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WTW: Chapter 11? (4Q14)

Takeaway: Disaster guidance release + premature debt service talk = deteriorating setup in a name that will struggle to tread water moving forward.

KEY POINTS

  1. ANOTHER DISASTER RELEASE: WTW's 2015 guidance came in $0.40-$0.70, well below consensus of $1.43 and our bear-bull case EPS range of $0.71-$1.09.  Management guided to 2015 revenues of $1.2B (down -14% y/y), with the majority of that pressure coming from its core North America segment, which is expected to decline in the low-20% range.  The more important note is that the 2015 may wind up being WTW's worst winter selling season in its history.
  2. AIRING ITS DIRTY LAUNDRY: We're not sure why management chose to highlight its cash preservation priorities, and upcoming 2016 debt maturity, to a sleepy sell-side audience with a 3-yr track record of grossly overestimating its prospects.  The metrics that management provided were somewhat unsettling.   What were once whispers of a potential bankruptcy are now front in center on the street.  
  3. SILENT ON THE HEALTHCARE OPPORTUNITY: Not too much to add here since management didn't provide any incremental color on either the HUM deal or its Healthcare opportunity, which is central to its recovery plans.  Our thoughts here haven't changed.  We don't believe the actual opportunity is anywhere near its $300M estimate, but even if it is, it's small change relative to the $1.4B generated by its core business, which may be in secular decline.  
  4. CHAPTER 11? Still way too early to say, but it doesn’t seem like there is much management can do to avoid it.  Aside from all the anecdotal chatter on how WTW can’t keep up with a rapidly evolving industry, its financials tell a more tangible story.  WTW needs to aggressively invest in its business to return to top-line growth, but its massive debt load ultimately limits most of its options (see charts below).

 

ANOTHER DISASTER RELEASE

WTW's 2015 guidance came in $0.40-$0.70, well below consensus of $1.43 and our bear-bull case EPS range of $0.71-$1.09.  Management guided to 2015 revenues of $1.2B (down -14% y/y), with the majority of that pressure coming from its core North America segment, which is expected to decline in the low-20% range.  The more important note is that 2015 may wind up being WTW's worst winter selling season in its history.

 

WTW: Chapter 11? (4Q14) - WTW   1Q Selling Season 2015 3

 

2015 guidance is inclusive of its plan to cut $100M, but doesn’t include the associated $10M restructuring charge in 1Q.  Management didn’t provide specific 1Q15 EPS guidance, but suggested that it expects to produce “marginally profitable” operating income, but expects to produce negative EPS.  Management is essentially saying that it can’t cover its interest expense in 1Q15.

 

AIRING ITS DIRTY LAUNDRY

We're not sure why management chose to highlight its cash preservation priorities, and upcoming 2016 debt maturity, to a sleepy sell-side audience with a 3-yr track record of grossly overestimating WTW’s prospects (Note the disclosure came before Q&A started).  

 

Management provided the following detail, which are hard to draw any confidence from.  The basic math suggest that WTW is expecting to generate ~$90M in CFO in 2015, vs. the $232M it achieved in 2014.  Further, management painted a picture that retiring its 2016 debt may be a challenge.  

  • 2014 Ending Cash: $301M
  • 2015 CapEx: <$40M
  • 2015 Year-End Cash Target: >$350M
  • 2016 Debt Maturity: $314M (due in April) 
  • 2020 Debt Maturity: $2.4B

Now it’s all on the table; what were once whispers of a potential bankruptcy are now front in center on the street.  

 

SILENT ON THE HEALTHCARE OPPORTUNITY

Not too much to add here since management didn't provide any incremental color on either the HUM deal or its Healthcare opportunity, which is central to its recovery plans.  Our thoughts here haven't changed.  We don't believe the actual opportunity is anywhere near its $300M estimate, but even if it is, it's small change relative to the $1.4B in 2014 revenues generated by its core business, which may be in secular decline.  

 

CHAPTER 11?

2020 is still a whiles away, so way too early to say.  But right now, it doesn’t seem that there is much management can do to avoid it.  Aside from all the anecdotal chatter on how WTW can’t keep up with a rapidly evolving industry, its financials tells a more tangible story.  WTW needs to aggressively invest in its business to get out of its hole; particularly marketing (ad campaigns)

 

WTW: Chapter 11? (4Q14) - WTW   Revenue vs. Marketing 

 

However, increasing advertising spend may not be enough moving forward.  Member acquisition costs (marketing expense/new member) have skyrocketed since 2011.  WTW is now approaching the point where it is barely generating enough gross margin to cover its member acquisition costs.  

 

WTW: Chapter 11? (4Q14) - WTW   Chapter 11 v2

 

Right now, WTW's 2015 guidance is essentially calling for Interest coverage ratio of ~2.0x, which means it doesn't have a  ton of wiggle room, especially given its high fixed cost structure.  Any gamble on investments and/or promotions (e.g. price cuts) could come back to bite them.  

 

WTW: Chapter 11? (4Q14) - WTW   Interest Coverage

 

In summary, WTW needs to aggressively invest in its business to return to top-line growth, but its massive debt load ultimately limits most of its options.

 

 

Let us know if you have any questions or would like to discuss in more detail

 

Hesham Shaaban, CFA

@HedgeyeInternet

 

Thomas Tobin

@HedgeyeHC 

 


Keith's Daily Trading Ranges, Unlocked

This is a complimentary look at Daily Trading Ranges - our proprietary buy and sell levels on major markets, commodities and currencies sent to subscribers every weekday morning by CEO Keith McCullough. It was originally published February 27, 2015 at 08:26. Click here to learn more and subscribe.

Keith's Daily Trading Ranges, Unlocked - HE DTR 2 27 15

BULLISH TRENDS

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BEARISH TRENDS

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February 27, 2015

February 27, 2015 - HE DTR 2 27 15

 

BULLISH TRENDS

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BEARISH TRENDS

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CHART OF THE DAY: Dr. House-ing (2nd Derivative HPI Matters!)

CHART OF THE DAY: Dr. House-ing (2nd Derivative HPI Matters!) - CoD2

 

This is an excerpt from today's Morning Newsletter written by Hedgeye U.S. Macro Analyst Christian Drake.

 

Anyway, after being on the right side of the acute housing demand infarction in 2014, we reversed our diagnosis for 2015 in November of last year alongside our expectation for a recession and reversal in many of the industries underlying maladies.  

 

Since much of what we like about 2015 is what we didn’t like about 2014, juxtaposing the two years across a selection of key factors should sufficiently capture the core of our call.

 

HPI | 2nd Derivative Trends Matter:  Housing demand leads home price growth and housing stocks follow the slope of price growth.  Since 2008 the correlation between housing equities and the year-over-year rate of change in HPI has been 0.90. 

  • 2014:   Home price growth decelerated sharply in 2014, slowing from ~12% YoY in February to ~5% in October according to CoreLogic data.  The housing complex (XHB/ITB) underperformed the market by ~15% alongside that expedited deceleration in HPI.
  • 2015:  Home price growth stabilized in Oct/Nov across all three of the primary price series (CoreLogic, Case-Shiller, FHFA) and have, in fact, shown modest re-acceleration in December.   Performance has again followed suit with the XHB and ITB outperforming the SPX by +12% and +10%, respectively, since the 2nd derivative HPI stabilization began in November.  Ongoing inventory tightness, with months of supply on the existing market holding below 5 months, remains supportive of stable to improving price growth trends over the immediate/intermediate term.  

Net: In the Chart of the Day we show the inflection in housing equity performance following the 2nd derivative inflection in HPI. 

 


Dr. House-ing

“There’s no ‘I’ in team. There’s a ‘me’ though, if you jumble it up.”

-Dr. Gregory House 

 

Sometimes pretending you’re a cynical, misanthropic drug-addict doctor with deific deductive dexterity is what it takes to stay excited about staring at your screen for 14 hours a day. 

 

The Dr. House metaphor is both apt and easy as it relates to the Hedgeye Housing teams (@HedgeyeFIG & me) inquisition for industry research alpha. 

 

Distilling the convoluted milieu of domestic housing data in the attempt to diagnose and front-run positive and negative dispersions from industry homeostasis holds obvious parallels to the challenges inherent to diagnosing physiological pathology in the attempt to front-run … death.   

 

Plus..you know..it illustrates our marginal cleverness with the whole “House” reference.

Dr. House-ing - CoD

Anyway, after being on the right side of the acute housing demand infarction in 2014, we reversed our diagnosis for 2015 in November of last year alongside our expectation for a recession and reversal in many of the industries underlying maladies.  

 

Since much of what we like about 2015 is what we didn’t like about 2014, juxtaposing the two years across a selection of key factors should sufficiently capture the core of our call.

 

HPI | 2nd Derivative Trends Matter:  Housing demand leads home price growth and housing stocks follow the slope of price growth.  Since 2008 the correlation between housing equities and the year-over-year rate of change in HPI has been 0.90. 

  • 2014:   Home price growth decelerated sharply in 2014, slowing from ~12% YoY in February to ~5% in October according to CoreLogic data.  The housing complex (XHB/ITB) underperformed the market by ~15% alongside that expedited deceleration in HPI.
  • 2015:  Home price growth stabilized in Oct/Nov across all three of the primary price series (CoreLogic, Case-Shiller, FHFA) and have, in fact, shown modest re-acceleration in December.   Performance has again followed suit with the XHB and ITB outperforming the SPX by +12% and +10%, respectively, since the 2nd derivative HPI stabilization began in November.  Ongoing inventory tightness, with months of supply on the existing market holding below 5 months, remains supportive of stable to improving price growth trends over the immediate/intermediate term.  

Net: In the Chart of the Day below we show the inflection in housing equity performance following the 2nd derivative inflection in HPI. 

 

 

Credit:  Discrete tightening in 2014 gives way to marginal easing in 2015

  • 2014 Contraction:  The implementation of QM regulations, FHA loan limit reductions and the expiration of the Mortgage Forgiveness Debt Relief Act collectively served to constrict the credit box and capsize housing demand in 2014. 
  • 2015 Credit Box Re-Expansion:  Recognizing the discrete drag on the housing recovery, regulatory policy momentum is shifting away from the over-pricing risk for the current wave of would-be borrowers and towards policy adjustments aimed at improving affordability and modest credit box expansion. 
    • FHA & Fannie/Freddie:  FHA premium cost reductions (from 1.35% to 0.85%) implemented in January along with the re-introduction of 3% down payment loan options from the GSEs for 1st time buyers could boost purchase demand by ~3% over the intermediate term. 
    • Vantage Scoring:  The FHFA is currently considering adoption of Vantage Scoring – a credit scoring system which provides a more comprehensive risk scoring framework than conventional FICO models and is capable of scoring thin file consumers previously locked out by FICO and other conventional models.  Vantage Score 3.0 is estimated to score approximately 30-35mm more consumers than conventional models and could bring ~500K more borrowers into the fold in the coming years under conservative assumptions. 

Net: Growth by the stacking of marginal easings in 2015, while likely to be modest-to-moderate, stands in sharp contrast to the restrictive QM/Loan limit reductions that headlined the regulatory environment in 2014. 

 

Ball Under Water:  The Illusion and the Inflection  

  • 2012-2014 | False Perceptions:  Since the start of 2011 there have been ~5.3mn net, new households formed which, using a historically consistent scalar, require 7.2mn new housing units.  However, there have been just 2.97mn housing units started, resulting in a cumulative supply-demand gap of approx 4.2mn units.  This math has underpinned the bullish ball-under-water housing demand/construction thesis for the better part of last two years.  The misunderstanding has been rooted in the reality that the imbalance has been largely illusory as the number of shared households have increased by over 3.4mn over the same period.
  • 2015:  Bear Market in Basement Dwelling:  The increase in shared households slowed markedly in 2014 and the bottom in “basement dwelling” and headship rates now appears to be in.    The implication of an inflection in shared household growth is that what has here-to been a perceived ball underwater becomes, in fact, a real ball underwater and a true support to new housing unit construction.    

 

Rates:  Rates are currently running ~40bps below their 2014 average, providing an approximate 4% boost to affordability.  With global growth slowing, disinflation/deflation predominating and DM yields anchoring the long-end, we don’t see acute upside risks to bond yields in the immediate/intermediate term.

 

Elsewhere Across Housing Macro:  Residential Construction Employment in January saw its largest sequential gain since November of 2005, employment growth across the key 20-35 YOA demographic continues to accelerate and  Consumer Sentiment around housing – as measured by the University of Michigan’s “Good Time to Buy a Home” index – continues to advance alongside the broader rise in Consumer Confidence and ongoing improvement in the domestic labor market.  Further, the latest CPS/HVS survey estimated that the total number of households grew by 2.0MM in December vs a year earlier, the largest yearly change since July 2005 and the first material acceleration in year-over-year growth in 8 years. 

 

The 2015 Score | RoC Solid:  Mortgage Purchase Applications were up +9.8% in the latest week marking the fastest rate of growth since June of 2013, Pending Home Sales accelerated to their fastest rate of growth in 18 months in December (we’ll get the January data this morning), New Home Sales in January held at 7 year highs, single-family housing starts were up 16% YoY in the latest January data and home price growth is reflecting a fledgling re-acceleration. 

 

In short, our expectation for improving rates of change across the preponderance of housing metrics in 2015 is finding positive confirmation in the early year data.  Of course, cheerleading a call that’s already worked is generally a great way to top tick yourself, but we still like the intermediate term fundamental outlook.  We’ll continue to let Keith risk manage the exposure in RTA. 

 

Was any of the above analytically ingenious?  Probably not, but having a process for effectively capturing, curating and contextualizing the monthly torrent of shifting housing dynamics in real-time is more than trivial for resource and time-constrained investors.   

 

As Sherlock Holmes (the figure on which Dr. House was based) characterized his investigatory process: 

 

“You know my method. It is founded upon the observation of trifles.” ….”It’s quite exciting, he said with a yawn”

 

Our immediate-term Global Macro Risk Ranges are now:

 

UST 10yr Yield 1.84-2.08%

SPX 2091-2120
RUT 1

VIX 13.08-16.65

USD 94.01-95.45

Oil (WTI) 47.61-50.97 

 

The risk of heart attack rises by 20% on Mondays, Enjoy the weekend. 

 

Christian B. Drake   

U.S. Macro Analyst

 

Dr. House-ing - CoD2


KSS – Why We Think Guidance Is Too Bullish

Takeaway: We’re not making any changes to our model, which assumes that last year’s EPS proves in hindsight to be the highest number KSS ever earned.

There was an unusually large number of statements from KSS management during the conference call that stood out to us as being in stark contrast to the bullish financial guidance provided. Despite guidance, we’re not making any changes to our model, which assumes that last year’s EPS proves in hindsight to be the highest number KSS ever earned.

 

KSS – Why We Think Guidance Is Too Bullish - kss financials

 

Here Are Some Of The Standouts From Where We Sit

  • Wage Increases. In commenting on KSS stance on the impact of WMT’s 25% wage increase, Kevin Mansell noted that employees at KSS are not monetarily driven. We understand the sensitivity of making comments about wages to anyone other than the employees themselves – especially the financial community. But he averted the fact that KSS faces the biggest wage risk out of any major retailer (even more than Target) . The fact is that KSS pays its floor associates and cashiers about 6% less than the TGT/WMT average. It even characterizes itself as ‘best in class’ when it comes to payroll optimization, i.e. not paying its employees. We aren’t making a moral judgment, simply following the laws of supply and demand. When we extrapolated the wage increases from WMT ($1850 per employee) to the 106,000 part time employees at KSS, we get to 104bps in margin pressure and $0.62 in earnings. Are we modeling all of that? No. But when the 900 pound gorilla in the US employment market makes sweeping changes to its hiring and payment practices, it’s hard to imagine that KSS won’t feel the impact. No doubt that the company will try to hold off as long as it can, but eventually it will be forced to follow suit.

 

KSS – Why We Think Guidance Is Too Bullish - 2 23 chart3

 

  • Shipping Costs.  Kohl’s currently has a $50 threshold for free shipping. In answer to a question about Target’s reduction of its shipping minimum to $25, management said “…free shipping at $25 – that’s something that I don’t think will work for us long-term from a profitability perspective.” They’re right. The irony is that even $50 doesn’t work for Kohl’s either as DTC margins are already 1000bps below B&M sales. The reality is, KSS was forced to drop the free shipping minimum because it needed to incentive shoppers to protect its market share. As KSS commoditizes its merchandise (more National brands) it will have to fight tooth and nail for every point share. TGT’s move is the first domino to fall on the shipping size, but the bottom is not $25, it’s $0 – which is where we think all the major retailers, including KSS, will be within 24 months.

 

 

Gross Margin

  • The company admitted to the fact that it will face a 30bps-40bps head wind per year from e-commerce. 10bps-15bps come from mix alone, and the other 20-25bps is due to shipping expenses.
  • That’s not new to us, and it’s something we already have factored into our model. For the year we are modeling GM down 40bps. How we get there…
    • For 2014 we estimate that the -9bps move in gross margin was a function of B&M margins up 45bps and DTC down 50bps. Store level margins are now at 37.9%, 100bps off 2011 peaks. We don’t see it going any higher from there as the company mix moves towards National brands and the Yes2You rewards increases as a % of sales giving consumers who previously didn’t qualify for a 5% rebate.
    • In 2015 - we’re modeling B&M margins down 25bps due to the aforementioned headwinds, and DTC margins up 100bps as ship from store helps offset some of the negative shipping impact. DTC moving from 11% of sales to 13.5% equates to GM down 40bps for the year

KSS – Why We Think Guidance Is Too Bullish - kss dtc gm

 

SG&A

  • Rewards Members – Since the analyst day in late Oct. Kohl’s has added 10mm new members to its Yes2You platform. That’s positive momentum in the program for sure, but the most troubling aspect of the increase is that almost 60% of the newest additions are existing credit card holders. Those credit card holders already account for about ~60% of sales and the fees generated from those sales account for about 25% of operating profit.
  • Of the 30mm credit users, 40% are now enrolled in the Yes2You program.

 

KSS – Why We Think Guidance Is Too Bullish - y2y table

 

  • Credit Income. On the call McDonald guided to credit income being up for the year. We’re highly skeptical on that front for a couple of reasons.
    • We think that KSS was playing defense when it rolled out the Yes2You program. The company is already tops in the industry in terms of credit penetration at 60% (M is only at 47%), and it got the last bps by switching its partner to COF from JPM. COF has a much lower credit threshold and allowed KSS to scrape the bottom of the credit eligibility barrel.
    • Now COF is pulling back the reins – so reaching new consumers is extremely difficult for KSS. Hence the Y2Y. The problem is that you now have 40% of a consumer group who accounted for 25% of operating profit enrolled in a program that lets consumers get double points. Once at KSS and once on a national credit program.
    • The manifestation of that will most likely flatten out the curve in penetration (and SG&A offset) until it rolls all together. By our math, $62mm in operating profit is at stake.

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