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JCP: Is Bad Actually Good?

Conclusion: A low quality quarter from JCP might actually add support to those in the Ackman camp.  Importantly, this quarter did little to change our mind that JCP is still facing fundamental challenges near and longer term.

 

From a fundamental perspective, JCP’s 3Q results did little to change our view on being short the shares.  The quarter was driven by two key factors, a slight miss on original topline plans offset by a measurable and unexpected level of SG&A savings.   Clearly not the quality quarter management and anti-activist investors were looking for.  But, with the company under the watchful eye of Ackmanism, the worse the business and its prospects become, the more challenging it becomes for management to fight the company’s largest shareholder. 

 

Overall there were a couple of key takeaways coming out of the quarter:

 

  • Inventories remain higher than they should be given the current run rate of sales.  On a 0.2% increase in 3Q revenues, inventories ended the quarter up 6.2%.  Weak outerwear sales at the end of October are partially to blame for part of the inventory build, but we still see some risk here if expected same stores of 3-4% over 4Q fail to materialize.  Either way, JCP remains the only player in the moderate department store space running inventories meaningfully ahead of sales growth.
  • Expense savings saved the quarter on a slightly weaker than planned comp.  SG&A dollars were expected to grow 2% but actually came in down 3.8%.  While this flexibility is noteworthy on a short-term basis, it did result in a $50 million after-tax swing in earnings (all things being equal) or about $0.21 per share.  Absent similar cost cuts, which we believe are counter to actually improving the JCP customer experience, there is minimal longer-term opportunity to continue to manage expenses down on an absolute basis.  Furthermore, the addition of the “growth brands division” will likely put pressure on the expense line as infrastructure, personnel, and marketing will require incremental investment.
  • Management’s announcement that the company has formed a “growth brands division” to pursue new concepts and additional growth vehicles is not exactly what capital preservationists and those looking for enhanced shareholder value are looking for.  The fact is JC Penney is not a growth company, nor are there any successful examples of a department store operator incubating, managing, and growing a successful specialty concept.   As reported in the Wall Street Journal yesterday and confirmed today, JCP will be developing an off-mall, big and tall concept as well as focusing on a younger consumer with an eye towards e-commerce growth.  Even more interesting is that these initiatives fall under the company’s 5 year plan to add $5 billion in incremental revenues but yet there was no mention of such plans when the original plan was unveiled in the Spring.  Bottom line, off-mall full line stores haven’t really moved the needle for the enterprise and it’s unlikely a specialty concept will either.
  • The issue of rising cotton and sourcing costs is nothing new but management noted that they are now encountering some factories which are not accepting orders due to input cost uncertainty.  While these orders primarily center around goods to be manufactured for Fall ’11 delivery, the data point is noteworthy. If this becomes a more widespread stalemate between manufacturers and suppliers, there will likely be capacity constraints come next year.  For now, this is something to watch.

JCP: Is Bad Actually Good? - jcp

 

Eric Levine

Director


The Week Ahead

The Economic Data calendar for the week of the 15th of November through the 19th is full of critical releases and events.  Attached below is a snapshot of some (though far from all) of the headline numbers that we will be focused on.

 

The Week Ahead - cal1

The Week Ahead - cal2

 


On the Road

This note was originally published at 8am this morning, November 12, 2010. INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK (published by 8am every trading day) and PORTFOLIO IDEAS in real-time.

"Behind us lay the whole of America and everything Dean and I had previously known about life, and life on the road. We had finally found the magic land at the end of the road and we never dreamed the extent of the magic."

-Jack Kerouac, On the Road

 

Jean-Louis Kerouac, or Jack as he was more popularly known, was the leader of the beat generation and is one of the most well known American novelists of the last half decade.  I recently took a break from my weekend readings of the Economist, Barron’s, Grant Interest Rate Observer, and other similar publications that make my girlfriend go to sleep, to reread Kerouac’s classic, On the Road.

 

I think it is fair to say that most type “A” investor types operate in stark contrast to the beat generation, and in particular to the writing style of Mr. Kerouac.  In 1950, Kerouac outlined The Essentials of Spontaneous Prose, which was an overview of his style of writing - a style which emphasized the unplanned spewing forth of ideas, emotions, experiences and so forth.

 

Our CEO Keith McCullough wrote his own book, which came out earlier this year, titled, Diary of a Hedge Fund Manager.   Far from being the spontaneous prose of a beat, the book is a well thought-out overview of the last decade of Keith’s journey in the world of Hedge Funds.  As one reviewer wrote:

 

“In telling his story, McCullough may end up inspiring a whole new generation of Wall Street achievers and innovators. He may also succeed in tipping a few sacred cows and instilling new paradigms for investing before all is said and done.”

 

Admittedly, I may be a little biased as I appear in the book via my nickname Jonesy a few times, but I would recommend you consider it as a stocking stuffer in the upcoming holiday season for that emerging fund manager in your family. ( http://www.amazon.com/Diary-Hedge-Fund-Manager-Bottom/dp/0470529725 )

 

Coincident to reading Kerouac’s book, I was literally on the road this week.  I flew out to Colorado Springs to participate in a bi-annual forum with a subscriber of ours, Huntley Thatcher Ellsworth Advisors (http://www.hteadvisers.com/). Aside from being very innovative in the ETF field, twice a year the folks at HTE get up in front of their clients, put on the accountability pants, and talk about what they got right, what they got wrong, and what’s next.  At the forum, I gave a presentation titled, “Should U.S. Debt Be Rated Junk Status?” and then participated in Q&A. An interesting question that came up a number of times from the audience was: should we own gold?

 

As we think about gold, it is pretty simple.  If the dollar continues to get debased, gold will go higher.  So longer term, it is likely an asset you want to own if you believe the dollar is going lower.  That fact is, if there weren’t monetary value in gold stock, the U.S. Federal Reserve wouldn’t be sitting on over 8,000 tonnes of gold and not selling it.  In the short term, we aren’t long gold and have highlighted a key reason in the chart of the day below, which shows the dramatic increase in the price of gold over the past few months juxtaposed against a recent front page New York Times article, “In Anxious Times, Investors Seek Cover in Gold.” If newspaper and magazine covers aren’t the best contrarian indicators, they are close. 

 

Another topic we discussed was the implications of Quantitative Easing, the monetary policy more popularly known at Hedgeye as Quantitative Guessing.  Our view is that QE will lead to inflation, without the commensurate pickup in economic activity. While we can debate whether we are seeing inflation in the U.S., globally we are seeing it.  In fact, yesterday Chinese CPI accelerated dramatically.  As Darius Dale wrote to our subscribers yesterday:

 

“Chinese October inflation numbers came in white hot this morning.  CPI accelerated to a 25-month high of 4.4% Y/Y and PPI also quickened substantially to 5% Y/Y.”

 

Chinese inflation will lead to one thing, Chinese tightening. If you don’t think that has global growth implications, then you haven’t turned on your Bloomberg terminal yet this morning. In the anticipation of tightening, Chinese equities are down more than 5% and the commodity complex is getting taken behind the barn and shot. Copper is down 2%. Silver is down 2%. Cotton is down 3.6%. Sugar is down 3.4%. It seems we may not have to guess as to the implications of Quantitative Guessing much longer.

 

My last road trip to Colorado Springs was about 15-years ago when Keith and I were members of the Yale Hockey team.  (Keith was a little quicker and I had a little more hair back then.)  We were playing Air Force in a two game series.  As I recall, Keith was suspended for the weekend and we were swept by Air Force. (Keith would likely suggest there was something to that correlation.)  Ironically, the Yale hockey team is back in Colorado Springs this weekend taking on Air Force and Colorado College.  Much has changed in the last 15-years, including the fact that Yale is now ranked 3rd in the country.  Let’s hope the Bulldogs find the “magic land at the end of the road” this weekend.

 

Keep your head up and stick on the ice,

 

Daryl G. Jones

Managing Director

 

On the Road - 1


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WEN: MAYDAY! MAYDAY!

Conclusion: 3Q10 was a terrible quarter for WEN and I don’t think it will get a whole lot better through the fourth quarter, despite Arby’s October performance, with the food cost outlook unfavorable and management guiding to the low end of their reaffirmed EBITDA growth guidance range for 2010.

 

Topline trends in the third quarter were disappointing for WEN, to say the least.  For the Wendy’s concept, company same-store sales came in at -3.1% versus -0.2% consensus.  This implies a two-year average same-store sales decline of -2.3% versus the -2.1% two-year average trend in 2Q.  As far as remedies for their soft trends at Wendy’s, management was not forthcoming with much detail. 

 

The strategy at Wendy’s is clearly in dire need of improvement but today's earnings call did not offer much reassurance that a solution is forthcoming.  QSR management teams across the board are highlighting the value proposition as being a major driver of traffic and it is clear that Wendy’s is falling short in that regard.  The “biggest” negative of Wendy’s sales performance during the quarter was, according to management, the area of value transactions.  There are many questions to be answered as to how the company is being run and what – specifically – can be done to improve the outlook.  The January Investor Day, we were told, will add much clarity to their strategy. However, assuming that the projected rollout of their breakfast program remains scheduled for late 2011, it seems that Wendy’s stands little chance of gaining significant market share any time soon.  In addition, taking market share in the breakfast day part may also prove difficult, but I will withhold judgment until further details are disclosed. 

 

Arby’s trends in the third quarter were equally disappointing, printing a decline in company same-store sales of 9.5% versus -6.5% consensus.  This result implied a sequential slowdown in two-year trends to -8% in 3Q from -7.3% in the second quarter.  On the plus side, Arby’s’ performance in October was much improved from the third quarter at +5.5% growth in same-store sales.  This was largely due to an increase in transaction counts (double-digit growth) and the impact of national advertising (albeit against October 2009 which also had national advertising). 

 

Management stressed that October’s success was “not just about advertising” but it was about “many things that we have had in our turnaround plan”.  Management expects sales to soften for the remainder of 4Q at Arby’s as the chain moves from the national advertising it enjoyed in October, to local advertising in November and December.

 

Costs are certainly not working in WEN’s favor either; cost of sales as a percentage of sales increased by 222 bps on a year-over-year basis and I expect a similar increase in the fourth quarter given another difficult comparison from 4Q09 and the outlook for beef.  As management highlighted, beef costs are not showing much sign of abating any time soon, “I actually think we may have one more quarter where it’s actually a little worse from where I sit today.  And then hopefully, I don’t think we are going to see any significant declines in the first half of the year, but hopefully it will stabilize in 2011”.  This fairly clear-cut outlook, combined with the company’s focus on premium products (fresh, never-frozen beef at Wendy’s and whole muscle Angus roast beef at Arby’s), indicates that the impact of commodity costs will likely be negative for the next three quarters, if not longer.

 

The outlook for Wendy’s/Arby’s is uncertain.  Management was reluctant to provide much granularity in there forward looking statements, pointing instead to the Analyst Day as the date when all will be revealed.  I am not expecting any silver bullet to be revealed at this event.  From an outsider’s point of view, all signs point to the Captain and being in distress.  Operational difficulties are being compounded by what seems to be a lack of communication between Trian and management.  A very interesting comment from today’s earnings call went as follows:

 

“As many of you know, Trian, our largest shareholder has a schedule 13D on file with the SEC, which indicated that it received an inquiry from a third-party expressing interest in a potential acquisition involving the company. And that Trian was considering this inquiry as well as alternatives with respect to its investment in this company. Because of this disclosure, we refrained from buying stock during the quarter.

 

We have asked Trian to bring us to ahead as promptly as practicable, so that we as a company can continue to focus on ways to enhance shareholder value including through commencing share repurchases under our stock repurchase program as legal and market conditions permit.”

 

There is a clear tone of frustration embedded in the quote above and it does not bode well for the company.  I wrote a post entitled “WEN – UNDERVALUED YES, WHERE IS THE OPPORTUNITY?” in June that discussed WEN’s stock and provided a sum-of-the-parts analysis that suggested that the company’s stock was trading below its intrinsic value. 

 

However, as the CEO of Hedgeye Risk Management, Keith McCullough, is so fond of saying, “A bargain that remains a bargain -- is no bargain”.  A last comment (or lack thereof) that I would like to highlight is management’s reluctance to give any indication as to the FY11 outlook, even with respect to a directional improvement from the -5% in EBITDA growth the company is now projecting for 2010.  The general lack of guidance and confidence in management’s tone is certainly a worry and it is reflected in the data.  A look at the chart below tells you all you need to know.  WEN is in a deep hole, and I don’t see them coming out next quarter.

 

WEN: MAYDAY! MAYDAY! - wen sigma

 

Howard Penney

Managing Director


Where Are We On Financials? 4 Short, 0 Longs

Positions: Short Capital One (COF); Short Bank of America (BAC); Short Hudson City Bancorp (HCBK); Short American Express (AXP)

 

Currently in the Hedgeye Virtual Portfolio we have four short positions in financials and no long positions.  So if you were wondering where we stand on financials, there you have it.  Lately in our morning meetings, our Financials Sector Head Josh Steiner has been highlighting the accelerating risk with certain financial stocks and the sector more broadly.

 

In part, this accelerating risk with certain financial stocks can be seen in their Credit Default Swaps.  In the chart below, we’ve highlighted Bank of America CDS swaps and the fact that they are well off of their YTD lows, which signals accelerating default risk.

 

As it relates to the four positions above, the cliff note version of the short theses are as follows: 

  • AXP - We think that imminent growth slowdown at American Express will lead to further multiple contraction over the next couple of quarters;
  • COF – We are concerned about Capital One’s mortgage put back liabilities, which we believe are not currently priced into the stock;
  • HCBK – Hudson City Bancorp has exposure to pending real estate shocks that will eventually be reflected on its balance sheet; and
  • BAC – Another case of put back liability is Banker of America, which will take the equity lower when the issues bubble to the surface. 

Two of our shorts are based on mortgage put back liabilities.  As Josh and his team wrote in a recent note, titled “BAC – Quantifying Mortgage Putback Liability - $19.0 Billion”:

 

“We've tried to quantify the exposure that we think is realistic and likely. We map out every step in our assumption process as well as which pieces are our assumptions and which are Bank of America's disclosures. The bottom line: we think BAC is under-reserved for mortgage putbacks to the tune of $19.0 billion, which works out to $1.31 in tangible book value per share, or roughly 10.2% of tangible book value. That's not to suggest tangible book value will actually decline by $1.31, as it is more probable that the company will earn its way through this. While this is well below recent Armageddon-esque estimates put forward by conflicted parties, the reality is that for those who think the concerns are wildly overblown this will consume most, if not all, of next year's expected earnings.”

 

This is a small portion of Josh’s extensive work on this issue.  We would recommend that if you are doing work on financials or currently own financial stocks, you connect with our sales team via to learn more about Josh’s work.

 

Suffice it to say, we don’t like the financials.

 

Daryl G. Jones
Managing Director

 

Where Are We On Financials? 4 Short, 0 Longs - 1


European Q3 GDP Slows, Germany Outperforms

Position: Long Germany (EWG); Short EUR-USD (FXE)

 

Most of Europe reported its Q3 GDP results today. Below we include a table of select economies to highlight two points:

 

1.)    The rate of GDP improvement in Q2 was very likely the best on a quarter-over-quarter basis for 2010 as Austerity’s Bite dampens growth and consumer and business confidence into year-end and in 2011.

2.)    The divergence in growth prospects for 2010 follow our theme of the Sovereign Debt Dichotomy—Germany’s fiscal conservatism will help positively positions its economy for growth, while the PIIGS will continue to wilt under fiscal imbalances.

  

European Q3 GDP Slows, Germany Outperforms - chart1

 

Temporary Inflections

 

Today we see an inflection in what has been an expedient rise in the credit risk over the last three weeks in Europe’s periphery, namely the PIIGS (Portugal, Ireland, Italy, Greece, Spain). In the chart below we calculate the spread between 10YR government bond yields of the PIIGS and Germany’s 10YR Bunds. We think the slight compression in government yields day-over-day  from the PIIGS is a reflection of German Chancellor Angela Merkel’s supportive comments at the G20 yesterday that “preparations are in place” for any aid requests by European Union countries facing debt crisis.

 

European Q3 GDP Slows, Germany Outperforms - chart2

 

The supportive comments from Merkel follow recent statements that tout tax consequences for European countries that fail to meet budget reduction targets, and a permanent rescue system to make bondholders foot part of the cost of any future debt crisis.  While the weight of gravity may also be pushing down yields for a few days, we’d expect (PIIGS) yields to continue to ramp up alongside investors’ credit risk fears. One catalyst to keep on the calendar is Ireland’s ability to pass through €6 billion in spending cuts and tax breaks on December 7th to tackle part of its massive 2010 budget deficit.

 

Quantitative Set-Up

 

Below we chart our quantitative levels for the equity indices of the PIIGS. Of note is that all indices are broken on the immediate term TRADE duration, a bearish indicator. Further, Ireland’s Dow Jones Index, Spain’s IBEX and Greece’s ATHEX Composite are broken on both the TRADE and intermediate term TREND durations. In contrast, Germany’s DAX is trading comfortably above both its TRADE and TREND lines, an outright bullish signal in our model.

 

In the Hedgeye Portfolio we remain long Germany (EWG) and short the EUR-USD (FXE) as the region’s credit risk continues to weigh on the Euro. Our TRADE range for the EUR-USD is $1.36-$1.39.

 

Matthew Hedrick

Analyst

 

European Q3 GDP Slows, Germany Outperforms - Greece1

 

European Q3 GDP Slows, Germany Outperforms - 2. ireland

 

European Q3 GDP Slows, Germany Outperforms - 3 Portugal

 

European Q3 GDP Slows, Germany Outperforms - 4. spain

 

European Q3 GDP Slows, Germany Outperforms - 5.italy

 

European Q3 GDP Slows, Germany Outperforms - 6 germany


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