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When it Rains it Pours (Literally)

China got a wad of sand kicked in its face, which is likely to impact footwear manufacturing capacity, logistics, and pricing. Another bad development for US footwear margins.
Typhoon Hagupit triggered a ‘once-in-a-century’ storm tide in the Guangdong province, which sparked a rise in water levels to more than 5 meters above the normal tide. Authorities, who described Hagupit as ‘the worst to hit Guangdong in more than a decade,’ evacuated more than 100,000 people before typhoon Hagupit made landfall around dawn.

Not a good narrative in China this year. First it sees the most debilitating snowstorm in 100 years in 1Q. Then in 2Q it is hit by the earthquake – for which the death toll is still uncertain. Now the typhoon and ensuing flooding is impacting a key manufacturing province.

Remember that 86% of US footwear consumption is made in China. Nearly 3,000 footwear factories closed in 1H as raw material prices skyrocketed, government support for factory margins eased, FX pressured margins, and migrant workers simply did not show up for work due to the forces of mother nature (in addition to the ability to find better jobs in major cities for more money), and the storms exposed the weak transportation infrastructure that precluded US companies from shifting sourcing to central China.

It was already apparent to me that we’ll see thousands of additional factories close in 2H. Now there’s no doubt in my mind. Not good for footwear pricing throughout the global footwear supply chain as the economic balance shifts in favor of the survivors in China. I’d hate to be a marginal US brand or retailer right now (SKX, DSW, BWS, and even WWW). I’m incrementally of the view that this will lead to more consolidation and M&A.

NYC: A BIG POTENTIAL DELTA

As discussed in our HOT post dated 8/31, the New York City market faces some major macro hurdles. A truly international city cannot be immune to a massive global economic slowdown. It is indeed global this time. We know the decline in domestic leisure travel will leak over to corporate travel. The conference and convention business displays a longer tail, so that’s a problem for 2009. The other major 2009 problem is that Wall Street is imploding in the middle of corporate rate negotiations for next year.

Located in the financial epicenter of the globe (for now), New York City hotels have historically drawn significant revenue from corporate guests – especially the high-end properties. The demise of Wall Street will certainly stymie the flow of guests arriving in lobbies across the Big Apple. We have already learned, from industry insiders, that the hotels in the proximity of Bear Stearns HQ saw a noticeable decline in traffic following Bear’s capitulation. Lehman, Merrill, AIG, Morgan Stanley, and others are all imploding at this critical phase of rate negotiations. Not good for Q4 RevPAR, and certainly not good for 2009.

NYC has been one of the best performing hotel cities in the country due, in part, to its reliance on international travel (see my 8/18 post US REVPAR “LINKED” TO THE DOLLAR). Other markets are in worse shape but it is the delta that matters. For HOT, this is a big part of the 2009 story. NYC generated over 15% of HOT’s owned hotel EBITDA the last 12 months and probably represents an even bigger part of analysts’ 2009 estimates. HOT also maintains significant exposure to other potentially troubled markets we’ve analyzed including London and Hawaii. I continue to believe another 20-25% reduction in EPS estimates for 2009 is prudent.

Perpetually Preferred

No problem can be solved from the same consciousness that created it.
-Albert Einstein

In a made for CNBC headline announcement last night, Larry Kudlow proclaimed the mystery of his faith… No socialist bailout is too far from him buying into, provided that it can make the stock market go up; especially if Warren Buffett rubber stamps it.

I wrote my senior thesis here in New Haven on Buffett. He remains, The Man. He also remains the only investor of consequence who has unlimited duration in his investment mandate. This morning, he is the only investor with these “perpetual preferred” terms on Goldman’s stock. So before you get all heated up and run out buying into consensus TV’s take on this “deal”, stop, breathe, and think about it. There’s one man in this world who gets this deal. The rest of you get the scraps of Goldman’s $5B raise that they just doubled down on. No, no – never mind what the company said yesterday, last week, and last month that they don’t need money. We simpletons are supposed to be stupid, and not hold people accountable to what comes out of their mouths.

Reality TV’s session with Hank Paulson yesterday enlightened America on the enormity of their financial system’s confusion. Confusion in markets breeds contempt. After this morning’s pre-market futures love fest, we’ll be staring down Paulson’s ‘You Tubing’ session with Chuck Schumer at 10:00AM tomorrow in front of the Joint Economic committee, then again at 2:30PM EST in front of Barney Frank and the Financial Services Committee. This is not going to be a positive catalyst folks. America has already voted.

In the Bloomberg/LA Times surveys this morning, 80% of Americans are now saying the country is headed in the wrong direction. More interestingly, 55% oppose the Paulson Plan vs. 33% supporting it, and 45% of Americans think Obama is more apt to handle this economic situation vs. McCain’s 33%. This mounting contempt is both unprecedented and warranted. Wall Street investment banks have compromised the integrity of their handshakes. If you didn’t get that yesterday, you’ll have another chance to watch it on Thursday.

Not surprisingly, the rest of the world isn’t stupid either. If you show people something on TV, they neither need to read or count to understand whether someone looks like they are afraid. It’s called intuition. Asian, European, and Middle Eastern stock markets are screaming this right now, and I think you should be paying attention to their vote.

Asia opened higher, and closed mixed. Bailout master of the universe, Japan, closed +20 basis points last night – hooray. European markets opened higher and have now turned lower as I hit these keystrokes. The major indices across Asia and Europe are broken, and they realize that the only investor getting a 10% preferred dividend in Goldman, is an American.

The contagion associated with our investment bankers losing the world’s trust is now spreading to the Middle East. Prince Alaweed threw up his hands last week and said, “I’m out.” This morning, despite the preferential All American investor treatment, why is the Saudi stock market trading down -5.5%. Why has the mother of all “Sovereign” support (Saudi’s Tadawul Index) dropped -21% in the last month? Why are Qatar and the United Arab Emirates trading down -3.7%, and -3.5% respectively this morning despite oil trading higher to $108/barrel? I think it’s because they aren’t stupid.

Pakistan is calling in the 1-800 US bailout line this morning. Moody’s downgraded their debt yesterday; their stock market gets stoned by their own people; and their currency has lost -21% of its value year to date. Their new “leader”, Zardari, is allegedly a lot of things, but one of those things may not be stupid. He meets with Condi Rice on September 26th. Is he going to ask for something the US cannot afford to give? What will he have to do if/when the answer is no?

It’s global this time. And yesterday assures you that there are more questions to answer locally, never mind globally. The US has a “perpetually preferred” investor who is much larger than Warren Buffett – the common American tax payer. That tax payer is not going to let the investment bankers one up him/her this time. Been there, done that.

I shorted the S&P 500 yesterday. Hopefully the government doesn’t ban me from doing so tomorrow. My immediate downside target is now 1150.57.
Good luck out there today,
KM



investing ideas

Risk Managed Long Term Investing for Pros

Hedgeye CEO Keith McCullough handpicks the “best of the best” long and short ideas delivered to him by our team of over 30 research analysts across myriad sectors.

Point Counterpoint: PSS, GPS, UA, FINL

I focus on fundamentals. Keith focuses on stocks. Together we generate Alpha. Here are some names that KM highlighted to me, as well as my response. Some changes on the margin…

COLLECTIVE BRANDS (PAYLESS – PSS)
KM: PSS continues to impress, posting + divergence days when the market swoons.
BM: Still one of my favorite fundamental stories. Top line visibility improving, cost synergies from Stride Rite evolving into revenue synergies. Cash flow growth should accelerate meaningfully with or without a steadier consumer backdrop.

GAP, INC (GPS)
KM: GPS is bullish, but not if it breaks down and closes below 17.75.
BM: I really like the Athleta acquisition, and yy EBIT growth trajectory looks good relative to the group. But I still think that GPS needs to take up SG&A ratio by 2-3pts in order to take the model to a point where it can grow at a sustainable rate. Any bullish action near-term is purely a ‘Trade’ not a ‘Trend.’

UNDER ARMOUR (UA)
KM: UA continues to hold the pos. momentum line, which shows me support at 34.66.
BM: I still think back half expectations are too high, but with 45% of the float short the stock, this one falls into the basket of names that will pop if the company hits the quarter even if by accident. I’m increasingly confident in top line growth in footwear, and FX here is a non-event. If margins find a bottom in 2H (which I think is a distinct possibility), this name could start one of those blistering 50% runs we’ve grown to love from UA.

FINISH LINE (FINL)
KM: FINL is teetering on the edge of a major breakdown all of a sudden, the next move will be big either way.
BM: I wouldn’t go near this name in advance of Nike’s quarter Wed pm (FINL is a day later), as unfavorable risk/reward with Nike could take FINL with it. But fundamentally, this is another name I am warming up to for several reasons. I’ll be back with more color on this one – but my inclination is increasingly to swap out of FL and into FINL.

MORE ON THE ALL IMPORTANT RELATIONSHIP: PRICE VS. TRAFFIC

O’Charley’s said at an investor conference yesterday that based on the casual dining industry numbers it is seeing, August was the worst sales period in 30 years. This statement reaffirms our view that the industry has not yet entered a period of stabilization, but instead continues to deteriorate at an accelerated pace. Management went on to say it would expect to see casual dining operators raise prices more aggressively than normal (up 3%-4% or more) in an effort to protect margins. The company said this is in line with Darden’s comments that it expects to increase FY09 prices at the higher end of its historical 2%-3% range versus its more typical 2.5% increase.

The primary driver of recent same-store sales weakness for casual dining restaurants has been negative traffic. In August, traffic declined 6.0% after falling 6.2% in July so although I am encouraged to hear O’Charley’s is focused on its margins and not just offering promotions across the board, I do not know if aggressive pricing is the answer to deteriorating traffic trends.

Short Selling Ban, Part III: Implications for Implied Volatility

Compromised markets create compromised data.

The impact of the short ban on the equity options market has been profound. There is debate surrounding the S&P level for Friday’s open that was used to calculate settlements given the fact that the final status of outlier prints on financial stocks from that morning is still up in the air. Meanwhile, bid ask spreads in some put series are wide enough to drive a truck through and the normally staid volatility levels for blue chips like GE are in the 40’s or higher.

When we say “volatility” we are talking about one of two things –either realized historical volatility or the volatility implied by option premiums. The VIX Index, the most commonly used barometer of market volatility, is a measure of the implied volatility of options on the S&P 500.

Implied volatility is calculated through a process of reverse engineering. Using a pricing formula such as Black Scholes, the premium for an option is used to derive the implied volatility level by backing out the known aspects (the maturity and strike price) as well as assumptions (the financing rate and hedge). These pricing formulas are all based on the assumption that a trader will be able to freely hedge the option exposure in the underlying market. The shorting ban leaves implied volatility calculations for those stocks heavily compromised by asymmetrical liquidity.

This may sound very abstract and irrelevant at first, but consider what a significant portion of equity trading volume is generated by quantitative managers who rely on implied volatility as an input for their modeling process. By changing the rules mid-game the SEC may be forcing these players to head for the sidelines.

Andrew Barber
Director

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