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Topping Off

Research Edge Position: Short UK (EWU)

 

We’ll let the data from the manufacturing and services Purchase Managers’ Index of the Eurozone, Germany and France speak for itself (see chart below). Suffice it to say we’ve been calling for a sequential slowing in fundamentals across the continent, which we expect to continue into 2010; November’s PMI reading, while improving across the region and for the region’s largest economies, Germany and France, is showing signs of slowing.

 

Matthew Hedrick

Analyst

 

Topping Off - pmi

 


GPS: Reverting Back to a Simple One Factor Debate

GPS: Reverting Back to a Simple One Factor Debate

 

At this critical time of year for all retailers, GPS has but one factor we’re keeping an eye on.  The re-emergence of the Gap brand is key to the next leg of the story.  Can TV and better merchandising drive positive same-store sales?  We can’t be sure either way, but that’s where the debate is centered.

 

Over the past year or so we’ve gotten many questions about GPS and the sustainability of the company’s turnaround.  There is no doubt along the way we underestimated management’s ability to put in place a sustainable, multi-year cost cutting plan, inventory reductions, and substantial product cost savings.  Despite the profit improvements, sales have continued to decline.  Although, more recently Old Navy is certainly showing signs of positive momentum. 

 

GPS: Reverting Back to a Simple One Factor Debate - GPS 2 yr

 

All these efforts have resulted in a very consistent and respectable EBIT margin just shy of  12%.  In the absence of any real growth (square footage is pretty much flat) and with a substantial war chest of cash (no debt) on the balance sheet of $2 billion, the company is a cash generating cow.  Putting sales momentum aside, stable EBIT margins and a limited growth profile basically means GPS can produce $1.4-$1.6 billion in free cash flow annually.  And while there is still some skepticism as to how long this cash flow generation and exceptional EBIT control can continue in the absence of a topline pick up, the past three years should act as a pretty good base for which to judge the limited volatility in the company’s earnings stream.

 

With that said, GPS is now a critical point from a sentiment standpoint.  The turnaround is largely complete on the cost side.  The inventories have been cut dramatically along with $700 million in SG&A expenses that are now permanently removed from the P&L.  The company is moving to offense from defense.  There is simply very little “addition by subtraction” left in the model, and as such investments will need to be made to drive the next leg of the story.

 

This is where it gets a bit less quantitative and bit more qualitative.  The single biggest issue/topic/focus facing GPS the company and the shares is the ability of management to drive same-store sales back into positive territory.  The recent resurgence in positive momentum at Old Navy is clearly a positive first step in the process.  Merchandising, pricing, and marketing changes are all yielding positive results at a time when “value” means more to consumer than ever. The timing couldn’t be better as Old Navy regains its leadership in the world of low priced apparel/accessories sales with a fashion twist.  Product cost improvements (whether it be company or market driven benefits) are allowing Old Navy to take improved profits to the bottom line while at the same time taking unit sales up.  This is the ultimate recipe for success and sustained improvement, especially in the absence of a major consumer-led recovery.

 

But what about Gap, the brand?  This is where the risk/reward lies.  After years of fixing and cutting, it’s now crunch time.  The next leg of the story hinges on Gap’s effort to reemerge with relevance, which will ultimately determine whether or not those comps finally turn positive.  A lot is hinging on the company’s marketing plans for this holiday with the company’s return to TV for the first time in a few years.  The real test here is whether the marketing message and merchandise is enough to make the brand relevant (and ultimately much more profitable) again.  This is just the beginning of the process and the answer is unfortunately not known at this point.  Old Navy’s recent turn suggests that there is potential here, but the brand has been losing share for years.  On the risk side, these incremental marketing efforts are somewhat contained (y/y spend is forecast to be up an incremental $45 million this 4Q) which means there is no reason to be concerned that management has suddenly gone on a spending spree. 

 

However, the real concern is what if this effort doesn’t work?  Access to capital is not the problem with GPS.  It’s truly the ability of Gap brand management to reinvigorate a brand that has now produced 5 years of negative same store sales in a row.  I’d argue that even some moderate success is enough to keep investors interested.  The leverage is substantial if productivity per foot can begin to rise again.  The debate though, is now relegated to a simple one factor discussion, and unfortunately for some this debate is rooted in denim and wovens and “Holiday Cheer” and no longer in expense cutting and sourcing benefits.  This makes some investors uncomfortable.  Talking product is not what most investors like to do.  Ask McGough if Fair Isle sweaters are in this season and you’ll see what I mean.

 

All eyes are on the holiday for sure.  But in Gap’s case, the eyes are keenly focused on TV.  November same store sales will give a glimpse of the new marketing effort’s success, but December will be the true tell tale sign.  If results are positive, then there is likely a good reason to believe there are legs to the story.  If it’s a huge flop, then it’s back to the drawing board for management and all eyes revert back to cash flow generation and preservation.  In the near term though, there is now simply one thing to watch.

 

GPS: Reverting Back to a Simple One Factor Debate - GPS SIGMA

 

 


Chart of The Week: Unsustainable and Unreasonable

It is funny listening to people justify why they’d hold short term US Treasury Debt at these yields (i.e. negative real yields). Funny because any student of economic history will recall that this storytelling rhymes with what American stock and bond market investors thought heading into the waning days of 1938 (the stock market closed up +25% that year; as of today, the SP500 is up almost +22%).

 

In the Chart of The Week, Matt Hedrick and I show the context of free moneys. If you go all the way back to 1938, you’ll find a very representative period where an American President figured out the power of both currency devaluation and reflation, and abused it.

 

Yields on short term Treasuries have not been this low since the 2nd leg of the 1930’s economic Depression. Many economic historians blame the bear market in stocks from 1 on the Federal Reserve “raising rates.” I disagree. I blame it on the US Government pandering to the political wind of keeping rates unsustainably low for an unreasonable length of time.

 

*Note to Fed Heads who currently think Japanese on the perpetual policy front of issuing ZERO rates of return for both their creditors and citizenry alike: “exceptional and extended” is UNSUSTAINABLE and UNREASONABLE – for we, the citizenry of savers and risk takers, that is.

 

Yes, the math of pending equity returns works is in reverse relative to the duration that governments keep Piggy Bankers at the trough (borrowing short and lending long).

 

Again, in capitalism speak:

  1. Exceptional = ZERO rate of return
  2. Extended = widened duration

The longer you stay “exceptionally low for an extended period of time” (1938 or 2009), the more unreasonable it is to assume that the next move in rates (UP) is going to create a sustainable economic recovery.

 

If you disagree with everything I am writing, that’s fine. Most “economists” who didn’t call the 2008 stock market crash didn’t agree with me that plummeting US Dollars and Treasury yields were a leading indicator of negative equity returns to come either.

 

Look at this chart below again, then pull it back to 1938, and look at it again.

 

Again!

 

Unless we sign off on making the USA a glossier version of Japan, the next big move in short term rates is up. This is as low as we can go. There is a bubble in short term US Treasuries that’s getting ready to pop.

KM

 

Keith R. McCullough
Chief Executive Officer

 

Chart of The Week: Unsustainable and Unreasonable  - 2Y

 


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Taiwanese Export Inflection

Research Edge Position: Long Taiwan via the etf EWT

 

While Taiwan’s political status is complex, the signal sent by the reported export numbers from Taiwan are unambiguous.  Taiwan’s export orders climbed for the first time in 13-months, up 4.4% in October from the year ago period, which was an improvement over the -3.0% drop in September.  Export orders are a leading indicator for shipments for the next 1-3 months and bode well for the economic growth of the Island state in the coming quarter.  This growth in exports was likely driven primarily by China, which is Taiwan’s largest trading partner and grew 8.9% last quarter on a year-over-year basis.

 

The government also indicated today that industrial production rose 6.6% in October from a year ago, a sequential acceleration from September’s +1.7% year-over-year growth, which was revised upwards today.  The other positive data point released today was a slight sequential decline in the unemployment rate, from 6.09% in September to 6.04% in October.

 

Taiwan’s largest export industry is electronics and Taiwan Semiconductor, the world’s largest custom-chipmaker, recently said it expects to see a re-acceleration in its business and end markets.  Specifically, Taiwan Semiconductor is raising its capital spending budget to $2.7BN from a July estimate of $2.3BN, an implication that the company is expanding capacity in anticipation of future growth.

 

Interestingly, over time the Taiwanese have consistently diversified their export base away from the United States. In the early 1980s US-bound exports represented ~50% of its export base; that number is now less than 20%.   Additionally, it appears Taiwan is better positioning itself to take advantage of global GDP share by attaching itself to the market share that the Chinese will take in the coming decade.  Currently China buys ~23% of Taiwanese exports.

 

The negative impact of current U.S. fiscal policy as implemented by He Who Sees No Bubbles (Bernanke) is that the weak dollar and emerging bubble we’re seeing in U.S. dollar priced commodities (i.e. copper and oil) is actually quite negative for Taiwan as the country imports the vast majority of its energy and basic material needs.  Currently Taiwan uses about 2.2MM barrels per day (importing more than 98% of this), so it is clearly at the whim of the volatile global commodity markets.

 

Setting aside the negative potential impact of commodity inflation, the economic data points emerging from Taiwan are supportive of a continued economic recovery and support our long thesis.

 

Daryl G. Jones

Managing Director

 

Taiwanese Export Inflection - taiwan23

 


RCL NOTES FROM ABOARD OASIS OF THE SEAS

Here are our notes from the investor presentation aboard the new Oasis of the Seas

 

 

Internal focus is on cost culture, international expansion, and superior hardware to drive ROI and better pricing

 

40% of guests outside of USA

50% non USA by 2012

Average age: RCL 42, CEL: 51, AZ: 60

 

New ships are dramatically better economically

 

Solstice: 40% larger, 86% have balconies vs 57% of Millenium’s, inside cabins only 10% vs 20% on Millenium, energy is 60% better.

 

Oasis vs Voyager: 74% larger, 72% have balconies vs 49% of Millenium, inside cabins only 17% vs 40% on mill, energy 30% better.

 

40% of their capacity is Solstice class, Freedom, Voyager and Oasis - approaching 50%.

 

Projecting 1.1mm international guests by 2010.

 

2009:

  • Tough but market for consumer demand has been very stable.
  • Seeing people trading down and seeking value
  • Generating a tremendous amount of cash flow > $1bn this year
  • Environment has forced them to refocus on costs, lowered per unit cost by 10%

 

4Q09:  Pricing since January has been relatively stable and as they got closer to sailing (post June), volumes picked up materially and since Oct their prices turned positive on bookings in the Q for the Q y-o-y

 

2010: Preliminary indications are positive and anticipating yield improvement driven by newer hardware.  They have seen a little bit of expansion in the booking window - small though – and are anticipating more stability in pricing.  Goal of flat net cruise costs.  Diversified sourcing (from Europe) should help them (going into Asia and South America).

 

1Q2010 sailings: since late august the y-o-y booking volumes picked up materially and became positive.

 

Pricing so far through ‘09 for ‘10 looks better than the indications for pricing did in 2008 for the year forward.  However, some of that is influenced by the fact that Oasis is booked early.  The non-Oasis ships are looking down on a 1 year forward basis comp to 2008.

 

Costs: reduced work force, wage freeze, pension reductions, lowered costs from venders.

 

Fuel: they are 50% hedged for 2010, 2011 and 10% hedged for 2012.

 

Capex for 2011:  $2.1bn.

 

Focusing on improving ROI and returning to an Investment Grade credit rating.

 

Oasis of the Seas: December 1st is the first for pay cruise (training crew) and showing off the boat to the media and travel community.  So far they are having no problems.

 

 

Q&A:

Penetration in North America and Europe?

  • 17% of Americans have taken a cruise
  • One of the maturation indicators is if they are getting new guests - 40% of guests are still first time cruisers, hence they don't think that it’s saturated
  • Still think there is a ways to go
  • Europe is only 2% penetrated. UK and Scandinavia - much higher
  • Asia - penetration is tiny - less than 1%, rating from Asian and South American cruisers are very positive, suggesting room to grow
  • Question of whether to enter new international markets with a local or US approach

 

Doesn't think that this ship will cannibalize their other ships - rather think that it will grow the market.

 

Under what circumstances could they see themselves contracting another ship today? Deleveraging? 

  • Their goal is to equally pursue deleveraging and improve ROI (will do painful things like cancel dividend and issuing bonds earlier this year)
  • Think that in today’s world, companies need a less risky balance sheet
  • They are not looking to add any more ships to their order book at this time

 

How much cheaper would building a new oasis be today? Incremental ROI?

  • Scale and more efficiency costs/smaller percentage of less desirable rooms
  • More premium rooms (balcony) and they sell at a big premium than Voyager
  • Huge amount of onboard revenue opportunities
  • Also more energy efficient (Solstice is more of an efficiency play)

 

Azamara (super premuim brand). Top end was the hardest hit.  Are beginning to see very encouraging signs of life there but too early to be sure.

 

What is the corporate ROIC rate?

  • Don't have a published target
  • Right now their cost of capital is higher than their ROIC - view their current ROIC as wholly inadequate - their target is double digit.

 

What is RCL doing to improve the direct to consumer sales?

  • A lot depends on the individual brand. Their direct business has grown considerably
  • Aside from international investments, handling direct bookings is the other area of investment
  • 2010 direct business will still not be material enough to really move the needle - "evolutionary"
  • Still need travel agents to sell the experience -they've all been on the ships so that's pretty powerful

 

Hedges are on the balance sheet and recognized once the hedges mature

 

Cost of what they incurring on this ship will be expensed in the 4Q

 

They never fill ship during the first few cruises. They do this on purpose (toilet and air conditioning issues) need to be able to move people in the event on an issue.  This ship's pricing is also higher than expected (heard 40% higher than legacy inventory)

 

Premium that Oasis is getting over Freedom class is better than any other ship is getting over its immediate predecessor.

 

Would they be ordering more ships if they were investment grade?

  • Balance sheet is not the only reason why they haven't added new ships

 

Refurbishing old ships?

  • Under the right circumstances that can be an attractive investment. Cut one of their ships in half and added more amenities was a great investment but when they went to do the next one cost 60% so they passed on it
  • They can also sell old ships
  • They can also move ships to other brands where that ship is more consistent with another brand

 

What % of business is meetings and incentive?

  • 15% and a little more than half is a real "conference"

 

 

 

 


PEET/GMCR – CRAZY TURNED RIDICULOUS

GMCR just made life miserable for PEET.    

 

After a competiting bid from Green Maintain Coffee (GMCR), Peet’s Coffee & Tea (PEET) was forced to raise its offer to buy Diedrich Coffee by 24% to approximately $265 million.  Peet’s increased its bid to $32 a share from $26. 

 

Green Mountain is offering $30 a share in cash.  Green Mountain has been consolidating its K-Cup licenses as it bought Tully’s Coffee in March and announced the acquisition of Timothy’s Coffees earlier this month.

 

In some respects, PEET management’s talking up the DDRX deal exposed a weakness in PEET’s long-term business model, although the company will be fine without it.  To justify the egregious purchase price (94% or $249 million is goodwill), management needed to signal how important the single-serve coffee market is.  When discussing the just announced DDRX deal on a conference call, senior management commented that “you've got to take a look at this single cup household penetration growth and what's happening, it's a very fast growing segment. It's here to stay and it's going to be a significant consumer segment and this isn't going to take five years.   This is happening now.”

 

There is no denying that the recent growth in the single-serve segment is astonishing.  Green Mountain’s Keurig brand holds 85% share of single cup brewer sales, with sales doubling over the last two years.  In 2010, Keurig brewers will approach penetrating over 4 million homes.  With approximately 90 million households with coffee brewers, Keurig’s share remains less than 5%, but it is growing rapidly. The increasing share base of installed Keurig brewers is the primary driver of K-Cup growth.  And, Peet’s management has now communicated the need to play in this game!

 

The acquisition of Tully’s last March gave GMCR a brand with manufacturing capabilities in the western part of the United States – PEET’s core market.  Without the ability to compete in the single-serve segment, PEET is facing the potential for significantly slower top-line sales trends as its market share erodes over time.

 

PEET now sits out there exposed; damned if they do, damned if they don’t.  If they do buy DDRX, the fact that the valuation of DDRX is so over the top is a big negative for PEET and we will not know if the acquisition has proven successful until 2011 (when it is expected to be accretive).  On the other hand, if they don’t buy it now, how is management going to explain away the urgent need to get into the single-serve segment. 

 

Clearly, the growth in the home brewer single-serve segment has benefitted from more people being unemployed and staying at home for their morning coffee.  That being said, it is not surprising that MCD and other QSR operators are talking about how challenging the breakfast day part is.  For PEET, as I said before, the DDRX acquisition is not expected to be accretive until fiscal 2011.  What is the likelihood the economy recovers and the U.S. economy starts producing jobs again in 2010?  If you think it is likely, then the timing of this purchase at such a high premium is all wrong.  As more people go back to work, more and more Keurig brewers will be sitting unused at home and K-cup sales will slow right when PEET needs them most!


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