- Qe3 Is a Risk to Latin American Growth via The Bernank Tax
- Quantifying the YTD Froth Across Emerging Market Asset Classes
- Brazil Takes a Step Forward Towards Sustainable Long-term Economic Development… And Then a Step Backward
Current Virtual Portfolio Positions in Latin America: None
Qe3 Is a Risk to Latin American Growth via The Bernank Tax
As we highlighted in our Friday note titled “Triangulating Asia”, we view the implementation of Qe3 as a downside risk to real GDP growth across Latin America, largely supported by the following equation – at least until global food and energy prices stop being priced in U.S. dollars:
Quantitative Easing = accelerating inflation [globally] = monetary policy tightening [globally] = slower growth [globally]
While our quantitative signals are not yet in confirmation from a DXY perspective, we think it is an acute risk to monitor, given the academic dogma, short-term political resolve, and career risk management of the current Federal Reserve Chairman ahead of the 2012 presidential election. We’re in the process of quantifying how Bernanke can help ensure his “boss” gets reelected come NOV and preliminary indications is that the S&P 500 leads Obama’s probability of getting reelected with a fairly high r². We’ll be out with more on this in the coming weeks.
Turning back to Latin America specifically, we saw YoY inflation readings across the region peak on a median basis in DEC, falling -20bps sequentially +4.2% in JAN. A near +200bps increase in median inflation rates across the region since Jackson Hole ’10 has coincided with a +200bps increase benchmark monetary policy rates across the region, a linkage highlighted by the aforementioned equation.
In our view, further slowing from here in Latin American inflation readings is largely USD-dependent, given its omnipotent role in determining global commodity prices and the [rightful] heavy weightings of food and energy prices in EM CPI readings. As of now, Latin American interest rate markets are taking the Bernank’s word for it, pricing in less monetary easing/more monetary tightening in recent weeks (with the lone exception being Brazil, where political pressure to lower nominal interest rates in the country remains the #1 factor).
All told, we continue to be in wait-and-see mode for further signs of the duration of the latest Inflation Trade. We’d be remiss to not call out the added liquidity from short-term E.U. sovereign debt crisis aversion as positive in the short-to-intermediate term for Latin American equities and FX. In the intermediate-to-long-term, however, centrally-planned Policies to Inflate will negatively impact this region from a growth perspective just as it did in late 2010 through 2011. It’s no wonder Brazil’s Bovespa Index – the regional benchmark equity index – peaked in early NOV 2010 as a leading indicator for the stagflation that largely ensued across Latin American economies in 2011.
Quantifying the YTD Froth Across Emerging Market Asset Classes
Speaking of the added benefits of liquidity, capital flows have been very supportive for EM assets in the YTD. So much so that the MSCI EM Equity Index is already up +13.7% YTD – the highest YTD return (through FEB 13) in over 15 years! The MSCI Latin America Equity Index is off to a similar start, closing today up +15.3% YTD – also a 15yr-plus high.
Looking to EM currencies (using UBS’ Carry Trade Index and JPM’s Global FX Volatility Index as proxies), we see that carry-trading strategies have returned +5.5% in the YTD – the best start to the year since 2001. On a vol. basis, the -20% YTD decline in global FX volatility – also a 15yr-plus high – has been incrementally supportive of capital flows to emerging markets, like Latin America.
One of the ways higher exchange rates and lower exchange rate volatility helps to inflate EM assets is through global capital flows – particularly as investors in developed markets rush to embark on a global search for investment yield.
To help “quantify the froth”, we use Brazil as a proxy, given its allure of G20-high real interest rates and its marketability as a “BRIC” economy, we see that debt capital flows are indeed flooding back to emerging markets after a quiet 2H11 where deals were hard to price amid heightened volatility. Using the USD as the funding currency, global investors have financed $16.6B in Brazilian debt issuance in the YTD, up from just $6B in the entirety of 2H12.
Looking at Bovespa Stock Exchange data, international investors pumped a net R$7.2B into Brazilian equities in the month of JAN alone – an all-time high using the 4yr data set – and is on pace to top that in FEB.
So what does this all mean? For one thing, it’s quite clear the global investors: a) took the opportunity of lower cross-asset volatility to load up on their favorite EM equity/fixed-income/FX plays at depressed prices; and b) the Federal Reserve’s implicit pledge to maintain ZIRP in near perpetuity is supportive of cross-border investment flows out of U.S. assets, on the margin, and into higher-yielding EM assets for the foreseeable future (not at every price, of course).
What could get this trend to reverse? A marginal shift in the direction towards sober fiscal and monetary policy in the U.S. could get both domestic and international investors to become increasingly comfortable holding U.S. assets on the margin, which would be supportive of the USD. Moreover, a stronger dollar backed by marginally hawkish monetary policy would depress the real yield advantage of emerging markets by allowing them to lower interest rates as inflation falls sustainably.
Do we see any of this happening? Certainly not in the near term, as the DXY is broken from an immediate-term TRADE perspective (see chart above). Bullish TAIL, however, we view this as a long-term tail risk, given where we are in the U.S. political cycle.
Brazil Takes a Step Forward Towards Sustainable Long-term Economic Development… And Then a Step Backward
Last week, Brazil auctioned licenses to the private sector for the right to operate airports in three of the nation’s busiest travel hubs. The licenses sold for R$24.5B ($14B) – or nearly five times the minimum bid – and each carries a mandate to invest R$16.1B into expanding capacity in the airports in time for the 2014 World Cup (500,000+ visitors expected) and 2016 Summer Olympics. The three airports involved accounted for ~33% of the country’s 179 million passengers last year and 57% of its air cargo.
Brazilian airports, which are notoriously overcrowded and operating well over capacity (12% of flights delayed in 2011 and 5% canceled outright), have seen passenger traffic increase +118% since 2003, making Brazil third in volume of domestic air travel behind the U.S. and China.
While the Brazilian government plans to maintain a 49% stake in each consortium (paid for by borrowing from the state bank BNDES – which the gov’t itself funds!), we view the increased private-sector participation as bullish for Brazilian GDP growth in the short run as the goals underpinning these infrastructure projects shift from utility maximization to profit maximization, meaning delays and circumventing bureaucracy are less of a risk going forward.
And now, the bad news (from Moshe Silver, our resident Portuguese-speaking translator of the Brazilian local press):
“Rousseff looks to curb bank profits – President Rousseff has asked her economic team for proposals to narrow lending spreads and reduce bank profits, which she says have been excessive. At a time when the central bank is lowering the SELIC rate, she says, banks should not continue to profit from exaggerated spreads.
Pressure will be put on financial institutions to lower their lending rates, especially on credit cards, as consumer credit is seen as a critical driver of economic activity this year. The government has a broad list of options to consider, including caps on profitability and possible tax reductions on credit operations, and reduction of bank reserve requirements.”
Net-net, Brazil continues to define the term “emerging” market quite well, offering promises of robust growth opportunities with the occasional hiccup along the way, usually in some form of anti-private sector interventionist policy. We’ll keep you posted on any further developments regarding the bank profits story, as it has clear implication for Brazil’s short-to-intermediate-term GDP growth.
Fundamental Price Data
All % moves week-over-week unless otherwise specified.
- Median: +0.5%
- High: Venezuela +9.4%
- Low: Peru -2.1%
- Callout: Latin American equity markets are up +13.6% YTD on a median basis
- FX (vs. USD):
- Median: +0.1%
- High: Brazilian real +0.5%
- Low: Argentine, Mexican peso both -0.2%
- Callout: Argentine peso -0.9% YTD vs. a regional median of +8.6%
- S/T SOVEREIGN DEBT (2YR YIELD):
- High: Colombia +8bps
- Low: Brazil -29bps
- Callout: Brazil -80bps YTD vs. Colombia +4bps
- L/T SOVEREIGN DEBT (10YR YIELD):
- High: Mexico +10bps
- Low: Brazil -12bps
- Callout: Brazil +4bps YTD vs. Mexico -30bps
- SOVEREIGN YIELD SPREADS (10s-2s):
- High: Brazil +17bps
- Low: Colombia -4bps
- Callout: Brazil +85bps YTD vs. Colombia -34bps
- 5YR CDS:
- Median: +0.3%
- High: Argentina +7.6%
- Low: Chile -3.6%
- Callout: Argentina +2.7% over the last six months vs. a regional median of -12.4%
- 1YR O/S INTEREST RATE SWAPS:
- High: Colombia +6bps
- Low: Brazil -13bps
- Callout: Brazilian swaps market pricing in -116bps of cuts over the NTM
- O/N INTERBANK RATES:
- High: Mexico +2bps
- Low: Brazil -2bps
- Callout: Brazil -59bps YTD vs. Colombia +18bps
- CORRELATION RISK: The liquidity trade prevails for now, with the MSCI Latin American Equity Index trading with a -0.86 correlation vs. the DXY on a 30-day basis, up from flat on a 90-day basis.
Conclusion: HBI’s quarter might be fine, but we think the market knows it. A wide gap remains in pricing for core product amongst HBI’s largest customers, and this is at a time when competition will heat up. Cost will come down in 2H, but we think price comes down faster. If HBI is up on the print, we’d short it.
We’re still seeing a meaningful price disparity for HBI product across Mid and Discount channels. There’s a lot of ways we can slice the numbers, but there’s no disputing the inconsistency we’re seeing at retail. Of particular note is Kohl’s, who is pricing product 50% above JCP – and that’s after BOGO incentives. WMT and Amazon are nearly the same step down yet again, but for product that is almost identical to KSS and JCP (something tells us that Ron Johnson is keenly aware of this). With over half of HBI’s EBIT coming from US mass and department store channels – the very channels that we think will face considerable pressure and volatility in 1H12 – we still think that HBI has meaningful earnings risk.
How to play it? The company whiffed the third quarter, and took 4Q down to a level that is consistent with their visibility at the time – likely with some breathing room. But we don’t think that 4Q is the issue here. HBI is banking on maintaining price increases in 2H. But we simply don’t think that industry dynamics will allow them to stick. In addition to the dominos that we expect to fall due to actions at JCP/KSS/SHLD and subsequently Macy’s, Target, Wal-Mart and perhaps Amazon, bulls should note that we already saw WMT cut 7 points of revenue out of HBI’s core due to a shift to private label. This is BEFORE competition started to heat up.
A common response here is “what about easier cotton compares?” That’s valid, but we think that price will come down at a greater rate than cost. That’s bad.
Here’s a snapshot of Hanes, Gildan/Starter, and private label pricing at the mid-tier as represented by JCP and KSS as well as WMT and AMZN along with some interesting callouts:
- There is a significant price differential between JCP and KSS in like-for-like basic men’s underwear (6pk crew t-shirts). On a price/unit basis, JCP now prices Hanes 12-15% lower than KSS.
- The other common brand Jockey, is priced 47% lower at JCP in this category.
- In Private Label, JCP’s Stafford line is actually priced 3% higher than KSS’s Crofts & Barrow.
- Comparable men’s underwear (Hanes 4pk boxer briefs) had the most significant price disparity ($13.46 at WMT; $16.99 at AMZN; $25 at JCP; $36 at KSS) between retailers. At a 167% premium, KSS will need to seriously visit its current price positioning.
- At WMT, Hanes maintains its 10%-20% premium positioning, or $1-$2 price gap differential from competitors Fruit of the Loom and Starter in the underwear segment (crew t-shirts and tanks) as well as socks, while boxer briefs are indeed now at parity.
- In looking at AMZN’s online pricing, it appears WMT is the only retailer where the two brands are at pricing parity in the boxer brief category.
---There are a lot of moving parts in the coming days and weeks in Europe. Below we show a calendar of the more notable events. As we’ve stated on numerous occasions, there will be no Bazooka to magically cure the sovereign and banking imbalances across Europe. Managing risk will include factoring in the uncertainty around decisions Eurocrats agree upon as they direct the Eurozone project forward.
15 February: European Finance Ministers will meet again and potentially sign off on the Greek bailout deal, although Eurogroup Jean-Claude Juncker says there are no guarantees a final decision will be made then.
27 February: The German Bundestag plans to vote on the issue of Greece’s second bailout, including the embedded terms of the PSI.
25-26 February: G20 Finance Ministers Meeting in Mexico City. Decision on IMF loan of €500B is expected.
29 February: 2nd 36-Month LTRO Allotment.
29 February: Eurogroup Meeting to sign the previously endorsed agreement between the 17 members on the Treaty for the European Stability Mechanism.
1-2 March: Signing of the Fiscal Compact by 17 Eurozone leaders together with the non-euro area leaders of countries willing to join. Further, the group will reassess the adequacy of resources under the EFSF and ESM rescue funds.
20 March: Greece’s €14.5 billion Bond Redemption due.
April: French Elections (Round 1) begins to conclude in May.
30 June: Deadline for EU Banks to meet €106 billion capital target/the 9% Tier 1 capital ratio.
1 July: ESM to come into force.
The bottom line is that the raw math suggests that there is no way the company is going to provide guidance in line with current consensus. Right now the current consensus is for 4Q11 EPS of $0.45, down 30% y/y and bringing the full year to $1.61, down 20% y/y. We think $0.43-$0.44 is more realistic and therefore so is $1.50 to $1.55 for 2012 EPS guidance.
Right out of the box, management needs to offset $0.26 to $0.30 of incremental EPS pressure in 2012 coming from share based compensation expense and incremental pre-openings costs. There are some offsets to those costs, but improving same-store sales trends in 2H12 will be one of the biggest contributors as the company begins to leverage the incremental labor costs implemented in 2Q11. Therefore, if the company can pull off a flat year in 2012, that will imply a strong year operationally and should go some way towards convincing investors that the turnaround is in motion.
As we said in our PFCB note two weeks ago, the “the road to recovery” for PFCB is 18 months in the making and the plan should come together in 2012, with management’s messaging taking a more distinctly positive tone in 2H12. In our aforementioned post of 2/6, “PFCB – The Queen Mary”, we summarized the evolution of the turnaround and the reason why we are close to the bottom that the top:
- DISCOVERY AND EVOLUTION: 2010 was the year of admitting to the real problems and 2011 was the year of planning for the future.
- IMPLEMENTATION AND EXECUTION: Now 2012 becomes the year of executing - new menu items, new look and new price points. The Irvine store will play a key role in this process.
- GETTING THE SYSTEM MOTIVATED: The onus in on management to get the employee base geared up for the changes, manage costs and driving consumer awareness of the changes taking place at PF Chang’s.
- CONTINUE TO EVOLVE: As a company, PFCB is not going to play defense, rather it is going on to be offensive in its strategy.
Here are some incremental thoughts around the messaging from the most recent earnings transcript and our view on those topics as we approach earnings this week:
THE PLAN: The challenge is converting that PF Chang’s brand equity into top-line momentum. The path to increasing traffic includes improving entry level pricing, enhancing our overall price-value equations, providing more differentiated options at lunch, and increasing menu diversity.
HEDGEYE: To-date, the details of how the plan will unfold and the implication for margins is still an unknown to the Street. See our note from 2/6, “The Queen Mary” for details.
REMODEL SPENDING: Management has discussed plans to invest in a Bistro remodel program, with the expectation of spending around $25 million 2012.
HEDGEYE: Management is still working through some of the design elements from the “Irvine Project” so we do not see this number being revised significantly higher.
IMPAIRMENT CHARGES: Last quarter there was a charge of $4.8 million or $0.16 per share related to one Bistro location in Corte Madera, California and two Pei Wei locations (one in Farmington Hills, Michigan and one in Chino Hills, California). We’re assuming that their 4Q11 quarterly analysis will identify more locations that need to be closed or written down.
HEDGEYE: This needs to happen sooner rather than later and will, in our view, help grow EBITDA in 2012.
LOWER GUIDANCE: The last full-year EPS range offered as guidance for 2011 was $1.60 to $1.70, assuming comp trends “will improve slightly from where they were in Q3” since, the company claimed, there were “easier comparisons coming up at the Bistro in the fourth quarter”. The company still expects full year comps to be down 2% to 3% at both concepts.
HEDGEYE: This is a difficult call to make, but given the risk/reward setup, we are a buyer on weakness after the earnings event. We think consensus FY12 EPS is likely to come down due to outlier estimates but we are a buyer on weakness once this quarter is behind us. This quarter should mark the bottom in negative revisions and the upside in the stock, in our view, far outstrips the downside. We believe that sales could be choppy for a couple of quarters, but – as we maintained with EAT in May 2010 – we believe that management is doing the correct things and that earnings revisions should turn, albeit slowly (like the Queen Mary).
We suspect that the current trends have improved at the Bistro, along with the rest of the industry. Here is a recap of 3Q11 performance for the Bistro.
- Bistro revenues were down 3.5% in the third quarter with comp sales coming at a negative 3.7%
- The impact of Hurricane Irene, which resulted in 75 closed store days and cost about 40 basis points of comp sales during 3Q11
- Bistro sales softness was widespread across all day-parts but weekdays continue to perform slightly better than a weekend, that’s like a reflection of the ongoing strength of our business guests
- From a geographic perspective, the Bistro saw negative comps in most states. Some of the weakness in the northeast was due to the hurricane
- The good news is that we are seeing some sequential trends flatten out a bit in large states like California, Arizona and Nevada
- Comp trends in Florida actually improved sequentially in 3Q11
- As the quarter progressed and year-over-year comparisons got a little bit easier, we saw overall comps get stronger
- Two-year trends have shown some improvements in recent months
The messaging from Pei We last quarter was not good and I don’t hold out much hope for Pei Wei in its current form.
- Pei Wei 3Q11 quarter comp sales were down 3.6%
- Pei Wei sales softness was also widespread as Texas, Arizona, Florida and California which collectively represent two-thirds of our business remain negative
HEDGEYE: This quarter is less important than the forward commentary which we think will be more positive than the Street expects. The Bistro has a strong January and some of the current initiatives are showing favorable trends in the test markets – any incremental positive or less-bad messaging around Pei Wei is an added bonus.
While much of the focus is around top line trends and deducing whether or not the company is turning its concepts around, commodity inflation and other factors are pressuring margins. Here is a recap of commentary on these items from the 3Q earnings call.
- Commodity costs were higher for most of their product basket, with cost of sales increasing about 50 basis points - Beef, wok oil, and Asian import prices all climbed, but with the benefit of contractual price rebate on poultry
- Without the poultry rebate, cost of sales would have been up more than a 100 basis points, consistent with expectations of 4% to 5% commodities cost pressure.
- Consolidated labor expense increased about 110 basis points. This includes the cost of targeted investments in staffing to support the Bistro guest experience and some pressure from new staff labor and efficiencies at Pei Wei.
- Operating expenses increased 120 bps in 2Q11 on sales deleverage as well as a number of cost pressures that were unique to 3Q11 (including additional supplies and printing costs related to the re-launch of Happy Hour, and the write-off of Bistro card printing expenses.)
- Overall, the top line and cost pressures added up to 340bps decrease in Bistro restaurant operating margins down to 16% and a 200 basis point decline in Pei Wei margins to 13.9%.
- Projecting commodities inflation of 4% to 5% in 4Q. Inflation pressure should moderate in 2012
- Continued pressure on the labor line, but some of the operating expense increases should moderate in 4Q11. In total, restaurant operating margins are expected to decline about 150 basis points for a full year (excluding asset impairment charges).
HEDGEYE: Without an improvement in top line trends, the expense side of the equation is going to be a drag on EPS in 2012.
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