“The noise can be deafening.”
When he wrote that in Knowledge and Power, Gilder was referring to government interference (in markets). He also went on to make the critical, but often overlooked, behavioral link between simple market signals (like interest rates) and central planning noise.
“Interest rates are critical for information-theory economic analysis because they are an index of real economic conditions. If the government manipulates them, they will issue false signals, breeding confusion that undermines entrepreneurial activity.” (pg 24)
That pretty much sums up what I think all of us are struggling with today. Inclusive of yesterday’s drop in interest rates (oil ripping new highs is an economic headwind), the bond market is becoming as good a leading indicator of the slope of US economic growth’s TREND as anything I can back-test. At the same time, we have to deal with the deafening impact of central planning commentary.
Back to the Global Macro Grind…
Yesterday’s 1-day drop in the US stock market was deafening too. It came on a legitimate Information Surprise (Oil ripping on Syria) and the rotation you’d expect to see when expectations for growth fall (bond yields and US growth stocks have a positive correlation).
How did that deafening drop (there was no volume) fair within the context of the Top 3 biggest 1-day drops since April?
- June 20th, 2013 = SP500 -2.5%
- April 15th,2013 = SP500 -2.3%
- August 28th,2013 = SP500 -1.6%
#EOW (end of world) type stuff, I know.
In both of the prior 1-day freak-outs (which were bigger in terms of both magnitude and volume), fear spiked (front-month VIX) to higher levels than what you saw yesterday too. In other words:
- US stocks keep making higher intermediate-term TREND lows
- US Equity Volatility keeps making lower intermediate-term TREND highs
That’s why we do the multi-duration risk management thing. How else are you going to contextualize the immediate-term TRADE noise of Mr. Market if you don’t have anything to signal the intermediate-term TREND?
Since we are raging bears on Emerging Market Equities (EEM), this morning’s discussion is more focused on how to interpret US market noise (US markets include big stuff like the currency and bond market). Here are the other two Big Macro Signals I care about most:
- US Dollar Index grinded out another higher-low (versus the recent FEB and JUN lows) and held long-term TAIL support
- US 10yr Treasury Yield (2.73% this morning) held both TRADE (2.69%) and TREND (2.44%) levels of support = higher-lows
And yes, the TREND is your less noisy friend, until he/she isn’t – I get that. I also get that Oil prices steadily rising from here could cut US consumption growth in half, sequentially. So there’s a lot to think about (including whether this will be the YTD high in oil altogether).
But while I think, I have to try hard to take the emotion out of the decisions I make on what to do next. That’s why my immediate-term TRADE signals determine my short-term risk management decisions. I’ve tried the feel thing – and it ends up not feeling good.
When running money in a bull market like this for US growth stocks, not selling the lows is one of the most important decisions you can make. What if you read Zero Hedge, capitulated to your emotional state, and sold the April 15th and/or June 20th lows?
- By April 18th (3days later), the SP500 locked in another higher-YTD-low of 1541
- By June 24th (3days later), the SP500 locked in another higher-YTD-low of 1573
Can you wait 3 more days to see if this noise settles? Or are we all high-frequency blog freaks now? By August 2nd 2013 (when the SP500 hit its all-time closing high of 1709) you’d have been up +11% and/or +8.6% in SPY, respectively. Just saying.
Maybe the world is going to end this time. I started making that call around this time in 2007 (and it almost did end). But this is not 2007, and not one of the people and/or risk management processes that called it last time is making that call this time either.
Maybe everyone who didn’t call the 2007 topping process is going to nail it this time. But maybe not. All I can tell you is that the noise of #PTCs (professional top callers) since April of 2013 has been deafening.
Our immediate-term Risk Ranges are now as follows:
UST 10yr Yield 2.70-2.93%
EEM (Emerging Markets) 36.91-38.49
Best of luck out there today,
Keith R. McCullough
Chief Executive Officer
TODAY’S S&P 500 SET-UP – August 28, 2013
As we look at today's setup for the S&P 500, the range is 45 points or 0.58% downside to 1621 and 2.18% upside to 1666.
CREDIT/ECONOMIC MARKET LOOK:
- YIELD CURVE: 2.35 from 2.35
- VIX closed at 16.77 1 day percent change of 11.87%
MACRO DATA POINTS (Bloomberg Estimates):
- 7am: MBA Mortgage Applications, Aug. 23 (prior -4.6%)
- 7:45am: BoE’s Carney speaks in Nottingham, England
- 10am: Pending Home Sales M/m, July, est. 0.0% (prior -0.4%)
- 10:30am: DOE Energy Inventories
- 11am: Fed to buy $2.75b-$3.5b in 2020-2023 sector
- 1pm: U.S. to sell $35b 5Y notes
- 10am: FDIC to consider new version of proposed Qualified Residential Mortgage rule that would require lenders to keep stake in risky mortgages they securitize
- 11am: 50th anniversary of March on Washington civil rights rally, Dr. Martin Luther King, Jr.’s “I Have a Dream” speech; President Barack Obama, former Presidents Bill Clinton, Jimmy Carter, will speak
- U.S. Defense Sec. Chuck Hagel attends mtg of defense chiefs of ASEAN and their counterparts from nations including Japan, South Korea and China in Brunei
WHAT TO WATCH:
- BofA’s Merrill reaches $160m deal in black advisers’ suit
- Syria strike looms as U.S. readies forces with U.K., France
- Ex-JPMorgan trader released, opposes U.S. extradition
- JPMorgan “London Whale” fines may reach $600m: WSJ
- Sumitomo Mitsui, Orix said to weigh bids for AIG-owned planes
- Currency spikes at 4pm in London provide rate-rigging clues
- AMR-US Airways trial should wait until March, U.S. says
- Switzerland close to resolving undeclared U.S. accounts issue
- China to strictly control new local govt debt: Xinhua
- TPG-backed China Grand Auto is said to revive $500m IPO
- PepsiCo may buy up to 25% in Balaji Wafers, Line reports
- India’s Foreign Investment Board clears Mylan deal: Express
- N.Y. Times, Twitter web-address data hacked by Syrian group
- Brown-Forman (BF/B) 8am, $0.71
- Canadian Western Bank (CWB CN) 8:30am, C$0.59 - Preview
- Chico’s (CHS) 7:15am, $0.32
- Express (EXPR) 7am, $0.20
- Fresh Market (TFM) Aft-mkt, $0.32
- Guess? (GES) 4:03pm, $0.36
- Joy Global (JOY) 6am, $1.36 - Preview
- National Bank of Canada (NA CN) 7:15am, C$2.06 - Preview
- Williams-Sonoma (WSM) 4:05pm, $0.47
COMMODITY/GROWTH EXPECTATION (HEADLINES FROM BLOOMBERG)
- LME Facing Big Bang After Largest Metals Bourse Names New Chief
- Potash King Becomes Hostage as Belarus Pokes Putin: Commodities
- Commodities Gain to Six-Month High as Oil Rallies on Syrian Risk
- WTI Crude Rises to Two-Year High on Syria; SocGen Sees $150 Risk
- Gold Nears Bull-Market Territory as Syrian Tensions Spur Demand
- Copper Retreats for a Second Day Amid Escalating Syria Tension
- Corn Output in China Seen Lower on Heavy Rain, Researcher Says
- Sugar Declines as Brazil Millers Favor Sweetener; Cocoa Advances
- Gold Supply Hit Record in 2Q on OTC Market, GFMS Says: BI Chart
- Oil Diverges From U.S. Stocks Most Since 2011 on Syria Concerns
- McDonald’s ‘Mighty Wings’ Seen Boosting Prices: Chart of the Day
- Gas Price Jump Seen in Record Europe Stockpiling: Energy Markets
- Cranes Hoist Lebanon Economy as Syrian War Helps Port: Freight
- Tocqueville Is Best Gold Fund Amid Price Plunge: Riskless Return
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Takeaway: Sales under pressure, margins rolling over, increased SG&A, and higher capex. Sorry, but the ‘cheap valuation’ argument is irrelevant.
This note was originally published August 14, 2013 at 19:11 in Retail
Conclusion: Macy’s has been #1 on our list of top three shorts (followed by Gap and Dick’s), and as such, the print today is not a surprise to us. We have no crystal ball as to the comp that Macy’s has been generating, so we’re not claiming to have forecasted the specific sales shortfall in this given 13-week period. But we’ve viewed the triangulation of M’s P&L, Cash Flow Statement and Balance Sheet as being like an increasingly stressed balloon under water. This event does nothing other than strengthen our confidence in our call.
Out of any name we cover (and we cover just about all of retail) there is not a single name we find ourselves more fiercely debating than Macy’s. The most common bull arguments we hear are a) the company has been so poorly run for so long, and that investments in Magic Selling, MyMacy’s, Omni-Channel, etc… are making up for years of share loss, and b) the stock is so cheap at just 12x earnings.
But we think that valuation is irrelevant, as it is not a catalyst – and never has been – especially with a levered zero-square-footage growth retailer where numbers can change so quickly.
We recognize that there are certainly ways that Macy’s can operate more efficiently and can fine-tune its approach to going after share-of-wallet. But we think that there are too many factors converging on both the P&L and balance sheet that are stacking the odds against a positive change in return on invested capital. When returns are going down, there’s no reason a 12x multiple can’t turn into a 10x multiple – and there’s no rule that says that it needs to stop there. Factors that specifically concern us are as follows…
1) Top Line
a) We can’t forget that in 2012, Macy’s grew its top line by $1.5bn, which is the same time that JC Penney lost $4.3bn in sales. Macy’s management completely discounts the idea that any of its sales gain has come at the expense of JCP. If not outright cocky, we think that at a minimum management is being intellectually dishonest. JCP will start to regain share at some point in 2H --- or lose share at a lesser rate (which is a negative change on the margin for competitors). If JCP fails, it will inflict pain while it tries. The other retailers (including Macy’s) are in denial.
b) Macy’s management did a very poor job articulating the source of the 2Q sales miss. Transaction count was down 1.6%, and they noted that consumers are more interested in buying cars, houses and spending on home improvement than they are in spending in department stores. Seriously? What’s ridiculous is that there’s no way for them to know why consumers are NOT shopping in their stores. This is particularly troubling in light of point A – in that Macy’s is blaming macro factors at the same time we’re seeing sales competition heat up in the mid tier.
c) The company noted that comps had turned up in 3QTD. That’s nice given that we’re just starting back-to-school. But there’s a long way to go in BTS. We give the company credit for trying to keep expectations somewhat grounded that its way too early to declare victory – especially when there so many unknowns as to why sales performance missed like it did throughout 2Q.
2) Gross Margins were down only 10 basis points for the quarter – which is pretty impressive given the magnitude of the sales miss. But keep in mind that the sales/inventory spread eroded by 700bp, as inventories were up 6.4% despite a 0.8% sales decline. Had the company more appropriately cleared out inventory on hand, we’d have seen more Gross Margin pressure. (Notice the swing into the third quadrant of our SIGMA chart below). Either way, management has been vocal about saying that gross margins would be tough to improve from here, and that EBIT margins would need to come from SG&A leverage…
3) …but SG&A is headed higher. In order to kick start the top line and have the proper marketing programs in place for a less-certain 2H, the company is taking up marketing costs. We’re not knocking it, as it’s the right thing to do. But the simple point is that with both the top line and gross margins under pressure, the P&L gets levered in the wrong direction with an uptick in SG&A. Let’s not forget that Macy’s has almost $400mm in interest expense as well – which is another negative leverage kicker.
4) Lastly, capex is running at $925mm this year. There hasn’t been any increase in capex guidance, which is good, but the reality is that it is still up 33% from $698mm last year.
The punchline is that we’ve got sales down, gross margins rolling over, increased SG&A spending, and higher capex. In that context, the ‘cheap valuation’ argument is simply irrelevant. We’re modeling flat operating profit over the next four years, with earnings growth only being driven by 3-4% of financial engineering (debt paydown and repo). Our earnings 3-years out are 25% below consensus (see our assumptions in financial summary below). While a 10x p/e and 5x EBITDA multiple only suggests a stock in the low $40s out that far, the reality is that those same multiples could get to a stock with a 3-handle closer in.
We’re bearish on MCD, so one could argue we have a bearish bias, but we remain present and well-grounded in reality. Make no mistake, MCD has a top line issue and not a cyclical one. That said, we don’t believe management is willing to acknowledge the secular issues the company faces and new products like Mighty Wings seem like a desperate attempt to hide from reality.
We think MCD’s decision to sell its Mighty Wings this fall could potentially be disastrous for the company. We have three main issues with the current MCD menu strategy:
- Mighty Wings will not enhance the McDonald’s brand (Premium Wraps have not helped either)!
- Both new products (Mighty Wings and Premium Wraps) have slow service times.
- Adding new products to an already complex menu is the wrong direction for the company to go.
Selling chicken wings may temporarily boost sales during the LTO, but it could end up doing more harm than good. Asking the currently disgruntled franchisee community to prepare yet another new product, with a slower than normal preparation time, will only add to the service issues the company is already experiencing. In our view, this is likely to lead to the further deterioration of the MCD brand.
McDonald’s franchisees that sold wings in the test markets have suggested that the above average cooking time for the new menu item was an impediment to their service times. If this is indeed true, we expect drive through times to slow significantly. What it ultimately comes down to is the margin on Mighty Wings relative to other products on the menu. If wings generate a lower margin than a core sandwich and slow service time, then MCD could be headed for a 4Q13 disaster.
This is all too reminiscent of the period from 1, when we witnessed the sad decline of a mismanaged McDonald’s brand. During that time, the company was focused on unit growth and cost reduction rather than driving high margin, top line sales. As the image of the brand began deteriorating, management failed to invest in the brand and customer experience. Rather, they turned to monthly promotional tactics to in order to drive short-term sales at the expense of brand equity and margins. This strategy did not end well for either the company or investors and we’d be surprised if this time was any different.
HEI vs. HEI/A: Pair Opportunity?
Heico is an interesting, family dominated industrial with a dual class structure (Common and Class A). Heico’s best business is the manufacture of FAA certified, slightly-lower-priced replacement parts for aircraft (Flight Support, ~57% of 2012 operating income). By undercutting OEMs like GE and Pratt, HEI has built a high margin business with plenty of runway for growth. Heico also has what could broadly be described as a successful aerospace/defense electronics business (Electronic Technologies, ~43% of 2012 operating income).
For the purposes if this discussion, what Heico does is not as important as the relative characteristics of the Class A (HEI/A) and Common (HEI) shares. The spread between the two share classes appears abnormally wide at current levels, as shown in the chart above, having reached this level of divergence only a handful of times in the past dozen years. Shorting the common and buying the Class A is worth considering, if it matches the reader's style,, even though it is not a position that could be all that large (HEI trades about 40k shares a day with 42.16 close yesterday). Positions like long HEI/A vs. short HEI can be useful at extremes. Reversals can be fairly quick once started, but timing the inflection is, of course, very challenging. It is also noteworthy that HEI options have recently displayed elevated implied volatility, although we are not entirely certain as to why, and may be a point for further research.
- Key Differences: The HEI Class A shares offer 1/10th of vote while the common HEI shares offer 1 full vote. The common shares are more liquid, with about 3x more volume over the past few months. Both classes of shares have been repurchase targets, with the HEI common shares more favored in 2011.
- What a Full Vote Buys: Heico insiders exert significant influence over the company, collectively holding about 6% of Class A shares and 21% of the common. Three members of the Mendelson family sit on the Board of Directors and are in senior management. While insider may not have a lock on corporate control, it appears to us that current management exerts significant control over the company. Anti-takeover provisions may leave a would-be activist challenged to acquire meaningful influence. For most shareholders, the extra votes do not appear to add much value.
- Liquidity Better in HEI/A: Better liquidity certainly matters, in so far as it persists. The HEI common shares likely deserve a liquidity premium to the Class A shares, but the >40% magnitude appears abnormally large.
- No Arbitrage: There is no mechanism that forces these two share classes to match, except in the case of a few specific events. The Common premium could theoretically go anywhere. Historically, the current premium is at the high-end of the range - even relative to stressed equity markets. That said, positions like these can be slow to work out and can diverge further. The two securities are economically pretty close to identical, by our assessment, but do not have to trade that way.
- Events That Could Collapse Premium: Many companies have eliminated dual class structures, but that seems an unlikely short-run outcome at Heico. A sale of the company or MLBO would also likely eliminate the premium. The Chairman, CEO and elder Mendelson, Laurans, is 74, so the company may well be preparing for an eventual change at the top.
- What Insiders Prefer: Since January 2012, insiders have only made one small purchase of HEI common. On balance, insiders have sold nearly 50,000 HEI common share. At the same time, there have been many HEI/A purchases (net addition of over 4,000 shares) with Victor, Eric and Laurans Mendelson choosing the Class A shares. We assume that they know which share class offers the best value.
- Even For Longs: A long-term investor interested in HEI should look at buying the Class A instead of the common at present levels. Long-term holders also may benefit from a swap, liquidity permitting.
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