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I’m Getting Fundamentally Bullish

Improving delta on consumption + controlled inventories + slowing rate of GM % erosion + impact of job and capex cuts = long awaited visibility in cash flow. I really like the risk/reward here on key ideas.

I’m really getting fundamentally Bullish. While it’s tough to admit that when the tape does nothing but go the other way, I think that fundamentals will line up in a way that will call the earnings/cash flow bottom by 3Q. Consider the following…

1) No one is allowed to be bullish on the consumer right now. It’s pretty simple – if you make a call on the consumer and you’re right, then you’re considered ‘lucky’ and don’t get paid for it. If you’re wrong, then you’re ‘stupid’ and still don’t get paid, and perhaps lose your job. I’m not making a sentiment call here. Sentiment calls and valuation calls are ‘unmakable’ in this tape (and it’s also not my job to do so). But the cash flow trajectory in the industry should change meaningfully in 2H09.

2) We’re currently looking at about a 2% EBIT margin for the entire softline retail industry on a consolidated basis (See Ehibit 1). Yes, that’s off by about 600bp vs. last year. I won’t begin to argue for a fleeting second that this is not completely warranted. This industry has over-earned and underinvested for the better part of 8 years. Those peaky margins of ‘05/’06 are history. But I do think that we’re going to bounce back to a 5-6% rate over 12 months. Yes, that’s 2% to 6% after a near-vertical drop in each successive quarter since 1Q07. How do I model this?

3) First, consider that real consumption went negative last quarter for the first time in 64 quarters (Exhibit 2). I’m not a consumption bull by any means, but unless our model’s math is way off, we’re going to see the second derivative in consumption improve meaningfully in 2 quarters (3Q09 – which starts in 4 months). We’ve recently seen a full 3-point-slide in the real consumption rate (from +1 to -2%). In modeling the two-year trend, we’ve got real consumption declining for four sequential quarters – the first time we’ll have seen this since well… ever. Bottom line: we should finally get visibility on top line erosion slowing – and likely improving on the margin.

4) We are 2 quarters into the biggest gross margin (Exhibit 3) hit that this industry will have seen in history. The good news is that inventory levels are being worked down fairly methodically. Days inventory in the channel are hardly healthy, but order levels and production out of China and India are not churning out the quantity of product that would scare me into thinking that there’s a supply-driven Gross Margin shock on its way. I’m not modeling that margins go up, but simply that they stop going down.

5) SG&A (Exhibit 4): Anyone watching these job cuts? Well, by my math that should take down the growth rate in SG&A by 2%, not to mention other discretionary cost-containment initiatives. All in, my math has SG&A growth going from 5-6% over 3Q/4Q down to 2-3% in 1H09.

6) Oh…by the way, Capex is swinging from +10% in ’08 to -5% in 2009. It’s been a while since US retail had a year where cash flow was greater than EBIT. ’09 is shaping up to the year.

7) Names I like. Quality brand, investment base in-tact, co invested through the tough economic cycle even if at the expense of margins, share gainer.
a. Ralph Lauren (RL)
b. Under Armour (UA)
c. Lululemon (LULU)
d. Nike (NKE)
e. Bed, Bath and Beyond (BBBY)
f. Liz Claiborne (LIZ)
g. Crocs (CROX – high risk-reward)

8) Names I’d avoid. Weak brand position. Share loser. Weakening internal investment base. Might show good EPS growth, but have ‘pulled the goalie’ and driven EPS growth the wrong way.
a. VF Corp (VFC)
b. Gap Inc. (GPS)
c. Ross Stores (ROST)
d. TJX Corp (TJX)
e. Jones Apparel Group (JNY)
f. Iconix (ICON)
g. Warnaco (WRC)
h. DSW
i. Brown Shoe (BWS – beware a bounce)


Eye On The Fish: Irving Fisher Revisited...

EYE ON THE FISH: Irving Fisher Revisited

We’ve been discussing Irving Fisher in our morning meetings lately, especially in context of the ever broadening adoption of Keynesians economics. As many of you already know, we are located in New Haven, CT on the fringe of Yale’s Campus, so we have an inherent interest in topics related to Yale, which is where Fisher received his undergraduate degree, PH.D, and taught for many, many years.

Famously before the stock market crash of 1929, Fisher predicted, “Stock prices have what look like a permanently high plateau.” This emphatic call from Fisher, which was incredibly wrong, proved to be the undoing of his reputation, and his personal wealth. The unfortunate side effect of the terrible market call by Fisher was that his debt-deflation analysis of the Great Depression was largely ignored and Keynesian economic ideas began their rise to prominence.

According to a recent Economist article, “Fisher was adamant that ending deflation required abandoning the gold standard, and repeatedly implored Franklin Roosevelt to do so.” The combination of going off the gold standard with FDR’s bank holiday, which stabilized the domestic banking industry, marked the bottom of the Great Depression. As many FDR critics accurately argue, true recovery would come only many years later after many missteps by FDR and his various advisors. Nonetheless, this Fisher idea of devaluing the dollar, or as we like to say, ”Breaking the Buck”, was key to the initial recovery.

Fisher wrote in “The Debt-Deflation Theory of Great Depressions” that there are two dominant factors in great booms and depressions, “namely over-indebtedness to start with and deflation following soon thereafter.” A recent report by the Bank Credit Analyst, suggested that current non-financial institution debt in the U.S. is at 190% of GDP versus 160% just prior to the start of the Great Depression. While we haven’t stress tested the 190% number, we do believe that it is directionally correct. As Fisher goes on to write, while “over-investment and over-speculation are often important; they would have far less serious results were they not conducted with borrowed money.” Thus the high debt level only serves to amplify the typical business cycle.

Many of our clients have asked about our thesis that the US dollar needs to go down for the stock market to go up. Partially this is driven by observations. We use price rule as a primary factor in much of our work and we have observed that the market and the dollar are inversely correlated, or have been for the last 3+ months. The derivative question is obviously, why is this so? In our view, it is that the market understands basic Fisher economics. Specifically, we have an emerging debt asset / imbalance that can only be solved by re-flating assets.

Fisher wrote that it was “always economically possible to stop or prevent such a depression simply by re-flating the price level up to the average level at which outstanding debts were contracted.” Without this re-flation, it is likely the deflation continues to occur such that the debt to asset imbalance becomes even more imbalanced as the price of assets decline and the price of debt, in U.S. dollar terms, stays constant, or increases.

As we have seen over the last two quarters, and as Fisher argued many years ago, fiscal stimulus will likely not be enough to stimulate a recovery in an economic environment where indebtedness is the primary factor. The risk in not re-flating is that the spiral of deflation continues.

As Fisher concluded in “The Debt-Deflation Theory of Great Depressions”, “great depressions are curable and preventable through re-flation and stabilization.” Indeed.

Daryl G. Jones
Managing Director

The USA Chart That's Not Ugly Enough...

This morning’s jobless claims number came in better both on a week over week basis and versus expectations (see chart).

Why isn’t this US stock market bullish?

Because what the US stock market needs is worse than expected economic data. I know, its perverse, but it’s reality – until the economic data is so horrendous that the US Dollar stops its ascent, the US stock market is going to go nowhere but down. The most important inverse relationship in macro in 2009 has been US$ UP, SP500 DOWN.

Got government stimulus? Got socialization? You bet your Madoff we do… but that’s the problem. What we don’t have is a government that just lets this free market price assets at an expedited pace to their market clearing price. So until the free market forces deteriorate to an unthinkable degree, creating a selloff in the confidence in the US currency, we’ll keep moving along in this government sponsored slow motion train wreck (otherwise known as asset deflation).

President Obama,

Please stop listening to Keynesian “economists”, and find someone in your crowded West Wing of yes men that knows something about Irving Fisher.

It’s time to break the buck,
KM

Keith R. McCullough
CEO & Chief Investment Officer

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EYE ON EUROPE: Assessing “Health” as Interest Rates Reduced Today…

EYE ON EUROPE: Assessing “Health” as Interest Rates Reduced Today…

The European Central Bank and Bank of England cut their interest rates in a last-ditch effort to spur economic growth… now what?

Both the ECB and BOE cut their benchmark interest rates today by 50bps to 1.5% and 0.5% respectively. Economists unanimously agreed on a cut and the negative data points we’ve been highlighting over the last weeks made it pretty clear that ECB President Jean-Claude Trichet and BOE Governor Mervyn King would follow suit today.

The Eurozone looks nothing short of a disaster: unemployment is on the rise throughout the region (France reported today that Q4 ’08 unemployment rose to 8.2%); bond spreads between the stalwart German Bunds and Europe’s other nations continue to rise (France issued a 10-Year sale today and its spread against the German 10-Year was 67bps; last month Austria’s 10-Year bonds blew out to its largest spread of 137bps versus the German) as investors expect a premium yield for default risk (see chart); housing and manufacturing output, especially in the all-important car industry, continue to show sequential deceleration; and critically the crisis of confidence suffered by Banks in the US and UK now appears to be hitting Western and Eastern European financials square in the face.

Last week East and Central Europe received $31 Billion in aid to refinance debt and equity, credit lines, and political risk insurance. Yet early indications (Hungary proposed a $230 Billion package for the region that was rejected by EU officials and Romania claimed it alone needs 10 Billion Euros to cover its account balance and budget gaps) suggest that the region will need more aid—at the very least “recovery” in 2010 may be far too optimistic.

Sweden yesterday committed to a $1.1 Billion loan package for the Baltic states, a region in which Swedish banks (Swedbank, SEB, Nordea) account for 53% of lending. For more on Western European Bank leverage to Eastern Europe see Monday’s article EYE ON EASTERN EUROPE: A Facelift of Funds, Hungary Wants More.

If you could see our playbooks on Europe you’d note the consecutive pages of red ink punctuating the negative data points from the region.

We remain the opinion that the ECB and BOE’s cuts are “too little too late” and stand firm that there is no auto-correlation among the European markets. We haven’t been long anything in Europe in 2009, and we remain bearish on Europe as a whole.

Matthew Hedrick
Analyst

UA Incremental Trends Are Net Positive

Yeh, I know, the overwhelming sentiment coming out of the channel is bearish on UA. I get it. But let me throw out a few nuggets…

1) UA just gained share for the 5-the week in a row at an accelerating rate – per SporscanINFO (+96bps, 101, 161, 189 and 213 for each of the 5 weeks ending this past Sunday).

2) Footwear sales continue to track in line with my expectations.
a. Average selling price trends for UA running footwear actually increased in the latest week from $90.8 to $92.5.
b. In fact, Foot Locker just added to that on its call by saying…
i. “In an effort to reinvigorate the domestic apparel segment, FL will be increasing offerings from UA by increasing the number of doors from ~800 to ~1300.”
ii. When asked how the running launch for UA has performed, response was that it “was off to a very good start.”
iii. Also working closely with FL to sell into Europe.

Granted, I have yet to hear any retailer ever bash one of its major vendors. The outcome if that were to be the case would be ugly to say the least. But the numbers and checks I have support what Foot Locker is saying.

My call on this continues to be that it is a company that should double in size over 3 years as it takes advantage of the consumer’s appetite for UA to succeed in footwear. I can’t find any other company that will grow to the same magnitude (except maybe Lululemon). My biggest worry at this point is that it is a ‘tweener.’ It is nowhere near cheap enough for a value investor at 15x EPS, but no growth manager will touch it until the top line starts to accelerate more meaningfully without sacrificing margins. I think that will be a 1H event.
Apparel Share Gains Are Accelerating

EYE ON INDIA: INTERPRETING INFLATION

The Wholesale inflation numbers released today registered at the lowest level since 2002 hot on the heels of yesterdays rate cut which moved the Repurchase Rate to an all time low of 5%. The rapid decline in wholesale price levels is not even across all commodities, nor has it been felt by the consumer fully –CPI for industrial workers (a measure of urban living costs) registered at 10.45% for January while CPI for farmers came in at 11.62%.

One specific component of Indian commodity matrix that we follow closely is fertilizer. Although agriculture officially accounts for less than a quarter of GDP, 60% of all employed Indians work in the sector. The majority for these workers are small farm operators, of which most are operating barely above subsistence level.

The impact of sustained higher costs for fertilizer, a subsidized commodity for which the country is officially 20-30% import dependent, are a constant concern for the Congress party as election loom.

Prime Minister Singh’s government is attempting to improve domestic capacity – fertilizer minister Ram Vilas Paswan has unveiled plans to the waive government debts of producers as part of an ambitious program overhaul the most antiquated factories by 2012 ( including the re opening of eight closed plants) and leave the country fertilizer self sufficient. The industry is currently in a complete shambles however, having been neglected during the past decade of unbridled growth, making the prospects for meeting these new goals dim without more significant stimulus measures.

Despite subsidies and government infrastructure projects, The grimness of Indian farmer’s lives cannot be overstated.

During the 90’s, the agricultural areas of Maharashtra, particularly the Vidarbha region, received the unwelcome nickname “the suicide belt” due to the high rate of such incidents among poor farmers there ( reportedly over 1,000 farmers took their own lives in Vidarbha in 2006). Although the national outcry caused by these deaths led to new government programs to improve rural life, the average Indian farmer is barely able to get by making any cost increase for fertilizer or pesticides untenable.

Anecdotal reports of increasing numbers of farmers that are going without fertilizer due to cost, despite the subsidized prices, are becoming more frequent. The impact on crop yields of going without, particularly if combined with poor weather conditions, could be catastrophic for the rural economy (and by extension relate consumer food prices nationally).

We continue to have a bearish bias on India, and will look for opportunities to short the equity market there again into any rallies.

Andrew Barber
Director

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