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2 Reasons Why Wayfair Is Still A Short

Takeaway: W continues to invest in an addressable market much larger than we believe it will ever recognize. Starting to see cracks in the foundation.

Editor’s Note: Below is an institutional research note on Wayfair written yesterday by Hedgeye Retail analysts Brian McGough and Alexander Richards. To access our institutional research email sales@hedgeye.com.

 

2 Reasons Why Wayfair Is Still A Short - wayfair 8 10

 

The -20% move today is a nice near-term win, but let’s be perfectly clear about one thing…this short call is far from over. We saw a few cracks in the foundation within the numbers printed this morning and we think there’s considerably more downside risk embedded in this story as the company continues to invest in an addressable market that is much larger than our research has us convinced it will ever recognize. And ever is a long time.

  1. This is no longer a US story as the company has clearly pushed international expansion up higher in the queue. To date, Wayfair is present in four countries and the management team has now talked to roughly a $180bn market opportunity between the US and Western Europe. What that tells us is the company isn’t done funneling dollars across borders in order to diversify its revenue base. Meaning a bigger drag on earnings for longer.
  2. Over the past 12 months, Wayfair has rung the register on $2.7bn in the US. The current market share on Wayfair’s math is 13%, or looked at another way, 4% of its long term TAM. That still leaves a considerable amount of share to be captured in the US if you believe Wayfair’s math. We don’t think the outlook is as opportunistic for W, which based on our work suggests that the company has a $27bn TAM with upside to $45bn vs. the company at $90bn. That tells us that Wayfair is spending up now to supplement an unrecognizable US end market.

KSS | Still Two Stages Left

Takeaway: Expectations as low as we can remember for KSS headed into tomorrow’s print. But we are only in stage 1 of 3 on the KSS short call.

We remain short headed into tomorrow’s print. No, this isn’t a call on the quarter, as expectations look to be in check at a -2% comp flowing through to -4% earnings growth – but a broader statement on where we think we are in the progression of the KSS short thesis. If the company throws the bulls a bone – as it does from time to time – then we’d get heavier on it. This is as much of a ‘core short’ as we can find in this market.

 

The progression of the thesis is in three stages, as follows…

1) 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. This is where we are today and gets us to an earnings number in the mid-$3s. At a HSD multiple, that’s a low-30’s stock which = 20% downside from current levels.

2) Stage 2: Here’s where credit income (currently about 1/3rd of EBIT and 60%+ of sales) 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.

3) 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 creeping off post-recession lows with some bearish commentary mixed in from the likes of Synchrony Financial and Capital One. 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 30% 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 Key Considerations Into The Quarter:

 

Comp Compares – Remain Tough

Despite the low expectations embedded in this name today, we think it’s important to point out that compares on the top line don’t get any easier as we pass through the balance of the year, which happens to be the tail end of the longest positive comp trend (5 quarters) that the company has posted since 2010-11. That was facilitated by an upward lift from traffic – somewhat due to the Y2Y introduction and some pricing power due to the shift away from private label towards national brands. The latter will still be a benefit, but we expect the traffic element to still be under considerable pressure from here. That’s important for a company like KSS who needs a 2% comp to leverage expenses across an already lean organization that is facing ‘significant wage pressure’ thanks to WMT.

KSS | Still Two Stages Left - 8 10 2016 KSS Comp Components chart1

 

Government Data Not Getting Better

We won’t complete the 2Q trifecta, as the government reports July retail sales the day after KSS reports 2Q numbers – but based on the government data, department store trends didn’t pick up in the first two months of the quarter down 5.8% in May and -3.7% in June. Softer than we saw in total for 1Q16, and about on par with 1Q on a 2yr run rate in the ballpark of -3% to -4%. Looking at the most recent data points, we saw every retailer who still reports monthly sales numbers post negative July comps (with the exception of LB). That was capped off by a -4% GPS print on Monday. Anyone looking for a hint of relief for the category isn’t going to find it here.

KSS | Still Two Stages Left - 8 10 2016 KSS dept store sales

 

UA Not Protecting This House

Perhaps the biggest selling point the company will talk to on tomorrow’s call is the introduction of UA in Spring 2017. It’s certainly a win for the company in that it gives KSS some good marketing material when talking with investors, but the way we are doing the math it’s worth no more than a 0.5% lift to comp. Here’s a quick summary on the math – the UA opportunity in year one is $142mm, that will be displacing about $53mm in product which we assume has a productivity rate 75% of the company average, for a net total of $89mm benefit to KSS. For full details, see our note: UA/KSS | The Best + The Worst = Not The Best.

 

No Turn Down In Credit… Yet

Perhaps the most vexing component of our KSS short call is the relative strength of the company’s credit portfolio growth since the introduction of the Y2Y rewards program at the tail end of 2014. Our logic after the introduction of the Y2Y, which essentially decoupled the rewards program from the credit card (in the past you needed a KSS charge card to get the promotional benefits), was that we’d at the very least see the growth of the portfolio stop, with a very high likelihood that the Y2Y would cannibalize the credit card business because consumers could use any form of currency to capitalize on the myriad number of Rewards promotional events.

To date, the credit income has continued to chug along, and has provided an offset to the underlying SG&A growth between 0-1% every quarter since the Y2Y was introduced in 3Q14. Though we have seen a few cracks in the metrics and the rate at which the portfolio has grown as a percentage of sales has tailed off, credit continues to be a net benefit to the company when recognized as an offset to SG&A. Each of the bars below represents the spread between SG&A ex. credit (i.e. if credit was flat YY) and the reported SG&A growth rate – any reading on the positive side = a net credit benefit. Put another way, SG&A grew -0.8% in 1Q16. Ex the $8mm credit benefit, SG&A dollars would have been flat YY.

We still think that the credit portfolio is stretched, as a) the company has tapped 75% of its total addressable market, and b) the company skimmed the bottom of the credit worthiness barrel when it switched to Capital One and took credit as a % of sales from 50% to 60% over a 5yr time period. Any softening in the contribution from the credit business would put considerable pressure on the expense line with a double whammy if we continue to see weakening in the consumer credit metrics (more on that below).

KSS | Still Two Stages Left - KSS creidt sga

 

Credit Considerations

This would characterize step 3 in our KSS short call (described above), and in summary, we’ve started to see a noticeable weakness in the credit quality on the margin. That’s import for KSS, who has 60%+ of its sales tied to its private label credit card and 1/3rd of its EBIT. The two most salient data points relevant to this discussion are…

 

1) Capital One, saw its net charge off rate accelerate in June, continuing the uptrend seen since September 2014. And let's not forget the denominator effect – the key there being that the charge-off calculation is basically bad debt expense divided by the total loan portfolio, so both numerator and denominator have an impact. Cap One (KSS credit partner) grew its loan portfolio 12% in 2Q at the same time charge-offs accelerated. So not only is default risk increasing, but the rate of change is being skewed positively by the rapid loan growth. The bottom line is the charge-off rate can accelerate much more rapidly than one might expect as the cycle rolls over. KSS shares in the bad debt risk with COF, so a change in the rate means less dollars to share in the partnership, which will minimize the SG&A offset that KSS has benefited from over the entirety of this cycle.

KSS | Still Two Stages Left - 8 10 2016 COF Charge Off YY

 

2) First consumer credit category turns to net tightening: After 2Q earnings season for consumer lenders brought about multiple warnings of building bad debt reserves and accelerating delinquencies, last week's Fed Senior Loan Officer Survey brought yet another warning sign. Bank lending standards on auto loans inflected to net tightening now in 3Q16. This follows C&I lending, which turned to net tightening in 4Q15, and CRE lending that turned in 1Q16. This is clearly a consequence of the cycle, and the credit cycle is like a Battleship: once it starts turning, it doesn’t want to stop. It’s likely we see the rest of consumer land turn to net tightening within a quarter or two.

KSS | Still Two Stages Left - 8 10 2016 Banks Tightening Standards

Props to Hedgeye Financials


Capital Brief: Trying Times For Trump & The Growing List Of GOP Defectors

Takeaway: A Party Dividing?; Trump Econ 101; Unanswered Questions

Editor's Note: Below is a brief excerpt from Hedgeye Potomac Chief Political Strategist JT Taylor's Capital Brief sent to institutional clients each morning. For more information on how you can access our institutional research please email sales@hedgeye.com.

 

Capital Brief: Trying Times For Trump & The Growing List Of GOP Defectors - JT   Potomac under 1 mb

 

“The bud of victory is always in the truth.”

-Benjamin Harrison

A PARTY DIVIDING?

Following one of his campaign’s worst weeks yet, Donald Trump claims he won’t change his strategy or alter his temperament even slightly. His Second Amendment comments were beyond the pale - overshadowing yet another headline on Hillary Clinton’s State Department emails and influence from the Clinton Foundation - and will likely cost him more party members and donors as some are now making their support of Hillary Clinton very public. The list continues to grow - this time including ME Senator Susan Collins saying she would not vote for Trump. In addition to Collins, and other high-profile former Bush Administration defections, a letter signed by 50 senior Republican national security officials warned that a Trump presidency would “risk our country’s national security and well-being.”  

TRUMP ECON 101

Amid protesters’ interruptions, Trump’s economic speech to the Detroit Economic Club was a mix of the good, the bad, and the ugly. The plan stitched together old ideas from the left and the right, including a large dose of tax cuts mixed with outdated protectionism, reformed conservative social policy and a deregulation plan that would make Wall Street cheer. Will the unusual mix of policy captivate those outside of Trump’s constituencies and stall his recent slide in the polls and recapture the momentum that led him to the nomination? Clinton is expected to lay out her rebuttal later this afternoon.

UNANSWERED QUESTIONS

It’s hard to dismiss the fact that Clinton is leading by double digits in most national polls and now with just 90 days until election day, Trump still has not spent a dime on television advertising, even as Clinton continues to flood the airwaves with more than $50 million in ad spending. It's not for lack of money as the Trump campaign raised $80 million in July and finished the month with $37 million cash-on-hand. We’re stymied that he hasn’t tried to make up any lost ground not even posting during the Olympics as Clinton drops $5.5 million on prime time ads.


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[UNLOCKED] Early Look: Inhaling All-Time Highs?

[UNLOCKED] Early Look: Inhaling All-Time Highs? - obama smoking

This is a complimentary Early Look written by Hedgeye CEO Keith McCullough on July 11th. "When I grew up in the hedge fund business, my bosses only cared about generating alpha," McCullough wrote. "Rather than inhale every little wiggle in the SPY for the last year (chasing up moves and freaking out on down ones), we just have to stay with our winners. Ride them. And breathe."


YELP | New Noise, Same Story (2Q16)

Takeaway: Mgmt is doing a much better job selling its story to the street, but not much has changed. We're on sidelines till we get closer to 2017.

KEY POINTS

  1. 2Q16 = ALGO STUNT ↑ SELF-SERVE ↓: 2Q was largely driven by the 1Q algorithm change.  ARPU accelerated again in 2Q16 (up 7% vs. 4% in 1Q16).  While mgmt suggested that there was “no step function kind of improvement” in 2Q ARPU, YELP probably saw an incremental tailwind from the algo change unless it was implemented exactly on Jan 1st of this year.  The other ARPU tailwind is slowing new account growth, which translates to higher % of LAAs paying a full quarter’s worth of revenue.  Interestingly, promo/self-serve accounts may already be losing steam.  Mgmt’s comments on 2Q16 salesforce-driven small-biz account growth of nearly 30% vs. its 2Q16 LAA growth of 32%, suggest YELP ended 2Q with +2K accounts that were driven by a combination of self-serve and multi-location.  Mgmt had suggested that a “meaningful percentage” of its 10K net new LAAs in 1Q16 were self-serve.  Collectively, we suspect that means self-serve growth either sputtered out in 2Q, or YELP already lost the bulk of its new self-serve accts from 1Q; the subtle spike in its 2Q churn suggests it may be the latter.
  2. NEW NOISE, SAME STORY: Mgmt is doing a much better job talking up the story, but when you break it down, not much has changed.  Revenue growth of 30-40% in its longest-tenured markets isn’t a surprise since those are its largest markets (est. 50% of TAM), and YELP is still ramping its salesforce at a ~40% growth rate.  Having ~75% revenue visibility into its following quarter is just a reflection of the portion of customer base that is locked into annual contracts.  Increased revenue retention in 2Q16 is a result of higher ad budget fulfillment (revenue) from the algo stunt (LAA churn increased).  Improving salesforce productivity (on revenue) is backward looking since it’s a reflection of past account wins that history suggests YELP will eventually lose, which is why we measure productivity on the new account side (more below).  All in, mgmt hasn't introduced much to the story outside of noise; most of which we've all already heard.
  3. WHAT'S CHANGED? The COO has decided to retire at age 42, and is being replaced internally.  Mgmt talked up National/Multi-Location Advertising & Transactional, but the core Local Ad business still represents 70% of its revenue.  That story YTD can be boiled down to the the algo change & sell-self serve; the former is just a one year benefit, the latter has already emerged as a headfake of a growth driver.  Meanwhile the core business continues to deteriorate, specifically on new LAA growth that continues to track below its rate of salesforce hiring; despite being partially aided by self-serve.  Remember, that its new LAA growth today is essentially a glimpse into YELP’s 2017 base business since YELP will lose most of the accounts that it entered 2016 with as those contracts lapse.  We remain on the sidelines for now since we do not believe we have a short catalyst until the 4Q16 release at the earliest.  We also suspect mgmt may still be shopping the company.  Meanwhile, we're not entertaining a long since there hasn't been any real fundamental improvement, and the runway on the long trade (i.e. the algo stunt masked as a fundamental inflection) is only 1-2 more quarters at best. 

 

Let us know if you have questions, or would like to discuss in more detail.  

 

Hesham Shaaban, CFA
Managing Director


@HedgeyeInternet

 

YELP | New Noise, Same Story (2Q16) - YELP   New LAA invert vs. ARPA

YELP | New Noise, Same Story (2Q16) - YELP   LAA attrition   rate

YELP | New Noise, Same Story (2Q16) - YELP   LAA v s. Sales 2Q16 scen


#GrowthSlowing: Did You Miss The Move?

Takeaway: Global 10-year sovereign bond yields are down across the board this morning.

I see plenty of email traffic (after the move) on the recent backup in yields, but will I get any emails this morning on the same as 10-year Yields around the world A) fail @Hedgeye TREND resistance and B) fall in unison as Global #GrowthSlowing data continues? UK 10yr -6bps to 0.52%.

 

But, but… “they’re expensive” (Old Wall PM speak for I didn’t and don’t own them) and “eventually” the bubble in bonds “has to pop” (but in “stocks”, never – always room to go higher)…

 

That’s what’s been filling up my inbox for the past few weeks. And that’s primarily because long-term bond yields, globally, bounced off their all-time lows. The widely watched widow-maker (for Long Bond Bears) – Japanese Government Bonds – sold off 22 basis points!

 

So if you nailed it (instead of being nailed for the last year shorting “expensive” bonds and their proxies) and shorted JGBs, Bunds, and Treasuries at the all-time lows in yields, I say you book those gains before the Gold Bond Bulls run you over.

 

 

Editor's Note: The snippet above is from a note Hedgeye CEO Keith McCullough wrote for subscribers this morning. Click here to learn more. 


Hedgeye Statistics

The total percentage of successful long and short trading signals since the inception of Real-Time Alerts in August of 2008.

  • LONG SIGNALS 80.43%
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