Conclusion: Leverage among U.S. corporations is currently indicating a level of speculative excess that has historically coincided with the onset of much-needed economic purging – i.e. a recession.
As mentioned in our 1/20 note titled, “Sentiment Update: Three Things I Learned Today (and Three Weeks From Now)”, Keith and I are in the full swing of our post-Quarterly Macro Themes marketing excursion. This week we’re out west visiting with clients and prospective clients in California after having made the rounds in Boston and NYC last week.
Sticking with the theme of the aforementioned note in terms of rebutting key points of contention that were as consensus as they were critical, we thought we’d take a stab at refuting the narrative fallacy that leverage among U.S. corporations is at a healthy level.
Nothing can be further from the truth.
The following chart is a little busy, but allow us to highlight the key takeaways:
- Despite the cost of debt financing (green line) falling to new all-time lows in the current cycle, aggregate corporate interest expense as a percentage of EBIT (white line) has marched steadily higher off of a secular higher-low and is now at 11.5%.
- This is likely due to the sheer amount of leverage on U.S. corporate balance sheets. Specifically, U.S. corporate debt outstanding as a percentage of aggregate corporate free cash flow (red line) just eclipsed four turns (4.1x to be exact). This is up from a secular low of 2.7x in early 2011.
- An economy-wide corporate debt/FCF ratio of ~4x meaningful because that level of leverage that has historically portended recessions in short order: 3.9x just prior to the 1990-91 recession, 4.1x just prior to the 2001 recession and 4.2x just prior to the Great Recession.
- Among the more interesting things to note in refutation of the narrative fallacy that “low rates = little-to-no #CreditCycle risk” are the secular lower-highs in the aforementioned interest expense/EBIT ratio. Specifically, the level this ratio reached just prior to the onset of recession has declined alongside the cost of capital in each successive economic cycle (25.2%, 22.1% and 15.5%, respectively).
- This is supportive of our view that there is no magic elevated level of interest expense that must be reached in order to see a recession commence. Moreover, this effectively implies low rates are not the panacea they are widely perceived to be in terms of staving off an economic downturn.
Source: Bloomberg L.P., Hedgeye Risk Management
How to Profit From This Realization
One conclusion we can all agree upon is that many U.S. corporations have taken advantage of low rates by levering up to finance “shareholder friendly” (read: “management compensation friendly”) activities. In fact, the past couple of years have seen record buyback and dividend activity among S&P 500 constituents.
As the ongoing corporate profit recession deepens, we highlight the obvious risk of companies allocating earnings to buybacks and dividends, rather than preserving cash and paying down debt. If our explicitly negative view on the domestic economic cycle continues to be corroborated by the data, then the growth rate of such payouts will likely have to slow dramatically – if not decline outright.
That is an obvious headwind to the broader equity market in terms of removing key cogs from the post-crisis secular bull case. It’s also an obvious headwind to individual equities as well. In that vein, the following 12 tickers are the output of a screen of U.S. corporations that may have become over-levered in the pursuit of such “shareholder friendly” activities:
Source: Bloomberg L.P., Hedgeye Risk Management
Specifically, the aforementioned screen looks for publically listed U.S. equities with market caps north of $1B that have seen double-digit growth in total debt over the past five years and negative geometric growth in basic shares outstanding (over the past five years as well) that are also in the top quartile of trailing five-year growth in gross dividends.
While admittedly crude, we think this list of names serves as a better-than-bad starting point for alpha-generating short/underweight candidates if you have been appropriately convinced of our bearish view on the domestic #CreditCycle.
In our 12/31 Early Look titled, “More Questions Than Answers”, we alluded to the fact that every crisis – either financial or economic – requires a broad-based refutation of a formerly widely-held belief. In light of that, we strongly posit the consensus view that zero percent interest rates equates to zero percent risk is one such widely-held belief that is being refuted almost daily by the market(s). As such, we believe investors would do well to adapt their belief system to incorporate such signals.
Best of luck out there today,
Takeaway: What happens when you hold a balloon under water for a decade? Watch Nike/Foot Locker and find out.
Conclusion: We spent the better part of last week with investors in London. We went in armed with one of those 100-page slide decks outlining all our ideas. But it took only a few hours for us to realize that the part of our presentation that would get the most traction by a long shot, was the 30-pages we allocated to Nike, Foot Locker and the other Athletic names. While this is a very datapoint-driven space, we’d argue that the biggest disruptive forces in the industry today were started in motion nearly a decade ago when Nike decided to shift incremental capital to build a DTC platform, and fund that with excess growth in the wholesale channel in the US. Now the building part is largely done, and the wholesale channel is very full of Swooshes. People have to get a handle on the economic freight train that’s about to tear through these brick & mortar stores. Without respecting history and decisions made behind the scenes – which might be different from posturing on conference calls – we think that bulls might have just enough research/confidence to sell (NKE) too early, and bears (on FL) might cover a multi-year short way too soon.
We think that bulls on Foot Locker are missing a huge negative fundamental turning point, and bears are bearish for the wrong reasons. It will get far worse than anyone thinks. This is not the typical ‘internet is taking over, so short the legacy retailers’ call. There’s a lot more to this, and it has been in the works for the better part of a decade. We’re simply just starting to see the result now, which is likely to accelerate every year throughout this as well as the subsequent economic cycle.
Paradigm is Breaking Down. To start, let’s just remember that manufacturing and distribution in the Footwear space has remained largely unchanged for the better part of 40 years since Phil Knight built it. We’ve got the same consolidated factory base in Asia (while there are about 20,000 factories for apparel, there are only 30 factory groups for sneaks), the same consolidated group of Brands (half dozen), and a largely fragmented group of retailers on a global scale. As such, consumer behavior related to buying shoes has largely not changed, either. While other industries have evolved, this one has not. It’s been very anti-Darwin.
But this paradigm is finally breaking, and we don’t think that people appreciate 1) what has happened, or 2) that the changes started behind the scenes a decade ago, and 3) that the manifestation of said changes is starting to rear its head today – quite purposely at the end of this economic cycle.
This change is great if you own content that consumers want — like Nike, UnderArmour and Adidas. But if you’re stuck between the all mighty Consumer and those Jordan 23s, Nike FlyKnit AirMax 180s, Yeezys or Curry 1s, then you (i.e. FL, FINL, HIBB and most other brick&mortar distributors) are in very deep trouble. Case in point, take a look at Sports Authority, which is headed for Ch11 once again.
This Change Starts with Nike, which leads not only with consumers, but also with innovation, suppliers, distribution, and just about every other area. Consider this. Nike generates about a 51% Gross Margin when it sells a $100 pair of shoes to Foot Locker. But it garners about a 68% margin when it sells on nike.com. That’s nice, but it’s not what we care about. We care about the Gross Margin dollars – not the rate. On that very pair of sneakers, Nike gets about $23 in Gross Profit from that ‘wholesale’ sale to Foot Locker. But it gets about $85 (by our math) when it sells direct. In other words, there is a magnifier effect, and the dot.com margin dollars go up by a factor of 3-4x.
Anyone wonder why Nike has had such strong Gross Margins over the past year when almost every other global ‘consumer non-durable’ company had its margins kicked in the teeth? Nothing has changed with Nike’s FX exposure – it’s still there. It’s simply been offset by the significant impact of a 68% gross margin e-commerce business growing at 50%. In fact, take a look at the chart below, which shows that in the latest quarter for Nike the wholesale business accounted for only 42% of incremental growth – the first time ever that Nike’s own DTC business carried more than 50% of growth (EVER is a long time).
Furthermore, Foot Locker has always been the most important single entity on Nike’s P&L, but this year FL and Nike retail will be around the same size. Starting in FY17, Nike will be its own biggest customer – and that spread will only accelerate.
It’s no secret that Nike announced last year that it would grow e-commerce to $7bn by 2020, which is a huge jump from its current $1.4bn (only 4% of sales). We think Nike is sandbagging, by the way, and that it will build its e-comm operation to about $11bn – adding $10bn in e-comm sales in the next 4-years. Let’s say 60% of that is in North America…we’re talking $6bn in incremental revenue to Nike. To put this into context, the entire Athletic Footwear industry is likely to add about $6bn in retail over that time period alone.
Why Now? But nobody is asking WHY Nike is building its e-commerce presence now. We think that could be answered by the chart below that looks at two of its retailers – Foot Locker and Finish Line. It shows the percent of sales that came from Nike over time. This is only through 2014, but by the time 2015 is reported we think they’ll be closer to 80%. We’d argue that both companies are two of Nike’s best off-balance-sheet assets. But mathematically, they really can’t get much better.
Both companies show a material pick up in Nike penetration starting in 2008. For the record, that’s when Nike started materially shifting incremental manufacturing dollars from ‘Lean Manufacturing’ to building an e-commerce platform that was consistent with its Brand name. While percentages may vary among competitors, the slope of the line remains the same. You could look at Dick’s, Sports Authority, Hibbett, Academy, and even Kohl’s, Macy’s and Nordstrom. You’ll see the same trend all around.
The critical point is that Nike accelerated penetration in its wholesale accounts over the past eight years while it built up its distribution network, on-premise manufacturing capability (i.e. you go to a Nike store, build a shoe and it is made before your eyes), and ability to ship single pairs efficiently to consumers rather than a containerload of 5,000 units to wholesalers. We’d argue that Nike funded growth in the DTC platform by way of outsized (and unsustainable) growth at its wholesalers.
Higher ASPs? Not for B&M. So let’s fast-forward… we’d argue that Nike is largely penetrated in virtually all its wholesale doors in the US. We’re seeing higher price points, which is great. But most of those higher-priced shoes are available only at nike.com or Nike’s ‘snkrs’ app. With those two taken in context, is it any surprise that Nike finally said in public that it will massively accelerate its e-commerce? Not at all.
Watch What They Do, Not What They Say. And yes, Nike says good things about Foot Locker on its investor calls. But seriously, what else do you expect? “We’re going to do our best to decimate the equity value of all the hard-working Foot Locker employees!”? Not a chance. In public, Nike plays very nice in the sandbox, but don’t think for a minute that it won’t do whatever is in its power to drive its own shareholder value. Over half of employees at Nike are paid in stock. They care. Nike does not have a mandate to gain share at Foot Locker or any of these retailers. It’s perfectly fine staying at 80%, or even drifting lower if need be to fuel its more-profitable e-comm biz.
Retailers Need Nike Allocations, Like a Fish Needs Water. THAT’s one of the keys to FL. While NKE share went from 50% to 80%, productivity went from $380 to $575, and margins went from 3% to 12.5%. FL was closing stores at this time, so it’s tough to say how much was Nike vs then-CEO Hicks being smart. But one thing is clear above all…when Nike as a percent of a retailer goes up, it’s good for traffic, good for ASP, great for margins, and usually a big positive for the stock.
Rate of Change is Critical! Also…and this is important given the pushback we get on this, all we need to see is for Nike’s ascent inside a footwear retailer to stop, and it’s a negative event. So we’re not arguing that Nike is going to hang FL out to dry. But by simply maintaining its presence, or keeping a 70-80% ratio, it is a negative rate of change for FL. What if it goes to 60%? It’s been there before, and there’s no reason why it can’t go there again – not to mention that 60% share in a specific account is nothing short of massive in any industry.
And no, it does not suffice if UnderArmour or Adidas (with Yeezy) picks up the slack on Foot Locker’s shelves. They don’t drive traffic (at least YET in the case of UA).
We think that the biggest financial tie-in for Foot Locker is with its SG&A. Why does this matter? Because the company is sitting on a 19% SG&A ratio, which is the lowest we’ve ever seen for any mall-based retailer. That’s how the company can comp 5%, and leverage that into a 30%+ EPS growth rate. We’ve seen that upside time and time again as FL rose from the ashes since the last recession. But unfortunately, leverage works both ways.
Our estimates for FL three years out are 30% below the street, as we think it’s at peak earnings today. Importantly, this is not the kind of story that will play out with a simple press release. This is a 40-year paradigm that is unwinding over a 5-year period. We think that three out of four earnings announcements will be negative – over and over again – at least based on current expectations. Along the way, we should see significant multiple compression, and margin erosion that will cut cash flow and torpedo that argument that we hear over and over about ‘FL throwing off so much cash”. It does until it doesn’t.
We think that there are also key changes with the manufacturing process, lead times, transit times, and changes that Nike might make to its Futures Program. All of these are key offensive weapons that the company has been investing in for the past decade. We’ll be back with a separate note on this, and which dominos fall in which order.
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“And again, we don't ever provide a forecast of what we might or might not do with stock buybacks. We've done a fair amount already and it's our lowest priority.” - Richard Moore 12/1/2015
Takeaway: Within the current reporting framework, we would have looked for a 2016 guide between $3.00 and $3.50. However, we instead expect CAT to embrace “restructuring”, blurring the line between operating items and one-time charges. As a recent downgrade suggests, CAT’s 2016 guidance is a widely anticipated negative catalyst. In the short-run, the ride for shorts may get a bit choppier. We are focusing on short opportunities in the supply chains of resource-related capital equipment suppliers, where investors have less visibility and more room for downside surprise. While we do not think that the CAT short is over, it is important to recognize that under ~$60 is potentially “overshoot” territory. Of course, the shares can overshoot to the downside for quite a while.
Key Earlier Publications
- Feeling Used? Short CAT Black Book (latest of many)
- Dear Barron’s, “Snap”? Yes. “Back”? Not So Much (8/8/15)
- It Gets Worse From Here (7/23/15)
- Naughty (11/4/15)
- Spin The Buldozer (11/20/15 review of Cat Financial Analyst Day)
Late Downgrade, Old News: The Goldman downgrade of CAT reads like a really old newspaper to us, with the exception of an anticipated decline in Solar turbine (gas compression) sales. Sure, mining and energy capital spending are declining from a massive boom and have further to go…that is why CAT shares have performed so poorly since 2012. While we highlighted “bubblish” compression activity for Solar in our June “CAT | Feeling Used” deck, it has yet to happen (slide below). The report misses a number of significant, forward-looking reasons to be negative on CAT including Cat Financial.
Some Reasons To Stay Bearish on CAT
- Used Equipment Overhang: Allows for sustained below trend new equipment & aftermarket parts sales
- Losses At Cat Financial: Management just held an analyst meeting that said Cat Financial was in great shape, but we don’t see that as entirely accurate
- Rail In Addition To Solar: Rail volumes are down, which should meaningfully impact Progress & EMD
- Buyback Is Dead: Buybacks are CAT’s “lowest priority” for excess cash (now that the stock is down)
Blurred Lines Help Adjusted EPS: In the short run, pressing a CAT short is somewhat riskier. While we do not think that the CAT short is over, it is important to recognize that under ~$60 is potentially “overshoot” territory. Of course, the shares can overshoot for quite a while.
- The 2016 guide is a widely anticipated negative catalyst.
- CAT management has finally got around to adopting the troubled industrial playbook. They are doing more small acquisitions, taking very large restructuring charges, and finally cutting costs/capacity. CAT is guiding to $800 million in restructuring charges for 2015 alone. The line between operating and restructuring can blur when the opportunity to hit consensus expectations is on the line, and $800 million buys a lot of greased, rose-colored lenses.
Chunking 4Q ’15 & Guiding 2016? We get $0.68 cents for CAT’s 4Q EPS ex items, and between $2.90 and $3.25 for 2016. Both are below consensus, and both may prove irrelevant if CAT changes the reporting game; it would be wise to do so. An annualized 3Q 2015 plus the expected cost reductions of $750 million actually produce an above consensus ~$4.00 number. If CAT guides in-line with the ~$3.50 consensus, ex-restructuring charges, the shares may well rise and management can get some breathing room. Of course, the GAAP 4Q 2015 print should be fairly horrific.
What About Cat Financial? Oddly, the GS report doesn’t deal with Cat Financial. We held a call with an Australian insolvency attorney last week, and were informed that Australian mining equipment lenders are “basically taking losses every day”. We have been tracking the accumulation of used inventory, which is likely to depress collateral values. Lower equipment residuals and resource-related bankruptcies will impact CAT later than the drop in orders and new equipment sales. CAT actually changed its reserve assumptions in 3Q 2015, lowering reserves. We expanded on that here http://app.hedgeye.com/feed_items/47347.
(Cat Financial in court right around that November Analyst Meeting)
(Used equipment remains an overhang)
Solar Turbines: Expectations of capital spending cuts for midstream players have accelerated with the continued MLP bubble unwind. While this business is likely to continue lower over the next several years, Solar’s non-dealer distribution model allows for the retention of lucrative aftermarket sales.
Upshot: Within the current reporting framework, we would have looked for a 2016 guide between $3.00 and $3.50. However, we instead expect CAT to embrace “restructuring”, blurring the line between operating items and one-time charges. As a recent downgrade suggests, CAT’s 2016 guidance is a widely anticipated negative catalyst. In the short-run, the ride for shorts may get a bit choppier. We are focusing on short opportunities in the supply chains of resource-related capital equipment suppliers, where investors have less visibility and more room for downside surprise. While we do not think that the CAT short is over, it is important to recognize that under ~$60 is potentially “overshoot” territory.
"Unfortunately, Illiquidity (institutional investors can’t get out of small/mid cap equity and junk bond exposures) and Leverage (hedge funds running 150-250% “gross long”, growth slowing companies like IBM levering up to buy back stock, the largest $ amount of corporate credit outstanding in human history, etc.), wasn’t objectively discussed @Davos." - Hedgeye CEO Keith McCullough, Early Look.
In this brief excerpt of The Macro Show today, Hedgeye CEO Keith McCullough cautions on Friday’s market “bounce” and how the Federal Reserve, ECB and BoJ “can’t centrally plan volume.”
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