Takeaway: Planned capex spending is higher for many retailers. Here's why they're spending and what it means.
Retail Sector Head Brian McGough's research shows that planned capex spending is expected be up 30% across the industry as you'll see from the chart below. Note that many companies that are on the lower end of the spending spectrum were big capex spenders in 2012.
McGough says capital spending comes just at a time when margins across the industry are the highest they have been in five years. McGough says this is not bullish for the sector: a haphazard approach to capital spending will drive down Return On Capital figures in the coming quarters and retailers will be under pressure to either drive margins still higher, or to show a major ramp-up in sales growth.
McGough says this is not a strategy of smart managers plowing profits back into their businesses, while managing investor expectations. “Retailers deploy capital when they can,” says McGough. “Not when they should.”
“Peak” profit margins are, by definition, unsustainable, and McGough sees this capital spending as a knee-jerk reaction, not a strategic allocation of resources. Wall Street analysts will now assume these peak margins are a “new normal.”
But Return on Capital will be substantially down in coming quarters. First, because “peak” is just that: the point before the decline. Second, because spending one-third more capital makes the denominator one-third larger, which results in a much smaller final number. Look for retailers to start reporting lower Return On Capital in coming quarters, causing analysts to go negative on some of today’s star players.
THE HEDGEYE EDGE
Melco Crown has quintupled in the last 2 ½ years since we began recommending it at $4. However, the upside has been driven mostly by higher earnings than expected and not as much by multiple expansion. We’re still higher than the Street on earnings but we believe that MPEL is finally ripe for some serious multiple expansion.
Here are some reasons why we believe the stock, even though it’s trading at its 52-wk high, can move higher: 1) We believe Macau should have a great year in 2013, with MPEL maintaining/gaining share. Current Q1 2013 and FY 2013 estimates for MPEL remain too low. 2) With one of the best locations in Cotai, MPEL’s JV, Macau Studio City, is scheduled to open in 2015. We believe a 20-30% ROI is not unreasonable. 3) Free cash flow (before project capex) is well over $1 billion and net debt is roughly zero 4) Given that MPEL is not yet considered to be an investable stock by most long only investors, there is opportunity to build a bigger base of investors which should boost the multiple.
On a forward EV/EBITDA basis, MPEL only trades at 8x 2014 EV/EBITDA after excluding Macau Studio City construction costs. The other US listed Macau operators currently trade between 9x and 14x. What’s the right multiple? We think a 11-12x multiple is sufficient for now, which implies a $30 stock with upside from there as investors begin to look forward to the opening of Macau Studio City.
INTERMEDIATE TERM (the next 3 months or more)
Q1 earnings should be a good one. The Street continues to underestimate MPEL’s potential and we’ve above for both Q1 and 2013.
LONG-TERM (the next 3 years or less)
Macau is poised to grow considerably with latent demand and better transportation infrastructure. MPEL will capitalize on the market growth but also maintains a deep bench of new unit growth. In addition to a Filipino project, Macau Studio City should be a gem in 2015, considering its prized location on Cotai. It is situated close to the Lotus Bridge and to the upcoming Light Rapid Transit station. We believe the stock is becoming more attractive to long only investors as management continues to prove itself, the company continues to grow same store EBITDA, and new growth projects move into the forefront.
ONE-YEAR TRAILING CHART
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We think the market’s reaction to Cyrus’ bailout is overdone and that these ‘crisis’ conditions will be short lived.
A quick update on the latest development is that parliament has delayed a scheduled vote today on the proposed bailout, namely on the levying of a one-time tax of 9.9% on Cypriot bank deposits of more than €100K and a tax of 6.75% on smaller deposits, until tomorrow.
Internally there’s much pushback on the scheme as the country’s banking system is tied with political and banking corruption that allows a home for Russian money laundering. It is therefore playing out on the streets that “oligarchs” banking in Cyprus should pay disproportionately more versus average deposit holders, if the latter should play at all.
Externally, the move to tax deposit holders for bailout packages (versus for example sovereign bond holders) sets a dangerous precedent that throws fear across Eurozone deposit holders. We expect Eurocrats to rhetorically smooth over the deposit levy and signal that Cyprus is a unique and extreme case given the inner workings of its corrupt banking system.
Note that today is a holiday in Cyprus and there’s talk that a bank holiday will be extended at least to Wednesday to prevent capital flight as the terms around a €10B bailout are voted on this week. This morning the WSJ cited an official that said the new proposal will allow depositors with less than €100K to be taxed at 3%, savers with €100K-€500K taxed at 10%, and those with over €500K taxed at 15%. While we cannot know the accuracy of this citation, it appears likely that the government will tax higher deposits at a higher rate to go after large Russian deposit holders. Depending on the crafting of the levy it would also seem probable that temporary restrictive measure may have to be put in place to prevent the flight of deposits to other countries.
Here are some take-aways to consider as the media runs hard with this story.
- It has been clear for many months that Cyprus would need external assistance to repair the country’s finances, a country with a banking system some eight times larger than the economy.
- Had a flat €17B bailout package been crafted, we would not have expected such a negative market move. We think the market will move past this development as terms around the deposit levy are likely mitigated for smaller deposit holders and the EU PR machine assures Pan-Europe that its deposits would not be considered for future bailouts.
- While Chancellor Merkel was hoping to delay the bailout until after her election in September, this deal is a political win for her. Why?
- Having Cyprus cover a portion of the bailout (~€5.8B) and a loan reduced to €10B instead of an estimated €17B looks good for Merkel’s constituency as Germany is writing the biggest portion of the bailout checks. Further, a bailout of Cyprus now allows the issue to be swept under the rug well before German elections in September.
- Even with an economy the size of less than one half a percent of the 17 nation Eurozone, Eurocrats are incentivized to throw money at the problem to limit fall out. The experience of Greece and Portugal in particular shows that even puny economies can impact economic sentiment. Eurocrats’ biggest incentive remains their own jobs -- they'll continue to squash any fears of contagion with bailout band-aids.
- Cyprus represents, to many, a huge flaw in the Eurozone system – allowing countries like Cyprus to enter the Eurozone in the first place. Again we expect the play from them to be throwing good money at bad, with initial attempts of setting forth banking reforms to limit corruption.
- Russian President Vladimir Putin has criticized the levy saying that the decision, should it be made, would be unfair, unprofessional and dangerous. Maybe Putin has some money in Cyprus too?? It is estimated that Russia has ~ €60B of total exposure to Cyprus on a ~€24B economy. So there’s a real fear of Russians pulling their money and the negative windfall it would have on the banking system and economy. This further suggests that restrictive measure will have to be placed on deposits to prevent flight.
While we think the market will move past Cyprus over the short term, this event along with the Italian elections provide good ammo to put pressure on the EUR/USD.
Nothing like another good crisis to stir up the markets!
Takeaway: Prior to this weekend, Europe's banking system was healing. We doubt Cyprus will have a game-changing effect on Europe's global banks.
* We'll buy fear for now. It remains to be seen what impact Cyprus will have on EU deposit perceptions. We think the lesson of the last 15 months has been that the ECB will do everything in its power to prevent interbank counterparty problems, reinforcing the too-big-to-fail dynamic among Europe's largest banks. Deposit safety fear, should it grow, should ultimately benefit the large EU banks as they'll be seen as relative safe havens. This should, in turn, minimize counterparty risk for the U.S. global banks seen as at risk from Cyprus contagion woes. The ECB's success thus far is evident in the move from 100 bps to 13 bps in Euribor-OIS, the measure of European interbank counterparty risk. While we would expect a nominal backup in this key risk indicator, we'll be focused on whether this Cyprus news results in a sustained rise in the Euribor-OIS spread over the coming weeks.
* XLF Macro Quantitative Setup – Based on this morning's open, the XLF is sitting just above trade support of $18.23.
* 2-10 Spread – Last week the 2-10 spread widened 10 bps to 176 bps.
* Chinese Steel – Steel prices in China fell 2.8% last week, or 105 yuan/ton, to 3654 yuan/ton. This brings the month-over-month change to -3.6%. Weakening Chinese steel prices are reflecting slowing demand for new construction.
Financial Risk Monitor Summary
• Short-term(WoW): Positive / 6 of 12 improved / 2 out of 12 worsened / 5 of 12 unchanged
• Intermediate-term(WoW): Positive / 6 of 12 improved / 2 out of 12 worsened / 5 of 12 unchanged
• Long-term(WoW): Positive / 11 of 12 improved / 0 out of 12 worsened / 2 of 12 unchanged
1. U.S. Financial CDS - Large cap U.S. financials were notably tighter last week. In fact, it was a perfect week in that 27 out of 27 institutions improved week-over-week. We'll see how much of those gains are retraced this week on Cyprus.
Tightened the most WoW: C, AGO, MS
Tightened the least WoW: PRU, UNM, ALL
Tightened the most WoW: MTG, RDN, MBI
Widened the most/ tightened the least MoM: AON, MMC, PRU
2. European Financial CDS - Unfortunately, these quotes are all as of Friday night. Clearly, that renders them rather stale. If we rewind to before Cyprus, what we see is a very uneventful week (last week) for EU financials across the board. Italian banks were slightly wider WoW, but otherwise it was extremely quiet.
3. Asian Financial CDS - Last week was uneventful for Asian banks, with most narrowly tighter. The biggest move of the week came from Nomura, which tightened by 8 bps.
4. Sovereign CDS – The European periphery continues to move wider, while the core tightens further. The U.S., Germany and France were all tighter last week, while Spain, Italy, Ireland and Japan all widened.
5. High Yield (YTM) Monitor – High Yield rates fell 6.7 bps last week, ending the week at 5.79% versus 5.86% the prior week.
6. Leveraged Loan Index Monitor – The Leveraged Loan Index rose 5.4 points last week, ending at 1781.69.
7. TED Spread Monitor – The TED spread rose 0.5 basis points last week, ending the week at 19.61 bps this week versus last week’s print of 19.11 bps.
8. Journal of Commerce Commodity Price Index – The JOC index rose 2.4 points, ending the week at 9.86 versus 7.5 the prior week.
9. Euribor-OIS Spread – As of Friday's close, the The Euribor-OIS spread was flat week-over-week at 13 bps. We'll stay tuned for an update as of the close today. The Euribor-OIS spread (the difference between the euro interbank lending rate and overnight indexed swaps) measures bank counterparty risk in the Eurozone. The OIS is analogous to the effective Fed Funds rate in the United States. Banks lending at the OIS do not swap principal, so counterparty risk in the OIS is minimal. By contrast, the Euribor rate is the rate offered for unsecured interbank lending. Thus, the spread between the two isolates counterparty risk.
10. ECB Liquidity Recourse to the Deposit Facility – Deposits at the ECB continued to decline in the latest week, albeit this data is through Friday. It remains to be seen how the Cyprus deposit tax will impact things. The ECB Liquidity Recourse to the Deposit Facility measures banks’ overnight deposits with the ECB. Taken in conjunction with excess reserves, the ECB deposit facility measures excess liquidity in the Euro banking system. An increase in this metric shows that banks are borrowing from the ECB. In other words, the deposit facility measures one element of the ECB response to the crisis.
11. Markit MCDX Index Monitor – Last week spreads were narrowly tighter, ending the week at 88.2 bps versus 91 bps the prior week. The Markit MCDX is a measure of municipal credit default swaps. We believe this index is a useful indicator of pressure in state and local governments. Markit publishes index values daily on six 5-year tenor baskets including 50 reference entities each. Each basket includes a diversified pool of revenue and GO bonds from a broad array of states. We track the 16-V1.
12. Chinese Steel – Steel prices in China fell 2.8% last week, or 105 yuan/ton, to 3654 yuan/ton. We use Chinese steel rebar prices to gauge Chinese construction activity, and, by extension, the health of the Chinese economy.
13. 2-10 Spread – Last week the 2-10 spread widened to 176 bps, 10 bps wider than a week ago. We track the 2-10 spread as an indicator of bank margin pressure.
14. XLF Macro Quantitative Setup – Based on this morning's open, the XLF is sitting just above trade support of $18.23.
Joshua Steiner, CFA
Here’s our investment call from this morning – Keith tells you what the situation in Cyprus really means.
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