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WSM | Not A Good Quarter

Takeaway: Earnings quality was horrible. Taking down numbers. WSM is still shortable here.

This was absolutely not a good quarter from WSM. Sales growth was decent at 7.8% – but to be clear, the company bought it. Gross Margins were -112bps, leading to Gross Profit growth of just 4.6%. And if the company didn’t pull the goalie on the SG&A line (corporate), EBIT would have been down 6%. To be clear, this was the WSM’s greatest SG&A leverage this cycle – and on a mediocre comp. Add on a lower tax rate, and earnings would have been $0.13 lower than the reported number, or an $0.08 miss. Oh yeah…cash flow was down 50%. No one talks about that.  We’re taking our 2016 number down to $3.70 vs the Street at $3.90. Does that make WSM a raging short? No. But we’d argue that unlike RH, only 40% of WSM’s mix is defendable in the face of a weakening consumer. All in, this stock has seen 12-13x earnings during a downward revision cycle. Let’s generously say 14x $3.70 next year – that’s a $52 stock vs $66 today. We’ll take that.

 

Comps – The company actually missed comp expectations by 50bps though sales beat as International revenue made up the difference. But, all concepts with the exception of Pottery Barn showed underlying strength accelerating on a 2yr basis. Ex-West Elm, by our math the company put up a 2.5% comp the lowest number since 4Q12. As noted above the company bought the comp.

 

Weak Guidance – WSM guided the mid-point of comps, sales, and earnings 200bps, 2%, and 6% below the street, respectively. There seemed to be a fair amount of caution embedded in the guide as the company held full year guidance and backed into the 4Q implied numbers with little confidence in the outlook for Holiday. That’s what happens when the rest of retail is imploding, mall traffic remains weak, and the 4Q comp is much more levered to things like Peppermint Bark and gifting than actual home furnishings. 4Q numbers look hittable, but the lack of a ringing endorsement by the management team is worth calling out.

 

West Elm – i.e. the only concept within the WSM family of brands that is growing square footage put up a 15.7% comp in the quarter which equated to a 40bps acceleration on a 2yr basis sequentially. The concept has always been a good bell weather for RH from a directional standpoint. The consumer/concept are much different, West Elm productivity is in the $800/sq.ft. range compared to RH at $3,300 (inclusive of e-comm) in the same size box, but it’s the only concept growing square footage. We are modeling a divergence in 3Q15 as RH pushed its growth into 2H from 1H with the release of two new concepts this Fall (Modern and Teen).

 

WSM | Not A Good Quarter - RH WE COMPS

 

GM – was down 110bps in the quarter, with merch margins relatively flat offset by dilution from International franchise growth and increased shipping expense as WSM continues to iron out its inventory position from the West Coast port contract dispute that we should mention was resolved nine months ago (and yet the company still talks about it). On the shipping front, new rate hikes at FedEx and UPS haven’t hit the P&L, so this was all self-inflicted. Each of the negative drivers on the GM line appear to be unique to WSM and shouldn’t be contagious to a name like RH.

 

SG&A – SG&A leveraged by 95bps with all and then some of the leverage attributable to unallocated corporate expenses, which was down 100bps (the best leverage we’ve seen this cycle). By our math that’s an $0.08 benefit to earnings or all and then some of the 3Q beat. If International (which was called out as the biggest drag to Gross Margin) is in fact EBIT margin accretive, we didn’t see it this quarter. Holding the unallocated corporate expense % of revenue line flat in the quarter EBIT would have been down 6% instead of up 6%.

 

International – We’re not convinced that this is a winning strategy for WSM. It’s not a new thought to call out the fact that WSM is desperately looking for growth in any corner of the globe it can get its hands on, but the gross margin drag we saw this quarter isn’t a one off, and the EBIT accretion associated with that trade off didn’t show up. Consider this for a second, RH hired Doug Diemoz, previously of WSM, back in March of 2014 (he has since left to be the CEO of Crate & Barrel). At WSM he was charged with structuring the International licensing agreements for Pottery Barn in the Middle East. So, RH acquired first hand knowledge on the ins and out of that business and has subsequently talked down its International growth opportunity. 


UA/LULU | Why The Rumored Merger Is Ridiculous

Takeaway: UA buying LULU would be one of the most painful mergers in retail history. The big winner would be Nike. That's why it won't happen.

Just because UA’s 43x EBITDA multiple suggests it CAN buy Lululemon at 15x, it does not mean it SHOULD. If it does, we think it will make UA a tremendous short. But we won’t ever make that call, because the likelihood of UA buying LULU is about as high as Nike buying Uber.

 

Key Considerations

 

1)      UA wants to beat LULU organically. Not just beat it, but kick it once it’s down, and dance over its grave. Sorry to be blunt, but it’s true. UA has even greater resolve to crush LULU than Nike does.

 

2)      UA would have to pay $7-8bn for the ‘privilege’ of owning one of the worst-managed brands in retail. That might be ok if UA had experience fixing things. But it doesn’t. In fairness, LULU is so broken it would be hard for even Nike to fix (and not just because Nike stinks at fixing things).

 

3)      Think of what UA can do with $1bn -- nevermind the $8bn it’d have to pay for LULU. Heck, UA has just shy of $400mm in forward Athlete Endorsement obligations sitting (off) its balance sheet. Nike has about $6.2bn. The difference is staggering. Will UA really invest 20% more than Nike’s entire 5-year forward endorsement obligation budget just to acquire a company it can beat organically with less than 1/10th the capital allocation?

 

4)      LULU is broken, and UA knows it. What optically appears to be $365mm in EBIT at LULU might really be closer to $275mm after the capital needed to fix the company is deployed – and that’s inclusive of the added top line growth.

 

5)      UA does not buy broken things. It’s acquisition strategy is to augment the core brand with deals where internal talent can’t otherwise take the brand. Example… MapMyRun, Endomondo, and MyFitnessPal.

 

6)      The last, and most important factor is Culture. You simply cannot find two more polar opposite cultures (let us know if you can think of any). LULU is a company based on a tree-hugger yogi mentality with little concern for planning, analysis, and close to no sense of urgency. UnderArmour, a short 43-hour drive East, is filled with amazingly energetic, Type-A high-performance athletes camouflaged in business casual clothes. Imagine JJ Watt (DE Houston Texans) in full gear doing ‘warrior pose’ in a peaceful yoga studio…with Nancy Pelosi. That’s about how awkward the cultural matchup here would be.

 

ACTION ITEMS

If we’re Right: Short LULU

If we’re Wrong: There are two trades.

1) Short UA with impunity on the deal, as this blows up the UA growth story in more ways we can count.

2) Buy every share of Nike you can get your hands on. This would be the modern-day equivalent of when Adidas bought Reebok back in 2006. That handed Nike 10 points of share in Footwear. Rest assured that Nike execs are praying that UA buys LULU. That’s why it won’t happen.


Correction: EDV: We Are Removing Vanguard Extended Duration ETF From Investing Ideas

Takeaway: Please note we are removing Vanguard Extended Duration ETF from Investing Ideas

Editor's Note: In the first paragraph below, the original version inadvertently read that we added ZROZ to the short side of Real-Time Alerts. We apologize for the error. Rather, we closed our long position. We have no open positions in ZROZ.

 

* * *

 

Today, Hedgeye CEO Keith McCullough advised Real-Time Alerts subscribers that they close their long position in PIMCO 25+ Year Zero Coupon U.S. Treasury ETF (ZROZ). The reasoning also lays out why we're taking EDV off Investing Ideas: 

 

"With the 10yr UST Yield pulling back to 2.23% today (you could have been plugged shorting the Long Bond like consensus did on the recent jobs report at 2.39%), I'm getting an immediate-term TRADE overbought signal (within a bullish intermediate-term TREND) in ZROZ. 

 

With the Fed hell bent on raising into a slow-down, we have to risk manage the risks associated with that. They have no idea on the economy (forecasts on growth have been wrong 70% of the time since Bernanke's un-elected reign). So the risk, is their forecast."

 

Correction: EDV: We Are Removing Vanguard Extended Duration ETF From Investing Ideas - Fed forecast cartoon 11.13.2015


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Can Beijing Maintain Exchange Rate Stability Or Is the Chinese Yuan the Next Thai Baht?

Takeaway: We think consensus is wrong on the outlook for the Chinese yuan.

Yesterday President Xi Jinping corroborated our long-held bias that that “the [Chinese] economy still faces relatively large downside pressures” – not that anyone needed Xi to confirm what we already knew. Growth in the volume of Chinese rail freight traffic and price trends across various key industrial commodities would seem to imply as much.

 

Can Beijing Maintain Exchange Rate Stability Or Is the Chinese Yuan the Next Thai Baht? - China Rail Frieght Volume YoY

 

Can Beijing Maintain Exchange Rate Stability Or Is the Chinese Yuan the Next Thai Baht? - Copper Monthly Average

 

Can Beijing Maintain Exchange Rate Stability Or Is the Chinese Yuan the Next Thai Baht? - Iron Ore Monthly Average

 

Can Beijing Maintain Exchange Rate Stability Or Is the Chinese Yuan the Next Thai Baht? - Rebar Monthly Average

 

Looking across a variety of key high-frequency indicators, Chinese economic growth has stabilized insomuch that it is no longer “rolling down the hill” but policymakers are decidedly still “walking [the economy] down the steps”. This phenomenon is most recently highlighted by sequential slippage in the growth rates of industrial production, fixed assets investment, foreign direct investment, total social financing, as well as various measures of supply and demand in the Chinese property market.

 

Can Beijing Maintain Exchange Rate Stability Or Is the Chinese Yuan the Next Thai Baht? - China Industrial Production YoY

 

Can Beijing Maintain Exchange Rate Stability Or Is the Chinese Yuan the Next Thai Baht? - China Fixed Assets Investment Growth

 

Can Beijing Maintain Exchange Rate Stability Or Is the Chinese Yuan the Next Thai Baht? - China FDI YoY

 

Can Beijing Maintain Exchange Rate Stability Or Is the Chinese Yuan the Next Thai Baht? - China Total Social Financing

 

Can Beijing Maintain Exchange Rate Stability Or Is the Chinese Yuan the Next Thai Baht? - China Housing Starts YoY

 

Can Beijing Maintain Exchange Rate Stability Or Is the Chinese Yuan the Next Thai Baht? - China Housing Construction YoY

 

Can Beijing Maintain Exchange Rate Stability Or Is the Chinese Yuan the Next Thai Baht? - China Value of Buildings Sold YoY

 

Can Beijing Maintain Exchange Rate Stability Or Is the Chinese Yuan the Next Thai Baht? - China Volume of Buildings Sold YoY

 

Offsetting the aforementioned “downside pressures” is a sharp reversal of what has been a disastrous and well-documented trend of capital outflows that coincided with the IMF’s tacit decision to include the CNY in its vaunted SDR basket.

 

Can Beijing Maintain Exchange Rate Stability Or Is the Chinese Yuan the Next Thai Baht? - China Estimated Capital Flows

 

Can Beijing Maintain Exchange Rate Stability Or Is the Chinese Yuan the Next Thai Baht? - China Capital Flows

 

Can Beijing Maintain Exchange Rate Stability Or Is the Chinese Yuan the Next Thai Baht? - China M1 Money Supply YoY

 

Moreover, Beijing has taken to capital controls to help it accomplish its goal of maintaining exchange rate stability. Specifically, the PBoC has recently stepped up verbal guidance to onshore banks to cull their offshore lending practices, which, in turn, has made it more expensive than ever to borrow and sell short the offshore yuan, or CNH.

 

While capital controls have rarely – if ever – been proven successful at staving off long-term currency depreciations, they can and will continue to be a short-seller’s worst nightmare from the perspective of consensus expectations for a material devaluation of the RMB.  The “Bejing Put” remains the #1 reason we aren’t raging bears on China; Chinese officials can and will do what they have to do to ensure an orderly downshift in their economy – if there even is such a thing.

 

Will the aforementioned SDR labeling bring stability to the outlook for the exchange rate? Judging by the spread between the spot rate and PBOC’s reference rate since the mid-AUG devaluation, one could make the case that stability is in – for now at least.

 

Can Beijing Maintain Exchange Rate Stability Or Is the Chinese Yuan the Next Thai Baht? - CNY Reference Rate

 

Can Beijing Maintain Exchange Rate Stability Or Is the Chinese Yuan the Next Thai Baht? - CNY Reference Rate Spread

 

As such, we feel comfortable reiterating the claim we staked in our 9/23 note titled, “When Will China Devalue Again?”: “…we think the Chinese are neither incentivized nor inclined to devalue the CNY again – certainly not in the near term. That said, however, we believe another round of euro debasement out of the ECB is likely the next catalyst for investors to begin pricing in this risk – rightly or wrongly.”

 

As a reminder, the ECB is scheduled to review its monetary policy on 12/3 and Draghi’s recent guidance has indeed been [appropriately] dovish, on the margin. From our 11/9 note titled, “What’s Driving Our Bearish Forecasts for Domestic and Global Growth?”:

 

In terms of cratering a narrative around the aforementioned mathematical reality of steepening base effects in the Eurozone, industrial production, exports, consumer confidence, business confidence and PPI are all slowing on both a sequential and trending basis throughout the region. Its composite PMI is still slowing on a trending basis and household consumption growth is trending at an unsustainably elevated rate in the context of our outlook for ECB monetary policy and it’s likely [negative] impact on the EUR.”

 

All told, while we are comfortable reiterating our explicitly dour outlook for Chinese economic growth, it bears repeating that we continue to view the Chanos “economic collapse” view as misguided given that the “Beijing Put” continues to largely offset that outcome. China’s trending GDP growth deceleration just feels like a collapse to the rest of world given China’s outsized contribution to global growth.

 

Can Beijing Maintain Exchange Rate Stability Or Is the Chinese Yuan the Next Thai Baht? - China Contribution to World Nominal GDP Growth

 

That is especially true for those suppliers that are over-indexed to Chinese import demand. As the following charts highlight, the lower commodity prices go, the slower global business investment and corporate profit growth are likely to become.

 

Can Beijing Maintain Exchange Rate Stability Or Is the Chinese Yuan the Next Thai Baht? - CRB vs. World Gross Capital Formation

 

Can Beijing Maintain Exchange Rate Stability Or Is the Chinese Yuan the Next Thai Baht? - CRB vs. MSCI World EPS

 

It all comes back to the rising U.S. dollar. Consider the following dynamics:

 

  • A significant portion of global demand growth in the pre and post-crisis eras was predicated on China’s “managed float” peg to the U.S. dollar.
  • Why? Because China had been importing a substantial portion of our Greenspan/Bernanke bubble-blowing monetary policy for over a decade (the DXY declined -39.7% from its July 2001 top to its April 2011 low).
  • Moreover, the country’s 2001 entry into the WTO opened up access to global export markets, which allowed it to generate the sizeable current account inflows needed to fuel gangbusters deposit growth throughout the onshore banking system (China’s “closed” capital account means every $ that enters the Chinese economy gets converted into RMB).
  • The M1 growth associated with rapid current account inflows helped to perpetuate a domestic fixed assets investment bubble via asset/liability matching.
  • INSERT insatiable demand for energy and raw materials HERE.
  • The U.S. dollar bottoms in 2011 and goes on a multi-year bull run, up +35.9% from the aforementioned April 2011 low.
  • Chinese export growth slows alongside a dramatic narrowing of its current account balance.
  • Mainland deposit growth slows, followed by a secular slowdown in fixed assets investment growth.
  • Growth in Chinese demand for incremental raw materials appropriately collapses… Meanwhile, every crude oil, copper and iron ore producer the world over is regretting having signed off of incremental exploration and production a few years back at the peak in Chinese economic growth.

 

CLICK HERE to review our deep dive analysis supporting these conclusions.

 

You can bet your bottom dollar that members of the PSC and broader CPC are well aware of these dynamics, which is largely why various officials have quite often used words like “messy” and “complicated” in describing Chinese economy over the past few years.

 

Moreover, this unspoken understanding is largely behind the stated drive to transform China into a services-oriented and consumption-led economy, which itself is a “complicated” task that will require a downshifting of GDP growth, a curbing of industrial overcapacity and a system-wide recognition of nonperforming loans – which have been both materially and serially underreported amid systemic “evergreening”.

 

Bigger picture, the aforementioned dynamics help explain a significant degree of the missing supply/demand link between the semi-perpetual (and often meaningful) inverse correlation between the U.S. dollar and commodity prices. As such, it’s not a coincidence that raw materials continue to crash in conjunction with the trending deceleration in global growth.

 

This linkage is largely behind why CAT’s management team can’t figure out why its order book continues to collapse.

 

More broadly, this linkage can explain a substantial portion of the current profit recession in the U.S.

 

Even more broadly, this linkage is largely behind why Brazil has been unable to escape recession and why many EM equity markets and currencies have crashed and/or continue to crash.

 

When the proverbial “dots” are connected, this linkage can even explain a portion of the BoJ’s shocking balance sheet expansion (now 75% of Japanese nominal GDP), which has perpetuated a peak-to-present crash of -38.3% in the JPY/USD cross and a +139.4% rally in the Nikkei 225 Index off its June 2012 lows.

 

“If you don’t do globally-interconnected macro, globally-interconnected macro will do you.”

-Me

 

As we’ve said at every turn since our 2008 inception, Global Macro starts and ends with the U.S. dollar – which itself is an extension of not just U.S., but rather global, monetary policy. In light of that, we think investors would do well to know exactly where the dollar is headed in 2016…

 

Feel free to email with questions or comments. As always, we encourage thoughtful debate.

 

DD

 

Darius Dale

Director


Cartoon of the Day: Chinese Growth Hits A Wall

Cartoon of the Day: Chinese Growth Hits A Wall - China growth cartoon 11.19.2015

 

"While the 'reflation' green arrow chasers are enjoying themselves today, I must remind you that President Xi (China) was quite bearish about the Chinese economy earlier this week (and China cut rates last night as a result of that weakness)," wrote Hedgeye CEO Keith McCullough in a note to subscribers today.


INSIGHT: China, Commodities & #GrowthSlowing

INSIGHT: China, Commodities & #GrowthSlowing  - china year of the snal

 

On The Macro Show this morning, Hedgeye Macro analyst Darius Dale discussed the divergence between China's economic reality and the movement in it's equity markets. 

 

Last night, the Shanghai and Shenzhen closed up 1.4% and 3.1%, respectively, taking the handoff from a strong close in the U.S. 

 

Now consider the recent economic data out of China. In November, the country's MNI PMI slipped to 49.9 from 55.6 in October, Dale noted. That jived with recently reported crashing rail freight traffic, along with sequential slippage in industrial production, fixed assets investment, foreign direct investment, total social financing, as well as various measures of supply and demand in the Chinese property market in the month of October.

 

It's worth noting that China's President Xi Jinping was a bit too honest this week when, in a speech, he admitted the country's economy faced "considerable downward pressures."

 

No kidding.

 

INSIGHT: China, Commodities & #GrowthSlowing  - China GDP cartoon 07.16.2015

 

As Dale pointed out, that "downward pressure" on Chinese growth is also putting considerable pressure on commodities like copper and iron ore. Here's a telling excerpt from a note sent to subscribers earlier this morning:

 

"Fresh cycle lows in copper and iron ore are not a good sign for global growth… How bad is it? The China Iron & Steel Association said it expects steel output to drop -2.9% in 2016. That’s not a small inflection considering China’s mills produce half of global output. Former chief economist of Rio Tinto had this to say about continuing deflationary headwinds: “There’s about 300MM tons (~40% of Chinese production) of surplus capacity (in steel refining) that needs to not just be shut down, it needs to be bulldozed.” The deflation continues."


Hedgeye Statistics

The total percentage of successful long and short trading signals since the inception of Real-Time Alerts in August of 2008.

  • LONG SIGNALS 80.64%
  • SHORT SIGNALS 78.57%
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