The Week Ahead

The Economic Data calendar for the week of the 9th of May through the 13th 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 - call111

The Week Ahead - call222

Greece Leaving the EURO? Not so Fast

The German publication Spiegel Online broke a story this afternoon that Greece is considering withdrawing from the euro and returning to the drachma, without revealing the source of the information. Allegedly a secret crisis meeting is being held in Luxembourg late tonight to discuss the restructuring of Greek public debt, with attendance limited to the Eurozone finance ministers and senior staff members.


Assuming the information is reliable concerning a meeting tonight to discuss restructuring Greek debt, we’d like to offer a few reasons why  the prospect of Greece leaving the euro over the immediate to medium term is utterly unreasonable, that therefore unlikely:


1.   The EU has battled over the last 18 months to contain sovereign debt across the region, earmarking  a total of €273 Billion to bailout Greece, Ireland and Portugal, and established both temporary (EFSF) and permanent (ESM) bailout funds to the tune of €500-750 Billion (including IMF support) to aid countries in fiscal “need”. While there has certainly been push back across member states on the guarantees for the funds, the bottom line remains that they’ve come together to “economically” support the currency union.


2.   To further underline the point of support, commitment to the union is more than just a monetary sum, but the belief that the union as a principle is sound, which is to say that the union provides mutual benefit, or that the whole is stronger than the individual parts. This commitment comes from the very top, including President of the European Council Herman Van Rompuy, President of the European Commission Jose Manuel Barroso, ECB President Jean-Claude Trichet, and European Commissioner For Economic and Monetary Affair Olli Rehn (to name a few) on down to all the foot soldiers in Brussels fighting for their constituents.


There’s no chance these Eurocrats are going to let one country at this stage of the game (the infancy of the union) threaten the union, neither in principle nor in the name of their job. And should Greece leave, there’s obviously contagion risk that other members, particularly the peripheral countries, would follow suit. While we’ve argued that from a competitive standpoint it could be far more effective for certain Eurozone members to have their own monetary policy (and therefore currency), it’s not politically expedient, and therefore won’t happen over the medium term. (Note we’re not limiting this outcome over the longer term).


3.   Greece is “sufficiently” capitalized with the bailout moneys received from the EU/IMF until 2013 so a departure from the euro, and therefore a default on its euro-denominated debt doesn’t make sense at this point (also ~ one quarter of EUR-denominated Greek debt is held domestically, making hardships at home unnecessary at this juncture)


4.  Counter liabilities across countries are huge, with Germany and France having the most skin in the game. The impacts from Greece and possibly others leaving the union, suddenly, would have such severe impacts on the government balance sheets, and the banks across Europe, that it would cripple the entire continent.



It seems far more likely that these meetings are being called to discuss the back and forth over recent days about the prospect of Greece restructuring its debt, a position Greeks deny the need for, while select European voices continue to press.  Greece’s equity market (Athex) had a tough week, closing down 4.5% w/w as sovereign cds and government yields remain elevated, with the Greek 10yr yield at 15.5%. That said, we’re not seeing a freak-out in risk intraday that would confirm the validity of the likelihood that Greece leaves the union.


If anything, a serious talk about Greece’s public debt and the prospect for restructuring was probably in order, and the weekend will help shield some of the downside risk to the meeting’s announcement. 


As we continue to highlight in our research, Europe’s sovereign debt contagion is far from over—this has a long term TAIL. Regardless of the monies secured by states, the pain of overcoming years of fiscal imbalances is not an overnight event. We expect headline risks for the EUR and European countries to persist as the region works through its fiscal imbalances and investor fears shift within the process.


Matthew Hedrick


WRC: Why?


Do you get those times when you analyze a company and the numbers simply don’t add up and you get that queasy feeling in your gut? That’s Warnaco.



We emerged from WRC’s 1Q with more questions than answers. Specifically, it relates to FX. This is a company that generates ~60% of its EBIT outside of the US.  When FX moves, WRC is always first on our list as it relates tweaking our model when the Dollar changes. With what we consider a ‘crash in process’ in the Dollar (-8% yy) we should have seen a blowout at WRC.  We saw the opposite.


In fact, incremental FX revenue was up $9.8mm vs. last year, marking a quarter where FX should have been a positive contributor. But at the same time, we saw incremental EBIT go the other way. This is the greatest deviation in this spread we’ve seen in at least 10 quarters.


WRC: Why? - WRC FxEbit


What does this mean?  There’s many possibilities…

  1. The company is doing the right things and investing in sales, marketing and infrastructure to support growth in its CK One launch this year. There’s probably some of this. But not enough to make up for the whole delta – or even half.
  2. WRC is building reserves for what will be heavy discounting in 2H to clear its 36% rise in inventory.
  3. WRC is feeling the operational pain of growing its store base by 80% over two years – remembering that it guided to 120k incremental square feet last year, but ended up adding closer to 200k. This year they threw out the same guidance, but have brought on the Taiwan retail stores since. We’ll likely see the accelerated growth continue. Store level SG&A is around $800k-$1mm per store. Initial productivity is around 60-70% of a more mature store – which run at about $2.5mm. That’s some pretty tough math to result in profitable growth. If we estimate a 3-year maturation curve, we’re looking at 2012 when we should start to see more meaningful leverage. Until then, we’ve got some tough expense numbers to overcome; such as more retail as a percent of the mix, disproportionately high SG&A relative to revenue due to International slant, and higher FX translation of both store-level SG&A as well as inventories needed to support the retail sales ramp.
  4. Gross margins were down 86bps – though the 2-year was a more upbeat +121bps. But what is odd is that Asia GM was up, and Europe was down – despite the FX tailwind. Product costs were only a minor part of the gross margin erosion – and were isolated to the sportswear group.
  5. New store productivity is a question mark. The imputed rate based on numbers given (stores, square footage, and comp) comes in at around 82%. This is great – but it is also a catch-all line item that includes sales, which are growing strong double digit. In the end, it does not have a huge incremental impact on profitability as it cannibalizes a degree of sales from wholesale and company-operated stores – but it can overstate the productivity of new stores.
  6. Speedo had a monster quarter and its WRC’s highest margin business in 1Q from a seasonal perspective. This alone contributed almost 100bp to consolidated margins (which ended up being down 222bp).
  7. Sportswear operating revenue was up by 10.8% -- but it certainly did not get any help from CK Jeans, which was down -3.7%. 19% growth at Chaps more than made up the difference, but there’s no way the single largest line item on the P&L should be down year/year.

All that said, WRC took up guidance for the year – both revenue and EPS. The revenue, we’ll give ‘em. The EPS, not quite. Our estimates are shaking out at $3.90 and $4.38 for this year and next, respectively. We’re ahead on revenue, and are meaningfully behind on margin.


The reality is that inventory is up 36%. They’ve got a lot of ‘stuff’ and it’s gonna sell. The question for us is the degree to which it sells at full price. We’re starting to see cracks in consumer accepting pricing increases, and we won’t be relying on the ‘trust me’ factor here. With some companies we will, but not WRC.


This thing is trading at about 7.4x EBITDA and 14.4x earnings. By no means is it expensive. But given how squirrely some of these items are on the P&L, we think it definitely deserves a risk premium relative to peers. When we can buy names like Nike, RL, GES, and other higher quality names within 1-2 multiple points, we simply think that the risk/reward here is unattractive.




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Oil Price Volatility Isn’t Transitory

For those that are long of commodities, in particular oil, the last 5 trading days have been unpleasant.   Unfortunately, we are in that camp as we are long of oil in the Virtual Portfolio via the etf OIL, and are currently down -3.7% in the position.  As we noted on our morning call today, we will stick with our long oil position to a price and that price is our TREND line of support on WTI of $98.63 per barrel.  Our current levels for oil are highlighted in the chart below.


Oil Price Volatility Isn’t Transitory - 1


While price has obviously corrected, which is an important factor in our models, there has only been a marginal shift in our other key factors of geopolitics, supply / demand, and monetary policy.


As it relates to geopolitics, the significant event over the last week was the killing of al-Qaeda leader Osama bin Laden.   While the longer term implications of this event are still being analyzed, broadly across the Middle East social unrest continues to percolate and with it the intermediate future of stability in the Middle East remains largely uncertain. A few points to highlight:

  • Protests continue across Syria, which are being aggressively cracked down on by the government. U.S. Secretary of State Clinton also gave her support for EU Sanctions against Syria this week;
  • Foreign Ministers are meeting in Rome to discuss continued plans to fund Libyan rebels.  In addition, both Britain and France have expelled Libyan diplomats.  The International Criminal Court is also reputed to be in the process of issuing warrants for the arrest of Gaddafi;
  • Hundreds of thousands took to the streets in Yemen to protest against Yemeni president Saleh, who called the protesters “outlaws”; and
  • In Bahrain, four anti-government protestors were sentenced to death.

From a supply and demand perspective, the deluge of negative economic data points (employment, ISM and housing prices) from the United States continues to support what our models had already indicated, which is that growth is slowing domestically.  The United States is the largest consumer of oil globally, so as domestic growth in the United States slows, so too does its consumption of oil.  By way of a proxy, in 2009 U.S. oil consumption declined 4.9% year-over-year, while global consumption was down 1.7% year-over-year.  This highlights the potential impact of a slowing global economy on oil demand.


In terms of the direction of global growth, we continue to get mixed signals.  The market-oriented proxy of growth is the Baltic Dry Index, which implies that we are setting up for a sequential slowdown in global growth on the back of tightening global monetary policy due to inflation concerns.  In the chart below, we’ve highlighted the 1-year plot of the Baltic Dry Index, which is down 64% year-over-year and 26% year-to-date.  This is not a reassuring picture as it relates to future economic growth.


Oil Price Volatility Isn’t Transitory - 2


That said, based on our modeling, the key driver of the price of oil continues to be the price of the U.S. dollar.   Over the past three months, the correlation of the U.S. dollar to WTI is -0.89.  Dollar down equals oil up, or, as we saw this week, just the opposite with the dollar rallying against global currencies and commodities correcting sharply.  On the back of the ECB not raising rates this week and appearing incrementally dovish, the U.S. dollar rallied +2.9% versus the Euro this week from trough to peak.  Over roughly the same time frame, WTI declined -8.4%.


Oil Price Volatility Isn’t Transitory - 3


Currently, based on slowing growth and the rally in the U.S. Dollar, we are seeing a Deflation of the Inflation, but interestingly the tepid economic news could actually lead to every inflation investor’s dream . . . Quantitative Easing 3.   With continued printing of money via debt monetization, the inflation trade should continue . . . until it doesn’t.


Daryl G. Jones

Managing Director

Europe’s Eye on Inflation

Position: Long British Pound (FXB)


Conclusion: We continue to flag our concurrent call of Inflation Accelerating with Growth Slowing across global economies. The UK remains one economy mired in this trend, with elevated levels of inflation persisting and choking off growth. Today’s UK Producer Price Index for April shows an upward acceleration in Input costs to 17.6% Y/Y (versus 14.8% in March) and Output prices slowed 30bps to 5.3% Y/Y versus the previous month. In total, we continue to note that increasing input costs should weigh to the upside on output costs, and therefore continue to hamper consumer spending, confidence, and ultimately growth.  We expect UK headline inflation, currently at 4.0% in March Y/Y, to accelerate over 2011 as we expect commodity prices to remain elevated over the medium term and due to the effect of “imported inflation”, or the impact of the weakness in the GBP-EUR over the last three years to heighten inflation pressures, especially considering that the UK imports roughly 50% of its goods from the Eurozone.


With no great surprise, energy and food prices were the largest inflationary components contributing to gains in input and output prices. Input crude oil gained 37.7% in April versus the 12 months ago period, and home food materials increased 15.4%.  Output prices saw the largest gain from petroleum products (up 14.9% in April Y/Y) and food products gained 7.3%. Notably, output tobacco and alcohol prices rose 5.5% Y/Y on increased tax from the government’s budget.


Europe’s Eye on Inflation - uk1


Both the ECB and BoE held benchmark interest rates unchanged on Thursday despite existing inflationary pressures (Eurozone CPI = 2.7% in March Y/Y). While we’ll have to wait for the BoE Minutes for more insight on the bank’s thinking, we remain of the camp that a hike of 25bps is prudent.  Trichet’s language in the press conference following the announcement was measured, indicating that monetary policy is “still accommodative” in an environment where there is “upward pressure on overall inflation, mainly owning to energy and commodity prices”. The market largely interpreted these statement as “dovish” for a hike next month in that he did not reiterate such phrases as “strong vigilance” or “prepared to act in a firm and timely manner”.


We’ve seen follow-through selling of the EUR-USD after yesterday’s announcement. In reality, the EUR-USD rose very expediently to just under $1.49 this week and was clearly disconnected with underlying fundamentals. We see immediate term support in the EUR-USD around $1.44, with upside resistance at $1.47, and expect this trade to be volatile given persistent weakness in the USD (despite a bounce yesterday) and uncertainty surrounding the sovereign debt contagion across Europe's periphery. 


With the unwind of the huge correlation trade to commodities this week, notably Russia’s equity market (RTSI) fell 4.4% week-over-week and Norway’s market declined 3.4%, as Greece blew up (down 4.5% w/w) on debt restructuring fears, we continue to like Germany (via the eft EWG), due to its fiscal sobriety and continued strong fundamental performance. Year-to-date the DAX is up 8.3%, within the top 10 performing global equity markets ytd. Below we highlight our support levels for the DAX. On strength, we’d short Italy (EWI) or Spain (EWP).


Europe’s Eye on Inflation - uk2


Matthew Hedrick



Data from the BLS today a positive data point for restaurants. 


April employment data was released today by the Bureau of Labor Statistics.  As our Healthcare team pointed out this morning in their daily Healthcaster piece, the employment recovery “continues to be a barbell recovery with younger demographics, who don’t consume much healthcare, and older workers.”  The 20-24 years-of-age and the 55 years-and-higher age cohorts continue to gain while the 34-54 years-of age cohort continues to slide.  For restaurants, the recovering in employment levels among younger people is a positive for quick service restaurants, as I have written over the last number of months in these updates.  Interestingly, looking at employment trends in the full-service and limited-service sub-sectors of the food service industry also strikes a positive tone for the industry. 





I am aware that many big corporations, as the saying goes, hire at the top and fire at the bottom.  However, as long as the employment growth in the younger age cohort continues to trend in the right direction, employment will continue to be a positive driver for QSR.  The chart below also shows a sustained growth, since early 2009, in hiring by full-service restaurants.  For eating out, as a whole, it is important to pay attention to the soft employment trends in the 34-54 years-of-age bracket.  This is an important group for restaurants and the continued slide in employment levels is a negative for casual dining.





Howard Penney

Managing Director


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