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CRI: Idea Alert. Shorting.

Takeaway: This is a core short idea and one that we see with 20%-30% downside from current levels.

We added CRI on the short-side of our Real-Time Positions on green today. This is one of our core short ideas and one that we see with 20%-30% downside from current levels.

We went into 3Q (10/25) and outlined in our CRI Black Book on 10/15 that we didn’t expect a miss due to an inflection in margins (i.e. product costs turn favorable), but that we expect the reality of our thesis – lack of product differentiation and increasing competition resulting in pricing/margin pressure – to play out more visibly in Q4 and into 1H F13. We had investors short the bounce on earnings and Keith is doing the same here today on lower highs.

In short, we think there is a disconnect between what management (and investors) think margins can get to and what will ultimately transpire. There’s a full 3pt spread between our margin estimates and consensus. Wholesale revenues just turned negative for the first time in 9-quarters and retail comps remain a concern with underlying (2yr) Carter’s and OshKosh comps decelerating with a tougher setup ahead over the next 2 quarters. With price increases no longer holding (a new development as of 3Q call), we think the lack of product differentiation/ segmentation will prove margin expectations overly optimistic.


To request our detailed CRI Black Book with complete analysis, please contact .

CRI Setup by Duration:

CRI: Idea Alert. Shorting. - CRI TTT

CRI Risk Management Levels:

CRI: Idea Alert. Shorting. - CRI TTT Chart



CRI SIGMA is starting to roll:

CRI: Idea Alert. Shorting. - CRI S

FDX: Process Positive on Purple

Takeaway: FDX can work in several ways, from cost cuts to improved inventory trends. We like the win-win dynamic in an uncertain, stall speed economy.

FDX: Process Positive on Purple

  • The Cycle:  The Express & Courier services industry cycle is driven primarily by economy-wide inventory levels, which are currently high relative to trend.  However, excess airfreight capacity, declines in global trade and the relative pricing of containerized freight have also been headwinds for express volumes.  Those headwinds have reversed recently or are likely to in coming quarters.  In addition, FedEx Express has significant cost reduction opportunities that can drive share price upside independent of the cycle, in our view.
  • Industry Structure:  The Express & Courier services industry has an attractive industry structure.  The industry is highly consolidated, with rational competitors, fragmented customers and few relevant suppliers. 
  • Valuation:  We think that FDX provides the best cyclically adjusted valuation opportunity in the group, with upside to our base case in the 30-70% range (bear $85, base $120-$150, bull $180).  Critically, our ~$85/share bear case model suggests little potential downside from current levels if our thesis fails.  In addition to improved operating conditions, we believe FedEx Ground is likely to displace UPS as the dominant US parcel ground operation.
  • Favorable Risk Balance:  With key cyclical factors apparently turning FedEx's favor, several sizeable internal cost reduction opportunities available, and market share gain potential in both US ground and Europe express, a lot can go right at FedEx.   While there are risks to our thesis (as always), we think that FDX represents an extremely attractive risk/reward balance at current levels.


Why Now(-ish)?

Cost Reductions - Better Late than Never:  The FedEx Express division is operating at a ~30 year low in margins.  The company has just turned its attention to improving margins in that division, as opposed to adding capacity.  The cost reduction opportunities, like swapping out 727s for more efficient aircraft, are unusually straight-forward.  It is a valid criticism, in our view, that these cost reductions should have been implemented some time ago.  Nonetheless, if margins return to historic or peer levels, the value of just the FedEx Express division could exceed the current market value of FDX, by our estimates.


FDX: Process Positive on Purple - 1



FedEx Ground Winning:  Investors we speak with frequently believe that UPS’s single network is superior to FedEx’s separate Ground and Express networks.  While there may be advantages in the UPS model, the reality is that UPS is steadily losing market share to FedEx Ground, in large part because of higher labor costs.  FedEx Ground has margins that we believe to be equal to or better than those of UPS’s ground operations, even though FedEx Ground has less than half UPS's scale.  At some point, the market may reprice FDX to account for this soon-to-be dominant franchise.  We also think that legal risks to the FedEx contractor model are lower under the current structure.


FDX: Process Positive on Purple - 2



FDX Ground Advantage Reflected in Market Share Trend


FDX: Process Positive on Purple - 3



Four External Headwinds:  Inventories, Containership Rates, World Trade Volume and Airfreight Capacity are important drivers of FedEx Express’s business.  The inventory to sales ratio is currently high relative to trend.  That has historically been a (rare) signal to buy Airfreight Logistics, by our estimates.  The price of containerized freight relative to airfreight reversed in the second quarter and airfreight capacity has begun to tighten in recent months.  World trade usually grows, but contracted in 3Q. 


1.  Inventories: The secular decline in the inventory to sales ratio stopped in 2005 and the ratio has spiked higher this year.  Both FDX & UPS shares are at or below their 2005 prices, despite significant business gains since then.


FDX: Process Positive on Purple - 4



2. Container Shipping: The trend of cheaper ocean rates relative to air rates appears to be reversing as the relative price gap has been narrowing since Q1 of 2012.  


FDX: Process Positive on Purple - 5



3.  World Trade: World export volumes have been down recently, but historically world trade has grown faster than world GDP.


FDX: Process Positive on Purple - 6



4. Air Freight Capacity: Weak volume growth amid relatively normal capacity increases has resulted in slack capacity.  A reversal of this trend should be positive for the group.

FDX: Process Positive on Purple - 7



TNT Deal:  At worst for FDX, the UPS/TNT deal would result in a more consolidated industry and distracted competition.  However, we believe that FDX is a potential buyer for the European express assets that have been a regulatory sticking point in the transaction.   A stronger European presence would improve Fedex Express’s global network, in our view.


FDX: Process Positive on Purple - 8



Valuation & Strategy

Win-Win Positioning:  From a strategy perspective, FDX should prove more resilient than the Industrials sector in a recession.  However, if the economy snaps back, cyclically stretched areas like inventories and world trade should drive improved results at FedEx.  While we may be a bit early in entering FDX, we like the win-win dynamic in an uncertain, stall speed economy.




F Jay Van Sciver, CFA

Managing Director

120 Wooster St.

New York, NY 10012

Race To The Top Or Bottom?

Looking at four major equity indices (S&P 500, Dow Jones Industrial Average, Nasdaq Composite, Russell 2000), we can see that the Nasdaq has been the best performer year-to-date. And up until mid-September, everyone would have laughed at you if you suggested that stocks would undergo a downturn later in the year. But since the September Bernanke Top, these indices are struggling to hold on to their gains. As growth slows and corporate earnings slow, it's tough being a bull.


Race To The Top Or Bottom? - image001

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Is the Gilded Age of High Yield Over?

Takeaway: On an absolute basis, high yield bonds are priced to perfection, especially with corporate earnings slowing.

Unless you have just been ignoring your Bloomberg terminal for the last few years, the fact that interest rates are literally at all-time lows should be no surprise.  In the chart below we look at the yield on 10-year Treasuries going back 30 years.  The yield on the 10-year Treasury hit an all-time low of 1.47% in July of this year.   


Is the Gilded Age of High Yield Over? - aa. 10yr



For the last few years, many investors have articulated a bear thesis on U.S. government bonds based on the extremely low yields.  For those that have actually implemented the thesis and shorted U.S. government debt, the trade was likely painful. In reality, shorting U.S. government bonds has been the proverbial “widow maker” trade over the past few years as bond prices have gone straight up and yields down.


Despite potential credit events, like the debt ceiling crisis in the summer of 2011 and a subsequent downgrade of U.S. government debt, yields on treasuries have continued to trend lower.  The monetary policy implemented by the Federal Reserve has had the intended impact of keeping rates low and has, seemingly, made investors think that the Fed is the ultimate lender of last resort, albeit by printing money.


By keeping interest rates at abnormally low levels, not only has the Fed induced lower rates on U.S. government bonds, but it has also induced lower rates on many types of loans – from mortgages to corporate debt.  In the two charts below, we highlight this by looking at the rates on 30-year mortgages going back 10 years versus a high yield US corporate bond index.


Is the Gilded Age of High Yield Over? - aa. mortgage



In some markets, like the residential mortgage rate, low rates have not increased money supply because of tightening lending standards.  Conversely, the high yield market is, as they say, flush with liquidity. Related to that last point, in October the U.S. high yield primary market hit $41.9 billion in issuance.  This trailed only September’s all-time high of $46.8 billion.  Yes, you read that correctly . . . September 2012 was the highest month of high yield issuance in the history of capital markets.  As of October, this year is 34% ahead of 2011’s full-year total and up 52% year-over-year through ten months.


Is the Gilded Age of High Yield Over? - a3



Clearly, low rates are inducing corporate issuers to refinance at record rates.  In fact, in the year-to-date 59% of total issuance of high yield debt has been utilized for refinancing.  This is a little less than the 64% of proceeds used for refinancing in 2010, although in 2010 55% of proceeds were used to address maturities versus only 43% this year.  So, corporations are taking advantage of the low interest rates to reduce their all in cost of borrowing.  In addition, these issuers are taking advantage of the search for yield by many investors to sell record amounts of bonds.


Morningstar published their most recent fund flows data for flows through October.  In the year-to-date, high yield fund inflows are +$27.9 billion and + $30.1 billion in the last twelve months.   High yield is the second largest inflow category in the last twelve months after intermediate term bonds.  On a percentage basis, though, high yield has seen the largest inflow of any of Morningstar’s top 95 asset categories growing 15.2% year-over-year.


The other interesting point relating to the high yield market -in addition to record low interest rates, record high issuance and record high yield fund inflows- is that terms for the issuers are almost as flexible as they have ever been.   This is best characterized by the re-emergence of covenant-lite loans, or loans with much more lenient terms for borrowers.   In the year-to-date, covenant-lite loan issuance is $49 billion.  According to Fitch, the recovery rate for covenant-lite loans is 55 – 60% versus an overall recovery rate of 62% for loans from 2008 – 2009.


Is the Gilded Age of High Yield Over? - a4



In aggregate, it seems like a frothy market for high yield, but high yield bulls would counter that the long term spread versus treasuries is not even close to its lows.  The chart below from the St. Louis Fed highlights this point as it looks at the spread of high yield versus comparable duration treasuries going back to 1997.  Currently, this spread is at 5.7% versus its low of 2.5% in 2007.


Is the Gilded Age of High Yield Over? - a5



While the spread versus Treasuries is an important metric, the underlying creditworthiness is probably even more critical, especially with high yields bonds trading at their lowest absolute level ever. The caveat is that defaults rates are currently very low on high yield bonds.   In fact, as of September the par weighted default rate, according to J.P. Morgan, fell to 1.83% and the issuer weighted default rate fell to 2.98%.  This is well below the peak on par basis of 16.3% in November 2009 and the peak on an issuer basis of 12.2% in March 2002.


Is the Gilded Age of High Yield Over? - a6



The reality is, though, that high yield bonds in aggregate are pricing in these low default rates.  On absolute basis, high yield bonds are almost perfectly priced given their all-time lows in yield.  So, investors are getting paid the lowest interest rate they have ever been paid to take the risk of owning high yield debt.


Our primary concern going forward relates to the corporate earnings and cash flow outlook.  One of our three Q4 themes is that corporate earnings growth is slowing, which we highlight in the chart below and played out in Q3 with SP500 earnings only up 0.9% year-over-year. To the extent that corporate earnings and cash flow begin to decline year-over-year, this will have a direct impact on the ability of corporations to pay their interest rates on borrowing and adversely impact their overall credit worthiness.  


Is the Gilded Age of High Yield Over? - a7



In addition to the outlook for corporate earnings and cash flow, the other key red flag we see for high yield is that volatility for the asset class is starting to accelerate.  By a recent estimate from ConvergEx Group, implied volatility for high yield bonds is up 64% in the last month.  This comes even as yields for these bonds have continued to decline.  Even if the high yield asset class is cheap on a relative basis, chasing high yield is far from a contrarian call at this point in the cycle, especially as corporate earnings look to be peaking.


Daryl G. Jones

Director of Research



  • With the implementation of the new slot machine rules in Macau today, five slot parlours will have to be relocated within one year— Yat Yuen Canidrome Slot Lounge and the Treasure Hunt Slot Lounge, both operated by SJM, and The Mocha Lan Kwai Fong, Mocha Marina Plaza and Mocha Hotel Taipa Best Western clubs, all operated by Mocha Clubs (MPEL).
  • As the cascading pie charts show below, we estimate the slot revenue that may be affected by this relocation is very minimal — only 0.5% of total GGR of SJM and MPEL combined.
  • The upcoming smoking restrictions and plateauing Mass table hold % are bigger issues facing Macau operators than the slot parlour relocations.



FL: Solid Update for Top Long

Takeaway: One of our top longs, FL’s sales are tracking ahead of plan and the setup is increasingly favorable into year-end

As a follow up to FL’s recent 3Q results, we think a reacceleration in athletic footwear industry sales after a slow start to November and a favorable near-term setup suggest a strong finish into year-end. We are also positive on FINL and NKE, which is another top long idea.

Consider the following on a TRADE basis (3-weeks or Less):

  • Athletic footwear sales have come in up +5.3% over the last two weeks after coming in down -6% in the first two weeks of November accelerating sequentially each of the last 3-weeks.
  • As seen in the chart below, continued underperformance in the other channels cause weekly sales to significantly understate performance in the Athletic Specialty channel (i.e. FL, FINL, DKS, etc.).
  • Basketball continues to be a significant driver with trailing 3-week domestic sales accelerating sharply higher +27% from +15% over each of the prior four weeks.
  • With FL reporting comps up +MSD through the first half of November despite the industry down -6% and sales over the last two weeks running +5%, we believe FL comps are tracking well ahead of the “upper end of mid-single digit” comp plan.
  • With a favorable setup through year-end and shift towards basketball in Europe, we expect more opportunity for further upside in performance.
  • Retailer sales gains over the holiday weekend were heavily reliant on deep promotional activity. We think athletic footwear retailers (FL/FINL) were substantially less impacted and benefitted from more full-priced sell through with several new launches hitting over the holiday week. Moreover, while several apparel and home furnishing retailers offered free shipping on certain items for the first time, there was no incremental hit to footwear retailer margins as free shipping has become standard.


The longer-term TREND (3-Months or More) & TAIL (3-Year or Less) call:

  • Still in the early stages of its turnaround, FL is not solely reliant on the ‘footwear cycle’ for growth.
  • A return to new store growth for the first time in over 6-years will augment comps benefitting from higher growth and higher margin businesses (i.e. Women’s, Apparel, and Kids).
  • After a decade of inventories outpacing sales growth and contracting margins under Matt Serra, FL has posted positive sales/inventory growth and margins expansion over the last three years under Ken Hicks.
  • We’re see more opportunity for upside performance over the intermediate-term and are looking at $3 in earnings power next year approaching $3.50 in F14.

FL: Solid Update for Top Long - FW App Table

Source: NPD Weekly POS Data


FL: Solid Update for Top Long - FW 1YR


FL: Solid Update for Top Long - FW Cat


FL: Solid Update for Top Long - FW Channl



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