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LIZ: Kate Does Asia


Now that the plausibility of LIZ jettisoning its ailing Mexx division is an increasing reality, we can’t help but think that people will start to look more closely at other pieces of the puzzle.


LIZ previously announced a Chinese JV that was literally lost by all the noise around this name. For those of you who are doing the deeper-dive analysis on LIZ (which we strongly recommend), here’s our analysis around this JV. Is it an absolute game changer? Probably not. But after doing the math, it turned out to be bigger than we initially suspected (over $0.20 in EPS run rate within 5-years – big for a company that’s currently losing money).


The Facts:

- LIZ has formed a new JV with E.Land, a Korean fashion company, to accelerate growth of Kate in mainland China

- the company has reacquired its Kate Spade business in China from Globalluxe starting June 1st, 2011 – at no cost

- The Kate Spade brand currently has 70 full price; 8 outlet stores in Asia (includes Japan roughly 50% of count, 5 stores in mainland China and SE Asia locations)

- Expects to grow Points Of Distribution in mainland China from 5 to 300 by 2020 = ~30/yr on average, but will ramp from ~10/yr initially (~5 in 2011)

      • PODs include mall stores, free standing, and shop-in-shop locations

- Company plans to also reacquire is SE Asia business in 2014


Financial Implications:

- The prior structure was a distributor agreement whereby LIZ sold to Globalluxe on a wholesale basis

- The new structure will be to sell to the JV on the same wholesale basis (no change in revs to Kate), but LIZ will also realize a share of the profits/losses from the JV – realized in the “Other Income Line” in the P&L


- Of Kate’s ~$180mm in 2010 revs, retail and wholesale account for a 70/30 split respectively

- approximately 15-20% of revs were int’lly-based = $28mm-$36mm, the majority of which was Asia

      • Assuming Asia accounts for 75% = $20mm-$28mm
      • Assuming $8-$14mm is Japan; the rest is mainland China (probably only $2-$4mm) and SE Asia $6-$12mm

- Under the current JV agreement, LIZ and E.Land share start-up store costs based on their proportionate share. This costs are similar to the current U.S. structure:

      • ~2k sq. ft. store
      • ~$350/ sq. ft.  initial capital costs
      • = ~$700k / store (shop-in-shops are considerably less, typically under $100k)

- The following EPS impact is based on the beginning number of stores (5) and assuming a blended rev/store since the POD locations include mall stores, free standing, and shop-in-shop locations. Current Revs/Retail Store are $1.7mm per store based on 2010 results – our estimates suggest that ramps to $2.5mm per store in 2011. We assume $0.8mm-$1.0mm per store for our calculations below.


LIZ: Kate Does Asia                                                                     - LIZ JV Total EPS Imp


LIZ: Kate Does Asia                                                                     - LIZ JV China1


LIZ: Kate Does Asia                                                                     - LIZ JV China2


 Contribution Forecast from Kate Spade China pre-deal:


LIZ: Kate Does Asia                                                                     - LIZ JV China3


Casey Flavin




Coincidence that slot suppliers post market share gains in their fiscal 4th quarter?



Two of the big 3 slot suppliers—WMS and BYI—will be reporting their fiscal year-end quarterly earnings in the next couple of weeks (IGT’s fiscal-year end is in September).  Funny how the slot suppliers seem to produce market share gains in their fiscal year-end quarters (FEQs).


As the chart below shows, slot suppliers generally post sequential increases in units sold and market share gains in FQ4 followed by declines in the next quarter (FQ1).  WMS and BYI generated increases of  10% and 23% QoQ on average, respectively in the FEQ.  In terms of ship share, WMS and BYI both on average gained share QoQ in the FEQ.  Interestingly, Konami is the most striking example as its FEQ units sold ballooned on average 31% relative to the previous quarter and its ship share is 5% higher QoQ in the FEQ.  We also see a large drop in share in the quarter subsequent to FEQ for all slot suppliers and a drop in volume for all suppliers except IGT.  




So what’s the deal?  There seems to be some speculation that WMS was aggressive in June with discounting to try and make the quarter.  We actually think it’s more likely that their sales force – every supplier’s sales force for that matter – pushed slots out the door to make their own quota.  We are doubtful that Scott Schweinfurth would be pushing discounts to make EPS, especially given how low sentiment and expectations are currently for the group, and particularly WMS. 


Keep the FEQ phenomenon in mind next time analysts/investors get excited about quarterly market share shifts.  

Shorting Spain, EWP

Positions in Europe: Short Spain (EWP); Short Italy (EWI); Short EUR-USD (FXE); Short UK (EWU)


Keith shorted Spain in the Hedgeye Virtual Portfolio on a rally in the etf EWP today. As a reminder, Spanish risk signals are flashing due to steep debt maturities in August and October (see chart below); mounting political pressure for early elections of Zapatero’s government (scheduled for March 2012); and ongoing concerns about the strength of its banking industry, including exposures to the PIIGS (note: EWP is highly levered to financials, composing 41% of the etf).


Shorting Spain, EWP - 1. H


To the latter point, Josh Steiner and Allison Kaptur of our Financials team have done excellent work quantifying the most exposed European banks to the PIIGS based on the results of the EBA’s EU Stress Test, which they’ve included in a recent piece titled “European Debt Crisis: Where the Bodies are Buried (the 14 Most Exposed EU Banks)”.  If you didn’t receive a copy, please email us at . In the report you’ll note that Spanish banks rank high in the categories of both total exposure to the PIIGS and exposure as a % of Core Tier 1 Capital.


Shorting Spain, EWP - 2. H REAL


Below is a chart of the Spanish equity index, IBEX 35, which is broken across both its immediate term TRADE (9,969) and intermediate term TREND  (10,426) lines. As a reminder, despite all “best efforts” of European leaders to come up with solutions to the regions's sovereign debt contagion, we think that if anything should come of the EU Summit meeting tomorrow, which plans to discuss a second bailout for Greece, it will at best be just another short-term band-aid to provide temporarily relief.


Spanish risks will by no means come off the table.


Shorting Spain, EWP - 2. H


Matthew Hedrick


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If consumers in Asia develop a fondness of pizza and cheeseburgers, what happens to CAKE's margins?


Cheese prices led the gainers last week, rising 4.1% to new highs which will surely put some pressure on CAKE’s 2H11 commodity guidance.  TXRH, too, has some dairy exposure and will likely be watching this recent price surge in dairy prices with keen interest.  Apparently, the growing popularity of pizza and cheeseburgers in Asia is driving cheese prices higher!  Coffee prices nose-dived week-over-week as concerns grew that a slowing global economy may bring slower demand.  Beef prices slid as news on Russia’s increase in beef and poultry production in 1H11 emerged.  Corn prices also dropped as yields in Ukraine’s average grain crops were 20% higher than last year.  However, concern over the hot and dry weather in the U.S. cutting yields has pulled prices higher for the second consecutive day.







Cheese prices are not supportive of CAKE’s call for +2.5% inflation in 2H11 versus +4.5% in the first half (guided, not reported).  Looking at the chart below, it is clear that dairy – as an important component of CAKE’s commodity basket – is far in excess of the average 1H11 price.   Kraft has cited Asia’s growing demand for pizza and cheeseburgers as being a driver of cheese exports from the U.S.  Recently, 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.




  • 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 has been taken (last night's earnings) and cheese was cited in particular.  If dairy prices continue higher, CMG could see food costs negatively impacted.  The company is rolling out a 4.5% price increase, however, as our note from earlier this morning discusses in more detail.
  • TXHR (5.2.11): “We've also got a lot of flow in the dairy markets, in cheese, so there's other things beyond produce that do move around throughout the year.”  Hedgeye: In 1Q09, TXRH called out favorable beef and cheese prices as being primary drivers of cost of sales being down 126 bps in the quarter.  We think it is highly likely that cheese will be a contributor to a cost of sales increase in 2Q11.





A stronger outlook for the dollar is bearish for coffee and coffee prices slid almost 9% after a -2.7% decline last week.  While prices remain elevated, up 52% year-over-year, the past couple of weeks’ decline is positive for SBUX, PEET, GMCR, MCD, DNKN, CBOU, and THI.  Even taking this recent decline into account, the still-elevated level of prices means that any coffee concepts that have to renegotiate contracts may face an increase in food costs on their P&Ls.  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 nearly 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 higher prices to come.



Live Cattle


Beef prices have declined -2.7% week-over-week to +18.5% year-over-year.  Corn prices moving higher over the past couple of days has provided some price support but news of Russia’s meat and poultry production surging 3.8% YTD boosted supply.  Additionally, news of contaminated beef in Japan as a result of cattle from the area near the crippled nuclear power plant in Fukushima may also have an impact on prices.  Japan’s government said it “can’t rule out” the possibility that contaminated beef has been exported.


As we mentioned before, the slaughtering of livestock in Texas and surrounding areas suffering from drought may have provided some relief in beef prices.  According to the Henry County Local this morning, cattle need 13 to 20 gallons of water in hot weather.  The arduous and costly task of maintaining herds could be leading to further slaughtering of cattle.  While this boosts supply in the short term, it could mean smaller herds and higher prices over the intermediate term.  Below is a selection of comments from management teams pertaining to beef prices from recent earnings calls.





  • RRGB (5/20/11): Ground beef could be higher by as much as 20% year-over-year, which has a meaningful negative impact to our margins.  Hedgeye: live cattle prices are up +18.5% y/y.
  • JACK (5/19/11): Beef accounts for more than 20% of our spend and is the biggest factor driving the change in our guidance. For the full year, we are now anticipating beef cost to be up nearly 14% versus our previous expectation of 9% inflation. We expect beef cost to be up approximately 14% to 15% in the third quarter. 
  • WEN (5/10/11): We communicated to you back in March that we expected beef cost to rise approximately 10% to 15% and that we expected our total commodity costs to rise 2% to 3% in 2011. We are now forecasting that our beef cost will rise 20%. Hedgeye: there is moderate upside risk to beef price guidance for WEN.
  • EAT (4/27/11):  Well, consistent with what we've talked about in the last month or so as we visited many of you, beef continues to present the most significant inflationary pressure in our commodity basket.
  • 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. If they stay around these levels, the 4% to 4.5% [commodity guidance for 2011] should be locked in. If they move dramatically up or down, then we'll have to reflect that as we move forward. Hedgeye: inflation guidance may have to be adjusted higher.
  • MRT (5/4/11): Q: I wanted to revisit the overall expectations for your commodities basket, and I missed the part about beef, just wanted to verify that it was up in the 20% range.  A: no, no, no.  I said in the low double-digits.  Hedgeye: This is possible, even probable, for the year looking at average 2010 versus average YTD 2011 prices, and given the easier compares in the fourth quarter, but will require no sustained upturns from here.



Howard Penney

Managing Director


Rory Green



WMT: Odds on WMT



Keith bought WMT this morning in the Hedgeye virtual portfolio after successfully going 2-for-2 on the short-side in 1Q. We’ve had a bearish view on the company for a number of reasons, but the fact of the matter is that the near-term and intermediate-term setup is now shaping up somewhat favorably for the first time in a while.


Among the factors behind our bearish view were concerns over internal execution, inventory build into year-end, and a hyper-focus on price leadership capping the potential for margin improvement. While not much has changed as it relates to internal execution, the fact of the matter is that it is lapping sins of the past. We have a pretty low degree of confidence that WMT is any closer to right-sizing the ship. But as it relates to the near term setup, expectations appear to be in check and fundamental downside risk is low – particularly on gross margins given the favorable sales/inventory spread, as well as sss comps.


We realize that this does not come across as having outsized conviction in our edge on Wal-Mart’s fundamentals.  And in fact, from a longer-term standpoint (TAIL duration), we’d rather own Target by a long shot.


But when WMT gets to a point where things simply stop getting worse, and the stock looks good in Keith’s multi-factor model, the odds are in favor of a long here.


WMT: Odds on WMT - WMT VP 7 20 11



HBI: There’s More Downside To Go


Even with today’s blow up, people are currently paying for uninterrupted growth today at HBI. Not only is the growth suspect, but the cadence is as well. We should see the top line growth rate erode meaningfully throughout the next 6 quarters. The risk/reward here is NOT favorable.



Not a surprise with HBI’s reaction to its print today. Yes, it was an in-line quarter, but we’re starting to see cracks for which its valuation left little margin of error. We’ve been concerned about HBI for about two quarters now, and have had it near the top of our short list more recently (along with JC Penney, Carter’s, Gildan, and more recently, Under Armour).


Our conclusion on HBI is that it could be a very good story, if the management team realizes what it is and manages its playbook accordingly. They’ve been executing very well with their factory consolidation – to an extent that no one (except Gildan) has done so in the past. The problem, however, is that HBI is trying to be a growth company, instead of a ‘steady-but-slower-growth top-line with meaningful cash flow and de-levering balance sheet’ story. More specifically…


Long  term top line growth is should be 2—4%. The category grows 1%. Then they take 1-3% share as they use proceeds of factory cost reductions to pass to retailers and consumers. But they’ve been printing top line of around 9% for the past 6 quarters. Much of that (5-6%) has been shelf space gains at Dollar Stores, WMT and TGT. But then, as they started to anniversary growth, what did they do?  They started doing deals. One was big, the other small. But they both happened within a quarter of one another.  Remember, the pitch upon the spin-off was lsd top line, hsd ebit, and mid-teens eps due to delevering the massive $2.6bn debt load that Sara Lee dropped on it. But instead of de-levering and paying underfunded pension liability, they’re doing deals?  In addition, CFO Lee Wyatt just resigned. Our sense is that Wyatt and Knoll simply did not agree on strategy.  Wyatt wanted to improve the balance sheet. Knoll wants to pursue an aggressive growth strategy – even if they have to buy growth.


People say it is cheap on earnings, which is absurd. There’s no reason why an asset-intensive vertically-integrated apparel company with $2bn in debt should be valued on anything other than EBITDA. It’s trading at about 8.2x EBITDA today.  When vertically integrated apparel assets have traded hands in the past, they’ve gone for 3-5x EBITDA (ask the folks at VFC who had to give away their ops several yrs back at 4.6x EBITDA). If HBI trades below 4x EBITDA, there’s no equity value left.


People are currently paying for uninterrupted growth today at HBI. Not only is the growth suspect, but the cadence is as well. We should see the top line growth rate erode meaningfully throughout the next 6 quarters – unless HBI does more deals. That’s possible, but we suspect that the market will start to see through this.


The risk/reward here is NOT favorable.


Here are some of the more notable statements from management on the call.

  1. The volatility in this model is picking up.
    • Moved from steady outlook to more volatility
    • They’re looking for a price hike in Q4 to offset increase costs in the first half of 2012.
    • Looking for negative price elasticity in back half
    • Cutting back on unit inventory levels to manage inflation, and units are falling off less than prices going up
    • But...HBI leads on price which allows temporary gaps in pricing against competitors
  2. They’re banking on MORE shelf space gains
    • Space gains happen again after back to school and into holiday
    • lot of programs across a lot of retailers in all categories
    • Looking for new offerings throughout a whole host of accounts (“lots of wins in lots of places”)
  3. On channel inventory levels, Knoll noted that some channels are up, and some are down. But the ones that are having the most success are those that are being the most liberal with inventory build. (This synchs with our view that retailers overall need to accelerate inventory growth to command any kind of growth multiple).
  4. Inflation outlook
    • Cotton went as low as a dollar – that was too low
    • Need to be above a dollar and a quarter to maintain acreage against other crops
    • Retailers don’t want low cotton as it will lead to negative comps in the back half of 2012


HBI: There’s More Downside To Go - HBI S 7 11





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