UA: Crusher, But Watch the Cash

There’s very little to punish UA for here. UA is giving the bulls all they need to keep the faith that this company will double over 3-years. But cash flow is eroding on the margin. That’s caused some pain in the past. Put your risk management hats on.


You gotta hand it to these guys...seriously. They crushed expectations, and it was not because they set crushable guidance over lackluster performance. This thing legitamently reaccelerated its top line to 36% (and by 12,000bps sequentially on a 2-yr run rate). EBIT grew 31% and EPS by 34%. Yes folks, that’s organic. It’s not because of one of these poor quality acquisitions that are blanketing the market, FX, or stripping the cost structure clean in anticipation of being LBO’d.  UA is the real deal.   That’s not real news to us, as it was one of our top names last year. But we hopped off early on 10/26 (see our note, UA: The Gap is Gone) at about $48 – content at a 2-bagger in six months at a time when 1) the consensus estimates moved up to our level, 2) we started to see headwinds on athlete endorsement costs, and 3) UA was in the heat of launching it’s first real cotton product at a time when cotton costs were up three standard deviations from the mean. We were wrong.


One thing that has changed in the market, and in retail in particular, is the premium people are willing to pay for organic growth. In retail, that’s UA, URBN, LULU. Levine and I are often asked about these three in the same sentence. One thing to consider is that UA’s model is far more exportable, and can appear to a larger audience globally. Let’s face some facts, they’ve blown it thus far going international. But UA is sticking its nose into a global duopoly (Nike and Adidas) where the primary channel would love nothing more that great quality product from a high-end US brand. Also, find me anyone that would take the other side of the debate that UA could add another $400mm in footwear sales over 2-3 years on top of a billion dollar apparel business.


So what are our thoughts with the stock near $60? Pretty much unchanged. The company has got great product momentum, and along with Nike, Footlocker, Dick’s, Sports Authority, and Hibbett, we should see both the space and this company materially outperform into 2011. If you want to short on valuation, then be our guest. But it’s probably gonna hurt.  I heard people say “sorry, it’s too expensive for me” at $20, $30, $40, and $50. Why not $70?


One thing to consider is that the biggest moves in this stock over time have happened at peak/trough cash cycles. Think about it some of the BIG calls on UA in the past.

  1. When the company began to shift into more ‘loose fit’ apparel, and away from its core compression product. That meant incremental spending on R&D, marketing, but also had to manage a different working capital cycle. Having replenishment product that turns 9x at Dick’s is a lot different that selling product with more variable pricing structure at Nordstrom at a 2x turn.
  2. Remember the (now infamous) time when UA went to ICR – even though they were not on the docket to do a presentation – and leak out the incremental SG&A spend for the Superbowl?
  3. On the flip side…nearly EVERY major move higher in UA was in conjunction with working capital coming down and SG&A growth peaking, thereby fueling the top line in the subsequent 12 months. (i.e. sales up<margins<fcf).

Therein lies the Bear Case:

“Top line growth is astounding today. But the cash cycle is weakening on the margin. Growth in company stores is accelerating, which means higher capex and working capital. The company already guided to top line growth of 25-27%, which is above its long term range. Heck, maybe that means its true intention is for 30%+ growth. But otherwise why raise expectations at the very start of what is going to be one of the years in retail with more pin action than we’ve seen in a while. If operating margins OR asset turns peak and roll (like our SIGMA shows yellow flags of doing) then the other will have to accelerate just as much in the other direction in order to offset erosion in RNOA. That will be a painful day to hold UA.”


When we net it all out, we think that the Bull case will prevail, but certainly at a heightened level of risk relative to where this name was for most of last year. We think this is a ‘do nothing’ stock right now. What’s funny is that ‘do nothing’ is actually positive on a relative basis compared to the rest of retail.



Review of the Quarter


Revenue Growth: Revenue growth was impressive up +36%, but more impressive was the fact that it came from every category – including footwear.  New product introductions will continue to be the primary growth driver including the company’s new Charged Cotton shirt (end of Q1) and additional footwear introductions on top of a full year of basketball sales. Very few companies in retail can come close to posting this type of sustainable top-line growth.


Direct-to-Consumer: Plans are accelerating here with management now expecting to add 25 stores in 2011 up from ~20 last quarter off a base of only 54 stores. With sales per store averaging ~$5mm per annum, Direct sales have quickly become a major growth driver accounting for 10% of growth in 2010 and is likely to drive a similar if not accelerated rate in 2011 with the majority of stores entering years 2 and 3 becoming increasingly more productive.


Margin Pressure(s): It’s no surprise that gross margins will face increasing pressure over the next 12-months, but higher investment spending is clearly in the plan for 2011 masking the margin expansion opportunity that comes from 20%+ top-line growth near-term. As such, guidance implies 10-50bps of EBIT margin expansion in 2011, which appears optimistic if not at the expense of lower marketing spend at year end. In addition to higher sourcing and labor costs in the 2H, the company will also be challenged by mix shift as footwear continues to grow particularly in Q2 offset in part by higher DTC revenues as well.


Inventories: With 45% growth on a 36% increase in revenues and further growth expected in the 1H, inventory risk remains a concern near-term. While the majority of growth is due to investments in core auto replenishment inventory, the reality is that at these levels the company is at a considerable risk if sales don’t materialize as expected. It’s also worth noting that aged inventory is half the size at year end compared to last year suggesting product is more current and would be easier to liquidate if need be. 




UA: Crusher, But Watch the Cash - UA S 1 11


No Longer In The Tail . . . Jasmine Revolution Being Exported

Conclusions: As we noted a week ago, the Jasmine Revolution has the potential to go global, and it has. This week we’ve seen massive protests in Egypt, the world’s 27th largest economy.  The Egyptian stock market is down 16% in the last three days.


On January 20th in an Early Look (some of this data is replayed below), we discussed the idea that Tunisian protests could represent a tipping point for civil unrest in emerging markets. These protests, or what is now being called the Jasmine Revolution, began on December 17th with the self-immolation of Mohammed Bouazizi (after police confiscated his unlicensed food stand) and ended on January 14th with current President Ben Ali fleeing the country for Saudi Arabia.  In the last week, we have seen protests accelerate in emerging markets, and this may just be the beginning.


Tunisia had seen steady economic growth from 1999 to 2008 with average annual GDP growth of 4.9%, until a deceleration in 2009 to 3.1%. The natural outcome of a deceleration in economic growth is a freeing up of capacity in the economy.  In Tunisia, almost 50% of the economy is driven by services, which is effectively “people” power.


So, as the economy in Tunisia has slowed, unemployment has picked up to 14.1%.  In conjunction with slowing growth and high unemployment, we have also seen basic commodity prices accelerate in the last year – copper up 24%, tin up 58%, wheat up 68%, cotton up 131%, and palm oil up 53%, to name a few.  In economic parlance, this combination of accelerating inflation, slow growth, and high unemployment is called Jobless Stagflation.


In democracies with longstanding institutions of law and government, Jobless Stagflation often leads to protest and change, similar to the change we saw in the recent midterm elections in the United States, where the Republican Party gained control of the House of Representatives.  The people demanded change in the United States and they went to the polls to get it.  In nations like Tunisia, this mechanism for change (free and open elections) does not exist, so the people went to the streets and demanded it.


Civil unrest as an outlet for protest against the government exacerbated when the population is youthful.   As healthcare broadly improved in these Africa and the Middle East in the late 1960s, birth rates went up dramatically.  Currently, it is estimated that around 65% of the regional population is under the age of 30. 


In the Early Look last week, we posited the rhetorical question:  could the Jasmine Revolution become a primary export of Tunisia?  The evidence early seems to suggest that the Jasmine Revolution is already spreading across the region; the most supportive evidence is coming from Egypt.


Over the last three days, there have been massive protests in Egypt against the autocratic regime of President Hosni Mubarak.  These protests are being driven by economic concerns, primarily spiraling costs of living (read: inflation).  As the costs go up, the underemployed and underpaid youthful population naturally vents, and in an autocratic regime they have no outlet other than, at least in their minds, to take to the streets.  No doubt the successful revolution in Tunisian was a catalyst for the Egyptian revolts; the success of overthrowing the Tunisian government has emboldened protestors across the region.  To wit, protests are occurring and growing in Yemen and Jordan as well.


Unlike Tunisia, Egypt is a country that matters on the global economic stage; it’s the 27th largest economy in the world with a GDP of $470BN (2009).   As well, the markets are signaling that there is more to come in Egypt, as the stock market there has reached its lowest level since July 2010, falling 16% in the last two days.  Further, credit default swaps, insurance on Egyptian government debt, have surged 15% in the last week.


The powder keg of high unemployment, youthful citizens, rising inflation, and limited democratic institutions are endemic to Africa and the Middle East.  Tunisia appears to be the flint that lit the powder keg.  As protests continue over the coming days and weeks, we expect the mantra “We are all Tunisians now” to expand across the region, as the Jasmine Revolution becomes Tunisia’s top export.


Daryl G. Jones

Managing Director


No Longer In The Tail . . . Jasmine Revolution Being Exported - 2

Japan: Land of the Setting Sun

Conclusion: From a secular perspective, Japan’s economy continues to implode. The acceleration of that implosion towards the Keynesian endgame is arguably the largest TAIL risk to the global economy.


Position: Bearish on Japanese Equities; Bearish on the Japanese yen; Bullish on Japanese CDS.


This morning, Standard & Poor’s came out with yet another lagging downgrade that seems to have caught the US financial media’s attention. By cutting Japan’s credit rating to AA-, Standard & Poor’s reminded us all what we already knew:


Japan’s economy is imploding in slow motion. Slowly, but surely, Japan is reaching the Keynesian endgame.


For the sake of not making too much of a deal about a late downgrade, we’ll spare you with the details on why we feel this way. Please refer to our 4Q10 Key Macro Theme of Japan’s Jugular for the work behind our implicit downgrade of Japan’s credit, currency and equity market. The presentation, originally published on October 5th, can be accessed here:


Replay Podcast (starts around 9th minute):

[To access the podcast, you may have to copy/paste the link into the URL of your browser.]

Slides (12-34):


Two alarming datapoints that hit our screens over the past couple of weeks were Japan’s widening central government budget deficit and subsequent burgeoning debt issuance. According to the Japan’s Finance Ministry, Japan’s budget deficit is forecast to grow to ¥51.8 trillion yen (~$630B) in FY13 and ¥54.2 trillion yen (~$660) in FY14. [For reference, FY13 starts April 1, 2012.]


When put into the context of a ratio, Japan could be running a PIIGS-like ~11%-12% deficit to GDP in a little over a year. Looking closer to this upcoming fiscal year, which begins on April 1st, Japan’s relentless acceleration in deficit spending has Japan’s Finance Ministry upping its projected debt burden +5.8% YoY to 997.7 trillion yen, or roughly 215-220% of GDP.


Japan bulls point to the fact 90% of Japanese government debt is financed through its domestic population of savers, making it less likely to experience a dangerous back up in yields or default. As we’ve shown in the aforementioned presentation, that tailwind is rotating on the margin towards becoming a headwind as a result of unfavorable demographics. We saw signs of this trend starting last year, with Japan’s largest pension funds selling assets and joining the global search for yield to meet payout obligations.


This will only accelerate over the next 20-30 years, with the next ten likely being a real wake up call for global investors. Currently, the ratio of retirees to working-age Japanese is equal to 35.5%. In just ten years time, that ratio will be equal to 48%. In a society notorious for luxurious pension packages, going from a 3-to-1 base in potential contributors to a near 2-to-1 base in a matter of just ten years means the domestic demand for JGBs bulls consistently refer to will decline by nearly 1/3rd.


All told, we foresee a major supply/demand imbalance for Japanese government debt and, in our opinion, this imbalance is one of the largest long-term TAIL risks to the global economy. But don’t take our word for it:


“The financial state of our nation is becoming increasingly severe. Fiscal management that depends excessively on bond issuance is becoming too difficult.” – Japan’s Finance Minister Yoshihiko Noda, January 24, 2011


 “The government must fix its finances to avoid a debt crisis that could trigger a global depression.” – Japan’s Vice Finance Minister Fumihiko Igarashi, January 2011


Obviously, we think it pays to pay attention here.


Darius Dale



Japan: Land of the Setting Sun - 1

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Playing Europe’s Mismatch on Duration

Position: Short Italy (EWI); Short Euro (FXE)


Conclusion: Our current short positions in the Hedgeye Virtual Portfolio of Italy via the etf (EWI) and the Euro (FXE) are working against us as Europe gets a confidence boost from Asian debt demand, positive speculation on a future bailout package for the region, and increased sentiment from ECB President Trichet to fight inflation (ie raise rates) which is supportive for the common currency.


We see this development potentially continuing to play out in the immediate-term, however over the intermediate-term TREND our negative outlook on Europe, especially for the countries with high fiscal imbalances (Italy, Spain, and Portugal), remains intact; the credit market and recent fundaments provide supporting evidence. Our TRADE (3 weeks or less) range on the EUR-USD of $1.35-$1.37.


Don’t Fight these Forces, Near-Term


As an update on our recent work on Europe, it’s clear that European equities (especially the PIIGS) and the EUR versus major currencies (particularly the USD) are getting a sizable near-term boost. While our thesis remains intact that the region’s debt imbalances will weigh to the downside on capital market performance over the next 3-5 years, recent strength in European equities and the common currency can’t be ignored, and we think they’re primarily a function of:


1.  A pledge by Japan and China to buy European debt in the first half of January:


- And Asian investors followed through on their promises – in the first auction from the European Financial Stability Facility (rated AAA) on January 25th of €5 Billion 5-year bonds @ 2.89% the Japanese government bought 20% of the issue, with Asian investors snapping up a full 38%. The auction drew considerable demand at €44.5 Billion!


2.  Bullish speculation on a “comprehensive package” to tackle Europe’s sovereign debt crisis:


- European Ministers have said that a package to revise the EFSF and map out a permanent mechanism to replace it in 2013 and tighten fiscal rules should be decided on by late March when the European Summit convenes. 


- Proposals for this package include:

  • boosting the region’s €750 Billion EFSF rescue fund
  • helping countries buy back their bonds; and
  • lowering interest rates on bailout loans

3.  Hawkish commentary from ECB President Jean-Claude Trichet:


- Following the ECB rate decision on 1/13 and in recent interviews at Davos, Trichet is signaling to the market that he 1.) Recognizes rising inflation (particularly in commodities), and is 2.) Determined (as ever) to maintain price stability over the “medium term” to address these pressures. This position diverges greatly from Bernanke’s stance in the US!


- In a separate note we’ll be addressing the timing of an ECB rate hike, however the chart below of the 2YR German Note provides a telling inflection that a hike in the near-term is being priced in. The yield is up a full +50bps since the end of last year.


Playing Europe’s Mismatch on Duration - o1


Here’s the equity performance of the PIIGS since 1/10:


Playing Europe’s Mismatch on Duration - o2



Beware: Long-Term, Sovereign Debt Issues Persist


Over the long term we see significant headwinds from the developing sovereign debt crisis in Europe. We think this “crisis” has a tail of 3-5 years. We don’t see politicians allowing for the failure of the Eurozone member states or the Euro, however what’s clear is that the long road to tighten up the fiscal imbalance of member countries, and construct frameworks to more effectively govern the unequal economies joined under monetary policy and currency will be a great challenge.


We’re not of the opinion that governments across the region will be able to meet their debt and deficit reduction targets over the next 2-4 years. One clear signal we’ve witnessed for the last year is a trend of rising credit yields for the PIIGS despite bailouts in Greece and Ireland.  We think Portugal, Spain, and Italy are next on the block.


Playing Europe’s Mismatch on Duration - o3


As the chart above demonstrates, rising yields put increased pressure on the sovereigns as they issue new debt, and so begins the viscous cycle of nations chasing yields higher to capture demand to meet future obligations. We’ve seen, using Greece and Ireland as examples, that a yield of 7% or above is a critical inflection line -- in both cases after the line was violated to the upside, a bailout came in mere weeks. 


While we applaud the concurrent austerity programs throughout Europe to suppress spending and increase revenue vis-à-vis tax hikes, slower growth (and therefore less revenue) should follow, another headwind for fiscally imbalanced countries (and their equity markets) that have sizable debt obligations due this year and next (see chart).


Playing Europe’s Mismatch on Duration - o4


Matthew Hedrick


Shorting Thai?

Conclusion: Don’t be fooled by the “Thailand is the fourth-cheapest market in Asia” talk. Cheap can get a lot cheaper and, in Thailand’s case, we think it will.


Position: Short Thailand Equities via the etf THD.


This morning, we added Thailand to our growing list of short ideas in Asia, and quickly opened a position in the Hedgeye Virtual Portfolio. While we wait to short the next dead-cat bounce in Indian equities, we’ll use today as an opportunity to get ahead of what we think is an asymmetric risk/reward setup.


Though Thai equities are down (-2%) on the week, we’ll use today’s +0.88% up-move as an entry point on the short side. Keeping in context 2010’s +40.6% appreciation of the benchmark Stock Exchange of Thai Index, we think there is substantial mean reversion to be had to the downside based on the following catalysts: 

  1. Growth is slowing;
  2. Inflation is accelerating; and
  3. Interconnected risk is compounding. 

From a global perspective, I know we sound like a broken record here, but until the 1H11 data suggests otherwise, we’ll stick to our guns…


Moving back to Thailand specifically, we think growth is setup to slow based on the confluence of two factors: a deceleration in trade and manufacturing b/c of waning external demand (trade surplus roughly 10% of GDP) and weaker consumer spending as a result of higher inflation and interest rates (~55% of GDP).


To put it simply, Thailand’s December trade data was nasty: YoY Export growth slowed sequentially by (-970bps) and YoY Import growth slowed sequentially as well, falling (-2,380bps).  Akin to our Japan’s Jugular thesis, a measured slowdown in Thailand’s export growth will reverberate negatively throughout the Thai economy, as Thailand is a very trade-heavy nation (its share of global exports is nearly 2.6x its share of global GDP).


Shorting Thai? - 1


Concurrent with the release, Thailand’s Commerce Minister Porntiva Nakasai affirmed our call for China to lead a regional deceleration of growth:


“It is hard to replicate last year’s exceptional growth. China’s economy, which is the main growth driver in the region, is slowing, while Europe is still having financial problems.”


From a mean reversion perspective, Thailand’s GDP is bumping up against some rather difficult comparisons in the coming quarters. The 3Q10 growth rate slowed to +6.7% YoY – nearly 1/2 the rate of 1Q10 (+12% YoY). Growth in 4Q10 looks to slow even further, bumping up against the first positive comparison in five quarters: +5.9% YoY in 4Q09 vs. (-2.8%) YoY in 3Q09. The comps in 1H11 look even more overwhelming and is likely another reason Nakasai cut his forecast for 2011 GDP by nearly half to +4.5% YoY from an estimated +7.8% YoY in 2010.


Shorting Thai? - 2


Accelerating inflation lends further conviction to our belief that growth will slow over the intermediate-term TREND. CPI accelerated for the first time in five months in December, climbing +20bps to +3% YoY. While not a high nominal level, the negative real interest rates (-0.75%) are cause for alarm and we think rates are going higher as the central bank attempts to ward off speculation. The Bank of Thailand shares our hawkish view, with Governor Prasarn Trairatvorakul saying today that the bank needs to increase borrowing costs to “dampen quickening inflation”.


Shorting Thai? - 3


We share his sense of urgency, as the US dollar remains comfortably broken, trading below its intermediate-term TREND line of $78.66 for nearly three weeks on feeble promises of “austerity” and an upward surprise to the US federal budget deficit.  While the inverse correlations between the DXY and many commodities have come down in recent months, we do anticipate them to pick up should the dollar exhibit further weakness from here. Currently rice, a dietary staple in the country, has among the highest inverse correlations to the dollar (r² = 0.80) on a trailing three-week basis.


Shorting Thai? - 4


A back up in food inflation could prove disastrous to Thai equities. This morning, Egypt EGX 30 Index showed the world what can happen when food inflation ails a country’s citizenry, closing down (-10.3%). There are already 2,500 protestors lining the streets of Bangkok, in an attempt to pressure the government to drop out of the United Nations’ World Heritage Committee, cancel a border-negotiation agreement and urge Cambodians to withdraw from disputed border areas. Should the rate of food inflation creep up from its current +5.6% YoY clip, we could see Thailand’s political risk discount widen, as more demonstrators lock arms in protest.


Currently, there are some in the market that believe Prime Minister Abhisit Vejjajiva can and will bring an end to this round of protests, citing generally firm support from the general public and, more importantly, the Thai military. We feel, however, that his suggestion to call an election “as early as April” might be too long a timeline for the tense political situation to die down over the immediate term. We’ll take the other side of the “trust the Thai government trade” for now:


“The political risks provide a discount, while the country’s economic fundamentals are solid… It’s not a market we want to sell.” - Masahiko Ejiri, a Tokyo-based senior fund manager at Mizuho Asset Management Co., which oversees the equivalent of $41 billion.


We think Masahiko here may be overlooking two very important facts: 

  1. Political risks provide a discount for a reason and the discount can get much deeper than (-2%) on the week; and
  2. When economic fundamentals go from “solid” to “less solid” stock market multiples typically compress. 

Don’t be fooled by the “Thailand is the fourth-cheapest market in Asia” talk. Cheap can get a lot cheaper and, in Thailand’s case, we think it will.


Darius Dale



Shorting Thai? - 5


We learned today that CMG has been awarded a US Trademark for Shophouse Southeast Asian Kitchen with the description Restaurant services, take-out restaurant services.  CMG first announced on November 3, 2010 that co-CEO Steve Ells was working on an Asian restaurant concept that follows the Chipotle model.  At that time, the company revealed its plans to open one Asian inspired concept in 2011.


Just recently, Ells stated at the ICR conference, “I would argue that different kinds of cuisine could be applied to this Chipotle model, that it’s the model that we’re best in the world at not necessarily burritos and tacos.  And so in order to prove that theory, we’re going to open an Asian concept this year. It’s very exciting. It’s completely different from the stuff that you see out there today. And we’ll open one and we’ll see how it goes and see what kind of opportunities come from that.”


CMG’s move into the Asian food segment will be interesting to watch but is certainly not a guarantee of accretion to shareholder value.  Many good operators have lost focus in the past by “diversifying” and have, ultimately, ended up failing. 


For now, they have said it will only be one restaurant in 2011, but as I have said before, there is likely so much more behind the company’s decision to move into the Asian segment.  Just ask any management team that has tried to take share in a new category; there are plenty of them.


 The key reasons usually are:

  1. More capital than they know what to do with
  2. Need another growth vehicle

Both reasons lead to management being distracted and to lower returns for shareholders - never a good combination.


Howard Penney

Managing Director

Early Look

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