“Shatter the Illusion of Integrity”
– Neil Peart
We created something in 2008 that didn't exist: Hedge fund-quality research for everyday investors.
We envisioned a level playing field between everyday investors and Wall Street. Our founding principles remain transparency, accountability and trust.
I would like to borrow a lyric from my favorite Canadian prog rock trio and say that we “Shatter the Illusion of Integrity” hence the quote above, which refers to taking the concept of integrity to an unmatchable level. Our Macro products have been the key conduit for our effort to democratize Wall Street, but as you may have seen from several of my colleagues, we’re now taking this to the sector level.
As such, last month we launched Retail Pro to our subscribers, and I’m excited to offer up our analysis and stock picks to a broader audience. Click HERE for more information.
Here’s some of my current thinking about idea generation in the group…
In the 25 years since I’ve had the extreme pleasure of doing this job – really I consider it a vocation – I can’t recall a time where there has been more uncertainty around earnings (or lack thereof). No shocker there to anyone.
Typically on Wall Street, people selectively ignore what they don’t understand. Looking at the beats/misses over the past 30 weeks of the pandemic, we see companies have gotten endless free passes for missing consensus estimates, which were off by a greater magnitude than any period I can recall/model in my career. A major part of that is that there’s been an absence of company guidance.
I don’t know about you, but I don’t get paid to echo guidance that companies spew out to the investor community. I have over 100 earnings models and my team and I are focused daily in grinding on our both fundamental and data-driven research process to find names where the companies are likely to come in meaningfully better or worse than the consensus over a TREND and TAIL duration. Plus, I think most guidance practices are flawed.
I used to work at Nike, and one of my jobs was to set guidance. Even a sophisticated company like Nike might know its upcoming quarter with 90% certainty – but in looking 1-2 years out – it does not have a clue. No joke. It’s one of the best companies in Consumer and yet its TAIL forecast accuracy is abysmal. But it sets and manages expectations with the Sell Side across that duration anyway – and is wrong more often than not. Arbing that information/research gap is often the best opportunity to generate Alpha.
Go Big or Go Home. I don’t care about a few pennies upside or downside in earnings in a given quarter. Quite frankly I have bigger fish to fry. I care about the BIG calls…like when we pounded the table on RH at $30 saying that it had better than $10 in EPS (earnings sub $3 at the time) which equaled a $300-$400 stock. It took a couple of (sometimes painful) years – as fat-tailed out of consensus calls tend to – but today the stock is sitting at $380…and yes, it’s on its way to $40 per share in earnings over a TAIL duration and a stock price of $700-$800. The company did not guide this, our research allowed us to figure out the answer before people knew there was a problem to solve for. This bottom up analysis is what gives me a spring in my step…it’s why I get out of bed every day.
But as much time as I spend on the Micro/Modeling part of the equation, I need to focus on the Macro call. Not necessarily the McCullough-driven Global Macro Grind – though that plays a big part in setting the tone for me at the industry level. He’s got that angle more than covered. I’m talking about Retail Macro. And in going through what internally we call the Pods (Pod 1 = Revenue, Pod 2 = Margin trajectory, Pod 3 = Working Capital/Cash Conversion, Capex, and Free Cash flow). That’s an area where I think Retail today has a severe problem relative to expectations. Think about the facts…
- Earnings matter again. In doing a bottom up analysis of earnings revisions across nearly 100 retailers, we just broke through the zero barrier of expected earnings growth. That means that forward earnings growth numbers have been going nowhere but down – to the tune of 30-40% -- but just this month has turned positive. In other words, investors are looking for earnings growth again. Over a near-term tactical window, of course earnings will grow as we lap the 1H20 period where earnings were simply decimated by covid. But the underlying assumptions driving the growth are simply flawed, and should lead to a divergence in earnings beats/misses over the next year like we haven’t seen in decades (aside from 1H20). Companies are starting to issue guidance again, and we should be careful about believing ‘em.
- Demand pull forward. This fourth quarter is unique, in that the concept of Black Friday is pretty much non-existent. Amazon Prime Day was pushed three months into October due to the pandemic, and we’re seeing a unique situation where most major retailers are trying to keep up and compete with Amazon – on Amazon’s terms. WalMart, Target, Best Buy, JC Penney (yes, it still exists), and Kohl’s are starting Black Friday promos 6-weeks early, and will basically be promoting countless deals to try to get consumers to open their wallets early. Early is the operative word. ‘Early’ does not mean that people will spend in October, and then again in November/December. We’re still talking the same number of gifts for the same number of people, but simply sold earlier in the cycle at a promoted price, and a lower gross margin. That’s Pod 1 (revenue) and Pod 2 (margin) bearish.
- E-Comm Is Winning, meaning retailers are losing. People think that online sales are the savior for retailers. Not true. Does it help generate sales at a time when store traffic is otherwise down? Yes, that’s a plus. But for the most part, third party retailers (retailers that sell other people’s stuff like Target, Wal Mart, Kohl’s and Ulta) do so at a dilutive gross margin as they pay for shipping and fulfillment costs. For most retailers each incremental e-comm sale is 400-600bp dilutive to Gross Margins vs shopping in a store.
- Wages are Reinflating at a Record Pace. Retail wages have traditionally grown at a 300-400bp discount to total private industry wages – like clockwork actually over the past 15 years. But just last month, retail wages spiked to be at a 200bp premium. That’s unheard of. This is partially driven by ‘hero pay’ and other bonuses given to front-line retail workers who weathered the pandemic to allow us to go out there and stock up on things like toilet paper. But retailers even as strong as Costco are on record as calling this temporary, and that it can be taken away as the pandemic eases. I call foul on that. It’s easy to give a pay increase – but really difficult to take it away without adverse consequences and employee backlash. Punchline…retail wage pressure is here to stay.
- There’s a Credit Powder Keg. For some retailers, the most profitable line of the P&L is credit income shared with the likes of CapitalOne and Synchrony. It’s funny…people needle management on conference calls about a point or two in comp here or there – that’s what…a couple pennies in EPS? But they never question the sustainability of shared credit income as card usage declines with store traffic, and we see the material uptick in delinquencies and charge offs that my Financials Analyst colleague Josh Steiner thinks is coming down the pike over the next 2-3 quarters given the levels of unemployment and lack of government stimulus. The biggest risk there belongs to KSS, M, GPS, JWN and DDS (all 40-70% of EBIT). Even TGT and WMT have exposure.
So how, may I ask, with more headwinds than we’ve seen this cycle, can the consensus be modeling that margin expectations in 2021 not only surpass 2019, but match 2018 levels – and THEN go up by another 40bp to 8.7% in 2022? Mind you that even in a very strong retail economy, we saw a 20% hit to the retail margin rate from 2015 to 2019 – and that is almost entirely due to the dilutive impact of e-commerce on margins. Now we’ve got 2x the ecomm margin pressure due to increased online adoption, higher wage costs, and a meaningful credit risk – and the consensus thinks that numbers are going to surpass pre-covid highs? Someone please explain to me how this makes one lick of sense.
While the model will trump valuation almost every time, we’ve got to at least acknowledge that with margin expectations reversing course and headed higher after an entire cycle’s worth of a decline despite increasing cost pressures, the XRT is trading at 27x forward earnings – or about 20x ‘normalized’ earnings (whatever that means). This compares to 14x pre-Covid, when fundamentals were decidedly better – by a country mile. Again, makes little sense.
Here are some thoughts on positioning…
• Online: The biggest winner overall in terms of share gains. The change is likely a permanent pull forward of penetration we would have seen over several years, new higher base to grow upon. Favorite name to play this is CHWY. Unlike brick and mortar retailers who face GM dilution from e-comm, each incremental sale for CHWY is accretive to margins.
• Business Model Changes: Some companies will have dramatically higher margin profiles post covid, bucking the industry trend. One is NKE, which should gain about 400bp in EBIT margin as it alters its model to sell consumer-direct instead of relying on the Foot Lockers of the world. The other is DLTR, which we think will raise price points in its core concept from $1 to $5, which will more than double earnings, and the stock.
• Food at Home: This should be a multi-year trend not a few quarter. COST is our way to play this. COST is also a winner as shoppers consolidate the number of shopping trips and grow basket size meaningfully. Plays right into COST’s model.
• Home Fitness: We see elevated demand til early/mid winter at least, meaning upside over the trend duration. NLS is our long here. PTON should still be a winner.
• Home Furnishings/Home Improvement: The de-urbanization theme will take several years to play out. Demand/turnover remains strong in suburban homes, especially at the high end. As people migrate out of city centers the living space goes up, meaning more home items to buy. Our top long on this is RH. We also like MIK as a TREND call as it beats numbers in a hot category with historically peak short interest. Waiting to short WSM and W.
• Sporting Goods/Outdoor: Sales momentum already appears to be slowing, as we hit winter months, we suspect comps will disappoint. Short DKS is our way to play this, ASO & HIBB are TBD.
• Credit Powder Keg: KSS faces the biggest risk here to an increase in delinquencies and charge-offs. We don’t think KSS will ever earn over $1 again.
• Electronics/Personal Devices: The replacement cycle for laptops, TVs, monitors, tablets, and other quarantine video consumption and learn from home items will be several years. Demand has been pulled forward leaving a 2021/22 air pocket. BBY is the short here. It’s overly loved, hardly shorted, and carries a valuation that suggests that the buy side thinks upward revisions are coming.
• Stimulus Riders: Names that saw significantly outsized comps were likely riding stimulus/gov benefit dollars and barring another big round should see significantly slowing comps. OLLI is our favorite short on this theme. Other names we are keeping an eye on include HIBB, BIG, HOME, Auto Parts retail.
Immediate-term @Hedgeye Risk Range with TREND signal in brackets:
UST 10yr Yield 0.65-0.81% (bearish)
UST 2yr Yield 0.12-0.16% (bearish)
SPX 3 (neutral)
RUT 1 (neutral)
NASDAQ 11,056-12,040 (neutral)
Tech (XLK) 114.70-125.01 (neutral)
REITS (XLRE) 35.69-37.38 (bullish)
Utilities (XLU) 60.16-64.84 (bullish)
Financials (XLF) 24.11-25.67 (bearish)
Shanghai Comp 3211-3398 (bullish)
Nikkei 232 (bullish)
DAX 120 (bearish)
VIX 24.01-29.73 (neutral)
USD 92.97-94.23 (neutral)
Oil (WTI) 38.09-41.90 (bearish)
Gold 1 (bullish)
Silver 23.30-25.55 (neutral)
Make it a great one…
Brian P. McGough