TODAY’S S&P 500 SET-UP - August 26, 2011


Both the US and the UK will remind the world what modern day Jobless Stagflation looks like this morning. This is not 2008. It’s 2011.  The UK printed their Q211 GDP at 0.7% y/y this morning and the US should come in wherever they make up the number (subject to 81% downside revision); headline inflation in both the US and UK will continue to run 5-10x real-GDP growth; markets have paid (and are paying) lower multiples for GDP slowing down hard (stag) and sticky/lagging/higher costs (flation)


As we look at today’s set up for the S&P 500, the range is 75 points or -4.51% downside to 1107 and 1.96% upside to 1182.









  • ADVANCE/DECLINE LINE: -1584 (-2757)  
  • VOLUME: NYSE 1209.19 (+8.99%)
  • VIX:  39.76 +10.75% YTD PERFORMANCE: +124.00%
  • SPX PUT/CALL RATIO: 1.72 from 1.73 -0.12%



  • TED SPREAD: 32.41
  • 3-MONTH T-BILL YIELD: 0.01% -0.01%
  • 10-Year: 2.23 from 2.29    
  • YIELD CURVE: 2.01 from 2.06

MACRO DATA POINTS (Bloomberg Estimates):

  • 8:30 a.m.: GDP, QoQ Annualized: est. 1.1%, prior 1.3%
  • 8:30 a.m.: Personal consumption, est. 0.2%, prior 0.1%
  • 9:55 a.m.: UMich Confidence, Aug. final, est. 55.8, prior 54.9
  • 2 p.m.: USDA cattle, hog slaughter



  • Bernanke speaks at 10 a.m. in Jackson Hole, Wyoming
  • Short-selling bans extended in France, Spain, Italy amid stock volatility
  • Japan Prime Minister Naoto Kan’s terms for resignation met with passage of bills
  • General Electric (GE); expects Latin America sales to double in next 3 or 4 years
  • Goldman Starts Internal Probe on Twitter Leaks: N.Y. Post



  • COMMODITIES: Gold holds the Hedgeye TRADE lines of support (1705) like a champ - new trading range is now 1.





  • U.S. Northeast Braces for Worst Hurricane Threat Since 1985
  • Glencore, Rio Speed Partner Deals After Stock Declines
  • German Nuclear Exit May End French Power Premium: Energy Marke
  • Gold Gain Cuts Weekly Drop as Stocks Fall Before Bernanke Speech
  • Oil Trims Weekly Gain on Concern of Slower U.S. Economic Growth
  • Gold May Slump 30% as Dollar ‘Outperforms,’ Aegis Capital Says
  • Crises Send U.S. Wheat Exports to 18-Year High: Chart of the Day
  • Copper Trims First Weekly Gain in Four Ahead of Bernanke Speech
  • Iron Ore Climbs to Three-Month High as China Boosts Stockpiles
  • Societe Generale Hires Haigh as Head of Commodities Research
  • Oil May Fall as Libya Rebels Move to Resume Output, Survey Show







  • The EUROPEAN train wreck continues!
  • Greece is gone!
  • GERMANY – Germany leading Europe on the down days now and that’s just not good; down another -1.7% here this morn and crashing (down -27% since May) to lower-lows; there is no catalyst (and it’s probably a bearish one) until mid-late SEP in Europe when 27 political countries arm wrestle on the EFSF
  • Germany Jul import prices +7.5% y/y vs consensus +7.0%, priior +6.5%
  • UK Q2 GDP +0.7% y/y vs preliminary +0.7%; +0.2% q/q vs preliminary +0.2%




  • ASIA: very much mixed overnight with China down 12bps, Singapore -0.6%, India -1.4%, KOSPI +0.8% and Thailand +0.87%.
  • Japan July core CPI +0.1% y/y vs cons (0.1%). Tokyo August core CPI (0.2%) y/y vs cons (0.1%).








Howard Penney

Managing Director


Chipotle’s same-store sales have been impressive with the company posting double-digit growth for the last four quarters.  Most of this growth has been driven by traffic gains.  Late in the first quarter, however, the company implemented a price increase in its Pacific region, which accounted for 1.5% of CMG’s 2Q11 10% comp.  After three years of nearly no menu price increases outside of this recent pricing in the Pacific, management decided to implement a 4.5% price increase on average across about 80% of its restaurants.  Management started to roll out this pricing during the third week of June and expects it to be fully implemented by the end of August, resulting in a 3.5% increase during the fourth quarter.  Due to the timing of the increase, the company expects to realize about two-thirds of the menu price increase during the third quarter. 


Although management commented during its second quarter earnings call that they had not yet “seen any evidence of customer resistance” from the recent price increases, I would not be surprised to see traffic trends fall off slightly on a two-year average basis, particularly in this current environment.  Either way, the traffic comparisons get increasingly more difficult over the next few quarters on a one-year basis.  It is important to remember that CMG’s traffic trends turned negative in late 2008 into 2009 when the company rolled out an incremental 6% price increase.  The macro environment was partly to blame at that time, but CMG’s traffic trends did not turn positive again until it fully lapped this price increase in 4Q09.


The magnitude of the company’s current price increase is not as great as the prior increase and recent traffic trends have surprised to the upside, but this price increase is coming at the same time the company’s traffic comparisons get increasingly more difficult.  That being said, I would not be surprised to see CMG’s traffic growth decelerate to a low single digit rate by the fourth quarter after growing by closer to low double digits for the last four quarters. 


On a same-store sales basis, I am currently modeling an 8.3% comp for the third quarter, which assumes a 30 bp acceleration in two-year average trends as I am expecting higher pricing to offset the slight deceleration in traffic trends.  In the fourth quarter, my 6.5% comp estimate assumes two-year average trends decelerate slightly, largely as a result of a fall off in two-year average traffic trends.


In 3Q11, the consensus has bakes in a sequential acceleration in revenue growth, which will be difficult to achieve.  As a result of a more conservative top line trends, our EPS estimates are $0.04 below the street.  



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


Early Look

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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…




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