Conclusion: In the three charts below, we highlight key risks to hopeful expectations of a sustained recovery in earnings growth and a tranquil global investing environment over the long-term TAIL. In fact, when analyzed with a wide enough lens, the data suggests that equity market headwinds are significantly less “transient” than is currently anticipated by consensus.
Position: Short US Equities (SPY).
We get called out a lot for coming off as short-term in nature. While there is certainly some merit to that claim (our style of managing risk acutely focuses on timing), we don’t necessarily agree with it in its entirety. In fact, we focus a great deal of our research on the longest of long-term trends (refer to our firm’s Sovereign Debt Dichotomy and Housing Headwinds presentations for key examples of our longer-term work), and, within the context of these bigger picture themes, we manage risk around the Duration Mismatch that’s typically ever-present in the world of investing.
Timing is everything. I believe a famous investor once said:
“It ain’t what you buy, but rather when you buy it that matters.”
To that tune, we think by the end of 2Q11 we will be able to confirm that the peak in corporate earnings for this cycle was actually in 1Q11. Including our own, many charts have been circulated around the street about peak corporate profits, but that hasn’t actually mattered until, well, now. To quickly rehash our out-of-consensus view, we think the stench of Jobless Stagflation starts to show up in the 2Q11 earnings season in the form of sequentially deteriorating corporate earnings growth on a go-forward basis. For more color on this topic, refer to the following reports:
- 5/18/11: “Eye on Earnings: Growth Slows as Inflation Accelerates”
- 5/22/11: “Early Look: The Last Stand of the Equity Bulls”
This stance is strongly supported by the fact that corporate profits are what we’d consider extremely stretched on a historic basis. Using BEA data, we were able to back our way into corporate EBITDA margins on a national level, as well as corporate EBITDA as a share of the overall economy. From a standard deviation perspective, both metrics are currently residing in rarefied air (2.3x and 2x, respectively). From a more quantified stance, 95% of observations fall within 2x standard deviations of the mean; thus, mean reversion in both series is likely over the longer-term. That’s not a bullish data point for long-term investors. It is, however, a “game on” challenge to risk managers. Be it boom/bust, bubble/burst, or expansion/contraction – alpha is always there to be captured.
The final chart we’d like to show you is borrowed from Carmen Reinhart and Kenneth Rogoff’s oft-cited, long-term work on sovereign debt. The illustration lucidly expounds upon a simple concept that we’ve been beating the drum on since late 2009: we are in the early stages of the global sovereign debt default cycle. As the chart repeatedly shows throughout the last 200-plus years, the sovereign debt woes of fiscally imprudent countries like Greece rarely (if ever) get better without first getting a lot worse. Moreover, when the cycle peaks, it’s typically a global phenomenon with 35-50% of countries in some form of default or restructuring.
While global financial markets will more than likely cheer on and celebrate any/all attempts to kick the proverbial “can” down the road, we continue to remind investors of a simple point we began making over 18 months ago: be very afraid of Europe’s periphery – especially if you are a long-term investor.
FINL’s comp of +6.5% came in just above the Street’s +5.7%, but below our proprietary blended rate that suggested comps of +8% during the quarter (our index is based on what FINL SHOULD have reported based on its mix and weighting in footwear and apparel relative to the reported NPD/SportscanINFO numbers). This is the second time in the last four quarters that FINL came in short of the blended rate with comps coming in only 30bps above last quarter – far different than FL’s margin of outperformance of at least 200bps relative to the index over the last three quarters.
We believe this suggests FL is likely gaining share in the industry. This isn’t a zero sum game and it’s not time to hit the panic button on FINL. Athletic footwear sales continue to be strong and the pipeline in the near-term suggests this momentum is likely to continue, but the reality is that these two retailers are growing at different rates. A factor to keep in mind here is that 1-point of comp equates to something quite different for each retailer. In fact, a 1-point change in comp at FL equates to just over a 4-point change in comp for FINL on an absolute dollar basis. Therefore, even if we were to assume that FL is capturing the entire difference, it’s not a 1-for-1 exchange, but rather FL would gain roughly a 40bps benefit to comp if this were indeed the case.
Some additional highlights of the quarter were the strength of FINL’s e-commerce business up over 55% and better than expected product margins more than offsetting the drag from toning. It’s worth noting that CEO Glen Lyon mentioned that the industry was the most “rational” he’s experienced in his 10-years with the company, which is good for margins – at least in the near-term. While apparel sales were up +3.3% during the quarter, they came in below industry trends and remain a continued area of focus for the company. All in, with Q2 marking the easiest comp of the year for FINL and both occupancy and product margins coming in better than expected and likely to persist at least through the next quarter, we’re shaking out at $0.41 for Q2 and $1.57 for the year above current Street estimates of $0.39 and $1.53 respectively.
While industry trends continue to benefit the FINL business, we see FL as the greater beneficiary of these trends over the intermediate-term. With continued progress in merchandising (particularly in apparel) and marketing (specifically e-commerce) in addition to the Foot Locker’s leading position in the industry, which affords the retailer access to exclusive product in all the key categories, FL remains one of our top long ideas here headed into the 2H. We’re at $0.16 for the quarter vs. Street at $0.13 with FINL results giving us further confidence in our above the Street estimates.
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R3: REQUIRED RETAIL READING
June 27, 2011
- In addition to product margins coming in better than expected at FINL during the quarter, CEO Glen Lyon mentioned that the industry was the most “rational” he’s experienced in his 10-years with the company. This is consistent with what we’ve seen in industry ASPs lately and is positive indication for margin stability – at least over the near-term.
- In what is likely to take social media to a whole new level from a retail/branding perspective, the International Olympic Committee (IOC) has approved the use of Twitter at the London 2012 games. We can only imagine the plugs brands will get not only from athletes they endorse, but also exposure from fellow Olympic athletes who weigh in and comment on the latest gear. As if mobile wasn’t already a key marketing initiative for brands in 2011, it just got bumped up a few notches on the list for the top global athletic brands.
OUR TAKE ON OVERNIGHT NEWS
Wal-Mart to Lease Zellers Units From Target - Target Corp. has found a tenant for some of the Zellers Inc. stores in Canada it doesn’t want — Wal-Mart Stores Inc. The companies’ Canadian units have inked a deal in which Wal-Mart will assume the leasehold interests of up to 39 sites currently operated by Zellers Inc. Terms of the agreement were not disclosed. The two companies said Friday that specific locations will be identified later this fall. The sites are among the 220 possible locations whose leasehold interests Target is acquiring from Zellers Inc., a $1.84 billion deal the Minneapolis-based Target announced in January. The transaction allows Target to open between 100 and 150 stores throughout Canada in 2013 and 2014. <WWD>
Hedgeye Retail’s Take: This deal was lined up the day TGT took over the Zeller’s locations, but there are still 30-80 leases the company is looking to unload. At roughly 100k sq. ft., the suitors for stores of this size are limited, but KSS and JCP are among the names that make the most sense.
Canadian Judge Rebuffs Target in Bid for Name - Target Corp. lost its first court bid to win the exclusive right to use its name in Canada, where the company plans to expand in the next several years. The Federal Court of Canada late Thursday denied Target's request for a preliminary injunction against Canadian merchant Isaac Benitah and his company, Fairweather Ltd., which owns 15 stores across Canada called Target Apparel, and has a logo similar to that of Target Corp The judge said he agreed that customers might be confused by the similar name, but he didn't believe that Minneapolis-based Target would suffer irreparable damage if Target Apparel stores continued to operate under that name pending a full trial on the matter, preliminarily set for November 2012. Target Corp. doesn't plan to open its first stores in Canada until 2013. <WallstreetJournal>
Hedgeye Retail’s Take: As we originally suspected, Benitah is in-line to be the big winner here, which phase one of this process now suggests is closer to reality. Target is not about to change its name. So, the company essentially has two options at this point, 1) buy the rights from the Canadian merchant - win, or 2) sell alongside him under a very similar nameplate – win. As you can see from the images below, Target’s marketing machine in Canada would only help Benitah’s Target Apparel chain as marketing targets less familiar Canadian consumers who are likely to unassumingly stumble into wrong retailer.
Hosa Pulls Hong Kong IPO Amid ‘Adverse' Market Conditions - Hosa International Ltd., a sportswear maker, said it won’t proceed with its planned Hong Kong initial public offering because of “adverse market conditions” and volatility. China Outfitters Holdings Ltd. is also likely to shelve its planned listing, Hong Kong’s South China Morning Post newspaper said today, citing an unidentified person. The company didn’t immediately respond to an e-mail after normal business hours, and has no phone number on its website or listed with Hong Kong directory inquiries. Xing Yuan Power Holdings Co. also said yesterday morning that it won’t proceed with an initial sale because of market conditions. The city’s benchmark Hang-Seng Index entered a so- called correction last week, dropping more than 10 percent from its April high. <Bloomberg>
Hedgeye Retail’s Take: A rarity among a flurry of brands and companies coming public of late – this could be viewed as a sign of demand beginning to slow. Looked at from another angle, this could also reflect the current state of the Chinese athletic market and the highly competitive environment in which domestic and foreign brands are vying for share. In thinking about the domestic companies and brands likely to succeed in this effort, Hosa and China Outfitters aren’t exactly the first to come to mind.
LVMH to Launch Sephora in India with Reliance Brands - LVMH is in talks with Indian company Reliance Brands over the opportunity of launching its beauty retailer Sephora in the country, sources reported. Reliance Brands wants to launch more international brands to target the country's emerging markets for fashion and personal grooming. Reliance Brands is reported to have already scouted locations for Sephora Stores, which offer cosmetics and accessories. <FashionNetAsia>
Hedgeye Retail’s Take: While the company has over 700 Sephora locations worldwide, entry into India, particularly with a well-known domestic player who has done similar deals with other top brands (Diesel, Zegna, Timberland, and Steve Madden) this would be a good win for LVMH.
Made in America Back in Vogue - Staying close to home can be very appealing. Skyrocketing costs in Asia and always-increasing product lead times have spurred American companies to take another look at making products in the States — or at least nearby. Big companies such as Timberland and Wolverine World Wide Inc. have added capacity to their facilities in the Western Hemisphere. Established domestic player New Balance is drawing more attention to made-in-America with a new customization program that leverages its New England factories. And smaller brands are getting in on the action, too: Portland, Ore.-based Keen opened a factory last October in its hometown, and Vere, a fledgling sandal brand shipping its first line next month, set up operations in Geneva, N.Y., last year. <WWD>
Hedgeye Retail’s Take: The price differential is contracting indeed, but the case for outsourcing manufacturing operations still strongly supports the need for a foreign supply chain. What’s likely to change on a larger scale is a shift back towards production in the Western Hemisphere, but primarily among the countries in both Central and South America.
Patent-Overhaul Bill Clears House - House lawmakers passed legislation Thursday to overhaul the U.S. patent system for the first time in nearly 60 years, despite disagreements over patent-office funding and a provision that could help large banks challenge some patents. The House passed the America Invents Act on a 304-117 vote, a bipartisan tally with more than two-thirds of lawmakers from each party supporting the bill. The bill would change how the U.S. grants patents and award them to the party which is "first to file" an invention instead of the "first to invent" it. The change would bring the U.S. in line with other countries who adopted first to file patent systems years ago, a move that will simplify the patent process for companies that file applications in multiple countries. <WallstreetJournal>
Hedgeye Retail’s Take: Sounds simple enough, but like most things we’re sure the related enforcement will be anything but.
Positions in Europe: Long Germany (EWG); Short Spain (EWP)
The long-awaited date of this Thursday’s Greek vote on austerity is now close upon us after what seems like 2 weeks of intense breath holding on the state of Greece. Late Tuesday of last week PM Papandreou’s government won the confidence vote in a 155-143 decision with every member of his PASOK party voting the party line.
Thursday’s vote on the newest austerity package, which includes €28 Billion of spending cuts and tax hikes and €50 billion of private assets sales through 2015, is essential for its passage is conditional on 1.) Greece’s next €12 Billion funding tranche from the IMF (of the original €110 billion bailout passed in May 2010) to meet maturing debt obligations beginning in July, and 2.) setting into motion Troika’s (EU, IMF, ECB) position on an additional bailout package for Greece (estimated between €70-120 Billion) and steps to “softly” restructure Greek debt, namely by extending debt maturities.
Over the weekend France floated the idea of French banks reinvesting 70% of their maturing debt Greek bonds, with 50% allocated to new Greek debt with a maturity of 30 years (instead of 5) and another 20% directed to a zero coupon fund of “high quality securities”. Clearly there are numerous unknowns surrounding this proposal, including if German banks would follow suit. But importantly, given that France and Germany have the most exposure to Greece of any Eurozone country, with €56.7 Billion and €33.9 Billion of bank and government debt liabilities, they’ll be the leaders in crafting a near to intermediate band-aid to uphold Greek funding needs.
While we’d expect to see more foot power in protest against austerity into and out of the vote on Thursday, ultimately we expect the measure to pass for it’s A.) in the interest of Troika to keep Greece on a short leash to quell talk of default/restructuring (and prevent any contagion weakness to the common currency), and B.) Greece may be able to reach a deal that broadly agrees with Troika’s deficit reduction demands, while specific terms like tax hikes and spending cuts could be back loaded towards 2014/15.
While this is only a hypothetical, such a tactic could be used to appease both Troika and the Greek populous. Ultimately it bodes poorly for any material change in the budget deficit, but then again given Greece’s poor prospects to grow any revenue with such a deflated growth profile, using smoke and mirrors by either party to reach any form of intermediate support should come as no great surprise.
For now, we continue to turn to our risk monitor indicators in Greece and throughout the periphery. While we’ve seen slight inflections, the TREND line in risk continues decidedly higher for CDS spreads and sovereign bond yields. Greek CDS levels defy previous default indicators, and Portugal and Ireland indicate that their previous bailouts will not solve their sovereign and banking imbalances.
Our European Financials CDS Monitor shows a similar picture, with bank swaps in Europe wider last week, on a week-over-week basis for 35 of the 39 reference entities (only 4 were tighter) with a strong negative divergence from Greek banks.
As Troika continues to socialize the Eurozone, we remain very cautious on the region, including on our long position in Germany (in the Hedgeye Virtual Portfolio via the etf EWG) as fundamentals have deteriorated over recent months. For more, see our post on 6/24 titled “Germany: High Frequency Data Slows. Period.” Additionally, we remain short Spain (EWP) where the data suggests continued headwinds from inflation, austerity, unemployment, and its real estate bubble. Just this morning, El Confidencial reported that Spanish banks may have $50BN in unrecognized problematic real estate loans.
With big brother Troika in periphery’s pocket, we see a EUR-USD trading range of $1.41-$1.45. Stay tuned.
No change to June revenue forecast of HK$19.5-20.5BN
Last week, Macau slowed down a tad with average daily gaming revenues decreasing to HK$664MM per day from HK$705MM per day the prior week. This is still in-line with the 3-week average daily gaming revenues. Our June GGR forecast of HK$19.5-20.5BN (+50% YoY) remains unchanged.
Market share continues to be volatile as Galaxy Macau and MGM were the biggest losers last week compared with the previous week, while LVS and WYNN gained the most share. Galaxy Macau’s big weekly drop was likely due to soft VIP volumes. We’re also hearing StarWorld appears to be maintaining most, if not all, of its previous volumes. MPEL also gained share last week as CoD continues to do well despite Galaxy Macau next door.
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