Chinese Cowboys Intact

Conclusion: If you have to be long something equity-related, we continue to side with the market and stand by our view that Chinese equities are your best bet on a relative basis. As China begins to fire up more strategic growth initiatives, we expect the delta in performance between Chinese shares and U.S./E.U. shares to widen even more dramatically that what we’ve already seen over the last few months.


Position: Long Chinese equities (CAF).


At Hedgeye we place a significant emphasis on timing and duration in both our research and risk management (expression of said research). From a timing perspective, our signal to buy Chinese equities on June 16thhasn’t been our best call on an absolute basis (the CAF is -2.2% against us in our Virtual Portfolio).  On a relative basis however, the Shanghai Composite Index has held up marvelously amid the recent global sell-off in equities:


Chinese Cowboys Intact - 1


A recent mainstay on our Hedgeye Alpha (a daily compendium of our firm’s 12 best L/S ideas), our Chinese Cowboys thesis continues gain traction as the research supporting the call  comes in as expected: 

  1. Real economic growth basing;
  2. Inflation is peaking; and
  3. Rate hikes stop and central bank becomes dovish on the margin

As we have said many times throughout our bullish bias on Chinese equities, we’re not calling for a reacceleration in Chinese economic growth. We’re merely calling for it to slow at a decelerating rate over the intermediate term – rather than fall off a cliff as the May/June China-bears wrongfully believed.


Over the last few weeks, we’ve received some (slight) bullish catalysts that we think are worth compiling: 

  • The State Council reported that Chinese officials intend for the construction of 10 million units of low-income housing to have begun by the end of November (as part of a larger initiative to build 36 million by 2015). We’re not big on China’s current “build it and they will come” growth model, but we can’t deny the impact of such a large-scale initiative will likely have on the Chinese economy over the intermediate term (~48% of GDP is Fixed Asset Investment).
  • China’s Finance Ministry drafted a preliminary plan that would allow the country’s municipal governments to issue bonds to investors. This is helpful because it would allow cash-strapped local government financing vehicles to smooth out their liabilities over a longer duration vs. the current credit structure consisting of ~80% bank loans and ~70% of the aggregate debt burden coming due in over the next five years. A successful follow-through of this plan removes major TAIL risk from the Chinese banking system.
  • The National People’s Congress recently finalized revisions to the personal income tax law, raising the minimum income tax threshold +75% to 3,500 yuan and also lowering the mill rate for lowest taxable income bracket. The former maneuver is expected to exempt an incremental 60 million Chinese consumers from paying income taxes. The changes take effect at the start of next month and we expect it to be incrementally bullish for Chinese consumption growth, which is already being buoyed by per capita disposable income growth accelerating to +14.1% YoY in 2Q.
  • The absence of tightening: China has held off from raising interest rates and banks’ reserve requirement ratios since July 5thand June 20th, respectively, with the latter hold being the longest in the current tightening cycle (beginning in Jan. ’10) since China held RRR’s flat from May through November of last year. The lack of tightening and shift in bank expectations away from further hawkishness has facilitated a -108bps peak-to-current decline in 3mo Shibor, an aggregated measure of interbank funding costs out of the National Interbank Funding Center in Shanghai. As banks start to pay less and less for funding, we expect the current credit crunch hampering the operations of many small-to-medium-sized enterprises to recede on the margin. This is a big deal, as SMEs employ ~80% of Chinese workers, generate 2/3rds of industrial output, and pay half of all tax revenues per China’s Ministry of Industry and Information Technology.
  • Perhaps the largest (and most speculative) bullish catalyst we could potentially see in the next 3-6 months is a widespread relaxation of fiscal spending and a broad easing of monetary policy in “some sectors”, as reported today by the China Securities Journal. Though largely an unsubstantiated rumor at this point, it is an important catalyst to keep an eye out for over the coming months – especially as our calls for Slowing Global Growth and Deflating the Inflation continue to play out in spades. 

Chinese Cowboys Intact - 2


Chinese Cowboys Intact - 3


All told, we continue to like Chinese financial and consumer stocks as China begins to fire up more strategic growth initiatives favoring these sectors. This will likely come at a time when developed markets, such as the U.S., have little to no bullets left on the monetary policy front and no headroom left at all on the fiscal front to attempt to stimulate growth. In such an event, we expect the delta in performance between Chinese shares and U.S./E.U. shares to widen even more dramatically that what we’ve already seen over the last few months.


Chinese Cowboys Intact - 4


We realize that it’s difficult for the Chinese economy to hum along while global growth slows broadly – especially considering weakness in important economies like the U.S., Japan, Germany, France, U.K., Brazil, etc. That said, however, if you have to be long something equity-related, we continue to side with the market and stand by our view that Chinese equities are your best bet on a relative basis.


Darius Dale


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PSS: The Decision Tree


This is 2008 all over again, where three words in a press release make all the difference in the stock – Reviewing Strategic Alternatives (or Hiring Goldman Sachs).



The quarter was definitely upbeat – especially in light of the weak numbers we saw today out of Brown Shoe – and was better than our expectations. What really surprised us there is that this was the quarter for them to take every charge, build every reserve, and find every possible area to front-load costs in the wake of Rubel’s departure. They did  this to some degree, but not as much as we thought.


There were two options for the management team heading into this event. A) Saying and doing nothing about its strategy, or B) taking the bull by the horns and showing that it is in control of its destiny. We definitely got #2, or at least the appearance of #2.


On one hand, they said that they were going to Review Strategic Alternatives – which could be complete smoke in mirrors. Perhaps they split the company up, but on the flip side, they said that they’re going full bore in closing 475 (~10% of total) stores – most of which are by year-end – and are on a very active hunt for a CEO. We can’t imagine that they’d hire, or attract, a high-quality CEO when there is an asset rationalization and Strategic Review Plan already in place.


At this point, there are essentially three outcomes for investors:

  1. An all out sale of the company.
  2. A sale of some part of the company.
  3. No sale at all. Instead, the company names a new CEO and gets to work on closing stores, or whatever the new strategy will be.

The first two outcomes have been on the table since ex-CEO Rubel’s departure, but the third and most likely outcome just got considerably more favorable. Here are our thoughts on each:


1) An all out sale of the company:

  • This is the least likely of the three scenarios given the disparate characteristics of two business that would ultimately attract different buyers.
  • The high fixed cost and real estate intensive nature of the domestic Payless business is best suited for a financial buyer. One with a Ron Johnson-like 7-year duration that can take control, absorb losses, and slowly but surely take the store count meaningfully.
  • Another possibility is a large property owner like a strip-mall REIT that is better equipped to utilize the company’s store base and either take out/take down the leases, or flip them to a more profitable concept. But these companies are hardly cash-rich right now.
  • Based on our breakup analysis, we get to a valuation of $3-$6 per share for the ‘core’ payless business (both domestic and international) taking debt into account and $9-$11 per share for the PLG business on our bear case assumptions. $3-6 + $9-11 = $12-$17. Using less than heroic assumptions, we can get a valuation for the PLG business in the mid-teens to low-20s alone.

2) A sale of some part of the company:

  • This is a distinct possibility, but the company is less likely to sell off PLG in its entirety as the company’s key growth engine.
  • Saucony and Sperry are the most likely candidates and both could see interest from both financial and strategic buyers.
  • Re Saucony:
    • VFC could buy it in a heartbeat. It’s small enough that they can do this side by side Timberland.
    • Adidas makes sense. They’ll do anything to get into the technical running market. They’d rather buy Asics, but if the price is right it can happen.
    • Why not Li&Fung? Li Ning? Yue Yuen? Li&Fung has stated flat out that it wants to buy brands to leverage its scale. Yue Yuen has diversified into retail. Moving into the content side of the equation would definitely leverage its manufacturing base.
    • New Balance, Asics, and Under Armour are all out.
    • Nike wouldn’t touch it with a twenty foot pole. The irony is that Nike does not do well at all in the technical running category – despite the fact that it views its birthright to be rooted in running (watch the movie ‘Without Limits’ or ‘Pre’). An interesting angle on Nike’s running share… it has about 35% share in the running space. But count the number of swooshes on the feet of the first 20 finishers of the Chicago marathon. You’ll see far fewer than 35%. Nonetheless, the factoid here is that as long as Nike THINKS it can dominate this category (which it does) it won’t buy anyone else. It’s a strategy that has paid off for shareholders, by the way.
  • Re Sperry:
    • A financial buyer is more likely. This brand is strong enough to be a stand-alone company – and even a public one.
    • On the strategic side, there’s everyone from VFC, to JNY, to the same Asian acquirers that we think are going to make their way into this market.
  • We’ve already hit on the valuations above, however in breaking out PLG further, Stride Rite and Keds are worth $1-$2 per share with Saucony and Sperry valued at $9-11 with slightly more than half of the value attributed to Saucony at $5-$6.
  • There are no structural impediments that would prohibit a carve out of PLG from happening. However, carving out a single brand within PLG would be a bit more difficult in terms of integrated back office functions. Consider the following…
    • It took the company a very very long time to integrate some of the back-end infrastructure (consolidated 2DCs and a manufacturing facility) and pulled roughly $25mm of SG&A out, but the PLG brands still operate independently to a large extent.
    • The entire PLG team still operates out of their own HQs in Lexington, MA.  
    • It wasn’t until Q2 that only some of the PLG stores were hooked into the same PeopleSoft financial systems that the core domestic Payless business uses and in a similar fashion, the retail systems that count traffic/store metrics are also still largely independent from one another.

3) No sale at all. Instead, the company names a new CEO and gets to work on closing stores:

  • Business as usual is probably the most likely outcome as the company completes its strategic review process.
  • Assuming an asset sale does not occur, who PSS hires as the new CEO will be the most important near-term catalyst. (positive or negative)
  • The board wasted no time in getting a plan in place to aggressively reduce underperforming stores, which is the most significant positive development to come out of Q2 results.
    • In total, the company expects to close approximately 475 stores (~400 Payless & ~75 Stride Rite) over the next 3-years with 300 closings by year-end with most coming after the holidays.
    • We are modeling approximately 60 store closures in Q3 and another 255 at the end of Q4.
    • With roughly $110mm in revenues associated with these stores, we expect closures to impact revenues by $5mm in Q3 and ~$15mm in Q4. The greatest hit to revenues will come in F12 (~$75mm) given the timing of closures in F11.
    • Additionally, there are $25-$35mm in costs (lease terminations, severance, etc.) associated with these closings, the bulk of which are expected to be realized in the 2H F11. Of course, the Street will strip these costs out as being non-recurring – even though they represent real cash going out the door, and PSS making up for poor decisions made in years past. Nonetheless, on an ‘adjusted’ basis, we’re likely to see far better comparision starting in 1Q12.
    • Lastly, the net benefit of these actions are expected to improve EBIT by $18-$22mm once all closures are completed. We’re modeling in an incremental $0.15 in F12 EPS as a result of these actions.
  • Gross margins came in worse than expected in Q2. Given continued pricing adjustments in the 2H along with 13% product cost increases, we’ve lowered our gross margin assumptions in the 2H to down -325bps and -100bps in Q3 and Q4 respectively.
  • Assuming PSS continues to operate as it exists today (incl store closures), we are shaking out at $0.75 for F11 EPS and $1.44 for F12 EPS.

Of course the biggest question is not being asked at all. And that is whether Payless has even earned the right to exist at all.

  1. It has underperformed in strong consumer environments, and underperformed in ‘trade down’ climates.
  2. It underperformed by having too much exposure to third party buyers/designers, so it took those functions incrementally in house. Then it overshot and underperformed, and realized that it needed to shift back closer to the original model (where it underperformed).
  3. It went in with more aggressive opening price points in the fall of 2009, and that did not work. So then they went in with higher prices in 2010 – which didn’t work. Now they’re ‘sharpening’ opening price points again.
  4. Should this be a 4,500 store chain? Why not 3,000? Why not 1,000?

It’s not clear if the Board is asking this at all.


So…what to do with the stock with the monsterous pop it is having today? Definitely don’t chase it – though that’s likely a foregone conclusion. When all is said and done, we’ll be interested to see how much of the day’s volume is short-covering. This stock typically trades at ~10x EPS and 5-7x EBITDA, which suggests a value about where it is now. We think that a break-up value is a good 25% higher, but we need better confidence that this beast will, in fact be broken up, or that a new CEO will raise the bar to take our estimates meaningfully higher before we get back involved…








"This quarter clearly contains numerous outside factors that make it difficult to compare our progress to prior year... As we look past the recent rather sudden economic nervousness among American consumers, we feel confident that we have the right operating plan, the right marketing programs and the right cost structure to improve results even further."


- Virginia McDowell, President and CEO



  • "The Company currently estimates the impact of flooding on EBITDA to be greater than $7 million, including a $1 million deductible. "
  • "Flooding along the Mississippi River during the quarter impacted results at our properties in Davenport, Iowa, Caruthersville, Missouri and Lula, Natchez and Vicksburg, Mississippi. Each of these facilities was closed for a minimum of six days during the quarter and up to 41 days for our Natchez facility. In addition to the actual days closed, the properties did not operate at normal levels for some period of time before or after their respective closure due to conditions in the surrounding areas. In Lula, we still are operating with only one of the two casinos as remediation efforts continue to get the remaining casino open."
  • "While visits were slightly down from last year, both our rated and retail revenue increased across the portfolio of properties not impacted by the flooding."
  • "In Colorado we increased our promotional spending in an effort to promote our renovated casino floor, expanded poker room, new Asian-themed restaurant and newly renovated Tradewinds grab-and-go restaurant. Moving forward we will be modifying the marketing spending to match business levels."
  • "Regulatory changes in Florida were effective for the entire quarter this year as compared to only 25 days last year. "
  • "During the quarter the Company selected the general contractor for its $125 million Isle Casino Cape Girardeau and expects to finalize the documentation on the guaranteed maximum price contract in the near future. Construction is proceeding on time and on budget, and the facility is planned to open late in 2012."
  • Nemacolin Woodlands Resort: "An appeal of the award has been filed by a competing party. The plaintiffs briefs must be filed by September 12, 2011. The timeline for ultimate resolution of the matter is not known at this time."
  • Capex in the Q: $14.6MM; $4.1MM at Cape Girardea and balance was maintenance
  • "The Company expects maintenance capital expenditures for the remainder of the fiscal year to be approximately $40 million and project capital expenditures for the remainder of the fiscal year to be approximately $50 million. We have removed any previously planned capital expenditures related to Nemacolin for the remainder of the year from our guidance pending resolution of the appeal"



  • In Lula, they are still operating with just one casino open 
  • $20MM on R/C drawn at 1Q
  • Capitilized interest $600k
  • Debt: $20MM drawn on revolver; $498MM in term loans; $300MM 7.75% senior notes; $357MM of sub notes; $4MM of other debt for total of $1.17BN.
  • Leverage: 6.4x
  • $155MM of available borrowing capacity



  • Their insurance proceeds/claim should exceed the $6MM of lost EBITDA less deductible
  • Consumer trends - with the exception of Lula - they are very happy with the way their properties recovered.  Choppy at best is the way that they would describe August observations.
  • Going forward, Pompano current margins are probably a good run rate. Remember they have new competitors too.
  • Seminoles in Coconut Creek are moving ahead with their project despite their appeal
  • Lula is currently at 60-65% of capacity; should be back to 1100 positions after Sept 2nd
  • They do anticipate to be in compliance with their covenants despite the flooding impact as long as they get settled in any reasonable time frame. They are currently one full turn inside of their covenant.
  • FY guidance: $6MM stock comp in corporate and $200k of property level stock comp
  • They are using electronic table games at Pompano.  At Lula the electronic table games will offer a lower betting limit table game.
  • Colorado: There are some road closures that have impacted them and therefore they have had to promote more.
  • They are doing about 2 systems conversions a year (re: BYI)
  • They are not actively pursing a license in MA even if gaming gets legalized
  • Putting in 3 SHFL E-tables at Lula
  • Proceeds from Crown casino sale and timing. Project was approved by gaming board last week. Now the referendum just needs to pass in Bossier. Then the sale would close in November.  The proceeds would go into renovations at the Lake Charles property. They aren't required to reinvest that money in Lake Charles but they were planning those renovations for a while anyway.
  • They are still working with a potential buyer on Davenport
  • Their Pompano property is 20 miles from Dania Jai Lai


This note was originally published August 25, 2011 at 10:26 in Financials

Past as Prelude?

Warren Buffett announced a $5 billion investment in Bank of America this morning. Goldman Sachs was a nearly identical investment for Buffet back on September 24, 2008. How did he fare on that one? The chart below shows Goldman's stock price following the investment. He invested $5 billion in 10% preferred with warrants struck at $115 when Goldman was trading at $125. Following the investment in Goldman, the stock closed 6% higher, but, importantly, went on to lose 58% over the next two months. Ultimately he made a solid return on the investment, but how many investors would be as comfortable as Buffett riding out a 58% drawdown?  


Remember that Preferred is Senior to Common 

Interestingly, we're not opposed to the idea of being invested at a level senior to the common equity. We share Buffett's sentiment that Bank of America is too big to fail. Remember that his original thesis for investing in Goldman was that the US Government wouldn't let them fail. Ultimately he was right. What's interesting is that his attachment point with the preferred puts him senior to the common holder and enables him to sidestep further dilution that may arise. While that dilution wouldn't be good for his 700 million common warrants at $7.14, he wouldn't lose any capital and he'd still earn his 6% return even if BAC ultimately has to raise an enormous amount of additional equity capital. This is a relatively risk free trade for Buffett and we applaud him for being creative in the midst of fear. That said, Buffett's investment doesn't create a risk-free trade for everyone else -  investors who don't have access to the preferred shares. Don't make the mistake of thinking that a straight up investment in the common is comparable to what Buffett has just architected. 


Bank of America Has Just Taken a Step in the Right Direction

We're not BAC curmudgeons over here. We try to evaluate the data for what it is. We acknowledge that this investment moves Bank of America forward in two important regards. First, they now have $5 billion more in capital than they had before. Considering the market was clamoring for them to sell China Construction in full so as to monetize roughly $7 billion in additional capital, this gets them almost as far along. Second, Buffett's "seal of approval" has significant intangible value, we get that. Nevertheless, as we stated yesterday, there are significant macro factors outside of Bank of America's control (and Buffett's for that matter) that the bank will continue to face in the next 6-12 months. Namely, the European banking crisis, a US growth slowdown, mortgage putback uncertainty and the conjunction of huge NIM pressure and ending reserve release. For reference, our firm's view on the US growth outlook is very different from Buffett's, and for Bank of America's outlook that difference matters.




The Quantitative Setup

The chart below incorporates this morning's squeeze into our quantitative model. The heightened volatility this morning has widened the range in our model and we now see TRADE support at $6.02 and TRADE resistance at $8.64. This implies upside of 6% and downside of 26%. We are sticking with our short position based on that asymmetry. The chart below summarizes the setup.




Joshua Steiner, CFA

Allison Kaptur

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