Takeaway: FL spending is headed up on PP&E and SG&A in the face of significantly more challenging growth. How could this be good?
Foot Locker’s big capital spending plan announced last night is anything but good for the financial return profile, and the stock. The company’s capex number for the upcoming year is expected to clock in at $297mm. That’s the most FL has spent since 1999, and it represents a 26% increase from the already-elevated levels we saw in 2015.
As context, our extremely negative long-term view on FL is predicated upon an unsustainable financial model, and a mismatch between how much FL is spending on both the P&L (SG&A) and on PP&E to drive the business forward in a changing footwear retail selling model.
Specifically, Nike has been spending on building up a world-class e-commerce model for the better part of 8-years – basically this whole economic cycle – and we’re now seeing Nike’s growth go parabolic, while FL’s is rolling over. Over that same period, FL’s ‘Nike Ratio’ (percent of inventory purchases that are Nike) has gone from 50% to almost 80%. It literally can’t get much higher. The same directional trend holds true for almost every other retailer that sells Nike. We get so much pushback on this – but our strong view is that Nike was stuffing the wholesale channel in the US in order to fund over $1bn investment in its DTC model. ‘Stuff’ is a strong word in retail, but call it what you want. As that ratio goes up, so does traffic (otherwise in a secular decline), ASP, revenue, margins and ROIC. EVERY single one of those things has happened at FL.
Now the paradigm is changing. Nike’s spending growth is rolling off as it harvests its investment by way of adding another $10bn in e-comm sales in 4-years (off a $31bn base). It’s e-comm numbers are completely blowing out to the upside. It wears its ‘we love our wholesale partners’ face proudly in public, but in reality it does not need to GROW that channel, it just needs to sustain. That’s a disaster for anyone who hangs their hat on selling branded athletic footwear for a living.
For FL, we’re looking at a company with a near 80% Nike ratio, productivity and margins that doubled in 8-years, leading to EPS up 4x, and RNOA up from 5% to 30%. Now we’re seeing capex push shift from OEM to the retailers, but that investment for companies like FL is still likely to result in declining earnings. One of the factors that so few talk about is the SG&A base at FL – which is only 19% of sales. That’s astoundingly low, but was easy to sustain while Nike was stepping up its commitment to the retail channel. Now, FL will need to spend more to stay still at a minimum.
This stock will be choppy quarter to quarter. But last we checked, stocks don’t go up when financial returns get cut in half.
And if you question exactly why the capital spending pressure is being felt by FL, check out this chart. It shows the athletic brands' e-comm visitation rate less FL. Nike is winning online in bursts of share gain.
Takeaway: Investors would do well to appropriately contextualize and actively risk manage head fakes in domestic economic data.
If I’ve heard Keith reference PTJ’s quote about the last third of the move being “the toughest to risk manage” in a meeting once, I’ve heard it a thousand times. In bear markets, those who mismanage “the last third of the move” are short sellers that cover too early (in fear of the policy response) and bulls that cite “valuation” as a reason to purchase securities – quite often far too early. Both are buy orders, FYI.
Did the shorts cover too early?
No, well at least not from the perspective of our short-term trading signals. Last Wednesday morning, we published an immediate-term risk range of 1 for the S&P 500, which was an explicit signal for investors to cover shorts well into last Thursday’s low (1810 to be exact).
That’s not to suggest that we’ve nailed it by any stretch of the imagination, but rather to reiterate the omnipotence of actively managing risk in bear markets. We’ve been vocal in stressing that bear-market bounces are typically more sharp than their bull-market counterparts. The +645bps rally in the SPX from Thursday’s intra-day low to today’s closing price is allegedly the sharpest three-day rally since the thralls of our last bear market in late-2008.
Indeed, high short interest stocks are the 2nd best-performing style factor on a WoW basis, just behind high beta stocks. We consider that to be ample enough evidence of aggressive covering of crowded momentum shorts. I’m sure there will be plenty of research notes from prime brokers highlighting this very point tomorrow morning – if there haven’t been already. Obvious is as obvious does.
In light of the aforementioned strength in the U.S. equity market, has anything materially changed, quantitatively speaking?
No, certainly not from the perspective of our Tactical Asset Class Rotation Model (TACRM), which shows that:
- Realized volatility continues to accelerate on a trending basis across asset classes.
- TACRM continues to generate a [bearish] “DECREASE Exposure” signal for U.S. Equities at the primary asset class level.
- Across the 47 sector and style factor exposures TACRM tracks within U.S. Equites, only two are signaling bullishly from the perspective of TACRM’s multi-duration, volatility-adjusted view of volume-weighted average price momentum.
***CLICK HERE to download the latest refresh of our TACRM presentation.***
A much more difficult question to answer at the current juncture is, “Has anything materially changed, fundamentally speaking?”
On a trending basis, the answer to that question is a resounding “no” – especially with respect to: 1) the corporate profit cycle, 2) the C&I credit cycle, and 3) the monetary policy cycle. As we’ve detailed extensively in recent notes, the confluence of the likely progression of each will be the determining factor for ultimate downside in risk asset prices:
- The Domestic #CreditCycle Is About to Get A Lot Worse (1/26): “As the ongoing corporate profit recession deepens, we highlight the obvious risk of companies allocating earnings to buybacks and dividends, rather than preserving cash and paying down debt. If our explicitly negative view on the domestic economic cycle continues to be corroborated by the data, then the growth rate of such payouts will likely have to slow dramatically – if not decline outright. That is an obvious headwind to the broader equity market in terms of removing key cogs from the post-crisis secular bull case.”
- Ex-Energy? (2/3): “And even if the U.S. economy avoids recording a technical recession, we could just have an 2000-02-style corporate deleveraging cycle that drags down equity market cap alongside it. After all, it's EPS that matters most to stocks, not GDP. Recall that the 2001 downturn was the shallowest recession in U.S. history; that didn't preclude the stock market (SPX) from getting cut in half.”
- Sentiment Update: Three Things I Learned Today (and Three Weeks From Now) (1/20): “While ZIRP and LSAP have proven to be powerful tools in perpetuating income-inequality generating asset price inflation throughout this economic and corporate profit expansion, the Federal Reserve has yet to demonstrate the effectiveness of monetary easing during concomitant recessions in economic activity and corporate profit growth.”
On a shorter-term basis, astute investors have been asking us the right questions about sequentially improving high-frequency economic data. In the 1Q16 to-date, we’ve seen three releases that lend some pause to our bearish outlook for the domestic economy – if only for a brief moment:
- First, the ISM Manufacturing PMI ticked up ever-so-slightly to 48.2 in JAN from a reading of 48.0 in DEC. The New Orders index rose back above 50 for the first time since OCT; its 51.5 reading for the month of JAN is the highest since AUG.
- Then, the growth rate of Retail Sales – specifically the omnipotent “Control Group” therein – accelerated meaningfully to +3.1% YoY in JAN from +2.2% in DEC. Per the JAN release, the growth rate of Retail Sales – which accounts for a third of consumer spending and a fourth of GDP – is now accelerating on a trending basis.
- Lastly, the growth rate of Industrial Production accelerated to -0.7% YoY in JAN from a downwardly revised -1.9% in DEC. Sequential strength was recorded across all key product categories as Capacity Utilization arrested what had been five consecutive months of MoM contraction and YoY deceleration.
While it would be easy to poke holes in each of the aforementioned releases (for example, the Employment index of the JAN ISM report crashed to a new cycle low of 45.9), it’s not clear to me that that would be a valuable use of your time; nor would it be a valuable endeavor on which to expend analytical credibility. The risk of being perceived as arguing with the data for too long for a research outfit that doesn’t have banking, trading or asset management to support its revenues is arguably just as punitive as the risk of a money manager fighting the market for too long.
A better use of our collective time is attempting to determine the sustainability of the aforementioned positive deltas in economic data:
- With respect to a sustained recovery in domestic manufacturing activity, we flag sequentially declining U.S. dollar comps throughout the balance of the year as positive and consider the high likelihood that we tip back into #Quad4 – which has historically been positive for the USD – in the upcoming quarter to be a potential negative shock.
- With respect to a sustained recovery in consumer spending, we still believe the sharp acceleration in base effects through the third quarter of this year will continue to be a material negative catalyst for reported growth rates of household consumption. Specifically, base effects for Real PCE growth in the four-quarters ended 3Q16 are far and away the toughest since the four-quarters ending in 3Q08. Recall that Real PCE growth decelerated sharply from +2.7% YoY in AUG ’07 to -1.2% in SEP ’08.
- With respect to a sustained recovery in the industrial sector, we highlight generally receding base effects throughout the balance of the year as a positive catalyst. This is juxtaposed with the negative cocktail of rising credit costs, peak inventories and GDP-negative capital allocation decisions from major U.S. corporations (e.g. AAPL, IBM buybacks).
All that having been discussed, let us turn our attention to the Atlanta Fed’s recent revision of their “GDPNowcast” for Q1 to 2.6% per the latest release. That forecast is up from a trough of +0.6% as recently as mid-January and has the attention of many concerned short-sellers and confident bulls alike.
How important is the aforementioned estimate within the context of the Atlanta Fed’s ~4.5 year-old track record at forecasting U.S. GDP growth? Not very.
The following chart shows us the Atlanta Fed’s peak (green line) and trough (red line) estimates 47 days into any given quarter as we are currently. These figures are juxtaposed with the actual recorded QoQ SAAR growth rate of U.S. GDP (blue line) and the maximum tracking error of the Atlanta Fed’s GDPNowcast (black line). The average maximum intra-quarter-to-date tracking error is a startling 248bps over the duration of this study. That is a whopping 113% of average growth rate of GDP over that same time frame (i.e. 2.2%)!
PLEASE NOTE: We are not showing this analysis with the intention of undermining the Atlanta Fed. Their GDPNowcast estimates are a good barometer of what consensus thinks about near-term growth prospects and their work in charting the “Shadow” Fed Funds Rate has been equally additive to the Macro discussion. We simply highlight the elevated risk of their current forecast for Q1 2016 being revised materially lower (or higher) as the quarter progresses. It’s worth noting that we’ve hardly received much in the way of January data – let alone enough data points to have statistical validity in any regression model.
As we highlighted in our 9/2 Early Look titled, “Do You QoQ?”:
“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)… 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.”
In the aforementioned note, we also highlighted the poor track records of both Bloomberg Consensus and the Fed in forecasting quarterly and annual GDP growth rates in the post-crisis era:
- “Over the past five years, Bloomberg consensus forecasts for headline GDP just one quarter out have demonstrated a quarterly average [maximum] 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 [maximum] 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.”
As the following charts demonstrate, the aforementioned updated quarterly and annual average maximum tracking errors are now 164bps and 91bps, respectively (data through EOY ‘15). These updated figures continue to reflect the fact that investors should remain highly skeptical of even the nearest-term growth forecasts from economists and/or policymakers. At best they’re playing a game of Marco Polo; at worst, they are feeding potentially hazardous information to market participants.
All told, as we discussed at length in our 1/29 note tilted, “What Recession?!”, predicting headline (i.e. QoQ SAAR) GDP is a fool’s errand. Don’t get caught up in the current strength of the Atlanta Fed’s GDPNowcast or what may actually turn out to be a decent Q1 GDP report on a headline basis. We strongly consider both of those catalysts to be head fakes in the context of the underlying sine curve of U.S. economic and capital markets activity.
Best of luck out there,
Takeaway: We think a crash is coming.
"We need to suck every last perma bull into believing that the 'bottom is in,' then kaboom," Hedgeye CEO Keith McCullough wrote earlier this morning.
McCullough has now advised subscribers to short eleven different stocks in Real-Time Alerts, up from two at last week's lows.
This bounce has a suspicious air about it.
... And all today proves is that there are a lot of investors out there who have not learned this ultimate lesson... yet.
Here's another reason not to be long equities. Below is a chart from our 73-page quarterly Macro themes deck which shows when S&P 500 earnings decline for two consecutive quarters stocks fall -20% or more.
Take two minutes to watch the video below with key risk management insights from McCullough in which he concludes, "Are you bearish enough?"
Here's what our subscribers are saying about us:
We're sticking with our process. Rinse & Repeat.
Takeaway: When we finally get a glance of JWN’s sales numbers–they need to be truly horrendous. We’d actually look to buy it on a sell-off tomorrow.
Conclusion: This is a multi-duration call. Bearish over the near-term as macro headwinds put earnings at risk. But, levers are there once the consumer stabilizes/recovers. The reality is that this is the only department store that really needs to exist.
We assembled a rather hefty slide deck on JWN as it emerged as a battleground stock ahead of this week’s print. Initially, we were very bearish. The precipitous increase in short interest from 6% to recession levels of 20% over the past month means that when we finally get a glance of JWN’s sales numbers – they need to be truly horrendous. By the look of its e-commerce business, that’s precisely what we’ll get. Sometimes, the consensus is right, and this time, it probably is.
Unfortunately, it’s still the consensus. And while we think that this quarter will be terrible. The rate of change on the sales, gross margin, sg&a, and capex lines will change on the margin in JWN’s favor by mid-year. At that point, we might actually look to go long this one. After all, it’s the only department store that really needs to exist, and it’s trading at less than 7x a doable EBITDA number.
In the end, we’d actually look to buy it on a sell-off on tomorrow’s numbers – something in the low-mid $40s sounds about right. Otherwise we might be interested in buying with a $5-handle later this year when the Macro environment is de-risked and JWN emerges from ‘investment mode.’
Trade (3 weeks or less): JWN is the only name amongst its peer group that has been radio silent throughout the holiday season that saw M and KSS pre-announce earnings growth rates of -20% (-30% ex. the Brooklyn asset sale) and -15%, respectively. Management lowered the 4Q bar by 9% post the 3Q print, and then the Street came down by another 7% over the past three months. Sales expectations still look too high given the general softness in the retail space (especially at the high end) over the holiday period and the fact that JWN is up against its toughest comp since 4Q12. E-commerce traffic trends have been soft across all of JWN’s concepts as it laps the launch year of the Rack website, while Full Price and Hautelook continued to weaken into quarter close. We’re about $100mm, or 2%, below the street.
These Traffic Trends Look Terrible
On the margin side, JWN likely took the biggest hit of any of the department store players in the quarter with gross margins down 160bps in 3Q, as it proactively managed its inventory position. Warm weather and weak demand will still be an issue in 1Q, and we expect inventory growth ahead of sales for the 16th time in the past 18 quarters. Canada and Trunk dilution is starting to roll off now that the sales base North of the border is forming a critical mass and the acquisition of Trunk Club is annualized. The company pulled a few SG&A levers last quarter by cutting its investment in its loyalty program (bullish for credit income). All in we’re modeling a 200bps hit to EBIT, broken out into 110bps of deleverage in the core, another 40bps from non-core investments, and the remainder allocated to the sale of the credit card receivables.
3Q15 SIGMA Chart
Trend (3 months or more): Not unlike the rest of the retail space, the street is looking for a snap back on the top line as we enter 1H16, chalking up most of the demand issues we saw in the back half of 2015 to just weather. We’re not buying it. And, after what we think will be another sales miss in the 4th quarter we expect the guide for 2016 to be conservative on the top line. Or, at least it should be given the price action on the stock over the past 3 months and the fact that short interest is at 5 year highs at 19% (up from just 6% in late November).
Here’s where we come out on each of the lines on the P&L in the first half of 2016…
- Revenue: No comp growth in the brick and mortar side of the business with negative LSD comps at Full Line and flattish comps at Rack against easy compares last year. That’s offset by low teens growth in the company’s e-commerce business (inclusive of FullLine.com, Rack.com, and Hautelook), about a half a point of growth from Canada and Trunk Club, and 5% square footage growth. That gets us to LSD sales growth in the first half of the year at the retail level (flat revenue growth reported due to the loss of credit revenue).
- Gross Margin: We’re looking at another 75bps of deleverage as the company continues to invest in its roll out of Rack and Canada stores, which caused about 30bps of deleverage on the gross margin line in 2015. As noted earlier, JWN took it on the chin on the margin side to keep inventories in check headed into 4Q15, but we expect the combination of weak demand and warm weather to lead to a negative move in the sales to inventory spread. That coupled with high inventories across the space = another ‘highly promotional’ environment in 1H15.
- SG&A: Growth in the mid to low single digit range as the company laps the Trunk Club acquisition, East Coast fulfillment center, and the profitability in the Canada business operation starts to head North. Offset by about $25mm in credit revenue from the TD Bank agreement in each quarter.
- Earnings: Add that all up and we get to a negative DD earnings growth rate in 1H. 5% and 10% below the Street in 1Q and 2Q, respectively.
Tail (3 years or less): Over a longer duration (3 years or less), we like the setup for JWN. Yes, macro headwinds and category risk are keeping this name on the long bench rather than the core set of names as trend earnings risk still looks likely. But, once we get through the macro reset JWN has the makings of a textbook long. Here’s why…
1) For starters, we have to ask the question does JWN need to exist? We think the answer is unequivocally yes. It has arguably the best e-comm operation in all of B&M retail, premium content, a concentrated footprint in the top malls/MSAs outside of the Northeast, and can hit 300 rack doors without skipping a beat. We’re not convinced that the ‘non-core’ (Canada/Trunk) growth drivers are ROIC accretive, but expectations have come down to a level where we think the point is moot.
2) JWN is coming off a peak investment year, and while there is still $3.1bn left on the $4.3bn 5 year CapEx plan, 2015 marks the tops of capital investment. Margins are washed out as the company invests in the Rack rollout (27 doors added this year), Canadian entry, new East Coast fulfillment center, credit card receivables sale, and absorbs the Trunk Club acquisition. That should in turn fuel top line growth in the HSD range once we enter the back half of 2016 (consumer environment permitting).
3) We don’t have to make wild profitability or sales assumptions for this model to work. By 2017, we assume that Full Line EBIT margins are 100bps off 2014 levels, Rack EBIT margins are 50bps off of 2014 levels, slight improvement in e-comm margins as the business (Rack and Full Line) climbs to ~$4bil, and a profitability donut in the non-core side of the business (Canada/Trunk). At that point Canada will be around a $400mm business, with the entire full line buildout complete, and Trunk (which was break even when JWN acquired it) will have benefited from 3 years of integration. Any improvement in each of the four segments will add additional upside.
4) On that math we get to earnings of $4.13 in 2017 on a sales base just north of $16bn. 6% ahead of the street today and likely higher as numbers come down after 2016 expectations are reset.
Takeaway: Is a standstill in the Senate likely with ensuing search for Justice Scalia's replacement. Can Paul Ryan unite Republicans around a deal?
Editor's Note: Below is a brief excerpt from Potomac Research Group Senior Analyst JT Taylor's Morning Bullets sent to institutional clients each morning.
Expectations for the Senate's productivity this year were already low, but the looming nomination fight over Justice Scalia's replacement threatens to grind the chamber to a standstill. Majority Leader Mitch McConnell's decree that any Obama nominee to the Supreme Court would be stonewalled all but invites an "obstructionist" tag for the whole party in the coming election (though we're willing to bet that Harry Reid, if in his shoes, would be using the same playbook). He's caught between the stated goal of "regular order," demonstrating his party's ability to govern, and a much-less ephemeral conservative base that will not countenance a nominee from the current president, period.
We wonder, why not just let the process work? There are several major hurdles that a nominee faces under normal circumstances -- the Judiciary Committee, a cloture vote, and finally a floor vote -- and there's opportunity throughout for Leadership to slow or block confirmation, with far less risk to the party brand. Not every Senator seems to be adopting the party's hard line -- Judiciary Chair Chuck Grassley said he would at least withhold judgment until a nominee is named, while fellow Judiciary member Thom Tillis warned about the "obstructionist trap" they risk by blocking a SCOTUS pick sight-unseen.
BUDGET BALANCING ACT:
Speaker Paul Ryan, facing stern opposition from conservatives to the budget caps agreed-upon by his predecessor John Boehner, laid out three options for members of his Caucus on Friday:
- Re-impose sequestration-level cuts for defense and domestic spending;
- Bump up the defense budget, to satisfy hawks, but maintain or lower caps on domestic spending; or
- Don't pass a budget at all -- with the budget topline already set for next year, appropriations bulls can still move forward unimpeded.
Options 1 and 2, he stated, would result in the one outcome conservatives hate even more than excess spending: a Democratic blockade in the Senate, followed by an Omnibus appropriations bill crammed down their throats at the end of the year. Option 3 would be an embarrassment for Ryan, former chair of the Budget Committee, and give Democrats yet another attack vector on the party's inability to govern -- but "the sky wouldn't fall," according to the Speaker. Partisan rancor over the SCOTUS shake-up increases the odds that House Republicans will take option 3.
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