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Mr. Volcker Goes To Washington
Wall Street is always the same: only the pockets change.
- Jesse Livermore
It’s all over but the shouting.
The Volcker Rule is scheduled to go into effect in July, just five months from now. This is good news for folks who want a Volcker Rule. It may also be even better news for folks who desperately do not want one. The Rule is set to take effect even if the actual rule-making is still in progress. Once the Rule goes into effect, there will be a two-year transition period, and the Fed will have authority to grant one-year extensions on a case-by-case basis. In this context the words “in progress” may be an overstatement. The SEC has had far greater success banging their head against the brick wall of Congressional contempt than obtaining the resources and support they need to do anything resembling market oversight. Their demonstrated ineptitude at market oversight may have some bearing on this situation, but undercutting an already pathetic agency is no way to achieve the goal of effective regulation.
The face that launched a thousand comments
The SEC closed the comment period for the Volcker Rule this week and now retires to give appropriate weight to the Will of the People in crafting a final Rule that will prevent Too Big To Fail financial institutions from jeopardizing the markets with wanton risk taking. The Volcker Rule is intended to fence off the banks’ risk-seeking activities, ensuring taxpayers will not be on the hook for losses incurred in the course of speculative activities. As many people have said about many phenomena: no right thinking person would ever say that citizens who do not stand to benefit from the risky behavior of a small number of institutions should be made to absorb the losses that arise when those risks go against those who knowingly incur them. But no right thinking person would have thought that private financial institutions could be deemed Systematically Important, to the extent that our elected officials would panic and throw trillions of dollars of our money at them precisely because they could not manage their own affairs.
In his comment on the Rule, former IMF chief economist Simon Johnson cautions that “the repeated pattern of ‘cognitive capture’ displayed by many regulators in recent decades” makes him “worry about the ability of major Wall Street firms to argue that they do not need close supervision.” We think this the Most Dead On of comments, going to the heart of the fecal hurricane surrounding the Rule.
We scrolled through a number of the comments in the SEC website and offer some excerpts, together with our own observations. We shall not be dismayed if we get an unpleasant response. We received some cranky emails over mentioning the inanities of Newt Gingrich and Rick Santorum – whose most ardent supporters admit both are barely capable of completing a sentence without making some highly embarrassing statement – but not a peep over the numerous times we have bashed President Obama for bumbling, fecklessness, or outright bait-and-switch politics. “Know Your Customer,” sort of thing…
The SEC says comment letters generally fall into three categories, which they call A, B and C. We reprint sample Letter B in its entirety:
I’m writing in support of a strong Volcker Rule. My family and I were affected by the economic collapse of 2008, and we don’t want it to happen again.
As you prepare the final rule, bear in mind the fundamental goal of the rule – to ban big banks from exposing consumers and taxpayers to risky proprietary trades.
Banks that break the rule should face swift, automatic penalties for violations. Violations of the Volcker Rule endanger the stability of our financial system. They should not be treated lightly.
Exemptions should only be allowed if they do not undermine this goal. If an exemption would result in exposing consumers and taxpayers to bank risk, it should be rejected.
Thank you for considering my comment.
Out of 16,488 tabulated comment letters, Letter B was typical of 15,838. Which way do you think the Commission will lean? Before you answer, consider: the SEC depends for funding on the good will of Congress, which goodwill is not currently at a high point. And SEC personnel, including Commissioners, are appointed, so they do not need to cater to the will of the electorate. And the Commission has still not addressed its two most fundamental problems: it is staffed by people who do not understand the industry, and the trajectory to success is defined as spending a few years at the Commission, then getting a high six figure job on Wall Street. Until the door starts revolving in the other direction, the Commission will remain largely a joke.
As an instance of how the SEC is desperately trying to sell itself to Capitol Hill, Chairman Schapiro, speaking this week at the Practicing Law Institute’s “SEC Speaks” touted as a major accomplishment of her chairmanship that the Commission is “outsourcing leasing and financial management reporting to other agencies.” Forgive our confusion. We thought this was connected to the incident last July when Schapiro testified the agency made a “terrible mistake” in overestimating its needs under Dodd-Frankenstein – and especially in overestimating the willingness of Congress to pay for their escapade.
The SEC Inspector General said the agency grossly overestimated the need for additional office space at a time when it did not even have hiring authority. The IG found the SEC leased office space without competitive bidding, and SEC employees had falsified documents to make the transaction look legitimate. The Commission was on the hook for $550 million for empty offices, money not yet authorized by Congress. The Commission’s leasing authority was yanked, and the IG made a Justice Department referral. Now Chairman Schapiro is patting herself on the back, as though she made a great managerial decision. All right, we hear you say. Jeeze, you make one mistake…!
Unsurprisingly, industry entities and their lobbying groups are critical of the Rule. In a more unusual development, foreign regulatory agencies, central banks and governments have filed public letters highly critical of the Rule. Washington has sunk to new lows of political disarray. The traditional terse nastiness that often governed Congressional debate is gone, and we wonder when Senators will revert to waving pistols on the floor and calling it “debate.” It is a clear sign there is no reliable interlocutor in Washington that foreign governments have taken to attacking the Rule proposal in public.
The criticisms should be largely familiar to readers of this Screed, most of whom come from our industry. Firms and corporate groups primarily focus on increased costs to market operators, with what many claim will be reduced capacity for corporations and governments to access the financial markets. Some provide an analysis indicating the Rule will increase bid-ask spreads by upwards of five basis points. We note market making firms have long complained that decimal spreads in equities have made market making unacceptably risky, so while issuers may end up paying more, Wall Street will no doubt figure out a way to make money off this. Observers believe the final Rule will respond with vague numbers, which will likely result in a legal challenge.
Professor Johnson takes this item head on. Referring to foreign sovereign issuers, he says “most participants in the market will be unaffected” by the Rule, and he challenges as “stretched beyond reasonable bounds” the methodology used in studies produced by SIFMA to demonstrate the Rule’s negative impact on the markets. Still, he says, if foreign governments are adamant on US banks’ being able to trade their debt at-risk, as they believe is necessary for sufficient liquidity, he suggests they indemnify the US to remove taxpayer risk. He suggests that Canada – which requests that its debt be exempt from the Rule – pledge its IMF quote, or other US dollar-denominated assets, to cover US bank proprietary trading. While this reads like “A Modest Proposal,” there may yet be room to create a global escrow fund, provided of course that the US stands its ground, which we find highly unlikely. Yet issuers’ insistence on being provided liquidity is, by definition, their requiring others to take on their risk. One might ask how a strong Volcker Rule is different than Germany refusing to take on the risks of Greek sovereign debt.
The letter from Credit Suisse argues that reduced liquidity in the US markets will lead to “the development of alternative trading platforms outside of the US,” which is exactly what the global markets need. CS argues that this will “lead to job losses,” not allowing that a job lost on Wall Street might equal a job created in Athens. Beggar Thy Neighbor remains the order of the day, but a Global financial system can not be made to function solely for the benefit of one national actor, even when – or particularly when that actor dominates the system.
A closely intertwined concern is the regulators’ inability to oversee the activities of these sprawling institutions. Commenting on the SEC’s pattern of settling cases (NYT Dealbook, 22 February, “Responding To Critics, SEC Defends ‘No Wrongdoing’ Settlement”) Chairman Schapiro made in passing what may be the single most important point as it relates to the Volcker Rule: that ‘in part because these firms are so enormous’ it is impossible to oversee all their activities. Recidivism is common, she says, largely because the same problems arise in unrelated divisions of a company, and there seems to be no unified internal compliance oversight. The Times identifies no fewer than 51 instances at 19 different firms where “the Commission concluded that the company broke antifraud laws that it had previously agreed never to breach.” Perhaps most damning is the example of what Professor Johnson calls “cognitive capture:” the Times “found nearly 350 instances in which the commission gave big Wall Street firms and other financial institution a pass on sanctions which. As written in the securities laws and regulations, were to be automatically imposed” in the event of a settlement. The SEC makes a judgment call when it allows companies to settle without admitting wrongdoing. It seems the Commission is also waiving the letter of the law, which likely exceeds their authority. Where’s Congress in all this? Clearly, their greatest concern in all the thousands of pages and millions of words written about the Volcker Rule is, if the banks get really angry at us, who will pay for our campaigns? Too Big To Fail meets Too Puny To Act.
Addressed To “Occupant”
Adding their voices to the 16,000 or so who support the Volcker Rule, the Senators who wrote the thing – Carl Levin of Michigan and Jeff Merkley of Oregon – submitted a comment of their own, calling the SEC’s proposal “tepid” and “focused on minimizing its own potential impact.”
A thoughtful comment letter submitted by Robert Johnson of the Roosevelt Institute and Nobel Prize-winner Joseph Stiglitz says the perceived complexity of the Rule is “at best a reflection of the incredible complexity that banking itself has created, and a worst a reflection of the proposed rule’s timidity” as it seeks to “implement a law that directs a reduction of trading by banks without reducing trading by banks” or, indeed, without at all disturbing the massive level of trading worldwide – trading in which US entities are often the leading participants. Johnson and Stiglitz open by saying “the American middle class and its economy have been the victim of three types of abuse by the financial industry: usury, bailouts, and prolonged tolerance of debt overhangs,” all of which have robbed the economy, they say, of significant resources and greatly diminished its vitality. “Banks,” they write further down, “have taken refuge in complexity to extract massive margins and fees that generate bonuses.” Hence their resistance to any interference at all. The banks’ insistence that neither legislators nor regulators understand their industry is made more credible by the disasters that have led to today’s situation, which proved that the bankers also do not understand their business.
Johnson and Stiglitz write that the Volcker Rule “mandates a fundamental reconsideration of activities… that served only the bonuses of the bankers, put taxpayers at risk, and did not serve the real economy.” They quote studies that show the current financial system to be “less efficient than that of 1950 or even 1980” and draw a causal link between “record compensation for Wall Street traders” and the decline in real wages, the increased offshoring of jobs, and the shrinking middle class. “Trading volumes should not be mistaken for efficient capital markets or productive investments,” they write.
Stiglitz has said that we create bad policies because we look at the wrong information. Our policies, he says, are driven by what we measure. And, if we measure the wrong things, we will make the wrong policies. Stiglitz led the global working group to find alternatives to GDP as a measure of national economic activity. In 1991, the US formally switched from GNP (Gross National Product) to GDP (Gross Domestic Product) as its official measure of domestic economic activity. This was made to look like an enhancement, and cleverly smokescreened away by the assertion that globally, GNP and GDP are identical figures – which is true, but meaningless, as US domestic policies are not predicated on a global perspective. If they were, we would have implemented the Volcker Rule decades ago.
The fundamental difference is as follows: GDP = value of product produced within a country’s borders; GNP = value of product produced by companies owned by citizens of a country. From a political perspective, GDP does not decline when US companies take on additional debt to finance revenue producing activities. Thus, a company’s earning (the GNP measure) may decline, while their revenues (GDP measure) remain stable, or even rise. The sale of a domestic firm to a foreign owner does not reduce GDP, even though profits are repatriated to the home country. This last aspect became important as IMF and other assistance programs pushed recipient countries to “standardize” their national accounts and employ GDP. Thus, countries with increasing debt burdens and diminishing national asset bases can nonetheless point to rising GDP as proof their economies are growing.
Developing nations caught in the global financing game call GDP the “colonialists’ measure.” Closer to home, Stiglitz points out that our lopsided extremely high levels of incarceration “improve” our economy by raising GDP, though they can hardly be said to improve our society. There are states who now spend more money on prisons than on education – which increases GDP. And Stiglitz points to our overpriced health care system, where small numbers of users suck up the lion’s share of resources (The Atlantic, 13 January, “5% of Americans Made Up 50% Of All US Health Care Spending”). The social disruption that accompanies this misallocation of health care resources is not reflected in GDP – which continues to climb, even as we fail to provide health coverage to 40% of our citizens.
A 325-page comment letter was submitted by “Occupy the SEC,” a working group of member of the Occupy Wall Street General Assembly, a number of whom are attorneys or former Wall Street professionals, and whose analysis and comment shows they are anything but a fringe group. As you would expect, they articulate a strongly pro-regulation position, and they criticize what they perceive as weaknesses and loopholes in the Rule.
They state early in their letter that “compliance requirements are viewed as a nuisance, and compliance officers are frequently ignored,” words we are having made into a brass plaque to hang over our desk.
“It is worth emphasizing that all major banking entities have had extensive compliance regimes in place for many years, and yet they did not prevent the various systematic failures that occurred in the 2008 financial crisis,” says the Occupy letter. Practitioners of the art of compliance understand this all too well. Compliance departments can only provide guidance to management if (a) management asks about a course of action before initiating it, and (b) if they follow the compliance department’s advice, or at least involve compliance in rethinking the firm’s actions. Otherwise compliance can only document what was already done. By that time it is too late, both from a business exposure perspective, and from the point of view of the regulators, who will routinely punish a firm and its principals for taking an action, even though the internal surveillance system may have spotted the problem and acted to correct it before an outside investor or client was harmed.
Often, though, management sets the tone, and the compliance department must figure out how to put a good face on it. As an example the letter quotes from Goldman chairman Blankfein’s financial crisis testimony which “seemed to suggest that any time the firm created a new mortgage related security and began soliciting clients to buy it, the firm was ‘making a market’ for the security.” The Occupy letter quotes members of the Congressional panel who understand that a one-sided market is not a “market” in the commonly accepted sense. The major banks’ efforts to squeeze this definition into the Rule would cancel a key aim of the legislation: that markets must be transparent as to risk, and market participants should not be able to manipulate markets by arbitrarily setting prices.
We have a few months to go before final implementation of the Rule. Until then, we expect to hear some outlandish verbiage. We expect a number of outrageous changes to the Rule will be proposed, and a number of them will be implemented, further weakening regulatory oversight and strengthening the already-mighty banks. We expect certain small victories as well, but on balance, we expect the Too Bigs will remain Too Big and, as we say in the neighborhood, the rest of us will pound salt. As Billie Holiday sang, “Them that’s got shall get, them that’s not shall lose.”
God bless the Blankfein that’s got his own.
Wake me up when it’s over…
Your Super-Model Portfolio
The “Super Bowl Indicator” might point to higher stock prices this year, as the NY Giants (a former NFC team) won the Lombardi Trophy and took it home to Wall Street… er, Trenton… whatever... We say “might” because the last time the Giants won was 2008, when the indicator rather stupendously failed to deliver. In the run-up to this year’s game, NY Times chief market columnist Floyd Norris discounted the indicator (23 January, “On Super Bowls, Elections and Stock Prices”) saying that since 1989 “the theory has forecast the market correctly 11 times, while getting it wrong 10 times.” We’re not sure why he bad-mouths the indicator. Those stats are better than ninety percent of the hedge fund managers who are paying themselves two-and-twenty.
Norris did his own review of Super Bowl correlations and found that “of 11 election-year Super Bowls, the Democrats are 4-3 when the game was decided by less than 14 points. But when the game was not close, the Republicans won all four times.” Obama supporters, breathe a sigh of relief.
Meanwhile, this year’s contest poses a unique opportunity for economists to explore the convergence of the Dow and S&P 500, with the “Gisele Bundchen Stock Index,” as reported last year by economist Fred Fuld (Forbes, 11 November 2011, “Gisele Bundchen Is Still Outperforming The Dow”).
Bundchen’s pick of QB husbands may be only second-best, but Fuld analyzed price performance of the stocks of companies associated with the supermodel – brands she wears and endorses – and found they performed rather spectacularly. As of November of last year, the “Gisele Index” was up 41% since January 2007, up 39% since January of 2008, and up 67% from January 2009-November 2011, all versus 4% or greater losses in the Dow over the same periods. We wonder whether the supermodel will launch a self-branded hedge fund. Maybe not. After all, not everyone can f***ing walk on the catwalk AND run a trading desk.
Managing Director / Chief Compliance Officer
Conclusion: We like LIZ heading into and out of the upcoming quarter. There's no change to our view that LIZ could double again this year. Increasing clarity on company fundamentals and balance sheet will be an incremental positive this quarter. It’s also worth noting that short interest remains at ~25% of the float heading into the quarter and sentiment remains one of the weakest in retail despite a stock move from $5 to $10. That’s going to change as the stock moves from $10 to $20.
TRADE (3-Weeks or Less):
LIZ closes the book on 2011 after the close Wednesday when it reports Q4 results. With all of the moving parts during the quarter, earnings results are going to be secondary to balance sheet clarity and the latest on brand sales with nearly 2/3 of Q1 now in the books.
- To be clear, screens still suggest the company has ~$735mm in net debt instead of its current position of $270mm significantly overstating Enterprise Value at $1.7Bn instead of $1.3Bn and multiples.
- This point may seem small, but when the biggest overhang on the stock has been its leverage coupled with the reality that screens still play a key role in generating ideas, it should not be overlooked in terms of what we expect to be increasing interest in LIZ coming out of the quarter.
- At the brand level, initial sales at Juicy since the brands re-launch in February and the turn in profitability at Lucky will be key issues of focus on the call. The turn at Juicy is certainly going to take more than a few weeks of sales or even a quarter for that matter, but most that have seen the new line would agree that it’s an incremental upgrade.
- As for Lucky, we think the turn in profitability may not have materialized quite as expected in Q4, but the brand remains squarely positioned to turn profitable here in 2012.
- There’s been no shortage of positive commentary on the luxury handbag market from both department stores and brands alike and we expect no different here from Kate Spade. The key item to keep in mind here is the cadence of last year’s compares which were most difficult in January (+96%) before getting progressively easier in Feb (+87%) and March (+44%). With 2-year trends running in the 40%s-50%s, we fully expect a meaningful sequential comp deceleration, but this might catch newer investors by surprise.
- All in, we’re ahead of the Street at $0.14 vs. $0.07E and expect interest in the name to continue to build following the quarter.
TREND (3-Months or More):
Kate Spade continues to fire on all cylinders. In addition to 20%+ store growth and increased store productivity, Kate is the company’s key growth engine. Moreover, Lucky and Juicy are both at inflection points. While our positive take on LIZ is not predicated on a significant change here, it would provide an additional tailwind.
TAIL (3-Years or Less):
If the success of Kate Spade is any indication, Lucky and Juicy have a lot to look forward to under new leadership. The company will have its lumps along the way, but at current valuation you get Lucky and Juicy for free. Using both COH and KORS as a proxy, Kate alone could grow over 4x in the next 3-5 years.
After years of underperformance, the company has shed the weight and is now re-emerging as a growth stock with mid-teens revenue growth and expanding margins. Most investors have yet to realize the magnitude of this transformation. We think this stock is a double from here with an opportunity for significantly more upside.
Investor Days are important events; there are always messages being communicated – explicitly and/or implicitly – by management teams to the Street. We are adopting a “wait and see” stance with Darden’s stock; management is clear about the direction it is taking the company but we see some twists and turns in the road ahead.
The positive aspects of the Darden story are still the same as they have been for some time; the company has a strong balance sheet, is well-organized, and has strong competitive advantages within casual dining due to the economies of scale inherent in its business model. Before we can get more comfortable on the long side of DRI, some clarity is needed regarding several issues. Paramount among these issues is restaurant operating margin. Investors in restaurants absolutely care about restaurant operating margins; healthy margins help to insulate the company from the myriad of macro and industry- or company-related issues that can impact a company over the longer-term.
The most prominent messages from the management during Friday’s meeting were:
- The business is poised to outgrow the industry over the next five years
- The company continues to generate strong cash flow
- The current trends at Olive Garden suggest that the worst has passed for the concept
- Management is focusing on EBIT margin more than ROP margin going foward
THE LONG-TERM BUSINESS MODEL
The company reiterated that it expects to achieve 5-year annual revenue growth of +7-9% from annual same-store sales growth of +2-4% and unit growth of roughly 5%. Given those top-line numbers, management believes that EPS growth of 10-15% can be achieved.
By brand 5 year outlook is as follows
- OG = 6% revenue growth (+2.5% SSS; +3.5% New Units)
- RL = 5% revenue growth (+4.0% SSS; +1% New Units)
- LH = 14% revenue growth (+4.0% SSS; +10% New Units)
- Specialty = 20% revenue growth (+3.0% SSS; +17% New Units)
CASH FLOW GENERATION
Management stated that over the next 5 years, they expect to add between $2.6 billion to $3.3 billion in cumulative dividends and share repurchase. This represents roughly 40-50% of the company’s enterprise value. Over the longer term TAIL duration, this is a highly positive data point for the stock. Absent a significant deterioration in the fundamental performance of the company, shareholders will likely be rewarded greatly through the dividend and share repurchase programs over the next 5 years.
Olive Garden has been a point of contention for analysts covering Darden. As the largest component of the Darden portfolio with AUV’s at $4.7 million at the 776 Olive Garden restaurants currently in operation, the Olive Garden’s recent woes have caused many investors to take a step back. Management assuaged concerns, somewhat, by announcing better-than-expected preliminary 3QFY12 results (following two consecutive misses) with blended same-store sales of 4% versus guidance of 2.5-3% and 2.3% in 1HFY12. Olive Garden’s preliminary 2% (flat ex-weather) 3QFY12 comparable restaurant sales number was impressive versus its 1HFY12 comp of -2.7%. While this number was aided by weather, a flat-to-positive top-line print is good news. However, we are waiting to see more evidence of the turnaround at Olive Garden. It is important to be cognizant of both the weather impact that benefitted the restaurant industry during the winter months and the fact that over half of the Olive Garden store base is in need of remodeling.
On the negative side, Friday’s Investor Day saw management push out the completion date for the Olive Garden remodeling program by one year to FY15. The unknown is how the new promotional offerings at Olive Garden will perform. With offerings like three-course dinners for $12.95 and a new advertising campaign being launched, management is clearly targeting increased traffic while focusing more on EBIT margin than ROP margin.
MANAGING TO EBIT MARGINS
We were interested to hear what we believe is a distinct shift in management’s focus on margins. While Clarence Otis was correct in saying that the company has always managed to EBIT margins, our chief concern is that this has typically been done via higher restaurant operating margins in the past. During the 2011 Investor Day, the focus on unit level margins by brand stood out; the company was managing with those metrics in mind. While EBIT margins were a prominent focus during last year’s presentation, what was noteworthy this year was that management is now suggesting that some restaurant-level margin may have to be given up in order to grow traffic and expand EBIT margins. In theory this is possible but will likely be more difficult to bring about in practice.
We raised this topic with management during the Q&A segment of the presentation and Clarence Otis offered a fair response, saying that the company has been consistent in its focus on EBIT margins in managing Darden. This may be true from his perspective, overseeing the portfolio from the CEO’s seat, but having covered the company for some time and thinking about the different components of the portfolio over time, Friday’s commentary from management indicated to us that the company is now willing to sacrifice restaurant level margins to grow traffic.
With the benefits of the remodel program still a year away and the persistent value perception problem at Olive Garden still unresolved – although efforts are underway to address it – we are going to wait and see before taking a definitive positive or negative view on Olive Garden.
Commodities have hampered EPS growth over the past year but management expects food cost inflation to ease meaningfully in FY13. Food basket inflation is expected to be +12% for FY12 (ending May) versus +2% in FY11. Seafood costs are expected to be down 3% in FY13 while beef and chicken are expected to be up 12% and 2%, respectively. Seafood, beef, and chicken FY13 needs are 60%, 95%, and 40% locked, respectively.
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