Gang of Six Plan . . . A Catalyst without Fundamentals

Conclusion:  The Gang of Six proposal will likely pave the way to a debt ceiling extension, but a credible and detailed deficit reduction plan is still a mirage.


The stock market’s reaction to the Gang of Six deficit plan was without a doubt positive.  The SP500 ended yesterday up 1.6% and the NASDAQ composite ended up 2.2%.  This reaction was interesting given the credit markets have been signaling that any risk of a U.S. government debt default was minimal based on the fact that credit default swaps for U.S. government debt have not budged this year. The equity markets did, however, rightfully cheer on compromise in Washington, DC, even if default was never realistically on the table.


There is no doubt compromise in Washington, DC, especially in these partisan times, is indeed a good thing for America.  While Republican leadership in the House continues to make noise about not being satisfied with the Gang of Six plan, the polls and American voters are shifting away from them.  In the last few days two meaningful polls have been released that likely influenced some in the Republican leadership in the Senate to step away from stalemate on the debt ceiling debate. The key polls were as follows:

  1. CBS Poll on July 18th: This poll from CBS showed that 46% of those polled believed the debt ceiling should be increased and 49% were against it.  Almost a month earlier, CBS ran the same poll and only 24% of those polled believed the debt ceiling should be raised and 69% were against it.  Clearly, on some level, the dramatic shift amongst Americans as it relates to the debt ceiling is influencing a Republican willingness to compromise.
  2.  Gallup Poll on July 18th: The key question asked in this poll was: “What would you like the people in government who represent your views on the debt and budget deficit to do in this situation?” Interestingly, in line with the shift noted in the CBS poll mentioned above, 66% of those polled indicated they would like their political representative to agree to a compromise plan, even if it is a plan they disagree with.

Given the shift in national sentiment it is likely not surprising that the Senate has come to a compromise and that is, as the equity market indicated, positive on the margin, at least in the intermediate term.  Conversely, last night the more conservative House, influenced by the Tea Party, passed a $6 trillion deficit reduction bill with a constitutional balanced budget amendment.   This piece of legislation has been dubbed “Cut, Cap and Balance”.  In contrast to the Gang of Six plan, which has been lauded by President Obama, the House bill is very unlikely to find support in the White House.


In reality, passing “Cut, Cap and Balance” was likely more of a symbolic move.  House Majority Leader Eric Cantor signaled as much when he stated the following about the Gang of Six proposal:


“This bipartisan plan does seem to include some constructive ideas to deal with our debt.”


This seems to imply that Cantor is ready to dance, which isn’t surprising given the polls are shifting away from him.


Our core issue with the Gang of Six proposal is its gross lack of detail, which potentially makes the ability to successfully implement the plan challenging.  The key points in the five page memo are as follows: 

  • Cutting $500 billion in discretionary spending over 10 years, including defense;
  • New discretionary spending caps through 2015;
  • Requirement of congressional committees to produce legislation within six months that finds billions in savings in entitlement programs over 10 years;
  • Creation of a 67-vote threshold to make it difficult for the Senate to exceed its spending caps;
  • Overhaul of the tax code, eliminating many tax breaks and using the savings to reduce marginal income tax rates;
  • Elimination of the $1.7 trillion Alternative Minimum Tax and the $298 billion Sustainable Growth Rate formula for Medicare (known as the “doc fix”); and
  • An overhaul of Social Security.

Interestingly, this may be a way of kicking the can down the road on a grand scale as the Gang of Six plan will be utilized to extend the debt ceiling, but the real work on implementation and legalizing will come at the committee level and over a longer period of time, perhaps years.


In the Congressional Budget Office’s current baseline case from January 2011, the combined federal budget deficit from 2011 to 2021 is $6.9 trillion.  Currently, Medicare, Medicaid and Social Security combine for 42.4% of annual federal budget outlays.  By 2021, as outlined in the table below, these three programs will combine for more than half of federal budgetary outlays.  In total, by shifting from 42% of federal spending in 2012 to 50%+ of federal spending by 2021, the combined programs of Medicare, Medicaid and Social Security are responsible for contributing an incremental $2.3 trillion to the deficit.


Gang of Six Plan . . . A Catalyst without Fundamentals - 1 


The math is pretty simple, if we want to solve the deficit problem, we need a credible plan to reduce future healthcare and social security spending.  Without further detail on how this is going to be effected, it is difficult to get very excited about the Gang of Six proposal from a longer term prospective.  In the shorter term, this plan will likely allow the debt ceiling to be extended.  As far as being a credible deficit reduction plan though, the devil is in the as of yet unseen details.


Daryl G. Jones

Director of Research 

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.  


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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



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



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