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Japan’s Jugular Update: Just Getting Started on the Short Side of Japanese Equities

Conclusion: Though we covered our oversold short position in Japanese equities today in the Hedgeye Virtual Portfolio, we remain outwardly bearish on Japan’s intermediate-term TREND and long-term TAIL.

 

This morning we covered our short position in the EWJ for a gain. We’ll look to re-short Japanese equities on a bounce back up to its immediate-term TRADE line of resistance at 10,909.

 

Japan’s Jugular Update: Just Getting Started on the Short Side of Japanese Equities - 1

 

Watching how US equities trade will be critical here, as both markets have been the beneficiaries of the “flows” into relative “safe havens”. If 1,307 in the S&P 500 doesn’t hold or if it can’t close above 1,330 in the immediate term, the probability of a meaningful bounce in Japanese equities dwindles. In an environment of Global Stagflation, these “safe havens” will wind up looking like relative value traps over the intermediate-term TREND.

 

Japan’s Jugular Update: Just Getting Started on the Short Side of Japanese Equities - 2

 

Regarding Global Stagflation specifically, Japan’s January trade data revealed more of the nasty tea leaves that we’ve been harping on since early November: 

  • YoY Export growth slowed sequentially by (-1,150bps) to +1.4%, driven primarily by a sharp reduction in Asian demand (China down sequentially: +1% YoY vs. +20.1% in Dec; Shipments to Asia down sequentially: +0.4% YoY vs. +14.8% in Dec);
  • YoY Import growth accelerated sequentially by +180bps to +12.4%, driven primarily by rising commodity prices, including Brent crude oil, which was up +29% YoY in Jan;
  • Japan's Trade Balance swung into a deficit for the first time in 22 months in Jan: (¥471.4B) vs. ¥727.7B in December. 

Japan’s Jugular Update: Just Getting Started on the Short Side of Japanese Equities - 3

 

Of course, any bull worth his shirt at a market top will find a way to massage this data into a less-bearish mosaic:

 

Seiji Adachi, Senior Economist at Deutsche Securities, argues that the timing of the Lunar New Year is distorting Japanese trade data a bit, as Japanese exporters started scaling back shipments to Asia in late January to accommodate for the early Feb start to the Lunar New Year (Feb 2-8 in 2011 vs. Feb 14-20 in 2010). He argues, “It’s hard to project how much the Lunar New Year holidays will affect trade as they change every year, so we need to look at the overall trend through March.”

 

In rebuttal to this view, the data shows that growth in the value of Japanese exports slowed on a global basis: 

  • YoY Export growth to the US slowed (-1,050bps) to +6% in Jan; and
  • YoY Export growth to the EU slowed (-900bps) to +0.7% in Jan. 

As we’ve been forecasting since October 5th via our Consumption Cannonball thesis, US consumption growth is slowing – a trend further highlighted by WMT’s sales/inventory problem. We knew that austerity and higher interest/tax rates would weigh heavily on consumption patterns in the EU, but it appears the US consumption dominoes are at the Tipping Point, and are currently being nudged by near $100 WTI crude oil prices.

 

Back to Japan specifically, Japanese stocks have indeed benefitted from the overwhelmingly bullish sentiment that is commonly associated with being at/near the top of a global economic cycle. Citing lagging 4Q global growth data points, Japanese Officials, CFOs, Economists, and PMs have all taken advantage of their chance(s) in the past few weeks to upgrade their assessment of the Japanese economy: 

  • Officials: Both the BOJ and the Japanese government upgraded economic outlooks, with the BOJ specifically raising their growth projections for the year ending in March to +3.3% vs. +2.1% prior;
  • Corporations: Toshiba, Cannon, and Toyota are among a handful of large Japanese exporters who recently guided higher on “strengthening Asian demand” and “robust US consumer demand”;
  • Sell-Side: Bloomberg consensus estimates for Japan’s 1Q11 GDP advanced from +0.5% QoQ SAAR in early Jan to +1.1% QoQ SAAR today; and
  • Buy-Side: “The worst of the economic conditions are behind us… If the global economy continues to recover, that should boost Japanese stocks.” – Junichi Misawa, Head of Equity Investment at STB Asset Management, which oversees $14B AUM. 

In stark contrast to such bullish sentiment, we continue to stick with the intermediate-term call embedded in our Japan’s Jugular thesis which shows just how vulnerable the Japanese economy is in a situation of Global Stagflation. In fact, Japan is among the least defensive economies in the world in such a scenario:

 

Hedgeye’s current global growth outlook (decidedly bearish) does not bode well for Japanese export and manufacturing growth, which, in turn, bodes poorly for Japanese employment and wage growth:

 

Japan’s Jugular Update: Just Getting Started on the Short Side of Japanese Equities - 4

 

The current global inflation trends bode exceptionally poorly for Japanese consumption growth, as rising food and energy prices tax Japanese consumers who have been accustomed to 10-plus years of flat-to-negative nominal wage growth and prices. In fact, four out of five Japanese citizens say higher prices would be “unfavorable” in a January BOJ survey – the common reason: lack of wage growth:

 

Japan’s Jugular Update: Just Getting Started on the Short Side of Japanese Equities - 5

 

The current global inflation trends are a headwind for Japanese corporate earnings, whose deflationary mindsets will continue to force them to Take it in the Margin as COGS increases fail to be met with offsetting sell-through price hikes:

 

Japan’s Jugular Update: Just Getting Started on the Short Side of Japanese Equities - 6

 

Last but certainly not least, the current global inflation trends are an unmitigated disaster for Japanese consumption growth on a combined government and private basis. It is without question that the Japanese economy is the least equipped to deal with rising interest rates, which is one of the many reasons it has kept rates near zero for such an “extended and exceptional” period of time.

 

Even the slightest backup in yields confounds the Japanese government budget, where debt service accounts for 44.8% of organic revenue (tax receipts + fee collections) – up +1,320bps from 31.6% in 2001, just ten years ago.

 

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To this point, the nominal yields on 10Y JGBs have backed up +41bps since bottoming out on October 6th (coincidentally one day after we published our Japan’s Jugular thesis). The more interest rates continue to back up, the more resolve Prime Minister Naoto Kan will have in his fight to hike the consumption tax. Should the current massive opposition to Kan’s proposal win out, Japan will be forced to issue additional debt to fund its burgeoning fixed social security expenditures, which currently consume 31.1% of total revenue – up +990bps from 21.2% in 2001, just ten years ago.

 

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We continue to maintain that sovereign debt buildup past the Rubicon of 90% Debt/GDP structurally impairs economic growth – a stance supported by eight centuries of empirical data. Japan is no exception here and Pavlovian investors who flock to Japanese equities, JGBs, and the yen as “safe havens” in times of heightened risk will be surprised to the downside on both an intermediate and long-term duration.

 

Darius Dale

Analyst

 

Japan’s Jugular Update: Just Getting Started on the Short Side of Japanese Equities - 8


WEEKLY COMMODITY MONITOR

Commodity costs continue to be a headwind for many restaurant companies.  Some relief has come around on some items but, by and large, year-over-year inflation remains an issue for all operators.

 

I’m beginning to sound repetitive but the pizza concepts are not getting any respite from the commodity markets of late.  The price of cheese has risen sharply over the past couple of months and, after weeks of flagging it in these posts, it seems the number of investors and analysts taking note is also increasing.  Below, I give my take on a few important points pertaining to commodity price action and the implications for individual stocks/categories.

 

Coffee is obviously the first item that catches one's eye in the table below.  News emerged today that demand for coffee beans from Guatemala is at a “near standstill” as roasters turn to countries with cheaper, lower-quality beans.  Brazil is also reported to have stockpiled 1.5 million bags of beans, which if released into the market “would bring some relief to a currently tight market”.   Starbucks revealed on its latest earnings call that it has effectively locked in coffee prices for the year.  GMCR, according to the most recent earnings call, had locked in six months coverage at fixed prices.  The company stated that it will “adjust our pricing as necessary”.  PEET passed along increasing costs to its customers via price increases recently.  The retail and home delivery business prices increased in the fourth quarter, the foodservice business saw an increase in January, followed by the grocery business.  The company did not disclose its current hedging strategy for 2011 (as of 3Q10, we know PEET had locked in 40% of its 2011 coffee needs), but management said it expects coffee costs to climb nearly 30% YOY.

 

WEEKLY COMMODITY MONITOR - coffee

 

Cheese prices have been a key concern and definitely are worth monitoring.  Dairy prices are receiving support from weather events (cyclones in Australia, for example), an increase in feed costs for dairy animals, and a lesser supply of dairy animals given the increased demand for meats that has seen protein costs go higher.   This is a concern for DPZ and PZZA and, as I mentioned in the Tales of the Tape yesterday, downgrades have begun and will likely continue as a result of this.  DPZ has been in the news a lot of late, with high-profile investors taking positions in the stock, but I believe the one-two punch of higher commodity costs and extremely difficult compares from a top line perspective do not bode well for the stock.  The latest news on DPZ is that the company is rolling out a new chicken menu.   While an increase in chicken sales would be accretive from a margin perspective due to relatively lower chicken costs, I think the increase in cheese – as shown below – will be a significant headwind.  On the most recent earnings call, management stated that its contract “still floats with the block.  But the way we’ve got it worked out, the contract kind of reduced about a third of that volatility”.

 

WEEKLY COMMODITY MONITOR - cheese

 

Chicken wing prices continue to provide a tailwind for BWLD earnings, declining again week-over-week.   The company’s guidance of 18% EPS growth may be revised upward if the current trend (shown below) continues, although the back half of the year will likely see less YOY favorability in chicken wing prices.

 

WEEKLY COMMODITY MONITOR - chicken wings

 

WEEKLY COMMODITY MONITOR - commodity 223

 

Howard Penney

Managing Director


The Gadhafi-Berlusconi Trade

With the world focused on the chaos erupting in Libya and Moammar Gadhafi’s intent to fight the uprisings until his “last drop of blood”, what’s garnering less headline attention is Italy’s outsized exposure to the North African nation. It is this exposure, especially to oil and gas vis-à-vis its partially state-owned energy concern ENI, that has helped to drag down the country’s equity market and ENI stock since late last week. We think the implications behind Italy’s exposure to Libya (and vice versa) are considerable, which we quantify below.

 

By the Numbers

 

Libya:

  • Produces roughly 1.8 million barrels per day (bpd) of oil, down from peak production of 3 million bpd in 1960
  • The world’s 12th largest net exporter of oil at 1.5 million bpd. (~95% of the country’s export earnings come from the hydrocarbon industry)
  • The largest proven oil reserves in Africa at 44 Billion barrels, followed by Nigeria 37.2 bb and Algeria 12.2 bb
  • 54 Trillion cubic feet (tcf) of natural gas reserves, the 4th largest in Africa behind Nigeria (185.3 tcf); Algeria (159.0 tcf); and Egypt (58.5 tcf)

ENI:

  • ENI is the largest oil consumer in Libya
  • Italy’s consumption of Libyan oil (via ENI) accounts for ~ 24% of local consumption
  • Italy is Libya’s largest export market at 365,742 bpd in 2010, or 29% of total exports, followed by France at 14%, China 13%; Germany 11%; and Spain 10% according to the EIA
  • ENI has committed $25 billion of investment in Libya over the next decade

Market Performance:

  • ENI is down -6.3% since 2/18
  • FTSE MIB (Italy’s broad equity market) is down -5.2% since 2/18
  • Etf EWI, in which ENI composes 18.3%, is down -5.3% since 2/18

 

Broader Implications for Italy and Berlusconi

  1. Despite calls from Italy’s Industrial Minister Paolo Romani that the country isn’t in danger of running out of natural gas we think Italy’s energy reliance on Libya is compelling.  On Tuesday ENI suspended its Greenstream pipeline that supplies ~ 10% of Italy’s natural gas needs. And while Romani cited that commercial stockpiles of 134 billion cubic feet of gas can be tapped if needed, and the country can increase import supply lines from Algeria, Norway and Russia, we take the view that a.) there’s significant probability that production will be completely severed/no one will be manning the equipment and, b.) increasing alternate supply lines is never as easy as flipping a switch, and would be expensive given this time of the year.
  2. Despite a phone call that Berlusconi gave to Gadhafi yesterday, urging him to avoid bloodshed, Berlusconi is viewed as buddy-buddy with Gadhafi, which reflects poorly on his already tarnished leadership. (Berlusconi stands trial beginning on April 6th for allegedly having sex with an underage belly dancer). Allegedly, Berlusconi shut down Rome’s largest park in June 2009 to allow Gadhafi and his entourage of all-female bodyguards to set up camp.
  3. Uncertainty abounds ENI’s footprint in Libya and conversely Libya’s investments with Italian companies, including: Fiat, UniCredit, or the Jeventus soccer club.
  4. We can’t substantiate the numbers, but just today in parliament Italy’s Foreign Minister Franco Frattini said that Italian companies stand to lose 4 Billion EUR in infrastructure projects.
  5. Italy could be one country to see a mass exodus of refugees to its shores. Officials in Brussels believe as many as 750K could attempt to cross the Mediterranean, but Libyan estimates put the figure as high as 2 Million (of a population of ~6.4 Million Libyans).  Italy already faced an influx of over 5K Tunisian refugees following the country’s regime change.  Clearly, policing an influx of these proportions would be a huge tax on the Italian state.  

Much like with the uprising in Tunisia and Egypt, we cannot solve for the unknowns that will transpire in the coming days. What’s clear is that share prices from energy companies in Libya, including companies such as Total, OMV and Repsol, will be taking a hit as these companies move to shut down production. In particular, we view Italy’s outsized energy exposure (via ENI) to Libya as a critical force weighting to the downside of its equity market, or the etf EWI with its heft ENI weighting. We’ve long been critical of the Italy’s excessive debt leverage and have been short Italy via the etf EWI at times over the last 6 months in the Hedgeye Virtual Portfolio. Now, we see even more short-term downside pressure for Italy’s FTSE MIB given the country’s exposure to the precarious state of Libya.   

 

As we show in the chart below, the FTSE MIB is trading between a rock and a hard place. It is trading above its TREND line of support at 21,193, but recently broke through what was its TRADE line of support, and is now resistance, at 22,709.

 

Matthew Hedrick
Analyst

The Gadhafi-Berlusconi Trade - mib


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Commodity Scorecard...The Good, the Bad, and Natural Gas

The confluence of increased geopolitical risk, easy monetary policy, slowing growth in emerging markets, and abnormal supply forecasts has whipped commodity prices about wildly in 2011.  Here is a quick recap of what’s driving the recent price moves (other than US dollar correlation) of ten commodities that we keep a close eye on.  For reference, the US dollar index (DXY) is down -2.80% YTD.

 

Cheddar Cheese: +47.67% YTD, -0.71 correlation w USD

  • Several factors have rocketed the price of cheese higher in short order.  First, higher feed costs (corn, oats) have made their way to the end product.  Second, attractive slaughter cow prices appear to be encouraging much heavier culling of cows from the herd.  And third, Australia and New Zealand, which account for 40% of the world dairy trade, have scaled back milk production forecasts for 2011 due to adverse weather negatively impacting pastures.

Cotton: +26.52% YTD, -0.57 correlation w USD

  • Cotton prices may have stabilized after hitting a 140 year high on February 17th, falling 15% since.  Cotton is still up 129% over the last year, which is hurting emerging markets.  Yesterday the Apparel Exports Promotions Council of India announced soaring cotton prices are likely to crimp India's apparel exports by at least 15% in volume terms this year.

Cocoa: +20.26% YTD, -0.76 correlation w USD

  • Alassan Ouattara, President of the Ivory Coast, has extended the country’s ban on cocoa exports until March 15, 2011.  As a result, cocoa prices are at a 32-year high.  The Ivory Coast produces 37% of the world’s cocoa.

Brent Crude Oil: +16.02% YTD, -0.55 correlation w USD

  • It appears that (at least for now) Brent crude is more indicative of global supply and demand for oil than is WTI, as the glut of supply in Cushing, OK has caused WTI to lag other light, sweet grades.  Brent crude is now at its highest level since September 2008 as violence in Libya and the fear of contagion has the market worried about future supply.  Currently, the Middle East produces 57% of the world’s oil.

Corn: +7.47% YTD, -0.53 correlation w USD

  • The US Department of Agriculture data shows that global corn inventories are at a 37-year low as producers are unable to grow enough grain to keep pace with consumption.  The global grain harvest for the past season was 2.18 billion metric tons, down 2.5% year-over-year.  The USDA estimates that the world will consume 2.24 billion metric tons of corn this year.

Gold: -0.61% YTD, +0.26 correlation w USD

  • Gold underperforms when real interest rates are positive and rising – that is why gold had its worst January in twenty years.  However, gold performs well when geopolitical risks escalate, which is why this safe haven is up 3% in the last five days.

Copper: -3.62% YTD, -0.27 correlation w USD

  • Weakness in copper is not bullish for global growth.  Copper stockpiles tallied by the London Metal Exchange are at the highest level since August 2010, while inventories monitored by the Shanghai Futures Exchange jumped to a nine-month high of 161,062 tons last week.

Wheat: -4.91% YTD, -0.65 correlation w USD

  • MENA buys 32% of global grain shipments and Egypt is the world’s largest wheat importer.  Violence and riots in the area will curb demand for soft commodities, which is why corn, wheat, and soy were limit-down on Tuesday.  On the supply side, India announced today that it may permit wheat exports as the country may harvest a record crop this season.

Natural Gas: -13.05% YTD, +0.32 correlation w USD

  • As the peak demand season for natural gas comes to a close, natural gas is stuck under $4/Mcf.  An extreme winter has US gas inventories 6.3% below the 5-year average, yet traders are confident that supply will come roaring back once the drawdown season ends.  Supporting this, BHP Billiton (BHP) plans to triple output from current levels in the Fayetteville shale in Arkansas, the assets that they acquired this week from Chesapeake Energy (CHK).

Coal: -15.38% YTD, +0.36 correlation w USD

  • China, the US, and India are the top three consumers of coal.  Growth is already slowing in India and China, and we don’t think that the US is far behind.  Coal down 15% YTD is not bullish leading indicator for economic strength in the US.

Kevin Kaiser

Analyst


TXRH – MANAGEMENT STRIKES AN OPTIMISTIC TONE

Management is confident from a top line perspective but is appropriately cautious on margins and earnings.  Long term, the growth potential seems strong but the risk of prolonged commodity inflation in 2011 and into 2012 may depress earnings power even if sales growth were to meet management’s expectations.

 

TXRH’s 4Q10 earnings of $0.14 per share came in slightly below the street’s $0.16 per share estimate despite stronger-than-expected company comp growth of +3.1%. The recent trend has been for companies to miss on the top-line and beat on the bottom line and TXRH was one of only a few names this quarter to report better-than-expected comp growth and fall short of consensus EPS estimates.  With inflation headwinds becoming more prevalent in the coming quarters, however, this will likely become more common.  Additionally, given that TXRH is trading down today, along with the broader market and most other restaurant names, it seems that investor focus is shifting somewhat toward potential margin and EPS performance and away from comp performance alone.

 

TXRH’s same-store sales growth improved 40 bps during the fourth quarter on a two-year average basis and 1Q11 quarter-to-date comp growth of +3.8% (vs. -1.2%  last year) implies that two-year average trends have accelerated another 100 bps since the end of the year.  Management guided to 10% full-year EPS growth (from its prior 5-15% range), which assumes 3.5% comp growth, 3% inflation and a 20-30 bp decline in restaurant-level margins.  Although the company raised its comp growth assumption to 3.5% from 2-3%, it also slightly increased its inflation outlook from its prior range of up 2-3%.  Management commented that it is now only targeting the mid-point of its prior EPS range because the high-end had assumed a +2% menu price increase and they have decided to be more conservative and only implement a 1% price increase by the end of the first quarter.

 

Like most of the casual dining names, there are risks to TXRH’s guidance.  Inflationary pressures could come in higher than anticipated and comp targets could be aggressive.  Specifically, TXRH has locked in 65% of its food cost needs for 2011, including more than 80% of its beef.  For the food items not yet hedged, however, most notably dairy, produce and some protein requirements for the end of the year, the company’s 3% inflation expectation assumes prices don’t remain at their current levels.  If prices stay where they are or move higher, commodity costs will be up more than +3%.

 

TXRH’s FY11 same-store sales growth target, like most other casual dining names, assumes a continued improvement in two-year average trends throughout the year.  The most important comp growth dynamic to watch going forward for the restaurant names will be the impact of price on traffic trends as most companies are taking price for the first time in a while.  TXRH’s current guidance only assumes a +1% price increase, but management said they could revisit their pricing strategy and raise prices again if the commodity environment warrants it.  It was encouraging to hear that TXRH management understands that it must be conservative with pricing in this environment and they highlighted that if traffic falls off as a result of higher pricing, that it will hurt them on the labor line. 

 

Traffic has been running positive for TXRH for the last three quarters with average check declining slightly.  As the chart below highlights, however, the traffic comparisons get increasingly more difficult going forward, particularly come 2Q11, so it will likely prove difficult for the company to hold traffic flat.  For reference, flat traffic growth in 2011 would imply almost 100 bps of acceleration in two-year average traffic trends from 4Q10 levels.

 

TXRH – MANAGEMENT STRIKES AN OPTIMISTIC TONE - TXRH traffic vs check

 

Inflation and tougher traffic comparisons will pose problems for most casual dining names in 2011.  Given that TXRH’s comp trends outpaced the industry in 2010 as measured by Malcolm Knapp by 2.5% to 3.5% on a one-year basis and 2-3% on a two-year average basis and trends have accelerated quarter-to-date, the company sits in a better position than many of its competitors to raise prices.  Additionally, the company has better  visibility on its commodity cost outlook than many other casual dining concepts since it has already locked in 65% of its food cost needs for 2011, most importantly, more than 80% of its beef.

 

That being said, the company’s 3.5% comp guidance could prove somewhat aggressive (I am currently modeling +3%), particularly when you consider the impact the menu price increase could have on already difficult traffic comparisons.  Along with my slightly lower comp growth estimate, I am modeling a 40 bp decline in FY11 restaurant-level margins relative to management’s guided -20 to -30 bp range.

 

At today’s Analyst and Investor Day in NYC, management struck a confident note that the company will be able to find new avenues of growth for investors.   The development team has found significant cost cuts in development costs and simply by comparing the number of TXRH units nationwide (346) versus Outback Steakhouses (778), the case could be made that there is some white space for expansion.  The fact that AUV growth has outpaced same-store sales growth for the last two quarters also implies that new units are performing well and makes the case for continued growth.  Kent Taylor, founder and Chairman, stressed that he visits each prospective site along with other top executives to ensure that each development is given due consideration and assessment prior to committing. 

 

From a sales perspective, TXRH is certainly taking a proactive approach in seeking to drive the top line in any way possible.  A call ahead service, designed to allow customers to “get in line” from home and arrive 10-15 minutes prior to being seated has seen strong growth in popularity and a text ahead service is also being considered by management.  Furthermore, the company is choosing to focus on local marketing rather than national advertising and other “noisy”, “undifferentiated” channels of communication.  One high-class problem the chain has is customers turning away from the door because of wait times.  Management is implementing several initiatives to combat this issue but it is unclear that they will make a significant difference.  The most compelling was a “pay-at-table ZIOSK” idea that is estimated to shave 2-3 minutes off the total time a party spends at a table. 

 

 

Howard Penney

Managing Director


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