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Red Letter Day

“You can sneer or disappear behind a veneer of self-control.”

-Pet Shop Boys


We have our British electronic dance music playing this morning in New Haven as the bulls are forced to sneer at the tail that’s been wagging this US growth dog since US Housing saw its cycle peak in April. As one of our three Hedgeye Macro Themes for Q3, we’ve called this Housing Headwinds.


The aforementioned quote comes from the Pet Shop Boys 1996 top ten hit, “A Red Letter Day.” What an appropriate quote and song name for a day like today where expectations for a bomb of an Existing US Home Sales report are finally being baked into this bear’s cake.


This day in 410 (AD) was also a Red Letter Day for the Roman Republic. Historians refer to this day as “The Sack of Rome” when the enemy (the Visigoths) took over the city for the first time in 800 years. This was a bad day for the professional politicians of Rome.


The US stock market has had a bad day for the last 3 days in a row. While our 2011 estimate for US GDP growth is still approximately half of the Bloomberg consensus, the Street is finally taking down its expectations for Q3 and Q4 of 2010. In recent weeks we’ve seen both Goldman Sachs and JP Morgan cut their estimates. There will be more of that to come.


Combined, with the prospective outlook for US unemployment, housing, and GDP growth finally getting a reality check, it will be interesting to wait and watch today as the SP500 finally takes a good hard look at our immediate term TRADE line of 1059 support.


Last week we penned this Red Letter Day on the calendar with both The Catalyst and The Line. While we do not think that the Fiat Republic will fall today, we do think that members of the risk management community will most certainly get paid on the short side.


To be crystal clear on this, today is not the day to be shorting stocks. Today is a day to book your gains and increase both your gross and net exposure. If you don’t run an asset management firm and you’ve gone self-directed, in Hedgeye Risk Management speak that means today is a day to invest some of the 61% we have allocated to Cash in the Hedgeye Asset Allocation model.


In terms of asset allocation, there’s an emerging and healthy debate about what percentage of your assets you should have in US “bonds versus equities.” This, of course, is born out of the last bubble that remains in global markets today – that which the Fiat Republic perpetuates by marking short term Fed Funds rates to model rather than letting the world mark them to market.


There will undoubtedly be a Red Letter Day for US Treasury bonds, we just don’t know when that will be yet. However, what we are comfortable saying right here and now is that it’s relatively safe to start shorting short term US Treasuries. The long end of the US Treasury market is not where we’d be focusing short positions. The 10-year yield could easily drop another 40-45 basis points from here and retest its prior lows.


On the short end of the curve, this morning you are seeing record lows in 2-year UST yields. At 0.46%, this may not be the lowest level of confidence global investors have had in US growth in 800 years, but the lowest US Treasury yields ever is still, by our calculations, a very long time.


So why is this so? Isn’t this ok? Yesterday while I was debating him on this topic on Bloomberg TV, Dean Baker of the Center for Economic Policy Research said it’s perfectly fine for America to keep on borrowing. He went on to say that “the bond market doesn’t have a problem with it.”


Admittedly, I think I was too surprised to absorb his summary conclusion on the spot. But after a good night’s sleep and some googling this morning, I am reminded of the partisan nature of Mr. Baker’s view point. After all, he does work at the center of modern day Rome in Washington, DC.


Rather than have barbarians hold professional politicians in the Roman Republic accountable, modern day risk managers have YouTube. For more Dean Baker and Paul Krugman thoughts on why we need to jack up government spending by another $800 BILLION dollars, please peruse the web.


Back to the question of whether you should buy US Treasury Bonds or US Equities - I don’t think you need to accept the preface of the question. Why not Brazilian or Chinese or Peruvian Equities? Why US Treasury Bonds? Why not cash?


Since 1997 when Paul Krugman told the Japanese to “PRINT LOTS OF MONEY”, you can pull up a chart of Japanese Government Bonds versus Japanese Equities and you’ll start to answer some of these questions on “bonds versus equities.” Foreign direct investment has been leaving Japan altogether for a very long time and Japanese bureaucrats are still trying to do more of what hasn’t worked.


On this Red Letter Day of August 24th, 2010, Japan will sell another 1.1 TRILLION Yen (that’s a lot of yens) in 20-year debt in order to attempt to boost expectations for another broken promise of “stimulus spending” still being the answer to their structural economic growth mess.


After losing another -1.3% overnight, Japanese equities have crashed, again, losing -21% of their already “cheap versus bonds” valuation since April the 5th.  Japan’s bond market “may not see a problem with monster debt levels” yet Mr. Baker, but her stock market sure does!


Best of luck out there today,



Keith R. McCullough
Chief Executive Officer


Red Letter Day - movie


Everybody’s got a secret…  

- Bruce Springsteen, “Darkness on the Edge of Town”



COMPLIANCE: Odd Lots - Screen shot 2010 08 24 at 7.09.57 AM



How Much Worse Could It Be?
“States Will Be Hedge-Fund Police” says the Wall Street Journal (19 August), describing the change under Dodd-Frankenstein which will raise the assets under management threshold for SEC oversight to $100 million from a current $25 million.  The SEC estimates that about 4,000 registered hedge funds will switch from SEC to state jurisdiction.  One of the knotty bits to work though: each state has a different regime, so funds will have to learn different practices state by state.  Another knotty bit: state budgets have been slashed, with some state regulators on unpaid furlough.  Here’s another knotty part: the SEC doesn’t believe the states have the resources to take up the slack – but out of 11,300 registered advisers under SEC oversight, more than 3,000 have never been examined.  Let’s face it, how much worse could the states do?
Guess we’ll find out…
You Mean Now?!
SEC Chairman Schapiro has cautioned Congress that they should not expect anyone at the Commission to actually do any work.  Speaking before the House Financial Services Subcommittee on Capital Markets, SEC Chair Mary Schapiro said the SEC may not be able to deliver all that is asked of it under the schedule for implementing Dodd-Frankenstein.
The SEC is required to issue a large number of new rules, create five new offices, and to conduct a number of studies, much of this on an accelerated timetable, with final results due in a year.  Some items must be completed in as little as 90 days.
“The importance and complexity of the rules, coupled both with their timing and high volume, and the rule writing agenda currently pending, will make the upcoming rule writing process both logistically challenging and extremely labor intensive,” Schapiro testified, which means the Commission will set aside the balance of its agenda for 2010.
President Obama has allocated $24 million to help the Commission with the implementation, which Schapiro says will enable the SEC to create 800 new positions.  That comes out to $30,000 per new employee, leading us to conclude the government has finally created an employment program for those laid-off New Coke deliverymen.  And heads up: many of the projects on a short time frame are hot-button issues like the proposed fiduciary standard for brokers.  You think the SEC couldn’t get anything accomplished before?  Just watch!
Darkness on the Edge of Town
So these guys from Washington come inna office down in Trenton, and they say we “created the false impression” that we were funding these pension funds, you know?  Even though everybody knows the teachers and the public employees, all these mokes depending on the State for their retirement are gonna end up pounding salt, so they better hope they die before they hit sixty-five – which I got a guy says he can arrange it.
So these guys from the SEC, they say we, like, out of the blue decided to change the value of the stuff in our portfolio, and then we wouldn’t have to write a check – which you gotta admit, it’s pretty ingenious.  So in June of 2001 we re-marked our whole portfolio back to the bull market prices of June 1999, which made a whole lot of liability disappear and didn’t cost a dime.  And which is a lot smarter than when New York had to pay money into their pension funds, and they borrowed $6 billion from the same funds, and then paid it back to them – which is totally stupid, because now they owe the same money twice.  Whereas we didn’t do anything except just tell the truth about our holdings, just, you know, it was the truth from a different point of view, which it so well for Lenny Dykstra that even Jim Cramer said he was “great.”  Maybe we should tell Ben Bernanke about this?
So then they say that since we created this alleged false impression, that when we sold $26 billion worth of munis we were supposed to tell people that the extra money wasn’t really money.  Like, these guys are from Washington, and they’re telling us we’re lying to people about how much money there actually is?  So we tell ‘em, look, we make-um deal.  You get to tell everyone that you told us not to be bad guys, and we’ll tell everyone that that’s what you told us.  And then you don’t show your face around Drumthwacket ever again.
Which is how it came to pass that, one day after agreeing to no monetary fine and no finding of wrongdoing on allegations of misleading muni bond investors by consistently misrepresenting the value of state pension funds, the State of New Jersey issued $2.25 billion in notes at a near-record low borrowing cost of 0.332438%.   (Full disclosure: your humble scrivener is a long-time New Jersey resident.)  Because we may be New Jersey, and you can say what you like, but we’ve never defaulted on our bonds, and the markets know that.  Because like Tony Soprano says, you’re only as good as your last envelope.
You Can Take That To The Bank
In a move certain to unleash general hilarity, Fannie Mae and Freddie Mac are trying to force major banks to take back mortgages.  The Dumb and Dumber of America’s social-fiscal policy just woke up to the fact that some of the mortgages they guaranteed, and which are now in default, may have been issued based on false information.  There are big bucks at stake here – Bank of America, for example, is haggling over $11.1 billion in buyback demands.  We have to wonder at the timing, as Dumb and Dumber have lost their only friend.  Barney Frank, of all people, stated publicly this week that the two GSE’s “should be abolished.”  A decade late and a trillion short, but hey, some guys are a little slow on the uptake.
With their only friend out of the picture, the desperate Pair Extraordinaire have hit on the notion that running their business responsibly is their only hope of salvation.  Time will tell.  After all, it’s never been tried before.
While all this is going on, the man credited with creating asset-backed securities, Lewis Ranieri, has resurfaced at the helm of a fund whose sole purpose is to buy out under-performing mortgages.  The Wall Street Journal reports (18 August, “Vultures Save Troubled Homeowners”) that Ranieri’s vehicle, Selene Residential Mortgage Opportunity Fund, has been cherry-picking residential mortgages, buying them at a deep discount from face value, then renegotiating the payment terms.
This is a natural business – indeed, it was what the TARP and the Public-Private Partnership were supposed to accomplish, except those darned banks wouldn’t cooperate, so we had to just give them the money instead.  We wonder whether this development indicates that some part of the banking / housing complex may be coming unstuck.  We are not sure how the banks will account for sales to Ranieri’s fund, but the willingness of any bank to countenance a write-down in these assets may signal the leading edge of a sea-change.  As with all massive shifts, this could explode.  Keith, our CEO, is fond of the image of a rubber ball being held underwater.  When you can no longer hold it – POW!
We bet dozens of new vultures will swarm the banks in the coming months.  And we haven’t forgotten that private equity firms raised millions in a frenzy the last time they saw “vulture” opportunities, only to be abruptly shut out of what turned out to be an extremely narrow market window.  The money is still there – and so are the bankers who raised it, being yelled at by their investors and by their partners. Watch for the next wave of scams as banks rush to clean up their mortgage portfolios.
For instance, a banker closes a file without including certain key financial information about the homeowners, and the bank sells a $100,000 balance mortgage to a vulture fund for $40,000.  The family pays off not $40,000, but $75,000, and the portfolio manager at the vulture fund hands the banker an envelope containing ten thousand dollars in cash.
Not in America, right?  Well, maybe in New Jersey.
I Speak, You Speak, We All Speak For Newspeak
Said President Obama this week: “We have a choice between the policies that got us into this mess and the policies that are getting us out of this mess.”  We question the Presidential use of the present continuous tense, properly used to describe an action already commenced and that proceeds uninterrupted.  It is not clear to us that Washington has put policies in place that have made progress towards getting America out of anything other than our hard-won place as Leader of the Free World.
We freely admit that we might be following the wrong line of reasoning.  The issue might not be what we understand by the words “getting out of this mess”, but rather what President Obama meant by the word “us.”
Just checking, Mr. President.
Moshe Silver
Chief Compliance Officer


TODAY’S S&P 500 SET-UP - August 24, 2010

As we look at today’s set up for the S&P 500, the range is 23 points or 0.8% (1,059) downside and 1.4% (1,082) upside.  Equity futures are trading below fair value ahead of the housing data.

  • PERFORMANCE ONE DAY: DOW (0.38%), S&P (0.40%), Nasdaq (0.92%), Russell (1.33%)
  • PERFORMANCE MONTH-TO-DATE: DOW (2.79%), S&P (3.11%), Nasdaq (4.22%), Russell (7.41%)
  • PERFORMANCE QUARTER-TO-DATE: DOW +4.1%, S&P +3.56%, Nasdaq +2.39%, Russell (1.12%)
  • PERFORMANCE YEAR-TO-DATE: Dow (2.43%), S&P (4.28%), Nasdaq (4.83%), Russell (3.63%)
  • ADVANCE/DECLINE LINE: -786 (-284)
  • VOLUME: NYSE - 865.17 (-23%) - no massive selling
  • SECTOR PERFORMANCE: 4 sectors positive on the day - XLU positive on TRADE AND TREND
  • MARKET LEADING/LAGGING STOCKS YESTERDAY: Washington Post +6.07%, Micron Tech +3.65%, and Avon +2.72%. Titanium Metals -4.5%, Flir -4.25%, and Intuit -3.97%


  • VIX  - 25.66 +0.67%
  • SPX PUT/CALL RATIO - 1.78 down from 2.03  


  • TED SPREAD - 16.94 0.203 (1.210%)
  •  3-MONTH T-BILL YIELD .16% +.01%
  • YIELD CURVE - 2.11 from 2.13


  • CRB: 266.03 -0.37% down 5 of the last 6 days
  • Oil: 73.10 -0.98% looking to be down 10 of the last 11
  • COPPER: 331.25 +0.03% - Not following oil on the down side
  • GOLD: 1,218 -0.17% - looking to be down for 3 days


  • EURO: 1.2668 -0.35% - headed lower for the 4th day
  • DOLLAR: 83.123 +0.08% - headed higher for the 4th day


  • ASIA - Most Asian markets followed Wall Street to the downside. China rebounded to black in late morning trading, helped by recoveries in exporters and resource firms.
  • EUROPE - European markets fell in a broad based retreat; concerns about the economic outlook and poorly received corporate news are not being well received. 
Howard Penney
Managing Director

THE DAILY OUTLOOK - levels and trends













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Honesty is the best policy – when there is money in it.
-         Mark Twain

What reserve price Justice?



COMPLIANCE: SEC-Bay? - Screen shot 2010 08 24 at 6.59.19 AM


On Wednesday, US District Judge Emmet G. Sullivan held his nose and approved a $298 million payment by Barclay’s Bank to settle criminal charges of violating US financial sanctions against Iran, Cuba, Libya, Sudan and Burma.  Noting that the charges were brought after Barclays itself reported internal findings to US officials, and that the bank cooperated in the investigation, the Justice Department disputed the Judge’s criticism that they had accorded the bank special treatment.
According to the settlement document, Barclays acknowledges that bank employees cooperated with requests from foreign banks to delete from funds transfers information identifying the originating banks, and that between 1995-2006 the bank processed more than $500 million of transactions that were prohibited under the Treasury’s Office of Foreign Assets Control (OFAC) rules.
We commented last month (30 July, “Quotations From Chairman Mary”) on the $160 million paid by Wachovia to settle liability for processing over US$ 420 billion in transactions from Mexico – including at least $4 billion in bulk cash – with no anti money laundering procedures in place.  The Justice Department identified $110 million in drug proceeds laundered through Wachovia, including money that went to purchase cargo planes and load them with cocaine.  Wachovia agreed to pay dollar for dollar the amount of drug money identified as being laundered through their neglect, plus a $50 million fine, for a total of $160 million.
Details of the cases differ.  Wachovia, says the Justice Department, “admitted failure to identify, detect, and report suspicious transaction in third-party payment processor accounts.”  Barclays, according to Justice spokesman Lanny Breuer, deliberately circumvented OFAC sanctions and “stripped vital information out of payment messages that would have alerted US financial institutions about the true origins of the funds.”  Each step of this process is potentially a separate criminal act.  Bank employees were allegedly asked by Iranian and other banks to remove information identifying the issuing bank and country of origin on some $500 million worth of transfers.  Failure to report such a request to internal Anti Money Laundering (AML) personnel is potentially a crime.  And if Barclays employees cooperated with these requests, each transfer was a separate criminal transaction.

On the other side, Barclays self-reported to Justice, and has spent $250 million improving their internal AML procedures.  Breuer said “we will take their disclosure, cooperation and remedial efforts into consideration.”
That’s some “consideration.”  Wachovia was dinged dollar for dollar on the illegal transfers, plus made to pay a fine of 45% of the total.  Barclays has negotiated a steep discount, paying only 60 cents on the dollar of the amounts processed, with no additional fine.  The government points out that both institutions have spent large sums of money to improve compliance – as though that were part of their punishment.
As far as anyone is telling – and we will never know the truth, because a settlement blocks any further information being divulged – Wachovia’s illegal transfers were the result of negligence on the part of the bank, while  Barclays’ transactions appear to be the knowing facilitation of criminal activity.  We do not care to offer an opinion as to which is “worse” – we don’t believe that no one inside of Wachovia knew what was going on, nor that nobody profited from turning a blind eye.  And given the terms of the Barclays settlement, we shall never know how widespread the crimes were, nor how high in the corporate structure they reached.  All we know is that Barclays has successfully negotiated down the price of major financial fraud – and for that, many in the shadowy world of not-quite-banking should be grateful.
Were we a senior executive or shareholder of either institution, we would make damn sure that people went to prison.  As taxpayers we believe we are entitled to that outcome.
Instead, it’s Welcome to the Homeland Shopping Network, where it’s All Money Laundering, All The Time!  It may be that Wachovia never had sufficient clout to get a better deal for itself.  Meanwhile Barclays, still a darling of the financial sector, is featured both above and below the fold on the front page of the FT’s Companies & Markets section (19 August).  The lead story quotes BarCap’s capital markets group’s estimate “that the 35 largest US banks will have to come up with half as much new capital as had been expected” under the new Basel rules, as compromises were reached on the structure of tier one capital.
Below the fold on the same page, the headline reads “Judge Accuses Barclays Of Paying For Justice In Sanctions Settlement,” quoting Judge Sullivan as saying the proceedings raised questions, such as “Why are the financial institutions being treated like this?”
Good question.  Under the settlement, Barclays is not permitted to dispute the charges that the bank knowingly stripped identifying information from funds transfers to avoid OFAC sanctions.  In other words, the bank’s employees knowingly committed crimes and were directly responsible for funneling at least half a billion dollars of illicit funds through the US banking system, and the bank would make sure that all the employees, and the executives on whose watch it happened, would stand in the dock and plead guilty, and go to jail for a long time, where they would be deprived of their Ferraris and their freedom, and not to mention the other unpleasant stuff that happens On the Inside… so yes, Barclays would be happy to do all this, except the DoJ decided they didn’t have to because after all the bank was so forthcoming five years after they found the crime in their midst…
This is why crime runs rampant.  It is encouraged.  It even has a price schedule.  And now, it’s negotiable.  Tired of overpaying for those nasty money laundering sanctions?  Come on down to DJ’s, where your crime is our dime!
Financial regulators publish sanctions guidelines that tell what you should expect to pay for any of a large number of violations.  In fact, managements confer with their lawyers, comparing sanction guidelines and established precedent to determine whether or not to break the rules.  Trust us.
Like a CDS or a simple listed option, the pricing requires inputs, based on assumptions.  What is the likely return if we break the rules?  What is the likelihood we will get caught?  How many people do we have to cut in on this to make it happen, and how much do we trust them?  What’s my piece of the action?  This can be mapped into a simple equation and run across a variety of scenarios.  Decisions to violate the rules are always based on a calculation of the low likelihood of getting caught (A), paired with a low likelihood of being successfully prosecuted (B), less probable legal fees (if B).  Reputational damage rarely factors into the equation because let’s face it, we already work on Wall Street...
The love affair between Washington and Wall Street marches on with a new round of settlements.  As long as no one goes to jail, the world will go on seeking new and untried forms of Bad Behavior – and the authorities will charge for the privilege.  Justice, despite Judge Sullivan’s demur, may not be for sale.  But clearly, you can rent it.
SEC boosters say they have substantially raised the price of corporate fraud – Judge Rakoff expressed his disgust with the B of A settlement, even as he signed off on the deal, decrying the fact that no one was held to account.  And the “record” Goldman settlement merely shows that the arrogant rich have to pay more for the privilege of renting the law.
It all seems to come down to popularity.  While the unloveable B of A gets a sharp uptick in the cost of lying to shareholders, Barclays managed to drive down the price of a ten year pattern of laundering money for the Iranian Revolutionary Guard.  Mark Twain said the efficiency of our justice system “is only marred by the difficulty of finding twelve men every day who don’t know anything and can’t read.”  The SEC and DoJ appear to have unearthed the mother lode.
As for Goldman, paying a half billion dollar fine for unloading fugazy paper on the Europeans looks like poetic justice.  Who do they think they are, Alan Greenspan?




Moshe Silver

Chief Compliance Officer

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