This note was originally published at 8am on May 29, 2014 for Hedgeye subscribers.
“Visual polish frequently doesn’t matter if you are getting the story right.”
-Ed Catmull (President of Pixar)
While it’s month-end-no-volume-markup time here in the US equity market, no matter where you go – and no matter how you have been positioned for the last 5 months, here we are. The score doesn’t lie; consensus expectations for #RatesRising in 2014 does.
Sure, there’s a polish to the reports and a gravitas to once great names in finance that still remain on their doors. But, to be clear, there is no responsibility in recommendation from the Old Wall anymore. Instead, every time they are wrong, “it’s different this time.”
The right story in 2014 has been to be long slow-growth bonds and/or anything that looks like a bond (Utilities +11.5% YTD). The 10yr US Treasury yield has crashed to a fresh YTD low of 2.42% this morning. US Growth (Russell 2000) and US Consumer (XLY) stocks are down over -2% YTD. And, depending on what piece of inflation you are long (food and/or energy) you’re up +8-22% YTD.
Back to the Global Macro Grind…
Yes, I hate losing. But I really hate it when people who are losing (including any of my teammates) try to say they really aren’t. This is a confirmation bias embedded in a society where no one is actually allowed to fail. Every lazy player in the league gets a trophy.
Instead of acknowledging what no Old Wall firm called (for US GDP Growth to be NEGATIVE) in Q114, all I hear are excuses instead of the most obvious call they don’t want to make – bond yields fall (and the yield curve compresses) when growth is slowing.
Sure, I have my own biases on leadership in action, transparency in process, and accountability in recommendation. And I am fully aware that on mornings like this that I can sound like the prickly coach. That’s who I am.
But who you or I are as flawed human beings doesn’t change the score. As the great Bobby Orr once said:
“Forget about style; worry about results.”
Having worn a black silk dress shirt and a mauve screaming eagle tie to work on my first day on Wall Street, I’d be hard pressed to convince you that my style has been consensus over the years. What I really care about is #process.
Our #process has now signaled the biggest “surprises” to both the upside (2013) and downside (2014) in US Yields, and I’m not going to apologize for it. Unlike most macro research I used to pay for when I was in your seat, our #process goes both ways.
*Note: our process takes a full team effort – here’s what our Senior US macroeconomic analyst, Christian Drake, had to say about the 10yr bond yield crashing (-20% YTD) to 2.42% this morning:
“The pro-growth panglossian contingent can take solace in the fact that after today’s negative GDP print, it can only really get better sequentially. Q114 GDP probably wasn’t as bad as the headline and Q214 won’t be as good.”
“Taking the average of the two quarters is the easiest smoothing adjustment and it will show we’re a high 1% economy – which is about right. #Hedgeye – we came here to drink the milk, not count the cows.”
It’s a 1-2% (at best), not a 3-4% US economy. And that’s why the 10yr is going closer to 2%, not 3%. Roger that, Dr. Drake.
Yes, I have fostered a culture of confidence. I don’t know one successful athlete who wakes up every morning not wanting to crush his or her competition. I’m not going to apologize for being that way either.
This is America – a country that I came to in the early 1990s when being a winner mattered more than being the whiner who wanted my winnings. We stand alongside you every day, committed to excellence. We refuse to accept mediocrity in big macro forecasting.
There is no I in Hedgeye and we reiterate our top non-groupthink Global Macro Themes for 2014 to-date:
Our immediate-term Global Macro Risk Ranges (with intermediate-term TREND signal in brackets) are now:
UST 10yr Yield 2.42-2.52% (bearish)
SPX 1888-1917 (bullish)
RUT 1089-1146 (bearish)
Nikkei 13905-14806 (bearish)
VIX 11.03-13.76 (bearish)
USD 79.89-80.61 (bearish)
EUR-USD 1.35-1.37 (bullish)
Pound 1.67-1.69 (bullish)
Brent Oil 109.06-110.97 (bullish)
Natural Gas 4.47-4.66 (bullish)
Gold 1249-1296 (bullish)
Copper 3.10-3.20 (bullish)
Best of luck out there today,
Keith R. McCullough
Chief Executive Officer
TODAY’S S&P 500 SET-UP – June 12, 2014
As we look at today's setup for the S&P 500, the range is 36 points or 1.49% downside to 1915 and 0.37% upside to 1951.
CREDIT/ECONOMIC MARKET LOOK:
MACRO DATA POINTS (Bloomberg Estimates):
WHAT TO WATCH:
COMMODITY/GROWTH EXPECTATION (HEADLINES FROM BLOOMBERG)
The Hedgeye Macro Team
This indispensable trading tool is based on a risk management signaling process Hedgeye CEO Keith McCullough developed during his years as a hedge fund manager and continues to refine. Nearly every trading day, you’ll receive Keith’s latest signals - buy, sell, short or cover.
Takeaway: If you missed it, don’t worry. The story has so far to go. If we’re right on earnings, the stock will be well north of $200 in 3+ years.
Editor's note: This is a brief excerpt from a research note written by retail sector head Brian McGough at 10:28pm ET last night.
This quarter served as another milestone for Restoration Hardware (RH) in its march towards $11.00 in earnings, and additional proof for us that this is perhaps the best idea in all of US retail.
The after-hours move to $80 is nice…we’ll definitely take that. But it’d be a mistake to lose sight of the very real potential for this to be a $200+ stock over a 3-4 year time period. The EPS CAGR RH needed to get there is over 40%, and our research says it will get there. What multiple is fair for a 40% EPS grower that earns $11? Let’s say 20x, conservatively. If we’re right on earnings, we can build to a stock well above $200.
In other words, the call is not done. It’s really just beginning.
Takeaway: If you missed it, don’t worry. The story has so far to go. If we’re right on earnings, the stock will be well north of $200 in 3+ years.
This quarter served as another milestone for RH in its march towards $11.00 in earnings, and additional proof for us that this is perhaps the best idea in all of US retail. The after-hours move to $80 is nice…we’ll definitely take that. But it’d be a mistake to lose sight of the very real potential for this to be a $200+ stock over a 3-4 year time period. The EPS CAGR RH will need to get there is over 40%, and our research says it’ll get there. What multiple is fair for a 40% EPS grower that earns $11? Let’s say 20x, conservatively. If we’re right on earnings, we can build to a stock well above $200. In other words, the call is not done. It’s really just beginning.
Think about it like this. RH went over six years shrinking its real estate footprint. But starting next quarter, it will go on a 5-7 year tear as it executes on its store growth strategy. Next year alone, we should see square footage grow in excess of 40%. And it’s doing this while it simultaneously executes its category expansion plan – such as kitchens, which alone should be a $2bn business. Our point is that it’s easy to get hung up on a given quarter with this (or any) company, and this quarter the stock is definitely getting its due. But if you look at a the story bigger picture, you’ll see that it consolidated for six years, and now should gain share of the market at an accelerated rate for another six years. The bottom line is that it seems a little short-sighted from where we sit to think that just because the stock is hitting new highs that the opportunity is over.
*Note: We’ll be issuing another RH Black Book in two weeks where we’ll be conducting a deep dive into specific drivers around the company’s new Design Gallery growth initiative. Stay tuned for details.
Our Take On The Quarter. As it relates to the print itself, it was pretty much spot-on with our model. The comp was exactly in line with our 18%, though revenue was slightly better due to better new store productivity. Gross margins were also a touch better due to better merchandise margins, and less ‘dead rent’ (see below) than we conservatively expected. That accounted for an extra $0.02 above our Street-high $0.16 estimate. We’re sticking with just about every assumption in our model, and remain well ahead of the Street this year, and every year thereafter.
We’ve got to note Gary Friedman again (he was a positive callout last quarter). There are still so many ‘Gary-Haters’ out there. We kind of get that you can’t radically change the perception of someone’s persona overnight. But we think it’s impossible for anyone that is ‘anti-Gary’ to be intellectually honest and not admit that the guy has tremendous command over virtually every part of the business – from stores, to product, to personnel, to cash flow (yes, cash flow). From the get-go, he laid out his vision and he took control of the narrative that he wanted to tell. So many CEOs default to playing defense to Wall Street’s agenda. Gary set his own, and we found it convincing. If you want a polar opposite scenario, look at Lululemon, which will have reported by the time most people read this. Both companies are about $1.5bn in sales, both are in unusually high growth categories for US Retail, and both can grow by a factor of 3x within 4-5 years. Our confidence that RH gets there is 90%+. Our confidence in the current LULU management team is closer to 10%. To mention both CEOs in the same sentence is almost laughable (note: LULU can get there, but we need to see serious change – they should look to RH for guidance).
In case you missed the call, here are some of the more notable callouts on key margin components.
For the balance of the year there are 4 key drivers on the Gross Margin line.
1) Pricing initiatives: With the product refresh starting to hit the P&L in 2Q, RH will benefit from the anniversary of its 2013 pricing initiatives while also getting a little boost by taking price on the new assortment.
2) Mix & Shipping: The company isn’t going to realize the full benefits of mix shift until the new Design Galleries account for a more meaningful percentage of the company’s square footage and Kitchens is added to the mix in Spring of ’15, but management indicated on the call that furniture’s penetration as a percent of sales was starting to flatten out. This, along with RH’s new source book strategy should help with shipping leverage, with more of the benefit weighted towards the back half of the year.
3) DC leverage: The company will anniversary the opening of its Dallas DC and Ohio shelf stock facility in 2Q, and will benefit from DC occupancy leverage in the 2nd half of the year.
4) Pre-opening expenses: The company will face some headwinds from retail occupancy deleverage in the back half of the year as it ramps up spend to facilitate 2015’s class of Design Galleries.
Biggest call outs here are fixed cost leverage and ad spend.
1) The company will leverage fixed and corporate costs, with headwinds in 4Q due to lower incentive compensation expenses in ’13 that will not recur.
2) As for Source Book costs, our math suggest that worst case the Source Book cost an extra $52mm this year when compared to last – taking Source book spend as a percentage of sales up 230bps. But, when accounting for the company’s 12 month amortization curve and the benefit realized in 1Q from the company’s change in strategy, the books add an incremental $35mm or about 140bps to SG&A for the year. That doesn’t include inestimable costs associated with marketing spend that the company will lap in the back half of the year which will help to further mitigate the dollar impact.
HERE’S OUR NOTE FROM EARLIER THIS WEEK OUTLINING SOME OF THE RISKS TO THE MODEL
RH – Where Can We Be Wrong?
Takeaway: RH is our favorite idea. It remains massively misunderstood. But let’s keep it real and vet all the areas we could be wrong near term.
RH is our top long idea in Retail by a country mile, and we remain convinced that the company will see earnings grow from $1.71 last year to near $11.00 in five years time. If we’re right on that earnings number, which we think we are, we think that this is ultimately a $200 stock. We don’t think this is just a square footage growth story (which is impressive in its own right), but rather one of the biggest market share stories in retail today. In effect, we think that RH is doing to the high-end home furnishings space what Ralph Lauren did to apparel on 1980. The parallels are staggering. For more details on the long term opportunity, check out our latest Black Book.
Looking more near-term, we feel really good about RH heading into the 6/11 print. Demand remains strong, the Sourcebook appears to be well executed, the May/June store openings are on track (Greenwich/NYC), the company’s on-line business appears to be tracking quite well, and EPS expectations for the quarter appear very doable (we’re at $0.16 vs the Street at $0.11).
Given our comfort level around the print and the year, at this point we’re hyperfocused on one thing…where can we be wrong?
Here are some factors that we think about as it relates to the print and guidance. To be clear, after vetting these factors we still come out positive. But let’s lay it all on the table such that there are as few surprises as possible.
Takeaway: Census Bureau revised Healthcare Spending estimates, the lone source of strength in 1Q GDP, a lot lower. A -2% report on deck for June 25.
We’ve highlighted repeatedly over the last few months that reported healthcare spending in 1Q14 was largely a guess by the BEA due to the implementation of Obamacare and a dearth of hard data. More specifically, we noted the following in March & April:
*Healthcare Spending: The strength in Healthcare Services spending stems largely from the implementation of Obamacare. The reported figures, by BEA’s own admission (see their note Here), are very much an estimate and the preliminary data are likely to be revised (significantly) over time as the Census bureau’s quarterly QSS and annual SAS survey’s provide harder data.
With reported Hospital and Outpatient spending both accelerating materially in 1Q14, it could also be that individuals are accelerating medical consumption ahead of ACA implementation and uncertainty around coverage changes.
Either way, in the context of the broader spending data, the takeaway is pretty straightforward – Healthcare Services represent ~17% of total household consumption expenditures and certainly impacts the direction of reported, headline consumption growth. To the extent that deceleration is the larger trend across the balance of services, a mis-estimation of ACA related spending and/or a significant, transient pull-forward in medical consumption could be materially distorting the prevailing, underlying trend.
The Census Bureau released the 1Q14 QSS data this morning (note: the QSS survey data feeds the calculation of household spending in GDP) and the estimate for Healthcare spending saw a sharp negative revision.
Specifically, the data showed total revenue for Healthcare and social-assistance declined -2% QoQ in 1Q14 while Hospital revenue (the largest component of healthcare spending) declined -1.3% QoQ.
Translating that into an exact impact on the final GDP estimate for 1Q14 (June 25th) is complicated by the fact that the reported QSS Healthcare spending data is both nominal and non-seasonally adjusted while the Hospital revenue is not adjusted for price changes (but is reported on a seasonally adjusted basis)
The translation complication is really besides the point, however. The larger takeaway is simply this:
Services consumption was the singular source of strength in the 1Q14 GDP report and most of that was from Healthcare Services which contributed +1.01% to GDP – that estimate of accelerating healthcare consumption just got revised to negative growth which will take the final GDP estimate for 1Q down to -2.0% plus or minus.
It also notable that Healthcare consumption growth, while decelerating modestly sequentially, was still very strong in April (again one of the lone sources of strength in household spending). If the April (& 2Q) numbers get revised lower also then 2Q growth estimates will take a hit as well.
Full year consensus growth estimates for 2014 remain in the +2.5%-3% range - implying 4%+ growth over the balance of the year (exclusive of the forthcoming negative revision to 1Q). Those estimates still need to come down.
Christian B. Drake
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