Covering Japan… We’ll Be Back

Conclusion: We covered our Japan short earlier this afternoon, as it is immediate-term TRADE oversold. The intermediate and long-term issues facing the Japanese economy remain, however.


Position: Covered our Japanese equities short (EWJ).


Today, Keith covered our short-Japanese equities position with the Virtual Portfolio for a gain. The position – perhaps aided by the global equity market selloff – continues to be one of our core theses in Asia over the intermediate and long term. From an intermediate-term perspective, the bearish catalysts remain: 

  • ZERO interest rate policy continues to depress confidence and growth;
  • Burgeoning debt/deficits is setting up a likely a growth-negative fiscal adjustment;
  • Regulatory uncertainty surrounding the timing of leadership changes and nuclear power regulation is depressing industrial production and both consumer and business confidence;
  • Sharp yen appreciation is weighing on corporate profits and (subsequently) job creation via declining business investment; and
  • Slowing sequential growth momentum bumping up against increasingly tough YoY economic growth comparisons. 

See our 8/1 note titled, “Things Are About to Get a lot Worse In Japan” and our 5/16 note titled, “Time to Press?: Revisiting Japan From a Secular Perspective” for more details.


Contrary to the consensus belief that quake/tsunami reconstruction is just what Japan needs to revive growth, we remain bearish on Japanese growth over the intermediate and long term. Despite Japan being very “cheap”, valuation, as consensus is finding out, remains no catalyst.


The economic grip around Japan’s Jugular is about to get incrementally tighter…


Darius Dale



Covering Japan… We’ll Be Back - 1

European Bank Swaps Shake

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

Below is our European Financials CDS Monitor that is tracked weekly by our Financials Managing Director Josh Steiner and his team.  As we’ve noted in recent work, the rising spotlight on the sovereign health of Italy and Spain have sent bank stocks in both countries shaking. Announcements over the weekend from Spain and Italy to further tighten spending to reduce budget deficits and the ECB’s decision to re-activate its bond purchasing program (SMP) did little to quell investor fears today: European equities fell -2 to -6%, and most towards the latter end of the range. [For more see today’s note titled “European Risk Monitor: In the Red”].


While the “news” did send 10YR Italian and Spanish sovereign bond yields tumbling around 70bps day-over-day to 5.35% and 5.23% respectively, it’s clear that the ECB too is worried about bond yields creeping up in both countries. Our break-out yield target level remains 6%, which both have flirted around, even after the announcement of Greece’s second bailout on July 21st. 


As it relates to the banks, we see the 300bps (affectionately named the Lehman Brothers line) as a critical break-out momentum line. And here the score card is very telling. Currently 13 out of the 39 large European banks are trading over the 300bps line. If we focus on the banks of the peripheral countries, the majority of them are above 300bps, and a significant number have cleared the line by a country mile. We think many of these banks that defy the line are in serious risk of default. 


A breakdown of the monitor shows that bank swaps in Europe were mostly wider last week: 34 of the 38 swaps were wider and 4 tightened. 


Widened the most vs last week: Banco Popular Espanol (Spain), Svenska Handelsbanken, Barclays

Widened the least vs last week: Alpha Bank, EFG Eurobank, National Bank of Greece

Widened the most vs last month: Banco Popolare (Italy), Banco Pastor (Spain), Bayerische Hypo (Germany)

Tightened the most/widened the least vs last month: Alpha Bank (Greece), EFG Eurobank (Greece), Hannover Rueckverischerung (Germany)


Today we covered our short position in European Financials (EUFN) in the Hedgeye Virtual Portfolio for a 15.7% gain (see levels chart below).


European Bank Swaps Shake - 1. josh


European Bank Swaps Shake - 2. josh


Matthew Hedrick

Senior Analyst

Change in FL/FINL Estimates Reflect Lackluster July


Weekly footwear data registered a third consecutive decline last week confirming that sales have indeed turned sharply lower through the back half of July. Not surprisingly, FL and FINL are among the names that trade most heavily on these numbers. We are adjusting our estimates based on the latest data, but remain well above Street estimates for FL while FINL is more in-line. With that in mind there are several key factors to consider:

  1. Many investors still trade on these numbers with similar conviction to the prior sample set (before Jan ’11) when only athletic specialty channel sales were reported. With department stores and national shoe chains now included in the weekly data, the variability factor has increased substantially tracking 4%-6% below athletic specialty channel sales.
  2. In terms of sizing July sales, it represents roughly 7% of annual dollars – the same as May both of which are less significant than June, which was up 12.3% (see chart below).  
  3. Based on monthly data where the athletic specialty channel is broken out, sales were up 9.6% through the first two months of FL’s Q2. With weekly sales coming in down -2% in July and assuming at least a 4% adjustment, we assume July came in up +2%. This suggests comps are tracking at 7.5% in Q2. With FL coming in at least 200bps above our proprietary blended rate in each of the last three quarters, we have adjusted comps to +9.5% for the quarter with EPS shaking out at $0.17 for Q2 and $1.68 for the year well aboveconsensus at $0.12 and $1.57 respectively.
  4. Taking a similar look at FINL, which closes its books at the end of August and has a tighter performance range around the blended rate, we have adjusted comps to +8.5% for the quarter with EPS shaking out at $0.40 for Q2 and $1.56 for the year essentially in-line with consensus at $0.39 and $1.56 respectively. Keep in mind, that August is the second largest month of the year from a dollar perspective aside from December and will be key to locking in the quarter for FINL.
  5. Importantly, July monthly numbers will be out next Monday ahead of FL’s earnings release Thursday afternoon providing further clarity to our adjustment to weekly figures. We’ll update our view if necessary as soon as we have those numbers.
  6. Lastly in looking at footwear trends over the last few weeks, sales declines have come from lower unit volume depsite relatively stable ASP trends +/- 1%. This suggests that we could see an increase in promotional acitivity during the critical BTS selling season as retailers look to drive top-line results.


 Change in FL/FINL Estimates Reflect Lackluster July  - FW App Agg Table 8 9 11


 Change in FL/FINL Estimates Reflect Lackluster July  - Fw App BrandTable 8 11 11


 Change in FL/FINL Estimates Reflect Lackluster July  - FW App FW Mkt Sh 8 9 11


 Change in FL/FINL Estimates Reflect Lackluster July  - FW App App 1Yr 8 9 11


 Change in FL/FINL Estimates Reflect Lackluster July  - FW App App 2Yr 8 9 11


 Change in FL/FINL Estimates Reflect Lackluster July  - FW FL Comp 8 11


 Change in FL/FINL Estimates Reflect Lackluster July  - FW FINL Comp 8 11


 Change in FL/FINL Estimates Reflect Lackluster July  - FW Mo as Pert of Annual Revs 8 11


 Change in FL/FINL Estimates Reflect Lackluster July  - FW Mo Channel 7 11



Casey Flavin


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In preparation for IHG's Q2 earnings release tomorrow, we’ve put together the pertinent forward looking commentary from IHG’s Q1 earnings call and subsequent conferences/releases.



Youtube from Q1 Conference Call

  • “RevPAR trends continued into April with global RevPAR growth of 6.1% excluding Japan, Egypt and Bahrain, 4.9% growth on a reported basis. U.S. RevPAR grew 7.2% and China RevPAR grew 14.6%.”
    • “On EMEA, we were up 1.9% excluding Bahrain and Egypt. And actually if you exclude Lebanon where there are other issues, we were up 3.1% in EMEA. And then in Asia-Pacific, the 5.3% is 12.8% excluding Japan, and that includes 14.6% in China”
  • “Looking further forward, our reported RevPAR figures were clearly be impacted to some extent by Japan and the Middle East, particularly in 2Q. April RevPAR in Japan was down 26%. Moving through the year, we’ll also face progressively tougher comparatives, particularly for our Shanghai hotels due to the world expo last year.”
  • “Overall, booking pace looks good with increases in both demand and rate. Future travel intentions data collected from guests in our hotels is positive, and specifically as we head into the key summer leisure season, leisure travel intentions are also up. We’ve not seen any impact from the rise in the oil price although clearly this remains a risk if the price spikes further.”
  • “We’ve estimated the full year impact of the events in the Middle East and Japan at between $15million and $20 million, and at this stage we expect much of this would be offset by positives elsewhere. The situation in each market is however clearly fluid and our visibility is limited with extremely short-term booking activity. Our estimates are based on no return to normality until at least the fourth quarter of this year.”
  • [Japan] “The cancellation activity has ceased and booking pace is starting to show a gradual pickup.”
  • “In the Middle East, the key impacted markets are Egypt and Bahrain, and although we’re starting to see some recovery in the outskirts of Cairo and the Red Sea resorts, we do not expect any return to normality until there is stability in government.”
  • [Regional/central costs] “For the full year, we still expect these cost to be between $250 million and $260 million at constant currency.”
  • “Looking now at the pipeline. Financing for new hotel construction remains constrained in some of our biggest markets, and we don’t anticipate much change in the short-term.”
  • “We have the industry leading pipeline, with 18% of the active global pipeline according to Smith Travel and our nearest competitor has just 13% and that pipeline is high quality. Around 70,000 rooms, close to 40%, are under construction. In Greater China, some 70% of the projects are under construction, and across EMEA, this figure is around 60%. It drops to around 20% in the Americas, where the figure is typically lower due to the shorter time from signing to opening for midscale hotels.”
  • “We remain confident with our 3 to 5% net system growth guidance from next year into the medium term as the level of removals revert to more historic norms.”
  • “Net debt at the end of March stands at $846 million. This is around $100 million up on year-end, due to seasonal working capital movements which we expect to reverse for the full year.”
  • “We’ve got around 20 hotels in Shanghai, out of 150 open and obviously more opening this year. So, we’ll have some impact but we’re, not only we’re seeing RevPAR growth but we also adding hotels in China, so the momentum is pretty strong there.”
  • “As far as the Barclay is concerned, I think historically we’ve always talked about the six to nine months for a disposal of a major asset. We aren’t a forced seller with that asset, so the important thing for us is to find the right buyer who is going to support that hotel, support the brand and invest in it, I think we said before, we’re going to require at least $100 million refurbishment program of that hotel. And if you play it right you can also get other hotels or built a good new relationship. So there is a lot of good interest in that hotel.”
  • “We’re actually seeing rate growth in the corporate negotiated area. At inflation or slightly above inflation. But what we’ve done is push quite hard for market share growth, which is obviously one thing you have to look at and with our move to dynamic pricing and real focus on bigger accounts, we’re seeing some quite significant share gains.”
  • “Booking windows are short…the momentum looks okay for leisure. We’ll certainly start feeling that much more in June, July as we get to that.”
  • “But as you say, that is new supply (in New York) and with our share of that particularly with the InterContinental in Times Square that’s been performing really well. Honestly for a brand owner with good product in the market, new supply is obviously a good thing for us if we get our share of it. And we’ve certainly been seeing that in New York.”
  • [FY2011 Capex] “$100 million to $200 million and it’s a broad range. But because most of this is working with third-party owners we are not dictating the timing, then it’s hard to be very specific about the amount. And then on top of that we’ll have about a $150 million of maintenance capital this year, which is slightly ahead of depreciation. I think I’ve always said that depreciation should broadly equal maintenance and over the last couple of years for obvious reasons we were significantly below depreciation, so a little bit of catch up this year. Quite a lot in the technology area which is obviously important for us.”

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



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