US STRATEGY – Sagging Sales

Thanks to the FED the S&P 500 finished higher by 0.97% on Wednesday.  Fed Chairman Bernanke intimated that the “Piggy Bankers” will be feeding at the trough of free money for an extended period of time.  This put the Financials (XLF) back on top of sector performance, rising 1.7%.  Taken together, the need for extended period of low interest rates, China’s current tightening monetary policy and declining global consumer confidence present evidence to challenge an extended rally.


The pullback in the dollar following yesterday's spike also offered some support for the stocks, but not the RECOVERY trade.  Two of the three worst performing sectors yesterday were Materials (XLB) and Energy (XLE).  The Hedgeye Risk Management models have levels for the Dollar Index (DXY) at – buy Trade (79.60) and sell Trade (81.16). 


On the macro calendar, new home sales plunged 11.2% month-to-month to a 309,000 unit annualized pace in January, marking a record low.  Sales were weak across much of the country last month, with a 35.1% decline in Northeast leading the way.  The decline in sales pushed the month’s supply of new homes to 9.1 from 8.0 in December, while the inventory of new homes for sale rose 0.4%, the first increase since April of 2007.  Not surprisingly, homebuilders were weaker on the news, with notable decliners including RYL, DHI and PHM.  We remain short TOL and are concerned about housing going into 2Q10. 


The banks led the market higher yesterday, with the Bank Index (BKX) up 2.28% after declining 2.36% the day before.  With little hard news, the FED is behind the rally.  Money-center and Large-cap regional’s were among the standouts in the group with C, BAC, KEY, STI and MI leading the way.  We are currently long the XLF.


The Technology (XLK) continues to be the worst performing sector year-to-date, but slightly outperformed yesterday.  Semis were a key driver of the outperformance yesterday, with the SOX up 1.9% after falling 2.8% on Tuesday.  Yesterday, ADSK was up 8.7% following its earnings release.    We are currently long the XLK.


Consumer Discretionary (XLY) is the best performing sector over the past month and continued its strong relative performance yesterday.  The strength is centered in Retail, with the S&P Retail Index up 2% yesterday and is up seven of the last eight days.  The sector continues to benefit from a strong earnings season.  


On the MACRO calendar today we will see initial Jobless Claims and January Durable Goods, while Fed Chair Bernanke gives a second day of pandering before the Senate.  As of the time of writing equity futures are trading below fair value.  As we look at today’s set up the range for the S&P 500 is 26 points or downside (1,094) and upside (1,120). 


Copper closed up 0.5% yesterday, but is looking lower in early trading today.  The Hedgeye Risk Management Quant models have the following levels for COPPER – Buy Trade (3.17) and Sell Trade (3.41).


In early trading gold is trading down to the lowest price in the past two weeks.  The Hedgeye Risk Management models have the following levels for GOLD – Buy Trade (1,087) and Sell Trade (1,117).


Oil is trading down on a higher dollar and a lack of momentum behind the RECOVERY trade.  The Hedgeye Risk Management models have the following levels for OIL – Buy Trade (77.09) and Sell Trade (82.10).


Howard Penney

Managing Director


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HBI: Mind the Duration

The ‘emotion factor’ is coming back to this stock after a year’s vacation. Duration is very important here, and our views differ based on near vs. intermediate vs. long-term.


HBI is an interesting name right here. It has historically been a ‘love it or hate it stock” with not a whole lot of sentiment resting between. That high-emotion factor deflated over the past year, and it fell on to the ‘who cares’ list – based purely on investor requests to us on the name.  Now we’re we’re seeing the emotion build up again on both sides. We view Duration on this one almost as a barbell.


We like it a lot near term – for the next two quarters, that is. The company has the top-line in the bag, cotton costs locked 30% below current prices, moderate channel restocking, and channel fill as a key customer – Dollar General – is back in rapid growth mode and will need HBI product to fill its shelves.  Over the longer term, HBI is the last company left in the industry that can capture such a major margin delta through sourcing savings and use it as an offensive weapon to gain share the same way Gildan did in the early 2000’s. We only need 2-3% growth to make that happen longer term, which would drive margins up and debt down.


But can the company sustain a 5-8% top line growth rate? No way. This is an underwear company, folks. Units grow at about the rate of population (ie 1%) and there’s no real pricing power to speak of. The channel fill is important and undeniable. But just because the channel is refilled (and perhaps overfilled) does that mean that the end consumer will wear more underwear? Nah… I don’t think so.


So what’s our concern? It’s that after we pass by these 2 slam-dunk quarters, then we have to bank on 1) sell through, 2) an improving consumer, 3) rational behavior by Wal-Mart in the wake of channel fill at other retailers, 4) that the Asian factory transaction goes as planned, and that either cotton prices come off, or HBI can offset them with pricing power.


Can all of these things happen? Yes. But our point is that they HAVE TO happen.


Our conclusion? Be mindful of your duration here. Over the next 2 quarters, it’s going to be tough not to like HBI – 3-4 quarters out is a different story. Once that risk passes, $3 in earnings share is a complete reality here.



Key Highlights from 2010 Analyst Day:


Int'l Growth Strategy:

  • Can leverage the Int'l business by integrating local business into global supply chain - overhead on par with local competition, but sourcing a distinct advantage.
  • Expansion in Mexico since 2008 has been a very positive model  that HBI can follow in other markets - expect to introduce outerwear in Mexico now that innerwear/essentials business is established.
  • #1 in Canada, Mexico, and Brazil, but significant gain potential in both China and India
    • China and India only markets with a double-digit growth profile versus low-to-mid single digit growth for other regions



  • Focused on core apparel categories
    • Not diversifying
  • New channels
  • New platform/geography
    • Min integration risk
    • Fund from FCF/ reduce leverage
    • Accretive Yr1
    • $200mm deal size


Multifaceted Savings Strategy:

  • Expect $150mm in savings over the next 3yrs
    • Network = $45mm
    • Distribution/Logistics = $30mm
    • Start-up & Rest. Eliminations = $20-25mm
    • Purchasing = $30mm
    • Optimization Initiatives = $20-25mm
  • These savings will drive 50-100bps in annual operating margin expansion




Detail on $150mm in savings:

  • Slightly more in 2010 compared to 2011
  • 60% in GM; 40% in SG&A
  • Cost of goods improvements driven largely by maturing supply chain network
    • more indirect purchasing and distribution savings


Cost inflation out of Asia - what's built into HBI's assumptions:

  • Have built in some wage inflation
  • If cotton up another 10% will take more costs out
  • Locked for Q1 = $0.52; Q2 = $0.59; Q3 = $0.73
  • Assume $80 oil (Q1-Q3)


Revenue growth organic vs. acquisitions:

  • 2-4% long-term growth excluding acquisitions
  • Domestic opp'y is first choice for acquisitions
  • $100mm goal for media spend annually
    • Plan is to reinvest - may hamper 35%+ growth in EPS in order to drive growth


Shelf space gains update:

  • Ahead of internal sell-through plans to date
  • Finished by summer

Sales/ft. versus current productivity?

  • Gains at WMT = 4ft.
    • Dyed underwear & t-shirts not quite as productive as core white tee



  • Mexico model gives mgmt confidence
  • "trade advantage" - tap into treaties low duty movement


Media Spend:

  • Key to moving upscale and into newer channels
  • Expect ~$90mm spend in 2010 with goal of increasing to $100mm/yr to grow with sales


Acquisitions - "superior returns":

  • Focus on cash on cash returns
  • Significantlyabove debt reduction + share repurchase
  • Not much exposure to Europe


Internet strategy:

  • "in the 1st inning"
  • Stores currently ~60% of direct-to-consumer mix, will shrink as internet grows
  • Strategy is less location growth than location expansion (footprint) - designed to capture greater $/cust, not necessarily drive increased volume
    • Adding brands in existing doors


Pricing Outlook:

  • Assumption in 2010 - minimal (any increases would be based on Q4 costs at most)
  • Beyond 2010 - predicated primarily by cost inflation
    • 2-4% top-line outlook for 2011+ assumes very little by way of pricing


Outerwear - Operating Margin growth opportunity:

  • Will be primarily driven by supply chain savings as well as mix
    • where smaller volume business is brought in-house
  • More branded product
  • Will be below company average over time


Tax Rate:

  • Was ~12% in 2009 - due to large domestic restructuring charges/ refi
  • Expect 20%-25% over next 2-3 years


View on 'commodity business':

  • Mgmt is focused on growing branded lines, which are more differentiated and defensible vs. the commodity business
  • Does not suggest they will neglect wholesale customers
  • Looking to leverage the supply chain to offer branded apparel and build out the screen print channel


Supply Chain - Opportunity to Internalize:

  • Currently outsourcing lower run product lines where there is less leverage opportunity
  • In the process of internalizing the Champion's C9 line



  • Spoke to ideal of $200mm in size
  • "some companies acquire as a growth strategy, but that's just not us" - Rich Noll
  • Won't lever up for growth via big acq.


Intimate Apparel - Shapewear trend:

  • Have plans in place
  • See some gains in 2010-2011


Private Label:

  • Didn't meaningfully impact the business in 2009
  • Less than 20% of the mass market
  • Starting to see same trends as in most retail where retailers are focusing on #1 and #2 brands and adding private label to shrink moderate brands


Cotton - regional purchasing:

  • Bulk is purchased in the US
  • Very small quantities out of China


Chinese facility (Nanjing)- Capacity Utilization:

  • Will continue to expand 1st phase through early 2011
  • Building can be doubled from current build out plan (essentially 50% utilization)
  • Phase 2 of build out will be to develop other 50%


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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

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