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US STRATEGY – NON SEQUITUR

On Friday, the S&P 500 got a boost from the end of the financial reform saga and a boost in the RECOVERY trade; the Russell 2000 was the best performing index in the world on Friday.

 

The Financials (XLF) dramatically outperformed, up 2.7% on the day, as the Banks led the way with the BKX up 2.9%.  With the consensus thinking that the financials “dodged a bullet,” the final impact to business is still to be determined. 

 

While the sectors leveraged to the recovery trade got a boost on Friday, the latest MACRO data released on Friday does not support the move.  GDP came in slower than originally released and consumer sentiment improved in June.  The 1Q10 GDP (final number) is now 2.7% vs. consensus of 3.0% (personal consumption 3.0% vs. prior 3.5%, GDP Price Index 1.1% vs. consensus 1.17%, and Core PCE 0.7% vs. consensus 0.6%).  

 

Treasuries finished higher on Friday, with the weaker economic growth numbers.  The dollar index traded down 0.45% on the day and the Hedgeye Risk Management models have the following levels for the USD – Buy Trade (85.21) and Sell Trade (86.57).  The VIX declined 4.1%, but was up 19.1% for the week.  The Hedgeye Risk Management models have the following levels for the VIX – Buy Trade (23.89) and Sell Trade (31.53).

 

The Euro moved higher by 0.1% on Friday, but declined by 0.1% for the week.  The Hedgeye Risk Management models have the following levels for the EURO – Buy Trade ($1.22) and Sell Trade ($1.24).

 

Along with the Materials (XLB) outperforming, commodities also had a strong day on Friday.  Crude and Copper prices were up 3.1% and 2.9%, respectively.  Also, the XAU rose 3.6%; FCX up 4.9%, NEM up 4.6% and ABX up 3.9%.  The Hedgeye Risk Management models have the following levels for GOLD – Buy Trade (1,241) and Sell Trade (1,259).  The S&P Steel Index rose 2.7% (X rose 2.8% and NUE rose 1.5%). The Hedgeye Risk Management models have the following levels for OIL – Buy Trade (77.70) and Sell Trade (79.45).  

 

In early trading today copper is trading at a four month high.  Shanghai copper stockpiles decreased by the most in 11 months last week, to the lowest level since the week ended February 19th.  The Hedgeye Risk Management models have the following levels for COPPER – Buy Trade (2.98) and Sell Trade (3.11).

 

The Consumer Staples (XLP) and Technology (XLK) were the only two sectors to decline on Friday.  The XLP was dragged down by the S&P 500 Beverages Index which declined 2.6% (KO down 3.0% and PEP down 2.6%).

 

As we look at today’s set up for the S&P 500, the range is 19 points or 0.8% (1,068) downside and 1.0% (1,087) upside.   Equity futures are trading above fair value, as the personal income for May is due out today. 

 

Howard Penney

 

US STRATEGY – NON SEQUITUR - S P

 

US STRATEGY – NON SEQUITUR - DOLLAR

 

US STRATEGY – NON SEQUITUR - VIX

 

US STRATEGY – NON SEQUITUR - OIL

 

US STRATEGY – NON SEQUITUR - GOLD

 

US STRATEGY – NON SEQUITUR - COPPER


The Week Ahead

The Economic Data calendar for the week of the 28th of June through the 2nd of July is full of critical releases and events.  Attached below is a snapshot of some (though far from all) of the headline numbers that we will be focused on.

 

The Week Ahead - c1

The Week Ahead - c2


FINL: Clarity on Positive Trends

As a follow-up to our initial thoughts this morning, there are several noteworthy read-throughs embedded in FINL’s Q1 results from this morning’s call:

  • The strength in footwear – particularly running was impressive. Despite basketball and athletic casual footwear comps down double-digits, footwear comps overall were up 12%.   This implies running was ‘running’ at a high-teen to 20%+ rate through Q1.  
  • Apparel underperformed the rest of the portfolio down LSD with a particular weakness in basics.  Given the inherent challenge in trying to differentiate basketball short and t-shirts and to compete with volume based value players, management made it clear that a shift is underway towards more performance product.   Branded business with NKE and The North Face stands to benefit.   Overall this confirms our belief that there are still opportunities for mall-based footwear retailers to sell performance apparel alongside technical footwear.  The good news here is that price points on branded, performance goods are measurably higher than the basics they replace.
  • Inventory management remains a key element to the company’s ability to maintain its impressive sales/inventory spread well above peers.  It was noted that improving turns remains a key focus, but there were probably some areas where orders could have been bigger to meet demand.  Importantly, there’s a divergence within consolidated inventory whereby the company is continuing to aggressively reduce aged/underperforming inventory while at the same time building inventory in key categories i.e. running and toning.  It was suggested that investments in inventory would accelerate heading into BTS relative to recent quarters.  Overall, based on inventory levels from the two largest mall-based players, there is little concern that promotional activity is about to increase.
  • The outlook for net store growth this year improved since last quarter due to landlords increasing willingness to negotiate. While maintaining 8-10 store openings, the company cut the number of closings in half to 10-15 from 20-30. With 200bps of occupancy cost benefits realized in Q1 and approximately 30% of the store base up for some kind of lease action this year, there’s upside to management’s expectation for a 30-40bps annual positive contribution to gross margins.
  • Lastly, traffic continues to be inconsistent– in fact management alluded to this volatility at least a handful of times on the call. While truly a small sample, the latest read on traffic in June is positive. In looking back over monthly trends, traffic was positive in March and then down a bit in both April and May - so far in June traffic is up 2%.  Perhaps just a sign of comping last year’s rebate checks, we struggle to view a positive early read on traffic as anything other than just that – positive.

 

With an even more favorable quarter ahead for FINL in Q2, coupled with further gains in sales productivity, product margin, occupancy cost and e-commerce, our view is that the company is on track to exceed recent peak margins of 8.3%.  As a leading athletic footwear retailer, FINL is one of the most direct ways to play the multi-year trend underway in the athletic footwear space.  We continue to believe that this is not a zero sum game and that there is more than one investible opportunity to capture the athletic cycle tailwind.  Importantly, Finish Line’s success has little bearing on our bullish outlook for Foot Locker.  We remain comfortable with our positive bias on both names following these results.

 

Below is additional color from the Q&A of today’s call:

 

 

Q&A:

 

Pricing - Vendor pass-throughs:

  • Vendors not pushing through price increases above and beyond expectations
  • Product in the $115 zone from SKX well received

SG&A Control - Labor Management/Commission Program:

  • Store labor costs for Q1 were flat in $$
  • Evaluating commissions program in a couple of markets and will be expanding to add'l mkts throughout the year
  • Store labor tool schedules labor according to traffic
  • Mgmt comfortable with LSD decline in SG&A over the balance of the year, 5%+ sounds aggressive

Inventory Mgmt vs. Comp Outlook:

  • Mgmt still sees upside on inventory turns
  • Aging inventories continue to improve
  • Seasonal carryover (i.e. boots) work to flush ahead of next season
  • Reducing less relevant inventory - growing inventory in categories driving growth e.g. Running and Toning
  • Planning to ramp inventories only in key growth categories

Comps - Traffic:

  • Traffic positive in March and then down a bit in April and May - so far in June traffic is up 2%

Comps - Trends:

  • Compares volume August is ~40% of the qtr, June/July the balance
  • June was 9% of total business in 2008, 7.7% of total sales in 2009 - mgmt planning on 8% this year

Balance Sheet - Uses of Cash:

  • Investing in the core business to drive growth
  • Strategic initiatives/Acquisitions
  • Looking to invest outside of the core brand
    • Potential buyback when shares at attractive levels

Gross Margins - Product Margin:

  • Compares get tougher going forward
  • Had mentioned 30-40bps contribution from product margins in FY11, obvious upside given +180bps in Q1

Running and Toning Inventory Levels:

  • Looking to invest in inventory here - key drivers for BTS
  • Levels are very lean after two quarters of -20% and -18% respectively

Exceeding Prior Peak Margins:

  • Optimistic they can exceed peak margins by:
  • Driving sales and increasing sales productivity in stores (~$300/sq ft last year, up 11% this qtr)
  • Product margin improvements
  • Occupancy savings a source of upside
  • Dot.com continues to grow well and at a more profitable rate

Toning Innovation:

  • FINL has tested new product from Skechers at higher price points and different aesthetics with 'good' reception
  • New entrants still aggressively hitting the category

Dot.com:

  • Average ticket runs +30% premium to average transaction in-store
  • Driven by footwear
  • Expanding assortment on the internet that they couldn't typically carry in stores - particularly apparel

Product Initiatives in June/July:

  • NKE AirMax10 in malls since May - adding some new colors
  • Lunar new models
  • Reebok ZigTech - took decent inventory for March Launch, ramping that based on success and rate of sell-through
  • Q3 and beyond, Reebok

Apparel:

  • Down LSD driven largely by seasonal product (e.g. basketball shorts, t-shirts, etc)
  • Branded business (NKE, TNF) was positive and look to grow as a % of sales going forward

2H Outlook:

  • They had built a plan that assumed flat to slightly down comp at the end of last year so environment still very favorable
  • Now willing to make some more investments and take more risks within reason based on strong demand

 

FINL: Clarity on Positive Trends - FINL S 6 10

 

FINL: Clarity on Positive Trends - SG Aggregate 6 10

 

Casey Flavin

Director


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BBBY: Subtle Conservatism

There’s little value in rehashing the finer points of yet another solid quarter from Bed Bath and Beyond.  Let’s be upfront and recognize that the opportunities ahead have very little to do with the past.  At least that’s the sense I get after talking with numerous investors over the past week.  So putting aside the above-expectation and above-plan same-store sales, the near $1.6 billion in cash on the debt free balance sheet, and the guidance which remains unchanged (and still conservative), the market seems to have made up its mind that this is as good as it gets.  At the same time, this also appears to be the sentiment towards most retailers.  And, perhaps this is fair given the optics ahead.  There’s no question that same-store sales will slow as the company butts up against more challenging compares beginning on Q3.  The same holds true for inventory management, which showed a tick down in its spread relative to sales and is no longer being cut at the same rate.  We knew the day of tougher comparisons on the horizon would come and we’re now one quarter away.  But, what’s new?

 

Despite what may be a near-term disconnect between tomorrow’s expectations and those in the intermediate term, we still believe there is ample opportunity for earnings to exceed expectations over the remainder of the year and into next for BBBY.  The key here is recognizing that EBIT margins are still about 100 bps off peak in an environment that is less competitive, has far less capacity, and is not overshadowed by aggressive promotional activity (i.e couponing).  We believe the company is almost half way through the process of unwinding the heavy use of direct-mail coupons and coupon inserts that were very much a part of a three-year trend in gross margin erosion.  At the same time, square footage growth remains a healthy 5% and the likelihood for additional share repurchases remains high.

 

Finally, a point about the elephant in the room, a.k.a sell-side concerns about a slowing topline coming into the earnings print.  There was absolutely no evidence in our view on the conference call to  suggest that sales have slowed.  The guidance for 2Q same-store sales stands at a mid-single digit increase.  Recall that guidance has called for a mid single digit increase since the end of 3Q09.  The question will be is this the “real” expectation, or is this a case of subtle conservatism?  We believe it’s more likely the latter.

 

Our view remains unchanged on the opportunities that still lie ahead for the shares.  We still believe earnings will grow by at least 25% for the year.  This is now the fourth quarter in a row in which gross margins have improved, after 10 quarters of declines.  We can’t fight a growing level of bearishness permeating the retail space, but we can and do remain objective on the fundamental opportunities that still exist for the shares.

 

BBBY: Subtle Conservatism - 6 23 2010 6 39 07 PM

 

Eric Levine

Director


MACRO MIXER – MAY WAS UGLY FOR EVERYTHING BUT CONFIDENCE!

The month of May was a difficult month for everything but consumer confidence.  Let’s recap the Month of May:

  1. The S&P 500 declined by 8.2%.
  2. Retail sales declined by 1.2%.
  3. The consumer sectors – Consumer Discretionary (XLY) and Consumer Staples (XLP) – declined 7.0% and 4.6%, respectively.
  4. The Housing market is collapsing.
  5. Consumer credit remains tight.
  6. Initial Jobless claims were horrible and the unemployment rate remains high.
  7. The economy is not growing as fast as the government is leading us to believe.

Today the University of Michigan is reporting that the Sentiment Index rose in June to 76.0 from 73.6 in May and up from 70.8 last year.  The Index is now at its highest level since January 2008. The Index remains 21.6% below the peak in January 2007 and up 37.4% from the low of 55.3 in November 2008.  Year-to-date, the confidence index is up 4.8%.   

 

The Expectations Index rose by 1 point sequentially and is only up 1.3% year-to-date.  The Expectations Index is down 20.3% from the peak in January 2007 (a year before the start of the recession and two years before it was declared by NBER).  Unfortunately, during the past 12 months the Expectations Index has not posted any further gains, signaling that consumers expect a very slow pace of growth in the year ahead.

 

While expectations remain muted, the consumer seems to more content with current condition.  The Current Conditions Index rose by 4.6 points sequentially and is now up 9.7% year-to-date.

 

With consumer assets deflating (equities and home prices) it seems unlikely that the current momentum in confidence will be sustained.

 

 

Howard Penney

Managing Director

 

MACRO MIXER – MAY WAS UGLY FOR EVERYTHING BUT CONFIDENCE! - uofm1

 

MACRO MIXER – MAY WAS UGLY FOR EVERYTHING BUT CONFIDENCE! - uofm2

 

MACRO MIXER – MAY WAS UGLY FOR EVERYTHING BUT CONFIDENCE! - uofm3


IGT: WOULD BE HARD PRESSED NOT TO GROW EPS NEXT YEAR

Goldman’s downgrade last week contributed to a big drop in IGT’s stock. While we don’t disagree with their macro call, their calculator seems to be malfunctioning.

 

 

Here at Hedgeye, we aim to be 100% objective.  That becomes more difficult when we uncover data points, research, and/or analysis that may go against our established opinions.  IGT is a perfect example.  We haven’t been big fans of this name recently – we’re worried about market share on the gaming ops side – but the recent Goldman downgrade has a major hole that we feel obligated to confront.

 

We certainly share Goldman’s cautious outlook on 2011 for the gaming industry as a whole.  Whisper expectations have gotten way too aggressive in our opinion.  However, if you think 2011 will not be a year of recovery for gaming, why would you short IGT and keep a Buy on MGM?  One follows the other.  If you are negative on slot replacement demand, then you can’t be bullish on casino revenues.  Slot floors are old – especially at MGM – so any kind of stability or casino revenue growth will spur replacements at potentially a very accelerated rate.  Why short a company with 2x leverage and only an indirect correlation with casino revenue versus a company with over 9x leverage and huge operating leverage?  You can’t have it both ways.

 

So GS has IGT’s earnings increasing only $0.04 to $0.88 in 2011.  North American new/expansion unit sales should increase at least 30% (excluding Acqueduct) and IGT’s market share will probably be higher since Illinois orders are likely to contain a higher percentage of video poker machines where IGT dominates.  Margins should be better and international sales flat to up; so for IGT only to increase 4% as projected by GS, replacement demand would have to actually shrink materially.  We think this is highly unlikely.

 

Thus, even a relative IGT bear finds the GS 2011 estimate way too low.  We are currently projecting $1.07 in 2011 EPS and we wouldn’t call that aggressive.  Taking out the convertible would add $0.07 to our estimate alone.  Following our meetings in Las Vegas this week, we don’t think much has changed for IGT and the sector.  Replacements are still up over last year and while new casinos and expansion slot sales will be down in 2010, they should rebound in 2011.  IGT’s near term earnings visibility is as good as any other gaming company with the exception of the Macau operators.  With the stock down 23% in less than 2 months and now trading at under 15x our FY2011 estimate, we may have to revise our bearish view.


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