This note was originally published at 8am on November 28, 2014 for Hedgeye subscribers.
“I wish you [turkey] didn’t have to die, but a bunch of white people put on sweaters.”
- Peter Griffin, Family Guy
Tryptophan – the amino acid in turkey responsible for the Thanksgiving post-gluttony coma - has to cross over the blood brain barrier in order to elicit its stuporous effects. And it can only do that in the presence of sufficient amounts of insulin/carbohydrates.
Without digressing into the underlying (paradoxical) physiological mechanics, the relevant peri-Thanksgiving takeaway is that if you only eat turkey & no carbs alongside it, you won’t get tired.
You can weigh the psycho-social cost-benefit of that biochemical reality for yourself as you ferret through the leftover’s fridge.
Back to the Global Macro Grind….
To attempt to crosswalk that holiday anecdote over the relevancy barrier to the investment space, the tryptophan paradox could be viewed similarly to the de-couplers fallacy.
Sure, you could go to Thanksgiving dinner and just eat some turkey and nothing else, but I’d probably only make that bet…with someone else’s stomach.
The U.S. could ramp into full, escape velocity de-coupling mode while the balance of the global economy harmoniously converges to a state of disinflation and decelerating growth but, right here, we’d probably only get long that improbability via high-beta, early cycle exposure…with someone else’s money.
The first chart of the day below is our global macro summary table which consolidates global estimate trends for growth and inflation.
I know you can’t really see the table detail but that’s not really necessary here - one need only observe the ubiquitous red, which represents negative growth and inflation estimate revisions, to see the global transition to Quad 4 manifesting in real-time.
Oil’s expedited descent to sub-$70 and the massive underperformance in the XLE are acute examples of the stuporous deflationary realities of Quad #4 as the duo of disinflation and decelerating growth remains the scourge of energy assets and inflationary leverage.
Given the pervasive, negative revision trends and the re-crescendo of the currency wars and central bank interventionism, both the market and policy makers are discretely acknowledging the deceleration in growth.
Extending the logic chain, an investor overweight and long of high growth (global) equities would then seem to fall into two broad categories:
Wrong: in terms of a fundamental forecast (why would one be levered long into slowing growth?)
Having & Eating Cake: Long under the premise that if growth accelerates you’ll be along for the ride and if it slows equities will (again) get juiced by a global “central bank put”
Given the frequency and magnitude of policy intervention over the last 5+ years and the near-Pavlovian, positive response in market prices, copping to strategy number 2 is somewhat defensible as it amounts to “playing the game that’s in front of you” and not the one you think you should be playing.
The binary nature and exogenous dependency (i.e. the fulcrum thesis driver being completely external to economic or company fundamentals) of that strategy, however, kind of divorces it from true “investing” in an organic sense. It’s also akin to Nassim Taleb’s Turkey problem.
To review Taleb’s popular probability parable:
“Consider a turkey that is fed every day. Every single feeding will firm up the bird’s belief that it is the general rule of life to be fed every day by friendly members of the human race…On the afternoon of the Wednesday before Thanksgiving, something unexpected will happen to the turkey. It will incur a revision of belief.”
It doesn’t take a lot of imagination to extend that metaphor to the equity market farm and envisage who’s the turkey and who’s the farmer.
Anyhow, getting back to the domestic decoupling…..
Inclusive of the crush of pre-holiday data on Wednesday, decelerating growth appears to be the emergent main course for 4Q.
Initial Claims deteriorated for a 3rd week. Peak improvement in claims has been a consistently solid lead indicator of the economic cycle. Are we pushing past peak?
Durable and Capital Goods spending softened (again). We expect the ISM/mfg data to soften alongside declining export demand, shifting seasonals, and middling domestic capex
Household Spending and Income saw tens of billions of dollars of income and savings revised away.
To delve into the last point a bit deeper.
Estimates for personal income were revised for the April-to-September period and the adjustments were remarkable as total disposable personal income saw some $200+ billion (SAAR) shaved away vs. prior estimates.
Alongside a meaningful downward revision to the savings rate in recent months, a net effect of the revision was a complete shift in the trajectory of salary and wage growth.
Whereas, prior to revision, the slope of aggregate wage growth in 2Q/3Q was one of acceleration, after the revision, it shifts to one of flat-to-modest deceleration.
Specifically, private sector salaries and wages were initially reported to be growing +6.1%, +6.0%, +5.9% over the July-to-September period. With the revision, those growth rates were marked down to +5.0%, +4.9%, +4.9%, respectively.
So, prior to revision, wage income was accelerating to a new cycle high alongside higher highs in savings. Thus, the capacity for incremental consumption growth continued to improve even if increased savings was muting the translation to actual spending growth.
The step function revision lower in both wage growth and the savings rate constrain the upside for consumption growth relative to that prior to the revision.
As the 3-D scatterplot below shows, the multiple regression between Disposable Personal Income growth and the change in the Savings Rate (independent variables) vs. the change in Consumer Spending (dependent variable) has an R-square of 0.95 across decades of data. More simply, growth in Disposable Income and the change in the Savings Rate explains ~95% of the change in aggregate household spending.
As we distilled it in our institutional note on Friday:
If ya don’t have it (no savings), ya ain’t gettin it (wages), and ya ain’t borrowing it (credit)…ya can’t spend it (PCE).
Macro forecasting can be complex and confounding but, every once in a while, it’s worth re-remembering that the strength and prospects for an economy boil down to some simple and very common sense realities.
To close the holiday Friday with some meditative macro invocation,
Grant me the serenity to accept a global entre into Quad #4.
The insight to understand the lagged benefit of lower energy prices.
And the wisdom to know (& time) the difference.
Christian B. Drake
U.S. Macro Analyst
Takeaway: Nice stock reaction, but really a lousy quarter on most metrics. We still need major change to make this name work. All eyes on the CFO.
Conclusion: We’ll take the market reaction, but this was actually a really lousy quarter – especially considering the pain it is lapping vs last year. The irony is that victory can be achieved by simply running this company like how it should be – not what it was built to be. The management team that exists today can likely never earn over $2.50 without a lot of luck. We think that the Board dynamics are such that the pending CFO hire will be a game changer, raising the profile of the Finance Organization at LULU – even if it means eventually getting rid of the ‘new’ CEO. That’s when we can talk about $3-4 in earnings and a $100+ stock. We’re still Long, but with a short leash.
We’re not as excited about this LULU print as the market is. Don’t get us wrong – we’ll take the upside, as the name has been on our Best Ideas list on the Long side since June 15 of this year. And for now it’s staying there. But let’s face reality – the stock was up because business is ‘less pathetic’ than it had been. Comps were +3.0% (Constant $), new store productivity was stable at 63%, and revenue was +10.4%. That’s all good. But from that point, the growth algorithm pulls a sharp 180. Gross profit was up only +3.2%, and EBIT was down -12.1%, and EPS off by -6.9%. Can we celebrate progress? Yes. But make no mistake, the financial model remains broken.
A few more thoughts on the print.
1. Why Aren’t Numbers Better, Sooner? We’re seven quarters removed from the Luon (see thru pants) debacle, and 4 quarters removed from the last of the ensuing PR problems that plagued the company. Numbers should, without fail, be getting better.
2. Questionable Risk Management. The West Coast port issues have been lingering in the news since July, yet this is the first consumer company we heard that actually adjusted revenue guidance because of inventory delays at the ports. Either it has very poor risk management processes to divert freight away from Long Beach, or it simply planned very poorly. We’d argue that it is both as a) this is not a process-driven company that places a priority on risk management, and b) with all the new employees hired in product planning over the past quarter, LULU simply didn’t have enough people in place when it mattered (that’s likely why they hired).
3. We’re mixed on the Gross Margin erosion (-353bps). When all is said and done, we think that LULU will be sitting here in 2-3 years with a 48% Gross Margin vs 51% today. It can either get there offensively, or defensively. We prefer offense.
a. Offense means that the company invests proactively in its R&D platform and innovation agenda, its ability to flow product more accurately throughout a multi-channel distribution platform, while maintaining price integrity, and its premium brand status. It accelerates sales at a premium merchandise margin, but does so through appropriately investing in the areas needed to win (like Nike and UnderArmour).
b. Defense means the exact opposite. It means that the company does not have the product engine to grow the brand, nor can it flow product down the price curve as a season progresses through an increasingly unmanageable number of doors. The best example of this is Coach. The company has been married to its Gross Margin for so long, and it ultimately cost Coach’s top line all hope of doing anything other than going straight down. When Laurent talks about returning to a mid-50s GM% on the conference call, we wish he could see half of his investor base grimace. Our strong sense on this one is that nobody will pay for Gross Margin improvement. They will pay for sheer growth – even if it comes at a lower gross margin than what the company is churning out today.
4. Still no convincing plan to fix the company. That’s actually one of the things that attracts us to the story. The brand, despite its problems, remains very relevant. As hard as Chip’s organization seemingly tried, it did not kill the brand. There is almost zero chance that there is a well-articulated plan internally that we’re simply not hearing. Trust me, if Laurent had rock solid strategic and financial models, we’d know about them. You don’t let your CFO go (or push him out) because ‘the financial model is just too good’. When JC Penney has articulated a better growth plan than you, then you should probably rethink a few things.
That Brings Us to Why We Still Like LULU.
No, we don’t like the lack of a financial model, we didn’t like the growth algorithm, or the inability of the company to accelerate growth at the precise time when it is anniversarying problems from last year. In sum, we simply don’t like management. They’re nice people, but we think that Potdevin (CEO) is punching far above his weight. This was Currie’s (CFO) last conference call, and it sounds like a new CFO will be on the next call. We almost never get too upbeat about a single individual in an organization. But we think that this role is the exception. Why?
For starters, the Finance function at LULU has always been extremely weak. Currie was appropriate to be Chip’s numbers guy in the early days of the company, but Chip purposely kept the entire function at bay as the company grew up, as he thought it would hurt the culture of the company.
At the same time, the Chairman of the Board is now split between Mike Casey (former CFO of Starbucks) and David Mussafer (Advent/new to the Board). The new CFO will not be hired by Laurent, he/she will be hired by Casey and Mussafer, who both know the caliber of person needed to get this company back on track. Our sense is that this person will be tasked with rightsizing the company. If Laurent wants to follow, then great. Everyone wins. But if he resists, then the new CEO will soon be the old CEO.
So What Does this Mean for the Stock?
The risk/reward definitely is not what it was 35% ago. LBO is off the table at this valuation, as is a sale of the company. Now we have to bet on an actual rebound in the business. If we had to make that bet on the team that’s in place today, it’s pretty clear that they’d get a vote of no-confidence, and we’d be out. At a price, we’d actually go the other way and short the stock.
But, we’re very interested to see the caliber of the individual that the company hires. It’s odd…in our conversations with investors, people agree that Currie had to go, but don’t necessarily think that there’s a problem with the finance organization being so weak at LULU. We think that people will only realize how problematic this has been once it is fixed.
There’s a lot of extremely competent leaders out there in or around retail finance that have proven that they can run businesses far bigger than LULU. Consider Nike, for example – which is a mere 300 miles South of LULU. It has at least eight divisional CFOs who run businesses at least 2x as big as LULU (and Nike North America is over 10x). The point is that the talent is out there, and our sense is that Casey and Mussafer are taking their time for a reason. This hire could be a game changer.
It will be painful along the way, but how we’re modeling it, we get to a 20% EPS CAGR, and earnings back above $3.00 by FY17. The stock is trading at about 24x next year’s number ($2.17), and if we hold that multiple – which is not a ridiculous assumption given accelerating growth to 20%, then we’re looking at $64 and $75 1 and 2-years out, respectively. Not a huge return, but we’ll take it.
This note was originally published December 05, 2014. CLICK HERE to subscribe to our Morning Newsletter.
“When your enemy is making mistakes, don’t interrupt him.” -Billy Beane
This week I had the pleasure of presenting the state of Hedgeye’s Research engine to nearly 60 of my colleagues throughout our Firm. There were about a dozen key conclusions, followed by a spirited dialogue (which is part of our DNA). But there was one key component of our discussion that I believe is relevant to not only our own team internally, but also to our customers, without whom Hedgeye would not have had such a banner year in 2014. That component is how our business model is structurally different, and how it allows us to think, act, and produce money-making ideas in ways that are dramatically different from the #OldWall.
The Model: WallStreet2.0
Before understanding how we generate ideas, it is important to understand the structure that allows us to do what we do – on a repeatable basis. Consider the table below. I compared an OldWall model against Hedgeye on some key operating metrics. The #OldWall could be your typical bulge bracket ibank, a regional research firm, or pretty much anyone else who is in the business of selling research. Let’s compare and contrast…
1) Stocks Covered: A typical #OldWall analyst will have a fixed coverage universe between 12 and 18 stocks. It takes an average of one month per company to ‘initiate coverage’ on a new name (been there, done that). If you ask that person about a name on the fringe of their coverage, they’ll likely answer “sorry, I don’t cover that”. They’re not allowed to have an opinion without an ‘official’ rating. Note: if an analyst at a Hedge Fund told his/her PM that “I don’t cover that”, they’d soon be out of a job. At Hedgeye, the typical Sector Head has about 100 names under coverage. In Retail, the sector I have the privilege of covering, there’s about 130 names I track regularly. No one at Hedgeye will ever utter the words ‘I don’t cover that’. They might say something like “I’m not familiar with it right now – can I get back to you in a day?” But “I don’t cover it” is not in our vernacular.
Does that mean that I have a ‘call’ on 130 names? Absolutely not. But I have a tremendous playing field from which to source big ideas. I hold myself responsible – as do the other Sector Heads at Hedgeye – to have a repeatable process in place to consistently fish where the fish are. By the time a company works its way through our vetting process, we’ve checked enough risk management boxes such that it’s like a batter stepping up to the plate with a 3 and 0 count. Chances are grossly in favor of that player getting to first base – at a minimum.
2) Big Calls: The way I see it, if I can’t find at least three big longs and three big shorts at any given time out of a group of 130 stocks, then I don’t deserve my seat. Plain and simple. If I were to look at those 130 charts (which I do every weekend) I can assure you that there’s a heck of a lot more than three names that doubled last year, and three that got cut in half.
Let’s add another dimension to the concept of a Big Call. Actually, let’s add two more. Now I’m talking Keith’s language -- TRADE, TREND and TAIL. We’re asked so often why we don’t have ratings. The answer is that the concept of a ‘rating system’ is broken. What if there is a name that we think will double in 18 months, but is going to miss the upcoming quarter by 20%? It might be a short for a more nimble investor, or a long for someone with a 3-year duration that looks through quarterly earnings oscillations (admittedly not many of those people exist, but you get the point). It’s our job to help customers navigate the duration curve.
3) Percent Short: Roughly half of our calls are short. And I’m not just talking about TRADE positions. Each of our Sector Heads has about half of their respective calls on the short side. Heck, our Energy and Internet Analysts have nothing BUT shorts – and they have an enviable track record (check out Kaiser’s call on LINE). The reason why I note in the table above that 0% of Sell-Side calls are Short is that I have yet to see an #OldWall report that actually uses the word ‘short’. About 10% of ratings in an informal check were either Sell or Underweight. But none made an outright short call, and the average price decline was only 5% (which is hardly shortable in today's liquidity environment).
4) Expected Return: The average expected upside for Buy ratings on the Sell side is about 12% for Retailers. If I’m investing real money, I’m probably not going to get too excited about something that gives me a 12% return, unless there is zero potential for downside (which is impossible). In my little world, I’d point out Restoration Hardware, which is a name we’ve liked since $32 (it’s $84 today), and we still think it’s a winner. For those that like it on the sell side, the debate seems to be whether it will be a $90 stock or a $100 stock. From where I sit, the bigger question is whether it is a $200 vs $300 stock. Will it get there tomorrow? No. But by 2018 I think RH will earn $11/share. The consensus is at about $6. It looks expensive today if you believe the Street. But it’s extremely cheap if I’m right. I can guarantee you that if I were at my former (sell side) employer, I literally would not have been allowed to go out with estimates and a resulting equity value that was so far outside of the mean.
One of the inherent challenges to having such a broad coverage approach is that we’ll miss some big moves. With a list of 130 stocks, I can guarantee I’ll miss some big longs and shorts in 2015. I’m not happy about that one bit, but as long as I’m right on the names I pick and help our customers make money, then that’s a win from where I sit. As long as we stick to our process and keep stepping up to the plate with a 3-0 count, I’m downright excited about what 2015 has in store.
Our immediate-term Global Macro Risk Ranges are now:
UST 10yr Yield 2.16-2.30%
WTI Oil 62.99-70.64
Get on base,
Managing Director and Retail Sector Head
Takeaway: Mutual fund activity during the past 5 days continued to be defensive with outflow in stock funds and inflow into money funds
Investment Company Institute Mutual Fund Data and ETF Money Flow:
Broad themes relayed throughout 2014 have not changed with an ongoing redemption in the domestic equity mutual fund channel and stubborn strength in fixed income. With another 3.0 billion lost last week in U.S. stock funds, the 30th week of outflow in the past 32 weeks, we remain cautious on shares of T Rowe Price (TROW) and Janus Capital (JNS). Conversely with the more defensive nature of recent market trends and the 7th consecutive week of inflows into money market funds, which have totaled over $79 billion, we highlight our newest Long idea Federated Investors (FII).
In the most recent 5 day period ending December 3, total equity mutual funds put up net outflows of $2.7 billion according to the Investment Company Institute. The outflow was composed of domestic stock fund withdrawals of $3.0 billion versus the $271 million subscription into international stock funds. The international and domestic equity categories continue to be polarized with international stock funds having inflows in 46 of the past 48 weeks, versus domestic trends which have been very soft with inflow in just 16 of the past 48 weeks. This data continues to be supportive of our underweight or short recommendations on the U.S. centric equity asset managers (see our research here). The running year-to-date weekly average for all equity fund flow continues to decline and now settles at a $936 million inflow, well below the $3.1 billion weekly average inflow from 2013.
Fixed income mutual funds put up inflows of $174 million with $667 million of outflows in taxable funds and $841 million of inflows in tax-free funds. Munis have had a solid run with subscriptions in 46 of the past 47 weeks. The 2014 weekly average for fixed income mutual funds now stands at a $1.1 billion weekly inflow, an improvement from 2013's weekly average outflow of $1.3 billion, but still a pittance of the weekly average of +$5.8 billion in 2012 (our view of the blow off top in bond fund inflow).
ETF results were strong during the most recent 5 days with substantial inflows into equities and decent subscriptions into passive fixed income products. Equity ETFs put up a $7.4 billion inflow which is above the 2014 weekly average of a $2.7 billion inflow. Fixed income ETFs netted $910 million in new investor funds, slightly below the year-to-date average of $1.0 billion.
Mutual fund flow data is collected weekly from the Investment Company Institute (ICI) and represents a survey of 95% of the investment management industry's mutual fund assets. Mutual fund data largely reflects the actions of retail investors. Exchange traded fund (ETF) information is extracted from Bloomberg and is matched to the same weekly reporting schedule as the ICI mutual fund data. According to industry leader Blackrock (BLK), U.S. ETF participation is 60% institutional investors and 40% retail investors.
Most Recent 12 Week Flow in Millions by Mutual Fund Product: Chart data is the most recent 12 weeks from the ICI mutual fund survey and includes the running weekly year-to-date average for 2014 and the weekly quarter-to-date average for 4Q 2014:
Most Recent 12 Week Flow Within Equity and Fixed Income Exchange Traded Funds: Chart data is the most recent 12 weeks from Bloomberg's ETF database (matched to the Wednesday to Wednesday reporting format of the ICI) and the running weekly year-to-date average for 2014 and the weekly quarter-to-date average for 4Q 2014. The third table are the results of the weekly flows into and out of the major market and sector SPDRs:
Sector and Asset Class Weekly ETF and Year-to-Date Results: In sector SPDR callouts, investors rebounded the energy sector with the XLE taking in +$740 million or an 8% increase in total assets for the week. The second biggest mover on the downside, was the materials XLB, with investors withdrawing $189 million or 6% of total assets.
The net of total equity mutual fund and ETF trends against total bond mutual fund and ETF flows totaled a positive $3.6 billion spread for the week ($4.7 billion of total equity inflow versus the $1.1 billion inflow within fixed income; positive numbers imply greater money flow to stocks; negative numbers imply greater money flow to bonds). The 52 week moving average has been $2.3 billion (more positive money flow to equities), with a 52 week high of $17.7 billion (more positive money flow to equities) and a 52 week low of -$37.5 billion (negative numbers imply more positive money flow to bonds for the week).
Exposures: The weekly data herein is important for the public asset managers with trends in mutual funds and ETFs impacting the companies with the following estimated revenue impact:
Jonathan Casteleyn, CFA, CMT
Joshua Steiner, CFA
The bear is making his presence known around the globe as U.S. perma-bulls plunge their heads ever deeper into the decoupling, "It's Different This Time!" sand.
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