“Even in his repetitive drills he had a way of making the mundane seem important.”
-David Maraniss (on Vince Lombardi)
That quote comes from an inspirational excerpt on page 212 of “When Pride Still Mattered” where David Maraniss boils down the deep simplicity of Lombardi’s coaching process. If you’re trying to lead a country, company, or family this morning, I confidently submit that consuming this perspective is well worth your time. America needs you, The People, to lead us out of this mess.
Vince Lombardi was “the football variation of a masterly novelist who could take the muddle of everyday life and bring clarity and sense to it, and allow readers to see, for the first time what was in front of their eyes all along. Bart Starr was on the edge of his seat, listening – getting it for the first time. All the crap was gone; this was right to the bone, simple, yet so refreshing and exciting.”
“Everything was accounted for, labeled, identified, put in order, fundamental and sound. You could tell that the coach believed in what he was doing. His tone of voice, his posture, his manner – it all made you believe. It all made sense.”
So let’s grind. This globally interconnected marketplace all makes sense – you just need to account for “everything”:
- US TREASURIES – across the curve, 2s, 10s, and 30-year UST yields are making fresh YTD lows this morning in the face of a very wrong bet by some of our industry’s losing teams that suggested there was US “credit risk” coming down the pike. Not today.
- US DOLLARS – had a breakout day yesterday, trading right back above an important line of immediate-term support ($74.11 on the US Dollar Index) as clarity on the “Debt Deal” found her way into the market’s currency expectations.
- US EQUITIES – not good folks; not good – but are you surprised? With “Debt Deal” being replaced by “Growth Slowing” in this morning’s headlines, many a macro market observer has come to realize that more than just US politics makes globally interconnected risk go round.
Perversely, since La Bernank has addicted the entire Institutional Investing Community to chasing yield, what’s good for America’s currency is quite bad, in the immediate-term, for stocks and commodities.
We’ve labeled this The Correlation Risk (USD up = stocks and commodities down). Sadly, Bernanke and Geithner have been negligent in addressing this massive tail risk to the American people when under oath.
So what do you do with that?
- Short the Euro
- Short European Equities
- Sell US Equity and Commodity exposure
People want “clarity” in this market place. There it is.
On yesterday’s proactively predictable opening market strength, I sold down my US Equity exposure in the Hedgeye Asset Allocation Model to 0%. That’s ZERO. Like my long exposure to European Equities – ZERO.
As of yesterday’s close, here’s how the Hedgeye Asset Allocation Model is positioned:
- Cash = 52% (up from 43% last week)
- Fixed Income = 18% (Long-term Treasuries and US Treasury Flattener – TLT and FLAT)
- International Currencies = 12% (US Dollar and Canadian Dollar – UUP and FXC)
- International Equities = 12% (China, India, and S&P International Dividend ETF – CAF, INP, and DWX)
- Commodities = 6% (Silver – SLV)
- US Equities = 0%
Now the Hedgeye Portfolio (14 LONGS and 12 SHORTS) is a different product obviously than long-only asset allocation. Neither of these products are perfect. No one’s risk management process in this business ever will be. We get that – but every move we make is based on a repeatable process that changes as the math does. And, believe me, the coach over here believes in what he is doing.
My goal is simple. I want to win. And my team will stand here alongside you on the front lines of Global Macro market risk, just as we did during the thralls of 2008, so that you don’t lose your hard earned net wealth. We don’t make excuses. We make moves.
Since January 2011, we have led the debate that Global Growth Slowing was going to equate to lower than expected US Equity returns. Every morning since, we have been banging the drums with our often Repetitive Drills to remind you what we are seeing and when.
That doesn’t mean I am going to own US Treasuries (TLT), Flatteners (FLAT), or Silver (SLV) forever. I could sell them all today and nothing will have changed unless I deviate from the process in order to make those decisions. If the process changes, I better know why. And I damn well better be able to explain it to my troops.
In a world where people have no reason to believe their country’s leaders…
In a world where politics trump objectively scored performance…
That’s the best we can do as leaders. We have to be accountable. We have to make sense.
My immediate-term support and resistance ranges for Gold, Oil, and the SP500 are now $1611-1637, $94.11-96.21, and 1, respectively.
Best of luck out there today,
Keith R. McCullough
Chief Executive Officer
EPS came in at $0.22 versus $0.23 consensus. The top-line numbers, as we expected were strong, but margins were weaker-than-expected and guidance for full-year EPS growth was as margin pressures were brought to bear on the company’s P&L. As we wrote this afternoon, there are other companies that we would prefer on the long side in casual dining, particularly given what we view as a lofty multiple for what TXRH offers investors.
Below is our Top Ten Takeaways from the quarter:
- The company’s top-line is healthy. Two-year average trends accelerated sequentially in the second quarter and accelerated in July versus the 2Q number also. For the first four weeks of the third quarter, comps were reported as +3.9%.
- Following a (average system) price increase of 1% in March, a further 1% (average) price increase has been taken to bring the store base up to 2% pricing on the menu. Despite this, traffic has remained strong and the comp overall, as pointed out above, seems to be improving through July.
- Later this month, the company will test an additional price increase of just over 2% at 19 locations. If successful, the hike could be rolled out system-wide next year if food costs remain at elevated levels.
- Despite this impressive top-line performance the comp growth has not been sufficient to offset the significant margin pressure brought on by commodity and labor costs.
- The company expects continuing deleveraging on the labor line due to new restaurant labor costs and higher investment in labor hours.
- The primary items that boosted the company’s cost of sales were proteins, cooking oil, butter, potatoes.
- The company anticipates increased inflationary costs, particularly around proteins, in 2012.
- New unit growth is set to accelerate in 2012 with 25% growth in unit openings versus the projected 20 company restaurant openings in 2011.
- This stock was priced for near perfection with a lofty EV/EBITDA multiple and, upon not delivering just that, is selling off sharply post-market. We do not expect this to be the last stock to do so this earnings season.
- Sell-side sentiment is certainly not bearish with zero sells on the stock and ~60% of analysts rating it a “Buy”. There is plenty of room for sentiment to swing.
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Conclusion: Growth in Japan is setup to slow meaningfully in 2H as a result of regulatory uncertainty, anti-growth legislation, and a good ol’ fashioned lack of enough demand to surmount increasingly tough comparisons. Moreover, we expect the BoJ to intervene in the FX market not too far beyond current growth-negative levels in the JPY/USD exchange rate.
Position: Short Japanese equities (EWJ); Short the Japanese yen (FXY).
Amid an unsurprising bout of legislative gridlock and proactively predictable, broad-based sequential accelerations in economic growth data, we’ve been quiet on Japan in recent weeks. Now, with a growing spate of “uncertainty” enveloping the global economy, we find it appropriate to revisit the secular trends we have identified within the context of our Japan’s Jugular thesis. Moreover, the research and risk management setups support being short Japanese equities and Japan’s currency, the yen. We identify levels and a few key catalysts below.
Regulatory Uncertainty is Depressing Growth
The hullabaloo around Prime Minister Naoto Kan’s eventual resignation continues to prevent the Japanese government from functioning at full speed; so much so that the Diet has yet to ratify legislation authorizing the issuance of ¥44.3 trillion ($575B) more JGBs to finance the FY11 budget – which began back at the start of April! The Ministry of Finance warns that they’ll have to begin restricting implementation of the budget as early as late September without a resolution of Japan’s own debt ceiling debacle. Much like in the U.S., we expect legislation to eventually be passed in time to avoid default; we also expect continued brinksmanship to weigh on consumer and corporate sentiment that has otherwise been steadily accelerating off the March/April lows. Barring a second extension, Japanese lawmakers have until the end of this month to figure it out (the current Diet session adjourns on September 1st).
Regarding the reconstruction effort, DPJ lawmakers have confirmed that the Japanese government plans to spend a total of ¥19 trillion ($246B) over the next five years to fund public disaster recovery efforts. Via two recent bills totaling ¥4 and ¥2 trillion apiece, as well as an additional ¥3 trillion in savings, ¥9 trillion of the total requirement has already been secured. This leaves an additional ¥10 trillion which is likely to be financed with higher taxes, according to official sources. A panel of the prime minister’s top economic advisors has suggested doubling the consumption tax to 10%, though the party remains reluctant to proceed with their suggestion, given that the last increase in 1997 sent the permanently-fragile economy into a recession. Raising the income tax and/or corporate taxes also remain viable outcomes.
Regardless of avenue, we see any moves by the Diet to raise taxes to this magnitude as incrementally bearish for Japanese growth over long-term tail, as the ever large government (deficit = 10.7% of GDP in FY11; debt = 212.4%) continues to swallow the economy whole. Nevermind the reconstruction story, even prior to the earthquake/tsunami, the Finance Ministry had already officially proposed that the consumption tax be doubled by “at least the middle of the decade” to cope with fast-rising social security costs (~30% of total expenditures). Public rebuilding efforts only speed up the timeline and increase the magnitude by which anti-growth fiscal policy must be implemented over the long term.
Uncertainty surrounding future energy policy is also slowing Japanese economic growth on the margin. Energy reform, which is the second of the two remaining pieces of legislation that Naoto Kan must see passed prior to resigning (the deficit-financing bond bill is the other), remains a key topic of contention in Japan and supports our view that Kan might remain in charge well into 2012 – despite his lowly 17.1% approval rating. Kan seeks to have Japan procure 20% of its energy needs from renewable energy by 2020 – up from around 1% currently. No details have been given surrounding how the world’s most heavily indebted sovereign entity plans to pay for such a broad-sweeping initiative.
The uncertainty here is a negative near-to-intermediate-term catalyst because it: a) potentially delays the timeline by which Japan’s nuclear plants come back online (currently 38 of Japan’s 54 reactors are either idle or offline); and b) it casts uncertainty amid Japanese manufacturers on whether or not Japan will have enough power supply to meet their production plans over the long term. Such ambiguity is already weighing on corporate decisions to invest in Japan, as a recent Cabinet Office survey shows the percentage of goods Japanese manufacturers plan to produce outside of the Japan by 2015 jumped +340bps YoY to 21.4%.
This secular shift would be incrementally exacerbated if Japan has any hiccups meeting its energy needs over the next 6-12 months as planned blackouts force consumers and corporations to slow energy use. According to Bloomberg calculations, 40 of Japan’s 54 reactors will be offline undergoing scheduled maintenance in August and it remains to be seen if the political will is there to quickly bring them back online. We’ve already seen Japan’s unemployment rate tick up +10bps in June to 4.6% - a noticeable and meaningful increase, given that Japan’s ever-dwindling working age population keeps an artificial and deceptive lid on Japanese unemployment statistics.
All told, the combination of fiscal and energy policy uncertainty and the likelihood that any resolutions are likely to take the shape of anti-growth policy have us bearish on Japan’s economic growth over the intermediate-term TREND and long-term TAIL. Broken from a TRADE perspective, we think that Japanese equities are starting to reflect this reality while the incredibly consensus storytelling about “cheap valuations” and “reconstruction” falls to wayside of underperformance.
Our models point to a measured deceleration in Japanese YoY GDP growth in 2H and the fundamental setup supports that conclusion. Moreover, we expect the recent trend of accelerating sequential growth (MoM; QoQ) to come to an abrupt end shortly, as nearly 2/3rds of the lost manufacturing capacity resulting from the March/April disasters has come back online already in just three short months. The current risk management setup suggests investors are giving the Japanese equities the benefit of the doubt – at least for now.
Bank of Japan Intervention
At the current 77.09 per U.S. dollar and recently as low as 76.76 on a closing basis, the Japanese yen is once again in crisis territory for Bank of Japan (BoJ) officials. In fact, their latest Tankan Survey of 1,472 exporters show that Japanese corporations are, on balance, forecasting the yen to average 82.59 per dollar this fiscal year, which ends on March 31st2012. Since the fiscal year began back on April 1st, the JPY/USD exchange rate has averaged 80.96 – a full 2% above corporate expectations. As further strength in the yen begins to depress corporate confidence and profit growth, we expect the BoJ to take matters into their own hands by unilaterally selling yen in the FX market, just as they did late last summer (¥2.12 trillion from Aug. 28ththrough Sept. 28th).
As such, we have elected to front-run the BoJ by shorting the FXY this morning. Recent policymaker commentary supports our view here: Governor Masaaki Shirakawa said last week that, “[the strong yen] could have adverse effects on the economy as a whole through a decline in exports and corporate profits, as well as a deterioration in business sentiment when appreciation is caused by uncertainties about overseas economies”. To the latter point on sentiment, recent data shows that the cash holdings of Japanese corporations hit yet another high in 1Q (up +7.1% to ¥211.1 trillion) and we would expect to see further upside here as the strong yen weighs on intermediate-term profit forecasts. Additionally, Shirakawa affirmed comments made by deputy governor Hirohide Yamaguchi the week prior in saying that the BoJ would take “appropriate actions as necessary”.
All told, we don’t ever find Big Government Intervention necessary and would prefer to let free markets reflect their fundamentals. Given that free markets have all but gone extinct, however, we’ve chosen to front-run the BoJ by shorting the yen in our Virtual Portfolio for a TRADE. Game Policy or be gamed yourself.
We still think that most people won’t really be interested in LIZ until it’s a $10 stock. The opacity of the model is lifting, and the value is there. Get in while you can.
One of the knocks on LIZ, and reasons for its underperformance, has been strategic inaction at the management and board level – those days are gone. In addition to posting positive top-line trends and its first revenue growth in 5-years back when sales were twice what they are today, LIZ provided much welcomed clarity around some of its recent strategic initiatives. With the addition of greater visibility, as well as positive fundamental improvement across each of its brands, the catalysts are in place to drive shares substantially higher over the immediate-term TRADE (3-weeks or less) and intermediate-term TREND (3-months or more).
Management acknowledged that it does indeed have “several irons in the fire”, confirming a recent article that it’s shopping its MEXX business. The senior leadership team is also pursuing other potential asset sales with the intention to de-lever and substantially ‘de-risk’ the company by year end. While a sale is one of the near-term catalysts, a deal can only be considered speculation until it’s made public. So let’s focus on the facts:
1) The company added both sizing and timing around its actions to reduce Mexx’s underperforming store base and regardless of a potential sale, it’s much bigger than expected. The plan is to close 1/3 of Mexx stores (all in Europe) by the end of the first half of FY12 with 70 by the end of January and another 35-40 by the end of the first half of next year. This could amount to a $60mm reduction in operating losses according to our math (see below).
2) Another incremental change in the quarter was an additional $25mm in cost savings expected in FY12 from the sale of the last company-owned DC facility. Combined, we expect these steps to reduce SG&A margin by at least 500bps next year in addition to increasing confidence in the company’s ability to achieve EBITDA of $200-$220mm in 2012.
3) For the first time in over 3-years, every direct brand comped positively with Juicy, Lucky and Mexx all comping significantly better than expected. Perhaps most noteworthy, were the results out of Mexx with comps coming in at +3.6% and fall wholesale orders up 11%. The results reflect continued momentum in the turnaround of the company’s biggest variable business - which is now under way (accounting for roughly 1/3 of total revs and generating $90mm in operating losses each of the last two years). We’re the first to admit that when something comps down for long enough, it’s eventually going to hit rock bottom. But this is positive for LIZ nonetheless.
Juicy was probably the next biggest surprise with comps coming in flat, but is still expected to comp down slightly in 2H with the new product coming through later than expected. A significant reduction in inventories (down 9%) impacted margins in the quarter, but will be key to driving improved profitability in 2H. At Lucky, a rebound in the women’s business and strong denim sales, which account for ~60% of revenues, accelerated the top-line. Kate Spade, to put it simply, is crushing it. We expect continued strength in these two brands throughout the back half.
4) Due to Q2 results and incremental cost savings initiatives underway, the company reaffirmed its prior 2011 and 2012 outlook. The only change was in the confidence with which management spoke to Mexx’s profitability, shifting from a ‘hope/goal’ of EBITDA breakeven to stating that it would be breakeven “at a minimum” by 2012. In addition, it was suggested that Mexx could in fact post a positive operating profit next year (ironic statement just as it prepares for a sale), which is what we have modeled given the changes underway. Regardless of the company’s wordsmithing of what it hopes, prays, or expects EBITDA to be – we are still confidently modeling $235mm.
5) It’s impossible to ignore leverage, given our sense that it is the #1, 2 and 3 most relevant factors for investors when analyzing LIZ. In fact, debt increased this quarter to $769mm up from $716mm in Q1 due to the increase in Eurobond debt as a result of the foreign currency exchange as well as CapEx and restructuring. While we expect debt to increase further in Q3 due to higher working capital requirements, we should see a substantial reduction by year-end. In fact, the company expects debt at year-end to be below 2010 year-end levels ($578mm). In an effort to mitigate this overhang, the company is clearly looking to sell an asset (or two) that would accelerate de-levering the company and be a materially positive catalyst for shares. It is important to remember that this is not a capital intensive business, it is a working capital intensive business. When LIZ jettison’s Mexx, the removal of working capital drag will be disproportionately large relative to the parent company.
Bottom-line, with greater visibility and improving fundamental performance, we expect multiple expansion and greater interest in the name to drive shares higher from current levels. Shares are currently trading at 5.8x our 2012 EV/EBITDA estimates. Assuming a 6.5-7x multiple suggests 25% to 40% upside from here and an $8 to $9.50 stock.
We recognize that stocks don’t trade on sum-of-parts…but the reality is that the opacity of this model has been so intense for the past four years that most investors literally haven’t known what they’ve been buying. Now that the core Liz brand is stable and growing, the sourcing office is shuttered, retail stores are closed, Mexx is on the block, and DC is on its way out the door, people will see what they’re getting to a much greater extent.
We have included our current 2011 SOTP (which takes into account current debt of $768mm) as well as what 2012 could look like assuming $500mm in debt and modest multiple expansion across key brands. Keep in mind that the DKNY license rolls off at year-end in 2012 (it’s operating at a slight loss) and Mexx will most likely no longer be in the portfolio accounting for ~$1.50 in value from this analysis. That still leaves you with over $15 in value and significant upside from here. As bullish as we have been recently on LIZ, we are incrementally more bullish on the near to intermediate term outlook for the company.
Mexx Store Consolidation Analysis:
Here’s our Mexx store consolidation analysis and the impact it could have on the company and Mexx business. At Mexx Europe you’re looking at close to a 60/40 retail/wholesale split. Based on the assumption that 70 stores close by year end and another 35-40 in 1H 2012 with stores up to 10-12k sq. ft. (we used a 9k avg.) at an average sales productivity of $200 per sq. ft., we are looking at a $190mm hit to revenue on a base of ~$315mm. With consolidated Mexx sales productivity of ~$250 per sq. ft. (including Canadian retail), we discounted these stores at 80% of an underperforming European store base. The key takeaway here is the removal of ~$60mm in operating losses associated with these stores.
Texas Roadhouse reports after the market close. Price action in the name has been soft lately as casual dining has underperformed other categories within Food, Beverage and Restaurant sectors.
Our fundamental view of Texas Roadhouse is currently negative from a top-line perspective. While there has been an improvement in average check from an increase in price, the comp remains traffic-heavy. Traffic compares are increasingly difficult over the next three quarters. Given that TXRH’s customer is sensitive to elevated gas prices, it is possible that high gas prices, while declining through 2Q from an early May peak, could have impaired the company’s top-line. In terms of any commentary around 3Q, July saw gas prices gain 4.4% to $3.70 on a national average basis. The stock is currently trading at 7.5x EV/EBITDA NTM versus 8.3x when we penned our casual dining top-line snapshot on 7/20. Still, it remains the fourth most expensive stock in the casual dining space (behind BJRI, DIN, and BWLD) and we think there are better plays on the long side within the category, such as EAT at 6.5x.
The macro environment is certainly raising some red flags at the moment. Various economic data points, as well as 2Q earnings in general, have come in below expectations. We will be listening keenly to see if management alters its forward-looking statements.
Hedgeye’s quantitative setup for TXRH is bearish, as the chart below illustrates.
Below is a selection of forward-looking statements from the most recent earnings call and our take on each.
SALES TRENDS: “First quarter comps increased 4.6%, and the first four weeks of the second quarter have started off very strong as well, with comps up 5.4%. Increased traffic has been the main driver and we believe that's a result of continued market share gains. In addition, the pricing we took in March is flowing through which is very encouraging…we are also experiencing improvement in check, as our average check is running up a little over 1% after the increase we took back in March. Based on what we're seeing in terms of sales, we're comfortable assuming 3.5% to 5% comparable sales growth for the year, and combining this with operating week growth of a little north of 5% gets us close to 10% revenue growth for the year.”
HEDGEYE: TXRH saw strong sales performance during the first four weeks of the second quarter and, given the continuing strong numbers from Malcolm Knapp’s Knapp Track casual dining sales figures, we would expect that the strong sales performances continued for the remainder of 2Q. Management’s assertion that the price increase in March flowed through well in April is positive, but as the chart below illustrates, the concept has typically relied on traffic for top-line growth. Any shift in consumer behavior in the face of higher check prices could impair traffic growth in the face of tougher year-over-year compares going forward.
GAS PRICES: “that's where we're closely monitoring it [gasoline prices]. I think there's some delayed reaction to this stuff and we need to be very, very careful.”
HEDGEYE: On the margin, gas prices were less of a headwind during the balance of 2Q than at the time when management held the most recent earnings call (May 2nd). However, we will be watching for commentary about the ensuing bounce in gas prices through July and the concurrent softening of economic data.
NEW UNIT PERFORMANCE: “In addition to our comparable store sales continuing to grow, sales performance at our newer restaurants continues to outperform our existing restaurant sales. This plus the cost reductions we saw in overall development costs last year further validates our decision to build more restaurants this year and in 2012.”
HEDGEYE: The Company is planning to grow aggressively in 2012 and we believe that changes on the margin in commentary on new unit performance are important to watch.
COMMODITY COSTS: "We now expect commodity inflation to be higher than we had originally anticipated and believe that it is prudent to slightly revise our EPS expectations for the year.
For the quarter, commodity inflation was approximately 3%. Although we have seen some easing on some specific produce items, we are certainly anticipating these costs to be higher for the year than we originally forecasted. This is the driver behind us increasing our expectations for commodity inflation in 2011 from approximately 3% to approximately 4%, and thus we are revising our diluted EPS expectations as well."
HEDGEYE: Commodity costs remain elevated for TXRH, and we expect the company to highlight the drought in Texas and other events as reason for caution regarding their commodity basket.
EARNINGS EXPECTATIONS: "Margins remain our biggest challenge. We are anticipating that restaurant margins will be down this year, although it's too early to predict how much. This is primarily due to the commodity inflation as I've mentioned. Netting the potential for better than originally anticipated comparable sales with higher commodity costs led us to moderate our estimated EPS growth for 2011 from approximately 10% to 5% to 10%...I’ll tell you to get to the upper end of our EPS guidance we’d be hard pressed to get to the 10% side of that without any additional pricing within that 3.5% to 5% traffic."
HEDGEYE: TXRH would not be alone this earnings season if it were to miss lofty expectations. Given consumer confidence trends, the fact that gas prices remain elevated, the employment situation remaining dire and economic data softening quite substantially, we would think it quite risky for a traffic-reliant concept like TXRH to raise prices further in 2H11.
GROWTH: We are absolutely on track in accelerating our development plans for this year and for 2012…We are growing faster and our pipeline is larger as we are preparing to grow even more restaurants in 2012…While this results in higher pre-opening costs, we understand that the key to creating long-term shareholder value is to invest capital and assets earning a higher rate of return than what that money costs. That is good for our shareholders and very good for our teams, as growth creates opportunities, energy and excitement.
HEDGEYE: There is a long lead time for TXRH to indentify a site and progress through the preopening process but it will be interesting to see if management remains as bullish on growth today as it was in May and if new unit performance is holding up in the recent months.
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