Where There’s Smoke… Notes for the Week Ending Friday, June 5, 2009


And What Is So Rare As A Day In June?


At the Devil's booth are all things sold
Each ounce of dross costs its ounce of gold

                   - James Russell Lowell, " The Vision of Sir Launfal"


This first week of June brought a special report in the Financial Times, the Monthly Review of the Fund Management Industry.  The lead article ("Investors Warned On Niche ETFs") addressed "the dangers of a class of exchange traded funds that is 'exploding' in popularity.  Leveraged and inverse ETFs - which claim to generate two or three times the return of an underlying index or a multiple of the inverse of the index." 


The article reports that leveraged and inverse ETFs have taken in $30 billion in the last two years, "and now account for 40 percent of the volume of US equity trading."  One takeaway of this discussion - though the article does not address this point - is that it is getting difficult to defend the notion that ETF trading does not affect prices or market action in the underlying instruments.


Leveraged and inverse ETFs are intended to track - at their respective ratios - the daily performance of the underlying instruments or indexes, which means that their reference prices are reset daily. The article discusses how treacherous these instruments are to anyone who does not think through the implications of pricing.  It is no wonder, in short, that retail investors have gotten clobbered with these instruments.


Morningstar gives as an example an Ultrashort Emerging Markets ETF, designed to yield two times the inverse of the underlying emerging markets index.  During a year in which the index itself lost 54.5%, the ETF, contrary to expectation, also went down by 25%.  This means that the average retail investor who bought the emerging markets in the face of problems in the US marketplace, and who bought the double-down ETF as a hedge, was twice clobbered, and taken totally by surprise by the inverse ETF trading, well... inversely.  How can this be?


Says Morningstar's ETF strategist: "a number of US financial advisers had put their clients into these funds without understanding the consequences."  This unqualified statement - accompanied by neither definitions nor figures - is apparently intended to show that even professionals do not understand these instruments.  But who are the professionals in question?


During the past decade the brokerage industry went from calling their salespeople "account execs" to calling them "financial advisers."  The term "stockbroker" or "Registered Representative" is a regulatory designation, and one must have a securities license to use the titles. 


For years, brokerage firms referred to their sales force as "Account Executives," until the world caught on that an "AE" was a "Stockbroker."  The industry duly switched over to Financial Advisers, a term that has no defined regulatory designation - which means that anyone can use the title, regardless of qualification.  This is along the lines of those mailers you get from organizations with names like "United States Mortgage Advisory Service", offering to refinance your house and advising that "You are eligible to participate in this limited-availability program..."


We have previously raised the question of improper licensing for brokers selling ETFs (27 February, "The Gold-Bug"), an issue that FINRA has not seen fit to address.   Many of the ETFs in retail brokerage accounts - and that have created unexpected losses - were bought as hedges for equities exposure.  They are proxies for oil, gold, or agricultural products, for example.  These ETFs (or ETNs, "Exchange Traded Notes") are based on physical commodities, or are baskets of futures contracts, sometimes garnished with swaps.  Stockbrokers, who are not qualified by license to handle commodities and futures, get paid commission on these ETFs because they are packaged as equity look-alikes and trade on stock exchanges.


Morningstar, by reporting that even financial professionals do not always understand ETFs, is obliquely pointing to the fact that the salespeople putting their customers' money into these instruments are not properly trained in the proper use of these instruments - not by the licenses they are required to hold, not by their firms, nor by their own sense of professional responsibility.  They do not explain the behavioral quirks of ETFs to their customers, because they are not aware of them until the sudden meltdown in the hedge portion of the portfolio.  And, despite two generations of being led down blind alleys by their brokers, customers do not ask how the ETFs behave. 


This looks like a large number of unsuitable transactions in customer accounts.  Thirty billion dollars' worth in leveraged and inverse products alone, according to the Financial Times.


Class Action, anyone?


We do not believe there will be regulatory or legislative action over the fact that the brokerage firms have apparently created billions of dollars' worth of unsuitable ETF trades.  This is a matter for FINRA to pursue with the brokerage firms that permit untrained brokers to recommend the trades.  The rules are already in place to discipline brokers and their firms for unsuitable transactions, but it may be difficult to prove a sales practices violation when even the regulator does not require that the sales force understand the instruments they are promoting. 


FINRA's new Chairman, Richard Ketchum, stepped into the position with the pronunciamento that FINRA is "an effective entity that doesn't need to be fixed in any way."  His misplaced confidence in the institution notwithstanding, we have faith in the fact that lawyers read newspapers and need money, and customers read newspapers and lose money.  Critical mass will be achieved when enough customers read enough articles like those in the recent FT, and enough lawyers educate themselves to the disconnect between advertisement and reality. 


We see a wave of ETF-related customer arbitrations, but it will likely not force the larger issue, which is having FINRA require brokers to become knowledgeable about the commodities and futures markets on which these ETFs are based.  Who will force that?  SEC Chairman Shapiro - who is FINRA Chief Ketchum's friend and predecessor?


How long can you hold your breath?


We believe regulators and governments will ultimately recognize that the ETF market is creating unrealistic price movements in their underlying instruments.  By then, with ETFs growing in visibility and influence, the regulators will find it impossible to bar the path of an oncoming freight train as investors and issuers alike howl "I want my ETF!" 


To the risks of dealing in the regulated markets, and the risks of dealing in the unregulated markets, we have added the risk of dealing in a faux regulated market where professionals have licenses, and firms have supervisory procedures, tended by self regulatory and federal structures, all designed not to oversee the products they are pitching to the investing public.


The Wall Street Journal (3 June, "As Some Contract, PIMCO Is Expanding") reports that the Gargantua of the bond markets is now entering the ETF business.  "PIMCO's entry into the ETF space signals the importance of that market," says the Journal.  PIMCO getting into the business is a positive for the ETF/ETN market, not to mention for the brokers handling their business.  As PIMCO gets into offerings with short-term resets, the frequent and extremely large creation and liquidation trades will be so many pennies from heaven for the desks servicing them.  See our next item for some specifics on this.


PIMCO's first offering is a 1-3 year Treasurys index ETF, and its introduction was deemed a success.  Seeking Alpha (4 June, "PIMCO ETF: Arbitrageurs Boosting Volume?") reports the new fund "opened with a bang. While it would be foolish to read too much into one day's activity, TUZ's strong open must give the mutual fund giant hope that its entrance into the ETF arena will be a successful one."


The Investment Company Institute reports there is $9.69 trillion currently invested in mutual funds, versus only $540 billion in ETFs.  Now it looks as though that figure is set to ramp up dramatically, and there should easily be a trillion dollars invested in ETFs in short order.  And while the fees are low - the 14 Treasurys ETFs in the marketplace today have an average expense ratio of 0.16 percent - the multiplier effect explodes in the fixed income marketplace, where the unit of calculation is a billion dollars.


Finally, for those still in need of encouragement before diving into the pool, the website offers investor education on these instruments.  It explains that "ETFs are low-cost index funds that trade like stocks."  What more information could an investor possibly need? 

Still confused?  Call your financial advisor.



iShares youShares we-all-Shares for iShares

The commodity ETF/ETN business has been a windfall for the marketplace.  While PIMCO's initial offering may hold a relatively static portfolio, there will be others to follow - an actively-managed ETF is in the planning stages as well, according to the WSJ article.  With the recent growth of commodities and futures-based ETFs, the locals - the screaming guys in the pits who execute for customers - have been handed a new risk-free revenue source. 


The traders are filling orders for the ETF managers, who execute their ETF creation and liquidation trades by buying or selling great quantities of the underlying commodity, sometimes multiples times in the course of a day.  The trades appear to be going off with nearly predictable regularity, adding tens of thousands of contracts to the daily order flows.


Our sources tell us floor traders are not being queried on pricing, but are being asked merely to deliver the quantities required.  What does this mean for the investor?  In the world of trading, where a floor or "upstairs" (trading desk) trader executes for a customer, Best Execution rules require that executed trades be within the "best" price range prevailing in the market at the time of the trade, as defined by a host of regulatory parameters. 


Not to single anyone out, a random Google search using "ETF best execution" brought us to Societe Generale's Best Execution Policy.  With respect to trading ETFs for customers, the policy requires SocGen's traders to execute on recognized exchanges, and to apply the same principles to ETF trades as are used for stocks.


What's missing?  There is no Best Execution between the floor of the commodities exchanges and the ETF managers.  Fractions of a penny on tens of thousands of contracts add up.  Don't take our word for it - ask your commodities broker.  We do not mean to imply that the commodities markets are rigged, or that the traders filling the ETF/ETN orders are acting improperly.  Rather, acting in the very best of good faith, these folks have just been handed a tremendous new reservoir of retail customer liquidity which, by nature, is not price sensitive.  Quite the opposite in fact: the ETF managers require executions to meet their specifications of Size and Timing - we need 50,000 ounces of gold now.  Soon enough, we predict the studies will start to emerge analyzing the effect of the ETF on the underlying instruments.  As we have pointed out in the past, equity-based ETFs have been seen to whipsaw stocks during creation and liquidation trades.  ETFs based on commodities may have an even more extreme effect, because the ETFs trade on stock exchanges, while the commodities trade during different hours.  This creates an anticipation or overhang effect, which may in turn yank the pricing of the underlying commodity when it opens for trading in the next session.


The ETF market participants claim there is no negative impact on the customer.  The ETF offers liquidity and trackable performance, based on the underlying contract or basket.  It is advertised as a way for the non-professional to trade like a pro. 


But not to get paid like one.  The ETF managers get paid a management fee for every aspect of the packaging and unwinding of the ETFs, the brokers get paid a commission for putting these in the customer accounts, and the floor brokers are now scooping up a tidal wave of unsolicited orders to trade with no pricing requirements.  It would appear that millions of dollars in fees and commissions are being paid to individuals and institutions with no exposure in any of these transactions. 


Q: What do you call the party at risk in a transaction? 

A: The Customer.



Strange Bedfellows


The promise given was a necessity of the past: the word broken is a necessity of the present.

                     - Niccolo Machiavelli


The SEC has launched a new challenge to those ossified entrenched corporate interests.


Or has it?


Bloomberg (20 May, "SEC Weights 1 Percent Threshold For Board Nominations") quotes Chairman Shapiro as saying "This crisis has led many to raise serious questions and concerns about the accountability and responsiveness of some companies."  "The most effective means of providing accountability," she said, is "to ensure that shareholders have a meaningful opportunity" to nominate directors.


Those who are positive on this proposal say the rule would significantly open up the proxy process and give shareholders greater say in corporate governance.  How could anyone be against such a rule?


Those who argue against this proposal include the US Chamber of Commerce.  "The U.S. Chamber will continue to vigorously oppose any plan that allows groups to use the proxy process to promote narrow interests," reads a statement from the Chamber's Center for Capital Markets Competitiveness. "Politicizing the boardroom would hurt millions of individuals who rely on these investments for retirement."


The naysayers believe that, far from promoting the interests of the individual investor, the SEC proposal is designed to enable a pet Democrat special interest group to launch proxy battles at will.  Those who complain that the Obama plan has unfairly placed excessive control - and upside - of the automobile industry in the undeserving hands of the unions, now predict that the unions will have the ability to harass managements at will.


Even among those who favor the concept, there is a concern that the rule will not hold up to a legal challenge.  The states have bodies of corporate governance law - some more robust than others - supported by custom and precedent.  On the other hand, there is no federal corporate governance statute.  This means an eventual SEC rule may not have a legal leg to stand on.


Is Chairman Shapiro serious about pursuing broadened shareholder rights?  If so, she will presumably have to push for an Act of Congress - a lengthy process.  Or is chairman Shapiro going through the cynical exercise of proposing a rule she knows will not stand up, in order to win Brownie points with an obstreperous constituency?


Corporate voting procedures are enshrined in state governance statutes, and only certain categories of participants can put forward director nominations.  We are not legal scholars, but we wonder why shareholders who do not have to disclose their investment position - under 5% holders - can fly below the radar, then spring their nomination by surprise.  Will the SEC, in order to make the new rule more even-handed, also require owners of one percent of the shares of a company to file under Section 13?


Finally, we wonder why the SEC believes it has the right to create a rule that is at odds with established bodies of state law. 


Or maybe they don't even believe they have that right.


Says SEC Commissioner Kathleen Casey, "The commission has been revisiting and debating the issue of proxy access for decades."  This proposed rule would be "imposed not only on the country's largest banks and Wall Street firms, but also on the thousands of other public companies, large and small, across the country."


The Commission has been discussing this for "decades".  This has been a non-starter for generations?  Does Chairman Shapiro think she will have the ability to undermine shareholder protections embedded in the laws of the fifty states, when her predecessors have never been able to get this notion off the ground?


Commissioner Casey may be onto something - though as a Republican she is presumably against the proposed rule on philosophical grounds.  She scoffs that it is "disingenuous" for Chairman Shapiro to predicate the proposed new rule on the current financial crisis.


For those not clear on the fine points of usage, our dictionary says "Disingenuous" is politician-speak for "Bullshit."   


Hail, Mary!

Sunlight is the best disinfectant.

                   - Justice Louis Brandeis


On a strongly positive note, we applaud the SEC's push for transparency on employee pay (WSJ, 3 June, "SEC Ready To Require More Pay Disclosures").  For reasons we could never fathom, the compensation of all but the top five of the highest-paid employees of public companies is considered a "trade secret."  Thus the people who pay those top employees know all about their compensation, but the owners of the company - those pesky folks called "shareholders" - are kept in the dark.  If we publish our compensation structure, managements argue, our competitors will hire our top employees away.



The fullest flowering of capitalism thrives in the fertile ground of disclosure.  This goes far beyond the mere cleansing effect of sunlight.  For sunlight also provides nourishment.  As any creative artist will attest, revealing everything opens the sluices of creativity - holding back only creates blockages.  This is now observable in corporate America, which is no longer focused on innovation, but only on compensation.  More than anything, this has caused American capitalism to collapse, and it is what underlies the global financial situation.


No less an authority on corruption than former New York Attorney General Eliot Spitzer, holding forth from his new soapbox - as a blogger for - offers analysis of a recent opinion by Federal Judge Richard Posner, author of the recent bestseller A Failure of Capitalism.  (, 15 April, "Judge Posner Wrote What?")  Judge Posner, a noted capitalist and founder of the Chicago School, has come to the conclusion that the market is not capable of setting proper levels of compensation for managers of businesses, or of investment portfolios.  We agree with Mr. Spitzer - this is big news.


Posner wrote that the compensation of senior managements "is excessive because of the feeble incentives of board of directors to police compensation. ... Directors are often CEOs of other companies and naturally think that CEOs should be well paid. And often they are picked by the CEO."


"Competition," Judge Posner wrote, "can't be counted on to solve the problem because the same structure of incentives operates on all large corporations and similar entities, including mutual funds."


The SEC proposal includes disclosure of the relationship between the company and any compensation consultants it may retain - critical because, as Judge Posner observed, compensation advisory firms are also retained for other corporate consulting assignments - and those whose compensation they opine on tend to serve on multiple boards of directors.  The mere fact that there is an industry whose job is to determine how much the most overcompensated, and generally unproductive, individuals in human history should get paid is in itself a clear sign that something is wrong.


Spitzer writes that Judge Posner concluded that "evidence of unreasonable compensation could be evidence of a breach of fiduciary duty. Yes, these are legal words, but they reveal a remarkable conclusion-courts should take a hard look at private-compensation issues-and demonstrate how far, and rapidly, the world has shifted. The two issues Judge Posner examined-setting CEO compensation at major companies and determining the fees to be paid to mutual fund-management companies on the base of trillions of dollars of mutual-fund investments-are central to the governance of our financial system."


Chairman Shapiro looks to be on solid ground with this initiative.  We fear it may not go far enough - but this may be an exercise in the Art of the Possible.  She has some good backing in this effort.  Judge Posner is no lightweight.


And hey - just because Eliot Spitzer said it, doesn't mean it isn't true.



Farewell, Happy Man


This week saw the untimely passing of David Geller, founder and CEO of Geller Capital Management.  As a colleague, David was valued for his warmth, his positive outlook, and his sense of humor.  In a world populated by overweening, self-important windbags, David enjoyed his success, yet he also cared for those around him and went out of his way for others.


David got it.  He knew what was important.  He was devoted to his employees, to his family, and to his community.  When he welcomed us aboard at one of the world's leading hedge funds, he said, "When you were on the sell side, you were dealing with miserable people.  They're millionaires, but they're miserable."  He waved his hand, indicating the sweep of the vast trading floor.  "Life will be different here," he said.  "Here, you're dealing with happy millionaires."  It was different.  And David was one of the reasons.


When people die young we sometimes hear "he died doing what he loved."  David Geller died in the midst of doing something he loved very much - something he loved with a passion that other people found inspiring.  David died in the midst of living his life.


We will miss you, David.  You were one of the Good Guys.


David Geller, 1


Moshe Silver

Chief Compliance Officer



If I had a nickel for every time I've heard that BYD is not cheap and the locals LV market is horrible, I'd own a lot more BYD stock.  Of course, I'm restricted from buying stocks I write about but you get my point.  I honestly don't know where BYD is going over the near term.  Research Edge is a bit negative on the US market, gaming has a high beta, and I'm increasingly cautious on gaming operators overall.  However, from a long-term perspective, the stock is actually dirt cheap, and the Las Vegas locals market is a growth market.  The company's incredibly valuable credit facility rounds out the positive thesis.  It is this final thesis point that I will focus on this note.


As a refresher, BYD's credit facility does not mature until May 2012 and its 2% spread above LIBOR is unmatched in the industry.  The effective interest rate is under 3%.  BYD currently has $2 billion of borrowing capacity remaining on the facility. The other operators (MGM, WYNN, LVS, ASCA, PNK, PENN) have all refinanced at significantly higher rates or will do so soon.


So what is this valuable asset worth?  We see value in two ways.  First, in terms of straight interest savings, the differential between BYD's interest rate and the "going rate" is approximately 6%.  This differential multiplied by BYD's outstanding borrowings on the line is about $67 million per year.  On a present value, tax-effected basis over the remaining 3 year life of the facility we estimate there is $114 million, or $1.30 per share in value.


Second, the additional liquidity gives BYD an incredibly cheap cash source to make an acquisition at near trough EBITDA and a low multiple.  The assets of Station Casinos come to mind.  Assuming a $1 billion acquisition at 8x EBITDA, above current public trading multiples, we estimate BYD could generate $2.50 per share in equity value, as shown in the following table.  Please note that these are not wild assumptions.  We are only assuming the market gives BYD a 5x multiple of the free cash flow accretion generated by the hypothetical acquisition.


BYD: THE VALUE OF A GREAT CREDIT FACILITY - BYD hypothetical acquisition


BYD's free cash flow yield is currently north of 20% (highest in the sector), which is not sustainable in our opinion.  The valuation doesn't appear to reflect the appropriate value ($3.80) of the credit facility nor does it reflect the 87 acres of Strip acreage.  We value the land at $3.50 per share so potentially $7.30 of real value is not being reflected in a $9.30 stock that is already supporting a huge free cash flow yield on current operations alone.


McDonald's reported global May same-store sales of 5.1% vs. consensus of 4.2%. The notable standout was MCD USA which was significantly below consensus 2.8% vs. consensus at 3.6%. Europe reported a solid 7.6% vs. consensus at 4.3% and APMEA 6.4% vs. consensus of 5.4%.


With MCD running 4%+ pricing (including the change to the $$ menu) the 2.8% is disappointing. The early read on MCD's coffee strategy is not good! Given the coffee push the traffic trends should be much better.


MCD - USA MAY SALES Trends Slow - mcdussss


MCD - USA MAY SALES Trends Slow - mcdeursss


MCD - USA MAY SALES Trends Slow - apmeasss


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Barking At Consensus

"One dog barks because it sees something; a hundred dogs bark because they heard the first dog bark."
-Chinese Proverb
I was in New York meeting with investors last Wednesday. When I started going through the second derivative effects of a US Dollar moving into crisis mode, and walked through how this story ends (with the US Federal Reserve eventually being forced to raise rates), I had some interesting looks at me from across the table.
On Thursday morning, Bloomberg TV's Erik Shatzker and I walked through the implications of what Bernanke had to say about quantitative easing (reigning it in) combined with the yield curve being at an all time peak. I said current US monetary policy was unsustainable, and that the next Fed move would be up.
This morning, a top 3 story on the Bloomberg box reads "Treasuries Fall as Traders Bet on Higher Fed Rate; Stocks Drop"...
I'll stop barking now.
On a percentage basis, Friday's move on the short end of the US Treasury curve was one of the most explosive one-day moves we have ever seen. Two-year treasury yields remain elevated at 1.34% this morning - that's a full +41 basis points above where they were at this hour of the morning last Monday when I was writing credit market factors down in my notebook.
As a result of the short end exploding to the upside, the yield curve (the spread between 10 and 2-year US Treasury interest rates) has come in from its all time highs. When I was talking about last week's "peak in the yield curve", I meant that the spread between 10's and 2's was +277 basis points wide - that was a PEAK, as in the widest the yield curve has been, EVER...
Ever, is a long time. For a risk manager, EVER is where we look for things to change on the margin. This morning that, thankfully, has. The spread between the 10 and 2-year yield has come in by a full +26 basis points to +251 basis points wide. Yes, in the land of rates and spreads, these are huge moves in compressed periods of time.
So what does it mean? It means that the Piggy Bankers will have less of a spread to chow down on as we move into Q3. Apart from a nauseating calendar of investment banking secondary issuance in Q2, another point that we made last week was that the bankers are having a blockbuster Q2 on that yield curve.
The way that this works is that the Goldmans and Morgans scare the living daylights out of Washington into believing that we are going into a Great Depression - then they borrow American moneys for free and lend it out to America's commoners for a piggish spread. I know - isn't that an America we can all trust!
The New Reality remains - as the US Dollar continues to trade in the crisis zone, the Three Little Pigs are getting paid: Bankers, Debtors, and Politicians. Since 53% of the world's foreign currency denominated debt is in Dollars, collapsing its value reduces debt obligations and allows Timmy Geithner to tell the Chinese that all has been corrected in the land of Wall Street Oz.
Obviously this is a joke, and that's why the Chinese laughed at tiny Tim. But make no mistake folks - the other side of 2-year rates shooting higher is that holders of those bonds (China and Japan) get smoked.
The other somewhat meaningful constituency who cares about this thing called cost of capital is the American public. If they weren't getting paid ZERO on their savings accounts in order to facilitate this pigging out on the trough of their yield curve, they might actually believe CNBC's narrative on this too... but, once again, betting that the hard working people of America are stupid, is a bet reserved for Washington and Wall Street.
Main Street pays for Bernstein to upgrade Goldman ahead of the quarter alright - they pay for it via higher mortgage rates and at the pump.
Pumps matter, especially when they start to feel like pump and dump. I know, I'm barking again.
Best of luck out there this week,


EWC - iShares Canada- We want to own what THE client (China) needs, namely commodities, as China builds out its infrastructure. Canada will benefit from commodity reflation, especially as the USD breaks down. We're net positive Harper's leadership, which diverges from Canada's large government recent history, and believe next year's Olympics in resource rich British Columbia should provide a positive catalyst for investors to get long the country.   

XLE - SPDR Energy- We bought Energy on 6/05. We think it works higher if the Buck breaks down.  Bullish TRADE and TREND remain.

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.

UUP - U.S. Dollar Index - We believe that the US Dollar is the leading indicator for the US stock market. In the immediate term, what is bad for the US Dollar should be good for the stock market. Longer term, the burgeoning U.S. government debt balance will be negative for the greenback.

XLU - SPDR Utilities - As long term bond yields breakout to the upside, Utility investments are the relative yield loser.

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.

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


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