This note was originally published at 8am on March 14, 2014 for Hedgeye subscribers.
“We fear things in proportion to our ignorance of them.”
-Christian Nestell Bovee
All week I’ve been putting the finishing touches on what we think will be a revolutionary dynamic asset allocation model/global macro signaling platform; as such, I haven’t had much time to consume my “fair share” of financial news media in the week-to-date.
When I was able to perk my head up for a brief moment, I was somewhat startled to see the SPX down ~20 handles on “China jitters” yesterday.
Like many other financial news media headlines, I’m not quite sure how to interpret that one. Granted, no one is paying such platforms for differentiated, cutting-edge analytical insights, but sometimes I think their need for speed and coherent storytelling in a globally-interconnected, nonlinear ecosystem can get the better of them.
HEDGEYE POLL OF THE DAY: please reply “yes” to this email if it’s news to you that Chinese economic growth is slowing.
It’s worth noting that in the 15 quarters since Chinese real GDP growth hit a cycle-peak of +11.9% YoY in 1Q10, Chinese economic growth has accelerated sequentially only three times. It’s basically been a straight leg down for four consecutive years – so much so that on a trailing 3Y basis, the z-score for this series is (0.6x), which is actually up from trough of (1.6x) in 2Q12. In non-statistical speak, this implies that the “surprise factor” of Chinese #GrowthSlowing is burning off.
That isn’t to say that Chinese economic growth is not still slowing. In fact, the broad swath of high-frequency economic data (including yesterday’s releases) points to a continued slowdown. The current risk range in our predictive tracking algorithm has probable downside to +7.3% YoY for Chinese real GDP growth here in 1Q14, which would: A) be the slowest growth rate since 1Q09; and B) imply that the Chinese economy is not taking advantage of extremely favorable base effect tailwinds – a sign that sequential momentum is indeed decelerating.
For those of you who do not follow China closely, below we’ve compiled the relevant data points for your review, color coding them appropriately for ease of interpretation:
Lots of red indeed…
Back to the Global Macro Grind…
So what do you do with all of this? Like we’ve been saying since the start of DEC, you should simply allocate assets to “New China” plays in lieu of “Old China” plays. Refer to the Chart of the Day below for an example of how to implement this investment strategy.
The worst thing you can do as a fiduciary of other people’s capital is freak out about China ~4 years into a well-telegraphed, policy-induced growth slowdown.
That’s not to say the Chinese economy and its banking system won’t have its day of reckoning (it will; it has twice before in the last ~20-30 years after the popping of two credit bubbles that were also policy-induced); it’s merely to suggest that it might not be tomorrow. At any rate, we’ve done a ton of work on such risks over the past 6-9M, so please ping us if you’d like our help getting up to speed.
One key catalyst on the horizon is a potential shift to a monetary easing bias by the PBoC. To some degree, they’ve done this already: selling CNY in the open market to lower the reference rate – as they have done in recent weeks – floods the domestic banking system with liquidity. On the surface, they’ve mopped up this liquidity by issuing repos, but money market rates falling to near 2Y-lows suggests there is ample excess liquidity in the Chinese banking system.
Two additional points to consider regarding this potential catalyst:
While we all know they cannot stimulate indefinitely, there’s little-to-no denying the short-to-intermediate term impact increased government investment or a lower WACC could have on a Chinese economy that remains levered to fixed capital formation at roughly half of GDP. It’s worth noting that real interest rates (i.e. the benchmark 1Y lending rate less headline CPI) in China have backed up from a then-3Y low of ~0% in mid-2011 to near-4Y highs just north of 4%.
As always, time will tell on this catalyst. For those of you who crave a higher degree of analytical color at the current juncture, please refer to our latest report titled, “IS THIS THE BEGINNING OF THE END FOR CHINA?” (3/10).
Our immediate-term TRADE risk ranges across Global Macro are now as follows:
UST 10yr Yield 2.59-2.75%
Keep your head on a swivel,
Associate: Macro Team
Hopefully, IGT cleared the decks this week on estimates but there is at least one more issue out of their control
On October 10, 2013, we published a Black Book: SLOThy Growth. Since that date, IGT stock is -26% and the S&P 500 Index is +10% on a total return basis. While much has been written about this week's re-organization plan and the subsequent stock devaluation, we feel compelled to warn investors who might be nibbling at the apple at these price levels of an additional negative headline which will cause additional downside pressure on IGT's stock price.
Call to Action:
IGT will likely be removed from the S&P 500 Index due to a market cap shortfall. At present, IGT's equity market capitalization is $3.33 billion making IGT constituent #499 in the S&P 500 Index but will be #500 after Cliffs Natural Resources Inc gets booted from the Index effective April 1.
The Index Committee is constantly reviewing Index composition for addition and deletions based on various criteria - mergers, spin-offs, too small capitalization (see below). IGT clearly falls below the $4 billion threshold. Ten out of the 17 removals from the S&P 500 in 2013 were due to insufficient market cap including recent removals: JCP, JDS, and ANF.
Current Index Activity:
Past Studies On S&P 500 Index Deletion Effects
Chen, Noronha and Singal (2004) concluded that companies deleted from the S&P 500 between 1989 and 2000 declined 8% upon announcement followed by an additional 6% between the announcement day and the effective deletion day. This study further referenced several earlier studies including Lynch and Mendenhall (1997), Dash (2002) and Beneish and Whaley (2002). All three of these studies found an average loss of +10% between announcement date and effective date, but that there were no long-term effects on share price due to deletion from the S&P 500 Index
The S&P 500 is maintained by the Index Committee, a team of S&P Dow Jones Indices economists and index analysts, who meet on a regular basis. The goal of the Index Committee is to ensure that the S&P 500 remains a leading indicator of U.S. equities, reflecting the risk and return characteristics of the broader large-cap universe on an ongoing basis. The Index Committee also monitors constituent liquidity to ensure efficient portfolio trading while keeping index turnover to a minimum.
The Index Committee follows a set of published guidelines for maintaining the index. Complete details of these guidelines, including the criteria for index additions and removals, policy statements and research papers are available on the website at www.spindices.com/sp500.
The Criteria for Index additions include:
U.S. Company - Determining factors include location of the company’s assets and revenues, its corporate structure, its SEC filing type, and its exchange listings.
Criteria for Index Removals
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TODAY’S S&P 500 SET-UP – March 28, 2014
As we look at today's setup for the S&P 500, the range is 36 points or 0.38% downside to 1842 and 1.57% upside to 1878.
CREDIT/ECONOMIC MARKET LOOK:
MACRO DATA POINTS (Bloomberg Estimates):
WHAT TO WATCH:
COMMODITY/GROWTH EXPECTATION (HEADLINES FROM BLOOMBERG)
The Hedgeye Macro Team
Takeaway: Great print from our highest conviction idea. The biggest surprise for us, however, was how the CEO is stepping up his game.
Conclusion: RH remains our highest conviction long idea in the Retail space, with ultimate earnings power of $11 per share and a stock price in excess of $200. The company’s 4Q print supported our thesis in many ways. But despite all the positives around revenue outlook, store growth, and margin upside, the biggest growth in the quarter from our perspective was not found in a line item…it was in the CEO.
When we talk to investors about RH, almost every single critic lists Gary Friedman as a chief concern now that (former Co-CEO) Carlos Alberini has left the picture. In investors’ minds, Gary was the product guy, and Carlos did everything else. That’s an incorrect view, but like it or not, that’s the perception. Well, this quarter Gary literally sounded like a different person. He spent more time talking about ROI, capital deployment and managing risk in the business as he did talking about product and merchandising. The only question to be answered is whether this is just a temporary Gary we’re seeing in the immediate wake of Carlos’ departure, or if this marks a structural change to how he approaches his role. Critics will claim the former. We think it’s the latter. Time will tell, but there’s no disputing the change as it appears today.
We’re not making any material changes to our estimates. We still think that the company will have a far better year than it’s guiding. As much as that should make the stock continue to grind higher, the real upside comes from earnings expansion as this growth story plays out – which literally begins in April/May with the redesign of its product line, launch of its Sourcebook (all 3,200 pages of it), and the opening of the new store in Greenwich (which kicks off a mini-burst of square footage growth).
As for valuation, the name seems expensive at face value, but is it? This is a 45% EPS grower that’s trading at 22.7x our 2014 estimate (Nike trades at a higher multiple and earnings are shrinking). That translates to about 10.5x EBITDA. By the end of our model we’re looking at less than 6x earnings and 3x EBITDA. If you care to look at it a different way, let’s look at the EV to total addressable market value. Not a perfect metric, we agree. But it gives a sense as to the value of the company relative to the underlying business opportunity. We chart that stat for a host of retailers and it’s pretty clear that RH is the cheapest of the bunch – by a long shot.
Here’s a few things from the quarter that we found notable.
1. We need to address the hiring of Doug Diemoz as the Chief Development Officer. While we’ve never quite heard of that title before, that doesn’t mean that it can’t be effective for RH. As focused as Gary is in steering the ship, the reality is that there are a lot of areas for growth where Gary simply does not have the bandwidth to pursue. Now he’ll have someone who reports directly to him that can explore these opportunities. And of course, Diemoz is part of the Williams-Sonoma alum club – along with Gary, Richard Harvey (Kitchens), and Ken Dunaj (COO). (We’d put CFO Karen Boone in there too from her Deloitte audit days).
2. ‘Always Innovating’ One thing we particularly liked was when Gary noted that people who are going to nit pick over timing of costs and revenue by quarter will perennially be disappointed with RH because “we will always be innovating.” There are other companies that have that same mindset – such as Nike and Ralph Lauren. Both have a dominant founder/leader who sets the tone inside the organization, and both have never been afraid to invest in the business even when it was not popular at the time by Wall Street. Both companies have emerged as superb stewards of capital over time. RH has the exact same feel to us as those other companies.
3. Holiday: One thing that we underappreciated in the quarter was the company’s reliance on Holiday. It’s markedly less than WSM, but some of the weakness on the top line was driven by the company’s gifting categories. Those weaknesses were attributed to a medley of weather and self-inflicted wounds the latter of which was focused on the company’s decision to send Holiday Source Books to only 20-30% of its mailing list. The source book strategy in total is still a work in progress (more on that below), but what strikes us is how data dependent the company is. There are still some wrinkles to iron out in the system, but the company is working through different strategies in order to maximize return on ad dollar spend.
4. Source Book Strategy: This spring’s 3200pg Source Book is exactly 2x what it shipped last Spring. The raw page count seems excessive, but it makes sense when you consider the breadth of the company’s product assortment in 2014. Add to the existing categories RH Rugs, RH Leather, and one unknown and you have the real core of RH’s product offerings – the one exception being Kitchens which isn’t scheduled for rollout until 2015. We estimated that the company saved about $40mm by eliminating the Fall Source Book. Some of those costs will be transferred to the Spring book, but when you consider cost savings from production and shipping, net-net the company is coming out ahead on this one. The reality is that the company won’t be mailing out the full assortment to all of its customers. When you look at the numbers from 2013, customers received about 40% of the assortment. That number will probably be even less as the company tries to leverage the shopper data it has collected over the past few years to target specific consumers with specific assortments. On top of all that you have UPS delivering the mailers this year which may increase shipping costs, but will ensure a targeted and on-time roll out of the books in 2014, with better data for the company to analyze.
RH: DURATION REVIEW INTO THE PRINT
Takeaway: There will be puts & takes on the 4Q print. But the multi-year catalyst calendar starts in April. Beware getting beared-up over 1Q guidance
Conclusion: They’ll be puts and takes on the 4Q print. But the multi-year catalyst calendar starts in April. Beware getting beared-up over 1Q guidance. We stand by our positioning on RH that we presented in our last update conference call/deck in early February. Specifically, we laid out how we’re thinking about the name across multiple durations. See the links below to both the slide deck and audio presentation. Our general view by duration is as follows.
TAIL Duration (long-term): One of the most powerful growth algorithms in all of Consumer. The company should earn around $1.70 this year, and we think that over 5-years that number approaches $11. Common perception is that RH is building a bunch of palaces and hoping that people will show up to shop. We think about it the other way around…they are creating assortments of product across multiple categories in the home space, and are subsequently taking a massive piece of a category where they only have 2-3% share. Yes, bigger stores are a part of this, which is critical to support the kind of product extensions we’ll see from RH. Currently, the Legacy 9,000 sq ft stores only house 20% of the SKUs and run at about $750/sq ft. The 25,000 Design Galleries highlight closer to 50% of the product, and they average an ‘per foot productivity’ rate that is 2x the existing core. People often ask us about why RH has the right to expand into new categories of Home. People asked that same question about Ralph Lauren in the 1980s when he expanded beyond neckties and polo shirts. Our full modeling assumptions are in the Deck (link below), but the key is to measure the success by product and design creation and sourcing, not by simply building stores.
TREND Duration (next 3-4 quarters): The trends should accelerate dramatically over the course of this year for RH. First and foremost, the product line is being meaningfully changed for the Spring. With that will come an updated Sourcebook – which the company has not released in the better part of a year. At the same time, after a full year of not adding a single square foot of space, RH will be adding four new stores throughout this year. In April/May we’ll see the much anticipated opening of Greenwich, CT, the store in the Flatiron District in NYC, then in the Fall we’ll see Los Angeles and Atlanta. As noted above, the actual stores are not as important to us as the product that goes behind them. But this year, the calendar is lining up nicely with a product refresh in the Spring and then four large stores immediately following, That’s about 12% growth in square footage. That might not sound huge for a company that will be looking at a 30%+ growth rate in square footage within two years. But it matters to us given that it has not grown square footage since before 2008.
TRADE Duration (Immediate-term): The TRADE duration was a slam dunk when the stock was in the $50s. The reality is the Street got beared up because just about every retailer was missing numbers due to weather and whatever else is going on out there in the economy. But with RH, 47% of it’s sales are dot.com, which are weather proof, and the category in itself is not very ‘at-risk’ due to snow. Think about it…if you want to go shopping for clothes, you might pick up a pair of jeans. If it’s snowing, that purchase is probably dead. But if your kids need new bunk beds, are you going to bag the purchase just because it’s snowing? No. We have some useful stats on the topic in the Deck. We’re not very worried about the actual number that RH reports. The company has extremely good visibility with its top line. The same factor that the Street beats this company up so often for – the long lead times in its shipping window – also gives the company great visibility into its top line for an extended time period.
The big question is around comp guidance for the first quarter. The company already noted that the first quarter would be its weakest comp of the year – due to the timing of the product refresh and catalog drop. The Street knows that. The consensus is printed at 11%, and we think that the whisper is for something in the high-single digits. Could guidance for 1Q be in the single digits? Yes – with no product refresh, a 41% compare vs last year, and the strong possibility that some 1Q purchases were pushed into 2Q,the upcoming quarter will be the weakest of the year – as management already indicated. What we can say is that with the tremendous delta in our estimates versus the Street over our modeling horizon – and with how good the TAIL and TREND calls are lining up, we’re not going to get too bent out of shape figuring out if people are going to freak out over guidance that was already largely given.
MATERIALS: CLICK HERE
AUDIO REPLAY: CLICK HERE
We summarily re-hashed our 1Q14 macro view along with our current thinking from a strategy perspective in a note late last week - #PROCESS: SUMMARIZING OUR CURRENT VIEW.
Below we highlight the notable trends across this morning’s GDP & Initial Claims data
GDP: GROWTH ESTIMATES FALLING
In short, with inflation estimates unchanged, the +0.2 positive revision to 4Q13 GDP resulted as the net of a +0.49 revision to consumption (driven by services) and -0.31 revision to investment (driven by downward revision to nonresidential investment).
The table below provides the detail on the final estimate and the complexion of the final revision.
Domestic growth expectations, meanwhile, continue to come in with the 1-month and 3-month change in 1Q14 GDP estimates down -30bps and -80bps, respectively.
Looking globally, the story is similar with growth estimates for 1Q14 and full year 2014 getting marked lower across both developed and emerging economies while inflation expectation, particularly across emerging markets, are beginning to flash some upside
(Note: we can email the tables below for a cleaner visual if you're interested)
As we’ve highlighted repeatedly QTD, slowing topline (GDP) and compressing margins (rising inflation) is not the stuff of market multiple expansion or macro P&L dynamics to remain lazy long of. #ItsNot2013
CORPORATE PROFITABILITY: RISING INEQUALITY
Corporate Profits - measured as the % of National Income or GDP - made another new high in 4Q13. The other side of higher highs in corporate profitability, of course, is that labor’s share of national income made another lower low.
The un-sustainability of that trend and the associated mean revision risk to peak margins remains perhaps the broadest, and most obvious, latent risk to investors.
The bureaucratic prescription for a (largely) policy driven rise in inequality, as we’ve seen with the recent statutory wage increases, is more policy aimed at legislating spread compression in the division of income via a de-facto income transfer from owners of capital to labor.
Please see our note LOSE-LOSE? WAGE INFLATION & LABOR'S BAD BANK for a fuller discussion of the impact of wage controls on labor economics.
With the income spread expanding and the goal of monetary policy effectively amounting to a hope for the ultimate trickle down/trickle around wealth effect, expect more populist rhetoric out of the beltway to help further churn existing populace angst.
CORPORATE CAPEX: THE GREAT PHANTOM RESURGENCE
Expectations for resurgent corporate capex have been fairly pervasive of late. Indeed, varying iterations of that same narrative/expectation have ebbed and flowed for the better part of 4 years now.
From a growth perspective, real gross private nonresidential investment growth extended the broader deceleration trend in 4Q13, slowing 90bps sequentially to +2.6% YoY.
Fairly, net private investment as a % of GDP continues to recover and the average age of the aggregate capital stock may be above historical triggers for accelerated capex spending, but that’s been true for a while now and general acknowledgement of that reality doesn’t make it a catalyst.
As it stands currently, productively continues to grow at a positive spread to unit costs and investors continue to reward the ‘pay-me-now’ corporate strategy.
There are some inflationary wage pressures percolating but they are far from acute and, with a little leverage & planned repo in the model, peak margins can stay peaked and EPS can continue to grow at a premium to topline over the intermediate term.
So, on balance, fundamentals aren’t signaling an immediate need to shift strategy and the prevailing corporate capital policy – which continues to reward both investors and management teams - has nearly a decade of inertial momo behind it.
Necessity may drive an ongoing, gradual shift towards rising capex but data supporting an imminent and significant inflection in business investment isn’t particularly compelling.
DURABLE GOODS DISAPPOINT (AGAIN)
Yesterday’s preliminary Markit PMI data for March was positive but the February Durable Goods figures were decidedly disappointing with the -1.3% MoM decline in core capex orders the notable, negative outlier.
Indeed, New Orders for Capital Goods non-Defense Ex-Air have been negative on a month over month basis for four of the last six months.
Weather distortion or not, measures of business investment and activity (Durable goods, Industrial Production, ISM, rising sales-to-inventory ratio’s) have to see a material, sustained acceleration from here for the resurgent corporate investment thesis to regain credibility.
INITIAL CLAIMS: PLAYING THE INFLECTION
In contrast to the accelerating improvement in jobless claims that characterized most of 2013, the 2014 trend has been one of discrete deceleration.
However, with headline rolling claims declining -9.5K WoW to 317K and the rate of improvement in the rolling average of non-seasonally adjusted claims improving 360bps sequentially, this week’s data was decidedly better.
Josh Steiner, our head of Financials research, provided the following context:
The labor market could be characterized as showing decelerating improvement since the start of January this year. This week marks an inflection from that trend. The year-over-year change in NSA initial claims came in at -13.4% this week, the strongest print since January 3, 2014 and a moonshot compared with the -5.0% print last week. This week was so strong, in fact, that it brought the rolling NSA y/y to -7.1%, up from -3.5% last week. We'll see in the weeks ahead whether the trend is beginning to reverse.
One of the arguments put forward in support of the generally weak 1QTD data has been weather. If weather is playing a role in suppressing the strength of the data then one would expect that as we move from the winter to the spring months we could reasonably expect to see improvement in the data. The next few weeks of data should be important in this regard, as they may serve to answer this fundamental question
Christian B. Drake
The total percentage of successful long and short trading signals since the inception of Real-Time Alerts in August of 2008.