If URBN holds onto the current trajectory in this graph for much longer, it will be setting new records for apparel retailers. We're not calling the bottom, but bottoms are processes, not points. In other words, it might be forming one now.
We expect a solid Q3 out of FL Thursday. Despite the overhang of NBA related headline risk, the already-anemic basketball category actually improved on the margin, and overall industry sales appear to have accelerated throughout the quarter. The latest NPD data which is a component of our (statistically-valid) comp predictive model, supports our above consensus view.
We’re at $0.46 for FL on a comp assumption of +7.5% for the quarter headed into Thursday’s print, which is ahead of the Street at $0.39 and +5.3% respectively. We’re increasing our comp assumption to +7.5% from +6% based on stronger sales coming through in October. Through the first two months of the quarter, the Athletic Specialty channel was tracking up +3.1% -- well ahead of the total industry -- which had been tracking up +0.8%. With the Athletic Specialty channel tracking ~200-400bps ahead of aggregate weekly numbers we took up our estimates as October came in closer to up +2% as reflecting in the weekly data.
It’s important to note that weekly footwear numbers reflect the broader industry sample and therefore understate the underlying sales performance in the athletic specialty channel that most accurately reflects sales at athletic retailers such as FINL, DKS, HIBB, and FL in particular given its contribution to the sample set. October data out today confirms continued outperformance in the athletic specialty channel, which came in up +4.8% compared to the broader industry up +1.2% right in-line with our expectations.
In light of sales coming in stronger at quarter end, we have increased our GM estimates to 160bps over last year driven by +100bps in occupancy leverage and 60bps from merchandise margin, which may prove conservative as well a 5% increase in SG&A to support more active marketing efforts. This equates to EPS of $0.46 for the quarter up from our previous $0.42 estimate and $1.83 for the year vs. consensus at $0.39 and $1.72.
While we have been incrementally less bullish on the stock up here north of $22 given the near-term headline risk associated with the pending NBA strike, we expect the stock to maintain its underlying momentum when it reports results Thursday. With the stock currently trading at 12.5x and 11x our F11 and F12 EPS estimates respectively and below its historical average of 13x-15x, we would be looking to get more constructive on any weakness.
Conclusion: Price and issuance data out of Latin American credit markets suggest a more negative outlook for regional economic growth than do equity markets. Additionally, this week’s data analysis contains a handful of supportive nuggets for our King Dollar thesis.
Latin American equity markets were mixed last week, closing up +0.6% wk/wk on a median basis. The divergence between the three largest economies was striking: Mexico +2.4%; Brazil and Argentina down -0.2% and -0.4%, respectively. Mexico appears to have benefitted from some better-than-expected U.S. economic data last week.
The action in Latin American currency markets was a bit more muted, closing down only -0.1% wk/wk on a median basis. The Brazilian real outperformed, closing up +0.6% wk/wk.
There were a few notable moves across Latin American sovereign debt markets, headlined by the -26bps wk/wk drawdown in Brazil 2yr yields. Mexico, which got a bid largely due to the aforementioned factors, saw their longer maturities back up +18bps and +23bps on the 10yr and 30yr tenors, respectively. We saw similar divergences across Latin American interest rate swaps markets as well: Brazil -20bps tighter on the 1yr tenor; Colombia +35bps wider on the same maturity.
5yr CDS signaled a fairly dramatic heightening of risk across the region, widening +13% wk/wk on a median percentage basis. Keith has been vocal about the widening divergence between the credit markets and equity markets globally and our research, Virtual Portfolio, and Asset Allocation positioning all suggest we think the credit markets will continue to lead the equity markets down the road to perdition.
THE LEAST YOU NEED TO KNOW
Rather than delineate these data points by country, given the varying size and importance of these economies, we thought we’d try something different by grouping them by theme. Ideally, this should make it easier to absorb and contextualize anything of significance. Lastly, the callouts below are from the prior seven days:
Global Growth Slowing:
Deflating the Inflation:
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The JCP print was yet another event boosting our confidence that there is a severe duration mismatch between expectations for most institutional investors vs. Activists, vs. Management. We think that understanding the different durations is especially important with JCP given that it is a reasonably well-hated name (22.4% of the float is short) in retail with management incrementally investing capital into the model to transform the business.
In other words, the Street is beating up the company for doing the right thing. Usually, we love stories like this, as they tend to lead to share gain and margin growth on a disproportionately smaller operating asset base. This was RL, LIZ, NKE, to name a few. And yes, we think that it will ultimately be JCP as well.
But as we’ve been saying since our July 28th Black Book (JCP: What the Ackmanists are Missing), before JCP becomes the best stock in the S&P, it’s likely going to be the worst stock in the S&P. The company is investing today to make changes. But as Johnson openly states, he needs to completely overhaul this company to make it ‘America’s Favorite Place to Shop.’ JCP has bad real estate where it is captive to mall traffic, below-average brands, very little pricing power despite its clout – even at the factory level given its near-vertical positioning, and a competitor in KSS that simply has better stores in just about every way, and as of this year reached 50% overlap with JCP as it relates to footprint (stores within a 5-mile radius).
Unless you are blessed with a mandate to Outperform over a 7-year time period (like Ron Johnson is), the biggest thing to consider with valuation is that it takes a distant back seat to actually understanding what the earnings levers are, and how and when the company gets there.
Let’s look at them over several durations.
TRADE (3-Weeks or less): JCP’s 4Q guidance is absolutely not a slam dunk. With Ullman getting up there and saying that comps will be flat to positive slightly and GM% will be flat to down slightly after six quarters of inventory growing an average of 5% faster than sales – we can’t simply give this company a free pass there. Here’s another consideration, in looking at year/year discretionary spending, over the past six months we’ve had a positive influx of 4-5%spending in non-essential categories on the part of the consumer. For the next five months – barring a collapse in oil or the unemployment rate – we’re looking at -2-3% yy. That’s a -5% sequential turn, and like most retailers, there’s very little chance that JCP can avoid this. We’re still shaking out below $1 in EPS assuming a 2% decline in comp compared to the company’s guidance of $1.05-$1.15 in Q4.
In the end, it’s easy for Ullman to throw out targets to the Street…because he won’t be on the call in January to defend why he missed.
TREND (3-Months or more): Ron Johnson will be coming out of his protective shell in late January at an analyst meeting in New York. That’s where he’ll roll out his strategy for reinventing the company. We can’t imagine that people will walk away uninspired…but we also think that this is the market expectation right now. One thing that RJ cannot do is roll out his plan without telling everyone how much it will cost. That’s when we think there will be sticker shock.
Do we know the dollar amount? No. But in adding up all of what we think is deferred maintenance over time, we can get to a number anywhere between $1-3billion. I realize that’s a range wide enough to drive a truck through. But the reality is that he’s going to pick a number he thinks he needs, and then he’s going to gross it up to a number that he wants. There’s a difference. Again, his $50mm in warrants get him paid based on what happens 7-years out. He’ll has a free pass with the Board to take a whack out of CASH earnings (every $1 billion is $2.50 per share) to get the company to a best-in-class retailer.
Some will argue that people will look through any special charges. We disagree. Remember that Johnson has absolutely no problem disappointing the shorter-term agenda on the Street – as was the case in his early days at Apple – in favor of building long-term value. While we’ll be the first to admit that this is the right thing to do, the reality is that this is a MAJOR execution story, and there will be bumps and bruises along the way. Earnings will matter, and it will be tough to simply ‘look through’ such big items. All honeymoons must end at some point. Eventually, Johnson will not be viewed as ‘the guy from Apple,’ but rather ‘the guy at JCP.’
TAIL (3-Years or less): This is one where the TREND meshes with the TAIL, as the announcements will be near-term, the execution will be intermediate-term, and the results will be long-term. The problem here is that JCP’s definition of long-term is 7-years. Over ‘3-years or less’, which is our long-term duration, JCP is still likely to be in execution mode. It is unlikely too see any of the real benefits of Johnson’s actions until after 2015. In other words, it’s a long time away…
Positions in Europe: Short EUR-USD (FXE); Short France (EWQ)
Crowds cheered the news of Italian PM Silvio Berlusconi’s resignation and Mario Monti’s appointment on Saturday, however let’s not forget what’s left in the balance—public debt at 120% of GDP; pushback on austerity that will not help to curb the deficit; a technocrat government in which new elections aren’t scheduled UNTIL early 2013; debt maturities north of €200 Billion over the next 6 months; poor growth prospects that should result in declining tax revenue; worries about core Italian bank leverage to European sovereign paper; rising government bond yields increasing the cost to raise capital; and market participants looking for a quick fix to Italy’s (and the rest of Europe’s) problems with a quick flick of the wrist.
The Italian economy and more broadly European capital markets are going to need Super Mario to save the day—well frankly, we don’t think Mario squared (+Mario Draghi) can save the day. Don’t forget that we don’t have any major planned catalysts into year-end around which Europe’s unanswered questions: expansion (leverage) of the EFSF, bank recapitalization, Greek haircuts will be solved for.
Talks that China would come to Europe’s rescue have faded—not surprisingly given the less obvious benefit to them—and the expansion of the role of the ECB and IMF are still undecided.
Today, at her Christian Democratic Union party’s annual congress in the eastern German city of Leipzig, German Chancellor Angela Merkel told leaders they must create a “new Europe” by deepening ties in the 27-nation EU, yet reiterated her rejection of jointly sold euro bonds.
She said: “The task of our generation now is to complete the economic and currency union in Europe and, step by step, create a political union… It’s time for a breakthrough to a new Europe… If the euro fails, Europe fails.”
In response, we don’t want to discount the resolve of Eurocrats to maintain the Eurozone project—after all the last two years have proven this out well—however we do want to sound the horn that the credit markets are telling a very different story around the risk of this very project. And more rhetoric without action is going to see investors punish most European capital markets.
Our weekly European Risk Monitors are included below. We remain short the EUR-USD via (FXE), which remains broken TRADE ($1.37), TREND ($1.42), and TAIL ($1.40), and short France (EWQ) in the Hedgeye Virtual Portfolio. For more specifics on both positions, see our recent work on the Hedgeye portal.
European Sovereign Yields – European 10YR yields were mostly higher last week. Greek yields shot up 228bps, Spain +44bps, Italy +35, while Portugal declined -62bps and Germany -12bps. As always, we’re keying off the 6% Lehman line as a critical breakout line. Italy has held tight above the 6% for the last three weeks, currently at 6.57%.
In its SMP bond purchasing program, the ECB bought €4.5 Billion in secondary bonds last week (vs €9.5B in the week prior), taking the total program to €187 Billion. Look for Super Mario (Draghi) to increasing buying alongside heightening Italian yields.
European Sovereign CDS – European sovereign swaps mostly widened last week. Spanish sovereign swaps widened by 7% (+28 bps to 427) and French by 11% (+20 bps to 202).
European Financials CDS Monitor – Bank swaps were wider in Europe last week for 32 of the 40 reference entities. The average widening was 6.2% and the median widening was 11.5%. The German bank Bayerische Hypo- und Vereinsbank saw swaps widen by almost 30%. In addition, the four Italian banks we track saw swaps widen an average of 18%.
POSITION: Short SPY
My position on the long-term TAIL being broken is, at a bare minimum, consistent.
So is my process. I run a core 3-factor model to measure the range of risk – PRICE, VOLUME, and VOLATILITY. Friday’s VOLUME was -27% below my immediate-term TRADE duration average. That, combined with a Bullish Formation in VOLATILITY, is bearish for US Equities, from this price.
Across durations, here are the lines that matter most right now:
In other words, watch 1253 today/tomorrow very closely. We think the inflation data (US PPI and CPI) will come in higher than expected (Tuesday/Wednesday). That should keep Bernanke in a box, and upward pressure on the US Dollar.
Keith R. McCullough
Chief Executive Officer
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