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LDG, Part V: Numbers Don't Lie, People Do

I don’t need to sit across the table from a CFO in a conference 1-on-1 to get the inside scoop on how it is managing its growth trajectory. I have a much better source – it’s called a balance sheet. Better yet, it is in the notes accompanying the balance sheet, where we find some very large obligatory payments that are treated by most on Wall Street as if they don’t exist.

Well, that’s something we just can’t let fly here at Research Edge.

I’m referring to the minimum rent obligations on a go-forward basis, which gives us some pretty solid insight into CVS leading up to its decision to buy Longs Drug. Why does this matter? Because aside from discretionary SG&A spending, these minimums represent the single most meaningful place a retailer could go to manipulate reported margins. Every CFO will argue with me on this, and give you fluffy reasons as to why they don’t do that. But the option is there.

How? There are 2 main ways this can manifest itself. 1) A retailer could guarantee a landlord a steep escalating rent structure in order to outbid a more profitable competitor with deeper pockets, 2) The retailer could sign rental agreements with much longer property lead times, taking on the risk from the landlord that the quality of the location does not pan out as planned.

Why? This usually happens when one of two factors exists – and both are bad. The first is when a management team is super bulled-up on its growth trajectory and thinks that it can fund a high hurdle rate for growth in rent payments regardless of the macro environment. These companies don’t ‘do macro.’ This includes Whole Foods and Dick’s (check out those charts). The second is when a retailer sees a growth or margin trajectory eroding, and management starts pulling levers to keep its margins high, instead of investing in better and more profitable growth platforms. This is Circuit City, DSW, and you guessed it, CVS.

Yes, lease escalators are in place for everyone. Including the likes of Wal*Mart – and especially CVS and LDG. But all leases that come due each year are backed out of this minimum. Hence, when it all nets out, no retailer should have minimum lease obligations 3-years out that are higher than they are today.

That’s where CVS looks so fascinating. The chart below shows the ratio of year 0 to year3 payments for CVS vs. LDG. As reference, $100 in rent today and $50 minimum in 3 years would equal a 200% ratio. That’s good. Unfortunately, both of these are sitting at about 100%. There are other small format retailers that operate near 100%, so I won’t dwell on absolute levels. But what concerns me more is the trajectory of CVS’ numbers.

Check out my Partner Tom Tobin’s 8/19 post on the secular slowdown in pharmacy revenue. We saw growth in Rx spend per capita peak in 2006, and then trend downward. Tom’s analysis builds a pretty strong case that it will continue eroding from here. Ironic that this is the precise time we began to see CVS’ longer-term rent minimums head higher relative to current payments (i.e. CVS either getting overly bullish or overly scared). Then by the time ’07 rolled around, the ratio continued to drop dramatically to what I’d call an unsustainable level, and CVS went ahead and bought Caremark in a transformational acquisition. Now it is sitting there almost 2 years since the announcement, and it needs yet another margin kicker. L-D-G.

Brian McGough
Director Of Research

Get Ready For A 6-7% Unemployment Rate

Some of the bulls are running around suggesting that this morning’s jobless claims number was "better than expected", c'mon. This week's jobless number of 432,000 ensures that the upward sloping "Trend" in the 4 week moving average continue to move higher.

The 4 week moving average takes out the noise, and this morning's report lifts that average by another 7,000 jobs to 446,000.

We won't see a 6% unemployment report when the August monthly report comes out in 2 weeks, but we will see that print in the fall, then the 7% unemployment rate line comes into play.

The US economy is experiencing stagflation. There are very few winners in this economic scenario. Be careful out there.

PVH: Pulling The Goalie? Initial Take on 2Q

PVH 2H guidance still does not look like a slam dunk to me. The company is in a precarious position right now. I’ll refer, as usual, to my little inventory/margin Quad chart below. This quarter PVH slipped into the zone where gross margins are 184bps higher than last year, but where inventories are outclipping sales growth by 4%. If you check out PVH’s chart over the past few years, you’ll see that when inventories are growing faster than sales, this stock does not go up.

Moreover, the company’s guidance suggests that we need to see a 200-300bp revenue acceleration on a normalized run rate. Yes, we’ll see a ramp in PVH’s new Timberland business, and growth in Izod, but at a combined size of sub-5% of total, they’re still not particularly meaningful. Calvin Klein’s licensing business continues to crank – and I don’t have many concerns there aside from the negative impact of FX that is passed through indirectly to PVH. But let’s remember that ½ of the company’s cash flow is still men’s dress furnishings, which is in the bulls eye of both the negative secular inflection point for margins due to changes in sourcing patterns and global trade, as well as a cyclical hurdle in the form of white collar layoffs (see my prior posts on this relationship ).

With the company beating 2Q by a penney, and deleveraging SG&A by 233bps (more than I suspected) it smells to me like this company could have beat the quarter by much more than it did. That’s a positive in some respects, unless PVH only printed what it had to in order to keep its powder dry to fund an otherwise daunting (or simply unknown) 2H.

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On YUM’s next quarterly conference call, listen for the following items - because this is how management gets paid - (1) EPS growth of at least 10%; (2) system wide unit growth of 1,000 stores and (3) system wide sales growth of at least 3% in the US, 10% at YRI and 30% in China.

Also, let me know if you hear about customer satisfaction within the first 20 minutes of management’s comments.

With those metrics in mind look at the table from the proxy on how YUM senior management gets paid.

(1) Including the leverage factor (not included in the table), EPS growth of at least 10% can account for more than 50% of the bonus.
(2) Referring to my previous post, capital spending as a % of sales has been steadily increasing. This allows the company to open more units, allowing the company to hit another 20% of the performance targets.
(3) A direct result of the aggressive increase in unit openings will be system wide sales growth, allowing management to make 20% of the performance targets.
(4) These three metrics are all management needs to do to get paid millions.

No wonder KFC and Pizza Hut are not going anywhere. There is no incentive for management to improve the operating performance of the company. In light of the poor operating performance in the US, it is very clear why management wants to leverage the balance sheet and reduce the share count by 8%.

As you may have seen, Moody's downgraded YUM’s debt yesterday. In all likelihood, this is due to the increased debt levels and the poor operating performance in the US.

But who cares as management is all but guaranteed to make millions this year.
From the YUM proxy

The Sovereigns

Pay attention to what they do, not what they say…

I feel like I am watching Survivor. Yesterday, it was Goldman cutting estimates on Lehman; this morning, it is Citigroup cutting estimates on Goldman and Lehman; and for the last few weeks we’ve had 9 other analysts cutting numbers on all of these would be financial “innovation” kings. What an embarrassing mess.

Yesterday we called this “Macro Time” and it’s nice to see that Dick Fuld and John Thain are on board with the investment theme. After doing their best to tell us everything other than what we needed to know, these two are flying across the world in a final attempt to sell their wares to Asian governments. Remember Wall Street’s “Sovereign Fund” calling card theme from the “its global this time” 2007 highs? Well, this one is back, in full force.

How do you think this Asian story ends? Thain is cozying up to Singapore, and Fuld is allegedly crawling to the Koreans. That first slug of $5B in stock that Merrill sold to Temasek (Singapore’s Government Investment Company) was in December of 2007, and the latest wet Kleenex MER paper they sold to the folks in ‘Sea Town’ brings Temasek’s ownership close to the 10% line, which requires regulatory approval. The scary part about all of this is that it’s exactly what the investment banks did to the Middle Eastern “Sovereigns” right before oil prices tanked. Trying to plug Asian governments with toxic paper just as Asian economic growth is slowing smells all too familiar.

You see, this entire “liquidity” trade hinges on inflation. There are two interconnected parts to it: 1. Oil and 2. Global Growth. These are primary ways that Middle Eastern and Asian “Sovereigns” get richer. The problem, of course, is that the US government cannot afford importing inflation or devaluing the US Dollar anymore. They can’t afford much of anything really. They need liquidity, and every day that Oil declines or Global Growth slows further, the “Sovereigns” have less of it to give.

Don’t worry though. Fuld, Pandit, Thain, and Paulson are going to get in a room, close the doors, and hammer this out. Right. Right…

This is why credit spreads continue to widen. The TED Spread that we keep focusing on in the Portal is screaming counterparty risk. The spread between 3 month US Treasuries and 3 month LIBOR this morning has blown out to +113 basis points. Why? Well, Asian markets are telling you that they don’t like the smell of Fannie or Fuld’s paper anymore. The Asians do in fact have live quotes and charts of FNM and LEH. Now, they too are running for the exits.

We’re short Japan, but we should really be short everything in Asia. This morning China reversed for another -3.6% down day. India broke short term support, dropping another -3%. Stocks from Hong Kong to Thailand lost another 2-3% of their value, and Pakistan has dropped right back into its dark cesspool, falling -6.4% in the last 48 hours. Asian inflation is accelerating alongside social unrest, as Asian economic growth is decelerating.

As Sherlock Holmes appropriately stated, “there is nothing more deceptive than an obvious fact”, and I don’t see any way for the US Financial systems to absorb a protracted global economic slowdown. Not at this juncture at least.

This will crush corporate earnings levered to international growth, but also remove the only liquidity valve that American central and investment bankers have left – the “Sovereigns”. I wrote it on July 31st. I’ll print it again this morning, and tomorrow too. I am 85% in cash, waiting patiently to see this play out.

Good luck out there today,

Fannie (FNM): Where's Paulson's BUY BACK?!?

FNM lost another -27% of its value today. Now we're seeing why credit spreads continue to widen. If Hank Paulson and the US Treasury has Fannie's back, is that clearing price $3/share? Next Support is $3.15.
  • Freefalling Fannie
chart courtesy of stockcharts.com

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