"We need to suck every last permabull into believing that the "bottom is in", then kaboom," Hedgeye CEO Keith McCullough wrote earlier this week.
Takeaway: YTD returns for Housing stocks are awful, but falling rates, a flurry of insider buying, and campaign promises are helping on the margin.
Our FHQ (Friday Housing Quant) tables present the state of the publicly traded Housing complex in a simple, quantitative format that takes ~60 seconds to consume.
Housing Macro | “If someone were to rent your home today, how much do you think it would rent for monthly, unfurnished and without utilities?” Recall, that perfectly subjective question from the BLS - at a ~32% weighting in the Index - anchors the CPI report and the Fed’s view of Inflation’s reality. Shelter inflation made a higher high in the January data released this morning, accelerating to +3.2% YoY and again buttressed muted pricing growth across the balance of services and further negative growth in core goods pricing. Rising rent costs flowing through to both Headline and Core CPI growth are supportive of the Fed’s inflation target and companies directly levered to rent inflation but the gains largely represent excess growth in a key consumer cost center a drag on other discretionary and housing related consumption.
Politician Promises / Housing Policy Update:
At least one of the candidates has weighed in with their plan for US Housing reform. Secretary Clinton recently unveiled a plan to help jumpstart housing in economically depressed areas by, among other things, offering up to $10,000 in downpayment matching for select first time homebuyers. While the plan would largely rely on Congress for implementation, here are the provisions as described.
- Match up to $10,000 in down payments for home-buyers earning less than their neighborhood's median income.
- Increase funding and loosen lending requirements for borrowers who go through housing counseling programs.
- Push government agencies to use new ways to assess borrowers' creditworthiness.
- Give agencies 90 days to clarify their requirements for backing loans so that lenders will know how to offer more mortgages without violating new rules.
- Increase the number of affordable rental properties and offer more low-income housing tax credits in neighborhoods where there are shortages.
- Offer more funding to local governments that build affordable housing in neighborhoods with better schools and more jobs.
Joshua Steiner, CFA
Christian B. Drake
Takeaway: We added DRI to Investing Ideas on the short side on 2/16.
Where do we go from here?
Having pulled all the levers to create shareholder value, it’s now down to the facts about how Darden's core business is performing. There are cracks in the Olive Garden story and the brand is not as healthy as the consensus believes.
Major capital investments are needed:
Olive Garden has been in need of a major remodel since FY2007. While the sales trends at Olive Garden have improved slightly, to sustain long-term growth the concept is in need of a major overhaul which will be expensive. As sales trends rollover at the brand, the need for significant capital investment will become more evident.
The real numbers suggest multiple compression:
Under the new business model the company is posting peak margins. In addition to significant capital investment, the company will need to invest in incremental food and labor costs to drive positive traffic across the enterprise.
INTERMEDIATE TERM (TREND)
Management doesn't seem to be thinking about Olive Garden the right way:
During the 2Q16 call DRI management was asked about unit growth plans:
Management’s thinking about unit growth is clearly evolving as the year goes on, and yet, Olive Garden’s top line performance continues to struggle. Plus, they have gone from vocalizing that they will open 1 to 2 Olive Gardens a year, to 8 to 10, which implies 1.2% unit growth.
Additionally, they are not spending aggressively on fixing the business:
Olive Garden’s last remodel was completed at the end of fiscal year 2001, when Joe Lee held the CEO position and Clarence Otis was the CFO. Management defended the remodels during 2002, although they struggled to increased their alcohol sales, which were supposed to be a benefit of the remodels.
In fiscal 2011, management started early remodeling tests on Olive Garden. Olive Garden has about 400 older RevItalia restaurant models that are in dire need of remodeling. In 2011, they remodeled 35 to test the effectiveness of the prototype. Clarence Otis successfully kicked the remodel can down the road until he met his demise in 2014:
To date, Olive Garden has done 32 remodels, and is far behind schedule, on a massive remodel project. Clearly, no one wants to remodel the Olive Garden concept because it will be disastrous for earnings.
LONG TERM (TAIL)
The Olive Garden is still not fixed and is in desperate need of a large capital investment to turn around their negative trends. Until management realizes this the business will continue to decline and the stock will go with it. Determining what management will do in the TAIL duration is not possible, and we don’t like to participate in that guessing game. What we know now is that Olive Garden is not fixed and management does not currently have a plan to rectify the situation.
Additionally, Darden is a multi-concept restaurant company and in our past experience it is very difficult for management teams to allocate capital effectively amongst its brands. On one hand you have high growth concepts such as Yard House, and on the other you have Olive Garden which makes up roughly 56% of sales and is in need of cash just to prevent declines. We look forward to following the story over the next couple of years to see what course of action management takes to recover the business.
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In this recent excerpt of The Macro Show, Hedgeye Managing Director and Demography analyst Neil Howe responds to a subscriber’s question about how the “glacial pace” of demographic trends and migration impacts investors’ portfolios. If you like this excerpt, you’ll love The Macro Show.
Takeaway: Mother Yellen’s more to blame than Mother Nature. Only saving grace in owning this is that everything else likely to go down more.
VFC is near the top of the list of names we really want to own. The portfolio (even though we don’t like portfolios of brands) has gotten so good over time, it diversified geographic exposure more than most people think with ~30% of sales coming from outside the US, and its channel distribution is just about as good as a wholesale portfolio can expect – and it is now by a factor of 3 it’s own largest customer. These factors add up to a degree of earnings defendability that you don’t find too often in retail. And of course, check out the 20-year chart. Some management teams are worth betting against – this one certainly is not.
With all that said, we saw an extremely sharp deceleration in organic growth – from 7.4% to 2.6%, at the same time Gross margins rolled 70bps vs last year and EBIT margins similarly turned down. Management came across as ‘beyond-beared-up’ on the global demand equation throughout the remainder of this winter season and at least for the next 6 months. Yes, weather played a part in the miss – we all know this part of the story without having to go through puffy coat inventory issues. But let’s be crystal clear, there was more than weather at play here. In fact, Janet Yellen likely had a bigger impact than mother nature.
Given VF's product diversity mass market/athletic and global reach, this company should be putting up more consistent and predictable earnings than just about anybody, anywhere. And yet, it didn’t, which might end up being one of the more negative data points we've seen through retail earnings season.
Yes, the stock is starting to look ‘cheap’ (whatever that means). But when a management team as good as this loses control over its business so quickly and to such a great extent, we absolutely positively cannot say that this guide down will be the last. If you have to maintain certain exposure to retail, then yes, it might be worth picking away at VFC on red – but only because everything else is likely to go down more.
Other Thoughts --
Macro Outlook - VFC sounded particularly bearish on the current Macro environment. Characterizing the Macro environment as 'worse than anyone expected'. Supporting that with numbers, this was the first time VFC reported negative revenue growth since 2009. But, unlike many street models would lead one to believe, it's not letting up now that we've entered 1H16.
Inventory - Inventory was up 9% and the sales/inventory spread weakened to -13% from -9% last Q. Despite management spin, the fact is that inventory is way too high at VFC and likely around the industry (DKS, TGT, WMT, etc.). Even if we were to adjust for the cold weather hit, we are still looking at a sales to inventory spread of -9%.
Outdoor Weak, Jeanswear Strength - If there was one positive in this print for VFC and its US wholesale partners it’s the jeanswear segment. Contrary to what we heard from HBI on the basics category at WMT and TGT, the jeanswear segment actually accelerated in 4Q. Not that the wholesalers can hang their hats on that one. Outdoor was the laggard at 1% C$ revenue growth, especially when considering the way it has carried the topline. But, North Face as a brand is anything but broken.
Takeaway: Is 2016 the next 2011, open interest says no.
The biggest risk for shareholders in the exchange sector is that volatility dries up and liquidity in the market recedes. This was the case in 2011 as volatility spiked when the U.S. lost is AAA sovereign credit rating from S&P and the 13.3 million average daily contract volume on CME Group (CME) cascaded down to just 11.4 million contracts per day for 2012. This analog is important because this is the risk for CME longs for 2016 and 2017. Open interest however signaled this trading slack in the '11/'12 slough off as by September of 2011, open interest tallies were comping negatively by late summer portending the forthcoming slack in trading for 2012. Fast forwarding 4 years, open interest tallies currently couldn't be more positive, with the 114 million contracts in the backlog threatening to set new monthly highs each rolling 30 day period. The combination of new electronic (digital) trading in options and new product introduction in rates (the back end of the Eurodollar curve and also new Treasury products), makes the stock one of the few solid long positions in U.S. Financials currently.
Weekly Activity Wrap Up
Volatility and volume eased in tandem this week, however average daily volumes (ADVs) are still tracking well above 1Q15 ADVs creating solid year-over-year growth. Cash equity volume for the week came in at 8.7 billion shares traded per day, bringing the 1Q16TD ADV to 9.3 billion, up +35% Y/Y. Futures activity at CME and ICE came in at 21.3 million contracts traded per day this week, bringing the 1Q16TD ADV to 24.5 million, up +22% Y/Y. Additionally, CME's open interest currently tallies 114.2 million contracts, 25% higher than the 91.3 million pending at the end of 2015, which will drag trading volume higher going forward. Options came in at 17.3 million contracts traded per day this week, bringing the 1Q16TD ADV to 18.5 million, up +19% Y/Y.
U.S. Cash Equity Detail
U.S. cash equities trading came in at 8.7 billion shares per day this week, bringing the 1Q16TD average to 9.3 billion shares per day. That marks +35% Y/Y and +32% Q/Q growth. The market share battle for volume is mixed. The New York Stock Exchange/ICE is taking a 24% share of first-quarter volume, which is consistent with the prior quarter and year-ago quarter, while NASDAQ is taking a 19% share, +49 bps higher Q/Q but -99 bps lower than one year ago.
U.S. Options Detail
U.S. options activity came in at a 17.3 million ADV this week, bringing the 1Q16TD average to 18.5 million, a +19% Y/Y and +16% Q/Q expansion. In the market share battle amongst venues, NYSE/ICE has been trending downward at a moderate pace, but at an 18% share it is +69 bps higher than the year-ago quarter. Meanwhile, NASDAQ's recent declines bring it -396 bps lower than 1Q15. CBOE's market share is down -141 bps Y/Y but has improved recently; its 27% share of 1Q16TD volume is up +137 bps from 4Q15. BATS and ISE/Deutsche have been taking share from the competing exchanges, with BATS up to a 10% share from 9% a year ago and ISE/Deutsche taking 16%, up from 13% a year ago.
U.S. Futures Detail
16.7 million futures contracts traded through CME Group this week, bringing the 1Q16TD average to 18.6 million, a +24% Y/Y and +41% Q/Q expansion. Additionally, CME open interest, the most important beacon of forward activity, currently sits at 114.2 million CME contracts pending, good for +25% growth over the 91.3 million pending at the end of 4Q15, although that is slightly lower than last week's +27%.
Contracts traded through ICE came in at 4.6 million per day this week, bringing the 1Q16TD ADV to 5.9 million, +18% Y/Y and +24% Q/Q growth. ICE open interest this week tallied 69.5 million contracts, a +9% expansion versus the 63.7 million contracts open at the end of 4Q15, a contraction from +10% last week.
Monthly Historical View
Monthly activity levels give a broader perspective of exchange based trends. As volatility levels, measured by the VIX, MOVE, and FX Vol should rise to normal levels after the drastic compression this cycle, we expect all marketplaces to experience higher activity levels.
Please let us know of any questions,
Jonathan Casteleyn, CFA, CMT
Joshua Steiner, CFA
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