“The more we try to provide full security by interfering with the market system, the greater the insecurity becomes.”
I have been focusing my quotes for the last few weeks on the most pertinent parts of Hayek’s “The Road To Serfdom” in hopes of someone in Washington finding it within themselves to stop doing more of what got us into this mess.
The Audacity of Hope, unfortunately, is not a Global Macro risk management process. Neither is John Boehner telling Barack Obama, “let’s lock arms and jump out of the boat together”…
Boehner was talking about raising the US Debt Ceiling limit (which the US is technically in violation of today). All US Constitutional “technicalities” aside, this country hasn’t had much of a memory when it comes to the original provision to let the US Treasury print debt in 1917 (in order to finance war). When in doubt, fear monger the citizenry into believing centrally planned security is the only way out.
For the week, with the US Dollar Index closing up +1.1% at $75.78:
- The US Dollar Index has been up for 2 consecutive weeks for a cumulative recovery of +3.8% from its YTD lows.
- The US Dollar Index has been down for 14 of the last 20 weeks and remains bearish on an intermediate-term TREND basis.
- The US Dollar Index is down -14.4% since Obama and Geithner took over in early 2009.
From a Correlation Risk perspective, here’s the 2-week cumulative declines in stocks and commodities priced in US Dollars:
- US Stocks (SP500) = DOWN -1.9%
- US Energy Stocks (XLE) = DOWN -8.3%
- US Financial Stocks (XLF) = DOWN -3.7%
- CRB Commodities Index = DOWN -8.6%
- West Texas Crude Oil = DOWN -12.5%
- Copper = DOWN -4.6%
So, if you didn’t know that the Globally Interconnected Marketplace is highly correlated to a US Dollar UP move, now you know…
Those who interfere with the free-market system, experimenting with Fiat Fool policies that take the US Dollar to all-time lows, didn’t get The Correlation Risk they were imposing on stocks and commodities in Q208 - and they most certainly don’t get it now. The game within the hedge fund game is now called Gaming Policy – and it’s volatile.
If you disagree with me that The Bernank perpetuates The Price Volatility by promising the world to remain “Indefinitely Dovish” (Q2 Hedgeye Macro Theme), the market disagrees with you. Since pandering to the political wind at the latest FOMC presser, the VIX (volatility index) is up +15.8%.
Global Growth Slows As Inflation Accelerates – I think the world gets that now… but do the world’s Risk Managers know how to deal with the most levered long trade in hedge fund history as it unwinds?
We call this “Deflating The Inflation” (Q2 Hedgeye Macro Theme) – US Dollar UP is the only way out of creating the highest levels of US-style Stagflation since the 1970s.
Two important points on stagflation:
- Real-time inflation (commodities, rents, education, etc) is reported real-time…
- US Government reported “inflation” is reported on a lag
Last week’s US Consumer Price Index (CPI) was +3.2% for the month of April – whereas Deflating The Inflation has occurred in May. This is where it gets tricky for the stagflation bulls who don’t think they’ll ever see a 600 basis point drop in the SP500’s PE multiple (like we saw in the 1970s when reported inflation broke out above reported (lagging) US GDP growth). Sound familiar? US GDP for Q1 was +1.8%.
Two points on US Growth and Inflation:
- Growth Slowing (joblessness) is going to remain throughout the summer months (the 4-week rolling average of weekly jobless claims just hit a new YTD high last week of 437,000).
- Reported Inflation is going to remain elevated because rents continue to climb (as US Housing double dips) and The Inflation “compares” get a lot easier through August (putting an upward bias on reported y/y CPI).
So what do you do with that?
Last week I moved as aggressively to Cash in the Hedgeye Asset Allocation Model as I have since mid-February. Here’s where our allocations stand as of this morning:
- Cash = 52% (up from 43% last week and 34% two weeks ago)
- International Currencies = 18% (Chinese Yuan – CYB)
- Fixed Income = 15% (US Treasury Flattener and Long Term Treasuries – FLAT and TLT)
- Commodities = 6% (Gold – GLD)
- US Equities = 6% (Tech – XLK)
- International Equities = 3% (Germany – EWG)
Mr. Macro Market does not owe any of us a return. When The Correlation Risk hinges on insecure policy like it does today, sometimes the most secure move for my own money is to simply get out of the way.
The problem right here and now is that everyone is still long The Inflation because The Dare was to chase The Yield – so we’ll need to wait and watch for entry points (capitulation maybe closer to $93 oil) before we take up our invested position again.
My immediate-term support and resistance ranges for Gold, Oil, and the SP500 are now $1, $93.18-100.58, and $1, respectively.
Best of luck out there this week,
Keith R. McCullough
Chief Executive Officer
TODAY’S S&P 500 SET-UP - May 16, 2011
The USD is now breaking out above the Hedgeye immediate-term TRADE line of $74.55 this morning. In terms of The Correlation Risk, this only enhances the probability that we’re going to see oil test $93 and a continued unwind of The Inflation trade. The entire commodity complex (CRB) is now bearish TRADE and TREND, confirming what Copper has been signaling since mid-Feb when we started confirming that Global Growth Slows As Inflation Accelerates. As we look at today’s set up for the S&P 500, the range is 14 points or -0.51% downside to 1331 and 0.54% upside to 1345.
SECTOR AND GLOBAL PERFORMANCE
By week’s end the US Equity market saw one more sector (Industrials – XLI ) break our immediate-term TRADE line. That makes 4 of 9 Sectors bearish on our immediate-term TRADE duration (XLF, XLE, XLB, and XLI) and 3 of those 4 (XLF, XLB, and XLE) are also confirmed by bearish intermediate-term TREND breakdowns (which we flagged in a risk management note earlier in the week).
Tech (XLK) and Healthcare (XLV) remain our two favorite sectors on the long side (in that order of preference from last price).
Beta is starting to underperform as expectations for Growth Slowing get baked in.
- ADVANCE/DECLINE LINE: -1319 (-2118)
- VOLUME: NYSE 898.43 (-5.57%)
- VIX: 17.07 +6.49% YTD PERFORMANCE: -3.83%
- SPX PUT/CALL RATIO: 1.81 from 1.80 (+0.40%)
CREDIT/ECONOMIC MARKET LOOK:
- TED SPREAD: 24.02
- 3-MONTH T-BILL YIELD: 0.03% +0.01%
- 10-Year: 3.18 from 3.22
- YIELD CURVE: 2.61from 2.65
MACRO DATA POINTS:
- 8:30 a.m.: Empire Manufacturing, est. 19.70, prior 21.70
- 8:30 a.m.: NOPA oil, soybean data
- 9 a.m.: Bernanke speaks on innovation/research in Washington
- 9 a.m.: Total net, net long-term TIC flows
- 10 a.m.: NAHB housing market index, est. 17, prior 16
- 11 a.m.: Export inspections, corn, soybeans, wheat
- 11:30 a.m.: U.S. to sell $27b 3-mo. bills, $24b, 6-mos. Bills
- 4 p.m.: Crop progress, grains
WHAT TO WATCH:
- State Street wants to expand by acquisition outside the US - FT
- Netflix announces strategic multi-year agreement with Miramax; terms undisclosed
- Wynn Resorts CEO Steve Wynn says company has not been investigated for violating Foreign Corrupt Practices Act - WSJ
- Japan earthquake came at unfortunate time for car dealers like AutoNation - WSJ
- Greece will plead for boost in its $155b bailout from European govts. in IMF talks clouded by arrest of Strauss- Kahn
- Primedia, majority-owned by KKR, may announce deal to sell itself to TPG Capital as soon as today
- A group of Canada’s biggest banks, pension funds made $3.7b bid for TMX Group, topping offer from London Stock Exchange
COMMODITY HEADLINES FROM BLOOMBERG:
- Speculators Cut Bets on Higher Commodity Prices by 15% in Week to May 10
- China Said to Sell Soybeans to Cool Inflation at Fastest Pace Since 2008
- Goldman ‘Most Constructive’ on Copper, Raises Outlook For Aluminum, Nickel
- Steel Consumption May Improve This Year on Economic Recovery, Stemcor Says
- Gold May Advance as EU Finance Mininsters Discuss Greece’s Financing Needs
- Copper Drops in London Trading as Speculators Cut Holdings: LME Preview
- Coffee Falls as Vietnam’s Production May Increase; Cocoa Prices Advance
- Crude Declines on Concern Over Greek Bailout Talks, U.S. Economic Growth
- Corn Advances for Third Day as Wet Weather Delays Planting in U.S. Midwest
- Hedge Fund Gas Bets Tumble 26% in Commodity ‘Game Changer’: Energy Markets
- Europe Commodity Day Ahead: Gold-Coin Sales at a High Show Rally Not Over
- Sumitomo Metal, Sumitomo Corp to Invest $724 Million in Chile Copper Mine
- Aluminum Stockpiles in Japan Advance 8.9% After Quake Disrupts Shipments
- European market are weak across the board
- Eurozone April final CPI +2.8% y/y vs consensus +2.8% and prior +2.8%; Eurozone April final CPI +0.6% m/m vs consensus +0.6% and prior +1.4%
- Russia breaking intermediate term TREND line as Spain did last week
- Asian markets were weak lead by Vietnam and Hong Kong
- India down another -1% to -10.6% YTD (we're short)
- Japan March core machinery orders +2.9% m/m vs consensus (9.9%). April domestic CGPI +2.5% y/y. April-June core machinery orders forecast +10%. April consumer confidence 33.1 vs 38.6 in March.
- Thailand was closed for a special holiday and will reopen 18-May.
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MCD hosted a reimaging tour yesterday in Tampa. McDonald’s is constantly focused on its brand position and customer experience and this shone through yesterday as management walked analysts through three restaurants in the Tampa area, detailing the improvements being made to restaurants through the reimaging/rebuilding multi-year plan. These improvements range from a complete overhaul of the exterior and interior appearance and feel to the construction of side-by-side drive-through lanes to the installation. The tour was impressive, insightful, and bodes well for the success of McDonald’s over the longer-term.
The first two restaurants of the tour were recently remodeled. Both remodels were completed in 2010, as part of the total 200 remodels completed last year. The intention going forward is for between 175 to 225 remodels to take place each year. These remodels are comprehensive, including interior and exterior overhauls, a new “modernized” menu, and new POS systems. Ultimately, management said, there is potential for roughly 4,500 restaurants to be remodeled over the coming years (compared to a total 14,000 system-wide U.S. restaurants. MCD offers to pay for 40% of the franchisee’s total renovation cost which serves to incentivize rollout across the system. In the case of early adopters, the company will pay 45% of total renovation costs for franchisees. As this plan is carried out, management expects a sales lift in renovated stores and a “halo effect” as the proportion of the system that has been renovated reaches 50%. This is an effect MCD has observed in Europe and Australia.
The targeted time-span for a remodel is 4-6 weeks. The first remodeled restaurant we visited in Clearwater took 60 days but management expects this to come down as the plan for system-wide remodeling progresses. The restaurants do not close during the remodeling process, rather the drive-through might remain open while the lobby is renovated and then, upon the reopening of the lobby, the drive-through would be closed or vice versa. After reopening, remodeled restaurants experience a sales lift of 6-7% in excess of market. Management did also say that the “Grand Opening” typically lasts for 13 months and consists of constant events and advertising to draw attention to the remodeled restaurant.
The exterior overhauls are quite dramatic when compared to the appearance of the restaurants before the remodel. The facades are far more striking and visible from the street. The arcade design is more aesthetically pleasing but a combination of prominent signage and lighting maintains the “McDonald’s” feel. The side-by-side drive-through has allowed for a significant increase in transactions-per-hour without any incremental investment in labor. Using digital photographs to match cars to orders, restaurant staff can quickly and accurately take, receive payment for, and deliver orders far faster than before. With a mere 20 seconds ordering time, a staff member in Brandon, Florida estimated that her restaurant saw an average of 120 transactions per hour during peak times versus 100 with the old drive-through format. On one day, she said, 145 transactions were processed in an hour. One challenge that management spoke of during the day was customers seeing long drive-through lines and deciding not to wait; this improvement clearly captures lost traffic and while we were standing beside one restaurant, it was noticeable that the cars were moving through the property rapidly. Inside the store, too, workers focused on the drive-through derive benefit from an optimized booth for beverages. The space for the expanded beverage capacity demanded by the addition of McCafe products was taken from the lobby. Workers presenting food at the drive-through window have all beverages within easy reach.
The interior renovations are, if anything, more striking than those of the exterior. Sleek design, higher ceilings in some cases, flat screen TV’s, and communal seating represents a distinct shift in the standard customers are met with. Most importantly, the speed and accuracy of service is enhanced in remodeled restaurants thanks to the new POS system. A reduction in the number of screens staff needs to navigate, as well as a simpler operating platform that reduces training time, has caused roughly 10 seconds to be shaved off the service time.
Overall, the improvements made to the restaurants serve to improve the customer experience, bringing improved service as well as a much-improved environment on the inside of the restaurant.
Scrape & Rebuilds
While rebuilds are obviously more disruptive and costly than remodels, management offered many reasons why they can be desirable from a long-term perspective. Restaurants producing lower-than-expected volumes are relocated at a rate of ~30-50 per year but the company has found significant results in rebuilds which, more often than not, require some repositioning of the restaurant on the lot and/or an expansion in the total size of the restaurant. This can accommodate the tackling of structural issues with water-pipes or power-lines that can exist with older stores. The third restaurant we toured in Tampa was a very good example of the benefit that can be derived from rebuilds. Rebuilds cost roughly $2.1 million, inclusive of $1.3 million for construction (split 50-50 between company and operator) and $1.1 million for fixtures, furniture, and equipment (operator covers this).
Generally the difference between a decision to remodel or to rebuild hinges largely on the exterior. Improving visibility of the restaurant to vehicular traffic is sometimes best achieved by moving the restaurant on its lot and we were able to see an example of this yesterday. Please see an example of this below (first chart). By reorienting the building so that it is perpendicular to the road, management improved the visibility of the restaurants to the road. Previously, visibility on the north end was obscured by the play area. The subsequent design, as the accompanying picture shows, incorporates the play area within the building, facing east, thereby not impeding drivers’ ability to recognize the brand immediately (second chart).
A rebuild typically takes 90 days and requires the full closure of the property. When reopened, sales increase by 15-20%. Throughout the event, different members of the IR team maintained that no particular day part seen a disproportionate benefit from the new look and feel of the remodeled properties; the sales lift is broad-based in terms of guest counts.
Foot Locker reports Q1 earnings next Thursday after the close, followed by a conference call on Friday morning. We expect a positive 1Q result with our model coming in at $0.46 ahead of the Street at $0.44. The key differential in our forecast is a +6.5% same store sales increase (vs. +5%E) with gross margins slightly ahead of full-year expectations offset in part by higher SG&A. Our forecast for the year is $1.42 in EPS above the Street’s $1.34E.
Is it super cheap at 6.2x EBITDA? No. But we still think that after the call, this will slowly but surely convert some of the perennial perma-FL-haters’ into viewing this as a story that can manage double digit EPS growth and can buy back 30% of the float within 3-years. That’s not half bad… While not our favorite stock, it is one we think should keep working in 2H.
Here’s a look at some of the key modeling considerations for the quarter:
Sales: +5.8% on a +6.5% comp - This represents a 2-year acceleration of about 300bps. A few factors to bear in mind…
a) First and foremost, this is a period during which the ‘new’ management team should really start to execute. We’ve had the closure of poor performing stores, and a big merchandise push by the likes of Nike. While Toning, however, is a concern vs. last year the trends at retail from a POS perspective have been encouraging. Higher sales and ASPs at a point where the space needed to ‘comp the comp.’
b) In looking at the results of the performance footwear categories to which FL is over-indexed (i.e. Running, Basketball, Casual Athletic, and Cross-Training), 1Q results look encouraging up +10% on +5% growth last year.
c) In addition, athletic apparel has been strong up +9% in Q1. With the category growing as a percent of sales, we expect it be an additional driver and likely recipient of another positive management callout similar to Q4.
d) Also, keep in mind that FX should be a factor here. About 19% of store count, 17% of square footage, and 15% of sales originate outside the US. Given the dollar having tanked vs. last year, it nets out to be around 1-1.5% FX benefit on the top line.
e) According to our blended comp chart, sales are up +4.3%. As you may recall, this indicator has consistently tracked sales within a +/- 2-3% range and has been low by -2.2% and -3.8% respectively over the last two quarters – a +6.5% comp suggests its low by -2.2% in Q1. It’s important to note the change at NPD as well since Q4 with the weekly data now including the department and family channels, which understates the performance in athletic specialty. In fact, according to the monthly data set (see chart below) athletic specialty (+6.9%) outperformed both dept (-6%) and family (-4.2%) channels significantly through the first two months of the quarter suggesting further upside to the +4.3% blended comp providing added cushion and confidence in our +6.5% comp estimate.
Even though ASPs have been hanging in there, we cannot ignore the interim hit at Nike last quarter and in its May quarter. That pain will be shared. But the reality is that with a +6.5% comp, the occupancy leverage combined with better merchandise margins here is meaningful. We expect the later to be the primary driver of gross margins in the quarter driven primarily by further improvements in mix and more modest promotional activity due to both higher ASPs and inventories that remain in check and continue to grow at a rate below management’s target of 50% of sales.
Management suggested that Q1 would come in below full-year SG&A growth expectations of +1-2%, Given the strength in the dollar, we’ll assume the higher end of the range.
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