This note was originally published at 8am on February 20, 2015 for Hedgeye subscribers.
"You can’t expect the Fed to spell out what it’s going to do...because it doesn’t know."
-Stanley Fischer, Fed vice chair
The economy is like a pendulum. It oscillates above and below productivity growth but never really falls exactly on center.
“Potential Output” and “NAIRU” (non-accelerating inflation rate of unemployment) are nice theoretical constructs and are helpful in conceptualizing a tractable macroeconomic framework but they can’t actually be measured with precision and can only be approximated after the fact.
Fascinatingly, despite the abject amorphousness and immeasurability of those concepts, the perceived real-time state of the macroeconomy relative to them remains central to the Fed’s policy calculus.
Policy makers often play the role of antagonist in our daily strategy narratives but, in truth, we don’t particularly envy their challenge.
Consider the following middle school riddle:
Q: How far can you walk into a forest?
A: Halfway – after that you are walking out of the forest.
Macro policy making can be similarly enigmatic. Policy makers generally know the correct direction to take (easing/tightening) but don’t necessarily know how big the forest is (the output gap) and the mapping tools (models) used for orienting oneself inside the forest to understand where you are and how far you’ve actually gone are underdeveloped…oh, and the forest isn’t static – it’s dynamic (subject to global/exogenous shocks), reflexive (policy action itself perturbs the system) and changes shape and size as you try to walk through it.
A perennial problem faced by policy makers is determining whether short-run deviations from potential (remember: the macro pendulum is always above/below potential & we don’t actually know the value of “potential”) represent a transient dislocation amenable to policy action and transition dynamics or if potential output/growth itself has changed. Discerning which scenario correctly reflects the underlying reality is critical as the appropriate policy prescriptions can be antithetic.
The post-crisis period has only added an exclamatory emphasis to Fischer’s characterization of the Fed’s limited capacity to convictedly forecast macrofundamental changes over any extended period. Indeed, in the wake of the Great Recession, what were once decreed macroeconomic “Laws” were downgraded to “Guidelines” and then further decremented to something akin to “conceptual guideposts”.
To review some of the notables:
Phillips Curve: The Phillips Curve – which can also be viewed as the aggregate supply curve in the vaunted AD/AS macro model - relates the change in the inflation rate to the level of short-run economic activity. Here, a negative output gap drives a negative change in the rate of inflation and a positive output gap drives a positive increase in the rate of inflation. The idea is compelling, intuitively appealing, and holds up fairly well historically. However, as Larry Summers has been apt to highlight, the relationship has failed to hold more recently: “inflation did not decelerate by much even a few years ago when unemployment was in the range of 10 percent. Nor was there much evidence of accelerating inflation in the 1990s, when the unemployment rate fell below 4 percent. “
This breakdown in the output-inflation link is important. The conventional view is that the level of output drives inflation which, in turn, drives the policy response. A structural break in the output-inflation connection leaves policy without its proverbial North Star.
Law & (Dis)order ….
Okun’s Law: Okun’s Law – named for Kennedy economic advisor Arthur Okun - links the growth rate of output to changes in the unemployment rate and says that short-run output needs to grow ~2.25% above trend to reduce unemployment by 1%. Historically, the relationship has been strong with ~70% of the annual change in unemployment explained by the change in GDP growth. In the Chart of the Day below we show Okun’s Law on an annual basis over the 1948-2014 period. We’ve highlighted the large dispersion/break from trend in the peri and post-crises period with unemployment spiking higher than predicted by the model in 2009/10 and subsequently falling faster than predicted over the 2011-14 period.
Secular and structural changes in the economy and labor market have certainly shifted the relationship over the last 65 years and the Great Recession served to bring those changes further into focus. But that’s also largely the point. If the forecast error in a workhouse macro model such as Okun’s Law rises to such an extent that its practical utility is lost when it’s needed most, the conventionalist forecaster’s tackle box gets increasingly bare.
Rules & Tools ….
Conventional expansionary policy works to increase investment (& export) demand by expanding the spread between the marginal product of capital and the real interest rate. This works well over “normal” cycles and particularly well on the right side of an interest rate cycle (think 1983-2008) when decades of lower highs and lower lows in both real and nominal rates support recurrent layering of debt augmented demand and asset price inflation.
Conventional policy breaks down in a demand vacuum perpetuated by the long-term rate cycle reaching its terminal end. In short, no one cares if the real interest rate is below the marginal product of capital if there is no demand for the output you produce using that newly purchased “cheap” capital.
Mo’ Money, Mo’…. Inflation?
But #StrongDollar is sweet, right?... Lower gas prices, higher share of wallet for other discretionary purchases, cheaper imports, stronger intermediate-term domestic consumption. Rising domestic demand, tightening capacity, and a taut labor market should support incremental wage and demand-pull inflation. Viva la Phillips Curve! True, but the inflationary impacts are more likely to manifest over the medium term and provided the domestic labor market remains something of an insular island of strength.
Duration Mismatch ….
In the more immediate term, an expedited appreciation of the dollar, the associated cratering in energy/commodity prices and decline in import prices drives disinflation domestically. Global deflationary pressures only exaggerate that impact.
Keepin’ it Real ….
The other side of lower inflation (besides the simple fact that it’s running at <50% of the 2% target) is rising real interest rates and the goal of expansionary policy is lower – and preferably negative - real rates. That disinflation is predominating globally and fixed investment (still) flagging with most central banks sitting on 0% six years post-crisis is not particularly comforting. Again, there are no good analogues for the current global dynamics and conventional policy efforts have been Sisyphean.
Wet Noodles & Rented Alpha ….
What do you do with this quasi-random redux of post-crisis creative destruction in conventional macro modeling?
Mostly it’s just an incremental noodle to noodle over as you noodle over the Fed’s latest noodling over lagging macro data.
More tangibly, I think it edifies Fischer’s quote above. Effective policy action, even in “normal” times is challenged by the realities of imperfect information, incomplete understanding and structural shifts unamenable to the coarse tools of monetary policy.
Those challenges have only been amplified in the post-crisis period and have only heightened the magnitude of uncertainty facing policy makers and, by extension, market participants.
Uncertainty breeds volatility and volatility breeds market dislocations. Market dislocations, however, are (still) alpha’s breeding ground. We expect the already rampant cross-asset class volatility to persist.
When I was in coaching/bodybuilding, the running punchline for steroid users with no process and marginal work ethic was that they had a “rented physique”. Great moderations, secularly depressed volatility and leverage is like rented alpha.
Our immediate-term Global Macro Risk Ranges are now:
UST 10yr Yield 1.79-2.15
Oil (WTI) 49.09-53.99
To not being “that guy”,
Christian B. Drake
U.S. Macro Analyst
Takeaway: KATE should be bought on the latest guidance freak-out. We review why we think the company will outperform the expectations traded on today.
Conclusion: We think that KATE should be bought on Thursday’s sell-off, which was spurred by concerns about 1Q comp trends after KATE hosted a meeting with investors. This company has all the credibility in the world executing on its business model, but not in guiding the Street. Quite frankly (and perhaps over optimistically) we’d have thought the market would start to see through the KATE guidance gauntlet. We think its guidance is conservative, and the Street’s interpretation even more so. More often than not, these communication bubbles create a great opportunity to buy a fantastic long-term story. This is one of those opportunities. Though this note focuses almost entirely on the 1Q comp number, the real call (including 1Q) is a roadmap to a $75 stock.
Today KATE did what KATE does, traded down significantly on information that we think is misleading. Specifically, a group of investors visited management, which resulted in a broker issuing a 1Q comp forecast of +3.5%. We don’t think anyone fabricated information out of thin air. Chances are (and we spoke with several people in attendance) the company gave tangible reasons why comps will start of the year soft, and we think that the ensuing report took an even more cautious posture on management’s assertions. We simply don’t believe either of them.
We hate to play the guidance game – and most people who know us know we usually look through most of it as noise. But let’s strap the accountability pants on for KATE management…
- At the beginning of 2014 it guided to 10-13% comp, and ultimately came in at 24% for the full year.
- KATE said it would start out last year comping in the high-teens, and it printed 29% six weeks later in 1Q.
- In 4Q KATE guided to 8-14%, and put up a 28%.
We’re going to go through the puts and takes below, but keep in mind that this is a company where you have to watch what they do, not what they say. They don’t have the communication thing down pat, but the company can execute on a world class business plan with the best of ‘em. That’s what matters.
Also… let’s keep one thing in mind – it was just last week that KATE printed the best comp in all of retail – or 28% on top of a 30% comp in the prior year. And now it is going to slow to 3.5%? Heck, e-commerce alone should get the brand above a 6% comp (it’s about 20% of the business and grew in 4Q at better than 50%). If the company is going to put up a 2,500bp deceleration on the 1 and 2-year comp, then the stock SHOULD sell off – probably a lot more than it did today – and doesn’t deserve its current valuation.
But we think KATE definitely deserves it, and then some. We’re modeling 10% in the upcoming quarter, and 18% for the full year. We’re getting plenty of hate mail for ‘disagreeing with the company’ and setting an unrealistic hurdle rate. But we didn’t just pick 10% out of the air. Below we go through all the puts and takes on factors including e-commerce, flash sales, Japan, FX, Saturday/Jack Spade, and inventory positioning.
Despite all the real estate in this note dedicated to a singular comp number in the seasonally least important revenue quarter of the year, the focus for us is still on the BIG call, which is $3 in earnings power as the brand footprint doubles over 3-4 years and EBIT margins go from 11% to 19% -- and that story plays out starting today.
What’s It Worth? So that begs the question as to what we should pay for KATE. By the end of this year, we’ll be eyeing about $345mm in EBITDA and $1.30 in EPS. When looking at the 50% and 100% growth rates in EBITDA and EPS, respectively, we could definitely argue a big multiple. On the flip side, this is a fashion business, and there will almost certainly be a time (like KORS is experiencing now) where it will see multiple compression as it matures. But keep in mind that KORS has a brand footprint of $6.4bn and EBIT margins of 30%. KATE has a $1.4bn footprint (smaller that Tory Burch at $1.9bn) and margins of only 11%. It will be a long time before we have to ask the ‘is it over’ question. Until then, we think the multiple will continue to defy gravity in the eyes of anyone that’s not a growth investor.
For argument’s sake, let’s keep the forward multiples in place that KATE has today – 50x earnings and 19x EBITDA. We think that there’s upside this year as the company beats. But on 2016 numbers we’re looking at 50x $1.32 = $66, or 19x EBITDA in the mid 50s. Roll ‘em to ’17 and you get to over $2+ in earnings power, or around a $75 stock.
HERE ARE SOME OF THE KEY FACTORS AS IT RELATES TO THE 1Q COMP
The company cites a reduction in flash sales as the main driver of the sales pullback in the year. For the record, management said the same thing last year during the 4th quarter where they turned a flash sale into a theme sale, and dot.com comps were up 45%-55% in the quarter.
We checked the e-mail archives and counted 6 major promotional campaigns during the first quarter of last year. 3 were flash sales, which occurred on: 1/22, 3/18, and 4/4. With one 3 day ‘Friends and Family’ event that kicked off on the 2nd to last day of the quarter.
To date KATE has done one flash sale on 2/10/15, right in line with when it appeared last year. It didn’t repeat the first 1-day bag specific event of the year, but as you can see later, it didn’t have a negative impact on traffic flow. We’ll be tracking each promotional event as the quarter progresses to see if they follow the same March playbook. The thing we don’t know is the velocity or overall product availability. That could cause some fluctuation in overall sales, but we don’t suspect a big divergence from last year.
Lastly, KATE launched its e-comm operation in England during the 4th quarter. That should have positive implications as the business builds and awareness grows into 1Q.
The first chart below shows the year over year change in traffic rank. Directionally we’ve found it to be a very good indicator of the overall health of a company’s online business. It takes into account 2 metrics (unique visitation and page views/user) and tracks each URL in relation the internet in aggregate. KATE’s rank has pulled back over the past few weeks, which is what we expected (as business slows seasonally after holiday and before Easter), but still sits +38% YY. For reference the trough in the chart below corresponded with 3Q when dot.com put up its lowest growth rate of the year at 21%.
If we look at visitation at a much more granular level, we see the same type of trend. Chart below looks at the reach spread and attention spread from 12/31/14-2/28/15. Here reach is defined as the percent of total users on the internet visiting a site on a given day and attention is the amount of time spent on the internet dedicated to a specific URL on a given day. The spread is calculated by taking this year’s reading minus last years, each day corresponds with the appropriate calendar day from LY. Anything North of the x-axis is positive. Anything south is negative. Overall the trend has been decidedly positive. With the big spike in February corresponding with the ‘Flash Sale’.
If we compare that to what we saw during the 4th quarter where there was 2 ‘Flash Sales’ and 1 ‘Theme Sale’ the trend looks very healthy.
Japan is one of the moving parts to the comp story here. Overall it is about $135mm-$165mm in revenue, or 12-15% of total. There are some puts and takes as it relates to the impact on comp that should be considered.
Japan was added to the comp base in the 1st quarter of last year. And it came out of the gates hot comping +37% (44% if you include the impact of the extra week). Some of that was driven in part by the nation-wide hike in consumption tax from 5-8%. But if we look at the trend in that business, comps accelerated to +25% in the 4th quarter on top of a +19% last year. Currency could be a headwind, but management noted on the call that the a) inventory is 75%-80% hedged for the year, and b) the Yen has only deprecated 200bps since the end of last quarter.
- Let’s say that comps in quarter are flat, which would imply a 300bps deceleration on the 2yr trend line, and sales growth for the rest of the company was 20%. We are looking at 360bps of headwind to the company average. Or, bear case, Japan is down 10% we are looking at 540bps of dilution.
- Realistically, let’s assume that the 2-year run rate stays even with 4Q levels – even though it is actually trending higher. A 6% Japan comp would imply a 22% 2-year trend. That suggests 250bps of sequential headwind on a consolidated basis.
Kate Spade Saturday could cause a slight disruption, but guidance doesn’t assume any effect from the closure. Relative to the size of distribution in the country (KSS and Jack Spade represent about 15% of the distribution in Japan assuming wholesale and retail doors increased by 15% this year) Saturday could curb some demand. But we think it’s important to remember a) these stores are in their infancy with the majority of doors still within a year of the open date, b) brand recognition is still extremely low, and c) there is a reason management shuttered the retail operation.
KATE inventory was up 16% to end the year compared to +46% last year. The consolidated balance sheets don’t reflect that because of the divestitures of Juicy and Lucky. But, a lot of that was due to excess inventory in the Jack/Saturday lines. The company took a 240 basis point hit to liquidate the 2013 Kate Spade Saturday launch year inventory in the 2nd quarter and cost the company ~$6.4mm. And it took another $8.6 million hit in 4Q from. Adjusting for that, inventories should be in-line to support the top-line growth we are modeling. Port closures are an issue, but KATE who will do just north of $250mm in the quarter should be nimble enough to accommodate.
Due to the calendar last year, Easter was pushed back to 4/20/14, compared to 3/31/13. It’s likely that some of the sales that would have been pushed into 2Q of last year were pulled forward due to targeted promotions. We think that’s extremely hard to quantify, but we’ll give them the benefit of the doubt. This year’s Easter falls on 4/5/14. One day after the quarter closes and should be good for a point or two of comp.
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