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Where There’s Smoke… Notes for the Week Ending Friday, May 1, 2009

Along Comes Mary


For once, then, something.
- Robert Frost

 

We flatter ourselves to think that Mary Schapiro has been reading these columns - no doubt in secret, and behind a locked door.  We have been flogging our idea of a high-level SWAT team of Wall Street compliance professionals (indeed, as recently as last week, qv).  Now the SEC has announced a program very much along the lines of our proposal.  With nary a gloat, we offer the following from this week's SEC release:


SEC Announces New Initiative to Identify and Assess Risks in Financial Markets

 


Washington, D.C., April 30, 2009 - The Securities and Exchange Commission today announced a new effort to identify and assess risks in the financial markets by attracting seasoned industry professionals to the agency's Office of Risk Assessment.
"It's a great way to bring in highly-seasoned financial experts who can help us keep pace with the practices of Wall Street and protect investors," said Chairman Mary Schapiro, "and provide industry veterans the unique opportunity to help us restore confidence in the markets."
The SEC will immediately begin recruiting candidates with extensive experience in the financial markets.

 

Now for the bad news.

 

Right off the bat, there is the inherent timidity of government initiatives in the face of generational entrenched bureaucracies.  Scrolling down the application information, we note - "The Program will initially include three full-time Fellow positions," and that "Salary is commensurate with experience. In 2009, salaries for Industry and Markets Fellows range from $108,286 to $227,300.

 


According to the SEC website, their job might include:

 


* identifying products, practices, and processes that pose risks to investors and markets; assisting staff in identifying and collecting additional information necessary to better understand the scope or impact of the risk; [Translation: telling the SEC what they really should be looking at, instead of the checklists and other nonsense they waste most of their time on.]

 


* developing educational/informational programs and materials to help familiarize SEC staff with current industry practices, products, trends and related risks; [Translation: explaining to the SEC staff how the industry actually works - from the perspective of people who have spent their careers on the inside.]

 


* working closely with managers in offices and divisions to help design responses and solutions to identified risks; [Translation: creating procedures that will actually prevent crime; also, coming up with punishments that will really hurt.] and

 


* engaging in discussions with representatives from a wide range of institutions, including but not limited to regulated and unregulated market participants, domestic and international regulators, academics and others. [Translation: acting as interpreter between the SEC and Wall Street.]

 

This is a once-in-a-generation opportunity to retool the inner workings of one of the most needlessly convoluted agencies in a government already noted for being Byzantinely labyrinthine.  (Or should that be "labyrithinely Byzantine"?)  Chairman Schapiro is widely credited with effectively combining the NYSE and NASD into FINRA, during which she engaged in pitched battles with warring embedded bureaucracies on both sides.  The NASD, a largely useless agency when Schapiro took it over, was nothing compared to the scope, size, and massive uselessness of the SEC.  (Note that we define "uselessness" as a function of size, budget, and target influence on the marketplace.)  The three "Industry and Markets Fellows" - terms limited to two years, with a single possible renewal - will be faced with a task better tackled by the fifty professionals we have been advocating.  Our approach also contemplated higher salaries, designed to attract serious Wall Street talent.


The job description reads as though written for a specific candidate - someone's nephew was fired during a round of cuts at Cadwalader, Wickersham & Taft.  After six years of late-night slogging and sucking up to senior partners, his dreams of making Partner had suddenly gone up in smoke - then along came Mary.  Or whoever.


We wonder how the selection process will actually work. Don't bet on the low salaries being a deterrent, as candidates are coming in for two years, plus a possible further two - in other words, just enough time to ride out what is likely to be the worst of the economic downturn, see a reconstituted Wall Street get back on its feet, and re-emerge into the private sector with "SEC" on the resume.  Pace Obama and the radical reimagining of government, it looks like the old-school revolving door is at work again.

 

Rounding out our proposal, we saw our Gang of Fifty pairing Wall Streeters with State Securities Commissioners and AGs to drill down on specific local challenges.  Thus, the SEC could provide insight into market abuses arising from Nevada's permissive approach to incorporating, and could coordinate with the Connecticut AG on the Securities Ratings Agencies case.  New York AG Cuomo would presumably want an entire cadre of his own - and such an idea is still not out of the question.  If the SEC won't bite, perhaps the Empire State will.


Just a thought.


Even though it looks to us to be way too small, we are tentatively cheering for this new program.  Even this little something is immeasurably better than the nothing we had before.  We will give Chairman Schapiro the benefit of the doubt: our guess is that when this idea was first broached, the lifers inside the SEC went ballistic.  Think of it - the notion of a bunch of investment bankers and traders telling the government how to regulate the market...  But if the public is made to understand this, and recognizes the benefits to the marketplace, things could rev up in no time.  All it takes is for the press to run with this in a positive way.

 

We wish Chairman Schapiro well, and we look for this program to expand - if not by fiat, then by stealth.  If not be stealth, then perhaps by acclaim.

 

The Lookaway

 

Misdirection - what we call the "Lookaway" - is studied by ninjitsu practitioners and by professional magicians. The Lookaway relies on common physiological and neural patterns, which are manipulated, forcing our attention to unconsciously shift away from the real action just long enough to accomplish the goal - be it sleight of hand, or a fatal attack to a vulnerable body part.

 

The Lookaway also applies in the financial markets.  When we are distracted by one set of seemingly important facts, other forces operate unfettered.  Usually, these forces are not even identified until they have created a very loud and nasty explosion.  Whether you are making money, or losing it, nothing provides a better Lookaway than fast and extreme movements of large quantities of cash.

 

The SEC has a new proposal out to impose restrictions on short selling.  Linklaters, the global law firm, sent us a thorough and lucid piece spelling out the specifics of the Proposal, and detailing the various options.  It is Linklaters' own comment on the SEC's position, though, that we find most illuminating.  We excerpt it here:

 

"The SEC is facing considerable political pressure to take action to restrict short sales... due to the widespread perception of the ability of hedge funds and other short sellers to talk down, and then to engage in unrestricted short selling of financial stocks...[which]  contributed materially to... the current financial crisis.  There is also a widespread assumption... that the Original Uptick Rule, which was in effect during the period between 1938 to 2007, did in fact help cushion the market, and indeed the broader economy, from collapse brought about by 'bear raids' and other short sellers."  They go on to observe that there is little love in the air for hedge funds or other professionals, but also that there is sparse empirical evidence to support the notion of re-establishing an Uptick Rule or other restrictions.
Here's the Lookaway.


Political pressure to crack down on short sellers lies along a continuum with the slaughter of the Kulaks.  High-visibility gentlemen in $2000 suits and Park Avenue addresses are on the fecal roster of everyone from the Speaker of the House, to the Che T-shirt crowd.  People will always hate those who rise high, but taking the billionaires to task in the interest of the SEC making headlines is not an efficient use of taxpayer dollars.


Short sellers are the original Smart Guys on Wall Street, capitalizing on the fact that they always know more than the Longs.  The Shorts are smarter than the Longs, work longer hours, do lots more research and are better informed, and have greater insight into human nature and the mechanisms that move markets. 


The FSA - the UK financial markets regulator - in their Discussion Paper 09/1, "Short Selling", issued in February - concluded that any restriction on short selling would limit both information and liquidity in the markets, without substantially adding to investor protection.  They quote an almost identical conclusion from the SEC's own report in the aftermath of the Pilot Program banning short selling on a basket of financial stocks.  Both government regulatory bodies come to the same conclusion: available data do not support the imposition of a regulatory ban or severe restriction on the practice of short selling.


How smart are the Shorts?  Floyd Norris' blog (http://norris.blogs.nytimes.com/ 30 April, "Is Naked Shorting Gone?") shares his correspondence with Patrick Byrne, Chairman of Overstock.com and a longtime foe of dirty-dealing short sellers.  The takeaway from this exceptionally articulate gentleman's analysis is that the shorts have managed to divert public attention to Upticks and Downticks, when the real skullduggery goes on in the world of settlements and deliveries.  We will return to this in greater detail in future posts, but - pun intended - the long and the short of it is, fails to deliver are covered up by a series of machinations to which the traders, the executing firms, and the prime brokers are all privy.  On a trade-by-trade basis, these wafflings do not cause obvious harm to the investors.  Yet, taken cumulatively, they can create immense pressure on the stocks in question, while possibly also cloaking the effect on firms' capital.


Stay tuned as we look closer into these practices.  Meanwhile, Norris' blog always makes excellent reading.  As the sign in our local pizzeria says: When you get something good, remember where you got it.

 

Secondhand Smoke: Our Paranoid Fantasy Du Jour

 

I admit that two times two makes four is an excellent dictum, but if we are to give everything its due, two times two makes five is sometimes a very charming thing too.
  - Dostoevsky, "Notes From Underground"

 

We hate it when we have missed the obvious.  Our only consolation is that everyone else missed it too.  When things suddenly seem to add up, it is useful to recall Dostoevsky's dictum.  Now an old two plus two is suddenly coming back into focus.

 

Floyd Norris, writing in his NY Times blog (27 April, "How Not To Regulate") describes the purposely lugubrious pace of Christopher Cox' Chairmanship at the SEC.  Cox was given a mandate to craft consensus at the Commission.  To obtain that consensus, says Norris, "Mr. Cox agreed to throw up a series of procedural hurdles in the way of the enforcement staff investigating and settling cases. Some former enforcement directors thought Linda Thomsen, the enforcement director Mr. Cox inherited, should have quit in protest. Had she done so, the result might have been an enforcement director who did not believe in enforcement. So she stayed, and took much of the blame."


Thomsen was made Chief of the Enforcement Division in May 2005, under outgoing SEC Chair Donaldson.  On 2 June, Cox was appointed SEC Chairman.  On 28 June, Thomsen - the ink barely dry on her appointment - took a call from Morgan Stanley counsel Mary Jo White, seeking insight into the SEC's position vis-à-vis Mack, who was Morgan's choice for CEO.
Thomsen, as we have noted, told White that there was "smoke, but no fire" in the Mack investigation.


Fast forward to November of that same year, when Thomsen fired Gary J. Aguirre, the SEC Enforcement attorney heading the Pequot investigation, finally closing the investigation in 2006 with no charges being brought. 


While some outside the Commission believe senior personnel, such as the Enforcement Chief, have discretion in having sub rosa communication with outsiders, the Commission's own Inspector General did not share that view, and issued a 191-page report that found "serious questions about the impartiality and fairness" of the SEC's investigation of possible insider trading at Pequot Capital.  The report recommended disciplining Thomsen, and derided the "common practice" of giving outside lawyers access to high-level SEC officials. 
Within hours of Thomsen and White speaking, Mack was named CEO of Morgan Stanley, a position he holds to this day.  Which means that, now that the SEC has re-opened the Pequot investigation, they will know where to find him.


We admit to being conspiraholics, and so we just love it when events click.
Like (former - tough beans!) BofA Chairman Ken Lewis testifying that (former - whew!) Treasury Secretary Paulson told him that (still serving... Hmmm...) Fed Chairman Bernanke insisted that BofA complete the Merrill Lynch acquisition, and that if Lewis opened his mouth about how bad Merrill's books were, he'd be fired and replaced with someone more pliable.
We have some new questions regarding a Commissioner who purposely Did Nothing, and an Enforcement Chief who, by all accounts, was known as being exceptionally tough on corruption.  Did Chairman Cox "tell" (wink-wink) Linda Thomsen to "tell" (nod-nod) Morgan Stanley about John Mack?  Like Hank Paulson "told" Ken Lewis to shut up and swallow?  We think it is likely that Cox knew about it before the fact, albeit under the cover of some form of Plausible Deniability.


Like Paulson and Bernanke deciding that they know what's best for the markets, and they will make the rules - here we have two senior government officials deciding who gets what information, and when.  Presumably, in their minds, this is a legitimate twisting of the rules in the service of market stability.  In other words: those who make the law, also decide who gets to be Above the Law. 


The body had not yet cooled, metaphorically speaking, when, in the January interregnum between the Bush and Obama Administrations, the SEC re-opened the Pequot matter.  Watch for "Smokey" Thomsen to be called in to testify, and we sincerely hope there will be questions about Who Knew What, and When Did They Know It? 

 

Chairman Cox may be brought in as well, and we expect an awkward moment or two. Cox apparently declared himself appalled at Thomsen's mishandling of the Pequot investigation.  His side of the story would seem to be, he was a newly-minted Chairman, working alongside a newly-minted Enforcement Chief, and watching helplessly as she eviscerated a long-running and exceptionally high-profile investigation.  We can not speculate whose idea it was to fire Aguirre, but if Chairman Cox is pulled into the re-opened proceedings, you can be sure this will be asked.  And as we know, the court of public opinion convicts, not on the basis of Beyond Reasonable Doubt, nor on Preponderance of the Evidence, but more along the lines of "Weren't you also in the room at the time?"

 

We are trying to imagine the political outsider brought in with a mandate to get everyone working together.  He is handed a longtime insider, newly promoted to a high-visibility spot, and in the midst of an investigation with the potential to rock Wall Street from end to end.  Cox calls Thomsen into his office and says, "This is Major Stakes.  Have you got the goods?"  Thomsen pats her pockets, rummages in her briefcase and says, "I had it... it's right... " She snaps her bag shut, pushes her glasses up on her nose and tells Cox.  "It'll turn up."

 

Chairman Cox may be fairly criticized for many things, but we wonder whether the botched Pequot investigation will turn out to be, not his first major cover-up as SEC Commissioner, but his first major head-slap.

 

And remember, New York Attorney General Cuomo may get to jump on this one before it's over.  We can't wait for the new season of this Reality Show.

 


Pigs is Pigs


You can put lipstick on a pig, but it's still a pig.
  - Barack Obama

 

Owning the Debate: Israeli newspaper Haaretz reports (27 April) "Ultra-Orthodox Deputy Health Minister Yakov Litzman declared that Israel would call the new disease 'Mexico Flu,' rather than 'Swine Flu', as pigs are not kosher."

 

America's pork producers (you know their advertising: "The other white meat") have chimed in, asking that the illness be referred to as H1N1, in recognition that eating pork does not cause this disease.  May have at one point incubated in swine, and there appears to be evidence that it affects humans who live in close proximity to large pig populations.  This gives credence to Vice President Biden's warning to stay away from enclosed spaces, especially when there are pigs around.  When boarding an airplane, we advise you demand to switch seats if the passenger next to you is a pig.

 

While our research is merely anecdotal, we note the health section of the website IslamOnline.net, which says "There is no evidence that it is transmissible to people through eating pork or any other products obtained from pigs. If pork is properly cooked, it will not transmit the virus, which is destroyed at a temperature of 160°F/70°C.  It is worth noting that consuming pork or any product derived from pigs is forbidden in Islam."

 

Indeed, every commentary on this illness makes the point that the best way to prevent infection is frequent washing of the hands.

 

This reminds us of an encounter witnessed in the men's room at the late, great Bear Stearns.  One gent was at the sink when another came in, used the urinal, zipped up and prepared to leave.  The first gentleman, wiping his hands on a paper towel, said, "At Harvard, they taught us to wash our hands after we pee."  The other replied, "At City College they taught us not to pee on our hands."


President Obama has just returned from a trip to Mexico.  There he was hosted by Felipe Solis, Director of Mexico's Museo Nacional de Antropologia, as reported in the Mexican newspaper El Norte (25 April).  Professor Solis, according to press reports, embraced President Obama, then accompanied him into the Museum where they examined an Aztec calendar and dined together.  The next day Solis was hospitalized with flu-like symptoms.  Within one week, he was dead.

 

The President and First Lady have returned hale and sound, for which we are grateful.  We marvel at the coincidence that this worldwide health scare blossomed from the very spot where the President stood - indeed, perhaps from the very man who embraced him.  Conspiracy theories aside - even we will not speculate on this one - we are comforted by the knowledge that both Obamas went to Harvard.  Presumably they were taught to wash their hands.  

 

Moshe Silver

Chief Compliance Officer


DUELING “BIG CAPS”

WYNN is a great company but at least for Q1, LVS may shine the brighter light in an otherwise dark economic quarter.  As we wrote about in our 4/14/09 note, "LVS:  Q1 SHOULD LOOK BETTER THAN WYNN", LVS should benefit from its convention exposure, easier comparisons, market share gains in Macau, and faster and deeper cost cutting. 

 

WYNN, on the other hand, is probably most susceptible to room rate cuts on the Strip since its Las Vegas properties generate a higher percentage of its profits from the hotel.  Moreover, the company was hurt by Encore cannibalization of Wynn Las Vegas and the drastic rate cuts designed to attract visitors to the added hotel supply.  In Macau, Wynn Macau maintains more exposure to the softer Rolling Chip segment which is facing very difficult, liquidity-driven comparisons.

 

WYNN will report EPS tomorrow morning while LVS is reporting after the close tomorrow.  The chart below details the year-over-year projected Q1 growth as implied by our models.  Clearly, LVS should have a much better ("less bad") quarter than WYNN, maybe even better than our projections.

 

DUELING “BIG CAPS” - LVS and WYNN comp q1


SUCKERS SQUEEZE

"No one can possibly achieve any real and lasting success by being a conformist."
-J. Paul Getty
 
Remember all that Swining, Stressing, and Whining from early last week? I do - it was just one more of 2009's great opportunities to capitalize on what we have labeled as Glaring Groupthink.
 
As most of you know, I really like to make up names for things. I start writing this note at an un-Godly hour of the morning, and I guess part of it is finding a way to entertain myself. Now that my morning missive is beginning to find its way into broader distribution, it is fascinating to see things like The New Reality or The Great Recession pop into Wall Street's bloodlines. At the end of the day, Wall Street is proving to be just what it is - one giant meme machine.
 
Jean Paul Getty was one of Main Street's real-life oil men and his aforementioned quote, when considered here in 2009, needs an asterisk - and that's that anyone can achieve lasting success as a politician by being a conformist. Did anyone watch Arlen Specter backpedal on Meet The Press yesterday? Wow - solid session of You Tubing there.
 
Now that Paul Volcker has a Transparency/Accountability date on the calendar to actually walk Americans through what he sees on these compromised Streets of the US Financial System (May 20th), he is going to get some overdue airtime. The men and women of Research Edge thank Mr. Volcker for supporting our program - he is calling this, "The Great Recession."
 
As a result, the manic media can now officially shift their focus away from Roubini and the Depressionista theorists, and see the light.  That is, the light that's been on. As in any Recession, however Great it may be... early cycle leading indicators begin to signal a recovery. The signals that I focus on most are grounded in marked-to-market prices. Since late February, these prices have been as crystal clear as the sun rising in the east.
 
To review the fundamentals:
 
1.       Chinese growth accelerated from the Q408' cyclical lows (all of Asia and the manic media covering it is going gaga over China printing an expansionary PMI number for April last night - Chinese stocks closed up another +3.3% at 40.6% YTD).  

2.       ASEAN countries (Southeast Asia) have adopted a $120B currency reserve fund (the Chinese replacement rhetoric for Yuan vs. the compromised US Dollar continues, and what's bad for the Buck, is great for REFLATION).   

3.       Breaking the Buck works, in the intermediate term (the US Dollar closed down again on a week over week basis last week, breaking down through TREND line support of 85.64 = REFLATION).  

4.       The Russians get paid when oil goes up (as the USD breaks down, oil is starting to breakout... oil was up for the 2nd week in a row last week and this morning Russian equities are tacking on another +2.2% to their YTD stock market gain of +34.7%)  

5.       The Saudis, The Canadians, The Australians, The Brazilians, etc... all get paid by either China or Petrodollars too (re-read points 1 and 4; The Client is China).  

6.       Credit markets look as good as they have looked in a year (as the credit mechanism is reinstated, capital starts to flow, and being long short interest becomes one of the best ideas an investor can have).
 
I'll stop at six relatively large factors that are A) Fundamental and B) Historical Facts, because if I broaden the note out to US Consumption being +2.2% in Q1 of 2009 or explain the fundamentals of the MEGA Squeeze in Consumer Discretionary stocks (Mortgage Rates, Employment, Gas Prices, Asset Prices), some people really get upset.
 
The New Reality remains that in a country that has lost the integrity of its Financial System and the validity of the handshakes by those leading it, that being a conformist of Wall Street consensus is starting to trade at a significant discount to even perceived wisdom.
 
With all of these fundamental realities in the rear view, expect consensus to morph into a liability again... at some point... but not yet. For now, we are still very early in Q2 and the hedge fund redemption cycle has the power of kicking in Part Deux of what I am now going to label the Sucker's Squeeze.
 
Hedge fund redemptions work both ways folks. I can assure you that those who missed the both crashes (on the way down and on the way up versus consensus expectations), will be forced to cover their illiquid short positions in the very near future.
 
There will be no "side pocket" or government bailout for unrealized losses on the short side. Unlike the crash on the way down, this recent one on the way up is going to highlight who the real Sucker's of Stress and Swine Tests really are.
 
In the immediate term, I have the SP500 overbought above the 883 line. I'll be back in the game buying short interest on the down moves using 860 in the S&P as my support.
 
Best of luck out there today,
KM

 

LONG ETFS  

SPY - SPDR S&P 500-The SP500 is positive from both a TREND and TRADE perspective.  Additionally, the market continues to make higher lows, which is a bullish indicator.  

EWD - iShares Sweden-We bought Sweden on 4/30 with the etf down on the day and as a hedge against our Swiss short position. Sweden is up a healthy 15.3% YTD and has bullish fundamentals. The country issued a large stimulus package to combat its economic downturn and the central bank has effectively used interest rate cuts to manage its economy. Sweden's sovereign debt holds a strong AAA rating despite Swedish banks being primary lenders to the Baltic states. We expect Sweden to benefit from export demand as global economies.  

EWC - iShares Canada- 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 resourcerich Vancouver should provide a positive catalyst for investors to get long the country.  

XLE - SPDR Energy- Energy decidedly outperformed the market on 5/1, closing up 3.2%. We're long this sector and think it works higher if the Buck breaks down.

EWA - iShares Australia-EWA has a nice dividend yieldof 7.54% on the trailing 12-months.  With interest rates at 3.00% (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.

TIP - iShares TIPS-The iShares etf, TIP, which is 90% invested in the inflation protected sector of the US Treasury Market currently offers a compelling yield on TTM basis of 5.89%.  We believe that future inflation expectations are currently mispriced and that TIPS are a compelling way to own yield on an inflation protected basis, especially in the context of our re-flation thesis.

USO - Oil Fund-We bought more oil on 4/20 after a 9% intraday downward move. We 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.

GLD - SPDR Gold-We bought more gold on 4/02. We believe gold will re-assert its bullish TREND as the yellow metal continues to be a hedge against future inflation expectations.

DVY - Dow Jones Select Dividend-We like DVY's high dividend yield of 5.85%.

 

SHORT ETFS
 
IFN -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.

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%.  SHY- iShares 1-3 Year Treasury Bonds- 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.

EWL - iShares Switzerland - We shorted Switzerland on 4/07 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. 
 
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 down versus the USD at $1.3268. The USD is up versus the Yen at 99.4750 and up versus the Pound at $1.4876 as of 6am today.


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Keeping European Retail On Life Support

JJB Sports announced this morning that it averted Administration (bankruptcy) by pushing through a Company Voluntary Arrangement (CVA).  While they have been around since the 1970s, CVAs are growing in popularity, which is very notable for landlord/tenant relations in Europe. The punchline is that they can keep alive a business that otherwise would/should go bust in this bankruptcy cycle - prolonging the inevitable. If we see many more of these in European retail, we could see the business cycle take meaningfully longer to recover when compared to the US. 

 

What is a CVA?

 

A CVA is a contract between the insolvent business and creditors to repay some or all of their debts with future profits. It's an answer for those companies who don't want to go completely bankrupt and a solution for creditors to at least receive some of the money they are owed.

 

A CVA does not just consist of two sides coming up with an agreement to pay back money. It goes much deeper than that. To start with the CVA process, one must believe that their business can come back and be profitable, and come up with a convincing enough argument such that the creditors believe it. The managers and owners still remain in control of the company, but open up the strategic plan and allow the creditors in to make suggestions. A 75% approval rate is needed at the creditor level, and it must be fully vetted and endorsed by the country court.

 

Anyone who has been following our teams' collective work at Research Edge has heard us refer to this bankruptcy cycle as a game of Survivor. The last one to get voted off the island is going to come out on top as it relates to market share, and likely get the highest multiple along the way.  The irony with these 'CVAs' is that they could prolong the inevitable (and prolong the pain) for European retailers.

 


JNY: A 5-Year Downward Spiral Ends?

JNY is closing 225 of its 1000+ store base over the next 18 months.  Did anyone even realize that JNY is one of the largest specialty retailers by door count?  Even if you were aware that JNY is a retailer is disguise, it's very positive to see that they are no longer growing for the sake of growth.  It's also positive to see management cutting its losses and moving on.  We applaud the move to close over 20% of the store base for a few reasons:

 

1) Closing unproductive, loss producing stores has an immediate and positive impact on the P&L.  In aggregate, JNY will save $37mm in losses and costs from closing these stores from '09-'11.  This equates to $0.29 per share.  Off of our new estimate of $0.65, this is substantial opportunity to help rebuild the earnings base

 

2) The cash cost to execute the store closing plan is only $5mm!  That seems incredibly low and should make any rational person wonder why they didn't close store more aggressively in the recent past.  Think about it, JNY gets to over half of the 20% number almost entirely by letting existing leases run off without renewing.  Seems simple - but prior management has never made anything simple.  Regardless of prior decisions or lack thereof, the net benefit of this effort is a no brainer.

 

3) Approximately 60% of the stores are mall-based, which leaves the base with a higher concentration of outlet stores.  The outlet stores have recently been comping down only a few points while the mall based stores have been tracking down 20%.  Outlets are a good compliment to a better distribution and inventory clearance strategy.  Leave the mall-based selling to the department stores.

 

4) Inventories will come down further as the chain shrinks, freeing up additional working capital.  This should be about a $30-$35mm reduction in working capital annually.

 

In JNY's case, addition by subtraction is not a cure-all for general market share loss and declining brand relevancy.  However, we believe there is still upside in the nearer term as the business shrinks and expenses are once again leveraged.  Of course, must of this is already in the shares which have now tripled from the March lows.  Gains from here will have to come from measurable EPS improvement. But check out the estimate revision chart below. This company has faced 5-years of downward revisions (for good reason). The downside has stabilized, and my strong sense is that any recovery will last more than just a quarter or two. Don't get me wrong, I would not touch this name here. I'd much rather play LIZ for so many reasons. But if you're looking at jumping on the shorty bandwagon now on this perennially hated name - beware.

 

JNY: A 5-Year Downward Spiral Ends?   - jnyeps

Eric Levine

Research Edge


Revisions Rule The Day

 

Another week passes where revisions are trending better, and the group is following suit. The major call-out, however, is that we're now sitting at peak valuations based on NTM consensus EPS estimates (17x).

 

The major question here for me is whether or not estimates are real. Has the sell-side finally overshot on the downside and what appears to be 17x earnings is actually something in the low teens?

 

In aggregate, I think that estimates are largely too low for the next 12-months, as our team has outlined since March 5th (We're Getting Fundamentally Bullish). But back then, it did not matter which names you played, as pretty much the whole group went up in unison.

 

The sector call still matters (check out Howard Penney's sector strategy work), but now, company-specific revisions matter a lot more than they did a month ago. If you're involved in a name and think that 'a miss is already in the stock,' then I feel for you come earnings day.  There are lesser quality names that have set themselves up to smoke estimates in the upcoming quarters - such as CRI, JNY and SKX. Expectations are now lofty and I'm not convinced the upside is coming in a healthy way (setting up for shorts as '10 nears). Then there are others like UA, RL, HIBB, and HBI where I think the upside is meaningful AND warranted. PSS is another, with my lingering concern being the upcoming quarter. It won't be squeaky clean - which probably matters after double in the share price. I think that 2H estimates need to go up by almost half, so I'd keep that name front and center.

 

Revisions Rule The Day - 90 day revisions chart

 

Revisions Rule The Day - NTM and Consensus Chart


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