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.


The good news: MGM management negotiated their way to an amendment on their credit facility to push them past a probable March 31st covenant breach. The bad news: the extension expires on 5/19/09.

Our initial view was that since the extension was only for 2 months, it probably means that MGM is either: 1) close to some transaction, financing, etc (good) or 2) the banks are throwing MGM a short lifeline but really just postponing the inevitable foreclosure (very bad). After discussion with people very versed in bankruptcies and reorganizations, we believe #1 is possible but #2 is unlikely. This is probably not as binary a situation as it may appear.

Our main takeaway here is that MGM and the banks are in pretty much the same situation as before their amendment agreement. The banks do not want to foreclose and MGM needs to make progress on a long-term solution to its liquidity issues. We don’t think May 19th is a drop dead date. It’s a reevaluation date.

So what are MGM’s options? Pretty much the same as before. Importantly, MGM did not collateralize any of its assets, so that improves their position to get outside financing. Any solution will certainly involve asset sales. More amendments, sale leasebacks, an equity infusion, and debt swaps (higher rate for longer maturity) could all be part of the mix.

We’re disappointed that the company didn’t announce a more concrete solution. The duration of any definitive outcome is likely to be much longer than the amendment would indicate. We are pretty confident in that. MGM will continue to trade as an option with huge volatility. MGM promises to be very communicative with the Street, unlike the last few weeks. With the number of potential data points over the next several weeks/months, MGM could be an attractive trading vehicle, particularly given what is likely to be an active day for the stock today.

Trend/Trade: Keep an Eye on DKS

“DKS breaking out on both TREND (12.46) and TRADE ... $15.19 is next; 20% short int!” Keith’s comment to me can’t be ignored when juxtaposed against my 3/13 post on DKS comps likely having bottomed.


Street estimates continue to look high to me. WMS probably should’ve lowered 2009 guidance in their FQ3 earnings release, but they didn’t. I don’t doubt the success of WMS’s new games but there aren’t many new casinos or expansions in the pipeline. Replacement demand won’t make up the difference. I know the sell side wants to get behind a growth story (11 out 16 ratings are buys), but the casinos (and their creditors) are not cooperating. EPS growth in 2H F2009 and full year F2010 may only be flat to up low single digits.

The first chart details our industry wide projections for slots sales into new casinos and expansions and the year over year change. From the data, it’s pretty difficult to walk away with the conclusion that WMS has a lot of near or intermediate term growth, even if they resume market share gains. The numbers are pulled from our database of every new casino and expansion opening in North America over the next 2 years. The September quarter of 2009 is the only quarter through the end of 2010 where there is a positive delta in domestic slots to new/expanded casinos.

The second chart provides the projected growth by the Street. Currently, the consensus EPS estimates for 2H F2009 and full year F2010 are $0.81 and $1.63, respectively, representing growth of 19% and 14%. Meanwhile, we project total domestic slot unit declines for the industry of 44% and 22%, respectively, over the same period. That’s with a 25% increase in projected replacement demand! As can be seen in the first chart, slot unit sales to new casinos and expansions will be down even more. WMS would need to grow its market share by 10 percentage points to 32% to hit the Street’s domestic unit sales estimate of 19,000 slots in F2010, based on our industry assumptions.

Clearly, there is a big disconnect between the two charts. Market share gains and replacement demand won’t be enough to bridge the gap.

Significantly negative growth in every quarter except Q3 2009
Hard to reconcile this chart with the one above

RE-SHORTING JAPAN: Does Bernie Madoff sit on the BOJ’s board?

Does Bernie Madoff sit on the BOJ’s board?

Today was day 1 of the BOJ policy board meeting and the top issue on the agenda has been what to do to help prop up Japanese banks, which are straining under the weight of their collapsing stock portfolios in a vicious cycle that sends equities lower, in turn.

The banking sector rejected the opportunity to sell preferred stock to the government last December for fear that the stigma would cause a loss of confidence among shareholders and overtures by the central bank last month to purchase concentrated cross-holdings directly from the banks in off market transactions were rebuffed by CEO’s unwilling to publicly book losses (Japanese accounting practices are more opaque than those in the US).

After attempting to lead a horse to water but failing to make it drink on multiple occasions, the BOJ is now trying a new approach. A new program is being discussed which will provide up to $10 billion in subordinated loans to banks whose capital ratios have been decimated by declines in their equity investments.

The hope is that this measure will help maintain capital ratios to prevent spiraling liquidations in the stock market, but the modest size suggests that this is a “band aid” and the impact on domestic credit liquidity could be minimal. The bank is also expected to announce treasury buying to combat rising yield. As of this morning, the Nikkei had rallied 12.67% for the week into high expectations for these and other programs.

By our reckoning there may be good news here for the markets in the short term but not for the actual economy. Extending margin loans to levered banks to prevent them from being forced to sell stocks while buying debt to keep yields low strikes us as just delaying the inevitable. After decades of stagnation Japanese financials are living on borrowed time.

Into the strength associated with the recent market squeeze, we re-shorted the Japanese equity market rally via the ETF EWJ today. This is a tactical short; we expect the market there to pull back when reality sinks in over the coming weeks. We will leg into our virtual short position at higher levels if the rally continues. Everything has a time and a price.

Andrew Barber

Shark Line 762: SP500 Levels, Refreshed...

I can assure you that AFTER making 17 consecutive shorts and long sales in our Virtual Stock Idea Portfolio this market’s resilience today surprises me. Being data dependent however, the math (refreshed for 3PM EST prices) is telling me a close above the 762 Shark Line (dotted white line) could get this short squeeze to 790 in the SP500 (dotted red TRADE line) in short order.

At 790, nothing from an immediate term TRADE perspective will have changed other than going straight up to the top of a trade-able range. The Bear Market’s intermediate TREND line remains overhead (solid red line) at 830.

I was first given the gun to manage a “carve-out” of a hedge fund in the year 2000. In the Baby Bear market of 2000-2003 the average trough-to-peak squeeze rally in stocks was just north of +17%. The 2009 SP500 closing trough price was 676 (we got bullish for a TRADE there); if we see that 790 print, that will have been a +16.9% move, trough-to-peak. I have seen this movie before.

TRADE and tread carefully as we push to the topside of the range. All of the Bulls have been Bearish, and you can bet your Madoff that they’ll get sucked into this at that immediate term top.

Keith R. McCullough
CEO & Chief Investment Officer

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