This LIZ/JC Penney deal is an absolute no-brainer. It’s also no surprise to us whatsoever. The core of our call is that LIZ has hit bottom, is taking a ‘no holds barred’ approach to its portfolio, and will realign in a way that actually makes investors remember that this company exists.
What’d we get today? The announcement that LIZ is taking virtually all Liz Claiborne brands solo into JC Penney, and is taking LCNY/Mizrahi into an exclusive with QVC is absolutely, positively, 100% the right move. It rids LIZ of nearly 75% of its exposure to Macy’s, swings to a positive profit contribution (if only due to the royalty structure of the deals), aligns with retailers that actually know what they’re doing as it relates to exclusive content, takes down LIZ corporate infrastructure and capex, and, as a kicker, meaningfully reduces working capital as LIZ leverages JCP’s superior sourcing structure.
Are there risks? Of course. Now there’s key customer risk with JC Penney. There’s also the potential for a brutally ugly transition as existing wholesale accounts blow out Liz inventory (though LIZ now has no incentive to share in markdowns). There’s also the morale issue given that the corporate structure at LIZ will take a hit – again – as resources that are no longer necessary are nixed from the equation.
But add it all together and what do you get? An $0.88 loss this year (our estimate) goes to $0.88 profit in 2010. My sense is that our number will still be meaningfully above consensus once the beans are counted. At the same time, free cash flow should go from -$30mm in ’08 to roughly $275mm in 2010. Yes, that’s almost a 10% FCF Margin.
So what happens when a highly-levered company that everyone has left for dead starts generating cash (note: 14% of the float is short, and of the 8 analysts covering there’s not a single Buy, 3 Sells, and 5 Holds)? It turns from a ‘Will this company remain viable’ call, to being a ‘let’s start to model margin improvement and financial delevering’ call.
Trust me, despite our best effort over the past six months I’ve had so few people willing to bite on this one. Now, sadly, with a 29% move on the day, people will start to pay attention. For someone willing to look at ’10 numbers, I think it makes sense. Why? A sub $7 stock with a buck in earnings power and an improving balance sheet in a rising cost of capital environment makes a heck of a lot of sense to me.
Position: Long Germany (EWG)
In our post “Bear Cubs” on 10/1 we discussed rising unemployment as a headwind facing the Eurozone into year-end. On further reflection however, we think that it is worth considering that European economies may better weather a rise in unemployment than their global counterparts.
It’s a question worth qualifying and quantifying as a rise in joblessness has a potential to ripple through a country’s and a region’s economic performance. If you’ve been following our US strategist and food industry analyst Howard Penney’s research, you’d know we’ve struggled to make a case for resurgence in the US consumer, especially concerning discretionary spending like casual dining. Conversely our Retail team has become incrementally more bullish, highlighting in our call this morning that a slow and gradual recovery in underway, supported by better sales, tighter inventories, and favorable compares that led to several upside earnings revisions in the September numbers. Could the outlook of the European Consumer differ in appearance?
Though we’ve cautioned against speaking about Europe in aggregate due to the divergence across countries on multiple factors, one aspect that much of the region shares collectively is a significantly stronger foundation of social services than those available to US citizens, and certainly greater than the safety net provided by governments in developing economies like China. One take away to note here is—without a job the fear of losing (for example) healthcare benefits and the inability to pay for comparable services is far greater in the US or in China (where all expenses are out of pocket), than in Europe due to government social programs, a comment astutely made by my colleague and Asia strategist Andrew Barber.
Secondly, it’s worth considering savings rates that may better pad one’s economic outlook. As our European clients on the ground have so eloquently compared European to American spending: “Americans spend everything they have.” If this translates to on balance Americans having less cash reserves to fall back on in a weaker economy with tight access to capital, could it be that European sentiment, and therefore consumption, is more resilient in the face of adversity than that of Americans? Could a more cushy savings account and social network lead to increased optimism? The chart below of unemployment levels in the US versus Eurozone over the last ten years speaks to the point that Europeans are more accustom to a higher jobless rate than Americans.
As we measure the impact of rising unemployment in Europe, we keep in mind the vast divergence in joblessness among European countries—Spain is pushing 19% unemployment while Germany has hovered around the 8.2% level. While comparing the structural nature of Spain to Germany is far from comparing apples to apples on numerous counts, we do believe that the sequential rate of change in many of the fundamental metrics we follow in Europe will slow over the next months.
But the reality remains, a jobless recovery in Europe may actually be more bullish than in the United States.
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Chinese Auto Industry executives are worried about swelling capacity. They should be.
The CEO of China Auto Logistics was quoted yesterday saying that the 40% increase in auto sales in China this year, which has brought the total new cars sold to over 1 million per month, was a “one-time event”. We agree with this assessment. The stimulus measure which drove these sales, particularly the tax incentives for rural buyers, created a lot of “replacement” sales: farmers and rural tradesmen trading up from ancient vehicles. The pace of those types of buyers coming to market should decline as we head into next year, but as the euphoria of the stimulus fades and “real” demand kicks in, we expect auto sales growth to continue at a healthy pace even if it looks weaker on a year-over-year basis compared with this year’s flood of purchases.
The critical question now is whether a moderation in the pace of sales growth will reveal excess capacity after a massive wave of investment by domestic and foreign JV producers. Any supply glut could create a chain reaction through the industrial complex. Officially, the National Development and Reform Commission estimates domestic automotive industry capacity utilization at 80% with a drop to 70% projected by 2013 as more new plants come on line.
The Beijing plans outlined in Q1 called for consolidation that would alleviate some of these issues by creating a handful of dominant producers who control the entire manufacturing process internally rather than the present diverse network. Any M&A cycle inside the Chinese automotive industry would be a welcome source of capacity reduction, but we see it as unlikely that new efficiencies through consolidation will be sufficient to offset the tide of diminished expectations as monthly sales figures comp to impossibly high 2009 levels. As such, the DBN 600 Automotive Sub Index current level appears likely to be unsustainable in the intermediate term after a 150% increase YTD and we are inclined to shift the group out of our industry focus group for Q4.
Land of Opportunity
The strategies adopted by US and European JVs pursuing market share in the Chinese market have produced predictably mixed results to date, and recent developments suggest that some (primarily the US firms) will continue to flounder.
With under 3% of the total market Ford is playing catch up with the announcement of a third plant with partner Chonqing Changan to be on line by 2012 which will lift total annual capacity on the mainland to 600,000 units. Given the macro factors outlined above, and the fact that the focus segment –the compact market, is so heavily competitive, this growth strategy appears to be too little too late. In contrast, French producer Peugeot Citroen has recently announced that its plan to construct a third facility citing looming excess capacity.
The luxury import segment has become lucrative enough for European manufacturers to start building domestic production facilities –with the Audi/FAW JV reportedly considering a plan to begin complete A3 and A5 production on the mainland. Audi has had great success in China on the heels of Parent VW’s early and successful entry into the market there .
NOTE: Domestic Chinese Markets have been closed for the first 3 sessions of this week in observance of National Day and the Mid-Autumn celebration.
The quarter was very messy and riddled with charges as expected. However, it looks like clean EPS came in at $0.15, beating the street and company guidance as well as our $0.14 estimate. Stronger leisure demand and solid cost controls contributed to the better than expected results. Earlier this morning we put out a quick review. Below are more details on the quarter.
- Full service room growth was lower than we expected, however, limited service growth more than made up for the difference. Limited service room growth actually accelerated in 3Q09 vs 1H09.
- Total managed rooms were 1,200 light of our estimate while franchised rooms grew by 1.8% more than our estimated growth rate of 8.4%
- ADR declines were a higher percentage of the RevPAR decline compared to our projections and chain scale results.
- There was a notable sequential improvement in occupancy (declines), especially for the Ritz brand and the full-service brands
- The FX drag on international RevPAR was 6.6%, highly correlating with the 6.2% y-o-y strengthening of the dollar vs Euro
Total Fee income:
- Base management fees were exactly in line with our estimate but franchise fees were $5MM better, driven primarily by more room additions in the quarter
- Incentive fees were also $7MM better than our estimate
Owned, leased and other:
- Owned, leased and other revenues of $226MM were $19MM above our estimate
- $6MM of the beat was due to termination fees
- $15MM was due to better F&B performance, which makes sense given that occupancy performed better than we expected for the full service hotels. Food and beverage outperforms RevPAR over the next few quarters as occupancy flattens out
- Assuming branding fees were in the same $19MM range as previous quarters, gross margins ex-termination fees and branding fees on “owned & leased” are about -$17MM. Since there is a lot of other stuff in “Owned, leased & other”, we would caution investors on extrapolating too much from the margin changes of this bucket
- Contract sales declined 42%, coming in 6MM lower than our estimate. Fractional sales were also weaker
- Development revenues of $138MM declined 48%, missing our estimate of $172MM by $34MM, while finance revenues came in $3MM better
- Timeshare results were 4MM below our estimate of $13MM due to lower JV equity earnings and lower timeshare sales & services, net results. Base fees were in line
- As a reminder, in 2010 the adoption of FASB 166 & 167 will require MAR to consolidate its existing portfolio of non-recourse securitized loans. This accounting change won’t change risk or cash flow from timeshare but will inflate liabilities & debt balance while benefitting pre-tax earnings by an estimated $30-40MM
We have a quick call out on natural gas as it relates to economic activity in the United States. A primary end use of natural gas is in industrial production, as a result the Energy Information Administration (EIA) releases data on natural gas uses in industrial production on a monthly basis. We have outlined this in the chart below and graphed it as a percentage change on a year-over-year basis.
No surprise, natural gas consumption has been in decline on a year-over-year basis since April 2008, which is in line with the broad decline in the U.S. economy that has occurred. Surprisingly, we have seen no pick up on a year-over-year basis in consumption. In fact, for the last four months we have seen declines year-over-year of greater than 5%. This is surprising because comparables are presumably easy and, based on other leading indicators such as the stock market, one would expect some pick up in industrial use of natural gas – a sign that industrial production is increasing.
On another note, the EIA’s weekly natural gas report is due out today at 2pm. We would expect to see much of the same in the way of continued inventory builds. As of last week, inventory broadly in the U.S. was almost 15% above its five year range. According to the EIA:
“At 3,589 Bcf, working gas in storage set a new record high for natural gas inventories. Current inventories exceed the previous 15-year-high reported on the Weekly Natural Gas Storage Report (WNGSR) of 3,545 Bcf, and the all-time high of 3,565 Bcf reported in the October 2007 Natural Gas Monthly. New record levels were established in the West and Producing regions, exceeding the previous records of 482 Bcf and 1,126 Bcf in the WNGSR, respectively”
The combination of soft end market demand, as emphasized in the chart below, with a domestic U.S. that is flush with natural gas supply, continue to paint a bearish picture for the commodity in the intermediate term. The underlying data by end use also provides an interesting insight into economic activity in the industrial sector in the U.S.
Daryl G. Jones
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