WSM: Getting Tough To Ignore

We continue to warm up to Williams-Sonoma (WSM) as a way to play two themes in the retail space.   


  • First, we are comfortable with the gradual, but increasing momentum in the home furnishing sector.  We know that big-ticket items remain under pressure but we are seeing encouraging signs in soft-home, cookware, and accessories.  Importantly, any pick up in non-furniture will be positive to WSM on the gross margin line as these categories tend to carry higher IMU's.  Consumers are spending more time in their existing homes which results in higher home-related capex.  


  • Second, in the wake of the severe downturn in the commercial/retail real estate market, we are becoming bigger fans of companies with large, scalable e-commerce businesses.  This is not only because it gives these companies a competitive edge vs. others who are levered to real estate values and dysfunctional/bankrupt landlords. More importantly, we think that companies with superior, e-commerce, and consumer-direct businesses will command a higher premium as we emerge from this cycle as strong companies without such platforms realize that they either need to build them (costly and risky) or buy 'em.


Despite recent sales woes and an expectation embedded in Street estimates that revenues will continue to be challenged for 2009, WSM derives 40% of its revenues from its online/catalog operation.   WSM's heritage as a direct marketer makes it a rare brand that actually understands the direct relationship with its customers and has profitably built a business around it.  Today WSM is the 20th largest ecommerce business in the U.S. 


Importantly, the company continues to de-emphasize its catalog mailings (down 30% in '08; down 17% in 1Q09) in favor of more cost-effective brand and targeted online advertising.  The benefit from a shift away from paper to a virtual world will not entirely accrue overnight, but there are few retailers with as a great an opportunity to cut costs and improve margins in this area.  Currently, the e-commerce business is the most profitable of all the WSM channels, and has the opportunity to produce an even higher ROI driven by shifts away from the catalog to the internet.  WSM has relied almost exclusively on the catalog (85-90% of total marketing spend) as its main advertising vehicle which has historically cost 10% of sales.

WSM: Getting Tough To Ignore - wsm catalog


We have heard for years about how catalogs are going away, consumers prefer to shop online, and call centers are a way of the past.  However, the reality of the market has been that most direct marketers were a bit wary to embrace these changes and were even reluctant to dial back catalog circulation for fear that sales would plummet.  Currently, WSM direct and retail sales trends are both tracking down in low to mid twenty percent range and within expectations.  Now is the time for companies such as WSM to become more aggressive as they seek to cut capex, cut costs, and to preserve and even grow cash flow in the wake of a topline that remains more sensitive to the overall environment.  We are seeing this same process unfold at J Crew where catalog circulation has also been cut dramatically as the company shifts it investment towards ecommerce. 


We're the first to admit that a company is never going to cut its way to prosperity. It's gotta grow to ultimately have any kind of earnings stability and sustain a reasonable multiple. But we think that the inefficiencies in the existing operation combined with the underlying strength in the brands and the consumer-direct platform should allow the company to pull away costs without meaningfully impacting either the brands or the top line - a rarity in this business.


While this pronounced shift in the direct business is occurring, it's also important to look at WSM's retail business in the wake of planned square footage growth slowing in '09 to only 1%.  Importantly, future lease obligations are properly aligned. Near-term obligations outweigh future obligations by a healthy margin - and they have improved in each of the past three years.  We view this as a positive sign in terms of the company NOT trading future margin for near-term benefits.

WSM: Getting Tough To Ignore - wsm leases


Combining the .com opportunity with a clean balance sheet ($100mm cash and no debt), substantial capex and inventory cuts planned for '09, and weak financial performance expectations, and high short interest at 14% of the float, we like how this story sets itself up..

WSM: Getting Tough To Ignore - wsm sigma


Eric Levine


On the Road: The Dollar, Interest Rates and Gold


"Everything has its limit - iron ore cannot be educated into gold." -Mark Twain


"We turned at a dozen paces, for love is a dual, and looked at each other for the last time." -Jack Kerouac, On the Road


Keith and I were on the road this week and had some of the most interesting conversation we've had since I joined the firm nine months ago and we started accepting macro clients.  Two key areas of discussion were the US Dollar and interest rates.  On the former, the discussion centered around whether this "dollar crisis", as we are calling it, is really anything more than a trade into more risky assets globally.  That is, investors are just selling the safe haven US dollar and shifting into riskier asset classes like emerging market and small capitalization equities. 


The second debate centered around the next move of the Federal Reserve.  The most contrarian point we heard was that the Fed may not raise rates for more than a year and a half from now.


As in the Mark Twain quote above, everything has its limits, even the US dollar.  With the US dollar down dramatically in the last 3-months and the U.S. stock market one of the worst performing global equity indexes, the facts clearly suggest that what is going on globally is a vote against the U.S. economic system.  That statement may sound unpatriotic, but it is simply a fact. 


While we have seen the appetite for risk assets increase over the past couple months, it is difficult to attribute the decline in the U.S. dollar to this asset shift.  There is clearly something else going on as investors have been buying gold in that period as we outline in the chart below, which is considers a safe haven in periods of heightened risk.  In fact, global political rhetoric is almost as much evidence as we need to convince ourselves this is not the case.  Over the past few days, there have been some public statements by Russian President Dmitry Medvedev, in particular, which highlight this point.  His quotes are below:


"The dollar is not in a spectacular position, let's be frank, and its prospects cause various questions as do the prospects for the global currency system.''


And as it relates to a new global currency Medvedev said:


"This idea has potential, even though some of my G-20 colleagues aren't actively discussing it at the moment.  However, for example, in the opinion of our Chinese colleagues it is quite a possible step. The most important thing is not to walk away from discussions on this topic.''


In the last statement, Medvedev is obviously appealing to The Client (China), who have voiced similar concerns as recently as this week with Treasury Secretary Geithner's visit to China.   Over the past 9 - 12 months this call by the Chinese has been getting louder and louder.  In a April 17th note entitled, "Is China Advocating for the Bancor?", we quoted Dr. Zhou Ziaochuan, a primary player in determining Chinese fiscal policy, who wrote the following in an essay:


"Though the super-sovereign reserve currency has long since been proposed, yet no substantive progress has been achieved to date. Back in the 1940s, Keynes had already proposed to introduce an international currency unit named "Bancor", based on the value of 30 representative commodities. Unfortunately, the proposal was not accepted. (Emphasis is Research Edge's.)"


We can theorize about why the dollar is crashing and whether it is a crisis or not, but I don't think any of us can ignore the drum beat of the people that are buying US dollars and Treasuries.  A key catalyst in this political rhetoric will occur on June 16th, when Russia meets with Brazil, India, and China in the Russian city of Yekaterinburg, which is in the Ural Mountains.  The Russians and Chinese have already played their cards and they will only turn up the volume on the rhetoric during and post this conference and encouraging their Indian and Brazilian "colleagues" to do the same.


Jack Kerouac, who is of course the famous beatnik author, wrote the line at the start of this note in his novel, On the Road; likely he did not intend that quote to be used as a euphemism for the global currency markets, but the quote is an apt description as any of the global currency dual that is going on.  To consider this merely a shift to a higher risk assets, would be very shortsighted indeed. 


We make our calls based on the facts in front of us and don't have a specific view on when rates will increase, but ultimately if the voices from abroad continue their heightened anti-dollar rhetoric this will also become a political issue in the U.S.  Clearly, in the short term anyways, one of the quickest ways to strengthen the U.S. dollar is for the Fed to raise rates.  To some extent, their hand will likely be forced on the inflation front in that regard as well.  That is, if the U.S. dollar continues to break down, reflation will turn into inflation, and the Fed will start raising rates.  As the yield curve is signaling (outlined in the chart below), this could happen much sooner than many equity investors expect.  After all, as most global macro fundamental analysts already know, bond markets are not lagging indicators.


Daryl G. Jones
Managing Director


On the Road: The Dollar, Interest Rates and Gold - dj1


On the Road: The Dollar, Interest Rates and Gold - dj2

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On June 3 BYI announced that it was awarded a contract with the Oneida Nation of Wisconsin to install Bally's SDS Version 11 system on a windows based platform. The system will be replacing an legacy IGT system across 8 locations, adding 2,375 slots to BYI's casino management install base.


The Oneida Nation contract represents the largest of 3 announced contract awards for BYI's Microsoft windows based system since it was released in January 2009.  We estimate that BYI will recognize $8.5-9.5MM of revenues, or $0.07 cents per share, in 2Q2010 when the system is scheduled to go live. This contract should also add approximately $1MM in recurring annual revenues to BYI's current run-rate of $52MM from its system's business.


We believe that the stability and growth potential of BYI's system business continues to be under appreciated by the investment community since its difficult to forecast and understand for most investors. The new windows based platform presents a large opportunity for BYI to continue to grow its install footprint and we expect several additional large contract wins to be announced through the end of this calendar year.  However, the larger opportunity of the systems business will be seen when and if networked gaming becomes a reality.  Being a dominant player in systems will put BYI in an enviable position. 

Misunderstood Employment Print?


Yes, the 345,000 print that the manic futures traders chased each other on was better than expected, but I don't think they could have had the time to model the number that matters here - the unemployment rate.


I was at 9.3% for the month and it came in even higher than that at 9.4% (consensus was 9.2%). I was at 9.3% because I thought that the sequential acceleration in the unemployment rate would stay at 40 basis points (month-over month). It shot above that to +50 basis points.


So THE point here is that the sequential rate of unemployment just RE-ACCELERATED!


Recall that one of the main tenets to our bullish bias for the last 3-months has been the (E - Employment) in our US Consumer MEGA Squeeze call. The call was based on the unemployment going up at a lesser rate - and that it did for the past few months...


That delta shifts back to the danger zone today. Sequential accelerations matter.



Keith R. McCullough
Chief Executive Officer


Misunderstood Employment Print? - unemply12



"He who will not economize will have to agonize."
Selling down my US Equity position in the Asset Allocation Model to zero looked smart Wednesday, and not so smart yesterday. Whether I'm right or wrong on this morning's unemployment report being worse than expectations won't really matter to our YTD absolute performance. A zero position implies no risk, if you're managing towards an absolute return that is...
Understanding (and respecting) that many investors get paid on a relative basis, having a zero position in an asset class does have repercussions. If the US stock market gets clocked this morning, zero exposure is a big win. If the market makes another higher high, a zero position is a big loser.  
On an absolute basis, this week has been what I expected it to be - boring. Credit markets still look great, equity volatility remains relatively low, and the SP500 continues to trade within a very proactively predictable range.
Yesterday's SP500 closing price of 942 takes the week-to-date return to +2.5%, and I have missed all of it. Do I feel shame? Give me 2 more hours and a look-see at that US jobs report, and I'll let you know...
While yesterday's US stock market price recovery was impressive, it was to a lower high (prior closing high = 944) and it came on very light volume. Volume needs to confirm from here on up, and I haven't seen that this week.
I have a top to bottom intermediate term trading range in the SP500 of 83 points. That's roughly a 9% trading range, and no matter what this morning's economic data tells us, I think we'll trade within it. With the manic media perpetually trying to call bubbles and crashes, guess what? They're not going to happen today. They are in the rear view, so trade the range. I have immediate term TRADE resistance of 962 for the SP500 and downside support at 919. For today, that implies +2% reward versus -2.5% risk.
I don't manage a hedge fund anymore but, by training (myself), I am a risk manager. Every 90 minutes I refresh the prices in my macro models and have a view on risk/reward, trading ranges, volatility, calendar catalysts, correlations, etc...
One of the more impressive correlations we have observed in global macro as of late is the trading correlation between copper prices and the Shanghai Stock Exchange in China - it is 88%! This morning, that correlation busted apart. To be clear, it broke for a day... but, on the margin, this may start to matter.
We remain long China via the CAF, and while that closed end fund had a rock-star +7% day yesterday, the local Chinese market did not overnight. It wasn't down a ton, but the point was that it was down (-48 basis points) with A) Asia up and B) copper up ($2.31/lb, a new high).
I call this a negative divergence. Sometimes they matter, sometimes they don't. My job as a risk manager is to get on our Macro subscriber morning call at 830AM and flag, well... the yellow flags. This is a very simple process, but one that requires a tremendous amount of manual and mental discipline (i.e. you have to wake up at an un-Godly hour of the morning every day, and write down every single positive and negative divergence you see, across countries and asset classes, globally). I know, nice life.
Now I may not be as "smart" as Tan-gelo Mozilo, Bernie Madoff, or the voles that followed them right into swallowing their own tongues, but I am smart enough to not hit snooze in the mornings, on the off chance that I might find inside information within this global market of real-time insider trading. Someone on the inside always knows something, and I am tasked with reading into where they may be acting on it.
The most obvious market where I am seeing that people have inside information as of late is in the global currency market. Russian insiders know that Medvedev and Putin are going to amplify the anti-US Dollar rhetoric this weekend. They also know that the current correlation between a DOWN Dollar and the REFLATION trade remains very high. That's one of the main reasons why the Russian stock market (up +3.2% this morning taking YTD performance to +81%) and the commodity prices that underpin it are ripping higher again.
A Credibility Crisis in a currency can be perpetuated by heads of state. Trust what the marked-to-market prices are telling you on that, not Timmy Geithner. They call it the "Russian Davos" for a reason. Expect plenty of "Supranational Currency" headlines to hit this weekend as Putin Power Inc. hosts its version of an international economic summit in St. Petersburg.
All the while Germany's Angela Merkel will be explicitly taking President Obama to task today (he's in Dresden) on the American "skepticism" she discussed yesterday (she was referring to US monetary policy and the politicization of US Federal Reserve powers). Be sure to note that the Russian, Chinese, and even the Australians are supporting her message. US centric investor beware. This shift in global balance of economic power is real, and this is why my position... for now... in US Equities remains zero.
Enjoy the weekend with your families,


CAF - Morgan Stanley China Fund- A closed-end fund providing exposure to the Shanghai A share market, we use CAF tactically to ride the wave of returning confidence among domestic Chinese investors fed by the stimulus package. To date the Chinese have shown leadership and a proactive response to the global recession, and now their number one priority is to offset contracting external demand with domestic growth.

TIP- iShares TIPS - The iShares etf, TIP, which is 90% invested in the inflation protected sector of the US Treasury Market currently offers a compelling yield on TTM basis of 5.89%. We believe that future inflation expectations are currently mispriced and that TIPS are a compelling way to own yield on an inflation protected basis, especially in the context of our re-flation thesis.

GLD - SPDR GOLD -We bought more gold on 5/5. The inflation protection is what we're long here looking ahead 6-9 months. In the intermediate term, we like the safety trade too.

XLU - SPDR Utilities - As long term bond yields breakout to the upside, Utility investments are the relative yield loser. Utilities underperformed the market yesterday; we're still short.

EWW - iShares Mexico- We're short Mexico due in part to the repercussions of the media's manic Swine flu fear.  The country's dependence on export revenues is decidedly bearish due to volatility of crude prices and when considering that the country's main oil producer, PEMEX, has substantial debt to pay down and its production capacity has declined since 2004. Additionally, the potential geo-political risks associated with the burgeoning power of regional drug lords signals that the country's economy is under serious duress.

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