The Economic Data calendar for the week of the 10th of October through the 14th is full of critical releases and events. Attached below is a snapshot of some (though far from all) of the headline numbers that we will be focused on.
Here is an interesting look at historical sell-side ratings for the restaurant industry.
This post will be short; the chart below says enough. The sell-side is quite optimistic at the moment, rating over 50% of the stocks in our monitor “Buy”. The number of “Sell” ratings is also at a low level. We believe there is significant possibility for downgrades throughout the space this earnings season. PFCB and CMG were downgraded yesterday but we expect others to follow suit over the remainder of the year. We may be wrong though; over the past couple of years, the street has been resolutely bullish.
As the first two charts below show, the street is fairly even in its sentiment on casual dining versus quick service. Given that quick service was more defensive during the ’08 downturn, we would advise clients of the view that a double-dip is likely to focus mainly on casual dining for shorts. Casual dining has seen multiples come in considerably, however, and while we expect many “bargains” in the category to remain so, we feel BWLD and TXRH have room to move lower.
Within QSR, we like PNRA on the short side. Sentiment charts on TXRH, BWLD and PNRA are also included below and show zero sells on either name from the sell-side.
The stocks used in this analysis are AFCE, BAGL, BJRI, BOBE, BWLD, CAKE, CBOU, CBRL, CHUX, CMG, DIN, DPZ, DRI, EAT, GMCR, JACK, KKD, KONA, MCD, MRT, MSSR, PEET, PFCB, PNRA, PZZA, RRGB, RT, RUTH, SBUX, SONC, TAST, THI, TXRH, WEN & YUM.
Conclusion: The threat local government financing vehicle debt poses to China’s banking system is very real. While there is certainly still time and policy wiggle room to deal with the current headwinds, we do think this issue will hang like a dark cloud over the Chinese economy for as long as it remains officially unaddressed.
To start, we think it’s worth stressing that wrapping one’s hands around the exposures and liabilities of the Chinese financial system is akin to explaining the true cause of gravity – insomuch that doing so remains much closer to “impossible” than physicists would prefer. That said, however, we think this growing issue is at least worth attempting to quantify and color.
By now, the headwinds facing Chinese property developers and local government financing vehicles (LGFVs) are not new news, but for those of you who do not follow our work on the Chinese economy closely, it’s worth re-hashing the numbers:
How Much LGFV Debt Is Out There?
Provincial and city governments in China, which are barred by law from issuing municipal bonds to fund investment in infrastructure projects, had set up 6,576 arms-length corporate entities (local government financing vehicles) by the end of 2010 – a reported 25% increase from 2008.
Arriving at a total amount of LGFV debt obligations is no walk in the park; in the year-to-date, we’ve seen estimates as high as ~14.3 trillion yuan (People’s Bank of China) and as low as 7.7 trillion yuan (China Banking Regulatory Commission). A June report out of the National Audit Office appears to have fixated the market on their 10.7 trillion yuan ($1.68 trillion) estimate as of year-end 2010, so we’ll use that admittedly stale figure in our analysis. For reference, the CNY10.7 trillion total is equivalent to 26.9% of China’s 2010 nominal GDP, which compares to the U.S.’s 24.6% muni-bond debt/nominal GDP ratio (not entirely apples-to-apples, however).
As an aside, we think China’s own inability to quantify these obligations speaks volumes to the convoluted nature of this matter.
How Are LGFV Liabilities are Structured?
Roughly 79% (CNY8.5 trillion) of the 10.7 trillion yuan of LGFV debt was in the form of bank loans, 70% of which will mature over the next five years. Nearly one-fourth (24%) percent of the total outstanding debt comes due in 2011 alone.
In terms of who owes what, the PBOC’s 2010 Regional Financial Performance Report suggests that local governments have the responsibility to repay 6.7 trillion yuan (62.6%) of the CNY10.7 trillion total debt outstanding and provided an explicit backstop for another 2.33 trillion yuan (21.7%), leaving the remaining CNY1.67 trillion (15.6%) hanging in the balance. The NAO’s mid-summer report – which consensus has adopted as the most relevant – suggests that some 60% (CNY6.42 tril.) of the total is the “direct” responsibility of local governments for repayment and another CNY2.55 trillion (23.8%) have an explicit backstop in the form of pledged land sales revenue, leaving CNY1.73 trillion (16.2%) hanging in the balance.
How Risky Are LGFV Credits?
As it relates to credit quality, the CBRC’s report on LGFV debt classified half of the loans as “low-risk”, or possessing the ability to be repaid with cash flows, fiscal revenue, or local government land sales (~40% of total local gov’t revenue, per China Real Estate Information Corp). Another 27% of the total was classified as “normal risk”, or possessing the ability to be serviced and repaid with future cash flows. The remaining 23% was classified as “high-risk”, or not backed by collateral or a visible cash flow stream.
Extrapolating these ratios to the NAO’s CNY8.5 trillion figure for total LGFV bank loans, we see that ~CNY4.25 trillion of such loans are of high credit quality, ~CNY2.3 trillion are of average credit quality, and the remaining ~CNY1.96 trillion are of low credit quality.
These findings rhyme with a recent China Asset Management Co. study whose results were published by the nation’s official bond clearinghouse. The study found that 28% of LGFVs have negative cash flow from operations and 22% of them had debt-to-asset ratios greater than 70%. Obviously we must absorb these numbers with a grain of salt, as they are indeed from a potentially conflicted source. Moreover, 28% of local government financing vehicles printing negative cash flows doesn’t necessarily mean 28% of the outstanding loan value is likely to go into default, as LGFVs vary in both size and loan guarantees. Still, the numbers are indeed eye-opening and, at face value, they do lend some credence to the widely-held belief that China faces a potential banking crisis should we see a material pickup in defaults across this space.
Attempting to Quantify the Downside
At 8.5 trillion yuan, loans to local government financing vehicles accounted for 17.7% of the total amount of loans held on Chinese bank balance sheets at the end of 2010. For the purpose of using consistent numbers in our analysis, we’ll ignore China’s oft-bandied about off-balance sheet banking assets. Simply put, there isn’t enough consistent data out there to analyze, but, for whatever it’s worth, Fitch Ratings estimates the disclosed off-balance sheet items to be ~25% of total assets (not all being in the form of loans, of course).
Assuming that LGFV bank loans maintained a similar ratio to total bank loans throughout 2011 we can back our way into a CNY9.3 trillion estimate for local government financing vehicle debt as of the latest reporting period, which shows a total of CNY52.4 trillion in outstanding bank loans throughout the Chinese financial system.
Currently, the Chinese banking system in aggregate has a rather healthy 1% non-performing loan ratio, which is the lowest on record (data going back to 1Q04). Over the last seven years, the ratio has fallen dramatically from a peak of 40% for state-owned banks during China’s last banking crisis (per the Cato Institute), which cost the Chinese government nearly 5 trillion yuan (27% of 2005 nominal GDP) in the form of bank recapitalizations, etc. in the eight years though 2005 (per Barclays). Like the current [potential] crisis, which was brought on by the Chinese government’s CNY4 trillion stimulus package introduced in November ’08, China previous banking crisis was brought upon by the government forcing banks to extend credit to largely unprofitable state-owned enterprises – whose cash flows were under the control of local governments then just as LGFV cash flows are currently.
So where could sour LGFV debt take China’s NPL ratio go from here? Well, we’d be lying if we told you we had an official estimate. We’ve seen estimates as high as 12% (Moody’s), which obviously seems quite aggressive. But without data to perform detailed credit analysis on each of the loans, as well as a crystal ball that could provide us a trustworthy estimate of credit conditions and the ability of these borrowers to obtain refinancing over the next five years, all we could do is speculate – which we’d argue isn’t entirely helpful.
What we can do that is helpful is keep you informed of any major developments pertaining to policy remedies and reported credit quality improvement/deterioration, all the while monitoring the health of the Chinese banking system along the way.
What we do know is that, as a result of well-documented government efforts to cool real estate speculation and consumer-price inflation, Chinese property prices have been under assault since 1Q10, which creates a headwind for local government revenue collection (40% of total) – the same revenues that are being pledged to backstop ~84% of LGFV debt. As we’ve outlined in our previous work, Deflating the Inflation will ultimately allow the PBOC to relax monetary policy, which should be accompanied by easing credit conditions, which, in theory, should then provide a boost on the margin to Chinese property prices. Still, a chart of the Shanghai Stock Exchange Property Index (34 developers and financiers) tells us that the headwinds facing the Chinese property market (and, as an extension, Chinese financials) are not going away any time soon.
As it relates to policy developments, in early August, it was leaked by an unnamed source that the Chinese Finance Ministry was drafting a preliminary plan to allow local governments to issue [long-term] bonds directly to investors. If implemented, this would be quite a constructive development as it would allow for the smoothing of any LGFV asset/liability mismatches arising from negative cash flows over the short-to-medium term. While we do not find that piling debt-upon-debt to be a “solution” that is likely to end well, we’d be remiss to ignore the positive impact this would ultimately have on alleviating any potential liquidity headwinds facing underwater LGFV borrowers.
All told, the threat local government financing vehicle debt poses to China’s banking system is very real.
While there is certainly still time and policy wiggle room to deal with the current headwinds (central gov’t debt/GDP = 33.8% per IMF; deficit/GDP = 2% per Bloomberg), we do think this issue will hang like a dark cloud over the Chinese economy for as long as it remains officially unaddressed.
Moreover, any large-scale “fix” of the issue could potentially be well over a year away if it is likely that it doesn’t occur until after the 18thPolitburo takes the leadership reins in March ‘13. That might potentially work in the Communist party’s favor in two ways: 1) it would allow current leadership to not have to admit it made a consequential mistake with the aggressive stimulus package of 2008-09 and 2) it could provide a “save the day” moment for China’s new leaders.
Net-net-net, a potential Chinese banking crisis is noteworthy risk to keep on your radar, and the likelihood that it hangs sustainably over the both China and the global economy for an extended period of time certainly won’t help investor confidence.
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The jobs data released this morning are positive, on the margin, for the restaurant space.
On the surface, the employment data were positive for the restaurant space and it is important to take these data points for what they are. Nonfarm payrolls came in way ahead of expectations at 103k versus expectations of 60k and an upwardly revised 57k in August. However, there are some important caveats within the employment report that we think are worth noting for restaurant stocks.
More specifically for restaurants, employment growth by age cohort and also by the industry itself provides insight into the state of the industry. The employment-by-age data is, on the margin, positive for both quick service and casual dining. For 20-24 year-olds, employment growth in September accelerated to 1.9% versus last year from +0.4% in August. This is a positive data point for quick service given that this cohort is a frequent customer for the category. For casual dining, 55-64 year-olds saw employment growth accelerated to +3.4% in September from +2.7% the month prior.
Hiring within the restaurant industry was less bullish in August (this data series is released on a lag). Year-over-year growth in limited service hiring picked up in August while hiring in full service was flat. We will continue to monitor this trend in the coming months. Within the payroll data, payrolls in “food services and drinking places” increased by 12k in September following a similar sequential increase in August. Considering the payrolls data, the lagging industry specific data, shown in the chart below, when it is released for August may show an improvement for September. We remain more positive on casual dining than quick service.
hiring by limited service restaurants and full service restaurants were
Positions in Europe: Short EUR-USD (FXE); Short Italy (EWI)
The currency pair EUR-USD remains a volatile trade as every rumor on Europe’s next move to limit its banking and sovereign risk significantly jolts the pair. Yesterday from a quantitative set-up, the EUR-USD was not able to breakout back above $1.34 which we took as a shorting opportunity. Since early September the EUR-USD has been broken TAIL (long-term duration), and broken TREND (intermediate term), an explicit short-selling signal in our models (see chart below).
Traders may well be betting that concrete action could come from this weekend’s meeting between Merkel and Sarkozy on Sunday to discuss bank finances ahead of the EU summit on OCT 17th (and hence today’s intraday bounce around $1.35), however it’s worth pointing out that any coordinated policy action will need the blessing of the other Eurozone member states, the ECB, and Brussels. While we don’t rule out a possible swift resolution, it probably won’t come this weekend.
It’s worth noting that while we’re not calling for the EUR-USD to hit $1.20 tomorrow, uncertainty on the region’s go-forward policy to contain or limit its banking and sovereign debt risks—either through a multifactor “bazooka” program or some form of Eurobonds and increases in the ECB’s SMP, for example —should incrementally weaken the pair until some form of “clarity” on policy decision is reached.
From a timeline perspective, it’s anyone’s guess on when Europe’s next band-aid will come—however we’re betting that something is in the pipe. A recent quote from European Commission President José Barroso suggest that Eurocrats are coming to terms with the market implications of their policy schedule: "Markets are much faster than our governments and our parliaments. We have to respect the rhythm of democracies, but I think in extraordinary times we must ask for an extraordinary effort.”
We’d expect any policy action to likely come after all member nations vote on the EFSF, which is expected to come by mid-month (Slovakia and Malta must still vote). Below is a calendar of the near-term events around which policy measures could be crafted:
Oct. 13: Euro-zone finance ministers expected to meet, to decide on release of Greece's next aid payment
Oct. 14-15: G-20 finance ministers' meeting. Europe expected to face pressure to act faster on the debt crisis
Oct. 17-18: EU summit to discuss reform of euro-zone economic governance
THE HEDGEYE BREAKFAST MENU
The Nonfarm Payrolls print came in at 103k versus 60k estimate and a revised prior number of 57k. The unemployment rate for September came in at 9.1%, in line with expectations and August’s number.
Casual dining restaurants underperformed yesterday while food retail, beverages, and food retail stocks posted strong gains.
DNKN: Dunkin’ Brands’ outlook was raised to “B+” by S&P on debt reduction after the IPO.
ARCO: Arcos Dorados Holdings Inc. today announced that preliminary 3Q systemwide comp sales growth was stronger than it was in the first half of the year. 3Q EPS is being guided to at $0.22. Net income was impacted year-over-year by higher compensation, 2019 notes redemption charge, and the stronger dollar. The company also announced the filing of a registration statement for a secondary offering of Class A shares.
COSI: In a letter to Brad Blum dated October 6th, and filed in an 8-K, Cosi’s management informs Blum that the company will refer to the firm if he wants consideration for the Chief Executive Officer role. The company also expressed concern regarding Blum’s compliance with federal laws regarding alleged solicitation of other stockholders “and their participation with you in certain activities, as well as any agreements or understandings you may have with other stockholders regarding such activities and the voting or disposition of the Company's common stock”.
SBUX: Starbucks tweeted today that the company is now allowing free Wi-Fi access at hundreds of its locations throughout the UK.
KONA: Kona Grill holder William Blair reported a stake of 437k shares or 4.75% of shares out. This is versus the previously reported stake of over 1.2m shares in March 2010.
The total percentage of successful long and short trading signals since the inception of Real-Time Alerts in August of 2008.