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The Revolution

“Every revolution evaporates and leaves behind only the slime of a new bureaucracy.”

-Franz Kafka

 

Many people in the pundit class are calling this the most important election of our lifetime. To be fair, that line seems to be trotted out every four years. Who knows? Maybe this time they’re right? Certainly, the extreme options that Americans are being faced with as an electorate suggest something is askew...

 

On the left, the extreme option that is very realistic is socialism, while on the right (and I’m sure this will offend some) there are options that appear akin to fascism, of sorts. Perhaps the next American Revolution is on its way? Regardless, the next 8 months will be entertaining as it becomes increasingly likely that Hillary Clinton and The Donald may be going toe to toe. As voters, we can be fairly certain we will get “the slime of a new bureaucracy.”

 

Speaking of revolutions, the Iranian Revolution occurred some 37 years ago this month. Over that period, America’s relations with Iran have been rocky to say the least. More recently, with the signing of the Joint Comprehensive Plan of Action between Iran and P5 + 1 (the five permanent members of the UN Security Council and Germany), relations have seemingly thawed and most importantly the oil spigot is coming back on.

 

Our view is that perhaps the single most important question determining the price of oil from a supply and demand perspective is how quickly Iranian production ramps back up. So far, Iran has surprised the experts with its ability to get production back online. The pace at which Iran goes from its current roughly 1.1 million barrels per day of production to its target of 4.5 million, will weigh heavily on the global oil market and the over-levered balance sheets of domestic producers for years to come.

 

The Revolution - oil iran saudi

 

Digging further into this topic, this coming Thursday, we will be hosting a small group dinner in New York with former U.S. Secretary of Energy Spencer Abraham, former Vice Chairman of the International Energy Association Joe McMonigle, and Guly Sabahi who is a partner in the internal energy practice at Dentons and a noted expert of the soon-to-be unveiled Iran Petroleum Contract. If you’d like to stay ahead of the proverbial curve and join the dinner, please email to reserve a spot.

 

Back to the Global Macro Grind …

 

In the world of global macro data points, one to note this morning is that a survey of Chinese economists indicated that the Purchasing Managers Index is expected to decline in March. As emphasized by the Chart of the Day, this would be the seventh straight monthly decline in Chinese PMI and just another in the litany slowing economic data points globally. But don’t worry, PBOC Governor Xiaochuan was speaking at the G-20 yesterday conference and indicated the Chinese central bank still has room to ease . . .

 

Japan has more significant headwinds than a monthly purchasing manager survey decline. According to the 2015 census, Japan’s population declined for the first time on record. Japan’s population shrank by about 0.7%, or almost a million people over the last five years. Most noteworthy is that population decline is really a broad based issue in Japan with 39 out of 47 prefectures and territories showing a decline. 

 

Given this backdrop, it should be no surprise when we report this morning that Japanese CPI came in at a blistering +0.0% this morning. When your population is in full on decline, it’s pretty hard to engineer inflation, no matter how many trillion Yen your central bankers throw at the problem.

 

In China, central bankers are telling us that they have room to do more. In Japan, they are telling us they aren’t worried about negative rates. And at the G-20, IMF Managing Director Lagarde was urging nations to implement more fiscal reforms and structural reforms. Clearly, whatever economic malaise we are currently experiencing and may experience through the course of the year, there is an appropriate government response. That said, with German CPI falling -0.2%, that response is not likely to be a fiscal one.

 

In the U.S., the major uncertainty still revolves around the Presidential election. According to our colleague JT Taylor at Potomac Research, Senator Rubio may have gained some much needed ground in last night’s debate. As JT wrote this morning in his morning bullets:

 

MARCO HITS HIS MARK: "Robo-Rubio" is officially gone. Marco Rubio needed a strong performance last night to show that he was capable of taking on Trump, and he delivered --whacking him with a phone book's worth of oppo research at the outset, and making much of the debate look like a one-on-one between himself and Trump. He also took a major step to solidify his standing in the establishment lane. He figured out that mocking Trump is far more effective than attacking him as a liberal. Cruz jumped into the fray, leveling additional attacks against Trump and his business dealings, but hewed closely to his stump speech and was argumentative and petulant for the second debate in a row. He did get some punches in, but because he split his time taking digs at Rubio and Trump, he was outshone by Rubio's sarcasm and agility. 

 

The big test for Rubio will come in the media cycle between now and Super Tuesday, and whether he can survive the certain counterpunch from Trump. The big test for the Republican party will be whether last night changes Trump supporters' feelings about the mogul -- if past is prologue, the answer is no. The big question for Rubio and Cruz -- where have you been for the past 10 debates?”

 

This may not be the most important election of our lifetime, but it will certainly have a direct impact on the economy and policy, so we will be reporting on it in real-time. If you’d like to be added to JT’s morning bullets, please email and let them know.

 

Our immediate-term Global Macro Risk Ranges are now:

 

UST 10yr Yield 1.65-1.82%

SPX 1

VIX 17.99-27.48
EUR/USD 1.09-1.13

YEN 111.30-114.95 

Gold 1178-1252 
Oil (WTI) 27.07-34.25

 

Keep your head up and stick on the ice,

 

Daryl G. Jones

Director of Research 

 

The Revolution - 02.26.16 Chart


The Macro Show Replay | February 26, 2016

CLICK HERE for slides from today's show.

 


RL -- Trainwreck

Takeaway: You don't let a guy like Peterson go when in the middle of a huge restructuring that he himself architected. There's no positive spin here.

Could ANYTHING be worse for RL right now than Chris Peterson (President) being fired/pushed out/leaving/fired?  Probably not.

 

The reality is that RL is in the middle of a simply massive restructuring (again). It’s one that is choppy at best, but it’s progressing. The crux of it is that the company has been operating in a simple two dimensional matrix, that is simply no longer appropriate for a company like RL that wants to look ahead and add another $10bn in sales.  Now it's shifting to a 6-dimensional matrix -- i.e. 6 Headed Hydra. As complex as it is, it's absolutely critical for RL.

 

The problem is that Peterson was the architect of this plan. He was basically ‘P&G-ing’ the operational side of RL (was CFO of largest biz inside P&G). The history of consumer packaged goods execs coming into the fashion business over time is checkered – and that’s being generous. But Peterson looked like he was one of the few that would make it.  Guess not – at least not after his new boss was inserted between him and Ralph Lauren.

 

On the plus side, it shows that Lauren is actually giving Stefan Larsson (CEO) some latitude to actually make decisions. But it seems a bit soon in his tenure to make such a massive decision as to let Peterson go.

 

So Ralph is left having to move forward with an incredibly complex reorganization without the person who crafted and is accountable for it. Either that, or things are blowing up inside the organization right now and someone had to take the fall. 

 

Either way, this is really really bad.  We backed off of RL earlier this year on the long side. No, we wouldn’t touch it no matter how cheap it gets…because the ‘e’ part of the equation is out the door, for now.


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KSS | Does America Need Kohl’s?

Takeaway: “Seriously dude – does America really need Kohl’s to exist?” – Darius Dale, Hedgeye Macro Analyst

Darius asked this question in passing yesterday when talking about the day’s earnings reports. My answer to that question is ‘No’, but I’m a cynical, crotchety retail analyst with opinions that might not speak for main street America. DD is hardly ‘main street’, but we think that more and more people will ask that question as time goes on – and they’ll probably come to a similar answer.  We have that answer represented in our earnings estimates, which – as outlined in the table below – are significantly below consensus. While we’re only looking for a $0.50 miss this year, as our annual numbers march forward, we get to $2.30 by 2019 vs the Street over $6.00. We think KSS will miss again, and again and again – and we think they’ll be a dividend cut along the way. Case in point, it’s cash flow literally got cut by 25% this year, and cash balance was halved. We often get the ‘there’s so much cash’ argument against a short. But never forget that a great cash flow profile in this business could deteriorate faster than a Presidential candidate’s credibility.

 

In this note, we give out take on KSS’ guidance, and then there’s an overview of our ‘3-Steps to Failure’ thesis on KSS.

KSS | Does America Need Kohl’s? - KSS earnings 

  

GUIDANCE: Management set more realistic expectations for 2016 then it did last year, which resulted in the 8% annual miss reported yesterday. Our thoughts on the line items KSS guided…

1)      Comp, 0-1% - Doable for KSS. The company just comped the comp in the 4th quarter, which is a big feat for KSS. But, comps stay tough from here as KSS goes up against the longest stretch of comparable store sales increases since 2010-11. We’re at the high end of guidance for comps this year (i.e. a whopping 1%) assuming negative LSD in store comps at 20%+ e-comm growth – but that ‘strength’ will come at the expense of GM.

2)      Gross margin, +0-20bps – Not going to happen. With guidance for -150bps for 1Q as KSS tries to clean up its inventory position, we have to assume that gross margins in quarters two through four are up 70bps. Inventory is a priority, as it has been for the past couple of years and we aren’t willing to give the company the benefit of the doubt on its ability to control inventory growth AND comp positive. One or the other with KSS, at best. National brand penetration was up 200bps over 2014 and 400bps since ’13 and that comes at an incrementally lower margin. Management talked about a stabilization in the mix shift, but National brands (i.e. Nike, Nike and Nike) have driven the comp over the past year plus. Add on to that e-commerce growth of 20%+ and that equates to a 35-40bps hit in gross margin even assuming a 75bps increase in e-comm profitability.

3)      SG&A, 1-2% - Looks low. Key drivers of SG&A growth: wage inflation, credit revenue no longer an incremental offset, and IT spending. All in we get to ~3% growth for the year. Might not seem like much, but this is a company that struggles to comp 1% on its best day.


4)      EPS, $4.05-$4.25. To get to the mid-point of guidance we need to see no erosion in the net income base which hasn’t grown in a year since 2011. With a $600mm buyback, at the tail end of an economic cycle. We’re at $3.65.

KSS | Does America Need Kohl’s? - KSS SIGMA 

 

Credit: Credit leveraged for the year, but we started to see some cracks after year 1 of the Yes2You rewards program. Most notably, credit card applications were down vs. last year. Management chalked that up to an increased emphasis on loyalty, but we think it has more to do with the fact that KSS has already hit 75% of the total customers it could possible attract (see math below).  Dipping down the credit ladder is no longer an option, as KSS already did that when it switched its card partner over to Capital One and over the subsequent 5 years took credit as a percent of sales from 50% to 60%+. We see significant risk to this line. To be clear, this one of the major pillars to our short thesis on KSS (see below). KSS could and should see credit income (25% of EBIT) erode without a turn in the credit cycle. Note: even Macy’s is seeing a rise in delinquencies.

 KSS | Does America Need Kohl’s? - KSS productivity

 

Sq. Ft. Growth/Store Closures – These Won’t Be The Last: This is the first meaningful store closures we’ve ever seen at KSS. It makes sense in theory as we’ve seen store productivity (ex-ecomm) fall by 8% over the past 4 years...see chart below. That will continue as e-comm continues to cannibalize the brick and mortar business. At its analyst day, management noted that there were few stores in the portfolio losing money on a cash business, which translates to limited cost savings as more stores are stripped. Though no exact numbers were given on expected sales recapture in neighboring stores and online, we don’t think this is a big opportunity. Macy’s commentary earlier this week on sales recapture wasn’t overly bullish. This is a non-event from where we sit.

KSS | Does America Need Kohl’s? - cust1

 

 

(Originally Published on 2/3 After KSS Preannouncement)

KSS | …And This Is Only Stage 1 of 3

This is the 1st Stage of KSS EPS permanently being held below $4.00. Stage 2 goes to $3.25. Stage 3 = $2.50 and dividend cut.

 

All along we’ve been saying that KSS would never earn $4.00 again. While today’s rather dramatic guide-down will make this premise seem a reality for some doubters, what we find most interesting is that this is only midway through Stage 1 of what we think is a Three Stage process to KSS cutting its dividend. Here’s our thinking…

 

Stage 1: Weak sales results as a result of the fact that KSS sells less and less of what consumers want to buy. Sounds overly simple – but it’s reality. That flows through to the gross margin line as online sales cannibalize brick and mortar, and come at a gross margin 1000bps below the company average. True SG&A growth becomes apparent as credit income stops going up as newly emphasized non-credit/loyalty shoppers become a bigger mix of the pie due to launch of Yes2You rewards program.

 

Stage 2: Here’s where credit income (currently about 25% of EBIT) erodes WITHOUT a rollover in the broader credit cycle. The company’s much-touted (but ultimately fatally flawed) Yes2You rewards plan cannibalizes credit income as shoppers can move to a loyalty program that offers similar rewards to the branded credit card but gives the consumers the opportunity to get 2x the points. Once at KSS and once on a National Credit card. That takes SG&A growth, which has been artificially suppressed as credit sales grew from 50% to 60%+ of total sales over a 5 year time period, from a run rate of 1% to 3%-4%. For a company that comps 1% in a good quarter, this is incredibly meaningful.

 

Stage 3: This is the doomsday scenario, and within the realm of possibility as the credit cycle rolls. On top of the self-inflicted pain we see in Stage 2, we see consumer spending dry up (sales weaken – down 5-10%), gross profit margins are down 2-3 points due to excess inventory, SG&A grows in the high single digits due to credit income (which is booked as an offset to SG&A) eroding, and EPS falls to $2.00-$2.50. Look at any data stream on the credit cycle and you will see that delinquencies and charge-offs are at pre-recession levels. Translate that to KSS, and it means that the credit portfolio is currently at its most profitable rate. Because the company shares in the risk/reward with its partner COF, any weakening in the consumer credit cycle exacerbates the problems brought on by Yes2You cannibalization and puts 25% of EBIT and half of the current FCF at risk. The result, cash flow dries up and by our math, cuts its dividend within 12-months.

 

Other Notables on The Preannouncement

The comp in this quarter missed, and believe it or not, the comps from here get much more difficult. This pre-announced $0.30 (7%) earnings miss for a fiscal year is monstrous. The last time a company with the cap and sales base that KSS owned (pre-blowup) missed at this magnitude in a fiscal year was back in 2012 at JCP under RonJon. Prior to that, we have to go all the way back to 2003 when TGT and KSS printed a miss of 11% and 8%, respectively.  

 

This is now the 5th straight quarter of positive SSS comps for a company that hasn’t put a string like this together since 3Q10 – 3Q11. By our math, given that e-commerce sales grew at 30%, brick and mortar comps were down 4% in the quarter. Gross margins were down to the magnitude of 100bps+ assuming SG&A growth of 3-4%.

 


Under 60 Seconds: Wayfair's Earnings Report | $W

Hedgeye Retail analyst Brian McGough highlights three key points from Wayfair's latest earnings report.


JT Taylor: Rubio & Trump Team Up On Cruz & The McConnell Stonewall

Takeaway: What to watch on the election 2016 campaign trail.

Below is a brief excerpt from Potomac Research Group Chief Political Strategist JT Taylor's Morning Bullets sent to institutional clients each morning.

TOE TO TOE IN TEXAS:

 

JT Taylor: Rubio & Trump Team Up On Cruz & The McConnell Stonewall - cruz 23

 

Tonight's debate in Houston is the final, critical chance for Ted Cruz and Marco Rubio to redefine the narrative over the next five days before the Super Tuesday contests. Some Rubio donors and establishment types have been reluctant to take on Donald Trump, fearing that he may suffer a similar fate to Jeb -- but if he wants to win, Rubio can't sit by and let Trump dictate the terms and tenor of the debate.

 

Look for him and Trump to tag-team against Cruz, capitalizing on his newly-exposed and unexpected crisis of character. Cruz and his campaign are clearly on the ropes, and we hear a sense of panic is starting to set in among his team -- we wouldn't be surprised if he comes out jabbing, but is limited to counter-punching the whole night. 

SUPREME STONEWALL:

 

JT Taylor: Rubio & Trump Team Up On Cruz & The McConnell Stonewall - mcconnell

 

Majority Leader McConnell's decision to deny President Obama a chance to fill the late Justice Scalia's seat raised just a few eyebrows in the Republican caucus, but he has strung together a nearly-united front and the Republican base appears appeased -- for now. McConnell now owns the narrative, and Democrats -- at some point -- will label their opposition with the obstructionist tag, and tie it into their other theme that Republicans can't govern effectively.

 

We see this as a clear and looming danger for vulnerable candidates up for re-election in swing states, but McConnell and the Judiciary Committee are unlikely to budge. We wonder if their calculus changes now that the White House is floating Republican Gov Brian Sandoval's name, or in the event Hillary Clinton is sitting on a big lead in the months closer to the general election. 


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