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WSM | Cat Out of the Bag, But Still Expensive

Takeaway: Here's a quick summary of where we stand on WSM, as well as links to our 90 page Home Furnishings Black Book and video presentation.

HOME FURNISHINGS BLACK BOOK

Slide Deck: CLICK HERE

Video Replay: CLICK HERE

 

Here's a quick summary of where we stand on WSM, as well as links to our 90 page Home Furnishings Black Book and video presentation.

 

WSM  |    Cat Out of the Bag, But Still Expensive  - wsm chart1

 

CONCLUSION: There’s nothing structurally broken here (nothing major, at least). This is a good company with a portfolio of above-average quality brands. But growth is absolutely slowing here – not just cyclically, but also secularly. This should half the EPS growth rate into the mid-single digits (without an acquisition), and take down WSM’s industry leading returns. At a 15x multiple, we wouldn’t care, especially given that the company just rightsized the upcoming quarter’s expectations last week. But at almost 22x earnings when we’re looking for growth of 8%, we simply think this is too rich.

 

What We Like:

a) The core Williams-Sonoma brand is extremely defendable.

b) West Elm scores very well on our consumer surveys. It’s like a down market RH – and there’s a market for that.

c) DTC stands at 50.5% of total, which is the highest in all of retail except for pure play e-tailers like Amazon and Wayfair. d) WSM has a demonstrated history of buying back stock.

What We Don’t Like:

a) The core brand only accounts for 21% of sales.

b) West Elm should have 87 stores by the end of the year. We think there are only about 120 markets in the US that make sense for WE.

c) WSM is not ‘channel agnostic’. It is set up in a way where Retail competes against DTC for the same sales dollar. It works for now, but we don’t like it.

d) When net income growth reverts down to the 7-8% range, the company is likely to cut its repo activity in half unless it levers up to support it.

e) Ultimately, we think that the balance sheet will be put to use to make an acquisition – a late-cycle move to get growth going. We’re actually not against this at all for WSM assuming the deal is right, which is odd for us to say.    

 

WSM  |    Cat Out of the Bag, But Still Expensive  - WSM chart2 


PIR | We're Going Against The Grain -- Long

Takeaway: Here's a quick summary of where we stand on PIR, as well as links to our 90 page Home Furnishings Black Book and video presentation.

HOME FURNISHINGS BLACK BOOK

Slide Deck: CLICK HERE

Video Replay: CLICK HERE

 

Here's a quick summary of where we stand on PIR, as well as links to our 90 page Home Furnishings Black Book and video presentation.


PIR  |  We're Going Against The Grain -- Long - PIR chart1

PIR  |  We're Going Against The Grain -- Long - PIR chart2

 

CONCLUSION: PIR is a beaten-up, ugly value stock…there’s no two ways about it.  But with the stock trading at just 0.5x sales – a level it hasn’t sustained in six years -- we think there are two primary questions to ask. 1) Are we going into a major recession? and 2) Is management going to do anything stupid and destructive that would otherwise emulate a major recession?  If you answer ‘No’ to both of those questions, then we think it’s a very good risk/reward to buy the stock.  

 

Our Answers:

1) We have some major questions marks as it relates to the economy, but we’re not calling for an all-out recession.

 

2) This is a company that is no stranger to execution issues, but we don’t think that management is about to do anything stupid that would cause a downturn in the business (espec w ouster of CFO in Feb). Quite the opposite, in fact.

 

Consider this…

1. Over the past three years, PIR gave up 5 points of margin as it played catch-up with its e-commerce business, which stood at only 1% of sales in 2013. Today it is pushing 17%. E-comm will continue to be a headwind as it grows to the mid-30s (about 130bps of dilution over 4 years), but the combination of merch margin recovery and store base rationalization should more than offset the dilution. We think that ~300bps of the margin recoverable.

2. Interestingly enough, in our survey in this report, PIR’s categories ranked as the ones where consumers are most apt to switch sales online. If there is any company that should have invested in e-comm, it is PIR. 

3. We’ve had three straight years of elevated capex as the company built out e-comm capabilities. That rolls off this year, with asset consolidation (closing stores) and multi-year margin tailwinds takes RNOA from trough levels at 19% in FY16E to 31% by 2020. That’s a long tail, but even the slightest sign that we’ve found the bottom should make this stock rally. 

 

 

 


RH | Here's Where We Stand

Takeaway: Here's a quick summary of where we stand on RH, as well as links to our 90 page Home Furnishings Black Book and video presentation.

HOME FURNISHINGS BLACK BOOK

Slide Deck: CLICK HERE

Video Replay: CLICK HERE

 

Here's a quick summary of where we stand on RH, as well as links to our 90 page Home Furnishings Black Book and video presentation.


RH  |  Here's Where We Stand - RH chart1

 

 

TRADE: The Sept 10 print marks one of the few times we’ll expect ‘only’ an in-line print from RH. The timing of new product launches (Modern/Teen) has been well-telegraphed by management for 2H, not 2Q. Nonetheless, we’ll still be looking at 25-30% EPS growth.

 

TREND: The catalyst calendar looks solid for RH. Immediately following the print, we’ll see the launch of RH Modern and RH Teen. Then we’ll see four successive Design Gallery openings in Chicago, Denver, Austin and Tampa. Square footage will subsequently accelerate from a mid-single digit level to over 30%.

 

TAIL: We think RH will earn close to $11 per share in 3 years, which compares to the consensus at just over $6. The square footage component is well known, but we think people are missing…

a) the productivity and market share that we’re likely to see from each new store

b) how scalable this business model is without commensurate capital investment,

c) the leverage we’re likely to see as below-market real-estate deals being struck today begin to impact the P&L.

 

RH  |  Here's Where We Stand - RH chart2


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W | Lightning Rod

Takeaway: W turned out to be the unintentional lightning rod of our Home Furnishings Black Book presentation yesterday. Here's the summary and links.

HOME FURNISHINGS BLACK BOOK

Slide Deck: CLICK HERE

Video Replay: CLICK HERE

 

W turned out to be the unintentional lightning rod of our Home Furnishings Black Book presentation yesterday. Here's the summary and links.

 

Full Text (in larger font) is below.

W  |  Lightning Rod - W chart1

 

This chart show the percent of people within each income bracket that are comfortable buying furniture without first touching it. 

W  |  Lightning Rod - W chart2

 

This chart shows that Wayfair's price points are meaningfully above what people are willing to pay. The company needs a high-end consumer, and even that might not be enough.

W  |  Lightning Rod - W chart3

 

CONCLUSION: We think Wayfair is a structural short. It might have RH’s sales base and market cap, but it’s unlikely to ever have RH profitability. Actually, it is very unlikely to earn a penny -- ever.  Here’s why…

1) Mono Channel does not work. Restricting sales to just the internet in this category, is just as bad as a retailer who focuses 100% on physical stores. Both are highly likely to fail over time.

2) TAM is limited. The categories that W needs to grow its business profitably skew to the higher-end consumer who is focused on aesthetic and assortment. W’s consumer is focused on Price. The competitive set there is not pretty. Of the $323bn home furnishings market, we think that just $20bn is relevant for W.  In other words, it currently has 12% share of its market. RH has 3%, IKEA 4%, WSM 6%, and PIR 1.5%.

3) The financial model does not work. Could W build from $2bn in revenue to $5bn over 3-4 years? Yes, it could. Given its solid balance sheet and lack of working capital, there’s no reason why that can’t happen. BUT, the whole time it will likely continue to lose something in the vicinity of $100mm/yr.

There will be ebbs and flows in this model when people will temporarily believe that it could make money. But let’s be clear, this is not like AMZN, who simply has to stop investing in drones and smart phones in order to make EBIT margins pop. Given Wayfair’s lack of capital intensity on the balance sheet, it has to continually invest in the P&L (SG&A) in order to grow.

 

 

 


CHART OF THE DAY: "It's The [CYCLE], Stupid

Editor's Note: The chart and excerpt below are from today's Early Look which was written by Hedgeye Senior Macro Analyst Darius Dale. Click here if you would like to leave lousy, consensus research behind and up your market game with the fastest-growing Independent Research platform on 2.0.

*  *  *

 

CHART OF THE DAY: "It's The [CYCLE], Stupid - Chart of the Day

 

  • Bayes factor (i.e. the base effect): Roughly two-thirds of the time, the second derivative of GDP in the forecast period carries the opposite sign of the second derivative of GDP in the comparative base period. Moreover, as the Chart of the Day below shows, there is exists a considerable degree of negative cointegration between the comparative base effect and the subsequent YoY growth rate. Translation: we have a reasonable basis for knowing which direction (up or down) to adjust the base rate.

 


Do You QoQ?

"Prediction is very difficult, especially if it's about the future."

-Niels Bohr

 

Most (if not all) of you are at least somewhat familiar with Nobel Laureate Niels Bohr and his contributions to the field of physics – namely developing a working model of the atom and laying the groundwork for modern-day quantum theory.

 

The study of various quantitative disciplines was never really my strong suit as an undergraduate, but I did manage to sneak in a physics course during my time at Yale. Thankfully as a result, I am able to at least hazily recall learning about Bohr’s Principle of Complementarity, which states that the more accurately one property is measured, the less accurately the complimentary property is measured. Some eight or nine years later, I now wish I took better notes during that lecture(s)…

 

Back to the Global Macro Grind

 

One debate Keith and I often find ourselves engaged in with clients is the merit of reacting to headline (i.e. QoQ SAAR) GDP prints versus the merit of focusing on the underlying growth rate of the economy (i.e. YoY % change). For the purposes of retroactively explaining financial market returns and, ultimately, factor exposure selection, both growth rates are important to contextualize.

 

Specifically, when you backtest our GIP Model quadrants using historical return data across key asset classes and factor exposures, the key takeaways are overwhelmingly similar regardless if the second derivative of real GDP (i.e. the rate of change of the growth rate in this instance) is a function of the aforementioned tangent or secant.

 

For better or for worse, however, we are firmly entrenched in our preference for the latter (i.e. YoY % change) and have built a proprietary asset allocation process that responds appropriately to meaningful deviations in this key economic variable, among others. Like most frameworks, our asset allocation process remains ever-expanding alongside the cumulative intelligence, experience and bandwidth of our now six-person macro team, but one thing is for sure according to Bohr’s Principle of Complementarity: the more you are able to learn about an object’s momentum, the less you are able to discern about its position – and vice versa.

 

In the context of modeling the economy, the more we learn about sequential momentum, the less we are able to know about the underlying growth rate of the economy. Recall that headline GDP growth accelerated +660bps to +7.8% in the 2nd quarter of 2000 and that it accelerated +470bps to +2% in the 2nd quarter of 2008. If you were prescient in forecasting these second-derivative deltas, you could’ve bought all the stocks you wanted en route to peak-to-trough declines on the order of -49.1% and -56.8%, respectively (S&P 500).

 

Oh, and by the way for all the QE4 bulls out there: the Fed cut rates by -525bps during the former downturn and by -500bps (in addition to introducing QE1) during the latter downturn. If our #LateCycle Slowdown view proves prescient, investors would do well to keep that in mind as the Consensus Macro bull case for U.S. stocks shifts from “we really like them despite $100-120 crude oil” to “we love them because of falling gas prices” to “growth missed our expectations, but that’s OK because the Fed is likely to ease monetary policy again”…

 

Going back to the aforementioned head-fakes, it’s clear that those read-throughs on sequential momentum failed to signal pending material changes to the underlying growth rate of the economy. To cite a lesson from macroeconomics 101: the annual growth rate of real GDP is calculated by averaging the YoY growth rate recorded in each quarter. In light of this, what does 2Q15’s revised growth rate of +3.7% QoQ SAAR signal to you about the forward outlook for the underlying growth rate of the U.S. economy?

 

Another reason we like to focus on the secant rather than the tangent is because the former is simply easier to predict on an out-quarter basis. Intra-quarter forecasting is fairly straightforward if, like us and the Atlanta Fed’s GDPNow Tracker, you apply a predictive tracking algorithm to record and coagulate trends across key high-frequency economic data. Out-quarter forecasting is a far more difficult task.

 

But don’t take my whining for it; just look at our competitors’ track records:

 

  • Over the past five years, Bloomberg consensus forecasts for headline GDP just one quarter out have demonstrated a quarterly average tracking error of 145bps. This means that at some point within 3-6 months of any given quarter-end, Wall St. economists’ estimates for QoQ SAAR real GDP growth were off by an average of 145bps. That’s flat-out terrible in the context of actual reported QoQ SAAR growth rates averaging just 2.1% over this period.
  • Over the past five years, the FOMC’s intra-year U.S. GDP forecasts have demonstrated an annual average tracking error of 100bps. Worse, the maximum deviation of their intra-year forecasts from the actual reported annual real GDP growth rate was an upside deviation in every single year, meaning that the Fed’s growth forecasts are consistently far too optimistic.

 

Moving along, as the guy on our team responsible for generating our GDP estimates, how am I going have a reasonable basis for predicting the sequential growth rate in 4Q15 if I do not yet know what GDP is in 3Q15? What if my 3Q15 estimate is wrong? In the context of tens of basis points making all the difference between noteworthy accelerations or decelerations, multiplying a mistake by four for the purposes of annualizing the growth rate can lead to costly errors.

 

At least in attempting to calculate out-quarter YoY estimates, we are equipped with a base rate that is far more useful than the prior QoQ SAAR reading and a Bayes factor that is substantially more robust:

 

  • Base rate (i.e. the prior reported growth rate): Over the trailing 10Y, the standard deviation of the YoY growth rate of real GDP is 30% less than that of the headline growth rate (186bps vs. 267bps). Translation: YoY readings are considerably less volatile, which implies the most recently reported growth rate is a far better starting point for the purposes of forecasting YoY % changes than it is for forecasting QoQ SAAR % changes.
  • Bayes factor (i.e. the base effect): Roughly two-thirds of the time, the second derivative of GDP in the forecast period carries the opposite sign of the second derivative of GDP in the comparative base period. Moreover, as the Chart of the Day below shows, there is exists a considerable degree of negative cointegration between the comparative base effect and the subsequent YoY growth rate. Translation: we have a reasonable basis for knowing which direction (up or down) to adjust the base rate.

 

Going back to Bohr’s Principle of Complementarity one last time, what buy-side analyst in their right mind would analyze a cyclical on a sequential growth rate basis? If that made even a lick of sense, we’d all be buying retailer stocks hand-over-fist into every fourth quarter of every year, in which this thing called “the holiday season” occurs. Sure, you could probably apply a seasonal adjustment overlay to smooth obvious calendar-related deviations, but who’s to know what duration is appropriate for the historical observation period? Do you minimize it to keep current with changing dynamics within the industry or do you elongate it to account for key mean reversion thresholds across cycles? I, for one, have no idea what the right answer is and this dilemma is at least part of the reason why the BEA – i.e. the government organization responsible for reporting GDP – struggles mightily with its own seasonal adjustment process (CLICK HERE to learn more).

 

Do You QoQ? - Residual Seasonality

 

Again, I don’t purport to know a ton about analyzing individual companies – certainly not on a relative basis to anyone reading this note – and I’m sure there are industries where the aforementioned practices might make sense, but, on the whole, analyzing corporate operating metrics on a QoQ SAAR basis doesn’t really tell you a whole heck of a lot about the underlying health of the business on either a retroactive or prospective basis. But don’t take my word for it; try it at home for yourself.

 

So why the long rant about modeling principles? Because the U.S. economy is one giant cyclical – especially its most meaningful component, personal consumption (~70% of GDP), which we highlight in the chart below. As said chart emphasizes, when cyclicals bump up against a series of outright tough or incrementally tougher compares, recorded growth rates tend to slow on a trending basis; the opposite is true of recorded growth rates when encountering outright easy or incrementally easier compares.

 

Given that the strength of the U.S. consumer is one of the remaining catalysts (if not the only remaining catalyst) underpinning largely sanguine expectations for domestic economic growth among sell-side and Federal Reserve economists, market participants must hope that the underlying growth rate of the U.S. economy is not poised to inflect and decelerate on a trending basis as our forecasts imply it likely to do for the foreseeable future. Hope, however, is not an investment process.

 

But then again, the science of prediction is very difficult – especially when said predictions are about the future…

 

Our immediate-term Global Macro Risk Ranges are now:

 

UST 10yr Yield 1.99-2.21% (bearish)

SPX 1 (bearish)
VIX 21.69-42.27 (bullish)
EUR/USD 1.09-1.15 (neutral)
YEN 117.71-124.89 (neutral)
Oil (WTI) 35.84-48.42 (bearish)

Gold 1115-1165 (bullish)

 

Keep your head on a swivel,

DD

 

Darius Dale

Director

 

Do You QoQ? - Chart of the Day


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