Punchback: More Reasons Why I’m Bullish

Since I put out my 3/5 “I’m Getting Bullish” post, to say that I’ve gotten ‘pushback’ would be under-stating the truth. I’d call it something like ‘punch-back’ On one hand, so many people seemingly still are ‘not allowed’ to be bullish, and will cling on to every bit of fundamental ugliness they can. Others will accept part of the argument, but are remarkably guarded (understandable). Out of all of my clients, there is only one who is ‘all-in’ as it relates to this theme (you know who you are!).

As a reminder, I think we are headed towards a perfect storm of positive fundamental inflection points. The real consumption delta turns positive, COGS declining while gross margin compares get easy, absolute SG&A cuts take discretionary spending down by 2-300bp, capex growth in retail goes from 10%+ down to -5% -- ALL AT THE SAME TIME! Talk about FCF pop…

What I’m interested to see is that there is one of these line items that people really don’t want to believe. You cannot argue with capex cuts or SG&A reduction. That’s simply because a bunch of CFOs stood up and proclaimed such as gospel (one of the few things in the model they can control). Initially, my assumptions on real consumption were the initial target – but once I walk people through the fact that it is the DELTA in real consumption that drives this model, I get less pushback there (i.e., for the delta to get worse, we’ll need to revisit the Great Depression.) Keith has been referring to our current situation as ‘The Great Recession’ and we are collectively firm in our view that we won’t revisit the doomsday scenario of the 20s and 30s.

The really big pushback has been on the Gross Margin line. We are 2 quarters into the biggest gross margin hit that this industry will have seen in history. Margins have been down 150bp, and are now looking at about -250bp. I am assuming that we hold this rate and then that the 2-year trend stays flat-out ugly into 2010. But to get there, it suggests that the 1-year trend turn up meaningfully in 2H. Let’s take off the simplistic ‘extend the trend’ modeling pants for a minute (that we never wear in the first place) and look at some real numbers and trends.

1) Anybody watching cotton prices? Check out my 3/15 post. It’s dropped like a stone back down to $0.50. Is this a huge component of the P&L? No. But even at 5% of COGS, it matters when it is down 40%. Anybody know what happens when absolute COGS dollars on a like-for-like item declines by 2%? Yes, more money is freed up in the supply chain.

2) Anybody watching China? The narrative here is so powerful. China accounts for 87% of US footwear consumption, and 30% of apparel (and growing). Let’s think about last year for a minute…

a. 2008 started out with the biggest snowstorm in China in 100 years. It completely shut down the Eastern provinces and the logistical infrastructure of the country was put to (and failed) the stress test. Factories were boxed into a corner.

b. The tragic earthquake in the spring was a double whammy. Not only did this test the infrastructure once again, but the ‘human factor’ prompted migrant workers – that account for about a third of production in the Pearl River Delta factories – to simply not show up. Migrant workers that don’t migrate? Yes, that’s a problem.

c. A third important point is that in advance of the Olympics, the Chinese government cracked down on sweat shops, and started to mandate that factories pay employees back-pay for unused vacation time. You know how Americans take 2-3 weeks of vacation per year at best? And how the Brits will commonly ‘go on Holiday’ for a 5-week clip at a time? Trust me; compared to the under-vacationed US workforce, the Chinese factory-worker culture makes us look like Americans are on permanent vacation.

d. What does all this mean? Natural disasters stressed output and tightened prices for exports in aggregate. Then the government decided to wipe out the ‘sweat shop’ factor to appease human rights activists. You might say ‘the Chinese don’t ‘appease’ anybody.’ Well, in the months alongside the Olympics – otherwise known as China’s coming out party – I’m willing to bet that China reigned in its pride and cleaned itself up a bit.

e. Oh yeah…did I mention that export taxes went up at a steady clip since 2006 as China changed its tax system to encourage local consumption over export? So we’re looking at a teens rate of import taxes…that has been recently reduced to zero. Yes, a donut.

f. Bottom line? China went through a 2-year capacity tightening phase, which pressured pricing in this industry. Using footwear as an example, there were 12,000 factories in the Pearl River Delta 2-years ago. Now there are about 6,000. That number stopped going down. Will it go up? I’m not sure. That will depend on demand. But price pressure out of China is easing on the margin, and arguably in absolute terms.

Our models are heavily dependent on rate of change. Just about any way I slice this onion, that gets better in 2H.
Supply chain squeeze turns reverses in 2H.


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