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IGT YOUTUBE

In preparation for IGT's F2Q 2013 earnings release tomorrow, we’ve put together the recent pertinent forward looking company commentary.

 

 

YOUTUBE FROM Q1 CONFERENCE CALL

  • [International] "There are systemic issues that have impeded participation in some markets, which we are working to overcome. And the economic headwinds in certain regions continue. However, we remain committed to harvesting the investments that we have made in this business particularly in expanding our portfolio of localized content. Long-term, we still expect international markets to outpace the growth of our North American business."
  • "We now expect that our objective of achieving flat year-over-year yield by the fourth quarter will be more challenging than previously anticipated. However, we remain focused on improving yields, confident that we can continue to offset a portion of yield pressures by managing costs."
  • "Looking forward, we expect to see a decrease year-over-year in our gaming operations capital expenditures, driven by a decline in installations."
  • [Doubledown] "As we develop these markets, we expect that the number of daily active users will grow, but the average revenue per daily active user could decline slightly...we continue to expect the transaction to be GAAP accretive by 2014."
  • [Product Sales margins] "Traditionally, we're in kind of the low 51% to 53% range and that's where I would expect it to stay over the remainder of the year."
  • "We do need some cooperation from GGR trends. And I would say, over the first two quarters of our fiscal year, we haven't seen anything to indicate that we're going to get some positive tailwind in that area."
  • [Operating expenses] "We expect it to retrench back to where it was in the first quarter, say, for costs associated with marketing and promoting DoubleDown, where we do engage in some direct – marketing expenses. We'll be in line or probably grow less than the revenue growth that we experienced, as is the case this quarter."
  • [Canadian VLTs] "We expect at the moment that we should see the vast majority of the remaining units ship in the year. But keep in mind these are large bulk orders and depending on either customer needs or other impacts, you could see swings and sometimes those swings border on a quarter. Right now I would say that we believe the vast majority of the remaining shipments will occur in the year. And then there may be some follow on activity as locations top off their floors in 2014."
  • [Doubledown] "We think we have the right product in place complemented by the IGT content to continue to grow those numbers. I mentioned we're penetrating a couple of different markets with new language offerings and we expect that will drive DAU though it may slightly impact bookings per daily active user. As you get into a market you need to build familiarity before you can convert to paying users. It's incredibly difficult to precisely identify which metric is going to go up. Lately we've seen them all rise and we continue to expect to make forward progress in all and we will continue to balance that which will provide us the greatest long-term return. So I think you can expect to see them move north."
  • [International systemic issues] "Europe tend to be more macro. The other two (Latin/South America, Asia Pacific) as we look at them probably have more of a systemic issue within the structure of how they allow the business to operate.

 


CAT: Bull Thesis Review & 2Q Expectations

Summary

 

We received a number of responses from more positive investors challenging our CAT thesis following last Thursday’s presentation.  The three key bullish themes that emerged were:

 

  1. Buyback: Better capital allocation for CAT going forward in the form of share repurchases
  2. Segment Models: The downside may look minor when modeled by segment, particularly when inventory reductions are factored in.
  3. Mining Cycle Already Well Known: The stock is hated already – how much downside could there be?  Investors should ‘look through’ the downturn.

 

CAT has already underperformed and we have been negative on the name for over a year.  However, we still see significant downside.  While we could always be wrong and will change views as appropriate, data and experience suggest these cycles go on for much longer than most investors expect and frequently overshoot.  This one seems to be just getting started.

 

Argument 1:  Better Capital Allocation/Buyback

 

Overvalued:   CAT announced a $1 billion buyback with its disappointing 1Q 2013 earnings.  That shift in capital allocation has generated some optimism – particularly on the day it was announced.  However, CAT’s equity appears overvalued.  Buying overvalued equity is not a great way to create value.

 

Good Acquisitions:  If anything, issuing overvalued equity to make acquisitions of cheap, good businesses might add some value, even providing a short-term reporting boost from some of the purchase allocation flexibility.  Following the challenges of ERA and Bucyrus, additional large acquisitions seem unlikely. 

 

Buyback Valuation Discussion Cringe-Worthy: On the call following 1Q earnings CFO Bradley Halverson said with respect to the buyback:

 

“So the question is why now. And our balance sheet is very strong. We think with the drop in stock price recently and where our PE is, the fact that we believe we have a slow growing economy but one that's stable…. We had a good cash flow quarter.  We have plans for a good cash flow year and we think, again, this is an opportunistic time here in the short term to reward our shareholders with $1 billion stock buyback.” - Bradley Halverson 4/22/13 (Bloomberg Transcript)

 

First, low multiple cyclicals tend to be overvalued - P/Es do not work as a valuation metric (cyclical investing 101).  Cyclicals tend to be cheapest when earnings are negative and they have no P/E.  Second, CAT already has plenty of leverage.  Does anyone really think CAT is underleveraged? Finally, CAT has not been generating all that much free cash flow recently.  If the cash flow impact of receivables growth and rental equipment purchases are included, CAT had negative free cash flow in 2012 (cash from operating activities less capital spending and investment in receivables).

 

CAT: Bull Thesis Review & 2Q Expectations - cv1


CAT: Bull Thesis Review & 2Q Expectations - cv22

 

 

 

Buy Backs & Performance:  Buybacks tend to be a last resort for companies that do not have anything better to do with cash.  They are also frequently used to manage investor sentiment by mingling the announced buybacks with poor financial results (like CAT’s 1Q 2013).  Large buybacks are often associated with underperformance (see RRD or RSH, for example).  When CAT was outperforming in the past decade, it was adding capacity and doing deals amid a robust market outlook.  Now, aggressive internal investment appears less attractive.  

 

Magnitude Insufficient:  The announced buyback adds back cents to EPS, while the down-cycle in mining capital investment is likely to remove dollars.

 

 

Argument 2: Segment Models

 

Hard to Normalize: CAT changed its segment definitions, so gathering segment level history before 2009 is challenging.  Add in acquisitions, and it is really difficult to look back at how changes in resources-related capital spending impacted the different businesses.  Even management thinks so:

 

“In terms of what's normal, man, as I look back over the last few years in mining, it's a little tough to decide actually what's normal.” – Michael DeWalt, 4/22/13

 

CAT: Bull Thesis Review & 2Q Expectations - cv3

 

 

Our Forecast Range for a Flat/Declining Commodity Price Environment

 

Deep cyclicals like CAT tend not to have gentle changes in results over time.  Many analysts nonetheless model gradual change, even when the evidence suggests otherwise.  The table below assumes that the move higher in commodity prices is largely over – principally that metal and energy prices will not rise much faster than inflation in the forecast period.  Our March 2013 Mining & Construction Equipment presentation supports that outlook, but it is a key assumption for the forecast.  When commodity prices stall, resource-related capital spending reverts to maintenance-type levels in our analysis.

 

We don’t do point estimates, especially in cyclical names where long-term forecasts are likely to be significantly off.  If an investor is on the right side of the cycle, industry structure and valuation, we have found that performance follows.  That said, we were asked for specifics on our outlook for CAT segments.  We provide the table below to give a sense of our views, with supporting discussion underneath. If the estimates for Resource Industries look extreme, just look up the volatility in results at Bucyrus, or in the shipbuilding industry or housing construction market.  When the demand cycle moves, revenue and margin swing hard in the same direction.

 

CAT: Bull Thesis Review & 2Q Expectations - cv444

 

 

 

Resource Industries

 

The decline in mining capital spending is not a deviation from normal levels, but a return to them.  Resource Industries is dominated by mining capital spending, with coal, iron ore, copper, gold and other minerals as key end-markets. 

 

Aftermarket Sales:  Many investors seem to believe that Resource Industries sales are more than half parts and service.  We think the actual number is a lower, perhaps only 25%-40% depending on the year.  (If it were half of sales, CAT would open every presentation with it, and rightly so.)  We see CAT’s dealer network as a liability in the mining equipment space, where there are only a couple hundred relevant customers globally.  For example, JOY does derive slightly more than half of its sales from aftermarket products – but it does not have a dealer network to support.  Dealers take a sizeable cut of the aftermarket revenue, as CAT dealers typically focus on service and support.  As another indication, CAT reports total Bucyrus revenue (excluding divestitures) as $4.76 bil in 2012.  Finning bought its distributorship for $465 million and reports that in the ~half year that it owned it, the distributorship generated $233 million in revenue.  If we assume the same service-to-new-products revenue mix for the Bucyrus distributorship as Finning and assume a similar sales multiple for the other divestitures, we get an aftermarket share of around 30%-35%.  It is also worth noting that if mining activity weakens significantly, existing equipment may be parted out, reducing aftermarket sales.  CAT should simply disclose the number in an unambiguous, wink-free way.

 

Scale & Duration of Decline:  We expect to see a 70% decline, give or take about 10 percentage points, in mining capital spending in total over something like four to seven years.  That is derived from an expectation that mining capital spending will return to maintenance levels (see slides 7 & 8 in our recent CAT slide deck for how we get there).  Near maintenance levels of capex is what miners normally spend.  That is because mining is a sub-GDP growth industry that tends to add its capacity in huge lumps (like in the ‘00s and the ‘70s).  That capex decline includes a portion of parts and service, since those are often capitalized expenses.  Importantly, CAT’s backlog already contains orders stretching out quarters and years, so investors can look ahead further than the reported topline. 

 

Margin Pressure:  Mining equipment companies added significant manufacturing capacity over the past decade.  If our view of the pending market decline is correct, it would be internally inconsistent not to model significant margin pressure.  CAT, Komatsu, Hitachi, Liebherr and others are likely to be more price competitive when backlog duration is short and capacity is available.  JOY’s operating margins ranged from slightly negative to a high single digit from 1.  In the resources-related capital spending boom, JOY’s operating margin nearly tripled.  Given the topline outlook for mining capital spending, the margin assumptions presented could prove generous.  In the early 1980s, following the last resource-related capital investment boom, competition from Komatsu helped drive very significant losses at CAT.

 

So Much Hasn’t Hit Yet:  Of course, dealer inventory adjustments are a major factor in the 1Q sales decline and CAT’s own inventory adjustments also negatively impacted margins.  However, Resource Industries has only reported one quarter of YoY revenue declines.  It seems a bit premature to call the end of a likely multi-year reversal in this segment after just one quarter.  Resource Industries pricing was still up in 1Q.  Pricing can hold for a little while as the industry works on backlog – like in 2009 – but a sustained downturn amid industry overcapacity is likely to produce intense price competition.

 

 

Power Systems

 

Resources Exposed:  We have generally referenced “resource-related” capital investment as opposed to “mining” capital investment.  That is so we could also reference energy-related capital investment at Power Systems.  While CAT has not done a great job at breaking down end market exposures for Power Systems, it is no stretch to suggest that the division is heavily exposed to oil & gas capital investment.  The division also has some exposure to mining capital spending, such as mine site power and locomotives.

 

Not As Big Of A Drop, But It Could Be:  Oil & gas capital spending also boomed in the past decade.  That helped growth in some of CAT’s highest margin Power Systems product lines.  We assume that Power Systems is half ‘resources’ exposed, with much of that exposure from oil & gas.  Even though oil prices, for instance, have held reasonably firm, they have still appeared to stall since 2010/2011, or even 2007.  Historically, stable commodity prices drive capital spending back toward maintenance levels.  Critically, large energy companies appear to have started cutting capital spending.  We have assumed drops in line with 1Q 2013 actuals, but oil & gas capital spending may well be the next shoe to drop for CAT if energy prices remain stagnant.

 

CAT: Bull Thesis Review & 2Q Expectations - cv5

 

 

 

Locomotives & Other:  Locomotive demand is exposed to commodity volumes. Sales should see slowing demand growth following a long period of significant investment by railroads (including mining railroads).  New locomotive emissions regulations ~2015 are a factor.  We assume the balance grows at a mid-single digit rate.

 

 

 

Construction Industries

 

Rebound Likely, Industry Competitive:  We expect a delayed but significant cyclical upswing in construction equipment.  We prefer developed market exposure in less competitive niche products to CAT’s broad product portfolio.  As a whole, the industry tends to be fragmented and competitive.  Even in a demand upswing, we do not expect Construction Industries to deliver margins comparable to those of Resource Industries near its peak. 

 

A Better Idea:  If an investor wants exposure to the rebound in construction equipment demand, they should buy a construction equipment company.  CAT’s profit outlook is not dominated by the outlook for construction equipment demand, in our view.  Even estimates that are above street expectations fail to deliver upside for CAT EPS.

 

 

Argument 3:  Mining Cycle Already Well Known

 

Not In Consensus:  From what we can see of consensus expectations, the “well known” impact seems limited to 2013, with remarkable improvement thereafter in 2014 and 2015.  If forecasters are looking for a one year speed bump, then the cycle is not known, or at least not well understood.

 

Not Unusual for Recognition:  In our launch deck last year, we included a table showing the up-cycle in Transmission & Distribution (T&D) equipment.  T&D stocks outperformed handily even after the huge northeast blackout in 2003, a demand sign that was hard for anyone investing in NYC, Boston or CT to miss.  That cycle was well recognized, but it still worked.  CAT has so far, too.  Mostly analysts hesitate to show how long and positive an up-cycle can be.  The opposite tends to hold true on the downside.

 

CAT: Bull Thesis Review & 2Q Expectations - cv6

 

 

Investors Are Not Going To Look Through It:  We do not know many analysts or PMs with the patience to ride out a four to seven year down-cycle. We expect resources-related capital spending to go down and stay down for decades.  There is no other side to see. 

 

 

 

2Q Outlook

 

1Q Weakness vs. 2Q Expectations:  Given how spectacularly weak 1Q 2013 headline results were, 2Q may well improve sequentially.  Inventory destocking is supposed to slow from 1Q 2013’s pace and production is guided to improve along with it.  However, just as in 1Q, we do not expect the market to respond much to headline results.  We also think there is a small chance that management drops the increasing unattainable $12-$18 2015 EPS guidance.

 

Implied Orders Matter More:  Implied orders are likely to matter more than the headline number (implied orders = period revenues – change in backlog).  These stabilized in 1Q amid a short-lived rebound in key commodity prices.  Weakness in iron ore, copper and coal is likely to generate a renewed decline in implied order rates this quarter.  For all of the focus on dealer retail sales, they lag.  Orders tend to lead.  This is where we expect CAT to struggle in 2Q and in 2H 2013.  Declines in implied orders are important for our short thesis.  If we are correct, those declines should start to push 2014 expectations lower, along with normalized profit expectations.

 

 

CAT: Bull Thesis Review & 2Q Expectations - cv7

 

 


UA: Our Thoughts Headed Into The Print

Takeaway: Expectations aren't low into UA's print, but based on trends we're seeing, they shouldn't be. If we were forced to bet, it'd be positive.

CONCLUSION: UnderArmour footwear and apparel trends look solid headed into Thursday's print, especially in comparing wholesale sell-in versus retail sell-through. Retail inventory implications are bullish, and combined with a positive sales/inventory spread trend at UA, it's left with a particularly positive Gross Margin set-up. That's a big plus, because at 35x EPS it needs to beat, and expectations aren't low. If we had to make a bet one way or another (which we don't), we'd come out with an upwards bias.

 

DETAILS 

We think that UA's trends look quite positive headed into its print on Thursday.  Our analysis shows that a) sell-through of apparel continues to outstrip sell-in, b) footwear is doing so at even a greater rate (and the Speedform launch is gaining traction), and c) the Gross Margin set-up is bullish given easing product costs and a favorable sales/inventory spread.  All that said, we think that these trends are necessary to materially beat consensus estimates (a beat is critical for a 35x p/e growth stock). The good news is that our sentiment monitor suggests that this name remains extremely hated, which is a bullish stock setup.

 

One of the few risks we'd point to is if UA comes out and takes up SG&A requirements to grow the business as initiatives into Footwear and International markets become more important. This had been a concern of ours for a while, but after the company's analyst meeting last month we threw in the towel and altered our view (and our model) such that it could attain 20% top line growth without having to take the margin levels of the company sub-10%.  But if it nudges up spending rates again after just having the investment community in Baltimore to sell its strategy -- then there are going to be credibility issues. We'd be surprised if this turns out to be the case.

 

So when we put it all together, we think that this is one of times where the consensus has it about right,  but if we had to make a bet one way or another (which we don't), we'd have an upward bias. 

 

UNDERARMOUR'S APPAREL RETAIL SALES HAVE BEEN GROWING AT A RATE FASTER THAN ITS WHOLESALE SELL-IN

UA: Our Thoughts Headed Into The Print - ua app sellin

Source: SportscanINFO and Hedgeye

 

UNDERARMOUR'S FOOTWEAR BUSINESS HAS BEEN OUTSTANDING -- AGAIN, WITH RETAIL OUTSTRIPPING WHOLESALE

UA: Our Thoughts Headed Into The Print - fwsellin

Source: NPD and Hedgeye

 

SPEEDFORM HAS BEEN A RECENT DRIVER FOR THE FOOTWEAR BUSINESS. THIS IS THE MOST COMMERCIAL LAUNCH UA HAS HAD TO DATE

UA: Our Thoughts Headed Into The Print - uafast

Source: UnderArmour

 

THE GROSS MARGIN SET-UP IS SOLID THANKS TO AND EXTREMELY FAVORABLE SALES/INVENTORY SPREAD AND FAVORABLE PRODUCT COSTS

UA: Our Thoughts Headed Into The Print - uagmsis

Source: Company Reports and Hedgeye

 

OUR SENTIMENT MONITOR SHOWS THAT THIS STOCK REMAINS VERY HATED

UA: Our Thoughts Headed Into The Print - uasentiment

Source: Hedgeye

 


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2013: It Ain't Rocket Science

The 2013 Global Macro playbook hasn't been rocket science. So far, anyway. From a US-centric investor’s perspective at least, all you’ve needed to do is:

 

A) Short Fear (Gold, Bonds, Volatility) and

B) Buy Growth (High Beta, Low Yield, Growth Stocks)

 

2013: It Ain't Rocket Science - Growth Equation

 

It really hasn’t been any more complicated than that.


KMB STRAINING TO MAINTAIN GUIDANCE

Kimberly-Clark reported 2Q EPS of $1.41 versus consensus $1.39 despite a miss on the top line. Management reaffirmed FY13 EPS guidance of $5.60-5.75. Per management, the impact of lower predicted sales growth is expected to be offset by higher cost savings and share repurchases. We remain bearish on the name.

 

 

Conclusion

 

We believe the stock traded off today, despite the earnings beat, because of soft volumes in the U.S. and a looming miss or guide down in the back half of 2013. Management’s reiterated FY13 EPS guidance seems much, much less stable than it was three months ago; higher cost savings and share repurchases are set to fill the void being left by slower-than expected sales growth. With inflation sequentially accelerating and FX rates acting as a top-line headwind, we see downside risk to the company’s FY13 EPS estimates and would advise clients to continue to look elsewhere for exposure to consumer staples on the short side. We do not expect the market to pay 17x for earnings increasingly driven by cost savings and share repurchases. Below are the positives and negatives we took away from the quarter.

 

 

What we liked:

  • Emerging markets have sustained strong volume growth
  • The company is finding incremental cost savings (raised annual target by $50m to $250-350m) to drive EBIT growth
  • Operating margin expanded by 90 bps to year-over-year to 15.5% despite no sales growth and commodity inflation
  • KCI produced broad-based top line growth and operating margin expansion

 

 

What we didn’t like:

  • Organic sales growth was dragged lower by negative volume growth in developed markets, particularly the U.S., Australia, South Korea
  • U.S. personal care volumes declined despite negative product mix
  • Management highlighted increasingly volatile macroeconomic environment, FX, and oil prices
  • Big K-C I markets like Australia and South Korea experienced a slowdown in 2Q
  • Negative 2Q FCF growth (-2.1%) with EBIT growth slowing to 5.8% from 15.6% in 1Q13 and 8.1% in 2Q12 (mgmt says cash flow to improve in 2H13)
  • Valuation is rich – now important with increasing risk to the downside (or limited upside, at least) in earnings estimates
  • Oil prices holding above $100 per barrel could push cost inflation above mid-point of company expectations ($150-250 million)
  • FX rates holding current levels will likely result in EPS below mid-point of guided range

 

 

Rory Green

Senior Analyst

 


RISK MANAGING “ABENOMICS” AND “XI-LI-NOMICS”

Takeaway: We remain bearish on the Japanese yen and Chinese financials stocks with respect to the intermediate-term TREND and long-term TAIL.

SUMMARY BULLETS:

 

  • To quickly get up to speed on our bearish bias on the Japanese yen, please review the following two research notes: “THINKING THROUGH A POTENTIAL CURRENCY CRISIS IN JAPAN” (NOV ’12) and “REMEMBER, WE’RE IN THE VERY EARLY INNINGS OF ABENOMICS” (JUN ’13).
  • To be clear, Japan has already experienced a currency crisis (as defined by a peak-to-trough decline of -20% vis-à-vis the USD). And, as the title of the latter note would suggest, we think the there is more downside to come with respect to the intermediate-term TREND and long-term TAIL. Sell-side consensus is at 110 on the USD/JPY cross for EOY ’14; we expect them to once again be dragged up by last price towards the ~125 range over the intermediate term as monetary policy at the Fed and BoJ continue to diverge at the margins.
  • A dwindling current account surplus and a compressing real interest rate differential will also put pressure on Japan’s currency from an FX flows perspective. Consensus expects Japanese real 2Y rates to average -1.8% in 2014 (down from 0.1% in 2013E), which compares to -1.1% the for the US (flat vs. 2013E). Our bearish bias on China’s fixed assets investment bubble keeps our expectations for a rebound in Japan’s export earnings rather muted.
  • To review our bearish bias on Chinese financials stocks, please review the following two pieces of research: “ARE YOU SHORT CHINA [AND OTHER EMERGING MARKETS] YET?” (deep-dive presentation) and “EARLY LOOK: UNCERTAIN CHINA” (cliff-notes version).
  • We think the outlook for Chinese credit growth is structurally impaired as the rate of incremental liquidity slows as a result of declining inflows of foreign exchange and/or declining corporate profit growth. Moreover, we anticipate that growth in non-performing loans will accelerate sustainably over the long term – regardless if they are reported or not. In fact, delaying the natural charge-off cycle will only slow Chinese growth even further, as incremental credit is diverted away from marginal economic activity towards servicing existing debt. Lastly, we believe that net interest margins across the Chinese banking industry face immense regulatory headwinds that may ultimately have dire consequences for China’s fixed assets investment bubble. The confluence of these three factors should perpetuate a reflexive cycle of slower earnings growth and depressed valuations for Chinese banks.
  • Contrary to the title of the latter note, we think the outlook for Chinese growth is rather certain – sustainably slower.China’s 10Y GDP growth targets are set in stone and policymakers across the fiscal and monetary policy spectrum continue to talk down market expectations for economic growth over the intermediate term. Regarding the aforementioned 10Y growth targets, it’s interesting to us to see the Politburo stick to their “doubling of 2010 GDP by 2020” as the baseline target amid their economic rebalancing agenda. That means China’s nominal GDP only has to compound at +6.4% per annum from here in order to reach the CNY80.3 trillion target by 2020. Either the target is going to be revised meaningfully higher in the coming years, or consensus needs to dramatically rein in its structural outlook for Chinese economic growth.

Our Macro Team is represented via three positions within our firm-wide Best Ideas product: SHORT Japanese Yen (FXY), SHORT Chinese Financials Stocks (CHIX) and SHORT Emerging Market Equities (EEM). We obviously have a number of other fundamental biases – such as LONG US Dollar (UUP), LONG US  Financials Stocks (XLF) and SHORT Emerging Market USD Debt (EMB) – that were outlined most recently on our 3Q13 Macro Themes call (see slide 11 for the full list).

 

RISK MANAGING “ABENOMICS” AND “XI-LI-NOMICS” - 1

 

Having just published a detailed research note updating clients on our EEM short bias this past Friday, we’ll focus this note on our views on the Japanese yen and Chinese financials stocks (specifically banks and property developers) from here.

 

QUANTITATIVE SETUP

From a quantitative perspective, both the JPY and Chinese financials stocks remain broken across all three of core risk management durations. In Hedgeye speak, that essentially means day-traders, trend-followers and long-term investors are all being forced to react to the same [bearish] PRICE/VOLUME/VOLATILITY signals.

 

In addition to perpetuating a negative feedback loop in the marketplace, a Bearish Formation in any security or asset class essentially means that there is no real support to the prior closing lows. From a mean reversion perspective, that’s roughly +10-25% higher on the USD/JPY cross and roughly -30% lower for Chinese financials stocks (using the CHIX ETF as a proxy).

 

RISK MANAGING “ABENOMICS” AND “XI-LI-NOMICS” - 2

 

RISK MANAGING “ABENOMICS” AND “XI-LI-NOMICS” - 3

 

A REVIEW OF RECENT FUNDAMENTAL CATALYSTS

In Japan:

 

  • The LDP took the Upper House in a firestorm (the LDP-NKP coalition is projected to claim a total of 135 of 242 seats), as expected. Now it’s on to the next series of catalysts for the LDP and its Abenomics agenda. Specifically, a slew of economic and fiscal reforms – including reducing the corporate tax rate, delaying the 2014 VAT hike, broader fiscal consolidation, labor market liberalization, etc. – will be debated by Japanese policymakers over the intermediate term.
  • This is  as good as an opportunity for meaningful reform as Japan has had in many years, so we have very high expectations that something grand will be introduced. We expect that to be positive for sentiment across Japanese financial markets, as well as for economic growth expectations throughout the Japanese economy. In this scenario, we expect Japan’s household sector to allocate financial assets to equities (currently 6.8% of the total), at the margins, in lieu of cash and bank deposits (currently 55.2% of the total, which are traditionally then intermediated into JGBs). All that being said, a failure for the Nikkei and USD/JPY to make new YTD highs pre/post any major announcements on the reform front(s) would be an ominous sign as it relates to investor, corporate and consumer enthusiasm for Abenomics.
  • With a likely improved consensus outlook for growth among global investors and Japanese corporates, we expect Japanese inflation expectations (via 5Y breakevens, which peaked at 1.84% in MAY and are now trading at 1.13%) to resume their upward trend after making a higher-low in recent weeks; that should drag the dollar-yen rate up with it in the process.

 

In China:

 

  • One by one, Chinese policymakers continue to guide the market towards its structurally slower economic growth targets. As highlighted by our previous work, China’s GDP growth potential is structurally impaired relative to the previous cycle due to a confluence of slowing credit growth that itself is a function of declining marginal liquidity and rising NPL’s – which continue to go largely unreported (1% recorded for 1H13).
  • Scrapping the interest rate floor will structurally compress NIMs as SOE borrowers demand a lower cost of capital, while the PBoC’s explicit admission of the risks associated with scrapping the deposit rate ceiling all but confirms our view that the Chinese economy is essentially one grand experiment with levered financial repression. A potentially higher cost of bank capital – in real terms – will put pressure on the ponzi scheme nature of China’s on-and-off-balance-sheet investment vehicles (LGFV debt and WMPs in particular) that tend to be rife with maturity mismatches.
  • Interestingly, the PBoC’s recent decision to heighten statistical scrutiny of China’s banking industry will make it harder for banks to raise cheap equity capital to extent they have to raise capital to maintain current CARs (as much as $50-100B is required over the next 2Y, per ChinaScope Financial estimates).

 

STRUCTURAL OUTLOOKS

Abenomics:

 

  • To quickly get up to speed on our bearish bias on the Japanese yen, please review the following two research notes: “THINKING THROUGH A POTENTIAL CURRENCY CRISIS IN JAPAN” (NOV ’12) and “REMEMBER, WE’RE IN THE VERY EARLY INNINGS OF ABENOMICS” (JUN ’13).
  • To be clear, Japan has already experienced a currency crisis (as defined by a peak-to-trough decline of -20% vis-à-vis the USD). And, as the title of the latter note would suggest, we think the there is more downside to come with respect to the intermediate-term TREND and long-term TAIL. Sell-side consensus is at 110 on the USD/JPY cross for EOY ’14; we expect them to once again be dragged up by last price towards the ~125 range over the intermediate term as monetary policy at the Fed and BoJ continue to diverge at the margins.
  • A dwindling current account surplus and a compressing real interest rate differential will also put pressure on Japan’s currency from an FX flows perspective. Consensus expects Japanese real 2Y rates to average -1.8% in 2014 (down from 0.1% in 2013E), which compares to -1.1% the for the US (flat vs. 2013E). Our bearish bias on China’s fixed assets investment bubble keeps our expectations for a rebound in Japan’s export earnings rather muted.

 

RISK MANAGING “ABENOMICS” AND “XI-LI-NOMICS” - 4

 

RISK MANAGING “ABENOMICS” AND “XI-LI-NOMICS” - 5

 

Xi-Li-Nomics:

 

  • To review our bearish bias on Chinese financials stocks, please review the following two pieces of research: “ARE YOU SHORT CHINA [AND OTHER EMERGING MARKETS] YET?” (deep-dive presentation) and “EARLY LOOK: UNCERTAIN CHINA” (cliff-notes version).
  • We think the outlook for Chinese credit growth is structurally impaired as the rate of incremental liquidity slows as a result of declining inflows of foreign exchange and/or declining corporate profit growth. Moreover, we anticipate that growth in non-performing loans will accelerate sustainably over the long term – regardless if they are reported or not. In fact, delaying the natural charge-off cycle will only slow Chinese growth even further, as incremental credit is diverted away from marginal economic activity towards servicing existing debt. Lastly, we believe that net interest margins across the Chinese banking industry face immense regulatory headwinds that may ultimately have dire consequences for China’s fixed assets investment bubble. The confluence of these three factors should perpetuate a reflexive cycle of slower earnings growth and depressed valuations for Chinese banks.
  • Contrary to the title of the latter note, we think the outlook for Chinese growth is rather certain – sustainably slower. China’s 10Y GDP growth targets are set in stone and policymakers across the fiscal and monetary policy spectrum continue to talk down market expectations for economic growth over the intermediate term. Regarding the aforementioned 10Y growth targets, it’s interesting to us to see the Politburo stick to their “doubling of 2010 GDP by 2020” as the baseline target amid their economic rebalancing agenda. That means China’s nominal GDP only has to compound at +6.4% per annum from here in order to reach the CNY80.3 trillion target by 2020. Either the target is going to be revised meaningfully higher in the coming years, or consensus needs to dramatically rein in its structural outlook for Chinese economic growth.

 

RISK MANAGING “ABENOMICS” AND “XI-LI-NOMICS” - 6

 

THE OTHER SIDE(S) OF THE TRADE(S)

Below we outline the three most probable counter-catalysts we’d need to see occur prior to closing either of these positions.

 

USD/JPY (up +28.2% since we introduced our bearish bias back in SEP ’12):

 

  1. TREND support on the USD/JPY cross is violated to the downside and is subsequently confirmed.
  2. A Japanese bureaucrat (either at the Cabinet Office or BoJ) extends the duration in which the LDP’s +5% “monetary math” targets are to be met, thus effectively narrowing the scope for aggressive easing out of the BoJ with respect to the intermediate term.
  3. The rolling 3M trend in US economic growth needs to inflect to the downside, which is becoming increasingly probable now that crude oil is back in a Bullish Formation. We’d likely see commensurate weakness in domestic interest rates as expectations for Fed tapering are reigned in. A violation of TREND support for the US Dollar Index and the 10Y Treasury Yield would likely front-run and confirm such expectations.

 

Chinese financials stocks (CHIX is down -8.3% since we introduced our bearish bias on JUN 7):

 

  1. TREND resistance for the CHIX is violated to the upside and is subsequently confirmed.
  2. In the event of a marked acceleration to the downside with respect to Chinese economic growth, either the Politburo introduces a meaningful stimulus package or the PBoC lowers its benchmark policy rates and/or RRRs in a meaningful-enough fashion to reinvigorate liquidity across the Chinese banking system.
  3. Either Central Huijin or the MoF introduces a policy to protect bank share prices ahead of what is a likely to be another dramatic round(s) of capital raises.

 

Obviously, we don’t view either of these counter-catalysts as being more probable than the aforementioned structural outlooks we laid out above, so we’re still going strong in both positions. As always we’ll let know you if that changes in real-time.

 

That’s about as much certainty as you’ll ever get from us. In fact, recent experience has hardened our view that consistently outperforming the field in Global Macro risk management requires a daily embracing of said uncertainty.

 

It’s not sexy, but neither is not getting blown up!

 

Darius Dale

Senior Analyst


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