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Licenses Are Not As Secure As You Think

Some apparel licenses will prove massively unstable in '09 as licensees pull back on investing in content. Some will miss minimums, and will lose business that some currently think is a lock.

Here's an issue that people are not focusing on, but should be - the risk associated with stability in cash flows from licensing streams. The apparel industry is riddled with examples whereby content owners license out their brand to others that have more expertise in a specific product area or consumer segment. Standard royalty agreements are usually in the 6-10% range, net of costs allocated by corporate. In other words, what is a smallish revenue event translates to a meaningful EBIT event given 100% incremental margin. With zero capital at risk, such arrangements are almost always ROIC-enhancing.

I have a high degree of confidence that we are entering a phase of the cycle where these licensing relationships will be strained meaningfully. We'd all be irresponsible not to consider the strategic implications.

Think about it like this... Let's say you are a mid-size company whose EBIT is derived evenly between your own content and content you license from other companies. For the past 7 years, the industry has had every bit of wind at its back (import quota changes, FX, input cost deflation, strong consumer) such that everyone made money - even the marginal players. Now we're in a multi-year period where the opposite is a reality, and many mid-tier brands will go away. So now your top line is rolling, you've underinvested in your brands, flowed through too much FX and sourcing benefit to your bottom line instead of plowing back into your model. So now what? You're probably cutting costs reactively and irresponsibly to keep your head above water. Do you cut costs out of your own content? Or from what you were allocating toward another company's content that you licensed and ultimately will return to them? I'd challenge anyone to find me a company that would opt to damage its own content over another's.

CEOs of companies that license a meaningful proportion of their EBIT (PVH, GES, ICON, to name a few) will argue that there are fixed amounts that partners need to contractually invest each year, which is controlled in part by the company owning the brand. Yes, there are usually fixed dollar amounts or percentages that are required for reinvestment, but that ALL leave plenty of room for unhealthy behavior on the part of the licensee. Remember when Jones Apparel Group said that its Lauren, Ralph, and Polo Jeans business was fine and was 'locked up' for years? 'Nuff said. DCFs don't matter when a business segment you have in your model suddenly ceases to exist.

All it takes is some bad investments (or lack thereof) and a couple of quarters of missed minimums, and the content owners could usually take back the business at will.

The table below shows the percent of EBIT for some major brands derived from licensing. Part There will be some big winners and big losers beginning in '09 folks...

 

Licenses Are Not As Secure As You Think - Table License

 


CROX: ‘Awesome’

Keith pings us with tickers each night that are standouts in his trade factor models. Tonight he said, "CROX looks awesome ... $2.27 TRADE support." That's the first time I've heard him use the word 'awesome' in months.

 

At $2.58 we're looking at an EV of $187mm. Yes, this has been a triple over the past two months. But I still find a major problem poking holes in my logic that the new CEO (or a strategic buyer who scoops up this company) could take CROX back to its roots, and takes the top line from the $847mm peak down to a core of $400mm and run at a 10% margin (I can defend this rate six ways til Sunday). That suggests about $43mm in EBITDA. With no store openings, Crocs can sustain itself on $10-15mm/yr in capex - so we're looking at about $25-$30mm in free cash. Not bad for 7x free cash with a call option on monetizing the Crocs brand above and beyond the current consensus view (or lack thereof).


WRC: Costs Cuts -- Could vs. Should

Let the debate begin on WRC. The company beat the Street by $0.27 and our model by $0.32.  The quality is not what headline suggests, but a beat is a beat, so I won't ignore that.  But pulling forward $25mm in revenue from 2Q while printing a massive 14% decline in SG&A has its clear leverage pressure points.  This says nothing about whether WRC SHOULD cut SG&A to this magnitude. The fact is, it did.  The $30mm decline in revs y/y was almost entirely offset by a $25mm decline in SG&A dollars. Yes, WRC has big Int'l exposure (i.e. FX helped SG&A), but it's so rare to see such variability in SG&A. The sustainability here and impact '10 will be THE question (i.e. is mgmt cutting off the third leg of a bar stool?).  This smells punk to me.

 

This name is setting up as a nice 'whack-a-mole.' Stay tuned....

 

On the bull side, if you like a wholesaler that is transforming into a growing retailer, driven by aggressive square footage growth and the associated mix benefit from high direct-to-consumer operating margins (20% Four Wall for CK retail) while real-estate costs serve as a tailwind, then WRC should continue to work for a while.  But, watch out for the very first instance that the rate of store growth slows and overall margin growth trends reverse. 

 

MAJOR CALL OUTS

  • Same store sales are slowing (meaningfully) for CK retail:
  • o April: -4%
  • o 1Q09: +5%
  • o 4Q08: +12% (+17% December)
  • o 3Q08: +13%
  • o 2Q08: +20%
  • o 1Q08: +11%

 

  • Raising square footage growth from 20% to 24% for the year. This looks like a classic case of opening stores to drive same store sales to keep overall momentum alive. You can't bet against this for now, but look out when new store growth slows.
  • Spent some time discussing a retail strategy for CK accessories. Clearly another lever here to drive DTC growth. Accessories currently has one free standing retail location and the total division is currently producing $100mm. This was the first mention of an opportunity to double the business over the next 3 years, driven primarily by square footage growth.
  • CEO quotes on store growth: ""If we could do more we would", "current softness in comps is a momentary aberration", we are pursuing "aggressive growth" in retail

 

  • Despite retail square footage going higher, Capex is going lower. Took Capex down to $35mm from just under $40mm. A nice positive.

 

  • Total SG&A dollars now guided to down $100mm year over year. This is a combination of the $70mm in cost cuts plus the benefit of a larger than originally expected F/X impact. The specificity around cost-cutting on the part of management was light. That's surprising given that we're only talking about a $715mm base in total SG&A for WRC.

 

  • Warehouse Clubs saved the day
  • Approximately $25mm in sportswear shipments were pushed into Q1 from Q2 at an above average operating margin. The impact added 5% to total revenues and approximately $0.06 to the quarter (assuming an above avg. 16% operating margin for this piece of business).
  • CK intimates also saved by shipment to the clubs at an above average margin.

 WRC: Costs Cuts -- Could vs. Should - WRC S 5 09

 

 


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BANDWAGONEERING

 

Research Edge Position: Long Chinese Equities via CAF

China's exports declined over 22% year-over-year in April, a sequential decline from March, significantly worse than consensus estimates with shipments to the EU and the US off by 24% and 17% respectively. While the external demand picture remains grim, the internal demand picture continues to demonstrate strength in the wake of Beijing's stimulus transfusion. Key data point takeaways released in recent days that underscore this are:

  • Motor Vehicle sales exceeded 1.15 million in April, a 25% Y/Y increase
  • Urban Fixed Investments up 30.5% Y/Y for April
  • Housing sales up 35.4% in the first 4 months of 09 Y/Y
  • Iron Ore imports up 33% Y/Y to 57 million metric tons

 

Tonight Industrial Output numbers will be released by the National Bureau of Statistics, with consensus estimates hovering at 9% Y/Y. Any upside surprise in output  could well put fire in the belly of China bulls looking for final confirmation that the demand story here is real, while Retail Sales data slated for this evening could provide assurance that that the ox is hungry for more than just iron ore and scrap copper. As we said yesterday, electronics exporters have already seen an uptick in mainland order flow as rural Chinese shoppers take advantage of government rebates and we will look for confirmation that the cash register is ringing in coastal cities as well.

 

BANDWAGONEERING - aprilch

 

 

We are long CAF and will be holding it into tonight's news.  All data points lead us to believe that the momentum of China's internal demand growth is accelerating.

 

 

Andrew Barber

Director

 


The Suckerpool Chart

 

My first job on the buy side was as a US Retail analyst. That was 9 years ago, and I think my boss gave me that group because it's the easiest one to analyze - I'm one of them Canadian hockey players, eh!

 

I started trading my own US Consumer "carve-out" of the fund within a few years, and effectively had to learn the art of job stability via not losing money. Losing money in the hedge fund business generally equates to losing one's job - as it should.

 

Making money on the long side isn't that hard to do. Not getting squeezed on the short side is. If the chart below had an audio clip, it would have a massive sucking sound - from now on I am going to refer to it as The Suckerpool Chart (this one will be really hard for Cramer to say is his - he hasn't used Squeezy yet either).

 

If you think being short the US Consumer Discretionary sector is a unique thought, think again. This sector, quantified, has the highest bottoms up short interest in the US market. It also now sports none other than Meredith Whitney as the latest doomsayer (yesterday she said short the group on CNBC). I thought she was a bank analyst? Maybe she's moving from the MEGA squeeze in her stocks on over to this one - who knows - but now she's in my sandbox this game probably won't end the way she thinks.

 

I sold my XLY (Consumer Discretionary ETF) on 4/29/09 at $23.18, so I haven't had to deal with the stresses associated with this sector's recent week of underperformance. Today, I am buying it back.

 

The Pain Trade that remains in this market is one that's really been a great story in 2009 - squeezing the US Consumer Depressionista shorts. Are they still out there? You tell me... how many people in your investment meetings are ragingly bullish and "long of" US Consumer Discretionary stocks?

 

I have painted the lines of support (green) and resistance (red) in The Suckerpool Chart below.

KM

 

Keith R. McCullough
Chief Executive Officer

 

The Suckerpool Chart - cd


Is the Republican Party A Distressed Asset?

 

"Is Michael Steele here? Michael, I don't care how many times you ask, the Republican Party does not qualify for bailout.  Rush Limbaugh is not a troubled asset."

                                                                -President Obama, White House Correspondents' Dinner, May 9th 2009

 

President Obama hosted his first White House Correspondents' Dinner this past weekend to much fanfare.  While much of the dialogue seemed to be fairly predictable, the line above actually garnered a great deal of applause and is a very insightful point. 

 

In fact, the Republican party is currently in trouble and does have a bit of a Rush Limbaugh problem.  While Rush may not be a troubled asset, the Republican Party does need a bailout, or at least a massive makeover.  We recently heard from a contact of ours who is a major conservative fundraiser and he wrote us the following:

 

"I was on the Hill this past Thursday. Very discouraging. Republicans seem exhausted. The party will take years to recover."

 

Installing Michael Steele as the Head of the RNC and the recently completed listening tour by Jeb Bush, Mitt Romney, and various other Republican leaders are certainly steps in the right direction in reinventing the face and energy of the Republican party, yet this process is in its early days.  In the meantime, the Democrats are consolidating power and President Obama's polling numbers continue to improve, while the Republican Party is trading at cents on the dollar.

 

In the past, we have quoted the Rasmussen presidential approval rating as a proxy for how President Obama is doing in terms of popularity.  We use this poll for consistency purposes and also because Rasmussen has been rated as one of the most accurate pollsters over the last decade. For the last five days, Obama's approval index has been in the +7 to +9 range (this is the difference between Strongly Approve and Strongly Disapprove), this range is at its highest since the first week in April.

 

While that poll is interesting and indicates a shift up in approval for President Obama, an even more interesting poll is the right direction / wrong direction poll.  Currently, 38% of likely voters believe the country is headed in the right direction.  While this does not seem like a large number, it is a five year high and is the highest number of the Obama Presidency.  In fact, it is up 11 points from his inauguration and 17 points from when he was elected.  President Obama has inspired a view among likely voters that he is getting this country back on track and with this popular support will come even more political capital.

 

On April 28th we wrote the following in a note about Senator Specter's decision to change parties:

 

"Make no mistake about it, the balance of power in the United States has officially swung to the left and as a result we should analyze both risk and reward accordingly with this new geo-political input."

 

In that note we made the call out that one way in which we could see this power shift manifest itself was on unionization and the potential that Senator Specter would reverse his view on Employee Free Choice, which relates to voting on union representation.  This shift in national political influence with the consolidation of Democratic power in the Senate and increasing popularity of President Obama, combined with the view that he is leading the country in the right direction, will also manifest itself in more subtle ways.

 

Specifically, the recent capitulation of bondholders in the Chrysler bankruptcy has the appearance of a situation whereby the bondholders are deferring to the strengthening power of President Obama and the Democratic Party.  According to the Boston Globe, "The group eventually came to the conclusion that there wasn't enough of them to withstand the enormous pressure and machinery of the US government." 

 

Obviously the bondholders are likely attempting to promote their own interest to the media, so the quote must be taken in context.  Nonetheless, the context is concerning.  Bondholders have rights and fiduciaries responsibilities, and in this situation chose to acquiesce to the government rather than aggressively pursue those rights.  Clearly, part of the decision making process on the side of the bondholders was that they were not only facing off with the U.S. government, but one that has a popular executive branch combined with a consolidated legislative branch - so would be difficult to beat.  

 

While this was a loss for the bondholders of Chrysler, it was also likely a leading indicator of future events.  These capitalists had clearly weighed the risk / reward and decided that based on the potential for future interactions with the government, according to simple game theory analysis, the best outcome was to acquiesce on their position quickly and quietly.  That said, not all  investment managers have walked away from this situation quietly.  In fact, Cliff Asness wrote the following in an open letter:

 

"Here's a shock. When hedge funds, pension funds, mutual funds, and individuals, including very sweet grandmothers, lend their money they expect to get it back. However, they know, or should know, they take the risk of not being paid back. But if such a bad event happens it usually does not result in a complete loss. A firm in bankruptcy still has assets. It's not always a pretty process . . .the above is how it works in America, or how it's supposed to work."

 

Indeed.

 

Daryl G. Jones
Managing Director


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