Conclusion:  There is no near-term upside for Burger King Franchisees as the brand is being hit with both weak top-line trends and higher beef costs.  The recent sale of the company has more than angered a number of key franchisees.  Guess what, they want out!


TAST’s Burger King trends decelerated during the third quarter, with same-store sales coming in -3.2% versus -6.1% a year ago.  On a two-year average basis, this implies a 160 bp slowdown from the prior quarter.  And, comparable sales growth continued to be weak in October, -3.5% (relatively flat on a two-year average basis with 3Q10 level). 


Making matters worse for the Burger King franchisee, beef costs were up 17.5% YOY.  Profitability was also hurt during the quarter by the concept’s promotional offerings.  Beef usage was actually up 9.1% YOY due to the increased mix of lower priced burgers.  Given the company’s outlook for comp sales to be down 3 to 4% in FY10 (implies -1 to -5% in 4Q10) and commodity costs at Burger King to be up 4 to 5% in FY10 and up about 3% FY11, there does not seem to be any near-term upside. 


The only seemingly good news for the brand stemmed from Burger King’s breakfast daypart as sales have improved following the concept’s new breakfast offering, supported by advertising.  The results are still early as the new breakfast promotion only launched in mid-September, but breakfast sales have grown to 16 to 17% of sales from 13 to 14%.  The stronger breakfast trends, however, have been offset by continued weakness during lunch and dinner.  That being said, TAST management stated that it remains cautious with respect to a near-term turnaround at Burger King, but they are “hopeful” that they are nearing the bottom of the cycle.



Management highlighted the recent ownership and management changes at Burger King Corporation and said they are awaiting the brand’s new marketing plans.  Specifically, TAST management said they expect Burger King’s new management should be able to revitalize the brand. 



Although the last comment seems to express some level of confidence in Burger King’s new management and the future success of the brand, what followed was less than bullish commentary about the Burger King brand, at least as it relates to its security as a brand within Carrols Restaurant Group, Inc:


“We, as I said are basically a company that is in transition, we recognize that our inventory of business is being a franchisee in the Burger King system and being owner operator of two very vibrant Hispanic brands may appear, and probably is, somewhat unnatural in terms of attracting investors and it becomes a very high priority for us to make ourselves look a little more natural for the investor public and will continue to pursue that possibility. We're very bullish on our Hispanic brand and their ability to provide long-term sustainable growth. “


Given that management thinks they need to make the company “look a little more natural for the investor public,” will pursue that opportunity and is bullish about its Hispanic brands, implies to me that the company would be happy to exit the Burger King franchising business if offered the right price.


These comments also highlight the broader Burger King franchisee community’s anger with Burger King Corporation, particularly as it relates to the company’s recent sale.  Franchisees are fed up!


Howard Penney

Managing Director



November 9, 2010





  • With costs locked in through the 1H of 2011, Warnaco’s management noted that it’s seeing a 6% increase in FOB costs of which 70% have been offset by pricing – the rest is expected to be offset by an increasing mix of international growth and retail sales. While many domestic retailers and brands lack similar growth opportunities, it’s becoming increasingly evident that gross margin expansion is simply not a given in much of retail in 2011.
  • The march towards a merchandising turnaround at Juicy Couture began yesterday with the unveiling of the brand’s new holiday collection designed by Erin Fetherston.  The collection is now available online and includes 11 looks, shoes, evening bags, hats, and jewelry.  Recall that Juicy brought Fetherston in this Spring to jumpstart the brand’s revival.
  • HD content still has a long way to go.  According to Nielsen, although 56% of US households now have at least one HDTV, only 13% of total day viewing on cable and 19% of viewing on broadcast television is “true HD” viewing.  In fact, 80% of broadcasts are still in standard definition. 



UA Nabs Brady - Under Armour has a new big-name endorser in the NFL, the company announced Monday. The Baltimore-based brand signed a multiyear deal with quarterback Tom Brady of the New England Patriots. Under the agreement, Brady will wear the brand’s apparel and footwear for training, as well as debut a customized Under Armour cleat in upcoming games. He will also receive an undisclosed amount of stock options. As a three-time Super Bowl champion, MVP and holder of several NFL records, Brady is the firm’s highest-profile spokesperson to date. “Tom Brady represents a lot of what Under Armour is all about,” founder and CEO Kevin Plank said in a written statement. “He’s humble and hungry and continues to be focused on winning and getting better every single day.” <WWD>

Hedgeye Retail’s Take: Big win for UA - kudos for successfully extracting Brady from Nike’s stable. Without knowing the terms of the deal, tough to say just how dilutive it will likely be in the near-term, but the move is consistent with what management said it would do as well as what the company should be doing at this stage of its growth. Expect marketing highlighting the company’s latest asset in media channels with 8-weeks left in the NFL season – particularly with the Patriots positioned for another post-season run. Keep in mind, however, that if Nike wanted to keep Brady, it would have. It had greater success in selling product around athletes that were lower-profile and not married to supermodels -- -but simply had more edgy off-field personas. This will be interesting to watch.


CK Opens First Pop-up in Tokyo - Calvin Klein has a new home in this city- at least for the next 13 days. The company opens today its first ever multi-brand pop up shop on Cat Street, a trendy shopping strip that intersects tony Omotesando Ave. The more than 1,600-square-foot-space, carries a mix of Calvin Klein Collection, Calvin Klein Jeans, Calvin Klein Underwear, Calvin Klein Home and a series of limited-edition ck Calvin Klein gold products. It will go dark Nov. 22. The entire Calvin Klein crew and soccer star Hidetoshi Nakata, who is also starring in the brand's underwear campaign, descended on the luminous white store to host an opening party Tuesday night. Tom Murry, president and chief executive officer of Calvin Klein, said the company is using the store to gauge the “interest level” for the top-tier Collection business. The company has been looking to reintroduce the designer brand to the Japanese market for a few years and Murry reiterated that he hopes to open a flagship store and shop-in-shops here in the near future. A Tokyo Collection store, operated by Onward Kashiyama, shuttered several years ago and the pop up boutique is currently the only place to buy the luxury collection in the country. Overall, Murry said the Japan business, which includes ckCalvin Klein and jeans, is faring relatively well. Although Japan accounts for only $200 million of the company’s $6.5 billion in turnover, the executive stressed the importance of the market, which is Calvin Klein's oldest outside the U.S. He said the men’s business never really slowed down- despite the recession- and women’s sales are showing signs of recovery. <WWD>

Hedgeye Retail’s Take: With a concentrated department store base more similar to the U.S., Japan makes a lot of sense for the brand. Moreover, given Warnaco’s comments earlier today, the rate of growth expected for the brand in China should help to drive greater awareness of the brand in across the far east.


Deckers Sues Bearpaw - Deckers Outdoor Corp. filed suit in United States District Court in the Central District of California against Tom Romeo and Romeo & Juliette, Inc. d/b/a Bearpaw, Inc. seeking a Court order to stop them from copying the trade dress design of several UGG boots. According to Angel Martinez, Deckers Chairman and CEO, in a statement, "UGG Australia's success has fueled an entire industry of knock-off products like Bearpaw. Bearpaw is misleading consumers and creating significant brand confusion by repeatedly copying our designs, but using inferior materials, constructions and craftsmanship." <WWD>

Hedgeye Retail’s Take: These knock-off lawsuits are rarely pursued given the associated cost and lack of timely resolution. However, a quick look on Zappos demonstrates the fact that Bearpaw’s boots sell for half the price of a comparable Ugg boot with little else differentiating the two. Even the size and positioning of labels make the cheap alternative a near ringer for the original. Recall that the “knock-off” bear case on DECK has been in existence Uggs made Oprah’s list of must haves.


Hermes Raises Full-Year Forecast - Hermes International SCA, the French luxury-goods maker in which LVMH Moet Hennessy Louis Vuitton SA holds a stake, raised its full-year revenue forecast after third-quarter sales jumped 31 percent. Revenue may climb around 15 percent in 2010, excluding currency swings, assuming that “solid” sales growth continues in the fourth quarter, Hermes said today in a statement, revising an Aug. 31 forecast of 12 percent growth. Sales increased to 590.1 million euros ($818.4 million) from 452.1 million euros a year earlier, the Paris-based company said. Hermes’s sales of leather goods rose 32 percent as more shoppers in Asia picked up handbags such as the company’s Birkin model. Sales of luxury goods may climb this year to the highest level since 2007 after the worst year on record, consulting firm Bain & Co. estimates. Revenue at PPR SA’s Gucci Group rose 27 percent in the third quarter and sales of fashion and leather goods at LVMH rose 26 percent. <Bloomberg>

Hedgeye Retail’s Take: Consistent with stories of out-of-stocks and supply shortages in the super-luxury segment, Hermes demonstrates the resiliency in the luxury sector.  Good time to take the trade for LVMH, but somehow we doubt this is merely a short-term investment.


Zegna Breaks Into e-Commerce - On Dec. 9, the men’s wear brand will launch an online store operated by Yoox that will offer both the firm’s signature line and Zegna Sport collections, targeted to a younger customer. The Z Zegna line is already available at, a virtual mall also operated by Yoox. The new online shop “represents a natural evolution of the brand, in addition to being the very first step in our second century of history,” chief executive officer Ermenegildo Zegna told WWD. Zegna is marking its centenary this year. The opening of e-commerce is part of the company’s “new digital strategy, with the purpose to increasingly connect with customers through Web marketing, interactive technology and social media,” said Zegna. The executive noted the company will thus “be able to open up to a new kind of customer, conquering another market segment, in addition to providing an additional service to our existing customers. I believe digital marketing is a substantial pillar of our brand strategy, one we cannot disregard.” While Yoox operates the back end, the brands control all communication strategies, creativity, product, pricing, marketing, events and special content, and maintain a direct dialogue with customers, said Marchetti. <WWD>

Hedgeye Retail’s Take: When your brand waits over a decade to launch e-commerce, it become newsworthy.  Good news for Zegna fans. 


NBA Store to Close on Fifth Avenue Citing Higher Rents - The NBA Store plans to close in late February, a victim of rising rents. The building that houses the store, at 666 Fifth Avenue and 52nd Street, was sold in 2007 for $1.8 billion, the largest single-building sale in the city’s history. Of the 85,000 square feet of retail space in the building, the NBA Store occupies 35,000, with 16,000 used for selling. Other tenants — Brooks Brothers and Hickey Freeman — departed in 2009. Real estate experts said retail space at 666 Fifth Avenue and buildings in its vicinity command some of the highest retail rents in the city. According to Jeffrey D. Roseman, executive vice president and principal of Newmark Knight Frank Retail, ground floor rents on Fifth Avenue start around $2,000 per square foot. According to experts, rents along Fifth Avenue between 49th Street and 59th Street rose 15 percent since the spring. The space the NBA store inhabits is expected to be priced around $2,200 a square foot, sources said. Uniqlo is taking over Brooks Brothers’ 90,000-square-foot space. The Japanese retailer set a record when it agreed to pay $300 million in rent over 15 years. A Hollister Epic flagship is also slated to open in 20,000 square feet of the former Hickey Freeman space. The NBA Store opened in 1998. “It does not make economic sense for us to remain in the current location given the increased rent,” said Linda Choong, senior vice president of global retail development at NBA. “We are actively pursuing a new location in New York City. We are also considering a temporary store location during the build-out process.”

Hedgeye Retail’s Take: At a $2,200 per foot asking price, there’s no question the NBA can find better value somewhere else.  Perhaps we also see a stepped up effort between Champs/NBA/Adi to bridge the gap during the transition to a new location?  The Footaction store on 34th St. (near MSG)  is a prime spot for an upgrade to an NBA theme. 


Mobile Web Penetration Grows Among College Students - While most children and teens still rely on feature phones, college students have graduated to the world of mobile internet devices—including smartphones, tablets and mobile game consoles. According to the “ECAR Study of Undergraduate Students and Information Technology” by Shannon D. Smith and Judith Borreson Caruso for the EDUCAUSE Center for Applied Research, 62.7% of US undergraduates surveyed had an internet-capable handheld device. That number fell about halfway between the 83.8% who had a laptop and the 45.9% with a desktop PC. Ownership of internet-enabled handheld devices increased by more than 11 percentage points between 2009 and spring 2010, with the number of students planning to purchase such a device in the next year holding steady. The study was fielded before the release of the iPad, which many students expressed a specific interest in purchasing. <emarketer>

Hedgeye Retail’s Take: Hmmm.  College kids use smartphones?  No kidding.   They also text and Tweet (excessively).


R3: WRC, UA, LIZ, DECK - R3 11 9 10


The President Talks FDI with India - Obama, here on a visit to talk up economic cooperation and trade between the two countries, has joined the chorus of those pressuring the Indian government to loosen rules on foreign direct investment in retailing. Currently India restricts overseas firms to 51 percent ownership of single brand stores, meaning they need a local partner. Foreign companies can own 100 percent of cash-and-carry stores, but these can sell only to other retailers and businesses, not to the general public. Multibrand retailing is forbidden in India — which blocks the likes of Wal-Mart, Carrefour and Tesco from entering the market. The rules are seen as protecting India’s thousands and thousands of small independent shopkeepers. Addressing business leaders, the commerce minister of India, Anand Sharma, and planning commission deputy chairman Montek Singh Ahluwalia in Mumbai over the weekend, Obama said, “Here in India, many see the arrival of American companies and products as threats to small shopkeepers and to India’s ancient and proud culture. But these old stereotypes, these old concerns ignore today’s reality.” Given the potential of the market, global brands are eager to see the removal of any barriers to their entering India. The Indian retail market ranks as the fifth largest retail destination in the world, according to the India Retail Report, and is expected to quadruple in size by 2025. Estimated at $511 billion in 2008, the retail sector is forecast to grow to $833 billion by 2013 and $1.3 trillion by 2018. And yet only about 5 percent of the Indian retail market is in the organized segment. Just weeks before Obama’s visit, Wal-Mart chief executive officer Mike Duke spoke about FDI in New Delhi. “Our desire is to certainly see a 100 percent opening up of FDI in the retail sector,” he told reporters. “We’re in India because of the size of the population as well as the aspiring middle class that is willing to spend.” <WWD>

Hedgeye Retail’s Take: The key here is that just 5% of India’s retail distribution is organized.  Yes, that means that almost $500 billion in retail sales are transacted via independent, small shops and stalls.  Even with FDI passed, it will take a long time for modern, multi-branded retailers to make meaningful inroads. 


Sourcing Relationships Change With the Times - In the new dynamics of global sourcing, partnerships are in and skipping around the globe is out. But maintaining a real business relationship — one where brand and factory understand each other’s needs and problems and allow for give and take in timeworn practices — will require a bit of care and attention. “When is the last time you guys took a box of chocolates to your vendor? Never,” Munir Mashooqullah, principal and founder of Synergies Worldwide, said at the WWD Forum, “Global Opportunities: Sourcing & Supply Chain.” “It’s an exception.” Today, he said the business is a “price-point game” where cotton prices, currency fluctuations, tight credit, even natural disasters, can affect how much products cost, as well as how fast they arrive. “We talk about partnership, but we really have not been partners,” Mashooqullah said. “We’ve treated vendors like a slave constituent and that time has gone.” In order to build relationships, Mashooqullah said companies should research and understand their vendors’ businesses and avoid “low-balling” them. Given the continuing consolidation of global apparel production, brands are finding it’s not as easy to pack up shop and move to another factory or another country with lower costs, in part because there are fewer new producers opening up. Sukumaran said the partnership model is the only one that is sustainable in the long term because it is focused on meeting customers’ needs. “The past is no longer a guide to the future,” said Chris Koh Lian Chye, business director at SL Ponie Pte. Ltd. The buyer needs to stop moving to countries where labor is just cheap, and instead should also consider countries where the political, economic and cultural climate is stable, he said. <WWD>

Hedgeye Retail’s Take: There is a clear shift that’s developed between brand’s focus on quality of relationship instead of solely on price. With a multitude of macro factors becoming more commonplace in the today’s market in addition to increased competition over top suppliers, we expect the shift towards a more collaborative dynamic between brands and factories to be more lasting than fleeting in nature.


Consulate-General of Pakistan pays visits to Wenzhou - Pakistan’s Consulate-General Zafar Hasan has recently led a group of leather footwear manufacturers to meet up with Wenzhou city Mayor Meng Jianxin in Shanghai. The purpose of the meeting is to seek cooperation on leather and footwear industry between Wenzhou and Pakistan. According to Hasan, Pakistan is the country known for its leather and leather goods production, with 40% of leather shoes being sold in Pakistan are made in China. He invited Wenzhou footwear producers to take part in the Pakistan Trade Expo to be held the coming February. Wenzhou has many shoemakers and tanneries, and there is a large room for bilateral cooperation between the two countries’ leather industry, said Mayor Mang. <FashionNetAsia>

Hedgeye Retail’s Take: Collaboration among leading export countries suggests further evidence that price disparity will be less important relative to the strength of foreign brand relationships with leading factories in the far east as borders become less defined.


Sri Lanka Taking Clean/Green Approach - Sri Lanka’s apparel sector has broadly adopted cleaner production methods and currently has been marketing its products under the slogan "Garments without guilt", according to the country’s foreign secretary Palitha Kohonain. According to Kohona, sustainable development means to attain sustained economic growth, which is socially just and ecologically sound as well as based on harmony and stability. Pertaining to this, the National Council for Sustainable Development (NCSD) has been formed in collaboration with all line Ministries, under the “Haritha Lanka” (Green Lanka) Program which puts  emphasis on energy, climate change and other environmental aspects. <FashionNetAsia>

Hedgeye Retail’s Take: With many of the leading export countries facing increasing scrutiny over tannery operations and its recent shift towards a textile economy, Sri Lanka makes an admirable stab at gaining share by targeting the increasing clean/green movement.



Sheldon likes it, while WYNN prefers profit share. MGM and MPEL should embrace it.



With SJM reporting, all the data is in.  The first chart shows quarterly Macau EBITDA market share by quarter.  We started looking at EBITDA share a few quarters ago when many thought rising commissions would eat into profits.  That really hasn’t happened.  In the second chart, one can see that with the exception of Wynn, every company increased its property level EBITDA sequentially in Q3, and Q3 EBITDA exceeded Q1 EBITDA in each case.


LVS dominates the EBITDA share discussion, which is probably why Sheldon Adelson is a huge proponent of this metric.  With low leverage, Steve Wynn likes to focus on profit share.  Hold percentage certainly impacts revenues and profitability, but the two newest EBITDA share champions could be MPEL and MGM.  Absent the hold impact, both of these companies are probably EBITDA share gainers going forward. 


MACAU EBITDA SHARE - macau property


MACAU EBITDA SHARE - macau property 2

Early Look

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Relied upon by big institutional and individual investors across the world, this granular morning newsletter distills the latest and most vital market developments and insures that you are always in the know.


TODAY’S S&P 500 SET-UP - November 9, 2010

As we look at today’s set up for the S&P 500, the range is 35 points or -1.98% downside to 1199 and 0.88% upside to 1234.  Equity futures rebound from lows to trade modestly above fair value, tracking numbers such as Tyco, reporting Q4 EPS $0.74 ex-items vs Reuters $0.66, and updates across European companies. In economic data today: Redbook Chain Store, Sep Wholesale Inventories and ABC Consumer Comfort Index.

  • Allscripts Healthcare Solutions (MDRX) posted 3Q adj. EPS 19c vs est. 17c
  • American Public Education (APEI) reported 3Q EPS 30c vs est. 29c
  • Boeing (BA) said Saudi Arabian Airlines ordered 12 Boeing 777s in a contract valued at $3.3b
  • Clear Channel Outdoor Holdings (CCO) reported 3Q rev. $695.1m vs est. $698.4m
  • Emdeon (EM) said it sees 2010 rev. at low-end of $1.0b-$1.06b range vs. est $997.9b
  • EnerNOC (ENOC) sees 4Q rev. $20m-$24m vs est. $28.8m
  • Genomic Health (GHDX) posted 3Q EPS 12c vs est. <1c
  • Hologic (HOLX) sees 1Q adj. EPS ~28c vs est. 31c 
  • Keynote Systems (KEYN) boosted Q dividend to 6c-shr from 5c-shr
  • McDermott International (MDR) reported 3Q adj. EPS ex-items 44c vs est. 28c
  • (PCLN) forecast 4Q adj. EPS $2.91-$3.06 vs est. $2.68
  • Rackspace Hosting (RAX) reported rev. $199.7m vs est. $197.6m
  • SciClone Pharmaceuticals (SCLN) boosted 2010 EPS forecast to 41c-46c from 31c-35c; says it expects “substantial expenses” in connection with previously disclosed SEC, DoJ probe
  • Warnaco (WRC) raised FY adj. EPS forecast to $3.45-$3.55 from $3.40-$3.50, vs est. $3.53


  • One day: Dow (0.33%), S&P (0.21%), Nasdaq +0.04%, Russell +0.02%
  • Month-to-date: Dow +2.59%, S&P +3.38%, Nasdaq +2.9%, Russell +4.75%
  • Quarter-to-date: Dow +5.74%, S&P +7.19%, Nasdaq +8.93%, Russell +8.97%
  • Year-to-date: Dow +9.39%, S&P +9.7%, Nasdaq +13.7%, Russell +17.81%
  • Sector Performance: Energy +0.34%, Materials +0.24%, Tech +0.05%, Consumer Discretionary (0.13%), Telecom (0.28%), Consumer Staples (0.29%), Healthcare (0.3%), Industrials (0.33%), Utilities (0.62%), and Financials (0.77%)
  • MARKET LEADING/LAGGING STOCKS YESTERDAY: Coventry Health +6.63%, JDSU +4.91% and Halliburton +4.73%/NY TIMES -4.93%, Micron Tech -4.68% and Anadarko -4.29%.


  • ADVANCE/DECLINE LINE: -238 (-749)  
  • VOLUME: NYSE: 909.45 (-26.86%)
  • VIX: 18.26 -1.40% - YTD PERFORMANCE: (-15.77%)
  • SPX PUT/CALL RATIO: 1.62 from 1.73 -6.41%  


  • TED SPREAD: 17.10 -0.406 (-2.319%)
  • 3-MONTH T-BILL YIELD: 0.13%
  • YIELD CURVE: 2.19 from 2.20


  • CRB: 315.25 +0.54% - up 10 of last 11 days
  • Oil: 87.06 +0.24% - BULLISH - up 6 straight days
  • COPPER: 395.65 +0.20% - BULLISH  - up 5 of the last 6 days
  • GOLD: 1,405.13 +0.63% - BULLISH


  • EURO: 1.39.41 -0.65% - BEARISH - looking to be down for 3 days in a row
  • DOLLAR: 77.027 +0.63%  - BULLISH



European markets:

  • FTSE 100: -0.43%%; DAX +0.69%; CAC 40 +0.74%
  • European markets, after a mixed open have moved higher to currently trade near session highs.
  • A positive response to corporate results from Barclay's and Vodafone outweighed continuing worries over the “burning” peripheral Europe, with peripheral debt spreads widened.
  • All but two industry groups trade higher with construction, basic resources and banks the leading gainers.
  • Healthcare and financial services trade lower.
  • UK Sept Manufacturing production +4.8% y/y vs consensus +4.9% and prior revised to +6.1%
  • UK Sept Industrial production +3.8% y/y vs consensus +3.5% and prior revised to +4.3%
  • Germany Oct Final CPI +1.3% y/y vs preliminary +1.3%
  • France Sep Industrial Production at 04:30 ET  

Asian markets:

  • Nikkei (0.4%); Hang Seng (1.0%); Shanghai Composite (0.8%)
  • Asian markets ended the day mixed.
  • Tech stocks retreated on earnings concerns, but South Korea edged up.
  • Japan retreated on profit-taking and a stronger yen.
  • China fell on fears that higher inflation may lead to further monetary tightening as the central bank surprised people by auctioning one-year bills at a higher yield than last week.
  •  Japan September current account surplus ¥1.960T vs survey ¥1.664T.
  • Japan October M2 +2.7% y/y. 

Howard Penney
Managing Director

THE DAILY OUTLOOK - levels and trends














The Macau Metro Monitor, November 9th, 2010


According to The (Sri Lanka) Sunday Times, the Sri Lanka government will legalize casinos and betting centres throughout the country despite criticism from the clergy and opposition political parties.  The new law is now before Parliament for approval.  The bill is to be enacted on January 1, 2012.



According to Securities Times, sources say the Chinese government is drafting rules that will allow local authorities to place a cap on the selling prices of homes and developers' profits if prices get out of control.

Europe’s Crisis in Confidence

“I work all the time. I sometimes take the liberty of looking at a beautiful woman’s face. It’s better to be passionate about beautiful women than gay men.”

-Silvio Berlusconi, 11/2/2010


If the quote above didn’t get your attention this morning, we’re not sure what will. What has been getting our attention over the last few weeks is heightening risk across Europe, especially in the region’s peripheral countries of Portugal, Ireland, Italy, Greece, and Spain, affectionately named the ‘PIIGS’.  This inflection in risk, which we’re measuring via government bond yields and CDS spreads, has re-emerged following a reduction in risk in the month of September and most of October.


We believe that this rise in risk is a reflection of the Crisis in Confidence, namely the continued inability of Europe’s peripheral governments to instill investor and public confidence that they can cut bloated fiscal imbalances and resolve internal political disunity.


Currently, Italy’s PM Berlusconi is the region’s poster child for this renewed Crisis in Confidence, including his latest scandal surrounding an 18-year-old belly dancer that he allegedly gave €7K to and helped free from a theft charge. Elsewhere, poor leadership in Europe, from Greece, Portugal, Ireland to Hungary and Romania, continues to propel market risk upward. Interestingly, economic indicators reveal that current levels of risk, in particular in Ireland and Portugal, resemble levels last seen shortly before Eurozone finance ministers were forced to issue a €110 Billion bailout for Greece on May 2, 2010 and days later, along with the IMF and World Bank, a €750 Billion package to rescue troubled European nations. 


Given this risk inflection in Europe, we took the explicit tact to short the EUR-USD via the etf FXE in the Hedgeye Virtual Portfolio on 11/3/2010 with the currency pair trading at our immediate term TRADE resistance level of $1.42. (From here we see TRADE support at $1.39 and intermediate term TREND support at $1.33). While we’re cautious on the region as a whole, we are positioned long Germany via EWG (bought on 11/8/10) and remain short Italy (EWI) as a way to play the developing Sovereign Debt Dichotomy.  Below we highlight the risks we see mounting and elaborate more on our positioning given the region’s outlook.


Risk is ON!


While the excessive public deficit and debts of the PIIGS are well understood by the capital markets, we believe that the recent heightening in the risk trade is a reflection of the perceived threat that these countries will NOT be able to meet their targeted debt and deficit reduction plans via austerity alone. While Greece was the first to report that its 2009 deficit must be revised up to 15.1% of GDP from 13.8% and debt to 127% of GDP versus a previous calculation of 115.1%, we don’t think it will be the last country with upward revisions.  But if you don’t want to take our word for it, the hockey stick curves in the charts of both government 10YR bond yields and sovereign CDS spreads (see chart below), might convince you that the market is pricing increased risk ahead.


Europe’s Crisis in Confidence - ell1


Europe’s Crisis in Confidence - ell2


It’s worth noting that the slight decline in Greece’s 10YR yield over the last days is a reflection of the support PM Papandreou’s socialist Pasok party got over the weekend in local elections. Despite the victory, we still believe there is a void of confidence in Greek leadership from a domestic and international perspective.  Also, we’d note in the CDS chart that the 400bps line has been an important indicator for us as a breakout line. Clearly, Ireland and Portugal are treading dangerously above this level.


As we’ve shown in our research since 4Q09 when we started to track Greece’s rising risk premium, Europe’s periphery has wholly “earned” its reputation: after pigging out on low interest rates for nearly a decade, many countries (and in particular Spain and Ireland) continue to deal with the flip side of that leverage coin in the form of ongoing housing price declines, high unemployment and slack growth.  Now with these governments overextended deficits-- and we’ll use Ireland as an example with a deficit/GDP ratio forecast to balloon to 32% this year--it’s increasingly clear that despite all efforts by the country to implement another €6 Billion in spending cuts and tax relief, investors aren’t buying a smooth recovery ahead, and rightfully so!  As yields push up so too does the cost of capital which further handcuffs a country’s ability to refinance and raise debt, which in turn snowballs the perceived sovereign default risk.


Finally, as the chart below drives home, the PIIGS are truly running up against a wall of debt, especially next year, compared to their more fiscally conservative neighbors. These are headwinds to keep front and center.


Europe’s Crisis in Confidence - ell3


Pants Down versus Pants On: Short Berlusconi versus Long Merkel


While we applaud countries focusing on trimming fiscal fat now to benefit long-term “health”, there’s clearly near- to longer term downside risk to growth across the region from austerity measures. In particular, we expect to see spending and confidence slow across much of Europe as such austere measures as increases in VAT, wage and benefit freezes, and job destruction impact these economies over the next 1- 4 years. To position ourselves in an environment of Sovereign Debt Dichotomy we’re long Germany (EWG) and short Italy (EWI) in the Hedgeye Virtual Portfolio. Again, here it’s worth considering the leadership differences that weigh on economic performance.


While it’s worth a laugh, and certainly worthy of Page 6 in the NY Post, the scandalous actions of Italy’s PM Berlusconi, including photos of him literally with his pants down at a vacation villa last year, have severe political and economic implications for country. While we’ll spare you the intricate political dealings, Berlusconi’s rule is in checkmate since he expelled his speaker of the Parliament, Gianfranco Fini, back in July. Now Fini, who has enough backers in the legislature to deny Berlusconi a majority and bring down the government, faces his own political impasse. Even if he were to bring a defeat to Berlusconi he would likely be forced into further political gridlock for competing coalition rule. So even in the best case, if there is one, we expect further prolonging of the “paralysis” that is Italian politics. 


With authoritarianism, inefficiency, and back-handedness hallmarks of Berlusconi’s rule, we also worry about the risks associated with the country’s public debt levels.  In 2009, public debt equaled 115% of GDP, the second highest in Europe behind Greece, and the country is rolling up against €500 Billion of government debt maturities (principal +interest) over the next three years--a level equivalent to Germany’s obligations, yet from an economy 1.6x larger than Italy’s. Equally, strong foot power (strikes) against the government’s proposed €30 Billion in austerity cuts remain and the country’s aging population is a longer term headwind worth considering. Statistics show that Italy will have the oldest population by 2015 and 2020 in the Eurozone, with a population >65 at 21.9% and 23.2%, respectively.  So, as Italy’s population ages its government will face increased outlays and reduced receipts, which will add additional economic headwinds.


On the other hand, while the Germans will also have to deal with an aging population, we continue to like the country’s intermediate term set-up. Germany’s growth profile of 3.3% this year and 2.0% next year outperform many of its peer countries, with inflation expected to be around the 2% level, a budget deficit projected around -3.5% of GDP in 2010, and strong export demand from Asia. Of note is the latest export data that shows a monthly increase of 3.0% in September, with sales to Asia 2x that to America.


From a policy standpoint, be it from Chancellor Angela Merkel to Finance Minister Wolfgang Schaeuble or Bundesbank President Axel Weber, the Germans continue to tout fiscal conservatism, most recently running a position to mandate that European states trim deficits to -3% of GDP or better and public debt to less than 60% (the current position of the EU’s Stability and Growth Pact) or else bear a tax (as a % of GDP) for the violation.  We think longer term this could be a viable strategy.


Putting fundamentals aside, there’s a clear divergence between Europe’s fiscally conservative and fiscally bloated counties on an equity basis. Year-to-date equity markets in Denmark and Sweden are up +27.7% and +17.2%, with the German DAX up +14.0%, while the PIIGS are some of the worst performers across all global indices: Greece’s ASE -31.0%; Spain’s IBEX -13.0%; Italy’s FTSE -7.3%; and Ireland’s ISEQ -7.1%. 


This Time Is NOT Different


We continue to note the seminal work of Reinhart and Rogoff, who in their book “This Time is Different”, show historically (across 800+ years) that countries reach a crisis zone of fiscal imbalance when their debt ratio is north of 90% and deficit ratio is greater than 10%. With the PIIGS largely in violation on both measures, the threat of sovereign default remains one to keep front and center.


While the case could be made that countries like Ireland, Portugal and Greece make up too little a share of Eurozone GDP (roughly 6.3%) to drag down the region’s outlook, two points are worth considering:

  1. Greece’s sovereign debt “crisis” in the 1H10 led to a 20% deterioration in the EUR-USD, so small economies can indeed have a significant impact, and
  2. Should Spain and Italy, economies representing ~ 28.7% of Eurozone GDP, run up further against a Sovereign Slide, we could see far greater repercussions for the region as a whole. 

Keep your risk management pants on.


Matthew Hedrick



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