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NKE: Solid Q. But Trajectory Will Change

I expected a good quarter from Nike, and with a 12% move in the stock in the back half of last week (up to $66.66) I think the market did too. While the actual results did not surprise me, the upbeat tone of the conference call definitely did. I outlined the case last week why the stock should not have traded up in advance of this quarter, as the meaningful headwinds the company will face this year will materially alter the quality of earnings as FY09 progresses – which I suspected would begin to be apparent on this call. Now the question is whether I take the tone of the call at face value, admit that there’s not the downside in the stock I initially suspected, and simply cut bait? Or do I use the insight gained from the call, stick to my analytical guns, and stand firm that there are issues that the industry and the company will be talking about in 3-6 months that it is not talking about today. I’m going with the latter.

I’m taking my estimate for the year down by a nickel to $4.09, and while not expensive at $62, I absolutely cannot argue one iota of multiple expansion given the headwinds Nike faces. Performance from this point forward needs to come from pure earnings juice. Again…tough to bank on. Here’s a few things to chew on…
  • 1) A few big positives… a) On the plus side, how can anyone not be impressed with Nike’s order book? The 2-year run rate across all regions is virtually unchanged from 3 months ago – about 10% in aggregate in constant dollars. B) Gross margins +233bps were solid. Ahead of my number (though they gave it back in SG&A). The incremental call out seems to be ‘lower than expected cost increases out of Asia.’ This is one of the factors that I think will change meaningfully over the course of the year.
  • 2) Nike is a ‘Beater.’ Nike beating each quarter is written in the cosmos. It has missed only 1 quarter in 6 years. And that was by a penny. In looking at history, we see that Nike needs a beat of at least +4% for the stock to not go down on the event. It takes a beat of 12% or better to get a post-quarter rally. This time we got +11%. Definitely a net positive, but within historical guidelines.
  • 3) Let’s look at what drove the beat. One region that smoked my expectations was Europe. 20% revenue growth on trailing 6 month futures of 6% is monstrous. It came in double my model. But tough to ignore that 15 points of this growth was due to FX. Also tough to look through the fact that the Euro is at 1.467, and just a few short weeks from having 0% yy change. Check out the chart below showing EPS surprise history vs. FX change. Not good.
  • 4) Nike needs the Dollar’s slide over the past few days to continue. Management noted that its’ model assumes no change in FX. With the greatest global geopolitical/macroeconomic cross currents we’ve arguably seen since the great depression, I cannot imagine FX stays still. Maybe it goes for them, maybe against them – but I’m inclined to think we see increased volatility here. In fact, this is the first quarter in almost 3 years where reported futures were not greater than constant dollar futures in Europe.
  • 5) Not a coincidence that EPS growth is so closely tied to changes in FX (see Exhibit below). Bulls might say that EMEA margins were down 54bps – so how can that mean that FX helped? The answer there is that Demand Creation spend (Olympics and football) was disproportionately high this quarter, as it more than offset the improved gross margin in EMEA. Total margins in EMEA were 24.9% this quarter. Down slightly vs. last year, but let’s not forget that they were in the high teens/20% range before FX ran up.
  • 6) I really really really don’t like the trajectory of the P&L.
    a. Revenue growth just hit 17%. 7 points of which was FX, and another 2-3 was Umbro.
    b. Nike is expecting full year revs in high single digit, in line with LT plan. If we assume that it is not sandbagging, a 9% annual rate, and its guidance for 2Q (where it has solid visibility) then simple math backs us into a 4Q top line that is flat with the prior year at best.
    c. Gross margin improvement just peaked – as it relates to incremental FX-related growth, product cost, and yy compares against pricing and supply chain initiatives put in place last year.
    d. 97% of the industry’s footwear is made in China (bad). Nike is less exposed at about a third, but it also is far overexposed to Vietnam (also a third of its footwear production). Three weeks ago, Hanoi announced 28% inflation – its highest rate in 16 years. In Vietnam and Thailand we’ve seen factory workers strike because mid-teens wage increases are not enough to keep pace with inflation. Ultimate, this has to impact Nike. They’re big and smart enough to pass it through to the rest of the global supply chain, but that process is lumpy.
    e. SG&A is clearly the buffer for the remainder of the year. +29% this quarter, and slowing to a negative number by 4%.
    f. ‘Other Expenses’ turn into other ‘income’ as FX hedges are market to market at more favorable rates.
  • So the bottom line is that we’ve got a global growth story that is facing a slowing global growth environment, increasing risk of global stagflation, and has a P&L trajectory where sales and gross margins are decelerating, but are likely to be made up by SG&A, ‘other’ income, and lower tax rate. That shows the power of how Nike manages its financial model. But I simply do not understand why putting capital to work here at $60 makes sense. I like it closer to a 5-handle.

PPC – Big bird deboned

PPC announced today that it expects to report a significant loss in the FY4Q08. The company attributed the loss to high feed-ingredient costs, but more importantly to weak pricing and demand for breast meat. Our thesis on PPC was based on continued weakness in pricing because that was what the competition wanted – PPC to fail. As an aside, this was also the reason to be long BWLD.
Not surprisingly, Pilgrim's Pride also informed its lenders that it does not expect to be in compliance with its fixed-charge coverage ratio covenant under its principal credit facilities, but expects to be in compliance with all other covenants as of the fiscal year end. Importantly, Pilgrim's Pride believes it has reached an understanding with the agents under its credit facilities to temporarily waive the fixed-charge coverage ratio covenant through October 28, 2008, and to provide continued liquidity under these facilities during this same period.

I see very little value in the equity of PPC. Right now, the banks (Co Bank and BMO) are trying to hang on in hopes that the market recovers. PPC looks to be a big black hole. PPC is bleeding significantly, with debt of $1.5 billion and $1.0 billion dollars of inventory that can only be sold at a loss. The company will have little choice but to shut capacity, or try to sell some assets that are not worth much because they can’t produce products that make money. They only way out of this is for corn to fall below $4.00 and that is not going to happen anytime soon!


Fear Mongering

"Whoever controls the volume of money in our country is absolute master of all industry and commerce . . . and when you realize that the entire system is very easily controlled one way or another, by a few powerful men at the top, you will not have to be told how periods of inflation and depression originate." -
- James A. Garfield, assassinated President of the U.S.

To date, Garfield remains the only sitting member of the House to be elected President of the United States. He was only in office for 6 months, and perhaps that’s why the aforementioned quote is so prescient. He wasn’t in Washington long enough to be smothered by self serving groupthink.

George W. Bush has been in office for almost 94 months, and history will not remember his judgment calls kindly. Empowering Paulson and Investment Banking Inc., and letting them hurry this country into an alarmist state sadly reminds me of a movie I saw before about Iraq. Last night, Bush not only looked scared, but he sounded scared. This is not what we needed. We have ourselves a crisis of confidence in the leadership of both our country and financial system. This culture of the Bush administration’s fear mongering is a “Trend”. Last night, the President of the United States literally threatened that the USA could “slip into a financial panic”. Are you kidding me?

Never mind Larry Kudlow’s call to action again last night that this bailout bill is going to get passed and that you should wakeup and buy yourself some US pre market futures. This is not a time for entertainers who have been wrong for almost the entire -25% swoon in the S&P 500. This is not a time for fear mongering. This is a time to wake up, smell the coffee, and realize that the said leaders of this mess need to stop talking and hand over the keys to your country. They didn’t have a proactive risk management process, and they should not be entrusted with scaring this country into financial Armageddon.

Hank Paulson has been to China many times. Why didn’t he tap Bush on the shoulder and tell him that if he says the words “financial panic” on national TV that the Asians could actually take those words literally? There are rumors spreading like Bush fires in the South China Morning Post this morning that China is ordering banks to stop lending to US institutions. Rumors are what they are, and who knows if this is true, yet… but Taiwan moved to a completely unexpected emergency rate cut last night. Watch what these Asian governments do, not what they say.

In Germany, their Finance Minister (who also has a TV), Peer Steinbruck, bypassed the hearsay and when straight on the record saying that “the US will now lose status as superpower of the global financial system”. He didn’t say that in German. No words were minced.

After opening higher, European markets are selling off because America’s crown jewel of industrial economic cycles past, General Electric, is guiding down earnings big time this morning. Maybe GE’s CEO, Jeff Immelt, called George Bush, and scared the living daylights out of him last night – maybe that’s why he had that look on his face; I do not know. I do not know what promises were made prior to this administration getting all of their economic facts straight either. What I do know, is that the proposed bailout plan was premised on Hank Paulson being called into action by his cronies at Morgan Stanley and Goldman Sachs, not Main Street America – and now GE is telling you the rest of the story. Let Buffett worry about Goldman – this is a far reaching economic problem that will take time to think through.

This is not a time to panic. This is a time to be thoughtful and prepare. The only thing worse than making grave judgment mistakes, is making the same ones over and over again. In my life, I have learned as much from people in terms of what not to do than anything else. I think Dr Bill Maynard states this more succinctly, “when what you are doing isn’t working, you tend to do more of the same, with greater intensity”… that’s not leadership. That’s just being plain dumb.

The US Dollar understands this. It’s trading down again this morning, and has lost an expedited -5% of its value since our said leaders put the integrity of their handshakes on sale. Odds of a Fed rate cut at the October 29th meeting have shot straight up this morning to an 80% chance, and the TED spread (LIBOR minus 3mth Treasuries) is blowing out again. The world is now as scared as we just made it.

KM




Hedgeye Statistics

The total percentage of successful long and short trading signals since the inception of Real-Time Alerts in August of 2008.

  • LONG SIGNALS 80.64%
  • SHORT SIGNALS 78.61%

RUTH – THE BANKS ARE DRIVING THE PROCESS, AT THE EXPENSE OF THE SHAREHOLDERS.

The press release associated with RUTH’s recently completed sale lease-back transaction was a difficult one to read. Basically, Wells Fargo wants its money back and forced the company to use the cash proceeds from the sale leaseback to reduce the Company's outstanding debt balance on its revolving credit facility.

In the press release, the company said “the primary corporate objectives in the current environment is to maximize free cash flow and pay down debt, so that we can ensure maximum operating flexibility as well as remove any risk related to our debt covenant compliance.”

Unfortunately, the sale leaseback accomplished the exact opposite from what the company was trying to accomplish. The only way that this transaction provides more flexibility is that it might put off the company filing bankruptcy. Owning real estate and not paying rent is a much more conservative restaurant operating model. In the end, although the company may have reduced debt balance on its revolving credit facility, the overall leverage of the company did not change much. How ironic that the banks look at leases differently than debt.

You can surmise from all of this that Wells Fargo wants its money and is happy to spread the risk to a broader audience. Given the bind the company was in, I would expect that this transaction was dilutive to EPS. The weighted average interest rate on the company’s senior credit facility is 6.074%. The CAP rate on the sale leaseback is 8.45%. Clearly, Wells Fargo is getting its money back and it’s not in the best interest of shareholders.

Apparently there is still more work to do as the company goes on to say “In addition to several ongoing cost-cutting initiatives in the areas of supply chain, G&A, and restaurant level expenses, we believe monetizing some of the assets on our balance sheet is an effective means to reduce our leverage."

Accomplishing this task is going to be a tall order. From a G&A standpoint, there does not appear to be much fat to cut. Also, other than the recently acquired Mitchell’s Fish Market, RUTH owns the real estate under two more stores and the corporate campus in Florida. Needless to say, there are few, if any, buyers of restaurant assets that are going to give them a fair price.


SONC – Sales accelerating to the Downside

Based on SONC management’s 3Q comments, we knew 4Q partner drive-in same-store sales would be bad, but we did not know they would be this bad. After partner drive-in comparable sales declined 3.9% in 3Q, management forecasted that 4Q same-store sales would be up 2%-4% with partner drive-in performance continuing to be 3%-4% below this range (implies 4Q same-store sales of -2% to +1%). SONC attributed this significantly weaker partner performance to overly aggressive price increases taken last year combined with a decline in customer service as a result of the company’s focus on margin management.

SONC preannounced its 4Q results after the close yesterday and same-store sales came in significantly lower than the already lowered expectations. The company stated 4Q partner drive-in comparable sales “continued to be significantly negative,” resulting in slightly negative system same-store sales. I did not find these results to be that alarming until I did the math and realized how bad these “significantly negative” partner numbers potentially were in 4Q. The press release went on to say that for the full year, franchise drive-in same-store sales came in slightly below the 2%-4% targeted range with partner drive-ins performing 3%-4% below that range (again implies slightly below the -2% to +1% range, but now for FY08 rather than 4Q). Based on partner drive-in performance in the prior three quarters, same-store sales could have declined as much as 9% in 4Q to end the year down 2% (much bigger potential downside relative to management’s prior guidance for 4Q of -2% to +1%). To be clear, for the partner drive-in same-store sales to finish out the year -2% to +1%, 4Q numbers could be anywhere between -9% and +3%. However, the company said numbers were significantly negative, which implies -9% to -3% is the more likely range.

Short Selling Ban, Part IV: Endangered Species...

During the past few years as the ETF menagerie was populated by increasingly unlikely and exotic creatures many investors never considered how the mechanics of the products they were purchasing would react to the kind of market stress we are facing today.

The Ultrashort Proshares Dow 30 (DXD) is a prime example. Many investors were taken aback today as they saw their leveraged short trade vehicle begin to positively correlate with the underlying index while options trading halt for the name –not realizing that they were receiving a special short term gain distribution due to the fact that DXD (as well as its ultra short siblings like SDS) are not actually holding short positions in the underlying securities, but rather are long OTC total return swaps that provide synthetic short exposure. As the system deleverages some of these winning trades held by these ETFs and others are being unwound and accrued interest is being realized creating extraordinary one time distributions.

I think that ETFS are an excellent way for investors to access the markets and I think that they will remain a popular product, but in the coming years I expect that some of the more exotic species that came to market during the boom will go the way of the dodo.

Andrew Barber
Director

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