“Shy and proud men are more liable to fall into the hands of parasites and creatures of low character. For in the intimacies which are formed by shy men, they do not choose, they are chosen.”
Tapeworm infestation is not something we would wish on our worst enemies. According to Wikipedia, tapeworm infestation is the infection of the digestive tract by adult parasitic flatworms called cestodes or tapeworms. Typically, consuming uncooked food is the way in which tapeworm larva find their way into humans. Once inside the digestive tract, a larva can grow into a very large tapeworm.
No doubt waking up to read about tapeworms is the last thing you need. Alas, we couldn’t think of a more appropriate analogy given the market’s recent fascination with the potential tapering of QE by the Federal Reserve. Yesterday, the market actually rallied on this tapering rumor based on a blog by Jon Hilsenrath in the Wall Street Journal that tapering, if it is to occur, would be a more manageable version, perhaps something akin to Taper-lite.
We haven’t been stock market operators as long as many of you, but we certainly don’t remember a period in which there has been such a fascination with, and focus on, the next move of the Federal Reserve. But until the market host rids itself of the QE parasite, this fascination and volatility associated with the next move of the Fed is likely to continue.
Back to the global macro grind . . .
Earlier this week, we reiterated our short call on emerging markets and China with a concise presentation by our Senior Asia Analyst Darius Dale. (Email to get a copy of the presentation.) This short call has played out positively for us and has been backed by asset flows out of emerging markets funds. In fact, in the most recent week the exodus from emerging market funds was $9 billion, which was the third largest weekly outflow ever (after March 2007 and January 2008).
The key new research we provided in the presentation was related to short Chinese financials. We view this thesis as three fold:
- Credit growth is slowing – The increasing likelihood that the People’s Bank of China tightens will provide an impediment to credit growth;
- NIM compression is occurring – Based on the current NIM spread, we think this ratio can only tighten from current levels, which will pressure bank margins; and
- Non-performing loans are rising – Even though the data is very opaque, NPLs of 20% are a reasonable estimate given by many experts.
In the Chart of the Day, we’ve highlighted one of the more insightful charts in the presentation, which is the Chinese 7-day repo rate monthly average, which highlights how tight money is in China currently. This rate has gone from about 3.5% in May to 5.7% in June, which is the second highest monthly rate in the last five years and a staggering shift month-over-month. If money sustainably tightens in China, economic growth will most certainly take a hit.
Our Senior Analyst covering Europe Matt Hedrick also gave a very lengthy and thoughtful update on Europe this week (once again email if you want to see this presentation). While we don’t see the financial sector risks in Europe that we do in China, the economic outlook does remain largely bleak in Europe. Some of the key points that we highlighted in the presentation included:
- Fundamentals in Europe remain challenged and we should expect long-term below mean growth;
- We see limited risk to any country leaving the Eurozone or the Euro being disbanded, so another Cyprus flare-up is unlikely;
- The bifurcation in Europe will continue and we are fundamentally bullish of Germany and the U.K. and fundamentally bearish of France, Italy and Spain; and
- ECB is unlikely to shift policy anytime soon, which should continue to support our strong dollar call.
A structural issue that makes it inherently difficult for Europe to recover quickly is the inflexibility of the labor force. In the United States, labor can flow freely from state to state based on employment opportunities. So, in theory, the U.S. would be very unlikely to have states where the unemployment rate was north of 26%, such as in Spain and Greece, and other states where the unemployment rate is below 7%, such as Germany and Denmark.
Given the inability of labor to flow easily through European borders, due to differing qualification levels, work quotas and cultural barriers, it is no surprise then that a recession in Europe should be more protracted. The bigger issue, of course, is that it creates unemployment hot spots, such as Greece, Cyprus, and Spain, that will have an inability to re-balance their economies, except over very lengthy time periods.
This dreary global growth outlook we have continues to push us back to the one economy and stock market we remain positive on – the U.S. of A. On that front, as it relates to macro data coming out today, the big one is Michigan Consumer Confidence which is released at 9:55am to the masses, and five minutes early for those that pay up for the early look! Regardless of who gets it ahead of you, it will still be a decent “tell” on how the consumer is feeling.
Our immediate-term Risk Ranges for Gold, Oil, US Dollar, USD/YEN, UST 10yr Yield, VIX, and the SP500 are now $1, $100.21-105.43, $80.26-80.24, 93.54-95.85, 2.07-2.27%, 15.21-1857, and 1, respectively.
Keep your head up and stick on the ice,
Daryl G. Jones
Director of Research
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This note was originally published at 8am on May 31, 2013 for Hedgeye subscribers.
“I raise my flags, don my clothes
It's a revolution, I suppose.”
For the last five plus years, Hedgeye has delivered an Early Look to your inbox every market morning. Primarily, it has been Keith delivering the goods with the rest of the team chipping in from time to time. With over 1,000 Early Looks written, you would think it takes some sort of Macro Imagination to get these notes out the door every morning.
Fortunately for us the world provides a great amount of economic fodder and this morning is no exception, but to be fair some amount of creativity is required to keep these notes at least somewhat interesting. Moreover our research team, like your teams, requires creativity to generate interesting investment ideas. But, what exactly is the root of creativity?
A study by Jordan Peterson of the University of Toronto found that the, “decreased latent inhibition of environment stimuli appears to correlate with greater creativity among people with high IQ.” In layman’s terms, the research says that people whose brains are more open to stimuli from the outside environment will likely be more creative.
Conversely, the risk of too much outside stimuli is mental illness due to overload. In this regard, the differentiator between creativity and madness is a good working memory and a high IQ. In essence, with these attributes a person has the capacity to “think about many things at once, discriminate among ideas and find patterns”. Without them, one can’t handle the increased stimuli.
So even if we know the root of creativity and innovation, how do we accelerate it within our companies and ourselves? Interestingly social networks may be giving us a huge leg up in this regard. According to Martin Ruef from Stanford Business School:
“Entrepreneurs who spend more time with a diverse network of strong and weak ties...are three times more likely to innovate than entrepreneurs stuck within a uniform network."
In a nutshell, creative people are more open to outside stimuli and best leverage that creativity when exposed to broad network of loose ties. (And just think, my ex-girlfriend used to tell me I spent too much time on Facebook!)
Back to the global macro grind . . .
As I noted earlier, this morning is certainly providing a fair amount of economic fodder. A few points to call out:
- The Shanghai composite sold off hard into the close on chatter that tomorrow’s manufacturing PMI will come in below 50. This is consistent with the flash PMI reading from Hong Kong and also the pattern of economic data being leaked early (we removed long Chinese equities from our Best Ideas list earlier this year);
- Japanese equities outperformed over night, but finished down -5.7% on the week. The more interesting data point from Japan was April CPI which came in at -0.4% and clearly signals that the Bank of Japan has more to do before sustainable inflation is generated (Short Yen remains on our Best Ideas list); and
- Japanese government pension fund with $1.1 trillion in assets indicated it would consider increasing its allocation to equities. To buy one asset class, another asset class must be sold. If the action in the Japanese government bond market is telling us anything it is that this allocation is already occurring as yields on 10-year JGBs have been spiking recently.
Domestically, our thesis of economic growth going from stabilization to acceleration continues to be validated. Market internals clearly support this as the SP500 is up more than 16% this year and the treasury market is literally at 12-month lows. If you didn’t know, now you know . . . economic growth is good for equities and bad for bonds.
As we dig deeper in the market internals, the performance of the sub-sectors of the SP500 validate this view even more. As of last night, the top two performing sectors in the year-to-date are healthcare up 23.3% and financials up 23.0% and the two worst performing sectors are utilities up 8.6% and materials up 9.1%. There we have it again, the growth sectors are dramatically outperforming.
Now if you are a thoughtful stock market operator, you probably want to call me out on something from the last sentence, which is that materials should do well in an environment in which growth is accelerating. This is true except for the one important factor: the U.S. dollar. In the Chart of the Day, we highlight the impact of the dollar and the associated correlations over the last 180 days, which are +0.80 with the SP500, -0.72 with the CRB index, and -0.83 for gold. A strong dollar equals weak commodities.
This Macro theme of up dollar and down commodities is very positive for a number of sectors. This year our Restaurant team of Howard Penney and Rory Green has done an outstanding job leveraging the macro call with their stock specific work. One of their best ideas in my view has been a sell call on McDonald’s on April 25th and since then the stock has underperformed the market by some 800 basis points.
At the time more than 30 firms had recommendations on MCD and no one had a sell. This is creative and contrarian research at its finest. Needless to say, our restaurant team eats alpha for breakfast, lunch and most value meals! Ping us at firstname.lastname@example.org if you want access to trial our restaurant research.
Our immediate-term Risk Ranges for Gold, Oil (Brent), US Dollar, USD/YEN, UST10yr Yield, VIX, and the SP500 are $1354-1423, $101.03-103.89, $83.10-83.98, 100.31-103.71, 2.03-2.19%, 12.28-15.31, and 1641-1674, respectively.
Keep your head up and stick on the ice,
Daryl G. Jones
Chief Creative Officer
THE MACAU METRO MONITOR, JUNE 14, 2013
GONGBEI BORDER RECORDED 800,000 VISITOR ARRIVALS Macau Daily News
The 3-day Dragon Boat Festival holiday ended yesterday in Mainland China. Gongbei checkpoint recorded a steady tourist arrival during the holiday, with an average daily arrival between 260,000 and 270,000, and total tourist arrivals reached 800,000 in the three days, a slight growth compared with the same period last year.
One of the reasons for the lower tourist number compared with the May Day holiday and the National Day holidays was due to the rainy weather, which caused some of the travelers to cancel their trips. Another reason was that many Mainlanders preferred to celebrate the Dragon Boat Festival with their families as it is a traditional Chinese festival.
PACKAGE TOURS AND HOTEL OCCUPANCY RATE FOR APRIL 2013 DSEC
Macau visitor arrivals in package tours increased by 10.2% YoY to 766,971 in April 2013. Package tour visitors mainly came from Mainland China (582,998), with 209,307 coming from Guangdong Province, followed by those from Taiwan (49,485); the Republic of Korea (35,301) and Hong Kong (32,678).
In April 2013, the hotels and guesthouses received 897,340 guests, up by 16.9% YoY. The average length of stay of guests decreased by 0.1 night YoY to 1.3 nights.
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:
- 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.
- 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.
- 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
- 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.
- 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.
A REMINDER ON WHY WE LIKE RH
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…
- Square footage is not growing today. The company has perhaps one more quarter where it shrinks and then it starts its' climb.
- 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.
- 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.
- 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.
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