Treasury Supply Set to Increase . . . By Trillions

Conclusion: We believe U.S. Treasury issuance over the coming three years could be ~34% higher than expectations.  Increasing supply is bad for price.


Position: Short Treasuries via the etf SHY


On a very basic level, supply and demand set the market price for any good, commodity, or product that is “traded”.  So, as supply increases, demand must match it, or price will decline.  Obviously in practice, especially when trading the global financial markets, it is slightly more complicated.  That said, large moves in either future demand or future supply still do matter.  As it relates to Treasuries, we believe future supply will be much higher than consensus expects primarily because the U.S. deficit will be higher than expected.


Currently, the Congressional Budget Office (CBO), which we consider consensus for this purpose, projects that the federal budget deficit for 2011, 2012 and 2013 will be $-1,066BN, $-665BN, and $-525BN, respectively.  This is a combined deficit of $-2.3TN.  (Yes, that is a big number.)  So, all else being equal and setting aside any maturities, the United States will have to issue $2.3TN in treasuries to fund the CBO’s projected budget deficit over the next three years.  So if we accept that there is ~$14TN in government debt outstanding (Source:, then the outstanding government debt over the next three years will grow 16%.   That is, supply is going up.  Given this outlook, it does make sense that interest rates on 30-year Treasuries are moving higher, as noted in the chart below.


Treasury Supply Set to Increase . . . By Trillions - 1


Interestingly, we think that the CBO’s budget deficit projections are low, and perhaps meaningfully so. Currently Hedgeye’s U.S. budget deficit projections for 2011, 2012, and 2013 are $-1.2TN, $-1.0TN, and $-0.9TN, respectively.  Combined, this is a total deficit for the ensuing three years of $3.1TN.  In aggregate, our projections are $800BN more than the CBO, or 34% higher for the three year period.  The implication being that the issuance of U.S. Treasuries may be almost 34% higher than “consensus” expects over the coming three years.  No doubt some of this is priced in, but our models have supply growing at an accelerated rate relative to what is likely priced in. And the questions remains, who is going to buy these treasuries?


Increasingly, of course, foreigners will have to buy more Treasuries, which is geopolitical risk for U.S. sovereignty.  We highlighted this risk in an Op-ed to Canada’s Globe and Mail, where we wrote:


“Dependence on foreign oil is a real economic and strategic risk for the United States, but what about the risk related to its dependence on foreign debt financing? The combination of a low domestic savings rates and lack of government savings (that is, a massive deficit) means that the U.S. will continue to rely on foreign financing to bridge deficits well into the future.”


As we reviewed the most recent TIC data, it is clear that the amount of foreign buying is increasing.  In fact, foreign ownership is up 16% y-o-y.  So, which nation is buying all this U.S. debt.  Well, the answer is unclear.  In the chart below, we’ve highlighted the nation that appears to be buying the bulk of his new issuance . . . the United Kingdom.  “UK Holdings” has increased their holdings of U.S. Treasury Securities by $356BN year-over-year, which is growth of 229%! In reality, it isn’t the United Kingdom buying the Treasuries, but other sovereignties buying debt through the United Kingdom.  Most likely the Chinese, who have to continue to buy U.S. dollar paper to maintain their exchange rate at parity.


Increasingly as the U.S. funds its deficit with more Treasury issuance, investors will undoubtedly demand higher rates.  Along with this, if the Chinese are indeed saying one thing, that is questioning the value of Treasuries, but continuing to buy via “UK Holdings” then the global market for U.S. Treasuries becomes even murkier, which can’t be positive for price.


Daryl G. Jones

Managing Director


Treasury Supply Set to Increase . . . By Trillions - 2

JNY Miss: Proactively Predictable


It’s been a while since a miss did not phase me whatsoever.  JNY has been one of our favorite short ideas. But importantly, it is not done. Three considerations…


1)  I’d call this a ‘mini-miss’. Yes, numbers are coming down, but are still based in part on ‘strong brand performance,’ selective price increases, and mid-single digit revenue growth.  Do you want to give them a free pass on that? Be my guess.


2)  There will be another one of these. Keep in mind that JNY values inventory on the lower of ‘cost or market’ and then layers this over FIFO accounting. Translation = gross margin weakness today is using raw materials procured anywhere between 6-12 months ago, and includes ‘rebound demand’ of msd comps.


3)  By mid-year we’ll be looking at ‘normalized’ demand, on top of raw materials being purchased today. Then we get to witness first hand the gong show that ensues as the supply chain beats itself up to protect margin, or find some growth.


The point is that no one should use this as an announcement as an indication of ‘ok, the blow ups are here, now I can selectively buy.’ Quite the opposite. The blowups are here, and will accelerate throughout the year.


Here’s a YouTube of JNY’s guidance today vs. 13 weeks back.


JNY Miss: Proactively Predictable - JNY Youtube 1 11

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Bullish on Brazil (and Other Emerging Markets)?

Conclusion: Much like China and India, we believe the Brazilian central bank will continue to tighten the screws on its monetary policy over the intermediate term. Further, we don’t think a pending slowdown in Brazil’s domestic growth as well as a deceleration in global growth is fully priced into Brazilian equities.


We’ve been getting a lot of questions over the past few weeks asking us whether or not we would like to get long Brazil here. The quick answer is, “no”, largely due to the quantitative setup: Brazilian equities are broken TRADE and are flirting with being broken TREND.


Bullish on Brazil (and Other Emerging Markets)? - 2


From a fundamental perspective, the question remains, "Do you really want to be getting long anything emerging markets right here and now?"


Our answer there is, “no”, as well. We’ve been advising clients to reduce their EM exposure for the last 2-3 months, citing these three reasons: 

  1. Slowing Growth Globally: growth, particularly in the bigger, more meaningful EM driver-seat economies (China, India and Brazil) is likely to slow in 1H11 due to:
  2. Accelerating Inflation Globally: rising inflationary pressures which will beget tightening of monetary policy and cause:
  3. Compounding Interconnected Risk: global EM redemptions are likely to accelerate as funds managers decrease their beta exposure due declines in the “Big 3” (China, India and Brazil) EM equity markets. Rising volatility and accelerating muni market risk in the US won’t help either. Don’t forget the structural issues associated with Europe’s PIIGiesS can’t be covered up by piling on more debt, irrespective of declining yields at recent auctions. No one ever beat a drug addiction by getting more drugs at lower prices… 

The real question investors should be asking is: “What’s an emerging market equity worth if topline growth is decelerating due to slowing GDP growth and margins are compressing due to COGS inflation?” Probably the same as a domestic equity is worth with the same setup = less.


The bullish storytelling about buying Brazil or other EMs on the pullback(s) lies in the hope that earnings growth could be maintained as rising costs are passed through to consumers. A handful of recently-ousted Tunisian and Indian officials will advise against that.


Moving back to Brazil, as we expected, new Central Bank President Alexandre Tombini hiked the benchmark Selic rate +50bps on Wednesday to 11.25%. The language within the associated press release signaled to investors that Brazil may be less hawkish on the margin with respect to raising interest rates, which are now the highest real interest rates in the G20.


Bullish on Brazil (and Other Emerging Markets)? - 3


We caution, however, that this is not a buying opportunity. The bank reiterated that it will remain steadfast in containing the “surge in consumer credit” via “macro-prudential measures” (i.e. reserve requirement hikes, etc.) to get inflation back in line with their target of +4.5% YoY. To a small extent, the measures have been effective in boosting the cost of capital throughout the economy: average consumer loan rates rose in December for the second consecutive month to 6.79% vs. 6.74% in November.


They’ll will need to hope their “macro-prudential” measures increase in effectiveness because we don’t see inflation in Brazil as an issue that is going to be solved with Wednesday’s +50bps rate hike and a +5bps backup in consumer borrowing rates. Further, efforts to prevent the real from appreciating (three measures in the last two weeks alone) only reduce the effectiveness of any tightening of monetary policy.


Both the market and the “economists” see it our way as well: investor expectations for Brazilian inflation over the next two years, as measured by the breakeven spread between Brazil’s inflation-linked and fixed rate bonds, rose to +6.5% – the highest since November 2008; a survey of economists regarding Brazil’s 2011 inflation rate rose for the sixth straight week last week, climbing to +5.42% vs. +5.34% prior.


In summary, much like China and India, we don’t think the Brazilian central bank is done tightening the screws on its monetary policy over the intermediate term. Of course, the question then becomes, “When is that all priced in?” Judging the by the first chart above, we’d posit there’s more pricing in to be done.The Ber-nank may be able to trick US investors by inflating domestic real GDP growth by understating CPI, but the rest of the world isn’t buying the hoax. Inflation kills emerging markets.


Don’t be swindled; have a great weekend.


Darius Dale


The Golden Arches are still infallible in the eyes of the sell-side.


Whenever you find yourself on the side of the majority, it’s time to pause and reflect.

-Mark Twain


A week ago, I held a conference call on MCD and the lofty expectations that I feel the company is unlikely to meet in 2011.  The Black Book I published that day detailing my thesis kicked off with a Mark Twain quote.   I think another of his quotes, above, would have worked equally well.  The Street adores MCD and is not keen to attach any real conditions to that affection.


In the days following my bearish conference call with clients I have heard plenty of push-back.  Having had time over the past week to think through my thesis further, my confidence in my thesis is high.  Several positive sell-side notes have helped bolster the price this week; to be clear, my call is for MCD to miss investor expectations from a sales and margins perspective for the year 2011.  I would like to take a few of the key points the bulls have made and address them.


In no particular order:


Bull case: MCD can pull the trigger on price increases in 2011, giving significant resilience to comparable restaurant sales growth.


Hedgeye Thought:  MCD has held back on price increases during 2010 and the value proposition that the chain offers is a large part of its success.  Given the outlook for the U.S. consumer in 2011, I would be less-than-confident in MCD’s ability to take pricing without significantly impacting traffic given the fragile nature of the U.S. economy’s “recovery”.   In addition, increased prices will only drive more consumers to the $1 menu, which is an unprofitable proposition.  Housing headwinds and anemic job growth, coupled with rising costs, will pressure the consumer this year.



Bull case: MCD benefits in times of rising food costs.   There is a 0.45 correlation between at-home inflation and fast food traffic. 


Hedgeye Thought:  First of all, I would be hesitant to wager too much on a correlation of 0.45.  Rising costs are a problem for the MCD system.  I am including a chart of beef, below, and one can clearly see the parabolic year-over-year move that QSR chains are enduring at the moment.  Without a doubt, the franchise model insulates shareholders somewhat from this risk but ultimately, with franchisees competing with other restaurants for value-seeking customers, the cost will have to be passed on to customers – many of whom are feeling a similar squeeze in terms of inflation (gas, education, food, clothing).  The reality is top line trends and input costs cannot be considered in isolation of the other.   I am not sure the MCD customer is ready for a price hike at this point. 


MCD: STREET IS LOVIN’ IT - beef costs


Bull case: New menu items will continue to drive sales at MCD and they will easily gain leverage and offset cost increases.


Hedgeye Thought:  In the Hedgeye MCD Black Book, published last week, I discuss the over-complication of MCD’s menu and the knock-on impact on operations.  This morning, a note published by Janney Montgomery, albeit with a “Buy” rating, detailed a survey of franchisees with some interesting commentary pertaining to the menu.  One question was “Is the menu overly complicated?”  While some of the answers cited expressed no desire to reduce or simplify the menu, the vast majority expressed an emphatic view that the menu was not only confusing customers, but also confusing employees and compounding operational difficulties.  The development that franchisees are facing increasing costs and conflict with Oak Brook is not positive for MCD.



Bull case: Inflation may be an issue, but it’s a sum zero game and competitors will likely take price before MCD, allowing them to take more price and drive same-store sales.


Hedgeye Thought:  That may be true conceptually but, absent any magic tricks; MCD cannot persuade consumers to keep paying for smoothies, frappes and lattes at higher prices.  As I illustrated in my Black Book published last week, frappes and smoothies accounted for more than 100% of same-store sales growth in 2Q and 3Q, respectively.  As prices are increased, consumers will purchase less of these discretionary items.  In 2011, this would mean pressure on margins year-over-year given that beverages are higher margin products than more staple products such as burgers.  With a complicated menu creating operational inefficiency, an increase in customer focus on low average check items will not help franchisees’ profitability.  Other “margin enhancing” initiatives being touted by many on the sell-side are also unproven at best.  24 hour restaurant openings, in particular, is not a new initiative and an idea I am less-than-convinced about.  BKC did not find this initiative accretive to their earnings.


Howard Penney

Managing Director

Company Insights from ICR Conf

As a follow-up to yesterday's industry insights from ICR, here are our company specific notes from the event. Please give us (or ) a shout if you’d like to discuss.






Cost Inflation:

  • Still too early to tell if they will be able to completely offet
  • See HSD increases as the peak
  • Key offset to cost inflation is markdown management - faster reaction increases turns = max gross profit $$
  • Keds most exposed brand (canvas) with 7-8mm  of ~195mm pair in total annually


  • Expressive consumer still larger portion of business than more cost conscience customer
  • Focused on hitting trends for expressive customer and driving price to offset lower end
  • At this point, a return of the lower end consumer would be gravy


  • ROST and TJX have offered lower price offering at times but not consistently
  • Have stopped trying to compete at the very low end - hurt them in early 2010

Gross Margins:

  • Engineer down to the material level to manage cost
  • Size Assortment Matrix (SAM) - key process used to decide whether to include tail sizes (beyond core sizing) for new styles + colorways to increase turns
    • At most Payless locations now shifting to implement at Stride Rite retail

Capital Spending:

  • Expect 2011 capital allocation to reduce debt to be ~1/3 of EBITDA consistent with recent years


  • Sperry - women's segment now as big as men's
  • Have reduced door count by 1000 doors while growing retail driving gross margin expansion
  • Likely to add another 10 stores this year
  • Not sure where ceiling is for stores beyond 50


Cost Inflation:

  • HSD, LDD price increases in 2011
  • Will continue to operate under the same margin requirements
  • Labor accounts for 25-30% of cost of shoe
  • Don't expect cost inflation to impact GMs in 2011 due to ability to pass through

Gross Margins:

  • Could see margins dip below 40% depending on how fast they can sell through overhang - but only for short periods of time


  • Still source 90%+ in China and expect to maintain that level near-term rather than shift like rest of industry


  • All core backlogs are positive, with mens and kids showing the most strength.
  • Women's SRR selling better than men's
  • Kids "on fire"
    • ~$300mm worldwide
    • Priced at the higher end
    • Accounts for ~20-25% of sales
    • Doing more business with FINL than in years past


  • Toning sales 50-75% the size of U.S. at peak

Marketing Spend:

  • Q2 & Q3 largest qtrs in terms of spend


  • <10% of sales
  • Did very well in Q3 & Q4

European Weather Impact:

  • Didn’t see material slowdown others have highlighted (boot sales offset declines in other categories)

Technical Athletic Launch in 2011:

  • July/Aug launch - first at SKX retail then at wholesale 4-6 weeks later
  • Lightweight running first test of $100+ product post toning – will also offer $70 entry point
    • Believes toning success gave brand confirmation/right to sell through premium priced product

DC Update:

  • Transition expected to take place in Q4 2011 - will store product in new facility starting in April/May
  • Expect to be shipping out of by the '11 holiday


  • Seeing new store opportunities for LIDS up to 1100-1200 locations domestically – not anchored to malls (i.e. ski slopes)
  • LIDS Locker Room concept born from Sports Fanatics acquisition/added capability adds opportunity for ~500 locations
  • Has been comping nicely
    • In-store embroidering capability a key sales driver
    • Adds ~8% to sales
    • Roughly 50% of stores have capability
  • Building Lids Team Sports concepts closely with NKE
  • NKE is well penetrated with top 100, but very little exposure to smaller teams both College and HS at the local level - GCO offers that oppy.
    • Most players in this space private players, Nike ramping efforts aggressively will have product/blanks that can be customized
  • Also issued 5-year financial targets


  • For the last several weeks men's footwear has outperformed women's
  • SKX did their homework in evolving the toning brand – like the evolution of product will continue to support
  • the Big Deal promotion has regularly been 12% of total sales for at least the past year.
  • Will have a mobile transaction system implemented by end of Q1
  • Capacity is freeing up as demand for toning shoes rolls over.


  • Int'l a key growth opportunity - only 5% of total sales
    • Currently $31mm in sales via distribution agreements - goal to get to $100mm+ by 2012
    • 7 new brands added since 2009 should grow to ~$150mm over next 3-years from $50mm currently
    • Fixing direct retail a key initiative with goal to get to 10% EBIT margins by 2012
    • e-commerce only accounted for $22mm in sales LTM (<4% of sales)


  • Goal to reach $2Bn in sales by 2015
    • Int’l be 40% of rev. by 2015
    • Marketing currently only 2% of sales, will be increasing UGG marketing spend by 1.5% of sales in 2011
    • Men's business a key initiative: Pilot program in U.S. for 2011 launching in Q4 (Tom Brady endorsement)
    • Stores expansion - 260 by end of 2011 - vs. ~180 at end of 2010Business very strong
    • 5-10% growth in raw materials
    • Shift to men’s on the margin
    • Tom Brady….ugg! Now’s he’s wearing UA AND Ugg. That’s a first…
    • SIGMA not looking good. Actually, it looks bad.


  • Core product now accounts for only 10% of revs
  • Excited about new technology in ’11, with emphasis on lightweight product.  5 crocs chuck taylor-like shoes equal weight of one original converse version.
    • Dual injection with both softer and harder material for increased durability
    • Expect the company to continue to operate under one brand.  Believes DECK is a great company to emulate.
    • Likely to see rollout of Jibbitz by Crocs at TGT.  $14.99 price point using molds from the Mamba line, originally slated for JCP 3 years ago.
  • Just launched "duet" product this week
  • Marketing Spend of $15-$18mm in 2010 towards integrated efforts nonrecurring 2011 efforts will shift toward direct to consumer


  • Footwear wholesale - goal to grow 2x industry
  • Believe Merrill will be company's first $1Bn brand
  • Sold more than 400k pair of new Merrill barefoot shoes for Spring 2011 season - launched mid Feb
  • Has been very well received at specialty running shops to get M into those doors
  • Consumer Direct only ~7% of sales expect to take to 15% of sales over time
  • Cost inflation MSD in 1H, MSD to HSD in 2H


  • One of the most bullish at the conference – on both square footage and comp
  • 12-15 new stores in 2010 were Movie Gallery locations
  • Opportunity for 30-35 net store additions in 2011
    • 40-50% from Movie Gallery or Blockbuster locations
    • Plan to expand an additional ~20 stores in 2011 up to 7-8k sq. ft. formats
    • Only 20-25% of store base competes with a FL
    • Nike supporting marketing both in-store and external - HIBB's full-service positioning a competitive advantage
    • NKE accounts for ~50% of sales overall; 60-65% of footwear
    • Interestingly, they specifically called out KSWS from a product standpoint
    • That matters when a company’s (KSWS) sales is cut in half over 3 years.
    • KSWS Tubes for Spring '11 one of CMO's highlights
    • E3 replenishment system hasn't resulted in material bump in inventory as expected - even more efficient
    • “A NFL lockout would have a small impact on comps.  However, we’re more excited about the prospects for the NFL/Nike relationship and what it will mean for new products.  Did you see the Oregon Ducks uniforms?  Very exciting.”
    • Landlords still not giving in on rents, even though these stores have sat vacant.  Expect capitulation and the sites are pretty good.
    • Being in-stock, aided by replenishment systems, is still key to driving comps.


  • Weather is simply impossible to read
  • Toning is a Fad
  • In 2H11 there WILL be a product margin squeeze.
  •  ‘We’ll all work together in ironing out the costs.’
  •  ‘But it won’t be an even distribution, and uncertainty is significant on timing and magnitude.


  • Paul Marciano, 1st presentation in 14 years.  Brand name inspired by billboard from McDonalds.  Wanted one syllable brand name.
  • 40% of rev’s licensing, 50% in Europe
  • 15% NA wholesale, 85% NA retail….global: 36% eur, 44% NA retail, 8% asia, 8% NA wholesale, lisc 4%
  • Opportunity in north Europe, currently in south.  Germany being evaluated
  • Italy is half of Europe


  • Pricing at wholesale Ts going up
  • Blank Ts demand is stronger
    • No unit degradation in last 6mo
    • 6mo lag between cotton costs and sale is puts significant strain on industry requiring much higher working capital
  • Spent another $15mm on inventory YY due to cost increases


  • “We want to own your closet, the whole closet. And, maybe some drawers and shelves as well” 
  • More than double north face to $3 bil. -5 yrs
  • Mid march investor day will layout 5 year plans
  • International EBIT 200 bps higher than total corp op margin.  Lower tax rate abroad helps EPS.  Will be 40% of total in 5 years.
  • China $1 bln opportunity
  • No single brand fully developed on retail. Vans largest.  67 TNF, grows to 190 globally 5 years
  • GM’s will continue to expand in same manner as prior 5 years.
  • Spent incremental $100 mm on sg&A in 2010 centered on marketinf.  Half on tnf and vans.
  • 5.6% of total (mktg) was, 5% historically.  Will be lower in 2011, to offset margin pressure
  • Cash flow: exceed $900 mm, was $850. Acquisitions top priority.
  • Focus on outdoor, action sports
  • 5mm repurchase in 2010, vs. historical rate of 1-2mm shares per year.
  • May see north of 80 new stores in 2011, incremental comes from international
  • Will cut incremental marketing spend from ’10 to offset cost pressures
  • Not yet locked in on denim for Fall.  Many denim mills still not accepting orders and holding out for more clairty.
  • Bought some denim textiles in late ’10, will show up in YE inventories.  Small but will help to offset costs.
  • Rock and Republic (if successfully closed with courts) will be positioned away from competing with Seven.  Likely goes downstream from super premium.
  • All brands taking price, but not all due to cotton.
  • Feb 1st will see price increases in denim at retail, at WMT
  • Low-end denim price increase will not fully offset costs
  • Expect 10-15% more cotton to be planted, which may result in substantial price relief by year end.


Gordman’s CEO:  “Pricing is not the issue to understand the Gordman’s model”.



  • Is it me, or did this story actually sound decent???
  • The growth profile seems to be improving.



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