Still Bullish: SP500 Levels, Refreshed

Takeaway: Our bull case remains the non-consensus one.

This note was originally published May 10, 2013 at 12:09 in Macro

POSITION: 12 LONGS, 7 SHORTS @Hedgeye        


The latest bear market correction lasted for 6 hours of trading. While we’re finally seeing an end to everyone and their brother trying to call the top, we aren’t getting any explicit sell signals other than very immediate-term TRADE overboughts.


The fundamental bull case (#StrongDollar, Commodity Tax Cut, Employment/Housing #GrowthAccelerating) is now strengthening as the market rises. And now Treasuries and Oil are starting to look like Gold did, before the epic fall.


Across our core risk management durations, here are the lines that matter to me most:


  1. Immediate-term TRADE overbought = 1646
  2. Immediate-term TRADE support = 1610
  3. Intermediate-term TREND support = 1535


In other words, I keep getting signals for higher-lows of immediate-term support as the market continues to signal higher all-time highs of resistance.


Our bull case remains the non-consensus one.


 Still Bullish: SP500 Levels, Refreshed - SPX


Takeaway: Today's preannouncement is in line with why we like RH so much. While we wouldn't chase it now we still think this is at least a $60 stock.

It's pretty safe  to assume that the few analysts that actually like RH just saw the stock blow through their price targets. We, however, still think that this is at least a $60+ stock over 2-years. Our note from a few weeks ago was titled #CONFIDENCE (see below), and today's positive preannouncement -- and 41% comp (WHAT?!?) certainly support our view. In short...


"This remains one of our favorite longs. Its so rare to find a defendable high-end brand with such an obvious, yet fixable, distribution problem. Having stores that are only large enough to showcase 20-25% of the company’s product is like having a fleet of Ferraris and only a two-car garage. This is the one instance in retail where bigger stores is not only a positive, but it is a necessity. As these stores grow, the company can scale into new categories (kitchen, kids, art, flooring, art, collectibles, textiles, etc…), and subdivide existing ones  to drive productivity.


We think that the earnings guidance of $1.29-$1.37 for the year will prove conservative by at least 10%, and ultimately this is a company with $3 in earnings power over 3-years.  If that’s right, we’re looking at over a 20% CAGR in EPS, which makes 20x $3 in the realm of possibility. Granted, that is by the end of 2014, so there’s some time to go. But until people start to realize this potential, we’re not concerned about the stock being expensive."


The biggest obstacle at this point is timing.  With over 1mm shares short at the same time we're seeing decreased opacity in the model, an equity offering that cures one of the biggest points of pushback we've gotten on the name (sparse liquidity), and such a material step-up in business levels (comps going from +26% in 4Q to +41% in 1Q) -- it's no shocker that the stock is behaving like it is today.


That said, we would not chase it right here, right now.  We'd treat this one like a fine wine -- simply let it breathe for a little while. At a minimum, we'd wait to see how it reacts when another 4-4.5mm shares enters the float with the company's secondary. If the stock trades down, then we'd look to get involved. If it holds current levels, then we'd buy it anyway.






Takeaway: Several near-term risks were mitigated this qtr. In addition, we're taking up our 'already high' long-term growth forecast. 2 yrs = $60.


RH’s $0.02 ps beat far understates the significance of the company’s earnings report. After running the numbers and listening to the call, we walked away with the following thoughts:


1)      Confirmation that this management team is executing on one of the most intriguing business opportunities in retail. Comping 26% on top of a 22% in the same quarter last year, and that’s before the launch of new businesses like Tableware and Objects of Curiosity.


2)      Not only is the Design Gallery pipeline robust, but management seemed to have a (borderline odd) epiphany that it could open significantly larger stores with far more favorable rent structures than previously anticipated. Given that increased furniture sales will put a natural damper on margins over time, lower occupancy hurdles are a nice offset.


3)      We made a rather significant change to our model, in that we took the average size of a Design Gallery up from 25,000 square feet to nearly 35,000 over the next three years. The Boston store, for example, is nearly 50,000 square feet. With a weighted average of 35k sq feet and our estimate of 15 Galleries by the end of 2015, it gets us to weighted average square footage growth of 15% by that time period. The interesting element here is that bears (and even common logic) will say that current comp trends will roll, and over 2-3 years we’ll be looking at a stabilization in sales/square foot trends. With that being the case, the acceleration in square footage still drives 15-20% top line growth through this model. We think that’s the biggest part of this story that people are missing.  


4)      Find us a company that is taking UP expectations for both revenue and earnings for the upcoming quarter and year. It would have been easy enough for them to give initial guidance right in line with existing estimates. #confidence.


5)      De-risking Sentiment. Like it or not, sentiment is a major factor with this stock. We’ve been positive on the name since the IPO, and when we bring it up with investors it’s pretty clear to us that it’s not too far from JCP as it relates to being hated. The two most common reasons. 1) There’s not enough float. 2) The company is probably going to do a secondary (that probably explains why 1.4mm shares of the 4.2mm float is short). That’s ironic when you think about it. Half the people don’t like the lack of float, and the other half don’t like the one event that could fix the ‘small float’ problem. 


Regardless, there are three things that happened this quarter that we think de-risk sentiment and improves ownership characteristics for RH.

  1. First, simple as it may be, the fact that RH finally ended what may be the longest quiet period in modern retail history is a positive. Other retailers are getting ready to report 1Q in 3-4 weeks, and RH is just getting out its 4Q numbers. It’s been a black hole of info, and it has not helped sentiment one bit. That’s over.
  2. IPO-related charges are out finally known, booked, and out of the way.  They made financial modeling a bear – and now that’s no longer an issue.  
  3. While we usually could care less about company guidance, the fact that RH issued quarterly and annual guidance is a massive positive for a levered and newly public company like this.

The reality is that so many people have had zero appetite for the name given such little float, funky accounting, no guidance, and such a huge delay in the earnings report.  The 4Q print ameliorated many of these concerns.


In the end, this remains one of our favorite longs. Its so rare to find a defendable high-end brand with such an obvious, yet fixable, distribution problem. Having stores that are only large enough to showcase 20-25% of the company’s product is like having a fleet of Ferraris and only a two-car garage. This is the one instance in retail where bigger stores is not only a positive, but it is a necessity. As these stores grow, the company can scale into new categories (kitchen, kids, art, flooring, art, collectibles, textiles, etc…), and subdivide existing ones  to drive productivity.


We think that the earnings guidance of $1.29-$1.37 for the year will prove conservative by at least 10%, and ultimately this is a company with $3 in earnings power over 3-years.  If that’s right, we’re looking at over a 20% CAGR in EPS, which makes 20x $3 in the realm of possibility. Granted, that is by the end of 2014, so there’s some time to go. But until people start to realize this potential, we’re not concerned about the stock being expensive.

Domestic Debt & Credit Trends: A Visual Tour

Summary Bullets:  

  • Loan Demand:  Commercial and Residential Real Estate demand continues to improve. C&I loan trends remain positive but decelerated in 2Q.
  • Credit Standards:  Credit Standards across Commercial & Consumer loan categories continue to ease.  Given rising demand, improving macro, & the pro-cyclical nature of bank credit policy, further credit standard easing is likely.
  • Household Debt:  Household Debt/GDP has retraced most of the exponential move in debt growth over the 2000-2008 period.  Meaningful downside remains to the long-term average, but we’re currently just north of trend growth. 
  • Debt Service:  Household debt service ratio’s continue to decline, making new 30Y lows in 4Q12.
  • Debt Growth/Credit Impulse:  The decline in debt growth has decelerated and is set to turn positive in 2013.  The Credit impulse (Flow of Debt) should remain supportive of consumption in the intermediate term.
  • Savings Rate:  Despite Household deleveraging and a lower debt burden, negative-to-flat real wage growth and tax law changes have continued to drive the trend in personal savings lower. 
  • Debt Capacity:  Ongoing labor market improvement (higher income) alongside rising net worth (higher collateral values), primarily via housing and financial asset re-flation, should continue to support incremental debt capacity.
  • Corporate Margins:  Corporate Margins and after-tax Corporate profits as a % of GDP are both at Peak.  Current market valuation and multiple upside should be understood within the context of that risk.   



From a Long-cycle and very Top Down perspective the underlying drivers of credit are fairly straightforward.  As Ray Dalio and Bridgewater have highlighted, and would we agree, fundamentally, a lender needs to believe 1.) they have a reasonable chance of being paid back an amount greater than the rate of inflation and 2.) that they will be paid back with dollars of similar purchasing power.   Given where we are in the cycle, this simplified approach can help explain much of the directional trend in household credit. 


Into and out of the financial crises, credit tightened as lender’s were justifiably worried that debtor’s wouldn’t be able to repay obligations or generate required returns on capital and, with the fed in full easing mode, it was also exceedingly uncertain that the purchasing power of the dollar would hold.  With the domestic macro data showing sustained, albeit modest, improvement and the Fed turning more hawkish on the margin, both credit and currency devaluation risk continue to reverse.    


Incomes are rising as employment continues its slow grind higher, household debt and debt service ratio’s continue to decline while household net worth has returned to nominal, pre-crises highs alongside higher savings and real estate and financial asset re-flation. 


In short, the drivers of incremental household capacity for credit – rising incomes and asset (collateral) values – drive demand with lending standards and bank credit policy reacting pro-cyclically.  Capacity for household credit expansion has improved, loan demand has begun to percolate, and credit standard easing remains ongoing. 


In the immediate/intermediate term, the flow of credit should remain supportive of consumption and positive growth in nominal debt could occur alongside a further decline in household debt ratio’s.        


2Q13 Senior Loan Officer Survey:  Demand Steady, Credit Standards Ease Further


The Fed released its 2Q13 Senior Loan Officer Survey earlier this week. On balance, the release was positive as lending standards continued to ease alongside pockets of relative strength for loan demand.  The Highlights:


Stronger:  Net percentage of banks tightening credits standards for Commercial Real estate (CRE) loans in 2Q13 declined -20.9%, the lowest level since the crises, while CRE loan demand remained strong with 40.3% of banks reporting stronger sequential demand.  On the Residential Real Estate side, net easing of standards on prime mortgage loans continued with 7.8% of banks reporting lower standards. Home loan demand from prime borrowed rose significantly with (net) 39.1% of banks reporting increased demand. 


Weaker: C&I loan demand remained positive but cooled sequentially with banks reporting a net 5.9% increase in demand vs 19.1% in 1Q13.  


Domestic Debt & Credit Trends:  A Visual Tour - Senior loan Officer Survey Standards 2Q13


Domestic Debt & Credit Trends:  A Visual Tour - Senior loan Officer Survey Demand 2Q13 


CREDIT FLOW:  The idea of the Credit Impulse, popularized by Biggs, Meyer & Pick (2010), centers on the idea that it’s the flow, not the stock, of credit that matters relative to economic growth. The implication is that if the change in net new credit is positive, credit can still support demand even if the nominal stock of total debt is still declining.  Put differently, a deceleration in the rate of decline of debt equates to a positive change in net new credit that can give economic activity a boost.  By and large, the empirical appears to bear out the theory.    


The first chart below illustrates the Credit Impulse (Household and Non-Financial Corporate Debt, Flow of Funds data) vs. the Y/Y change in consumer and business demand (represented by the y/y change for the Consumption and Investment components of GDP) along with the Y/Y change in total household and Non-financial corporate debt.  As can be seen, the trend in private sector demand growth tracks the credit impulse closely and leads the positive inflection in y/y debt growth. 


The second chart shows the Credit impulse vs. the ‘Banks Willingness to Lend’ measure from the Senior Loan Officer Survey (above).  Again, the Trend relationship is strong and with Willingness to Lend accelerating in 2Q13 the read through for credit catalyzed private consumption remains favorable.   


Domestic Debt & Credit Trends:  A Visual Tour - Credit Impulse vs. Private Demand


Domestic Debt & Credit Trends:  A Visual Tour - Credit Impulse vs. Bank Willingness to Lend


Household Debt to GDP:  Household Debt/GDP remains in decline as nominal debt continues to fall y/y alongside ongoing, modest GDP growth.  We’re currently 16.7% off peak 2009 Debt/GDP levels and while there is still meaningful downside to the long-term average, we’ve nearly retraced back to (1) trend.  


Domestic Debt & Credit Trends:  A Visual Tour - Household Debt to GDP


Household Debt vs. Consumption: Beginning in ~2000,  growth in Household debt decoupled from household consumption as debt growth went exponential.  As growth in household debt accelerated, debt became increasingly ineffectual in driving incremental consumption.  That is, marginal consumption declined as a dollar increase in debt drove increasingly less than a dollar increase in consumption.


This dynamic is a typical antecedent of financial crises whereby incremental debt is used to speculatively acquire already overpriced (financial) assets instead of going towards entreprenurial or productive output/investment.  


Domestic Debt & Credit Trends:  A Visual Tour - HH Debt vs Consumption


Domestic Debt & Credit Trends:  A Visual Tour - HH Debt vs Chg in PCE


Household Debt Burden:  Debt Service Ratio’s continue to trend lower due to a combination of organic delevering, low interest rates, and nominal earnings growth.  Both the Household Debt Service and Financial Obligation ratio’s made new 30Y lows in 4Q12.  


Domestic Debt & Credit Trends:  A Visual Tour - Household Debt Burden


Debt Growth vs. Income Growth:  In the long-term debt cycle, debt growth can exceed income growth until debt to income levels reach a critical  upper bound at which point cash flows to service debt (income) become inadequate to meet debt service obligations and monetary policy is impotent to help as interest rates cannot be lowered further in support of easing household debt burdens. 


In the wake of the financial crisis and through to the present, income growth has run at a positive spread to debt growth.  Debt growth has already inflected and given positive mortgage, auto, and consumer loan trends YTD is likely to turn positive in 2013.  The closing of the delta between income and debt growth represent the upside to credit driven consumption.   


Domestic Debt & Credit Trends:  A Visual Tour - Household Debt Growth vs Income Growth


HEADWINDS:  Corporate Profits, Real Wage Growth & Personal Savings…and a Valuation Reminder

Peak corporate earnings as a % of GDP, trend deceleration in Real Wages and a trough in Labor’s Share of national income obviously aren’t supportive of aggregate demand acceleration and credit expansion longer-term. 


Despite Household deleveraging and a lower debt burden, negative-to-flat real wage growth and tax law changes have continued to drive the trend in personal savings lower.  Higher payroll taxes in 1Q13 had a discrete impact on personal savings as individuals reduced savings to maintain consumption in the face of higher taxes.    


A quick valuation reminder as it relates to peak returns to capital  - while the SPX isn’t particularly expensive on a historical basis, its important to contextualize that “cheapness “ within the construct of peak margins and mean reversion risk to peak corporate profits.   


Domestic Debt & Credit Trends:  A Visual Tour - Corporate Profit vs Real Wages


Domestic Debt & Credit Trends:  A Visual Tour - Real Weeky Earnings vs Savings Rate


Domestic Debt & Credit Trends:  A Visual Tour - SPX valuation vs Peak Profits



Christian B. Drake

Senior Analyst 

Where’s Europe At?

Below we hit on a number of topics and developments across Europe.


Call:  Largely our bullish outlook on the capital markets across much of the region has not changed, anchored behind the ECB’s willingness to leverage its balance sheet at all costs to save the Union; the European Commission’s willingness to extend fiscal consolidation targets and abandon or lessen austerity programs; and Germany’s willingness to continue to write bailout checks versus the very adverse option of a strong D-Mark.


Further, we’re seeing a decrease in the broader risk profile as Italy has named a new PM and works through a new budget; Slovenia is willing and able to take care of its own bailout needs; and Portugal has set forth a fiscal consolidation program and issued its own sovereign debt this week. Finally, peripheral sovereign auctions continue to price debt lower and data has looked mostly better in APR compared to MAR.


That said, the disconnect with muted to weak fundamentals remains anchored. The credit system across the region, in particular to small-and-medium-sized enterprises (SMEs), remains clogged; unemployment remains staggeringly high; and the Union of uneven countries under one monetary policy and currency remains flawed in its present set-up. This is in line with our call for a very protracted period of low to negative growth throughout Europe.


GBP/USD:  On Thursday we added a real-time long position in the GBP/USD via the etf FXB given the BOE opted to leave rates and the QE program unchanged on Thursday. We also see the replacement of Mervyn King in July by the slightly more hawkish Canadian Mark Carney as a bullish catalyst.


ECB Playing Large

Following the 25bps rate cut last week from the ECB below are two statements that stood out this week. While the statements are bullish in terms of the Bank signaling it is ready to act, we expect Draghi to wait and watch the data over the upcoming months to assess the impact of the actions he’s already taken. One thing the bank has little control over is the rate at which it can help unclog the credit channel, especially to small-and-medium-sized enterprises (SMEs).

  • Draghi signaled that the central bank stands ready to do more if economic conditions in the Eurozone continue to deteriorate.
  • ECB Executive Board Member Yves Mersch said that the ECB still has tools at its disposal, though he noted that it could only spur lending to SMEs in conjunction with other European institutions.


Austerity is Mostly Dead

One on-going theme remains the backlash against austerity. Below are some statements from this week:

  • French Finance Minister Pierre Moscovici said that the era of austerity is over in the Eurozone.
  • European Commission President Jose Manuel Barroso defended the current prescription, though he also reiterated that policies seen as pure austerity have reached their limits of social and political acceptance.
  • German Finance Minister Wolfgang Schaeuble said that there is a "certain flexibility" in allowing France and Spain additional time to meet their deficit targets (France and Spain to get 2 extra year to reach its deficit target, and the Netherlands one extra year).

In the charts below we show a snapshot of 2012 debt and deficit levels (as a % of GDP) across the region. What governments need to do is have a balanced approach to austerity and structural reforms. The problem is that structural reform is a broad term that means different things for different countries and given the current fiscal set-ups (and recent consolidation measures), it may be easier or harder to implement based on the country. Most governments are on very uneven terms with their constituencies (given the bite of austerity, or in the case of the Germany the open checkbook), so policy makers are advancing without great leverage. In June EU leaders will sign binding “contracts” on structural reform, yet we have our doubts and foresee little being accomplished.


On the argument for the need of unit labor costs to come down in the periphery, part of the problem is that inflation is typically higher, so it’s simply another competitive tax vis-à-vis Germany. While the idea of higher unit labor costs in Germany has been floated, what really needs to happen is to allow unit labor costs to inflate or at least remain flat (so the people don’t revolt) and to stoke inflation to minimize the debt repayment that much of the periphery owes. This naturally goes against the inflation mandate of the ECB, so here too we expect continued gridlock, with Germany benefitting over much of the region’s loss.


We think German Chancellor Merkel will continue to play her cards, toting the line of not giving up on other country’s need to implement austerity but at the same time not supporting austerity that fully chokes off growth. She’ll be cautious in her tone as she crafts her re-election face domestically and internationally ahead of elections this September.   


Where’s Europe At?   - ww. debt


Where’s Europe At?   - ww. deficit



Portugal Mending?

This was a big week for Portugal. Into the end of last week Portuguese PM Pedro Passos Coelho outlined further austerity measures that involve €4.8B in spending cuts over the next three years. The plan includes:

  • shrinking the number of public sector employees by 30K, or 5%
  • requiring public employees to work 40 hours a week (five hours longer than they do now)
  • increasing the retirement age by one year to 66
  • raising the tax on some pension income

While its passage may face opposition, we believe it’s the right directional step. Further, Portugal returned to the bond market on Tuesday, selling €3B of 10YR notes at 5.67%. Demand for the new paper was strong at more than €10B of orders. Portuguese Treasury Secretary Maria Luís Albuquerque said that foreign investors took down 86% of the issue. She added that traditional investors were the biggest buyers, while hedge funds purchased just 7%. Separately Portuguese Finance Minister Vítor Gaspar said that the country had already met its financing needs for this year and was “pre-financing” 2014.


Of note on the successful bond auction is that the 10YR maturity is symbolic because it is viewed as a key criterion for "market access" that the ECB has determined as condition for OMT eligibility.




While Final APR PMI figures looked better than initial readings, you’ll note the PMIs across Services and Manufacturing remain well below the 50 line dividing expansion (above) and contraction (below). The fundamental data continues to contrast with the strong performance from most European capital markets.


Where’s Europe At?   - ww. PMIs



Slovenia Helps Itself

Slovenia on Thursday outlined a plan to help avoid an international bailout. The key elements of the plan included an increase in the VAT to 22% from 20% and the sale of about 15 state-owned companies. The funds will be used to recapitalize the banking sector, where the three state-owned banks together have about €7B in bad loans, equivalent to about 20% of the country's annual economic output.


The decision by the government confirms our thinking that Slovenia would not possess the spotlight Cyprus did given the limited leverage to the banking system in comparison. The EU has said that it will study the plans and issue its own recommendations later this month.


Where’s Europe At?   - ww. slovenia


Enjoy your weekend!


Matthew Hedrick

Senior Analyst


EVEP is Still a Short

EV Energy Partners (EVEP) remains a high conviction short idea for us.  For background information on this idea, please see the materials from our 5/2/13 presentation: EVEP: Beyond the Yield.  Today’s result changes little, except for that it seems as if we gave the Company too much value for its Utica package, and EVEP’s funding situation is now even more precarious given that it will JV the oil window acreage instead of sell it outright.  We would be adding to short positions today on the back of the poor 1Q13 result and outlook.

On the Quarter

Open EBITDA (before hedges) was $31.4MM, down from $36.7MM in 4Q12 due to a 1% decline in production and higher operating costs.  Excluding a 1Q-only G&A expense of $3.2MM, open EBITDA was $34.6MM (this is not a one-time item, but a recurring 1Q-only item).


On EVEP’s management metrics – which are pretty meaningless to us even though everyone else uses them – “adjusted EBITDA” was $48.5MM vs. $56.7MM expected and $69.6MM in 4Q12.  “Distributable cash flow (DCF)” was $21.8MM ($0.51/unit) vs. $37.9MM ($0.89/unit) in 4Q12, for a distribution coverage ratio of 0.67.


The main reason for the miss was the hedge book rolling off, especially on the NGL side.  Realized cash gains from commodity derivatives were $12.3MM vs. $28.4MM in 4Q12.


DCF would have been lower had it not been for the generous (and inexplicable) ~$5MM haircut to “maintenance CapEx” in the quarter.  Production fell 1% q/q and EVEP invested $21.1MM into its E&P operations in the quarter, though deducted only $13.6MM ($0.91/Mcfe) of maintenance CapEx from DCF vs. a consistent run-rate of $18 - $19MM ($1.25/Mcfe) over the prior four quarters.   


EVEP defines maintenance CapEx as “expenditures necessary to maintain the production of our oil and gas properties over the long term.”  But, EVEP could not manage to keep production flat on $21.1MM of total E&P spending.  In our view, EVEP slashed maintenance CapEx this quarter to make the already poor coverage ratio look a little better, and that a realistic maintenance CapEx number is ~$20MM per quarter.  If maintenance capex were $20MM in 1Q13, the coverage ratio would have been 0.47.


EVEP is Still a Short - evep1


On the Utica Shale Sale Process

EVEP is no longer looking to sell its acreage in the oil window of the play, which it once boasted would fetch more than $15,000/acre.  It will now attempt to find a joint venture partner for the majority (~82%) of its marketed acreage, which is in the oil window.  If any deal gets done, it will likely be for a drilling carry (and maybe a small cash bonus); we won’t be holding our breath – CEO John Walker said on the call,


“There are not enough wells drilled there yet and through one or more joint ventures we intend to find the completion technique that will solve this problem. It could take one to two years for us to find these solutions and maximize the value of our position in the supply.”


That leaves EVEP with 18,200 net acres (18% of marketed acreage) to sell in the wet gas window (majority in NW Carroll county).  Timing and price remains uncertain.


On Valuation


EVEP is still trading above a price that would reflect anything close to the intrinsic value of the assets.  We’ve updated our NAV analysis taking into account the change in plans for the Utica acreage, the decrease in FV of the hedge book, and the increase in net debt.  Our NAV is $22/unit.


EVEP is Still a Short - evep2


On conventional E&P valuation metrics, the story is the same: EVEP trades at 40x 2013e earnings, 16x Adjusted EV/2013e Open EBITDA, 1.9x book value (despite having acquired the majority of its assets), and 3.1x standardized measure.  The Company is over-levered with net debt of $925MM exceeding the value of its proven reserves (YE12 PV-10 $867MM), and adjusted net debt/2013 open EBITDA at 5.0x.  Leverage ratios will tick higher this year without meaningful asset sales or equity-funded acquisitions as the Company invests heavily in its nascent midstream businesses.


EVEP is Still a Short - evep3


Kevin Kaiser

Senior Analyst

FNP: Lucky vs. True Religion

Takeaway: The True Religion sale is mostly a net positive to Fifth & Pacific (FNP), but we need to consider both sides of the valuation argument.

This note was originally published May 10, 2013 at 12:32 in Retail

The True Religion (TRLG) sale to TowerBrook Capital is mostly a net positive to FNP, but we need to consider both sides of the valuation argument for Lucky.  On one hand, it shows that the appetite for mid-sized apparel brands remains hot, and TRLG is just about the closest comp for Lucky that we can find. With FNP being very vocal about finding another home for Lucky, this supports the  high level of interest in the brand speculated on in the general press.


On the flip side, the valuation multiple for TRLG is an even 7.0x EBITDA. That's something we'd put in the 'good, but not great' category. If we apply the same multiple to Lucky, we're looking at $308mm on 2013 EBITDA, and $371mm using 2014. There's nothing wrong with those numbers, as the midpoint is enough to complete wipe out FNP's debt -- and that's without monetizing any part of Juicy. But it is lower than the $400mm+ levels that have been thrown around by Wall Street M&A publications.


All of that said, we could argue a premium to TRLG for a few reasons. 1) TRLG is a less basic brand that carries more fashion risk. In its push to become a lifestyle brand, it's EBIT margins have slipped from 25% to 17% in 5-years' time, and EBIT has been stuck between $70mm-$80mm during that period. There's no indication that margins are stabilizing, which hardly warrants a premium valuation.


Lucky is the polar opposite from a financial perspective. We've got EBIT margins clocking in between 3-4% this year on a fully-loaded basis. They're on the rise as the brand regains momentum, sales productivity improves, and the company enters into higher-margin accessories categories.  Given that estimates are likely too low for Lucky and margins and returns are both solidly improving, we can justify a premium valuation to TRLG. If we assume a 20% valuation premium, it suggests 8.4x EBITDA. That's $300mm using TTM EBITDA, $370mm using 2013,  and $445mm on 2014.


When all is said and done, we remain comfortable with our view that FNP could net a minimum of $600mm for Lucky and Juicy combined. (See our 5/3 note. FNP: Where Do We Go Now?)




FNP: Where Do We Go Now? 

Takeaway: If you own FNP for a transaction, you should get out. The call is bigger than that. The upside is there under both scenarios.


The single greatest takeaway from this FNP quarter is that the 17% top line growth rate is the highest we've seen out of the company since March 2003. We cringe every time an analyst congratulates a management team on a conference call (do any of us get publicly congratulated for doing our jobs?) -- but we gotta hand it to McComb. This quarter was a big step forward for FNP.


All of that said, this stock has been one of the best performers in the market over the past 6, 12, and 24-month time periods. It's been one of our favorites all along. But with the stock at $21 we need to step back and really re-evaluate where we can go from here. The answer, we think, is 'higher'. 


We think we need to tear apart the model and look at two scenarios. 1) FNP as is today, with Juicy and Lucky as part of the portfolio, and 2) what the model will look like on that day the company announces that it's selling 55% of its revenue (but only 25% of next year's EBITDA). We think many people will be surprised to see that the profitability levels don't look dramatically different under both scenarios. The difference, however, is in the flexibility to maximize and optimize the amount of capital allocated towards highest-return businesses. 




Contrary to what many people think, we're not against FNP abandoning its efforts to sell Juicy and Lucky. Yeah, the stock would take a hit due to people renting it for the deal. But here are our assumptions...

a) Juicy: The reality is that we're convinced that Juicy has hit a bottom, and the new initiatives coming down the pike  over the next 12 months (like outlet redesign and Juicy Sport -- it's answer to Lululemon) have very minimal downside for the brand and its cash flow. Even if we assume that it stabilizes comps, adds minimal square footage, and returns to a (still paltry) sub-8% EBITDA margin, we get to a 5-year EBITDA growth CAGR of about 25%. It's not a slam dunk, as we need to see the new org chart at Juicy execute on the hype. But we think that our assumptions are hardly heroic.


b)  Lucky:  This is a brand that we think has meaningful upside under FNP's umbrella. We think that having a sister brand like Kate pave the way to grow outside of traditional denim categories could take productivity well above management's stated goal of $600/square foot. After square footage shrank over the past three years, we think we're finally going to see a reacceleration in store growth, and will see the company once again break through the 10% EBITDA margin mark.


c) Kate: There's not much that hasn't been said here. Management subtly took up square footage growth goals on this conference call (10 outlets for this year up to 10-12, and 30 US Specialty stores up to 30-35), which is a drop in the bucket relative to the 300 stores that the company is likely to add globally over a 3-4 year time period. Seriously, the store growth potential here is very difficult to find in retail. We're often asked what gives us the confidence that it can grow at this clip -- and one of our answers is that it is currently running at just a low double digit operating margin. Brands like Coach and Kors are hovering around 30% (ie we need to ask the question of whether they are investing enough capital to sustain brand momentum and allure). Same goes for other high margin concepts like LULU. But this is not the case with Kate. In fact, after it is done with its multi-year investment phase, we should see EBITDA margins climb past 20% (EBIT margins still in teens), which should make profitability explode. In short, we have Kate's EBITDA going from $94mm in 2012 to $425mm over a 5-year time period, with comps and unit growth fueling the early years, and margin improvement (up to 22% EBITDA margins) driving the back-end of the model.


d) Total Company:  Bottom line, EBITDA from $106mm to nearly $500mm over 5-years . It will not have the cash flow to start paying down debt until 2015 given the step-up in capex in 2013 and the absence of what would likely be $600mm+ from the sale of Juicy/Lucky. But on the flip side, it still likely has a good three years until it has to pay cash taxes due to NOL carryforwards, which serves as a big offset to interest expense.  On a fully taxed basis, FNP should break-even this year excluding streamlining charges, and then ramp at a precipitous rate thereafter -- with an extra $0.40-$0.60 per share in earnings per year through 2017. Perhaps the most telling statistic is FNP's RNOA. It has not earned its cost of capital since 2006 -- and that was a fluke due to the operating environment. Previous peak RNOA was 17%, which happened when the company was using a low cost of borrowing to roll up the industry.    But over the next 5-years, the new FNP should see its returns in the 70-80% range. Not a bad return on capital by any stretch.


FNP: Lucky vs. True Religion - fnp liz vs fnp



We think we can safely assume that FNP sells both Juicy and Lucky for a combined $600mm. We're going to ignore what the press is saying for the time being (which would get us to a higher valuation) -- as we don't want to fall victim to bankers negotiating a transaction through Deal Reporter or Women's Wear Daily. If we look at 2013 numbers, we think that $300mm-$350mm is fair for Lucky, and $250mm is fair for Juicy.  Interestingly enough, when all is said and done, the earnings numbers don’t look much different whether FNP owns these two divisions or not. The offsets to losing Juicy and Lucky's EBIT are a) $383mm in debt goes away, which saves about $50mm in interest expense, b) D&A comes down by about 40%, and c) both stock-based comp and unallocated corporate costs come down by 10-20%.  


FNP: Lucky vs. True Religion - chart2fnp

So the question then, is 'why do the deal'? The answer comes down to the balance sheet, as eliminating $383mm in in debt definitely means something. In addition, at any given point, the company has over $100mm in capital tied up in inventories at Juicy and Lucky, as well as what we think is $10-$20mm in maintenance capex in those two concepts. In the end, this is not a balance sheet killer for FNP. But when you're painting a picture of a $4bn ultimate brand roadmap, there's something to be said about keeping capital flowing towards the highest margin and highest return opportunities.



If you're in it for a transaction, then we'd suggest that you get out. It's not the right reason to own it at this point in time. You should be buying FNP today for one reason…and that's because you think that the Kate Spade brand can triple its store size globally, build out its e-commerce business, and layer on additional concession shops  at a rate such that revenue grows 4-5x in 5 years without having to make assumptions that Kate ever prints an operating margin above 20%. With this kind of brand growth, we should see the company handily beat consensus whether they sell Juicy/Lucky or not.  Would we rather see the brands go? For the right price, yes. But it's not imperative to the underlying call. Until the Street realizes our modeled earnings power and EBITDA trajectory, we're not concerned about valuation. It is trading today at 30-35x next year's earnings. Yeah, that's high. But for a company growing earnings well in excess of 30% while the balance sheet continues to de-risk itself and returns head from 0% to 70%...we'd give pretty big pushback to anyone who is short and making a valuation 


FNP: Lucky vs. True Religion - 5 3 2013 1 29 26 PM

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