Tomorrow is the FOMC meeting announcement. We'll see if Yellen & Co. have anything to say about the recent stock selloff.
Hedgeye highlights the three key points from McDonald's strong quarter courtesy of our veteran Hedgeye Restaurants analyst Howard Penney in under one minute.
Takeaway: We added FL to Investing Ideas on the short side on 1/13.
We are confident Foot Locker will prove to be one of the best multi-year shorts in retail. The bulls on Foot Locker are missing a huge negative fundamental turning point, while the bears are bearish for the wrong reasons. This is going to get far worse than anyone thinks. To be clear, this is not the typical ‘Internet is taking over, so short legacy retailers!’ call and the catalyst has been in the works for a while now.
This change starts with Nike. Nearly a decade ago, Nike decided to shift incremental capital to build a Direct-To-Consumer (DTC) platform, and fund that with excess growth in the wholesale channel in the US. Now, with the building part largely done and the wholesale channel very full of Swooshes, the tides are turning. None of this bodes well for Foot Locker.
In other words, the old industry paradigm is breaking down. This change is great if you own content that consumers want — like Nike, UnderArmour and Adidas. But if you’re stuck between the all mighty Consumer and those Jordan 23s, Nike FlyKnit AirMax 180s, Yeezys or Curry 1s, then you (i.e. Foot Locker (FL), Finish Line (FINL), Hibbett Sports (HIBB) and most other traditional “brick & mortar” distributors) are in deep trouble.
INTERMEDIATE TERM (TREND)
In the upcoming Fiscal Year 2016, FL will be working against 2 consecutive years of around 8% comparable sales growth with the economy weakening, and an SG&A rate at an all-time low of 19% (the lowest we’ve seen in a mall-based retailer). That’s how the company can comp 5%, and leverage that into a 30%+ EPS growth rate. But unfortunately, leverage works both ways.
We think that emerging competition from Foot Locker’s top vendor, Nike (=80% of sales), will stifle growth, and leave the company with an earnings annuity somewhere around $3.50-$3.75 per share. Is that worth $66? Not a chance. Not for a company that is Nike’s best off-balance sheet asset. And definitely not when the street is in the stratosphere approaching $6.00 in EPS (#NoWay). The company is likely to earn about $4.20 this year, which we think will prove to be the high water mark in this economic cycle.
LONG TERM (TAIL)
It’s no secret that Nike announced last year it would grow e-commerce to $7bn by 2020, which is a huge jump from its current $1.4bn (only 4% of sales). We think Nike is sandbagging, by the way, and that it will build its e-commerce operation to about $11bn – adding $10bn in e-comm sales in the next 4-years. Now, let’s say 60% of that is in North America…we’re talking $6bn in incremental revenue to Nike. To put this into context, the entire Athletic Footwear industry is likely to add about $6bn in retail over that time period alone.
Our estimates for Foot Locker three years out are 30% below the street, as we think it’s at peak earnings today. Importantly, this is not the kind of story that will play out with a simple press release.
This is a 40-year paradigm that is unwinding over a 5-year period. We think that three out of four earnings announcements will be negative – over and over again – at least based on current expectations. Along the way, we should see significant multiple compression, and margin erosion that will cut cash flow and torpedo that argument that we hear over and over about ‘FL throwing off so much cash.” It does until it doesn’t.
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Takeaway: Sad and funny at the same time.
We love central planners here at Hedgeye... if only because they provide such amazing fodder for our cartoonist Bob Rich to lampoon. Heading into tomorrow's FOMC meeting, we've highlighted five of our favorite central planning cartoons below. If you like what you see, click here to sign up for our free Cartoon of the Day.
Commodity-leveraged credit, which moved on a lag to top-down commodity deflation, is now FAST on the move.
With large impairment charges and write-downs foreshadowed by many large producers, credit markets are front-running balance sheet contraction to reflect lower short and long-term commodity price assumptions:
As we flagged in a recent note PRODUCER LEVERAGE , much of the spread risk lies with what are current IG credits.
Two important points we would make with respect to the more recent moves in credit markets:
1) Both high-yield AND investment grade have historically moved together when spreads widen (all corporate credit is at risk), and there is a large amount of IG credit that could move high-yield in 2016 in the current price environment.
2) A good chunk of low-notch IG commodity credit trades like it’s going high yield, but there is also a large chunk that is 1-2 notches off lowest IG-Notch that has just started moving in the last couple of months – These issues are worth a look if you are behind our pending recession call.
To consolidate concerning commentary from S&P & Moody’s on the shift in credit quality at the end of last week:
- Iron Ore: Cut to $65/MT for 2015-16 vs. $85/MT back in October
- Copper: $2.70/lb. for 2015 through 2017, down from its previous forecast of $3.10/lb. for 2015-2016
- Gold: Forecasts remain flat at $1,200 per ounce for the period from 2015-2017.
- Nickel: Lowered from $8.00/lb. in 2015-2016 to $6.50/lb. this year and $7.25/lb. in 2016
- Zinc: Lowered from $1/lb. this year to $0.95, but maintained its $1/lb. forecast for 2016
In the table below, we have pegged a significant amount of investment grade credit from commodity producers that could get downgraded to high-yield ($227Bn) -- some credits much more at risk near-term than others.
A move to HY from IG should perpetuate spread risk with forced selling from institutional money. As mentioned above and with regards to our short JNK position, the insurance on low-IG credit in the commodities space that hasn’t moved as much (YET) is worth a look into a potential recession as a way to play our short JNK view outlined in the Q1 Themes deck.
One of the bubbliest charts we’ve put together alongside the above slide as it relates to commodity producer balance sheet leverage is one that shows interest expense skyrocketing despite unprecedented lows in financing expense. We continue to think the deleveraging here is in the early innings.
Takeaway: We think that ‘The Space Stinks’ argument is drying up. The biggest winner here might be KATE.
Let’s face facts…these Coach numbers stunk something awful. Sales were +4%, but down 3% excluding the addition of Stuart Wietzman. Even including the deal, gross profit was down 2%, EBIT was down 5%, and EPS down 7% -- and this was on top of a 31% EPS decline last year, and 14% decline the year before. Terrible numbers for any company that actually cares about driving a basic financial model.
But we’re not talking about one of those companies. We’re talking about Coach – a company that has not grown sales organically since the debut of the iPhone 5. When we added Coach to our Long bench (after being short for over 2-years) in December all we were looking for was incremental lack of weakness on the margin. We definitely got that.
So what would make us get full-on bullish? It would be confidence that this company can actually grow it’s top-line sustainably. From a modeling perspective, we can move the 69% gross margin or the 50% SG&A ratio around by a few points here or there. But the only thing that makes this clock tick is revenue growth. Our confidence on that one still needs some work.
But until then, there are a few metrics that keep us in the game with a positive bias.
1. The first is the raw earnings algorithm. For two years it’s been terrible, and for two quarters it’s been…well, better. The chart below suggests that earnings are hitting a trough – and we’d point out that that this is the same time other companies will see increased downward revisions as the economy weakens.
2. The SIGMA chart for COH looks outstanding. Coach has not been this clean with its inventory position since 4Q10 (iPhone 4…to stick with that metaphor). This is an extremely positive gross margin setup for COH. Stocks usually don’t (almost never) go down when the picture looks like what you see below.
3. The last thing that keeps us positive is not a metric, but a group attribute. Since August 2014 ‘The Space’ has been a disaster. Not necessarily the business trends, but definitely the stocks. This hit KATE the hardest, as it continued to deliver but had its multiple cut in half while Kors and Coach put up horrific numbers. But now Coach is stabilizing. We’re pretty sure that KATE is performing well. That just leaves Kors as the lone brand hemorrhaging share. It’s tough to make the case that ‘The Space’ is broken when only one brand is on the decline. In this scenario, COH and KATE (which have a dramatically different customer, by the way – see graphic at the bottom of the note) help each other, allowing Kors to shoot itself in the foot – in the US, at least – all by its lonesome.
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