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Uncertain China

This note was originally published at 8am on June 26, 2013 for Hedgeye subscribers.

“Nothing is certain but the unforeseen.”

-J.A. Froude

 

No stranger to intellectual debate, British author James Anthony Froude (1818-1894) was well-known for stirring the pot – perhaps even more so than @HedgeyeDJ (Daryl Jones, our no-holds-barred DoR) and @HedgeyeENERGY (Kevin Kaiser, our oft-controversial senior energy analyst).

 

Froude’s generally polemic works were often met with fierce debate and rejection among the British intellectual elite – perhaps none more so than his seminal work The Nemesis of Faith (1849), which was carefully crafted to call into question blind acceptance of the popular Christian doctrine of the time. Widespread public backlash in response to the novel ultimately cost Froude his fellowship at Oxford University.

 

Eventually Froude’s avoidance of institutionalized groupthink won out. Froude and his wildly contentious ideas ultimately found a permanent home when he was appointed Regius Professor of Modern History at Oxford (i.e. a really big deal) in 1892 – the very institution he was driven away from nearly a half-century prior.  During his regrettably brief stint at Oxford (he died in 1894), Froude quickly earned a reputation for being among the most popular lecturers of his time.

 

If nothing else, Froude’s journey from the top to the bottom and back again is a lesson for analysts young and old to avoid the safety and comfort of groupthink. Never is this advice more important than when a time-tested, comprehensive and repeatable research process leads one to hold a counter-consensus view. Hold the LINE [short], Kaiser!

 

Back to the Global Macro Grind

 

Incorporating another one of Froude’s lessons, we call attention to the aforementioned quote in the context of China’s banking system woes – which, thanks to the recent spate of legacy media coverage, are now as obviously present as a 6’3”, 325lb left tackle in one of Froude’s 19th century lectures.

 

Specifically, anyone even tangentially following recent press will arrive at the conclusion that a growing consensus among analysts across both the buy and sell sides believes with a fair amount of certainty that China’s credit binge and alleged housing bubble are sure to cause a Western-style financial crisis.

 

We aren’t so sure. With less than 2% of all financial assets held by foreigners, strict capital controls have, thus far, prevented a mass exodus of liquidity through the capital account. Domestically speaking, the PBoC’s own words from yesterday should douse any hopes of a crisis:

 

“Financial institutions’ cash reserves stood at about 1.5 trillion yuan ($244 billion) as of June 21, compared with the 600 billion yuan or 700 billion yuan sufficient under normal circumstances to cover payment and clearing needs. The present liquidity is not insufficient.”

 

Indeed, by comparing China’s present-day banking woes to the early tremors of Bears Sterns or juxtaposing China’s property market – rife with “ghost cities” – with our own pre-crisis froth, consensus has undeniably fallen victim to the availability heuristic. We don’t think that’s a prudent call to make at the current juncture; the Chinese sovereign has the resources, political will and mobility to prevent any Western-style financial crisis.

 

We’ve become a broken record on this, but it’s critical to remember that China’s present day economic woes are actually a function of very deliberate macroprudential policies. While highly unlikely, at any given time, Chinese officials can reverse course and keep the credit bubble inflating longer than any of us short-sellers can remain solvent.

 

On the contrary [to consensus], we think the outlook for China’s banking sector is likely to resemble that of a slow bleed, rather than sudden cardiac death. We’ve published a ton of work recently backing our conclusions with detailed analyses, but for those of you who weren’t able to tune in until now, we’ll take this opportunity to rehash our views:

  • Alas, it remains our view that the headwinds facing China’s banking system are structural (i.e. NOT cyclical) in nature.

Please email us if you’re interested in reviewing the full compendium presentation materials and research notes backing these conclusions, and we’ll get them right over to you. We also have a list of ancillary securities and asset classes to underweight/sell/short if you’re interested in those as well.

 

At any rate, we urge you to embrace the uncertainty of this situation by running full speed away from anyone who tells you they know how this all ends.

 

In fact, the only certainly anyone can promise you regarding these risks is that the outcome is presently unforeseen and, quite possibly, hidden deep within the “shadows” of China’s financial sector.

 

Our immediate-term TRADE Risk Ranges are now (TREND bullish or bearish in brackets):

 

UST 10yr Yield 2.35-2.69% (bullish)

SPX 1560-1614 (bearish)

DAX 7619-8108 (bearish)

Nikkei 12,406-13,449 (bearish)

 

VIX 16.59-20.98 (bullish)

USD 82.21-83.39 (bullish)

Euro 1.30-1.32 (neutral)

Yen 96.25-99.17 (bearish)

 

Oil 99.18-103.39 (bearish)

NatGas 3.64-3.82 (bearish)

Gold 1226-1324 (bearish)

Copper 2.98-3.12 (bearish)

 

Keep your head on a swivel,

DD

 

Darius Dale

Senior Analyst

 

Uncertain China - Chart of the Day

 

Uncertain China - Virtual Portfolio



Fed Conversations

“The one who engages in conversation should not debar others from participating in it.”

-Cicero

 

That’s one of the many quotes from Stephen Greenblatt’s The Swerve (page 70) that gets the juices flowing. Whether you’re tapping into the minds of the early Greeks (Epicurus = 341-270 BCE) or the arena of debate in the Roman Republic (Cicero = 106-43 BCE), it’s all there.

 

If you work within an investment culture that demands both constant questioning and collaboration, it’s all there too. Is there any other way to find the truth? Those who put their political pride over the market’s truths have never made good Portfolio Managers, fyi.

 

Sadly, politicians have provided the Fed, ECB, and BOJ closed forums where un-elected bureaucrats call the shots. While that may have been normal in Stalin’s Russia, it’s not in the area code of what America’s Founding Fathers envisioned. Who really cares about today’s Fed “minutes”? Until the Fed opens itself up to the Dalios and Druckenmillers of the world, they’re not even having a conversation.

 

Back to the Global Macro Grind

 

China’s economic data was horrendous overnight. So let’s not talk about the implications of Asian #GrowthSlowing, copper demand collapsing, mining capex bubbles, etc. Let’s start begging for a Bernanke-style bailout for the Chinese economy!

 

Yeah baby, that’ll do it – look at how well things turned out for every other Asian government that levered itself up since the Ming dynasty. I am hearing the Chinese are really into the whole Krugmanomics idea of turning China’s balance sheet into Japan’s too. Shhh.

 

To be crystal clear on this, we do not think China will “stimulate” you. Here are Darius Dale’s Top 3 reasons why:

 

1.   Property Bubble – they are trying to pop it before they get popped like we did (imagine that, learning from US history); property price growth continues to accelerate (+7.4% YoY in JUN; 13 consecutive months of sequential gains)

 

2.   Rebalancing, Not Levered Growth - Politburo's economic rebalancing agenda (quality of growth now more important than quantity of growth), which they've supported with recent rhetoric and (in)action during the recent credit crunch

 

3.   Psychology – despite the intermediate-term TREND slowing Chinese growth is still trending in-line to above long-term targets; if growth doesn’t fall off a cliff, new leaders will be reluctant to appear weak in the context of their long-term plan

 

Unlike team Obama, Geithner, and Bernanke (or Abe, Aso, and Kuroda in Japan), Xi and Li will be in charge for another 10 years. Why on earth would they implement short-term Western-style “stimulation”, when their ultimate goal is for history to respect them long-time?

 

I know, I know – whatever you do, do not engage in rational discussions about this when you can always defer to trading on the latest Chinese, Eurocrat, of Fed horse whispering rumor. That’s where the vig is at, bros.

 

The vig?

 

Yeah, you know – “also known as the juice, the cut or the take…” (Wikipedia definition). Or the amount a Washington “consultant” gets paid for his super secret inside info on what the Fed Minutes are actually going to say today (or what Bernanke is going to whisper next).

 

Just like Jefferson envisioned, for sure.

 

In other #StrongDollar, Strong America news, US stocks closed up for the 4th day in a row yesterday, taking the Russell 2000 to yet another all-time closing high of 1,018. For those of you who are still into keeping score for the 2013 bears, that’s +20% YTD.

 

All-time is also a very long-time, so why not sell some up here? You know, lather yourself up with some booked gains. As our Financials guru (and birthday boy), Josh Steiner, always reminds me, ‘no one ever went broke booking a profit.’

 

From our process’ perspective, making some sales up here in US Equities is your short-term, high probability, bet because:

  1. PRICE – SP500 is immediate-term TRADE overbought in the 1 range
  2. VOLATILITY – front-month VIX is immediate-term TRADE oversold around 14.02
  3. VOLUME – has been nowhere to be found on this no-volume meltup (down -13-27% versus our TREND avg)

What goes up on no-volume can come down on no-volume. So, as consensus is forced to chase price again, and again, and again in 2013, just take a deep breath and focus on proactively managing the risk of a very trade-able range (SPY range = 1, for now).

 

Despite the “rumors” of being “stimulated” by some Chinese dudes, both the Shanghai Composite and the Hang Seng closed well below their bearish TREND lines of 2,190 and 21,991, respectively overnight.

 

Oh, and Oil is testing a breakout above our long-term TAIL risk line of $108.36/barrel this morning too. So, Bernanke, before you think about devaluing the Dollar again with a closed network “communication tool”, think about the rest of us who are engaged in open discussions about you while we’re taking your Policy To Inflate in the pump.  

 

Our immediate-term Risk Ranges are now (we have 12 Macro Ranges in our new Daily Trading Range product too, fyi):

 

UST 10yr 2.56-2.73%

SPX 1

Hang Seng 20,124-20,991

VIX 14.02-16.21

USD 83.89-85.09

Oil 105.06-109.39

 

Best of luck out there today,

KM

 

Keith R. McCullough
Chief Executive Officer

 

Fed Conversations - Chart of the Day

 

Fed Conversations - Virtual Portfolio


Hedgeye Statistics

The total percentage of successful long and short trading signals since the inception of Real-Time Alerts in August of 2008.

  • LONG SIGNALS 80.30%
  • SHORT SIGNALS 78.51%

THE HEDGEYE DAILY OUTLOOK

TODAY’S S&P 500 SET-UP – July 10, 2013


As we look at today's setup for the S&P 500, the range is 37 points or 1.90% downside to 1621 and 0.34% upside to 1658.                     

                                                                                                          

SECTOR PERFORMANCE

 

THE HEDGEYE DAILY OUTLOOK - 1

 

THE HEDGEYE DAILY OUTLOOK - 2

 

EQUITY SENTIMENT:


THE HEDGEYE DAILY OUTLOOK - 10


CREDIT/ECONOMIC MARKET LOOK:

  • YIELD CURVE: 2.27 from 2.27
  • VIX closed at 14.35 1 day percent change of -2.91%

MACRO DATA POINTS (Bloomberg Estimates):

  • 7am: MBA Mortgage Applications, July 5
  • 10am: Wholesale Inventories, May, est. 0.3% (prior 0.2%)
  • 10:30am: DOE Energy Inventories
  • 11am: Fed to buy $3b-$3.75b notes, 4/30/2019-6/30/2020
  • 1pm: U.S. to sell $21b 10Y notes in reopening
  • 2pm: Fed releases minutes from June 18-19 FOMC meeting
  • 4:10pm: Fed’s Bernanke speaks on economic policy in Boston

GOVERNMENT:

    • Senate procedural vote on bill to extend 3.4% interest rate for subsidized Stafford college loans for yr
    • 9:30am: House Oversight and Government Reform Cmte hearing on GAO reports that show federal govt is deficient in tracking money, performance
    • 10am: House Ways and Means panel hearing on delay of the health-care law’s employer mandate
    • 10am: House Financial Svcs panel hearing on “Reducing Barriers to Capital Formation”
    • 10am: Joint Economic Cmte hearing on job opportunities for veterans
    • 2:30pm: Senate Agriculture, Nutrition and Forestry Cmte holds hearing on “Smithfield Acquisition, Future Foreign Purchases of American Food Companies,” w/ Smithfield CEO Larry Pope
    • 3pm: House Republicans meet in private conference to discuss strategy on immigration legislation

WHAT TO WATCH

  • DirecTV, Chernin/AT&T group said to bid ~$1b for Hulu
  • China’s June exports, imports drop in drag on economy
  • T-Mobile said to show quarterly gain in contract subscribers
  • Citigroup said to plan sale of 90 Calif. branches for $300m
  • EU to unveil euro-area bank-failure plan amid German opposition
  • UBS leapfrogs Bank of America to top global wealth manager ranks
  • Consumer Bureau to sanction banks over debt collection methods
  • Cheapest panel no longer best in solar market: SunPower CEO
  • Maxim is said to fetch bids of $20m as losses pile up
  • Nintendo, Sony shrs move after report China to end console ban

EARNINGS

    • Fastenal (FAST) 6:50am, $0.41
    • Family Dollar Stores (FDO) 7am, $1.03
    • MSC Industrial Direct (MSM) 7:30am, $0.97
    • Pricesmart (PSMT) 4pm, $0.64
    • Yum! Brands (YUM) 4:10pm, $0.54
    • Cleco (CNL) 4:22pm, $0.66
    • Texas Industries (TXI) Aft-mkt, $0.20
    • Adtran (ADTN) Aft-mkt, $0.19

COMMODITY/GROWTH EXPECTATION (HEADLINES FROM BLOOMBERG)

  • Gold Trades Near One-Week High on Physical Purchases, Dollar
  • Cattle Herd at 60-Year Low Cuts Tyson Beef Margins: Commodities
  • Gold Contracts Climb to Four-Year High to U.S. Stocks: Options
  • Copper Advances as China Imports the Most Metal in Nine Months
  • Corn Extends Biggest Gain in 10 Weeks on USDA Production Outlook
  • Robusta Coffee Advances as Investors Boost Buying; Cocoa Gains
  • Rebar Rises on Higher China Property Demand, Shrinking Supply
  • OPEC Sees U.S. Shale Boom Eroding Demand for Its Crude in 2014
  • Aluminum Hampered by Lack of Western Supply Cuts: Bear Case
  • Wheat Imports From Pakistan May Climb to Highest in Five Years
  • Blackstone Treasure Hunt Under Way for German Tankers: Freight
  • Williams %R Returns Most in Gold Bear Market: Technical Analysis
  • Iran LNG Dreams Vanish as U.S. Shale Gas Looms: Energy Markets
  • Gold ETF Assets in India Drop for Third Month as Prices Plunge

THE HEDGEYE DAILY OUTLOOK - 5

 

CURRENCIES

 

THE HEDGEYE DAILY OUTLOOK - 6

 

GLOBAL PERFORMANCE

 

 

THE HEDGEYE DAILY OUTLOOK - 3

 

THE HEDGEYE DAILY OUTLOOK - 4

 

EUROPEAN MARKETS

 

THE HEDGEYE DAILY OUTLOOK - 7

 

ASIAN MARKETS

 

THE HEDGEYE DAILY OUTLOOK - 8

 

MIDDLE EAST

 

THE HEDGEYE DAILY OUTLOOK - 9

 

 

The Hedgeye Macro Team

 

 

 

 

 

 

 

 

 

 

 


RH: Turning A Frown Upside Down

Takeaway: Sensing the Chinese water torture of S1s could hurt, RH upped guidance a lot closer to what we think it will earn (but still not enough).

RH got some good advice on this one and averted what could have been a multiple-killer.

 

When the company announced yet another follow-on offering on July 5, the story immediately lost some momentum. The underlying fundamentals were still solid, but anyone with a shred of analytical integrity had to step back and wonder if it was going to be like a 'Chinese water torture' of additional stock sales.

 

That was particularly the case with the size of the deal growing to 12mm shares from 10mm after the close tonight, and with officers and Directors participating instead of just Home Holdings (the three firms that took it private -- whose ownership will be down to 15.9% post offering ).

 

But alas, RH came out and issued new long-term growth targets that are nothing short of parabolic. It made the following changes…

    1. revised revenue growth to low 20s vs prior goal of mid-high teens. 
    2. EBITDA growth from twenties to high 20s
    3. EPS growth of mid-high twenties from prior growth of 'about 20%'

 

Note that the revenue growth guidance is a bit closer to our model, but our much more aggressive top-line forecast of 30%+ is the base of our roadmap for RH to achieve triple-digit status (see our research below). We should also note that we think that the company is being conservative with the leverage to the EPS line of a company in this business that is growing its top line in excess of 20%.  In three years' time we get to $3.36 in EPS vs the Street at $2.22. Ultimately, in 5-years we're over $5.

 

RH: Turning A Frown Upside Down - 1

 

HERE'S OUR RECENT NOTE POST 1Q THAT WE THINK BEST HIGHLIGHTS OUR CALL

06/14/13

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.

 

 

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…

      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: Turning A Frown Upside Down - 2a 

RH: Turning A Frown Upside Down - 3a

 

 

 


Circus Bears of Consensus

There is nothing worse for the 2013 Perma-USA stock market bears than a no-volume ripper day like today.

 

Circus Bears of Consensus - cirbe

 

It’s now four up days in a row for US Stocks. The S&P 500 is just a hair away from its all-time closing high of 1,669.16. The Nasdaq posted its best close since October 2000. And to top it all off, the Russell 2000 just notched a third consecutive all-time high.

 

In case you missed it this morning, here's a #timestamped look at how off-the-mark the #OldWall consensus bear has been. 

 

Circus Bears of Consensus - Chart of the Day


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