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We’re Wrong On U.S. Growth (Well, Kind Of)

Key Takeaway: We don’t want to be trite by offering a token golf clap to the U.S. economy bulls in response to the strong JAN PCE data and positive revision to Q4 GDP. It’s more appropriate to offer a standing ovation instead. But what happens after standing ovations? Hint: the audience sits back down... All told, our views on the likely progression of the domestic economic and financial market cycles remain unchanged (see section #3 below for more details).


Section I: January Personal Income & Spending Recap

Both income and spending accelerated to start 2016 as the combination of accelerating aggregate wage income and a small decline in the savings rate, off of multi-year highs, combined to drive sequential improvement in household spending. The January NFP data signaled as much (see: yesterday’s Early Look: Number 2 for details) so we got largely what we were expecting with the official release this morning. 


An annotated visual tour of the underlying data is below but here are a few key points:


  • The January data was solid but the Trend remains one of deceleration.  Income growth, employment growth, consumption growth, consumer confidence and corporate profits all peaked in 4Q14/1Q15 and have been slowing since. Income growth drives the capacity for consumption growth and with weekly hours flat and employment growth slowing, we’ll need to see an ongoing acceleration in wage inflation to maintain the pace of aggregate income growth near current levels. Unless one believes wages will accelerate towards +3.5% in fairly short order, the Trend slope of aggregate income growth (and consumption growth by extension) should remain negative. 
  • Core PCE marked its 45th month below target in January but accelerated for a 3rd consecutive month to +1.67% YoY.  From a policy perspective, the gain bolsters the argument for continued interest rate normalization.  It also, however, bolsters the risk that further policy divergence out of the Fed serves to perpetuate the deflationary and growth slowing trends that have characterized most of the last eight months.  The probability that positive seasonality and easy comps optically boost reported fundamentals in 1Q (see: Early Look: Optical Mischief) also raises the risk of a potential policy blunder. 
  • The dynamics underlying the rise in inflation are also not inconsequential. The benefit of lower energy prices for consumers is being absorbed by higher savings and services consumption (which is why it hasn’t really shown up in the Retail Sales data). Inside of services consumption, much if it is going towards housing (rent/housing inflation is running at a wide premium to income growth & broader price trends) and healthcare consumption.  The rise in healthcare consumption is largely attributable to Obamacare and the influx of newly-insured seeking care. Rising housing costs, while supportive of the Fed’s inflation target, largely represent excess growth in a key consumer cost center and a drag on other discretionary and housing related consumption. Rising inflation driven by disproportionate growth in major consumer cost lines is different than demand-pull inflation driven by (persistent) wage inflation and rising discretionary consumption.


We’re Wrong On U.S. Growth (Well, Kind Of) - Income   Consumption Growth


We’re Wrong On U.S. Growth (Well, Kind Of) - Core PCE YoY


We’re Wrong On U.S. Growth (Well, Kind Of) - CPI Shelter vs Ex Shelter


We’re Wrong On U.S. Growth (Well, Kind Of) - Income Spending Summary Table


-Christian Drake, Senior U.S. Macro Analyst


Section II: Q4 GDP Revision Recap

The headline number beat on flimsy-at-best internals:


  • Consumption was revised down by a small amount.
  • Net Exports were revised up as the negative revision to Imports outpaced the negative revision to Exports. That setup is good from a GDP accounting perspective but lower Import and Export activity calls attention to waning aggregate demand trends – both domestically and externally.
  • Almost all of the +30bps revision to the headline growth figure was due to the positive revision to Inventories, which was revised higher by 31bps.


We’re Wrong On U.S. Growth (Well, Kind Of) - U.S. GDP Summary Table


-Christian Drake, Senior U.S. Macro Analyst


Section III: Revising Our Outlook for U.S. Economic Growth

With the advent of this 1-2 punch of generally positive economic data, we are revising up our outlook for domestic economic growth:


  • Our GIP Model has U.S. Real GDP growth tracking at +2.0% YoY in 1Q16. This figure represents a +20bps revision to our previous forecast. This moves us ever-so-slightly into #Quad2, which is what had been and still is being implied by the comparative base effect for Q1. Our initial #Quad3 forecast was a function of extrapolating the trending deterioration in growth momentum into the first quarter, but that looks to be less appropriate with the advent of some JAN data including this morning’s Real PCE print.  
  • The aforementioned +2.0% YoY growth rate translates to +1.0% on a QoQ SAAR basis. This figure represents a +40bps revision to our previous forecast. For comparison’s sake, the Atlanta Fed’s forecast for Q1 was just revised down to +2.1%. We expect their model to continue heading towards our [much-lower] estimate as the quarter progresses. Refer to the 2nd half of our 2/17 note titled, “What’s More Important: the Short Squeeze in the Market or the Data?” for details on why.
  • On a full-year basis, we now see U.S. Real GDP coming in at +1.4%, which is up small from a previous estimate of +1.3%. This would still mark the slowest annual growth rate since 2009. Our 2016 GDP estimate implies Nominal GDP growth of +2.8%, which would also represent the slowest rate of annual change since 2009. Please note this as a meaningful headwind to the current Bloomberg consensus forecast of 119.58 for S&P 500 NTM EPS.


We’re Wrong On U.S. Growth (Well, Kind Of) - UNITED STATES


We’re Wrong On U.S. Growth (Well, Kind Of) - GDP COMPS


We’re Wrong On U.S. Growth (Well, Kind Of) - Atlanta Fed vs. Hedgeye Macro GDP Estimate Tracker


Moving along, the conspiracy theorist in me doesn’t want to believe the strength in this morning’s JAN Real PCE data. Having consumed enough @Zerohedge tweets about seasonal-adjustment shenanigans over the past two weeks, I came away somewhat surprised to learn of no holes in today’s print. This was a good number and represents a healthier U.S. consumer than we anticipated when we published, “50 Charts On Why Consensus Macro Is Dead Wrong On the U.S. Consumer” back on January 19th.


In fact, further analysis would seem to suggest that U.S. economy bears such as ourselves were perhaps reading too much into the SA vs. NSA debate that’s emerged in recent weeks with the advent of the Retail Sales, Durable Goods and Capital Goods releases for the month of January. Specifically, the Z-Scores for the basis point spread between the SA and NSA YoY growth rates for each reading were 1.6, 0.7 and 1.0, respectively; each is on the high side of historical readings, but not high enough to suggest a not-yet-reported material leg down in the underlying health of the U.S. economy.


We’re Wrong On U.S. Growth (Well, Kind Of) - RS SA


We’re Wrong On U.S. Growth (Well, Kind Of) - DG SA


We’re Wrong On U.S. Growth (Well, Kind Of) - CG SA


So what does this all mean for markets? We believe the three most important takeaways are as follows:


  1. Growth is still slowing on a trending basis across a variety of key high-frequency indicators. And outside of personal consumption data, the preponderance of indicators that are showing sequential and/or trending accelerations in recorded growth rates are still contracting from a YoY perspective and remain sensitive to incremental commodity price deflation from here.
  2. On an inline-or-better FEB Jobs Report next Friday, the Federal Reserve may read into the positive JAN PCE report – specifically the Core PCE Deflator within – and/or Q4 GDP as justification for another rate hike at its 3/16 meeting. At +4bps and +7bps DoD, respectively, both 1Y OIS spreads and 2Y Treasury note yields support this conclusion, on the margin. The implied probability of a rate hike at the FOMC’s 3/16 and 4/27 meetings are up +200bps (to 12%) and +540bps (to 20.8%), respectively, on the day. It goes without saying that incremental tightening of domestic (and global) financial conditions from here remains a key risk to asset markets.
  3. As highlighted in our 2/24 Early Look titled, “Relatively Insignificant”, the probability of a U.S. recession over the next 2-3 quarters continues to rise on a trending basis. Additionally, both the credit and corporate profit cycles continue to have extremely dour implications for asset markets on a forward-looking basis from here. As such, investors would do well not to read too much into January’s solid Real PCE print.


We’re Wrong On U.S. Growth (Well, Kind Of) - U.S. Economic Summary Table


We’re Wrong On U.S. Growth (Well, Kind Of) - U.S. Economic Summary


We’re Wrong On U.S. Growth (Well, Kind Of) - U.S. Household Wealth as a   of Disposable Personal Income vs. Shadow FFR


We’re Wrong On U.S. Growth (Well, Kind Of) - U.S.  CreditCycle Bubble Chart


We’re Wrong On U.S. Growth (Well, Kind Of) - CORPORATE PROFITS VS. SPX


All told, we were wrong on the pace of economic degradation thus far in 2016 and hope you appreciate our objectivity and intellectual honesty here. We aren’t perma-bears insomuch as we aren’t perma-bulls. We have no horse in this race other than preserving our analytical reputations.


We simply want to be continue being right on forecasting the data and financial market returns from a trending perspective and our intermediate-term TREND calls on both remain unchanged.


-Darius Dale, Senior Global Macro Analyst

Under 60 Seconds: Foot Locker's Earnings Report | $FL

Hedgeye Retail analyst Brian McGough highlights three key points from Foot Locker's latest earnings report. If you like this excerpt, you’ll love our research.

NEM, ABX, GG: Charts that Matter

Of the major North American miners, Goldcorp finished off Q4 Earnings season last night with an awful print which included a net loss of -$4.3Bn when you include impairment charges of -$3.9Bn (-$128MM without charge).


In addition to the impairment charges, Goldcorp wrote-down the carrying value of heap leach inventory and stockpiles at two mines to the total of $104MM. The impairment and write-down charges assumed a long-term gold price of $1,100/Oz. While by no means apples-to-apples, the carrying value of Newmont’s stockpile and ore on leach pads is multiples of Goldcorp, and both companies previously assumed $1,300/oz.


These charges are a reality of a cyclical downturn, one that Newmont may be trying to push out as long as possible (or avoid). ABX and GG have taken impairment charges and downwardly revised for lower gold price expectations and Newmont has not. Rather, they’ve kept aggressive gold ($1,300/oz.) and copper ($3.00/lb.) price assumptions for capitalizing their much larger inventories and stockpiles.


We believe Newmont’s higher cost profile and aggressive capitalizations will matter in a lower gold price environment. However, we’ll be the first to say that these names are trading vehicles with leverage to gold prices, and being long of gold with leverage which has worked YTD.


With the release our monthly sector sentiment deck on Tuesday morning, we’ll outline some of the behavioral factors behind the move YTD as well as to outline what is becoming more of a consensus trade in gold ahead of policy catalysts in the coming weeks.


Behavioral factors along with Newmont’s failure to address aggressive accounting practices pushed us to add NEM to our Best Ideas on the short-side last week (link to the 02/18 note).   


Below we use 4 charts to highlight what we view as two of Newmont’s biggest long-term headwinds:

  1. High Cost of Production (Adjusted AISC has trended higher since Q3 2014)
  2. Stockpiles and Inventories:
    • Large quantity of stockpiles and inventories (relative to other producers)
    • Aggressive long-term price assumptions for the capitalization of these inventories (meaning they have not yet realized the impairment and write-down charges normally taken by producers in a lower gold and copper price environment) 


NEM, ABX, GG: Charts that Matter - Stockp iles   Gold Sales


NEM, ABX, GG: Charts that Matter - AISC Adj. For stockpiles


NEM, ABX, GG: Charts that Matter - NEM Write downs vs. stockpiles


NEM, ABX, GG: Charts that Matter - AISC Table adjusted for stockpiles and sustaining capital






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RH: An Update On Restoration Hardware

Editor's Note: In light of the recent blow to RH shareholders, please see the following research report written by Hedgeye Retail Sector Head Brian McGough. According to McGough, "My timeframe has always been on the company's 2018 numbers. The fundamental thesis still holds and should start to play out before then. But that's no excuse for getting caught in this collapse."


*  *  *  *  *  *  * 



As the mega bulls on Restoration Hardware, this preannouncement is a clear kick in the gut. But there are 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.

  1. 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%.
  2. 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%.
  3. “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.

FL | Eroding on the Margin

Takeaway: As good as 4Q was, most metrics look sequentially worse to us. This is a fat-tailed short call, and we think it’s starting to play out.

FL numbers looked fine, good actually. But our point on the stock all along is that there’s asymmetric risk to the downside in a) the rate of change in fundamentals, and even more so b) the stock. FL beat by $0.04 ($1.16 vs the Street at $1.12) and put up a very respectable 7.9% comp. But…

  1. FL has beat every single quarter this economic cycle save one, and by an average amount well above what we saw today. This company is EXPECTED to beat.
  2. The flow through in profitability is less than half of where it trended 3 and 4 quarters ago. Compares are starting to get tough.
  3. Comp trends are disappointing in Feb, at a low-single digit rate month-to-date EVEN THOUGH a) there was a sequential uptick in Nike/Jordan launches this month versus last, and b) Feb 2015 was disappointing – so it faced an easy comp. i.e. there’s an increasing bifurcation between Nike’s solid release schedule and FL results. That’s bad.
  4. The steady sequential decline in e-commerce is unsettling, to say the least.
  5. Management sounded very confident in 1Q and the year – but this team only knows how to be confident. They’re reign started in the middle of the biggest multi-year surge in Volume and ASP-boosting Nike product since the early 1980s. Now that ends.


On Wednesday we said a whole mouthful on FL when we presented out 65-page Black Book – here’s the link to our report (CLICK HERE). This quarter was in line with our thinking.


Additional Details:


Comp Trends: Solid 4Q number at 7.9% showing an acceleration on a 2 and 3 year basis.  That was mostly generated outside the US, as the FL banner domestically put up a MSD comp for the first time since 3Q13. Quarter to date trends at LSD for the month of February are not encouraging.

FL  |  Eroding on the Margin - 2 26 2016 FL chart1


Monthly Comps: Below are our estimates of the monthly comps based on management commentary. i.e. MSD = 5%, LDD=11%, etc. We’ve now seen two consecutive months of LSD comp growth. Commentary around the February trend doesn’t add up. Per Nike’s website the basketball launches accelerated sequentially into the All-Star game and it is the easiest comp of the year for the company. From here, everything gets more difficult for FL.

FL  |  Eroding on the Margin - 2 26 2016 FL chart2


e-Commerce Erosion: Another bad indicator on the margin for FL who now competes directly with Nike online for dollars. Yes, FL has the stores that Nike does not, and there is still a place in this space for that experience. But, with more of the growth headed online we think a disproportionate amount of those dollars go directly to the brands – Nike in particular.  Nike hosted its analyst day back in October of 2015, where it laid out its $7bil e-commerce plan by 2020. A number that we think is low by $4bn. No surprise that the sales trends have followed the traffic trends at FL we’ve called out over the past few months at the same time Nike took its intentions public. Banner dot.com growth was just 20%, a big deceleration from the 50% we saw early in the year.

FL  |  Eroding on the Margin - 2 26 2016 FL chart4


Profitability: Incremental margin is down to 36% from the mid-70s in 1H15.  Now working against tough compares as comps moderate and spending accelerates. The leverage in this model is all but tapped, as noted by management on the call when talking about the need for MSD comps to leverage fixed expenses vs. the prior LSD.

FL  |  Eroding on the Margin - 2 26 2016 FL chart3

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