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The Pain of Rain

“One can find so many pains when the rain is falling.”

-John Steinbeck

 

Timing is everything in life.  As it relates to my current trip to Southern California, my timing couldn’t have been worse.  I took a few hours away from the screens yesterday to finish up my Christmas shopping and a number of local business people informed me that this was one of the rainiest weeks Los Angeles had seen in, well, a really long time.   

 

Today Keith is off to his hometown of Thunder Bay, Ontario with his wife and little ones, Jack (already a heck of an ice skater at only three years old) and Callie.  Tomorrow I’ll head to my hometown, the small Alberta prairie outpost of Bassano, Alberta (total population of 1,200 and 75 some dogs).  I think both of us, like many of you I’m sure, will take the next week to relax and begin planning for 2011.  Much to the Steinbeck quote above, as I contemplate the future on this dark wet California morning, I do see a few pains.

 

While Steinbeck is most known for his literary career which culminated in the Nobel Prize for literature in 1962, he also knew a thing or two about state and local finances in California.  In fact, his father was the long serving Treasurer of Monterey County.

 

California has become the poster child for one of the key potential pain points heading into 2011, that of municipal debt and deficits.   We recently shorted municipal bonds in our Virtual Portfolio via the etf, MUB.  While clearly not all municipal bonds are created equally, the general short case for the municipal bond market is as follows:

 

1.  Rates are going higher – We’ve obviously already seen this over the last 30-days, but as the Fed is unable to keep the long end of the curve down, bonds will continue to suffer, especially as inflation expectations accelerate.   Rates, obviously, have much more room to the upside from these historically low levels.

 

2.  Housing prices have more downside – We are bearish on housing prices to the tune that we think home prices have 15 – 30% more downside nationally.  Since appraisals for tax purposes operate on a 2 – 3 year lag to market prices, municipalities will begin collecting taxes based on dramatically declining home prices, which should hurt their tax receipts.  Real estate taxes are the single largest revenue source for local governments.  In the Chart of the Day, we show the Case-Shiller index versus property tax receipts.

 

3.  State deficits set to expand – Currently, state level revenue is 12% below pre-recession levels, which is substantially worse than the revenue recovery in the past three recessions going back to the 1980 – 81 recession.  This pain is likely to intensify, with States facing a $140 billion budget gap in fiscal 2011, according to the Center of Budget and Policy Priorities.

 

This is obviously the cliff notes version of our body of work on the municipal market, so if are a subscriber or prospective subscriber and would like more information, or to set up a call to discuss this topic with us, please email our Head of Sales Jen Ken at .

 

While Steinbeck has become one of America’s most lauded authors, he was also, while alive, one of its most controversial.  He had left leaning politics and was long suspected to have ties to the Communist Party.  In fact, perhaps his greatest work, The Grapes of Wrath, which is considered by almost all as one of the top ten English language novels of the last century, was originally harshly critiqued because it was deemed to be too pro-worker and overly critical of capitalism.

 

In addition to his full-time career of writing, Steinbeck was also a very active traveler.  In 1947, he travelled to the Soviet Union with noted photographer Robert Capa.  They were two of the first Westerners to visit the Soviet Union after the Communist Revolution.   The output of this trip was A Russian Journal, which describe the harsh living conditions in the Soviet Union. 

 

Since Steinbeck’s visit almost 60-years ago, much has changed in the former Soviet Union.   While the transition to a fully functioning democracy in the vein of the West is still a work in progress, the introduction of capitalistic ways has certainly benefitted Russia, particularly as it relates to its vast natural resources.  Due to modern reinvestment and the opening of her oil fields, since 1999 Russian oil production has increased 62%, or 3.5MM barrels per day, while total global oil production has only increased 10.5%, or 7.6MM barrels per day. The Russians are taking market share.

 

Despite the pain we see in municipal debt markets headed into 2011, we do have some great long ideas.  As it relates to the Russian oil theme above, one of our favorite long ideas is Lukoil (LUKOY).  According to our Energy Sector Head Lou Gagliardi:

 

“Although labeled a National Oil Company (NOC), Lukoil is 100% publicly owned. But, geopolitical risk, the Russian economy, a weak global economy and energy demand, and an onerous export tax duty have all weighted heavily on Lukoil’s share price in 2010 widening its market price discount to its discounted cash flow valuation further to 50%.

 

Historically NOCs trade at a discount to cash flow valuations and Lukoil’s historical discount has been in the 30% range. We believe its market discount will narrow reverting to the mean in 2011 driven by several catalysts. Lukoil’s high oil production weighting of 87% levers its share price to higher crude prices; its long-lived reserves, its expanding production profile internationally, and its growing crude oil production profile of ~2% per annum will contribute to significant earnings growth in 2011.

 

Lukoil’s balance sheet is strong with a debt to capital ratio of ~16% and a net of cash ratio at ~12%, as the Company is living within its capital spending. At $85.00 crude oil in 2011, we expect Lukoil to easily beat consensus with a ~25% E.P.S increase from 2010 to $14.75/ADR. For 2011, NCF at $85/bbl is targeted at $8.4 billion, or $10.12/ADR. At $89.00/bbl, earnings would jump 35% from prior year to nearly $16.00/ADR, adding roughly another $1 B in NCF.”

 

To put it simply: Lukoil is cheap, growing, has deep reserves, and a pristine balance sheet.

 

While the outlook does seem a little cloudy and rainy, there are plenty of Lukoil type opportunities out on the horizon.  Moreover, as another well know American literary figure Dolly Parton once sang:

 

“The way I see it, if you want the rainbow, you gotta put up with the rain.”

 

Enjoy the holidays with your families and stay out of the rain,

 

Daryl G. Jones

Managing Director

 

The Pain of Rain - Property Tax Case Shiller


THE M3: CPI

The Macau Metro Monitor, December 21st, 2010


CONSUMER PRICE INDEX FOR NOVEMBER 2010 DSEC

Macau November CPI rose 3.93% YoY and 0.45% MoM.  Prices of outbound package tours were higher YoY and lower MoM.


NKE: It’s All on Nike U.S.

NKE will come through, again. 10% beat likely without futures rolling. Look for a major relaunch of Free. But given interconnected global risk, low short interest, key management stock sales, and the best sell-side sentiment since October ’08 (14 Buys and no Sells) Nike NEEDS the US to lead. The good news is that it is.

 

On some level, I think that NKE planned its May Fiscal Year just so they could keep shareholders walking on eggshells during holiday weak in addition to 2Q EPS. The eggshells aren’t warranted this time around. 

 

1) We’ve got Nike printing $0.96 in our model, which is 10% greater than the Street at $0.88. Importantly, this EPS algorithm starts with 10% sales growth levering to 28% in EPS growth; showing improvement in both Gross and SG&A simultaneously for the first time since 2Q08.

 

2) It would be very uncharacteristic of Nike to change guidance at this time of the year. The caveat is that if they smoke the quarter (our estimates count as at least a puff or two) Don Blair has all the ammo he needs to keep forward hurdles low; raw material costs, more air freight to keep up with strong demand, quadrupling in apparel R&D budget, to name a few.

 

3) Sustainability of Futures. The biggest question for everyone that cares about Nike – or anyone that even grazes some part of Nike’s supply chain – is whether or not Nike can sustain its North American growth. While this is usually not on the top of our list given how broad Nike’s portfolio has become. But let’s face some facts…the setup in Europe and Asia is not setting up to be pretty into 2011. Check out the charts below where you’ll find eroding consumer confidence pretty much everywhere. The US actually looks good by comparison. In other words… for one of the first times in years, Nike ABSOLUTELY needs the US to hold on tight.

 

Given the importance of North America, let’s dissect the 14% futures number we saw last quarter. 14% growth over the next 2 quarters is the equivalent of adding $289mm in new business (assuming that 85% of the base is on the Futures program). This number annualized is bigger than the ENTIRE US BUSINESS for over 90% of the footwear brands in the world. The good news is that the number is balanced over footwear and apparel. That definitely makes this number more easily digestible.

 

NKE: It’s All on Nike U.S. - NKE Fut 12 10

NKE: It’s All on Nike U.S. - NKE Fut 2 12 10

NKE: It’s All on Nike U.S. - NKE Fut 3 12 10

 

Precise quantification of this order number is tough. But here’s our best crack. When we add up comp and square footage growth by customer and by channel, we get to about $128m top line growth for the YEAR – or about 2.5%. Now…this excludes growth in Nike retail and Nike.com – both of which should take the aggregate growth rate on a reported basis for Nike up by another 2-3 points. So what we need is to justify doubling this growth rate again due to market share gains in order to get to 14%.

 

This is very much realistic. But here are a few considerations.

 

1) Free: I think that Nike has done an admirable job in hiding from the outside world how bothered they are by missing out on the Toning category. That’s not to say that they want to have been first to market with a ‘tush toner’.  But does anyone remember Nike Free? This is a technology that Nike debuted around 2005 – the same time that Adidas bought Reebok and immediately started to seed share to Nike (their combined share went from 17% to 6%).

 

So what are we left with? The toning category has taken off, the book “Born to Run” was on the NYT best sellers list.  (This focused on a group of hardcore runners and Mexican tribes who would run (often barefoot) as a way to minimize injury and maximize speed and safety.)  And all the while, Nike is left out in the cold even though they invented the technology to lead this category.

 

Translation = the tools, molds and other capital equipment to produce these shoes en masse have already been amortized. My sense therein is that we’re going to see a MAJOR re-launch of ‘Free’.

 

This should be showing up in Futures today. (and we probably saw some last qtr).

 

2) Endorsements: Yes, we’re in a solid R&D cycle. But with that comes an Athlete Endorsement. We already saw Nike outbid for the NFL contract. It dropped Tom Brady, who was then picked up by UA. It also goes down the curve to athletes like Allyson Felix, who Nike recently took from Adidas. To those that don’t know, Felix is one of the top sprinters in the world and is a solid brand statement (recently had a full billboard in Times Square).

 

3) Global Interconnected Risk: Not that many people ask me about the Macro side of Nike. But they should. While being the clear leader in a Global Duopoly with a fixed structural forex and sourcing advantage, the company is not immune to global turmoil. They have bucked it in the past – but we cannot give a free pass – even for a company like Nike.

 

4) Model Shift: We’ve been looking at Nike as a sheer top line growth story with improving Gross Margins. As we anniversary World Cup, the top line will still be there, though margins should be driven more by SG&A and FX hedges. Same result, but different path. The risk is whether Mr. Market will give the stock the same multiple in trading GM for SG&A/FX.

 

  Europe (Western): Largely stronger on a sequential basis

- Most significant consumer confidence ramp with four consecutive months of positive retail sales - the longest such streak in more than 5-years before turning slightly negative in October.

 

  Europe (Eastern/Central):

      - Russia rolling over slightly relatively to Q1

 

  Key issues/events across Europe:

      - Consumer Pullback from Austerity measures issued or discussed, many enacted for Jan. 1, 2011

      - Austerity measures in Ireland, UK, Spain, Portugal, Italy, France, Greece, Hungary, Romania

      - World Cup spill over early into the qtr 

 

  Euro - GDP:

 

NKE: It’s All on Nike U.S. - NKE Eur GDP 12 10

 

NKE: It’s All on Nike U.S. - NKE Eur Cons RSales 12 10

 

NKE: It’s All on Nike U.S. - NKE Ger Cons RSales 12 10

 

NKE: It’s All on Nike U.S. - NKE Russ Cons RSales 12 10

 

  China: Retail sales growth stable in low 20s while confidence is beginning to roll

 

NKE: It’s All on Nike U.S. - NKE China Cons RSales 12 10

 

  Japan: Rolling over hard relative to Q1

- stimulus measures and policy changes helped buoy the Japanese consumer in 3Q10, including a subsidy for energy-efficient cars and a tobacco tax hike scheduled for October 1st. Both programs pulled forward consumer demand to the tune of a 0.7 point contribution to 3Q10 GDP, after having no contribution from private consumption in 2Q10. In addition, Japan’s hottest summer in over a century fueled demand for cooling products. These tailwinds helped boost 3Q10 GDP growth to +3.9% QoQ SAAR and their absence will create a drag on growth in 4Q10 and potentially into 1Q11 – just around the time bearish 4Q10 economic data is being reported in globally. (11/30/10 Macro post )

 

NKE: It’s All on Nike U.S. - NKE Japan Cons RSales 12 10

 

  South America:

      - Brazil - retail sales started to slow heading into Nov though relatively flat with Q1

 

NKE: It’s All on Nike U.S. - NKE Brazil Cons RSales 12 10

 

  Fx: Nearly 1% drag on top-line in Q2

 

NKE: It’s All on Nike U.S. - NKE Fx 12 20 10

 

 

 


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DRI – A TALE OF THREE CONCEPTS

Conclusion: Overall no great surprises but LongHorn exceeded expectations while Red Lobster once again disappointed.  I will have another post out tomorrow after the earnings call.

 

Darden International is not cited regularly as a bell weather for consumer spending, but I think the company’s performance offers an interesting, if small, glimpse at the state of the consumer.  The news out of Washington of late has led to more questions than answers.  From a MACRO perspective, it will be interesting to see if this momentum will continue once the holiday season high subsides and the hangovers set in.  Whether or not companies continue to invest in their concepts will likely be a huge differentiator in 1Q11 as the holiday season ends. 

 

Clearly, for whatever reason, the mood of the consumer has been stronger of late and the better-positioned concepts are performing well.  In Darden’s case, LongHorn is leading the way with mid-single digit traffic growth, The Olive Garden’s comparable restaurant sales are in the low-single digit range, and Red Lobster’s comparable restaurant sales figures have deteriorated on a two-year average basis for the past three consecutive quarters.

 

Darden has spent considerably amounts in investing in LongHorn and the results from that concept today are impressive.  As you can see in the chart below, LongHorn almost beat the street consensus for comparable restaurant sales by a factor of two.  The stellar performance of LongHorn will likely distract investors from the never ending turnaround that is Red Lobster.  However, heading into tougher comps in 3Q11, coupled with the prospect of elevated beef prices, could put more of a deadline on Red Lobster’s ever-pending revival.

 

I expect management to strike a cautious tone with respect to top line trends.  A sequential slowing was clearly evident in trends at LongHorn over the course of the quarter.  One line-item that will need to be addressed is labor, which declined by ~120 basis points year-over-year.

 

DRI – A TALE OF THREE CONCEPTS - og sss

 

DRI – A TALE OF THREE CONCEPTS - rl sss

 

DRI – A TALE OF THREE CONCEPTS - lh sss

 

Howard Penney

Managing Director


Zappos/Amazon = Incumbents Should Be Afraid

AMZN/Zappos is growing into more of a formidable competitor in softline retail than many people think. Hsieh' goal of $1Bn going to $5Bn would get this name in the top 5 apparel/footwear retailers by today's metrics. Only internet sales tax could slow this beast down.

 

 

Here’s some food for thought for all you Holiday on-line ‘shop-a-holics’. Remember Tony Hsieh? Yeah…he’s the dude that created Zappos from scratch, and ultimately sold it to Amazon last year for $888million.

 

We all knew the deal sounded expensive – but that’s without considering what Amazon would gain from the transaction – most notably talent to scale up both the footwear and apparel market. That’s about a $350billion opportunity.

 

To be clear, Amazon’s apparel offering in the past has been abysmal. It’s gotten a bit better, and will continue to do so. But Footwear has clearly improved at both Amazon (i.e. New Balance/Heidi Klum) and Zappos alike. There’s still a lot of room to go if AMZN ultimately wants to make money in footwear, such as weaning the consumer off the free-shipping model at Zappos – or getting smart with leveraging other ‘sticky marketing’ tactics (like Amazon Prime – which is evil for a shop-a-holic who’s trying to get sober).

 

Here’s a recent quote from Hsieh that is absolutely worth noting.

 

“For the next couple of years, we are moving into clothing. we started out in footwear but clothing is actually a much larger market. It should be enough to take us to $5 billion.” What does all that mean? He thinks that this deal will be a 5-bagger for his company. $1bn in sales going to $5bn?

 

Those are some mighty big numbers. Consider this…Zappos hitting $5Bn in sales would make it the 10th largest apparel/footwear retailer in the US. If you add in Core Amazon it climbs into the Top 5. 

 

Nothing says it all better than the picture below outlining Hsies’ collective vision with Amazon.

 

 

Zappos/Amazon = Incumbents Should Be Afraid - zap

 


Fashionable Consensus

This note was originally published at 8am on December 20, 2010. INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK (published by 8am every trading day) and PORTFOLIO IDEAS in real-time.

“Nothing is more obstinate than a fashionable consensus.”

-Margaret Thatcher

 

You’d think that some of the sell side’s finest would have learned something from being unanimously bullish on the US stock market in December 2007. Think again. It’s December of 2010 and, after a few minor bailouts and major bonus seasons, the bulls are back.

 

Don’t wince. Without a Fashionable Consensus, how else would we generate long term absolute returns? This weekend’s edition of Barron’s “Outlook For 2011” may be one of the finest gifts of Groupthink that we’ve been offered in years.

 

As Barron’s themselves reminds risk managers (not in the cover story article), the SP500 has only seen double-digit gains for 3 consecutive years twice since World War II (1951 and 1994). Looking at the bullish 2011 predictions for US stocks that way, maybe consensus is contrarian!

 

Will 2011 mark a 3rd year in a row of double-digit gains?

 

Well, let’s go through that…

 

Let’s start with a level. My immediate term TRADE zone of resistance for the SP500 into year-end is 1249-1256. Giving year-end bonus and mark-up season the bullish benefit of the doubt, let’s use the top end of that range and round the number up to 1256.

 

Since a +10% or better gain in the SP500 for 2011 (versus 1256) = 1382, let’s take a gander at who is more bullish than that:

  1. Deutsche Bank = 1550
  2. Goldman Sachs = 1450
  3. JP Morgan (formerly known as partly Bear Stearns) = 1425
  4. Barclays (formerly known as Lehman) = 1420
  5. Bank of America (formerly known as partly Merrill) = 1400

Now, to be fair, we’ll need to provide some disclosures (it’s a sell side thing)

*the aforementioned 2011 targets are from last week’s Bloomberg survey and subject to revision

**some of these estimates are the mid-point of Big Broker’s internal range (that’s a CYA thing)

***some estimates are from economists and bond strategists (yes, on Wall Street, cops are sometimes firefighters for commission)

 

The only person we can find who is more bullish than Binky Chada at Deutsche Bank isn’t a sell-sider, but he was equally as Bullish As Binky back in 2008. Don Luskin called for a +30% move in US stocks when I debated him on Kudlow on Friday night. Luskin’s made for YouTubing estimate implies a +377 point move in the SP500 to all-time highs in 2011 to 1633.

 

Now let’s not get caught up in what’s going on in the rest of the world this morning (Global Growth Slowing, Inflation Accelerating, and Interconnected Risk Compounding). Chinese stocks closed down for the 4th straight session to -13% for 2010 YTD and the CRB Commodities Index level of 320 is +25.5% inflated since the beginning of July.

 

Per the US stock market centric bulls, these interconnected global economic realities don’t matter, until they do.

 

Let’s get back to the US stock market’s 2011 Fashionable Consensus and dig a little deeper into its tapestry.

  1. Everyone loves Tech
  2. Everyone (except Doug Cliggott at CS) hates Healthcare
  3. Everyone has no short ideas

Most risk managers realize that doing what everyone else is doing isn’t a great idea (especially if you want to charge your clients 2 and 20). That’s why I’m short Tech (XLK) and Industrials (XLI) going into year-end. Both are reaching extreme levels of being intermediate-term TREND overbought.

 

I’m bearish on US Equities (SPY) and US Bonds (SHY). I’m bullish on the US Dollar (UUP).  As a result, I’m bullish on building up a large cash position as we head into what I think is going to be at least a 7% correction in the next 3-6 months (SP500 downside target = 1168).

 

No, I’m not reckless enough to give you my “year-end target” for the SP500 (that’s what unaccountable Big Brokers do). But I will tell you what I think every day between now and then. I’ll tell you what my upside/downside probabilities are across my 3 investment durations (TRADE, TREND, and TAIL), and I’ll take a long or short position that I’m accountable to.

 

If I’m wrong on US Equities in the next 3-6 months, I think some combination of the scenario laid out by Jeff Knight at Putnam (buy side PM) and Doug Cliggott (ex buy-sider at Credit Suisse) has the highest probability. Upside in the SP500 to the 1325-1350 range with the two sectors that I think auger best to an environment of US style Jobless Stagflation (Energy and Healthcare) outperforming.

 

My immediate term TRADE lines of support and resistance lines for the SP500 are now 1236 and 1249, respectively.

 

Best of luck out there today,

KM

 

Keith R. McCullough
Chief Executive Officer

 

Fashionable Consensus - thatcher


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