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CRI: Eye On Capital Intensity

Takeaway: We liked the CRI print, but we don’t like the change we’re seeing in capital intensity. The movements are severe and could impact returns.

Conclusion: There were puts and takes in the CRI quarter, but the major standout to us is the change that we’re seeing in the capital intensity of the model. The colossal rise in capex and spike in SG&A ups the ante for the well-telegraphed ‘14% EBIT Margin’ bull case we need to see come to fruition in order to prevent a decline in returns. If this happens we think you’ve got 16-17x $4.25 in EPS in 2015, or a 8-10% annualized return on a number that you have to wait 3-years to see. If our concerns about pricing spreads and high cost/low return of international growth play out, we think CRI has downside to about 13x on $3.00, or $15 downside over the next year. Capital deployment shorts don’t play out overnight, but at a minim we’d avoid the long side of this name. There are far better places to be in our opinion.

 

DETAILS 

Obviously the market doesn’t like the CRI print today, and we agree. But we think we don’t like it for different reasons. The stock started to trade down just as CEO Casey mentioned that 1Q to date showed negative comps in Carter’s stores. While that’s not good, we think a bigger negative was the change in tone regarding capital allocation and margin makeup.

 

Harvesting Is Over: We think CRI is entering a meaningfully different stage in its investment cycle. The way we see it, it just made its second international acquisition in 18 months, it is bringing its product sourcing from 20% of total today to 50% in 5-years, it just took SG&A up 40% in the latest quarter on top of a 14% sales growth rate, and management noted that GM upside (ie pricing better than costs – something it has sparse control over) will need to happen in order to offset higher planned costs. Furthermore, capex in the coming year is slated to be $200mm. As a frame of reference, this is 4x the rate of Carter’s D&A, and it has never spent even half that much in a given year (even as a % of revenue) in all the years it has been public.

 

Don’t get us wrong. We like when companies spend money – at least those who prove to be good stewards of capital and drive returns higher through share subsequent share gain or margin improvement. But CRI is simply unproven in that regard. We’re not saying that it will fail. But rather that you need to believe that it will succeed in order to buy the stock here.

 

The ‘14% margins due to direct sourcing’ bull case is very well telegraphed. If we assume that the company gets there within 3-years, we’re looking at about $4.25 in earnings power. That’s a great lift over the $2.86 it printed last year and $3.28 it is guiding towards in 2013. But with the stock at $55, you’re paying 12-13x a best-case earnings number that may or may not happen in 3-years.

 

In the interim, there are some puts and takes.

International is clearly growing, US Carter’s retail is still putting up mid-teens square footage growth, and dot.com is growing nicely – up to 18% of store sales in this quarter vs 11% last year. The new DC should keep this heading higher.

 

On the flip side, we remain concerned about more normalized product costs and increased competition by both retail partners and competing brands alike. In addition, while International is nice, it’s definitely not a slam dunk.

 

a)      Bonnie Togs comping down only 2-quarters after it is included in the comp base.
 

b)      The new dual-brand stores in Canada are launching, but are not proven yet.  
 

c)       Just after CRI anniversaries the Canada acquisition, it’s investing capital in the last place we want to see incremental money put to work – Japan. For a luxury brand (like Kate Spade, Kors, or Ralph) perhaps that makes sense, but not for a kids mass apparel maker. Also, keep in mind that the dominant brand for CRI in Japan is Osh Kosh, which it has a hard enough time growing in the US nevermind Japan. The opportunity is for the for Carters brand, but Japanese Moms are not US moms. It will cost money to build that opportunity. 


Have Stocks Conquered Commodities?

Since we moved in to #GrowthStabilizing territory in mid-November of 2012, we've been a proponent of the long US stocks/short commodities game plan as the great commodity bubble created by the Federal Reserve deflates. Over the last three months, the S&P 500 has gained +7% while the CRB Commodities Index has dropped -1.1%. 

 

Have Stocks Conquered Commodities? - CRB SPX


DRI: EASY YARDS ARE OVER

We would not short Darden today, as our short thesis that we first outlined in July has become common knowledge, but we retain a bearish bias.  It is possible to construct a valuation/earnings case for 8-20%of downside but, for want of catalysts, we would not be taking a short position today.  With the emergence of a catalyst, we may become more vocal on the short side of DRI but for now we are covering our short position in the Hedgeye Restaurants Position Monitor.

 

Our rationale:

  1. The company has announced that earnings over the next 5 quarters will be disappointing
  2. SRS are likely to see a sequential uptick in 3QFY13
  3. The company has reduced capital spending enough to cover the dividend

Our bearish bias remains due to capital spending plans that remain overly aggressive and the fact that Darden’s most important asset – The Olive Garden – is a long way from being fixed.  

 

 

Summary of Our Thoughts on the Darden Meeting

 

The theme for the meeting, “Operating Successfully in a New Era”, was the first indication that this presentation would be somewhat detached from reality.  Several of the statements from management surprised us but most striking was the company only now stating that the change in the casual dining industry has been structural, not cyclical.  Darden has the largest system in casual dining.  Its national competitors have been recognizing the structural nature of the shift in casual dining customers’ habits for several years.  The demographic changes that we have written about are among the most obvious indications that the go-go days are over for casual dining.

 

 

Core Brands Remain the Problem

 

We believe that management has been tone deaf to consumer trends.  That may sound like an exaggeration but the two charts, below, speak to that argument.  An objectivity-damaging trust in internal customer satisfaction results rather than actual traffic trends is one factor we inferred from the presentation content.  The fact that the “Darden i-Tracker” is implying a consumer perception diametrically opposite to the trend in same-restaurant traffic growth perhaps calls into question the relevance of the internally generated metric.

 

The charts below show that, by the metrics that matter, Olive Garden and Red Lobster need a lot of work.  What’s more, management wasn’t forthcoming with many details on the Olive Garden turnaround; the technology segment of the Analyst Meeting was longer in duration that the Olive Garden segment. 

 

DRI: EASY YARDS ARE OVER - dri big 2 gap to knapp traffic

 

 

Sacrificing Growth to Keep the Dividend

 

The company pointed out that cash flow had to be managed more conservatively to support the dividend.

  • The current dividend is currently running at roughly $263mm on an annual basis
  • Free Cash Flow is anticipated to be $245-265 million in FY13
  • Mgmt has a policy of raising the dividend each year with a target of 50% payout ratio
  • The roughly $125 million cut in cap ex will eliminate that funding gap for the dividend

 

Cutting CapEx at Olive Garden

  • Cutting back CapEx from $700-$725 million in FY 2013 to $600-$650 million in FY 2014
  • OG new units scaled back from about 35 to 15 and
  • OG remodels put off until late FY14
  • LH openings from 40+ to 35-40

 

 

Olive Garden

 

The company’s most important business unit had the shortest presentation.  The new President, Dave George, is still settling into his role and impressed us with his observations and perspectives.  There were two major takeaways from the Olive Garden segment:

  • Remodels are being stopped and new unit openings are being slowed likely until sometime in FY14
  • Details of Tuscan remodel being tweaked, logo being updated
  • No new initiatives were announced

 

 

Red Lobster

 

Inconsistency has plagued Red Lobster over the last few years as promotions have failed to deliver steady results.  The Bar Harbor remodel program has been yielding some positive results for traffic but it seems that the turnaround at Red Lobster will take some time.  

 

 

Pricing

 

Management’s claim that limiting price increases to 1% will help drive incremental traffic growth seems to contradict recent Knapp Track, Gap-to-Knapp, and company data.  The underperformance of Olive Garden and Red Lobster in recent years would suggest that management’s understanding of its customers may not be acute enough to make such a claim.

The theory goes:

  • Management said “we are trying to target the check to the guest that need the relief” but how?
  • They said they are just now building the technology to have the ability know the consumer better, so how can they have target messaging now?
  • This technology will not be in place until late in FY 2014

 

 

Truth Hurts

 

We were a little perturbed by a statement from CEO Clarence Otis, at the end of the second day, that the company’s traffic problem is only a year old.  The data (charts earlier in this post) show otherwise and we believe this Analyst Meeting exposed a degree of detachment between Darden’s CEO and the nuts and bolts of the company’s operations. 

 

 

 

 

Howard Penney

Managing Director

 

Rory Green

Senior Analyst

 

 

 

 

 


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Why Is The VIX Getting Smoked?

It’s all about expectations. I get the front-month VIX is different than the term-structure of volatility’s curve. Looking at expectations, across durations, will amplify my point:

 

  1. VIX (front-month) TREND resistance = 17.18, and that was only violated to the upside for ½ a day
  2. VIX topped on Monday at another lower long-term-high (on DEC28, 2012 the lower-high = 22.72)
  3. VIX was at 40 in Q1 of 2010 after we were legitimately concerned about European Dominos

 

As you can see in the Darius Dale’s Chart of The Day, front-month Volatility (VIX) continues to make a series of long-term lower highs as the volume of the manic media’s freak-outs make higher-highs. Think they’ll make the call on the end of the world, together?

 

If this is just a mini-mania of what you saw in November-December (substitute Italy for US Congress), what is it, specifically, that you have a as a catalyst that would stop the VIX from going straight back down to 12 from here?

 

It’s not going to 12 this week. I get that. But the VIX is probably not going back to 22.72 or 42.96 (the SEP2011 freak-out) this week either. If I see anything real developing that changes my view on this, I’ll just change my mind. I don’t have to do that yet, thank God.

 

Selling fear has been working since we turned bullish on US stocks in late November.

KM


Crude Intentions

Our thesis regarding the recovery of the US economy involves having a strong US dollar. A stronger dollar helps drive commodity prices down, which in turn helps boost consumption. Consumption is the key to recovery as people consume more and see a material improvement at places like the gas station and grocery store. Right now, the US dollar (DXY) continues to strengthen since the beginning of January while WTI crude oil falls lower. The one headwind we still face in the recovery of the economy is high energy prices and if we continue to see the dollar strengthen, that headwind could soon be a thing of the past.

 

Crude Intentions - USD CRUDE


HONG KONG STILL LOOKS AWESOME

Takeaway: We maintain our bullish intermediate-term bias on Hong Kong’s stock market as the territory's GIP outlook remains particularly robust.

SUMMARY BULLETS:

 

  • Hong Kong’s GIP outlook continues to look as robust as any across the Global Macro universe and remains supportive of our TREND-duration bullish bias on the Hang Seng and we remain well above the Street on 2013 GDP and well below the Street on 2013 CPI. Random bearish catalysts aside (Google: “comedian + Italy”), Hong Kong remains one of our favorite ways to play our #GrowthStabilizing theme across Asia – along w/ China and Singapore. Refer to our 2/4 note titled, “ON A TEAR, WILL ASIA #GROWTHSTABILIZING CONTINUE TO WORK?” for more details.
  • It’s worth noting that all three of the aforementioned countries are somewhat (SGD and  CNY) to heavily (HKD) pegged to the rising USD, meaning that they will reap an outsized tailwind (more disinflation + more room to ease) from the continued popping of Bernanke’s Bubbles because their currencies won’t be under as much selling pressure as many other Asian and LatAm currencies are likely to experience in the [likely] upcoming era of sustained USD strength.
  • Additionally, as it relates to the risk of negative absolute returns if the Global Macro environment deteriorates substantially in the near-term, Hong Kong, Singapore and China all have limited downside relative to the rest of the region from a mean reversion perspective (as opposed to a Philippines, Thailand or Japan). Speaking explicitly, if you have to remain allocated to Asian and/or int’l equities, we think those three markets will offer the least amount of downside risk over the intermediate term.
  • Moreover, from a factor risk perspective, Hong Kong, Singapore and China’s forward-looking GIP outlooks all compare quite favorably (each in their own ways) with the top five factors most associated with equity market outperformance on a 1M basis. As such, it is reasonable to anticipate “the machines” will start bidding up these three markets over the intermediate term.

 

Official reports released overnight showed Hong Kong’s Real GDP accelerated in 4Q12 to +2.5% YoY from +1.4% in the prior quarter. On a QoQ basis, the Hong Kong economy accelerated +1.2% from +0.8% in the prior quarter. The positive deltas in both the YoY and sequential figures provides a great handoff to the start of 2013 and this favorable growth outlook is confirmed by the +47bps widening of Hong Kong’s 10Y-2Y Sovereign Yield Spread in the YTD.

 

HONG KONG STILL LOOKS AWESOME - 1

 

HONG KONG STILL LOOKS AWESOME - 2

 

Also reported overnight was Financial Secretary John Tsang’s announcement of HK$33 billion of one-off relief measures in the upcoming budget, including lower taxes and electricity subsidies. The measures also include food assistance and the waiver of two-month’s rent for public housing tenants and are expected to boost growth by +130bps. With a budget surplus worth 2.7% of GDP and a deficit/GDP ratio of 33% (both are ~at their respective 10yr averages) Hong Kong policymakers do indeed have the fiscal space necessary to implement the aforementioned stimulus measures without imposing any undue economic or political risks.

 

HONG KONG STILL LOOKS AWESOME - 3

 

Hong Kong’s GIP outlook continues to look as robust as any across the Global Macro universe and remains supportive of our TREND-duration bullish bias on the Hang Seng and we remain well above the Street on 2013 GDP and well below the Street on 2013 CPI. Random bearish catalysts aside (Google: “comedian + Italy”), Hong Kong remains one of our favorite ways to play our #GrowthStabilizing theme across Asia – along w/ China and Singapore. Refer to our 2/4 note titled, “ON A TEAR, WILL ASIA #GROWTHSTABILIZING CONTINUE TO WORK?” for more details.

 

HONG KONG STILL LOOKS AWESOME - HONG KONG

 

In line with our previous work on the territory, we typically start off our analysis of Hong Kong (and Singapore) from a top-down perspective at the international level. That’s because:

 

  • At 226% and 209% of GDP, respectively, Hong Kong and Singapore are far and away the most export-oriented countries in Asia – far more levered to global demand than other noteworthy Asian economies (China: 31.4%; South Korea: 56.2%; Japan: 15.2%; Thailand: 76.9%; and Taiwan: 66.9%);
  • The ratio of Hong Kong and Singapore’s share of world exports to their individual shares of world GDP are 7.1x and 6.5x, respectively – besting the next closest economy in Asia (Malaysia) on this metric by a full 3.7 turns; and
  • Singapore and Hong Kong are home to the world’s second and third-busiest container ports, handling 29,937,700 and 24,384,000 TEUs, respectively, per the latest yearly data from the American Association of Port Authorities (2011).

 

HONG KONG STILL LOOKS AWESOME - 5

 

With that in mind, our global #GrowthStabilizing theme should continue to auger well for the Hong Kong economy and its financial markets; we remain above the Street on 2013 World Real GDP growth.

 

HONG KONG STILL LOOKS AWESOME - WORLD

 

It’s worth noting that all three of the aforementioned countries are somewhat (SGD and  CNY) to heavily (HKD) pegged to the rising USD, meaning that they will reap an outsized tailwind (more disinflation + more room to ease) from the continued popping of Bernanke’s Bubbles because their currencies won’t be under as much selling pressure as many other Asian and LatAm currencies are likely to experience in the [likely] upcoming era of sustained USD strength. Refer to our 1/25 note titled, “WHERE IS THE “GREAT INFLATION” GOING TO COME FROM?” and our 2/20 note titled, “CURRENCY WAR UPDATE: THAILAND AND NEW ZEALAND SOUND THE ALARM BELL” for more details on this developing theme.

 

HONG KONG STILL LOOKS AWESOME - FX MoM

 

Additionally, as it relates to the risk of negative absolute returns if the Global Macro environment deteriorates substantially in the near-term, Hong Kong, Singapore and China all have limited downside relative to the rest of the region from a mean reversion perspective (as opposed to a Philippines, Thailand or Japan). Speaking explicitly, if you have to remain allocated to Asian and/or int’l equities, we think those three markets will offer the least amount of downside risk over the intermediate term.

 

HONG KONG STILL LOOKS AWESOME - Equities YoY

 

Moreover, from a factor risk perspective, Hong Kong, Singapore and China’s forward-looking GIP outlooks all compare quite favorably (each in their own ways) with the top five factors most associated with equity market outperformance on a 1M basis:

 

  1. Relatively more scope for monetary easing
  2. Relatively higher expectations for currency strength
  3. Relatively high growth
  4. Relatively low inflation
  5. A relatively strong currency

 

HONG KONG STILL LOOKS AWESOME - EQY FM

 

As such, it is reasonable to anticipate “the machines” will start bidding up these three markets over the intermediate term. Refer to our 2/11 note titled, “WHAT’S DRIVING OUTPERFORMANCE ACROSS ASIA AND LATIN AMERICA?” for a detailed walk-through of the methodology behind our bi-regional factor models.

 

From a quantitative risk management perspective, Hong Kong’s Hang Seng Index is bearish TRADE/bullish TREND and TAIL. breakout above the immediate-term TRADE line of resistance would confirm our bullish bias and a breakdown through the TREND line of support would force us to reconsider our base case scenario altogether.

 

Darius Dale

Senior Analyst


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