Editor's Note: Below is a brief excerpt and chart from today's Early Look written by Hedgeye U.S. Macro analyst Christian Drake. Click here to learn more.
Editor's Note: Below is a brief excerpt and chart from today's Early Look written by Hedgeye U.S. Macro analyst Christian Drake. Click here to learn more.
“It’s no insult to say a dead man is dead.”
-Odysseus, Troy (2004)
There have probably been 3 substantive cinematic sea changes over the last few decades.
The early 1990’s was characterized by the unlikely but epic cresting of Kevin Costner. In short succession, the mantel was passed in what has been affectionately dubbed ‘The Hanks Crescendo’ of the mid-90’s.
Then, as we moved towards the new decade, the non-Adonis leading man movement petered, giving way to Peak Pitt in the early 2000’s …. and spawning the forgettable ascent in celebrity neologism (i.e. #Brangelina) and the early transition of “attention” supplanting “money” as the root of all social media age evil.
Since our headline quote, the last decade has seen some Dicaprio gems, the Downey Jr. renaissance and the rise of the “geriaction” star, but Hollywood has mostly meandered in its unsuccessful bid to change the guard and topple the HBO model.
Over that same multi-decade period, there have been zero sea changes in monetary policy.
Lower highs and lower lows in the Fed Funds rate have characterized successive economic cycles for the last 35 years as policy makers have Doved Slowly in their attempt to simultaneously and successively stimulate and drive debt service costs lower while marching the debt/interest rate cycle to its terminal end.
You can’t blame them really, the waters of academic economic theory are deep but, practically, active policy is about as shallow as a puddle.
The conventional theory, depicted in the chart below, is that the level of output drives inflation which, in turn, drives the policy response in a circular, counter-clockwise inflation-output loop.
As we’ve highlighted, these output-inflation cycles were the prevailing macro reality when Janet et al. were coming of age and conventional monetary policy is designed to function within the context of this (formerly) archetypical cycle.
In practice, conventional policy is predicated on manipulating the (real) interest rate to drive changes in interest rate sensitive investment and consumption and for the flow through impacts to the currency to shift net external demand.
That’s pretty much it.
It’s no insult to say a broken model is broken.
Back to the Central Bank Observation Grind…
Policy makers don’t always “judge that the case for an increase in the federal funds rate has strengthened”, but when they do, they simultaneously lower their growth, inflation and neutral interest rate forecasts to their lowest levels ever.
In terms of summarizing yesterday’s Fed action, that’s pretty much it.
The market’s reaction to the latest iteration of the Fed’s When In Doubt, Dove It Out bias was unsurprising:
Dovish => Dollar ↓ => Reflation ↑ = Gold/Utilities/Bonds Outperform, commodity reflation ↑, Financials underperform => slower-and-lower-for-longer remains the prevailing fundamental and policy outlook reality.
Much of the pre and post-conference punditry centered on how 2016 parallels 2015 with rising market angst into a no-go September decision with the stage set for a highly probable December hike.
Since December is both the main talking point and the lone comp – and because Janet repeatedly highlighted the strengthening economy – let’s juxtapose current domestic macro conditions with those from December of last year.
The “improvement” is given by the delta at the far right of each series:
It’s no insult (or unpatriotic) to say that a negative second derivative is negative.
I’m tempted to take the rest of the day off because if I hear “hawkish hold” one more time my brain may collapse in on itself in a kind of meme du jour supernova.
Anyway, the net of yesterday is that the late-cycle macro reality and the associated allocations we’ve been espousing for the last year continue to find confirmation in both the data and negative revisions to the forward outlook.
Our immediate-term Global Macro Risk Ranges are now:
UST 10yr Yield 1.55-1.72%
To Brangelina, may it RIP.
Christian B. Drake
U.S. Macro analyst
Takeaway: This print is spot-on with our recent short call. This is no longer the quality mgmt. team of old. It needs major capital investment.
The biggest takeaway from this quarter from where we sit was the general tone of doom and gloom when it comes to the long term prospects of this business. Of course missing top line expectations for the 11th time in 13 quarters and having EBIT down for the 10th time in 11 quarters would cast a shadow over the mood of any management team (we happen to think this one is better than average – at least it used to be), but it was more than the continued softness in the numbers that no one with any shred of intellectual integrity could look through. Don’t get us wrong – there was plenty of spin about investing for the future – but BBBY is stuck between a boulder and a piece of aircraft-grade aluminum. Here are the key callouts…
Below is our previous note from 9/12/16:
BBBY | Some Things Are Cheap For A Reason
Takeaway: 2 major underappreciated factors. 1) size & rate of W/AMZN pressure. 2) need for DC investment. Stock left for dead. Short on strength.
We’re putting BBBY on the short side of our ledger. This is not a high conviction short in absolute terms, as the name is trading at ≈10x a realistic earnings number for next year, a 5-6x EBITDA multiple, and at an 8% FCF yield – even on our beared-up numbers. Given that the stock is already off 46% relative to the market since last year’s peak, the short interest remains near an all-time high (10%), and this has traditionally (ex the past 3-years) proven to be one of the best management teams in retail, we initially looked into this with a long bias.
But after digging deeper into the numbers, BBBY’s investments, and synching with the competitive pressures in the market, we’re not so sure earnings deserve to ever grow again. This is a fairly prevalent theme for us right now (Target is our top short and is predicated on its lack of investment and likelihood of a series of prolonged misses). Case in point, our analysis shows that BBBY faces 32% customer overlap with Wayfair – a company that explicitly states that it is going after BBBY’s jugular. This ratio is up 1,000 basis points over only the past 16 months. If that last sentence did not shock you, it should – it certainly shocked us. We have NEVER seen a company be marginalized that quickly by an online competitor. Not Dick’s, not Kohl’s, and not Foot Locker. The bad news here is that it is still quite low at 32% Wayfair overlap. There is no reason it can’t continue to get clipped all the way up to 50-60%. It is, without question, moving briskly into BBBY’s turf, and likely at a rate faster than expected. And that’s on home furnishings – nevermind the hardgoods you can easily get on Amazon. For the record, with the exception of brands like Ralph Lauren bedding and Henckel knives we’re hard pressed to find brands that sell at BBBY that you can’t also find at either Wayfair or Amazon (or both). Wayfair now even has a full color palette of Le Cruset cookware, and items like the Nutri-Ninja have been commoditized with 100% price transparency. Remember that 90% of what BBBY sells does not have to be tried on for size. It’s the most susceptible of any type of good to shift to online competition.
This Chart Is Scary If You Own BBBY
One thing that is telling for us is that when we measured distribution center throughput for BBBY versus retailers that share similar characterustics, we see that it has near peak productivity – speaking to how good it is. But on the flip side, it is sitting at extremely low e-commerce penetration of 5% (see analysis below). That tells us that BBBY is likely underinvested in DCs and other infrastructure to accelerate its competitive positing vis/vis Wayfair, Amazon, an increasingly desperate Target/Kohl’s and an increasingly competitive (for now) JC Penney.
Though these fat-tailed trends take time, we’d point out that the past 2-years of competitive pressure show just how things can accelerate faster than expectations. We’d also point out that we’re putting our money where our mouth is with our earnings estimates. We’re at $4.28 next year versus the Street at $5.06, and have estimates 40% below consensus by 2019. Given that BBBY has a fairly high quality management team, we think that it likely recognizes that it has underinvested – or as soon as it does it will pull all the right levers, no matter how painful (unlike TGT which will likely miss until management has to be swapped out).
We totally get it that this stock has been left for dead. That’s why we’d much rather revisit it as a stand-alone short after a pop on low expectations – likely next Wednesday’s print. But the reality is that so many funds have to own some of it, as it is in the benchmark (S&P 500). For those people, we’d definitely own a lot less of it into any form of strength from its current mid-$40s level.
The biggest area we could be wrong is on the non-Bed, Bath & Beyond stores. Could Cost Plus (250 of ≈1,500 stores) finally turn out to be a growth or margin engine after 3-years of struggling? Doubtful, but it’s possible. Is there underlying monetizable value in Christmas Tree Shops or Harmon Cosmetics? Doubtful. But these other business increasingly deserve more attention. We don’t want to get caught focusing on the broken piece of the business from which an otherwise good management team is acquiring away. More to come on that.
But in the end, our near-term positioning is that if you own it, there might not be a rush to sell it. But we also think there is close to zero reason to own this name over the next three years. Sometimes things are cheap for a reason.
Here’s a More Detailed Analysis:
Investment Buckets – This is billed as the peak investment year from a capex perspective as the company wraps up its second fulfillment facility in two years and rolls out its new POS system to stores. But, we think the need to invest in e-comm to make itself competitive (it’s only 5% of sales) as well as the need to add additional distribution capacity will weigh on margins and ultimately FCF. Here’s where the company is focused and our two cents.
IT Infrastructure – 4x the budget from 5yrs ago, 500 person team.
Merchandising – exclusive online merch, health/beauty, food & beverage, exclusive brands, mattresses, jewelry, and furniture. Last 3 direct from the vendors.
Pricing – Dynamic pricing
Fulfillment – 2 new facilities opened in past 2 years.
Category Looks Broken
The bellwethers in this category – BBBY, WSM, RH, PIR – look particularly broken. With average comps for the group decelerating from the mid-DD range in 2012 to MSD through 2014 and 1H15, down to negative territory in the quarter the companies will/have reported. The government data doesn’t quite synch with the trends we’ve seen reported by the public entities, though numbers have decelerated to 3.5% in 2Q16 (May-July) from a MSD run rate 1yr ago. One explanation, and we think it will be no surprise to anyone, is the considerable share being taken by Wayfair, adding an incremental $1.7bn over the past 2yrs.
Now it may sound a bit silly to call out a company who has 1% share of a highly fragmented $320bn market. But, hear us out. We think that W is causing considerable disruption to the space for two reasons…1) product deflation as the company has no margin to protect and 2) increasing the consumer’s willingness to buy the product online. To be clear on the last point, we are not talking about furniture as we think (and our research confirms) there is a very big need for product interaction in a physical store. What we mean is that the soft-goods part of the equation is very much up for grabs as consumers push more of their purchases in this category online.
Wayfair Taking More & More Traffic
So what does it mean for BBBY specifically? The numbers here are clean as day. They look at the consumer overlap online for Wayfair vs. Bed Bath & Beyond. With the trend line going straight up and to the right from 20% in early 2015 to 30% where we currently sit. We expect that number to continue to tick hire as W doubles down on the soft-good side of the business as it recognizes that the online only furniture model has many more limitations than a $90bn management suggested TAM would otherwise suggest.
Categories Best Suited For Online – BBBY Sells Em, But Not Online
BBBY’s product offering is the most susceptible to online competition in the home furnishings category. Based on our survey work, it’s clear that the consumer is 2x more likely to purchase décor, linens, tableware, and kitchen online compared with furniture. And while the company works to diversify its online only offering to include jewelry and furniture – it’s the core product that should be a slam dunk for the company to win online. Yea, Christmas Tree Shops will probably never cater to an online demographic, but that doesn’t explain BBBY’s dot.com penetration at a measly 5% of sales. What that tells us is, the company needs to spend – A LOT – in order to compete with the likes of AMZN, Wayfair, WMT, you name it.
Not Set Up To Win Online
BBBY used to be extremely efficient in the way it flowed product from its vendor base directly to stores – limiting overhead in the form of distribution centers. That unfortunately doesn’t translate to online commerce – where the key to competing outside of price is speed to customer. Prior to the Linen Holdings/Cost Plus acquisition in 2012, BBBY operated a total of 16 distribution/warehouse centers for an aggregate of 3.1mm sq. ft. After the acquisition the square footage jumped to 5.8mm sq. ft. and has held relatively steady coming in at 6.1mm sq. ft. at the end of this past year. The company has added two new additional distribution facilities over the past 2 years – one in Vegas the other in TX to help augment the 175 stores set-up as regional fulfillment facilities, but we think there is still a lot more that needs to be added. Meaning the peak capex year promised in 2016 probably isn’t a reality.
We pulled down the total distribution square footage for a handful of retailers in BBBY’s competitive set to gauge the efficiency of the company’s distribution network. The metric (which is represented by the blue bars below) is calculated by taking total sales/distribution square footage. We then paired that up with each companies e-commerce as a % of sales. The trend here is pretty clear…lower distribution productivity = higher e-comm penetration. Intuitively that makes sense as the company’s with a higher e-commerce mix invested ahead of the consumer transition to DTC. BBBY is pretty far behind the curve.
Financial Engineering Drying Up
That’s a big deal for a company like BBBY who hasn’t grown net income since 2012. The company fired the last bullet in its chamber when it announced its dividend earlier this year, and without a material change in the operating environment we think FCF in the range of $400-$500mm is the new norm. A dividend is probably a good idea for a company like BBBY, as it offers up significant valuation support on otherwise decent cash flow. But this also hampers BBBY’s ability to buy back stock. And, let’s not forget that this is now a company with leverage, which it built throughout the economy recovery when other retailers were increasingly delevering financially.
The total percentage of successful long and short trading signals since the inception of Real-Time Alerts in August of 2008.
Takeaway: The BoJ underwhelmed but suggests incremental easing on the horizon. Meanwhile, Fed stands pat but raises specter of December rate hike.
Editor's Note: Below is a brief excerpt from an institutional research note written by Hedgeye Senior Macro analyst Darius Dale. To access our institutional research email email@example.com. For more on the subject of central planning check out analysis via Hedgeye CEO Keith McCullough here and Dale here.
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