prev

GIL: Follow the 'Leader'?

I don’t believe in GIL’s strategy or sustainability of returns, but the Q looks OK to me, and the CEO is buying again after selling 250% higher. This guy can trade his stock. Follow the ‘leader’?

This quarter should be abysmal, with a 3,000bp sequential slowdown in sales, and a 1,000bp erosion in margins. Yes, you read that right, I did not err with too many zeros. It would take a lot for me to ever turn fundamentally positive on the trajectory of this company’s margins long-term, as it is growing into slower growth businesses where it is a price taker with increased capital requirements to sustain growth and profitability. That’s not a disaster scenario as long as management realizes it. This team does not.

But few things are linear in this business. After missing and/or guiding down for the past six quarters, 1Q09 should mark the bottom for GIL. Note that the CEO sold 3.6mm shares of stock about this time last year – just before the business completely fell apart and over $4bn in equity value went away. Well…at least he avoided losing $130mm in his own capital.

Here are a few considerations on the quarter.
1) Revenue:
a. Negatives: 1) Pricing down 7-9% at a minimum, and GIL does not benefit from price increases granted by WMT to the extent as Hanesbrands and Fruit due to meaningfully less exposure. 2) FX has been a 1.5% tailwind over the past year. At current FX cross rates, this reverts to a -1.5% headwind. 3) Prewett acquisition has helped revs for the past 11 months. GIL shows 1 quarter of that in this quarter, which helps by 4% in total, but then we’re back to relying on organic growth – where GIL has struggled.

b. Positives: 1) 1Q is the least significant revenue quarter. 2) There’s a 5-10% volume opportunity this year from Europe, with a call option on Japan and Mexico. 3) The US mass retail underwear program started in 3Q, which still leaves some yy growth for 2 more quarters.

2) Margins: a) GIL comps in 1Q against a 600bp margin boost due to mix last year. b) Inventories were +32% at the end of 4Q relative to 27% growth in sales. That’s not great, but does not make me too queasy. c) The biggest negative is also emerging into a positive. Cotton will be a crushing blow to GIL this quarter. Every penny in cotton prices equals about $0.035 in EPS. With cotton having been cut by $0.30 to about $0.50 over the past nine months, we’re approaching the inflection point where the 9-12-month gap from purchase to booking as COGS on the P&L shows up in earnings.

3) Capex/Working Cap: Capital expenditures should be up by about $15mm off a base of ~$100mm in ’09 to expand the DR facility and Rio Nance One. This should add an incremental 7-8mm dozens of annual capacity (8%). Keep in mind that there should also be $70mm of additional working capital to support growth in 2010 and the cash payment resulting from the CRA audit (~$17mm).

Q4 SLOT SHIP SHARE

While we don’t have the Aristocrat Leisure Q4 figures (the Aussie’s don’t report quarters), all the other major players have reported. The chart below provides market share trends for the gaming suppliers. After 2 quarters of market share losses, WMS regained some of its lost share, coming in close to 20%, in-line with BYI’s share. BYI appeared to lose about 4 percentage points. BYI typically outperforms in the replacement market but Q4 contained a higher percentage of slots into new and expanded casinos. IGT lost a few percentage points but at 38%, its share remains well above the Q1 2008 low of 30%.


EYE ON BRAZIL: CPI

For the third consecutive month consumer inflation in Brazil declined on a year-over-year basis according to data released today, sparking speculation that Banco Central do Brasil President Meirelles will cut rates next month. Despite the fact that inflation is still 1.25% higher than the government’s target level, the central bank is now forecasting that the target will be met by year end which, when combined with the relatively sky high Selic rate of 12.66%, leaves Meirelles with seemingly more than enough room to cut when the Bank board meets on March 10th.

The numbers for the broad IPCA show that, for the most part, price pressure seems to be cooling (interestingly, the decline in transportation costs was driven by big decreases in the cost of new and used cars, a factor which largely offset significant increases in metropolitan public transport costs). Below is a breakout for some of the major basket components in January :

{SEE CHART BELOW}

The component of primary concern remains food. Despite declining biofuel prices, food costs rose 0.68% broadly for the month while the IPCA 15 , which specifically tracks consumer inflation in major cities only, showed an increase of 0.72% M/M in January, up from 0.32% in December. This increase has been attributed to speculation that a drought in southern Brazil will curtail output this year. Agriculture Minister Reinhold Stephanes has publicly stated that grain production may drop as much as 8% in 2009 versus last year. Some of the biggest increases in the IPCA 15 food price basket were potatoes at +11.87% for the month and fruits at +2.41%. President Lula’s government has arguably made significant strides in reducing poverty; but with nearly 35 million people still living on less than 125 Reais per month (~$55) it is unlikely that the populist leadership will be willing to risk increased food costs regardless of the impact on growth. As such, Meirelles faces real limits in his ability to cut deeply.

Even with food costs still a cause for concern, we continue to be bullish on Brazil and believe that the same prudent management that proved successful in expanding the middle class while still somewhat keeping a lid on inflation during the bubble could now help domestic consumption offset cooling external demand enough to sustain positive growth levels.

We are long the Brazilian equity market via the ETF EWZ.

Andrew Barber
Director

Matthew Hedrick
Analyst

GET THE HEDGEYE MARKET BRIEF FREE

Enter your email address to receive our newsletter of 5 trending market topics. VIEW SAMPLE

By joining our email marketing list you agree to receive marketing emails from Hedgeye. You may unsubscribe at any time by clicking the unsubscribe link in one of the emails.

EYE ON EUROPEAN ENERGY

Two events took places last week concerning energy policy in Europe that are worth returning to: Russian Prime Minister Vladimir Putin in his keynote speech at the World Economic Forum in Davos discussed (among other topics) energy policy, and officials representing Europe, the Caspian region, and the Middle East met in Hungary to discuss the construction of a pipeline running from Turkey to Austria that would bypass Russia. The former certainly received more press than the later.

Dissecting Putin’s speech adds some color on Russia’s energy outlook, yet his words are laced with rhetoric. He started by saying:

“Every one of us realizes that a sharp and unpredictable fluctuations of energy prices are a colossal destabilizing factor in the global economy…It is necessary to return to a balanced price based on an equilibrium between supply and demand, to strip pricing of a speculative element generated by many derivative financial instruments.”

RE: Russia has not shown signs of attempting to balance the price equilibrium between supply and demand. For one, Gazprom carves out natural gas contracts on a per country basis, on such factors as a country’s wealth and its allegiance to Russia. After all, there’s a reason why former Soviet states receive gas at half the price Western Europe pays for. It isn’t just a hand-out, there are political strings attached.

Putin then went on to reference the treaty establishing the European Coal and Steel Community as a beacon of international stability, saying:
“Consumers and producers would finally be bound into a real single energy partnership based on clear-cut legal foundations.”

RE: Russia has no interest in confining itself to a partnership or any relationship in which it must abide by the rules of the group. Russia has the largest natural gas reserves and at the moment is the majority supplier to Europe. Russia will exploit this leverage until Europe finds a substitute.

Finally Putin concluded by saying that his country is making efforts to expand the infrastructure of oil pipelines across Europe and Asia, suggesting that more pipelines would equate to “reduced transit risks” and prevent energy disturbances.

RE: This logic is plain backwards! In short, it doesn’t matter how many pipelines Putin and his countrymen build to service natural gas to Europe. At the end of the day, Russian leadership calls the shots on price and who receives supply. Europe is still very energy dependent on Russia so they’re left in a tenuous and reactionary position. This dynamic will not change until the EU finds a substitute to Russian gas.

The second event that took place was a conference in Hungary to discuss the construction of the Nabucco pipeline. Attended by officials from Europe, the Caspian region, and the Middle East, the conference proposed a 3,300 km pipeline that would stretch from Turkey to Austria (See Map Below) with supplies expect to come primarily from Azerbaijan, with Turkmenistan and Kazakhstan eventually joining.

RE: Nabucco is a very ambitious project packed with question marks. For one, the project would cost an estimated ~€10 Billion. Presently the European Commission is only willing to commit €250 Million to the project. So long as the EC (or another joint venture for that matter) does not put up real money to support this project, it appears unlikely that this project would get off the ground in this recessed and risk-averse environment. Secondly, the pipeline is estimated to deliver ~31 billion cubic meters of gas a year, which represents by consensus estimates less than 10% of Europe’s needs. Again, why would Europe back such a costly project for such little return?

While the conference ultimately failed to provide clarity on the proposal, the significance of the conference is noteworthy. It demonstrated that Europe is determined to find alternate sources of natural gas to remove the gas politics from its agenda. This is a very positive signal. Czech Prime Minister and acting President of the EU Mirek Topolanek said,

“Nabucco is a project of paramount importance for the freedom of the continent…the gas crisis lasted only three weeks. Nevertheless, it had a drastic impact on the economy of numerous European countries…with losses running into the billions and millions of people suffering from the cold. That is the very high price we pay for our energy dependency.”

Conferences are scheduled to address the Nabucco project once again in April and May of this year. Clearly, the EU has learned its lesson from the previous gas shut-offs. Already the European Commission has announced a pledge of €3.5Billion for off-shore wind farms to go along with talks of improving liquefied natural gas hubs around the continent. These European measures to reduce energy dependence on Russia are positive for Europe on the balance, yet funding, especially while Europe is deep in recession, may be hard to come by. In any case, Putin and Russia will have to respond to a Europe seeking alternative energy solutions.

Matthew Hedrick
Analyst

US Employment: Consensus Gets Squeezed

This morning’s unemployment report revealed a major liability that the Street levered up on earlier this week – pressing stocks on the short side ahead of a well anticipated number of 7.6%.

While the “consensus” Street estimate was 7.5%, I was hearing whispers of an 8 handle from the Depression-ista camp all week long. As the guys on Monday Night Football would say, “C’mon Man!” – this is not a Great Depression.

Reality is that what’s bad for the US Dollar (which is down today), like an annual chart like the one spiking below, is good for the US stock market. This inverse correlation has continued to fortify itself since the November SP500 low of 752. Most of the December rally was met with a weakening US$ index, and the most powerful squeezes in 2009 have come on the heels of US$ down days.

There is a ton of resistance in the SP500 range of 863-873. Unless the US$ Index can break down and close below $84.44, I think the probability of this February US stock market rally continuing goes down. I am making sales today as a result.

Trade the ranges.
KM

Keith R. McCullough
CEO & Chief Investment Officer

MGM: OPTIONS YES, AN OPTION? NOT YET

MGM will report its Q4 earnings in a couple of weeks and the shorts are having a field day. The short thesis is that the fundamentals are horrible, numbers are coming down, and the company will either bust a covenant or be forced to raise highly dilutive equity. Citibank recently slapped a sell rating and a $2.50 price target on the stock (why not just call it a zero?) and, like a pot calling a kettle black, Bank of America/Merrill reiterated an underperform rating. Clearly, we have a consensus call here folks.

Now for an “out of the box” call. MGM has more credit remedies than people think. Some of these may come out of the Q4 conference call. With a short interest probably higher than the 33% reported on 1/12/09, this stock has squeeze written all over it. I’m not sure the catalyst will be fundamental, unless they’ve cut costs more than expected. Rather, it is likely to be related to liquidity/covenants/balance sheet. Here are some possible remedies:

1. Bond buy backs – MGM should be buying its heavily discounted bonds back with borrowings off their credit facility or from proceeds of asset sales. The only reason they wouldn’t be is because they want to maintain their very strong relationship with their banks which brings me to #2.

2. Renegotiation with banks – MGM actually has some leverage in the negotiations because of the threat of bond buy backs which devalue the bank debt, and the fact that banks do not want to own casino assets. MGM has a very good relationship with its banks. These factors could lead to a lifting of the leverage covenant to get MGM through 2009.

3. Asset sales – MGM should be taking whatever they can for their significant but non-cash producing land portfolio. Any land sale would be a positive.

4. Hotel/casino sale – Rumors of the death of The Mirage sale are greatly exaggerated.

5. Government help – Don’t laugh. CityCenter is a huge job creator and the Senate Majority leader Harry Reid just happens to represent Nevada. As we wrote about last week, there is already a provision in the stimulus plan to defer taxes on the gains from bond buy backs. The provision was crafted by Harry Reid and the other senator from Nevada, John Ensign. Stay tuned, this may not be all.

6. CityCenter financing – Obviously, this would be huge.

7. Shareholder help – Whether it’s Kerkorian, Dubai World, or others, credit relief could come from unlikely sources.

We are not making a call on improving fundamentals. We were negative on MGM’s prospects for all of 2008. It’s not a call on the long-term value of MGM either. It is a call that there are credit remedies MGM can pursue to get through 2009 and buy some time for a more favorable credit environment. Interestingly, on their Q4 conference call PENN management indicated that the banks were becoming more flexible recently and relations with the industry were quite good.

Bearishness is unprecedented in this sector and in this stock. The negatives are generally known but the positives may not be.

get free cartoon of the day!

Start receiving Hedgeye's Cartoon of the Day, an exclusive and humourous take on the market and the economy, delivered every morning to your inbox

By joining our email marketing list you agree to receive marketing emails from Hedgeye. You may unsubscribe at any time by clicking the unsubscribe link in one of the emails.

next