TODAY’S S&P 500 SET-UP – April 21, 2014
As we look at today's setup for the S&P 500, the range is 47 points or 1.71% downside to 1833 and 0.81% upside to 1880.
CREDIT/ECONOMIC MARKET LOOK:
MACRO DATA POINTS (Bloomberg Estimates):
WHAT TO WATCH:
COMMODITY/GROWTH EXPECTATION (HEADLINES FROM BLOOMBERG)
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Takeaway: This might have been the meeting LULU wanted, but certainly not what we expected. LULU could have crystallized its growth plan, but whiffed
Conclusion: This LULU analyst meeting had all the potential to be a world class Analyst Event to catapult the Company beyond the PR gaffes and product blunders of 2013. Unfortunately, the company blew it. We liked new CEO Laurent Potevin, but think that he got some really lousy guidance and support from his Finance organization as it relates to how to speak to the investment community (something he’s never done). What management said was fine, but it could have been so much bigger, better, and far more strategic. Overall, the messages came across as very tactical, and had a lack of focus and cohesiveness. We understand that sounds punitive on our part, but we don’t see how anyone with a 2-3 year investment horizon (where our best Retail ideas live) could have exited that meeting thinking otherwise. That said, over an intermediate-term duration (2-3 quarters), we think that LULU is still probably headed higher as it is one of the few Retailers that will have an accelerating EPS growth rate (reasons outlined below). No changes to our model, which already calls for meaningful acceleration in the top line, but with EBIT margins slipping from 24.5% to about 19% over our modeling horizon. We left the meeting with greater confidence that the current margin level is not sustainable if this company is to grow like we think it should. With the stock at $52, we think that top line growth trumps any margin degradation. We won’t get concerned about the margin risk until the stock is well into the $60s.
We’re not going to make any friends in Vancouver with this one. Then again, making friends is not our job. Here goes…
Let’s cut right to the chase. This LULU analyst meeting was one of the most underwhelming investor events we’ve attended in many years. To be clear -- it wasn’t what the company said, as it said a lot of good things – but rather the problem was in what it didn’t say. After a year that Lululemon would like to forget, plus new blood in the executive suite, this was a layup opportunity for LULU to showcase a big fat-tailed growth strategy, and solidify a crisp message to the investment community. But the layup missed.
After being short the stock since the Fall, we turned bullish before the fourth quarter print (LULU: PULLING THE PLUG ON THE BEAR) after our research showed that consumer sentiment on the Lululemon brand was getting better on the margin. But that was just a near-term tactical change in opinion. We were really looking forward to this meeting to get a good sense of the strategic vision of the company under the leadership of new CEO Laurent Potdevin.
Unfortunately, we couldn’t find it.
If we had to sum up Potdevin’s strategy in our own words, it would sound something like this “We have a great company, and a great brand. Nothing is broken. We made some missteps last year and those need to be undone. But overall, it’s business as usual.”
That’s a pretty disappointing thing for us to hear. We wonder if a) he simply was not ready for this event – in fairness, he’s only been on the job for three months and has never spoken to a group of analysts before (a daunting task for even the most capable executive), or b) his mandate by Chip (who still owns half a billion worth of stock) and the Board is to make tweaks rather than institute major change at the company. Of course, a less desirable option is that he has the mandate to make change, but does not have the experience to recognize that it is necessary. We don’t think that’s the case here.
We’re going to give Potdevin a pass on this one. We think he’s a better executive than the sum of his messages suggested.
The biggest problem, we think, was the absence of the Finance organization at the Analyst event. No formal presentation by CFO John Currie? No long-term financial goals? Potdevin should be leaning heavily on his CFO for guidance around how to communicate with Wall Street – a crowd he’s never interacted with before. This was Currie’s shot to step up and show his new boss how valuable he can be. But he missed – in a very big way. This showed us how weak the Finance organization is inside Lululemon relative to the power of the Brand and market opportunity. Maybe that was acceptable when the Brand was growing up. But now with the Brand in adolescence and experiencing severe growing pains, it’s at a point where it needs superior leadership from the Finance organization. The fact that the Board is OK with its absence is disappointing to us on many levels.
IMPLICATIONS FOR THE STOCK
All in, we don’t think our disappointment over the meeting means that the stock is a short. We want to be clear about that. Again, the company didn’t say anything bad. They just didn’t say anything that gives us confidence that they can navigate through the changing competitive landscape while making the right capital deployment decisions to regain market share and strengthen its financial returns. In fact, we think that over the next few quarters the stock is still likely to be a decent-enough long at current levels given a) near-term earnings recovery (one of the few retail names that will post an accelerating sales, margin and EPS trajectory for this year as it anniversaries Luon and Chip), and b) reasonably supportive valuation. As much as that might suffice for an intermediate-term call on the stock, it’s not enough for us to make the big multi-year double call. Not even close. What kills us is that this thing has all the nascent ammo to be a tremendous stock – but we didn’t hear enough for us to think that will come to fruition. We hope we’re wrong. But hope is not an investment process.
Here’s a few more takeaways from the meeting.
1. Management noted how the company is going to grow outside the core (into non-exercise categories where competition is fierce), while investing in innovation around its Yoga and Running business (which we applaud). But in doing so, the company thinks that current margin levels are sustainable over the long term. We don’t doubt the growth potential for LULU for a minute. But we question how it will come at a margin level equal to what we see today. It simply does not add up.
2. There was a genuine focus on product quality and innovation that we have not seen from LULU in the past. That was definitely a breath of fresh air. But again, we wonder how this can possibly enter the equation without any degradation to margins.
3. We’re still not sure if LULU has a strategic plan. We’re not saying that as a slight to the company. It has a strat planning department, so presumably it has a plan. But we did not hear a single part of that during this meeting.
4. Usually, I’ll ask a company if its deck is available so I can review all the stats and figures it gives out in meetings such as this. I didn’t have to ask LULU. There was no deck. That’s a first.
5. Another first… noted above but worth noting again -- no presentation by the CFO. I was beyond floored by this. I’ve been going to analyst meetings for 20 years, and never have I seen the CFO not give a presentation with long-term targets or other forms of quantitative context. To be clear, this is not only important to give Wall Street a framework with which to analyze the company, but more importantly, it shows Wall Street that the company actually has that context internally. If a company is consistently firing on all cylinders and creating value for shareholders, then maybe it can pull off omitting a financial plan. And I stress ‘maybe’. But LULU does not exactly have that luxury. It needs to provide more information, not less. At least Laurent has an excuse – he’s brand new -- but Currie does not.
6. It’s important to elaborate on the point above about Laurent making ‘tweaks’ as opposed to major change. Our biggest concern here is that LULU is a powerful and iconic brand that is – metaphorically speaking -- going through puberty. All brands go through these growth stages. It needs the right oversight and investment to ensure that it can double in size over 3-5 years. We didn’t get that. We heard someone who does not sound like he’ll be heavy handed with investment, and we don’t get the sense that CFO Currie is steering that ship either. It’s still early, so we won’t count Potdevin out. His tenure is still young. But he’s never seen a major brand through this part of a growth spurt before. Our biggest concern is that he is running the company as Chip Wilson otherwise would – simply because he has no one there to guide him through uncharted waters.
Of course, there were some positives to the day.
1. The people at Lululemon are truly passionate about what they do. This sounds like fluff, but the only other company I’ve ever seen where people are that passionate about coming to work every day like this is Nike. There’s something to be said about that. It’s part of what makes the Brand great.
2. As much as I was displeased with the messaging from the Finance team, Tara Posely (Chief Product Officer) absolutely crushed it. She has a lot of experience at a lot of different retailers – some good, some not so good – but there’s no doubt that she found her calling at LULU. She came across as extremely confident, competent, authoritative, and a clear leader within the company. And yes, she too has only been there four months.
3. The product/innovation lab was impressive. It seems like a mini-version of what Nike houses in the Mia Hamm building. But that should in no way diminish how important it is to LULU. Having only been open for two weeks, we should presumably see some of the benefit by year-end.
4. The building blocks for International expansion are slowing coming into place. The company opened its first store full line store in London two weeks ago and just finished the onboarding process for its head of Asia, Ken Lee. International showrooms now total 15 (8 in Asia and 7 in Europe).We agree with the company that there is significant opportunity in markets outside of North America and Australia, but the company failed to communicate exactly what investments need to be made in order to facilitate this rollout. We tie all this back to our optimism about where the top line will go, but the sacrifice they are likely to make on the margin line to get there.
Takeaway: Current Investing Ideas: CCL, DRI, HCA, HOLX, LM, LO, OC, RH and ZQK
Below are Hedgeye analysts' latest updates on our NINE current high-conviction investing ideas and CEO Keith McCullough's updated levels for each.
*Please note we have removed TROW from Investing Ideas.
We also feature three research notes from earlier this week which offer valuable insight into the market and economy.
Trade :: Trend :: Tail Process - These are three durations over which we analyze investment ideas and themes. Hedgeye has created a process as a way of characterizing our investment ideas and their risk profiles, to fit the investing strategies and preferences of our subscribers.
CCL – Hedgeye gaming, lodging and leisure sector head Todd Jordan likes the stock of Carnival Cruise Lines (CCL). Jordan and his team continue to hear agent tidbits of good volumes but there also appears to be discounted pricing for summer 2014 sailings. Stay tuned for results from our proprietary pricing survey next week, which should provide more insight.
DRI – Hedgeye restaurants sector head Howard Penney maintains his bullish stance on Darden, parent company to restaurants including The Olive Garden and Red Lobster among others. In an exclusive HedgeyeTV video, Penney calls DRI a “generational buying opportunity.” Penney says DRI is an unconventional long because the management team needs to be replaced before investors can really make money on the stock.
HCA – Hedgeye healthcare sector leader Tom Tobin still likes the prospects for HCA Holdings. He sees a potential recovery in orthopedic case volume, such as knee replacements, which will benefit hospitals such as HCA.
HOLX – Hedgeye healthcare sector leader Tom Tobin remains bullish on Hologic. He has reached out to his clinical contacts in the field to get more insight regarding DBT (Digital Breast Tomosynthesis), which is a relatively new breast-screening technology that is important to driving HOLX revenue. Much of those field responses indicate that DBT take-up is continuing to grow and supports Tobin’s thesis that DBT adoption will accelerate meaningfully in the next two to three years.
LM – The mighty BlackRock (BLK) reported earnings on Thursday this past week essentially validating our view on why we think investors should be buying Legg Mason (LM) from an intermediate to longer term standpoint. BlackRock is the largest asset management company in the world with $4.4 trillion in assets-under-management (AUM) and thus has a very informed view on emerging trends within the asset management industry. On the first page of its earnings press release this week, BLK highlighted that it is seeing a noteworthy development within the pension fund market, as now “at funded” pensions are rotating from formerly appreciated asset classes (i.e. selling stocks after the recent 5 year run in equities) and are moving into other asset classes including fixed income (the bond market was down 2% last year with the first loss in 14 years so technically it underperformed and should be rotated into) and also alternatives (the hedge fund business is gaining share of pension fund asset allocation versus traditional plain vanilla equity and fixed income products). Legg Mason should be the prime beneficiary of this emerging trend with the highest percentage of institutional assets of the public asset managers at 71% of its AUM versus a group average of 42% with also a large exposure to fixed income at 52% of AUM versus the group average of 33%. Legg has also repaired its fixed income performance over the past 5 years which suffered during the 2008-2009 credit crisis with over exposure to U.S. corporate credit.
LO – Lorillard outperformed its Big Tobacco peers rising ~ +2% week-over-week (as of Thursday intraday) and traded above the Consumer Staples sector (XLP) that rose ~ +0.5% w/w.
This week LO publically praised legislation signed into law in Kentucky that will bar minors from buying electronic cigarettes. We see this announcement as an example of the responsibility Big Tobacco is taking around the regulation of e-cigs, despite still no action from the FDA to regulate the category.
We continue to believe LO will grind higher on advantaged menthol fundamentals, limited regulatory risk, and a growth engine in blu e-cigarettes. The company will announce Q1 2014 results on April 24th at 1 p.m. EST.
OC – Owens Corning Q1 2014 earnings call is set for Wednesday April 23, 2013 at 11am EST. Beating or missing estimates for Q1 will not change our bullish stance on Owens Corning. The chart below is from a 2014 investor presentation of Owens Corning’s Insulation EBIT Margin. With the margin roughly a third of its historic average, it suggests potential upside for OC’s most important segment as commercial and residential buildings catch-up to state-wide building codes. The International Energy Conservation Codes or IECC notes the majority of states of both commercial and residential buildings are at 2009 IECC energy efficient levels. So as homeowners and companies look to cut energy costs insulation is among the first materials installed.
RH – After 5 years of store consolidation, Restoration Hardware’s square footage is set to start to grow in a material way starting next month with the opening of the 6th Design gallery in Greenwich, CT and the completion of the New York – Flatiron remodel. We expect to see square footage grow from 800 thousand in 2013 to 2.5 million by 2018. This square footage growth and new product introductions will be the key drivers for the $3.5bil incremental revenue growth over that time period.
Here’s a quick update on RH’s real estate initiatives. The company will open 4 design galleries in 2014, the aforementioned spaces in Greenwich and New York, one on Melrose Ave. in Los Angeles, and a 65,000 sq. ft. store in Atlanta towards the end of the year. For 2015, we are modeling 9 new design gallery locations – 3 have been announced (Chicago, Denver, and Las Vegas). In the outer three years we see an incremental addition of 33 new additions taking the total design gallery doors to 51 by 2018.
ZQK – Quiksilver CEO Andy Mooney was brought in to spearhead the turnaround in early 2013, and the company made sure that he was properly incentivized to expedite that process. As part of his compensation package, Mooney was granted 2 million restricted stock units (RSU’s) that would vest under two conditions. 1) If the stock price, for a period of 30 consecutive days, equals or exceeds $12.50, or 2) if the company is acquired at a price that meets or exceeds $9.28. That means Mooney would stand to gain almost $20 million if the company were to be acquired above the $9.28 threshold.
Two companies that we have identified as possible acquirers are VF Corp. and Kering. We discussed the possibility of a VF acquisition a few weeks back, and added Kering to the watch list after the announcement that Kelly Slater was moving to the brand and subsequent comments by the French company’s CEO that he was looking to acquire sports/lifestyle brand portfolio to round out his company’s portfolio which already consists of Puma, Volcom, Electric, Cobra golf, and Tretorn.
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