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The Dance with Deflation

“Yes my life is better left to chance,

I could have missed the pain but I’d have had to miss the dance.”

-Garth Brooks

 

Back when Keith, our President Michael Blum, and I were undergrads at Yale, we used to sing Garth Brooks tunes late into the night over a keg of warm beer.  Things were much simpler on college campuses back then.  In fact, I’m not even sure we dressed up for Halloween.

 

The most recent controversy on the grounds of our alma mater has gained national attention.  Inasmuch as I can discern, the debate is over whether Halloween costumes are offensive or are examples of free speech.  Also, whether the proverbial, and literal, adults in the room have any right to comment on any of this or should be focused on creating “safe places.”  Heady issues to be sure.

 

Since we tend to stay away from both social and political opinions at Hedgeye, we will stick with that path on this controversy as well.  We should submit, though, that this episode does offer an interesting , albeit anecdotal, view into the mind of the Millennial.

 

Speaking of which, we are pleased to have Neil Howe, the man who actually coined the term “Millennial,” speaking  next week at Macrocrosm: The Dock Debates, our first conference.  On the topic of demographics, we asked Neil to discuss the impact that the super-connected 75+ million Milllenials will have on the upcoming Presidential election.

 

As it relates to the Yale “controversy,” Neil had this to write:

 

“When it comes to controlling misbehavior, Millennials insist that the institution step in with rules where earlier generations (Xers, Boomers) would have pushed peer pressure or peer-on-peer intervention. In the "Animal House" era, you *never* punished a jerk by going to the dean--you did it yourself, when the dean wasn't looking!”

 

Indeed.

 

Please email if you’d like to reserve a spot for the conference as we expect to be at full capacity by the end of the week.  Full details on Macrocosm (full lineup of speakers, topics, etc) can be found here.

 

The Dance with Deflation - z macrocosm

 

Back to the Global Macro Grind...

 

Inasmuch as college administrators are doing the dance with Millennials, the more interesting dance for those of us with an interest in the real economy is the dance with deflation.  Part of our macro team is in Texas this week meeting with prospects and clients and of course experiencing the epicenter of energy deflation.

 

Interestingly, Texas has so far largely shaken off the impact of substantially lower oil prices on employment.  Other than March of this year, in which Texas lost 24,500 jobs, the state has continued to add employees.  This is a much better scenario then when WTI was at the same level in 2009 and Texas lost almost 340,000 jobs that year.

 

The bigger challenge for Texas is related to the government’s budget.  With WTI -1.1% this morning to $43.02, the 4.6% tax the state imposes on the value of all oil produced in the state is not going to add up to much this year.  As a result, there is no question that Texas will be running a budget deficit for the forseeable future.  And an even greater likelihood is that a Fed interest rate hike pushes Texas (and other oil producing areas) into recession.

 

North of the border, Canada is faring much worse.  In Alberta, the "Texas of Canada," it is expected that 185,000 oil and gas jobs will be lost in 2015.  This is a substantial number of jobs to lose on Alberta’s population base of only 4.2 million.  In aggregate, Canada employs 720,000 people in the oil & gas industry with a full 2/3 located in Alberta.  The loss of these jobs has had a broad impact on Canada. Since 2014, Alberta was responsible for 90% of the new jobs created in Canada.

 

Unlike Texas and the United States, this Dance with Deflation has already impacted Canada.  After two quarters of negative growth, Canada is officially in a recession.  As a result, the Canadian central bank has cut rates twice this year.  The next shoe to fall in Canada is likely to be deflating residential real estate prices.  

 

To add fuel to the fire, the newly elected Canadian Prime Minister has pledged to raise taxes on those making over $200,000 per year.  This move is only likely to accelerate home price declines in markets like Calgary, Toronto, and Vancouver. 

 

Nonetheless, Canadian housing cheerleaders point to the fact that home prices nationally were up 6.1% in September.  To a point, this is fair.  So far, the Canadian housing market has shrugged off the recession.  But economic gravity will eventually prevail and while the Canadian central bank will do everything it can to protect home prices.  This is all likely to end very poorly for the Loonie and Canadian banks.

 

On the topic of commodities and deflation, Hedgeye is launching its new "Materials" sector tomorrow November 12th at 1:00pm led by two stalwarts of our research team Jay Van Sciver and Ben Ryan.  Their initial presentation will be on gold and their proprietary supply and demand model will attempt to answer this question:

 

“Gold prices in dollars have declined since 2011, despite two incremental rounds of quantitative easing and perpetual zero interest rates.  US long bonds have performed well in a similar environment.  What are the gold bugs missing?“

 

Before signing off today on this Veteran’s Day, I wanted to salute the men and women in uniform.  We all thank you.

 

Our immediate-term Global Macro Risk Ranges are now:

 

UST 10yr Yield 2.09-2.38%

SPX 2055-2094

VIX 13.74-18.87 
USD 98.15-99.98 
Oil (WTI) 43.02-45.73 

Gold 1069-1113 

AAPL 116-123 

 

Keep your head up and stick on the ice,

 

Daryl G. Jones

Director of Research 

 

The Dance with Deflation - zz COD


November 11, 2015

We've made some updates and enhancements to Daily Trading Ranges. You'll now receive risk ranges for 20 tickers each day -  the last five of which will be determined by what's flashing on Keith's screen and by what names you're asking about. Contact support@hedgeye.com if you have any questions or feedback.

 

  • Bullish Trend
  • Bearish Trend
  • Neutral

INDEX BUY TRADE SELL TRADE PREV. CLOSE
UST10Y
10-Year U.S. Treasury Yield
2.38 2.09 2.32
SPX
S&P 500
2,055 2,094 2,081
RUT
Russell 2000
1,160 1,206 1,1847
COMPQ
NASDAQ Composite
5,035 5,175 5,083
NIKK
Nikkei 225 Index
19,106 19,781 19,671
DAX
German DAX Composite
10,562 11,017 10,832
VIX
Volatility Index
13.74 18.87 15.29
DXY
U.S. Dollar Index
98.15 99.98 99.39
EURUSD
Euro
1.06 1.09 1.07
USDJPY
Japanese Yen
121.33 123.95 123.21
WTIC
Light Crude Oil Spot Price
43.02 45.73 43.63
NATGAS
Natural Gas Spot Price
2.20 2.38 2.33
GOLD
Gold Spot Price
1,069 1,113 1,088
COPPER
Copper Spot Price
2.18 2.28 2.22
AAPL
Apple Inc.
116 123 116
PCLN
Priceline.com Inc.
1,290 1,375 1,311
VRX
Valeant Pharmaceuticals International, Inc.
71.01 92.69 85.41
BABA
Alibaba Group Holding Ltd.
80.49 86.11 81.43
W
Wayfair Inc.
38.02 43.36 39.43
NUS
Nuskin Enterprises, Inc.
33.04 37.94 36.20

 

 


USD, Oil and Greece

Client Talking Points

U.S. DOLLAR

Relentless USD strength as my Berkeley boy Williams (San Fran Fed) hits USA Today with the “recent data supports a rate hike” – apparently he missed all the industrial/cyclical, ISM, and GDP data. But raising rates into #LateCycle slow-down is mucho deflationary for many asset prices – DEC 4th U.S. Jobs Report up next.

OIL

Oil continues to get smoked on the biggest risk that remains (the Fed’s forecast for an economic acceleration), with WTI down -1.1% to $43.69 with an important level of immediate-term support at $43.02. One interesting idea (developing, timing matters) is buying Oil if that DEC 4th jobs report is more in line with the slowing labor TREND.

GREECE

Strong Dollar Debt #Deflation is public enemy #1 to the world’s most levered countries and companies. Greek stocks continue to diverge negatively vs. DAX this morning, down -1% and the Greek 10YR Yield is up +14 basis points day-over-day.

 

**Tune into The Macro Show with Hedgeye CEO Keith McCullough at 9:00AM ET - CLICK HERE

Asset Allocation

CASH 59% US EQUITIES 7%
INTL EQUITIES 3% COMMODITIES 0%
FIXED INCOME 31% INTL CURRENCIES 0%

Top Long Ideas

Company Ticker Sector Duration
MCD

Post earnings, the next catalyst for McDonald’s (MCD) is going to be next week's November 10th analyst meeting. The meeting will be an opportunity for management to shed more light on the progress of all day breakfast, additional G&A cuts and the potential of doing a REIT.

 

Our Restaurants team remains bullish on the name, and they look forward to giving you some material updates after the meeting.

RH

Restoration Hardware (RH) hit all-time highs this week, but this story is far from over. We think RH will earn close to $11 per share in 3 years, which compares to the consensus estimate of just over $6. We estimate that the stock is worth $300.

 

The square footage component is well known, but we think people are missing…

  1. The productivity and market share that we’re likely to see from each new store,
  2. How scalable this business model is without commensurate capital investment,
  3. The leverage we’re likely to see is below-market real-estate deals being struck today and that should begin to impact the P&L. 
TLT

Current policy makers remain fixated on the jobs market, and this Friday’s report was good on the surface. Here’s the rundown:

  • The U.S. added +271K to non-Farm payrolls in October which blew out the expectation for +185K additions (last month’s awful print was revised even lower to +137K additions). Remember that the estimates are useless as the number is near impossible to predict. Keep that in mind.
  • Unemployment Rate moved lower to 5.0% for October from 5.1% in September
  • Wage growth was a positive surprise as Avg. hourly earnings printed a +2.5% growth rate for October vs. an expectation of +2.3%. The growth rate in September was +2.2%

So, again, on the surface it was a positive report. However, as we’ve emphasized, consumption and labor market strength are staples of an economy that is late cycle.

Growth continues to slow, and a rate hike has the potential to pull-forward a recession and flatten the yield curve. In the event this happens, you’ll be happy you held onto your long-bond position. If you haven’t bought into the #slower-for-longer view, the market is giving you the chance to buy bonds at another lower high… For the 5th time this year.

Three for the Road

TWEET OF THE DAY

**NEW VIDEO (2 mins)

McCullough: It’s Looking A Lot Like November 2007 https://app.hedgeye.com/insights/47457-mccullough-it-s-looking-a-lot-like-november-2007… via @KeithMcCullough #markets $SPY #earnings

@Hedgeye

QUOTE OF THE DAY

The best way out is always through.

Robert Frost

STAT OF THE DAY

The Dallas Fed’s Manufacturing Outlook has dropped for 10 months in a row.


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INVITE | NUS | NEW BEST IDEA SHORT TODAY AT 11AM ET

Today, November 11, 2015 at 11:00am ET we will be hosting a Black Book presentation going through our SHORT thesis on Nu Skin (NUS).

 

WATCH THE REPLAY BELOW.

 

 

Our call will cover the following topics and more:

  1. What is VitaMeal?
  2. How material is VitaMeal to the company?
  3. How NUS and its global charity partners work together. 
  4. Can VitaMeal and the selling process bring about increased regulatory risks?
  5. Is VitaMeal actually a tax deductible charitable contribution?  
  6. The NUS financial problems.
  7. What a new scandal means for future profitability.  

 

CALL DETAILS

Toll Free:

Toll:

Confirmation Number: 13624607

Materials: CLICK HERE


 

Please call or e-mail with any questions.

 

Howard Penney

Managing Director

 

Shayne Laidlaw

Analyst


The Macro Show Replay | November 11, 2015

 


KSS | Here’s Why KSS Is Expensive

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.

 

KSS | Here’s Why KSS Is Expensive - kss chart1 11 10

 

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).

  1. Back in 1995, KSS wisely took advantage of a strong environment for proprietary credit by starting the Kohl’s card. Good move.
  2. 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.
  3. 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.
  4. 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.
  5. 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.
  6. 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.

 

KSS | Here’s Why KSS Is Expensive - kss chart2 11 10

KSS | Here’s Why KSS Is Expensive - kss chart3 11 10

 

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.

 

KSS | Here’s Why KSS Is Expensive - kss chart4 11 10

 

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%.

 

KSS | Here’s Why KSS Is Expensive - kss chart5 11 10

 

“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.

 

KSS | Here’s Why KSS Is Expensive - kss chart6 11 10

 

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.

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