Why the ECB Decision and EU Summit are not Bullish Catalysts

Positions in Europe: Short France (EWQ)


On Thursday the ECB convenes to announce changes to its interest rate policy and on Friday the EU Summit concludes in Brussels. We think the ECB should cut 25bps to address contracting growth forecasts and are positioned for a Summit outcome not dissimilar to previous Summits: disappointment. Here we do not expect to get definitive color on Europe’s next steps to address its sovereign and banking crisis beyond guidelines on a fiscal union to monitor budgets of member countries, which alone will not provide intermediate term support to European capital markets. It’s worth noting that Europe already has had a fiscal union of sorts, named the Stability and Growth Pact (to limit a country’s debt and deficit levels) which proved highly ineffective as its mandates were ignored by the majority of member countries (including Germany) at some point over the last ten years, and could simply spell another inefficient bureaucratic agency. 


ECB Clippers Are Out

At the last interest rate decision on 11/3 ECB President Mario Draghi surprised the market with a 25bps cut to the main interest rate to 1.25%. On Thursday, we’d expect a similar cut as Europe’s macro environment continues to deteriorate, despite the move by the Fed and global central banks on 11/30 to reduce the interest rate on dollar swap liquidity swap lines by 50bps. Key statements from Draghi’s last speech highlighted the “ongoing tensions in a number of euro area sovereign debt markets” and the "impact of the still high energy prices, protectionist pressures and the possibility of a disorderly correction of global imbalances”, all of which and we think should encourage a cut. 


We’re looking for $1.36 in the EUR-USD as a level to short the currency pair and expect the lack of resolve out of the EU Summit to drive EUR-USD weakness (more below).


In the chart below we show the move in the EUR-USD post the 11/3 announcement, which is 3.2% lower today. We don’t see material downside support in the cross until its previous low of $1.21.


Why the ECB Decision and EU Summit are not Bullish Catalysts - dada


The Summit Coming Up Short


While capital markets may see a short-term rally on any rumors (which we expect to be abundant) and initial statements around the Summit this week, ultimately we think Eurocrats will not craft solutions necessary to put medium term support in markets. Frankly, we still don’t think Eurocrats have answers in hand—the prevailing thread continues to be a willingness to keep the Eurozone intact, however without the firepower to do so on the sovereign or banking sides.  We see European banks and the sovereigns needing a funding facility to the tune of $2 to 3 Trillion [$1.25 to 1.75T to recapitalize banks and $0.75 to 1.25T to fund future sovereign deficits].


The current EFSF has a mere €250 Billion left to address both fronts. Further, we do not see the Chinese riding in on a white horse with a significant loan or the IMF in a position to lend in the area code of our target. Remember, despite recent rumors that the IMF may make a €400-600 Billion loan to Italy (on 11/28) or that central banks may funnel loans through the IMF to select countries to the tune of €200B (12/1), the IMF only has €385 Billion in lending capabilities. So even in a scenario in which the IMF unloaded all of its balance sheet on Europe (which is highly improbable, and don’t forget that the USA is the largest contributor at 17%), this “max” loan would still come up short of addressing Europe’s banking and sovereign funding needs to sustain a medium-term market rally.


Central Questions Left Unanswered


In the balance lies the central question: if peripheral European countries can’t grow and can’t fund themselves with rising credit spreads, and therefore can’t balance their budgets no matter how much austerity is delivered, aren’t allowed to default (Greece), and can’t adjust monetary policy, 1.) how do weak states get out of this vortex? and 2.) what’s the benefit to weaker states to be bound in the Eurozone?


Merkozy Pact Flaws


If it wasn’t clear before, yesterday’s meeting between France’s Nicolas Sarkozy and Germany’s Angela Merkel solidified that Sarkozy is Merkel’s puppet. This unified voice supports maintaining the Eurozone fabric and Friday’s big news should center around the implementation of a fiscal union, Germany’s counter proposal to its rejection of the issuance of Eurobonds or using the ECB as the lender of last resorts.


Ultimately, a fiscal union is at best a 2.0 version of the Stability and Growth Pact, which already exists in the main treaties to limit member countries to 60% debt as a % of GDP and 3% deficit to GDP.


Here Merkel notes: “The lessons are very simple: Rules must be adhered to, adherence must be monitored, non-adherence must have consequences. Leaders have to overcome fundamental flaws in the construction of the euro area…. We are going to Brussels with the intention to change the EU treaty."


Unfortunately, since the Euro’s creation, numerous countries, including Germany, have violated one or both of the Pact’s limits. Should Eurocrats run in the direction of preserving the Eurozone’s current fabric, such a fiscal union is marginally bullish, however could well signal another bureaucratic institution that may at best have longer term benefit but contribute little to present sovereign and banking imbalances, which the market is demanding.


More Risks on the Horizon Without ECB Support


While we view the actions of ratings agencies as lagging indicators, yesterday’s move by Standard & Poor’s to place the ratings of 15 Eurozone nations on CreditWatch negative and today’s announcement that the EFSF’s AAA rating is being placed on CreditWatch negative, adds one more bee in the Eurocrats’ bonnet ahead of Friday.  S&P said that ratings could be cut up to one notch for Austria, Belgium, Finland, Germany, Netherlands, Luxembourg – and by up to 2 notches for everyone else (France, Italy, Spain, Portugal, Ireland, Slovakia, Slovenia, Estonia, and Malta.) [Note: Greece was spared, and Cyprus remains on negative watch].


While S&P said it would review following the Summit,  its warning portends negatively for the EFSF, a facility that is built around its AAA rating. Should downgrades come to Germany and France, its main contributors at 28% and 22%, respectively, we’d expect funding costs to rise,  which negates the very purpose of this facility. In short, this will further force Eurocrat hands to meet the demand (especially by the periphery) of sovereign issuance, which we increasingly think can only be met by ECB participation.  Remember, the ECB continues to state that its secondary bond purchasing program, the Securities Market Program (SMP), is only intended to be a temporary program.  Last week the SMP bought another €3.7 Billion (versus €8.6 Billion in the previous week) to take its total since May 2010 to €207 Billion. Should the Eurocrats look to maintain the Eurozone’s fabric, this temporary rhetoric, and ultimately the size the ECB’s involvement, will have to change.



In our preview, we do not expect announcements on Friday to directly address the pressing sovereign and banking risks.  First, we do not see an expansion/leverage of the EFSF without the ECB’s involvement, which we expect the Germans to continue to stand against. Second, we don’t expect Germany’s stance against the issuance of Eurobonds to change.  Third, we see banking risk rising without more explicit funding packages.  Insolvent banks in this environment will struggle to raise money on the secondary market, may well not have the sovereign backing, and it’s clear the EFSF is far undercapitalized to meet their needs. Here we think French and German banks will be critical to watch. Under these scenario we don’t see the market cheerleading post Friday’s announcement if in fact the bulk of the announcement is focused mostly around the establishment of a fiscal union. Further, there’s nothing on the calendar in terms  of summits, etc. into year-end around which markets could get behind.  


We remain short France via the eft EWQ in the Hedgeye Virtual Portfolio.


Matthew Hedrick

Senior Analyst


Buffalo Wild Wings should be down more on the Darden news.


The larger casual dining names, particularly those in the Bar & Grill category, are trading lower on this Darden news.  We feel that BWLD should be trading down more sharply than it is given that the read-through on DRI is perhaps most relevant for BWLD, of all the casual dining names, going forward.  The lesson to be taken away from the Olive Garden’s lackluster results in 2QFY12 is that promotion is not a sustainable strategy to drive top line trends.  A favorable commodity environment can help mask the lack of sustainability in promotion as a strategy but, if and when commodity costs do not cooperate, the music stops abruptly. 


Without dwelling on Olive Garden too much (see our note from this morning), it is clear that the company recently became reliant on promotions to sustain traffic at a concept where menu price increases had previously been taken consistently over a number of years.  Buffalo Wild Wings' story is very similar.  The strategy can be effective in the short term, as it was for Buffalo Wild Wings in the third quarter, but when the wind turns from a commodity perspective it can handcuff the company and lead to EPS downside surprises. 


The charts below illustrate our view.  The first chart illustrates our point that if traditional wing prices head to $1.20 and $1.40 for 4Q and 1Q, respectively (they are at $1.37 today), it is likely that menu price increases will need to be taken to protect margin.  That eliminates the possibility of another “unlimited wings” promotion in 1Q12 or, if management goes ahead with it, will eliminate the flow through to EPS that was seen from the same strategy in the third quarter.  





The second chart shows wing prices versus margins.  It is fairly self explanatory; if our estimates for traditional wing prices are at all reasonable – so far so good – then margins are likely to decline further from 3Q levels.  Even with traditional wing prices down 16% in the third quarter, the unlimited wing promotion brought margins down sequentially from 2Q.  As the tailwind turns into a headwind, that strategy is rendered ineffective.


BWLD: DRI NEWS CONFIRMS THESIS - BWLD wing price vs margin



Howard Penney

Managing Director


Rory Green


Bearish TAIL: SP500 Levels, Refreshed

POSITION: Long Healthcare (XLV), Short SPY


I’m not naked short this market. Maybe I should be. I am getting a ton of questions about “year-end rally.” That means that idea might be a liability to expectations now. As long as we keep making lower-highs and this market’s TAIL remains broken, I’ll be fading beta.


Across our risk management durations, here are the lines that matter most: 

  1. TAIL resistance = 1270
  2. TRADE resistance = 1260
  3. TRADE support = 1233 

Meanwhile the EUR/USD pair, which has the highest factor weighting in my Global Macro model to Correlation Risk, is setting up for another rally in the USD and selloff in the Euro into and/or on the EU Summit catalyst.


It’s all interconnected, until it isn’t. Stay tuned.



Keith R. McCullough
Chief Executive Officer


Bearish TAIL: SP500 Levels, Refreshed - SPX

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Darden is an impressive company and the investment community has liked the stock for some time.  Issues highlighted in this morning's press release are important for Darden and other names within the industry.


Since he became CEO of Darden, Clarence Otis has been focused primarily on one thing: maintaining 4-5% unit growth.  Buying LongHorn Steakhouse was one means to this end and, while the concept has proven to be successful, Darden paid a premium and may have incurred other costs indirectly.  Despite the impressive infrastructure the company has built up, managing a large number of brands is difficult.  The acquisition of Eddie V’s Restaurants, Inc. is another step in that direction.  The company now manages seven brands.


As a public company CEO, Mr. Otis only has 80% of his time to manage the business after the basic duties of a public company CEO are fulfilled.  That time is now spread between those brands and it not likely that any one of them has his full attention.  Darden is a large company with many competent executives but the overall resources of the company are being stretched further as more brands are brought in to help sustain unit growth.


This morning’s press release, in our view, constituted an admission of two key issues for Olive Garden that can only occur, at a company like Darden, from management taking its eye off the ball:

  1. "At Olive Garden, we're addressing the erosion in one of the brand's essential attributes, its value leadership in casual dining. In working to re-establish that historical value advantage, Olive Garden more strongly emphasized containing check growth this quarter than in prior periods, and that was reflected in its promotion and in-restaurant merchandising tactics." 
  2. “Our anticipated second quarter results reflect increased investment to rebuild guest counts at Olive Garden, as well as our decision to limit pricing across our portfolio of brands to levels that did not fully cover a meaningful increase in our year-over-year food costs"

How can Olive Garden have lost its value advantage?  We would posit that annual 2-3% menu price increases have been a factor. This is a pattern that is difficult to reverse.  Promotions and in-restaurant merchandising tactics did not succeed in driving guest counts, as the press release says, because promotions as a strategy for driving the top-line are not sustainable.  This unsustainable nature of this promotional strategy can be masked by favorable food costs but, as Olive Garden’s 2Q results show, a “meaningful” increase in year-over-year food costs can rain on the parade.  Going forward, we do not anticipate the strategy mentioned in this morning’s press release as being a “silver bullet” for Olive Garden; the asset base is impaired and the turnaround will be a multi-quarter event, at best.  During 2QFY12, Olive Garden saw trends deteriorating through the quarter. Red Lobster is another concept that is producing comps largely sustained by promotions.


As Darden continues to spread itself thin from a concept management standpoint, we believe it will be difficult to aptly address the issues facing Olive Garden and Red Lobster as they compete in what has become a very competitive industry. 


In terms of the broader industry, we view this press release as having serious implications for BWLD going forward but EAT’s outlook is largely unaffected by the factors outlined by DRI.  We would be a buyer of EAT today on any DRI-related weakness.









Howard Penney

Managing Director


Rory Green








Comments from CEO Keith McCullough


Another low-volume rally to a lower-high in US stocks as the interconnectedness of Asia’s slowdown gets ignored by consensus (so 2008).

  1. ASIA – Chinese stocks down again overnight, taking out their lows from last wk that were established prior to their rate cut (lower-lows) as the rest of Asia continues to print slowing econ data (PMIs) and countries cutting rates (Australia last night) are seeing their markets fall on that news (Australia down -1.3%). Get Growth Slowing right, you’ll ultimately get the stocks right.
  2. EURO – big league failure at my immediate-term TRADE zone of 1.35-1.36 resistance, again, yesterday. We think the EU Summit is a liability now that expectations/hopes are so high – or is it fear? Tough to discern if institutional investors are more afraid of missing a “year-end rally” than understanding what it means if there is no Eurobond (ie money printing backstop to bail out German and French banks).
  3. YIELDS – it’s trivial to realize that European bond yields continue to make a series of higher lows – that now includes German Bund Yields which are trading back up to 2.24% this morn (10s) and +18bps wider than USTs. Spread risk remains our focus. UST yields are actually lower for the week to date with 10s down at 2.06%, signaling US Growth Slowing Sequentially in Q4 vs Q3.


Next catalysts = Chinese economic data for NOV (thur) and an ECB rate cut (thur). Both should perpetuate what you see on your screen this morning (weaker Asian equities and weaker Euro).







THE HBM: SBUX, DNKN, DPZ, DRI, BWLD, KONA - subsector fbr





SBUX: Starbucks has processed more than 26 million mobile payments since January, according to the company. Of the $2.5 billion loaded on to Starbucks cards in fiscal year 2011, $110 million was loaded on to cards via Starbucks mobile apps.


DNKN: Dunkin’ Donuts was reiterated “Equalweight” at Barclays.  The price target is $27.


DPZ: Domino’s Pizza was cut to “Hold” at Feltl.


PZZA: Papa John’s was cut to “Sell” from “Hold” at Feltl.





DRI: Darden Restaurants lowered FY12 EPS growth guidance to 4%-7% from 12%-15%.  Sales growth guidance was cut to 6%-7% from prior 6.5%-7.5%.  Preliminary 2Q EPS came in at $0.41 versus consensus at $0.54.  The company estimates that 2Q same-restaurant sales for 2Q will be approximately +6.8%, +6.0% and -2.5% for Red Lobster, LongHorn Steakhouse and Olive Garden, respectively.  The company also announced the acquisition of certain assets of Eddie V’s Restaurants during the second quarter.  Closing costs associated with the purchase negatively associated EPS by roughly $0.01 and the acquisition is expected to be neutral to EPS for the full fiscal year. The stock is down roughly -9% premarket.


BWLD: Buffalo Wild Wings was downgraded to “Hold” at Feltl.  We have been bearish on this name and believe that 1Q12 will pose some serious issues for the company.


KONA: Kona Grill has appointed Marci Rude to the new position of vice president of development.






Howard Penney

Managing Director


Rory Green




Revisiting An Important Theme: Margin Pressure

We noted a number of stories of late about Bank of America redeeming Trust Preferred Securities in exchange for debt and equity.  This is the follow-through from their November announcement in the Q that they may issue as many as 400 million shares ($2.3B of capital at today's share price).  We noted at the time that this flies in the face of management's repeated insistence that no capital raises are necessary.  As we said then, we think this represents the beginning and not the end of their campaign to raise common equity.


Leaving aside questions of adequacy of capitalization for a moment, what are the NIM implications?  For a number of regional banks, the upcoming retirement of the TruPS will be a significant event.  So what are the numbers for Bank of America?


Not so good.  While it is unclear how much equity the company issued, giving the company the benefit of the doubt and assuming that the full $2.3B was used to pay off TruPS at 8%, the savings to interest expense would be $47M per quarter.  This would push 3Q's $10.701 billion net interest income (FTE basis) to $10.748 billion.  With interest-earning assets of $1.841 trillion, the beneficial NIM impact is exactly 1 bps.  In fairness, we get that the impetus here was not to enhance NIM; rather, the goal was to improve Basel III capital. Towards that end, we estimate that IF the company swapped the full $2.3 billion of common for TruPS, the benefit to Tier 1 common would be 13 bps, assuming RWA of $1.8 trillion (their target).


We have been negative on BAC's NIM since September (for details, please ask for our September 7th, 2011 slide deck and conference call).  In that presentation, we outlined why Bank of America and the other moneycenter banks would face considerable NIM pressure over the coming quarters. The correlation between asset yields and a moving average of the 10-year treasury is very high.  


Our NIM analysis from September showed that the best fit for asset yields was a trailing 4Q average of the 10-yr treasury. This relationship means that NIM pressure from August's rate plummet will be realized ratably over the course of the next three quarters, provided that rates don't fall any farther from here.  


It's worth noting that an increase in interest-earning assets will serve to mitigate the effect of NIM declines on net interest income dollars. For those who believe this offset is sufficient, however, we would venture the following. Over the last twelve months, BAC's NIM fell from 2.69% to 2.31%, a decline of 14%.  At the same time, their net interest income in dollars fell from $12.43B to $10.49B - a decline of -15.6%, or almost exactly the same proportion.  


Ultimately, we expect the current environment to engender ongoing NIM pressure across the moneycenter banks, and Bank of America's small-so-far capital actions don't change that conclusion.


Below we show five charts from our September 7th presentation.  Here's how our predictions shook out in 3Q vs. consensus and reality.

JPM reported 8 bps of NIM decline (vs consensus at -2 bps & Hedgeye estimate of -7 bps);

BAC reported 18 bps of decline (vs consensus at +1 bps & Hedgeye at -8 bps);

WFC reported -17 bps of NIM decline (vs consensus at -1 bps & Hedgeye at -9 bps);

C reported +2 bps of NIM increase (vs consensus at -10 bps & vs Hedgeye at -13 bps).






BAC: $2B IN CAPITAL BUYS YOU 1 BASIS POINT IN NIM - slide   asset yields2








Joshua Steiner, CFA


Allison Kaptur


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