Shipbuilding Short Update: Sinking Far From Port



We typically introduce the Hedgeye Industrials research process using the shipbuilding cycle and industry structure as an illustration.  The discussion typically goes something like “after WWII, war related tonnage was converted to commercial use, but ships last for only, give or take, 30 years, so there was a replacement cycle in the mid-1970s”…and so on.  But shipbuilding is not just an example of a capital equipment cycle and a flawed industry structure, it has also been, and will likely continue to be, a once in a career short opportunity


Shipbuilding Short Update:  Sinking Far From Port - shi1



Beyond the Fishfinder updates, we have only written on shipbuilding occasionally because not much happens that is relevant to our thesis.  Basically, our view is that shorting South Korean shipbuilders should work for several years; the next move for investors is to buy Chinese shipbuilders in roughly 2030 (only partly kidding).  Recently, however, there has been more action.



Industry Structure: Extremely Fragmented, Government Subsidized

Shipbuilding Short Update:  Sinking Far From Port - shi2


We focused on Samsung Heavy in our launch deck and subsequent notes because it had fewer non-shipbuilding exposures.  Samsung Heavy shares have dropped about 45% in the past year, significantly underperforming the KOSPI.  Below, we provide some updates.


Shipbuilding Short Update:  Sinking Far From Port - shi3


Key Highlights

  • Chinese Shipbuilder ‘Bailout’:  Excess shipbuilding capacity has largely been of a massive ramp in Chinese capacity.  To us, it has become clear that China isn’t exactly planning to layoff shipbuilding employees.  For instance, the handling of China Rongsheng, a theoretically private competitor, has consisted of local government support for the company while it does a restructuring analysis due in mid-2015.  Apparently, the government is looking to merge the shipbuilder with a financially stronger competitor at some point, but maybe not.  This is consistent with our view that the industry is more of an employment project than a viable profit center.  Excess Chinese capacity will likely continue to weigh on industry pricing.

Shipbuilding Short Update:  Sinking Far From Port - shi4


  • Pressure on Margins, Pricing:  SHI’s orders have been below management expectations this year and excess capacity has pressured industry pricing.  Given the intense competition in standard ship categories, Samsung Heavy and others South Korean builders have competed for complex offshore energy-related orders (drill ships, FPSOs, etc).  Unfortunately, the margin on these complex ships has been poor. Costs and schedules have proved more difficult to forecast than those of more traditional products.  As a result, SHI’s margins have suffered so far in 2014.  We would expect that earlier orders in backlog carry better pricing than current orders, setting the stage for ongoing margin pressure.

Shipbuilding Short Update:  Sinking Far From Port - shi5


  • Not Just Samsung Heavy:  Obviously, Chinese shipbuilders are experiencing stress, but other South Korean firms have also seen margin degradation.

 Shipbuilding Short Update:  Sinking Far From Port - shi6


  • Last Time It Took 13 Years To Bottom:  The global shipping fleet is young, having just completed a replacement cycle.  Energy and bulk commodity prices have seen pressure in recent months, with customers in those end-markets driving demand.  We expect pricing pressure from weak demand, excess capacity, and government subsidization to depress SHI’s profitability for years.  In the last replacement cycle, deliveries peaked around 1975 and bottomed in roughly 1988.  

 Shipbuilding Short Update:  Sinking Far From Port - shi7


  • Low Profitability, Except During Peak Demand:  Aside from the boom years of the replacement cycle, shipbuilding seems more like an employment scheme than a profit-making enterprise.  

Shipbuilding Short Update:  Sinking Far From Port - shi8


  • Still Lots of Value to Lose:  Given that the South Korean shipbuilding industry has lost significant ground to Chinese competitors in the last decade, we would expect valuations to compress below pre-boom norms.  We also expect that Chinese shipbuilders will further develop capability in drill ships, FPSOs, and other more specialized vessels.

 Shipbuilding Short Update:  Sinking Far From Port - shi9


  • Prior Valuation Range:  We continue to think that our June 2012 launch deck valuation range for Samsung Heavy is still reasonable.  The shares are now below our “Best” case scenario, however, but have downside to the “Optimistic Base” case.

 Shipbuilding Short Update:  Sinking Far From Port - shi10


  • Over-Sold & Inheritance Tax Issue:  We are not expert in the Samsung inheritance tax issue, but it seems clear that minimizing shareholder value may be a short-run priority.  The shares have declined precipitously in the past year, and it might be best to wait for a bounce to press the short or initiate a position.  The tax liability may be a fruitful topic for further analysis.
  • Overseas Plant Addition:  Samsung Heavy has announced plans to add an overseas facility in a location with lower labor costs.  Vietnam, Indonesia, and Malaysia are apparently under consideration.  The plant would cost $950 million and focus on lower value ships.  In an industry awash in excess capacity for less complex vessels, this seems a bizarre idea at best. 
  • Merger with Samsung Engineering:  The merger with Samsung Engineering, an engineering & construction company with exposure to the Energy sector, makes a bit more sense than the addition of overseas capacity (almost anything would).   That said, it is difficult to see how the minor cost synergies would offset the customer perception problems that may result.




We continue to believe that Samsung Heavy is, well, somewhat doomed and that the shipbuilding industry is good hunting for shorts.  While SHI may have a numerically substantial backlog, the margin on that backlog need not be good or even positive and a portion is pass-through.  SHI’s plan to add capacity and merge with Samsung Engineering looks like a strategy developed by a flailing capital intensive enterprise caught in a long downcycle.  That said, the inheritance tax issue, pressure on commodity prices, and sell-off in the shares would probably leave us looking for a bounce (like the one CAT recently completed) to press or enter a short.  While we expect the shares to eventually trade much lower, we might wait for a better short-run entry point.




(Interested readers should feel free to ping us for our earlier materials.)



Takeaway: The must-read below walks through why the preponderance of our quantitative signals support our view that the US economy is mired in #Quad4.

Keith is on the road this week visiting with customers and prospective customers in London; no doubt he’s accumulating reps at the one thing I am personally most passionate about as it relates to being some version of a sell-side research analyst: explaining why we’re different.


One of the core tenets to our process that differentiates us from our perceived competitors across the independent research landscape is our ability to consistently extract predictive color from financial markets. Furthermore, we apply those top-down quantitative signals in a reflexive manner to our bottom-up qualitative analysis (e.g. our Growth/Inflation/Policy framework) in order to generate actionable investment ideas and themes. Our process isn’t perfect, but 6+ years of growing a business with no banking, trading or asset management fees to help “keep the lights on” would seem to suggest it’s as valuable as an input to your respective processes as we’d humbly submit it is.


Today, the preponderance of the aforementioned quantitative signals support our fundamental research view that the US economy is mired in #Quad4 – which is an economic scenario whereby the 2nd derivatives of both real GDP and headline CPI are negative. If either the anticipated delta into this quadrant is meaningful or the setup is expected to last for more than one quarter, it becomes a meaningful macroeconomic headwind to the valuation of most financial assets. 




Keith’s Model Is Signaling #Quad4

For example, take Keith’s proprietary factoring of Price/Volume/Volatility data across multiple durations (i.e. TRADE, TREND and TAIL) for various asset classes and style factor exposures. If you too subscribe to the view that financial markets are leading indicators and that various periods throughout history often rhyme with the present setup, it’s easy to conclude from these signals that the market is pricing in a #Quad4 setup at the current juncture – especially in the context of our GIP Model backtest results:




























TACRM Is Signaling #Quad4

If that combination of History, Math and Behavioral Psychology isn’t robust enough for you, then let’s expand this search for quantitative confirmation to our Tactical Asset Class Rotation Model (TACRM). On this measure, there are a number of indicators that suggest the market is pricing in a #Quad4 economic scenario. To highlight a few of the most noteworthy signals:


  • Only 18% of the nearly 200 ETFs comprising the TACRM risk management system have Volatility-Adjusted Multi-Duration Momentum Indicator (VAMDMI) readings greater than 0x. You have to go all the way back to the week-ended June 22nd, 2012 to find a commensurately low proportion.
  • TACRM is generating a “DECREASE Exposure” recommendation for every primary asset class except Cash, which is comprised simply of US dollars and volatility – two things that have historically appreciated in value when investors liquidate assets or close out carry trades in order to raise cash.
  • Regarding Foreign Exchange and Commodities specifically, TACRM generated the aforementioned bearish recommendations during the weeks-ended August 29th and August 15th, respectively. The broad-based breakdowns across style factor exposures within these asset classes – and across European equities and currencies – was one of the reasons we first started to openly debate the possibly of #Quad4 back in early August.
  • TACRM is generating a “DECREASE Exposure” recommendation for even the historically defensive Fixed Income & Yield Chasing primary asset class. This is due to the fact that nearly 2/3rds of the ETFs comprising this asset class have negative VAMDMI readings.
  • To highlight the market’s rotation into historically defensive fixed income exposures, the Vanguard Total Int’l Bond Market ETF (BNDX), the iShares National AMT-Free Muni Bond ETF (MUB), the iShares 20+ Year Treasury Bond ETF (TLT) and the PIMCO 25+ Year Zero Coupon US Treasury Bond ETF (ZROZ) are the only ETFs within the Fixed Income & Yield Chasing primary asset class that have VAMDMI readings greater than or equal to +1x at the current juncture.
  • At +0.8x apiece, the S&P 500 sector SPDRs with the two highest VAMDMI readings currently are Consumer Staples (XLP) and Healthcare (XLV); that rhymes with our GIP Model backtest results highlighted above.
  • We are constantly monitoring the composition of the bottom-20 and top-20 VAMDMI readings in the broader sample of ETFs with the expectation that breakdowns and breakouts in individual markets may front-run critical inflection points in the chaotic system that is the global financial marketplace. Among the top-20 are the iShares Nasdaq Biotechnology ETF (IBB), Health Care Select Sector SPDR Fund (XLV), iShares US Pharmaceuticals ETF (IHE) and the iShares US Medical Devices ETF (IHI) at 15th, 12th, 9th and 8th, respectively. Our Healthcare Sector Head Tom Tobin was keen to remind us of the demonstrable outperformance of these sector style factors well into the summer of 2008 – just ahead of the most meaningful #Quad4 occurrence since the Great Depression. Just something to think about…










For those of you’d who’d like to learn more about TACRM and how to fully harness the power of its signals within the scope of your respective investment mandate, please review the following presentation or ping me directly ():


The Median Consumer Is Signaling Recession

Lastly, one of the things we don’t do that many of competitors anchor on is survey work. This is because:


  1. Our six-person Macro Team is flat-out better at forecasting the 2nd derivate of both growth and inflation than most corporate executives.
  2. Consensus among both corporate executives and the fundamental analyst community is almost always dead wrong at critical inflection points (e.g. early-2000, late-2007 and early-2009).
  3. Quite often, surveys tend to be an incestuous process that would generate a Circular Reference warning in the most basic of spreadsheets. For example: “Banker A” tells “CFO B” that 2015 growth will 3-plus percent; “CFO B” orders 3-plus percent worth of inventory from “Supplier C”; “Supplier C” tells “Banker D” that its order book is “off the charts”; “Banker D” relays that information to “Economist E”, who then updates his 2015 GDP growth forecast to 3-plus percent. #Magical.


That being said, we will happily cherry pick survey data that supports our fundamental conclusions when the preponderance of high-frequency economic data is not yet supportive of our forecasts as it is currently.


Given that so few investors actually analyze macroeconomic data in a repeatable and robust manner, we constantly find ourselves having to debate what we think are moot points regarding lagging indicators such as continued strength in the labor market and the 2Q14 GDP print.


So in light of that, we thought we’d use the following PwC survey data to highlight the ongoing “early cycle slowdown” Keith has being writing about all year:


  • The projected average household expenditure during the upcoming holiday season of $684 is down -6.9% YoY.
  • 84% of US households plan to spend the same amount as last year or less.
  • 72% of US households believe the economic environment is the same or worse than it was last year.
  • 67% of US households are in what PwC labels as the “Survivalist” bucket, which means they earn less than $50k annually and have budgets that are constrained by the rising cost of living. The proportion of US households that fall into this cash flow constrained category is up +200bps YoY and up +400bps from 2012.
  • 84% of shoppers cite price as the primary factor for choosing a particular retailer, up from 74% in 2013.


All told, at least 2/3rds of the country thinks we’re already in or heading into what may ultimately turn out to be a recession or, at best, a recession scare. This conclusion is very much in line with our work on the median consumer as part of our #ConsumerSlowing theme.


If you’re buying risk assets at these valuations and spreads, you better have some darn good edge on why the 1/3rd will prevent that from occurring. Refer to our #Bubbles theme for a detailed discussion of the still-egregious mispricing of many financial assets.


Investment Conclusion: Continue Rotating Out Of #Quad4 Losers and Into #Quad4 Winners

We obviously understand that most investment mandates will prevent you from raising what we perceive to be adequate levels of cash or from tilting defensively enough to weather such volatility. In light of that, we’ve created a daily product – The Hedgeye Macro Playbook – to help you better incorporate our research conclusions into the scope of your respective strategy. Be on the lookout for that 1-page summary every weekday prior to the market open.


Beyond that, we’ve put together the following list of US equity subsectors that have historically fared really well (i.e. quarterly performance in the ~90th percentile and above) or really poorly (i.e. quarterly performance in the ~10th percentile and below) in #Quad4:


    • Tires & Rubber
    • Homebuilding
    • Automotive Retail (only 6 historical occurrences)
    • Drug Retail
    • General Merchandise Stores
    • Home Improvement
    • Agricultural Products
    • Tobacco
    • Specialized Finance (only 8 historical occurrences)
    • Real Estate Services (only 4 historical occurrences)
    • Health Care Facilities
    • Managed Health Care
    • Pharmaceuticals
    • Industrial Gasses
    • Specialty Chemicals
    • Metal & Glass Containers
    • Consumer Electronics
    • Specialized Consumer Services (only 6 historical occurrences)
    • Coal & Consumable Fuel (only 4 historical occurrences)
    • Other Diversified Financial Services (only 8 historical occurrences)
    • Diversified REITS (only 5 historical occurrences)
    • Industrial REITS (only 5 historical occurrences)
    • Office REITS (only 5 historical occurrences)
    • Residential REITS (only 5 historical occurrences)
    • Retail REITS (only 5 historical occurrences)
    • Health Care Technology (only 5 historical occurrences)
    • Research & Consulting Services (only 4 historical occurrences)
    • Trucking
    • Electronic Equipment & Instruments
    • Multi-Utilities


NOTE: If any of the aforementioned GICS Level 4 industries have recorded at least 10 quarters in #Quad4, we did not include the number of historical occurrences in parenthesis; most had 14.


Best of luck out there,




Darius Dale

Associate: Macro Team

FXB: Removing the British Pound from Investing Ideas

Takeaway: We are removing FXB from our high-conviction stock idea list.

Our macro team is removing the British Pound (via the etf FXB) from Investing Ideas.


We are removing the FXB because:

  1. The best of the UK economic data (in rate of change terms) may very well be behind us
  2. The Bank of England is starting to sound less hawkish than they have for the past 18 months
  3. We encourage you to raise your Cash position and allocate to the Long Bond (TLT, EDV)


FXB was added to Investing Ideas on 8/13/2014. We’ve been offsides on our position in recent weeks, despite resilient fundamentals to support our positioning.


Going forward, should Fed policy become increasingly dovish alongside the ECB, we could return to the FXB on the long side.


FXB: Removing the British Pound from Investing Ideas - FXB

investing ideas

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.

Cartoon of the Day: Hedgeye + $TLT = Love

Cartoon of the Day: Hedgeye + $TLT = Love - TLT cartoon 10.07.2014


As the 10-year yield drops back below 2.40%, we reiterate our non-consensus, best macro long idea of the year: Long the Long Bond.


Hedgeye Reiterates Our Non-Consensus Call to Stay Long the Long Bond | $TLT

Takeaway: You down with TLT?

The 10-year Treasury yield has dropped back down to 2.39% after some hoped (prayed?) that Friday’s U.S. jobs report was going to mean they would finally get paid on the short side of bonds.


Well… not so much as the 10-year yield moves back toward full-blown crash mode (-20% year-to-date).


Long the Long Bond remains our best Macro Long Idea for 2014.


Hedgeye Reiterates Our Non-Consensus Call to Stay Long the Long Bond | $TLT - 10.07.14 TLT YTD Performance

Retail Callouts (10/7): ICSC, KATE, TGT, KSS, WMT, AMZN

Takeaway: Quantifying KATE in Hong Kong. TGT focused on the pipe, but needs to get content right. KSS rewards program is misunderstood.



Wednesday (10/8)

COST - Earnings Call: 8:30am


Thursday (10/9)

FDO - Earnings Call: 5:00pm





ICSC Same Store Sales

Takeaway: Sales trends are holding steady, with 3.9% growth for the week, and about 2.8% on a 2 and 3-year trend.


Retail Callouts (10/7): ICSC, KATE, TGT, KSS, WMT, AMZN - 10 7 chart1





H.K. Retail Chains See 50% Sales Drop, Survey Shows



  • "Sales at major Hong Kong retailer chains have fallen as much as 50 percent during the bulk of the Chinese National Day holidays after pro-democracy protests disrupted the shopping season, according to a survey."
  • "Sales dropped at least 15 percent during the first five days of the holidays known as Golden Week, versus a year earlier, the Hong Kong Retail Management Association said in a statement yesterday, citing a survey on its members. Retailers selling watches and jewelry were among the most affected, according to the group."


Takeaway: The situation in Hong Kong is clearly a concern for luxury retailers. Our biggest initial concern was Kate Spade -- that is, until we did the math.  KATE closed on the acquisition of Globalluxe on Feb 12th. That includes Hong Kong, Macau, Taiwan, Singapore, Malaysia, Taiwan, and Indonesia. For some reason the Philippines is not in there.  Globalluxe sales of Kate Spade were $44mm in 2013. About a quarter of their stores are in Hong Kong.  That’d equate to about 1.5% of Revenue if it went away entirely. But that’s probably not going to happen. Let’s say it’s off by 50%. We’re talking 0.8% hit to sales for a company that’s otherwise growing 40%.  For KATE in aggregate, we're really not worried.


TGT - Target Rolls Out Online Tools



  • "Target Corp. is aiming at the Millennial customer with its launch of competitive omnichannel efforts and features that will roll out in the next few weeks."
  • "On Monday, the retailer unveiled many new initiatives that would cater to its young consumer, who will soon be able to readily shop with a full omnichannel experience via e-commerce and separate iPhone and iPad applications."


Takeaway: Props to Target for adding to its omnichannel toolbox. But the reality is that separate iPhone and iPad apps is not something to be celebrated -- it's something that every retailer needs to have. Our sense is that TGT needs to fix what's inside the store and make the brand relevant again to Millennials before it gives that consumer more ways to not shop there.

Retail Callouts (10/7): ICSC, KATE, TGT, KSS, WMT, AMZN - 10 7 chart2



KSS - Kohl’s Pioneers New Approach to Customer Engagement with Launch of Yes2You Rewards Loyalty Program



  • "Kohl’s Department Stores today launched Yes2You Rewards™ nationwide, introducing an innovative approach to customer loyalty focused on building deeper relationships to provide a more personalized, value-driven shopping experience at Kohl’s stores and"


Takeaway: Put in simple terms, this is a decoupling of KSS' credit card from its loyalty program. Previously, anyone that wanted to enroll in the 'rewards program' also had to have a KSS Credit Card.  This is a program with CapitalOne, switched three years ago from Chase. It's worth noting that the average credit scores for CapitalOne's portfolio range from 600-650 compared to Chase at 700-750. Earlier this year KSS decoupled it in Pittsburgh, Milwaukee, and most markets in Texas and California. In our recent survey, 18% of people said that they are members of KSS rewards program, which is the highest rate of any department store in our survey. The interesting thing is that 57% of KSS Sales flow through the credit card -- up from 47% 5-years ago. While it's possible that Kohl's 'Pioneered Approach to Customer Engagement' increases customer loyalty, we'd actually wonder if this gives an outlet for current rewards members to no longer use the KSS card. KSS flowed $407mm in credit card income through its P&L as an offset to SG&A last year -- that's 9.5% of total SG&A. That's probably headed down, not up.


Retail Callouts (10/7): ICSC, KATE, TGT, KSS, WMT, AMZN - 10 7 kss1


Retail Callouts (10/7): ICSC, KATE, TGT, KSS, WMT, AMZN - 10 7 kss 2




AMZN - Amazon’s Luxembourg Taxes Under Fire as EU Expands Global Probe



  • " Inc. faces an in-depth European Union probe into a 2003 fiscal deal with Luxembourg over suspicions the company unfairly shifted profits to the country to lower its taxes."
  • "Most European profits of Amazon are recorded in Luxembourg but are not taxed there as a result of the pact, which is still in force today and applies to a subsidiary in the Grand Duchy, the EU said in a statement."


TGT - Target in same-day curbside pickup pilot with startup Curbside



  • "Curbside, a new startup that specializes in same-day pickup from local stores, launched its service on Monday with several retailers on board, including a pilot with Target Corp."
  • "The new service is currently available in 10 Target stores across the greater San Francisco Bay area, including the retailer’s Metreon and Geary St. locations downtown."


WMT - Walmart expands role in health care with in-store one-stop insurance shopping



  • "Walmart is expanding its role in health care. The retail giant is teaming up with, an online health insurance comparison site and agency, to set up counters in its stores where shoppers can speak with licensed agents about available health insurance options. Walmart’s expanding role in health care comes as drug store chains, including Walgreens and CVS, continue to beef up their own healthcare services."


WMT - Wal-Mart Moves Forward on Made in USA Push



  • "Wal-Mart Stores Inc. has been making good on its pledge to spend $250 million over 10 years on products made in the U.S."
  • "Since the initiative was launched in January 2013, the retail giant has been forging ahead. In July, Wal-Mart held its first open call for products made in the U.S. The event attracted 500 suppliers and generated 800 meetings. Buyers had their pencils out."

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