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Little Bankruptcy, Major Theme

Just 1 day after we conducted our conference call on the reemergence of the bankruptcy cycle, Shoe Pavilion, a 115-store retailer of off-priced footwear, publicly filed for Chapter 11. Two of my key themes in this space – footwear supply chain squeeze and aggressive off-balance sheet activity – are teaming up to KO those with little reason to exist.

There are several major implications and themes here…
  • 1. This is not just a ‘weak consumer issue’ issue. Margins are under pressure due to the supply chain squeeze that I think is just starting, and the weak players are dropping off. There will be more.
  • 2. Investors need to look at retailers with different lenses (check out Exhibit 1). One of the key themes I highlighted on yesterday’s call is that you can’t just look at EBIT margins and debt levels in evaluating bankruptcy candidates. You’ve gotta look at REAL debt (incl off balance sheet liabilities) plus the duration and flexibility of a company’s lease portfolio. In the case of SHOE, accounting for operating leases doubles its implied debt. Also, minimum rent obligations are going up while competitors’ are coming down. In other words, SHOE was borrowing from the future to prop margins and keep its head above water. An aggressive strategy that just came home to roost.
  • 3. Big Box Footwear Retail simply does not work! Look at the facts over time; Just for Feet, Footstar, Foot Action, Stave and Barry’s, and now Shoe Pavilion – can’t this industry take a hint?!? Managing hundreds of brands, with each design in multiple colors across 28 different sizes simply does not leave enough margin to justify paying higher rent structures for bigger and better real estate.
  • 4. Note to DSW and Brown Shoe (Famous Footwear) – that’s exactly why I think your margin structures are headed towards zero.
  • 5. Impact on competitive landscape. 72% of SHOE’s 115 stores are in California and Texas. How I’m doing the math, this overlaps with about 24% of the store base for Payless. DSW could benefit as well as 21% of its stores are in those states – but are geographically not as aligned – and not enough jump ball business to offset DSW’s own flawed real estate strategy (DSW’s rent escalators look similar to SHOE’s). Also keep in mind that Dick’s sporting goods and Hibbett are both adding capacity in Texas (and DKS is stepping up in CA). That’s concerning.
  • 6. Creditors. The most notable point to me is that of the top 20 creditors, Nike is not one of them. Kind of interesting given that Nike has a 40% share of the Athletic Footwear business. This also is a good nugget as it relates to Nike’s US Footwear business (i.e. not jamming product into bad channels). Here’s a list of top creditors in the Athletic/Athleisure space. Solid representation from Adidas and Reebok. Not good.
    a. New Balance, $324,302;
    b. Asics America, $196,166
    c. Adidas, $128,514
    d. Reebok, $117,583
    e. Diesel USA, $111,212
    f. Keds Corp., $100,165;
    g. Naturalizer (Brown Shoe), $95,310
We can't simply look at reported debt levels. We need to add the value of operating lease obligations and then adjust by the flexibility of those obligations. This exposes big differences in risk management.

VFC: Model Getting Stretched

In line with the positive preannouncement earlier this month, VFC beat its previous guidance of $0.80 and printed $0.94. That’s nice at face value, but consider the following…
1. The company guided for EPS -10%, and then came in +5.5%. Big delta from guidance, But this proved to be VFC’s lowest quarterly EPS growth in 2 years. This INCLUDED a $0.07 tax benefit, excluding which earnings would have been -2% -- a rate not seen since early 2004. The icing on the cake is that this excludes FX benefit – which can’t be ignored either given that Int’l is nearing a third of sales and the delta on the dollar gets tougher in 2H.

2. Operating profit was up only 1.8%, which included an 8.5% boost from the addition of its Contemporary businesses at this time last year (Lucy and Seven). Compares start getting tougher in 2H.

3. Jeanswear EBIT was down 22.8% -- supporting my concerns in watching Levis in recent weeks. Jeanswear accounts for a disproportionate amount of VFC cash flow (about 45-50%). This is the biggest decline in this business I have seen at VFC in years.

4. The Outdoor segment (about 1/3 of cash flow) posted a respectable 17% top line and 11% EBIT growth, both represent a very material deceleration in 2-year run rates. Keep in mind that this group (The North Face, Vans, etc..) has fueled virtually every part of the company’s global growth in recent years. This is a troubling statistic.

5. Amazingly, Nautica’s numbers fall into the ‘less toxic’ group. EBIT decline of 25% is hardly anything to write home about. But one could make the argument that Sportswear has hit bottom.

6. 3Q guidance is 9% EPS vs the Street at 15%. VFC kept the year’s guidance even, and geared it towards 4Q. Regardless of numbers relative to expectations, we need to bank on a meaningful ramp in EPS in 2H vs 1H, which is the same time VFC anniversaries recent acquisitions and faces tougher dollar compares.

7. Cash from ops guidance for 2008 came in at $700mm, versus $821 in 2007. Down 15% year/year.

8. I keep coming back to the top line and slowing after we roll past recently-acquired brands, FX benefit easing, and the company reverting to a low-mid single digit organic top line growth rate vs the 10%(ish) numbers we’ve seen over 2 years. Gross margins are at peak and are likely to head lower as industry headwinds play out throughout 2009, and both cash from operations and free cash flow slow on the margin. Yes, VFC is one of the better-run apparel companies out there. But sentiment remains net positive, and I have no clue as to who the incremental buyer is if my model is correct.

Stoned

“If you don’t have time to do it right, when will you have time to do it over?”

John Wooden would ask his players that, and I often ask myself and my team the same. After a melt up day like yesterday, you’d think a lot of hedge fund PM’s might too, but they don’t. Some of them point fingers instead.

You may or may not be surprised that the cadence of my inbox picked up into the market’s rally yesterday. It’s kind of sad really – like I need to be blamed for people being squeezed. I actually had to point people to the July 15th time stamp of 10:59AM where I wrote plainly on the portal “that was likely a short term trading bottom for US stocks”. I guess that if you were busy IM’ing your buddy about what his best short idea was (at the bottom), you missed my call to get longer.

If you don’t prepare and don’t have a risk management process, you’re going to get whipped around this summer. If you’re not a trader – don’t trade. If you’re a “long term” guy or gal though, just don’t sell capitulation lows and buy hopeful highs. Selling psychological capitulation levels like that which we saw at my VIX target of 31, and S&P 500 print of 1201, is certainly not going to differentiate your returns.

So where to from here? Well, the market is a lot smarter than most people these days, and the bottom we’re looking back at from 48 hours ago has plenty of characteristics that make me less bearish. Volume hit its highest point, literally, at the bottom. Volatility peaked at the same point. Breadth was as negatively lopsided as it’s been year to date. Do not ignore these facts.

Fundamentally, two of the main components of my 9 month old “NOT BEARISH ENOUGH” thesis saw their cards turned face up for the consensus players to read – Inflation Up; Growth Slowing = Stagflation. On Tuesday, Bernanke threw in the towel, defining his outlook as stagflationary. On Wednesday, we saw the highest consumer price inflation number in the US since 1991. Today, we’re seeing China print its economic growth slowdown, with Q2 GDP coming in at +10.1% year over year (slowest growth since 2005). All of the river cards are face up. Stocks don’t trade on trailing expectations.

Was the crowd “BEARISH ENOUGH”? Well, if you’re into the “it’s global this time” theme, you might call authorities closing the Karachi stock Exchange in Pakistan overnight due to “investors STONING the stock exchange”, somewhat bearish. If you’re more into the “local thing”, trading against 25,000 hedge funds here in the US, you might call the biggest up day ever in the Financials yesterday at +12%, somewhat of a short squeeze.

Why is the squeeze going to continue? I think this answer is simple – the timing of the fade inflation trade is finally right. My models rang short term trading alarm bells on the commodity fade side of the “Trade” yesterday. The Commodities Index (CRB) broke my short term momentum level of 454, down -3.7% for the week to date at 444; and Oil broke my critical short term momentum level of $138.14, having its 3rd consecutive down day, moving lower this morning to $134. While the “Trend” in inflation remains higher, the “Trade” is lower, for now.

Timing in this business is everything. No, I do not have to trade this tape hostage to a long term view. No, I don’t have to clear my short term strategy call with the powers that be at Goldman Sachs. All I have to do is change as the facts do.

As a result of Bernanke agreeing with us that stagflation is here, the US Dollar stopped going down, short term interest rates are pushing higher, and the bond market is selling off as those who sold the bottom in stocks are being walked back from the ledge. Don’t manage money on a ledge. Stick with the Research Edge (nice ring to that!).

If the S&P 500 can close above 1246, and commodities not close above my aforementioned levels, I think the immediate “Trade” here is going to take the S&P 500 to at least test 1297. The “Trend” remains bearish. The “Trade” looks like you should be long those liabilities of short sellers who began to be “STONED” by the madness of crowds yesterday.

Good luck out there today,
KM











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LIQUIDITY RULES THE DAY

When I undertook the bankruptcy analysis for our recent conference call, I figured I would be loading the ball in the musket for the shorts. High leverage, big spending, declining returns all should’ve given me some ammo. On the contrary, my analysis uncovered a surprising level of liquidity which blew a hole in my initial bankruptcy thesis and may turn the shorts into duds. After trashing casino management teams over the years I have come away with a new respect for the CFOs at a lot of these companies and even less respect for this country’s big financial institutions. While levering up in the boom years could’ve been disastrous during this downturn, these guys negotiated credit facilities that provided their companies with very low borrowing costs and tremendous liquidity. They’ll be some serious sticker shock when these facilities are renegotiated beginning generally in 2010 but we’ll save that discussion for a later post.







  • The first chart shows the average trailing leverage ratio over the past 10 years. We are at a 10 year high which on the surface is troubling and looks like the end of the classic boom and bust cycle. However, liquidity profiles for most of the casino companies are in great shape and borrowing costs are low. Contrast this with the private gaming companies. This is where we’ve seen the recent bankruptcies and will likely see the next few bankruptcies.







  • The next chart is busy I know but drills down into the specific metrics for the casino operators. On the surface ISLE appears to be a bankruptcy candidate but Dale Black, CFO, has done an outstanding job with this once dire financial situation. Despite a ton of leverage and a low coverage ratio, near term liquidity is significant, the company is free cash flow positive on a net basis, and there are no significant debt maturities until 2012. BYD, PNK, and LVS maintain aggressive development pipelines but for the most part, projects can be cancelled or delayed. MGM is probably at most risk due to its high exposure to Las Vegas where I see the most downside. Moreover, MGM has high leverage and significant maturities in 2010. Kerkorian and Dubai World are, of course, potential backstops.







  • As the shorts continue to press the regional casino companies along with other highly leveraged companies, an advantageous liquidity situation seems to have been overlooked. The industry capitalized on the financing fat years by negotiating significant liquidity and low borrowing costs. Sure there are issues but significant liquidity will keep these guys out of the red zone until at least 2010.







Significant liquidity offsets historically high industry leverage
Low borrowing costs keep coverage ratios reasonable despite high leverage

CASUAL DINING – TRENDS IN FOOD AND LABOR COST

If it’s going to be different this time - Food and Labor inflation are going to be the driver of this bankruptcy cycle. Clearly, the trend in these costs is disconcerting, and there does not appear to be any relief in sight for the foreseeable future. In my mind, food or labor costs, alone, are not going to bankrupt any single company, but rather the risk lies in how a management team manages these inflation pressures. To date, inflation pressures have been partially sidestepped by raising prices. However, as I have seen over and over again, excessive pricing can kill a concept.
  • As a result, I believe that restaurant analysts are going to increase their scrutiny of traffic trends as traffic is the primary indication of the health of a concept.

SMOKING AND GAMBLING WON'T MIX

Research Edge recently held a consumer bankruptcy conference call. One of my slides covered the impact of a hypothetical smoking ban across the regional gaming markets, a distinct possibility over time. Following sharp declines in revenues in Illinois and Colorado, some short sellers have focused on the smoking ban to press the regionals. I estimate a worst case scenario of a 20% decline in EBITDA. The impact on the credit ratios is not as severe as I would've thought. Leverage obviously increases but with only ISLE in the danger zone. With the exception of ISLE, coverage ratios remain in good shape even after the EBITDA reduction. ISLE will still cover interest and should have liquidity until 2012. ASCA and PNK have large credit facility maturities in late 2010 which could present a liquidity problem for both companies should the credit environment remain unfavorable.


Even after 20% decline from a potential smoking ban, most regional operators maintain decent credit ratios

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