Year of the SG&A Cut

The multi-year cycle is clear. ’03-’06 = organic revs and ‘free money’ gross margins. 1Q07-3Q08 = inventory draw down and capex reduction. 2009 = cut SG&A, and where no fat remains kill the muscle.

We all know that margins drive stock prices in this space. But visualizing the derivation of the change in margin over the past five years for the apparel and footwear retail space puts the current situation into a much clearer perspective. The punchline is that there will be some questionable head fakes by companies that should not cut costs, but will anyway. Others can genuinely afford it -- like LIZ, ZQK, and HBI.

Cycle considerations:

’03-’06: Revenue consistently ran ahead of inventory growth, the rate of gross margin improvement trumped SG&A margin changes, money increasingly flowed through the acquisition landscape, and capex was coming off a cyclical low and slowly building. This was a multiple-enhancing environment that allowed less severe competition allowed average brands and management teams to exist.

1Q07-3Q08: Revenue growth slowed by about 1,000bp nearly spot on with the inventory growth slowdown. But weaker pricing dynamics took gross margins down steadily while SG&A margin went the complete opposite direction as the retailers were (as usual) 9-12 months behind in aligning costs.

Interestingly, capex growth came down before SG&A – which is a departure from past cycles. We’re already benefitting from slower capex growth in 2009, but the big theme for the year will be SG&A. Think about it – more than half of companies in this industry have announced layoffs. With slower capex growth and even the slightest (even if temporary) reprieve in top line pressure, SG&A cuts could spur some meaningful EBIT growth pops this year.

I’ll never pay up for SG&A cuts as opposed to real organic growth. But for companies that have been left for dead like Liz Claiborne, Quiksilver, Hanesbrands and even Macy’s – a directional change in EBIT growth at current valuations can’t be ignored.

Quote and Chart of the Week: Choking On US Treasuries...

“We hate you guys. Once you start issuing $1 trillion-$2 trillion [$1,000bn-$2,000bn] . . .we know the dollar is going to depreciate, so we hate you guys but there is nothing much we can do.” –Luo Ping

While some America’s self perceived “financial savants” (Larry Summers) think that going Greenspan is the only way to bail ourselves out of this colossal mess, some of the objectively sober think about this a little differently. While the quote above, not surprisingly, is being back-pedaled on now by Beijing… the reality is that Ping said it, and it certainly sounded like he meant it.

Over the course of the last few week’s we have started to see what we have been calling “The Queen Mary” turn (10 year yields on US Treasuries turning higher). The 25 year chart of American long term debt yields has made many a leverage hound look like a financial genius… until most recently, of course.

The Chinese and Japanese are finally choking on the Greenspan/Bernanke legacy of rate cutting and debt issuance. At this point, it’s only a matter of math and time before America’s top debt customers say enough is enough. In the meantime, never mind what they say - watch what they do from here.

The government sold a record $67 billion in notes and bonds last week:

• FEB 10: a record $32 billion of three-year debt at a yield of 1.42%
• FEB 11: a record $21 billion of 10-year notes at yield of 2.82%
• FEB 12: $14 billion of 30-year bonds (the most since the auction when it reintroduced the security in 2006 -also $14 billion), at a yield of 3.54%

According to Bloomberg “The Fed’s custodial holdings of Treasuries for foreign institutions including central banks rose 0.5 percent to a record $1.743 trillion, central bank data showed. The holdings slipped last week to $1.735 trillion, the first decrease in 24 weeks.”

Keith R. McCullough
CEO / Chief Investment Officer

Andrew Barber

US Market Performance: Week Ended 2/13/09...

Index Performance:

Week Ended 2/13/09:
DJ (5.2%), SP500 (4.8%), Nasdaq (3.6%), Russell (4.8%)

FEB 09’ To-Date:
DJ (1.9%), SP500 +0.1%, Nasdaq +3.9%, Russell +1.1%

2009 Year-To-Date:
DJ (10.6%), SP500 (8.5%), Nasdaq (2.7%), Russell (10.2%)

Keith R. McCullough
CEO / Chief Investment Officer

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"No Drama" Obama's Nasty Breakdown...

This week saw Darwin’s 200th birthday. Unfortunately we live in politically charged times where socialization/intervention is the solution of US Government choice versus Darwin’s. At a point, the rules of survival of the fittest will take hold, however – they always do. In the meantime, they will be measured, real time.

One of these measures is the confidence interval of the American people. In both the Rasmussen poll and this real time February report from the University of Michigan (see charts), “no drama” Obama is starting to see a nasty breakdown. After seeing a nice lift out of its November hole, this confidence report of 56.2 versus the 61.2 we saw a few weeks ago has rolled over, hard.

If Obama gets a NO confidence vote from a world stage that blessed him with some of the highest approval rating ever, eventually it will catch up to the US Dollar. US Dollar weakness will beget strength in the US stock market. This is a perverse relationship, but at least it’s Darwinian.

Keith R. McCullough
CEO & Chief Investment Officer


You won’t have time to read all 1,071 of the stimulus bill but that’s ok. Neither will any of the members of congress and they will still vote on it. Trust us, the provision allowing for a 5 year deferral of taxes associated with buying back discounted debt is in there. We’ve spoken extensively on the deleveraging aspects of a discounted bond buyback strategy even with the tax implications. This will only make the strategy even more deleveraging.

The trick of course is to balance the benefits of buying back bonds with potentially damaging the bank relationships. Buying back discounted bonds generally transfers value away from the senior bank debt holders. We’ll leave that up to the companies to decide but it’s nice to have the lower cost option.


"Neither shall you allege the example of the many as an excuse for doing wrong."
-Exodus 23:2
After the market close last night, I went for a run. It was windy and getting dark, and I could see my friend, the raccoon, taking cover in his usual spot in this great big old tree near the end of my road. He’s one of them fat 15 pound garbage eating raccoons. He thinks he’s smart… but I know where he sleeps when he thinks no one is looking. The end of his tail is a dead giveaway…
Raccoons, like some people in the hedge fund community, have a distinct facial mask. They genuinely believe that they are smarter than everyone else. They are extremely sensitive and, per Wikipedia, they “are able to remember the solution to tasks up to three years later.” Traffic accidents, and now short squeezes, are two of their most common causes of death.
Having spent the last decade hanging around the hedge fund community, I have come to appreciate the quality of research originated by some of the most upstanding and thoughtful people I have ever met. I am fortunate enough to now call a lot of those people both friends and clients. It is both a pleasure and a privilege to do business with all of you. You are the men and women who are going to lead us out of this mess. You are men and women of principle.
I have also met a lot of raccoons in this business. They like to steal, collude, and trade ahead of other people’s work. Ordinarily, I would preface that comment with “unfortunately”… but I actually feel blessed to have met these creatures, analyzed where they sleep, and figured out the patterns by which they operate.
For some of you whose attention I have at this stage of my missive… yes, I am talking to you. Did you really think you were getting away with not paying for our research? I am now telling you that I have been watching you, and keeping really good notes. It’s not just the bankers who are going to be held accountable to the rules of The New Reality. Sorry.
Yesterday, at 3:18PM I posted a note to our Macro clients that was titled “Covering/Buying: SP500 Levels Into The Close” ( <> ). Making that call ended up generating a tremendous amount of feedback, so let me thank all of you for your very kind words and compliments last night. While I have spent the better part of my career on the “buy side” of information flow, I finally understand the power of helping other teams win rather than just my own. It’s a wonderful feeling.
After an outstanding 25 point (+3%) move in the SP500 in the last hour of trading, what do we do now? Do we chase the raccoons and the gold diggers? Do we hold back? Do we do nothing? As corporate America has been taught to say on their conference calls, these are all “great questions”… and my answer is quite simple – stay with the proactive plan that we’ve had in place. Everything has a price.
In my “Gold Diggers” note yesterday I said “my downside target for the SP500 is 808. I am short the Dow, and I still think that the US market continues to make higher lows on selloffs.” The only part of that strategy that I have to edit is that I am no longer short the Dow – I covered it at 3:22PM in the Hedgeye Portfolio, and I will be looking to re-short it when it’s up. The SP500 still has -3% immediate term downside from last night’s 835 close. Nothing has changed here, other than price.
The price of gold has backed off of the predictable “Fast Money” immediate term high that we signaled, trading down to $935/oz so far this morning. I am in that  “Trade” (on the short side) for a 3% move, partly because I love to play the game, and partly because I love shining the flashlight on raccoons. While a 3% move isn’t going to make a man rich on a principal basis, it does solidify one’s principles. Wall Street, sometimes, has a hard time delineating the difference between those two words – they are pronounced the same, but have materially different definitions.
If you’re mantra is “make money” – that’s cool. That’s capitalism, and I support your message. All the while, don’t forget that in The New Reality, you will be held accountable for how you made that money. If you asked for bailout moneys, you are going to be regulated. If you are in a Madoff camp, you are going to be unearthed. If you are found taking other people’s intellectual property, or trading ahead of non-public material information, you will have the flashlight shone on you.
As we head into President’s day weekend, rather than pointing fingers at partisan politicians and pandering banking CEOs alike, I think we should all take a few steps back, put the crackberries down, and think long and hard about how we can take our financial system back from the raccoons.
They, of course, aren’t just “hedgies” and bankers. This is an urban migration that has been around for a long time. They are in your neighborhoods. They “allege the example of the many as an excuse for doing wrong.” They will be smoked out of their holes. We can all figure out where they sleep – all we have to do is look.
Have a relaxing weekend with your families and loved ones – we all need it.


Raccoons - etfs021309

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