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Discover Financial Services (DFS) has been a darling for the market over the last several quarters. Between improving credit and the ability to return capital, the company at face value looks very solid.


Behind the curtain, however, are issues that raise concerns. So much so that Hedgeye Financials Sector Head Josh Steiner has immediately gone bearish on TRADE, TREND and TAIL durations. Steiner has effectively found four main issues with the company and the stock that make his case clear:


  • Peak earnings on what is now a peak multiple. When everything is going right, it’s usually not long before something goes wrong.
  • We see 18% downside just from mean reversion, and that incorporates no credit quality deterioration.
  • Volume slowdowns precede credit slowdowns. We’re seeing evidence on multiple fronts now that volume growth is decelerating.
  • Sentiment on DFS is uber-bullish. Not one sell rating among 26 analysts (19 buys / 7 holds) and short interest in its bottom quintile since coming public.

So while the banks and sellside analysts remain primarily bullish on DFS, Steiner continues to stand contrarian. It appears that the good times can only roll for so long before something goes wrong.


DFS:  TWIN PEAKS - DFS shortinterest.ng



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CONCLUSION: We continue to warn of material long-term risks to prices in Hong Kong's property market, potentially exposing the territory’s banks to a non-performing loan crisis.


On MAR 25, despite not yet enjoying the privilege of universal suffrage, the people of Hong Kong “elected” its new Chief Executive Leung Chun-ying through a combination of polling and widespread popular discontent with the wealthy elite’s preferred candidate Heny Tang Ying-yen. His supporters in the 1,200-member election committee were eventually outdone by the demands of Hong Kong’s seven million-plus citizens – many of whom had become outright dismayed with the territory’s widening socioeconomic inequality and rising consumer price inflation (particularly in what has become the world’s least-affordable housing market per Demographia at 12x the median salary per the Economist).






Enter Chun-ying (or “CY” as he is popularly referred to). As a member of the pan-Establishment camp (i.e. pro-Beijing), CY campaigned on a populist approach and was often seen rallying support in the city-state’s poorest districts. The statement: “I will be willing to upset the status quo and bring about change,” is indicative of his platform. Upon election back in MAR, he pledged to adequately address the territory’s structural wealth gap as part of his agenda to prepare the nation for universal suffrage in 2017 – making him Hong Kong’s first Chief Executive at risk of being denied a second term as a result of popular mandate. We think that risk will impose great pressure upon him to fulfill his populist agenda over the next five years.


One area where CY could enact great change is in Hong Kong’s property market, where prices have increased +88.2% off of the NOV ’08 lows to an all-time high in the latest reported period (MAY ’12). For reference, the last time Hong Kong property prices were around this level was in late ’97; in the 5-6 years following, prices plunged nearly -70% to a APR ’03 index bottom. Capital outflows predicated by the Asian Financial Crisis, the Russian and Argentinean defaults, the Dot-Com Bubble bursting, and a Chinese banking crisis all contributed to destabilizing forces then. Will the Sovereign Debt Dichotomy play a destabilizing role now? That’s certainly a tough question to answer at the current juncture; nonetheless, it is one that must be debated.


Already, Hong Kong officials have targeted the nation’s property market with regulations designed to remove what appears to be a heavy speculative bid. The latest measures include introducing a special stamp duty (SSD) on housing transactions, forcing borrowers to disclose more information about their mortgage history (potentially forcing some borrowers into lower LTV buckets), and raising minimum down payments and deposits for foreign buyers (mainland Chinese account for 14% of all residential sales) to 50% and an additional 10%, respectively, for dwellings costing HK$10M or more.


If the aforementioned measures are deemed insufficient by the incoming administration – as they have been particularly ineffective at containing prices – CY could impose further measures, potentially opting to speed up the development of subsidized housing and increasing land supply at new home development auctions – the decline of which has limited incremental supply in recent years an been a supportive factor for speculative gains.


A sustained regulatory effort to cool house price appreciation in Hong Kong could potentially lead to a dramatic reversal of that market’s latest melt-up. Whether Hong Kong property prices are officially in bubble territory or not is beyond any point we’d ever try to make; rather we prefer to focus on the risks associated with any policy-sponsored regression to the mean. Per the IMF, commercial and residential mortgages accounted for 22.6% of assets at Hong Kong banks at 15.8% and 6.8%, respectively (DEC ’11). Loans to and equity/debt securities of Hong Kong property developers surely account for additional shares of Hong Kong bank assets – increasing the industry’s aggregate exposure to a potential NPL shock over the long-term TAIL.


Below are a few statistics to highlight the imbalances within Hong Kong’s property market – imbalances that may contribute sustainable inertia once prices start to decline:


At the current prices of 6,288 HK$/sq.ft., a family earning the median income (HK$21k/MO) in Hong Kong can only afford to buy 3.3 square feet of housing per month – down from 5.4 at year-end 2008 and 6.7 in 2000.




Despite property prices nearly doubling in just under four years, the aggregate loan-to-value (LTV) ratio of mortgages in Hong Kong has dropped only -3,600bps to 57.9% – suggesting that the rapid price gains of recent years were supported primarily by a dramatic increase in borrower leverage (+37.8% since year-end 2008).




The previous cyclical bottom in Hong Kong property prices roughly coincided with the announcements of QE1 and China’s major economic stimulus package (CNY4 trillion), as well as the Fed Funds Rate being lowered to the zero-bound. All three massive injections of liquidity served to ignite speculation in Hong Kong’s low-supply property market due to the territory’s tight linkages with both economies (increasingly wealthy Chinese buyers; the Hong Kong dollar’s ~30yr-old peg to the USD essentially binds Hong Kong interest rates to those in the US).Given these linkages, a harder-than-expected landing in the Chinese economy or a lack of further injections of liquidity out of the Federal Reserve could remove the speculative bid and/or prompt outright selling in Hong Kong’s property market.




All told, we continue to warn of material long-term risks to prices in Hong Kong's property market, potentially exposing the territory’s banks to a NPL crisis – something we dug into as early as MAY ’11 in a then-bearish cyclical piece on Hong Kong equities. With a persistent budget surplus and low debt-to-GDP by international standards, the Hong Kong sovereign certainly has the fiscal space to offset any potential domestic banking crisis. That said, however, counting on international policymakers being proactive – rather than reactive – relies on some fairly aggressive assumptions, especially given all that we have learned from watching the US/EU political gong show(s) over the past 4-5 years.




Turing to the scoreboard, the aforementioned cyclical thesis has played out in spades, with Hong Kong’s economic growth – largely a byproduct of the global trade flows – slowed, consecutively, from +7.8% YoY in 1Q11 to +0.4% YoY in 1Q12. Moreover, Hong Kong’s benchmark Hang Seng Index is down -17.6% since last MAY (inclusive of a -31.4% peak-to-trough decline from MAY ’11 to OCT ’11).






Now, we hold a neutral-to-slightly-bearish fundamental bias on Hong Kong equities on our TRADE and TREND durations. On one hand, Hong Kong does not necessarily screen bearishly on our G/I/P processes; on the other, its exposure to mainland China – which itself screens poorly on our quantitative factoring in spite of recent policy easing – is worrisome to say the least.




All told, when it comes to property prices in Hong Kong, even Sir Isaac Newton would find this opportunity asymmetric, favoring short-sellers, as “what goes up, must [eventually] come down”.


Darius Dale

Senior Analyst

Focus on Italy

Greece has been the flavor of the week for some time now, drawing the most criticism over the European financial crisis. Spain recently made its foray into headlines after accepting a €100 million bailout from the IMF, which will presumably get worse over time. It appears that the next country to make headlines will be Italy.


Focus on Italy - sp.ital.10yr


Hedgeye Director of Research Daryl Jones recently penned a piece for Toronto’s Globe and Mail that focuses on Italian debt. Italy has a €255 billion repayment schedule over the rest of the year that will force it to address its problems in an accelerated fashion. Truly, the worst is yet to come.


Italy, not Spain or Greece, should be on the mind at G20 meetings [Globe and Mail]

FRANCHISING: Fool's gold

Hedgeye Restaurant Sector Head Howard Penney hosted a conference call with industry expert John Hamburger on Tuesday to discuss the risks revolving around heavily franchised restaurants. The main takeaway is that franchisors are realizing that it’s easier to sit back and collect royalty payments than to own and operate a store, but areas of difficulty in the industry have arisen that plague weakly franchised companies.


They include, but aren’t limited to:

  • Poor asset quality: concepts that allow their asset bases to unduly deteriorate tend to fall behind and aren’t able to rectify the situation. Cash-hungry private equity firms do not help with the situation as they focus on the cash and not the subsequent consequences.
  • Franchisor/Franchisee disharmony: The disagreements between management and franchisees has been well documented over the years. Communication is more crucial than ever and when a franchisee goes “rogue” by going around corporate-directed rule sets, it raises concerns about the relationship.
  • Inconsistent unit performance: Management teams resorting to short-term, promotional strategies to “dress up” the numbers tend to produce choppy results.


FRANCHISING: Fool's gold - franchisors


The current turnaround strategy at Burger King and Wendy’s (WEN) have been particularly capital intensive as older stores remodel to comply with the new image management has created for them. To quote John Hamburger: “Half of the current restaurants operated by chains are not at the current prototype standard and it’s very capital intensive when remodeling.”


McDonald’s (MCD) will always be a top dog, but Burger King and Wendy’s have their work cut out for them over the next few years.

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