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Shorting Italy: Uncertainty Portends More Downside

Positions in Europe: Short Italy (EWI); Long Sweden (EWD); Long Germany (EWG)

Keith shorted Italy via the etf EWI today in the Hedgeye Virtual Portfolio. There are a number of uncertain events surround Italy, most particularly that the country has now joined its PIIGS brethren in the long-awaited spotlight on its fiscal imbalances, which encourage a risk/reward profile to the downside.


Here are the main near term catalyst to get through this week:


1.   Final vote on €40 Billion Austerity Package – The Italian Senate could approve the package of tax hikes and spending cuts tomorrow (Thursday) with the lower house following on Friday. PM Berlusconi has voiced support for the package, calling on short-term sacrifice for longer term stability.


2.   Italy auctions a total of €3 to €5 Billion EUR in 2016 and 2026 maturing debt tomorrow —Questions remain if the offering can find demand and at what yield. Italian yields broke out this week (the 10YR rose above 6%) and we’ll have to wait and see if the ECB intervenes to support the issue.


Shorting Italy: Uncertainty Portends More Downside - 1. italy


3.   Results of European Bank Stress Test Results, Part Deux on Friday (7/15) – We could see additional volatility in and out of the release.  News on Monday that Italian regulators are ordering a new short-selling rule on Italian-listed securities until September 9th sent banking stocks swinging around in the last days. 


4.   Speculation on a tense relationship between Berlusconi and his Finance Minister Guido Tremonti –the Finance Minister admitted to graft late last week, revealing that Marco Milanese, a lawmaker accused of corruption who until early July was his political advisor, had been paying €8,500 a month on rent for his apartment in Rome. This “news” further erodes the lack of credibility in Berlusconi’s government.



Fundamentals and Fiscal Health Remain in Check:


A.   GDP Drag – Even should the new austerity program pass, Italy’s GDP is expected to grow only 1% in 2011 and 1.3% in 2012. We think this number could be revised down as domestic demand wanes alongside further fiscal consolidation (austerity), unemployment rises (at 8.6% but near 30% for persons <25 years), inflation remains above the 2% target, all of which will put additional pressure on the government’s ability to generate revenue and reduce its debt and deficit levels. The government has said it will cut the deficit to 3% of GDP by 2012 from 4.5% in 2010. [Italy’s debt as a % of GDP stood at 119% in 2010—the second highest behind Greece in the Eurozone].


B.   Debt Maturities—While an IMF report on Italy (July 2011) calculates that over 75% of Italian government debt is long-term debt (with average maturity at 7.2 years) and less than 12% of its total debt is at variable rates, the country is coming up against some significant payments in the coming months (see chart below). Based on the recent move in yields and auction results, there’s increased risk that Italy will have more difficulty finding demand for its paper without significantly boosting yield premiums.


Shorting Italy: Uncertainty Portends More Downside - 11. italy


C.   Needy Banks—According to the IMF report, Italy’s five largest banks face large refinancing requirements of over €65 Billion and €104 Billion of bonds coming to maturity in 2H2011 and 2012, respectively.  While Italy’s top five banks are estimated to have only €3 Billion of exposure to Greece, Ireland, and Portugal, across major metric the banks continue to underperform their EU peers, and declining sovereign bond prices will further worsen bank balance sheets.


D.   Bleak Legacy – Over the last decade Italy has proved the relative loser on competitiveness as wages have risen faster than productivity and the gap between Italy and the major economies of Europe (Germany, France, Spain, and even the Eurozone avg) on the metrics of GDP per Capita and Productivity per Employed Person has continually widened. Additionally, Italy ranks near the top of the list across European countries for the oldest population in Europe. Look for this aging population to eat into government coffers in the form of increased spending on pensions, healthcare, and other social services.


Matthew Hedrick


China Says Buy Everything?

Conclusion: To the woe of many short-sellers, the Year of the Chinese Bull is just getting started. Don’t mistake that for the Year of the [insert consensus’ top long idea] Bull. Risk will need to be acutely managed around expectations.


Position: Long Chinese Equities. Vehicle: CAF; high exposure to Financials and Consumer stocks – which are our favorite sectors within China.


“Expectation is the root of all heartache.”

-William Shakespeare


As Keith pointed out in this morning’s Early Look, China’s June/2Q economic data was rock solid. The slopes of nearly every major data series came in positive on the margin, and those that didn’t slowed at a slower pace (a leading indicator for inflection points): 

  • Retail Sales growth accelerated in Jun: +17.7% YoY vs. a prior reading of +16.9%;
  • Industrial Production growth faster in Jun: +15.1% YoY vs. a prior reading of +13.3%;
  • Money Supply (M2) growth faster in Jun: +15.9% YoY vs. a prior reading of +15.1%;
  • Loan Growth accelerated: +5.1% YoY vs. a prior reading of -13.7%;
  • YTD Fixed Asset Investment growth slowed to +25.6% YoY vs. a prior reading of +25.8%; and
  • Real GDP growth slowed to a healthy +9.5% YoY vs. a prior reading of +9.7%. 

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On a QoQ basis, Chinese GDP actually accelerated (albeit marginally) to +2.2% vs. the +2.1% pace recorded in 1Q11. Accepting the fact that the Chinese government makes up the number anyway (per China’s own Vice Premier Li Keqiang), we think it pays to be on the long side when they start to print data that looks increasingly better on the margin. Of course, we don’t think it will pay to be long any/all things levered to Chinese demand. As we can plainly see, consensus is back on its “global growth” horse today, using the solid Chinese economic data as a reason to be broadly bullish. We must remember that this is the same consensus that has been saying for 3-6 months that: 

  • Global growth was accelerating;
  • US growth was accelerating;
  • US housing would bottom soon;
  • The US labor market would strengthen materially;
  • China is careening towards a banking crisis;
  • Etc… 

Speaking to the Shakespeare quote above, one has to wonder why consensus wasn’t more bearish on the slope of global growth given that both market prices and fundamental data have been telling us that Chinese demand has been slowing since 1Q10. Consensus has a habit of ignoring data points that don’t support its top long ideas. Given this institutionalized conflict, we find it best to remain both Duration Agnostic and permanently objective. Being a perma-bear or a perma-bull isn’t profitable across market cycles.


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Fully understanding that consensus lacks a Global Macro Process to properly contextualize data like what we saw from China overnight allows us to manage risk around the key trading ranges. We’ll go through this in more depth on Friday in our 3Q11 Key Macro Themes presentation. Additionally, we’ll be digging into our long-China thesis a bit more. If you have any questions on this topic ahead of the call, please email us at .


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Net-net, the key takeaway from today’s Chinese economic data is that growth in China aint as bad as the shorts would have you believe. In late June we called out short-interest at an all-time high in the MSCI China Index as a classic contra-indicator. With Chinese growth nowhere in the area code of where China perma-bulls hope it is and inflation setting up to slow sustainably post June/July, we continue to expect more short-squeezing in Chinese equities – perhaps just enough to make the charts look good enough on the long side for some of the bigger players in our industry.


Ride the wave.


Darius Dale


JCP: Shorting (Again)


Keith just re-shorted JCP, our top short idea, in the Hedgeye virtual portfolio here on an up day.


Our thesis remains unchanged – people expect transformational change and they very well may get it, but not before an increase in capital spending that will significantly impact margins before the benefit of Johnson’s initiatives are fully realized.


JCP: Shorting (Again) - JCP VP 7 13 11



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Agricultural commodities went higher, week-over-week, with just a few exceptions.  Despite prices coming down during the latter part of the quarter, 2Q earnings are likely to hit on significant spot market inflation for many restaurant companies.


Corn, sugar, and wheat prices went sharply higher week-over-week. Coffee and cheese were the only commodities to decline over the last week.  Coffee traded with a tight inverse-correlation to the US Dollar.







Corn prices have gained strongly over the past few weeks, reassuming the positive trend that has prevailed for much of the past twelve months.  China, the second largest consumer of corn globally, may more than double purchases to a record as it seeks to boost stockpiles and cool the fastest inflation in three years, according to Bloomberg.  Corn is up 95% year-over-year, which continues to pressure the food processors.  While some companies like SAFM may have corn hedged at favorable prices currently, as the TSN management team candidly put it during its most recent earnings call, to the extent that contracts are rolling over in the next six months or so, margins are likely to remain depressed in that space in FY12.  Below is a selection of comments from management teams pertaining to corn prices from recent earnings calls.



  • CMG (4/20/11): The only things we have locks on corn for most of the year, rice for the entire year, our tortillas and beans for most of the year as well.  Hedgeye: CMG will likely have to renew any corn contract at a level far higher than the one it currently holds. 
  • MCD (4/21/11): And so if the commodity markets move significantly from here and the main ones obviously looking at beef, looking at corn, wheat, coffee, et cetera, our guidance reflects where the markets are today. Hedgeye: Looking at where the prices of these commodities have gone since this quote, one would have to think guidance for commodity costs are going higher.




Coffee prices have declined sharply week-over-week as the dollar has, week-over-week, strengthened.  Over the last couple of days, the price of coffee has gained as the dollar has faded.  For the coffee concepts, SBUX, PEET, GMCR, MCD, DNKN, CBOU, and THI, rising commodity costs are a serious concern.  While some of these companies have prices locked in, to the extent that contracts may be coming up for renewal, prices are likely to burden restaurant-level margins sooner or later.  Below is a selection of comments from management teams pertaining to coffee prices from recent earnings calls.



  • PEET (5/3/2011): We believe we're better off lowering our earnings guidance by $0.10 this year and continuing with the plans we have in place than we would be curtailing spending activity or taking extraordinary pricing action that would be inconsistent with our long-term business interests, and the more sustainable long term cost of coffee we foresee.  As a result, you will see throughout our call today that we have a very strong performing fundamental business, but we have to buy some unusually high priced coffee in the short term, then we're not going to do unnatural things in reaction to an unnatural market environment short term. Hedgeye: We’ve noted this before: coffee prices trade on a very tight inverse-correlation to the US Dollar.  While it seems that price may have been “unusual” to management teams in May, it is taking quite a while for prices to adjust, making these levels less and less unusual.
  • GMCR: (5/3/11): Before closing, I also want to touch on rising coffee costs and the effect of our business. Like others in the industry, we are closely watching coffee prices. When we announced our last price increase in September of 2010, coffee prices had increased roughly 30% from $1.45 to $1.90 per pound over the course of roughly three months. Since then, costs have continued to escalate, recently hitting historic highs of more than $3 a pound, a nearl 60% increase since September.  In attempt to offset rising green coffee costs, as well as increases in other input costs, we are currently in the process of raising prices for all packaged types. We expect that consumers will see an increase of approximately 10% at the point-of-purchase as the result of this price increase. We expect to see the full benefit of this price increase during our fiscal fourth quarter of 2011.  We generally fix the price of our coffee contracts three to nine months prior to delivery so that we can adjust our sales prices to the marketplace.  Hedgeye: Coffee has backed off the “historic” high of more than $3 per pound but is still at $2.60 plus.  Demand remains strong; without a rising dollar, expect price to continue to pressure retailers.
  • SBUX (4/27/11): Regarding coffee costs, as I have indicated previously, we have fully locked our coffee costs for 2011 and are price-protected for a couple months into fiscal 2012.  As we progress through the balance of 2011, we will progressively take actions to secure our coffee needs and lock coffee costs for additional months into 2012. While we expect that the costs we pay for coffee may be higher in '12 than they are in '11, we remain confident that we can offset those increased costs and preserve our long-term earnings growth targets.  Hedgeye: SBUX is confident that it can pass on price and offset coffee inflation with other efficiencies.  It is interesting that it expects higher coffee prices in 2012 than in 2011, which would somewhat contradict PEET’s assertion that in May that prices at the time had been unusual.  SBUX expects worse prices to come.





Cheese prices have come down sharply over the last week but remain above the 1Q highs.  For DPZ, PZZA, CAKE, YUM’s Pizza Hut and other restaurant companies, this is a crucial data point.  CAKE has been maintaining a +2.5% inflation target in the back half of the year after +4.5% in the 1H (guided, not reported).  Looking at commodity costs, and dairy in particular which is important for CAKE’s basket, the implausibility of this +2.5% target is clear.  Some large holders of DPZ have been paring their positions of late as cheese prices have marched higher.  Given the volatility in dairy markets this year, it is unwise to extrapolate any given data point, but trusting the guidance of management teams on cheese prices could prove equally unwise.  Below is a selection of comments from management teams pertaining to cheese prices from recent earnings calls.



  • JACK (5.19.11): “Cheese also accounts for about 6% of our spend and we continue to expect a 15% increase for the year.” Hedgeye: This is a headwind for JACK – cheese prices are up more than double the 15% guidance. 
  • DPZ (5.5.11):  “And really the one to watch as always is cheese and our best bet right now is that it's going to stay relatively close to where it is right now but cheese is the one that often gives the biggest surprises either up or down and that's the one to kind of watch but assuming cheese stays relatively flat from here on out then, the absolute food costs from – through the rest of the year are probably going to stay pretty consistent with where they were in Q1 which to your point means the percentage year-over-year increase will probably ease a little bit over the course of the year.”  Hedgeye: Hope is not an investment process.  DPZ’s earnings call took place at a trough in cheese prices.  I expect a different tone on the next earnings call in discussing this particular item.
  • CAKE (4.20.11):  “The first half of the year, we're expecting food cost inflation of about 4.5% plus and then in the last half of the year, about 2.5% minus. And a lot of that has to do with the fact that we expect to lap a lot of high dairy costs from 2010 and the fourth quarter of 2011, but also due to the fact that we expect to have slightly lower fresh fish costs, slightly lower cheese prices, than last year as well.”
  • CMG (4.20.11):  As we move into 2011, we’re expanding our use of cheese and sour cream made with milk from cows.  Hedgeye: This company has driven sufficient traffic to gain leverage over commodity costs but, I would caution, some margin pressure is likely from their unparalleled exposure to commodity spot markets.


Howard Penney

Managing Director


Rory Green




Notable news items and price action from the restaurant space, as well as our fundamental view on select names.




Commodities over the past week have largely gained in price.  Coffee and cheese prices are exceptions, their prices declined -2.7% and -3.2%, respectively.  We will be following up with a more detailed commodity post this morning.


In terms of consumer subsectors, quick service restaurants stood out on the downside yesterday as the high-flying coffee names retraced some of their outperformance.  The beverage space declined sharply also, led by SODA and LBIX.






  • YUM is reporting today after the close.  Consistent with my view of this earnings season’s trends, top line is what matters most.  I expect YUM to be strong on the top-line where it matters most: China.  Inflation in China is starting to impact consumer confidence but the KFC value promotions/day-part expansion is driving double-digit same-store sales.  In the USA, the consensus decline of -1.6% is too meek, in my view.  I believe the number could be down as much of 3 or 4%.  YRI will likely be in line, with same-restaurant sales of 1-to-2%. 
  • CBOU, GMCR, PEET, and SBUX all declined yesterday. CBOU and GMCR declined -6.4% and -5.1%, respectively, on accelerating volume.
  • DNKN’s IPO is expected to price on July 26th.



  • PFCB will be celebrating its 18th anniversary this month by giving away free lettuce wraps between now and July 31 to anyone who “likes” their Facebook page.  The offer of free lettuce wraps is resulting in a strong uptick in traffic to the company’s Facebook page.
  • CBRL is trading ex-dividend and is currently a SHORT in the Hedgeye virtual portfolio.




Howard Penney

Managing Director


Rory Green




The Macau Metro Monitor, July 13, 2011



The Macau Gaming Industry Employees Association, Macau's biggest casino workers union, says the local casino sector needs at least 1,000 more workers as new properties on Cotai are set to open in the coming years.  According to the association’s head, João Bosco Cheang Hong Lok, Macau casinos are already facing manpower shortages. 



China Q2 GDP came in at 9.5% YoY growth, higher than the 9.4% polled by economists. Q2 GDP also accelerated 2.2% sequentially.