This note was originally published at 8am on February 19, 2015 for Hedgeye subscribers.
“He that can have patience, will have what he will.”
That’s a great fishing strategy inasmuch as it is a macro risk management one. While I don’t think Benjamin Franklin was talking about either, we can always learn something from a thought leader’s timeless quotes.
The Fed wants you to focus on being “patient” too…
And while it may be intellectually stimulating to consider the removal of that wording, yesterday the Fed’s Jay Powell (voting member of the FOMC) cautioned against rising expectations of “dropping the patient language” at the March 18th Fed meeting.
Back to the Global Macro Grind…
Powell’s comment was a real-time one yesterday, whereas the Fed’s “Minutes” from their January meeting were not. That said, both helped drop the 10yr US Treasury Yield in a straight line from 2.16% 24 hours ago, to 2.05% this morning.
The key to the Fed Minutes was the FOMC acknowledging what I’ve been very concerned about – a policy mistake – i.e. raising rates as both the global economy is slowing and #deflationary headwinds continue to manifest.
“So”, I think our almighty overlords on the central planning committee did the right thing in suggesting that a “premature hike might dampen the recovery.” That is indeed, the truth.
Or is it?
I’m on the road seeing Institutional Investors in California this week, and THE question in every meeting surrounds this basic, but critical, question on rates rising or falling from here. What is going to be the truth?
I like to measure the truth with what the market does on data and events:
And obviously the politics, wording, and timing of all Fed comments have mattered along the way. Don’t forget that Powell’s comments were plugged into the marketplace to offset a non-voting Fed member’s comments about removing the “patient.”
So I’d say the truth is that it all matters – and that markets are reflexively reacting to price action which, in turn, is driving Fed rhetoric, as the Fed reacts (on a lag) to data that the market is already discounting.
If you don’t want to deal with all of the data, noise, etc., and want to take a longer-term and more patient view of this gong show of gaming un-elected-political-policy-expectations, this gets a lot easier:
A) You have to decide if year-over-year GROWTH is going to accelerate or decelerate
B) You have to decide if INFLATION is going to continue to #deflate or start to reflate
C) Then you have to take a view on how to front-run the Fed’s behavior depending on answers to A) and B)
And/or you can just let Mr. Macro Market hold your hand along the way, signaling in real-time where the probabilities on A) and B) are rising or falling. He tends to do a better job than most on that.
I don’t get to take the easy path. I have to write to you every day and attempt to explain every little data wiggle and watch word. But I’m cool with that. It’s what makes this game of expectations the one that I love.
To review how we’d answer A, B, and C:
A) Global Growth will continue to surprise on the downside as US Growth has a solid Q1, then slows Q2/Q3
B) Global #Deflation remains our Top Global Macro Theme for Q1/Q2
C) Even if the Fed does a token 25bps hike, they’ll have to say no more of that by Q3 anyway
The patient investor has bought every pullback in the Long Bond (TLT) for the last 8 months and made plenty of money doing so.
That’s because they understood that the best way to play global #GrowthSlowing and #Deflation was to buy low-volatility duration as the manic had to unload commodity and energy related equity beta as Oil Volatility (OVX) went from 15 to 60.
Never mind Oil Vol 60 – that’s epic, 2008 style volatility! Can you imagine if US Equity Volatility (VIX) went from 15 (closed at 15.45 yesterday) to 20, 25, or 30 again? I can. And a lot of #patient equity investors will be happy to buy lower (again) on that.
Our immediate-term Global Macro Risk Ranges are now:
UST 10yr Yield 1.74-2.16%
Best of luck out there today,
Keith R. McCullough
Chief Executive Officer
Takeaway: Our FL Short Call has a lot of layers that we expect to play out systematically throughout ’15. $20 down/$6 upside.
Conclusion: The biggest pushback, by a long shot, on our FL short call is timing, and how long we have to wait for it to play out. While FL is unlikely to completely melt down this week on the print, especially 2-weeks ahead of an analyst meeting, we definitely think that the building blocks of our thesis will be incrementally evident in the quarter to be reported on Friday (as well as in the meeting on 3/16). But this is a complex call with many layers that will peel off one at a time systematically as 2015 progresses, resulting in downward revisions and revealing a down year in 2016. Ultimately we think it will result in consensus estimates coming down meaningfully for the first time in six years, and we’ll see both lower estimates and multiple compression. We get to $20 downside, and $6 upside.
FL remains one of our top short ideas, but it is also perhaps the most complex. It’s not just about Nike, or about Ken Hick’s leaving, or about e-commerce threats. It’s about this company just having come off a six-year run that was driven by a ‘perfect storm’ (the good kind) of …
a) Margins: economic expansion and margin tailwind,
b) The Hicks Era: a new stellar CEO taking capital out of the model while simultaneously taking productivity and margins to new peaks, and adding 2,000bp to RNOA (RNOA to 25% from 5% pre-Hicks),
c) Nike Penetration: FL taking NKE to 70% of its inventory purchases from 56% – which has meaningful positive implications for gross margin,
d) ASP Cycle: Nike driving a 12-year ASP cycle which accrued to the retailers (like FL) just as much as it did NKE.
e)e-Commerce: Growth in e-commerce without meaningful brand competition.
But today, those factors have changed for the worse... (Here’s the links to our recent Black Book deck and audio presentation where we outline these factors in more detail.)
Call Replay: CLICK HERE
Materials: CLICK HERE
a) Margins: The post-recession margin tailwind is over. We need raw top line growth and productivity improvements to boost margins.
b) The Hicks Era:
1. Ken Hicks is gone. His team is still there. But we think that one of the highlights of the analyst meeting on March 16 will be how the company will be spending to grow. That’s fine, but keep in mind, it has just come off a period where it grew without spending and boosted returns by 2,000bps. Big difference – especially when it’s still sitting at a peak 15x p/e.
2. Also, there’s no more capital to pull away from this model. We outlined in our Black Book how the fleet is largely optimized, and perhaps with the exception of some Lady Foot Locker stores, there’s little left to close or ‘rebanner’.
c) Nike Penetration: Is the next move in Nike as a percent of total higher, or lower? It’s lower. And, quite frankly, it’s HEALTHY for Nike to be a smaller percentage. It’s just probably less profitable. We actually have people tell us “I called Nike and they said the Foot Locker is a really important customer – and that your thesis is wrong’. That’s what Nike HAS TO say. They fight their battles in private, and win where it matters -- on the P&L and the balance sheet. At a minimum, Nike not going higher as a percent of total sales is a negative, as the tailwind that’s existed for half a decade has been underappreciated.
d)ASP Cycle: We’re in a 12-year ASP cycle. Chances are, there will be a year 13. And probably a year 14. This is a space where the tail wags the dog. As the brands spend up in R&D, they drive prices higher. But the difference is that we’re at a point where the higher prices will start to accrue disproportionately to the brands. They (especially Nike) finally have the infrastructure and the product tiers in place to grow their DTC businesses aggressively.
e)e-Commerce: And we’re already seeing this part of the story play out. The charts below show the yy change in reach for FL vs NKE (reach spread is defined as the percent of people using the internet that are using Footlocker.com/Nike.com today versus last year). This will accelerate. What this does is maintains the mid-upper price business for the retailers, but allows Nike to dominate the $160-$225 business on its own site. That’s a problem for FL as its ASP increase has not been broad based. It has been because the retailer added a better mix of shoes at extreme price points.
The biggest pushback we get on any of this is “yeah that’s great guys, but am I going to have to wait another three years before seeing this? Show me the near-term catalyst and roadmap.” Fair question (and trust us, it comes from 80% of the people we talk to). When all is said and done, though FL is unlikely to melt down this week, we definitely think that parts of our thesis will be evident in the quarter to be reported on Friday. But this call has many layers that will peel off (usually) one at a time systematically as 2015 progresses, and ultimately result in consensus estimates coming down meaningfully for the first time in six years.
We’re about in line for the quarter at $0.91 and 6% comp, but are 5% below the consensus for 2015. And by the time we look toward 2016, we’re at $3.46, 17% below the Street.
So what’s this worth? Not 15x earnings, we’d argue. But we’re not going to make a multiple contraction call. But the call we will make is one for lower earnings and growth, and once that is apparent to the Street, the multiple will follow. We think that 12-13x $3.60 in EPS by year end 2015 is realistic as the story plays out, or a $45 stock (20% downside). Looking into 2016, and the likelihood of a down year ($3.46 despite the Street's $4.17) we think we're looking at 11-12x $3.46, or a stock in the high $30s. All in, we're looking at about $20 downside over the next two years, with about $10 per year.
That's about 4.9x EBITDA and a 8% FCF yield, which seem fair for a zero square footage growth retailer with earnings that are shrinking. If we're wrong, we're looking at about $4.25 in EPS power. Keeping today's peak 15x p/e, that suggests a $64 stock. That's about $6 upside versus $20 downside. We think the path of least resistance is on the downside.
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Takeaway: We are removing Yum! Brands (YUM) from Investing Ideas.
Takeaway: We are adding ITB to Investing Ideas.
Note: The excerpt below was written earlier today by Hedgeye CEO Keith McCullough. Stay tuned for further updates from our housing team.
Going back to the proverbial wood, and signaling buy on Housing.
US #HousingAccelerating remains 1 of the Top 3 Global Macro Themes in the Hedgeye Institutional Themes deck right now. Not only did US home prices accelerate (in rate of change terms) in the Core Logic data this week to +5.7%, but the supply/demand data has been improving throughout the last 3 months.
So, on days like today, we can to #FadeBeta (take the other side of the market's move) and buy our Best Ideas at the low-end of their respective risk ranges. Housing (ITB) and related companies (like OC) are some of those ideas.
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