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CHART OF THE DAY: Homebuilder Seasonality (Ave Performance by Month, 1996-2014)

CHART OF THE DAY: Homebuilder Seasonality (Ave Performance by Month, 1996-2014) - HB Seasonality

 

Editor's Note: Below is an excerpt from today's Morning Newsletter written by Hedgeye U.S. Macro Analyst Christian Drake. Click here to learn more and subscribe.

 

  • March:  Seasonality | Performance in Housing related equities shows marked seasonality. In short, the housing complex outperforms from Nov-Feb ahead of the Spring selling season and subsequently underperforms modestly in March as (presumably) some of that cumulated optimism comes off and again in mid-year as the heart of the selling season concludes (see 1st and 2nd charts below).  We show the seasonal pattern that has typified the last 20 years in the Chart of the Day

 


Gizmo or Gremlin?

“No matter how much it cries or begs, NEVER feed it after midnight”

-Gremlins, 1984

 

According to 1980’s legend, feeding a mogwai after midnight catalyzes the transformation from cutesy, wellmeant Gizmo to mischievous, malevolent Gremlin.   Hijinks, hilarity, and the creation of the first PG-13 rating ensue. 

 

The spat of soft early March housing demand data had many wondering whether we’d already reached midnight on the current housing inflection and if the fund flows and improving sentiment feeding the multi-month run of outperformance were set to spawn a reversal in the related equity complex. 

 

We think the hour is nearer twilight than midnight… and Gizmo has more to give as it relates to housing. 

Gizmo or Gremlin? - 15

 

Back to the Global Macro Grind….

 

We reviewed our bullish thesis on Housing in a late-February Early Look – see: Dr. House-ing.  The subsequent ping-pong match in housing data over the last month has, at the least, been interesting.

 

In a recent note to institutional clients we compared and contextualized the competing realities promulgated by the March to-date data. 

 

Consider the following juxtaposition: 

 

(False) Reality:   

  • 3/13:  Mortgage Purchase Applications | Purchase demand declined -1.5% sequentially with year-over-year growth sliding back towards the zero line at +0.7%.
  • 3/16:  NAHB HMI | Builder Confidence declined -2pts month-over-month in March, marking the 3rd consecutive month of decline and the lowest reading since July of last year.
  • 3/17: Housing Starts | New Home Starts in February dropped -17% sequentially, posting their biggest month-over-month decline since January 2007
  • March:  Seasonality | Performance in Housing related equities shows marked seasonality. In short, the housing complex outperforms from Nov-Feb ahead of the Spring selling season and subsequently underperforms modestly in March as (presumably) some of that cumulated optimism comes off and again in mid-year as the heart of the selling season concludes (see 1st and 2nd charts below).  We show the seasonal pattern that has typified the last 20 years in the Chart of the Day below.

So, certainly not the numbers accelerating recoveries and sustainable outperformance are made of. 

 

We think the underlying reality is more sanguine with the preponderance of the weakness in the reported February data largely attributable to weather. 

 

As it relates to builder confidence, the Current Traffic component of the index led the weakness in the composite reading, which is consistent with a severe weather related drop in the flow of active buyers.  The NAHB also cited supply chain concerns, particularly in terms of labor supply.   Residential construction employment saw its largest monthly increase in employment in nearly 10 years in January and employment at the industry level continues to run in the high-single digits.  

 

There is clearly strong demand for labor in the sector, however, wage growth has yet to really accelerate according to BLS data so it remains equivocal whether rising labor demand is, in fact, driving accelerating builder cost pressure and/or labor supply shortages at the aggregate level.  Further, while labor supply constraints may serve as a drag to builder confidence, presumably it is rising demand trends that are driving tighter conditions in the resi employment market.  All else equal, we’d view improving demand as a net positive. 

 

On the New Construction side, while the sharp drop in Housing Starts captured most of the headlines, we believe the real story was in the 3% gain in permits. The 57% collapse in starts in the Northeast drove the bulk of the headline decline, again consistent with unusually cold/severe weather weighing on activity.  

 

Sure, seasonality and weather are not new phenomenon but resolving the volatility and vagaries inherent in month-to-month changes in activity in seasonal industries remains challenging despite the best efforts of evolving seasonal adjustment methodologies.   

 

Further, staring at industry numbers from the aseptic environment of a spreadsheet has the sneaking ability to, at times, drive a wedge between expectations conceived in an analytical echo chamber and the practical realities of the underlying business.  Having been in the construction industry, digging a foundation or auguring down to below the frost line to pour piers in frozen terrain is a largely quixotic pursuit. 

 

Anyhow, we expect to see a big rebound in the next two months in housing starts as the data plays catch-up to the thaw.

 

Reported Reality:  

  • 3/19-20:  Builder Earnings | Reported results for 1Q15 out of the Builders LEN and KBH had both companies beating sales and earnings estimates while reporting strong pricing and accelerating orders growth.  Further, they talked down the weakness in reported Starts in February and guided to incremental margin improvement over the balance of the year with the expectations for continued, ongoing improvement in the demand environment.  We’re not inclined to take management’s word for it but in this particular case, we’d agree on the intermediate term outlook. 
  • 3/23:  Existing Home Sales | Sales of Existing Homes accelerated to +4.7% YoY, marking the fastest rate of growth in 17-months. 
  • 3/24: New Home Sales | New Home sales in February hit their highest level since February 2008 rising +7.8% MoM to 539K vs an upwardly revised January estimate.  More notably, sales were up a remarkable +25% year-over-year and should continue to look strong from a second derivative perspective as we traverse a 5-month period of easy comparisons.  
  • 3/25:  Purchase Applications | Purchase application saw some positive mojo in the latest week, rising +4.9% sequentially and accelerating +200bps to +2.7% on a year-over-year basis.

 

What’s our suggested interpretation of this Tale of Two Housing Realities?

 

We’d argue that much of the weakness in the reported February data was weather related and, in effect, created a mini-ball underwater dynamic.  Over the next 6-8 weeks, we expect a modest backlog of deferred housing consumption in conjunction with healthy organic demand trends to manifest in accelerating improvement in reported activity.   

 

Indeed, behind the data volatility in March, the crux of our underlying thesis remains largely unchanged.   Labor market strength + credit box expansion + (very) easy compares should continue to support improving rates of change in housing demand over the intermediate term.  

 

We’ll be hosting our 2Q Housing Themes call next Thursday, April 2nd at 11am to update our outlook for the industry and the related equity complex.  Please contact if you are interested in attending. 

 

No matter how much it [your position] cries or begs, NEVER capitulate at a manic, short-term bottom.

 

Our immediate-term Global Macro Risk Ranges are now 

 

UST 10yr Yield 1.81-1.98%
SPX 2046-2084

DAX 113
VIX 14.03-16.97
EUR/USD 1.04-1.11
Oil (WTI) 42.37-52.28 

 

To hair bands, Hungry Hippos and Volker-style policy sobriety,

 

Christian B. Drake

U.S. Macro Analyst

 

Gizmo or Gremlin? - HB Seasonality


The Changing Food Landscape is Just Beginning

With this note we are announcing the addition of Shayne Laidlaw to the Hedgeye Consumer Staples team.  Shayne has spent the past three years working at General Mills and brings a differentiated view of the food industry to the Hedgeye team. 

 

Deal Overview

  • H.J. Heinz and Kraft Foods announced that they have entered into a definitive merger agreement to create the Kraft Heinz Company, forming the third largest food and beverage company in North America
  • Kraft shareholders to own 49% and Heinz shareholders to own 51% of the combined entity
  • Kraft shareholders to receive a one-time cash payment of $16.50 per share ($10 billion aggregate value), fully funded by $10 billion of new common equity contributed by Berkshire Hathaway and 3G Capital
  • The cash dividend represents 27% of Kraft’s closing price on 3/24/2015
  • Board of Directors to be composed of 5 members of current Kraft Board and 6 members of current Heinz Board (3 from 3G and 3 from Berkshire Hathaway)

 

Strategic Rationale

  • With combined sales of $29.1 billion, of which $22.2 billion are generated in North America, the Kraft Heinz Company will be the third largest food company in North America and the fifth largest in the world
  • Improved scale in key North America retail and foodservice markets
    • Foodservice platform raises brand awareness with iconic portfolio of center-of-store brands
    • Significant cost efficiency and synergy opportunities
      • Expected to achieve $1.5 billion in run-rate annual cost savings across COGS and SG&A by 2017
        • Implement zero-based budgeting
        • Integrate distribution networks and rationalize manufacturing footprints
        • Improve productivity and optimize procurement expenditures
        • Streamline organizational structure
        • Optimize advertising and marketing spending
  • Significant revenue synergy opportunity, with strong platform for international growth
  • International expansion from Kraft brands through Heinz platform
    • Heinz currently generates 61% of sales internationally
    • It is anticipated that the new company will use this manufacturing footprint to expand Kraft brands globally (currently only 2% of sales outside North America)
    • Kraft has many international brands currently licensed to Mondelēz that are due to revert back to Kraft in the near future
    • Investment grade company with sustainable capital structure built for long-term growth

 

Industry Implications

  • The food industry has seen a steady amount of M&A over the recent years involving acquisitions of small to mid-sized companies by larger food manufactures
  • But now, with this merger it will leave the big players; General Mills, Kellogg’s, Mondelēz, Campbell’s and J.M. Smuckers thinking, could we be next?
  • With this merger and Berkshire Hathaway’s backing we expect increased competitive pressure forcing other industry players to respond before their hand is forced
  • Kraft has had lackluster performance lately leading management to really think, can we return to growth? Or would it maximize shareholder value to sell now?
    • Obviously they chose to sell, most likely led by their newly appoint CEO John Cahill, known as a deal maker
    • When you look across the major competitors listed above, it will be interesting to see if current management is willing to rock-the-boat and make a move, or will an ousting or “retirement” be required for change to occur
    • Either way, I believe we will begin to see large transformational acquisitions or mergers in the space in order for companies to stay competitive. There is just no way all five of these companies will stand still, when starring down the barrel of Mr. Buffett’s elephant gun

 

Getting 3G’ed                 

  • 3G Capital has become synonymous across the Restaurant, food and beverage industries with cost cutting and creating efficiencies
  • Over the last two years since 3G and Berkshire Hathaway took Heinz private, they have turned it into a lean mean fighting machine and one of the most profitable food companies globally
    • In the process, realizing $1 billion in operating improvements by:
      • Implementing zero-based budgeting and management by objectives
      • Simplified corporate structure; and
      • Rationalization of the manufacturing footprint
  • Through these cost cutting efforts and operational improvements the new leadership has brought EBITDA margins from 18% to 26%

 

Words from an Insider

  • Warren Buffett when asked if he would continue to work on deals in this space, declined to comment, but said that Kraft Heinz will be a company with ‘ambitions for a long time’ and did imply that there is no ‘finish line’ with respect to the partnership with 3G

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RH – Key Issues Into (And Out Of) The Qtr

Takeaway: Here's all the numbers we care about into the print -- and why we still think it a very big, very under appreciated idea.

CONCLUSION

Here are the key financial metrics we’re looking for into (and out of) the RH print. The quarter was already preannounced, so the announcement is all about guidance. As we’ve already stated, we think that there will likely be a revenue push from 1Q into 2Q associated with slower deliveries due to the port strike in the quarter. Unlike other retailers that will lose revenue forever, with RH it is simply delayed. Even if this does not actually materialize over the course of the quarter, RH is likely to guide conservatively – a) to play it safe, and b) because it can (other retailers did, and the market is expecting it).

 

In the end, RH remains our top idea in retail. People are finally starting to appreciate the square footage growth story – growing today for the first time in seven years. But we don’t think that they appreciate why. Yes, larger stores a) stimulate greater spending in new categories and b) allow RH to showcase product that previously was shown to consumers in an iPad look-book or a Source Book (physical catalogue). But the story is so much biggger than that. The fact of the matter is that RH is rapidly consolidating the high end home furnishings space not unlike what Ralph Lauren did to the high-end apparel space in 1990 – and virtually all of its competition is structurally unable to compete. On top of that, we think that people are really missing out on the Gross Margin upside in the model as the company halves its occupancy rate (from 12% to 6% of revenue in Denver, for example) as it rolls out its new stores.

 

In the end, we have earnings growing at a CAGR of 45% over the next three years. If our model is right, then the current 30x p/e – which most people tell us is too expensive – will turn out to look downright cheap. And unlike other fashion-driven retail stories (i.e. current concerns about KORS) – you never really have to worry about this business going out of style.

 

When all is said and done, by the end of this year, we think that people will be looking at $5.00 in earnings in 2016 – that’s 30% above the Street’s $3.84. If we assume no multiple expansion (despite the higher earnings CAGR) then we’re looking at a stock price of $150 in a year. A year after that over $200 ($7+ * 30x). The biggest problem we think people will have is modeling the dilution of the convertible debt when the stock breaks $190.

 

RH – Key Issues Into (And Out Of) The Qtr - rh financials

 

Key Details On The Quarter

 

Sales

 

1Q

Revenue/Comps - For the quarter we are at 21% revenue growth. That’s broken into a few parts, full details below.

  • Average sq. ft. growth of 10%, with no new openings scheduled for 1Q15.
  • New store productivity of 10%. We should start to see sales flow in from the newly opened stores in LA and Atlanta but given the timing of the openings in late 3Q14 and early 4Q14 respectively and the extended fulfillment window (8-10 weeks +) we should see that accelerate beginning in the 2nd quarter.
  • Retail store comp of 10%.
  • Direct revenue comp of 30%. Overall we like what we’ve seen out of the visitation statistics from rh.com. The chart below looks at the YY % change in traffic rank which takes into account both unique visitation and page visits per user and ranks each site relative to every other site on the internet. It doesn’t translate to an exact comp number, but directionally it’s a very good indicator as to how things are trending. We expect the new source books/product to be released in early to mid-April, which should lead to a reacceleration of the visitation metric.

RH – Key Issues Into (And Out Of) The Qtr - rh traffic

  • That translates to a 21% combined brand comp. Down 400bps sequentially on a 2yr basis. Port issues could cause some revenue to be moved from 1Q into 2Q, but against weather impaired compares LY we like the set-up in the first quarter on the top line.

Port Disruptions: Our sense is that we will hear a little bit about the West Coast Port disruptions on the call. But, keep in mind that 95% of RH’s business is fulfilled from a DC, or put another way, only 5% is cash and carry (our estimate). Unlike WSM, and just about every other retailer on the planet RH doesn’t need product in its stores to conduct a sale. Could it push dollars from 1Q into 2Q? Of course – and it’s a strong possibility, but unlike WSM and apparel/general merchandise retailers, it’s far less likely those sales will be lost forever.

Outdoor – One of the big whiffs last year in the 2nd quarter was the company’s packaging of its Outdoor Source Book into the 3,200 page bundle that arrived in homes in June and July. The big problem with that is that consumers don’t buy Outdoor furniture in June, they’re sitting in it. The category refresh was unveiled on 3/13/2015, a month earlier than last year when it hit the internet on 4/10/2014 last year. The new collection is not in stores currently, but the e-comm presence should provide an extra boost in 1Q & 2Q this year. Management hasn’t articulated how it plans on handling it’s Source Book strategy this year, but our sense is that we will see 3 or 4 targeted mailings this year delivered at content appropriate times instead of a 17-pound shrink wrapped package that is 6x larger than the average phone book.

 

Full Year
There are still a lot of moving parts on the comp line heading into 2015. Here is a quick look at when the 4 newest Design Gallery’s/remodels will be entering the comp base. We don’t expect any additional Legacy Store closures outside of those closed when RH opens new Full Line Design Galleries in Chicago, Denver, Tampa, and Austin.

  • Greenwich, July 2015 (tail-end of 2Q15)
  • NYC Flat Iron, August 2015 (beginning of 3Q15)
  • Melrose Ave., December 2015 (middle of 4Q15)
  • Atlanta, February 2016 (late 4Q15, early 1Q16)

For the year we are at 27% revenue growth. That’s driven by 14% growth in average sq. ft., a 17% retail comp, 27% growth in DTC, which equals a 23% combined brand comp. We are modeling a sequential improvement throughout the year on a 2yr basis with the highest comp YY falling in 2Q as the company laps the Source Book hiccups in 2014.

 

Margins 

1Q

  • Gross Margin - On the occupancy front the company is facing similar headwinds to start the year as it did in the 1st quarter LY. Additional details...
  • DC occupancy headwinds due to the opening of the new West Coast DC are similar to what we saw when the company dealt with the added cost of the Dallas DC and Ohio Shelf Facility last year.
  • Dead rent started to hit the P&L in 4Q and will continue to be a headwind until the company gets the 4 new doors planned for 2015 fully operational. It takes RH on average 6 months to turn a property once it gets the keys from the landlord. RH opened 4 stores in 2014 so the incremental cost in ’15 should be very slight on YY basis. The only difference here is the Beverly Boulevard store which is currently sitting dark while the landlord collects rent.
  • On the positive side, the company will see a benefit on the merch margin side as the price increases associated with the 2014 Source Book launch flow into the 1st quarter.
  • SG&A – The change in source book strategy will be a headwind in 1Q similar to the prior two quarters. On the positive side, there are no incremental costs associated with new store openings. Net/net we think it’s a positive. We’re modeling 45bps of leverage in the quarter.
  • EBIT Margin – For the quarter we are modeling operating margins at 5.3%, driven by 100bps of GM improvement and 45bps from SG&A leverage. 

Full Year

  • For the full year we are modeling 210 bps of EBIT margin improvement from 9.2% this year.
  • Gross Margin – The 70bps of GM improvement in 2015 is driven by a) occupancy leverage as the new Full Line Design Galleries start to make a meaningful impression on the top line and b) the once per year Source Book strategy continues to smooth out the product flow curve helping on the shipping side. We don’t expect a big benefit from mix (as in a larger percentage of non-furniture business) until some of these new categories hit critical mass and kitchens fully ramps up. That will be a 2016 event. Dead rent and DC occupancy will be a headwind for most of the year.
  • SG&A – Leverage on this line item should improve sequentially throughout the year as the company laps the increased marketing spend from last year driven by the 17lb Source Book. That coupled with G&A leverage on higher sales volume gets us 140bps of leverage for the year.

GS: Adding Goldman Sachs to Investing Ideas

Takeaway: We are adding GS to Investing Ideas.

Editor's Note: Below is a brief note written earlier today by Hedgeye CEO Keith McCullough. Our Financials analyst Jonathan Casteleyn will provide a deeper update this weekend.

GS: Adding Goldman Sachs to Investing Ideas - 45

 

I still don't like the Financials (XLF) so I get why they are down -2% YTD (vs TLT +5.5%). But I also get that there is a time to cover shorts when they are signaling immediate-term TRADE oversold. 

 

Instead of buying the ETF, we'll opt for 3% of it, Goldman Sachs (GS), which continues to signal bullish on both our intermediate-term TREND duration and research.

 

Long-term, Jonathan Casteleyn likes Goldman Sachs, but in the short-term, he sees the upcoming GS quarter as follows:

 

The Q1 period is seasonally the best for FICC and intra-quarter commentary at several investment conferences lends confidence to a much better sequential print for fixed income trading from an abnormally low 4Q14 result.

 

GS Asset Management is also taking share and will contribute to an improved upcoming quarterly result. 

 

Buy on red.

KM



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