“You become. It takes a long time.”
That’s a quote from one of the best children’s books I have ever read to my kids, The Velveteen Rabbit. It was also cited in Brene Brown’s recent #behavioral book, Daring Greatly (pages 110).
“Real isn’t how you are made… it’s a thing that happens to you.”
“Does it hurt?” asked the Rabbit. “Does it happen all at once, like being wound up – or bit by bit?”
“It doesn’t happen all at once,” said the Skin Horse. “You become. It takes a long time.”
While that resonates with me as a husband, Dad, hockey coach, etc., it really hits the nail on the head in becoming a Velveteen Bear on the US stock market. I haven’t been this bearish since the fall of 2007. Getting really bearish is a process. It takes time.
Back to the Global Macro Grind…
After Europe moved back into crisis mode (easing, printing, praying) and we received the worst US jobs report in 7 months, you just have to buy the all-time-bubble high in SPY on that, right? Right. Maybe with other people’s money.
After almost (I reiterate, almost!) having its first-four-down-days in a row of 2014 on Friday, the SP500 rallied from down to up on the day, to close up a whopping +0.2% on the week. That’s 5 consecutive “up” weeks. #hooray
In other news, the Russell 2000 (which derives 80% of its revenues from the US) flashed yet another bearish divergence, closing down -0.4% on the week to pretty much flat for 2014 YTD.
To give US equity bulls credit, this is what I liked about last week:
- After the ECB torched the Euro, the US Dollar (vs. the Euro) was up another +1.4% on the week
- The US 10yr Treasury Yield rose +12 basis points on the week to 2.46%
- The Yield Spread (10yr minus 2yr) widened +10bps on the week to +195bps
Not only was that something to like last week, it was something I loved all of last year. Dollar Up, Rates Up – that’s what should drive a US growth bear insane.
Other than the Russell 2000, what I don’t like in 2014 is that a key component of the Dollar Up, Rates Up storyline is missing - rates are down, hard, in 2014:
- Inclusive of last week’s bounce to lower-highs, the 10yr yield is -19% (or -57bps) YTD
- For 2014 YTD the Yield Spread (10yr minus 2yr) is still crashing (-26%) or down -70bps
In conjunction with these classic early cycle slow-down macro signals (which most European growth bulls said weren’t growth slowing signals until the ECB reminded them how fast things were slowing), you’ve seen:
- Early Cycle Stocks (Housing, Consumer Cyclicals, Regional Banks, the Russell, etc.) underperform
- Slow-growth #YieldChasing Stocks (Utilities, REITS, Big Cap Dividend Stocks, etc.) outperform
In case you aren’t long something like Argentina (stock market up another +6.1% last week to +93.2% YTD) whose economy still sucks, and you’ve stayed with the long #YieldChasing thing:
- Utilities (XLU) were up another +0.8% last week to +14.9% YTD
- REITS (MSCI index) were up another +1.0% last week to +19.6% YTD
Seriously. Who needs to be long the spoos when you can be long the good stuff!
While Ocham’s Razor (boil it down, simplify) is a really sexy concept, you can’t over-simplify. While a stronger Dollar (burning Euro) has toned down some of the commodity #InflationAccelerating that we saw in the first half of 2014, at some point you have to ask yourself if it’s going to be incremental enough to stop an early cycle US slowdown that’s already in motion?
To contextualize that key risk management question, don’t forget that the US is 63 months into this economic expansion. And the jobs market (both ADP slowing for 2 consecutive months and last week’s jobs report), which is a classic late-cycle indicator that strengthened, well, at the end of the cycle… is starting to hint that the bond market has #Q3Slowing nailed.
If US jobs and housing data slows, at the same time, what do you think Janet is going to do next? That’s right. She’ll do A) what Draghi just did and B) the Japanese are going to keep trying – moarrr incremental easing… That’s bullish for bonds and anything stocks that looks like a bond. And that’s all your cuddly Velveteen US Growth Bear has to say about that.
Our immediate-term Global Macro Risk Ranges are now:
UST 10yr yield 2.32-2.46%
Best of luck out there this week,
Keith R. McCullough
Chief Executive Officer
TODAY’S S&P 500 SET-UP – September 8, 2014
As we look at today's setup for the S&P 500, the range is 15 points or 0.68% downside to 1994 and 0.06% upside to 2009.
CREDIT/ECONOMIC MARKET LOOK:
- YIELD CURVE: 1.94 from 1.95
- VIX closed at 12.09 1 day percent change of -4.35%
MACRO DATA POINTS (Bloomberg Estimates):
- 11am: U.S. to announce plans for auction of 4W bills
- 11:30am: U.S. to sell $26b 3M bills, $23b 6M bills
- 3pm: Consumer Credit, July, est. $17.0b (prior $17.255b)
- Senate, House return from summer recess
- 8:45am Treasury Sec. Lew speaks on tax reform
- 9:30am: HHS SEC. Burwell speaks to students, staff and faculty
- U.S. ELECTION WRAP: Roberts Shakes Up Campaign; Polls
- Obama’s immigration delay forced by Republican amnesty attacks
WHAT TO WATCH:
- Electrolux to acquire GE’s appliances unit for $3.3b
- FMC buys Cheminova for $1.8b as CEO tweaks break-up plan
- Facebook’s WhatsApp takeover faces fast EU review, Almunia says
- EU seeks to extract Google concessions to rescue antitrust pact
- CenturyLink said seeking to acquire Rackspace for cloud services
- Brent crude declines below $100 for first time since 2013
- Alibaba M&A spree to be questioned at Waldorf as IPO starts
- U.K. races to extend powers to Scots to blunt independence drive
- Scotland independence seen risking $23b of power projects
- Disney’s ‘Guardians’ leads slowest box office weekend since 2001
- EU Banks sidestepping bonus cap face crackdown from regulators
- German trade surplus at record as exports rise to all-time high
- GM to introduce hands-free driving in Cadillac model in 2016
- Schumer draft proposal on inversions could reach back 20 yrs
- Ryanair said poised for $11b purchase of Boeing Max Jets
- Rakuten in talks to buy U.S. online shopping operator Ebates
- U.S. expands air offensive to protect Iraqi dam from militants
- Ukrainian deaths test cease-fire as both sides report casualties
- U.S. gasoline falls to $3.4631 a gallon in Lundberg Survey
- Campbell Soup (CPB) 7am, $0.49
- Casey’s General Stores (CASY) 4pm, $1.25
- FuelCell Energy (FCEL) 4:10pm, ($0.03)
- Korn/Ferry Intl (KFY) 4:05pm, $0.40
- NCI Bldg Systems (NCS) 4:05pm, $0.09
- Triangle Petroleum (TPLM) 5:58pm, $0.15
COMMODITY/GROWTH EXPECTATION (HEADLINES FROM BLOOMBERG)
- Nickel Climbs to 9-Week High on Philippine Ore Supply Concerns
- Brent Crude Declines Below $100 for First Time in 14 Months
- Raw Sugar Rebounds From 7-Month Low While New York Cocoa Drops
- Gold Bulls Retreat as $1.6 Billion Erased From ETPs: Commodities
- Palm Oil Rises to Two-Week High as Exports May Expand on Waiver
- Gold Trades Little Changed Near 12-Week Low on U.S. to Ukraine
- Corn Declines as Traders Weigh Record U.S. Production Outlook
- Philippine House Body Approves Bill Banning Mineral Ore Exports
- Drillers Piling Up More Debt Than Oil Hunting Fortunes in Shale
- BNP Paribas Said to Curb Commodity-Trade Finance to Trafigura
- China Aluminum Exports Rise With Steel as Demand at Home Wanes
- Hedge Funds Reduce Bullish Gas Bets as Volatility Slides: Energy
- Clearinghouses Get CFTC Scrutiny So Solution Isn’t Problem
- China’s Import Drop Caused by Falling Commodity Prices, CBA Says
- Credit Suisse Sees Aluminum Rally Overdone Amid Plentiful Supply
The Hedgeye Macro Team
Risk Managed Long Term Investing for Pros
Hedgeye CEO Keith McCullough handpicks the “best of the best” long and short ideas delivered to him by our team of over 30 research analysts across myriad sectors.
Takeaway: RH remains our highest-conviction long term idea, and the model checks out into this qtr. In this note we flush out where we could be wrong.
Conclusion: We think that people are missing the magnitude of earnings growth at RH, the sustainability of that trajectory over a long period of time, and ultimately the degree to which that will accrue to equity holders. The question is not whether the stock will go to $90 vs $100 (where we see most price targets), but whether it will get to $200 vs $300. Even the best stories, however, are not linear. There will be bumps along the road. But this print should not be one of them. We’re well above the Street in Sales, Margins and EPS, and we flush out in this note where we could be wrong.
We still think that RH is the best idea in Retail today. We think that most parts of the thesis are at least acknowledged by the market (category growth, real estate expansion), but people are absolutely missing how all the pieces are coming together to drive such outsized earnings growth over an extremely long duration. The consensus is looking for long-term earnings growth of 28% -- we’re at 45%. That equates to $11 in earnings power by 2018. At a 45% earnings CAGR, what kind of multiple does this kind of earnings growth deserve? 25x? 30x? 40x? UnderArmour has a 30% CAGR and it trades at 65x earnings. Our point here is that if the consensus is as wrong as we think it is on the earnings trajectory, then it will be equally wrong on the multiple. 25x = $275. 30x = $330. 40x (which seems like a stretch) = $440. Yes, that’s 4.5 yrs out, but even discounted [30x $11 = $330) back by 15% over 4-years and you get about $190 today. You want to use an earnings number closer in? We’re at $6.25 in 2016. The Street is at $3.76. Let’s keep the current 30x multiple, though we’d argue that we’ll see multiple expansion if numbers are going up that high. That suggests a $188 price in about a year and a half. This stock is headed a lot higher.
All of that said, we fully acknowledge that the slope of a multi-year earnings growth story is not linear – especially for an early-cycle transformational story like this. There will definitely be some bumps in the road along the way, but we simply don’t think that the quarter to be reported after the close on September 10 will be one of those bumps. The way we see it, RH is in an enviable position in that it could print a number as high as $0.77 if it so chooses (compared to the Street at $0.64) without borrowing from investment dollars that should otherwise be spent to fuel the long-term plan.
Here’s a look at some key line items – and a little stress-test on where we could be wrong.
Revenue: We are at $468 for the quarter, ~3.5% above the top end of guidance and consensus. There’s a few important factors to consider here.
1) First off, remember that two points of growth were pulled forward into 1Q. That’s in our estimates.
2) This is the first full quarter where the Flatiron store in NYC will be pulled out of the comp base. That’s meaningless as it relates to Sales contribution. In fact, the store is a positive for the top line because the newly renovated store can begin to boost revenue. But it is the most productive store in the whole fleet (we think it accounts for 5-7% of sales) and it will no longer be part of the reported ‘comp’. We think we have this accounted for properly, but if our 21% comp proves wrong, we think this is the most likely factor.
3) The late source book launch this year, shallow inventory buy to support the product refresh, and extended fulfillment windows could push revenue for orders booked in 2Q into 3Q. Similar to last year where the 2Q brand comp of 29% was bookended by a 40% brand comp in 1Q and 38% brand comp in 3Q. We think we have this factored into our model appropriately, but it is a part of the model where we could revenue shift between 2Q and 3Q.
4) We think that the on-line business looks solid. Based on the strength we’ve seen in our e-commerce index over the past few months, it is clear that RH is drawing a lot of incremental interest to its web site. This synchs with the timing of its sourcebook, so it is to be expected from where we sit. But the company is clearly executing well in driving its online strategy in conjunction with selling product in physical stores.
Gross Margin: This is the area where we’re probably the most aggressive in our model, with a 200bp improvement vs last year. A couple points…
1) Last year margins were down 250bp due to significant pricing actions, and we don’t think RH is anywhere near as aggressive this year.
2) A quick point on Order Fulfilment: RH does not get paid by customers until the product is delivered. As such, Fulfillment is the key to revenue recognition. We think the company is in a much better position this year to fulfill orders than LY for two reasons. a) Inventories are in a much better position to meet demand headed in to 2Q. The sales to inventory spread (sales growth – inventory growth) was -11% in 1Q14 compared to +3% in 1Q13. b) The company has added over 1.2mm sq. ft. in DC square footage, an increase of over 30% since 2Q13. That should help alleviate some of the shipping bottlenecks attributed to the once per year product refresh.
3) Dead Rent will start to be an issue. It should not start to deleverage occupancy until 3Q, but these deals are definitely in constant flux. We wouldn’t be shocked in the least to see it opportunistically take control of certain properties earlier than expected to give it room with construction. This shows up entirely in COGS. But to illustrate, a property line Denver/Cherry Creek will be about $2mm in rent per year. An extra quarter is $500k, or about a penny a share.
SG&A: Not a ton of moving parts here. We have SG&A growing at 20% this quarter, a rate that we have accelerating throughout the year as the real estate plan plays out and the company laps its change in Source Book strategy. Our math suggests that RH will spend an extra $52mm this year on its 3,200 page Source Book, but that will be amortized over a 12-month time period. Most of the year-over-year increase will be recognized in the back half of the year. One thing that’s worth noting is that we’re only modeling 54bps of SG&A leverage. That’s the smallest SG&A leverage rate RH will have achieved since 3Q11. In other words, we think our estimate is on the conservative side.
We think that sentiment factors are checking out for RH. Consider that the stock popped on the last earnings print but has actually traded down 12.2% since the June 30 peak, compared to a 2.4% gain for the S&P. In fact, our Sentiment Monitor looks abysmal for RH. This combines both sell side ratings and short interest, and the simple fact is that Sentiment for RH has never been worse. It is almost entirely driven by elevated short interest, which stands at 7.4mm shares – an all-time high. It’s up modestly since RH priced its convert, which makes sense as people buy the convertible and simultaneously short the equity. But the fact remains that 20.7% of the float is currently short. We’ll take the other side of that. In addition…
- When Williams-Sonoma guided down for 2H, it definitely sucked some of the air out of the momentum sail for RH. RH lost 6.8% since the WSM miss – even though most of the factors were WSM-specific.
- Though not a traditional peer, RH traded down when Kate Spade put up an otherwise spectacular quarter, but the stock was crushed due to a poorly communicated message regarding long-term outlook. Our sense is that from a PM’s perspective, these names are pretty much in the same bucket. Consumer discretionary, momentum, significant operational leverage, high multiple. We had several calls that week from people afraid that RH was going to be the next KATE.
Takeaway: Here's a quick look at some of the top videos, cartoons, market insights and more from Hedgeye this past week.
Contributor Call: Short iRobot Says Spruce Point Capital's Axler
Hedgeye CEO Keith McCullough talks to Seeking Alpha Contributor and Spruce Point Capital's Ben Axler about Axler's high conviction short idea, iRobot. It's the first video of a partnership between Hedgeye and Seeking Alpha.
(This is the opinion of Ben Axler of Spruce Point Capital and does not necessarily reflect the opinion of Hedgeye Risk Management).
O'Rourke: Beware of Bear-Mageddon
Hedgeye CEO Keith McCullough sits down with JonesTrading Chief Market Strategist Mike O'Rourke, one of the last remaining bears on Wall Street, in the latest installment of Real Conversations. O'Rourke contextualizes the current bubble, warns of a coming "bear-mageddon" scenario, and addresses the waning effectiveness of QE.
Burn, Baby Burn!
Now that they've all cut to 0%, what happens when we go into the next global recession?
Russian President Vladimir Putin tries to be the global ringmaster.
A Monetary Paradox? #ECB Deposit Rate
#CONSUMERSLOWING (Look A Little Closer)
POLL OF THE DAY
Who's Right On Bonds? Tepper or McCullough?
It's “the beginning of the end of the bond market rally," hedge fund manager David Tepper, told Bloomberg Thursday following the ECB's decision to adopt stimulus measures. After starting 2014 at 3%, the yield on the ten-year fell to less than 2.4% during the summer and is currently trading near 2.41%. Hedgeye CEO Keith McCullough has been one of only a few advising investors that yields were headed lower and to buy bonds. What do you think?
Gisele (Under Armour) vs. Miranda (Reebok)
Which one of these endorsements below is more likely to win a woman’s athletic apparel dollars: Under Armour/Gisele, or Reebok/Miranda Kerr?
Takeaway: Current Investing Ideas: EDV, FXB, GLD, HCA, HOLX, OC, OZM, RH and TLT.
Below are Hedgeye analysts’ latest updates on our nine current high-conviction long investing ideas and CEO Keith McCullough’s updated levels for each.
We also feature three recent institutional research notes that offer valuable insight into the markets and the global 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.
- "Trade" is a duration of 3 weeks or less
- "Trend" is a duration of 3 months or more
- "Tail" is a duration of 3 years or less
CARTOON OF THE WEEK
Staying Long TLT; Adding EDV
(We added EDV Vanguard Extended Duration ETF to Investing Ideas on Friday.)
What an awesome week it’s been for bond bears. In addition to the -2% decline for the iShares 20+ Year Treasury Bond ETF (TLT) and the -3.6% decline for the Vanguard Extended Duration Treasury ETF (EDV), a new leader emerged amongst the consensus bond bear lobby – legendary hedge fund manager David Tepper.
While Tepper’s returns since 2009 have been nothing shy of brilliant – as any levered-long equity fund’s returns should be – we don’t think it pays to get caught up in the emotion of it all and sell your bonds here.
Specifically, the data would support actually adding to safe, long-duration assets here. Looking to the brutal AUG Jobs Report – which was appropriately foreshadowed by misses in the ADP Employment Report and Initial Jobless Claims – we see that:
- Nonfarm Payrolls slowed to a pace of +142k MoM from a revised +212k pace prior
- Private Payrolls ticked down to +134k MoM from a revised +213k pace prior
- Average Hourly Earnings and Average Weekly Hours held flat at 2.1% and 34.5, respectively
Our backtest studies show long-duration Treasuries rally strongest when domestic economic growth slows – which is precisely the outlook we have for the US economy in 2H14.
Layer on economic weakness and fears of deflation in the Eurozone, and you have a potent cocktail for declining interest rates here in the US. In particular, we’ve found that long-duration German Bund yields, long-duration French OAT yields and medium-duration German breakeven rates have explained 56-75% of the rate of change in 10Y Treasury yields over the trailing intermediate-term duration.
In short, buy bonds; nothing has changed fundamentally.
FXB: The GBP/USD is down around -1.7% on the week, beat down on a couple factors:
- Increasing support for Scottish independence. A YouGov poll out on Monday showed a mere 6 point spread to “no” versus a 22 point spread in early August. The expeditious closure of the gap caught us by surprise, although our outlook remains that the populous will vote down independence.
- Marginal strength in the USD. European Central Bank President Mario Draghi cut rates and signaled that the ECB is willing to lever up its balance sheet to 2012 levels, or to the ~ €3Trillion versus the current ~€2Trillion.
Otherwise, data out this week was mostly bullish for our positioning:
- The Bank of England (BOE) kept rates unchanged at 0.50% and the asset purchase target unchanged at £375B
- UK August BOE/GfK Inflation (next 12 months) indicated higher inflationary conditions, to 2.80% versus 2.60% prior
- UK Construction PMI rose to 64.0 in August vs 62.4 prior; Services PMI rose to 60.5 in August vs 59.1 prior; and the Composite rose to 59.3 in August vs 58.6 prior
- UK Car Registrations rose to 9.4% in August Y/Y vs 6.6% prior
As a reminder, our positioning in the cross remains based on what we see as relatively healthy underlying fundamentals for the country into 2H (to drive strong UK = strong Pound), versus our forecast for decelerating growth trends in the U.S. and Eurozone, combined with dovish policy expectations from central bank heads Draghi and Fed Chief Janet Yellen.
Recent BOE Minutes showed that for the first time in more than three years there were 2 votes to increase interest rates (by 25bps). We expect this marginally more hawkish tone taken together with the outperformance of UK growth over the US and Eurozone in 2014 to push the GBP/USD higher.
GLD: Gold has been in a BULLISH set-up on an intermediate-term TREND duration for all of 2014. Draghi proved his ability to move the Euro this week and Gold broke its $1271 TREND Line of support this week on the back of the ECB’s rate cut on Thursday:
- Benchmark Rate: cut from 0.15% to 0.05% (0.15% est.)
- Marginal Lending Facility: cut from 0.40% to 0.30% (0.40% est.)
- Deposit Facility: cut from -0.10% to -0.20% (-0.10% est.)
With growth slowing in both the U.S. and Eurozone, most of the commentary into the ECB decision this week echoed speculation as to how soon the ECB would implement a quantitative easing type program. Of importance is that Draghi and the policy committee does not yet have the authority to implement a broad-based asset purchase program. The policy path to a further rate cut was largely unexpected but it was one of the tools readily available to prove Draghi would standby his “anything it takes” rhetoric.
With the ECB moving to devalue, Yellen will get her chance next to play the FED hand at the FOMC’s policy meeting in two weeks. If Friday’s non-farm payrolls (NFP) report is any indication, she certainly won’t surprise consensus macro she’ll be easing up on the QE pedal any faster than already expected.
- Change in NFP: +142K for August vs. +230K estimate (+209K prior)
Gold and bonds catch a bid on the number as growth continues to slow on the margin in the U.S. The reactionary policy response is straightforward, and Yellen will have the next formal stage chance to talk the dollar down at the FOMC policy meeting in two weeks which would be bullish for gold on the margin:
- Currently below its $1271 TREND Line (previous support)
- The move below $1271 would have to hold for confirmation: GOLD CURRENTLY NEUTRAL ON A TREND DURATION
HCA: In meetings this week at sell-side conferences, hospital executives have apparently been talking about a sequential slowdown in volume, which we’ve heard from some people who met with companies.
Universal Health Services (UHS) made headlines during a 2-day selloff in the group talking about a third of their strength in recent quarters coming from the ACA. That was taken to mean that Affordable Care Act (ACA) had led to an early 2014 bonus of patient volume, but also that 30-40% of the volume upside would fade in the second half. When we listened to UHS’s presentation at the Baird conference, we heard a more positive outlook than what the stocks were reflecting on big volume down moves. We thought Steve Filton, as usual, sounded measured and reasonably positive.
Then, moving over to the HCA presentation, we heard what can only be described as a continuation of their positive commentary from 2Q14. So are volumes soft and getting weaker? Our macro overlay work suggests that the positive environment that really began back in 3Q13 is continuing. But as always, we’re monitoring trends and looking for reasons to change our mind.
The only negative we’ve seen is in a monthly trend for US ICD volume, key for high margin cardiovascular cases and revenue trends for companies such as BSX , MDT, and STJ. But our initial take will be to look at the short side there and stay long HCA.
Our survey data is in which will give us a look at maternity and patient volume trends. More later.
HOLX: Our OB Survey data for August/September came in this morning. It shows patient volume declined in August and year-over-year pap trends were down an adjusted -17%.
In meetings with clients this week, we heard that the CEO is making some strongly positive comments about reducing their tax rate significantly near term. It's something they have commented on publicly, helps earnings, but is not part of our thesis. We just don’t think people pay a multiple for below the line upside, they pay for revenue growth.
In that light, out Tomo Tracker update was very soft for August. After converting a record 35 facilities in July, we found only 15 new facilities in August, almost a record low. What may explain the slowdown, however is the approval of GE’s 3D system. News of upcoming approvals are often previewed to customers, and telling prospects to hold off is a likely possibility.
But the better news in GE’s approval is what we’ll see when CMS releases their revised mammography codes in November. A big reason it has taken so long for CMS to revise their codes and possibly add reimbursement for 3D scans, was the absence of GE on the market. With both players approved, a major political hurdle is off the table. It's still a big uncertainty what if anything 3D scans will receive in excess of a normal mammography. We’re hopeful there is at least a modest bump for 3D which can drive significant adoption. A slow august is concerning….but more later.
OC: As we have mentioned in previous notes, a more favorable environment stemming from economic indicators may be a tailwind in the back half of 2014 for Owens Corning. We are now seeing some encouraging signs from some recent economic data.
This week the Census Bureau’s construction spending data came in favorably for July. Total construction spending increased 8.2% year-over-year, while total private spending increased 10.9%. More importantly, total nonresidential spending increased 8.6% year-over-year and sequentially 2.5% led by lodging, office, power, and manufacturing segments. Private nonresidential spending increased at 14.1% year-over-year, while private residential spending increased 7.6% year-over-year.
OZM: Financials analyst Jonathan Casteleyn has no update on Och-Ziff.
RH: Restoration Hardware is set to report earnings on Wednesday, September 10 after the close. For the quarter we are at $0.77, 20% higher than consensus.
Here are some factors that we think about as it relates to the print. 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.
- Buying shallow. When the company launches a Sourcebook, it usually does so with a redesigned product line, which is exactly what it did with its goliath 16-lb book that was distributed to customers via UPS from mid-May through early-June. But given the ever-growing breadth of RH’s product line – the company has a tendency to go very shallow with inventory around the book. The strategy is simple…let consumers tell you over the course of 2-3 months which items they like the best, and then go very heavy on inventory for those items in the subsequent three quarters. That means that growth will be more heavily weighted towards the back half of the year. For the year, it is a strategy that clearly maximizes gross profit dollars and ROIC. But there could be a shift between 2Q and 3Q.
- Deferred Revenue. The RH-haters out there love to talk about the company’s deferred revenue as customers wait 10-weeks or more for custom items (keeping in mind that RH does not get paid until the customer takes delivery). In 2Q14 we could see an uptick in deferred revenue around non-custom items due to the strategy around buying shallow that we outlined in point #1. It could provide ammo for those RH bears who want to poke holes in the company’s revenue recognition. We’re not worried about the economic reality -- but just the perception based on how some people will take it.
- Margin Weakness. With any new assortment, margins will usually be lower given that the company will not have hit its own costing hurdles to lower its COGS (cost of goods sold) on high volume. The margins will be better on the product 3-4 quarters out when RH focuses its inventory spend on key items and gets additional volume discounts. Initially, it will be buying some items that might not be as popular as it otherwise planned. That leads us to think that there’s the potential for a margin ramp throughout the year.
- Dead Rent. RH is officially in growth mode. It opened the Greenwich store successfully in May and the Flat Iron store in NYC in June. Then there’s Atlanta and Chicago in 2H followed by a meaningful acceleration in 2015. It takes between 6 to12 months to complete a store. The bigger the store, the more time it will take. And make no mistake, the stores are getting bigger. While the company is overseeing construction, it is paying rent – and a lot of it. It’s known as Dead Rent, and it has never been a part of the RH equation as it has been in store shrinking mode. But there will be a meaningful ramp in rent over the next 12-18 months, and we’ll see some of it this quarter. The company is getting great deals, which helps. For example, the Greenwich store just opened up at $1.1mm in annual rent. That seems like a lot, but it is replacing a store up the street that is one-third the size where they pay $1mm in rent. That’s only $100k extra for about 15,000 extra square feet. The ROI is astounding. But as it relates to quarterly occupancy costs, there is clearly some overlap. We think we’re accounting for all this correctly. But it is an area where we could be wrong on the near-term earnings flow.
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We hosted an expert call recently with Judith Gaines of J. Gaines Consulting featuring her fundamental, non-consensus call that the outlook for Brazil’s crop into 2015-16 is much worse than expected.
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