Apocalypse Now

I penned Hedgeye's Early Look this morning. Check it out below. 

Apocalypse Now

“I love the smell of napalm in the morning.”
–Col Kilgore

Ok…here’s the deal… An #oldwall analyst came out a few weeks ago with a report entitled “The Retail Apocalypse Is Over”. Respectfully, my answer to that is “Apocalypse Now”. Not to go against the grain just because I can…but because the facts and underlying research points to a 1,000bps+ miss in earnings in 3Q/4Q at a time when multiples are at peak, sentiment is beyond toppy, and management teams are beginning to make people think that an underlying 2H top line acceleration with minimal cost flow-though is possible.

Playing up a narrative that retail is broadly investable when we’re ten months into the most hated retail rally in 5-years is not only reckless, but I think it’s flat out wrong – with the exception of some notable Longs where there are companies that will meaningfully buck the trend (TPR, RH and VFC are my favorites today). Here’s my point. Let’s look at the facts…

1. We're coming off of an earnings season with 28% of companies putting up a 10% stock move or more -- the greatest volatility since 2Q09. Remember what happened back then? I do. Respect history. People got ripped this past EPS season on core short positions (including me) and are either afraid to be bearish, or are not allowed to be.
2. Looking back 12 months...in 3Q17 (August) we had the biggest sequential increase in consumer spending and GAFO (general merchandise, apparel, furniture and other) retail sales since March 2015. Yes, that’s a fact. If you sell stuff – life was good in 2H17.  
3. Even a junk-tail retailer like Kohl’s put up a comp of 7% in holiday of last year – which is anomalous (this happens once every 4-5 years). I’m completely aware and respectful of the fact that retail is a full-contact outdoor sport - like seriously. And 4Q17 was full proof of that. Sometimes, good things happen for no reason aside from an extraordinarily positive macro backdrop and yet the CEOs think it is the result of their own creative and merchandising genius. With the exception of Wal Mart, I can’t point to a retailer with a solid macro #process that drills down how much of business strength/weakness is idiosyncratic company initiatives vs Macro cross currents.
4. Then came 1H18, when retail experienced a 300bp top line benefit through a change in the retail calendar. Yes, the world knew about it – it happens every 5-6 years, but the reality is that the sell side did not model it appropriately. Why? Because management teams did not guide it. Hence, we’ve seen the greatest magnitude of earnings beats in a decade. Note point one re 28% of companies putting up outsized stock reactions to EPS.
5. Then we saw a favorable 2Q weather calendar. I hate the weather card, to be clear. CEO’s never call out weather as a positive, but only call it out as a negative. This time it helped – period – to the tune of another 100-200bp in positive sales.
6. Then we had the summer conference circuit where CEOs were outright bubbly in their one on one’s with the Hedge Fund world.
7. The punchline there is that commentary from companies and industry sources (whatever that means) is as positive as you’ll see – especially when US Growth likely peaked in 2Q (as you know from Keith’s 3Q Macro Themes call).

Now let’s actually look forward…that helps when it comes to making money.

1. Starting in August, we’re going against the hardest retail sales compares in 4 years.
2. The same calendar issues that helped 1H by 300bp hurts 2H by a similar magnitude – that should seem obvious, the reality is that it’s not in consensus numbers bc it’s not in the guidance narrative.
3. Retailers are budgeting for a 2-3% comp, which is extremely aggressive. Whether you believe this plan or not, the fact of the matter is that retailers have ordered enough product to drive the comp (they order in units, not dollars). The goods are being made today and will be on a container ship within 2-3 weeks. The flow of product can’t be stopped.
4. The simple fact that the freight is on the water means that the product must be sold at the end of the 13 week selling season – regardless of price. If the increased consumer demand is not there, we see a decline in ASP, or average selling price, which is top line bearish and flows right through to lower merchandise margins.
5. If we don’t see the top line hit then we see the inventory build. That means Retail Quad 3 – which is about as bad a scenario as you can imagine for retail valuations – which are currently sitting at peak. (see chart below – Retail Quad 3 is inventories growing faster than sales with margins down. It’s bad -- for real).
6. Have I mentioned cost pressures? Spot freight rates are up 20% yy. Contract rates are up 10%. Yeah…contract rates matter.
7. Labor costs are up near 10%. Companies like TGT are seeing a $0.33 per share hit to higher labor costs yy simply because competitive pressures dictate it.
8. Raw materials matter – cotton costs are up 23% since august – and there’s a 9-12 month lag from when higher costs hit the p&l – do the math. The only raw materials that are down are leather goods – by about 18% (TPR and KORS bullish).

Add all that up, and our estimates are 1,100bps below the street for 3Q, and 1,400bps below for 4Q – at a time when retail valuations are downright complacent and comfortable.

INVENTORIES LIKELY TO BUILD AT A GREATER RATE THAN WE’VE SEEN IN 3-YEARS.

Let’s consider timing for a minute. The reality is that there’s a lag between when these trends occur vs when management teams capitulate and take down guidance.

1. We don’t see retail earnings season til the back half of August. Who in their right mind – that’s hanging on to a so-so year – would want to be short this group into what will be a bullish end to 2H earnings season? Note the 1Q earnings/price volatility on EPS day. Want to be on the wrong side of a 20% price move on an earnings beat? No.
2. The June/July conference circuit is telling the Street that business is flat-out bullet proof. CEOs are pumped and think that that the trailing 10 months of sales trends will continue – even though there’s little Macro evidence that supports it – in fact, as Keith’s 3Q themes presentation suggested, we’re starting to see growth slow. Let’s face it – retailers have about 3 days’ worth of visibility into sales trends. They’re so bullish today, which is making even the most seasoned investors ask themselves…”Maybe this strength IS sustainable after all.”
3. Then in the first week of September we’ll have the Goldman conference, where retailers will likely be bullish – in part because sales trends won’t have meaningfully slowed down in the few weeks since reporting 2Q results. Too bad the GS conference is now instead of Oct. Much different story...
4. Then we’re braced for the either the biggest 3Q negative pre-announcement season in 5 years, or flat out misses with November results or 4Q (Jan) guide downs.
5. THAT’s why we’re at peak P/E and EBITDA valuations today…because people either don’t want to be early short side after getting blown up in the past two months, or think that the macro climate will allow retailers to  ‘comp the comp’ and validate the narrative that the consumer is en fuego in perpetuity.

From a catalyst perspective, timing is dicey. This is where I rely on Keith for precise risk management levels. Tops are processes, not points. The end of this topping process is within reach. Maybe weeks, maybe months. But it’s highly likely a 2H18 event.

Take your pick…KSS is my top short pick here. Then HBI (after the 2Q print). Then GPS, TGT, URBN, AEO, ROST, TJX, W, SFIX, RL, WSM… the list continues. I like putting my eggs in one basket – the big losers and winners – take your pick. But the reality is that if you short a group of any of the names on our Best Idea short list – I think you emerge a winner. I like winning.

Our immediate-term Global Macro Risk Ranges are now:

UST 10yr Yield 2.79-2.90% (bearish)
SPX 2 (bullish)
RUT 1 (bullish)
NASDAQ 7 (bullish)
Energy (XLE) 73.48-76.55 (bullish)
REITS (VNQ) 80.03-83.25 (bullish)
Industrials (XLI) 71.00-72.97 (bearish)
VIX 13.02-18.55 (neutral)
USD 93.50-95.31 (bullish)

Make it a great one...

Brian P. McGough
Managing Director