Takeaway: We reiterate our call of not having a high-conviction call on Japan here amid a convoluted globally-interconnected monetary policy outlook.

When we last published our extended thoughts on Japan, we openly debated the outlook for the “Abenomics Trade” (i.e. SHORT Japanese yen + LONG Japanese equities) with respect to the intermediate term. To recap the pros and cons of allocating capital to this investment strategy:


  • A likely transition from Quad #3 (i.e. growth slowing as inflation accelerates) in 2Q14 to Quad #1 (i.e. growth accelerating as inflation decelerates) in 3Q14
  • A re-risking of the GPIF portfolio
  • Favorable micro tailwinds
  • Abe’s “Third Arrow” is more talk; less walk
  • Easier Fed + Japanese monetary policy vacuum = stronger JPY


For those of you who like to get into the weeds on the numbers, please refer to our JUN 30 note titled “JAPAN POLICY VACUUM PART II?” for a deeper discussion of those puts and takes. It might not even be worth your time, however, as not much has changed since then.


Specifically, the BoJ’s latest policy meeting (statement out earlier today) was yet another nonevent. It left its QQE program unchanged, in line with the entire analyst community and the wording of the statement was broadly in line with previous guidance. Moreover, BoJ Governor Haruhiko Kuroda reiterated the board’s sanguine view of the Japanese economy and its progress on achieving #StructuralInflation in Japan.


In fact, a marginal tinkering of the FY14 real GDP growth estimate was the only update to their official guidance:


  • Real GDP:
    • FY14: +1%, down -10bps vs. the prior forecast
    • FY15: +1.5%, unchanged vs. the prior forecast
    • FY16: +1.3%, unchanged vs. the prior forecast
  • CPI (excluding the impact of the consumption tax hike):
    • FY14: +1.3%, unchanged vs. the prior forecast
    • FY15: +1.9%, unchanged vs. the prior forecast
    • FY16: +2.1%, unchanged vs. the prior forecast


The key takeaway for investors here is that the resiliency of the Japanese economy post the APR consumption tax hike coupled with no material change in the BoJ’s own outlook for inflation roughly equates to an incremental delay in the timing of incremental easing (i.e. expanding their QQE program).


Speaking to that resiliency, the preponderance of Japanese high-frequency growth data is now accelerating on a trend basis as of JUN:




This sequential momentum is highly likely to support a bounce in real GDP off an easier compare here in 3Q14. To the extent that catalyst materializes, we could now be looking at the DEC 18-19 meeting or early-2015 for the timing of the BoJ’s next move, which would likely follow two consecutive quarters of decelerating CPI readings, or at least be in response to a dovish policy delta out of the Federal Reserve that impacts the currency markets.




A lot could happen between now and then, so, net-net, we do not think it’s appropriate for investors to gross up their exposures to the Abenomics Trade in either direction at the current juncture. While our late-MAY call for investors to cover Abenomics shorts was highly appropriate (e.g. the Nikkei 225 Index is up +4.9% since then), the outlook from here remains unclear.


As such, we reiterate our call of not having a high-conviction call on Japan right now. Up until very recently, we’ve had one since 4Q12 (in both directions of the Abenomics Trade), so we’re more than content to stand pat and let the data instruct our next move. Why force it?


Have a great night,




Darius Dale

Associate: Macro Team


Takeaway: Recent economic data supports renewed optimism across Chinese capital markets, but we don’t think improvement in the former is sustainable.

Today, we received what was the latest in a string of directionally positive economic data out of China. Specifically, the JUN credit growth data confirms what we already knew: a multi-month string of fiscal and monetary policy “mini-stimulus” efforts have successfully stabilized the slope of Chinese economic growth. Not surprisingly, Chinese equity ETFs have performed fairly well on that catalyst (3M performance):


  • iShares China Large-Cap ETF (FXI): +8.8%
  • Guggenheim China Technology ETF (CQQQ): +9.4%
  • Global X China Consumer ETF (CHIQ): +0.1%
  • Global X China Financials ETF (CHIX): +7.3%
  • EGShares China Infrastructure ETF (CHXX): +5.7%


Digging into the weeds, aggregate financing accelerated materially in JUN on a sharp acceleration in deposit growth and shadow credit formation. Both are in line with the easing of fiscal and monetary policy over the past 3-6M and the former should continue to ease as we progress through the year (deficit spending out of Beijing tends to be back-half loaded).




This should come as no surprise to our subscribers, as we’ve literally been harping on this very point for the past two months. Refer to the following research note for more color on this topic, as well as for incremental color on the key takeaway of this note.



That key takeaway is very simple: don’t extrapolate recent data as something that resembles China turning the corner from a domestic demand perspective.


Specifically, the monetary policy guidance out of the PBoC would suggest that the bulk of the easing we’ve seen the Chinese money markets in recent months is now rear view mirror – especially with credit growth running so hot of late (this was the fastest pace of credit formation in any JUN since 2009!).






That should weigh on the outlook for fixed asset investment – particularly in the property sector, which remains a complete disaster (PRICE, DEMAND and FINANCING are all tending resoundingly negative amid positively trending SUPPLY). Moreover, Chinese credit formation (and headline GDP growth) tend to be skewed toward the first half of the year anyway. Add tougher GDP compares to that mix and you have what is a reasonably sound argument for rates of Chinese growth to peak here in the mid-summer.










It’s worth nothing that we’re not calling for Chinese economic growth to tank in 2H14, nor do we see its obvious financial risks materializing in a meaningful way over the intermediate term. With CPI running well below the State Council’s +3.5% target in the YTD and a conservative sub-2% deficit/GDP ratio, Chinese authorities have plenty of scope to meaningfully ease monetary and fiscal policy in an effort to stave off anything resembling a crisis.




Moreover, we think the threat of crisis is precisely why we don’t think they’ll waste their “bullets” on a likely marginal deterioration in economic conditions in 2H14. As our proprietary EM crisis risk modeling work continues to suggest, the Chinese financial system is rife with tail risks.






We’ll cross that bridge when we eventually get to it. For now, trade your China exposures accordingly.




Darius Dale

Associate: Macro Team

LULU - LBO Math = Downside Support

Takeaway: LULU LBO not as prohibitive as we'd previously thought. Deal or no deal, we think there's defendable downside support in the low $30s.

Conclusion: We had previously bought into the popular thought process suggesting that LULU was too expensive to be an LBO, and it had the wrong financial and style characteristics for a private buyer. In the ‘strategic outcome bracket’ below, we assigned it only a 10% chance of happening, behind an all-out strategic acquisition (20%), and Chip selling his stock outright (35%).  But after running through some LBO math, we’re more inclined to think that an LBO actually makes financial sense.  Do we think that a deal will be announced tomorrow with the stock at $39? Probably not -- although the math would support it.  But for those like us who are trying to get a handle on where the real downside support is in this stock, we think this helps show that it is in the low-$30s.  The risk/reward on the long side still looks really favorable here to us.


Here are some key considerations in our analysis.


1. A Traditional LBO is Not In The Cards.  The IRR makes sense for a traditional LBO, but the leverage characteristics do not. Our analysis below suggests a 20% premium from the current price, 35% equity, an exit multiple 25% below entry multiple, and that margins come down below 18% over the modeling time horizon. All of that suggests an IRR of just over 20%. Overall, that’s reasonably attractive. But the problem is with leverage.

LULU - LBO Math = Downside Support - LULU Op A

*Click image for larger view


2. This chart shows the leverage ratios for the highest levered deals in the market over the past decade. The highest leverage ratios occurred in 2007/08 just before the recession, and those numbers topped out at 8.2x debt/EBITDA. A standard, run-of-the-mill Private Equity buyout would imply leverage of 8.8x. That’s simply way too high for us to view as any margin of support.

LULU - LBO Math = Downside Support - Lulu Leverage

Source: Forbes


3. But, here’s where Chip can help. The fact is that the guy owns 27.7% of the common equity. There’s no reason he cannot team up with a private buyer in a way where he contributes his stock to the partnership, and gets the same return as the financial buyer on the way out.  In effect he becomes a de-facto creditor to a financial buyer. That way, the combined entity still puts up $6.8bn for LULU, but one of the sources of financing is Chip’s $1.9bn in stock. That brings the leverage ratio for a deal down to 6.1x, which is right in line with the 5.7x rate we’ve seen year-to-date for LBOs.  


4. Here’s the revised model assuming that Chip facilitates this transaction with his own stock. Assuming the same operational inputs in the model described above, this suggests an IRR closer to 24%, but importantly, with palatable leverage.

LULU - LBO Math = Downside Support - LULU Op B

*Click image for larger view


5. Here’s a sensitivity analysis that we use to triangulate price, leverage, and IRR. The punchline is that a deal works with the stock (before takeout premium) anywhere starting with a $3-handle. Obviously, the return gets a lot more attractive as the stock nears $30. But for that reason, it might never get there.

LULU - LBO Math = Downside Support - luluB sensitivity

*Click image for larger view


6. We used a 20% premium for no other reason than it has been the gold standard for retail names over the past decade. Some would argue that we need a bigger premium given how much LULU has declined over the past year. But truth be told, all LBOs are beaten down before they’re bought. It’s the nature of the beast. We shouldn’t think of LULU any differently.

LULU - LBO Math = Downside Support - lulu lbo premium

Source: SSRN





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.


LULU - LBO Math = Downside Support - lulu1


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.


LULU - LBO Math = Downside Support - LULU2


Board Considerations

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.


LULU - LBO Math = Downside Support - lulu3


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.


LULU - LBO Math = Downside Support - lulu4


LULU - LBO Math = Downside Support - lulu5


LULU - LBO Math = Downside Support - lulu6 


LULU - LBO Math = Downside Support - lulu7

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Poll of the Day Recap: 77% voted they disagreed with Goldman Sachs Bearish Call on Gold

Goldman Sachs grabbed headlines yesterday, sticking with its view that gold will be lower by the end of December as the economy improves.  In today’s Morning Newsletter, Hedgeye CEO Keith McCullough spelled out exactly why we are taking the other side of GS and sticking with our bullish call on gold.


We maintain that  #InflationAccelerating will continue to weigh on consumers and a growth miss will warrant easier policy on the margin.


CLICK HERE for more on why you should stay long gold with Macro Analyst Ben Ryan.


In  today’s poll we asked: Do you agree with Goldman Sachs’ bearish call on gold?


At the time of this post, 77% voted they disagreed with GS, 23% agreed with GS bearish call on gold.


VIDEO | Ignore Goldman Sachs, Stay Long Gold $GLD

Macro Analyst Ben Ryan discusses why Hedgeye remains bullish on gold despite recent news that Goldman Sachs has reiterated its bearish call. He speaks with Director of Research Daryl Jones.


Takeaway: Recent data supports our expectation that inflation will quash US consumption growth, while developing quant signals challenge that view.

Each day one of our summer interns, Kevin Brooke – the offspring of Yale Hockey legend Bob Brooke – compiles a blog run for our team. The purpose of the blog is find insightful macroeconomic or financial market analyses that challenge (or support) our existing macro themes, as well as those thought pieces that are generally informative.


Today Kevin hit a home run with two of the better pieces I’ve seen in recent weeks:


  • Commodities Reverse Their Gains!: CLICK HERE to access the article
  • Here’s Why Americans Are Having a Lot Less Fun This Summer: CLICK HERE to access the article


In discussing the latter data point first, we are most welcoming of this incremental evidence of our #ConsumerSlowing theme, as it shows a net percentage of Americans are spending more on Groceries (49%), Gas/Fuel (46%) and Utilities (35%). Per the cited Gallup Survey, those expenditure categories were the three largest in terms of the net percentage of Americans feeling the effects of cost-push inflation.




Interestingly enough, those three expenditure categories just so happen to be the three inputs to our Hedgeye Macro Consumer Squeeze Index, which continues to show #InflationAccelerating eroding domestic purchasing power.




On a prospective basis, we obviously need to see incremental commodity price appreciation in order for cost-push inflation to threaten the outlook for consumer spending in a material way (a la 2008 or 2011).


One key driver of our forecast for said price appreciation is #DollarDevaluation. Specifically, we think the Fed is gearing up to surprise investors by introducing directionally-dovish monetary policy, at the margins, as we progress through the back half of the year. Refer to the following pieces to review that thesis in full:



Today in the Federal Reserve’s Semiannual Monetary Policy Report to the Congress, FOMC Chairwoman Janet Yellen continued to “connect the dots” on an outlook for easier monetary policy:


  • “The housing sector, however, has shown little recent progress. While this sector has recovered notably from its earlier trough, housing activity leveled off in the wake of last year's increase in mortgage rates, and readings this year have, overall, continued to be disappointing.”
  • “Although the economy continues to improve, the recovery is not yet complete. Even with the recent declines, the unemployment rate remains above Federal Open Market Committee (FOMC) participants' estimates of its longer-run normal level. Labor force participation appears weaker than one would expect based on the aging of the population and the level of unemployment. These and other indications that significant slack remains in labor markets are corroborated by the continued slow pace of growth in most measures of hourly compensation.”
  • “Although the decline in GDP in the first quarter led to some downgrading of our growth projections for this year, I and other FOMC participants continue to anticipate that economic activity will expand at a moderate pace over the next several years, supported by accommodative monetary policy, a waning drag from fiscal policy, the lagged effects of higher home prices and equity values, and strengthening foreign growth… As always, considerable uncertainty surrounds our projections for economic growth, unemployment, and inflation. FOMC participants currently judge these risks to be nearly balanced but to warrant monitoring in the months ahead.”
  • “Of course, the outlook for the economy and financial markets is never certain, and now is no exception. Therefore, the Committee's decisions about the path of the federal funds rate remain dependent on our assessment of incoming information and the implications for the economic outlook. If the labor market continues to improve more quickly than anticipated by the Committee, resulting in faster convergence toward our dual objectives, then increases in the federal funds rate target likely would occur sooner and be more rapid than currently envisioned. Conversely, if economic performance is disappointing, then the future path of interest rates likely would be more accommodative than currently anticipated.”
  • “In sum, since the February Monetary Policy Report, further important progress has been made in restoring the economy to health and in strengthening the financial system. Yet too many Americans remain unemployed, inflation remains below our longer-run objective, and not all of the necessary financial reform initiatives have been completed. The Federal Reserve remains committed to employing all of its resources and tools to achieve its macroeconomic objectives and to foster a stronger and more resilient financial system.”


If you’ve subscribed to our research for longer than one day, you’ll no doubt have realized that quantitative, market-based signals tend to front-run our interpretation of or expectations for underlying fundamentals, while our those same underlying fundamentals help instruct our outlook for market prices. It’s a dynamic, reflexive process that tends to generate “Circular Reference Warnings” among the linear, Consensus Macro forecasting community.


Right now, those quantitative signals aren’t as supportive as they were even 2-3 weeks ago. Looking to our Tactical Asset Class Rotation Model (TACRM for short), we’re seeing a SELL signal in FX for the first time since late APR and the third-consecutive week with a SELL signal in Commodities, after having been squarely in BUY territory since mid-FEB.




Refer to the following presentation for more insight into TACRM’s quantitative signaling capabilities:


It’s worth noting that TACRM’s BUY and SELL signals aren’t necessarily meant to generate absolute returns (although the backtest data on slides 15-20 of the aforementioned presentation suggests TACRM is quite good at doing just that); rather, these signals are relative to the other asset classes (e.g. BUY Fixed Income & Yield Chasing in lieu of XYZ asset class, which would have a commensurate SELL signal).


Additionally, it’s also worth noting that within our hierarchy of quantitative risk management signals, TACRM sits squarely below Keith’s multi-factor, multi-duration model that is core to each of our fundamental views. Regarding those signals, the key levels to watch are:


  • WTI Crude Oil: we need to see it hold sustainably below these levels in the coming weeks for us to consider materially altering our economic outlook
    • Threatening Bearish TREND = 101.89
    • Threatening Bearish TAIL = 100.27
  • CRB Index: we need to see a sustained breakdown below the TREND line for us to consider materially altering our economic outlook
    • Threatening Bearish TREND = 297
    • Squarely Bullish TAIL = 291
  • Gold: we need to see a sustained breakdown below the TREND line for us to consider materially altering our economic outlook
    • Squarely Bullish TREND = 1281
    • Squarely Bearish TAIL = 1324
  • USD Index: we need to see a sustained breakout above these levels line for us to consider materially altering our economic outlook
    • Squarely Bearish TREND = 80.71
    • Squarely Bearish TAIL = 81.19










Our process is dynamic and, if nothing else, mentally flexible. We aren’t wed to any thesis, so if the facts change (i.e. commodity inflation reverses and the Fed is supportive of a stronger USD),  we’ll change with them.


Hope this is helpful and thanks for the questions,




Darius Dale

Associate: Macro Team

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