Takeaway: Expect a lot of pin action in 2015. Here’s a) where we think the pins will fall b) when they'll fall, and c) what to be long/short.
Conclusion: The cadence of earnings growth in 2015 is more critical to retail than we’ve seen in a long time. We constructed a bottom-up financial model of key players in the industry to plan a quarterly playbook. The punchline is that near-term, Retail still has a quarter of opacity left which will keep names like KSS trading at seemingly ridiculous multiples -- but the clock is ticking. By quarter; 1Q is a slamdunk, 2Q should show the real (i.e. less favorable) earnings power of the group, and 3Q/4Q should show accelerating cost pressures on top of tough margin and working capital compares – which will pressure growth and returns. All in, we’re looking at mid-teens earnings growth today slowing to perhaps 300-400bp by year end (and all of that 300-400bp is driven by today’s financial engineering that will carry throughout the year).
Names To Own: RH, KATE, (and less enthusiastically) WWW. Also KORS, NKE, RL, CROX, MW, ANF, VNCE on our Bench.
Names To Short: KSS, HIBB, FL, JCP, TGT, M. Bench names include: WSM, GPS, DKS W, CRI, GES
Expectations By Quarter
There should be a meaningful bifurcation in the financial model for the softline brands and retailers as 2015 progresses – more different than we could recall in recent memory.
Details Of Our Analysis
In the analysis below, we reconstructed an income statement and balance sheet based on a group of 15 companies that we consider to be representative of the US Softline retail space. Note that quarterly numbers for 2-years are represented on the left side, and the corresponding annual numbers for the past decade are on the right. Here are some key points to consider (each numbered point refers to the corresponding chart in the Exhibit below).
Something To Keep In Mind as it Relates to Margins
Aside from the ‘tough compares’ argument (which is usually thin on its own), there are other factors that we think will temper margins in 2H. Those are a) wages and b) shipping.
a) We all know how Wal-Mart announced that it is taking up wages by 40% for its store-level employees. Target has since increased wages, and we think other retailers will follow. So many retailers seem to have blown this off thinking that it’s really not a big deal, but rather a WMT PR stunt that won’t affect them. It may be a stunt, but when the biggest retailer in the world raises wages by $1,800 per employee, it is a big deal for everybody. We’ve heard half a dozen CEO’s say “We already pay above minimum wage, so it’s not a big deal.” Or in Kohls’ case, “Our employees love to work, so we don’t have to pay them more.” We understand that the companies can’t negotiate wage increases with employees through Wall-Street conference calls. But there will be an impact to almost everyone who sells to the low/mid-level consumer. The reason why we haven’t seen it yet is because we’re now at a seasonal lull for retail. By July, retailers will start beefing up temporary workforce ranks for ‘Back to School’ and then they kick it up a notch again in October as they prepare for Holiday. With the exception of grocery retailers, they ALL follow that pattern. That’s precisely when we’ll see the biggest wage pressure.
b) The other big issue is ‘free shipping’. Target went ‘free shipping’ last holiday, and just cut its free shipping threshold in half to $25. We suspect that it will go Free again this year, and would not be surprised in the least to see several other retailers use this as an offensive weapon. Unfortunately, for almost everybody except the bullet-proof content-owners of the world (i.e. Nike) such a move will be dilutive to margins. Even worse news is that if they don’t play ball, then there’s risk to the top line (i.e. if either KSS or JCP opts-in to the free-shipping game, they both lose). We still think that by the end of FY16, all of retail will be 100% Free Shipping, 100% of the Time.
Other Considerations On the Group
6. SIGMA Looks Outstanding. This is exactly what we’d expect to see given the easy margin compares and solid working capital trends outlined above. As a reminder, this analysis triangulates sales, inventories and margins, and has a 0.92x r-squared with stock movements of the underlying security. In this instance, the Retail Softlines group is sitting in the upper right quadrant – Quadrant 1 – which we call the Sweet Spot. Simply put, sales are growing faster than inventories, and margins are expanding. It really does not get better – unless it happens again, and again. We think we’ll get one more move higher into the upper right. After that, any possible move results in the group trading lower.
7. The RNOA Map Is Really Peaky. Think of this analysis as a longer-term SIGMA. Margins are on the Y Axis, and Operating Asset Turns are on the X. It’s like a SIGMA including all elements of working capital and capex instead of just inventories. When we see a stock or index trading at new highs, we expect its’ RNOA Map to look precisely like it does below. Moving up and to the right. Could we see improvement in asset turns from here? It’s unlikely given that working capital is already troughing, and we’re seeing capex trend higher in 2015. In that case, could we at least see margins head higher? Again, we don’t think so…especially with the cost pressures emerging in the back half.
8. RNOA. The components of RNOA broken in #7 matters most to us. But the simple math is that you multiply tax adjusted margins by operating asset turns to arrive at RNOA. If a company has 6% margins and 3x asset turns, it results in 18% RNOA. The group is sitting pretty today at about 28%. We’ll be surprised to see this group above 28% (and even above 27%) at the end of this year. We think that both margins and asset turns will start to go the wrong way.
Companies Included: CRI, DDS, DKS, FL, GPS, JWN, KSS, M, NKE, PVH, RL, ROST, TJX, VFC, WWW
Hedgeye Retail Idea Summary
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CZR - CEO Loveman said on CNBC, "Things in Vegas are getting better." The gambling mecca "is more buoyant, in large part because supply has been stable now for some time, demand patterns are improving, the convention and meeting business is robust," Loveman said. "We've enjoyed a great start to March Madness, which is always a good time for us."
Galaxy- Francis Lui Yui Tung, vice chairman of Galaxy, said, "You cannot expect that from now on all the profit growth you [Macau operators] have enjoyed for the last 10 years is going to continue… So personally, I think, [that] you have to adjust yourself to make sure that in the next 10 years’ time you will be equally profitable.” “We used to have 38 tables at Grand Waldo, so the initial plan is that we could bring 30 tables back in,” stated the executive.
Asked about reports that Macau government proposals to amend the Individual Visit Scheme (IVS) system of inbound visas for mainland travelers to Macau had been submitted to Beijing, Lui said: “I have no information that ideas on the IVS policy have been sent to Beijing. I have been reading in the newspaper that there are talks we should review the IVS policy, making sure it is not going to interrupt the lifestyle of the citizens of Macau. I do agree you can’t forever keep pumping people in here [Macau]. I think you have to encourage quality customers to come into Macau and make sure there is a balance [of locals’ interests and visitor interests].”
Takeaway: A new normal is here for Macau. Galaxy Ph2 may only get 150 tables.
AMAYA - sold Cadillac Jack to AGS for C$476 million comprising cash consideration of C$461M, subject to adjustment, and a C$15M Payment-in-kind Note, bearing interest at 5.0% per annum and due on the eighth anniversary of the closing date. Sale is anticipated to close in 2015.
Landing - Landing International Development Ltd confirmed that negotiations for the company to acquire the foreigners-only Alpensia casino at Holiday Inn Resort in Pyeongchang, South Korea, have ended without a deal. “Some of the conditions set out in the…sale and purchase agreement had not been satisfied or waived and no extension of the long stop date had been agreed; hence, [the] sale and purchase agreement lapsed on 28 February 2015,” the company said in a filing on Friday.
SGMS - announced that the El San Juan Resort & Casino, a Hilton Hotel in Puerto Rico, has selected an array of Bally systems and games products to upgrade and enhance the property's overall gaming and entertainment experience.
As part of this technology upgrade, El San Juan Resort & Casinowill also install 56 new Bally-branded slot games, including the award-winning Pro Series Wave cabinet and such premium titles as 88 Fortunes, Michael Jackson Wanna Be Startin' Somethin'TM, The Magic of David CopperfieldTM, TITANIC, and ZZ Top Live From TexasTM. The casino operator is also installing Scientific Games' Shuffle Master Blazing 7s blackjack progressive side bet as part of its technology upgrades.
Graft - Two senior officials with Macau’s Marine and Water Bureau are under investigation on suspicion of accepting bribes to commit illegal acts, the city’s Commission Against Corruption said on Saturday night. Both of the officials, who were not identified, have been taken off public duties, the commission said in a statement. The pair have also been restricted from leaving Macau.
Japan - Prospects for legalizing casino gambling in Japan suffered another blow on Monday as proponents said they would delay a bill allowing "integrated resorts", as the ruling coalition remains divided on the controversial measure.
Pro-casino lawmakers had said last week they would resubmit a previously failed bill by Tuesday, the end of the fiscal year. But they backed away from that plan on Monday as efforts continued to get the backing of the junior partner in Prime Minister Shinzo Abe's coalition.
Takeaway: Could be nail in coffin
Hedgeye Macro Team remains negative Europe, their bottom-up, qualitative analysis (Growth/Inflation/Policy framework) indicates that the Eurozone is setting up to enter the ugly Quad4 in Q4 (equating to growth decelerates and inflation decelerates) = Europe Slowing.
Takeaway: European pricing has been a tailwind for CCL and RCL but a negative pivot here looks increasingly likely in 2015.
In this excerpt from today’s edition of The Macro Show (click HERE for the full replay), Hedgeye CEO Keith McCullough reveals how he looks at volume relative to price when analyzing a security, and how moving averages trumpeted by traditional media don’t show the whole picture.
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