“My business is making things.”
-William S. Knudsen, May 28, 1940
That’s a quote from one of America’s finest immigrant business men during a time in this country where business builders and innovators built your military and economy, not politicians. It comes from a book that I started reading as I saw the election results roll in – Freedom’s Forge: “How American Business Produced Victory in World War II.”
Election Day 2012 was the 5 year-anniversary of building My Business. I am not in the business of producing a racial, gender, or class war in this country. I am an immigrant who is in the business of manufacturing innovative research and risk management ideas.
I didn’t ask for a bailout in 2008, and I’m not begging for a solution to a #FiscalCliff situation that the beggars themselves perpetuated. My Business is to fight the winds of government intervention in my life. My Business is to stand up and fight for the core values of a liberal – equality and liberty.
Back to the Global Macro Grind…
How has My Business thrived during one of the worst secular declines in Wall Street trading commissions on record? First, I don’t have a trading desk. More importantly, I started from a place that more should have the opportunity to rise up from – getting fired.
The problem with both our government and many of my sell-side competitors that they’ve bailed out (and paid) is that they get re-hired to do more of what has not worked.
Every mistake I make, either in building My Business or in research ideas, can and should hurt me. I need to wake-up every morning, lick the blood off my paws, and do whatever I can to make up for my mistakes. There is responsibility in recommendation.
To review where we haven’t made mistakes in Q4 of 2012, here are our Top 3 Hedgeye Global Macro Themes:
- Earnings Slowing (worst revenue and EPS slowdown since 2008)
- Bubble #3 (Commodities down -9.3% from Bernanke’s September 14th Top
- Keynesian Cliff (political gridlock perpetuated by the bubble in US politics and the media that supports it)
My Business only works if I have a great team. While I may personally make a lot of short-term mistakes, I think my research and operating team does a great job getting the intermediate-term TRENDS and TAILS right. If they didn’t, we’d fail.
I can’t tell you how rewarding it was to walk into one of the world’s biggest bond manager offices on Election Day and have him tell us that our #GrowthSlowing call in 2012 has helped him buy every dip and have a great year.
That, of course, may sound a little odd to the Equity only clients we have. But, really, that’s the point about what we do. Multi-factor, Multi-Duration Risk Management, across Global Macro Asset Classes.
Yesterday’s down move in the US stock market wasn’t about Germany. It wasn’t about the #KeynesianCliff either. It was about everything that’s been coming to a boil in the US stock market in 2012 as our economic and fiscal reality disconnected from it.
Blow-up days (biggest down day since June 1st, 2012 of -2.46% SP500) are processes, not points. If you don’t think people who chased the top in commodities in September have been blowing up, think again:
- CRB Index -9.2%
- Oil (WTIC) -14.7%
- Copper -10.6%
- Gold -3.2%
Gold isn’t blowing up. But it’s not going up anymore after 2 of the most bearish macro events in US history for the US Dollar either:
- Bernanke Printing to Infinity & Beyond
- Obama getting re-elected
That last point isn’t a political point. It’s a fact. You can’t say Obama has been great for commodity and stock inflation since 2009 and not, at the same time, acknowledge the loose fiscal and monetary policies that Debauched The Dollar all the while.
This isn’t new. Neither is it an Obama or a Democrat thing. Both Nixon/Carter were as bearish for the US Dollar as Bush/Obama have been. Why? Because both Democrats and Republicans went all-in Keynesian in both periods. And it didn’t work. Romney being advised by a hard core Keynesian (Glenn Hubbard) on the key topic of the debate didn’t work either.
What could work – and God help us all if he doesn’t get this – is Obama reaching across the aisle to people like you and me; people running small businesses who have their costs and taxes rising; people who have to meet a payroll before they can start hiring again; people who really want to see Obama succeed inasmuch as patriot Democrat and Republicans wanted Reagan and Clinton to.
You can judge us and you can demagogue us, but you cannot fire us. After all, we are The People too.
Our immediate-term risk ranges for Gold, Oil (Brent), US Dollar, EUR/USD, UST 10yr Yield, and the SP500 are now $1, $105.46-108.67, $80.22-80.98, $1.27-1.29, 1.64-1.72%, and 1, respectively.
Best of luck out there today,
Keith R. McCullough
Chief Executive Officer
This note was originally published at 8am on October 25, 2012 for Hedgeye subscribers.
“You can boil down what we're thinking about 2013 to a short statement, and that goes both for economic environment and sales, and that statement is steady-as-she-goes, not much change from 2012.”
– Michael DeWalt, Caterpillar, 10/22/12
This morning, Hedgeye ran a proprietary P/E screen to identify a couple of bargains. JDS Uniphase (JDSU) is trading at only 3x its 2000 EPS. Lennar (LEN) is at only 4.5x its 2005 EPS. Multiples were much higher when those earnings were reported, so today these names are on a big sale. OK…probably not. However, those “bargains” highlight the problem with using the peak margins and a simplistic framework to value companies.
The Industrials sector is loaded with mini-bubbles. Capital equipment goes through replacement cycles, driving sales and margins to very high levels only to have them drop-off following the boom. Our favorite cycle is shipbuilding. After World War II, war tonnage was converted to commercial use. Ships only last for about 30 years, so there was a replacement boom in the mid-1970s. Tonnage deliveries were nearly three times higher in 1975, at the peak of the boom, than they were in 1980, after the bust. The industry just had another replacement cycle with deliveries peaking in 2011. The group looks like a promising short today and should be a great long around 2035. Mark your calendar.
We joke that mining is the world’s second oldest profession and that there is a reason the iron-age was called the iron-age. Mining is a highly mature industry with long-term cyclical growth slightly below global GDP growth. It should not boom. When it does, you know something interesting is going on.
Mining capital spending is an obvious bubble. For example, global iron ore output went from ~1 billion tons in 2005 to ~3 billion tons last year. Capital spending above depreciation at the eight largest miners went from about $10 billion in 2004 to $56 billion in 2011. And 2004 was a fantastic year for mining capital spending.
Today, Caterpillar is best defined as a manufacturer of mining and resource-related capital equipment. Among its largest customers are BHP, Rio Tinto, and Vale. Typical of companies caught up in a boom, CAT has made overpriced acquisitions and added excess capacity to meet peak demand, in our view. Investors who hold CAT through the down-cycle may end up paying for management’s investment errors in addition to their own. Buying CAT today is similar to buying Lennar in 2005 or JDSU in 2000. The peak $9.20/share or so that CAT will likely earn in 2012 may prove just as irrelevant for valuation as any other bubble-driven profit.
The Hedgeye Industrials team hates P/Es. Extreme profit cyclicality leaves multiples useless in the Industrials sector. We prefer to build DCFs to estimate (wide) valuation ranges. We forecast reasonable longer-term growth rates, margins, capital needs, and other factors, making assumptions explicit. November 5th, we are presenting on the Express & Courier Services industry, including Fedex. Fedex may grow at 2% or 6%, but it isn’t going to grow at 15% in the long-run. Similarly, global iron ore production is not going to keep tripling every 5 years. To value CAT by extrapolating recent trends in mining capital investment would be to assume the surface of the earth ends up covered in ferrous rocks. A normal peak multiple applied to recent profits implicitly makes that assumption.
To note that there is a bubble in many commodities is different from explaining why. The narratives that drive bubbles tend to be very persuasive and contain much truth. The internet will revolutionize commerce. Check. Home prices rise over time and will be supported by the government. Check. A rising middle class in the developing world will need more appliances and cars. Check. Narratives allow investors to feel better about applying absurdly simplistic valuation ratios to companies serving highly complex markets.
We’ll throw out a narrative to explain the commodity bubble to allow CAT short sellers to feel better. We suspect that the commodity bubble has been driven by world’s second largest economy pegging its currency to the world’s largest economy while the world’s largest economy engages in highly simulative and largely experimental monetary policy. The peg contributes to inflation in China, which drives savers in China to protect real wealth by investing in property and other hard assets. Maybe check. Maybe not.
Narratives aside, our view on CAT is straight-forward. Don’t be the investor who buys a cyclical at a multi-decade peak in margins. We may well come back to CAT when it hits our proprietary P/E screen in a few years.
Our immediate-term risk ranges for Gold, Oil (Brent), US Dollar, EUR/USD, UST 10yr Yield, and the SP500 are now $1699-1733, $106.63-110.71, $79.69-80.25, $1.29-1.31, 1.71-1.89%, and 1401-1419, respectively.
Jay Van Sciver, CFA
Managing Director Industrials
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Takeaway: There are a lot of reasons why we don’t like $Macy’s with a 4-handle, and even have a tough time getting excited about it with a 3-handle.
There are a lot of reasons why we don’t like Macy’s with a 4-handle, and even have a tough time getting excited about it with a 3-handle.
The way we look at it, the best bull case is that even with EBIT down 5% next year (which we think will happen) we still get to earnings being about flat. Due to the debt tender and share repo activity, the financial engineering here rivals what we saw at GPS for much of the past decade. Tack on the potential success of My Macy’s and the Millennial Stores, and we’re looking at yet another year where M comps consistently higher, and add on 100bp leverage in gross margin as a result without commensurate SG&A spend. Add on some financial engineering… and you get to about $4.75 in 2013 earnings – suggesting that the stock is actually trading at 8.5x earnings and 5.5x EBITDA today.
Now comes the very simple bear case. Do you REALLY want to pay 8.5x/5.5x for a department store under the assumption that everything goes absolutely perfect?
This a business that has no square footage growth, no ‘birthright to comp’ in its core, struggles to consistently earn its cost of capital (what happens when lease accounting rules change and M has to account for its property?), and has zero competitive advantage in the core area that will be driving incremental consumer purchases for generations to come – dot.com. Try as they will with ‘The Millennial store’ and My Macy's, but the reality is that as they grow, our kids are unlikely to go en masse to Macy’s to buy their apparel at a rate greater than what we’re doing today. If they do, it will be the result of some considerable capital investment that we have yet to see (or model). Also, let’s not forget the risk that taking down the target age in these new store concepts has to Macy’s existing customer. They’re smarter than most retailers, but we’ve seen some of the best and brightest fire their customers with horrible circumstances.
Other thoughts to consider.
1) Estimates Are Too High. We’re modeling flattish earnings in 2013, the consensus is looking for growth of about 18%.
2) Can't Comp Forever. The Street is banking on another 2-3% comp for Macy’s next year. Seriously? Go back into the pages of retail history and find a time when Macy’s comped up 4-years in a row. Have fun with that research. It’ll take a while.
3) JCP Matters Now. Is anyone considering that precisely 1-year ago JC Penney started hemorrhaging revenue, and essentially handed over $3bn in sales to anyone who wanted it? We’ll give Macy’s (and GPS) all the credit in the world…they saw the opportunity, and they took it. But JC Penney is coming on strong. What people don’t get is that even if JCP fails miserably in putting the wrong higher-end brands in front of an audience who could care less, the inventory still needs to be sold…somewhere, somehow. To think that this will not come back to haunt M is being intellectually dishonest.
Macy's Definitely Saw A Lift From The JCP Debacle
4) How big of a deal is JCP? We’re talking roughly $2.8bn over four quarters if our estimates are right. To put that into context, that equates to about 10% of Macy’s sales right there. We’re not saying that Macy’s got it all – or even half (Heck, KSS comped down during this period so we know it wasn’t them). But 2-3% comp points worth? We think so. Macy’s management won’t agree with that assessment, but the reality is that there is no way for them to know why people walk into their stores, or walk right by. One fact that is impossible to argue with is that we are just beginning to start off on a period where Macy’s needs to comp against these share gains -- whatever they are. Let’s say that they are prepared…I can promise you that all of their competitors are not. Desperate competitors equals an unhealthy environment.
5) They'll Get It The Painful Way. In the end, we think that if Macy’s wants the comp, they’ll get the comp. But they’ll need to buy it. And we quote CFO Karen Hoguet…
“We’ve consciously tried to bring more goods into the stores to help us transition to the Spring and have more newness as Christmas approaches and for a post-Christmas strategy. So this is a conscious change from what we’ve done in the past.” Much like we see with JCP, the merchandise will need to be sold.
There were a couple of times during the conference call where we heard statements that encouraged us...
a) It is impressive that over 290 M stores are up and running to support the dot.com business in the same way the a DC would otherwise function. That compares to just over 20 a year ago. Definitely great execution there. We’d note, however, that at some point the dot.com focus will need to be in getting people genuinely excited about shopping on the site. That’s apparent today, but will be harder to keep it up as the business scales off of such small numbers.
b) “White space opportunity with the new model they are creating with Finish Line.” Is it any coincidence that Macy’s is doing more of these shops at the same time JCP is becoming the Shop in Shop poster child? This is likely a winner, but likely has more of an investable impact on FINL than it does on M. On the margin, it is probably a slight negative for FL to the extent that 1) it works and 2) it scales.
c) “We’re trying to see if there are ways of using technology, whether it be through mobile devices or visual or mannequins, digital mannequins and things like that…” Didn’t Ron Johnson say this a year ago? JC Penney is not exactly the beacon of excellence in this industry. These things are cool. But they cost money. It is in line with our view that the cost of growth in this business is going up.
In the end, if our numbers are right, there’s no reason why this stock deserves a double digit multiple on an earnings number that people realize is shrinking. You gotta remember, zero growth retailers have traded at 6x forwarded earnings – several times – and there’s no reason why M can’t test that again. We’ll give the best case earnings of $4.75 a 10x multiple. If you buy today, you’re playing for $7 upside. That’s good, but not when you put a 6x or 7x multiple on an earnings number closer to $3.00. That’s almost 3 to 1 downside/upside for a consensus long at a point when the competitive pressures are going to start coming on strong and M’s revenue base will be assaulted. That sounds dramatic, but we think it’s how you need to contextualize the massive move that JCP is making to kick its merchandise into high gear, and how the competitive landscape will respond.
In preparation for IGT's F4Q 2012 earnings release Thursday, we’ve put together the recent pertinent forward looking company commentary.
YOUTUBE FROM F3Q CONFERENCE CALL
- "We continued to see positive growth in our global fixed fee installed base, with an increase of 10% this year."
- "We remain confident that our international business will continue to be a strong contributor to both revenue and earnings moving forward."
- "The gaming operations environment, particularly in the wide-area progressives, remains extremely competitive."
- "We expect our fully diluted weighted average shares outstanding to be 291 million shares for fiscal 2012. Inclusive of dividends, we anticipate returning over $0.5 billion to shareholders in fiscal 2012, a clear indication of the strength of our cash flows and confidence in our strategies."
- [4Q outlook] "I think Double Down is the same. Double Down, we have a couple new products launching in August."
- "We have a couple thousand, I think, coming in the next quarter, but it's coming into new provinces where we have to get through the compliance process, so those things are in the balance. We have a little bit of Illinois in the fourth quarter. Currently, again, those things sit in the balance in many cases. We've got a couple of new Ohio properties that can go either way in the quarter."
- "We always hear very optimistic things about the intent to purchase. I think it has been less predictable. You can see in our North American replacements there were very strong shipments this quarter. We felt very good about the replacement market, so I think that that's an indication of confidence. We'd like to see that trend continue. The things that we hear from operators would indicate they'd like to continue to put capital to work, so we just have to get a little help from the economy."
- "The share repurchase is now factored into our guidance."
- "It's a fiercely competitive market and probably as competitive as it has ever been."
- "I'd characterize the VLT and the used unit sales, they're obviously dragging down the ASP. And then absent that, the sales pricing is flat against the backdrop that Patti mentioned on a unit-to-unit basis, with the non-MLD units in the mix higher than we had expected, but essentially pricing flat among those products."
- "We're obviously handily beating last year on the revenue line, but we're having challenges on the margin associated with game ops and then some of the international product sales, and we expect that those will continue to a degree."
- "But I think the yield declines are really, it's a three-headed monster for us, right. We have the economy, which I think is having an impact for us. It has been a much more elongated, as we all know, protracted recovery. So the economy is having an impact. The competition is having an impact. There are a lot more choices of games, particularly in the wide-area progressive area. That wide-area progressive business model has been under pressure for some time, and there is a lot of choices there. And then the last is we have a couple of products that aren't performing in that area that we're addressing. We've made some changes. We've made personnel changes and some process changes and some quality testing changes that I think have been long overdue."
- [2Q SG&A, R&D, D&A good run rates?] "I think you're going to continue to see some level of growth there as, for example, advertising and selling continue to factor into the Double Down model. But we will continue to make those investments as long as they're accompanied by growth in revenue, which we are seeing."
- "There's nothing that leads us to believe in any way, shape, or form at the moment that we would have an impairment issue with Double Down."
- [NA competitive environment] "I think the competitive environment there has remained relatively constant. So I would say it certainly hasn't decreased, but we haven't really seen a significant uptick either in either discounting or in the sheer volume of competitive product that's available."
- [Double Downs] "It's that need to move into the translation era with the product, into new languages... If you looked at English speaking companies, you would see it's the lion's share of the revenue. So that's an area I think that we have to make some improvement in, not just from a product perspective, but from a marketing perspective....(timing of new language conversions) I would say most of it you'll see in calendar year 2013."
Today, we held our expert call with former Special Inspector General of the Troubled Asset Relief Program (SIGTARP) Neil Barofsky for our subscribers. On the call, Barofsky discussed his time as Special Inspector General and the intricacies of working with the Treasury Department and America’s largest banks. He provided an incredible look at how the government and Wall Street work together in times of distress.
After the call, Hedgeye CEO Keith McCullough and Barofsky held a Q&A session which we’ve posted below. Enjoy.
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