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Intellectual Honesty

This note was originally published at 8am on May 20, 2011. INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK (published by 8am every trading day) and PORTFOLIO IDEAS in real-time.

“I think we are very good at intellectual honesty.”

-Seth Klarman

 

I was flying to Kansas City from Denver last night and an outstanding interview in the Financial Analysts Journal bubbled up to the top of my pile – an interview with one of the world’s most thoughtful Risk Managers, Baupost’s Seth Klarman.

 

“We actually hire for intellectual honesty. In an interview, we work hard to see whether people can admit mistakes. We hold our people accountable to that standard.” (Klarman, “Ahead Of Print”, 2010 CFA Institute)

 

Accountability. Honesty. Standards.

 

That works for me and, from what I can tell, it works for a lot of our clients who understand that there is a difference between running a P&L and running a business. There’s a difference between rigorous research and disciplined risk management too. The best teams in this business do both.

 

“We have all our own money invested in the firm, and so we are very conservative. We have picked our poison. We would rather underperform in a huge bull market than get clobbered in a really bad bear market.” (Klarman, “Ahead Of Print”, 2010 CFA Institute)

 

Ownership. Preservation. Conviction.

 

Those principles work for me too.

 

“We ask people, what is the biggest mistake you’ve ever made? It’s a very open-ended question because it’s not solely an investment question, although prospective hires often answer it as if it were.” (Klarman, “Ahead Of Print”, 2010 CFA Institute)

 

Introspection.

 

Back to the Global Macro Morning Grind

 

In the face of awful US Economic data yesterday:

  1. CONFIDENCE: Bloomberg Weekly Consumer Comfort Index dropped to a fresh YTD low of -49.4 vs -46.9 last week.
  2. HOUSING: US Existing Home Sales  fell -0.8% for April, dropping from 5.09 million in March (seasonally adjusted annualized) to 5.05 in April.  This is a sharp divergence from the March Pending Home Sales, which increased 5.1% month-over-month.
  3. GDP GROWTH: US Leading Indicators for April were down (0.3%) sequentially vs. +0.7% in March (the sharpest decline in well over a year)

And … with the US Dollar down on the day… the inverse relationship (The Correlation Risk) between Fiat Fool policy and stocks continued to hold (USD down = stocks up). The US stock market was able to hold a +22 basis point gain. With the SP500 closing at 1343, it’s down -1.5% from its April 2011 YTD high, and down -14.2% from its October 2007 all-time high.

 

You mean, on alarmingly low-volume, the mistakes we’ve all made between late 2007 (where I got bearish too early) and early 2011 (where consensus has been too bullish on US Growth) has only equated to lower immediate-term and long-term highs in US stocks? Yep. This special case of making lower-highs in stocks has been occurring in Japan since 1992. Big Government Intervention has its perks.

 

No matter where I go this morning, the entire risk management community can see all of my mistakes. My current mistakes are attached at the bottom of every morning’s Early Look (my biggest mistake on the long side is currently Suncor (SU) at -5.3% and, on the short side, Consumer Staples (XLP) at -2.9% against me). My longer term mistakes are all time stamped on our website and on the back of my ankle.

 

Transparency. Accountability. Trust.

 

These are principles that plenty of politicians give lip service to. In real-life, they are extremely hard to achieve. I don’t think my firm is there yet, but I do know that the people I have working with me have Intellectual Honesty – and in terms of re-thinking industry standards on independent research, I think we’re well on our way.

 

My immediate-term support and resistance ranges for Gold, Oil, and the SP500 are $1480-$1502, $95.16-$100.91, and 1324-1358, respectively.

 

Best of luck out there today,

KM

 

Keith R. McCullough
Chief Executive Officer

 

Intellectual Honesty - Chart of the Day

 

Intellectual Honesty - Virtual Portfolio



Distributing The Future

“The future is here. It’s just not evenly distributed yet.”

-William Gibson

 

Speculative-fiction author Bill Gibson is my kind of guy – he’s an American-Canadian. He also likes to make up his own terms for things and put himself out there with contrarian predictions about the future.

 

I’m currently in the middle of reading “The World In 2050” by Laurence Smith (excellent research read on resource risk, demographic risk, etc). In the very first chapter of the book, Smith gets your attention with the aforementioned Gibson quote and another by Niels Bohr.

 

Making market “calls”, or proactively managing risk around the edges of this globally interconnected marketplace, isn’t as hard as people crack it up to be. Sure, the daily grind is hard - but the data is there.

 

The future of Global Macro Risk Management is here.

 

Getting what people in this business used to call “edge” doesn’t come without orange jump suit risk. Ask The Raj about that. In economic cycles that are being shortened by Fiat Fool policies, the future of Risk Management Edge is going to be grounded in getting TIME and PRICE right.

 

To do that, in today’s marketplace at least (and this will change), you really need to get The Correlation Risk right.

 

To get The Correlation Risk right, you need to get the US Dollar right. To get the US Dollar right, you need to get monetary policy right. To get monetary policy right, you have to grind (or buddy up with The Gopher).

 

If the future was evenly distributed, you wouldn’t be seeing these massive moves in asset classes from quarter-to-quarter. It was only 6 months ago that Hedgeye had a Global Macro Theme called “Trashing Treasuries” (as in short them). Today, one of my highest conviction positions is long the long-bond (TLT). And in 3-6 months, I am sure that will change too.

 

What if you don’t change? What if you haven’t evolved your risk management process since 2008?

 

Dagny Taggart probably has a few answers for us all to those questions. My simple one is this – if you don’t evolve the process, you’ll lose. And I don’t mean lose whatever moneys you’ve made. I mean you’ll lose your confidence in making emotionless decisions. You’ll lose the conviction that it takes to change your mind.

 

So what is my Global Macro Risk Management process flagging this morning?

  1. Vietnam is the first Asian Equity market to crash – down -4% last night and down -20.5% since May 4th
  2. Japan continues to resemble the Big Government Intervention train wreck that bailout beggars in America want our markets to be
  3. Chinese equities have once again broken their intermediate-term TREND line of support (2811 on the Shanghai Composite Index)
  4. Indian stocks were down another -0.7% overnight to -12.8% YTD and remain one of our best Macro short ideas in 2011
  5. South Korean and Australian Equities have moved to bearish TRADE and TREND in our model – nasty signals for Global Growth
  6. Pakistan was up overnight, hooray
  7. European Equities are starting to look as ugly as their socialist policy to keep Greek and Portuguese bond markets ticking
  8. Germany, which we like, doesn’t look good
  9. Sweden, which we like, doesn’t look good
  10. Spanish and Italian Equities have broken their TRADE and TREND lines (this is new – in Q1 they were bullish on both durations)
  11. Russian stocks have broken their intermediate-term TREND line on the RTSI of 1964 – bearish signal for The Petro Dollar markets
  12. The Euro is testing and intermediate-term TREND breakdown of $1.41 TREND line support
  13. The US Dollar has moved to bullish immediate-term TRADE – what was big resistance at $74.41 is now big support
  14. US stocks have been down for 3 consecutive days and 4 consecutive weeks
  15. TREND lines in the SP500 (1321), Nasdaq (2794), and Russell2000 (826) are all broken as of last price
  16. Only 3 Sectors in our S&P Sector Risk Management Model are bullish TRADE and TREND (Healthcare, Utilities, and Staples)
  17. Volatility (VIX) is bullish on 2 of our 3 core durations (TRADE and TAIL), with a big breakout line at 18.04 daring you to buy the dip
  18. US Treasury Bonds look awesome – as in awesome bullish

Awesome is as awesome does. That’s the future. It’s here. And it’s our job to manage risk around it.

 

My immediate-term support and resistance ranges for Gold, Oil, and the SP500 are now $1 (bullish), $96.98-100.93 (bearish), and 1311-1321 (bearish), respectively.

 

Best of luck out there today,

KM

 

Keith R. McCullough
Chief Executive Officer

 

Distributing The Future - Chart of the Day

 

Distributing The Future - Virtual Portfolio


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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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