TODAY’S S&P 500 SET-UP – September 10, 2014
As we look at today's setup for the S&P 500, the range is 17 points or 0.32% downside to 1982 and 0.53% upside to 1999.
CREDIT/ECONOMIC MARKET LOOK:
- YIELD CURVE: 1.96 from 1.95
- VIX closed at 13.5 1 day percent change of 6.64%
MACRO DATA POINTS (Bloomberg Estimates):
- 7am: MBA Mortgage Applications, Sept. 5 (prior 0.2%)
- 9:45am: Bank of England’s Carney speaks in Parliament
- 10am: Wholesale Inventories m/m, July, est. 0.5% (prior 0.3%)
- 10:30am: DOE Energy Inventories
- 1pm: U.S. to sell $21b 10Y notes
- 9:30am: Senate Homeland Security Cmte hearing on Islamic State terrorism and cybersecurity
- 10am: House Ways and Means Chairman Dave Camp, R-Mich., CEA Chairman Jason Furman speak at “Tax Reform: Lessons Learned and the Path Forward” discussion at Business Roundtable
- 12:30pm: Rep. Mike Fitzpatrick, R-Pa., holds conf. call on legislation introduced to “squeeze” financial assets of Islamic State
- 2pm: House Financial Services subcmte holds hearing on credit reporting system
- 9pm: President Obama speaks to nation from White House about strategy to degrade, destroy Islamic State terrorist group
- U.S. ELECTION WRAP: Presidential Failure; Udall Misstep; Ads
WHAT TO WATCH:
- Microsoft said to near $2b deal to buy Minecraft maker
- Dollar General will make hostile Family Dollar bid, Reuters Says
- EU weighs more Russian sanctions amid fragile Ukraine cease-fire
- TransFirst said to draw interest from TSYS after IPO filing
- Sprint CEO deploys ‘IPhone for Life’ plan to win back customers
- Hertz seen taking $200m writedown on aging vehicle fleet
- Detroit reaches Syncora deal that may change bankruptcy plan
- Vivendi said to eye Italy comeback via Mediaset pay-TV stake
- China said to consider letting car dealers sell multiple brands
- Japan’s Recruit plans $1.7b IPO to fund deals, expansion
- AngloGold raising $2.1b amid international split plan
- Ferrari chief Montezemolo steps down after clash with Fiat
- Empire Co (EMP/A CN) 7:31am, C$1.35
- Five Below (FIVE) 4:01pm, $0.14
- Lands’ End (LE) 7am, $0.17
- Men’s Wearhouse (MW) 4pm, $1.06
- Restoration Hardware (RH) 4:02pm, $0.64
- Vera Bradley (VRA) 8am, $0.19
- Wet Seal (WTSL) 4:05pm, $(0.15)
COMMODITY/GROWTH EXPECTATION (HEADLINES FROM BLOOMBERG)
- Industrial Metals Extend Drop on China Concern and Dollar Rally
- Brent Trades Below $100 for Longest Run in 16 Months on Surplus
- Steaks for Argentines Mean EU Diners Eat Uruguayan: Commodities
- Philippine House Ore Export-Ban Debates Unlikely Until Late 2015
- Corn to Soybeans Trade Near 4-Year Lows on Record Crop Outlook
- No Named Storms First Time in 22 Years as Hurricane Season Peaks
- White Sugar Declines for Fifth Day as Arabica Coffee Rebounds
- Former Obama Aide Summers Backs End of U.S. Crude Oil Export Ban
- Olam Hires Alex Tan as Head of Palm Oil Trading From Golden Agri
- Goldman Calls End to Iron Age After ‘Dramatic’ Drop in Ore Price
- Gold Is Little Changed Near Three-Month Low on Stronger Dollar
- Ivory Coast Cocoa-Growing Areas Got Increased Rainfall Last Week
- China Province to Cut Irrigated Wheat to Save Water: Heibei News
- Philippine Ore Ban Bill Not Priority for President, Senator Says
The Hedgeye Macro Team
Takeaway: Great category, solid brand, weak company, and a horrendous mgmt team. But in the $30s, we think there are more ways to win than lose.
We like LULU, but it is not for the typical reasons we traditionally look for in a long. We added the name to our best ideas list on June 15 because of our view that things were so pathetically bad at LULU, that it would lead to positive change. Add on what we thought was capitulation by the sell-side (LULU currently has its lowest Buy ratio in history), and very defendable downside in the low-mid $30s due to attractive LBO/acquisition math, we think that this is ripe for a restructuring. Even most LULU bears would probably admit that this is a very strong brand in a superior category with global appeal – they’ll probably just argue that the competition is too fierce and LULU is ill equipped to face it head-on. We actually agree with that logic. That’s why it needs to be changed radically from what we see today. Yeah, John Currie is on his way out as CFO – that’s a plus. Also, Chip Wilson sold half his stake to Advent, and we think that the rest of his stake is on the way out. But, we think the change we’ll see will be a lot bigger than that. The problem is that this is a global mid-cycle growth company approaching $2bn in sales, but it has a management team that is appropriate for a sub-$500mm localized brand.
As for what’s next on the ‘change agenda’, we think that the speed of change depends on the company’s own financial results. If the next couple of quarters pan out as we think – which is not very good – then we think the most probable outcome is that the Board fires Laurent Potdevin – the CEO it hired just 8 months ago. He’s simply not the right guy for the job. Never was, and never will be. He’s only led small brands like Toms and Burton, but he simply does not have the skill set to make LULU a great global brand with efficient operations across multiple distribution channels. Our view is that the only reason the Board approved Laurent is because Chip simultaneously agreed to give up his Chairman title if Potdevin was named CEO. That move left Wilson powerless (no Chair, no CEO, no majority, NO power), which led to him unwinding his stock. It also suggests that the Board is not married to Potdevin, and we think it will make the right call in replacing him if need be. We think that there’s an 80% chance that Potdevin is gone in a year’s time.
There are a lot of other changes as well beyond human resource management. Other changes should be made regardless of who is at the helm – like developing a competitive pricing process. LULU is the worst company that we’ve seen in many years when it comes to appropriately changing the prices on its product as the selling season progresses. It needs the information systems, potentially physical outlets, and definitely a more sophisticated system to sell aged inventory online and ship directly from stores. And yes, it might even need a wholesale model. These are all decisions that should be vetted by the management team LULU deserves – but does not have.
So basically, if trends weaken further and it is clear that this management team cannot create value and grow this business profitably, then we think we’ll see a completely new executive team put in place to make it happen. Advent did not buy back 14.8% of LULU for $845mm after all these years to passively watch it die on the vine. So in this case, we think Bad News = Good News. If by chance (and we think it would be sheer luck) that this management team gets this engine running, then that’s probably good for the stock as well. Good News = Good News.
We’re very careful about these ‘things are so bad that it’s good’ calls, because they usually have a way of missing even lowered expectations and destroying value. But that mattered to us when the stock was near $70, and even earlier this year when it was in the $50s. But with the stock in the high $30s, sentiment worse than it has ever been (EVER is a long time), and value investors increasingly coming out of the woodwork exploring with us what the trough earnings number is for LULU (it’s $1.50, by the way), we’re simply not as concerned at current levels. Could it trade down on horrible print? Yes, but we think things are bad, not horrible. In a perverse way, we’d like to see LULU faceplant this quarter. Because we don’t think the equity market would punish it commensurately to the economic impact of the miss itself, but it would be an event that would likely cause the Board to shake things up. Ultimately, there is $4bn in revenue to be realized here – likely at a high-teens margin. That’s $3-$3.50 in EPS power. At $38, that’s 11.6x earnings, and 7.5x EBITDA. Sounds pretty defendable to us. We just need a team in place that can deliver.
THINGS TO CONSIDER FOR THE QUARTER
- In LULU’s 28 quarters as a public company it has beat estimates 27 times by an average of 16.5%. Over the past 8 quarters the average beat was 7%. There have been pre-announcements and guide downs along the way, especially over the past 12 months, but in general LULU doesn’t miss.
- Luon Recall was 3/18/13 and Luon was back on shelves 6/4/13 about a month into the 2nd quarter last year
- Chip comments on Bloomberg fell at the start of the 4th quarter (11/5/13)
- Internet traffic rank which takes into account organic visits and page views per visit was up 25% relative to all other sites on the internet.
- Monthly traffic improved sequentially in June and July from trough levels in May and was up 68% in the quarter. A 2000bps improvement sequentially from 1Q14. The improvement could be driven by LULU jamming more inventory through the e-pipe. That could have negative margin implications, or if it does not result in better e-comm sales it could simply mean that the company did a lousy job converting. But the trends initially look decent.
Gross margin – key negative driver here are product margins
- Over the past 5 quarters (1Q13 -1Q14) product margins have been down by 90bps, 220bps, 220bps, 270bps, and 310 bps respectively. Two year comp in 1Q, -200bps. Management guided margins down another 300bps for the upcoming quarter that would assume product margins down 200bps, 50bps from fx, 30 – 40bps hit from new Ohio DC. Much of deleverage comes from mix away from core to seasonal which has lower IMU due in part to inefficient supply chain and inventory chase.
- Investments listed below and 14 pop-up shops adding an incremental $10mm in SG&A
Near term stop gap measures intended to drive ‘traffic and sales’. These all seem weak at best. But it’s what LULU has called out.
1) Allocating additional floor space to men’s at store locations in Santa Monica, Vancouver, and Miami
2) London – on track to do in excess of $2,200 per square foot in year one
3) A social media platform focused on Brand Ambassadors
4) In-store tablets allowing guests to shop online inventory
5) Paid search advertisement
6) 14 pop up shops across the US and Canada open from April through September
Long term (these make more sense to us, but only partially address LULU’s problems)
1) Additional 120 stores to be added across North America
2) 40 international stores (20 Europe, 20 Asia) by the end of 2017 in addition to anything added on top of 30 store base in Australia and NZ
3) Go to market calendar – Spring/Fall 2015
4) Rebalance of core and seasonal product – Starts in 2H14 but won’t be fully implemented until 2Q15
5) Revamped product engine – 1Q16
Getting within spitting distance of management guidance for the quarter is not terribly heroic. To get to the mid-point of guidance and in line with consensus for the quarter calling for revenue of $375mm - $380mm and EPS of $0.28-$0.30 we need to assume the following…
1) Revenue growth of 9.6%. Square footage growth of 20% YY, -4.3% consolidated comp (-9% store and +22% DTC).
2) Gross margins down 300bps and flat sequentially from the first quarter on the 2yr trend line
3) SG&A up 25%, implying 440bps of deleverage
4) EBIT margins down 738bps YY.
5) EPS growth of -26%
A little tougher to get to annual guidance. To get to the mid-point of guidance and in line with consensus for the full year calling for revenue of $1.77bil - $1.80bil and EPS in the range of $1.71-$1.76 we need to assume the following…
1) Revenue growth of 12%. Square footage growth of 18%. Flat consolidated comps (-5% store and +24% DTC).
2) Gross margins down 170bps to 51%.
3) SG&A up 24%, implying 300bps of deleverage
4) EBIT margins down 465bps
5) EPS growth = -10%
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Please see the conclusion of this note for recent changes in the expectation of supply-side dynamics in the base metal complex.
Indonesia’s move to ban the exporting of unprocessed minerals in January has undoubtedly helped propel nickel prices +~40% YTD:
- Indonesia previously the largest exporter of nickel ore
- Decrease of ~$3Bn in annual exports
- Indonesia previously accounted for 1/5th of global supply (largest producer)
- China and Japan were two largest buyers:
- China consumed 47% of nickel produced globally in 2013
The Indonesian government has no plans to lift its ban of unprocessed nickel ore. Jakarta believes producing, refining, and smelting domestically will be much more lucrative moving forward. Miners have now been forced to develop this capacity:
A report from Indonesia’s Investment Coordinating Board indicates they are in fact investing in the second-leg of the production process:
- $8Bn spent to build three alumina refineries and two ferronickel projects
- 102 Nickel Smelters in the process of being constructed
On August 28th we published a note outlining the new exemptions created for the exporting of unprocessed copper bauxite, but Jakarta doesn’t appear willing to move in the same direction for nickel:
With the Nickel Ore supply from Indonesia cut-off, both China and Japan were forced to turn elsewhere for raw minerals:
- Chinese imports of nickel ore from the Philippines have more than tripled since Indonesia’s ban
- The Philippines is now the LARGEST Nickel Ore supplier to China
- THE Philippines has supplied 61% of China’s unprocessed nickel ore for pig-iron production YTD; iron ore can also be used
- Pig iron a common ferrous metal used by the steel and metal casting industries
On August 27th the Philippine House Natural Resource Committee proposed a bill to ban raw mineral exports following Indonesia’s move in January. The logic for the proposal echoes Jakarta’s reasoning in that building the infrastructure for the domestic capacity for the second-leg of the production process is a more lucrative venture than just exporting the raw mineral itself.
Congressman Erlpe John Amante estimated Indonesia’s revenue from exports would triple if miners were forced to refine the raw minerals (implement this second stage of the production process).
The speculation fueled heavy buying late last week:
Thursday (09/04): +2.85%
Friday (09/05): +1.67% on volumes +34/51/46% above 1/3/6-month averages
Monday (09/08): +92bps on volumes +26/39/34% above 1/3/6-month averages
The market pulled back significantly late in the day London time after a statement from Jakarta (-4.9% in late trading):
- Philippine congressman Erlpe John Amante stated today that a mineral ban may not actually be in place for an estimated 7 years
- 2 years before proposed bill is put into law
- 5 Year reasonable grace period for miners to adapt
THE INDONESIAN EXAMPLE….
- Indonesia moved to pass the bill in 2009 which gave the government the POWER to implement the ban which
- Most miners wrongfully assumed the bill would not be signed into law
- The move in January forced the necessary cap-ex and infrastructure spending. As mentioned above, this is now happening with the 102 Nickel smelters now being developed across Indonesia
CONCLUSIONS: THE QUANT SET-UP REMAINS BULLISH IN THE BASE METALS COMPLEX
1) QUANT: The quant set-up is the most bullish of all commodities in TACRM, and we will continue to manage the risk of the range with a bullish intermediate-term TREND bias on the China catalyst.
2) LONG-TERM: Late cycle cap-ex spend from miners will continue bringing an increasing supply of copper, nickel, and iron ore that will have to be met with a sustained increase in demand (China in particular).
- The implementation of a nickel ore export ban from the Philippine government appears less threatening on the margin over the next several years
- Chinese coal imports hit 18-month low in August (China consumes 1/4th of coal globally)
- Chinese iron ore Imports from Port Hedland, Australia reach a record 32M tons in August in as BHP and Rio Tinto increasing production
- Indonesia lifts the ban of unprocessed copper ore bauxite:
- A shipment of 10,000 tons of copper concentrate left Indonesia for China on Aug. 8
- Meanwhile more of a push elsewhere to diversify supply lines:
- China’s MMG closed on a $7Bn acquisition of the Las Bambas copper project in Peru in July
- Chinese backers are now behind one-third of all Peru’s new mining investments by value
Please feel free to ping us with questions or additional color.
Takeaway: Decline in NFIB Hiring agrees w/ the sequential deceleration in the NFP and ADP data in Aug. Measures of labor slack continue to tighten.
We discussed the burgeoning divergence between actual consumption and capacity for consumption yesterday >> FIVE-FECTA: CONSUMER CREDIT GROWTH ACCELERATES (AGAIN) IN JULY
Today’s small business confidence and labor turnover data reflected sequential deceleration in employment, agreeing with the sequential declines reported in the ADP and NFP releases for August.
Meanwhile, measures of labor slack continue to point toward ongoing, albeit slow, tightening in labor market conditions – lending some incremental support to the emergent view of supply-side barriers to hurdling secular stagnation.
NFIB/Employment: Headline Small Business Confidence increased for a second consecutive month, rising +0.4pts in August. Job Openings and Outlook for General Business Conditions led the upside but Hiring Plans and Sales Expectations dropped -3 and -4 pts, respectively.
Private payroll growth continues to run ~2%+, which matches peak growth in the last cycle and may be as good as it gets given the demographic and labor supply headwinds and the secular slowdown in employment growth over the last 30 years.
(Declining) SLACK: Both the Jobs Hard to Fill and the Compensation Indices rose to new cycle highs in August (NFIB data) while Total Job Openings, Total Hires, and Quits moderated sequentially but held at 13 year highs in July (JOLTS data).
Further, the share of short-term unemployed continued to rise in August while labor supply (total available workers per job opening) remains just north of pre-recession averages.
In short, while signs of moderate sectoral shift and employment hysteresis remain, the labor market remains moderately tighter than the FED officialdom gives lip service to.
Whether the acceleration in hourly earnings for nonsupervisory and production employees to a 4-year high of +2.5% in August is evidence of that tightening being passed through in the form of accelerating wage inflation remains TBD.
Cycle Accounting: Historically, over the last half century, initial claims and peak monthly NFP gains have led the peak in equities and the peak in the economic cycle by 3 months and 7 months, respectively.
Whether the recent trough in claims in early August or the Apr-June NFP gains represented peak improvement in those measures remains to be seen, but it’s worth monitoring given the fairly consistent temporal sequence in the labor --> equity market --> economy over the last half century.
Christian B. Drake
Takeaway: It's all fun and games and pink fluffy unicorns until the music stops.
In the latest sign of our hyper-valued, bubbly marketplace, we give you EBates...
- "Rakuten Inc. agreed to buy U.S. rebates website Ebates Inc. in Japan’s largest e-commerce deal as the operator of the country’s biggest online mall seeks overseas growth through acquisitions."
- "Rakuten will pay $1 billion in cash for all of Ebates, it said in a filing to the Tokyo Stock Exchange today. San Francisco-based Ebates offers cash rebates to customers who buy products ranging from laptops to lipsticks from the website’s retail partners."
- "Rakuten’s billionaire chairman Hiroshi Mikitani is betting the purchase will help the Tokyo-based company push its global e-commerce strategy. Rakuten has also been plowing cash into technologies such as mobile applications and online video as it seeks to add to its online marketplace business."
There are no direct public company implications here. But the simple fact that a Japanese company is buying an early cycle, non-asset-based US e-tail startup for $1bn in cash is pretty much huge any way we slice it.
In order of magnitude, this is like when Amazon bought Zappos for $928mm six years ago -- near the top of the last cycle. Except for the fact that Zappos actually had a brand... And a loyal customer base... And warehouses... And suppliers... And revenue...
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