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PSS: To Puke, or Not to Puke?

 

Conclusion: PSS couldn’t have printed a worse number if it tried. Any analyst worth his/her salt should question the business model and value proposition. We certainly are. In the end, numbers are coming down and the stock is cheap – but that’s not enough. The good thing is that Rubel will make the changes he has to – even if they are draconian – and in short order. We’re not inclined to sell into the puke with the rest of the herd. But rather wait and see where estimates shake out for the quarter and the year, and get a sense as to whether people are negative for the right reasons.

 

 

I think it’s fair to characterize this quarter out of PSS as an unmitigated disaster. With a -7% comp, 265bp Gross Margin hit, and 23% growth in inventories, I don’t think that they could have printed a worse number if they tried. No joke. Retailers can usually trade off these three factors such that one improves, while the other one or two erodes. Here, there appeared to be complete lack of control.

 

What I won’t do is sit here and try to blame the weakness in the business on weather, holidays, unemployment and economic malaise. The reality is that every other retailer is facing the same factors, and PSS underperformed all of them by a country mile.

 

Maybe the weather factors have some validity (mgmt noted that they were on plan until 3.5 weeks before end of quarter). But quite frankly, the ‘weak economy and high unemployment’ factor is getting old. In fact, it’s not the level of unemployment that matters as much as the delta, and that actually improved 90bp yy and 50bp sequentially. In other words, employment should be helping, not hurting.

 

Gas prices? We’ll give them a pass there – but that doesn’t mean that our growth expectations should come down, but simply that this team needs to have a proactive plan in place to grow in light of other challenges – however sudden they may rear their ugly heads. PSS lost share in its base business this quarter, and a lot of it. That’s unacceptable to us.

 

The big disconnect is that we genuinely think that this company has assembled a better management team than a company the size of PSS probably deserves – that is pretty clear to anyone that has met the top dozen-plus managers that Rubel confidently puts in front of the Street. And yet PSS STILL fails to perform.

 

On the call, Rubel made some kind of comment like “you’re all very good at your research, which is why the stock went from $22 to $18 in the past few weeks.” Perhaps he was right to an extent – but we’re sorry to inform that the market was in no way, shape or form expecting this mess. Based on after hours trading, we’re looking at a $14-$15 stock. That’s probably deserved.

 

So there are several questions to be asked and answered.

  1. What’s the earnings power of the company?
  2. Does it matter?
  3. Other ways to unlock value?
  4. Ultimately, what’s it worth, and is there any reason to own this stock?

 

1. Earnings Power

We’re shaking out at $1.17 and $1.66 for FY11 and FY12, respectively. Broadly speaking, our model calls for a slight sequential pick-up in comps – which by default needs to happen by way of clearing the 23% growth in inventory – though we have gross margins coming down accordingly. We’re holding PLG growth at 15% for this year, and conservatively at 11% next year. We’ve got gross margins up 100bp next year due to a better relative comp (a -7% has a nice way of destroying occupancy leverage), but are taking SG&A up to account for growth capital at Saucony and Sperry to maintain brand momentum and Payless International for expansion. Interest expense should continue to come down by about $1.5mm per quarter as PSS de-levers.

 

2. Does it Matter?

I wonder if people will really care one way or another about earnings power right now. It’s easy to put on the bear hat and view this as the levered, small cap, ultra-volatile name that it is, where the core business is structurally lackluster at best. Our view around PSS the name focused on having a flattish base business – that was +/- 3% in a given quarter/year – that funded a growth PLG businesses and enabled de-levering and repo. We still like that thesis…but unfortunately, EBIT in the quarter was down by $40mm, or 48% while PLG accounted for an incremental $1mm in EBIT. Our thesis simply did not work this quarter. It didn’t work in 4Q, either.

 

3. Other Ways To Unlock Value

Earnings power not mattering has pros and cons. The biggest ‘con’ is that the name is being taken outside behind the barn and shot. The level of concern with this business won’t be whether or not it will earn $1.50 – but whether or not it should actually exist as it appears today.

 

That brings us to the ‘pro.’ I don’t think that this company is afraid to make the draconian call and close a meaningful portion of its stores. Rubel knows his numbers. Talk to the guy… He knows store performance at the micro level – which is impressive when you have 4,800+ stores. He knows spending by consumer, by price point, geography, etc…better than most managers I know.

 

That said, let’s do some simple math. Core Payless accounts for $2.5bn in revs, with PLG at about $1bn. But PLG accounts for about $70-$75mm in EBIT. Yes, that means that core Payless stores are currently churning out about $70mm/year based on our model. $70mm on $2.5bn in sales? That’s a 2.8% margin business, which is simply awful for a model with relatively low operating asset turns.

 

The Hypothetical… So, if we’ve got 4,800 stores running at an average margin of 2.8%, do you think they’re all running at that rate? No. In fact, one of the most poorly understood parts of retail (due to GAAP reporting standards) is the massive gap that exists between a given company’s better vs. poorer performing stores. Our sense is that about a third of Payless stores are dilutive to the P&L, and upwards of half that number are cash-flow dilutive. If we assume that these stores have sales productivity that are 2/3 that of the average PSS store, and that 800 are taken out, it gets us to about $275mm in revenue lost, but $25-$30mm in EBIT gained. Our math might not be spot on, but we think it’s directionally accurate. In this situation, we think the Street would look right through a special charge – even if it’s all cash.

 

Most people would argue that this math is a bit extreme, as its clearly many times what management has referred to in the past as % of stores that are cash flow negative. But we think this is the new normal. A consistent low growth, high inflation environment is a game changer for evaluating the quality and consistency of a portfolio.

 

The Reality… This kind of math is useless if the CEO and the Board ignore it. But we think that Rubel is going to do what he has to. We’ve looked at stories like Liz Claiborne where sleepy Boards sat there and watched as shareholder’s capital eroded by the minute. This one is going to be more active. Keep in mind that Rubel is still young at 53. He’s was very successful at Cole Haan (Nike), and my opinion (he has not commented), the guy has another job left in him. But let’s be real, who will want to hire a CEO who has little Street Cred due to a rep of not making the tough decisions when it mattered? No one.  He’s going to make the draconian call. Putting up inconsistently mediocre/poor results is not what he wants to be known for.

 

Getting rid of underperforming stores would give better transparency and consistency into the core, take up margins and returns, and would provide a better lever of stability for the core engine – which is PLG.

 

4.  What’s It Worth? Reason To Own?

Let’s look at it a few ways…

a) Assuming it opens at $14.50, the stock is trading at 12.3x this year, and 8.7x next year. On this year, it’s probably fair. On next year, very cheap.

b) At that same price, we’re looking at 5.1x and 4.5x EBITDA for ’11 and ’12x

c) We know that stocks don’t trade on break-up values, but given the fact that numbers are a moving target, we think we should look at things in broader context. We’ve got PLG generating about $1bnm in revenue and $90mm in EBITDA. These businesses are growing in the mid-teens at a minimum, and we think that 8x EBITDA is fair multiple. That gets us to a $720mm value. The total EV for PSS, however, is $1,278. That suggests that  the core business is being valued at $558mm, or 3.1x EBITDA, with an equity stub of $2.70.

 

In the end, numbers are coming down and the stock is cheap – but that’s not enough. 4x and 5x EBITDA is low, but why not 3-4x? There’s no reason why not while earnings risk remains. The good thing is that Rubel will make the changes he has to – even if they are severe. We’re not inclined to sell into the puke with the rest of the herd. But rather wait and see where estimates shake out for the quarter and the year, and get a sense as to whether people are negative for the right reasons.

 

PSS: To Puke, or Not to Puke? - PSS ModelAssmpts 5 11

 

PSS: To Puke, or Not to Puke? - PSS S 5 11

 

 




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Hong Kong is Not Mainland China

Conclusion: The combination of slowing growth, accelerating inflation, and a property bubble that will either pop or continue to be addressed from a policy perspective has us bearish on Hong Kong equities over the intermediate-term TREND.

 

Position: Bearish on Hong Kong Equities for the intermediate-term TREND.

 

Of the limited push-back we have received on our Year of the Chinese Bull thesis, the off-limits nature of the Shanghai Composite Index to many foreign institutional investors appears to be among the most concerning. While it’s certainly true that capital controls prevent many funds from taking direct ownership of mainland Chinese equities, we don’t necessarily agree that the Hang Seng is always a safe substitute for your investment allocation to Chinese stocks.

 

While history shows us both indices tend to move in tandem, registering a positive correlation of r² = 0.77 over the last 20 years, further analysis shows that Hong Kong can indeed sucker punch investors looking for surrogate exposure to China. Pulling back a historical chart of the Shanghai Composite vs. the Hang Seng, we do find two periods where Hong Kong equities experienced major bear markets while Chinese equities either remained flat or appreciated slightly: 

  • During the period from August 6, 1997 to August 11, 1998, the Hang Seng Index lost (-59%) of its value while the Shanghai Composite gained +3%. Admittedly, the events of the Asian Financial Crisis, in which the Hong Kong Monetary Authority (HKMA) was forced to aggressively defend the Hong Kong dollar from speculators, contributed to this large negative divergence.
  • During the period from March 27, 2000 to September 18, 2001 the Hang Seng Index lost (-49.1%) of its value while the Shanghai Composite gained +1.3%. As in the example above, special circumstances contributed to the Hang Seng’s drastic underperformance; a confluence of selling pressure from the HKMA unwinding the positions it took to support the market during the height of the Asian Financial Crisis, the SARS epidemic, and the Dot.com bubble bursting all played a role in the aforementioned bifurcation. 

Hong Kong is Not Mainland China - 1

 

Net-net, while we certainly agree that exogenous events have played a role in historical bifurcations of Hong Kong’s equity market performance from mainland China’s equity market performance, we think the simple point we are trying to make is clear enough – Hong Kong is not mainland China. On occasion, macro fundamentals have the ability to create incredible divergences in equity market performance over sustained periods of time. As such, we have been and will continue to analyze each market on its individual merit, rather than accepting them as a package deal.

 

On an individual basis, the fundamentals of Hong Kong’s economy do not warrant being long its equity market. From a growth perspective, Hong Kong’s GDP growth is slowing; the monster +7.2% YoY number in put up in 1Q (+170bps above consensus) only augments our call for a measured decline in the YoY growth rate of Hong Kong’s economy over the intermediate-term TREND.  From an expectations perspective, a slowdown is already built into the models of both Hong Kong policy makers (+5-6% YoY in 2011) and sell-side economists (+5.4% YoY in 2011 according to Bloomberg consensus estimates).

 

We do, however, question whether the magnitude of the slowdown is accurately reflected in current estimates. If the slope of Hong Kong’s yield curve is telling us anything, it’s that perhaps growth is slowing more than what is already baked in from an expectations perspective.

 

Hong Kong is Not Mainland China - 2

 

Additionally, having declined (-6.8%) from an intermediate-term lower-high on April 8th, the Hang Seng itself might be its own best leading indicator. Our quantitative models have it broken from an immediate-term TRADE perspective and demonstrably bearish from an intermediate-term TREND perspective, which tends to suggest risks to economic growth are mounting.

 

Hong Kong is Not Mainland China - 3

 

Over the intermediate term, we flag inflation as the main risk to growth in Hong Kong. Early in the year, we made the research call that CPI in Hong Kong would accelerate and surprise investors to the upside, as the combination of easy credit (+31% YoY in March) and cash handouts totaling HK$6,000 to each permanent resident (in response to at least four major demonstrations protesting inflation) fuels demand-side price pressures, while the confluence of exorbitant property prices (+22.2% YoY in March) and higher commodity prices (CRB Index +34.6% YoY) fuels supply-side cost pressures.

 

As of April, CPI in Hong Kong hit a 32-month high of +4.6% YoY and our models have further upside over the intermediate term. The HKMA agrees, as evidenced by the recent upward revision of their full-year inflation forecast to +5.4% YoY from a prior estimate of +4.5% YoY. The sell-side has been slow to react, maintaining their +4.5% YoY forecast for Hong Kong’s 2011 CPI since late March (Bloomberg consensus estimates). All told, we expect higher rates of inflation to detract from Hong Kong’s economic growth over the intermediate term by slowing Household Consumption (~62% of GDP) and ratcheting up the GDP Deflator by which real growth is calculated.

 

Higher inflation, particularly in the property market, brings us to our third key reason for being bearish on Hong Kong equities over the intermediate-term TREND – macroeconomic policy. As mentioned before, property prices are indeed a major problem for Hong Kong consumers, as well as a major risk for Hong Kong’s banking system and economy at large.

 

According to proprietary data published by Centaline Property Agency, Hong Kong’s largest private real-estate broker, home values have surged +70% since the start of 2009 and are now at an all-time high. Their data has Hong Kong home prices +3% greater than the prior peak reached just prior to the Asian Financial Crisis. While our data has Hong Kong housing prices per square foot at “only” (-7.7%) below the prior peak on a nominal basis, the pace and magnitude of the recent run-up is similar across data-sets.

 

Hong Kong is Not Mainland China - 4

 

As a result of this liquidity-fueled surge in property prices, in large part due to purchases by mainland Chinese buyers, Hong Kong now ranks dead last in the world (325 out of 325 major urban markets) on the metric of housing affordability, with the territory’s Median House Price at 11.4x Gross Annual Median Income. Government efforts introduced in November which included, among other things, a levy designed to discourage speculative transactions, have done little to cool the rapid inflation in Hong Kong’s housing market. On a YoY basis, growth in residential real-estate prices has bounced around in a tight range since the measures were implemented last fall.

 

Hong Kong is Not Mainland China - 5

 

As recently as April we have, however, seen signs of cracking in this market, with the volume of transactions declining (-37.6%) YoY (a 25-month low) and the prices of those transactions falling (-26.8%) YoY (a 10-month low). While we need more data to accurately determine whether this is the start of a startling trend in Hong Kong, on an absolute level, the data is what it is – the first indication of property market weakness in quite some time. 

 

Despite this one-off sign of cooling, the HKMA remains vigilant in dealing with this issue – at least from a rhetorical perspective (the HK$’s peg to the USD prevents the de facto central bank from raising rates). As such, Hong Kong authorities remain limited in their policy options to deal with this issue, currently opting to run the “central banking 101” play of notifying the market that it is “watching price developments closely”.

 

Hong Kong is Not Mainland China - 6

 

One of the more tangible things they can do in the near term to curb credit growth and mitigate the financial impact of a potential wave of defaults is by forcing Hong Kong’s banks to build reserves. While we believe that it is perhaps too early to call for a major property market bust in Hong Kong, we do not think it’s too early to start calling out the downside risk to Hang Seng earnings based on the likelihood of future reserve ratio hikes. Currently, the index is overwhelmingly weighted to the Financials (banks, real-estate developers, and insurance companies combine to equal 56.2% of the Hang Seng’s market cap.), so weakness in this sector has the ability to drag down the rest of the market on beta alone.

 

Hong Kong is Not Mainland China - 7

 

All told, the combination of slowing growth, accelerating inflation, and a property bubble that will either pop or continue to be addressed from a policy perspective have us bearish on Hong Kong equities over the intermediate-term TREND. As the title aptly points out, Hong Kong is not mainland China.

 

Darius Dale

Analyst


Is There A Silver Lining In Housing?

This morning U.S. new home sales were reported for the month of April and rose 7.3% month-over-month, climbing to 323K versus 301K in March.  Initially, this was treated as a positive data point by the market as the Homebuilding Index, represented by the ticker XHB, was trading up almost a percent in early trading.  Unfortunately, despite marginal sequential improvement, the April number is representative of a continuing bleak long-term trend.   

 

As outlined in the chart directly below, while the months of supply dropped to the second-lowest level since 2006, it is still well above the long term range of 4 – 5 months. 

 

Is There A Silver Lining In Housing? - 1

 

Further, our Financials Team has authored a long-term displacement theory as it relates to new home sales.  In effect, the theory postulates that because of the massive over-building that occurred, it will take a commensurate period of under-building to bring the market back to equilibrium. According this analysis:

 

“In May of last year the government reported that new home sales came in at a 300k annualized rate (seasonally adjusted), which was the lowest rate of new home sales ever recorded since the data series began in 1963. Based on our cumulative displacement model, new home sales would need to remain at 300k for approximately the next 10 years in order for this cycle to fully play out and be consistent with the prior three cycles.  The green circle shows where we were a year ago on this chart, and the yellow circle shows today.”

 

The chart below highlights this analysis and the cumulative time until the new homes market will be back in balance.

 

Is There A Silver Lining In Housing? - 2

 

The new home market is, of course, only a small part of the overall housing market.   In fact, based on the most recent annualized monthly numbers, new home sales are roughly 6% of the overall market.  Therefore, even if we are seeing marginal sequential improvement in new home sales, it is not necessarily indicative of any real change in the housing market.  In fact, the existing home market is likely a much better indicator of where new home sales are going than vice versa.  In the existing home market there is definitely no silver lining.

 

The April numbers for existing home sales was reported last week and were down -0.8% from March to an annualized number of 5.05MM home sales.  At the same time, inventory jumped, as reported by the National Association of Realtors, to 3.87 million homes on the market, which is a +9% increase compared to March.  On a months-supply basis, inventory rose to 9.2 months from 8.4 months in March.  

 

 The impact of this large amount of inventory is, logically, that home prices continue to decline absent a commensurate build-up in demand. The median price of an existing home was $163,700 in April, once again according to the National Association of Realtors, and down -5% versus a year ago.  The year-over-year decline moderated slightly in April compared to the -5.9% decline in March.  Since the series is not seasonally adjusted, sequential changes are not meaningful in analyzing price. 

 

The other key metric we watch, which will be reported for the most recent week tomorrow, is mortgage applications for new home purchases.  This is one of the best measures for future home purchases and it dropped -3.2% week-on-week last week, though did tick up +2% year-over-year.  The chart below shows the long term trend in mortgage applications, which suggests what we already outlined above, which is that housing demand remains quite weak, despite mortgage rates at near all-time lows.

 

Is There A Silver Lining In Housing? - 3

 

As a potential bright spot, our Financials Team also recently noted the following:

 

“Purchase apps for 2011 YTD are 5% below the full-year average for 2010, but are down 17% YTD vs. the comparable period last year.  Given that the next few months will mark easier comps as we lap the post tax-credit doldrums of summer 2010, it's looking possible that overall demand may be close to flat in 2011 relative to 2010. Should demand start to stabilize, this would mark a definite positive inflection from the secular falling demand trend that's been in place since 2005. Recall that our home price model is driven by 12-mo lagged demand.”

 

If the purchase applications do turn, this would indeed be an inflection point and something to keep front and center as a way to gauge an improving housing market, but so far any turn is minimal at best.

 

Also on the negative side of the ledger is the current debate and discussion over the Federal Housing Authority in Washington.  The Republicans circulated a proposal Monday that proposed to both increase the size of down payments from 3.5% to 5%, and to also decrease the size of the loans.  The issue is scheduled to be discussed Wednesday at a House Financial Services subcommittee hearing led by Rep. Judy Biggert (R-Ill.).

 

Despite the sequential pick-up in new home sales, we still don’t see a silver lining in the U.S. Housing Market.  As Housing Headwinds continue to percolate, that also supports our Q2 Macro Theme titled Indefinitely Dovish which postulates that the Federal Reserve will keep rates lower longer than investors expect.

 

Daryl G. Jones

Managing Director



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