Estimates still seem too high. People should focus on Demand, not Doors. In the end, consumer demand always prevails. There’s too much Hope baked into this story.
Our take on VRA following Q4 results hasn’t changed, we’re still negative on the name. People seem overly focused on doors, and not on end-demand. Demand will always win that battle. There still appears to be a substantial “trust” factor associated to 2H expectations. Hope, as we say here at Hedgeye is not a risk management process, we prefer to stick to the math. Here are some key takeaways from the quarter:
- Let’s start with the good news. The Direct segment came through better than expected. Comps up +9.3% resulted in a more modest deceleration in the 2yr trend than expected while e-commerce remained solid up +28% (but down sequentially from +50% in Q3). In addition, VRA’s sales/avg. sq. ft. productivity continues to climb up to $1,290 from $1,150, which is to be expected as stores mature on such a small base (now 56). However, our concern hasn’t been the retail business per se, which we expect to grow 32% in 2012, it’s the wholesale business that we think is at risk.
- In that regard, indirect sales were down -0.7% for the quarter on top of the easiest compare of the year. While management points to not having “those breakout patterns that we traditionally do” and how we should look at revenue growth trends on a full-year basis not quarterly, the reality is that sales across VRA’s network of 3,300 small independent retailers slowed meaningfully.
- Our sense is that VRA’s efforts to aggressively fill its uncharacteristically fragile wholesale channel with product headed into the holiday season has left little appetite for anything but modest reorders headed into the 1H.
- As expected, management discussed the 60 new doors at Dillard’s this year (~20% penetration) and also noted how they are “starting discussions” with other department store accounts. As noted in our prior note, this could certainly proved upside to sales growth in the channel, but we aren’t baking it into our model.
- This actually highlights a major piece of our call. People focus too much on door growth and not enough on product relevance and desirability. Additional retail stores and major department store accounts on top of its 3,300 existing doors does very little to impact end demand for the product. Yes, it will get more eyeballs on it. But it has an inverse impact on scarcity value. Retailers are not stupid. If they see product in a store at the other end of the mall that is identical to what is sitting in their stockroom collecting dust, they’re not reordering.
- VRA is ramping to nine new patterns in 2H compared to the historical 6-8, which helps address the issue, though the company is now extending some older successful patterns into new styles, something VRA has not typically done. Delaying the retirement of these patterns appears to undermine confidence in the current run if not indicate uncertainty/concern regarding current demand.
- In addition, Indirect segment margins were down sharply -580bps in Q4 due to higher fixed expenses (i.e. a larger sales force). It’s worth noting that the Indirect business needs to grow revenues MSD-to-HSD in order to leverage this new investment. Perhaps it should come as no surprise then that management’s full-year guidance for the business is…you guessed it, up mid-to-high-single-digit.
- This guidance for the Indirect business implies that when you strip out the contribution from another 60 Dillard’s doors accounting for roughly 3% revenue growth and incremental shop-in-shops in Japan, it assumes a modest contraction in the core channel. We don’t think that’s conservative enough. We have Indirect sales down 4% for the year reflecting cannibalization from company-owned stores and more conservative ordering to work down inventories. At this point in VRA’s growth cycle we shouldn’t be seeing the wholesale business rolling like this if there strong underlying demand in the market.
- As for margins, we expect operating margins down -275bps in Q1 and -215bps in Q2 and down -50bps for the year. We expect higher costs and the likelihood for higher promotional activity to weigh on gross margins in the 1H in addition to higher SG&A investments made in the 2H that we don’t expect to lever until Q4.
- Inventories at quarter end were one of the highlights of the quarter up +11% compared to +23% sales growth. As a result, the sales/inventory spread improved substantially after five straight negative quarters (see SIGMA below). This is bullish for gross margins on the margin, but we don’t think enough to offset the aforementioned pressures.
- Lastly, the DC expansion underway will moderate VRA’s typically strong FCF. With $36mm in CapEx budgeted for the year, we expect FCF margin to come in at 3% compared to 13% and 7% in each of the last two years. While we expect FCF margin to return to a HSD rate next year, this will limit VRA’s balance sheet flexibility near-term
All in we are shaking out at $0.27 for Q1 and $1.58 and $1.64 in EPS for F12 and F13 respectively 19% below Street expectations next year (F13). We continue to think the Street is missing the structural risk in VRA’s wholesale account base as it rolls out its owned-retail stores more aggressively. Despite a 9% hit to the stock today, we think there is more downside ahead as expectations head lower.
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Positions in Europe: Short Greece (GREK), Short Spain (EWP)
Keith shorted Greece in the Hedgeye Virtual Portfolio today with the Athex trading comfortably below its immediate term TRADE and long term TAIL levels (see chart below).
Greece remains the poster child for Europe’s sovereign debt excesses, of which its banks are highly levered. While many expect the ECB’s two 36 month LTROs liquidity injections to put Europe’s sovereign debt and banking crisis to bed, we’ll take the other side, and take advantage of price swings across the PIIGS equity indices, as growth expectations should continue to decline throughout 2012.
At a bare minimum, we think the assumptions from Troika that Greece can reduce its public debt to 120% of GDP by 2020 are overly optimistic, which implies the need for yet another bailout. But aren’t Eurocrats wishing for more bailouts ahead in artificially supporting an uneven union of countries, some of which should default and consider returning to their own currency?
In addition, we expect social unrest to erupt in Spain on the near horizon over unemployment and fiscal consolidation, which will further pack this already topped-off Eurozone powder keg.
Following a disappointing February sales release, MCD spoke at the UBS Global Consumer Conference yesterday and added some perspective to the long term outlook for the company. In particular, investors are asking if momentum is going to be maintained whether or not there are measures the company can take to counteract the negative impact of austerity in Europe on its top line.
COO Don Thompson spoke to the audience at the conference and the standout comment from him was that “globally, breakfast is a huge opportunity”. Looking at the proportion of sales that breakfast represents in different geographies as a percentage of sales, it is clear that some markets are not leveraging breakfast as much as others.
Below we highlight some of the key topics that were discussed during the McDonald’s presentation yesterday along with our thoughts on several issues for the company.
BREAKFAST, BRAKFAST, BREAKFAST
MCD: “In the U.S., breakfast continues to be strong. Keep in mind as well, in breakfast, we've done a lot of things to make sure that breakfast continue to be a very viable strength for us, everything from operational changes and organizational changes in the restaurant to the products, to the breakfast value menu, even to the percentage of products relative to McCafés that are sold at a breakfast timeframe, albeit lower, still accretive to the overall sales at breakfast.”
HEDGEYE: The biggest issue facing the breakfast day part for all operators is employment. Increasing frequency in the breakfast day part on a global basis is important for the continued growth of the company. In the end, cultural differences may limit the ultimate potential of breakfast in international markets and the levels seen in the U.S. may not be an appropriate yardstick to measure success. However it is clear that the company is seeking to export its success in breakfast to other markets where possible.
THE STATE OF THE CONSUMER – TRAVEL BUNDLING
MCD: “When gas prices become elevated consumers do some things we call ‘travel bundling’… so rather than go out four or five times, one to go to the grocery, one to go to the cleaners, one to go someplace else, they tend to do a bundle and they'll make one travel path and get all three or four of those things done.”
HEDGEYE: Consumers are stretched and behavior is changing to better enable navigation of inflation, stagnant wage growth, and economic uncertainty. MCD’s stock performance is not as tightly correlated to initial jobless claims (inversely) as other restaurants but breakfast, especially, would be aided by employment gains and consumer uncertainty would be assuaged by a continuation of positive macro-related headlines. For the company’s side, management is focusing on the marketing message and paying close attention to its consumer’s behavior.
EUROPEAN CONSUMER COMMENTARY
MCD: “Some consumer confidence issues clearly around the world based up on the economies, but you have variances around the world. When you are in the U.S., we typically say whether U.S., Europe, Asia, well there is no country called Asia or Europe and so when you look at the various markets you see different things. So as an example in Europe, if I looked at a markets like the U.K., markets like Russia, tremendous growth, the GDP is solid, I mean we're just, we're rolling along. You go to a market like France, markets like Germany, these are markets that now we see consumer confidence weighing in the scales and there is a lot more trepidation.
HEDGEYE: Four companies that we follow have used the word “austerity” in describing risks to their businesses: YUM, MCD, SBUX, and DPZ. Clearly, any consumer-facing business with exposure to Europe faces this risk but on March 8th, MCD became the first company that we cover to state that austerity is having an impact on income growth. Don Thompson including Germany in his commentary above was incremental to our conversation with management following the February sales release. Perhaps Germany is somewhat on the fence but we left the conversation with management last Thursday under the impression that Germany was performing well.
INCREASED VALUE MESSAGE IN EUROPE
MCD: “There were two adjustments made in two of the major markets yesterday and the day before yesterday. And by adjustments what I mean, for us what an adjustment means is an opportunity we get with the franchisee base to talk about where we position in the marketplace and what lever we may need to pull more … So but some adjustment may be we've got bring in this new platform because things are bad now it just means we may do a little shifting … crank up certain messages a little bit more. We may focus a little bit more on P&L optimization efforts at a restaurant level as we stress value a little bit more in certain markets.”
HEDGEYE: Given that Don Thompson met recently with operators in Italy, Spain and France, we would be confident that those two markets mentioned above are two of the three he visited. All three markets have been struggling of late and McDonald’s needs to crank up the value message to improve traffic trends.
MORE ON EUROPE AND REMODELS
MCD: “We have 50% of our exteriors done in the U.S. versus 90% in Europe. In Europe they still have a way to go on exteriors. We will be close to 100% of all the sites that we've identified that we want to do by the end of 2012.”
HEDGEYE: In 2012, we are anticipating a slowdown in two-year average trends in Europe. Clearly the European market has also benefitted from remodels and the company selling premium products. The conclusion of the remodeling program and the result now-impactful austerity measures could nullify these positives.
For the majority of 2011, the two-year average trend for MCD’s Europe comps was just above 5%. McDonald’s has said that in the past that the remodel program has boosted sales by 6-7%. Heading into 2012, 85% of stores in Europe are remodeled. This program has allowed McDonald’s to increase capacity via the drive through, in particular, but the new look and feel has also enabled the company to sell more premium products.
INFLATION IN GROCERY AISLE IS GOOD FOR MCD
MCD: “I think the projection for 2012 is for the grocery store prices, the food at home to moderate a little bit in the maybe 4% to 5%, 3% to 4% range and food away from home to be more like 2% to 3%. So that gap is closing but the projections are still for the grocery stores to be a little higher. If that means for us, our back store cost won't increase as much, that's a good thing.”
HEDGEYE: As our chart below illustrates, the spread between food at home CPI and food away from home CPI has been narrowing over the past four months. If the trend over the last four months were to continue, assuming the average rate of narrowing since the spread stopped widening, by the end of the second quarter the spread would be closed. While this is not a foregone conclusion, it is important to note that – on the margin – the gap has been closing and offering less of a competitive advantage to restaurants versus grocery stores. CPI data released tomorrow will update us on this trend.
Conclusion: CAPE valuation is at a level last seen on July 2011.
In the past, we’ve written a number of notes discussing the valuation of the broad equity markets and the implications of this metric. Anyone who watches CNBC, has often heard the refrain that the market is either cheap, or expensive, based on earnings multiples. Therefore, based on the valuation, the stock market is either a buy or a sell. Most often market pundits quote forward earnings estimates as their proxy for valuation. Unfortunately, these estimates are only as good as their inputs.
In the chart below, which is courtesy of McKinsey Consulting, we highlight the trend of S&P earnings estimates at the start of the year versus the actual realized earnings estimates going back to 1985. In 22 of the 24 years, the earnings estimates at the start of the year were higher than the actual estimates at the end of the year. To put that in context, 92% of the time over a 25-year period, analysts were too optimistic for SP500 earnings.
Now, of course, the world is replete with bad predictions, and I’ll flag a couple for some midday humor:
“Heavier-than-air flying machines are impossible."- Lord Kelvin, president, Royal Society, 1895
“I think there is a world market for maybe five computers."- Thomas Watson, chairman of IBM, 1943
The disturbing thing with many predictions or estimates is that they are made by perceived experts and are often wrong. Even more disturbing is when the perceived experts are wrong because of an obvious bias. As it relates to earnings estimates, there is clearly a positive bias among Wall Street analysts. For the time being, we will set an analysis of Wall Street 1.0 biases to the side, but just wanted to flag caution when buying a stock or equity market based on consensus forward earnings. History tells us that they are consistently too high.
We obviously have a number of factors we utilize when contemplating the direction of the markets. From a valuation perspective, we actually think that Yale Professor Robert Shiller’s methodology is a very relevant way to consider broad market valuations. By way of background, Professor Shiller uses what is called CAPE, or Cyclically Adjusted Price to Earnings. In terms of the numerator, or price, Shiller uses the monthly average of daily closes for the SP500. To derive the earnings data, in this instance the denominator, Professor Shiller uses the quarterly earnings data from the SP500’s website and utilizes an interpolation to provide earnings data by month. He then adjusts both the numerator and denominator for inflation using CPI from the Bureau of Labor Statistics. Finally, the inflation adjusted price is divided by an average of ten years of real monthly earnings to determine the CAPE.
In the chart below, we show the CAPE ratio going back to 1881, so more than 130 years. On this long range analysis, the current CAPE valuation, as the chart below shows, is clearly elevated. Currently, the ratio is at 21.94, which is the highest level since July 2011. Coincidentally, the SP500 began an almost 14% correction from early July 2011 to early August 2011.
To better quantify where the market currently is based on CAPE versus its long run averages, we split the CAPE ratios into quintiles. As the table below shows, the current valuation is in the highest quintile of the past 120 years.
Quintile Ranges of CAPE Rations 1
Certainly, a valuation case can be convenient, but if we look at the long run normalized cyclical earnings of the market, reversion to the mean suggests there is more downside than upside. Unless, of course, earnings growth accelerates dramatically, which isn’t a scenario we see in the current slow growth environment.
Daryl G. Jones
Director of Research
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