TODAY’S S&P 500 SET-UP – February 1, 2011
Equity futures are trading above fair value in a continuation of Monday's gains with geopolitical concerns more than offset by a mix of corporate earnings, ongoing M&A and positive economic data. Overnight, China's PMI data fell to a 5-month low suggesting the government's fiscal tightening policy is starting to filter into the manufacturing component. As we look at today’s set up for the S&P 500, the range is 21 points or -0.79% downside to 1276 and +0.85% upside to 1297.
MACRO DATA POINTS:
TODAY’S WHAT TO WATCH:
5 of 9 sectors positive on TRADE and 9 of 9 sectors positive on TREND.
CREDIT/ECONOMIC MARKET LOOK:
Treasuries were weaker with slight steepening; 2s10s widened ~4bps
OTHER COMMODITY NEWS:
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Back in mid-August, we published a note articulating the Bull and Bear cases on TGT. At that time, I was admittedly in the Bullish camp with Brian centered on the other side. So far, many of the bullish underpinnings of the Target outlook have not materialized as I expected- at least not as consistently and not as quickly. That’s not to say that over time the company’s strategies to drive topline growth in an uncertain macro environment are a complete failure. Instead, it is likely that these strategies will take time to materialize and will result in a choppy topline along the way. This, in conjunction with Keith’s bearish stance on the name, leaves us far less optimistic in the near term on TGT shares. Below we YouTube our original bullish thesis (in white) and update each point accordingly (in blue).
Topline has more drivers now, ex-macro, than it has had in some time. The company’s focus on rolling out the 5% rewards/loyalty program and the continued rollout of P-Fresh is accretive to sales. Management says each could be worth 1-2 pts of comp on an annualized basis. Clearly there is something they are seeing in the Kansas City test market (loyalty) and in the P-Fresh remodels to give them confidence. Either way, both company led initiatives offer internally generated sales drivers that others (i.e. WMT) don’t appear to have.
Update: With disappointing same store sales growth of just 0.9% in December and January’s expectations racheted down (in part due to weather) we believe the topline is not likely to show a material snap back in such a short post-holiday period. Yes, we’re aware that electronics and toys were in large part the culprit for underperformance over the holidays, but these categories don’t go away now that Christmas has passed. With the market expecting an acceleration in sales, categories beyond food have to work.
Traffic is the key here, an TGT clearly has momentum. More food and consumables=more traffic. This also leads to opportunity, which in this case may mean a customer picks up an additional non-food item on any given trip. Probably works.
Update: Perhaps the consumables-driven traffic enhancing strategy will take longer to materialize. This concerns us primarily because inflation is now here and most anecdotes suggest that WMT and others are likely to become more aggressive on price. More food does in theory mean more visits. However it also means more competition. In this case, we believe the competitive environment is heating up on the margin, not good for any major player in the space let alone a growing one in TGT.
Management disciplined about opening new units in this environment, instead using capital to fund .com infrastructure and P-Fresh remodels. We like the conservative approach and discipline in not growing for the sake of growth. Yes international is still on the table, but we suspect that means Canada first. There is no rush here and this is a positive for cash flow.
Update: Canada expansion came sooner than we expected and we applaud the move. Yes this will be the biggest use of company’s cash in many years and we think it will be worth it. However, this really has no bearing on the intermediate or near-term as the timing of the deal makes this more noise than anything else over the next couple of quarters. Stores are slated to open in 2013 which means we should expect 2012 to be a year in which start-up costs weigh on the P&L. Keep in mind that the less competitive Canadian market has provided a backdrop for WMT, COST, and BBY to operate their most profitable divisions. This will ultimately be a net positive, but for the longer term.
Aggressive pricing activity from Wal-Mart seems to be a perpetual thorn in the side of traditional grocers and now BJ’s. However, TGT has clearly found a way to compete effectively. The introduction of the “Up and Up” private label brand and differentiated store and merchandise assortment seems to be keeping Target relatively insulated from pricing pressure issues. Perhaps this past quarter is the best example of this, where core retail gross margins were up 5 bps while WMT and BJ both saw pressure as they took prices down. We don’t need to remind anyone of the trend in grocery margins. The bottom line here is Target’s success away from commodity consumables affords better margins.
Update: In the short run, we can’t underestimate the rhetoric and the reality of a more aggressive WMT. Whether you believe the NY Post article from this morning, or the one from last week highlighting WMT’s fear of dollar stores, there is an increasing amount of concern for MORE aggressive pricing activity from the world’s largest retailer. Short of a price war, lowering prices in an inflationary environment is a dangerous spot for TGT to follow, especially when they price against a spread on national brands with WMT.
Credit card portfolio risk gradually dissipating for two reasons. One, the overall credit environment is improving leaving opportunity to reduce reserves. Secondly, Target is shrinking its receivables base as tighter credit restrictions and increased government restrictions no longer allow for unabated growth. Target also discontinued its co-branded Visa program, which leaves future receivables growth entirely tied to store sales.
Update: In conjunction with Canadian expansion comes an announcement that TGT is looking to actively pursue a sale of its credit card receivables portfolio. This would clearly offload a majority of the risk associated with “owning” the portfolio’s receivables and also leave the company with a slightly less complex corporate structure. However, this is not a simple sale, as management notes that such a transaction would need to retain operational control of the financial services business. In other words, a sale is possible but it’s not likely to be a 100% break with the retail business. Still, selling the assets now rather than waiting for credit quality or the regulatory environment to deteriorate makes sense. Still we think near term sales and margins trump the risk of being short if this transaction takes place.
Expense pressure from investments in dot.com will remain through 2011 as the company carries duplicative costs during the transition away from Amazon (TGT’s outsource partner). The flip side here is we should see leverage on such investments begin to materialize in 2012, the year in which Target.com becomes fully operated in-house.
Update: This still holds true but with a new twist. Costs to ramp up Canada in 2012 are more than likely to trump any benefits resulting from a wholly owned and operated .com infrastructure. Longer-term both assets are a positive.
Management has clearly articulated the benefits of adding incremental food/consumables sales into their boxes via the P-Fresh remodel. However, the result over time will be lower gross margins and commensurately lower SG&A. Net, net EBIT rate should remain unchanged. While in theory this makes sense, we know that investors are not fully onboard with trading margin for expense savings. Over time, this will become more clear. In the nearer term, headline gross margins could remain under pressure from this mix issue alone.
Update: In the absence of an accelerating topline, we may be setting up for a situation where both gross margins AND sg&a are under pressure as the company goes up against tough 2010 comparisons in the first quarter. Inflation should not be a surprise to anyone at this point, but the confluence of food/consumable increases and price hikes on apparel and home out of Asia (internally sourced goods) make for a challenging earnings leverage situation.
While TGT offers a more discretionary play vs. WMT, it also offers greater visibility over the intermediate term in my view. The two strategies currently underway to drive topline results have been tested. We already know that inventory management coupled with differentiated product helps Target to drive a higher EBIT structure than WMT. While the Street may be excited to learn that WMT has dialed back rollbacks (after they didn’t work to drive demand elasticity), the non-consumables part of the story is still very much in limbo. This is the single biggest wild card in the WMT story and one that in our view, has not been answered by a few mid-game personnel changes.
Update: Target is quickly becoming a show-me story after having the benefit of the doubt on topline initiatives heading into 4Q. We don’t disagree with management’s strategy over the longer term and believe the company’s merchandising expertise still differentiates the box from WMT and others. However, the margin structure here is changing due to mix and the topline is beginning to show signs of volatility at a time when then the relative outperformance and consistency was expected to take hold. The risks outweigh the reward here in the near-term, especially with January sales being reported later this week and the company having already pre-announced 4Q EPS. Official results and 2011 guidance will come on February 24, long after the debate about WMT’s woes and rub-off impact on TGT become more commonplace.
Conclusion: Brent oil broke the $100 barrier today, with little fanfare except to those European consumers who buy gasoline created from Brent. Additionally, despite a strong couple of months for Brent, it continues to trade higher suggesting political upheaval in the Middle East may be poised to accelerate.
Globally, oil is up as much as 3% today on the back of accelerating tensions in Egypt. As it relates to global production, Egypt is not a meaningful player. The country produces ~650K barrels of oil per day, which is roughly in-line with its domestic consumption. The key oil supply and demand factor relating to Egypt to focus on is related to transportation.
The Suez Canal links the Mediterranean and Red Seas and is considered to be one of the world’s chokepoints for energy. It is estimated that more than 35,000 ships travel through the Suez Canal every year and that approximately 10 percent of those are petroleum tankers. In recent years close to 2MM barrels per day of oil has been transported through the Canal, which is about 2.5% of the world’s daily oil consumption.
Given that the Suez Canal is located in Egypt, there is some risk that accessibility to the Canal could change with a less stable regime in place in Egypt. Or, alternatively, as tensions escalate and are prolonged in Egypt, shipping companies may be less willing to utilize the Suez Canal. As it relates to the last point, we have already seen global shipping companies begin to back out of Egypt. Earlier today Danish shipping and oil conglomerate, A.P. Moller-Maersk, suspended its port terminal operations and closed its shipping offices located in Egypt.
Since the Middle East, via the Suez Canal, is a key supplier to European oil markets, it is no surprise that we are seeing, and have seen, the price of Brent Oil accelerate upwards. As highlighted in the chart below, Brent recently surpassed $100 per barrel. This is more than an $8 premium above West Texas Intermediate (WTI). In effect, the demand for Brent Oil (it is sourced in Europe from the North Sea) increases with the perception that oil coming from the Middle East to Europe will be costlier to ship.
Interestingly, both Brent and WTI were at roughly $85 per barrel on December 1st, 2010. Since early January, Brent has outpaced the price performance of WTI dramatically and correctly predicted the acceleration of popular upheaval in the Middle East. Despite Brent being up more than $15 in the last two months, the price increase is still not abating, which suggests the issues in the Middle East may get worse before they get better.
Daryl G. Jones
Conclusion: With the recent spike in crude oil prices, one might think Brazil is a good derivative play on the geopolitical risk in Northern Africa. Unfortunately, the math suggests otherwise and we are inclined to maintain our cautious stance on Brazilian equities.
Position: Bearish on Brazilian equities; Bullish on the Brazilian Real.
This is known: Brazil is an economy with vast natural recourses and uses those resources to profit from global demand for crude oil, sugar, corn, wheat, iron ore, and other commodities.
This is, at times, is overlooked: Brazil is home to one of the world’s most unequal economies from an income distribution perspective. Brazil’s GINI Coefficient, which measures income distribution, is 57 – good for 11th highest in the world. That means Brazil is the 11th most unequal country in the world from a wealth dispersion standpoint – significantly more so than Egypt (34.4), Tunisia (39.8) and the United States (40.8).
We’ve been calling this out since November, but it’s worth repeating: You don’t want to be long countries where growth is slowing and inflation is accelerating – especially in poorer countries, where the citizenry is most apt to be plugged by rising food and material prices. While we didn’t necessarily predict events such as the Jasmine Revolution and Egypt’s current uprising, the tea leaves were most definitely telling us to stay out of Emerging Markets for the last 2-3 months.
Today, Brazilian equities continue to lose bids, despite the strength we’re seeing in crude oil prices (up over 3%) and commodity prices (up over 1.5%) on the day.
We are all well aware that Brazil is home to arguably the most robust consumer story in all of global macro. With record low unemployment (5.3% in Dec) and near-record low consumer loan rates (6.79%), it’s no surprise investors (including us) poured money into this story in 2010 – sending the Brazilian Consumer etf (BRAQ) up +30.3% in 2010 from its first trading day (7/8/10).
Both the price action and investor interpretation of the fundaments have reversed sharply in 2011, sending the BRAQ down over (-12%) YTD. The fundamentals themselves have been eroding for the last four to six months – particularly on the inflation front:
Ignoring the delta between the government’s reported numbers and the unofficial series (see: Egypt, Argentina, US, etc.), we see that inflation is indeed becoming the problem we anticipated a few months back. This issue is reflected in the Bovespa’s underperformance – falling (-7%) since it peaked on the 12th of January. With the exception of the now infamous EGX 30 (Egypt), that decline is tops among global equity markets over that duration. The fall leaves Brazil decidedly bearish from an intermediate-term TREND perspective.
With the dollar catching no bid amid the acceleration of global geopolitical risk, we don’t see inflation as something that will quietly go away in Brazil. Brazil’s bond market agrees; yields on 10Y government securities having backed up +79bps since January 3rd. For what it’s worth, Brazilian economists see the same thing: the latest survey for full year 2011 CPI estimates came in at +4.7 YoY, up +16bps wk/wk.
Unfortunately, for the poorest of Brazil’s citizenry, Brazilian policy makers have been reluctant to let the real appreciate meaningfully. Of the firm belief that the current bout with inflation is driven by rising commodity prices (see: India) the central bank is reluctant to use further rate hikes to beef up the real in an effort to combat rising inflation. Instead, Brazil continues to manufacture attempts to weaken the real, raising the reserve requirement on short dollar positions, authorizing the sovereign wealth fund to buy dollars and auctioning reverse swaps – all since January 1st.
Until Brazil’s central bank stops buying the IMF-led hype of “destabilizing fund flows” and “global capital imbalances” and realizes that inflation is priced locally and is a direct function of local monetary policy, the inflation issue will hang like a dark cloud over Brazil’s economy.
Perhaps the market is discounting this, understanding full well that Rousseff is a woman of the people and a strong advocate for Brazil’s poor. She’ll likely not let inflation get further out of control than it already is. Given this, we expect measured tightening on the horizon in the Brazilian economy, and a potential subsiding in anti real-strength policies. Perhaps the prospect of future real strength is the underlying reason Brazil’s Industrial Confidence fell in January (-1.5%) MoM. While merely a hunch at this point, we’d be remiss to ignore the interconnectedness of these risks.
If you’re still bullish on Brazilian equities, we’d recommend you buy them at an even greater discount at some point in the intermediate future. If you’re bearish, continue to watch the US dollar and how it interplays with commodity inflation. For now, the dollar is decidedly bearish-TREND, which, in turn, is bullish for global commodity prices on the margin. We don’t think we’ll see the usual benefit of these rising prices reflected in Brazilian equities until inflation subsides in Brazil – which is likely only to happen after a measured increase in hawkish monetary policy.
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