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Rolex | Short the Rich

Takeaway: Rolex is evolving. We’re not so sure it should.

Editor's Note: This is a recent research note written by our Retail team. Email sales@hedgeye.com for more information.

 

Rolex | Short the Rich - z ro ro

 

We always pick up on anecdotes of private brands, as do most retail analysts. But here’s our take on an interesting one as it relates to Rolex (private) that we think serves as a good brand study.

 

Rolex is evolving. We’re not so sure it should.

 

  1. We’re seeing a number of developments with the brand. Specifically, the styling is very updated, but starting to look very much unlike the traditional Rolex that is the mainstay for a $20,000 anniversary gift that is ultimately passed down through generations. 
  2. We’re not suggesting that Rolex is coming out with a ‘me too’ iWatch, but simply that a brand like this with such an amazing cache has to be careful about changing it up too quickly. Check out the images below. The first image looks more like a Tag-Heuer 1990s knockoff than a Rolex. 
  3. Oh any by the way, distribution is evolving too. These things are selling in the secondary market in flash sales on sites like ‘Touch of Modern’ (which is admittedly a wicked site for men who have cash to burn and like toys – like a desk Jellyfish aquarium or a tactical Damascus Blade knifes handcrafted in Brazil). 
  4. Brand evolutions are not all created equal. For example – Kohl’s and Nordstrom have failed to allocate capital in a manner that allowed them to evolve. Now they’re as close to perma shorts as you can find in retail – barring a big capital infusion to dig out of the hole. That in itself is a negative stock event. 
  5. But then on the high end, there’s validity to not changing up a design. The best parallel to Rolex, we think, is the BMW 3-series. Check out a 3.25i from 2006. Then check out a 3.25xi from 2016. The styling is remarkably similar to the extent that non-owners probably cant tell the difference from a distance, which boosts aftermarket value. The same goes for a car like the Lexus RH300/450. Slight evolution, but no sudden movements. If it ain’t broke, don’t fix it. 
  6. Maybe this is why the late-model Rolex designs are selling for a 50-70% discount in the secondary market. 

 

Short the rich.

 

The best play here is Tiffany – though that call goes far beyond this Brand Study (it’s only the 446th ranked keyword on Tiffany.com). Sales should still slow, as its traditional customer gradually shifts away from the brand, sales per square foot weakens, and margins compress as the inability to sell successfully online while maintaining brand cache plagues the long-term story. Numbers remain too high.

 

Rolex | Short the Rich - 2 ro


PRTY | You Gotta Fight, For Your Right, …To Stay Public

Takeaway: Should this company really be public?

Ok, that title is a meaningless reference to the 1985 Beastie Boys Classic. But putting one of the most genius musical concoctions in a generation aside, we’re having a tough time figuring out why Party City is NOT a short. As such, it’s officially on our ledger. It’s not yet a ‘Best Idea’ as we have several more factors to vet. But this name definitely failed nearly every litmus test in our arsenal as to what makes a good company and a great stock. We’ll dive deeper in to the next layer and likely come back with a deck as well as what could potentially be a meaningful change in our conviction (i.e. why it is a Best Idea short, or why our initial analysis was wrong).

 

Here’s what we’re thinking by duration. But first, three quick points on the setup here.

  1. One might wonder how in the world a sub-par company like Party City landed Goldman, Morgan, CS, and Merrill as managers of the IPO back in April 2015. This is a deal that at least Goldman and Morgan would avoid. The price action is self-evident – its currently trading below the IPO price, and 24% below where it closed on the first day of trading. Not a good deal unless you sold an hour after it priced.
  2. The answer to this conundrum is majority owner Thomas H Lee, which led a consortium of investors in buying out Party City in 2012. The deal was for a total of $2.69bn – or an even 10x EBITDA – which was $261mm in 2011. It then quickly restructured the company, including folding in Amscan, one of the largest piñata (yes) manufacturers in the world, which was bought by co-owner Advent in 2008.  In fairness, the parties involved restructure companies quite well, and they’re also good at capturing the lion’s share of the profits afterward. This gem IPO’d at a $2.0bn market cap plus another $2.1bn in debt. So we’re talking a $4.1bn EV and about $1.5bn in book profit for the investment group, or a 54% unlevered return. So why did Old Wall underwrite this deal? It needed to maintain a critical pipe for future deals. They did this for the client, not for public equity investors.
  3. Regardless of rationale, the fact is the consortium levered up the company with so much debt such that when it finally surpassed prior peak EBIT levels in 2014, it did so with $157mm in interest expense. THL held the company for about 33 months (along with Advent, Berkshire Partners and Westin Presidio) --  that’s ½ the 5-7 year holding period we see for typical retailers that are taken private, and even beats the record 35 month hold after KKR scooped up Dollar General in 2007 and then gave the gift back to the Street. We wrote in that fateful week when both PRTY and ETSY went public that we should mark our calendars to revisit short side in 18-24 months after the IPO window-dressing is fully transparent. It looks to us like we’re there with PRTY (check out the ETSY chart).

 

Now let’s go into the fundamental TRADE, TREND and TAIL call. We’ll go in reverse order and start with the tail call, which is where most of our confidence rests.

TAIL – Bad

  • At the time of the IPO, we were told that the 898 US store count had room to go to 1,250. How many have we seen added since then? Fourteen, on a NET basis, by our count. At this rate it will take 384 months to saturate the US – that’s about 32 years to you and me. For the record, this is longer than the other three (non-McGough) members of the HedgeyeRetail team have been alive.
  • Now…bulls will assert that this means that there’s still a lot of growth out there for this company. We think the opposite. For most concepts, profitably getting over 1,000 stores is a pipe dream. Party City is definitely no exception. Maybe we could get there with pop-up shops around Halloween and Christmas/New Years – but unfortunately, so can anyone else that has the ability and willingness to source the poorest quality goods that China has to offer for pennies on the dollar and sell them marginally above cost. [Note: drive down your local high-retail-traffic area – near a Trader Joe's or a Wal-Mart. Chances are you’ll see a Halloween pop-up shop that competes with PRTY at a critical time of year. To be fair, PRTY flexes its model to participate in these pop-ups, and it has been building a wholesale model to sell vertically manufactured product to competitors. But that’s well known, and is in expectations. Also, the wholesale model has gone from supplying 25% of sales a decade ago, to 75% today. Most of this upside is already realized.
  • Maybe PRTY can win online, right? Not really. About 6% of its sales are online, which is decent, but the $142mm in e-comm did not grow last year. That’s not what we want to see for any brand, as the e-comm comp is arguably the best metric for anyone who sells anything, anywhere. PRTY can’t source product better or cheaper than Amazon or WMT/TGT.com, potentially not better than product it makes on its own. The only real competitive advantage it has is when a person literally needs decorations or costumes THAT DAY, or for costume day tomorrow in school. AMZN can’t deliver that quickly – not yet, at least. But what happens when it can? (which is a matter of time).
  • Merchandise margins have been the key driver over the three years – rising 280bps to 43.4%, a historical peak. Peaks are dangerous on both sides. On one hand, it was at peak last year, and yet it set a new one. On the flip side added competitive pressures and less productive store locations will not help gross margins by any means. Current 12% EBIT margins are also at historical peak – up 340bp over 3 years. In other words, 80% of the trailing 3-year margin improvement came from merchandising margins. While we admit this is a dangerously unqualitative way to think about it, we wonder if selling silly string and DeadPool costumes while increasingly competing with AMZN, WMT and no-name pop up shops as mall REITs scramble to fill increasingly vacant space is really worthy of a 12% EBIT margin over the long term. Our bet is No. That’s not to say that they drop immediately from ldd levels, but we have a hard time getting to upside either. That matters when this name is trading at 10x EBITDA and people realize growth is slowing and margins are peaky. In other words, that this is not a growth company anymore (if it ever really was).

TREND:

  • Is this model really ‘a-cyclical’? That’s part of the long pitch (it was at the time of the IPO), but the reality is that it is not true. Check out comps over the past two years. They’ve been as high as 5.4% and as low as -3.4%. That looks more like GPS or KSS than a more stable and predictable retailer like PRTY claims to be, and like we see with specialty retailers. This pitch is great for the roadshow, but it does not ring true in real life. Yes, people always need to party, and ‘accessorize’ accordingly. But they only really need PRTY as a last minute purchase alternative. To its credit, when this is a NEED, (i.e. when little Johnny NEEDS a rubbery Hillary Clinton mask or Donald Trump wig for costume day at school tomorrow) it arguably has notable pricing power. These are low cost/price items that don’t put a dent in the budget for most consumers. But that’s always been the case – there’s not any positive change taking place on the margin as it relates to assortment or purchasing behavior.
  • The TREND top line outlook is mixed. There are certainly favorable aspects. In 3Q last year (what it is comping against today) comps were down 3.4%. then two quarters later it goes against another negative comp. This could set up some good momentum over our TREND duration. But we’d argue that the company comped down in 2 of the  past 4 quarters because it is losing momentum and share to an increasingly competitive set. In other words, this could be a name that comps down on top of a negative comp. Again…no longer a growth company.
  • International expansion will be costly. PRTY already has the mid-upper part of North America (6% of stores are in Canada). But now it’s headed to Mexico. That’s a different futbol game. How is PRTY tackling the necessity for different sourcing strategies as it goes international. The holidays, customer demographics, purchasing patterns and process around securing real estate are quite a bit different in Guadalajara than they are Punxsutawney, PA. To what extent is this factored into management’s sourcing/costing/logistical model? The US is the most homogenous retail market in the world. Exit its borders, and it’s a game changer – a high cost one and significantly volatile one. Our point here is that we’d look for these costs to show up over a TREND duration, ahead of the revenue. That’s a net negative for the stock.
  • We’re also watching out for the near-term benefit from the Festival acquisition (in Madagascar), which allows PRTY to vertically source costumes on a small scale. Our initial analysis suggests that won’t have a material enough net impact on gross margins. We stress NET impact, because what people are likely not factoring in is that as the competitive environment gets tougher, PRTY will likely have to compete any sourcing savings away. To date, it has kept most, if not all.
  • Lastly, keep an eye on oil prices. It accounted for about half of the margin improvement in the latest quarter. There is an 8-9 month lag from when input costs (oil based) flow through the P&L. That’s a consideration with the $20 upward swing in Crude since February (i.e. 8 months ago) Not many people we know are talking about this.

TRADE

  • Our biggest concern in being short on a TRADE duration – which is arguably the biggest factor we have to vet further – is a) the sourcing upside which drove the 2Q and continuation of these benefits into 3Q. Input costs should start to squeeze PRTY in the upcoming quarter.
  • On the flip side, 4Q, which is its strongest quarter of the year from a seasonal perspective (it usually loses money in Q1-Q3 and makes up for it in Dec) is actually facing a ‘sort of tough (or at least not easy)’ SSS compare of 2.8%. A tough sales comp matters much more in Dec than it does in June for this company.
  • Sentiment on this name is fairly controlled relative to what we’d expect given the underlying characteristics. Short interest is 11% of the float, which is lower than we’d otherwise expect and almost half of where it was earlier this year. Ten analysts cover the stock with a 50/50 split between Buy and Hold. Of course, there are no Sells.

 

Other Key Open Issues We Need To Resolve To Gain Conviction

  1. PRTY has 180 franchised locations, where it arguably has better stability in the economic model. We need to figure out relatively accurate-unit economics on these stores versus company-owned stores.
  2. Does brand matter? This is worth a consumer survey to see to what extent the consumer is loyal to PRTY because it simply trusts that it will have all the cheap nick knacks that she needs. Will a consumer increasingly shift to AMZN? Or is the impulse-purchase/add-on nature of this category more suited to stay in a bricks & mortar format that we think? We can opine all we want. But likely need to take it a step further and ask the customers en masse. Stay tuned for that.
  3. What is the revenue/cost cadence for Mexico/International expansion. PRTY needs a more sophisticated logistics network, sourcing organization, real estate partners, to name just a few key factors. We need to quantify all of them and see where there is or isn’t leverage off of the existing model.
  4. Volatility in cash flow as the company bolts on acquisitions and goes into more volatile markets. This is key to the FCF element, which is likely to bolster valuation if the company can sustain margins, preserve working capital, and pay down debt. We don’t want to get in the way of that steamroller. A slowing grow and weaker margins are almost certain to pinch working capital. Capex is hardly elevated at 3.5% of sales, so there’s not a ton of room to cut there. What levers are left to reduce debt load as the earnings algorithm weakens?
  5. Could the desperation on the part of mall REITs to up vacancy rates with seasonal pop-ups actually accrue to PRTY in the form of great temporary real estate deals? This could offset margin pressure it should see otherwise.
  6. Holding/Selling intentions of the remaining holders from when it was private.
  7. Most importantly, we need to get a better understanding of the real bull case, which definitely exists as it does with all stocks. Until we know the real pushback, we arguably won’t have the command we need to make this into a Best Idea – if it is worthy of such a call. 

PREMIUM INSIGHT

REPLAY: About Everything with Neil Howe and Tom Tobin | Medicaid for the Middle Class?

REPLAY: About Everything with Neil Howe and Tom Tobin  | Medicaid for the Middle Class? - z dome

Join Demography Sector Head Neil Howe and Healthcare Sector Head Tom Tobin as they discuss the latest About Everything edition Healthcare for the Middle Class? 


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CHART OF THE DAY: #ACATaper Likely = #NFPTaper

Editor's Note: Below is an excerpt and chart from today's Early Look written by Hedgeye U.S. Macro Analyst Christian Drake. Click here to learn more.

 

ACA has proven effective as a jobs and consumption stimulus program.  It served to augment employment growth over the last two years and has helped support headline payroll gains in the face of ex-healthcare softening in 2016. 

 

However, as the #ACATaper theme plays out and the benefit decays, the support to NFP will similarly diminish. 

 

CHART OF THE DAY: #ACATaper Likely = #NFPTaper - cd 1


#NFPTaper

“We don’t know what we’ll be doing a year from now ... you can’t expect the Fed to spell out what it’s going to do... because it doesn’t know."

-Stanley Fischer, FOMC Vice Chairman

 

Has your investing enthusiasm stagnated, secularly?

 

Is your proclivity for abandoning rationality in favor of serial attempts to front-run changes in policy rhetoric now past peak?

 

Are you unsure whether bad (macro data) is still good (for asset prices)?

 

Has your early cycle euphoria gradually ceded share to existential late-cycle angst?

 

You are not alone.  And the chronic fatigue you are experiencing may not be your fault. 

 

Not too many people know this but some compelling, early-stage research suggests that that constellation of psycho-emotional symptoms singularly characterizes a new category of acute disorders broadly classified as Fed Associated Recurrent Torpidity Syndrome … or, #FARTS.

 

There’s good news and bad news.

 

The bad news is that there is no existing remedy for FARTS and it’s likely only to worsen nearer-term.

 

The good news is it’s Friday. 

 

Back to the Global Macro Grind …

 

#NFPTaper - cd2

 

When I was a teacher, a pedagogical point of emphasis was repetition and restricted focus. 

 

In other words, focus the lesson on a singular or limited set of topics and repeat/practice to the point of inanity.  Students may begin to get bored but they will remember the main takeaways of an exclusive topic.  An eclectic and ranging discussion may be more interesting in the moment but retention will be close to zero in t+x days. 

 

In that didactic spirit, I wanted to update an isolated theme we’ve given some focus to in institutional notes but not in Early Look-scape: 

 

It’s an offshoot of a great call our healthcare team has had with their #ACATaper theme (email if you are interested in the Healthcare team’s work).

 

Here’s the conceptual and quantitative underpinning.   

 

The implementation of the Affordable Care Act (ACA) resulted in a largely unprecedented influx of newly insured individuals.  Because many of those formerly chronically uninsured had deferred care and carried higher acuity, their utilization rates subsequent to gaining coverage were comparably higher.  The ramp in the insured base coupled with higher utilization and cost rates for the newly insured drove healthcare consumption higher and a discrete ramp in sales in earnings growth for the sector.  Growth rates in healthcare relative to the S&P500 broadly and its defensive brethren (staples and utilities) decoupled, leading to marked outperformance in the related equities.  The #ACATaper theme is centered on the reversal of this dynamic as the sector comps out of the benefit and growth shows a meaningful deceleration.

 

At the macro level, the implementation of ACA has provided a clear benefit to both employment and aggregate consumption growth.  

 

That benefit becomes evident in the data concurrent with the initial enrollment deadline for ACA at the start of 2014 and builds conspicuously through 2015. 

  • Employment Palooza: Healthcare's share of total employment began to ramp in mid-2014 with Healthcare payroll gains driving ~16% of total NFP growth from 2Q14-2Q16.  With healthcare industry employment just 10% of total, this represents a disproportionate share of growth.
  • Benefit = Past Peak!  Healthcare Job Openings (JOLTS) and net monthly payroll gains peaked in late 2015 alongside peak NFP gains and have begun a modest retreat in 2016.  After broadly accelerating for 2 years, Healthcare employment growth peaked in March 2016 and has now decelerated in each of the last 5 months.  Meanwhile, Job Openings in Healthcare – which show a strong relationship with overall medical consumption spending – dropped -6% sequentially in July and posted their first year-over-year decline in 26 months at -4.75% YoY.  The Chart of the Day below depicts the ACA associated ramp in Healthcare employment and the emergent deceleration. 
  • Amplification Goes Both Ways:  While trailing 6M/12M NFP gains have slowed in 2016, monthly Healthcare job gains have slowed only modestly until the most recent month.  Healthcare employment rose just +14K in August, down from the +40K TTM average and marking the smallest monthly gain in 3 years.  Should the fledgling deceleration in Healthcare employment progress, Healthcare would reverse from a relative support to a negative amplifier of the headline trend.
  • GDP Juicing:  As the chart above illustrates, over the last 8-quarters Healthcare’s contribution to GDP has seen a step function increase, contributing almost double its average contribution observed over the last 20 years.

 

Alas, the vision that we could one day all work in the healthcare economy and use our collective earnings to pay for each other’s collective healthcare under ACA in one utopian, incestuous circular economy was not to be.   

 

ACA has proven effective as a jobs and consumption stimulus program.  It served to augment employment growth over the last two years and has helped support headline payroll gains in the face of ex-healthcare softening in 2016. 

 

However, as the #ACATaper theme plays out and the benefit decays, the support to NFP will similarly diminish. 

 

The simple macro punchline is that #ACATaper is likely to = #NFPTaper.

 

Our immediate-term Global Macro Risk Ranges (with intermediate-term TREND signals in brackets) are now:

 

UST 10yr Yield 1.51-1.63% (bearish)

SPX 2166-2190 (bullish)

VIX 11.59-14.48 (bullish) 

Oil (WTI) 42.86-48.61 (bearish)

Gold 1 (bullish)

 

Have a great weekend.

 

Christian B. Drake

U.S. Macro Analyst

 

#NFPTaper - cd 1


The Macro Show with Keith McCullough and Neil Howe Replay | September 9, 2016

CLICK HERE to access the associated slides.

 An audio-only replay of today's show is available here.

 

 

 


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