No Current Positions in Europe in Hedgeye Virtual Portfolio
While yesterday European equity markets ripped ahead of today’s opening of the ECB’s first 3YR Long Term Refinancing Operation (LTRO) facility, with 523 banks expected to take up €489 billion in loans at 1% (vs initial estimates of €293B from Bloomberg and €310B from Reuters), European equities have turned down today and sovereign yields actually increased day-over-day. (Italy’s 10YR rose 20bps to 6.85%; Spain’s 10YR rose 6bps to 5.16%; and the Greek 10YR gained over 100bps nearing 36%!)
This is an initial indication that the LTRO will not be the panacea that the market had hope for yesterday. What a difference a day makes!
While we’re bullish on the LTRO as a facility to help reduce risk by providing more liquidity to European banks, we’d caution against an absolutist view that banks will be buying all European sovereign paper issuance going forward as they’ll stand to benefit from the carry trade, or spread. After all, these same banks have taken significant measures to sell their Europig debt holdings in the last 6-12 months. Why would they jump back in now?
A more likely scenario is one in which banks look to take care of their own houses first before looking to participate in sovereign bond buying. European banks have an estimated €230 Billion maturing in Q1, or around €720 Billion in 2012, to meet. In this light, we’d expect the ECB’s SMP secondary bond purchasing program to remain critical to arrest sovereign yields, especially in the periphery, despite mandates from the ECB that it is meant to be a temporary facility with limited firepower. To date, the SMP has purchased €211B.
In the face of the inability to lever up the EFSF and no change on the ECB’s position to print money, we do think the opening of ECB’s LTRO facility is bullish, yet we don’t think we’re going to cross some magic bridge that will firewall the major issues. We’ve yet to see one or a collection of definitive programs to really put an arrest to the sovereign and banking crisis in Europe. The Fiscal Compact of the December 8-9 Summit meeting still leaves a lot of questions unanswered, and the sovereign and bank downgrades of the ratings agencies (though lagging indicators) will continue to drag markets lower. Therefore, we do not expect to see sustained European capital market gains over the intermediate term.
We’d short the EUR/USD on any bounce to $1.33.
Fact…I was wrong headed into this quarter. My estimate was high by a nickel, as I thought that the company would start to show meaningful SG&A leverage and gross margin improvement (sequentially), which would offset a modest deceleration in top line.
This is one of those very rare instances where I’m cool with being wrong. Why? Both the top line and futures looked fantastic, and inventories improved on the margin. Our long-term TAIL duration call remains unchanged (see below). But as it relates to our TREND and TRADE duration, everything lives in changes on the margin. Those changes were net positive.
It was somewhat surprising that half of the Q&A focused on the company’s Gross Margin. Admittedly, this came in 60bp below guidance, and presumably about 100bp below Nike’s real internal plan. Some of this was FX, some was lingering labor cost pressures, some was clearance-related, but all was easily digestible intellectually. But what was amazing is that no one seemed to care that Nike is one of the very few (i.e. I can count them on one hand) multi-nationals that is actually printing such tremendous top line growth numbers – ie 18% for a $24bn company – in the midst of a global economic
slowdown. This is what happens when a company invests continuously in its business (i.e. over the past 3-years) when everyone else is harvesting and cutting costs.
As a kicker,
a) futures growth of 13% is more heavily weighted towards the back-end of the 5-month window,
b) this only partially reflects pricing increases that are in the midst of going into effect. In other words, futures will accelerate simply bc of pricing in 2H (this is one of the very few times in the better part of 15 years that I can recall the company having the confidence to actually guide futures), and
c) the company is looking at an outstanding event year, with assumption of the NFL license in April, European Football Championship (Euro 2012) , and the Olympics from July 25 to Aug 12.
d) rest assured, as we do, that these events will simply not come and go, leaving Nike with a tough revenue hurdle in 2013. The company will use each of them to build sustainable businesses to take share long after the games are complete. In fact, Charlie Denson noted several times that there are a few ‘surprises’ coming down the pike later this year. This is the same kind of posturing we saw around major launches like Air 180, Free, Lunar and Nike +. Again, these are platforms, not just products.
So, gross margins were definitely weak. But consider the following. Futures look extremely healthy. Futures lead revenue. Inventories improved sequentially. When those things converge, gross margins almost ALWAYS improve. The following two charts spell it out. And that’s not to mention the positive impact pricing is having on the equation, or the fact that we’re about
to anniversary meaningfully higher raw materials and shipping costs last year (labor costs continue to rise).
So what’s the punchline? Though the company missed our estimate by a nickel, we remain 15-20% above consensus for the next three years.
The biggest risk here is the ‘can things really get any better’ factor. Sales momentum is strong, margins are on the mend, inventory is coming down, the event schedule looks great, capital intensity is moderating, and Nike is showing greater focus in returning capital to shareholders. But the reality is that we don’t have to worry about that for another year – at least.
If the S&P 500 is your benchmark and you have to at least have an opinion on Nike, how can you afford to miss this? A bear case is very difficult to build.
Again, the crux of our call is that investors are underestimating both the duration and intensity of this growth story. We’re
looking at 3-years of 20% EPS growth after having lived through 3-years of 7.6% avg growth. We had a 3-year setup, now we’re in year 1 of harvesting and taking share. That’s not bad in this market by even the strictest of standards.
A lingering consideration for you…remember 3 quarters ago when Nike scared the Street and numbers came down by 15% across the board? Each quarter since the company has overdelivered, and guess where numbers are today? Yes, they are above where they were before the earnings scare became reality. Great example as to why you gotta keep the big picture strategy and motivation for compensation (i.e. to crush both competition and expectations simultaneously) front and center for this company.
Here are some of our notes from the call:
Footwear performance by category:
- Basketball up DD in the quarter
- Lebron 9 combines flywire and high perfused technology
- Running up DD in the quarter
NA continues to outperform:
- Growth driven by DD growth in every category except action sports which declined MSD
- DTC up 17%
- Store productivity drove 14% comp
- Online sales +16%
- Have yet to launch NFL product – April partial launch. Fall full force.
- Category offense now fully developed
- NA is most developed retail marketplace with own stores, wholesale partners and online
- Thanksgiving weekend
- In-line and factory stores delivered DD comp store gains
- Growth in part due to changes in shipping timing LY
- Fueled by growth in running, football, women’s training and basketball
- Partially offset by lower sportswear revenues
- DD growth in AGS territory (Austria, Germany and Switzerland) partially offset by declines in other territories
- EBIT margin decline due to unfavorable FX rates and higher product costs which more than offset DTC and higher pricing
- Remains a challenging economic environment
Central & Eastern Europe:
- Growth driven by higher revenues across all categories:
- DD running, football and men’s/women’s training
- DD growth in Russia, and turkey more than offset lower revenues in southern and central European markets
- Apparel +34% due to shift in timing from Q2 to Q3 of last year
- Apparel would have been up 20% excluding the shift
- Gross margins down due to higher costs and increased promotional activity to clear inventories
- Revs down 7% reflected holiday futures orders taken in immediately following the natural disasters
- Sales declines in most categories, running up DD
- Every category and territory posted higher revenues with Brazil, Argentina, Mexico and Korea driving the largest share of the growth.
- Revenue declines in 4 of the “other” businesses were offset by 20% growth in Converse
Gross Margins down 260 bps:
- Took more meaningful price increases in spring and summer
- Expected discounting to moderate but it did not which NKE expects to continue into 2H12
- Primarily due to higher products costs, partially offset by growth in DTC, moderate price increase in fall and holiday and benefit from cost reduction strategy
- Futures increased at a double-digit rate for all categories except sportswear and action sports which grew at a mid-single digit rate.
- Unit orders increased 7% while ASP added six points of growth (due to price increases that take effect in Spring and Summer 2012)
- Future order were more back weighted in the window due to price increases- did not see a significant change in unit velocity
Q2 Inventory growth:
- Nike inc up 35%
- 39% up on the Nike brand side
- 20 pts of the growth due to unit increase (vs. 34% increase in Q1)
- Remaining 19 points due largely to increased cost per unit
- Don’t expect costs to continue up or expect it to go down
- Spring 2011 was the peak
- Won't come down until the tail end of summer 2012
- “We continue to expect inventory balances to remain stable over the remaining quarters of the fiscal year with the rate of inventory growth declining sequentially and coming more in line with revenue growth by Q4”
T12Mo ROIC: 22.6%, up 1.4 pts YoY-
Free Cash Flow: Generated $360mm of FCF in Q2 and expect levels to normalize as inventory balances stablize
- Revenues: Mid Teens (due to Q2 results and future order)
- Q3 and Q4 revenues expected to grow slightly above the reported futures growth in 2Q
- Gross Margins
- Down 160 bps for the full year
- Down 150 bps in Q3
50 bps in Q4
- Material Costs
- Holiday 2011 and Spring 2012 seasons will reflect peak material costs seen earlier in CY2011
- Expect COGS to reflect lower material costs moving into Summer 2012
- Price increases:
- Spring and Summer 2012 price increases are more significant than those that have already taken effect
- SG&A Spend:
- Expect demand creation investment weighted in Q4 with operating overhead growth in Q3
- 24.5% tax rate expectation for the full year
- Q3 tax rate will be slightly higher
- 1 : FX is a big factor
- 2: in 2Q, expected to see an improvement in discounts which was actually flat and expect trend to
- Keeping discounting focused by had to move through some excess apparel in China
- Want to keep inventories clean
- 3: seeing strength in NA vs. international which has a mix shift to the downside
Converse China license:
- Positioned very differently than the Nike brand
- Have seen good steady healthy growth in FW in China
- Looking to build a good apparel base in China for converse
- Bullish on China and feel great about the brand
- Looking to be locally relevant while having the right brand at the right time
- Looking to get better on the apparel side- great appetite for apparel in the Chinesemarketplace
- Still more work to be done
- DC-pleased with overall performance
- Greenest building in china
- Have been short term hickups getting it up and raining but provides huge competitive advantages moving forward
Western Europe into 2012
- Certainly one of the more challenging geographies
- Keeping a sharp focus on inventories
- Large part of the impact on GM from FX in the quarter
- Most pleased with the performance product which is performing well
- Opportunity to get more market share on the sportswear side in both FW and APP
Direct to consumer:
- Seeing Stronger growth out of inline stores- both formats up on a comp store bases
- Strong growth out of digital as well
Western Europe futures:
- More acceleration in the back half due to events?
- European championships come at the end of the FY with olympics in FY2013 neither of which is reflected in futures
- Will see initial products go into market place in April
- Won’t see material impact until the Fall season
Price increases: Completely reflected in futures order already?
- Current futures number 7% increase in units, 6% increase value per unit
- Next futures window will be spring and summer and will reflect full impact from price increases
- Manage and measure sell through with wholesale partners to monitor reaction to price increases
- Thinking differently about pricing than in the past by season and expect to see improving gross margins improve in the long term
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THE HEDGEYE BREAKFAST MONITOR
Comments from CEO Keith McCullough
Another debt laden central plan, another short covering rally – Joy to the Levered World.
- CHINA – apparently the Chinese didn’t get the Institutional AM short covering memo (short red; chase green) – China looked more like Oracle’s guidance last night, losing another -1.2%, still in freefall at -22% YTD (Shanghai Comp). Remember, adding more leverage to the system structurally impairs Global Growth.
- LTRO – genius. brilliant. Right, right – for another short-term TRADE squeeze but piling another 498B Euros (monster #) in LTRO leverage onto this sick puppy is like lathering up tricky Dick Fuld a month before the blowup. This has both the DAX and CAC getting squeezed right back above TRADE lines of support (5809 and 3062, respectively) and I would not be short European Equities or the Euro here. EUR/USD mini breakout line = 1.31; waiting on 1.33 to re-short.
- SENTIMENT – the best thing about not running money is I get much better feedback on how people are really positioned. While its fashionable to say “everyone is bearish”, as of DEC the data no longer supports that qualitative claim (VIX anywhere in the area code of 21-23 is a very complacent signal and the II Bullish/Bearish Survey Spread just popped right back up to a 3mth high (to the Bull side) of +1800bps wide (last registered Dec 7th, before we swooned, again)
I have no European or US Equity Index/Sector shorts. I’ll say that’s plain lucky – because I didn’t see people hoping for this LTRO being the elixir of a levered life. Big risk management range in the SP500 of 1 is now the game that’s in front of us, so play that. Bullish TREND; Bearish TAIL.
MCD: McDonald’s Romania expects sales to top EUR 100 million this year, versus EUR 99 million in 2010.
WEN: Wendy’s is set to overtake Burger King as number two in the domestic QSR sales rankings. Sales at Wendy’s restaurants in the U.S. are on track, according to the Wall Street Journal, to be $8.42 billion or $53 million higher than Burger King’s this year .
"Alcohol is the anesthesia by which we endure the operation of life."
-George Bernard Shaw
Keith is New York today for meetings and to co-host Squawk on the Street at 10am eastern, so I’ve been handed the keyboard on the Early Look. I actually have the pleasure of writing this missive from my vacation in Mexico (Cancun to be exact), so unlike many of you stock market operators who have had to endure the manic volatility over the last couple of days, I´ve been enjoying the sun, beach, and, dare I say, a few nips of that old magic agave elixir . . . tequila!
To be sure, this has been a year in which the consumption of alcohol has gone up in proximity to many of the world´s financial districts. Although I certainly would not condone overconsumption, to Shaw´s point above, a few drinks does, at times, provide an appropriate release and if there was ever a year in which a suspension of reality was needed, it may be 2011.
Yesterday, the SP500 closed up almost 3% at 1,241. Interestingly, that is about 5 S&P points below the price at which November closed, 1,246. So, despite the massive squeeze the SP500 is still down roughly 40 basis points on the month. So far, at least, Santa Claus has not delivered.
Although the stock market will likely not end the end the year with a meaningful decline, at least not in the U.S., underperformance has been rampant at many mutual funds and hedge funds. To those that have generated positive performance and alpha this year, Hedgeye salutes you as it has not been easy.
Roughly a year ago, Fortune asked us for our perspective on 2011, so I wrote an article on December 31stwhich outlined our key thoughts with the following summary:
“When contemplating the outlook for the upcoming year, the best place to start is consensus expectations. Currently, according to a Bloomberg survey of the strategists from 11 of the largest brokerage firms in the United States, the mean consensus target for the S&P 500 by year end 2011 is roughly 10% above current levels. Further, every single strategist is expecting a positive performance out of the index in 2011.
Suffice it to say, Hedgeye is decidedly non-consensus heading into 2011.
As it stands, we see a trinity of negative fundamental macro clouds on the horizon that have yet to be properly discounted by the market, and which are poised to cast a potentially long shadow over domestic equities heading into next year. The three key risks we see to these lofty consensus expectations heading into 2011 are: global growth slowing, inflation accelerating, and interconnected risk heightening.”
(The article in its entirety can be found here: http://finance.fortune.cnn.com/2010/12/31/a-new-year-brings-new-economic-headwinds/ )
Interestingly, interconnected risk has become the most noteworthy of the three risks we flagged at the end of last year. The most relevant evidence of this is probably a recent statistic emphasized by Jim Grant. According to his analysis, in the entire history of the SP500, going back to 1957, there has never been a day when all 500 stocks rose or fell. There have, though, been 11 days when over 490 stocks moved in the same direction and 6 of those have occurred since July 2011. Still think government intervention has no impact on your portfolios?
At times, our outlook for 2011 looked really wrong. In fact, by April 29th2011 the SP500 was up 8.4% for the year and on track for a 25%+ gain on an annualized basis, which, of course, would have made our outlook not just wrong, but dead wrong. As for those of you who have followed us closely for the past few years, we are anything if not convicted in our research. In 2011, it paid to have conviction on that macro process.
Related to the game in front of us, the short term question is what to do with yesterday's massive squeeze. The key drivers of the squeeze were both a better than expected new housing data point in the U.S. and the newest panacea from Europe (or is it the newest acronym?), the ECB’s LTRO facility. On the first point, housing starts were up 9.3% sequentially to 685K on an annualized basis, but this was driven by a 25% growth in multifamily starts (single family starts have been flat since the expiration of the second tax credit in April 2010 and remain well off prior cycle peaks of 2.27MM on an annualized basis). As it relates to Europe, Italian 10-year yields are up at 6.85% this morning, which suggests we may be shortly awaiting the next European panacea to keep the equity rally going. (Incidentally, Greek 10-year yields are north of 35%.)
Unlike Taiwan equities which posted a 4.56% gain overnight, that market’s biggest gain in 2.5 years, on the back of the government saying it will let its National Stabilization Fund buy equities to support domestic markets, China closed down 1.2% and is now down 22% on the year. The Chinese, it seems, are less excited by the continued path of structurally impaired growth as insinuated by the 498 billion Euros to be lent from the ECB to the European banking system.
As for our moves yesterday, Keith bought back long term Treasuries (TLT) and shorted oil (BNO) as the SP500 remains Bearish from a TAIL perspective with a range of 1,207 and 1,270. As for me, I’m headed back to the beach to enjoy a few more margaritas before my vacation ends, but rest assured I will be risk managing my consumption. For as Seneca once said:
“Drunkness is nothing but voluntary madness.”
Happy holidays to you and your loved ones,
Daryl G. Jones
Director of Research
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