This one speaks for itself.
Takeaway: Golden State Warrior, Bernie Weakened; A Better Way
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With wins in CA, NJ, SD and NM last night, Hillary Clinton has now fully assumed the mantle of presumptive Democratic nominee. She has been victorious in a majority of the primaries, garnered three million more votes than her opponents, has 2,497 pledged delegates to Bernie Sanders’ 1,663, and has 571 superdelegates to Sanders’ 48. The party will now begin to unify around her with a popular president by her side as she moves into the next phase of her campaign. She and her allies will continue to define and dismantle Donald Trump and his policies.
Priorities USA, a pro-Clinton super PAC, has allocated $20 million for an ad buy against Trump – building on her effective foreign policy speech last week pegging him as unfit to be president. Clinton will also need to reassess her trust and likeability factors – repairing and retooling her image will be critical - it will become her advantage when voters decide the “lesser of two evils.”
Bernie Sanders is all but out of the race – but that doesn’t mean he’s dropping out...In order to be viable for the nomination at this juncture - Sanders’ only option is to flip superdelegates – something that remains completely unrealistic (he’s flipped one in six months). He and some in his inner circle have been hard-pressed to accept his fate, but nonetheless he says he will not relent until the convention. With Minority Leader Nancy Pelosi’s endorsement of Clinton and President Obama’s expected soon, Sanders risks becoming a pariah in his party the longer he holds out.
Speaker Ryan rolled out a wide-ranging conservative agenda just a few weeks ahead of the Republican convention in July. The product of several task forces and dozens of meetings with House members outlines conservative proposals for jobs and the economy, taxes, health care, national security, constitutional authority, and poverty. The plan is a byproduct of the autopsy of the failed 2012 Romney campaign as well as Ryan’s vision for an optimistic agenda for his Congressional colleagues and the party writ large. Ultimately, in the face of Trump terrorizing the party – the proposal gives Republicans a platform to run on in the fall, trying to put the Republican party back on track.
Takeaway: The latest round of changes means more #ACATaper not less as HHS more or less limits access to Marketplace and other plans
On May 12, we told you about the Obama Administration's decision to eliminate a number of Special Enrollment Periods (SEPs) in the Health Insurance Marketplaces. One SEP in particular - the one to accomodate a "permanent move" - was being exploited by highly mobile lower income individuals to access insurance coverage only as long as necessary to obtain services. Insurers asked for a change and HHS agreed. That announcement, however, has been followed by requests for double digit rate increases in a number of states suggesting insurer concerns are not assuage by the change to SEP and that a whole lot more needed to be done to get risk pools (and the associated costs) under control. From HHS's perspective, insurer happiness - or at least their participation - is important to combatting public perception that the ACA's Health Insurance Marketplaces are in a death spiral.
Today's changes include:
1. Changing the definition of short-term health insurance plans from: "health insurance coverage provided pursuant to a contract with an issuer that has an expiration date specified in the contract (taking into account any extensions that may be elected by the policyholder without the issuer’s consent) that is less than 12 months after the original effective date of the contract" to "Coverage must be less than three months in duration, including any period for which the policyholder renews or has an option to renew with or without the issuer’s consent."
Futhermore, HHS is requiring insurers to include in a prominent place on their contracts the following warning:
THIS IS NOT QUALIFYING HEALTH COVERAGE (“MINIMUM ESSENTIAL COVERAGE”) THAT SATISFIES THE HEALTH COVERAGE REQUIREMENT OF THE AFFORDABLE CARE ACT. IF YOU DON’T HAVE MINIMUM ESSENTIAL COVERAGE, YOU MAY OWE AN ADDITIONAL PAYMENT WITH YOUR TAXES.
Short term plans like those sold by QIIH and UNH, because they are exempt from the rather onerous requirements of the ACA like Essential Health Benefits and guaranteed issue, have become more popular in response to the rising costs to the consumers for qualified plans on the Marketplace. People that purchase these short plans - often relatively healthy individuals who do not need a lot of health services - do not enter the risk pool thus driving up costs.
It will be interesting to see if HHS is successful here. As long as premiums on the exchanges remain high and the benefit design of the plans offered there includes services many people do not want to buy, we are skeptical. State regulation would probably be more effective but that will be far from uniform.
2. A proposal to propose in future rulemaking changes to the risk adjustment program. These would changes include:
The risk adjustment model is the only permanent risk mitigation program in the ACA. The other two, risk corridors and reinsurance end this year. The risk adjustment model requires payments from insurers that accepted lower than average risk to insurers that accepted higher than average risk. Partial year enrollees like those that entered through a SEP were not being properly scored. In other words, the risk score did not accurately measure that reality which is the partial year enrollee was there largely for the purposes of getting services and then planning to exit.
The inclusion of the prescription drug utilization data is meant as a proxy for patient health. Larger insurers like UNH have the resources to access diagnosis data on their enrollees in a way that smaller firms cannot. So, a few have mispriced their plans and pressured HHS to make some accomodation. This change should make smaller insurers more competitive on the exchanges.
3. Outreach to educate Marketplace enrollees when they are eligible for Medicare and what they need to do to make the switch.
4. Implementing a Special Enrollment Confirmation process. This change is a big one for the insurance industry. When the changes in May were, AHIP and others were quick to point out the need for a confirmation process that included submission of documentation in support of SEP eligibility. HHS has relented and included their demand in this latest round of changes. The documentation requirement will go into effect on June 17.
5. Addressing data matching issues that discourage younger enrollees. Eligibility data is verified electronically but from time-to-time it cannot be and in that case HHS advises the enrollee of the need for additional information. Younger enrollees tend to drop the enrollment process at this point thus limiting their admission to the risk pool.
HHS indicates that they will be making three announcements in June, today's being the first. The purpose of these announcements is: "strengthen the risk pool by spreading the costs of care over a diverse mix of enrollees, work with issuers and state Departments of Insurance to improve coverage options, and step up Marketplace outreach, especially to young adults and uninsured families in advance of Open Enrollment 4." Today's announcement is clearly meant to address risk pool issues. Later in the month we should hear more about enrollment options and outreach.
In sum, HHS is bowing to considerable insurer pressure - the political kind and the rate request kind - in making these changes. Changes like those to the SEP and tighter eligibility processes that make insurance harder to obtain, mean less access to services. Limiting short term insurance - even if that proves effective - is likely to send people to the uninsured category not to the exchanges. And that means more momentum to the ongoing #ACATaper.
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Takeaway: Healthcare job openings posted the slowest growth rate in 7 quarters and provided confirmation of our Healthcare team's #ACATaper theme.
Editor's Note: Below is an excerpt from an institutional research note written by Healthcare analysts Tom Tobin and Andrew Freedman on healthcare employment. Why is this important? As our analyst Tom Tobin wrote in an article that appeared on Investopedia earlier this year:
"The Affordable Care Act created legions of newly-minted medical consumers which benefited the bottom line of the companies that cared for them... [in other words] ACA has created a year-over-year comparison so enormous that healthcare stocks will probably unwind rather violently."
Our healthcare team calls the coming "unwind" the #ACATaper. Healthcare job openings are essentially a proxy for this massive pull forward of demand. That's why today's slowing JOLTS data (Job Openings and Labor Turnover Survey) was so critical.
Of the thousands of macro and fundamental data series we track on a daily basis, Healthcare Job Openings (JOLTS), proves to have the most consistent and reliable relationship to utilization trends in the industry.
Despite a slight sequential uptick in the absolute number of Healthcare Job Openings (1,015 April / 957 March), on a trending basis, growth was the slowest in 7 quarters with the 3-month YoY growth rate at +12.2%.
Why does that matter?
JOLTS as a percentage of Healthcare Employment remains extended at +2.1 standard deviations, suggesting there is a lot more downside to go as the #ACATaper takes hold and the U.S. Medical Economy mean reverts.
The latest JOLTS and Employment report is consistent with an organic growth slowdown at AHS and implies a sequential decline in adjusted same-store admissions volume at HCA, and is a sign of potential weakness for HOLX’s diagnostic business.
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Takeaway: We wouldn’t touch this stock for all the Goji Berries in the world.
We wouldn’t touch this stock for all the Goji Berries in the world. Yes, the comp was great at +8%, but the company still managed to leverage a great top-line algorithm -- 8% comp and 17% sales growth – into a -12% EPS decline. How we look at it, comparisons on the top line begin to get tougher immediately, LULU just showed us that the cost of its growth is getting much more challenging, and it all but assured the investment community that gross margins will start to inflect – even though it lacks the operational excellence to make such a statement. Again, not for all the Goji Berries in the world. All in, at 30x earnings and 15x EBITDA, LULU is in the top 1% of retail as it relates to being expensive. We’d flat out short this name. While our estimates are not wildly outside of the Street, they carry – by a country mile – the greatest likelihood of any of any retailer/brand to completely blow a quarter, year and reshape investors’ view materially to the downside.
Comps – The 8% constant currency comp puts LULU in the 97th percentile during the 1Q16 earnings season. That’s nothing to scoff at – especially in this environment. Though, if we peel back the onion a few layers on the LULU comp trends – especially at the store level – the underlying trends paint a much less bullish picture. Specifically, the 3yr trend which eliminates all of the quarterly noise, hit an all-time low at 0% in the quarter (see exhibit below). That type of trend doesn’t add up to a growth stock.
Now comps get more difficult, going from a -1% compare this quarter to +5-6% comps, as the company laps Chip’s “our customers are fat” tailwind which benefited LULU in final 3 quarters of FY15.
Gross Margin – Definitely the highlight for LULU in the quarter, beating expectations by 130bps. Add on the better inventory balance, and LULU appears to be on track to reach its gross margin goals for the year. Guidance of 120bps of leverage in 2Q16 reflects that. Yet, despite the positive tailwinds from the sourcing side, product margins still were pressured by markdowns and discounts. LULU may very well get the gross margin lift this year (it’ll more or less give it back in SG&A), but that requires a level of operational excellence that this company has never proven it can deliver sustainably – if not momentarily. And…at this price the market absolutely demands it.
Up at 30,000 ft., the 35bps of deleverage in the quarter caps off a 5 year stretch in which margins have declined by a cumulative 10.5 percentage points. 2Q16, according to the company, will be the inflection point in the GM slide. That may be true, but we still think a mid-50’s gross margin is a pipe dream. Keep in mind that the bulk of this deleverage came at the same time LULU should have experienced its most profitable growth period – as it built out its store network in the US. Now growth becomes more expensive (Intl, ivivva, men’s) at the same time the DD comps dry up.
Also keep in mind that while inventory levels improved on the margin, we’re still looking at five quarters in a row – including this one – where inventory grew faster than sales. The only time we’ll give credence to a management team’s assertion that gross margins will turn around imminently is when it makes that statement with only a few weeks left in the quarter, or if inventory is exceptionally clean (i.e. there is a significant sales/inventory spread). We’re looking at neither here.
SG&A – Let’s ignore for a second the 100bps of SG&A deleverage caused by a strengthening of the CAD in the quarter. SG&A still delevered by 300bps in the quarter, or 75bps higher than street models called for. Yes, the cost of growth is growing.
Now on to currency, the headwind experienced in the quarter is part of doing business when the corporate headquarters are stationed in Vancouver. Over the past 3 years – LULU has recognized a $12.7 million benefit from currency revaluations. Now that’s going the other way, as are the cost savings associated with paying employees in Toonies, but there is an equal benefit to the top line.
We know that there’s supply chain investments underneath the SG&A hood, but let’s not forget where LULU’s growth is coming from. In this year alone, the combination of ivivva and Int’l accounts for more new doors (23) than North American LULU (17). That’s a meaningful margin headwind in light of the profitability characteristics of the two vs. the core business. The punchline = growth is more expensive.
International – the store growth plans for the Int’l markets remain on track (the reduction in store additions for the year came in the US market) at 11 new openings in FY16. That will put LULU at 22 locations in Europe and Asia by the end of the year, meaning a minimum of 18 openings in FY17 to hit guidance for 20 doors in Europe and Asia by the end of that year. Commentary was again mixed on the success of the International operation. With the positive being the store in Hong Kong putting up monster productivity of $5700/sq.ft. on a 1,300 sq. ft. box for a grand total of $7.4m. About 7% higher than an average 2.5k-3k sq. ft. US door at the peak. The rest of the doors in that region are tracking at or above $1,500-$1,600/sq. ft. Not shabby, but far below where LULU needs to be if it wants to hit its $1bn Intl sales goal (more below).
Europe appears to be a different story all together, with the case study being the London Market. The company has 5 doors in the country now and the hit rate is sitting at 60% in terms of winners – with 3 doors tracking at plan, and 2 doors lacking the community ‘vibrancy’ to be effective. To be clear, 60% winners equals 40% losers. Shouldn’t it have more success in a nascent market like the UK? Heck, maybe that’ll change with some nice therapeutic Brexit. No, not really.
We give LULU credit however, for looking at additional alternatives like shop-in-shops to broaden the International reach, but for International to work according to plan and meet the $1bn sales target which we will assume will get it to its ROI targets, it needs to average productivity of $4,500/sq.ft. The initial reads are not even close, and as LULU steps on the accelerator outside of NA, the company will move into lower tier markets. Zurich ≠ London or Hong Kong.
The Loonie Bump
LULU was explicit in calling out the SG&A impact caused by a 6% appreciation in the Canadian Dollar vs the US Dollar in the quarter (about 2x what the company expected). However, management failed to highlight the top line benefit created by the same currency move. Assuming 20% of sales are in Canada, the change in currency value caused a $6mm bump in revenue or 140 bps of growth in the quarter. On a full year basis, the currency change implied in guidance gives LULU about a $12mm (+0.5%) benefit from the Loonie appreciation. Meaning nearly all of the full year upward revenue revision can be explained by changes in the FX rate and not in a material improvement in the underlying health of the brand.
Takeaway: Join us tomorrow, Thursday, June 9, 2016, at 1 PM ET for a run-through of our latest analysis on ECPG and PRAA.
Over the last 18 months, we have released a number of detailed research notes on two of our best short ideas: Encore Capital Group (ECPG) and PRA Group (PRAA). We will be hosting a conference call this Thursday, June 9, 2016 at 1 PM ET to explain our latest in-depth analysis on both companies.
Encore Capital Group
Toll Free Number:
Conference Code: 13638888#
Watch Live: CLICK HERE
Materials: CLICK HERE (Materials will be available approximately one hour prior to the start of the call)
Joshua Steiner, CFA
Jonathan Casteleyn, CFA, CMT
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