State & Local Government Finances Not Just a Problem for Muni Bonds

Conclusion: Recent developments in the FY12 State & municipal government budget season reveal to us several trends that are incrementally bearish for US GDP growth and the US Dollar over the intermediate-term.




Given recent unrest in the Middle East, State and municipal finances have been placed on consensus’ back burner even as protestors continue to flock to the streets of Wisconsin, Indiana, and Ohio while minority legislators of these States camp out across State lines to avoid voting on controversial bills.


With States facing a collective $125-$140B budget gap in FY12 (starting on July 1 for all but four States), we expect investors to pay increasing attention to this topic as we advance further into a historic budget season, which is being delayed on the margin by the world’s largest game of “kick the can down the road” (referring specifically to the federal government’s resolve to fund itself for two weeks at a time).


One could make a compelling argument that the public employee protests currently impacting the Midwest region will spread throughout the country like wildfire, especially considering the relative health of Wisconsin, which just recently issued arrest warrants for its fugitive legislators. The chart below speaks volumes to the potential for growing civil unrest throughout the nation, given that the fiscal adjustment needed in WI, IN, and OH are fairly benign relative to States like NV, IL, NJ, TX, and CA:


State & Local Government Finances Not Just a Problem for Muni Bonds - 1


At the bare minimum, the key takeaways here are:


I: Widespread protests and delays in passing State & municipal budgets are, on the margin, bearish for GDP growth in the near term due since the outcome is likely layoffs of public employees and a delay in implementing true fiscal reform. Accordingly, the US dollar is reacting negatively to these budget battles, which are not being resolved expeditiously (refer to our Q1 theme of American Sacrifice for more details):


State & Local Government Finances Not Just a Problem for Muni Bonds - 2


II: As we outlined in our deep dive munis presentation a few weeks ago, many of the cuts, tax hikes, and union-shrinking proposals are not politically palatable. The result of widespread public backlash and legislative uproar to governors’ budget proposals is more than likely to result in some combination of declining public payrolls, accelerating retirements by public employees afraid of losing pension benefits/eligibility, and an acceleration of muni bond issuance, which, on the margin, is incrementally supportive of our case for higher interest rates throughout the US economy. (refer to our Q1 theme of Trashing Treasuries for more details):


State & Local Government Finances Not Just a Problem for Muni Bonds - 3


State & Local Government Finances Not Just a Problem for Muni Bonds - 4


State & Local Government Finances Not Just a Problem for Muni Bonds - 5


Neither of these outcomes is supportive of consensus’ current US GDP growth estimates.


As mentioned before, threats to union rights and their collective bargaining power are fueling the current demonstrations in WI, OH, and IN. Regarding State & local government employment specifically, various studies have concluded that public sector employees earn more in aggregate compensation relative to private sector employees.


Per a December report out of the BLS, wages and salaries for State & local government employees averaged $26.25 per hour vs. $19.68 per hour for private sector workers. In addition, State & local government employee benefits outpace those received by private sector employees by $5.65 per hour worked ($13.85 vs. $8.20). A recent study by USA Today found this to be true in 41 States (including D.C.).


Given the relatively healthy compensation of heavily-unionized public sector workers (36% vs. 15% in the private sector), an accelerated deterioration in labor trends in this sector will be an incremental headwind to aggregate US consumption growth over the next 3-4 quarters (in addition to consumer price inflation and housing deflation).


In aggregate, a potential reduction of over $100B from GDP by cutting State & local spending, in addition to a contraction in household consumption associated with a decline in the commensurate savings from soon-to-be-cut services provided by the government, is not bullish for growth. Moreover, tax hikes like those proposed in CA, CT, and IL (to name a few) won’t help either…  




Federal Budget Cuts: House bill 302(b) has proposed to cut non-defense discretionary spending by $63B below the original FY11 budget and 15-16% below the current continuing legislation. Aside from Medicaid, this is the category where the bulk of federal funding for States and municipalities is derived from. These cuts are on top of the well-known collapse in federal stimulus funding beginning in FY12: 

State & Local Government Finances Not Just a Problem for Muni Bonds - 6


State & Local Government Finances Not Just a Problem for Muni Bonds - 7


Inability to Adequately Pare Rising Medicaid Costs: Republican governors have met with Obama this week to ask for more flexibility in managing Medicaid implementation. Many of them, including New Jersey’s Chris Christie and Kansas’ Sam Brownback left the talks uninspired and incrementally worried about upcoming budget deadlines. Current federal mandates severely limit the amount of cost cutting States can do with regard to Medicaid (21% of total expenditures), so the focus of budget cuts will be forced to shift elsewhere.


State & Local Government Finances Not Just a Problem for Muni Bonds - 8


Changes to Federal Tax Code: Federal legislation enacted in December allows corporations to immediately deduct the entire cost of capital investments on purchases made from 9/8/10 - 12/31/11, rather than the typical depreciation schedule. Absent changes to current State tax code, 19 States stand to lose roughly $5-$6B in corporate tax revenues in the upcoming fiscal biennium.


Rising Unemployment Insurance Costs: Starting this fall, 30 States will be responsible for paying $1.3B in interest payments on $42B in loans taken out from the federal government to support depleted unemployment insurance funds. Currently, President Obama is attempting to push through legislation that will delay these interest payments for an additional two years, though Republican Congressmen refuse to support the proposal because it effectively doubles the portion of worker incomes subject to unemployment insurance taxation. Many States plan to issue bonds to fund the interest payments should the bill fail to pass the legislative process.


All told, the tea leaves provided by the standoffs in Wisconsin, Ohio, and Indiana, paint a cautious mosaic for this sector’s contribution to US GDP in 2011 and beyond. At 12.2% in 2010, State & Local government consumption was a close third in US GDP weightings; our call is for that “close” third to shift to a “distant” third and weigh on growth over the intermediate-term TREND. From a long-term prospective, however, a much-needed dose of austerity is exactly what this country needs to salvage its prosperity.


Will the professional politicians of America have the political spine to make the tough choices they’ve been called upon to make? Wisconsin Governor Scott Walker (R.) best summarizes the urgency of addressing this question with his recent comments:

 “We’re broke in this State because time and time again, politicians of both political parties ran away from the tough decisions and punted them down the road for another day. We can no longer do that.”


New Jersey Republican Governor Chris Christie’s recent comments confirm this growing sense of urgency due to States running out of “outs” themselves:


“We can’t print money. We can’t run trillion-dollar deficits.”


To his point, 46 States have to balance their budgets by July 1 or risk delays in payments to vendors and creditors alike. If the US Dollar and the protests in Wisconsin et al are indicating anything, it is that this catalyst is closer on the horizon than a resolution of the budgetary debates. Stay tuned…


Darius Dale


The Week Ahead

The Economic Data calendar for the week of the 7th of March through the11th is full of critical releases and events.  Attached below is a snapshot of some (though far from all) of the headline numbers that we will be focused on.


The Week Ahead - zz1

The Week Ahead - zz2


Crude Oil in the U.S. – Is the Price $103/bbl or $115/bbl?

Conclusion: Refined products (gasoline and diesel) in the U.S. are tracking Brent crude oil, and not WTI.  If you are using WTI as your marker for oil’s impact on consumers in your macro model, you should reconsider.


Beginning in November 2010, the price of WTI oil began to lag behind other light, sweet oil benchmarks.  For many weeks the market was perplexed by the widening spread between WTI and other oils.  It was not just Brent that pulled away from WTI, but ALL light, sweet crudes.


Now, the issue is understood well.  The glut of crude oil at WTI’s pricing hub – Cushing, OK – is weighing down the price.  Additional barrels coming from Canada via the Keystone pipeline and new shale oil plays in the mid-continent, namely the Bakken (ND), Niobrara (WY/CO), and Woodford (OK), are bidding for storage in Cushing.  There is no quick solution.  Only a pipeline running from Cushing, OK to the Gulf coast will allow WTI to play catch-up to other light, sweet grades, and construction of such a pipeline is nowhere in the foreseeable future.  Until then WTI will trade at a considerable discount to comparable crude oils.  Currently, the Brent-WTI differential is $12.50/bbl.


Interestingly, the prices of refined products in the U.S. are no longer tracking WTI.  When WTI began lagging other oils, gasoline and diesel did not hang back with it.  Currently, the correlations between a barrel of WTI crude oil and refined products since Nov 15th, 2010 are:


Gasoline: +0.83

Diesel: +0.69


Over the same duration, the correlations between a barrel of Brent crude oil and refined products are:


Gasoline: +0.98

Brent: +0.98


Crude Oil in the U.S. – Is the Price $103/bbl or $115/bbl? - kk brent1 wti1


What is going on here?  Well, WTI is the traditional benchmark for oil prices in the United States.  Up until a couple a months ago, this worked because all light, sweet crudes traded close to parity.  However, now that WTI is at a considerable discount to other oils, the price of WTI is not consistent with the price of oil everywhere in the U.S.


Here is the breakdown of where the U.S. holds its oil:


East Coast (PADD 1) – 3.5%

Midwest (PADD 2) – 30% (which 1/3 of which is Cushing, OK, or 11% of total U.S. stocks)

Gulf Coast (PADD 3) – 48%

Rockies (PADD 4) – 4.5%

West Coast (PADD 5) – 14%


Crude Oil in the U.S. – Is the Price $103/bbl or $115/bbl? - PADD Map


The benchmark oil price is different in each PADD.  We contend that the best light, sweet benchmark for each PADD is:


East Coast (PADD 1) – Brent, spot = $115/bbl

Midwest (PADD 2) – WTI, spot = $103/bbl

Gulf Coast (PADD 3) – Light Louisiana, spot = $120/bbl

Rockies (PADD 4) – WTI, spot = $103/bbl

West Coast (PADD 5) – Alaska North Slope (not light and sweet, but really the only crude West Coast refiners run), spot = $115/bbl


The weighted average U.S. light, sweet oil price based on location of the barrels and the benchmark price for each location is $115/bbl – exactly the current price of Brent.  This is why the prices of Brent crude oil and refined products in the U.S. have a 0.98 positive correlation.


So, if you were worried about $103 oil squeezing U.S. consumers, how does $115 oil sound?


On the micro, energy level, mid-continent refiners are benefitting from both ends of the refinery gate, with lower feedstock costs, WTI, and higher refined product prices.  Our favorites are Holly Corp. (HOC) and Frontier Oil (FTO).


From the Oil and Gas Patch,


Lou Gagliardi


Kevin Kaiser


How many people passed up buying MCD at $15 or SBUX at $10 because they were unsure of whether or not the brand can thrive and generate the revenue and profits it once did. 


You can make up 100 reasons not to buy a stock and they may all be valid.  However, finding a true turnaround story requires the ability to look past the inconsequential noise and identify positive change and value creation in a company.


Just for a minute, put aside any baggage you may carry about WEN (however justified) and take a look into what could be for a brand that has been lost for the past ten years. 

Wendy’s is traded up 7.6% yesterday on volume of almost 18m shares (+111% versus the 30-day average).  The story appears to be gaining more traction on the Street, but it is still untold with 67% of the sell-side analyst community having a hold or sell on the name.   Trading up above $5 at the time of writing, I think it could go far higher.


As a practice, we don’t set target prices but, if I were going to dream a little, I would have a $10 number in mind.  What would it take for Wendy’s to get to $10?  Such a move would almost be McDonald’s/Starbucks-esque and, while I recognize that Wendy’s is not a category leader and competes in a more competitive industry, I think it is possible.




The Wendy’s brand is very healthy and its current trends of positive comps in 1Q11 speak to the health of the concept.  Currently, management is guiding to 1-3% for 2011.  What if those expectation prove to be conservative.  Unlike a brand like Burger King, Wendy’s has a very loyal and broad customer base.  There is a possibility that the national rollout of the new cheeseburger in 2H11 resonates with the loyal customers and sparks increased usage of the brand.  The burger patty will also allow the company introduce more new product using the name of founder Dave Thomas.  


If management expectations for same-store sales prove conservative, this could provide significant upside in the stock.  The only incremental information from today’s earnings release and conference call was that comps were positive in February and will be flat-to-positive for 1Q.  The stock reacted positively to this and I believe additional improvement in comps would likely instigate another leg up in the stock price.




It’s obvious to those close to the company that the company has struggled trying to find an advertising campaign that resonates with the consumer.  As I alluded to above, the use of Dave Thomas’s name in the new hamburger could be that undiscovered marketing boost the company needs.  The Wendy’s advertising message has not resonated as strongly since Dave Thomas passed away.  Naming the new burger after him will allow the company to bring back Dave’s name and promote a message of the company going back to the basics that Dave endorsed such as high quality food and a high level of customer service.  I’m not sure how this is going to play out, but reconnecting the Wendy’s core customer to Dave Thomas could bring incremental traffic.


Initially, the company has a new advertising campaign, starring Dave Thomas daughter Wendy, which has seen a favorable response.  While this is unlikely to cure all ills for the brand, it is a start and indicates to me that management is taking a measured and targeted approach to how they drive brand awareness and image going forward.




All of management’s attention being focused on repairing Wendy’s margins over the next few years spells good news for the future.  It is important to note that the current improvement in margins has come from better operations and not leverage from increased sales trends.  Wendy’s margins have recovered from 11.6% in 2008 to 15.5% in 2010.  If the current initiatives have an out-sized impact on same-store sales, the concept is perfectly positioned to capture the flow from the increased sales volumes.  In the past cycles, Wendy’s margins peaked out at 16.5% (+/-) and the concept was never really managed with a surgical focus on operations.  Given the lessons of past business cycles and the new focus management seems to have adopted, who is to say that Wendy’s margins can’t reach 18-19%?




Investing alongside Trian could provide some upside to expectations.  In this environment (and given how troubled the brand is) just the announcement that there is actually a deal for Arby’s will be a net positive.  The Arby’s brand can benefit from being a standalone organization too.  Like Wendy’s, Arby’s needs to return to its roots and focus on operations.  This can't be accomplished as a secondary brand in a bigger organization.


Upon completion of the sale of Arby’s the WEN balance sheet will be in much better position.  The freed up capital will allow the company to buy back more stock, pay a dividend and increase the company’s domestic and overseas growth initiatives.  In the end, I would err on the side that the partners at train will come up with a deal that benefits there significant equity stake in Wendy’s.


I realize that this narrative seems far-fetched; for Wendy’s to get to $10 in two years, the company EBITDA will need to grow by 40-50%.  Yes, that seems like a big number, but if I told you two years ago that Starbucks EBITDA was going to grow by 43% by the end of fiscal 2010 you would have laughed. 


In the short run, management’s confidence in the company’s ability to grow margins next year in the face of commodity headwinds is also good news.  Again, this could prove conservative, if sales trends improve significantly in 2H 2011.  In 2011, a simply menu and investment in point-of-sale technology, coupled with sales leverage, are key to management’s optimism and I believe, having seen this strategy play out before, that the strategy will be successful.  The outline I have provided here may be fanciful and there are certainly a lot of contingencies attached to the path to $10 for Wendy’s.  Nevertheless, I see significant upside for this stock over the next two-to-three years and $10 may not seem unreasonable.


I also feel very comfortable in being out of consensus.  The sell-side community is very much not behind the Wendy’s story. 


Lastly, being bearish on MCD is bullish for WEN.  If you believe (as I do) that MCD is too focused on driving incremental sales from selling beverages not burgers, when WEN will be one of the bigger beneficiaries.


THE WEN DREAM OF $10 - qsr sell side sentiment


Howard Penney

Managing Director


A seventh consecutive month, albeit sequentially slower, of employment growth is supportive of quick service restaurant stocks.


The data, detailed in the chart below, show that the 20-24 year old age cohort saw month-over-month employment growth of +3.0% versus +3.6% in December.  Unemployment in this demographic, a key source of traffic for QSR companies, is extremely high on an absolute scale but growth in employment levels for this age group is encouraging.  Given that growth slowed on a sequential basis by 61 basis points, this data point is not as positive as January’s was.  The decline represents the largest sequential slowdown in employment growth among 20-24 year olds since October 2009.


QSR: EMPLOYMENT UPDATE - employment chart 34


MCD, SONC, JACK, BKC, YUM, and WEN have all mentioned unemployment among younger age cohorts as being a primary impediment to same-store sales growth over the past year or so. 

We will be watching closely to see how unemployment trends transpire over the next few months.  With significant commodity cost headwinds first and foremost in investors’ minds, a slowdown in unemployment growth among the key age cohorts would greatly exacerbate the impact. 


The chart below shows that for the first time since July, the Labor Force Participation Rate did not contribute to an understatement of the Unemployment Rate on a normalized basis.  I am using the trailing ten-year average Labor Force Participation Rate as the “normalized” rate to which I compare the monthly Labor Force Participation Rate.


QSR: EMPLOYMENT UPDATE - unemployment lfpr


Howard Penney

Managing Director



March 4, 2011





  • Zappos (6), Nordstrom (74), Men’s Wearhouse (87), and Aeropostale (94) are all retailers that made Fortune’s 2011 list of best companies to work for.  Number one overall was software firm SAS.
  • Keep an eye on Gap’s efforts to engage in new and creative promotional strategies.  This weekend the company will host its first “flash” sale which they are calling “Flashion”.  The 24-hour only sale focuses on just one item – a woman’s trench coat on sale for $50 (original price $89.95).  Probably not a needle mover but still something different from a coupon.
  • Kroger noted that overall inflation in the company’s 4Q was about 2.3%, driven primarily by higher meat costs.  In grocery inflation measured 1%, which marks the first inflationary quarter for the category after six quarters of deflation. 



Family Dollar Rejects Buyout, Adopts Poison Pill - rejected a hostile takeover offer from Nelson Peltz’s Trian Fund Management LP, saying it “substantially” undervalues its business, and adopted a defense to discourage unsolicited offers.  A plan outlined last year to accelerate store openings and remodelings, and to repurchase shares, is the best way to deliver value to shareholders, the Matthews, North Carolina- based discount retailer said today in a statement.  Family Dollar shares had fallen seven of the ten days since Trian’s offer Feb. 15, through yesterday, signaling investors were skeptical about the bid of $55 to $60 a share, or as much as $7.7 billion. Peltz, an activist investor who rarely buys entire companies, hadn’t arranged financing for what would be the biggest acquisition of a U.S. retailer in six years.  <Bloomberg>

Hedgeye Retail’s Take:  Take a look at today’s NY Post article for further insights into the company’s brewing battle with Peltz.  The article suggests FDO’s CEO was not amused to hear from Peltz just 15 minutes before Trian’s filing hit the tape.


Ugg Australia to Launch Luxe Collection - Ugg Australia is exploring life beyond the shearling-clad Outback with the launch of “rugged luxury” line Ugg Collection.  Ugg Collection by Ugg Australia is a 30-piece line of handbags and shoes, sourced in Italy, being introduced for fall. The collection has an earthy palette of olive green, black and tan, with pops of royal blue and leopard. Handbag silhouettes include the side-strap satchel, a slouchy hobo and an oversize weekender bag, in Italian Toscana leather, sheepskin, merino, suede and pony hair. Ugg Collection footwear was designed to harness the comfort of Ugg Australia in more upscale designs, with booties, stacked wedges and knee-high leather boots.  “A lot of our customers carry their designer handbag with the [Ugg Australia] classic boot, so we thought, Let’s give them something else that they can wear and still feel good [in],” said Leah Larson, vice president of product for Ugg Australia. “We’ve been known for quality, and we took that and put it into a couture fashion line.”  <WWD>

Hedgeye Retail’s Take:  Not the first time the company has looked to move into accessories in a bigger way, this effort appears to be far more likely to succeed.  Still only a small part of the business, the Luxe collection should in theory provide a fashion umbrella for which the more mainstream products will benefit. 


JJB Seeks Rent Cuts  in CVA- JJB Sports set out the details of its company voluntary agreement (CVA). Under the plan, the U.K. sporting goods retailer intends to shut 43 stores on or before April 24 2012 while keeping another 46 under review until the same date in 2013. The retailer will also pay landlords 50% of the contractual pro rata monthly rent ahead of closure and other sums. JJB will make a further payment of between £2.5m and £7.5m in cash or shares to landlords 'compromised' by the CVA. The exact amount will be linked to the company's market performance. All of JJB's stores will also move to monthly rents for the next two years. The CVA must be approved by creditors and shareholders at meetings on March 22. JJB chairman Mike McTighe said: "JJB's restructuring plan is on track. Last week we completed the first capital raising to provide short term finance for the group and delivered our revised business plan to Bank of Scotland. <SportsOneSource>

Hedgeye Retail’s Take:  JJB has long been “challenged”  making the company’s CVA seem like a long shot towards a profitable recovery.  With no buyer however, this is the only option left before more dramatic measures. 


Feldenkreises to Sell Shares of Perry Ellis - The Feldenkreises are set to cash in $16 million of their Perry Ellis International Inc. stock in a offering that was priced at $28 a share Thursday. George Feldenkreis, chairman and chief executive officer, and his son, Oscar Feldenkreis, vice chairman, president and chief operating officer, each registered to sell 300,000 shares of the firm, according to a filing with the Securities and Exchange Commission. After the underwriting discount, the sale of each share will reap proceeds of $26.60  <WWD>

Hedgeye Retail’s Take:  After a substantial run in which PERY shares went from $4 in early ’09 to $28 in 2011 it’s hard to fault the “family” for taking some money off the table. 


Tom Ford Renews Eyewear Agreement - Tom Ford International is set to take its eyewear to the next level. The American designer and Marcolin Group said Thursday they have renewed their current licensing agreement for the design, production and worldwide distribution of Tom Ford optical frames and sunglasses through December 2022. The original agreement was signed in 2005. Maurizio Marcolin, style and licensing director for the Marcolin Group, said the contract was renewed well ahead of its expiration date in 2015 because of the brand’s strong sales since the products were introduced in October 2005 and the desire on both sides to plan long term. <WWD>

Hedgeye Retail’s Take:  One of the most iconic Tom Ford branded products to date, it’s clear that this high-margin accessory is key to company’s growth strategy for many years to come. 


The Shopping Habits of Teens - Today’s teens have grown up with the internet, and their status as digital natives places them in the avant-garde of internet and technology use. eMarketer estimates that by the end of 2011, 96% of US teens ages 12 to 17 will use the internet at least monthly, significantly higher than the 74% penetration for the total US population. “The internet is not only fun, but is also indispensable for a host of tasks such as communicating, learning and shopping,” said Jared Jenks, eMarketer analyst and author of the new report, “Demographic Profile—Teens.” <eMarketer>

Hedgeye Retail’s Take: Near full saturation, an effective online presence is no longer an opportunity, but a necessity for teen retailers. Those who fail to keep pace will struggle to maintain/grow mindshare among this highly coveted demographic.


R3: GPS, KR, FDO, DECK - r3 3 4 11


Study Suggests Web Shoppers Browse more Before Buying - Online retailers are spending more on paid search ads to generate a purchase, which means they must sharpen up their bidding strategies, says search marketing firm NetElixir. Two facts lie behind the higher cost: Consumers are clicking on more paid search ads before making a purchase and the average cost per click was up 16% in January 2011 from January 2010, says NetElixir founder and CEO Udayan Bose. Bose says on average consumers clicked on 3.1 paid search ads before making a purchase in January 2011 versus 2.7 clicks in January 2009. They’re also taking more time to shop around—the time between the first click on a paid search ad and the purchase increased 12% in that two-year period. <InternetRetailer>

Hedgeye Retail’s Take: Simple supply and demand dynamics at play here given the growing U.S. consumer tendency to vet pricing more thoroughly online prior to actual purchase – however, with more comparative shopping sites surfacing we expect it unlikely to see the cost of paid search keep pace with growing online purchasing trends.




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