This note was originally published at 8am on June 12, 2014 for Hedgeye subscribers.
“For of those to whom much is given, much is required.”
- President John F. Kennedy
Last night Keith and I took a private car service into Manhattan to watch the New York Rangers play the Los Angeles Kings in the fourth game of the Stanley Cup Finals. Clearly, given such an experience, there is no doubt we are among the fortunate in this fine nation.
While most of you that are reading this have worked hard to achieve your position, we have all also received a helping hand along the way. That helping hand may have been from a mentor, from a coach, or just being born somewhat lucky. But, regardless, we all now have the opportunity to give back.
In the spirit of #PayingItForward, Hedgeye has formed a non-for-profit called Hedgeye Cares, which will be dedicated to giving back to charities in Connecticut. Our inaugural event will be the 2014 Hedgeye Cares Golf Challenge to be held on September 16th at the Great River Golf Club in Milford, CT. The proceeds from this event will go to Bridgeport Caribe Youth Leaders (BCYL).
BCYL is non-profit based in Bridgeport, CT, one of the more economically disadvantaged cities in Connecticut, and provides athletic and enhanced educational opportunities to youths aged 5 to 18 to whom much has not been given. Currently, the program provides opportunities for some 500 kids in the Bridgeport area and we will be focused on expanding that number.
We hope you will consider joining us for a golf outing on September 16th and if you aren’t a golfer and or cannot make the event, we hope that you will consider sponsorship or auction donations and join us in #PayingItForward. Details can be found here.
Back to the Global Macro Grind...
Speaking of giving, the Kings actually gave the Rangers a fighting chance last night by losing 2 -1, so the Stanley Cup Finals return to the City of Angels this Friday. On some level, the Rangers have already exceeded expectations by winning last night. Specifically, of the 320 NBA, MLB or NHL teams that have found themselves up 3 – 0 in a seven game series, 65% have gone on to win the next game and close out the series.
In terms of coming back and winning the entire series from a 3 – 0 deficit, it has only happened four times in 171 opportunities in the NHL. For you math geeks, that equates to right around a 2.3% chance of overcoming a three game deficit. So is a comeback probable? No. But as they say, hope springs eternal.
Speaking of probabilities, as equity investors we can be pretty sure that volatility on the SP500, as measured by the VIX, won’t stay below 11 for long. Pull back a long term chart of the VIX on your Bloomberg this morning and you will see what we mean. The last time the VIX hit this level was actually January of 2007. Thereafter, volatility made a steady climb before peaking in October 2008 at ~60.
So as investors, feel free to bet that VIX will go lower from here, but practically that is about as likely as Iran, Honduras, or Costa Rica winning the World Cup. According to Oddshark.com, the odds on that are more than 1500 – 1. Math doesn’t always work, just ask California Chrome, but over time life is much simpler when we play the odds.
Speaking of odds, the likelihood is high that many of us wouldn’t have bet on a Eurozone Industrial production number that came in well ahead of expectations this morning. According to my colleague Ben Ryan:
“Industrial Production printed much stronger than expected (five-month high) for April with strength in energy and non-durable goods production which increased +2.5% and +2.1% respectively. Month-over-month, seasonally-adjusted industrial production increased +0.8%, beating expectations of +0.5%. Note that March was downwardly revised to -0.4%, so April’s increase follows a pretty bad number."
Following a bad number or not, that is the kind of number that we macro analysts underline with a big green highlighter (green being bullish) in our notebooks.
Even as European data continues to get better on the margin, we remain cautious, to say the least at current VIX levels, on the U.S. economy. In the Chart of the Day, we’ve highlighted our U.S. GDP summary table going back two years to March 2012.
The key takeaway from this table is that healthcare spending was critical in supporting GDP in the 1st quarter. With the census bureau’s release of the 1Q14 QSS survey yesterday, that estimate of healthcare spending saw a sharp negative reversal.
According to my colleague Christian Drake:
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.
The net-net of this is that the final estimate of 1Q GDP (June 25th) will be (even more) dismal and GDP is likely to miss the ever bullish consensus expectations for full year 2014. When combined with increasing uncertainty in the 2014 mid-term elections, see Eric Cantor, we may just have an opportunity for you equity bears to #PayItForward in the coming months.
Our immediate-term Global Macro Risk Ranges are now:
UST 10yr Yield 2.44%-2.67%
Keep your head, stick on the ice and belief in the Rangers,
Daryl G. Jones
Director of Research
TODAY’S S&P 500 SET-UP – June 26, 2014
As we look at today's setup for the S&P 500, the range is 41 points or 1.40% downside to 1932 and 0.69% upside to 1973.
CREDIT/ECONOMIC MARKET LOOK:
MACRO DATA POINTS (Bloomberg Estimates):
WHAT TO WATCH:
COMMODITY/GROWTH EXPECTATION (HEADLINES FROM BLOOMBERG)
The Hedgeye Macro Team
Takeaway: Here’s why we think Chip’s activist campaign will fail miserably, and why it’s ultimately good for shareholders.
Conclusion: Today we hosted a conference call to discuss the rationale behind why we added LULU to our Best Ideas list as a long after the stock’s latest collapse. As we’ve said before, the call right now has nothing to do with our confidence in the business or the team running it. This is a company in a defendable category with an outstanding brand, a $95bn addressable market, and a realizable $4-$5bn revenue stream over 5-years. But the catch is that it’s still sitting on a $500mm management team and operating structure. The good news is that never in LULU’s history has there ever been a path to creating value, and that’s due to the sometimes painful, and usually embarrassing presence of its founder, Chip Wilson. But we think that the Board structure that he created will ultimately lead to him outright failing in his current attempt to regain control of the company. That is likely to be a catalyst for one of many forms of change, which we explored in our presentation and deck. We plucked out a few of the more salient slides that we think are worth considering. Let us know if you’d like the replay and the full materials.
The LULU Bracket
This diagram is noisy. It’s supposed to be. Start reading it on the left with the decision of whether or not Chip Wilson wins control of the Board We very generously gave him 20% probability. But in reality he’ll be lucky to get 10%. If he loses, which he will, we think that one of two outcomes is most likely; a) he sells his stock (35% chance) – representing 27.7% of shares outstanding, or b) there’s a deal – 10% likelihood of a buyout, or 20% chance of an acquisition. When all is said and done, about 80% of the outcomes get us to a price well above $41.
Outcomes, As We See Them
1) Management Team Upgrade (49% probability): Each scenario results in a potential management upgrade, but the biggest likelihood is if Wilson sells his stock. All in, we get to a 49% chance of a meaningful change in management (including putting in place a high caliber CEO). This company needs better executives, and a lot more of them. This is a team that we think would proactively invest in systems needed to more appropriately discount product – something LULU sorely needs – and tackle its competitors head on instead of clinging on to a ridiculous hope of a perma 55% Gross Margin. The way it is being run today, the company is on its way to becoming Coach. We firmly believe changing that path is not a very difficult one. All in, this scenario gets us back to the discussion of $3-$4 in earnings power, or a $60-$100 stock (20x $3.00, and 25x $4.00).
2) Deal (30% probability): The biggest barrier to a deal getting done in the past has been that Chip didn’t want it to happen. Now he’s likely searching for one. Our sense on Wilson is that he feels handcuffed by LULU. He’s not allowed to participate in anything having to do with the company aside from attend Board meetings, but he’s too big a shareholder to go off and start another brand (something he’s actually very good at) due to his non-compete. If he can’t gain control, he could look to get the company sold. We think that a buyout with a PE partner is not very likely – as there’s not a ton of private buyers that would take out a high margin company at 15x EBITDA. But we think that the set of strategic buyers is a) far more expansive and b) less price-sensitive.
3) Status Quo (21% probability): This outcome pretty much stinks. The reality for LULU is that a status quo management team and status quo operating plan results in a far less than status quo stock price. We see about $10 downside to $30-32 if this is the case ($1.50 in EPS – 15x p/e and 10x EBITDA). This is the outcome that would cause us to pull the plug on our call – though we don’t think this will come to fruition.
There’s a few reasons why Chip will likely not regain control of the Board.
1) Giving up the title of Chairman in late 2013 is the worst thing Chip could have done. We think that was one of the final moves in a game of chess the real Board was playing with him. He agrees to step down from being Chairman if Laurent Potdevin gets the green light to be CEO. Potdevin is likely not the guy for this job, but it was a great move in hindsight by the Board.
2) Why? Only the CEO, Chairman or a majority of the Board can call a special vote at LULU. Chip cannot do it. He literally has a better shot at selling the company outright than he does in calling a simple special Board meeting.
3) There are 10 Board members, and three are clearly on ‘Team Chip’. But the Board has an offensive weapon in that it is authorized to have between 3 and 15 Board seats. All the Board needs is a simple majority (which Chip likely will not be included in) and it can appoint up to five new Directors -- none of whom are likely to be aligned with Wilson.
4) Better yet, there are staggered seats with three year terms. So if Board members are appointed today, he or she doesn't have to be voted on by shareholders until 2017.
5) All in, Chip’s ownership has been steadily shrinking, but his influence has been shrinking faster. He knows this. All the more reason to make a move to get out.
Who’s A Buyer?
We think that there’s a lot of companies that want to own LULU, but unfortunately, not a lot of companies can afford to do the deal at $8bn. We calculated the leverage for a host of suitors pre and post transaction, and also looked at year 1 accretion and dilution for each company. The punchline for us is that LULU is not likely to be bought by an American company. We’re thinking German, French or Japanese.
a) Nike: NKE won’t buy what it thinks it can build for less money. Whether you agree with them or not is irrelevant. They think they can beat LULU organically, so they won’t buy it.
b) Adidas: AdiBok needs it, can afford it, and couldn’t care less about near-term dilution. This makes a ton of sense.
c) UnderArmour: This makes zero sense strategically or financially. I’m surprised I’m asked this so often.
d) VFC: This would be a big nut for VFC to digest, but they could afford it – barely. VFC has gotten less value-conscious in recent years (i.e. TBL) so maybe it’s a possibility. But a dark horse for sure.
e) PVH: This is a company that needs a deal like LULU, but it would crush PVH financially. Tough luck Manny.
f) Fast Retailing: The Japanese owner of Uniqlo is looking to aggressively expand into the US, and needs to diversify away from its mall retail fashion push. The fit makes sense, the accretion is a no brainer even past $70, and let’s not forget that Fast was almost on the hook for buying J Crew in March for $5bn until it saw how bad Mickey’s business was trending.
g) Kering: CEO is on the tape saying he wants to buy sports brands to augment Puma, Tretorn and Volcom. KER could digest LULU in a heartbeat. French company might keep Laurent on board, as well.
h) GPS: This one is another consideration – albeit a long shot. It would take GPS’ debt to total capital to about 65%, which is likely far above the Fisher family’s comfort level. Perhaps GPS will be content chipping away at LULU with Athleta, which is crushing it.
Takeaway: Market sentiment suggests investors are preparing for the next geopolitical catalyst
Brent has now closed in the red 3 out of the last 4 days but remains within 1% of year-to-date highs reached last Thursday:
Despite the relatively light volumes and inactivity over the last several days, BRENT, WTI, and Natural Gas are flashing bullish @Hedgeye TREND signals:
With the week-over-week increase, investors at NYMEX have the most bullish exposure of 2014. Weekly data from the CTFC detailing futures and options positions shows investors are leaning long 479K contracts in BRENT futures, a level more than 2 standard deviations above the trailing twelve-month average. Net futures and options positions increased significantly moving into this week: +8.9% for BRENT and +8.1% for Natural Gas.
With all of uncertainty in global energy markets, implied volatility in BRENT spot contracts spiked last week and has held its level, hovering slightly above 1 standard deviation from its trailing 12-month average.
The week-over-week increase in bullish sentiment and implied volatility, coupled with relatively lighter volumes, points to the uncertainty in the next geopolitical catalyst that may roil supply lines.
The Hedgeye Macro team will be hosting an expert call featuring Dr. Meghan O'Sullivan, Kirkpatrick Professor of the Practice of International Affairs and Director of the Geopolitics of Energy Project at Harvard University's Kennedy School. The call will be on Friday, June 27th at 1:00pm EDT. We hope to gain a better understanding of the regional tension in the Middle East from someone who has firsthand experience:
Meghan served as special assistant to George W. Bush and National Security Advisor for Iraq and Afghanistan from 2004-2007. She has spent two years in Iraq, most recently in the fall of 2008 at the conclusion of the security agreement and strategic framework agreement between Washington and the government of Iraq. Prior to her current post, Meghan was a senior director for strategic planning and southwest Asia in the NSC as well as political advisor to the coalition provisional authority administrator and deputy director for governance in Baghdad.
Takeaway: 23x p/e is a tough risk/reward for a company that can barely grow EPS when the brand is hotter than ever.
We’re no more or less excited about owning Nike into the 4Q print to be reported after the close on Thursday. A few thoughts…
We’re not averse to owning Nike for someone who has an extremely long duration. But there’s no way we can justify putting money to work here for a company that is barely growing earnings when the brand is hotter than ever. With the stock at 23x next year’s earnings, we simply think that there’s much better risk/reward elsewhere.
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