In this excerpt from The Macro Show earlier today, Hedgeye Financials analyst Jonathan Casteleyn reiterates his short call on Lazard ahead of its earnings report on Thursday.
Takeaway: Wabtec (WAB) has fallen over 30% since Jay Van Sciver made it a Best Idea Short.
Editor's Note: Our Industrials analyst Jay Van Sciver added Wabtec (WAB) as a Best Idea Short on February 20, 2015. Shares are down over 30% since he laid out his bear case. Here's an excerpt from his original note. For information on how you can subscribe to our institutional research email firstname.lastname@example.org.
While we might be a bit early, we believe that a short WAB position offers excellent exposure to the downcycle in resources-related capital spending. Stating the obvious, railroads provide transport for bulk commodities. The rapid growth in output for iron ore, shale oil, and many other commodities drove a boom in capital investment in rail transport infrastructure. The gradual stagnation in bulk commodity output growth amid lower prices should drive global rail investment back toward long-run norms. This one may not be quick, but the return opportunity appears significant, as we currently see a normalized valuation range for WAB between $40 and $60 per share.
We believe the valuation of WAB shares reflect a premium ‘growth industrial’ story, which we see as analogous to the mining equipment companies (JOY, CAT) in early 2012. Back then, similar rationalizations based on population growth and aftermarket opportunities were employed to justify overvalued equity. We view both rail capital equipment and mining capital equipment as GDP-ish growth deep cyclicals, not industries experiencing secular growth.
There are several risks to our view including a huge commodity price rebound, S&P index addition, and the potential for WAB to be acquired. We would look to be long a cheaper industry player, or hedge appropriately, as discussed in last week's note.
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Should we be worried about the rise of pro forma?
Editor's Note: In this complimentary edition of About Everything, Hedgeye Demography Sector Head Neil Howe discusses the growing use of "pro forma" accounting and explains the broader implications for investors.
There’s been a lot of hoopla so far this year about corporate America’s growing use of “pro forma” accounting—or its growing aversion to U.S. generally accepted accounting principles (GAAP), depending on how you think of it.
Sure, all public companies still have to comply with GAAP, the New Deal-era accounting playbook that ensures consistent tracking and reporting of vital financials. But firms are free to supplement their GAAP numbers with figures that aren’t required by SEC regulators.
These customized earnings reports go by many names—“pro forma,” “adjusted,” or simply “non-GAAP.”
Whatever nomenclature you prefer, these terms are a catch-all for the myriad ways companies may present a different picture than the one portrayed by their GAAP statements. Maybe a company wants to exclude taxes or regulatory fees that are not likely to reoccur again soon. Maybe they want to eliminate the effects of a currency shift. Perhaps they want to draw attention to an alternative metric not required under GAAP—such as operating earnings, EBITDA, or cash flow.
Undeniably, over the past two decades, more and more companies have flocked toward pro forma reporting. Back in 1996, nearly half (42%) of current S&P 500 constituents handed in only GAAP numbers. By 2006, that share had dwindled to just a quarter, and by last year, just 6% of S&P companies used GAAP exclusively.
Certain types of companies have long been in love with pro forma—especially young high-growth companies that have just gone public or financial companies with unusual valuation issues. That pattern still shows up today. According to one comprehensive sample of listed companies, tech companies continue to show the most pro forma adjustments by number (an average of eight per company in 2015) and financial companies show the most by dollar amount (roughly $40 billion in 2015).
WHAT PRO FORMA CRITICS SAY
What’s the problem with this shift toward pro forma accounting? Critics have no shortage of complaints.
Companies use pro forma to artificially boost earnings. Bloomberg analysis finds that 80 percent of S&P 500 tech firms used pro forma figures in order to revise their earnings higher in the most recent fiscal year. It’s not just Silicon Valley: More than half of the Dow Industrials did the same.
Herein lies the problem: Research has found that pro forma inflates net income by an average of 44% among profitable firms—and by a whopping 70% among companies reporting net losses. Funny how a more “accurate” non-GAAP view so often looks so much better than a GAAP view. Many analysts refer to pro forma earnings as “EBBS,” or “earnings before the bad stuff.”
Firms are “leaving out” more and more types of costs. When pro forma first became popular, most companies only removed costs that were clearly extraneous to the basic business proposition—because they were either a one-time hit (like a licensing fee) or a well-understood “external” item (like taxes). Today, virtually any charge—from restructuring costs to depreciation charges to pension expenses—can be removed as long as the CFO can make a plausible case for it. Accounting firm Sanford C. Bernstein finds that the average dollar amount of recurring charges held out of pro forma statements has never been higher.
Inevitably, the practice is spreading even among those who don’t care for it. If your hi-tech competitor sweeps stock options and IP amortization off the table when computing earnings, can you afford not to show a similar perspective to your own investors?
Adjusted earnings undermine the purpose of GAAP. Generally accepted accounting principles were adopted to ensure consistency; a manufacturing company would use the same measures and standards as a telecom provider, a trucking company, and everyone else. But pro forma earnings reports, by their very design, are inconsistent across companies and industries.
WHAT PRO FORMA SUPPORTERS SAY
Pro forma is not all bad. Plenty of analysts and executives feel that non-GAAP reports serve a vital purpose for investors and companies.
All information is good information. Remember: Pro forma isn’t replacing GAAP figures, but merely supplementing them. These adjusted reports add a layer of context to traditional earnings statements, giving investors a picture stripped of expenses (and earnings, mind you) that obscure the underlying business outlook.
Pro forma is a boon to young businesses. Start-ups routinely use “pro forma” assumptions to demonstrate their ability to generate a profit. Even after these firms go public, their valuations are so weighted on future profitability that current GAAP earnings say little or nothing about how investors should value them.
Any GAAP alternative is fine by me. The strongest support for pro forma accounting comes from those who believe that GAAP is an archaic, outdated tool that needs replacing. Authors Baruch Lev and Feng Gu fall in this camp. They contend that GAAP prioritizes backward-looking indicators and all but ignores future growth potential.
Just think of a company like Amazon, which regularly falls short of earnings estimates and openly eschews profitability yet sees its share price skyrocket. Are all of those investors wrong, or does Amazon’s true value lie outside of what GAAP measures?
The pro forma camp holds that GAAP is rooted fundamentally in a 1930s materials-oriented economy that is passing away. GAAP was an appropriate way to assess company value back when goods producers like U.S. Steel were the tentpoles of American industry. But today? What’s the use of an accounting method that hinges so heavily on inventory and COGS (cost of goods sold) when a growing share of today’s star performers—from Facebook to Google—don’t sell goods at all?
Remember that the “earnings gap” widens during economic downturns. The gap between pro forma and GAAP earnings reached 23% in 2015, a yearly figure not seen since the Great Recession. In the first two quarters of 2016, however, this gap has started to close again.
In hindsight, it looks like select troubled sectors sent the gap soaring last year: S&P 500 energy companies had an estimated GAAP loss of $48 billion in 2015—but a gain of $45 billion in pro forma terms. Health care companies boosted their earnings by more than $50 billion using pro forma.
One interesting pattern we can observe since 1999 is that the gap seems to widen very late in the boom cycle and grow to maximum size during the following bust. In 2001 the gap peaked at just over 1.9 x GAAP earnings. And in 2008 it peaked at 5.6 x GAAP earnings. Explanation? Late in a cycle, firms are tempted to downplay the earnings deceleration. And in a recession, they will do anything to stop the appearance of bleeding—including writing off their losses as a one-time catastrophe.
Late in 2015, the gap seemed to point to an impending repeat bust. The closing of the gap in 2016 may be taking us a step back from the brink. The next two quarters are worth careful watching.
Expect regulators to turn up the heat on pro forma abusers. The SEC is making accounting consistency one of its top priorities. In May, the SEC issued interpretive “guidance” on Regulation G (which allows publicizing pro forma numbers) warning firms against a variety of possibly noncompliant practices.
The guidelines are very explicit about what companies can and cannot do regarding pro forma presentation. Whether in press releases, earnings calls, or official SEC documents, GAAP figures must always be listed before any comparable pro forma figures. A company cannot refer to pro forma figures without disclosing that they are not GAAP numbers—for example, listing pro forma EPS as simply “EPS.” Pro forma metrics cannot even be listed in a more prominent font (larger, bolder) than GAAP numbers.
Nevertheless, there are companies that stretch these rules—and the SEC is going after them. Regulators have questioned at least 80 companies in recent months (with growing frequency of late) about their pro forma usage. Tighter oversight may be contributing to the closing of the pro forma earnings gap in 2016.
Get ready for growing support for a move to international accounting standards. The U.S. Financial Accounting Standards Board and the International Accounting Standards Board have been working since 2002 to find a way to merge U.S. GAAP with International Financial Reporting Standards (IFRS).
While the United States currently has no plans to switch over, such a move would enable companies to better convey underlying growth than GAAP allows. (IFRS is a principles-based system that gives firms more flexibility to include or exclude items than does the rules-based GAAP.)
To be sure, IFRS seems a tough sell for SEC regulators who want explicit rules in place for every contingency. But it’s an attractive and flexible alternative to the unstandardized world of pro forma accounting.
- More and more companies are issuing adjusted earnings reports that have been proven to inflate income. While critics say that companies are using pro forma to paint a falsely positive picture, supporters believe that anything would be better than our outdated GAAP system.
- There is growing tension between the SEC and listed firms over how earnings may be defined and publicized. The apparent impossibility of pushing earnings back into the GAAP bottle means that some non-punitive solution—whether it’s a loosening of pro forma rules or a move to international accounting standards—will eventually be needed.
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Takeaway: As consensus macro piles into the S&P 500, total equity market volume is crashing and the VIX hits a disquieting level.
Sell low, cover high, baby!
That's the latest expressed by consensus macro positioning as the S&P 500 hit a new all-time high last week.
"The S&P 500 (index + E-mini) net LONG position ramped another +94,526 contracts last week to +154,009 futures & options contracts. To put that in context, that’s a +2.37x move on a 1-year Z-score (at the lows in February, it was a net SHORT position of -280,000 contracts)," Hedgeye CEO Keith McCullough writes this morning.
On a related note, a no confidence vote for the all-time high came by way of total equity market volume which crashed -23% versus its 1-year average on Friday:
The VIX is registering a foreboding level. As Hedgeye U.S. Macro analyst Christian Drake pointed out in Friday's Early Look:
"In the Chart of the Day below we simply show VIX vs S&P500 (S&P500 is inverted on right axis). What you’ll simply notice is how simply effective it is to take down gross exposure and tighten net exposure when VIX goes <13."
None of this bodes well for the bulls blindly buying the all-time high.
Takeaway: RH building some positive momentum. 1st - Gary buying stock, now first new store opening in 2016.
After about 7 months of nothing but bad news for RH, the company is finally building some positive momentum. It started two weeks ago with CEO, Gary Friedman, making his first public market purchase since the Fall of 2014, and was followed up by the announcement that the company would be opening its newest next generation in Kansas City during the first week of August.
At ~55k gross sq. ft. with an additional 10k sq. ft. in outdoor selling sq. ft. this is the first new door of the four promised that the company will open in FY16. We still are expecting plenty of choppiness over the next 6-12 months for the company, as it irons out the Gray Card program, fixes the supply chain, and rationalizes its SKU count. But, the combination of Gary buying stock and then the company inviting the Street to one of its gala events where people can nit-pick management sounds like at least a hint of confidence to us. At a minimum, it suggests that things certainly are not getting worse.
Key Details On The Market:
1) This is the 2nd store the company will have finished by early August. KC in addition to the Austin door that is sitting and waiting for the rest of the development to be finished up. That leaves two additional doors the company needs to bring to the goal line to hit the 4 store target the company set. The two additional markets = Seattle and Las Vegas. Compared to prior years, the timeline for real estate is favorable with two projects out of the way by early August. Of course, each market and project is on an independent time line, but given the head start the company has in 2016, additional HQ resources can be focused on completing the opening calendar for this year and the new batch for 2017.
2) At just south of $400mm, the Kansas City/Leawood market is the 3rd smallest the company has tapped for a Design Gallery. Tampa was the first in the big format in a smaller market back in Nov. 2015, and Indy was a first generation store with a footprint of ~15k sq. ft. and opened in 2013. The key here is that there is a precedent for a big format store in a lower population density market, and by all accounts (mostly anecdotal) the Tampa door along with the rest of the Next-Gen Design Gallery fleet has performed at or above plan.
3) The KC market demographics are more favorable than those of Tampa and Indy, with 22% of the population inside the TAM (which we define as households making over $100k/year in income). The average household income at $73k has a 14% and 6% premium respectively to the markets cited above. Don’t get us wrong that’s a far cry from the 50% TAM rate in Greenwich, CT and $143k avg household income number, but we think the buffer here is the rent profile on the store. The ideal situation for RH, we think, would be to have its Full Gen model in every market, but the fact is that there are a few markets where the economics don’t work – we say a few markets because RH went through a 5 year stretch of culling its footprint. But, the buffer is the rent profile. We don’t have the specifics on the KC market, but given the absence of any meaningful sq. ft. growers for the REIT’s to choose from, and the repurposing of a failed restaurant concept to a 3 level RH – we’ll assume that the math on the store is Denver-esque (i.e. Incredibly favorably).
4) With its new store, RH is now in furniture Alley. There was a little competition in its Legacy Store at Country Club Plaza – mainly West Elm, but in the new property RH is smack dab in the middle of Arhaus, Crate & Barrel, PB, etc. (see chart below for distance in miles to competition). What does that mean…a) RH doesn’t have to work too hard to generate additional foot traffic for the category, the shopping center is already a destination for Furniture, b) given the positioning of the real estate (external vs. internal mall) and the size and scale of both the footprint and product relative to the rest of the competitive set we think RH can take considerable share as long as the company continues to get the right product in its doors, and c) lastly, RH will be lined up against these 'competitors' offering better product at lower prices. This market is likely to end up being a case study for people wanting to compare price/value positioning.
Takeaway: A closer look at global macro market developments.
Editor's Note: Below are complimentary charts highlighting global equity market developments, S&P 500 sector performance, volume on U.S. stock exchanges, rates and bond spreads, key currency crosses, and commodities. It's on the house. For more information on how Hedgeye can help you better understand the markets and economy (and stay ahead of consensus) check out our array of investing products.
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