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Takeaway: Capital markets businesses are starting to turn down signified by JPM and this cyclical stock "looks" cheap only on trailing results.
"When you expect things to happen...strangely enough they happen." - J.P. Morgan
Most of the JP Morgan Investor Day this week was backward looking with the bulk of the presentation spent on an annual recap of the Corporate and Investment Bank (CIB) in 2015. The most relevant data however was the simple reference to running 1Q16 activity trends which are down -25% year-over-year. While there was no deconstruction of the drivers of this slack, our data suggests a 30-40% decline in underwriting, with a negative 5-10% start for M&A (described as "holding well" by the CIB Head). JP Morgan matters with top 3 share across the board in capital markets.
Global M&A announcements have started down mid-single digits in January and February with U.S. announcements more volatile having putting up a solid January, up 42% year-over-year, with a forming -20% decline for February. The across cycle look at merger activity shows the new 2015 zenith having taken out the '07 highs, with even the slight decline to start 2016 looking like a massive slough off. We think this slow start to the year turns into an intermediate term trend and that the M&A advisory group will be comping negatively throughout 2016. The main culprit at his juncture is the backup of corporate credit costs which are maintaining levels, some 100 basis points higher across Moody's most widely referenced indices. Historically, M&A has comped down by -20% with a 100 basis point back up in credit, which implies an M&A market just starting a more substantial decline.
On the asset management side, headwinds persist with a stubbornly high U.S. dollar and risk aversion for EM assets. The Chinese Yuan devaluation now appears to be driving the depreciation in the MSCI Emerging Markets index and with the outlook for the Chinese currency weak at best considering capital flight and slowing growth, the situation warrants caution.
Like most cyclical stocks, Lazard "looks" cheapest at market tops as its earning downturn is just getting started versus at market bottoms when the company is underearning and shares "look" expensive (but they are actually great early cycle longs). We have earnings flat at $2.80 for 2016 and 2017 which we capitalize at 8-9x for a fair value of $25. However in a 1 Emerging Market type downcycle, Lazard asset management with ~50% of its asset-under-managments in EM credit and equity will cause LAZ stock to overcorrect and spit off more downside (substituting current day China for Thailand in '97 in running out of FX reserves to support its currency and plugging in Venezuela or the Ukranine for Russia's '98 default).
The update on 1Q16 trends from JP Morgan matters as a top 3 player in most business lines in capital markets:
The flattish start to global M&A for 2016 looks like a massive decline being that M&A activity put in its high water mark in the middle of last year. In addition to "comping the comp" as we move further into the year, M&A activity will be battling volatility and the fundamental change in corporate credit costs:
U.S. activity had a solid January but is putting in a slump in February. Historically, U.S. activity is 60% of global announcements.:
The inflection in corporate credit costs hasn't normalized which pressures funding costs and M&A synergies:
And the year-over-year change in credit costs (inverted - left scale) does drive the growth or decay of M&A volume:
Every 100 bps of credit cost expansion has historically depressed M&A by -20%. Currently, the four quarter moving average of corporate credit has backed up by 25 bps, essentially confirming the -4-6% start for global M&A:
And although the firm will have a strong 1Q16 report (the company advised on 6 of the 10 largest deals in 2015 but only closed 1 of them during the year), the stock discounts the revenue environment 3 quarters ahead of time:
Lazard stock is a great early cycle performer but kicks off decidedly negative returns at the end of cycle:
The rising volatility environment is not good for cyclicals as the VIX (inverted right scale) historically pushes the stock down:
On the asset management side, non-local Lazard Asset Management strategies regress closely to EM markets which means their exposure is understated:
And the debasement of the Chinese Yuan (inverted scale) is down driving EM market returns:
The last EM down cycle created redemption rates of between ~ negative 2-5% in 2002-2004 versus the +2% organic growth in LAZ asset management to finish 2016:
We hear alot from investors that the stock "is as cheap as its ever been" however like a true cyclical, the best time to buy shares is when it is underearning early in the cycle (note 20x LAZ earnings multiple in 2009-2010). LAZ is overearning currently coming out of the M&A boom of 2014-2015:
Please let us know of questions,
Jonathan Casteleyn, CFA, CMT
Joshua Steiner, CFA
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Takeaway: 80% of release has zero bearing on thesis. Kitchen sink clearly in the mix. We could look all year and not find a risk/reward as favorable.
Conclusion: As the mega bulls on RH, this preannouncement is a clear kick in the gut. But there’s a few things at work...a) more than half of the shortfall was because RH couldn’t fill orders in its new Modern product line. We’d rather that than have no orders and too much product. b) Energy markets still a drag. c) the smallest part of rev miss (18%) is a miss in Jan as business slowed due to market volatility. Biz came back in Feb, we think, that qtr was not disclosed. d) incremental margin on lost sales is too high (41%) for this business model. We think RH knew it had to preannounce, so it put the highest octane it could find in the preannounce-o-meter. All in, this stock is trading at 14x what we think is a trough earnings level. An all-out recession gets us $2.50 x 12, or $30. An acceleration in 2H with all its growth drivers (that no one cares about today) gets back above $100 in a year. We could talk about the 2-3 year earnings/multiple upside – but admittedly that does not matter now. How we see it, there’s $60 up and $10 down. We can search all year for better odds, and still never find it in US retail.
This flat-out stinks. We knew an 8k was coming from RH, but certainly wasn’t expecting a 35% guide down for the quarter, with no forward guidance whatsoever. Furthermore the company’s press release is riddled with ambiguity and lacks important context that we’re certain will hurt the stock more than it deserves. And to be clear, it definitely deserves to be down from a traders duration.
Our implied earnings for 2016 is $3.10, suggesting that the stock is trading at about 14x earnings. We can argue til we’re blue in the face how ridiculously low that multiple is for a company that grew 13% in a transition year (’15), should grow another 15% in a pseudo-recession year, and then 30%+ long term (starting in ’17). But in the end, we’re going to need to see this business stabilize and reaccelerate for the stock to work. That should be within two quarters.
As a frame of reference, we outlined two recession cases in our January Black Book (see link below), which implied $2.63 in EPS in a ‘normal recession’ (whatever that is), and $2.30 in EPS if we revisit the downside we saw in the Great Recession. Our $3.10 for this year is likely to come out ahead of consensus, and we’re relatively confident in our number.
But from where we sit, the magnitude of the revenue shortfall in no way is indicative of solid demand, and the earnings shortfall is even further overstated. By our math, we’re looking at $66mm. Consider the following.
Top Line: Reported a 9% comp versus prior expectations of 22% -- that’s about $66mm. There are several reasons for this.
- Modern Revenue Shortfall. The simple fact is that RH bit off more than it could chew with this new product line. Bookings were up 21%, though it could only fulfill 11%. Definitely a big execution problem with vendor management, but certainly not a demand problem for the brand. Those orders – at least the ones that are not cancelled due to miffed customers – will ultimately be delivered. Of the $66 revenue miss, we think the execution issue in delivering Modern accounted for about $35, or 53%.
- Energy/FX Market Drag. This is nothing new, but the weak performance we saw in 3Q continued at -400bps to the comp. Keep one thing in mind…this company – at least how it exists today – has never really managed through a major Energy or FX cycle before. That’s no excuse – it’s shareholders expect it to do so, and they should. Overall Energy/FX cost about $19mm in the quarter, that’s 29%.
- “Weakness in the High End Consumer”. This is classic. Not because it isn’t happening, but because out of the entire $66 revenue miss, this only accounted for about $12mm (18%). On its own, it’s not even worth preannouncing over, and yet we all know it will capture the headlines tomorrow “RH Guides Down Due to Weakness at the High End”. In reality, our sense as to what happened is that the company saw a slowdown for about three weeks in January as the equity markets were in a freefall. Then markets stabilized, and sales rebounded in February. But February is 1Q, which RH won’t comment on until March 23rd. Overall this cost about $12mm in the quarter due to fewer orders, and an increase in cancellations.
Funky Incremental Margin Math
Can someone explain to us how revenue missed expectations by $66mm, but EBIT missed by $27mm. Yes, that’s an incremental margin of 41%. That is simply ridiculous from our vantage point. Keep in mind that a given retail operation like Nike, Ralph Lauren, Tiffany, Ulta…you name it…keeps virtually all product in a storeroom or on the floor. The consumer picks the merchandise, pays, and they walk out the door satisfied. Given the inventory carrying costs associated with this model, and almost all retail models, the incremental margin on a dollar won or lost can often be as high as $0.50-$0.60.
But in a business model like RH, only 5% is ‘cash and carry’ (i.e. minimal storeroom usage) with the remaining 95% on order for delivery over the coming 1-2 months. That, by definition, means that the incremental margin on lost revenue will be dramatically closer to the company’s EBIT margin rate – usually 10-20%. So how or why did RH put up a 40% incremental margin?
Go Big or Go Home!
As noted, RH’s incremental margin of 40% is simply too high. We’re completely reading into this, and would never look for anyone to confirm or deny it, but we think this high rate of flow through is on purpose.
Think of it like this…RH has never missed a quarter – at least not in this iteration of being public. And now, largely because of execution gaffes around keeping up with demand for a new product line (Modern), it has to guide down. This is a competitive management team, and one that definitely cares about its stock. We like that, but sometimes it comes at a cost.
The entire team has been in business planning sessions over the past month, and when a preannouncement became necessary, we think someone probably said something like “If we’re going to miss for the first time ever, let’s miss big, and make 100% sure it does not happen again.”
As such, we think RH likely made investments in the quarter that would have otherwise taken place in 2016 – hence taking the incremental margin on the revenue loss meaningfully higher.
We also think that the lack of 2016 guidance was purposeful. First off, the company gave a mouthful and plenty to digest with this announcement. Second, the consensus numbers for 2016 are likely to come down 20% or better given the absence of any other information. THEN, when RH issues guidance on March 23, it will have a very low hurdle – and it probably won’t guide much above that.
Then we’ll have a low earnings bar, likely upside to earnings, anniversarying weakness in Energy/FX markets, a meaningfull step-up in contribution from six opened design galleries as they enter the key part of the maturation curve, and an upgraded vendor base for Modern and Teen. THEN and only then will people care about the outsized square footage growth, new product flow, and astoundingly favorable rent structures on new properties.
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