European Risk Monitor: In the Red

Positions in Europe: Short EUR-USD (FXE); Covered short EUFN (European Financials) position today

European equity indices closed last week down -9 to -14% week-over-week with neither the periphery nor core immune to the move. This weekend’s European news flow on the ECB’s decision to re-implement its bond purchasing program (SMP) and buy Italian and Spanish debt had some impact on bond yields for Italy and Spain today, however the terms of the program remain vague and largely appear at best an intermediate term package or cover before the terms of the EFSF is voted on in mid to late September by the EU. In any case, European equities got smacked today alongside this weekend’s news, falling -2 to -6%.


In our eyes, neither facility will be a panacea to the region’s longer term fiscal imbalances. At the right price we’re getting more comfortable shorting the equity or credit of Germany or France as debt risks move beyond Greece, Ireland and Portugal and closer to Italy and Spain, which should erode the sovereign credit worthiness of Germany and France and its lending institutions, and drag on the broader equity indices. While consensus, we’d also short the equity markets of Italy (EWI) and Spain (EWP) on any bounce.



New News and More Known Unknowns

Late Sunday the ECB released a statement following an emergency meeting Sunday afternoon in which it praised actions by the governments of Italy and Spain in the last days to accelerate and enlarge austerity measures in order to (better) adhere to Eurozone debt and deficit targets. We’ve been largely negative on peripheral countries’ ability to meet accelerated deficit targets, nevertheless Spanish Economy Minister Elena Salgado said on Sunday that the government would use an August 19 cabinet meeting to outline further savings. Salgado did not give details except to say that €2.5 billion of savings (worth an estimated deficit reduction of half a percent of GDP) could be made through changes to the methodology for large companies' tax payments.  Spain is projected to run a 6% deficit (as a % of GDP) this year.


On Friday, PM Berlusconi announced that Italy will balance its budget, by bringing its deficit to -3% of GDP by 2013 instead of 2014. Finance Minister Giulio Tremonti said costs would be saved in reforming Italy's extensive, and expensive, social welfare system, which includes national health care and generous retirement payments, and by amending its labor laws.


The ECB’s release also noted that it will re-implement its bond purchasing program, known as the Securities Markets Programme (SMP), which began in May 2010 and bought up some €74 billion in bonds from Ireland, Greece, and Portugal, but had remained dormant over the last four months. There were few explicit details in the statement—no individual countries, amounts, or a time horizon was specified. Yet based on rumors over the weekend it appears the Bank will buy Italian and Spanish debt (which it may have started on today) in additions to the paper of the rest of the PIIGS. 


Speculation includes a purchasing program of €500-600 Billion spread out over 6-12 months. Tobias Blattner, a former ECB economist, estimates the central bank will have to buy about €200 Billion of Italian bonds and €60 Billion of Spanish securities to make an impact.


The ECB’s positioning is clearly in response to heightening bond yields in Spain and Italy, especially since the second bailout package for Greece was announced on July 21st. As we’ve noted in our work, the critical breakout level on sovereign yields is 6% based on the historical performance of Greece, Ireland, and Portugal, countries which after breaking this level required a bailout package in short order to temper yields (see chart below). While the aforementioned countries received bailout packages to help tame default, should Italy and Spain require a fiscal package to prevent default/meet its maturities, the existing loan facilities of the EFSF is undercapitalized to handle them.


European Risk Monitor: In the Red -


And this is the danger. While Eurozone leaders have agreed to expand the scope of the EFSF, they have not agreed to expand its overall size. This meeting comes in mid to late September. Further, the €440 Billion posted as AAA collateral in the facility has been reduced by existing portions of the original loans to Ireland (€85B), Portugal (€78) and Greece’s second loan (€109B), and we're raising the threat that France could lose its AAA rating, which would greatly impair the facility.


The scenario that presents itself for a “solution” given recent development are:

  1. The EFSF must be expanded by an estimated 2-4x from its current size of €750 Billion (adding in €250 IMF contribution)
  2. The ECB unloads far more debt on its balance sheet in directly buying up bonds across the Eurozone

We put “solutions” in quotation markets for neither option is very certain nor guaranteed to be an explicit solution to very pervasive fiscal imbalances across the region that are bottled in with political indifference. To point one, political indecision could well get in the way of expansion (approval is needed from every EU member). To point two, assuming point one isn’t acceptable, it appears the ECB would have to roll out the printing press and take far more risk on its balance sheet. This could have disastrous inflationary consequences for the common currency. This action would go directly against the Bank’s mandate for price stability. 


In all of this, the common currency has held up relatively well against major currencies. Against the EUR-USD, we continue to outline $1.43 as an important intermediate term TREND level and $1.40 as a critical immediate term support TRADE level. Should both break to the downside, we don’t see long-term support until $1.28. That said, the pair has traded in a tight range of $1.40-1.45 over the last 4+ months, largely on the back of implicit guarantees of the EU community to support any member country in need with fiscal assistance. We don’t expect this to change, but caution that the terms are going to get a lot more challenging as Italy and Spain take a brighter light in the arena of European sovereign debt contagion.   


Matthew Hedrick

Senior Analyst


JACK underperformed the S&P 500 by 370bps and 210bps over the past week and month, respectively.  The under-performance raises some alarm bells going into its earnings release on Thursday.  All of the work done during the quarter suggests that the fundamentals have been shaping up well.  Commodity inflation is one concern, as it is for the vast majority of restaurant companies, but we believe that the market has long taken this into account when assessing JACK.


The trends at JACK are getting better “on the margin” but the company is not in the clear just yet.  As I see it, the current risk/reward is favorable.  JACK is the last QSR company with a market capitalization over a billion that is trading below 6.0x EV/EBITDA.  By comparison, the average multiple for the QSR sector is now at 10.3X EV/EBITDA.  However, excluding CMG and GMCR and DNKN, the QSR average multiple drops to 8.7X EV/EBITDA. 


I see FY3Q11 same-store sales growth guidance of +2-4% for Jack in the Box company units as reasonable, given the sequential improvement in two-year average trends during fiscal 2Q11 and the stable/improving QSR macro environment. 





The following are some of the important forward-looking statements from the last JACK earnings call and our take on the current quarter trends.





“We're on track to substantially complete our restaurant re-image program system-wide by the end of the calendar year. And we're ahead of our timeline to increase franchise ownership to 70% to 80% of the Jack in the Box system.”


“Overall commodity costs are now expected to increase 4.5% to 5.5% for the full-year with Q3 inflation expected in the 6% to 7% range. Restaurant operating margin for the full-year is now expected to range from 12.5% to 13.5%, with better sales versus our prior guidance largely offsetting higher commodity inflation."


“We have not changed our full year guidance for diluted earnings per share of $1.40 to $1.65. Gains from refranchising are expected to contribute $0.70 to $0.83 to EPS, with the penny increase on the upper end due to the lower expected tax rate for the full-year.”


“Operating earnings per share, which we defined as diluted EPS on a GAAP basis less gains from refranchising, are expected to range from $0.70 to $0.82 per share. EPS includes approximately $0.10 to $0.12 of incremental re-image incentive payment franchisees in fiscal 2011 as compared to fiscal 2010. The incremental re-image incentive payments for Q2 were $0.02 higher and year-to-date $0.03 higher than in fiscal 2010, although re-image incentive payments were $2.7 million year to date versus $650,000 through Q2 of 2010.”


“We would expect that our restaurant operating margins at the conclusion of our refranchising strategy will be above 16% in a normalized inflationary environment. In addition, we have said previously that we expect G&A excluding advertising as a percentage of consolidated system-wide sales to be in the 3% to 4% range. And Q2 year to date, we were at approximately 4.3% of system-wide sales.”


“We’ve raised our full year same-store sales guidance for both brands. Same-store sales are now expected to increase approximately 1% to 3% at Jack in the Box Company restaurants versus our prior guidance of down 2% to up 2%. At Qdoba, we now expect system-wide same-store sales to increase 4% to 6% versus our prior guidance of a 3% to 5% increase.”


“For the third quarter, we expect same-store sales for Jack in the Box company restaurants to increase from 2% to 4% and system-wide same-store sales for Qdoba to increase 4% to 6%. Our guidance reflects the sales trends we've seen thus far in the quarter.”


“So, driving the AUVs in all of the system restaurants is going to be important. So if you look back at when we had the restaurant operating margins that I spoke about earlier, at 16% and then one year as high as – they were over 17%. That was with average unit volumes about 1.440 million. If you look at where our average unit volumes are annualized based upon current year performance, they're about 1.375 million. So we need to get those average unit volumes up, and I think that's going to be a significant piece. We need to continue to grow same store sales. I don't think it will be as simple as just refranchising all of those units; however that is going to be a significant portion of this."



HEDGEYE: The macro environment continues to be challenging for JACK, especially on the commodities side.  However, the employment trends have been improving for JACK in the most important regions.  The “less bad” macro environment, coupled with the SSS momentum that started in last quarter, suggests that this quarter should meet or exceed expectations.  In particular, management has emphasized employment trends among young Hispanic males as being particularly important for Jack in the Box’s top-line trends.


JACK – EARNINGS RELEASE PREVIEW - young male hispanice employment





“As we said on our February call, we expect that Q2 restaurant operating margins will be similar to Q1, which was 12.6%.”

“Based on the increases we've seen in most commodities since that time, we now expect full year commodity inflation to be 4.5% to 5.5%.”


“Beef accounts for more than 20% of our spending 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. Our third quarter forecast for beef 90s, in the low $2 per pound range and for beef 50s; we expect prices to average in the $0.95 to $1.05 per pound range in Q3.”


“Pork accounts for about 6% of our spending. It's expected to increase 4% for the full year. Cheese also accounts for about 6% of our spending and we continue to expect a 15% increase for the year. We now have 100% coverage on cheese through the remainder of the fiscal year.”


“Dairy costs, which are over 3% of our spend, continue to be impacted by higher butter prices and are now forecasted to be up 6.5% for the full year versus our prior forecast of up 5%.”


“Bakery accounts for about 9% of our spending and we continue to expect a 1.5% decline for the year. We now have 90% of our bakery needs covered through December of 2011.”


“There has been no change in our outlook for chicken, which is about 9% to 10% of our spending, as we have fixed price contracts that run through March of 2012. Produce represents about 5% of our spending and Q3 and Q4 costs are expected to normalize after the weather-related inflation we experienced in Q2. We have fixed price contracts in place for potatoes, which accounts for approximately 8% of our spending; with 100% of our potato needs for the full year contracted with prices essentially flat versus last year.”


“We’re anticipating Qdoba margins to be about 50 to 60 basis points accretive to our back half margins for the full year.”


“Then getting back into more of your question on the restaurant operating margin, if we can go back to what our initial outlook was for the full year, back in November we were talking about flattish comps down 2 to plus 2. We talked about commodity inflation of 1% to 2% and that was going to drive restaurant operating margin expectations in the 14% range. And now that – the decline from that 14% to the midpoint of our range right now of 13% is largely driven by the commodity inflation, which we're now expecting to be 4.5% to 5.5%.”


HEDGEYE: One key to the bull case for the stock over the next 12-18 months will be the company’s ability to improve SSS and see incremental leverage to the margin structure of the company.  If JACK can get to their goal of 16%, the stock will behave accordingly.  





“We've increased our guidance of – for Qdoba unit growth this year and now expect 60 to 70 restaurants to open system-wide, as franchisees are now expected to open 35 to 45 restaurants.”


“And capital expenditures are expected to be $110 million or less, with the majority of that spend going towards new unit growth for both brands versus maintenance and remodel capital. In addition, the change in our business model should result in growing royalty and rental income streams, be less capital intensive, improved returns on invested capital, and EBIT margins and generate higher free cash flow.”


“We have $25 million available for repurchases under a Board authorization, which expires in November of this year. And last week our Board authorized an additional $100 million repurchase program, which expires in November 2012.”



Howard Penney

Managing Director


Rory Green



GIL: Gong Show


The Gildan quarter came across as what we’d most appropriately call a ‘Gong Show.’ There is so much noise with this company, but the key issue is simple…its’ core category is under pressure, and GIL is losing share in that context. Efforts to make up the slack in other businesses – socks, most notably – are not coming at the margins needed to offset the core. That’s why management moved forward with the acquisition of Gold Toe – to add opacity to an otherwise troubling transparent picture. While the diversification to third party manufacturing and brands is nice, it adds an element of risk to a model that already has proved to be one of the more volatile businesses in retail. We still do not like GIL after the guide down, and think that risk remains to 2012 numbers. We’re at $1.97 vs the Street at $2.34.


With margin compression a clear and present risk, concerns over the company’s base business headed into the 2H were briefly muted when the Gold Toe acquisition was announced in April driving estimates higher. On one hand, greater diversification should improve earnings stability and ultimately the multiple the stock is awarded. However, a sharp deceleration in Q3 shipments to distributors (down -9%) and a reduced outlook for Q4 shipments down -5% vs. +3%E due to softness in the U.S. screenprint channel (roughly 60% of total sales) has rekindled concerns about the base business.


Both Gildan and Broder cited the likelihood of pre-buying ahead of July 5th price increases last year as the primary cause of weaker demand along with differed spending in an attempt to capitalize on declining cotton costs. But what’s more difficult to reconcile is the fact that Gildan lost 90bps of market share to 61% across all product lines in aggregate during the quarter as well. It’s likely due to more aggressive pricing, which was up +26% for activewear and underwear offset in part by a -4% decline in unit volume. In fact, second only to softer industry demand, GIL’s move to start promotional discounting to drive sales in the U.S. distributor channel was the next biggest callout of the quarter resulting in lower margins  and a meaningful reduction to the Q4 outlook (EPS of $0.40 vs. $0.52E).


Moreover, just as margin pressure becomes a reality and the company anticipates a 900bps swing in sequential gross margin, management is becoming increasingly more opaque about the cost at which cotton is covered. Rather than providing a price, they simply confirmed that it’s covered through the 1H of F12. While GIL expects cotton to weigh on margins through the 1H, management has several initiatives (energy, supply chain, ramping Rio Nance IV, and distribution & transportation) underway that could drive material margin expansion over the next 12-24 months, but that’s a long way off for most who are hyper-focused on the next 6-months. Over the immediate-term TRADE (3-months or less) and intermediate-term TREND (3-months or more), GIL is faced with increasing volatility and further downside risk.


Cost induced margin risk can be challenging enough, but the threat of greater variability in the top-line can lead to highly volatile earnings near-term. With the stock trading at 13.5x our EPS fiscal '11 and '12 estimates and a buck a share in debt compared to two dollars in cash prior to the acquisition, there is little room for doubt. It’s one thing to operate a stable business model through challenging times, but Gildan is trying to transition its business from a full vertically integrated manufacturer into expanding both at retail and internationally at the same time the industry is becoming increasingly volatile exacerbating the near-term earnings risk in this name. GIL remains near the top of our short list along with JCP, HBI, and COH.



Notable management commentary from the call:


Inflation outlook:

  • “we have very good visibility and covered for the Q1 and Q2 of next year. And in each of those subsequent quarters, our cotton cost will be less than it was in, obviously, Q4.”
  • The company raised prices to cover cotton costs at $1.50 – right now it’s at $1.05 plus ~$0.10 of basis. Considering it takes ~6lbs. to make a dozen shirts, there is roughly a $2 spread.
  • Inflationary costs across the industry (energy, labor, transportation, dyes, chemicals, etc.) are up roughly $0.80 a dozen offsetting the positive pricing spread.

Volatility in the model picking up:

  • “margins in Q3 were, obviously, over 28%, and we've reported and we've guided to 22% in Q4. That changes really because of the significantly higher cost of cotton that's being consumed in Q4 which negatively impacts margins in Q4 versus Q3 by about 900 basis points.”
  • “Overall, industry unit shipments from US distributors to US screen printers declined by 9% during the quarter according to the CREST report, compared with our assumption in our May guidance, the industry demand will grow by 3%.”
  • The company also guided Q4 down -5% vs. prior expectation of +3% - an 8 pt. swing.
  • Based on weaker demand, the company has initiated promotional discounting in the U.S. distributor channel in order to simulate demand.
  • “the quality of the inventory that's in the marketplace may not be as good as it should be.”
  • Q: “you've covered cotton at dollar x or dollar y or you partially covered dollar x or dollar y into a given quarter. Are you still willing or able to give that degree of color?”
  • A: “No, I don't think we want to provide any more details than what Glenn said. We will be initiating our guidance for 2012 when we report at the beginning of December”


GIL: Gong Show - Cotton 8 6 11


GIL: Gong Show - GIL S 8 11



Casey Flavin


get free cartoon of the day!

Start receiving Hedgeye's Cartoon of the Day, an exclusive and humourous take on the market and the economy, delivered every morning to your inbox

By joining our email marketing list you agree to receive marketing emails from Hedgeye. You may unsubscribe at any time by clicking the unsubscribe link in one of the emails.

Short Covering Opportunity: SP500 Levels, Refreshed

POSITION: no position SPY


I want to be crystal clear - this market will finally be immediate-term TRADE oversold sub 1153 today. That doesn’t mean I am bullish on US Equities. It’s what I call a Short Covering Opportunity.


Lines that matter across our core 3 investment durations (TRADE/TREND/TAIL):


1.       SELL TREND = 1314

2.       SELL TAIL = 1257

3.       TRADE range = 1153-1183


On my immediate-term TRADE range those are lower-lows and lower-highs of support (1153) and resistance (1183) than I gave pre-open. That’s the way the math works in my model. With every 90 minutes of new data, ranges and levels change.


Follow The Leader,



Keith R. McCullough
Chief Executive Officer


Short Covering Opportunity: SP500 Levels, Refreshed - SPX


Early August data indicates 34-44% YoY growth for the month.



August is off to a slower start – but still strong – than July with the first week of table revenues of HK$4.5 billion.  Average daily table revenues were HK$647 million versus HK$728 million for all of July.  For the full month Gross Gaming Revenues, we are projecting HK$20.5-22.0 billion which would represent YoY growth of 34-44% but a drop of 6-13% MoM.  July was such a strong month – and surprising considering that July is seasonally slow - we would not be surprised with a sequential slowdown.  It’s tough to reach any definitive conclusions with only one week of data but we are monitoring the data closely for any hints of a sustainable downturn in VIP volumes.


In terms of market share, Wynn and Galaxy were the big takers in the first week.  MPEL lost share but we are hearing that it was hold related.  










Global growth is the key variable in defining investors’ outlook on commodities, it seems.  Goldman Sachs has maintained its constructive outlook on commodities, keeping its overweight recommendation on raw materials relative to other assets, saying that global growth is “sufficient” to drive demand, according to Goldman Sachs.  Commodity prices, however, have dropped on concerns that the global economy may be slowing materially as S&P downgrade may worsen slowdown, according to Bloomberg.



The following comments from TSN today are bearish for restaurant margins: 


“Because many of our sales contracts are formula based or shorter-term in nature, we are typically able to offset rising input costs through increased pricing. However, there is a lag time for price increases to take effect.”


“Chicken prices were up 10.2% - “we expect weak market pricing conditions to continue as a result of an imbalance of available supply relative to customer demand. Current USDA data indicates reduced broiler egg sets and placements in the fourth quarter of fiscal 2011. However, we do not expect to see a meaningful impact of the reduced supply in our results until late in our fourth quarter of fiscal 2011 and continuing into fiscal 2012. Because of these factors, we expect our Chicken segment will likely experience a loss for the fourth quarter of fiscal 2011.”


“Beef were up 13.5% - “We expect to see a gradual reduction in fed cattle supplies of 1-2% in fiscal 2012 as well as exports to remain strong as compared to fiscal 2011. Despite reduced domestic availability, we expect adequate supplies in the regions we operate our plants. Based on these factors, we expect the strong fundamentals in our Beef business to continue in fiscal 2012”


“Pork prices were up 3.0% - “We expect hog supplies in fiscal 2012 to be comparable to fiscal 2011 and to be adequate in the regions in which we operate. We expect pork exports to remain strong in fiscal 2012.”





Restaurant stocks are underperforming the food and beverage categories as commodities slump, particularly sugar over the past two weeks, as concerns over a global growth downturn mount.


THE HBM: MCD, YUM, SBUX, PEET, CAKE, TXRH - subsector fbr




  • MCD July Global comparable restaurant sales exceeded estimates in July, increasing 5.1% versus consensus 4.6%.  US comps grew 4.4% versus 4.1% consensus, Europe grew 5.3% versus 6.6% and APMEA grew 4.0% versus 1.9%.
  • MCD Japan comparable restaurant sales growth fell -3.8%.
  • YUM raised to Outperform versus Neutral at Baird.  The price target is $60.
  • SBUX raised to Outperform versus Neutral at Baird.  The price target is $45.
  • PEET was downgraded to Hold from Buy at Gabelli.



  • CAKE was downgraded to Neutral versus Outperform at Baird, the price target is $30.
  • TXRH was cut to Neutral versus Outperform at Baird, the price target is $16.





Howard Penney

Managing Director

Daily Trading Ranges

20 Proprietary Risk Ranges

Daily Trading Ranges is designed to help you understand where you’re buying and selling within the risk range and help you make better sales at the top end of the range and purchases at the low end.