I’m convinced that supply chain pressure of the past 2 yrs will ease. Perhaps temporarily…but it will ease. And Soon. Add SG&A/capex cuts, positive sales delta and cheap stocks… You get the picture.
This might be the longest note I’ve ever posted, but the narrative must be spelled out in every detail. To ignore this will be to ignore a potentially meaningful second leg of a retail rally (but this time driven by fundamentals – augmenting my 3/5 call).
China accounts for 87% of US footwear consumption, and 30% of apparel (and growing). Let’s think about history for a minute…
1) From 2000-2007, margins for Asian manufacturers went down by 8 points. Margins for the brands went up by 8 points. Retail margins have been flat. There's only so much margin to go around, so the direct inverse correlation is no coincidence.
2) In the early 2000s Asian manufacturers had around a 15-20% gross margin, which was more than enough to offset the roughly 10% in SG&A and capital costs to turn a profit. This was especially the case given that the Chinese government rebated the VAT tax, which added between 3-7% in net profit for the manufacturers. All said, life was good as a manufacturer, which is why capacity grew at a mid-single-digit clip. Excess capacity = more pricing leverage on the part of the front-end of the supply chain.
3) Starting in early 2007, factory gross margins approached the break-even hurdle, Chinese VAT tax rebates were phased out to stimulate local consumption as opposed to export, and costs headed higher across the board.
4) The result? Capacity growth slowed meaningfully, and was flattish by the end of the year. This meant that the pendulum swung back into the hands of the US supply chain with $3-4bn annually to pad the supply chain.
Then came last year, which caused a massive reversal in the Asian side of the equation – and came alongside (and intermingled with) the US Great Recession.
1) 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.
2) 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.
3) 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.
4) 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.
5) Oh yeah…did I mention that not only did the VAT tax rebate come down, but absolute export taxes went up at a steady clip in 2007/08 as China changed its tax system to encourage local consumption over export?
6) China went through a 2-year capacity tightening phase, which pressured pricing in the US supply chain for this industry (and others). Using footwear as an example, there were 12,000 factories in the Pearl River Delta 2-years ago. Now there are about 6,000.
Ok smarty pants…so now what?
1) We’re looking at a teens rate of import taxes…that has been recently reduced to zero. Yes, a donut.
2) Today China announced that its VAT (Value Added Tax) tax rebates on garments go up to 16%. Yes, this means that local factories are incentivized again to export product as the government funds enough of their P&L so they can sell product at a break even rate and still be cash flow positive.
3) Within hours of China’s announcement, Vietnam proposed to cut its Value Added Tax (VAT) on VAT on yarn, fabric, and garments, as well as reduce the corporate income tax rate by 30 percent for textile, garment and footwear industry.
4) As a kicker we see Nike pulling out of four Asian factories – three in China and one in Vietnam. This is part of Nike’s restructuring, but is pretty darn well timed given geo-political events. I guess Nike ‘does macro.’
The bottom line: I am convinced that the supply chain pressure we’ve been feeling over the past 2 years will ease. Perhaps temporarily…but it will ease. Add on SG&A/capex cuts, a positive sales delta and cheap valuations… You get the picture. Names I like best in retail include BBBY, RL, LULU, LIZ, UA, and DKS. I don’t like those who are cutting into bone to print profit, such as Ross Stores, Iconix, Sears, Carter’s, Jones and Gildan. The challenge here is that this latter basket of companies will also show a reversal in cash flow trends, temporarily masking the damage they are doing to their base business.
I’ll be working closely with Keith to game the sizing and timing on these fundamental ideas when the group looks more ‘shortable’ and/or when the near-term fundamentals for each of these names present an opportunity.
I’m convinced that supply chain pressure of the past 2 yrs will ease. Perhaps temporarily…but it will ease. And Soon. Add SG&A/capex cuts, positive sales delta and cheap stocks… You get the picture.
As market practitioners, we wake up every day with a hunger to find order in the markets. And to Benoit Mandelbrot’s (the Father of Fractals) point above, order does not come by itself. Global markets are complex and to some seemingly unpredictable.
In the Early Look today, we wrote:
“Across asset classes, global markets have revealed themselves as being as interconnected across a multiple of interacting fundamental factors as they have ever been. Mathematicians call this chaos theory.”
It is our fundamental belief that while markets are complex, they are neither random, nor uniformly unpredictable.
Our idea of applying chaos theory to markets was probably first and most widely used by Bruce Babcock, a Yale graduate, former State attorney in California, and prolific trader of commodities. He wrote as it relates to chaos theory and markets:
“According to respected authorities, the markets are non-linear, dynamic systems. Chaos Theory is the mathematics of analyzing such non-linear, dynamic systems. Chaos analysis has determined that market prices are highly random with a trend component. The amount of the trend component varies from market to market and from time frame to time frame. A concept involved in chaotic systems is fractals. Fractals are objects which are "self-similar" in the sense that the individual parts are related to the whole.”
As outlined in Bruce Babcock’s quote above, chaos theory is used to describe the behavior of a system that is constantly evolving, a dynamic system. The stock market is, for its ever evolving nature, the perfect system for utilizing chaos theory as a framework to analyze and forecast.
When we make a market call, it is based on a proprietary 27-factor model, in which the primacy of the factors evolve, much like a chaotic system, with time. But the basic organization, the 27-factors, remains largely constant, even as certain factors become more important over different market periods. While we don’t disclose our proprietary methods, or all 27 factors, clearly we are focused on both the US dollar and volatility currently as primary deterministic factors.
In some sense, the term chaos is at contrast with the theory. Chaos suggests disorganization, while chaos theory itself implies that there is a pattern, or initial deterministic conditions, behind the seeming randomness. That is, there is actually a method and reason to the madness.
In 1890, while studying the three-body problem, Henri Poincare found “that there can be orbits which are non-periodic, and yet not forever increasing nor approaching a fixed point.” As result of this discovery, Poincare is considered the father of chaos theory. If Poincare is considered the father, then Edward Lorenz would have to be considered the person most responsible for inserting the theory back into modern scientific thought.
Lorenz was studying weather prediction in 1961. He was using a basic digital computer to run his simulations. In an attempt to see a prior sequence of data, he started a simulation in the middle by entering data from a print out. In contrast to the prior simulation, this simulation produced a completely different set of data outputs. The key difference was that the revised simulation used only printouts, which had 3-digit numbers versus the original simulation which used 6-digit numbers. The key conclusion was that small changes in initial conditions can lead to large changes in the long-term outcome.
As a start-up business, we have also applied chaos theory to internal organization. When Keith, Michael, and Brian started Research Edge over a year ago now, the Company was much less complex, in fact it was a concept on a whiteboard. In less than a year’s time, we have evolved to three offices and over thirty full and part time employees, and a great client base of savvy investors who continually keep us challenged and add to our research network.
A key way in which we try to differentiate ourselves is to be first to market with information that is meaningful on the margin. As we say repeatedly at Research Edge, when the things change that matter, they change on the margin, so this is where we want to focus. Marginal changes will predict much larger changes in the future, which is consistent with chaos theory.
Only time will tell whether we will be proven right on the ability to make stock market calls based on a foundation of chaos theory or whether our internal organization based on a fractals is as effective as we expect it to be, but as the Father of Fractals also said:
“When the weather changes, nobody believes the laws of physics have changed. Similarly, I don't believe that when the stock market goes into terrible gyrations its rules have changed.”
Daryl G. Jones
To be clear, I said that housing would bottom in terms of sequential price declines and inventory growth in Q2 of 2009.
We are getting closer by the day!
According to the S&P/Case-Shiller index, home prices in 20 U.S. cities fell -19% in January from last year. The decline was more than the -18.6% decline in December. The index has declined every month since January 2007.
There are two new incremental data points since the December S&P/Case-Shiller numbers were reported that support our call. First, while the glut of foreclosed homes will keep prices down, sales of new and previously-owned homes rose in February, indicating the housing slump could be at an inflection point. Second, Robert Shiller himself said on Bloomberg TV this morning that "the rate of decline of the rate of decline" will begin to turn shortly.
Arresting the slide in residential real estate should become the leading indicator that the worst of times is over; or at the very least, that the bottom is near. Increased confidence in the real estate asset class will allow the assets to obtain higher prices.
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Starwood has beaten quarterly expectations 6 straight quarters. We call that sandbagging, since the company knows that the analysts robotically model to management guidance. What is more important though is that management also lowered full year guidance on five of those quarters. We’re predicting that the streak won’t end in Q1.
We estimate 1Q09 EBITDA of $170MM and full year 2009 EBITDA of $750MM. Our quarterly estimate is 11% higher than the mid-point of HOT’s guidance and consensus. However, even with a projected Q1 beat, our 2009 estimate is 11% below the street and 14% below company guidance. The gap between our EBITDA expectations vs. the Street widens further to 19% in 2010, as we project EBITDA of $675MM.
Using a weighting of HOT’s top 10 US cities and reported Smith Travel data through March 21st we estimate that HOT’s US RevPAR will be down 24.5% in the 1Q09. International RevPAR is tracking down 20% in local currency, while Mexico is flat-ish and Canada is negative -13% QTD, before layering in the FX drag. As we wrote about in our MAR note “KEEP A TRADE A TRADE” (03/30/09), now that ADR is making a larger % of the RevPAR drop, the margin impact should be materially greater than what HOT experienced in 2008. We assume no easing in RevPAR drop until 4Q09. In 2010, we expect ADR to be down in the 3-5% range with occupancy increasing 1%.
Our estimates assume cost cutting at both the SG&A level and at the property level. We assume that cost per occupied room “COSTPAR”, will decrease 5% in local currency and around 12% on an FX adjusted basis for 2009. For 2010, we assume modest cost increases in the 50-100bps range at the property level. However, we don’t think that there will be much room to cut costs, and therefore we expect another year of margin erosion. We assume that SG&A decreases 15% in 2009 and remains flat in 2010.
Based on these assumptions, we expect owned, leased and consolidated JV margins will deteriorate 750 bps in 2009 and 340 bps in 2010. As a reference point, the chart below shows what happened to margins during the last lodging downturn which began in 2001. HOT’s owned/ leased/ JV margins peaked in 2000 at 33.5%. Margins bottomed in 2003 at 22.5% after an 11% decline from peak to trough on a 15.9% cumulative RevPAR decline. In the years to follow, cost growth ate away at the much of the RevPAR increases, with peak margins only recovering to 25.7% in 2007 on a cumulative RevPAR increase of 35.5%.
Fortunately, we’ve been on the right side of this story, first calling for margin and estimate cuts in our 06/23/08 post, “IF YOU DO MACRO YOU WON’T DO THESE STOCKS”, and continuing with the theme throughout the rest of 2008 and 2009. We’ll take a shot trading these stocks from time to time but for right now, HOT and the sector are not likely to sustain any rally until estimates come down and occupancy stabilizes.
"Never mistake a clear view for a short distance"
~ Paul Saffo
As we push this puck over the goal line into another solid quarter end, we'll have plenty of math to reflect upon this evening. Winners and losers for both the month of March and 2009 YTD will no longer be a trivial exercise. Some people missed stuff - some people nailed stuff - it's all cool.
By some market strategist counts, 3-months is not a very long time - particularly for not so cool horse and buggy whip Street savants who still profess the US centric mantra of "stocks for the long run."
What is the long run these days anyway? Is it what it used to be? Is it what the asset manager whose objective is having money to manage needs the client to think? Or is investment duration what the client decides?
I have a sneaking suspicion that most Americans invested in, say, the Dow or the SP500 index funds are starting to generate different views to Wall Street's answers on some of the aforementioned questions. The New Reality is that all of the received wisdom of managing risk and portfolio diversification will continue to be challenged. Losing other people's money isn't cool.
Despite yesterday's -3.5% correction, the SP500 is still +7% for March-to-date, and +16.4% from the March 9th low. After seeing the SP500 down -11% in February, plenty of investors rightly ran for the exits. All the while, those who were diversified across countries, currencies, and commodities stayed cool.
Staying cool? Isn't this the Great Depression? While that definitely turned into the crutch for those who were YouTubed as destroyers of capital, making up narrative fallacies for their incompetency, isn't cool. In 2009, there have been many meaningful reflation TRADES to capitalize on.
In USD terms, let's look at some YTD performance:
1. China +30%
2. Russia +10%
3. Copper +27%
4. Oil +9%
5. Gold +5%
I know, I know... up until say 18 months ago, a lot of "smart" people in this business proclaimed to me that global macro wasn't a place where you "could get edge"... While I acknowledge that some of this industry's insecure only feel warm and fuzzy about buying something after having a "one on one" with a corporate executive who gives them "body language" on the upcoming quarter - that isn't cool.
Does the client understand that there are problems associated with that investment plan when the CEO or CFO across the table from you doesn't do global macro either?
You see, there is no received wisdom in doing "one on one's" with companies who have less of a clue than you do about global macro. Acting on what they think is not an investment process. That's called a hope and a prayer, and it ain't cool.
As an investor who has made plenty of mistakes in my career, I have learned one thing - evolve. If I don't, someone will be more right than me every day - and I really don't like that. The New Reality is that global macro is cool. Across asset classes, global markets have revealed themselves as being as interconnected across a multiple of interacting fundamental factors as they have ever been. Mathematicians call this chaos theory. Einstein would call this cool.
Cool is one of my favorite words. Cool is having a 17-month old son with big teeth and crazy curly hair. Cool is what having positive absolute performance in our Asset Allocation Portfolio in February, March, and 2009 YTD is (it also lets my wife tolerate my work hours!). Cool is being able to tell our clients that we can quantify solving for alpha in 2009 to-date. Cool is understanding that we don't have to be professional "one on one" meeting organizers to earn a client's respect.
Cool isn't what Larry Kudlow does every night in this country. Kudlow was calling the US Dollar being up yesterday a "mustard seed"?? Last night he said the US Dollar has had a great move in the last 2 weeks - notwithstanding that checking the replay reminds us that within his stated duration was the worst down move in the US Dollar index EVER (that's why stocks went up Larry, fyi), what are investors and our hard working American families to do with this received wisdom? Just turn it off... being politically polarized and sloppy stating your gospel as fact ain't cool any more Larry...
The New Reality is all about evolution. Tonight, as we reflect upon the macro TREND of 2009 (US Dollar UP = US Stocks DOWN), I can only hope that Larry and his reckless entertainers over at CNBC correct their mistakes, review their performance in the last month, quarter, and year to-date, and hold themselves accountable.
Hope, unfortunately, is not an investment process... but man would that be something that's really cool for all Americans who were sold on the "stocks for the long run" by Kudlow and Co. to see.
From yesterdays SP500 close of 787, my immediate term risk versus reward for the US market is -3%/+2% (SPX 763 and 802).
RSX - Market Vectors Russia-The Russian macro fundamentals line up with our quantitative view on a TREND duration. Oil has benefited from the breakdown of the USD, which has buoyed the commodity levered economy. We're seeing the Ruble stabilize and are bullish Russia's decision to mark prices to market, which has allowed it to purge its ills earlier in the financial crisis cycle via a quicker decline in asset prices. Russia recognizes the important of THE client, China, and its oil agreement in February with China in return for a loan of $25 Billion will help recapitalize two of the country's important energy producers and suppliers.
QQQQ - PowerShares NASDAQ 100 - We bought QQQQ on Wednesday (3/25) on the pullback. We believe the NASDAQ has moved into a very bullish tradable range and is breaking out from an intermediate TREND perspective alongside the more Tech specific XLK etf.
USO - Oil Fund- We bought oil on Wednesday (3/25) for a TRADE and are positive on the commodity from a TREND perspective. With the uptick of volatility in the contango, we're buying the curve with USO rather than the front month contract.
EWC - iShares Canada-We bought Canada on Friday (3/20) into the selloff. We want to own what THE client (China) needs, namely commodities, as China builds out its infrastructure. Canada will benefit from commodity reflation, especially as the USD breaks down. We're net positive Harper's leadership, which diverges from Canada's large government recent history, and believe next year's Olympics in resource rich Vancouver should provide a positive catalyst for investors to get long the country.
DJP - iPath Dow Jones-AIG Commodity -With the USD breaking down we want to be long commodity re-flation. DJP broadens our asset class allocation beyond oil and gold.
XLK - SPDR Technology-Technology looks positive on a TRADE and TREND basis. Fundamentally, the sector has shown signs of stabilization over the last several weeks. Semiconductor stocks, which are early cycle, have provided numerous positive data points on the back of destocking in the channel and overall end demand appears to be stabilizing. Software earnings from ADBE and ORCL were less than toxic this week and point to a "less bad" environment. As the world stabilizes, M&A should pick up given cash rich balance sheets in this sector and an IBM/JAVA transaction may well prove the catalyst to get things going.
EWA - iShares Australia-EWA has a nice dividend yield of 7.54% on the trailing 12-months. With interest rates at 3.25% (further room to stimulate) and a $26.5BN stimulus package in place, plus a commodity based economy with proximity to China's H1 reacceleration, there are a lot of ways to win being long Australia.
GLD - SPDR Gold- We bought gold on a down day. We believe gold will re-assert its bullish TREND.
DVY - Dow Jones Select Dividend -We like DVY's high dividend yield of 5.85%.
UUP - U.S. Dollar Index - We believe that the US Dollar is the leading indicator for the US stock market. In the immediate term, what is bad for the US Dollar should be good for the stock market. The Euro is up versus the USD at $1.3283. The USD is up versus the Yen at 98.3150 and down versus the Pound at $1.4274 as of 6am today.
XLI - SPDR Industrials- We shorted XLI on 3/26; industrials remain broken on a TREND basis.
EWL - iShares Switzerland - We shorted Switzerland for a TRADE on an up move Wednesday (3/25) and believe the country offers a good opportunity to get in on the short side of Western Europe, and in particular European financials. Switzerland has nearly run out of room to cut its interest rate and due to the country's reliance on the financial sector is in a favorable trading range. Increasingly Swiss banks are being forced by governments to reveal their customers, thereby reducing the incentive of Switzerland as a tax-free haven.
LQD - iShares Corporate Bonds- Corporate bonds have had a huge move off their 2008 lows and we expect with the eventual rising of interest rates in the back half of 2009 that bonds will give some of that move back. Moody's estimates US corporate bond default rates to climb to 15.1% in 2009, up from a previous 2009 estimate of 10.4%.
EWJ - iShares Japan - Into the strength associated with the recent market squeeze, we re-shorted the Japanese equity market rally via EWJ. This is a tactical short; we expect the market there to pull back when reality sinks in over the coming weeks. Japan has experienced major GDP contraction-it dropped 3.2% in Q4 '08 on a quarterly basis, and we see no catalyst for growth to return this year. We believe the BOJ's recent program to provide $10 Billion in loans to repair banks' capital ratios and a plan to combat rising yields by buying treasuries are at best a "band aid".
DIA -Diamonds Trust-We shorted the DJIA on Friday (3/13) and Tuesday (3/24).
EWW - iShares Mexico- We're short Mexico due in part to the country's dependence on export revenues from one monopolistic oil company, PEMEX. Mexican oil exports contribute significantly to the country's total export revenue and PEMEX pays a sizable percentage of taxes and royalties to the federal government's budget. This relationship is unstable due to the volatility of oil prices, the inability of PEMEX to pay down its debt, and the fact that PEMEX's crude oil production has been in decline since 2004 and is down 10% YTD. Additionally, the potential geo-political risks associated with the burgeoning power of regional drug lords signals that the country's economy is under serious duress.
FN -The India Fund- We have had a consistently negative bias on Indian equities since we launched the firm early last year. We believe the growth story of "Chindia" is dead. We contest that the Indian population, grappling with rampant poverty, a class divide, and poor health and education services, will not be able to sustain internal consumption levels sufficient to meet targeted growth level. Other negative trends we've followed include: the reversal of foreign investment, the decrease in equity issuance, and a massive national deficit. Trade data for February paints a grim picture with exports declining by 15.87% Y/Y and imports sliding by 18.22%.
XLP - SPDR Consumer Staples- This group is low beta and won't perform like Tech and Basic Materials do on market up days. There is a lot of currency and demand risk embedded in the P&L's of some of the large consumer staple multi-nationals; particularly in Latin America, Europe, and Japan.
SHY - iShares 1-3 Year Treasury Bonds- On 2/26 we witnessed 2-Year Treasuries climb 10 bps to 1.09%. Anywhere north of +0.97% moves the bonds that trade on those yields into a negative intermediate "Trend." If you pull up a three year chart of 2-Year Treasuries you'll see the massive macro Trend of interest rates starting to move in the opposite direction. We call this chart the "Queen Mary" and its new-found positive slope means that America's cost of capital will start to go up, implying that access to capital will tighten. Yield is inversely correlated to bond price, so the rising yield is bearish for Treasuries.
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