“One can find so many pains when the rain is falling.”
Timing is everything in life. As it relates to my current trip to Southern California, my timing couldn’t have been worse. I took a few hours away from the screens yesterday to finish up my Christmas shopping and a number of local business people informed me that this was one of the rainiest weeks Los Angeles had seen in, well, a really long time.
Today Keith is off to his hometown of Thunder Bay, Ontario with his wife and little ones, Jack (already a heck of an ice skater at only three years old) and Callie. Tomorrow I’ll head to my hometown, the small Alberta prairie outpost of Bassano, Alberta (total population of 1,200 and 75 some dogs). I think both of us, like many of you I’m sure, will take the next week to relax and begin planning for 2011. Much to the Steinbeck quote above, as I contemplate the future on this dark wet California morning, I do see a few pains.
While Steinbeck is most known for his literary career which culminated in the Nobel Prize for literature in 1962, he also knew a thing or two about state and local finances in California. In fact, his father was the long serving Treasurer of Monterey County.
California has become the poster child for one of the key potential pain points heading into 2011, that of municipal debt and deficits. We recently shorted municipal bonds in our Virtual Portfolio via the etf, MUB. While clearly not all municipal bonds are created equally, the general short case for the municipal bond market is as follows:
1. Rates are going higher – We’ve obviously already seen this over the last 30-days, but as the Fed is unable to keep the long end of the curve down, bonds will continue to suffer, especially as inflation expectations accelerate. Rates, obviously, have much more room to the upside from these historically low levels.
2. Housing prices have more downside – We are bearish on housing prices to the tune that we think home prices have 15 – 30% more downside nationally. Since appraisals for tax purposes operate on a 2 – 3 year lag to market prices, municipalities will begin collecting taxes based on dramatically declining home prices, which should hurt their tax receipts. Real estate taxes are the single largest revenue source for local governments. In the Chart of the Day, we show the Case-Shiller index versus property tax receipts.
3. State deficits set to expand – Currently, state level revenue is 12% below pre-recession levels, which is substantially worse than the revenue recovery in the past three recessions going back to the 1980 – 81 recession. This pain is likely to intensify, with States facing a $140 billion budget gap in fiscal 2011, according to the Center of Budget and Policy Priorities.
This is obviously the cliff notes version of our body of work on the municipal market, so if are a subscriber or prospective subscriber and would like more information, or to set up a call to discuss this topic with us, please email our Head of Sales Jen Ken at .
While Steinbeck has become one of America’s most lauded authors, he was also, while alive, one of its most controversial. He had left leaning politics and was long suspected to have ties to the Communist Party. In fact, perhaps his greatest work, The Grapes of Wrath, which is considered by almost all as one of the top ten English language novels of the last century, was originally harshly critiqued because it was deemed to be too pro-worker and overly critical of capitalism.
In addition to his full-time career of writing, Steinbeck was also a very active traveler. In 1947, he travelled to the Soviet Union with noted photographer Robert Capa. They were two of the first Westerners to visit the Soviet Union after the Communist Revolution. The output of this trip was A Russian Journal, which describe the harsh living conditions in the Soviet Union.
Since Steinbeck’s visit almost 60-years ago, much has changed in the former Soviet Union. While the transition to a fully functioning democracy in the vein of the West is still a work in progress, the introduction of capitalistic ways has certainly benefitted Russia, particularly as it relates to its vast natural resources. Due to modern reinvestment and the opening of her oil fields, since 1999 Russian oil production has increased 62%, or 3.5MM barrels per day, while total global oil production has only increased 10.5%, or 7.6MM barrels per day. The Russians are taking market share.
Despite the pain we see in municipal debt markets headed into 2011, we do have some great long ideas. As it relates to the Russian oil theme above, one of our favorite long ideas is Lukoil (LUKOY). According to our Energy Sector Head Lou Gagliardi:
“Although labeled a National Oil Company (NOC), Lukoil is 100% publicly owned. But, geopolitical risk, the Russian economy, a weak global economy and energy demand, and an onerous export tax duty have all weighted heavily on Lukoil’s share price in 2010 widening its market price discount to its discounted cash flow valuation further to 50%.
Historically NOCs trade at a discount to cash flow valuations and Lukoil’s historical discount has been in the 30% range. We believe its market discount will narrow reverting to the mean in 2011 driven by several catalysts. Lukoil’s high oil production weighting of 87% levers its share price to higher crude prices; its long-lived reserves, its expanding production profile internationally, and its growing crude oil production profile of ~2% per annum will contribute to significant earnings growth in 2011.
Lukoil’s balance sheet is strong with a debt to capital ratio of ~16% and a net of cash ratio at ~12%, as the Company is living within its capital spending. At $85.00 crude oil in 2011, we expect Lukoil to easily beat consensus with a ~25% E.P.S increase from 2010 to $14.75/ADR. For 2011, NCF at $85/bbl is targeted at $8.4 billion, or $10.12/ADR. At $89.00/bbl, earnings would jump 35% from prior year to nearly $16.00/ADR, adding roughly another $1 B in NCF.”
To put it simply: Lukoil is cheap, growing, has deep reserves, and a pristine balance sheet.
While the outlook does seem a little cloudy and rainy, there are plenty of Lukoil type opportunities out on the horizon. Moreover, as another well know American literary figure Dolly Parton once sang:
“The way I see it, if you want the rainbow, you gotta put up with the rain.”
Enjoy the holidays with your families and stay out of the rain,
Daryl G. Jones
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The Macau Metro Monitor, December 21st, 2010
CONSUMER PRICE INDEX FOR NOVEMBER 2010 DSEC
Macau November CPI rose 3.93% YoY and 0.45% MoM. Prices of outbound package tours were higher YoY and lower MoM.
NKE will come through, again. 10% beat likely without futures rolling. Look for a major relaunch of Free. But given interconnected global risk, low short interest, key management stock sales, and the best sell-side sentiment since October ’08 (14 Buys and no Sells) Nike NEEDS the US to lead. The good news is that it is.
On some level, I think that NKE planned its May Fiscal Year just so they could keep shareholders walking on eggshells during holiday weak in addition to 2Q EPS. The eggshells aren’t warranted this time around.
1) We’ve got Nike printing $0.96 in our model, which is 10% greater than the Street at $0.88. Importantly, this EPS algorithm starts with 10% sales growth levering to 28% in EPS growth; showing improvement in both Gross and SG&A simultaneously for the first time since 2Q08.
2) It would be very uncharacteristic of Nike to change guidance at this time of the year. The caveat is that if they smoke the quarter (our estimates count as at least a puff or two) Don Blair has all the ammo he needs to keep forward hurdles low; raw material costs, more air freight to keep up with strong demand, quadrupling in apparel R&D budget, to name a few.
3) Sustainability of Futures. The biggest question for everyone that cares about Nike – or anyone that even grazes some part of Nike’s supply chain – is whether or not Nike can sustain its North American growth. While this is usually not on the top of our list given how broad Nike’s portfolio has become. But let’s face some facts…the setup in Europe and Asia is not setting up to be pretty into 2011. Check out the charts below where you’ll find eroding consumer confidence pretty much everywhere. The US actually looks good by comparison. In other words… for one of the first times in years, Nike ABSOLUTELY needs the US to hold on tight.
Given the importance of North America, let’s dissect the 14% futures number we saw last quarter. 14% growth over the next 2 quarters is the equivalent of adding $289mm in new business (assuming that 85% of the base is on the Futures program). This number annualized is bigger than the ENTIRE US BUSINESS for over 90% of the footwear brands in the world. The good news is that the number is balanced over footwear and apparel. That definitely makes this number more easily digestible.
Precise quantification of this order number is tough. But here’s our best crack. When we add up comp and square footage growth by customer and by channel, we get to about $128m top line growth for the YEAR – or about 2.5%. Now…this excludes growth in Nike retail and Nike.com – both of which should take the aggregate growth rate on a reported basis for Nike up by another 2-3 points. So what we need is to justify doubling this growth rate again due to market share gains in order to get to 14%.
This is very much realistic. But here are a few considerations.
1) Free: I think that Nike has done an admirable job in hiding from the outside world how bothered they are by missing out on the Toning category. That’s not to say that they want to have been first to market with a ‘tush toner’. But does anyone remember Nike Free? This is a technology that Nike debuted around 2005 – the same time that Adidas bought Reebok and immediately started to seed share to Nike (their combined share went from 17% to 6%).
So what are we left with? The toning category has taken off, the book “Born to Run” was on the NYT best sellers list. (This focused on a group of hardcore runners and Mexican tribes who would run (often barefoot) as a way to minimize injury and maximize speed and safety.) And all the while, Nike is left out in the cold even though they invented the technology to lead this category.
Translation = the tools, molds and other capital equipment to produce these shoes en masse have already been amortized. My sense therein is that we’re going to see a MAJOR re-launch of ‘Free’.
This should be showing up in Futures today. (and we probably saw some last qtr).
2) Endorsements: Yes, we’re in a solid R&D cycle. But with that comes an Athlete Endorsement. We already saw Nike outbid for the NFL contract. It dropped Tom Brady, who was then picked up by UA. It also goes down the curve to athletes like Allyson Felix, who Nike recently took from Adidas. To those that don’t know, Felix is one of the top sprinters in the world and is a solid brand statement (recently had a full billboard in Times Square).
3) Global Interconnected Risk: Not that many people ask me about the Macro side of Nike. But they should. While being the clear leader in a Global Duopoly with a fixed structural forex and sourcing advantage, the company is not immune to global turmoil. They have bucked it in the past – but we cannot give a free pass – even for a company like Nike.
4) Model Shift: We’ve been looking at Nike as a sheer top line growth story with improving Gross Margins. As we anniversary World Cup, the top line will still be there, though margins should be driven more by SG&A and FX hedges. Same result, but different path. The risk is whether Mr. Market will give the stock the same multiple in trading GM for SG&A/FX.
Europe (Western): Largely stronger on a sequential basis
- Most significant consumer confidence ramp with four consecutive months of positive retail sales - the longest such streak in more than 5-years before turning slightly negative in October.
- Russia rolling over slightly relatively to Q1
Key issues/events across Europe:
- Consumer Pullback from Austerity measures issued or discussed, many enacted for Jan. 1, 2011
- Austerity measures in Ireland, UK, Spain, Portugal, Italy, France, Greece, Hungary, Romania
- World Cup spill over early into the qtr
Euro - GDP:
China: Retail sales growth stable in low 20s while confidence is beginning to roll
Japan: Rolling over hard relative to Q1
- stimulus measures and policy changes helped buoy the Japanese consumer in 3Q10, including a subsidy for energy-efficient cars and a tobacco tax hike scheduled for October 1st. Both programs pulled forward consumer demand to the tune of a 0.7 point contribution to 3Q10 GDP, after having no contribution from private consumption in 2Q10. In addition, Japan’s hottest summer in over a century fueled demand for cooling products. These tailwinds helped boost 3Q10 GDP growth to +3.9% QoQ SAAR and their absence will create a drag on growth in 4Q10 and potentially into 1Q11 – just around the time bearish 4Q10 economic data is being reported in globally. (11/30/10 Macro post )
- Brazil - retail sales started to slow heading into Nov though relatively flat with Q1
Fx: Nearly 1% drag on top-line in Q2
Conclusion: Overall no great surprises but LongHorn exceeded expectations while Red Lobster once again disappointed. I will have another post out tomorrow after the earnings call.
Darden International is not cited regularly as a bell weather for consumer spending, but I think the company’s performance offers an interesting, if small, glimpse at the state of the consumer. The news out of Washington of late has led to more questions than answers. From a MACRO perspective, it will be interesting to see if this momentum will continue once the holiday season high subsides and the hangovers set in. Whether or not companies continue to invest in their concepts will likely be a huge differentiator in 1Q11 as the holiday season ends.
Clearly, for whatever reason, the mood of the consumer has been stronger of late and the better-positioned concepts are performing well. In Darden’s case, LongHorn is leading the way with mid-single digit traffic growth, The Olive Garden’s comparable restaurant sales are in the low-single digit range, and Red Lobster’s comparable restaurant sales figures have deteriorated on a two-year average basis for the past three consecutive quarters.
Darden has spent considerably amounts in investing in LongHorn and the results from that concept today are impressive. As you can see in the chart below, LongHorn almost beat the street consensus for comparable restaurant sales by a factor of two. The stellar performance of LongHorn will likely distract investors from the never ending turnaround that is Red Lobster. However, heading into tougher comps in 3Q11, coupled with the prospect of elevated beef prices, could put more of a deadline on Red Lobster’s ever-pending revival.
I expect management to strike a cautious tone with respect to top line trends. A sequential slowing was clearly evident in trends at LongHorn over the course of the quarter. One line-item that will need to be addressed is labor, which declined by ~120 basis points year-over-year.
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