RL: Quantifying Japan Risk

Our best shot in quantifying Japan gets us to about a $0.43 risk to Fiscal 2012(Mar) EPS. That STILL leaves us a buck above consensus.


We definitely cannot say that the devastation in Japan will not impact Ralph Lauren. There will be logistical disruptions in Japan, which probably don’t matter as much as a dried up tourist market, and what can only be a massive distaste for luxury shopping as Japanese consumers cope with the magnitude of how their Country has changed. We hate to bring this into a stock discussion, but hey… we need to manage risk. It’s what we do.

First of all, let’s focus on some numbers.


Ralph’s overall exposure to Asia is about $850million, with most of that focused on Japan and South Korea. That number sounds colossal when looking up RL’s $5.7bn GAAP revenue base. But remember that RL has wholesale, retail, and licensing revenue streams.

  • Retail is the most pure at about $2.7bn
  • Licensing’s $175mm in GAAP revenue needs to be grossed up by an average royalty rate of 7%, which gets us to global brand value of another $2,500
  • Wholesale sales of $2.8bn needs to be grossed up to a retail equivalent of about $5.5bn

All in, we’re looking at just over $10billion in global Ralph-related sales at retail.


If we conservatively assume that 80% of the existing $850mm business is Japan, Then we’re looking at 6.5% of total global brand sales.


Profitability is below company average.


Management on 3Q call: “As you can imagine, it takes a fair amount of time for us to execute our plans. Japan, South Korea and what I'll call China territories are each at different stages of development for us and it takes time to understand the varying tastes and preferences of our customers throughout this region. We are simultaneously looking for ways to maximize operational efficiencies throughout the region. This is easiest to do with our corporate shared services and creative teams, but we are also exploring synergies with inventory management and merchandising initiatives; again, recognizing there are often substantial differences between countries. We’ve made good progress in Japan in a relatively short period of time and despite extremely unfavorable market conditions, but we're still far away from where we want to be.”


All in, when we stress test the model and assume that JAPANESE REVENUE GOES AWAY,  we get to $0.33-$0.43 per share.


There are other factors to consider, including the shared services factor as it relates to implementation and integration of the Chinese and South Korean businesses. Could we see extra costs? Yes. Pushed back by 1-2 quarters? Yep.


But that would take our Fiscal 2012(Mar) estimate down to about $7.40-$7.50. Yes, that's STILL a buck above consensus.



Brian McGough

Managing Director






The EU’s Extend and Pretend Summit Lean

Positions in Europe: Long Germany (EWG); Short Spain (EWP)


The initial report of results from the EU Summit on Competitiveness on Friday and into the weekend suggests that: (1) far more was agreed upon at the Summit than advertised, and (2) in aggregate, most of the agreements leaned dovish, meaning leaders elected to throw more monies and more generous loan terms at the region’s sovereign debt issues. Again, we contend that over the intermediate to long-term, policy that facilitates piling more debt-upon-debt only increases the inevitability of another crash.


The main Summit agreements include:


On Temporary vs Permanent Bailout Structures


-The temporary European Financial Stability Facility (EFSF) will be able to access its full funding (from the member states) of €440 Billion, versus the approximately €250 Billion previously available.


-Agreement was reached to let the EFSF buy bonds directly from governments; however, the EFSF is not authorized to buy bonds in the secondary market or finance debt buybacks by governments. Ahead of the Summit, the EFSF was only authorized to loan funds to governments. Therefore, under this agreement, credit risk for primary bond purchases will move onto the EFSF (taxpayer) balance sheet.


-Funding for the permanent bailout fund, the European Stability Mechanism, starting mid-2013, is pegged at €500 Billion.


On Existing Loans


-European leaders agreed to lower Greece’s bailout interest rates of about 5% by 100 bps, and extend the repayment period of the loans to 7 1/2 years from 3 years.  (Greek PM George Papandreou estimates the moves would save about €6 billion over the life of the loans.)


-Ireland did not receive its request to have the interest rate on its bailout loan (~5.8%) reduced by 100bps, as Irish PM Enda Kenny refused to raise the country’s 12.5% company tax rate, which compares to the EU corporate tax rate average of 23%, or Germany at 30% and France at 34%.



Overall, the agreements reached at the Summit far exceeded the syllabus, with the gravitas expected to come at the EU Summit for a Comprehensive Package on March 24-5. In particular, the more hawkish stance of Germany (via Chancellor Merkel) going into the Summit was lost over the weekend, namely that government bonds could not be bought directly by the EFSF and that funding for the facility would not be increased.  The only point that Merkel (and Sarkozy) stood strong on was maintaining that Ireland could not receive more favorable loan terms unless it raised the country’s corporate tax rate, an issue that’s very contentious and one that the Irish refuse to budge on.


In any case, the market response to the weekend is clear: bond yields from the PIIGS have come in, notably the Greek 10YR yield was down as much as -50bps d/d and the equity market (Athex) closed up a monster +5.2% today (see first chart below). The results of the weekend also alleviate the pressure that major compromise has to be met at the second Summit, which should tone down the recent return of sovereign debt fears.


We are by no means of the camp that this news is positive for the health of the region. On the contrary, we see Europe’s action as confirmation that it will choose to kick the can of debt further down the road.  In this light, the European Commission forecasts Greek public debt will reach 159% of GDP in 2012!


And while the expansion of the EFSF and talk of funding for the European Stability Mechanism will instill a level of confidence in the market and common currency, the underlying issue is not if there exists adequate funds to bail out the next overly indebted country, but should be enacting policy measures to more properly incentivize or punish countries that exceed debt and deficit levels. This will better direct the region’s future economic growth. Further, simply loosening debt payback terms sends the wrong message to countries, namely that mismanagement is permissible and the union will always be around as a backstop/crutch.


And to the point of more favorable loan terms for Ireland, we believe the island nation is going to have to play ball: it’s not going to be able to have its cake (an extremely low corporate tax rate) and eat it too (have its bailout loan more generously restructured).


What’s also clear from this weekend is that the ECB will continue to play a role as buyer of government bonds in the secondary market, currently at €77 Billion since May 2010.


We’ll get the final approval for the agreements reached this weekend at the March 24-5 Summit. While we could very well see stability in European markets and the common currency over the short run as optimism surrounds the Summit meetings, over the longer term our concern remains grounded that Europe is simply pushing its sovereign debt imbalances further out on the curve.  At the very least, we’d expect the PIIGS, some of the best equity market performers year-to-date, to mean revert over the coming weeks (see second chart below). We’ll continue to manage risk on a day-by-day basis.


Matthew Hedrick



The EU’s Extend and Pretend Summit Lean - wohl1


The EU’s Extend and Pretend Summit Lean - wohl2


The following companies are currently enjoying positive same-store sales and margin growth as of the most recently reported quarter: CMG, BJRI, PNRA, SBUX, YUM (US), DPZ, MCD, DIN, PFCB, DRI, RT, MRT, KONA.  All of these companies, with the exception of DPZ and KONA, were operating with positive same-store sales and expanding margins during their most recently reported quarter.  Also, as one can see in the chart at the bottom of this post, these stocks saw significant price gains during the fourth calendar quarter.  It is important to note that, since the end of the fourth quarter, MCD, MRT, and RT have all slowed from a price performance perspective.


Last time around, I highlighted YUM China, TXRH, MRT, CAKE, and RT as five names that I believed were “moonlighting in Nirvana”.  As it happened, YUM China, TXRH, and CAKE dropped out of the quadrant into “Trouble Brewing”, the lower-right quadrant where same-store sales remain positive but margins are contracting on a year-over-year basis.  


RT posted a strong quarter for 2QFY11 and seems well-poised for the remainder of the fiscal year.  In the immediate term, 3QFY11 could show some weather-related top-line softness.  From here, I still believe that MRT faces significant headwinds from a margin perspective and could well drop out of Nirvana.


YUM China will likely face continuing labor, food, and paper inflation throughout 2011.  On the last earnings call, management guided to 5% food and paper inflation in China with wage inflation running in the mid-teens.   As of February 2nd, the date of the most recent earnings call, management expected the modest price increase taken by the company just before Chinese New Year to cover the majority of the company’s inflation expectations (at the time) for the year.  I would expect that inflation expectations may  have changed somewhat given that many foodstuffs have increased markedly over the last five weeks.  Clearly, given the record margins YUM enjoyed last year, driven by commodity deflation, some year-over-year margin contraction is to be expected.  It will be interesting to see if comps slow in China during this year as compares step up in difficulty.


As a side note to trends in China, MCD has reported that January/February (combined) same store sales in China were up mid-to-high single digits.


MRT is not contracted on any beef prices for 2011 and that commodity has risen sharply in 2011.  Management has expressed confidence in its ability to take price as business traffic has been increasing at their restaurants.  The company has indicated its willingness to take price if necessary to offset inflation.  Obviously, margins may come under pressure as beef costs are absorbed and top-line trends may weaken if price is passed on to the customer. 


CMG is a notable constituent of Nirvana at this juncture.  The top-line growth has been nothing short of spectacular but there are definite negative factors impacting the outlook for the company.  Commodity headwinds are impacting Chipotle at least as much as any other restaurant chain given their sourcing of food ingredients from the spot market in order to abide by their “Food with Integrity” mantra.  Labor costs are also a question mark from here; federal investigations of 50 Chipotle restaurants in Minnesota resulted in the firing of 450 workers for not possessing the appropriate paperwork.  An internal review of hiring practices in Washington, D.C., has resulted in a further 40 jobs becoming vacant. 



The Deep Hole quadrant has been vacated by a large number of names over the past two quarters.  SONC, JACK, and CPKI are still languishing down there, however, as same-store sales are negative and margins are contracting on a year-over-year basis. 


SONC is a name that has received a boost recently on the back of a sell-side upgrade and a preannouncement of 2QFY11 sales of between +1% and +1.5%.  While this will mean that SONC is due out of the bottom-left quadrant when 2QFY11 results are reported a week from Tuesday.   However, as I wrote on March 8th, compares are stepping up materially from here and the preannounced same-store sales range for 2QFY11 actually implies a slowdown in two-year average trends.  Interestingly, following a strong showing in 4Q, SONC is down almost 14% year-to-date.



The lower-right quadrant, “Trouble brewing” , is where YUM China, TXRH, CAKE, and WEN are operating at present.  With the exception of WEN, which is in the midst of a turnaround, each of these names has dropped from the upper-right quadrant as a result of declining margins in 4Q10.  WEN is a name that I have a bullish outlook on; the sale of Arby’s and simplification of the menu will lead – in my view – to continued top-line growth and leverage over costs as well as labor efficiencies.  WEN’s stock gains in 4Q were somewhat muted but, for the reason I mentioned above, the stock has performed strongly since mid-January.



The upper-left quadrant, “Life-line” is currently inhabited by EAT and BWLD.  BWLD is a unique company in the restaurant industry; continuing commodity cost favorability due to declining chicken wing prices is greatly boosting margins.  The company is vulnerable to an NFL strike and, as that situation seems to be worsening, it could definitely effect traffic at BWLD if the points of contention between the players and owners is not resolved in time to save the 2011 season.   The company’s stock price declined in 4Q10 but has outperformed year-to-date, gaining over 20%.


EAT is a name I have been positive on for some time.  Operational improvements and sales-driving initiatives are greatly improving Chili’s performance.  Sell-side sentiment is only just beginning to change on this name and I believe there is significant outperformance left for this name in 2011.  Following a gain of 11% in 4Q, year-to-date the stock has risen an additional 17%.  I believe it is likely that, as EAT reports 3QFY11 results, the company will be operating in “Nirvana”, with positive same-store sales and margins.





Howard Penney

Managing Director

Drawdown: SP500 Levels, Refreshed

POSITION: no position in SPY


All 3 factors (PRICE, VOLUME, and VOLATILITY) in my core immediate-term risk management model continue to flash bearish for US Equities: 

  1. Immediate-term TRADE resistance of 1311 wasn’t overcome on Friday
  2. Immediate-term VOLUME signals continue to flash very bearish (3/11’s DOWN day = +31% VOLUME study)
  3. Immediate-term VOLATILITY (VIX) for the SP500 continues to build upward momentum > 18.52 support 

Since we’re Duration Agnostic, it’s important to expand this view to our intermediate-term duration (TREND): 

  1. Intermediate-term TREND resistance for the SP500 remains overhead at 1343
  2. Intermediate-term TREND support for the SP500 remains lower at 1271
  3. Intermediate-term VOLUME and VOLATILITY studies support a heightening probability of a 1271 test 

On a downside test of 1271, I’ll probably get longer of US Equities. I’m in a good position to do that because I’ve proactively cut my US Equity exposure (Hedgeye Asset Allocation Model) from 9% last week to 3% this morning (sold Healthcare on the open – XLV).


No one said managing drawdown risk of -5.4% is going to be easy (1). No one here was saying you should chase US Equities into their February 18th top either. Waiting and watching for risks, ranges, and spreads will be critical in the coming days.


The crowd is still too long,



Keith R. McCullough
Chief Executive Officer


Drawdown: SP500 Levels, Refreshed - 1


Still on a pace for mid to high 30s% growth.



Through March 13th, table revenues were HK$7.3 billion month to date.  We’ve seen a slowdown compared to the last few weeks but we believe it is primarily hold related.  Nevertheless, we are now projecting full month March revenue of $17.5-18.5 billion, +33-40% YoY.  Based on just the first week’s data we had been estimating HK$1 billion higher.


In terms of market shares, SJM and LVS gained from week 1 at the expense of Galaxy.  Relative to their 3 month market share averages, LVS and WYNN remain below trend while MPEL and Galaxy are above.  We still see MPEL as delivering the most upside relative to consensus near term EBITDA estimates.




Conclusion: Knapp Track comparable restaurant sales in February indicate that the casual dining recovery is slowly progressing.  However, a sizeable downside revision of January’s number from +0.6% to -0.1% is concerning.  Another factor that has been receiving a lot of attention is highlighted by Knapp in his report; gas prices have advanced to over $3.50 per gallon at a brisk pace.


Knapp Track preliminary results for February suggest that the casual dining recover, which took a pause of sorts in the fourth quarter, may be back in place.  February comparable restaurant sales of +1.6% signifies a sequential uptick in two-year average trends of 95 basis points.  The revision in January’s trends means that the sequential uptick in two-year average trends in January was 80 basis points.  Q4 saw a sequential slowdown in comparable restaurant sales to +0.6% from +0.8% in 3Q10.  At present, 1Q to-date is tracking at +0.8%, almost 100 basis points above those seen in 4Q on a two-year average basis.


Comparable guest counts in the casual dining space saw a sequential gain from a revised -2.2% result in January.  February’s preliminary decline of -0.4% shows that the recovery is far from secure, especially as gas prices continue to gain and discourage discretionary travel by automobile.   Additionally, an inevitable raising of prices from here could slow any further acceleration in comps.  On a two-year basis, February’s result implies a sequential acceleration in guest counts of approximately 60 basis points.  


We continue to favor EAT and PFCB.



Howard Penney

Managing Director

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