters with the stock trading at 14.5x EBITDA and 6.5x an EBITDA number that’s five years out.

 

Liquidity is something to consider as it’s no longer a key point of the debate today (nor should it be based on current conditions).  To be fair, if we’re going to assume that the economy grows at a normal clip every year for the rest of this decade, then it shouldn’t be part of the debate, as JCP will be just fine. But not having a very bad sales/margin event at some point over the next four years would make this latest expansion one for the record books. We know it’s ‘out there’ to be so focused on what could happen as far as 2018, but the company faces a very big maturity in ’18 – $2.2bn to be exact. If it had to refi that today, it would probably not have a major problem.

 

But what happens if the company has to do so defensively in the event of a recession/bad economic event in 2016/17? The loan is secured by JCP real estate. It would be backed into having to either a) refinance at a grossly unfavorable rate, b) issue some equity-linked security, or c) surrender the property and then pay market rents if it wants to retain the business. None of those outcomes is attractive. In fact, they’d all send the stock a lot lower from where it is today. This did not matter as much for us with the company growing sales in the mid-high single digits. But our previous assumption seems far too aggressive based on what we’re seeing right now.

 

Are we making the ‘bagel’ call? No. We are not. We want to be clear about that. But in stress testing the model, we think that a double from here is just as likely as the stock going to $0. That’s not a risk/reward we like to see. We’d simply stay away at this price.

 

Why Such A Dramatic Change?

 

Business Changed Very Quickly. Just five weeks ago, JCP lowered guidance to a ‘low single digit’ comp versus previous guidance of ‘mid-single’. That’s usually interpreted as a 2-3% comp, which we think the company implied. But for the quarter, comps came in flat versus a year ago. That means that October must have been an unmitigated disaster. But yet JCP said that September was the worst month of the quarter. Sounds to us like the company was missing materially a month ago, and threw out a ‘low-single’ target with its fingers crossed along with a healthy dose of hope that October would improve. That’s extremely poor risk management.

 

Gaining Share? JCP only comped 140bps ahead of Macy’s (and KSS based on its preannouncement).  Let’s be clear, for this story to even approach something that is palatable, it needs to gain significant share on a reasonably consistent basis without buying it.  The problem with this quarter is JCP did not have a merchandising miss, didn’t stumble in a specific category, or suffer anything else that is company-specific other than a 30% decrease in liquidation sales. But that was known when the company provided guidance. It was because of the same old reasons we hear from all the other mediocre retailers – weather, competition, promotional climate, and overall ‘tough retail environment’. Note: Great companies – or even mediocre ones with solid revenue plans – don’t talk about these factors.

 

What Happens When Things Aren’t So Good Out There? We understand that there are likely to be quarters where JCP performs closer to the peer group than others. This might be one of them. Also, the company put up a stellar 718bp improvement in Gross Margin. It could have easily forgone some of that margin in favor of a better comp. But management said flat-out that it will do mid-single digits longer term…just not this year. What we don’t understand is that this is a company that is in recovery, and is only putting up comp store sales growth (including e-commerce) of 3-4% in a decent enough economy.

 

What happens if the consumer cracks? What happens if the current 6-year growth and margin retail expansion cycle comes to an end, and ‘re-cycles’. It’s been known to happen from time to time (about twice a decade for the past 40 years).  So basically – the company all but admitted that it can only comp msd when the economy is extremely healthy and/or the retail climate becomes ‘easy’. That’s just something that we’re not willing to put in our model for ANY company.

 

No Store Closures: Sounds like store closures are definitely not on the front burner. Not even close. Maybe down the road, but not now. Management admitted the same exact thing that KSS said a few weeks back – virtually all stores operating today are making money, and are cash flow positive. Furthermore, our work suggests that unlike in past cycles, retail CEOs will avoid closing stores that are otherwise considered marginal as retail stores are inextricably linked with e-commerce. Closing stores – even bad ones – risks losing e-commerce revenue. The only line item (aside from SG&A) growing for any department store is dot.com revenue, and the companies won’t risk shooting themselves in the foot by shutting down one of the biggest assets that enable e-commerce. The point is…no major store closure/cost cutting plan.

 

Key Assumptions In Our Model


Sales: We assume store sales grow at a 3% clip, with e-commerce growing closer to 10%. That lands us at around 4% top line growth through 2018. It also suggests that JCP gets back to $130 per square foot. That’s a far cry from its former $195 and KSS $210. But it’s better than the $108 JCP is sitting on today.

 

Gross Margin: We tempered our assumptions here. Assuming JCP adds 200bp over 5 years to 36.4% -- that’s down about 150bp from our previous model. On one hand, the company has been doing a great job in recovering margin, but on the flip side, a lower comp growth base will mitigate occupancy leverage.

 

SG&A: Growth of 1-2% per year. This is a company that used to have $5.3bn in SG&A on the same store base we have today. Today SG&A is just below $4bn. It’s probably headed higher. No changes in our modeling assumption here.

 

Capex: $250mm this year ramping to $400mm by year 5. Yes, the $1bn RonJon cap spending was too high. Now JCP is overshooting on the downside. If it wants to gain share, capex will need to rise. As with SG&A, we did not change anything here.

 

Free Cash Flow: We have FCF within about $100mm of break-even (usually positive) over the foreseeable future. The challenge is that we’ll need more than that to handle debt maturities which total $600mm over the next five years until the big $2.2bn refi in 2018. 

 


TWTR: Long on Promise, Short on Detail (Investor Day)

Takeaway: The bigger issue remains: the perverse relationship b/w its user & revenue growth. The Street will not accept weakness on either front

Investor DAY HIGHLIGHTS

  1. COURT THE PASSIVE VISITOR: TWTR gets a lot more passive traffic than its MAU metrics suggest.  Visitors get routed to twitter when clicking a twitter-related link while on another site, but most of these visitors do not interact with twitter past that point.  TWTR is looking to court the passive user by presenting them with a timeline of tweets when that occurs, hoping it will boost their registrations & MAU metrics.
  2. EXPAND PRODUCT PORTFOLIO: There was a greater emphasis on enhancing private chat options.  TWTR also wants to introduce new products to expand its product portfolio, suggesting a greater emphasis on Vine, but no other detail regarding other potential ideas.
  3. ENHANCE DEVELOPER FUNCTIONALITY: TWTR wants to make it easier for developers to interact with the twitter platform.  The rationales is that if developers can build and monetize their third-party applications, TWTR could reach a broader audience.

 

TAKEAWAYS

  1. LONG ON PROMISE, SHORT ON DETAIL: The only real detail came on its efforts to court the passive user.  Outside of that, nothing material.  Remember that FB also experimented with private chat options (Facebook Messenger), then wound up acquiring WhatsApp.  In terms of additional products, we suspect that means acquisitions (TWTR just raised $1.7B in new capital).  Expanding third-party application efforts could have the perverse effect of routing TWTR users away from the platform (same as Tweetdeck did before TWTR acquired it).  In short, we wouldn’t get too excited.
  2. THE BIGGER ISSUES REMAIN: TWTR’s strength over the LTM has been driven primarily by monetization, which we estimate has been driven by surging ad load more than anything else.  We suspect there is a perverse relationship between ad engagements (monetization) and user growth, which suggests that its surging ad load strategy is pressuring user retention.  This relationship creates a tug of war between user and revenue growth; if TWTR experiences any weakness on either front, the street will hammer the stock for it.

 

TWTR: Long on Promise, Short on Detail (Investor Day) - TWTR   Ad Engagement vs. Pricing 3Q14

TWTR: Long on Promise, Short on Detail (Investor Day) - TWTR   Ad Load vs. US MAUs 3Q14

TWTR: Long on Promise, Short on Detail (Investor Day) - TWTR   HRM vs. Consensus 3Q14

 

For more detail on our short thesis, see link to our most recent note below.  Let us know if you have any questions, or would like to discuss in more detail.

 

TWTR: The Story Has Changed

10/28/14 07:13 AM EDT

http://app.hedgeye.com/feed_items/38904

 

 

Hesham Shaaban, CFA

@HedgeyeInternet

 


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Cartoon of the Day: On the One Hand...

On the one hand, gas prices have dropped for 46 straight days to their lowest level in four years.

 

On the other hand...

 

Cartoon of the Day: On the One Hand... - gas price cartoon 11.12.2014


Retail Callouts (11/12): FOSL, KORS, WMT, DKS, AMZN, EBAY

Takeaway: FOSL hits trifecta–beat, algorithm, KORS – with big ROE kicker. WMT’s employee problem is bigger than grocery. Golf sales still in the tank.

EVENTS TO WATCH

 

Retail Callouts (11/12): FOSL, KORS, WMT, DKS, AMZN, EBAY - 11 12 chart2

 

 

COMPANY HIGHLIGHTS

 

FOSL - 3Q14 Earnings

 

Takeaway - Fossil hit the earnings trifecta this quarter. Not only did it beat the quarter by 8%, but did so by putting up a clean algorithm of +10% sales, +15% net income, and +25% net income. Its SIGMA trajectory swung towards the upper right hand quadrant, which is bullish for gross margins in the upcoming quarter. One thing we particularly liked was how we're starting to see a meaningful diversion between ROE and ROIC for this company. Too many companies that tout improving ROIC trends leave out the fact that they're letting cash build on their balance sheets. FOSL is doing the inverse. When we see ROE trending above an upward-sloping ROIC curve, we definitely take notice.  Oh, and by the way, the Michael Kors agreement -- which accounts for 22% of FOSL sales -- was renegotiated until 2024.

 

Retail Callouts (11/12): FOSL, KORS, WMT, DKS, AMZN, EBAY - 11 12 chart4

 

Retail Callouts (11/12): FOSL, KORS, WMT, DKS, AMZN, EBAY - 11 12 chart5

 

AMZN, EBAY - Sequential slowing for both AMZN and EBAY in ChannelAdvisor Comp Sales

Takeaway: The noticeable spread between the two companies in 2014 held in October.  Sales growth slowed for both companies slowed on a 1 and 2 year trend.  Ebay's +4.4% is the worst month since early 2011.

  

Retail Callouts (11/12): FOSL, KORS, WMT, DKS, AMZN, EBAY - 11 12 chart1

 

AMZN, EBAY, DKS - Golf Comps

Takeaway: Amazon golf comps put up yet another strong month.  The delta between  Amazon and eBay can partially be explained by the fact that eBay implemented a defect rate as part of its seller profile earlier this year, thus pressuring used product sellers to be more selective in their inventory.  At the same time Amazon has added features to expand the used category.  Either way, strong sales in this channel -- which is the bottom of the food chain for golf sales -- does not bode well for the category in general. The malaise that became apparent earlier this year (plaguing DKS and others) is still alive and well. 

 Retail Callouts (11/12): FOSL, KORS, WMT, DKS, AMZN, EBAY - 11 12 chart3

 

 

WMT - Walmart Memo Orders Stores to Improve Grocery Performance

(http://www.nytimes.com/2014/11/12/business/walmart-memo-orders-stores-to-improve-grocery-performance.html)

 

Takeaway: The writer here clearly had an agenda from the start. Taking a confidential memo about the need for improvement in the grocery department and dovetailing that with a singular store visit is just flat out irresponsible. For starters, these types of memos get circulated all the time. We're sure if you found a disgruntled Whole Foods employee you could get your hands on something similar. Asking your employees to execute on the 'Would I Buy It?' grocery test isn't egregious. The troubling thing for WMT is the overall discontent from its employee - that's nothing new, we know that, but to have store managers tactically leak information to the press is never a good recipe.  This is an employee-relations problem, not a grocery problem.

 

 

OTHER NEWS

 

WMT - Wal-Mart Stretches Black Friday Deals to Reach Shoppers

(http://www.bloomberg.com/news/2014-11-12/wal-mart-stretches-black-friday-deals-to-reach-shoppers.html

 

  • "The 'New Black Friday' will include five days of sales on Walmart.com and in stores, starting at 12:01 a.m. online on Thanksgiving and running through Cyber Monday, the Bentonville, Arkansas-based company said in a statement today."

 

JWN - Nordstrom Rolling Out Shoes of Prey In-Store Shops

(http://www.wwd.com/retail-news/department-stores/nordstrom-rolling-out-shoes-of-prey-in-store-shops-8029587?module=Retail-latest)

 

  • "Nordstrom is rolling out in-store shops for Shoes of Prey, an Australia-based online firm that enables women to design their own shoes."

 

Cambodia to Increase Minimum Wage

(http://www.wwd.com/business-news/government-trade/cambodia-to-increase-minimum-wage-8030212?module=Business-latest)

 

  • "The minimum wage in Cambodia’s garment sector will be raised to $128 beginning in 2015, a 28 percent increase over the current $100 monthly wage."

 

REI names its first-ever chief creative officer

(http://www.chainstoreage.com/article/rei-names-its-first-ever-chief-creative-officer)

 

  • "Outdoor outfitter REI has added a chief creative officer slot, and hired Ben Steele to fill the position, effective Jan. 1. Steele most recently served as executive creative director at global brand firm Hornall Anderson in Seattle."

 

BBY - Best Buy to open 5 p.m. on Thanksgiving, one hour earlier than last year

(http://www.chainstoreage.com/article/best-buy-open-5-pm-thanksgiving-one-hour-earlier-last-year)

 


Keith's Macro Notebook 11/12: Sentiment | Europe | UST 10YR


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