Is it me, or are ‘breakout sessions’ at conferences becoming even more of a commodity as each day passes. Yes, a great way to meet new management teams and engage in Q&A – that is if you can get within earshot of a CEO. Check out the photo below. Try having a coherent Q&A session when 60 random people are trying to squeeze in a question. Here’s a smattering of our notes from Day 1 of ICR. I’ve got a ton more. If there is any company you are particularly interested in, please let me know.

Major Theme: 90% of the companies I met with sand the same song…”We’re slowing square footage growth, cutting capex, pulling back sg&a, and are closely managing inventories.” Thanks, but it’s a little reactive, don’t you think? Shouldn’t they have said this a year ago? I want to find a company that can confidently articulate a growth strategy and vision that includes something other than getting smaller. There were two companies that did so today. Lululemon and VF Corp. One I believe and the other I do not.

LULU: To say that I was impressed was an understatement. This company absolutely has a plan, and they are in control of their own destiny. Two things were abundantly clear to me; 1) They are moving ahead aggressively with their rollout – likely ahead of initial plan, and 2) LULU is sticking to its guns in lowering its average lease duration by shifting to 5-year leases from whatI calculate as a current weighted avg portfolio age in the mid teens. The thing I still need to flush out is how the company can lower terms while also cutting rent/ft so meaningfully (which it claims to be doing). That’s tough to achieve. I’m not doubting it, but need to vet it more before I completely buy in. Lastly, it sounds like the company is going heavy into women’s running apparel (shorts, especially) with an eye on Nike’s market share).

VF Corp: As we expected, VFC negatively preannounced into this event (see our ICR Preannouncement Considerations note from Sunday). But what knocked my socks off was management’s view that earnings in ’09 will exceed the long-term growth target of 10-11%. I don’t see how this is possible. First, they excluded higher pension expense and negative FX impact. Sorry folks….you simply can’t do that. Second, compares in 1H09 are super tough, and my sense is that they come out on the 4Q call and make earnings back-end loaded (ie take down 1Q and 2Q). Then They’ll hope that either a) an acquisition will come along to goose numbers, or b) the business environment will improve. Is this really worth paying a 30% premium to the group??? Apparently the market thinks so – the stock was down 6%.
More VFC Notables…
• Jeanswear mass channel was one of first impacted, will provide more detail in Feb
• Slower store growth in 2009 comp to 2008 below 5yr growth plan - fine with that (plan to most likely open less than 75, 5-yr plan is 75-100)
• Inflationary costs have come down, now flattish expectation for next year vs. orig expectation of 3% increase
• More marginal suppliers have gone out of business - not necessarily VF suppliers - not planning to use the balance sheet to help suppliers survive through 2009 - haven't changed terms (i.e. 30 days to 45) with suppliers, holding firm
• Markdown dollars - mostly at dept store level (3% of revs) - Nautica has been impacted, by markdowns, but not a major issue on the whole
• Had a very good qtr in TNF (will touch on in Feb)
• They are re-evaluating, making adjustments to internal compensation structure
• Under constant pressure to expand the distribution (footwear is <20% of TNF)

Quote of the Day – J Crew
“And I personally don't really pay much attention to history, but we try to figure out where the world is going.” – Mickey Drexler, CEO JCG

I’d juxtapose this vs one of our favorite quotes here at Research Edge from noted US/Spanish aphorist George Santayana. “Those who cannot learn from history are doomed to repeat it.”

No offense Mickey, but I side with Mr. Santayana on this one. If you followed his advice, you’d have seen that jamming the channel with more product when business starts to turn down simply is not a winning strategy. It did not work at Gap, and it does not work at JCP.

The irony is that I’m tempted by this story down here. But I need to up the management trust factor before I get more greedy in betting on the timing of the bottom.

Decker’s: Someone asked a very fair question… “What levers do you have to proactively manages through a potential protracted downturn or incremental hit to product momentum in 2009?” In the wise words of one of my Research Edge colleagues, “management sounded like they were throwing pancakes against a wall and hoping one would stick.”

• Still have significant excess inventory that will take at least 6-9 months to clear
• The decision on whether their long awaited distribution facility will be passed takes place this week.

The facility will be immediately accretive. They currently have 5 buildings that they operate from and they will be able to consolidate into 1. Will have short term duplicative facilities, but their buildings currently have very short leases all of which will expire by February. Big deal as they will be able to potentially reduce their headcount from ~1500 to ~500 with the benefit of significant automation. Fred claimed that if they could do that, they might be able to keep SG&A flat. They will be able to cut ~$7M along in transportation costs between the facilities.
• Have committed to 20-25 new stores in 2009, but not all are built and will not pursue additional locations if these aren't completed.
• Commented several times how inefficient their operations are currently
• 35% of sales through department stores – very weak channel

$100M that the company needs to have on hand (through June 2009) is all ARs
Have to get rid of more inventory, won't have good idea of what lies ahead until BTS 2009 after bankruptcies shakeout

Have lost ~500 doors from bankruptcies from 15-20k
• Wrote off $1M on Mervyns and Goodies, less than $100k for GOTT, but they have inventory that will have to be reallocated
• KSS family footwear was a bit stronger relatively
• Expect China to be in the black by end of F09/early 2010 to get to a point where they can leverage infrastructure and headcount

Big 5 Sports
• Look to take advantage of retail store environment in 2009 to grow locations and build inventories
• Only focused on states currently in, not new opportunities to expand
• Average store costs / sq ft is less than $30, are seeing retail prices like some others coming down by as much as 25-30%
• Mentioned that they can open stores very fast if the opportunity presents itself - in a matter of a few months vs. much longer for competitors
• "We believe we are advantaged in our growth and that we are very flexible in the type of real estate that works for us. Our stores average 11,000 square feet in size. This, we believe, allows us to fill the role of being a convenient neighborhood store. We provide a comfortable shopping experience for our customers. We don't need nor operate what's often referred to as cookie-cutter stores. We are successful in freestanding locations, small strip centers, major power centers. We have a small number of mall stores that perform very well."

PNRA – Implications of Management Comments

Bloomberg reported that PNRA’s CEO Ron Shaich said in a phone interview today that 2008 comparable store sales growth was “north of 3 percent.” Based on the company’s prior 3 quarters of company-owned same-store sales growth of 3.3%, 6.5% and 3.0%, respectively, this would imply that 4Q same-store sales were down about 1% to get to 3% for the full year. Based on the CEO’s comment that full-year same-store sales growth came in north of 3%, however, there could be some upside to that -1% number. For reference, a 1% increase in 4Q same-store sales would yield 3.5% growth for the full year, also north of 3%. That being said, a 1% decline represents a slowdown from 3Q and is below the company’s 4Q comparable sales guidance of up 1%-3%. The company was guiding to a 5.0% YOY increase in retail checks in the fourth quarter, including a 1% negative impact from mix, so a 1% decline in same-store sales would also imply that transactions declined 6% (also a falloff from 3Q’s 3.2% transaction decline).

Eye On China: Keeping The Money At Home

Keeping money at home

China's total foreign currency reserve increased by 418 billion USD in 2008, 44.1 Billion less than the increase in 2007 -with an increase of just 45 billion in Q4. Make no mistake - the stack of chips in front of China may be growing at a slower rate, but they are still the big money at the poker table and can still splash the pot at will.

As the pace of the stimulus measures picks up pace however, they may become more selective in the places they choose to hold their capital –with yesterday’s M2 figures released by PBOC saw broad money supply increased by 17.8% year-over-year with a 62% increase in new Yuan denominated loans and no signs of slowing pace, FX reserve growth rates could go negative in the coming quarters.

For now, China is still financing two separate stimulus packages, one at home and one in the US. As the “new normal” takes effect, the question of who calls the shots in international economic policy may well change. Creditors have a nasty habit of expecting to get their way.

Andrew Barber

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Eye on Europe: Grinding To The November Halt

Eurozone Industrial Production continues to decline

November Eurozone Industrial Production came in lower than expected today at -7.7% Y/Y versus consensus of -6.1%. We’re cognizant that a November number is stale, but the slowdown trend is clearly showing no signs of bottoming yet. The impact of the slowdown is being felt harder in some places than others, Italy reported a -12.32% Y/Y production number today for instance, and that divergence creates the possibility of discord among the EU member countries as they plot a course for recovery.

The big factors to watch remain the same:

1. The outcome of Europe’s €200 BN joint stimulus package to jump-start the economy (€50 BN of which Germany committed this week): We’ve written much about Obama’s US stimulus package over the past several weeks. The risk that Europe’s package (along with tax cuts and fiscal policy changes) will fail to increase consumer spending and create jobs sufficiently and require a second round of heavy spending. Back in October Germany and France issued bank rescue packages to the tune of €500 BN and €360 billion respectively, yet today Deutsche Bank made headlines that its Q4 ’08 loss totaled €4.8 BN and HSBC is expected to require an additional $30 BN cash infusion. Another trip to the well will be painful (particularly for EU members that have a higher cost of funding like Greece, which will likely see it’s relatively high cost of borrowing increase further in the wake of today’s ratings cut by S&P).

2. Rate Cut Impact: Tomorrow the ECB will all but certainly cut interest rates, with consensus estimating a -50bps cut, yet will this be enough to accomplish anything? Additionally as ECB interest rates change we’ll be watching its affect on the Euro-USD currency exchange. Should the Euro continue to rise against the dollar, it will put further pressure on European exports. If this should be the case you’ll see exports decline along with PPI and CPI numbers on deflationary pressures.

For all of 2009, we have been short the UK via the EWU exchange traded fund. We covered that position today. Booking gains on the short side continues to be what we do. We will look to re-short EWU on an up day.

Matthew Hedrick

Need A Level? SP500 Levels Refreshed...

Suffice to say, after the SP500 has been hammered for a 100 point, -11% move, since we we’re calling it as overbought last week, the math in my macro model has changed!

Last week I said the VIX could have a +27% squeeze to the upside and nothing will have changed its fundamentally negative intermediate “Trend.” This is not October/November 2008; if you are managing risk around those same levels of risk/volatility assumptions, I think you’re going to miss the next move. The VIX is +18% today, and it is waking people up because it should… too many people are long the same catalyst – Obama’s inauguration. As a result, the big move in volatility (off the bottom) is now a historical event. Unless I see the VIX close > 54.65, I think it continues to make lower 3-mth cycle highs on rallies. The SP500 can then be traded on the long side from its newly developing range of support.

The next move is to respect the math associated with that new range - I have outlined it below: SP500 836-889 – that’s a 6% range; its going to be very tradable with pending PPI and CPI reports here in the US on Thursday/Friday, then Obama after the market comes back from the long weekend.

Make no mistake, that breakdown of the SP500 “Trend” line at 889 remains today’s reality. Unless we can close above that line, any rally towards it is to be traded with an immediate term defensive bias. Any freak-out selloff testing 836 is where I first cover shorts (like I just did in NKE and EWU), and then consider buying longs.

Keith R. McCullough
CEO & Chief Investment Officer

Big Broker

Big Broker - asset allocation011409

“Few people are capable of expressing with equanimity opinions which differ from the prejudices of their social environment.”
-Albert Einstein

Groupthink is not good, particularly when it becomes your culture. If you are not allowed to challenge the received wisdom of your bosses, and you are a financial services firm living in The New Reality, you are going to have a serious problem. Yesterday while I was taking Q&A on a panel at the AQR conference in New York City, I couldn’t shake these thoughts out of my head.

While I was on yesterday’s panel, Barry Hurewitz, whose title is “COO of Investment Research” at Morgan Stanley, made a statement, then asked me a question. Sorry Barry – you’re getting You Tubed. I will paraphrase his statement because it was a bit long winded, but Barry proclaimed the mystery of his “clients” faith in saying “what our clients really want from our analysts is insights – you know, like the conversations.”

Herein lies THE difference between the horse and buggy whip brokerage model that is going away and my vision of the future. Having been a Morgan Stanley prime brokerage client, I think THE client has always expected “insights”, but what they really want today is for your research calls to be right. That’s it Barry – make the call, put a time stamp on it and a price – and be accountable. If the accuracy rates of your compromised and conflicted “calls” are too low to show the world, then I guess the only thing to conclude is that clients want you to talk to your analysts on the phone and have you set up conference meetings for them.

The pundit patrol is going to be all over the manic media today with their view of Barry’s firm merging its brokerage unit with Smith Barney. Now it’s going to be called “Morgan Stanley Smith Barney” and there is nothing that scares me more than Merrill’s “thundering herd” than a team of consensus that’s even larger! Instead of 16,000 Bank of Americans strong, the client gets a 20,000 man team of brokers selling “Investment Research” tied to a groupthink culture.  This is The New Reality – if you dont think THE client wants you to have a process and stand up every morning and make a call that’s grounded in that process, I’ll be standing on the other side of that Trade.

Suffice to say, the US stock market has weakened in the last week in the face of a hard earned “Crisis In Credibility” (see Early Look from 1/7/09). The US brokerage stocks don’t lie, people do. With 3-month LIBOR hitting a new low this morning at 1.09% and the TED Spread (3mth LIBOR minus 3mth Treasuries) as narrow as it has been in well over 3 months, many a supermarket brokerage house strategist is confusing last year’s liquidity crisis with the crisis in the credibility of their employer. We do not have anything in the area code of the liquidity crisis we had in October-November. What we have is a crisis in the structure of the US brokerage model – like Big Auto… Big Broker is creatively self destructing in painfully slow motion.

Brokerage businesses are still ran by starting with a revenue number and trying to understand the cost structure needed to support those revenues. These are compensation structures, not businesses that can stand the test of economic cycles. There are great talents at Morgan Stanley (I have hired 3 of their former horses). Today, this is how they attempt to compensate their best people: 1. with cash bonuses (begging the government for that cash if need be), 2. with options that have ultimately proved worthless, and 3. by promising their “smartest” group thinkers titles, like “COO of Investment Research”.

No one at Morgan Stanley is empowered to be a capitalist right here and now. As I said, they have some great people working there, but they are afraid. I guess that begs the question as to whether you can empower people with fear of economic insecurity.  Where I come from, that creates situations where colleagues start looking after themselves instead of the team. There are two T’s in Morgan Stanley Smith Barney. Neither of them stand for Team. Its sad.

So are Deutsche Bank’s numbers this morning  - they printed a loss of over $6 Billion and shook European equity markets to the core of the matter, the credibility crisis at hand. The #1 and #2 stories on Bloomberg this morning are about Deutsche and Citigroup. This isn’t a surprise – it’s just really all turning out to be what it is – sad.

It is sad to think that the people running these firms tell the client what they need them to want. Let me tell you what they don’t want: THE client doesn’t want you trading prop ahead of them; THE client doesn’t want an investment banking disclosure on your “Overweight” recommendation; and THE client doesn’t want you to lose their money. THE client simply wants to be put ahead of house’s revenue “expectation”, and for THE house to be right.

Both Asian and European stock markets are breaking down now, and they probably should. Their crisis in confidence has no clear path of resolution. In America, the SP500 has broken it’s 889 support line, and while hope is not an investment process, at least we have a catalyst of change in Obama.

The only change I can hope for in the brokerage model of accepted compromises past, is for it to go away in as orderly a fashion as Americans can tolerate. It’s time for change. It’s time for Big Government to manage Big Broker, and let American Capitalists rebuild THE client’s trust.

Best of luck out there today.

Big Broker - etfs011409

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