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RH: Can EBIT Go Up By 10x?

Takeaway: RH is expensive and it's built to stay that way. It continues to meet or beat our lofty expectations. The consensus is low by 60%.

Conclusion: Still one of our favorites. The company overdelivered on a heck of a lot more than the EPS line. It took up sales and EPS guidance well ahead of what the 1Q beat would imply. It accelerated square footage, announced yet another two businesses, two new catalogs for Fall, and made a  major hire in luring away the President of the Williams-Sonoma brand to be CMO for its RH Kitchens and Tableware business (where current share is near zero). RH continues to meet or beat our expectations in almost every area. The biggest question for us here revolves around how much higher the stock can go. After all, the stock is up 82% in six months, and is flat out expensive. But it was also expensive 82% ago. In addition, if our model is right, we're looking at an earnings CAGR of about 50% for each of the next three years. Then it eases to something in the mid/high 20s. So what's a fair multiple for that? 30x? 40x? It's tough to say. But what we can say is that we're 60% ahead of the Consensus in the outer years, and until the Street realizes that there's $5.00+ in EPS over 5-years, then we're comfortable owning it even if it's expensive. 



RH was one of our favorites headed into the quarter, and it remains so after the quarter. But aside from a solid beat, we did not expect much in the line of new disclose or thesis-changing information with this print given that the company just executed on its secondary on May 15th (which in itself was just weeks after a delayed 4Q earnings print and subsequent positive preannouncement).  We were wrong -- they gave the thesis some more positive go-juice.


Here's what changed on the margin:

  1. First off, RH beat the quarter by $0.03, but took up full year guidance by $0.10-$0.12. Not many companies are doing that these days. RH took up annual revenue guidance by 4%, and 2Q revenue by 7%. None of these things are thesis-changers for us, and in fact, we're still well above these numbers. But they're confidence-builders nonetheless.
  2. RH is fresh off the ICSC conference in Vegas and the company had better than expected success in pairing up with potential landlords for new Design Galleries. Not only does it take up the number of Galleries we're likely to see over time (over 50), but we think it also takes up the average size per store. These two factors are a critical on a combined basis as it relates to our margin of safety on the RH growth algorithm (see below). With more favorable availability of sites comes more favorable rents and cap rates -- it's economics 101.
  3. RH is launching two new businesses -- again.  Does this sound familiar? In RH's first quarter out of the IPO gate it announced the launch of RH Tableware, RH Objects of Curiosity, and RH Fine Art. Now we've got RH Kitchen and RH Antiquities. Both of these are massively fragmented businesses and present huge opportunities for RH. These are in addition to RH Leather and RH Rugs, two new catalogue drops this fall. #growthaccellerating
  4. RH managed to snag Richard Harvey from Williams-Sonoma to be CMO for RH Kitchens and Tableware. The simple fact that RH's share of this category is close to zero today, and they went ahead and hired the person with the best track record in the world in brand-building, sourcing and merchandising in the kitchen space….that's just huge.
  5. There's only one new risk that we can point towards…and that's execution. We're looking at a company that should double square footage, triple revenue, and take up its EBIT ten-fold over the next 5-years (seriously…let us know if you want to see our model). In doing so, RH will need to introduce and scale new categories in some of the most fragmented categories in all of retail. Fragmentation is good from a competition standpoint, but it is also usually characteristic of a category is difficult to scale. From a modeling perspective, we can quantify the cost of a new store. We know square footage. We can make pretty good estimates on the new store productivity curve. We can also make assumptions about rents and leverage hurdles for occupancy expense. But what we find very difficult to do is modeling SG&A. We think that we're safe in modeling a 15-20% SG&A growth rate in each of the next 5-years. SG&A might not be very sexy, but we think that this is the biggest and most unknown lever in the model.




We think that RH is to home furnishings what Ralph Lauren is to Apparel and what Nike is to Athletic Shoes. It's the preeminent brand in the space, and sets/leads consumer style trends/wants/needs but with very little fashion risk. From a maturity perspective, we think that RH is 8-10 years behind RL, and 15-20 years behind NKE. Its got the runway. And even though it has such minimal market share across its categories, the competitive set is actually not very strong.


One thing that makes the RH model stand out is the growth algorithm over the next 5-years. Specifically…

  1. Square footage is not growing today. The company has perhaps one more quarter where it shrinks and then it starts its' climb. 
  2. But our point is that today it is the comp that's driving the model. We can clearly see where that's coming from, we can map out additional sales as new businesses come on line, and we can draw out the comp curves for new higher productivity stores entering the comp base and hitting more mature productivity levels. We're modeling sales per square foot going from $846 last year to just shy of $1,500 in year 5.
  3. Ultimately, comps will slow. It's a mathematical certainty. But at the time comps slow we're likely to see square footage growth accelerating to peak rates of growth. Square footage is shrinking slightly today, and should be up at a rate near 20% by year 3.
  4. So you see…we can safely model the comp today due to reasons discussed above. Then as that starts to level off, we have square footage ramping up. We can safely model that too. As the second chart shows, that gets us to just over 20% annual revenue growth with comp and square footage flip-flopping their importance to the model as time passes.

RH: Can EBIT Go Up By 10x? - 1


RH: Can EBIT Go Up By 10x? - 2

Trade of the Day: CCL

Takeaway: We re-shorted Carnival (CCL) at 9:41 AM at $32.95.

We are re-shorting Carnival (CCL) one of our Best Ideas (on the short side). Hedgeye Jedi Felix Wang says what happens to his CCL model in New Haven, "stays in New Haven."


Trade of the Day: CCL - CCL

FDX: Will FedEx ‘Show Me’ June 19th?


FedEx reports on June 19th, providing the first major data point for our thesis.  For FY4Q 2013, expect a terrible looking headline number, since charges for buyouts and accelerated depreciation are expected in the quarter. That should not matter and we are instead looking for three significant items:


  • Express Margin:  We expect to see meaningful sequential margin improvement at FedEx Express from the low bar set in FY3Q.  This is a key “show me” item and necessary evidence for our valuation and thesis.
  • Fleet Update: A new fleet replacement schedule, which should show how Express will manage accelerated retirements.
  • Guidance:  FY14 guidance, which we expect to look something like $7.00-$7.50.



We think FDX is a show me stock.  Investors may see the opportunity, but the company needs to deliver margin expansion in FedEx Express for buy-in.  In terms of timing, it did not help to have the Investor Meeting and get the market excited about the prospects for margin expansion, while at the same time not expecting to deliver any visible benefits until FY 4Q 2013 (the quarter they report on June 19th).  The FY 3Q disappointment does set a low bar, in our view.  As long as FDX shows decent margin improvement sequentially, and a path to further progress in guidance, we expect the shares to regain their pre-FY3Q momentum.



FY2014 Guidance Outlook


FedEx management has told us to expect $1.6 billion in profit improvement at FedEx Express by FY16, with 75% coming by FY15.  They have also indicated that those gains are ahead of schedule and should be relatively evenly distributed through time.  The improvement is measured from FY13 Express operating income, which we do not know precisely, but should come in around $850 million.  That puts FY14 at around $1,450, or a little better given that the cost reductions are ahead of schedule.  Assuming FedEx Ground comes in around $1,950 (growth below recent volume growth) and FedEx Freight at about $300 million, one gets ~$7.30-$7.40 for FY14 EPS at a 36% tax rate.  So the current implied guidance matches current Bloomberg consensus of $7.35.


Last June, FDX guided to a $6.90-$7.40 for FY13, which it will miss with a number closer to an adjusted $6.00-$6.15.  Last year, FY13 consensus estimates were about where they are now (~$7.35) for FY14. Expectations this time do not appear out of line with what is achievable and what the company has communicated.  While the range may leave some downside wiggle room, we do not expect guidance that does not include consensus within its bounds.  A decent guess for the range is probably $7.00-$7.50.  Given the expectations implied by recent share price performance and investor skepticism, that range will probably be interpreted favorably.



2014 Specifics


Looking at the specifics around the FY14 guidance expectations, we highlight some of the key differentials vs. a challenging FY13.



Postal Contract vs. Pension 


The new USPS contract lowers pricing by about $100 mil and adds some volume, a headwind likely to be in the range of $100-150 million.  However, in FY13, FDX saw “a historically low discount rate at our May 31, 2012 measurement date … increase these [Pension] costs by approximately $150 million.”  The recent sell off in bonds, in addition to favorable equity market performance, is likely to have a favorable effect on FY14 pension expense.  While difficult to calculate precisely, we estimate that the pension improvement should largely offset the negative impact from the new postal service contract.



International Express & Aircraft Reallocation/Retirements


In recent quarters (particularly FY3Q), FDX has had too much low yielding Deferred volume in its high cost International Priority line haul.  Weak international trade has also left many channels unbalanced – i.e. full planes out, part empty ones back.  Both of these factors hurt profitability in what is typically one of FedEx Express’s highest margin product categories. 


The solution FDX began implementing April 1 was to shift the Deferred volume to the belly space of commercial aircraft.  This has three key benefits.  First, capacity can be removed while maintaining service.  Second, the partially empty flight back can be eliminated since the commercial aircraft space can be one way.  Finally, the excess aircraft capacity freed can be reallocated to the U.S. express market.  FedEx has its most efficient aircraft in the international express market, so reducing capacity in international express has permitted those more efficient aircraft to swap out high cost domestic aircraft.


The net impact of these changes is substantial, consisting of higher utilization, better network balance, earlier aircraft retirement and potentially better pricing.  While one fewer Asia route probably saves an annualized ~$100 million in fuel and a bit more in related costs, there are follow-on impacts from aircraft reallocation.  The early retirement of the 727 fleet, A310s, MD10s already announced likely add an additional $75-125 million.  Additional aircraft retirements during FY14 should also contribute, as may the impact of better network balance and capacity.  Aircraft retired during FY12 should also help the comp.  Ping us back if you want more specifics, but on balance, we think these factors should contribute $300-$400 million relative to FY13. 



Headcount Reduction


While FDX has yet to disclose how many employees have taken the voluntary buyout offer, we estimate that it is likely to impact 3%-4% of headcount.  Assuming the reductions are straight-lined through the year, the lower headcount and administrative should favorably impact costs by ~$150-$200 million.



Squishier Items & Fuel


DHL had great success with harder to specify profit improvement efforts in areas like at IT and sales.  While much of the FedEx restructuring is more specific, items, like “yield management” can be harder to quantify.  Fuel prices also appear to be lower for FY14 and FDX guides assuming stable fuel prices, providing a small benefit relative to lagged surcharges.  On balance, the benefit from this category readily makes up the balance for FedEx Express’s $600 million in profit improvement.



International Trade Down vs. Volume Growth


If FY 3Q 2013 international IP vs. Deferred trends persist during FY14, that would create a sequential headwind.  At the moment, there doesn’t seem to be much reason to expect the trade down to reverse, but there rarely is.  The increased use of commercial lift should help offset the impact.  Further, the domestic express market appears to be improving and the negative mix shift may end up offset by volume growth, which has been less of a focus for investors.



Ground Assumption


The difficult comp in FY3Q 2013 for FedEx Ground (vs. a previously not highlighted insurance reserve reversal) may have lowered the expectations for this segment.  Improving U.S. economic activity, particularly on the consumer side, could create profit growth in line with volume growth – a favorable variance relative to our expectations.




Upshot:  FedEx is likely to guide FY14 in line with what it has already hinted.  We see the guidance as attainable now that it is the management focus.  For the quarter, we expect the sequential trends in Express to be the most relevant to our thesis and valuation.

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Turkey ... Much Ado About Nothing?

Takeaway: Turkish protests are creating a lot of headlines, but we think they will have little impact on long term fundamentals.

This note was originally published June 12, 2013 at 15:10 in Macro

Turkey ... Much Ado About Nothing? - turkey protests


"Turkey is not a second-class democracy.”


-Turkish Foreign Minister to Secretary of State John Kerry


To say Turkish equity markets have been volatile over the last two weeks would be an understatement.  In fact, on June 3rd the main Turkish equity index was down more than 10% as emphasized in the chart below.  While Turkey was largely immune to the so called Arab Spring, the current series of protests that have  been grabbing media headlines around the world appear to be a Turkish version of sorts, at least at first blush. 


Turkey ... Much Ado About Nothing? - yowsa


Turkey ... Much Ado About Nothing? - Turkey XU100 During Protest


Stepping back, the Turkish economy has been the fastest-growing economy in Europe since the early 2000s. In 2002, current Prime Minister Recep Tayyip Erdogan won his first general election and since then the XU100 index is up almost 9x, which can be seen on the graphs presented. Turkey is now the 15th largest world economy on purchasing parity basis.  The key components of the highly diverse Turkish economy include: agriculture which is 30% of employment (Turkey is food independent), the fourth largest ship building sector in the world, the 10th largest producer of minerals, and a very active tourism industry (with 11 of the top hotels in the world located there).


Turkey has also been much less affected by the financial crisis of 2008/2009 than many of its European peers.  In fact, Turkish GDP grew 9.2% in 2010 and 8.5% in 2011 (long term growth rates are highlighted in the chart below), which were some of the highest growth rates in the industrialized world.  The derivative impact of this economic growth is that the country level fiscal situation level is very healthy.   In fact, Turkey has met the 60% debt-to-EBITDA criteria of the Maastricht Treaty every year since 2004. As a result of the healthy economy, the Turkish Lira has been stable over the past few years with inflation under control.


Turkey ... Much Ado About Nothing? - Turkey GDP


Much of the economic success over the past decade can be attributed to Prime Minister Erdogan, who has been in power for most of that period.  Erdogan inherited an economy that was deep in recession in 2002 and with the help of Finance Minister Ali Babacan, Erdogan implemented a series of reforms. One key reform included dramatically reducing government regulations, which subsequently altered the path and outlook for the Turkish economy.  Perhaps most telling on this front is the fact that inflation was at 35% when Erdogan gained power and CPI is now running sub-5%.  


Given the economic backdrop and improving economic situation of the average Turk over the last decade, the protests against the government are somewhat counterintuitive.  Regardless, they are occurring with increasing scale.  The map and timeline below highlights this fact showing the spread of protests across Turkey. To date, these protests have led to 3 fatalities and 5,000 injuries.  


Turkey ... Much Ado About Nothing? - Turkey Map


Turkey ... Much Ado About Nothing? - Turkey Events


The protests in Turkey, though similar to the protests against local governments that erupted in the Arab Spring revolutions seen in northern Africa with Tunisia, Egypt, and Libya, also hold some specific differences. The unrest shown against Erdogan and his government is different because in the Arab Spring countries the protests were directed to the dictatorships that ascended to power, rather than democratically voted into office. On the other hand Erdogan has won every important democratic election.   As well, the Arab Spring was initially catalyzed by the poor economic situation of the broad populace.


To be fair, the AKP and Erdogan have lost some of their popular appeal and are being accused of infringing on personal freedoms in Turkey.  Recently the government implemented a restriction on alcohol sales and has also been allegedly imposing conservative Islamic views in legislation. The protesters have stood up, and have fought against police brutality and restrictions on labor unions.


There are a few options to what will happen next in Turkey. A scenario similar to the Arab Spring does not seem plausible, where protests fueled by the dissatisfaction of government led to complete regime changes in Tunisia, Egypt, and Libya. It is unlikely because the Erdogan has had such a positive impact on Turkey’s economy and the violence in the Turkish protests are not to scale of the Arab Spring.  In essence, there is no military or armed support to the protests.


Another option is for the protesters to eventually give in with no major changes being enacted or seen in the government. Erdogan has been visiting cities to gain more supporters so that he and the AK party will again win the popular vote in the Presidential elections in 2014.  


Ultimately, we do not think these protests will trump the strong track record of Erdogan and will eventually pass, although he may have to acquiesce on the civil liberties front.  The biggest tell to us on this front is a chart of credit default swaps on Turkish government debt.  While they are elevated, they are still largely in normal territory and are not signaling imminent economic or fiscal stress, which would come from a broad popular uprising akin to what occurred across the Middle East during the Arab Spring.


We aren’t ready to advise buying Turkish equities just yet, but our Hedgeyes are watching and waiting.


Daryl G. Jones

Director of Research


Turkey ... Much Ado About Nothing? - Turkey CDS

Retail: Japan Not Helping Margin Equation

Takeaway: Developments in Japan are not a welcomed change to the retail margin equation. Here's who has the greatest exposure.

Our Macro team is bearish on Japan from a long-term TAIL perspective (see the latest of Darius Dale's notes below). And yes, it matters for US retailers. Here's a list of brands that have direct exposure to Japan. We've already heard some of the companies (like Ralph Lauren) talk about taking up prices in Japan to help mitigate currency fluctuations, but those actions are not enough to cover the whole deficit. That's when secondary exposure comes into play, as the primary brands look to extract value from other supply chain partners to maintain their margins. We wouldn't consider this as 'critical' for US Retail right now, but with raw material tailwinds coming to an end, and labor costs accelerating to the upside, it is not a welcomed change -- particularly with margins at peak. At a minimum, let's be aware of it.


Retail: Japan Not Helping Margin Equation - one



06/13/13 02:05 PM EDT



Takeaway: Trading Abenomics from here depends primarily on your specific investment duration.




  • All in, the BOJ’s opting to stand pat as the currency market demands additional easing measures is the primary reason for the recent bout of yen strength (up +9% vs. the USD since its 5/17 YTD low).
  • More importantly, the USD/JPY cross has broken our intermediate-term TREND line of support at 95.95.
  • To the extent you have been short the yen or playing the Abenomics Trade in ancillary vehicles, it may prove prudent to sell/reduce your exposure upon confirmation (i.e. give it time to breathe) of a breakdown through the TREND line.
  • The long-term TAIL line of support is down at 88.67; that would be a good level to put the position back on/increase your exposure (as would a breakout back above the TREND line).
  • As one of our core research views, we remain the bears on the Japanese yen with respect to the long-term TAIL. We’re merely attempting to manage the immediate-to-potentially-intermediate-term risk of the position.


The minute-by-minute week-to-date chart of the dollar-yen tells us all we need to know about the Abenomics trade. Unlike last week’s sharp decline, the stair-step function exhibited in the week-to-date suggests that investors are slowly losing faith in the collective ability of Abe, Aso and Kuroda to deliver on the LDP’s contextually aggressive +3% nominal GDP and +2% inflation targets.


Retail: Japan Not Helping Margin Equation - 1


This is primarily due to the trifecta of headwinds that we outlined last Friday in a research note. Perhaps the most critical of those headwinds is the fact that the BOJ appears increasingly content to “play chicken” with market participants, meaning that they continue to stand pat on their previously outlined policies and guidance.


Essentially, they are asking the market to patiently trust that they’ll deliver the results that the Abe administration seeks with regards to not just ending structural deflation expectations, but instituting inflation and the broad-based expectation that inflation will be sustained. As we pointed out in a 3/15 research note titled, “JAPAN’S “INVERSE VOLCKER” MOMENT IS UPON US”, Japan’s monetary policy phase change is not unlike what the US experienced with the transition from Arthur Burns to Paul Volcker in the late 70s/early 80s.


Just today, BOJ policy board member Sayuri Shira warned that: A) it will take considerable time to achieve +2% inflation target given that the economy has been in a deflationary slump for 15 years and B) there needs to be more focus on the downside risks. She also affirmed previous guidance by BOJ Governor Haruhiko Kuroda that the board is not planning to implement additional programs to calm JGB market volatility, stating that “sufficient tools” already exist.


All in, the BOJ’s opting to stand pat as the currency market demands additional easing measures is the primary reason for the recent bout of yen strength (up +9% vs. the USD since its 5/17 YTD low). More importantly, the USD/JPY cross has broken our intermediate-term TREND line of support at 95.95.


To the extent you have been short the yen or playing the Abenomics Trade in ancillary vehicles, it may prove prudent to sell/reduce your exposure upon confirmation (i.e. give it time to breathe) of a breakdown through the TREND line. The long-term TAIL line of support is down at 88.67; that would be a good level to put the position back on/increase your exposure (as would a breakout back above the TREND line).


As one of our core research views, we remain the bears on the Japanese yen with respect to the long-term TAIL. We’re merely attempting to manage the immediate-to-potentially-intermediate-term risk of the position.



Retail: Japan Not Helping Margin Equation - 2


Darius Dale

Senior Analyst




Retail (Pop)

Takeaway: This print synchs with our overall (decidedly non-consensus) bullish view on US consumption.

Witness the nice pop in May US Retail Sales popping 0.6% and past head-scratching Wall Street consensus.


Retail (Pop) - reb


This print synchs with our overall (decidedly non-consensus) bullish view on US consumption. Yes, we remain bullish on #GrowthAccelerating.


In particular, check out Restoration Hardware (RH) seeing a tidy uptick jumping around 3% today ahead of its earnings report.


That said, weather may be a factor in June for apparel and footwear retailers. #GotRain?


Retail (Pop) - bri

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