Impact of a 1% Sales Tax Hike in CA

A 1% boost in sales tax in CA is a double-edged –sword. Here’s an overview of those most heavily exposed. ROST is a name I keep coming back to where risk increasingly outweighs reward.

For those not watching the financial disaster unravel in California with Schwarzenegger’s budget impasse, keep in mind that the current proposal includes a 1% increase in sales tax, which is not particularly welcomed by the retailers. Sadly, 1% is probably better than the state going bankrupt, government payrolls shutting down, and the regional economy contracting further.

The chart below outlines retailers with the greatest percent of their respective store base located in California. The one that stands out for me is Ross Stores. It is overexposed to CA, is in a space that I increasingly do not like (off price channel), is near peak margins, has two more quarters until inventory, GM and SG&A compares become very difficult, sentiment is generally positive, and is trading at a 30%+ premium to the group. I still think it is too early to get super negative on this name – but the fundamental cards are starting to line up.

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

Hedgeye Statistics

The total percentage of successful long and short trading signals since the inception of Real-Time Alerts in August of 2008.

  • LONG SIGNALS 80.46%
  • SHORT SIGNALS 78.35%

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

"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.

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