Yesterday's Pile

“Here yesterday, gone today.”

-Niall Ferguson


Yesterday’s Early Look note about my Pile yielded some very thoughtful replies. I don’t do this enough, but I’d simply like to say thank you - thanks to all of you who take the time to send me your thoughts. I read each and every one of your emails. I learn from you every day.


Going back to the well this morning, here’s what came out of my Pile on last night’s flight to Kansas City, Missouri:

  1. Jeremy Grantham: “Longest Quarterly Letter” (February 2012)
  2. Niall Ferguson: “Western Civilization – Decline or Fall?” (March 2012)

Grantham’s long-term quibble is one we write about a lot – getting quantitatively oriented: “It would certainly help if the general public were better educated, especially in science… it is said that 8 of the 9 senior leaders in China’s government are scientists. At that high a level, of our 535 Congressmen and the President, less than a handful – arguably only 2 or 3 – would pass the test.”


Ferguson’s thoughts preface his latest book. They’re very much in line with Grantham’s when it comes to reminding the American People, Media, and Markets to wake-up to a non-US centric world before history’s lessons really start to rhyme: “The bad news is that its shape is more like an exponentially steepening slope that quite suddenly drops off like a cliff.


Two of the world’s Top Economic Historians warning us that The Fed and Congress have un-qualified opinions and un-checked policies that infect globally interconnected markets, every day. Think about it.


Back to the Global Macro Grind


“Here yesterday, gone today”, whatever happened to that no-volume “bull market” in US Equities?


Instead of calling a trivial 1-factor model like the 50-day Moving Monkey a risk management process, let’s get real with the 21st century here and get quantitative. Multi-factor, Multi-Duration is what we do and using a very simple 3-factor baseline model, here’s what we see in the SP500:


1.   PRICE – since immediate-term TRADE support (1391) snapped, our intermediate-term TREND line (1331) is now in play. Managing your risk within this dynamically evolving range of 1 is how you should think about gross and net exposure.


2.   VOLUME – there was no volume on the elevator up, and now that it looks like some are taking the window route on the way down, we’re seeing Volume Studies confirm the gravity of the situation. Yesterday’s volume was an animal, up +46% day-over-day! And up +15% versus my composite average of market down days in 2012.


3.   VOLATILITY (VIX) – since immediate-term TRADE (16.24) and TREND (18.76) resistance are now support, US Equity Volatility can continue to put on one heck of a move from here, provided that 18.76 holds. It’s critical to acknowledge that our long-term TAIL zone of 14-15 VIX support held like the rock of Gibraltar, again.


Now if you only look at US Equities through the prism of the SP500, you’re missing part of the point. Looking at the correction in the SP500 versus the Russell2000, you can start to see what index is overweight Apple:

  1. SP500 – stopped going up on April 2nd(1419) and has since corrected -4.3%
  2. Russell2000 – stopped going up on March 26th(846) and has since corrected -7.3%

Unlike the SP500, which is holding its intermediate-term TREND line of 1331 support, the Russell2000 has already broken its TREND line of 795. So, inasmuch as you should be watching 1391 resistance in the SP500 today/tomorrow, watch 795 in the Russell.


Globally Interconnected?


There’s 0% irony that when Small Caps (Russell2000) stopped going up on March 26th, the following occurred:

  1. CRB Commodities Index stopped going up at 326 = down -8% since
  2. Japanese Equities (Nikkei225) stopped going up at 10,255 = down -8% since
  3. US Equity Volatility (VIX) stopped going down at 14.24 = up +43% since

Got an “exponentially steepening slope” (turn the VIX upside down), that “suddenly drops off like a cliff”? Got Apple? Got Global Macro Risk Management?


After cliff diving from the Q1 highs in 2008, 2010, and 2011, how many more times do we have to do this? Do you blame the little guy (Old Wall Street still calls her the “Retail Investor”) for not getting sucked into the Storytelling vortex of another Q1 high?


And if you still doubt that collapse comes suddenly, just think of how post colonial dictatorships of North Africa and the Middle East imploded this year… One minute rulers had legitimacy in the eyes of their people, the next they did not.” (Ferguson)


When it comes to managing what’s left of their own money, The People of America do not appear to be as mathematically inept as either their Congress or Central Planner in Chief. In the long-run, if you break the trust of The People in markets, volumes are dead.


My immediate-term support and resistance ranges for Gold, Oil (Brent), US Dollar Index, Russell2000, and the SP500 are now $1, $116.92-123.12, $79.58-80.28, 774-795, and 1, respectively.


Best of luck out there today,



Keith R. McCullough
Chief Executive Officer


Yesterday's Pile - Chart of the Day


Yesterday's Pile - Virtual Portfolio


McDonald’s has a market capitalization of $100 billion for a reason.  With the exception of a few years in the early 2000’s, McDonald’s executives have been very good stewards of their shareholders’ capital.  Sadly, the same cannot be said for Burger King’s leadership over the past 10 years and the latest developments will do little, in our view, to enhance the company’s reputation.  Bill Ackman recently gave a presentation which we refer to and reproduce material from time to time in this note.


As you can see from the timeline of Burger King, below, the brand has been a cash cow that has lined the coffers of several different firms such as Pillsbury, Grand Met, and Diageo from 1989 through 2002.  TPG and others got in on the act from 2002 through 2006.  From 2006 through 2010, PE firms tried to cash out while the company was public but, ultimately, the chain failed to gain fundamental momentum and 3G Capital took it over.     




Our view is that the overriding motivation of several owners throughout the years, and now 3G Capital, has been to starve the brand of capital in order to pay parent shareholders nice and quickly.  Burger King’s issues may be so substantial that the chain may be “too big to fix”, at least in the near term.  By our reckoning, the last two private equity firms that have taken ownership of the company have deprived the it of $1 billion or more in capital that could have been used to improve the company’s relative standing versus its competitors, many of whom Burger King now struggles to keep up with.  The least favorable comparison for Burger King is McDonald’s.  Between 2002 and 2011, McDonald’s has spent between $5 billion and $6 billion in capex on its U.S. business alone.  While McDonald’s system is still in the process of being upgraded and does include some stores in need of remodeling, a plan is in place and the system has not been starved of capital as Burger King’s has.


As an aside, it is not at all surprising that Wendy’s is in a similar position.  Similarly to Burger King, the company has been mismanaged for years and now faces a $3.7 billion price tag to fix its system with no prospect of generating cash flow any time soon.  Over the past four years Wendy’s current owners were more concerned about buying back stock, it seems, than upgrading the asset base.  We can ask the same “too big to fix” question about Wendy’s and becomes more apparent as the Burger King conversation grows as the IPO nears. 


However, despite the continuous issues that have dogged the chain, its owners of 18 months have claimed that Burger King is back.  Somehow, having invested no capital into fixing the business, its problems have been resolved. 


Ask yourself how many of your own problems have you solved by ignoring them.  Not many.  Not only has 3G Capital not invested any capital in the company, it sucked $295 million out of the business last year. The evidence for the company being back, in terms of its fundamental performance, is four months of positive same-store sales during the most favorable weather the restaurant industry has seen in years.  Before this recent period, comps were negative for three years.


There are very few industries that are more competitive than the QSR segment of the restaurant industry.  Consumer tastes are constantly changing and barriers to entry are low.  The dramatic changes that have taken place within the industry over the past ten years underscore that point.  The bar has been risen in terms of the consumer experience at every stage of the process; Chipotle’s “assembly-line” ordering, Starbucks’ look and feel, and Domino’s online ordering experience are three examples of companies making the necessary investment to capture share.  Burger King has done none of that and is facing a difficult reality in this new QSR world.


The harsh competitive environment awaiting Burger King is typified in every day part and most categories – the burger category in particular.  Breakfast has been dominated by MCD, along with SBUX and DNKN in the North East.  Others, such as Wendy’s, have found it difficult to gain traction and we expect the same for Burger King.  Upstart “better burger” chains are growing rapidly and taking share in a market that Wendy’s has also signaled intent to capture better.  As consumers demand higher standards, Burger King is going to have to invest billions of dollars in capital over a period of years to get its brand perception to where it needs to be. 


According to Bill Ackman “the most valuable businesses in the world are brand royalty businesses that can grow without capital investment.”   We have to give credit where it is due, Mr. Ackman is going to make money on this deal, but as independent observers, we have to assess what happens after his payday.  Shareholders will be holding the bag and their rank will likely be swollen by new shareholders offering PE firms a selling opportunity.   


It’s worth bearing in mind the factors driving the decision of Justice Holdings to make this transaction.  Having been public for over a year, the company – as a SPAC – was compelled to complete a transaction by February 2014.  The company’ s objective, as stated on Nicolas Berggruen’s website, was to “consummate a transation of $5 billion to $10 billion in Total Enterprise Value.  We think Justice Holdings saw in Burger King the same attributes that many PE investors have seen in the past.  BK is a tried and tested cash machine and it fits the bill perfectly for Justice Holdings. 


Looking at valuation levels of peer companies that could accurately be labeled as “brand royalty”, it makes sense for a deal to be done now.  We believe that the success of the Dunkin’ deal – for the insiders and others that got a piece of the deal – is the biggest driver behind the timing of the Burger King deal.   We have reservations about Dunkin’s long term prospects for growth but, for now, the valuation implies that the market disagrees.


3G Capital purchased Burger King in October 2010 for $4 billion, which implied an EV/EBITDA multiple of 8.7x.  Looking at the terms of the transaction with Justice Holdings, it seems the LTM EBITDA of $585 million and net debt of $2.6 million, implying a trailing EV/EBITDA valuation of 12.6x. 


The clear question here is: what did the buyers of Burger King do to create ~4 multiple turns of value without one dollar of investment?  The current strategy does not seem to be focused on investing in the brand.  The remodel program is not yet being bought into by the franchisee base.  If the current strategy fails, the question is whether that could be a death knell for the Burger King brand?  We don’t think that is as dramatic as some might believe.  Our best guess at this point is that Burger King may be better off shrinking in order to grow.  As it currently exists, the turnaround may be too great a task.  Closing underperforming stores and bringing the system AUV's higher may be a good first step on the road to recovery.


Below are our top 10 ten reasons why, according to the “Justice is Best Served Flame Broiled” slide deck, Burger King is fixed (so to speak):

  1. CAPITAL DRAIN: In April 2011, BK issued $685 million of notes, yielding $401.5 million of proceeds, of which $294 million was returned to 3G in the form of a dividend.
  2. BRAIN DRAIN: Last year, management gutted the company of G&A by $107 million and cut head count by 40%, taking EBITDA up 50% but various one-time adjustments have to be made to get there.
  3. ROYALTY STREAM/REMODEL PROGRAM: The company has reduced store ownership by 3%, reducing the need for capital spending.  Unfortunately, 85% of the franchisee-base (measured in stores) has not bought into the remodel program thus far.
  4. NEW MENU INITIATIVES: BK is introducing a new menu that is defensive and looks just like products that McDonald’s is selling. 
  5. POSITIVE SAME-STORE SALES: On the back of an extra trading day in February and the warmest winter in generations, the chain is seeing four months of positive SSS after three years of declines
  6. THE BRAZILIAN CONNECTION: The presence of Brazilian management professionals on the team somehow lends credence to the notion that BK could have more stores than MCD in Brazil?
  7. DOMESTIC QSR GROWTH: The QSR market in the USA is growing?  That may be true but that growth is not coming from tired old chains like Burger King.  Quick casual is the growth engine of QSR.
  8. IMPROVED FRANCHISEE RELATIONS: The franchisees apparently like the new management team but, at the same time, the new owners did not exactly take care of franchisees in 20 states with the Carroll’s refranchising deal.
  9. STRONG MANAGEMENT:  Despite this claim, we are unsure that the team outlined in the presentation is best-equipped to overcome the challenges BK faces, particularly in the uber-competitive U.S. market
  10. THE ART OF A DEAL: The fact that Bill Ackman gave the presentation on behalf of a company he does not bode well for the storytelling capabilities of BK’s team.  They will need to hone those skills rapidly over the coming months! 



As you can see from the management structure chart it does not look like the senior management team has any experience running a restaurant company or a U.S. publicly traded company for that matter.  It explains why Mr. Ackman was speaking on behalf of the company in an unconventional conference call.  However this story plays out, it will be very interesting.






The divergence between what the companies is saying and doing is very interesting.  Management touted a $250 million line of credit from RaboBank as a source of capital for franchisees to help them jump start the re-image program.  One slide in the presentation showed a staggering levered return of 50-87% from the remodel program.  If the returns on capital offered by the reimaging package are that great, why did the Board of Managers decide to pay the shareholders of Parent, including 3G, a dividend of over $393 million in October 2011 having raised $401 million from the April 2011 sale of 11% senior discount notes due 2019.


Carroll’s Corp (TAST) is a key player in the Burger King turnaround and is probably a better way to play the U.S. component of the story.  On March 26th, Burger King refranchised 278 company-owned restaurants in the Ohio, Indiana, Kentucky, Pennsylvania, North Carolina, South Carolina and Virginia to Carrols Corp.  In exchange for the stores, Burger King received a 28.9% equity interest in Carrols and total cash payments of $15.8 million.  Upon completion of the transaction, Carrols will own a total of 575 units. To sweeten the deal, TAST also has received the right of first refusal on sales of Burger King restaurants by existing franchisees in 20 states and pre-approval to grow to 1,000 restaurants.  With this transaction, Carrols also committed to remodeling approximately 450 of its units over the next three and a half years.


Strategically, the deal was great for Carrols, but came at the expense of the other franchisees.  Without the Carroll’s deal in place (only completed a week before the Justice deal being announced), management could not tout the franchisees buy-in of the new remodel initiatives.  But the reality is that the terms of the deal mean that Carrol’s shareholders will be gain much more than non-TAST franchisees or new BK shareholders.  Without assuming further cuts to G&A, we see the deal as being dilutive to Burger King’s EBITDA.


Lastly, the company is stating that it has franchisee commitments to remodel 1,500 units with no specific time period for investors to go on besides what TAST has said in its press release.  The obvious issue here is that 450 of the 1,500 units are going to be converted by Carrol’s Corp, leaving 85% of the system with no time frame or money to fix the system. 


The future health of the franchise system is also far from certain.  The idea that an inflection point in sales has been reached, independent of exogenous factors like weather, is premature.  Sales trends have been near-worst-in-class at BK for years now.  Volatility in commodity markets, particularly beef, may not impact the parent company if the store base is heavily franchised but to the extent that it impacts franchisees and their willingness or ability to agree to terms of reimaging agreements, it could impair Burger King’s ability to compete with MCD and others.  If 85% of the system is not ready to play ball, who is going to pay for the reimaging program? 


The management of Burger King has shown us that franchise systems are doing more now to help their franchisees get financing, and this is being confirmed by our friends at the Restaurant Finance Monitor.  We have learned recently that Franchisors are not only developing their own loan programs and guaranteeing debt, but they may also need to “predict future health care costs.”  The saga of the Affordable Healthcare Act and its myriad implications for the restaurant industry only adds more uncertainty to the equation for franchisees.  According to the Restaurant Finance Monitor, “Brett Willis, senior vice president of franchise sales for California-based Johnny Rockets, said he was recently speaking with a lender who warned him that his bank would like to see franchisees' potential health insurance costs under the new health care law going forward."




The new owners of Burger King have bet the ranch that the competition is “bloated”.  Ackman, on the conference call last week, used that word to describe McDonald’s.  The crux of the Burger King turnaround story is the reduction in expenses, not growth in EBITDA.  Management cites three factors in its “Cost Reduction Initiatives” section:

  1. The implementation of “Zero-Based Budgeting”, resulting in $107mm G&A reduction in year one, with additional savings expected in 2012 (will G&A be cut more through refranchising?)
  2. Reduced 40% of corporate headcount, with entire restructuring completed by 2Q11
  3. Changed culture by creating meritocracy and restructuring incentive compensation

While the cost cutting drove 29% EBITDA growth in 2011 it’s a one-time event and now the story becomes more about the turnaround and the real financial performance of the store base.  The easy money has been made!


More importantly, the lean corporate structure raises questions about the long-term impact of Burger King’s ability to invest human capital in future growth of the business and making the appropriate support and services available to franchisees. 


Most analysts that live and breathe the day-to-day happenings within the QSR business know that BK’s system has seen little-or-no progress in terms of the look and feel of the stores.  No new formats have been introduced across a significant slice of the system for 12 years.  This is evidenced by the fact that a large proportion of the system needs to be remodeled.  By our estimation, as much as 95% of the asset base may need remodeling.  A redesign program that was first mentioned in 2009, called 20/20, included a flashy design that included red-flame chandeliers.  The cost was going to be $500-600k per store before the company decided to “revise” its plans. The reason for this revision and eventual abandonment, we believe, was that the cost was prohibitive for the majority of franchisees.  Negative comps and $1.1m AUVs are not going to inspire confidence among franchisees to lever up.


The $1.1 million in average unit volumes makes the math of spending up to $600k per store a daunting prospect for franchisees.  A 10-17% sales lift, or $110-187k, with a 35-40% contribution margin resulting in $75k in extra profit implies an eight-year payback period.  We don’t think many of the franchisees we have spoken to would rush to sign up for that.  Spending $300k per store with a 40% contribution margin halves the payback period but we think that is difficult to envision. 


McDonald’s has been spending around $500,000 per store, with Wendy’s citing number closer to $750,000.  This is possible because those chains’ stores generate higher unit volumes.  While I think Wendy’s and their franchise system are unlikely to be able to afford to spend that much money, chances are they will come close to around $400,000 to 500,000 per store at the very least. Companies are making these capital commitments because they are compelled to; young consumers are demanding an experience – rather than just food – for their dollars and companies that are meeting that demand are driving the growth of QSR.  In this respect, Burger King has been in the slow lane for a decade.  Catching up to the competition, improving the consumers experience in every regard, is going to be an expensive proposition. 


In order to sell a more palatable story to investors and to increase franchisee remodel activity, the current management team developed a less costly “20/20 hybrid” remodel, with an estimated average cost of $275,000. Further, the company is offering incentives of $150,000 per restaurant to franchisees, in the form of royalty reductions. The company is targeting 1,000 franchisee remodels in the US/Canada by the end of FY2012 and to complete 40% of the system in three years.  As of the end of 2011 the company had 240 units remodeled and management has said that gross sales uplifts on the remodels are in the double digit range.











The new menu and marketing initiatives seem defensive to us.  Devoid of anything new to the QSR consumer, the menu seems to essentially take on McDonald’s head on.  We don’t see this as a viable strategy for Burger King at this stage of its turnaround.  McDonald’s dramatically outspends Burger King in terms of marketing dollars (~30:1).  To grow same-store sales, Burger King needs to branch out from its core customer base.  With a menu that offers nothing new, essentially tackling the marketing machine that is MCD head on, how are they going to do that with a subpar asset base?









Justice Holdings likely took some time to reflect on which metric would make its Burger King story most attractive from a valuation perspective.  That metric, as it turns out, is EV-to-EBITDA less capital spending.


The problem with this analysis is that it penalizes peer restaurant companies that are growing and, in the process, generating significant shareholder returns.  Unfortunately for Burger King, it is not economical for the company to grow its store-base given the $1.1m AUVs and roughly $2m in cost associated with building and opening the store.  Looking at EV/EBIT would be a more conventional way to frame the valuation point, and management does use it when outlining the potential value of Brazilian operations in the future, but taking capex out rather than D&A assigns Burger King a loftier multiple. 


When we look at the potential transaction on an EV/EBITDA basis, Burger King is more expensive than THI, MCD, YUM, WEN, DPZ, and PNRA.  Only PEET, SBUX, DNKN, and CMG would be more expensive.  Should Burger King be trading at a premium to MCD?  We do not think so.


BKC – TOO BIG TO FIX? - qsr valuation table







Howard Penney

Managing Director


Rory Green



China Is Boring

Conclusion:  While China looks to have limited downside from an economic growth perspective over the intermediate term, the same can be argued with regards to China’s upside growth potential over the long term, making the country uncharacteristically boring from a fundamental perspective.


As the world’s second-largest economy and arguably the single-most important source of global demand for raw materials (copper ~46%; aluminum ~42%; etc.), China matters a great deal to the Global Macro Universe. This is especially true on days where China is rumored to be: A) easing monetary and fiscal policy; B) bailing out the Eurozone; or C) falling off a cliff from an economic growth perspective.


On most other trading days, China has really taken on a reduced role in the calculus of the consensus fundamental outlook – which intuitively makes sense to us, given the consensus bullish bias within the U.S. financial newsmedia community and the fact that China's GROWTH/INFLATION/POLICY trends have largely been deteriorating for 2+ years now.


While almost trivial, we can’t help but remind clients that Chinese equities (via the Shanghai Composite Index) have been down quite a bit each of the past two years (2010: -14.3%; 2011: -21.7%) – underperforming U.S. equities (via the S&P 500) by a wide margin. The trend in Chinese equities is akin to the long-term decline in rates of Chinese economic growth.


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China Is Boring - 2


Again, while the more newsy headlines out of China and other countries have dominated the intermediate-term tops and bottoms of global equity, commodity, currency and bond markets in recent years, we always find it important to contextualize and handicap the trailing and future trends in Chinese growth, inflation and policy data. In doing so, we have created a process that helps us get ahead of the aforementioned headline risk.


China’s Multi-Duration Growth/Inflation/Policy Outlook:


TRADE: 3wks or less

At some not-yet-specified point over the next 48 hours, China will release its monthly New Loans and Money Supply data for the month of MAR. On APR 12, we’ll also receive China’s 1Q12 GDP report along with its MAR Industrial Production, Retail Sales, and Fixed Asset Investment figures. That will be followed by China’s [purposefully vague] Property Price statistics on APR 17. Most growth rates are forecasted by Bloomberg Consensus to be flat-to-down relative to the prior month/quarter.


Rather than pretend like we have any edge in modeling [likely] made-up statistics, we defer to the quant to get a real-time read on what these data points are likely to look like. Chinese equities, which recently snapped their immediate-term TRADE line, are still bullish from an intermediate-term TREND perspective. This setup tells us two things:

  1. The risk of a downside surprise in the data is much greater than the risk of an upside surprise; and
  2. The trend in reported Chinese growth data is likely to continue on its secular downtrend without a measured acceleration (to the downside) at the upcoming reporting juncture.

China Is Boring - 3


In support of the latter claim, we point to the tug-of-war between China’s sequentially-improving MAR PMI reports and China’s sequentially-deteriorating MAR Trade data (particularly on the import side).


On the PMI front, China’s Manufacturing Index ticked up in MAR (alongside every subcomponent) to 53.1 from 51 prior; the new seasonally-adjusted Services Index ticked up to 58 from 57.3 prior.


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China Is Boring - 5


On the trade front, Chinese Export growth accelerated in MAR to +8.9% YoY from a +6.8% pace in the JAN-FEB period. Accelerating U.S. demand for Chinese goods (+14% YoY) overshadowed waning demand from the E.U. (-3.1% YoY). Chinese Import growth slowed in MAR to +5.4% YoY from an +8.2% pace in the JAN-FEB period; +5.4% YoY is the slowest pace of Chinese import demand growth since OCT ’09.


China Is Boring - 6


TREND: 3mos or more

As highlighted in our recent work, we remain of the view that Chinese policymakers are unlikely to come out with any dramatic policy easing measures in the immediate-term. Rather, we expect Premier Jiabao’s to continue making good on his repeated promises of policy “fine tuning”, such as the recent increase in QFII quotas, SME bond pilot program development, RRR cuts, CNY15 billion SME credit facility, and relaxing of SME loan capital requirements.


Taken collectively, these and a growing list of other measures are supportive of Chinese growth on the margin; for example, SMEs account for 2/3rds of industrial output and employ 4/5ths of Chinese workers. That said, however, we remain convinced that China is unlikely to move the dial on its growth trajectory in a material way absent an implementation of the following two steps:

  1. Lowering interest rates; and
  2. Removing the curbs on real estate speculation.

Regarding step #1, we think China is indeed inching closer to cutting rates based on a combination of a dramatic decline in inflation/inflationary pressures, as well as a priced-in easing bias in China’s interest rate and FX markets. While the MAR CPI figure did accelerate to +3.6% YoY, our proprietary models and the Chinese yuan’s sustained outperformance of global food and energy prices (due to its now-convenient peg to the USD) both point to lower-highs in China’s reported inflation figures over the intermediate term.


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Regarding step #2, we continue to hold the belief that this China isn’t even in the area code of taking their foot off the brakes of their property market. Both rhetorically and actively – in the form of eschewing a signaling of a broader policy reversal in favor of “fine tuning” – Chinese policymakers remain committed to achieving their long-held goal of deflating the property market in an orderly fashion.


Further, it is unlikely that China will embark on such a dramatic inflection in policy so late in the leadership of the 17th  Politburo (its term concludes in MAR ’13), in our opinion. The ill-effects of the 2008-09 stimulus package haven’t yet truly come home to roost in China’s banking system – which extended CNY10.4 trillion ($1.7T) in credit in span of just 12 months through NOV ‘09. For China to move away from tight policy at the current juncture would be far from “prudent”, which both the PBOC and State Council have pledged to maintain in the policy arena as recently as last month.


China Is Boring - 11


TAIL: 3yrs or less

Perhaps the most important conclusion we can stress is that if both of the aforementioned steps (#1 and #2) are not implemented largely in conjunction, we don’t see meaningful upside in China’s long-term economic growth potential. 


Much like valuation remains is not a catalyst to invest in a company, rate cuts are rarely a bullish catalyst for a country’s equity market if a positive inflection in economic growth (which, in theory, would be slowing during a rate cut cycle) is not within reach. Overlaying Chinese interest rates with the CRB Commodities Index or the Fed Funds Rate with the S&P 500 from 4Q07-1Q09 speaks volumes to this point. It remains prudent to avoid the classic consensus mistake of buying the dip the entire way down on monetary easing alone.


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China Is Boring - 13


Turning our attention back to China, we maintain our view that Chinese policymakers are well aware of the risk that being over-levered to investment – particularly real estate investment – poses to their economic growth potential. Specifically, at 48.6% of GDP, China’s ratio of “I” to GDP is greater now than the corresponding ratios of any of the countries that were most affected by the 1997-98 Asian Financial Crisis from a capital outflow perspective leading up to and through that event.


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China Is Boring - 15


To mitigate the risk of destabilizing capital outflows and a corresponding banking crisis over the long term, the State Council has called for a structural downshift in the rate of Chinese economic growth to +7.5% per annum, as well as a rebalancing towards increased household consumption in lieu of further investment. While mean reversion in the aforementioned GDP expenditure ratios seems likely over the long term, it remains to be seen whether or not Chinese policymakers have enough savvy and firepower to ensure an orderly transition over the long-term TAIL. History would suggest China’s odds of a structural “soft landing” are not favorable.


Looking to China’s property market, which is the primary beneficiary of high rates of domestic investment, the latest supply and demand data suggests real estate prices are quite likely to be headed lower on a sustained basis.


In the JAN-FEB period, the growth rate of completed supply accelerated to an all-time high of +45.2% YoY as seen in the Floor Space of Buildings Completed series. From a pending supply perspective, growth in Floor Space of Buildings Under Construction accelerated to +35.5% YoY in the JAN-FEB period – good for the second-highest rate on record. The State Council’s goal of building 36 million units of affordable housing from 2011-2015 is a key policy initiative affecting the underlying trends in supply.


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From a demand perspective, growth in Total Sales of Buildings slowed in JAN-FEB to an all-time low rate of -20.8% YoY. Moreover, growth in Floor Space of Buildings Sold and Floor Space of Residential Buildings Sold have each slowed to multi-year lows of -14% YoY and -15.9% YoY, respectively.


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Looking at the investment climate, the one positive data point we’d highlight is that growth in domestic financing for real estate investment accelerated to +16.3% YoY in JAN-FEB, which is the fastest rate of growth since NOV ’10. That said, however, China Economic Network’s Real Estate Climate Index ticked down to a 32-month low of 97.89 in the JAN-FEB period; the index’s YoY growth rate of -4.9% is the slowest rate since JUN ’09.


China Is Boring - 18


China Is Boring - 19


With supply increasing at much higher rate than any measure of demand, continued price declines seem likely and may be poised to accelerate. Our financials team, led by Josh Steiner, has shown that demand leads U.S. housing prices by one full year. While certainly not an apples-to-apples case study, one would expect Chinese property prices to continue trending lower over the long-term TAIL given the current and [likely] future supply and demand imbalance – a setup which doesn’t look to inflect in a meaningful way absent the implementation of the aforementioned steps “#1” and “#2”.


The one bright spot we’d point to that lets us know that the Chinese property market isn’t quite falling off a cliff – at least not yet – is growth in China’s raw materials demand (consumption), which has largely trended sideways over the last 18 months. Even amid the Great Recession/Global Financial Crisis, Chinese demand for raw materials only briefly went moderately negative from a YoY perspective, suggesting to us that any sustained declines here would be quite an ominous signal for China’s Fixed Assets Investment Growth.


China Is Boring - 20


All told, while China looks to have limited downside from an economic growth perspective over the intermediate term, the same can be argued with regards to China’s upside growth potential over the long term, making the country uncharacteristically boring from a fundamental perspective. Further, while not a great thesis, playing for mean reversion on the long side of Chinese equities in a strong-dollar environment is about all that an investor can hope for at the current juncture.


Darius Dale

Senior Analyst

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Prepare The Pile

This note was originally published April 10, 2012 at 07:21am ET.



“The key is not to predict the future, but to be prepared for it.”



I was on a plane to Denver last night and was reviewing some of the required reading in my pile. For those of you un-familiar with my research process, my pile is part of it. I never leave home without it. I typically read my pile on a 1-3 week lag.


The Pile revealed 2 different perspectives on preparing for the future trajectory of long-term Global Economic Growth:

  1. Goldman Sachs: Global Strategy Paper No. 4 – “The Long Good Buy” (March 21, 2012)
  2. Reinhart & Rogoff: “Five Years After Crisis, No Normal Recovery” (April 2, 2012)

Goldman’s view acknowledges that “future growth may be lower than experienced over the past decade in many parts of the world”, but that equities are already pricing in “unrealistically large declines in growth.” They’re making both a growth and valuation call.


Reinhart & Rogoff suggest that “the concepts of recession and recovery need to take on new meaning” and that “financial crises leave behind deep recessions of long duration and considerable volatility.” They’re calling for debt and volatility to slow growth.


The Pile did not change my 5 year-old view on the Global Growth Cycle. Neither did it change my risk management process. From these debt and deficit levels, Big Government Interventions in our markets and economies will continue to:


A)     Shorten economic cycles

B)      Amplify market volatility


As growth slows, “cheap” markets get cheaper. Valuation isn’t a catalyst until growth re-accelerates.


Back to the Global Macro Grind


While it’s interesting to observe the emotion and Storytelling associated with why the US stocks are going down, this morning’s Global Macro research process reveals pretty much the same thing we have been flagging since February. While Growth Slowing, globally, may be new to a US stock market centric media consensus, it’s not new to the rest of the world.


Here’s a quick Global Equity market update:


1.   ASIA – context is always critical, so it’s important to acknowledge that 2 of the major leading indicators in Asia, the Hang Seng and the Nikkei, stopped going up on February 29th and March 27th, respectively. Inclusive of this week’s declines, the Hang Seng and Nikkei are down -6.1% and -7.0% from their YTD tops. India, Australia, and Singapore are all bearish TRADE.


2.   EUROPE – if Germany’s DAX is susceptible to a 6.2% correction from its YTD high (March 15th), any equity market in the world is. Germany’s employment situation is much more stable than that of the US, despite neighboring some of the most dysfunctional debt/deficit laden countries in the world. Spain is the Global Macro train wreck of the YTD, down -11%.


3.   USA – the SP500 finally broke our immediate-term TRADE line of 1391 support yesterday, but has only corrected -2.6% from its April 2nd top. The Russell 2000 stopped going up 3 weeks ago and is down -5.1% from its March 26th top (immediate-term TRADE resistance there is now 822). As for the 50-day moving averages – we only use them for behavioral observations.


The rest of the world, of course, doesn’t hinge on Dow 13,000 or the price of Apple. It’s globally interconnected, across asset classes, from countries, to currencies, bonds, and commodities.


Here are my Top 10 cross asset class callouts to make a note of this morning:

  1. US Equity Volatility (VIX) has held its long-term TAIL of 14.41 support and is now breaking out above our 16.24 TRADE line
  2. Oil Volatility (OVX) remains above its immediate-term TRADE line of 28.43 support as Oil prices break TRADE support
  3. Brent Oil (BNO) has finally broken its immediate-term TRADE support line of $124.23/barrel
  4. Copper continues to be broken from a long-term TAIL perspective and immediate-term TRADE resistance = $3.85/lb
  5. Gold is in a freshly formed Bearish Formation (bearish TRADE, TREND, and TAIL) with next support = $1616/oz
  6. Spanish and Italian 10yr bond yields remain in a Bullish Formation (bullish TRADE, TREND, and TAIL)
  7. US Treasury 10yr bond yields continue to signal Growth Slowing, under both TRADE resistance of 2.18% and TAIL 2.47%
  8. US Treasury Curve Yield Spread (10s minus 2s), which is a proxy for growth’s slope, has compressed 14bps wk/wk
  9. US Dollar Index is moving into a stealth Bullish Formation with intermediate-term TREND support = $79.55
  10. Japanese Yen is bumping up against another lower long-term high at $81.23 (vs USD) and remains in a Bearish Formation

I have a passion for my team’s process because it’s had repeatable success in revealing the deep simplicity of Growth and Inflation Accelerating or Decelerating, globally, on a real-time basis. I Prepare The Pile every day so that I am always reading the counter punches to our overall risk management conclusions, but I do not defer to The Pile’s views based on short-term market moves.


What we’ve all had the opportunity to learn in the last 5 years is that if you get the intermediate-term TRENDS in both Growth and Inflation right, and you’ll get a lot of other things right. Valuation calls with no catalysts are called opinions. If you’re using the wrong Global Economic Growth assumptions, you’re basing your “valuation” work on the wrong numbers anyway.


My immediate-term support and resistance ranges for Gold, Oil (Brent), US Dollar Index, and the SP500 are now $1616-1655, $121.31-123.84, $79.55-80.16, and 1374-1391, respectively.


Best of luck out there today,



Keith R. McCullough
Chief Executive Officer


Prepare The Pile - Chart of the Day


Prepare The Pile - Virtual Portfolio


Keith shorted MGM in the Hedgeye Virtual Portfolio at $13.70.  According to his model, the TRADE resistance is $14.06 and the TREND support is at $12.93.



While Q1 should be ok, we think the Street's estimates for Q2-Q4 are aggressive.  Numbers just released from Nevada for February were in line with our projections while March faces a difficult comp despite 2 extra weekend days.  The Q2 calendar is unfavorable and the US jobs picture looks a little bleaker.  As it is, we are projecting 15% company wide EBITDA growth for 2012 and we are one of the lower estimates on the Street.   




Preliminary April forecast of HK $24-25 billion, up 21-25% YoY



Average daily table revenues (ADTR) were HK$768 million for the first 9 days of April, slightly above the March run rate.  However, 4 of the 9 days were weekend days so ADTR should be higher.  We are currently projecting HK$24-25 billion in full month GGR for April, up 21-25% YoY.  Relative to the first 8 days of April last year, ADTR was up 15% but those 8 days contained only 2 weekend days which indicates there would be a little downside to our estimate.  However, the opening of SCC this week should juice the numbers into our range.  The April hold comparison is much more difficult than March (approximately 30bps of hold %).  March was the last of the easy comparisons.




In terms of market share, Galaxy is the only company significantly below trend while MGM is the only one significantly above.  With LVS opening up SCC this week, we would expect to see its shares rise, mostly at the expense of Galaxy and WYNN.



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