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INSTANT INSIGHT | Recessionary Data Is Not "Transitory"

Takeaway: The latest round of economic data is the "cycle" rolling over. No, it's not "transitory."

INSTANT INSIGHT | Recessionary Data Is Not "Transitory" - fed in a box

 

We think you deserve the truth.

 

Yesterday, the divide between truth and economic storytelling stretched to the point of ridiculousness. Between the Fed, Old Wall and the mainstream media we just don't know what to say anymore.

 

Forget this troika of economic storytellers. Here's the reality that the market told us yesterday as summarized by Hedgeye CEO Keith McCullough in a note to subscribers earlier this morning:   

 

"Wait ... I thought they 'raised rates' yesterday? This is what I mean by the market read-through being dovish on growth – UST 10yr down -7bps this morning, Yield Spread (10s minus 2s) testing YTD low at +123bps, and Utilities (XLU) led the relief rally +2.5% on the day!"

 

INSTANT INSIGHT | Recessionary Data Is Not "Transitory" - treausry 10yr

 

The fact that #LowerForLonger rate proxies rallied yesterday — i.e. XLU and Housing stocks (ITB) — while credit did nothing and commodities continued to crash — see Oil and Dr. Copper below — confirms what we've long argued about growth, namely the Fed just hiked into an industrial and corporate profit slowdown.

 

INSTANT INSIGHT | Recessionary Data Is Not "Transitory" - CRB crash

INSTANT INSIGHT | Recessionary Data Is Not "Transitory" - oil fed

INSTANT INSIGHT | Recessionary Data Is Not "Transitory" - copper fed

 

Yellen & Co. continues to assert that these #LateCycle indicators are "transitory." While crashing industrial production or sustained deflation may appear "transitory" to the academic central planners in Washington, other Americans would likely disagree.

 

Talk to the 10,000 workers at Caterpiller (CAT) who are projected to lose their jobs in the coming year. Or ask a cattle rancher — beef cattle prices are off more than 25% this year — whether these factors feel "transitory" or not. We are confident that you'll hear a much different story. 

 

Clearly, we disagree with the Fed. We think there's a more apt term for the recent spate of data that's been rolling over since the beginning of the year. It's cyclical. This data is undoubtedly cyclical and falling off its peak. 

 

Of course, time will tell but we're sticking with our original conviction perhaps best articulated by Hedgeye Senior Macro analyst Darius Dale during our coverage of the Fed yesterday:

 

“This is the most obvious slow-moving economic train wreck that we’ve ever seen.” 

 

And that's not transitory...

 

To hear more economic truths (with tons of analysis) from McCullough and Dale on the Fed's economic storytelling, click here to watch a replay of our post-FOMC coverage yesterday.   


PIR | Our Best Bull vs Bear

Takeaway: We think the Bull and Bear cases both have a lot of merit. Unfortunately, the Bull weakened slightly since August, and the Bear got angry.

Conclusion: The call here is simple. It’s not easy, but it is simple. If you DON’T think we’re headed into a recession, or are not concerned about growth slowing incrementally from here…then you’re looking at a 20% FCF yield and 6% dividend yield as PIR recovers from a 3-year investment to build its online business from 1-20%. In a normal economy next year, this stock could be a 4-bagger.  But if you’re in the other camp, then the equity value could go away entirely.  That’d be a great buy for some financial buyer at just $200mm – but it wouldn’t help equity holders much. Since we put PIR on our Best Ideas List in mid-August, the margin recovery part of the story really has not changed, and valuation looks extremely attractive. Unfortunately the Bear case gained serious momentum – most notably with premium players like RH even calling out the promotional nature of the space (if it gets to RH’s level, you know its bad). We still think that the upside to a $20-something stock is there. But so is potential downside to zero.  That’s a push from where we sit. A ‘push’ is not good enough for us to stand behind this one, as such it’s being relegated to our Idea Bench.

 

Our Best Bear Case:

Does Pier 1 Imports really need to exist? Seriously, if the chain went away entirely overnight, would the consumer really miss a beat? Probably not. They’d buy their rattan furniture and decorative nick-nacks at Target, Wayfair, or one of the other thousand places to buy cheap goods from China. The company seemingly has no real product strategy – at least that’s what someone listening to the call (like us) would surmise. All the company talks about is its tactical marketing plan needed to drive more people into the store. In this business, great product can get by with mediocre marketing, while mediocre product needs world class marketing. Also, the company talks about how [these volatile consumer shopping patterns are changing how we think about and plan our business.] Really? Couldn’t the company anticipate that traffic would be under pressure? It’s been written in the cosmos for the past three years at a minimum. We’d be a lot more comfortable with a clear vision as to how PIR can lead the consumer to create its own destiny as opposed to having to make tactical adjustments everytime Target or Wayfair burps in the wrong key. Comps were negative this quarter for the second time in five years, and we have yet to see any Gross Margin recovery from its e-commerce build-out initiatives over the past three years.  SG&A (-9%) made the quarter, and while much of this is sustainable, the reality is that the company is reactionary in planning more TV advertising, which kind of shoots the SG&A leverage angle in the foot for 2017 (Jan). Ultimately, PIR is in a relatively good category in retail – one that does not have anywhere near the volatility as apparel. So will PIR be here in 5-years? Yes, it will. It’ll likely have 2/3 the number of stores it does today, but it will still probably be around. That, however, does not mean that the equity needs to be worth anything. With the stock approaching $5 and a market cap of $450mm, it’s entering no-man’s land. There’s not a very big pool of institutional investors out there who are going to step in and load up on a marginal quality, levered, home furnishings retailer, with a footprint that’s too large, a market cap that’s too small, when we’re at the tail end of an economic cycle. Sheer gravity could cut this stock in half again from here.

 

Our Best Bull Case

As noted when wearing the Bear hat, this is a relatively stable category, and PIR is an established brand that has relevance across a very wide age demographic. Brand weakness has not driven earnings down in recent years, it’s been investment in the infrastructure. By and large, PIR’s product has always been primed perfectly for on-line distribution. But as recently as three years ago, on-line as a percent of total was only 1%. Yes o-n-e percent. So the company invested to build its capability to make small shipments to many individual customers instead of only making large shipments to a much smaller number of stores. This investment cost PIR over 500bp in margin, and our math suggests that about 300bp is recoverable. About 20% of sales is on-line today.  At the same time, the investment the company made in e-comm is clearly rolling over, with capex coming down 33% and SG&A off 9% in the quarter. The company’s commentary suggests a conservative guide for FY17, and even on a – flattish comp we’re still looking at $0.60 in earnings, and better yet, a $30mm sequential positive change in cash flow. If you look at valuation today, you’ve got 0.3x EV/Sales, which is about as low as it’s going to get unless you think the business is going away, which we don’t. Despite the volatility in the stock, on an annual basis revenue and EBITDA are fairly predictable. Yes, the company has around $200mm in debt ($150mm net) but we don’t have any maturities till 2021, when we’ll be in a completely different economic cycle. We think that PIR earns about $0.60 next year, or about $100mm in free cash flow – that’s less than 8x earnings, about a 20% FCF yield and a 6% dividend yield.

 

PIR | Our Best Bull vs Bear - PIR EV SALES

 

Details on the quarter... 

 

Top Line

PIR put up only its 2nd negative comp number since 2Q10 (Aug ’09). That’s an impressive string for a company who sells marginal home goods, but is further evidence of the fragmentation in the market place. The question we have to ask ourselves now with a -2% to -4% comp on the horizon in 4Q and ‘conservative’ topline planning in FY17 is, has something fundamentally changed in the industry that makes a name like PIR a secular loser? Essentially the Wayfair question. When we look at the numbers – PIR is operating in a $175bn category, with $27bn of that done online. PIR now competes in the online arena, it didn’t 3 years ago, and has just over 1% of the total market share. The largest player in the space, Ashely Home Furnishing has ~2.5% share of the market. In that type of competitive environment we don’t think that there is a net loser and a net winner. PIR has inflicted a lot of wounds to itself over the past 18 months, but we don’t think that the competitive environment is so vastly different that it can’t produce the 2% top line growth it needs for this model to work.

 

Gross Margin

Merch margins were down another 380bps in the quarter with supply chain inefficiencies accounting for 200bps of the decline and the balance attributed to an increase in promotional activity. For the year, merch margin guidance stands at 55% down from the 58%-58.2% guide giving on the 4Q15 conference call. Supply chain inefficiencies have continued to dilute the gross margin line and will continue longer than previously anticipated through 1H17. 140bps of the decline is from executional issues on the DC front, tack on another 60bps from inventory clearance issues in 2Q16 and another 30bps in 4Q15 and we get to 230bps from supply chain issues that will start to roll off in 2Q17. In light of the promotional environment, it’s likely that PIR will compete some of that gain back in the form of price, but the margin leverage from efficiency measures + lease negotiations/store closures + e-comm fulfillment scale = a nice gross margin lever in 2017.

 

SG&A

PIR made the number on SG&A leverage with dollars down 9% YY, that largest decrease since Aug ’09. The obvious whole in the cost structure is the marketing spend which was down 16% in the quarter as the company pulled back on national TV media spend. But, let’s not forget that PIR is reaching the tail end of a 3yr e-comm buildout that not only ate away gross margin in the process but required a significant amount of spend on the SG&A side.

 

Balance Sheet

Big improvement in working capital with inventory growth down 6% YY. The sales to inventory spread went into positive territory for the first time in 2 years, and inventory per square foot was down 5% from the big build up headed into Holiday 2014. But, there is still a lot of wood to chop on that line as inventory per square foot sits at levels 36% higher than in 3Q12. You could make the argument that with e-commerce now in the mid-teens as a percent of sales and exclusive online content making up a portion of the inventory balance, that the comparison isn’t apples to apples. But, we think that a 10%-15% drop is more than possible. By our math that would free up about $60mm in working capital.

 

PIR | Our Best Bull vs Bear - PIR INV SQFT


The Macro Show Replay | December 17, 2015

 


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CHART OF THE DAY: This Isn't 'Transitory.' It's Cyclical

Editor's Note: Below is a brief excerpt and chart from today's Early Look written by Hedgeye CEO Keith McCullough. Click here to subscribe.  

 

"... But can they find a way to call today’s Chart of The Day (US Industrial Production) slowing indefeasibly into a recession “transitory”? Or shall we agree to agree that this rate of change dropping to its lowest level (-1.2% year-over-year) since 2009 is called cyclical?

 

If we’re going to call everything cyclical “transitory”, then we’ll probably get to what most economic ideologues actually believe  that they can bend gravity – and that there is no economic cycle to concern yourself with anymore because they can smooth that too."

 

CHART OF THE DAY: This Isn't 'Transitory.' It's Cyclical - 12.17.15 chart

 

 


Janet's Transitory World

“Our pleasance here is all vain glory – the false world is but transitory.”

-William Dunbar

 

After listening to Janet Yellen yesterday, I finally realized that the difference between our economic forecasts boils down to the difference in one word. What we call cyclical, she calls “transitory.”

 

To give her some air time on this, the Miriam Webster Dictionary defines “transitory” as “ephemeral, momentary, fugitive, fleeting, evanescent, meaning only lasting or staying a short time.”

 

Sounds like yesterday’s US stock market move, not the consistently slowing US economic and corporate profit data!

Janet's Transitory World - rate hike cartoon 12.16.2015

 

Back to the Global Macro Grind

 

You see, even if you aren’t paid to see, this all became very clear yesterday. Despite both the data and market signals we’ve seen develop since July, the Federal Reserve had to maintain a bullish growth and inflation “forecast” that corroborated its political action.

 

Now that we have that out of the way, we can get back to measuring the non-transitory economic cycle.

 

The best part about the “rate hike” is that rates fell on that. Yep. The long-end of the curve is falling again this morning too. With the 10yr US Treasury yield down 7 basis points to 2.23%, that’s also flattening the curve.

 

So, forget the transitory spike you saw in most things equities for a minute and consider the causal factor that has driven long-term interest rates Lower-For-Longer, well, for a long time – both long-term inflation and growth expectations slowing. #Demographics eh.

 

Instead of having an un-elected-linear-economist characterize #LateCycle indicators like employment as non-transitory and everything she didn’t forecast as transitory, what does Mr. Bond Market think about this?

 

  1. Long-term rates are falling, despite a transitory rate hike
  2. The Yield Spread (10yr minus 2yr) just flattened to a YTD low of 123bps
  3. Credit Spreads continue to signal a classic cyclical breakout

 

Yes, we get that people are in the business of seeing stock prices rise into year-end. There are only 2 weeks left to get the Russell 2000 back to break-even. So you’ll need to get the sell-side to make up a narrative for a transitory +5% rally (from here) to get there.

 

They can be very creative.

 

But can they find a way to call today’s Chart of The Day (US Industrial Production) slowing indefeasibly into a recession “transitory”? Or shall we agree to agree that this rate of change dropping to its lowest level (-1.2% year-over-year) since 2009 is called cyclical?

 

If we’re going to call everything cyclical “transitory”, then we’ll probably get to what most economic ideologues actually believe - that they can bend gravity – and that there is no economic cycle to concern yourself with anymore because they can smooth that too.

 

But, if gravity fans just call cycles what they are – we won’t blow up our net wealth at every turn of every #LateCycle slow-down. Since the Federal Reserve has NEVER proactively predicted a recession, I’m thinking we stay with mother nature.

 

Back to tightening into a cyclical (and secular/demographic) slowdown…

 

  1. That’s US Dollar bullish
  2. That’s Bond Yield bearish
  3. When USD is RISING and UST Rates are FALLING, that’s deflationary

 

Mr. Macro Market nailed that yesterday too. It appears that he believes the inaccuracy of Janet’s forecasting process is inherent and unchallengeable. How else can you explain yesterday’s market reaction?

 

  1. Utilities (XLU) led gainers, closing up +2.5%
  2. Housing Stocks (ITB) came in 2nd place on the day, +2.4%
  3. Oil & Gas Stocks (XOP) led losers, deflating another -2.2%

 

As the legendary Herb Brooks would have said to Janet, “Again!”

 

On a historic day where the Fed “raised” into a both an industrial recession and corporate profit slow-down (hasn’t happened since 1967), Lower-For-Longer rate proxies rallied, credit did nothing, and commodities continued to crash.

 

Our immediate-term Global Macro Risk Ranges are now:

 

UST 10yr Yield 2.13-2.33%

SPX 2004-2088
RUT 1105--1171

VIX 16.49-24.55
USD 97.06-99.51
Oil (WTI) 34.09-37.26
Copper 1.99-2.10

 

Best of luck out there today,

KM

 

Keith R. McCullough
Chief Executive Officer

 

Janet's Transitory World - 12.17.15 chart


"Transitory"

Client Talking Points

USD

While there have been plenty of “reflation” and relief rallies across asset classes throughout 2015, the #1 thing to have stayed with from a TREND perspective is #StrongDollar and its deflationary force on bubbled up asset classes. What the Fed did (and maintained) in their dead-wrong growth forecast was keep a USD super spike > $100 on the USD Index in play.

#DEFLATION

Interestingly, but not surprisingly, that’s exactly how the macro market read the Fed’s hawkish statement – dovishly on growth! The CRB Index hit a fresh new low on the “news”, Oil (and its related equities) continued to crash, and Credit Spread risk didn’t change from a bearish TREND perspective either. Copper and Oil are down another   -1% each this morning.

UST 10YR

We thought they “raised rates”? This is what we mean by the market read-through being dovish on growth – UST 10YR is down -7 basis points this morning, Yield Spread (10s minus 2s) testing its year-to-date low at +123 basis points, and Utilities (XLU) led the relief rally +2.5% on the day!

 

*Tune into The Macro Show with Hedgeye CEO Keith McCullough live in the studio at 9:00AM ET - CLICK HERE

Asset Allocation

CASH 67% US EQUITIES 2%
INTL EQUITIES 6% COMMODITIES 0%
FIXED INCOME 15% INTL CURRENCIES 10%

Top Long Ideas

Company Ticker Sector Duration
MCD

MCD remains one of our top LONG ideas in the restaurants space. All indications are that all day breakfast is working, bringing back old customers and driving growth of new customers. Customers are pairing both breakfast and lunch items together in the lunch and dinner day, part which is helping drive additional sales.

 

McDonald’s Canada opened its first standalone McCafe this month. The much simplified concept intends to appeal to customers by offering both speed of service and low cost. They intend to be faster than their main competitor Tim Hortons and cheaper than Starbucks, carving out their own niche in the market.

RH

This RH quarter is going to draw a Mason Dixon line between the Bulls and the Bears. The key factors that the Bulls (including us) need to see were profoundly present – giving us confidence that revenue will double, that we’ll see a 16% operating margin, and $11 in earnings power. In addition, RH beat the quarter, delivered 33% EPS growth in what should be the slowest growth quarter of the year, and it took up 4Q revenue guidance based on what it’s seeing so far this quarter (to 20%+).

 

The Bears got a nice little gift in the form of weaker Gross Margins due to promotional activity, and renewed concerns about management. The reality is that this is a transformational growth story that will change on the margin more often than it doesn’t. Based on our confidence in the earnings power at play here, we’d use any weakness as an opportunity to buy.

TLT

Implicit in our long TLT/short JNK bias is an expectation for high-yield spreads to continue along their recent trend of widening throughout the YTD.

 

“The U.S. economy is #LateCycle and the probability of a recession commencing by mid-2016 is extremely elevated – both in absolute terms and relative to the belief held by the overwhelming majority of investors and policymakers. Moreover, the risk of a global recession is also great in this scenario.”

 

The economic cycle doing what it always does (i.e. decelerate into a recession before bottoming and then reaccelerating) is reason enough to be bullish on the long bond and bearish on junk bonds, which are accelerating into full-blown crisis mode (the JNK ETF declined another -2% on Friday and is down -4.1% WoW, -5.8% MoM and -12.7% YTD).

Three for the Road

TWEET OF THE DAY

REPLAY | Fed Day Live with Hedgeye CEO Keith McCullough https://app.hedgeye.com/insights/48087-fed-day-live-with-hedgeye-ceo-keith-mccullough-wednesday-at-2-10pm-et… via @hedgeye

@KeithMcCullough

QUOTE OF THE DAY

Time and tide wait for no man.

Geoffrey Chaucer

STAT OF THE DAY

A new study found that heads of state lived 2.7 fewer years than the opponents they beat.


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