WRC: A Balloon Can’t Stay Underwater Forever

This was perhaps the earliest (and often most painful) call of my career. But you can only hold a balloon underwater for so long. WRC is finally being exposed for what it is. A massive over-earner.
A colleague shot me an email this morning saying “Warnaco finally pulled a Warnaco!” How true. I’m not going to waste your time or mine giving the run-down of what they said on the call, or what happened. The bottom line is that this has largely been a FX-induced margin story as the company printed too much FX benefit, and understated the impact to the Street. Check any of my past posts for the math. I won’t bore you with it now.

So what’s in the stock now? That a 10% margin is not sustainable after all without FX tailwind. 7% is closer to reality. But what happens if a new Obama Administration takes up rates in '09 and the dollar along with it? Then FX turns into a headwind, and there is no reason margins cannot go back to the low/mid single digit range. That’s when cash flow gets to a point where we need to start to look at debt covenants again.

There will come a time to buy this stock. But even with a 30% hit from yesterday – and 2/3 off its 1-year high, we’re not there yet.

The Consumer Needs Prozac

Not a shocker that spending continues to decelerate across the board. What happens in Nov/Dec when unemployment is 1% higher vs. year-ago, and we comp a negative ’07 personal savings rate?

I didn’t see much in this morning’s sales numbers that change my prevailing view on the consumer. In fact, fundamentally I have to admit that the yy decline at many retailers is accelerating faster than even I’d have thought – and per my Oct 12 Consumer Spending Analysis, I think we’ll see a $170bn decline in consumer spending in 2009. A few points…

While we can hardly call what we’re seeing today a blanket positive stock reaction with 1 only in 5 retailers on my screen up for the day – it is interesting to note that the positive moves are largely in larger liquid names like JCP, KSS, M, JWN, COST that posted horrible numbers.

Let’s try to ex-out all the Oct noise for a minute. Every sector of retail that reported comps showed a sequential decline in trends on a 1, 2 and 3-year run rate by an average of 200-300bp. Sure, there is share shift within each segment and each company. Both the overriding trend is big.

What’s next? A massive question mark. November of last year was big across the board. When adjusting for calendar shifts and looking at Nov and Dec together, we’re still looking at 2% trend-line spending heading into holiday ’07. On the plus side, gas prices are lower than the year-ago period. But unfortunately, it does not come close to the magnitude needed to offset 1% higher unemployment, and the fact that during holiday ’07 the personal savings rate went below zero to help fuel spending that shouldn’t have happened. That’s not repeatable.

S&P500 Levels: Refreshed For 11:00AM

The quantitative setup for the US market has returned to negative, but the range is tighter and the next low is likely going to be higher. I mentioned this in the prior TED Spread post - here are our S&P500 levels associated with that immediate term "Trade" call:

Sell "Trade" = 967.86
Buy "Trade" = 862.72

This market is to be traded, aggressively, with an appropriate amount of powder saved for down days.

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The Light, In A Darkened Tunnel: The TED Spread

Amidst a major quantitative breakdown of multiple factors across my global macro model, one shining light of positivity remains - the dampening of global counterparty risk.

3 month LIBOR minus 3 month US Treasuries (TED Spread) has come down appreciably since the week of October the 13th (see chart). This is the PRIMARY reason that I think this current selloff in global equities will be met with higher lows than those freak-out ones that we saw last month.

Casual Dining – Ugly is as Ugly gets

Yesterday we posted a bleak Macro view of the consumer. What we left out was the impact of the October stock market crash on spending.

As you can see from the commentary below the trends in 4Q08 are very bad. Complicating the bad consumer environment is management missteps. (1) MRT was still buying back stock in 3Q08 and is planning on adding capacity in 2009. (2) MSSR also plans to add 5-6 units next year. (3) Poor RUTH, they are just trying to stay alive. There is no reason to own RUTH, MRT or MSSR.

You can throw a dart at a dart board to find a good short in this group, but to me LNY, DIN, RRGB, CPKI and PFCB stand out.
RUTH – Madison Dearborn to the rescue, but still on the Bankruptcy watch list

RUTH is on our short list of Bankruptcy candidate, but it should be noted that a very larger shareholder has capital and access to those that have capital.

In 3Q08, RUTH’s same-store sales decreased 6.9%. The average check fell 1.5%, driven by menu mix shift and year-over-year pricing of approximately 2% - RUTH saw a 5.2% reduction in traffic. Same store sales in 3Q07 declined 0.4%.

This is where its gets really ugly - October comps at Ruth's Chris declined approximately 15%. On the call the company said “If we assume company operated, comparable restaurant sales at the Ruth's Chris Steakhouse decreased 15% for the entire 13 week period, we would expect earnings per share between zero and $0.02 (street at 0.17) for the fourth quarter and between $0.33 and $0.35 for all of 2008 (from prior guidance of $0.55-$0.60).

MSSR – Management does not get it

More of the same…. October same store sales were horrible and they are still growing too fast
MSSR reported 3Q08 EPS of $0.09 vs. street at $0.11. Same-store sales declined -5.5%, with traffic declining -9.8%.

On the conference call the company said that October same-store sales declined approximately 10%. Management offered that if same-store sales trends do not change for the balance of 4Q, 4Q EPS would be $0.15-$0.20 (street at $0.29), and for every 1% change in quarterly same-store sales, there is a $0.02-0.03 impact to earnings.

MSSR is a classic case of watch what I do not what I say! Management provides the customary balance sheet commentary; “Given the recent credit market crisis, we have focused on maintaining maximum financial flexibility and ensuring that our balance sheet remains financially sound, including managing our debt level and limiting our new unit development for next year.”
But in the next breath MSSR’s management says we still plan on opening 5-6 new units in FY09 (a slowdown from FY08’s 11 units). WHY?

MRT – In a very difficult position

Morton's Steakhouses 3Q08 same-store sales declined 7.6%. This includes the benefit of a pricing impact of approximately 3.5% in the quarter. The balance of the change was driven by menu mix and decreasing guest traffic. This compares to strong comparable restaurant revenues of +7.3% in 3Q07. MRT commented that same-store sales for the month of October declined 15%.

The Company currently expects 4Q08 revenues to range between $98 million and $100 million, which reflect a 9% to 11% same-store sales decline.

The Bitterest

“By three methods we may learn wisdom: First, by reflection, which is noblest; Second, by imitation, which is easiest; and Third, by experience, which is the bitterest.”

After experiencing my worst performance day of 2008, yesterday was indeed my “bitterest.” In thinking through my mistakes, I would be a hypocrite not to cite the same wisdom of a philosopher whose thoughts summarized where I thought this US market could go next. Confucius emphasized transparency and sincerity. I have no excuses this morning. I was leaning far too bullish on the edge of another bear market trap. I was sucked into the vacuum of politically inspired hope. Hope is not an investment process.

So what do I do when I am wrong? Point fingers and whine about it? No. I take a good long hard look in the mirror and stare at who made the call. Then, I review my notebooks, calendar catalysts, and macro models. Then I start over, remembering that as Confucius said, “no matter where you go, there you are…”

As the facts changed yesterday, I did. As the S&P500 broke my “Braveheart line in the sand”, my first move was to get smaller. We now issue our ‘Hedgeye Portfolio Allocation’ levels to you every morning at the top of the ‘Early Look’. What is that exactly? Good question. That’s $100,000 in an E-Trade account that I put there at the beginning of the year (when that’s all the FDIC would insure, and my best “idea” was being in cash). In that account, I don’t trade around in any stocks that our sector analysts are writing about. I predominantly use it to manage portfolio level asset class allocations using indices and exchange traded funds.

Getting smaller is what I always do when I am wrong on the fundamentals. That’s another piece of portfolio management wisdom that I had to learn the hard way. When I was younger, more brash, and inexperienced, I would sometimes add to my losers, irrespective of my potentially being dead wrong on the fundamental change in facts. That was, is, and will continue to be, the gravest capital mistake you can make in this business.

“Getting small” means selling down gross exposure. Yesterday I took my 33% allocation to US Equities down to 20%. I sold my SPY’s (S&P 500 index), and our Research Edge Macro clients saw that, real time, on the ‘Hedgeye Portfolio’ portal. I am 100% accountable to being transparent to our subscribers. Wall Street doesn’t do that. That’s their problem, not mine. The “New Reality” that I spoke to yesterday is going to demand transparency/accountability from market participants in the very near future.

The US Futures are getting smacked around again this morning, and they should. Albeit on low volume (bullish signal), yesterday’s technical breakdown in the US market was a bell ringer for anyone with a legitimate risk management process. For me, losing over 200 basis points of performance in one day is unacceptable. When that happens, it’s always because I am leaning too far to one side of the boat and the market breaks what I refer to as the “shark line.” If you have ever been shark fishing, you know how scary it is to be on the edge of the boat with a live and large monster still in the water – that image is what you should be thinking about when the S&P500 gets there. Yesterday I called it “line in the sand” because I was getting too cute with a Braveheart metaphor, but it’s the same idea, and the same line – the one you don’t want penetrated. This morning my model flashes that line in the S&P500 at 977.

Everything that matters in my risk management model occurs on the margin. If we close above 977, it’s bullish – below that shark line, your longs get eaten. Last night, Asian and European stock markets reflected the quantitative waters being bloodied. I have more red in my notebooks this morning than I have had since mid October. Is it time to panic? No. Is it time to take a deep breath and find your bearings? Big time.

Hong Kong led Asia lower, closing down a stiff -7.1%. One of the positive moves I made in the last 48 hours was selling our EWH (Hong Kong etf) into the strength of its 6 day +30% up move. Chinese stocks outperformed last night, closing down -2.4%, and we remain long its domestic market via the FXI etf. India closed down for the second day in a row, finishing -3.8%, and we are hedged in Asia this morning via our long standing bearish position in the India Fund (IFN). Not surprisingly, after squeezing the shorts for a +35% one week move, Japanese stocks were shark bitten last night, closing down -6.5%. I am embarrassed for not being short EWJ (Japan) here.

European markets are trading down -4% across the board. We are long Germany and Switzerland (EWG and EWL), and short the UK (EWU). The main reason why I was amped up and leaning over the boat’s edge yesterday was that the Europeans were, and are, going to be cutting interest rates this morning – AGGRESSIVELY. If the reaction to the most aggressive European rate cuts that we have seen in 2008 is negative, I will change my positioning in Europe alongside those facts. Countries that are on my short list are Italy, Austria, and Spain. These countries have leverage characteristics that are to be shorted. I want to own liquidity – and as boring as they are, the Germans and Swiss give me that, on a relative basis.

I’ll take a man or woman of wisdom onto our team all day long over a whiner. Citi and Goldman are firing another 12,000 people right now. There are plenty of winners in that group that we are interviewing. The problem with ‘Investment Banking Inc.’ is their Captains, not their people. Captains who whine and point fingers don’t have a process for winning.

The best thing about today is that yesterday is behind us. My feet were on the floor 3 minutes earlier than they were yesterday. My chin strap is done up. No matter where we go from here, “there you are.”

Good luck out there today,

Long ETFs

JO – iPath Coffee – Heavy rains in Vietnam’s highland region continue, increasing harvest delays.

EWL –iShares Switzerland- Swisscom AG traded down yesterday after reporting Q3 profit decline of 32% y-o-y, and warned that the Franc’s rise it may prevent it from reaching its full-year sales target.

EWA –iShares Australia- Employment numbers came in surprisingly strong, with over 34,000 jobs added in October. The Central bank expanded the list of securities it accepts for repurchasing operations to include AUD commercial paper, asset-backed commercial paper and high rated debt securities rated AAA.

EWG – iShares Germany – Porsche will seek enforcement of an EU court ruling that Germany must amend the law that gives the state of Lower Saxony control rights over Volkswagen as part of its plan to take full control over the company. Adidas was down almost 10% today after reporting earnings for the third quarter.

FXI – iShares China – Obama’s public stance on Yuan policy is placing pressure on policy makers in advance of December’s U.S.-China Strategic Economic Dialogue. Among many heavy industrials curbing production, Aluminum Corp. of China, today announced it has idled 38% of capacity.

VYM – Vanguard High Dividend Yield ETF – The Ambac ratings downgrade to Baa1 by Moody’s sparked higher corporate CDS prices globally on anticipation that some holders will be forced to unwind positions hedged by the insurer.

Short ETFs

UUP – U.S. Dollar Index – The Euro declined against the dollar on anticipation of EU rate cuts.

EWU – iShares United Kingdom – BOE CUTS BENCHMARK RATE BY 150 BASIS POINTS TO 3% U.K. House prices fell at the fastest pace in at least 25 years according to monthly HBOS data - the average cost of a home dropped 14.9% y-o-y in October the most since the index began in 1983.

IFN – The India Fund – Wholesale inflation numbers registered at 10.7%, higher than anticipated by Indian leaders, which suggests that rate cuts could continue.

Keith R. McCullough
CEO & Chief Investment Officer

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