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COMPLIANCE: An Epiphanous Moment

COMPLIANCE: An Epiphanous Moment - Screen shot 2010 08 24 at 6.55.37 AM
 
Amid jealous barbed praise and a certain amount of heartfelt respect, hedge fund great Stanley Druckenmiller has announced he is taking his marbles and going home.  Druckenmiller was George Soros’ investment strategist when they famously “broke the pound sterling” and generated over a billion dollar profit.  After he struck out on his own, Druckenmiller became widely known as one of the finest risk managers in the business, and his Duquesne Capital Management has long been a top performer.  Now Druckenmiller has decided to call it a day, announcing that Duquesne will return its outside investors’ money.  His announcement is seen as a bellwether “as many of his far less illustrious peers in the hedge fund world are suffering” (Financial Times, 19 August, “The Letter That Shook World Of Hedge Funds.”)
 
We wonder at the FT’s use of the word “peer,” which our dictionary defines as someone “who has equal standing with others…”  We are aware that inexact common usage (“peer pressure,” “a jury of one’s peers”) means anyone else in the room, though they may not share the critical characteristic that sets a person apart.  Such as the fact that Drunckenmiller’s hedge fund has averaged about 30% annual return going back to 1986.  “Peers”?  We think not.
 
The FT article quotes a prime brokerage executive as saying Druckenmiller “probably had an epiphanous moment” – a usage we are positively drooling over.  Indeed, it is clear that there have been fundamental changes in the financial markets.  It was just such an “epiphanous moment” in the life of hedge fund manager Keith McCullough that led to the creation of Hedgeye Risk Management.  Whatever has driven Druckenmiller’s decision, with his track record he has earned his peace and quiet and need apologize to no one.
 
As we never tire of pointing out, the art of managing money is the art of having other people’s money to manage.  According to the Journal, Druckenmiller “has some $8 billion of his own money to invest,” which makes him no longer a “money manager” by our definition.  If lesser managers – Druckenmiller’s “peers” – are not having epiphanous moments of their own, it is likely because they can not afford them.

 

Moshe Silver

Chief Compliance Officer


TGT: Multiple Targets

Is TGT teeing itself up as one of the best large cap growth stories in consumer discretionary, or is this setting up as the mother of all ‘Ackman Assault Hangover’ sucker punches? Our best ideas often stem from internal debate. We’ve got plenty of that here. Here’s the Bull vs. Bear…

 

Eric’s Bull(et) Points

  • Topline has more drivers now, ex-macro, than it has had in some time.  The company’s focus on rolling out the 5% rewards/loyalty program and the continued rollout of P-Fresh is accretive to sales.  Management says each could be worth 1-2 pts of comp on an annualized basis.  Clearly there is something they are seeing in the Kansas City test market (loyalty) and in the P-Fresh remodels to give them confidence.  Either way, both company led initiatives offer internally generated sales drivers that others (i.e. WMT) don’t appear to have.
  • Traffic is the key here, an TGT clearly has momentum.  More food and consumables=more traffic.  This also leads to opportunity, which in this case may mean a customer picks up an additional non-food item on any given trip.  Probably works.
  • Management disciplined about opening new units in this environment, instead using capital to fund .com infrastructure and P-Fresh remodels.  We like the conservative approach and discipline in not growing for the sake of growth.  Yes international is still on the table, but we suspect that means Canada first.  There is no rush here and this is a positive for cash flow.
  • Aggressive pricing activity from Wal-Mart seems to be a perpetual thorn in the side of traditional grocers and now BJ’s.  However, TGT has clearly found a way to compete effectively.  The introduction of the “Up and Up” private label brand and differentiated store and merchandise assortment seems to be keeping Target relatively insulated from pricing pressure issues.  Perhaps this past quarter is the best example of this, where core retail gross margins were up 5 bps while WMT and BJ both saw pressure as they took prices down.  We don’t need to remind anyone of the trend in grocery margins.  The bottom line here is Target’s success away from commodity consumables affords better margins.
  • Credit card portfolio risk gradually dissipating for two reasons.  One, the overall credit environment is improving leaving opportunity to reduce reserves.  Secondly, Target is shrinking its receivables base as tighter credit restrictions and increased government restrictions no longer allow for unabated growth.  Target also discontinued its co-branded Visa program, which leaves future receivables growth entirely tied to store sales. 
  • Expense pressure from investments in dot.com will remain through 2011 as the company carries duplicative costs during the transition away from Amazon (TGT’s outsource partner).  The flip side here is we should see leverage on such investments begin to materialize in 2012, the year in which Target.com becomes fully operated in-house.
  • Management has clearly articulated the benefits of adding incremental food/consumables sales into their boxes via the P-Fresh remodel.  However, the result over time will be lower gross margins and commensurately lower SG&A.  Net, net EBIT rate should remain unchanged.  While in theory this makes sense, we know that investors are not fully onboard with trading margin for expense savings.  Over time, this will become more clear.  In the nearer term, headline gross margins could remain under pressure from this mix issue alone.
  • While TGT offers a more discretionary play vs. WMT, it also offers greater visibility over the intermediate term in my view.  The two strategies currently underway to drive topline results have been tested.  We already know that inventory management coupled with differentiated product helps Target to drive a higher EBIT structure than WMT.  While the Street may be excited to learn that WMT has dialed back rollbacks (after they didn’t work to drive demand elasticity), the non-consumables part of the story is still very much in limbo.  This is the single biggest wild card in the WMT story and one that in our view, has not been answered by a few mid-game personnel changes. 

 

Brian the Bear

One factor I can’t shake is the Ackman Attack. Let’s look at the timeline.

 

Oct 07-Mar 08: As the credit bubble implodes and sets the stage for the worst economic downturn since the Great Depression, Bill Ackman buys 20.5mm shares of TGT at average price of about $50. By the end of 2009, Ackman owns 3.55% of shares outstanding.

 

Wanna hear some irony? Ackman’s activist stance was focused on 1) TGT’s outsized risk in credit operations, and 2) lack of accountability and responsiveness in addressing TGT’s valuation. As of latest filings, Ackman has 28.7% of his fund’s assets in TGT (even after having sold down to 2.81% of s/o). Over a third of one fund’s assets on one security???  C’mon Bill. I’ll give you the benefit of the doubt and assume that you aren’t even levered. How ‘bout holding yourself to the same risk management and accountability standards you demand from companies  in your ’50-year model’?  Give our Macro team a call. They can help you there.

 

This is more than McGough ranting. I actually do have a point there…

On Target’s May 7 sales release last year, comps were in-line, but more importantly TGT noted that tight expense controls and better gross margins (markups better, markdowns fewer) will lead EPS to be “well above First Call estimates".  Credit quality also came in line vs. a trend of coming in slightly below plans. Then, four days later, TGT issued a press release titled “Questions That Attendees May Want To Ask At The Pershing Town Hall.’ In other words, TGT started to pull out all the stops to make Billy go away.

 

Ultimately, Billy took it on the chin, and lost his proxy battle on May 28 of 2009 after it was clear that the momentum of the business was going against him. The ‘strong cost control’ is particularly notable to me. Being cost-conscious is great – I tell my wife and kids that all the time. But this is a company that has added $1.5bn in revenue (2.5% over 2 years) since The Ackman Assault, but has held SG&A dead even. And yes, that’s despite 9.5% square footage growth over that same period. Last I checked, a new store requires a few bucks.

 

Yes, TGT is great retailer. No doubt. But my point this is a company where working capital is eroding on the margin, and starting next quarter, the Gross Margin compares get very tough at the same time Target will need to actually start to spend real SG&A dollars to support the much-touted growth initiatives that prompted positive press and sell-side upgrades.

 

In fact, there’s a sell-side consensus “Buy Ratio’ of 82%. For those of you counting, that’s the most favorable since April of 2000. Yes, 2000.  The short interest is down by a factor of 2-3x from the beginning of the Ackman Assault.

 

If it were not for context that Eric Levine adds to the equation, I’d have the bear claws out big time.

 

We’ve got more work to do on this puppy.

 

 

Keith’s factor models suggest that TGT is bearish TREND with resistance = 53.63.

 

TGT: Multiple Targets - tgtss

 

TGT: Multiple Targets - tgtbs

 

TGT: Multiple Targets - tgtsgma


MCD: BLAZING HOT SUMMER COMPS TO CONTINUE IN AUGUST

Comps have accelerated through the summer for MCD and I wouldn’t bet on them slowing down in August.

 

Sales of frappes and smoothies at McDonald’s restaurants have performed well throughout the summer and continue to do so.  Smoothies in particular have created tremendous noise in the market.  Earlier this month, the release detailing July sales underlined frappes and smoothies as top contributors to the month’s 5.7% print in the U.S. market.  Based on current sales trends for frappes and smoothies, I expect two year average sales trends in the U.S. to accelerate in August on a sequential basis.  Taking calendar shifts into consideration, I would not be surprised to see McDonald’s USA print a 6 to 7% comparable restaurant sales number for August.  Globally, there is a chance that July’s 7% figure could be exceeded in August.

 

MCD: BLAZING HOT SUMMER COMPS TO CONTINUE IN AUGUST - mcd us auge

 

Additionally, news has emerged that McDonald’s is testing a new line of products – Chicken Flatbread Sandwiches – in the Baltimore market.  If successful, this product could provide needed support for sales trends in the lagging lunch day part.

 

MCD: BLAZING HOT SUMMER COMPS TO CONTINUE IN AUGUST - flatbread sandwich

 

MCD: BLAZING HOT SUMMER COMPS TO CONTINUE IN AUGUST - flatbread sandwich 1

 

Howard Penney

Managing Director


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Sticking With Our Short on Dr. Copper

Conclusion: As the global economy slows sequentially, we expect the price of copper to decline as inventory builds and currency tailwinds unwind.

 

Position: Short Copper (JJC).

 

Refined copper imports by China (the world’s largest consumer) grew in July for the first time in four months. The 6% M/M increase reflects May and June demand for imports (it takes one to two months for the imports to arrive in Shanghai), which was high, as higher prices in Shanghai prompted arbitrage trade. A recent report out of Orient Securities Futures suggests the window for arbitrage may be closed, which is bearish for Chinese copper imports going forward.  Also, it is important to note that this important number is down -23% on a Y/Y basis.  So, while copper inventories are low in China, the culprit is really low imports rather than accelerating end market demand.

 

Admittedly, we were early shorting copper from a timing perspective, but we continue to have conviction on the short side – despite current low inventories. Copper stockpiles as measured by the London Metals Exchange hit the lowest levels since November 11th and are down 2.8% this month after declining 8.3% in July. Since the YTD high of 555,075 tons on February 18th, copper stockpiles on the LME have declined 27.6%. We have seen a similar decline in stocks on the Shanghai Futures Exchange, down 42% since the high of 189,441 metric tons in the week ending 4/29.

 

Sticking With Our Short on Dr. Copper - 1

 

Sticking With Our Short on Dr. Copper - 2 

 

Interestingly, and despite these bullish fundamentals, copper is only up 0.2% since Feb. 18th and down 1.3% since April 29th. On a two and three month basis, however, copper is up 14.1% and 11.8% respectively, which is supported by dollar weakness (the Dollar Index is down 3.1% and 2.9% over the same durations).  The fact that the price of copper has barely moved in a declining inventory environment is a bearish indicator for us as it relates to the future direction of price.

 

Normally, we look to the price of copper as a leading indicator for global growth, but with the mixed signals we have been receiving from a price perspective as a result of prolonged periods of dollar strength and weakness, we must turn to our outlook on global growth to forecast where we think Dr. Copper is headed. As a reminder, we are bearish on global growth in 2010 and we have a 1.7% estimate for 3Q10 and 2011 U.S. GDP growth (roughly half of consensus estimates), which is largely driven by our forecast for housing prices to fall 15-20% in the next 12 months and rising structural unemployment. In addition, we have been bearish on Chinese growth since January 15th, and with consumer price inflation hitting a 20-month high in July, we don’t expect China to loosen its tightening measures anytime soon. Additional factors supporting our bearish stance on global growth are austerity in Europe and slowing end demand from Western consumers which may serve to reduce industrial production and trade internationally.

 

With the looming global growth backdrop, we expect copper inventories to build, or at least see a deceleration in the rate of declines. Either result is incrementally negative for price. Furthermore, we could see dollar strength from accelerated dollar purchases by central banks globally as exporting nations from Asia to Latin America look to increase their slice of the contracting pie that is global trade in 2H10.

 

Managing Risk

 

As always, our style of investing requires a prudent risk management approach that is duration agnostic. We will continue to analyze and interpret the near-term risks to our short position in Copper. Those risks include further dollar weakness from here and reduced production in China, the world’s largest smelter of the material.

 

We expect tomorrow’s existing home sales to be a bomb, in the range of down 20%-30% M/M. Obviously, this will come as a shock to investors (consensus estimates are for a 12% decline), which will likely serve to conjure up more calls for increased stimulus in order to avoid a pending double dip in housing. If Bernanke and Co. give in to market pressure, we expect the dollar to resume its decline after closing up on a weekly basis for the previous two weeks. Further dollar debasement from here is positive for copper prices (r-squared = 0.69 on a two-month basis).

 

 Sticking With Our Short on Dr. Copper - 3

 

With regard to supply, the latest rumors out of China claim that the government may shut smelting plants that violate environmental rules as it looks to tighten regulation after a series of industrial accidents led to waste spilling into rivers and seas. The latest data (2008) show that China accounts for nearly one fourth of total world copper smelting output, so a reduction in production there will provide support for the price of copper. Accidents are running at an annualized rate of 204 in 1H10 compared with 171 in all of 2009, according to China’s Environmental Protection Ministry.

 

Absent the development of these risks, we expect the price of copper to decline from here as the fundamental and currency tailwinds look to unwind. For now, copper is bullish from a TRADE ($3.25/lb) and TREND ($3.14/lb) perspective with TRADE resistance at $3.31/lb. 

 

Darius Dale

Analyst


Bear Market Macro: SP500 Levels, Refreshed...

One of the hallmarks of bear markets is that they rise to lower-highs on low-volume bids. We affectionately refer to this as hope.

 

Hope, unfortunately, is not an investment process…

 

After a low-volume rally on this morning’s open, the SP500 could not hold above our most immediate term TRADE line of resistance (1082). All the while, the dominating intermediate term TREND line up at 1144 continues to cast its shadow of doubt.

 

While we won’t see any of the shadow inventory in tomorrow’s US Existing Home sales report for July, we’ll see plenty of reported inventory. Don’t forget that despite the tax credit in the June data, housing inventory was already moving up into the right hand corner of your charting system.

 

The overall market is a very dynamic ecosystem that absorbs both inside and reported information. That’s why we apply the principles of chaos theory to manage risk around it.  Our refreshed risk management level of immediate term TRADE support is 1059.

 

We continue to be short both the SP500 (SPY) and Russell 2000 (IWM) in the Hedgeye Virtual Portfolio. We think this week’s US housing data will be plenty Bearish Enough.

 

Keith R. McCullough
Chief Executive Officer

 

Bear Market Macro: SP500 Levels, Refreshed... - 5


WYNN: LOW HOLD IMPACTING SHARE

From our understanding, Wynn is holding only around 2.6% thus far in August, which explains some of the sequential market share loss.

 

 

We continue to think the Macau narrative for Wynn may soon turn to Encore and the seemingly lack of incremental contribution from the sister property.  Market share will likely be a focus.

 

In July, the Wynn properties posted a disappointing market share of 15%, the lowest full month share since Encore opened in April.  Through the 8/15, Wynn's share fell further, to only 12.8%.  By contrast, Wynn's June market share was 17.4% and averaged 14.2% in the 12 months prior to Encore opening.

 

Our sources indicated that Wynn's August hold % fell to 2.6%, below a Wynn's average hold of of 3% since 2007.  We calculate that if Wynn's hold was 3%, its market share would have been 14% in the first half of August.  14% is not good enough either.

 

We recognize that we don't have the data yet to normalize everyone's share so this analysis is not as useful as it could be.  However, what is clear is that Wynn is on track to post its second straight month of disappointing market share with Encore.  Given the overall market strength, this may not matter but at some point, overall growth will slow and market share will become a more important metric in the eyes of investors.  At that point, a narrative of disappointing ROI from Encore may be the story that will start to be told.


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