Takeaway: Miss or no miss, KSS should start with a 2. Major unappreciated risks: credit, online, labor costs, full penetration, 40mm sq ft too many.
It’s hardly a unique line of thought – given the sales weakness across retail -- that KSS is likely to miss or guide down on Thursday. After all, the stock is off 25% since the 2Q print, which in itself was off by yet another 25% decline 13 weeks earlier. While we find it odd that short interest is sitting at 18 month lows, it’s pretty obvious that expectations into Thursday are for a miss. While we share that line of thought, we want to be clear about something…the REAL reason we are short KSS has yet to meaningfully transpire. We have high conviction that this will begin to play out over the next six months, which should result in at least another 25% downside in the stock – for starters.
The REAL Short Case
The real part of the story we think people are missing has to do with KSS Credit, and the dangerously elevated risk that exists regardless of whether the consumer environment or credit cycle weakens. The punchline is that KSS recognizes about $430mm, or 25% of cash flow, in the form of credit income. There’s nothing wrong with that – though people should understand that it is booked as a counter-cost, artificially lowering reported SG&A. In other words, KSS SG&A of $1.6bn is actually over $2bn. That’s about $1.50 per share in earnings associated with credit. At face value, it appears that KSS grew SG&A by a 0.9% CAGR over the past 4 years, but in actuality it grew by 2.3%. A mere 140bps might not seem like much, but it’s rather HUGE for a zero-square footage growth retailer that can’t comp.
That, by itself is nothing more than flagging a part of KSS model that is certainly taken for granted – until the cycle rolls. But our view is that credit income will begin to go down, hence taking up SG&A meaningfully and threatening earnings. Here’s why…
The History of KSS Credit Is Actually A Statement About the Future Growth. Consider the following chain of events (outlined in the chart below).
- Back in 1995, KSS wisely took advantage of a strong environment for proprietary credit by starting the Kohl’s card. Good move.
- Fast Forward to 2006 -- the company sold the credit portfolio to JPM/Chase – another timely move. KSS had only 650 stores at that point, and Chase rode the wave as KSS broadened its footprint to over 1,000 stores – and $250 in credit income for KSS.
- But in 2011 – about the same time KSS meaningfully slowed the growth rate in its footprint, Chase saw its growth rate in this portfolio slow dramatically as KSS hit a wall with customer acquisition. The options were to add more stores to find new customers (impossible), or lower FICO standards to acquire a lesser quality consumer.
- Solution? Switch to Capital One who has ‘easier’ credit standards and was willing to take one lower-quality customers in KSS existing markets. Over the next four years, credit income went up by a full $1.00 per share to nearly $1.50. Again, this represented higher spending by a more marginal consumer as the economic recovery shifted into innings 4 through 8.
- Then, in 2014 the COF partnership hit a wall, and had to either lower consumer credit standards again or find a new party who would underwrite the marginal consumer. That’s when KSS started its own Yes2You rewards plan. This is a non-credit plan, but importantly it offers rewards members similar promotional benefits as if they were Kohl’s Card holders. This is targeted at the people that would not have been approved for the COF card. Again…targeted at people who were not approved for a Capital One Card! Note: the COF agreement is still in place. It simply does not have SSS growth opportunity as it once did.
- Our research suggests that there is a high probability of cannibalization. For example, a person who previously got rewards points through buying with the COF/KSS card could now go ahead and buy the same merchandise, get the same discounts, but sap down their Mastercard, Visa, Amex, Diner’s Club…whatever. The sale still shows up on the top line, but no longer is the corresponding credit charge netted against SG&A. There is absolutely no way we can rationalize that this is anything other than #bad for KSS.
This whole ‘cannibalization thing’ is not just theoretical. Our survey work shows that there is a 16 point delta in credit card usage between a KSS card holder and Y2Y rewards member only.
This Was Inevitable
Why would KSS do this? Because it HAD TO. If it’s history of credit partners doesn’t tell the story, then simple penetration math does. Based on our calculations, KSS has already attracted 75% of the potential customer base to its stores every year. We can assure just about anyone that the last 25% costs a lot more to acquire than the middle 50%.
“But KSS Is So Cheap”
Optically, KSS is trading at 10x forward earnings, 5x EBITDA, and a 10% free cash flow yield. Yes, that’s definitely cheap. But that assumes that the Street’s numbers are right. We think they’re off by a wide margin. We think a base-case 2016 number is 20% below the consensus – or $3.90, and a more beared-up number of $2.50 – assuming credit cannibalization, a weaker and more deflationary retail environment, and slight pressure in the base credit business. In this case, KSS is trading at 20x earnings and a 6.5% FCF yield. Hardly ‘cheap’ considering that department stores have traded over 20% FCF yield in past downturns.
Here Are Some Factors to Consider on the Upcoming Quarter
Comps – This stock has gone from high expectations to low expectations in just six months, collapsing by 44% from the April pre-earnings euphoria that KSS would actually put up a 4-5% 1Q comp. Unfortunately for the Bulls, KSS gifted them a 1.5% 1Q comp, and then proceeded to miss 2Q as well (0.1% vs 1.5% expectations).
Consensus comp expectations for the 3rd quarter have come down by 180bps from 2.5% to 0.7% a level that we think is actually very doable in the grand scheme of KSS. Is that enough to make the stock work? Not at a 17x multiple when management was hosting a different investor group every week to bolster expectations like we saw in 1Q. But how bout today with KSS at 9.7x the Street’s NTM estimate? Yes, it probably is – at least over the near term until the street contextualizes the ramp we need to see in the business organically for the company to hit 4Q numbers which calls for a 280bps pop in the 2yr trend line.
Margins – On the margin side there is a lot more good news baked into consensus numbers as we head into 2H. To get to managements guidance (we characterize that as ‘best case’) which calls for 0bps to 20bps of GM improvement and 1.5% to 2.5% SG&A growth for the year and hasn’t been updated since the company reported numbers in February we need to assume the following…
- GM – flat to up 30bps to hit the top end of the range in the face of a) a negative sales to inventory spread of -8% the worst number we’ve seen in 2+yrs, b) bloated inventories across the wholesale channel cited by, VFC, SKX, RL, FINL, NKE, etc., c) a growing dependence on e-comm, though the company no longer reports that number, it’s been the only part of the sales equation actually growing and it comes at a GM 1000bps below a brick and mortar sale, d) rising shipping costs as retailers in this space use ‘free shipping’ as the offensive weapon of choice this holiday season, and e) the 2nd warmest September in history and warmest October since 1963. Remember that the GM leverage guide was predicated on the assumption that inventory would be tightly managed in order to offset e-comm dilution, that’s a much tougher assumption to make in this current environment. Yet, consensus is still modeling 3 years of GM expansion.
- SG&A – growth of 1-3% in 2H to get to the top and bottom end of the guided range which implies slight leverage best case and 35bps of deleverage worst case. With 80% of costs fixed its largely a function of what the company prints on the comp line and how much its able generate through its credit portfolio which we think is tapped and was out comped by non-credit for the first time in recent memory last quarter. That coupled with the rising retail wages this holiday season in the face of a 5% employment rate and wage inflation brought on by the $9.00 minimum wage mandate at two of the three biggest employers in the retail space (WMT & TGT) = a tough comp on the expense line.
Takeaway: We'll take the other side of Jim Cramer on Wayfair any day.
Earlier this morning, CNBC's Jim Cramer was on TV at the open trumpeting Wayfair (W) which had just released its earnings. He said the numbers were great and that the online furnishings company was "the most important stock in the market today."
Wayfair closed down 14% today. While shares popped at the open to just shy of $50, reality soon set in. Take a look at the chart below.
For the record, our Retail analyst Brian McGough has Wayfair on his Best Ideas Short list. Here's an excerpt from a research note he sent to institutional subscribers after Wayfair reported earnings:
"Consider the following…a) Wayfair added $266mm in revenue – an astonishing number. But the company still lost money. True, the operating loss narrowed, but only by $13mm. That pegs the company’s incremental margin at only 5.1%.
To be clear, companies like Restoration Hardware and Williams-Sonoma – who are consolidating a different end of the home furnishings market (the good end) have incremental flow-through rates of about 20-25%. Heck, even AMZN, which is not afraid to lose money for a very long period of time, has an incremental margin of 15%. Then why are we looking at 5% for W?
The bottom line is that this company is spending – and it’s spending big – around penetrating what management believes to be the company’s TAM. Unfortunately, we think they are overestimating it by a country mile, and are building an infrastructure for growth that will not materialize – at least profitably."
Key to McGough's short thesis is the estimation of Wayfair's addressable market. The company's management puts that number at $90 billion.
"That’s just flat-out wrong," McGough writes. Here's another excerpt:
"We’ve done extensive research on this one, and when all is said and done, we think that the end market is no more than $30bn. To put that into context, it suggests that Wayfair has about 10% share of its market. That’s 2-3x the share of players like RH and IKEA. There’s absolutely no reason why this should be the case."
Why? Because most consumers buy furniture and home goods through a combination of online research and in-store visits. Wayfair is an online-only shopping experience. As McGough writes, "you can't touch and feel the seven million items sold by the company." By his estimation, Wayfair consumers don't ‘blind buy’ above $750. That's "well below the prices listed for furniture sold on its websites."
Bottom line: We'll gladly take the other side of Cramer on Wayfair any day.
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"We’ve had an explicitly bearish opinion on inflation expectations (for almost 18 months now) and continue to see Red Shoots this morning when I look across the risk spectrum of Global #Deflation," Hedgeye CEO Keith McCullough wrote in this morning's Early Look.
Takeaway: Let’s be clear about something…this stock should definitely be a lot lower – but not because of the print.
In going through Wayfair’s 3Q and listening to management on the conference call, one question keeps popping up…”why am I short the stock of a company that is growing its core business over 90% and where 44% of its float is held short?” After all, a) the company crushed sales expectations by 14%, and is now larger than (pseudo-competitor) Restoration Hardware, b) almost every operating metric improved on the margin, c) management clearly has a better handle on its business than ever (and absolutely killed it when someone asked about the NYT article about potential legal liability in its flooring business), and d) management set up 4Q expectations for more top line upside.
At face value, that’s pretty tough to beat.
But then we consider the following…a) Wayfair added $266mm in revenue – an astonishing number. But the company still lost money. True, the operating loss narrowed, but only by $13mm. That pegs the company’s incremental margin at only 5.1%. To be clear, companies like Restoration Hardware and Williams-Sonoma – who are consolidating a different end of the home furnishings market (the good end) have incremental flow-through rates of about 20-25%. Heck, even AMZN, which is not afraid to lose money for a very long period of time, has an incremental margin of 15%. Then why are we looking at 5% for W?
The bottom line is that this company is spending – and it’s spending big – around penetrating what management believes to be the company’s TAM. Unfortunately, we think they are overestimating it by a country mile, and are building an infrastructure for growth that will not materialize – at least profitably. It mentioned 5 times the rate at which it’s hiring (390 people in the quarter vs 225 in 2Q). We’re fine with growing headcount, as long as the opportunity is there. But we don’t think it is.
As we’ve been saying, Wayfair has considerably higher penetration in its TAM than people believe. People – including Management, are using numbers like $90bn as an addressable market. That’s just flat-out wrong. We’ve done extensive research on this one, and when all is said and done, we think that the end market is no more than $30bn. To put that into context, it suggests that Wayfair has about 10% share of its market. That’s 2-3x the share of players like RH and IKEA. There’s absolutely no reason why this should be the case. The primary reason is that Wayfair sells furniture and home goods. The purchasing process for a consumer durable like a set of bunk beds, for example, almost always includes in-store visits as well as online research. You get that at Williams-Sonoma, Restoration Hardware, and even Pier 1. But you can’t touch and feel the seven million items sold by Wayfair before you buy. In fact, our research suggests that W’s target consumer has a ‘blind buy’ threshold of around $750. That’s well below the prices listed for furniture sold on its websites.
To be fair, that only applies to furniture, but what about things like lamps, linens, and kitchen utensils? Yes, that’s where we think Wayfair will drive incremental volume, and management seems to agree. But how defendable is it when that product can also be bought online/in-store at Bed Bath & Beyond, Kohl’s and Target? Overall, our work shows that the incremental customer is likely to be much more price sensitive, which not only challenges long term Gross Margin targets, but takes customer acquisition costs higher off a reprieve in 2015. We do think there’s 500bp upside in Order Margins over time, but we need to see 700bp to get Wayfair in the black.
Could Wayfair manufacture a quarter or two in earnings along the way? Probably. But we have an extremely hard time modeling a sustained operating profit – ever.
Here are some callouts from the quarter...
Top Line Ripping – Revenue accelerated to +77% from +66% last Q, improving from 56% to 59% on a 2yr basis. The rapid growth rate has continued in the 4th quarter to date. Growth was being driven by an increase in both the active customer base, better order metrics, and a higher ticket. Sequential customer growth accelerated to +14% from +12%, LTM orders per customer grew 3% yy, and average order value grew 8% which is the best growth seen in Wayfair's reporting history. For two quarters in a row now sequential customer growth and percent of repeat customer orders have accelerated, which can be attributed to a lower churn rate.
Ad Leverage – Even as the company expands its TV advertising campaign W posted massive advertising leverage of 290bps yy to 11.9%. This paired with accelerating customer growth drove the company's customer acquisition cost down 4% yy. But, we still need to see 400bps of leverage to get to company's LT target of 6-8% advertising margin. The flywheel is easy to spin when the company is growing its direct revenue base at 90%, but how about when the top line slows to a 20% rate as brand awareness peaks out and market share gets harder to capture?
Rebounding Cohort Spend – W’s updated cohort analysis indicates spending has improved in the last 2 years for old cohorts (2011 & 2012) that had previously appeared to flatline. This implies the company was either able to re-engage customers which had drifted away from the brand, or that loyal customers have accelerated their spending. Either way an upward trend on these lines is needed to prove the long term viability of the model since the contrary would mean previous customers and revenue were lost forever.
Wayfair as an everyday store? That’s how the company justifies its 60mm household addressable market targets. But, let’s be clear about one thing, Wayfair is a Specialty Store that happens to sell 7mm+ SKUs in the home furnishing space. The comparison to a retailer like WMT and TGT is flawed in so many ways, but the most obvious fact is that the average Walmart shopper makes 25+ visits to the store per year, and the average Target shoppers makes 12+ (per our survey data), and that doesn’t count the number of visits/purchases transacted online. The average Wayfair shopper makes only 1.7 orders per year. For a category as event driven as Home Furnishings where the replacement rate is amongst the lowest in retail (especially for the big ticket items) we have a hard time getting comfortable with that logic. If W is going to deliver on its ‘everyday store’ promise it will be in categories like lamps, linens, and kitchen utensils, and that’s not a competitive set that we’d want to be going head to head with.
Brand Awareness and TAM – aided brand awareness by the company’s measure hit 67% during the quarter. That’s up from 55% in 4Q14, 52% in 3Q14, and 36% from 4Q13. Why has the revenue base doubled in 2yrs, look no further than this metric. We can’t argue with the trajectory of the W top line, especially after a quarter in which it reported 91% direct revenue growth. But, now the company will have to prove its mettle in a market that it a) already has 10%+ share of and b) has far less low hanging fruit now that the consumer knows what wayfair.com actually is.
Incremental Margin – Wayfair added an incremental $266mm in revenue during the quarter but only $13mm in operating profit. Need any indication of how much it will cost W to continue to keep the top line spinning? Look at the comparison to RH and OSTK who will/have revenue growth of 14% (estimate) and 11%, respectively in 3Q15. OSTK obviously has a much more mature model than W, but RH is at a similar stage of its growth cycle as it reinvents its store base, and consolidates a fragmented part of the market. The only difference is that RH is putting up industry leading operating margins this year on its way to the mid-to-high teens.
Earlier this morning on The Macro Show Hedgeye CEO Keith McCullough strung together a laundry list of some concerning economic signals.
Here’s the chart McCullough called up on copper:
… And his analysis:
“I can’t for the life of me see how that would be considered a green shoot. Copper is making fresh, new lows after crashing 22% year-to-date. Never mind where it’s come from its all-time bubble peak when Bernanke was devaluing the dollar. That created a bubble in commodities and overcapacity which is creating deflation.
They used to call this [commodity] Dr. Copper. Dr. Copper is signaling that demand worldwide is beginning to slow.”
Another economic indicator McCullough is also watching is the Korean stock market. “But that’s down too,” he says. The Kospi index was off as much as 1.4% last night. “So when we’re looking for red shoots we’re finding them.”
In related news, our Macro team has been concerned about #Deflation risk for a while now.
The latest deflationary reading comes from China. McCullough addressed this too earlier this morning:
“[Chinese] producer price deflation remains firmly intact for these producers, with prices down 5.9% year over year. If you’re looking for reasons why Chinese companies have missed earnings and revenue estimates that’s one of the big ones. It’s called deflation and that has not gone away.”
It’s another worrisome data point.
But don’t take our word for it. Here’s Reuters on China, global growth and Apple’s earnings miss today:
“The report on Apple added to fears of a slowdown in global growth, especially in China… China's October inflation data on Tuesday showed persisting, if not intensifying, deflationary pressure.”
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