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Growth Crisis

This note was originally published at 8am on March 02, 2012. INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK (published by 8am every trading day) and PORTFOLIO IDEAS in real-time.

“Europe does not just face a debt crisis, Europe also faces a growth crisis.”

-David Cameron

 

Growth Slows As Inflation Accelerates. I wrote that in every other Early Look note between February-April of 2008 and 2011 and, unless the US Dollar doesn’t catch a credibility bid soon, I’ll write it again from February-April of 2012.

 

Why is it that people in our profession didn’t believe me then? Why is it that they don’t believe me now? Do less people believe me less? I really have no idea on what the answers to these questions are. The only thing I am certain of is that my process for intermediate-term economic forecasting using the US Dollar as my lead indicator for Growth and Inflation has not changed.

 

Sadly, neither has the broken processes of those who had both the 2008 and 2011 Growth Slowdowns wrong.

 

Back to the Global Macro Grind

 

Britain’s Prime Minister David Cameron gets this. The Chinese, Indians, and Brazilians get this. So why is it that the Crack Keynesian economists, who got the USA, Japan, and Italy into this mess to begin with, don’t?

 

That’s pretty simple. It would mean they’d have to hold themselves accountable for structurally impairing the long-term economic growth prospects of Global GDP via Keynesian/Fiat Policies to Inflate.

 

Got data to support these attacks on the aristocracy of our academic elite?

 

Let’s look at yesterday’s American Institute of Supply Management Report (ISM) for February (see Chart of The Day):

  1. GROWTH: Slowed -3.1% sequentially (month-over-month) to 52.4 from 54.1
  2. INFLATION: Accelerated +10.9% (month-over-month) to 61.5 from 55.5 (Prices Paid)
  3. POLICY: Dollar Debauchery began January 25th after Ben Bernanke push his Policy to Inflate to 2014

So why didn’t markets go straight down on that yesterday?

 

I have no idea – they didn’t until May of last year either. Markets will do what they do, until they don’t. The German hyper-inflation of the 1920s saw its stock and commodity markets rise as real (inflation adjusted) German Growth Slowed to all-time lows too.

 

No worries. According to the Chairman of The US Federal Reserve’s CYA Career Risk Management campaign:

  1. GROWTH: Qe2 (ended Q2 of 2011) was supposed to get us a US Growth acceleration to 3.5-4% (it was 0.36% in Q1 2011)
  2. INFLATION: never – at all-time highs in food and energy prices, you’ll never see it, ever (it ramped to 4-6% in 2011)
  3. POLICY RESULTS? Bernanke said this yesterday and I almost fell out of my chair:

“We’ve had about 2.5 million jobs added … and we’ve seen big gains in stock prices…”

 

Oh. Ok. Now that the stock market is up, we need to do more of what we did from an inflation policy perspective last year – because, uh, it actually worked? This is the kind of groupthink, dogma, and confirmation bias that almost every behavioral psychologist of the modern Millennium shuns. Enough of the Great Depression fear-mongering thing already.

 

It’s ok to admit it.

 

We have a pending Growth Crisis in Japan, Western Europe, and the United States of America. Like an AA meeting, we might have to all say it together: “we are addicted to easy money, inflation, and debt – they structurally impair growth.”

 

Got math to support these plainly visible claims? Let’s look at how US Growth (GDP) did as the US Dollar Strengthened in Q4 of 2011:

  1. US Dollar Index and American Purchasing Power rose +6.7% from mid October to the end of December 2011
  2. US GDP Growth Accelerated from +1.34% in Q2 2011 (highest inflation quarter of 2011) to +2.98% Q4 2011
  3. US Consumption Growth Accelerated from +0.38% in Q2 2011 (lowest since Q1 of 2009) to +1.17% Q4 2011

The math is so trivial that only an un-elected Central Planner can obfuscate it to the Muppets in Congress at this point.

 

Facts about US Economic Growth:

  1. US Consumption represents 71% of US GDP – get that right, you’ll get mostly everything else right
  2. Export Manufacturing won’t move anything but the political dial – debauching the Dollar for “export” growth has not worked
  3. Strong Dollar Deflates The Inflation = Higher Real-Inflation Adjusted Consumption = Higher US Growth

Setting aside the accounting irregularities of the US Government on silly things like birth/death adjustments to the US Employment report and using a GDP “Deflator” that’s usually understating US inflation anywhere between 50-1000% (GDP Deflator for Q4 was 0.86%, when CPI and PPI blended averages for Q4 were approximately 500% higher), you should feel better now.

 

You shouldn’t feel better about America’s long-term Growth Crisis. You should just feel better because I am telling you the truth.

 

My immediate-term support and resistance ranges for Gold, Oil (Brent), US Dollar Index, and the SP500 are now $1697-1735, $123.29-126.41, $78.11-79.22, and 1363-1375, respectively.

 

We’ll be hosting our Sovereign Debt and Demographic Reckoning Conference Call on Japan at 11AM EST. Please email Sales@Hedgeye.com if you are interested in participating.

 

Best of luck out there today and Happy Birthday to my beautiful little girl, Callie.

 

KM

 

Keith R. McCullough
Chief Executive Officer

 

Growth Crisis - Chart of the Day

 

Growth Crisis - Virtual Portfolio


CZR INTERACTIVE SPIN MAY BE JUST “SPIN”

The reality is a spin may only be a split/sale which could benefit enterprise value but not necessarily shareholder value.

 

 

Despite the fact that roughly 95% of CZR’s EBITDA comes from its core casino operations, most of the focus remains on the company’s interactive division.  This division currently comprises online gaming operations in the UK and social gaming through Playtika’s platforms.  Speculation (dare we say “spin”?) is that CZR’s unencumbered interactive assets will be spun off to shareholders.  Under this scenario shareholders would hold stock in 2 companies – “bad company” consisting of highly leveraged core gaming operations and “good company”, essentially an option on a huge growth business comprised of online and social gaming.  Sounds good, but doesn’t really mesh with reality.

 

As we wrote about in “SPIN-OFF OF CAESARS INTERACTIVE? NOT SO FAST….” on 2/28, a spin-off of CZR’s interactive assets presents several challenges:

  • A spin-off poses material tax consequences for both Caesars Entertainment and its shareholders unless they can effect a tax-free spin under Section 355
  • While it is true that Caesar’s Interactive has no debt, that doesn’t mean that it is truly “unencumbered.”  CZR’s secured lenders at the operating company and CMBS entity have upstream guarantees secured by stock in Caesar’s Entertainment Corporation (CEC) and thereby an indirect claim to anything that CEC owns.  If a spin-off occurs and debt holders don’t receive consideration for their stake, they have a strong case of fraudulent conveyance should CZRs eventually file.  Even if no filing occurs, there are likely to be lawsuits brought by debt holders to either prevent a spin or get a piece of the proceeds.
  • Federal legislation now looks a lot less likely than a few months ago since the “Barton Bill” did not get tacked on to payroll tax extension as many hoped.  There is still hope that HR 2366 will get tacked onto a piece of must pass legislation this year (e.g. Highway Bill), but the odds look slim.  An online gaming market developed through the State route will take longer to develop and be smaller in size.
  • Without the exciting growth opportunity of social gaming and the option on US online gaming legalization, the core business is a collection of a over-leveraged Regional/ Las Vegas/AC assets with a lot of deferred cap ex and a sky high interest expense bill where every cent of FCF will go towards interest service for the foreseeable future.

We recently obtained some clarification to some of these issues.  The company confirmed to us that if they decide to monetize CZR’s interactive assets in a separate entity it would likely have to be in form of a split-off or sale where the proceeds would go back to Caesar’s Entertainment.  While this may seem like a subtle clarification, for an entity that is over 11x leveraged, an accrual of proceeds from any sale back to the enterprise vs. shareholders makes huge difference.  Essentially, with a monetization of Caesars Interactive, shareholders would be left holding the bag of a highly leveraged portfolio of Caesar’s casino holdings where proceeds of any sale would likely go towards debt reduction.  This is not necessarily a bad thing but on a $22BN pile of debt, it’s hard to move the needle enough to create material equity value.

 

CZR’s also needs to consider the synergies of keeping the company intact:

  • State by state legislation will likely require having physical assets in each state in order to get a license. This means keeping CZR Interactive in-house maybe a necessary reality for the foreseeable future
  • Co-branding opportunities for the social gaming site
  • Question of whether a split-off of the assets would create value in excess of what investors are currently assigning to the interactive business.  A split-off of the interactive company would also introduce a second set of reporting and public company expenses as well as a fee payable CZR’s would also diminish the standalone entities’ value.

We believe that the vast majority of CZR’s $1.6BN equity cap largely reflects the value of the Interactive division and an option value of a major recovery on the core.  Without a tax free spin, the equity value of the Interactive division may be less than investors perceive.




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VRA: Demand, or Doors?

 

Estimates still seem too high. People should focus on Demand, not Doors. In the end, consumer demand always prevails. There’s too much Hope baked into this story.

 

 

Our  take on VRA following Q4 results hasn’t changed, we’re still negative on the name. People seem overly focused on doors, and not on end-demand. Demand will always win that battle. There still appears to be a substantial “trust” factor associated to 2H expectations. Hope, as we say here at Hedgeye is not a risk management process, we prefer to stick to the math. Here are some key takeaways from the quarter:

  • Let’s start with the good news. The Direct segment came through better than expected. Comps up +9.3% resulted in a more modest deceleration in the 2yr trend than expected while e-commerce remained solid up +28% (but down sequentially from +50% in Q3). In addition, VRA’s sales/avg. sq. ft. productivity continues to climb up to $1,290 from $1,150, which is to be expected as stores mature on such a small base (now 56). However, our concern hasn’t been the retail business per se, which we expect to grow 32% in 2012, it’s the wholesale business that we think is at risk.
  • In that regard, indirect sales were down -0.7% for the quarter on top of the easiest compare of the year. While management points to not having “those breakout patterns that we traditionally do” and how we should look at revenue growth trends on a full-year basis not quarterly, the reality is that sales across VRA’s network of 3,300 small independent retailers slowed meaningfully.
  • Our sense is that VRA’s efforts to aggressively fill its uncharacteristically fragile wholesale channel with product headed into the holiday season has left little appetite for anything but modest reorders headed into the 1H.
  • As expected, management discussed the 60 new doors at Dillard’s this year (~20% penetration) and also noted how they are “starting discussions” with other department store accounts. As noted in our prior note, this could certainly proved upside to sales growth in the channel, but we aren’t baking it into our model.
  • This actually highlights a major piece of our call. People focus too much on door growth and not enough on product relevance and desirability. Additional retail stores and major department store accounts on top of its 3,300 existing doors does very little to impact end demand for the product. Yes, it will get more eyeballs on it. But it has an inverse impact on scarcity value. Retailers are not stupid. If they see product in a store at the other end of the mall that is identical to what is sitting in their stockroom collecting dust, they’re not reordering.
  • VRA is ramping to nine new patterns in 2H compared to the historical 6-8, which helps address the issue, though the company is now extending some older successful patterns into new styles, something VRA has not typically done. Delaying the retirement of these patterns appears to undermine confidence in the current run if not indicate uncertainty/concern regarding current demand.
  • In addition, Indirect segment margins were down sharply -580bps in Q4 due to higher fixed expenses (i.e. a larger sales force). It’s worth noting that the Indirect business needs to grow revenues MSD-to-HSD in order to leverage this new investment. Perhaps it should come as no surprise then that management’s full-year guidance for the business is…you guessed it, up mid-to-high-single-digit.
  • This guidance for the Indirect business implies that when you strip out the contribution from another 60 Dillard’s doors accounting for roughly 3% revenue growth and incremental shop-in-shops in Japan, it assumes a modest contraction in the core channel. We don’t think that’s conservative enough. We have Indirect sales down 4% for the year reflecting cannibalization from company-owned stores and more conservative ordering to work down inventories. At this point in VRA’s growth cycle we shouldn’t be seeing the wholesale business rolling like this if there strong underlying demand in the market.
  • As for margins, we expect operating margins down -275bps in Q1 and -215bps in Q2 and down -50bps for the year. We expect higher costs and the likelihood for higher promotional activity to weigh on gross margins in the 1H in addition to higher SG&A investments made in the 2H that we don’t expect to lever until Q4.
  • Inventories at quarter end were one of the highlights of the quarter up +11% compared to +23% sales growth. As a result, the sales/inventory spread improved substantially after five straight negative quarters (see SIGMA below). This is bullish for gross margins on the margin, but we don’t think enough to offset the aforementioned pressures.
  • Lastly, the DC expansion underway will moderate VRA’s typically strong FCF. With $36mm in CapEx budgeted for the year, we expect FCF margin to come in at 3% compared to 13% and 7% in each of the last two years. While we expect FCF margin to return to a HSD rate next year, this will limit VRA’s balance sheet flexibility near-term

All in we are shaking out at $0.27 for Q1 and $1.58 and $1.64 in EPS for F12 and F13 respectively 19% below Street expectations next year (F13). We continue to think the Street is missing the structural risk in VRA’s wholesale account base as it rolls out its owned-retail stores more aggressively. Despite a 9% hit to the stock today, we think there is more downside ahead as expectations head lower.

 

Casey Flavin

Director

 

 VRA: Demand, or Doors? - VRA SIGMA

 

 


Shorting Greece (GREK): Trade Update

Positions in Europe: Short Greece (GREK), Short Spain (EWP)


Keith shorted Greece in the Hedgeye Virtual Portfolio today with the Athex trading comfortably below its immediate term TRADE and long term TAIL levels (see chart below).

 

Shorting Greece (GREK): Trade Update - 11. GREK

 

Greece remains the poster child for Europe’s sovereign debt excesses, of which its banks are highly levered. While many expect the ECB’s two 36 month LTROs liquidity injections to put Europe’s sovereign debt and banking crisis to bed, we’ll take the other side, and take advantage of price swings across the PIIGS equity indices, as growth expectations should continue to decline throughout 2012.

 

At a bare minimum, we think the assumptions from Troika that Greece can reduce its public debt to 120% of GDP by 2020 are overly optimistic, which implies the need for yet another bailout.  But aren’t Eurocrats wishing for more bailouts ahead in artificially supporting an uneven union of countries, some of which should default and consider returning to their own currency?

 

In addition, we expect social unrest to erupt in Spain on the near horizon over unemployment and fiscal consolidation, which will further pack this already topped-off Eurozone powder keg.

 

Matthew Hedrick

Senior Analyst


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