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Munis: Flurry, Blizzard or Avalanche?

“No snowflake ever falls in the wrong place.”

- Ancient Zen Proverb

 

Both the title of this morning’s Early Look and the quote above are very apropos for the current weather gripping New Haven, CT and much of the northeastern United States. Though the mounds of snow which line our streets are several feet high, it’s “business as usual” for those of us who refuse to blame our disappointments on things like “the weather”.

 

Addressing the quotation specifically, the saying above traces its origins to Zen, a school of Mahayana Buddhism. Per our friends at Wikipedia, what distinguishes Zen from other schools of Buddhism is its search for enlightenment through self-realization in Dharma practice and meditation rather than a reliance on text and intellectual reasoning.

 

In the asset and risk management industry, an overreliance on intellectual reasoning can get us into trouble, as we often lean towards the conviction we receive from our data analysis and channel checks versus what may or may not be blatantly obvious. In fact, we’ve all been trained to fade the obvious – even sometimes to a fault.

 

This brings up an interesting topic that is gathering momentum in the marketplace: Muni Bonds. The divergence in sentiment between retail investors and institutional investors seems to get wider by the day, as one group (retail) rushes to avoid what is perceived by some to be a pending crisis while the other (institutional) finds current valuations as a definite reason to “fade the obvious”:

  • Yesterday, it was reported that retail investors withdrew an additional $1.9B out of muni bond mutual funds. Though down from last week’s record $4B redemption, the trailing four-week average increased slightly to $2.3B. All told, the last eleven weeks saw a cumulative outflow of $22.5B, according to Lipper FMI. That’s ~22.5% of the roughly $100B poured into the funds from January 2009 – October 2010. Yes, there’s another side to the Bush Tax Cut extension trade…
  • Amidst the selling by retail investors, asset managers have used the latest backup in yields as a buying opportunity to lock in exceptional tax-adjusted rates, sending average yields on G.O. muni bonds down (-16bps) wk/wk, as measured by the Bond Buyer 20 Index. To a lesser extent, revenue bonds were bid up as well, with yields falling (-5bps). This was the first weekly decline in muni bond yields in four weeks.

To state it bluntly, we don’t see current prices for muni bonds as an investable opportunity to “fade the obvious”. We’re neither brave nor smart enough to get in the way of a potential wave of defaults, restructurings and credit downgrades (emphasis on potential, as we disagree with Whitney that $50-$100B worth of defaults is a foregone conclusion).  You don’t need defaults for the price of a bond to go down.

 

Even for those brave investors who possess the analytical firepower to find value in the muni market at current yields – including the highly-regarded Lyle Fitterer – we think many of them may actually be using faulty data in their analysis. Fitterer, the top muni bond fund manager of the last decade, remarks, “The baby has been thrown out with the bathwater”; as such, he’s using the current back up in yields as a buying opportunity for specific revenue bonds.“If a State were to file bankruptcy, I have a bond with a dedicated revenue stream,” he says.

 

Fitterer’s comments beg the question, “What’s a revenue bond worth when it doesn’t meet its revenue target?” Probably the same as an equity that misses estimates amid bullish sentiment: less. While we’re not yet calling for a spate of “misses” across the nation, we do think the confluence of slowing domestic growth, rising interest rates and a rapidly deteriorating housing market will weigh heavily on the finances of States, municipalities and municipal authorities alike in 2011:

  1. Consistent with our Consumption Cannonball theme, we expect consumer spending to roll over in 1H11. Sales and income tax receipts combine for ~55-60% of State and local government revenues. Deteriorating fundamentals = bad for muni bonds.
  2. Consistent with our Trashing Treasuries theme, accelerating inflation on the strength of a Debauched US Dollar continues to support rising US Treasury bond yields. The Ber-nank may not see inflation, but the global bond market sure does. A rising interest rate environment = bad for muni bonds.
  3. Consistent with our Housing Headwinds Part II theme, we think US housing prices could end up down (15-20%) by the time the July 2011 Case-Shiller data rolls in (early fall). Property tax receipts make up roughly 26% of local government revenues, though they are typically assessed on a 2-3 year lag. Regardless, municipalities across the nation are running out of headway to finagle with their accounting. US housing wasn’t exactly robust over the last 2-4 years. The oncoming wave of lower property tax receipts = bad for muni bonds.

Speaking of borderline accounting fraud, a very alarming trend has emerged over the course of the most recent economic downturn. Rather than lie about their deteriorating finances, a growing number of municipalities have opted to hide them instead.

 

A recent study done by DPC DATA Inc. revealed that over 56% of municipal issuers did not file a financial statement in any given year between 2005 and 2009. Over 33% of them skipped filing in three or more of the past five years. In the latest year (2009), the percentage of non-filers jumped +360bps to 40.2%. An additional 30% filed “extraordinarily late” that year, according to the analysis.

 

It’s tough to analyze what you can’t see. Moody’s Managing Director of Public Finance, Robert Kurtter, agrees, saying on CNBC’s Squawk Box that 2/3rds of all muni issuers are unrated (1/14). And even if they we’re “rated”, we’re not buyers in blind faith of America’s ratings agencies!

 

Regardless of your perception of the fundamentals, the “snow” is falling in the muni bond market and the thick coat of snow accumulating serves as a metaphor for the opacity that’s associated with issuer finances. When the ice melts in the coming months, will you be holding a bag full of “unforeseen” risk because you bought the first dip after a 30-year bull market in muni bonds? We definitely won’t be – that’s for sure.

 

Remember, no snowflake ever falls in the wrong place.

 

Darius Dale

Analyst

 

Munis: Flurry, Blizzard or Avalanche? - red


Chart OF THE DAY: If You're Going to Dance with the Devil, Make Sure You Pick the Music

If You're Going to Dance with the Devil, Make Sure You Pick the Music...

 

Chart OF THE DAY: If You're Going to Dance with the Devil, Make Sure You Pick the Music -  chart of the day


WEN: FOCUSED, REAL & UNDERVALUED

There are some investor meetings that can be boring and many times you walk away saying to myself “why did I even waste my time; I did not learn anything.”  But this meeting was different and I decided to sit in the front row.  Maybe it was because Nelson Peltz was going to say a few words and I wanted to make sure I got a good look. 

 

History may not repeat, but it certainly does rhyme; I have made this call a least a dozen times in my career and two of them in the last two years (SBUX in 2009 and EAT in 2010).  Senior management is finally getting down to doing what should have been done two years ago – letting the Wendy’s brand thrive on its own.    

 

Wendy’s is following the classical rinse and repeat process of successful restaurant turnaround stories: simplify operations by shedding any surplus, dilutive brands that are distracting management and focus on executing the core business to the highest level possible.  Today’s investor meeting shed plenty of light on the progress WEN is making on this path and, while some question marks remain, I was convinced that the painful lesson of the Arby’s merger has been fully absorbed by management and they are now poised for significant growth over the longer term.   The presentation, in its totality, put forth a frank account of the errors that WEN had made in terms of operations and a convincing list of steps it is now taking to turn around the concept. 

 

The meeting obviously kicked off with Wendy’s new breakfast, supplied by Wendy’s, and the team was quick to tell the audience about the new rollout.  According to management, the day part has the potential to add $150,000 to the concept’s $2.4 million in average unit volumes.  The immediate success of breakfast is not critical, to the degree that management does not build in a significant expectation on what it will add to same-store sales growth.  They will only have it in 1,000 stores by the end of next year and only 2/3 of the system will be able to execute it. 

 

The most critical element to the turnaround is management’s plan to upgrade the menu to enhance the quality of its offerings.  This new menu strategy focuses on introducing new products that compete with some of the more premium products and brands in the QSR segment.  The company has rolled out new “natural cut” French fries that rival the style of those available at Five Guys.  Additionally, the company will be rolling out a new hamburger called the “golden burger” which is expected to compete with the quality offered at In-N-Out Burger, Five Guys and other premium prices products.  The new burger will be rolled out nationally during the second half of 2011.  They will also follow up in the coming months with a new chicken sandwich to compete with Chick-fil-A.

 

While unit growth is not currently a focus it remains another vehicle through which management aims to grow the top line.  WEN announced a new partnership in Argentina with Desarollo y Gestion (D&G), to open 50 franchise stores.  Other opportunities are being pursued in Brazil, China, and Japan, and management is optimistic about the prospects in all three markets.  Interestingly, while WEN expects earnings exposure to international markets to increase, it also plans on opening 1,000 new stores on top of the current ~6,000 unit restaurant base.

 

Aiming for operational excellence was a key theme of the presentation and management outlined how it can have the obvious benefit on margins but also on top line trends.  One fine example is the drive-through window.  WEN detailed the significant uptick in sales seen as operational creases were ironed out and speed-of-service times were reduced.   I’m assuming it is for Wendy’s in the U.S., but management said that 67% of sales are made at the pickup window. 

 

Management is also using a pricing model to best calculate stores where there is room for pricing versus those stores where a price increase would likely result in a drop off in traffic.  Remodels are another strategy that the company is following to support sales; 75 remodels are scheduled for 2011. 

 

The presentation elaborated briefly on the current standing of the share repurchase program, which was, of course, interrupted because of the filing of a 13-D by Trian, WEN’s largest shareholder.  For this reason, it was explained, there were no stock repurchases in the fourth quarter.  The current intention is for repurchases to resume as soon as possible.

 

In terms of outlook, management reiterated the guidance disclosed in yesterday’s preannouncement of 4Q and FY2010 earnings.  For 2011, the company outlook expects same-store sales growth of 1-3% at Wendy’s North America company-operated restaurants and an improvement of 30 to 60 basis points in Wendy’s company-operated margins.  Capex is projected to be $145 million.  Unit development is expected to include 20 company stores in North America, 45 franchise stores, and approximately 50 international franchise stores.  From a cash flow perspective, the company aims to produce annual EBITDA growth of 10-15%, beginning in 2012.  Commodity inflation is projected to be around 2-3% for the company with beef costs impacting on approximately a one-month lag basis.  Chicken is contracted out on an annual basis and will offset some of the inflation beef is causing in the commodity basket presently. 

 

While focusing on simplifying the menu and the process (Burgers, Fries, Cokes), the chain is also focusing on simplifying the marketing strategy.  Using the namesake of the brand and daughter of the founder, Wendy Thomas, in select advertising is just one of the initiatives management is using to heighten WEN’s profile among QSR customers of which, according to the presentation, 60 million visit QSR restaurants 4 or 5 times per week in the U.S. 

 

The most positive and all-important take away from this investor day was the resounding “yes” management gave to me in response to my question about whether or not this definitively meant that Wendy’s, as a concept, would now be given sole attention of management and room to breathe.  The response was important and the benefits obvious.  Management teams across the space are generally better served focusing on a few simple operational tasks and executing on them clinically.  The sale of Arby’s allows WEN to forget about trying to right the wrongs of Arby’s and invest capital and management time into Wendy’s.  Of course, from a dollar perspective, the reduction of corporate G&A to support a single brand is also a positive.  Beyond that, focusing on the core menu will also yield benefits.  Hamburgers, fries, salads, value, and chicken comprise 70% of total sales for WEN.  That is a slice of the pie worth getting right.

 

As with all turnarounds there is always the X-factor.  The X-factor in this case is the implication(s) this has for the employees and the franchise system.  You generally see most people be revitalized by the new initiatives and the stores tend to see a higher level of execution and the turnaround progresses.  This is why when the ball starts rolling it goes further and lasts longer than most expect it to.  This was clearly evident in the most recent quarter that SBUX reported. 

 

We will have more details around valuation in the coming days. 

 

Howard Penney

Managing Director


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UA: Crusher, But Watch the Cash

There’s very little to punish UA for here. UA is giving the bulls all they need to keep the faith that this company will double over 3-years. But cash flow is eroding on the margin. That’s caused some pain in the past. Put your risk management hats on.

 

You gotta hand it to these guys...seriously. They crushed expectations, and it was not because they set crushable guidance over lackluster performance. This thing legitamently reaccelerated its top line to 36% (and by 12,000bps sequentially on a 2-yr run rate). EBIT grew 31% and EPS by 34%. Yes folks, that’s organic. It’s not because of one of these poor quality acquisitions that are blanketing the market, FX, or stripping the cost structure clean in anticipation of being LBO’d.  UA is the real deal.   That’s not real news to us, as it was one of our top names last year. But we hopped off early on 10/26 (see our note, UA: The Gap is Gone) at about $48 – content at a 2-bagger in six months at a time when 1) the consensus estimates moved up to our level, 2) we started to see headwinds on athlete endorsement costs, and 3) UA was in the heat of launching it’s first real cotton product at a time when cotton costs were up three standard deviations from the mean. We were wrong.

 

One thing that has changed in the market, and in retail in particular, is the premium people are willing to pay for organic growth. In retail, that’s UA, URBN, LULU. Levine and I are often asked about these three in the same sentence. One thing to consider is that UA’s model is far more exportable, and can appear to a larger audience globally. Let’s face some facts, they’ve blown it thus far going international. But UA is sticking its nose into a global duopoly (Nike and Adidas) where the primary channel would love nothing more that great quality product from a high-end US brand. Also, find me anyone that would take the other side of the debate that UA could add another $400mm in footwear sales over 2-3 years on top of a billion dollar apparel business.

 

So what are our thoughts with the stock near $60? Pretty much unchanged. The company has got great product momentum, and along with Nike, Footlocker, Dick’s, Sports Authority, and Hibbett, we should see both the space and this company materially outperform into 2011. If you want to short on valuation, then be our guest. But it’s probably gonna hurt.  I heard people say “sorry, it’s too expensive for me” at $20, $30, $40, and $50. Why not $70?

 

One thing to consider is that the biggest moves in this stock over time have happened at peak/trough cash cycles. Think about it some of the BIG calls on UA in the past.

  1. When the company began to shift into more ‘loose fit’ apparel, and away from its core compression product. That meant incremental spending on R&D, marketing, but also had to manage a different working capital cycle. Having replenishment product that turns 9x at Dick’s is a lot different that selling product with more variable pricing structure at Nordstrom at a 2x turn.
  2. Remember the (now infamous) time when UA went to ICR – even though they were not on the docket to do a presentation – and leak out the incremental SG&A spend for the Superbowl?
  3. On the flip side…nearly EVERY major move higher in UA was in conjunction with working capital coming down and SG&A growth peaking, thereby fueling the top line in the subsequent 12 months. (i.e. sales up<margins<fcf).

Therein lies the Bear Case:

“Top line growth is astounding today. But the cash cycle is weakening on the margin. Growth in company stores is accelerating, which means higher capex and working capital. The company already guided to top line growth of 25-27%, which is above its long term range. Heck, maybe that means its true intention is for 30%+ growth. But otherwise why raise expectations at the very start of what is going to be one of the years in retail with more pin action than we’ve seen in a while. If operating margins OR asset turns peak and roll (like our SIGMA shows yellow flags of doing) then the other will have to accelerate just as much in the other direction in order to offset erosion in RNOA. That will be a painful day to hold UA.”

 

When we net it all out, we think that the Bull case will prevail, but certainly at a heightened level of risk relative to where this name was for most of last year. We think this is a ‘do nothing’ stock right now. What’s funny is that ‘do nothing’ is actually positive on a relative basis compared to the rest of retail.

 

 

Review of the Quarter

 

Revenue Growth: Revenue growth was impressive up +36%, but more impressive was the fact that it came from every category – including footwear.  New product introductions will continue to be the primary growth driver including the company’s new Charged Cotton shirt (end of Q1) and additional footwear introductions on top of a full year of basketball sales. Very few companies in retail can come close to posting this type of sustainable top-line growth.

 

Direct-to-Consumer: Plans are accelerating here with management now expecting to add 25 stores in 2011 up from ~20 last quarter off a base of only 54 stores. With sales per store averaging ~$5mm per annum, Direct sales have quickly become a major growth driver accounting for 10% of growth in 2010 and is likely to drive a similar if not accelerated rate in 2011 with the majority of stores entering years 2 and 3 becoming increasingly more productive.

 

Margin Pressure(s): It’s no surprise that gross margins will face increasing pressure over the next 12-months, but higher investment spending is clearly in the plan for 2011 masking the margin expansion opportunity that comes from 20%+ top-line growth near-term. As such, guidance implies 10-50bps of EBIT margin expansion in 2011, which appears optimistic if not at the expense of lower marketing spend at year end. In addition to higher sourcing and labor costs in the 2H, the company will also be challenged by mix shift as footwear continues to grow particularly in Q2 offset in part by higher DTC revenues as well.

 

Inventories: With 45% growth on a 36% increase in revenues and further growth expected in the 1H, inventory risk remains a concern near-term. While the majority of growth is due to investments in core auto replenishment inventory, the reality is that at these levels the company is at a considerable risk if sales don’t materialize as expected. It’s also worth noting that aged inventory is half the size at year end compared to last year suggesting product is more current and would be easier to liquidate if need be. 

 

 

 

UA: Crusher, But Watch the Cash - UA S 1 11

 


No Longer In The Tail . . . Jasmine Revolution Being Exported

Conclusions: As we noted a week ago, the Jasmine Revolution has the potential to go global, and it has. This week we’ve seen massive protests in Egypt, the world’s 27th largest economy.  The Egyptian stock market is down 16% in the last three days.

 

On January 20th in an Early Look (some of this data is replayed below), we discussed the idea that Tunisian protests could represent a tipping point for civil unrest in emerging markets. These protests, or what is now being called the Jasmine Revolution, began on December 17th with the self-immolation of Mohammed Bouazizi (after police confiscated his unlicensed food stand) and ended on January 14th with current President Ben Ali fleeing the country for Saudi Arabia.  In the last week, we have seen protests accelerate in emerging markets, and this may just be the beginning.

 

Tunisia had seen steady economic growth from 1999 to 2008 with average annual GDP growth of 4.9%, until a deceleration in 2009 to 3.1%. The natural outcome of a deceleration in economic growth is a freeing up of capacity in the economy.  In Tunisia, almost 50% of the economy is driven by services, which is effectively “people” power.

 

So, as the economy in Tunisia has slowed, unemployment has picked up to 14.1%.  In conjunction with slowing growth and high unemployment, we have also seen basic commodity prices accelerate in the last year – copper up 24%, tin up 58%, wheat up 68%, cotton up 131%, and palm oil up 53%, to name a few.  In economic parlance, this combination of accelerating inflation, slow growth, and high unemployment is called Jobless Stagflation.

 

In democracies with longstanding institutions of law and government, Jobless Stagflation often leads to protest and change, similar to the change we saw in the recent midterm elections in the United States, where the Republican Party gained control of the House of Representatives.  The people demanded change in the United States and they went to the polls to get it.  In nations like Tunisia, this mechanism for change (free and open elections) does not exist, so the people went to the streets and demanded it.

 

Civil unrest as an outlet for protest against the government exacerbated when the population is youthful.   As healthcare broadly improved in these Africa and the Middle East in the late 1960s, birth rates went up dramatically.  Currently, it is estimated that around 65% of the regional population is under the age of 30. 

 

In the Early Look last week, we posited the rhetorical question:  could the Jasmine Revolution become a primary export of Tunisia?  The evidence early seems to suggest that the Jasmine Revolution is already spreading across the region; the most supportive evidence is coming from Egypt.

 

Over the last three days, there have been massive protests in Egypt against the autocratic regime of President Hosni Mubarak.  These protests are being driven by economic concerns, primarily spiraling costs of living (read: inflation).  As the costs go up, the underemployed and underpaid youthful population naturally vents, and in an autocratic regime they have no outlet other than, at least in their minds, to take to the streets.  No doubt the successful revolution in Tunisian was a catalyst for the Egyptian revolts; the success of overthrowing the Tunisian government has emboldened protestors across the region.  To wit, protests are occurring and growing in Yemen and Jordan as well.

 

Unlike Tunisia, Egypt is a country that matters on the global economic stage; it’s the 27th largest economy in the world with a GDP of $470BN (2009).   As well, the markets are signaling that there is more to come in Egypt, as the stock market there has reached its lowest level since July 2010, falling 16% in the last two days.  Further, credit default swaps, insurance on Egyptian government debt, have surged 15% in the last week.

 

The powder keg of high unemployment, youthful citizens, rising inflation, and limited democratic institutions are endemic to Africa and the Middle East.  Tunisia appears to be the flint that lit the powder keg.  As protests continue over the coming days and weeks, we expect the mantra “We are all Tunisians now” to expand across the region, as the Jasmine Revolution becomes Tunisia’s top export.

 

Daryl G. Jones

Managing Director

 

No Longer In The Tail . . . Jasmine Revolution Being Exported - 2


Japan: Land of the Setting Sun

Conclusion: From a secular perspective, Japan’s economy continues to implode. The acceleration of that implosion towards the Keynesian endgame is arguably the largest TAIL risk to the global economy.

 

Position: Bearish on Japanese Equities; Bearish on the Japanese yen; Bullish on Japanese CDS.

 

This morning, Standard & Poor’s came out with yet another lagging downgrade that seems to have caught the US financial media’s attention. By cutting Japan’s credit rating to AA-, Standard & Poor’s reminded us all what we already knew:

 

Japan’s economy is imploding in slow motion. Slowly, but surely, Japan is reaching the Keynesian endgame.

 

For the sake of not making too much of a deal about a late downgrade, we’ll spare you with the details on why we feel this way. Please refer to our 4Q10 Key Macro Theme of Japan’s Jugular for the work behind our implicit downgrade of Japan’s credit, currency and equity market. The presentation, originally published on October 5th, can be accessed here:

 

Replay Podcast (starts around 9th minute): https://www.hedgeye.com/feed_items/9746

[To access the podcast, you may have to copy/paste the link into the URL of your browser.]

Slides (12-34): http://docs.hedgeye.com/Q4%202010%20THEMES.pdf

 

Two alarming datapoints that hit our screens over the past couple of weeks were Japan’s widening central government budget deficit and subsequent burgeoning debt issuance. According to the Japan’s Finance Ministry, Japan’s budget deficit is forecast to grow to ¥51.8 trillion yen (~$630B) in FY13 and ¥54.2 trillion yen (~$660) in FY14. [For reference, FY13 starts April 1, 2012.]

 

When put into the context of a ratio, Japan could be running a PIIGS-like ~11%-12% deficit to GDP in a little over a year. Looking closer to this upcoming fiscal year, which begins on April 1st, Japan’s relentless acceleration in deficit spending has Japan’s Finance Ministry upping its projected debt burden +5.8% YoY to 997.7 trillion yen, or roughly 215-220% of GDP.

 

Japan bulls point to the fact 90% of Japanese government debt is financed through its domestic population of savers, making it less likely to experience a dangerous back up in yields or default. As we’ve shown in the aforementioned presentation, that tailwind is rotating on the margin towards becoming a headwind as a result of unfavorable demographics. We saw signs of this trend starting last year, with Japan’s largest pension funds selling assets and joining the global search for yield to meet payout obligations.

 

This will only accelerate over the next 20-30 years, with the next ten likely being a real wake up call for global investors. Currently, the ratio of retirees to working-age Japanese is equal to 35.5%. In just ten years time, that ratio will be equal to 48%. In a society notorious for luxurious pension packages, going from a 3-to-1 base in potential contributors to a near 2-to-1 base in a matter of just ten years means the domestic demand for JGBs bulls consistently refer to will decline by nearly 1/3rd.

 

All told, we foresee a major supply/demand imbalance for Japanese government debt and, in our opinion, this imbalance is one of the largest long-term TAIL risks to the global economy. But don’t take our word for it:

 

“The financial state of our nation is becoming increasingly severe. Fiscal management that depends excessively on bond issuance is becoming too difficult.” – Japan’s Finance Minister Yoshihiko Noda, January 24, 2011

 

 “The government must fix its finances to avoid a debt crisis that could trigger a global depression.” – Japan’s Vice Finance Minister Fumihiko Igarashi, January 2011

 

Obviously, we think it pays to pay attention here.

 

Darius Dale

Analyst

 

Japan: Land of the Setting Sun - 1


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