This note was originally published
at 8am on September 08, 2011.
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“Half the world hates, what half the world does every day…Half the world lies, half the world learns…Half the world talks, with half the mind on what they say.”
– Neal Peart
To suggest that these lyrics by Canada’s son Neal Peart apply to Wall Street would be all too appropriate.
There’s the buy side half, and there’s the sell side half.
But even within those groups, there are the big guys – with a big sense of entitlement – such as the Morgan Stanleys, Citigroups and BofAs of the world who use the Fed as their piggybank at our expense. No, Hedgeye did not accept any TARP money and we won’t in 2012, either.
Similarly on the buy side there are the PMs and Analysts who have exclusive access to management teams to get inside info during ‘double secret one-on-ones’ at broker conferences.
And then there are the others who have to fight harder and rely on a tried and true investment process that will consistently generate positive returns across all durations without what we call “orange jumpsuit risk”. We’re proud to call many of them our clients.
But as for the big guys, especially on the sell-side-half, it’s pretty amazing that despite all the resources, access and clout, there’s still such absence of any rigorous quantitative modeling of earnings and cash flow.
This translates into what we’ll call ‘entitlement to grow’. It’s what the sell side seems to bestow ad nausea to virtually every company in (and out) of the S&P.
Sit next to any analyst – even someone considered halfway decent – while they’re building out a model. When plugging in a growth rate for a certain product, business line, or region, and ask them to build a bearish revenue case. The chances are that they’ll take revenue growth closer to zero.
Then what about gross margins? Maybe they’ll take them down a few basis points . . . let’s say 50bps.
As for SG&A, here’s the real kicker. Companies in retail give SG&A guidance – for the most part – as a percent of sales. That means, of course, that the sell side models it that way as well. But the guided SG&A ratios are simply the product of the company’s sales results from a largely predetermined SG&A plan. That sell-side “bear” will end up with margin deleveraging of around 50bps.
In reality (which is where we live) what happens if sales targets come in light – or heaven forbid – are actually down year on year?
SG&A is planned predominantly on a fixed basis. Roughly 60-70% of SG&A costs are headcount-related for the average retailer or brand. Then there’s another 10-15% that’s marketing and R&D. The remainder is largely corporate (i.e. fixed). Are these expenses pliable? Yes, in part. Some can be flat-out cut, even if they shouldn’t be. But those that are certainly take more time than the cadence of revenue recognition.
So what’s the REAL bear-case?
- Unemployment is still in the dog house, and there’s no near-term tax stimulus;
- Consumer spending – which is 72% of our economy – is down 1-2%;
- Zero percent 4Q GDP growth;
- ‘Essential Spending’ which includes housing, food, energy, etc… +2-4%; and
- Discretionary spending -5-7%.
If this is the scenario, can the Wal-Marts of the world do, ok? Yes they can, which is why WMT is one of our top long ideas. Nike, which has a structural advantage and is gaining share in a global duopoly in a GDP+ category? Definitely. Liz Claiborne, which has more asymmetric factors to outperform in a bad economy than almost anyone in retail? Yes.
How about JC Penney, which is…well…it’s JC Penney? Absolutely not. The other key losers are those that are posting unsustainably high growth rates today, like Hanesbrands and UnderArmour (even though the latter is a great longer-term story).
Whether a company wins or loses is one thing, but being fully represented in expectations is another. If JC Penney’s sales square footage is -1%, comps are down 3-4%, gross margins are down 100bps+, and SG&A is growing by 3%, does anyone want to guess what that does to EPS growth? Do the math, it gets you to something like -125% -- or some other meaningless number when EBIT is wiped out entirely.
Is that dude whose shoulder you’re watching over running any of these numbers? My sense is that he’s probably not. Actually, my opinion is meaningless when the flat-out fact is that the consensus is looking for EBIT to grow for JC Penney in the high single digits over the next year.
So Mr. Ackman, do you believe +8% or -125%. Not exactly a delta I want to be looking at in this tape.
There’s this little thing called leverage. It’s a wonderful thing on the upside (circa 2003). But unfortunately, today it’s looking like 2008 all over again.
If you’re not part of the right half, get there… fast…
Keith’s immediate-term ranges for Gold, Oil, and the SP500 are now $1779-1897, $87.51-90.73, and 1148-1207, respectively.
Brian P. McGough