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Time is Fleeting for Department Stores

We could debate forever and a day about the viability of the department store business model, and the health of the consumer that shops there. Over the past year, that has not mattered. When capex is being cut by 20%, working capital is coming down by 15%, and SG&A by 5% -- the companies still have enough juice to the model even if sales are punk.


I’m so often hit with the argument that “if sales only bounce back, XYZ Co will see massive leverage on the operating profit line.”  Yes, that’s probably true. IF sales bounce back. Some companies get lucky and temporarily realize this sales lift. But others invest in their models to drive it, and to sustain it. Unfortunately the department stores are banking on the former.


What do I mean?

Check out our SIGMA chart below, which layers the past 4 quarters for Macy’s, JC Penney, and Nordstrom on top of one another. As a reminder, the vertical axis measures the sales/inventory growth spread (i.e. 10% sales growth and 2% inventory growth = +8%), while the horizontal axis measures the year over year point change in margins.  Observations…

1)      All three companies are either in the sweet spot (positive sales/inv spread) or headed in that direction for at least 3 quarters. They’re going to have to start comping this. Nordstrom is the most problematic from my perspective.

2)      Note that for EVERY one of them, the latest data point on this chart market a slight downtick. That’s very, very soon relative to other retailers who traced this path. We call that a negative divergence.


Also, can anyone explain to me why Macy’s and JC Penney are at their highest free cash flow margins in almost a decade. Yes, cash flow and working capital are at historic lows.  This actually is not much of a problem overall for most companies. They simply come up with a proactive plan for taking capital, and allocating it throughout their model (including in SG&A) in a way that will drive the top line without increasing the volatility and risk on the gross margin line.


In other words to invest in these names, we need to value the growth, as opposed to value component.


Good luck with that.


I don’t like any of ‘em (KSS is the exception, and the one outlier that is managing their business right).


Add JWN, JCP, and M to the list of names we don’t like – incl DG, FDO, ROST and JNY.


Time is Fleeting for Department Stores - M  JCP  JWN SIGMAS


Time is Fleeting for Department Stores - Dept Stores FCF



Hedgeye Retail Team

Tough Love

“Think not those faithful who praise all thy words and actions; but those who kindly reprove thy faults.”


This weekend I read a booked called "Nurture Shock", which outlines some new theories relating to raising children.  The first question one might ask, is why a 36-year old bachelor is spending weekends reading child psychology?  That is actually a pretty good question and I’m not sure I have an answer.  Regardless, the studies in the book appeal more broadly than to just parenting.  Specifically, there is one chapter that discusses praise and how to effectively use praise.  As I will outline, the insights from this chapter are broadly applicable to the work force and other interpersonal relationships.  Not to mention, quite interesting to a 36-year old bachelor!


To some extent, Socrates hit the proverbial nail on the head in his quote above, which is that we need to be very careful with praise.  Not only because there may be ulterior motives behind praise, but also because praise itself may be much less effective than we realize.  In "Nurture Shock", the authors open this chapter, which is called “The Inverse Power of Praise”, with the following quote:


“Sure, he’s special.  But new research suggests if you tell him that, you’ll ruin him. It’s a neurobiological fact.”


To this point, a survey conducted by Columbia University indicated that 85 percent of American parents think it is important to tell their kids they are smart.  Ironically, a number of recent studies suggest just the opposite, which is that telling your kid he or she is smart may be actually leading to underperformance.


Dr. Carol Dweck  studied fifth graders in New York City over a period of 10-years.  The kids were taken out of their classes and given a non-verbal IQ test consisting of a series of puzzles.   At the end of the IQ test, the kids were given a single line of praise.  They were told that they were “very smart at this” or they were told “they worked really hard”.  In effect, they were either praised for their innate intelligence, or praised for their effort and process.


In the next round of tests, the kids were given a choice of a set of harder tests or a set of easier tests.  They were told that they would learn a lot from the harder tests, but that they were definitely harder.  Almost 90% of the students that were complimented on their work ethic and process in the first round, chose the more challenging tests. Conversely, the majority of kids who were complimented for “being smart” chose the easier tests.  In effect, the “smart kids” took the easier path.


In the next round of tests, none of the kids had a choice and all the kids were given a more difficult test, which was designed for kids who were two years ahead of their grade level.  Not surprisingly, everyone failed the second, but the two groups responded very differently.  The group that was praised for their effort, and not their smarts, after the first round “got very involved, willing to try every solution to the puzzles.”  Conversely, the group that was praised for their smarts “were sweating and miserable.”  The results were astounding. The students that were praised for their effort on the first test improved by ~30% on their first score, while those that were praised for their smarts scored worse by ~20%.


In the follow up interviews, Dweck quickly determined the key variable.  Those students that believed success was based on innate intelligence, grossly discounted the impact of effort.  The reasoning was in effect, “I’m smart. I don’t need to put out effort.”  Dweck repeated this initial experiment and found that the results held true for every socioeconomic class and both males and females.


The irony of the results of this experiment, and many like it, are that its results are totally disregarded by many school systems and have been for years.  According to Dwek, since the early 1980s:


“Anything potentially damaging to a kids self esteem was axed.  Competition was frowned upon.  Soccer coaches stopped counting goals and handed trophies out to everyone.  Teachers threw out their red pencils.  Criticism was replaced with ubiquitous, even undeserved praise.”


Much of this self esteem movement was actually supported by studies.  In fact, from 1970 – 2000, there were over 15,000 scholarly studies on self esteem.


In 2003, the Association for Psychological Research asked Dr. Roy Baumeister to review this body of research.  Of the 15,000 studies, Baumeister  found that only 200 utilized a scientifically sound way to measure self esteem and its outcomes.  After reviewing those 200 studies in greater detail, Baumeister concluded that self esteem didn’t improve grades, career achievement or decrease alcohol usage.  Ironically up until that point Dr. Baumeister had been an advocate of the unadultered praise philosophy and called this study the biggest disappointment of his career.


Dweck’s work and others like it calls into question how we encourage our children, motivate our employees, and coach our players.  One fact that is increasingly clear, telling someone that they are “smart” or “great” merely to boost their confidence will likely have an adverse impact on their actual performance.  The key is to encourage the process or actions that will lead to the successful outcome.


As the old saying goes, “Hard work beats talent when talent doesn’t work hard.” That is of course especially true when the talent is only a mirage created by ill advised attempts to promote self esteem.


Is not being full of praise for your kids tough love? Maybe, but a little tough love may actually going a lot way towards their future success.


Daryl G. Jones
Managing Director


Mr. Bernanke: What Does "Macro-Prudential" Mean?

Recently, we have stopped being as critical of Ben Bernanke. This is primarily because he had the political spine to raise the Discount Rate. This is progress, however, this doesn’t mean that we underwrite (or understand) what he talks about real-time. He’s testifying in front of Congress right now – here are my thoughts:


After being chastised by Ron Paul, then supported by Barney “The Republicans Did It” Frank, Ben Bernanke has started to do what the politicians who were paid off to keep him in his seat expect him to do – pander to the political wind of keeping the Fed Funds rate at zero for an “exceptional and extended” period of time.


That, of course, is either a Japanese or unreasonable monetary policy to uphold in perpetuity. I am ok with neither. Nor should you be. The outcome of zero percent returns on your nest egg of savings is implied – its zero – and the output of carry trading on asset prices with easy money is also implied – its inflationary.


Fortunately, Bernanke pandering like this was proactively predictable. This is why we took our allocation to US Equities from 3% to 9% in the last two days of US stock market weakness.


To be clear however, sad is as sad does. I will be the first to admit it, even though we are getting paid by it today. Bernanke is completely politicized and will continue to sponsor a stock market that can rally to lower-highs on easy money speculation.


I suppose that a short term risk management model for America’s manic stock market is what he means by “Macro-Prudential.” He can’t be serious in telling us that this is a long term macro risk management plan.


My immediate term resistance line for the SP500 is now 1120. Ride the Bubble in US Politics while you can. This is like riding a bull - 8 second rallies can be fun in the short term – then one day, the bull runs you right over.



Keith R. McCullough
Chief Executive Officer


Mr. Bernanke: What Does "Macro-Prudential" Mean? - berny



Early Look

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“The early signs of stability seen at the end of the third quarter continued through quarter four, with growth in hotel revenues in all regions and overall revenues (pre Real Estate) up 17%. EBITDA margin was ahead of 2008, with the result that adjusted EBITDA (pre Real Estate) grew by $3.3 million to $13.5 million. Whilst we cannot yet celebrate the end of these challenging times, these results, coupled with improved bookings pace, are strong indicators that the revenue and RevPAR declines of 2009 will not be repeated in 2010."

- Paul White, President and Chief Executive Officer



  • "Owned Hotels same store RevPAR was down 7% in local currency. However, because of a weakening of the US dollar in the last quarter, RevPAR in US dollars was up 11% compared to the fourth quarter of last year."
  • "The principal variances from the fourth quarter of 2008 included results from owned hotels in Italy (up $3.8 million), Grand Hotel Europe, St Petersburg (up $1.8 million), La Samanna, St. Martin (down $1.5 million), Mount Nelson Hotel, Cape Town (down $1.6 million), and Venice Simplon-Orient-Express (up $1.1 million)."
  • "Porto Cupecoy enjoyed strong sales in the run-up to completion of the construction, with ten apartment contracts signed during the quarter, and a further five units sold since the end of the year. This means that 99 units or 54% of the total are now sold. The grand opening of the development took place in January 2010."
  • Europe: "For the region, the effect of the weakening US dollar in the fourth quarter of 2009 compared to a strengthening US dollar in the fourth quarter of 2008 had a $3.2 million positive impact on EBITDA versus the prior year."
  • North America "Excluding EBITDA of $3.2 million from Charleston Place, there was an EBITDA decrease of $1.1 million. Same store RevPAR for the region fell by 18%."


  • Weather impacted them in Peru
  • Non rooms revenues and trains & cruises had good growth in the quarter
  • Increase in Europe was all FX
  • Cost reductions implemented in the 1H09 started to flatten out
  • Key focus in 2010 will be on the sale of the residential real estate.  $68MM of sales to date and $34MM has already been received. The remaining 85 units will be sold free of debt, since the proceeds from the originally sold units will pay down the construction loans
  • Last week Madeira was hit with flash flooding, so that may impact their results
  • Quarter one bookings are tracking 6% ahead, but pricing is lower given the promotions and discounting
  • 2Q2010 is tracking behind, but they expect it to catch up given the recent pick up in volumes
  • Trains business is up 23% for 1Q2010
  • Charleston is seeing some recovery in group bookings
  • Minimal opportunities to cut costs further, now it's all about growing revenues
  • Leverage Covenant was 8x
  • Term debt maturity : 548MM in 2011, 176MM in 2012, thereafter 1445MM. $60MM due in 2010, but $34MM is related to the construction loans which will be repaid when the units close
  • $5MM of Capex in the Q + 11MM in Porto Cupecoy 
  • Cash tax was $14MM in 2009, $12-14MM expected in 2010
  • Plan to refinance maturing 2011 debt by 4Q2010


  • Europe will show better RevPAR growth since they all saw huge occupancy drops but only small drop in rate.  This is still going to be another tough year
  • Booking window in Brazil has always been short. They are 16% up on rooms booked y-o-y or 2010, but that's a small % of the total
  • Peru though tends to get booked 8-9 months in advance and because of the train closure they are down 10-15% for on the books business for 2010
  • No NY development update
  • Tone of refinancing on R/C is good, but the pricing is clearly going to be higher.  Think they can get 200ish spread. Think they can roll 75-85% of the commitment with a 3-5 year term
  • Why is Copacabana doing so well?
    • Domestic demand is very strong - over 1/3 of the travelers are domestic
  • Even in Italy the domestic demand has increased dramatically to double digits from 1-2% just a few years ago
  • 40% of their customers are from NA, 40% European
  • What are the plans with Keswick?
    • Have 40 plots left to sell, have been working with Robert Stern on designs. Hope that they will sell the plots over the next 12-24 months
  • Outlook for Grand Hotel Europe & Italian portfolio and their pricing strategy
    • In the shoulder season months they are much more focused on occupancy
    • In the peak season, they are feeling more confident that they don't need to discount as much to get occupancy
    • Grand Hotel: pickup is very strong on the room side, but are concerned on the F&B side. Don't think that he 6-7% growth they saw in Jan will continue throughout the year but still expect good results
    • Italy: too early to tell.  Bookings really just starting coming in at the end of Feb through East period.
  • TTM EBITDA at the Copa around $13MM for 2009 and peak was $14.5MM
  • Real Estate strategy
    • Cupecoy - customers have already paid about 75% of the purchase price, so they are very confident they will close on all the sold units. Just need face to face time with the client to hand the keys over which will take 3-4 months
    • Expect to sell the remaining 84 units over the next two years.  Demand has been very strong
    • If the economy recovers, will they consider starting new projects? Unclear - still far away, question of when and how

Domestic Pigs

A lot of the news flow in recent weeks has focused on the P.I.I.G.S. (Portugal, Iceland, Ireland, Greece, and Spain) and their balance sheet woes - and rightfully so. As usual, we like to focus our Hedgeyes on other issues once our calls become consensus and have been spending time state pension liabilities.


A recent release by the PEW Center on the States shows a $1 trillion gap between the $3.35 trillion in pension, health care, and other retirement benefit-related liabilities currently on States balance sheets and the $2.35 trillion in assets they have to cover them.  Moreover, that funding gap is likely to increase when 2008's losses are factored in, as many states smooth gains/losses over a average of five years.


Currently, 41 States' pension programs are less than 10% funded.  In addition, only 5% of the $587 billion liability for current and future retiree health care and other non-pension benefits is currently funded. Interestingly enough, Illinois - where current president Barack Obama was a Senator prior to taking the Oval Office - was in the worst shape of any state, with a funding level of 54 percent and an unfunded liability of more than $54 billion.


Below are some of the State level exposures that the PEW Center coagulated:


 Domestic Pigs - State Pension Funding Levels


To deal with massive deficits  - totaling approximately $290 billion - many States have tapped into their rainy day funds in fiscal 2009 and 2010 at levels not seen since the 2001 recession. 


Several States have dried up their funds to balance their current budgets, including Alabama, Arizona, California, Connecticut, Maine, New Jersey, Ohio, Oklahoma and Pennsylvania. Sixteen other states relied on their reserves to help eliminate 2010 budget deficits according to a recent NASBO survey.


Factoring in last year, a total of 41 states have accessed reserves to cover their deficits. An interesting takeaway here is that many politicians and state legislators are reluctant to draw upon their rainy day funds out of fear that it would hurt their State's bond ratings, which would ultimately drive up their cost of capital at the worst possible time.


 Domestic Pigs - Two Decades of Saving and Spending


So what's left for poor states to do? They have essentially the same three options they always have:


  1. Raise taxes
  2. Cut programs and reign in spending
  3. Issue debt to fund their deficits


Fiscal 2009 estimated tax collections of sales, personal income, and corporate taxes were 7.4% lower than actual fiscal 2008 collections. Furthermore, States are projecting a further decline of 1.4% in tax collections relative to fiscal 2009 current year estimates. Despite the low projection, raising taxes seems unlikely, considering the current state of unemployment. Although jobless claims have been, for the most part, improving steadily since last March, a 9.7% unemployment level is hardly an environment to raise taxes in. But never say never. If some of these States were named Greece, they’d be told to raise taxes.


Some States have been cutting and plan to continue cutting funding, which has been hanging many municipalities, school districts, and health programs out to dry. For example, in fiscal 2009, 29 States cut K-12 resources (21.1% of State spending) and 30 are planning to do so in fiscal 2010. Likewise, 27 States cut Medicaid funding (21% of State spending)  in fiscal 2009 and 28 are planning to do so in fiscal 2010. In New York, Governor David Paterson temporarily held back $750 million in local aid last December. In Arizona, Governor Brewer wants to defer about $350 million that is owed to school districts this fiscal year until next fiscal year.


Unfortunately for State governments, purging the balance sheet is only a temporary fix. Across the country, State governments are facing lawsuits from municipalities school districts outraged by budget cuts. Expect these lawsuits to continue until States can find a sustainable way to fund their budgets.


So with their backs against the funding wall, States must find a cumulative $18.8 billion to balance their budgets in remaining months of the current fiscal year and an additional $53.6 in fiscal 2011. Moreover, expectations for state pension fund returns on the heels of a 65% rally in the S&P seem aggressive at best.


Lucky for them, they can join Portugal, Iceland, Ireland, Greece, Spain, and our very own United States government in kicking the can down the road by issuing more debt. Piling debt, upon debt, upon debt - now that's a novel concept! Furthermore,  an interest rate hike would effectively raise the cost of capital for each of the 50 states, which would leave states like Kansas that have no access to rainy day funds feeling the pressure to issue as much paper as they can before the cost of doing so increases.


 Domestic Pigs - State Govt Debt Issuance


With funding levels at only 50-60% of liabilities, States like Illinois and Oklahoma will start to see their CDS levels rise meaningfully if fiscal 2011 budget shortcomings are not addressed. A wise man told me that governments  make bad companies, as far as balance sheet analysis is concerned. U.S. Federal and State governments are no different. While the Fed balance sheet has been getting better on the margin in recent weeks, a +$364 billion y/y number is hardly something to ignore. Furthermore, unfunded liabilities have been on the rise and will continue to be an issue.


 Domestic Pigs - US Unfunded Liabilities


By now, it's hardly news that the U.S. has found itself in a serious fiscal hole. It is important to note, however, that the $1 trillion hole left by the developing State pension funding crisis adds one more straw to the camel's back. As we say here at Hedgeye, everything that matters in global macro happens on the margin. With that in mind, the PEW Center's findings are incrementally more negative, and, on the margin, this report should make the U.S. government debt situation appear a little worse. While were not calling for the United States of America to default on its sovereign debt for the first time in history, we are raising concerns that its expanding balance sheet and accelerating sovereign debt issuance could potentially lead a downgrade in its credit rating.


While the decisions of Moody's sovereign debt rating team hardly move us at face value here at Hedgeye, we do recognize their decisions have great influence over debt markets. And we're all familiar with the inverse correlation between credit ratings and cost of capital.


Expect this to get priced into the market over the coming months, as the biggest long term TAIL risks that the global economy faces when it comes to government debt isn’t that of Greece, but of that of both Japan and our very own.



Darius Dale



According to a franchise consultant, one of McDonald’s largest Co-Ops in the country showed a $0.39 decline in breakfast average check for the first week of February with a 3.1% increase in breakfast sales and a 10.9% increase in TCs. 


The February data points are significant as they reflect the beginning of the national launch of the $1 menu at breakfast.  In the same Co-Op for the same period, “regular menu” sales were down 1.6%.  The regular menu accounts for 70%+ of total sales for McDonald’s US Business.  Considering this, and taking the Co-Op example cited above as representative of the wider system, a 3% increase at breakfast would not be enough to move the US business back into positive territory. 

McDonald’s has a big voice when it comes to marketing so with transactions up more than 10% at breakfast there will be other companies within the breakfast day part that will begin to suffer.  For starters, it will make it nearly impossible for WEN and BKC to take any significant market share at breakfast.  Neither company has the marketing muscle or the margins to afford to be competitive. 


Given the lessons learned from 2009, I do not think that a typical SBUX customer is going to make the switch to MCD; although Dunkin has responded to the new McDonald’s dollar menu.

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