Headline consumer sentiment is on the mend, but there is once again a dramatic divergence between consumer expectations and present situation which is driving the over-all improvement.  The divergence between the two is what we call the Optimism Spread.


The Conference Board Expectations Index has gained rapidly since the trough in February 2009 and is now merely 1% from its most recent peak of December 2006.  Coincidentally, the Conference Board Present Situation Index has moved largely sideways since early 2009, remaining a staggering 76% off its most recent high of March 2007.


The topic of the U.S. consumer is foremost in investors’ minds and is of ten used by management teams to express when business may be good or bad in any given quarter.


The recent uptick in consumer sentiment is being driven by the increase in expectations of better times ahead and not by the “present situation.”  On Monday, the inflated optimism was exposed for what it is as the government reported that “real” spending fell 0.1% in January, following a 0.3% increase in December and a 0.2% rise in November.  Importantly, January’s decline was the first since April and puts real spending at 1.2% at an annualized basis in January 2011.  We estimate that the current pace of annual spending needs to double to drive GDP growth above 3%.


Consumption drives approximately 70% of GDP and we have been uncomfortable with the bullish case for consumer spending since the introduction of the Consumption Cannonball theme in September of last year.  We sometimes present themes that can are early, but in this case it is clear that there are acute risks pertaining to the consumer that are largely being ignored by investors.  We are more comfortable with our belief that consumption is set to slow following Monday’s consumer spending data, and are further encouraged by the fact that Hedgeye’s bearish thesis on housing continues to play out.   Although housing hasn’t spooked the market of late, if our Financials team’s forecast continues to play out as it has been, it will have a serious impact in 2011.


In January, personal consumption expenditure was weak despite a 1% surge in personal income.  January’s gain was mainly due to a number of special factors including a $100 billion reduction in contributions for government social insurance.  Social security withholdings were reduced as part of the Tax Relief, Unemployment, Insurance Reauthorization and Job Creation Act of 2010. Although employment grew by just 36,000 jobs in January, wages and salaries also expanded at a fairly strong and steady pace, increasing by 0.3%. The personal savings rate reached 5.8%; the first time since June 2010.


Rising food and energy prices are a drag on real spending and can influence expectations that the economy is getting better.  In addition, the prospect of public sector cutbacks is looming large over broad swathes of the workforce.  With so much inflation uncertainty inherent in the system today, why are consumers so much more about the future versus  the current situation?


(1)    Bernanke/QE is working?

(2)    The republican takeover of Washington?

(3)    Tax cuts?

(4)    The jobs picture’s gradual improvement?

(5)    The S&P 500 being up 5 of the last 6 months?


While our cautious stance on consumer spending appears warrented looking at the January data, it is too early to claim victory.  Winter weather was a drag on January spending.  As we look forward, anything less that 0.7% in personal spending for the next two months will likely lead to the consensus to reduce its GDP forecast. 


Below, we attempt to interpret the usefulness of our Optimism Spread from a market standpoint and the results are interesting but less-than-conclusive.   While the consumer’s rosy expectations have generally been prescient indications of recessions coming to an end, the track record from a market perspective has been less impressive. 


The question I believe is most pertinent from here is whether or not we are in an economic environment that is more anomalous to the 70’s or the period following Volcker hiking rates and the ensuing equities bull market that played out as rates were cut to zero. 


Howard Penney

Managing Director





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2010 was an exceptional year for DPZ.  2011 will likely not be as impressive, however, given higher commodity costs and tough comparisons from a top line perspective.  Management knows the company’s YOY momentum will slow in 2011 and, accordingly, cautioned investors to not focus too much on YOY comp growth as the company laps the strong performance from 2010.  Specifically, management said it expects to post a negative sales comp in 1Q11. 


Comparisons get a little easier during the balance of the 2011 after lapping the initial trial period around the launch of DPZ’s new and improved pizza in 1Q10, but they remain difficult.  Although management did not comment on its same-store sales growth expectations for the remainder of the year, it is important to note that if two-year average domestic company-owned comp trends stay flat with 4Q10 levels throughout 2011, it would imply a -3.4% comp for the full-year.  Even if two-year average trends accelerate from here, same-store sales growth will slow meaningfully on a one-year basis.  I am currently modeling flat comp growth for FY11, which assumes a quarterly decline in both the first and third quarters.




Rather than comp growth, management directed investors to focus, instead, on overall volumes and profitability.  Nevertheless, I have my concerns about DPZ’s profitability in 2011.  DPZ achieved margin growth in 2010, despite the 16% increase in cheese prices.  Cheese prices moved straight up, but so did comp growth.  Cheese prices will move higher again in 2011, up 13-17%, based on management full-year forecast of $1.70-$1.75 per pound.  The company guided to a 3-4% increase in total commodity costs in FY11.  For reference, DPZ does not lock in any portion of its cheese needs but has a contract in place with its supplier that allows the company to reduce the impact of cheese market price volatility by approximately one third.  Outside of chicken, the company has not locked in any of its other meat needs.


The expected 3-4% increase in commodities assumes cheese prices ease from their current level of nearly $2.00 per pound so there is risk to management’s current expectations.  Either way, DPZ contended with higher cheese prices in 2010 thanks to elevated domestic company-owned comps, which increased 9.7%.  In 2011, however, cheese prices will continue to move higher as comp growth moves lower.  Both store-level and supply chain margins will take a hit from the expected 13-17% increase in cheese prices (could prove conservative) as same-store sales and volume growth moderates significantly and potentially turns negative. 


Management said that they have not yet decided whether to take price in 2011 given that consumers still want value, but commented that a 1% price increase would be necessary to offset a 3-4% increase in commodities.  The company also highlighted that some of its QSR competitors are starting to take price now, “but with the sorts of increases [they] are looking at right now, you are not looking at a big issue at this point.”  I have to disagree with this point because, as I said earlier, the expected 3-4% increase in commodity costs could prove conservative and any price increase in this environment will likely take a toll on traffic, which could turn into a big issue for DPZ when you consider the level of traffic gains the company is lapping in 2011.




Howard Penney

Managing Director

PSS: Top Line Expectations into Q

 In looking at the upcoming quarter for PSS after the market close on Wednesday, we remain positive on the fundamentals (in fact, Keith just added to the Hedgeye virtual portfolio).  Making a call into the quarter for such a high-beta stock rarely sits well with us – especially for a company  that is hardly afraid to miss a number.  But the reality is that we’re seeing good signs out of PSS’ PLG business, and the comp on the core Payless business seems to be holding its own.



As a reminder, our call on this name is that its two primary growth brands (Sperry and Saucony – which account for about 30% of EBIT) are fueled by an annuity revenue stream out of the base business. Trends in those segments are nothing short of robust (see chart 1 below).




All in all, we’re at a loss of $0.15 this quarter versus the Street at ($0.19) – its seasonally lowest quarter of the year.

Next year we're shaking out between $2.00 and $2.10 vs street at $1.76 -- but will need some questions answered w the print.  


The charts below have had a good directional impact in the past


 PSS: Top Line Expectations into Q - PSS PLG Q4 trends 2 11


PSS: Top Line Expectations into Q - PSS CompTrends 2 11 Q4

Could the Kingdom Fall?

Conclusion: Though once unthinkable, the fall of the Saudi kingdom now seems at least in the realm of reality.  That is, popular unrest in Saudi Arabia and the Middle East could lead to a shift away from the autocratic rule in Saudi Arabia.  Keep March 11th on your calendars as Saudi youths have organized a day of protests against the monarchy called the Day of Rage.


Conventional wisdom suggests that Saudi Arabia will be immune from the popular upheaval that is occurring more broadly in the Middle East. The key factor supporting this view is simply that the standard of living is quite high in Saudi Arabia.  In fact, Saudi Arabia’s GDP per capita was $23.7K in 2010 based on the most recent data from the International Monetary Fund, which ranks it 39th in the world and just below such stable democracies as New Zealand. 


We often use market prices as a leading indicator for fundamentals in our model, and the Saudi stock market has been flashing some amber lights.  In the chart below, we’ve attached a 3-week chart of the Saudi primary equity index and 5Y CDS quotes.  As you can see, there has been a severe correction in the Saudi stock market of more than 10% and an expansion by more than 20% in CDS spreads.


Could the Kingdom Fall? - 1


While this correction is not surprising given the geo-political uncertainty in the Middle East (Tunisia, Egypt, Libya, and so on), on the other hand, the price of oil has gone up dramatically in that period, which, on a fundamental basis, improves the financial position of Saudi Arabia.  Specifically, almost 90% of Saudi Arabia’s export revenues are petroleum based.  Moreover, Saudi Arabia has 260 billion barrels in oil reserves, which is about 1/5 of the world’s total, and is the world’s largest exporter of oil.


Despite this and higher relative GDP per capita, all is not well in the Kingdom of Saudi Arabia.  In fact, both inflation and unemployment are pervasive in Saudi Arabia.  While data from the Saudi government is questionable at best, some reports reasonably put inflation at north of 5%, which is clearly squeezing those near the bottom of the income pyramid.  In the same vein, while unemployment measures are also difficult to come by, most estimates put the national rate at close to 11%.  The International Labor Organization (ILO), considered more credible, has put the unemployment rate for those between the ages of 20 – 25 at closer to 30%.  This is particularly important given then demographics of Saudi Arabia, where the population is young with median age of 23.4 years old.  (This is compared to 36.9 in the United States.)


Directly below, we’ve highlighted a chart from ILO, which compares unemployment, youth unemployment, and GDP globally.  The slow growth and high unemployment issues are quite clear in MENA.


Could the Kingdom Fall? - 2


In signal that the Saudi royal family is taking the risk of social upheaval  very seriously, last week Saudi King Abdullah bin Abdul-Aziz’s announced a $37 billion benefits package to create 1,200 new jobs, raise cost-of-living allowances, grant interest-free home loans, and more.   This was underscored by Prince Alwaleed bin Talal from Saudi Arabia, said to be the world's eighth-richest man, who wrote an op-ed in the New York Times, calling for "unwavering, enduring and sincere" reform.


The stock market, despite this package, the strong price of oil, and positive rhetoric, continues to signal danger.  In fact, the Tadawul, the largest stock market in the Arab world by capitalization, plunged (-6.78%) to 5,538.72 overnight, bringing its decline for the year to date to (-16.34%).


So, could the Kingdom of Saudi Arabia fall? While the Royal family has much in the way of wealth to appease it citizens, sharing power and democratic rights could be the real lynchpin to satisfy popular protests.  To that end, it is not clear the royal family is there yet.  The Day of Rage on March 11th could be a key catalyst in the future of Saudi Arabia, and its royal family.


Daryl G. Jones

Managing Director

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