In preparation for CMG’s 2Q12E earnings release on 7/19, we’ve put together some recent forward looking company commentary and important consensus metrics for the upcoming 2Q12 earnings release.


Summary Thoughts

  1. CMG is comparing against very weak 2Q11 results, due to significant food inflation last year
  2. Street modeling 10.1% SSS for 2Q12, a 250 bps slow down in 2-year trends
  3. Consensus expectation for 2H12 food costs look low
  4. Short interest is 7.45% of the float, and trended lower during the quarter
  5. CMG has lost ground on the Hedgeye Restaurant sentiment scorecard over the past 8 weeks
  6. New store performance continues to be the future for this stock




“In March, we raised prices in our Pacific region by about 4.5% to reflect the higher cost of doing business in the region, and to help narrow the pricing gap with other U.S. markets. This price increase was completed in March. And because it laps a similar increase in the Pacific region at about the same time last year, it will have no additive effect to our comps going forward.”


“While we continue to believe we have pricing power, we do not have plans for any additional menu price increases during 2012 to offset expected food inflation.”


HEDGEYE – Every management team has pricing power until they don’t – just ask the management of DRI about the pricing power at Olive Garden.  The bottom line is that consumers determine whether you have pricing power or not, and if you abuse the privilege you can get burned badly.  Yes, even Chipotle.




“Our comps held up well in the first quarter despite the toughest quarterly comparison in 2011 of 12.4%. Unseasonably mild weather through much of the quarter helped transaction trends remain strong. And in addition, we benefited from the leap day in February, which added about 1% to the comp.”


“Our sales comps continue to benefit from the menu price increases taken during the second and third quarters of 2011. At the current menu price increase run rate of 4.9%, we will lose 3.9% of the benefit over the next two quarters as we lap the price increases from last year, with about 30 basis points dropping off in Q2 and about 360 basis points dropping off in Q3. We also face tough sales comparisons in the back half of 2012, as beginning in the third quarter we will comp against two full years of double-digit comps for the first time since before the recession. Taking all this into account, we reaffirm our full-year comp guidance of mid-single-digits.”


HEDGEYE – Expectations are loftily for CMG, but this is not new.  Some of our own internal metrics suggest that 10% same-store sales figure is likely a good estimate for the quarter.





“G&A was 7.7% in the quarter, up 140 basis points from last year, due primarily to higher non-cash, non-economic stock compensation expense, and higher payroll tax expense related to the exercise of options during the quarter. The non-cash, non-economic stock comp expense was about $20.5 million in the quarter, or $11.5 million higher than last year. About half of the increase, or $5.6 million, was due to a one-time catch-up adjustment for performance shares issued during 2010. These performance shares have a three-year vesting schedule ending in October 2013. And the amount of the award can increase or decrease depending on our financial performance during the three years.”


HEDGEYE – Outside of another “one-time” adjustment compensation expense with 10% same-store sales, there should be no surprises in this line item for the quarter.





“Restaurant level margins increased by 220 basis points to 27.4%, just 30 basis points shy of our highest quarterly restaurant level margin set back in Q3 of 2010. The higher margins were driven by sales leverage, including the benefit of the menu price increase, and from lower promo costs due to the large promotion in Q1 of 2011. Operating margins increased by 130 basis points, lower than the restaurant level margin expansion because of increases in non-cash stock comp, which I'll talk about in more detail shortly.”


HEDGEYE – The Street is expecting a 156bps improvement in restaurant level margins as the company should be able to leverage labor costs and other expenses with 10% same-store sales.  Food costs appear to be the wild card.





“We continue to expect food inflation in the mid-single-digit range over the next few quarters, due primarily to rising costs of beef, dairy, and avocados.”  “Contributing to these higher costs is the expectation that all of our sour cream will come from cows that are pasture raised beginning in the second quarter, and from seasonally higher avocado costs as we return to buying avocados from California this summer.”


“Right now we think that over the next two quarters it's going to be mid-single-digit inflation. We think that if things go as planned then the fourth quarter will level off a little bit. So I think when you take that mid-single-digit inflation and convert that into impact on food costs, I think you are looking at somewhere between 100 basis points to 150 basis points of higher food costs over the next couple quarters.”


“But more importantly, from the fourth quarter to the first quarter, we had the same food costs. So we didn't see any net effects of food inflation so far in 2012. And that's, I think, the most reflect – I think the most – the best way I think to look at it is kind of sequentially from the fourth quarter.”


“If you look at the fact that we had a – we've got a run rate of about a 5% menu price increase, and our food costs went up by 20 basis points, you could just back in to the fact that we had like a, call it a 6% or 7%, in that kind of ballpark inflation year-over-year.”


“But more importantly, looking at it sequentially, didn't get hit in the first quarter. We do think that the mid-single-digit inflation going forward will kick in, and we think it'll hit over the next two quarters.”


“And we expect higher costs as we move into the second quarter and the third quarter. It's coming from three principal places. We continue to see inflation in beef costs. We will see seasonally higher prices. Even though avocados year-over-year will be lower, as you get into the second and third quarters, they're going to be higher than they are in the first quarter, because we're going to start buying from California and they will be more expensive.”


HEDGEYE – The Street is modeling a YoY 5bps decline in the cost of sales for the quarter and a 61bps sequential increase.  CMG is losing some benefit from pricing, and food inflation in the company's P&L is accelerating quarter-to-quarter.





“Our new restaurants continue to perform very well, reflecting the success of our real estate development strategy and the growing awareness of the Chipotle brand across all U.S. markets. Our new restaurants are opening at or above our $1.5 million to $1.6 million communicated range. And A-Models continued to perform well with sales just below traditional sites, but they generate higher returns.”


HEDGEYE – All eyes are on this metric as investors seek to gain a clearer idea of how big this company can be!


CMG - THE 2Q12E REMIX - cmgmetx


CMG - THE 2Q12E REMIX - cmgsss


In preparation for YUM’s 2Q12E earnings release on 7/18, we’ve put together the recent pertinent forward looking company commentary from 1Q12 including Hedgeye commentary and important consensus metrics for the upcoming 2Q12 earnings release.


Summary Thoughts

  1. YUM is comparing against a more difficult 2Q11 results.  It’s unlikely they raise full-year EPS forecast above the current 12% pace.
  2. Short interest is very low at 1.82%, but has risen sharply in the last month.
  3. Sentiment has turned down over the past eight weeks but remains one of four names in the restaurant space with a Hedgeye sentiment ranking of 90 or better.
  4. The sentiment surrounding YUM China drives this stock.  Given the news flow from China, it will take nothing short of a spectacular quarter for the street to be comfortable with how 2H12 is shaping up.    



“KFC now has 3,819 restaurants with average unit volumes of $1.7 million; in 800 cities throughout the country and continues to expand into new cities as well as increase its penetration levels in existing markets. KFC is deeply rooted in China with its localized menu and broad appeal. Virtually all KFCs in China serve breakfast, which accounts for about 6% of sales. Nearly half our KFC restaurants offer delivery service and over half have 24-hour operations. These service and day part extensions are all in the early phases of development and provide tremendous growth potential for years to come as we further leverage our restaurant assets.”


“Next, I want to provide an update on our China margin expectations. Let me start by discussing our pricing strategy in China as our approach continues to evolve. Historically, our pricing actions have been implemented nationally and all at one time. Going forward, we will take pricing across our system at various levels and at different stages, depending on the trade zone. This will allow our team to more effectively monitor the consumer reaction to pricing."


“In 2011, we had a 3% price increase at the end of January. With the phase-in pricing approach, we have a relatively small impact from new pricing in the second quarter. As a result, we will likely see a decline in margins in the second quarter that is somewhat higher than what we saw in the first quarter. However, we are still roughly on track with what we outlined in our December meeting.”


“As you may recall, we estimated that first quarter margins would be about two points below last year. As the year progress, we expect the combination of our cumulative staged pricing and moderating inflation to result in year over year margin improvement of up to 2% in the second half of the year. I'm confident the team will continue to generate annual Restaurant margins of about 20%.”


“As we look into the balance of 2012, I believe that this will be another year of improvement to our competitive position and our business model. Our new unit development opportunities are as robust as they have ever been. Higher return new unit development continues to be the foundation of our growth in China. As I've said before, it's a pretty easy decision to improve capital investments when you have average cash paybacks of less than three years. It's even easier when you know how much discipline our China team incorporates into the development process."


"Now I want to provide a brief update on Little Sheep. As indicated on our fourth quarter call, with revenue of about $300 million, the Little Sheep business will add about 5% to our revenue base in China this year. In 2011, the Little Sheep business started strong but struggled in the second half of the year. Operating profit was about $20 million for the full year. We are still in the process of getting our arms around Little Sheep as we transition this business into Yum! China. We will begin reporting Little Sheep numbers in our second quarter results."


"I want to reiterate when you take into account transaction and transition costs, we expect only a modest profit benefit, if any, in 2012. However, we remain excited about having Little Sheep in our portfolio and we believe in the long-term potential of the brand and will invest behind its future success.”





“The biggest impact, we said we expect sales to moderate, but the impact is really inflation was very, very high in the third and fourth quarters last year. We got behind from a pricing standpoint. We think this staged pricing will start to have an impact in the second half of the year."


"Plus we expect inflation to moderate in the balance of the year. Again, to put things in perspective on the inflation side, on the commodity side in particular, we said going into the year, we expected 6%. We had 10% in the first quarter. If anything, we're gaining more confidence that 6% is the high end of what we expect from commodity inflation. So you have that benefit plus the cumulative pricing coming in that should help the margins in the second half.”


HEDGEYE – For YUM, the MACRO outlook on China is difficult to read.  The Chinese government is trying to make the

economy more dependent on consumption and less on exports.  To the degree that it is successful, YUM’s brands will benefit.  Consumer confidence has been trending lower since 2007, but has improved in early 2012.  Longer-term the potential for a housing bubble could hurt consumption.  The biggest hurdle the company faces are difficult same-store comparisons from 2011.



“Our ongoing model does not meet the high level of same-store sales growth that we've recently experienced. We expect same-store sales to moderate at some point, although it's difficult to tell when that will occur. The important point is during 2012, we are again building up day parts and initiatives that can help drive sales well into the future.”


“I think it's really hard to forecast same-store sales in a year, in 2012 coming off a year like 2011, which was so strong from a same-store sales perspective. On the positive end you have momentum, on the negative side you know you're going to be lapping some big numbers, especially as we get into the second half of the year. We're not going to give a forecast for the second quarter. What I would say is traditionally we let people know if there's a significant bending in the trend. And we're not saying there's a huge change in the trend versus what we saw in the first quarter. So we're obviously off to a very good start.”


HEDGEYE – The comments are referring to the fact that SSS will slow in China sooner rather than later, but primarily as a result of difficult comparisons.  News from other consumer product companies would suggest that YUM could see a significant slowdown this quarter.



“For Yum! Restaurants International, our sales results have been mixed in Western Europe and we expect this to continue, at least in the near term. Our focus in our strategic growth markets remains, driving profitable new growth development.”


HEDGEYE – Fortunately for YUM, Western Europe is a small part of the business and it’s primarily franchised.  That being said, “Slowing growth” compresses equity multiples! 



“In the United States, we expect strong second quarter sales at Taco Bell. The first quarter included only a few weeks of the Doritos Locos taco sales. This has been an enormously successful product introduction and thus far the second quarter sales at Taco Bell are running higher than they were in the first quarter. For the second quarter, we expect same-store sales at Taco Bell to be in the high single digits or low double digits.”


HEDGEYE – The Company reiterated the comment about Taco Bell’s performance on 5/8 but failed to mention it in two other conference appearances.  How refreshing after a five year drought that we are seeing YUM’s business in the USA post strong numbers.  Especially compared to what’s happening in a number of key regions around the world, the USA is looking stable, and Taco Bell has some momentum.  





“In our U.S. business, the 53rd week provided $18 million of operating profit benefit in the fourth quarter of 2011. This benefit was offset with higher spending throughout the year including franchise development incentives and higher than normal costs from restaurant closes. While the combined full-year impact is modest, the 53rd week will have a significant operating profit headwind for the U.S. in the fourth quarter of this year.”


"It will also negatively impact Yum! Restaurants International profits by about $8 million in the fourth quarter. International development continues to be quite strong. We opened 297 new units in the first quarter and our new unit pipeline is solid. We are expecting to open over 1,500 new international units in 2012, including 800 at Yum! Restaurants International, 100 units in India, and at least 600 in China. This is a key growth driver in 2012 and 2013 and I am encouraged by this pace of development."





“Our expected full year tax rate is about 26% prior to special items. This is almost two points higher than our 2011 effective tax rate of 24.2%. A full year rate of 26% would result in a drag of about three points on full-year EPS growth. We expect the year over year impact on tax to be severe in the second quarter, due to the unusually low rate of 16.7% last year. This will materially impact our second quarter EPS growth.”


HEDGEYE – Both of these issues are cosmetic and can be fodder for the bear case.  This is not a substantial concern and might be the least of the company’s concerns if the operating environment in China is as difficult as some believe.


YUM - THE 2Q12E REMIX - yummetx




YUM - THE 2Q12E REMIX - yumchinasss


Howard Penney

Managing Director


Rory Green



The Macau Metro Monitor, July 17, 2012




Non-performing loans surged in the city of Wenzhou, Zhejiang province in June 2012 to 2.69% of overall loans, up from 1.33% at the beginning of 2012.  Wenzhou was named a pilot zone in March to test a series of financial reforms aimed at ending reliance on shadow banking.  Bad loans has reached 18.1 billion yuan (US$2.8 billion).  In June 2011, the bad loan ratio was 0.37%, one of the nation's lowest.  Since then, the rate has been increasing as growth slows in the city.



According to internal documents obtained by reporters working for the University of California's Investigative Reporting Programme, as part of an ongoin collaboration with ProPublica and PBS, there was a September 2009 email from Leonel Alves to Steve Jacobs, where the lawyer (Alves) says the unnamed high-ranking person claimed he could help Sands China to gain government authorisation to sell units at its Four Seasons luxury apartment hotel.  The deal was also to include a settlement for the on-going litigation process between Sands and Taiwanese Asian American Entertainment Corporation Ltd, led by businessman Marshall Hao.  Another email dated December 2009, shows that in return, the unnamed person requested US$300 million (MOP2.4 billion).


The alleged emails also show that Sheldon Adelson instructed Jacobs to pay about US$700,000 in legal fees to Alves, a move opposed by the company’s general counsel and an outside law firm, who warned that the arrangement could potentially violate the Foreign Corrupt Practices Act, as Alves was (and still is) a Macau legislator, and a member of the Executive Council, an advisory body to the Macau government.  He is also a member of the Chinese People’s Political Consultative Conference.

In an interview with the Portuguese channel of Radio Macau aired over the weekend, Mr Alves said the person who approached him in Beijing was not a high-ranking Beijing official, but a high-profile Macau developer.  Alves confirmed the US$300 million request, and added that Mr Jacobs ordered him to continue negotiating regarding the Four Seasons deal only.  He said during the interview that Jacobs was willing to pay up to US$500,000 to the Macau developer for “consultancy services” regarding the Four Seasons serviced apartments.  According to Alves, such “consultancy services” would have meant assisting to publicly clarify the concept surrounding integrated resorts and apartment hotels.  However, the middleman refused the offer and the negotiations ended there, according to Alves, who claims all negotiations were legal.



The Venetian Macao was hit last night by a bomb scare.  The presence of a suspected bomb at the hotel-casino’s premises led the police to evacuate and seal off part of the property’s west lobby and car park, although the casino remained operational.  The suspicious box contained two small megaphones.

Hedgeye Statistics

The total percentage of successful long and short trading signals since the inception of Real-Time Alerts in August of 2008.

  • LONG SIGNALS 80.46%
  • SHORT SIGNALS 78.35%


TODAY’S S&P 500 SET-UP – July 17, 2012

As we look at today’s set up for the S&P 500, the range is 26 points or -1.08% downside to 1339 and 0.84% upside to 1365. 











  • ADVANCE/DECLINE LINE: on 07/16 NYSE -306
    • Down versus the prior day’s trading of 2044
  • VOLUME: on 07/16 NYSE 602.07
    • Decrease versus prior day’s trading of -11.85%
  • VIX:  as of 07/16 was at 17.11
    • Increase versus most recent day’s trading of 2.21%
    • Year-to-date decrease of -26.88%
  • SPX PUT/CALL RATIO: as of 07/16 closed at 1.47
    • Down from the day prior at 1.62 


BERNANKE – what started slowing growth, globally, in late Feb early March was Bernanke’s pushing of the goal posts on 0% money to 2014; oil ripped and consumption growth slowed – so, now the Qe people want more of that? Brent Oil busting back towards $104 this morning is only going to compound the #GrowthSlowing problem in July. 

  • TED SPREAD: as of this morning 36
  • 3-MONTH T-BILL YIELD: as of this morning 0.09%
  • 10-Year: as of this morning 1.48%
    • Increase from prior day’s trading at 1.47%
  • YIELD CURVE: as of this morning 1.25
    • Unchanged from prior day’s trading 

MACRO DATA POINTS (Bloomberg Estimates): 

  • 7:45am/8:55am: ICSC/Redbook retail sales
  • 8:30am: Consumer Price Index M/m, June, est. 0.0% (prior -0.3%)
  • 8:30am: CPI Ex Food & Energy M/m, June, est. 0.2% (prior 0.2%)
  • 9am: Total Net TIC Flows, May (prior -$20.5b)
  • 9am: Net Long-term TIC Flows, May, est. $41.3b (prior $25.6b)
  • 9:15am: Industrial Production, June, 0.3% (prior -0.1%)
  • 9:15am: Capacity Utilization, June, 79.2% (prior 79.0%)
  • 10am: NAHB Housing Market Index, July, est. 30 (prior 29)
  • 10am: Bernanke delivers monetary policy report to Senate
  • 11am: Fed to sell $7b to $8b notes maturing Feb. 15, 2014- Aug. 31, 2014
  • 11:30am: U.S. to sell $ 4-week bills
  • 1:15pm: Pianalto speaks on economy in Erie, Pennsylvania
  • 4:30pm: API inventories 


    • House, Senate in session
    • HSBC officials appear before Senate Homeland Security subcommittee to testify on lapses in London-based bank’s money-laundering controls
    • Bernanke will discuss the outlook for economy, U.S. central bank monetary policy in semi-annual report to Congress
    • CFTC Chairman Gary Gensler testifies before Senate Agriculture on Dodd-Frank, consumer protections; Robert Cook, SEC’s director of trading, also gives testimony
    • Committee for a Responsible Federal Budget holds event on debt reduction at National Press Club, with Dave Cote, CEO of Honeywell International; Larry Fink, CEO of BlackRock; Paul Stebbins, CEO of World Fuel Services, 2pm
    • Bloomberg Government hosts breakfast with Southern Co. CEO Thomas Fanning; NextEra Energy Chairman Lew Hay; NV Energy CEO Michael Yackira, 8am
    • FERC, Energy Dept. hold technical conference on small generator interconnection agreements, 9am
    • Senate Energy holds hearing on protecting the electric grid from cyber attacks, 10am
    • House Energy panel holds hearing on alternative fuels, vehicles, 3pm
    • U.S. International Trade Commission meets on third review of stainless steel bar from Brazil, India, Japan, Spain, 11am
    • Former Fed Chairman Paul Volcker speaks at State Budget Crisis Task Force discussion, 11am 


  • Yahoo names Google’s Marissa Mayer as CEO
  • Joblessness issue prompts Fed to shift its focus as Bernanke set to testify to Senate committee today
  • Fed’s George says U.S. growth may not exceed 2% in 2012
  • Spain borrowing costs fall at 12-month bill auction
  • U.K. inflation falls to 2.4%, lowest rate in 2 1/2 yrs
  • HSBC probe shows bank allowed laundering, dodged Iran sanctions
  • Libor manipulation losses probed by 5 state AGs
  • Consumer price index in June probably was little changed
  • US Airways, American Eagle pilot leaders to meet: union 


    • Host Hotels & Resorts (HST) 6am, $0.33
    • Mattel (MAT) 6am, $0.21
    • Comerica (CMA) 6:40am, $0.62
    • Mosaic (MOS) 7am, $1.15
    • Omnicom Group (OMC) 7am, $1.01
    • Goldman Sachs (GS) 7:30am, $1.18
    • State Street Corp (STT) 7:17am, $0.97
    • Coca-Cola (KO) 7:30am, $1.19; Preview
    • TD Ameritrade Holding (AMTD) 7:30am $0.26
    • Johnson & Johnson (JNJ) 7:45am $1.29; Preview
    • Forest Laboratories (FRX) 8am, $0.32; Preview
    • Kansas City Southern (KSU) 8am, $0.84
    • M&T Bank Corp (MTB) 8am, $1.69
    • McMoRan Exploration Co (MMR) 8am, $(0.13)
    • Charles Schwab (SCHW) 8:45am, $0.18
    • Intel Corp (INTC) 4:01pm, $0.52
    • CSX Corp (CSX) 4:01pm, $0.47
    • Wynn Resorts (WYNN) 4:02pm, $1.49
    • Yahoo (YHOO) 4:05pm, $0.23
    • Albemarle (ALB) 4:05pm, $1.22
    • Fidelity National Info Svcs (FIS) 4:05pm, $0.59
    • United Rentals (URI) 4:15pm, $0.50
    • AAR (AIR) 4:24pm, $0.46
    • Fulton Financial (FULT) 4:30pm, $0.20
    • Cathay General Bancorp (CATY) 4:30pm, $0.32
    • MB Financial (MBFI) Late, $0.38
    • Equity Lifestyle Properties (ELS) Late, $1.02
    • Ironwood Pharmaceuticals (IRWD) Unknown time, $(0.31) 



OIL – Oil looks different than Gold coming out of the weekend’s Israel/Iran chatter; there is nothing that will slow the world’s marginal real-consumption growth than higher oil prices; rising food/oil prices also puts further Chinese rate cuts on hold don’t forget. 

  • Good Dirt Gone Dry Wilting Corn as Food Costs Gain: Commodities
  • Oil Supplies Decline for Fourth Week in Survey: Energy Markets
  • Oil’s Center of Gravity Shifts Toward Asia: Chart of the Day
  • Rio Tinto CEO Closely Watching Economic Turmoil as China Slows
  • Oil Near Seven-Week High on Iran Tensions, Stimulus Speculation
  • Corn Slides From 13-Month High as Demand Slows for Fuel and Feed
  • Gold Set to Gain in London on Speculation Over Further Stimulus
  • Copper Seen Rising Ahead of U.S. Data and Bernanke Testimony
  • Sugar Falls on Surplus Outlook; Cocoa Gains on El Nino Concerns
  • Iron Ore Drops to Lowest Price Since May as Chinese Demand Wanes
  • Rubber Gains as China May Add Stimulus, Thailand Boosts Support
  • Palm-Oil Refining Capacity Seen Climbing 24% in Indonesia
  • Zinc Poised for 9% Rally on TD Buy Signal: Technical Analysis
  • Mosaic Doubles Dividend as Profit Beat Estimates on Planting
  • Soybean Acres in India to Climb as Record Prices Boost Planting
  • Palm-Oil Options Seen Boosting Futures Volume on Malaysia Bourse





US DOLLAR – get the Dollar right and you’ll get today/tomorrow right; watching that closely into and around Bernanke at 10AM EST; if we had to bet (we don’t, so we won’t take a position until we see the river card), USD and Gold are saying Bernanke doesn’t deliver the drugs. USD remains in a Bullish Formation and Gold a Bearish one.




















The Hedgeye Macro Team

A Crisis of Confidence







Another day of what Jesse Jackson would call “keep hope alive.” The market is rallying pre-open this morning as the masses use hope as a risk management process. The hope is that Fed Chairman Ben Bernanke will continue on his path of quantitative easing, kicking the goalpost down the line past the current 2014 date. And in turn, oil is ripping higher with Brent crude at $104 a barrel. It appears everyone really enjoys those prices at the pump.



...and you get a lot of other things right, especially in lieu of Bernanke today. Get the USD right and you’ll solve the correlation puzzle connected to commodities, oil, currencies and equities. Just so you know: we view the USD in a bullish formation and gold in a bearish formation.



71% of the US Economy is based on consumption. That’s a lot of big macs, Ford trucks and Chinese buffets. The inflation in food and oil we’ve experienced since the dawn of the age of QE has pissed the public off and with good reason. Why people continue to subject themselves to $10 boxes of cereal and $5 a gallon gas is beyond us. You get the US economy right and it helps guide you on the slope of growth.




Cash: Up                U.S. Equities: Down


Int'l Equities: Down    Commodities: Down


Fixed Income: Up        Int'l Currencies: Down





The bulk of the bad news is on the table following disappointing F2012. Rebased F2013 estimates far more reasonable, and revenues should be supported by our expectations for rising physician utilization, and in the near-term, a flu season that is shaping up as a considerable tailwind.







SS volume accelerated in 1Q12 and employment remains a tailwind to both admissions & mix. We expect acuity to stabilize and births and outpatient utilization to accelerate out of 1Q12, while supply cost management continues as a margin driver and acquisition opportunities remain a source for upside.







The company continues to control its own destiny through investments in all the right areas. We think 30%+ top line and EPS growth for 5+ years. One of its failures, however, has been in penetrating markets outside the US. That will happen. But for now, its failure is a competitive advantage in the face of a strengthening dollar. We like it in sympathy with a LULU sell-off.








Tweet of the Day: “BoE's KING: First we knew of LIBOR fraud was two weeks ago; BoE not responsible for regulation of markets.”-@DailyFXTeam


Quote of the Day: “Character is much easier kept than recovered.” –Thomas Paine


Stat of the Day: CHINA: +0.6% for the Shanghai Comp on the bounce after yesterday's -1.7% smackdown






Lie-bor Losses Set to Balloon

This note was originally published at 8am on July 03, 2012. INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK (published by 8am every trading day) and PORTFOLIO IDEAS in real-time.

“The fellow that can only see a week ahead is always the popular fellow, for he is looking with the crowd. But the one that can see years ahead, he has a telescope but he can't make anybody believe that he has it.”

-Will Rogers


To Will Rogers’ point, telescopes are in short supply these days. Ask an investor what they would have predicted for the XLF three years ago, and chances are their reply wouldn’t have looked much like the chart at the end of this note. The reality is that it’s a natural investor tendency to extrapolate the recent past as the most likely path for the next twelve months of trading. Obviously, the problem with this approach is that it misses big turning points.


Looking at the last three years there have been at least six big turning points in the Financials space. We’re not talking about small rallies or corrections. Being on the right or wrong side of these big moves has made or broken investors’ years.


What’s so interesting to us is that in hindsight they seem to follow a very recurring and seemingly predictable pattern. The XLF peak in 2010, 2011 and 2012 occurred on April 14, February 21 and March 26, respectively. The XLF low for those same years occurred on August 30, 2010, October 3, 2011 and as-yet-to-be-determined, 2012, though no earlier than June 4.


We’ve come up with a framework for thinking about why the pattern seems to rhyme so consistently over the last three years. The foundation of the framework is the distortion of government economic data, which was introduced by faulty seasonal adjustment factors arising from Lehman Brothers’ bankruptcy. The recurring annual effect makes many of the government’s data series appear stronger than they really are from September through February and weaker from March through August. We’ve quantified this effect in the initial jobless claims series, and it is strong enough to create the illusion of both robust recovery in Q4 and Q1 of each year and an economy teetering on the brink of recession in Q2 and Q3. Given that we just entered Q3 on Monday, we think the effect still has a few months to go before predictably beginning to reverse.


The second thing to understand is that central banks play a predictable role in exacerbating this trend. As the data appears to weaken steadily over the course of the March through August period, the calls for QE grow louder. In 2010 this culminated at Jackson Hole with the unveiling of QE2. In 2011 QE-Light (aka Operation Twist) was unveiled in September while the ECB’s large-scale LTRO program came out that December. The takeaway here is that the announcement or start of these massive intervention programs coincides with the turning point in the cycle when the economic data is already beginning to roll from bad to good.


This phenomenon is likely to be with us for the next two years. Government seasonality models work on a five year look back, this being the third year following the incorporation of the original data distortion. As such, we’d expect to see this effect present itself again in 2013 and again in 2014. That said, the effect should become progressively smaller, as the government models weight older years less heavily than more recent years.


There are other factors at play. For instance, May 2010 saw Dodd-Frank roll out – a major Financials sector overhang. 2011 saw the debt ceiling debate culminate in the S&P downgrade of the United States. Additionally in 2011, the large cap banks were plagued by mortgage putbacks and Basel III SIFI concerns; none more so than Bank of America. And, of course, Europe has played a central and recurring role in the last three years. This year it’s a combination of Europe (again) and angst over how punitive the Volcker Rule will be for the large banks.


Looking ahead, the most likely candidate on the radar for the next large-cap bank boogeyman is the rapidly emerging LIBOR scandal. So far it has claimed only Barclays as a victim, as that bank agreed to pay three regulators a total of $451 million in penalties in addition to actually admitting wrongdoing – when was the last time you heard a bank admit that? Specifically, the bank has acknowledged that it deliberately reported artificial borrowing rates from 2005 through 2009. The company’s Chairman resigned over the weekend and CEO Diamond bowed to the pressure to resign this morning. Barclays got a slap on the wrist in exchange for enormous cooperation in helping regulators understand the extent of the wrongdoing. Remember that price fixing is a criminal violation under the Sherman Act, so Barclays was treated with kid gloves. The fear that the large US banks will be treated less favorably is appropriate.


There are approximately $10 trillion in loans tied to Libor and another $350 trillion in notional value derivative contracts linked to the rate. Just one basis point of that notional total, for reference, equates to $36 billion. Early indications suggest that Libor may have been manipulated by as much as 30-40 bps, though this has yet to be confirmed. Any way you slice it, the math is big. Back in the Fall of 2010 we estimated that the mortgage putback fiasco would cost the big banks $49 billion in total, with Bank of America shouldering almost half that amount. Putbacks were the principal concern driving BAC shares down to $4.99 (38% of tangible book value). Given the magnitude of the affected securities in this scandal, it doesn’t seem hard to imagine a class action process that reaches into the tens of billions of dollars, with fears and chatter about “hundreds of billions”. We expect this issue to heat up over the coming 12 months as there are active investigations by the Dept. of Justice into all the large banks involved in setting LIBOR. Domestically, JPMorgan, Citigroup and Bank of America appear at risk.


Perhaps the most important thing to understand is that the big banks have, in the last few years, been overshadowed by one cloud of uncertainty after another: mortgage putbacks, AG settlements, Durbin, Reg-E, Volcker, etc. Until it’s crystal clear to the market how much an issue is going to cost and/or how detrimental it will be to the business going forward, the market shoots first and asks questions later. This Libor scandal fits that mold perfectly: it’s big, it’s as yet unquantifiable and the media is in the bottom of the first inning getting its arms around what’s happened. The numbers that will start to get thrown around will be staggering: “trillions”. Very few investors, as well as the banks themselves for that matter, will have any real handle on what the loss profile may look like. As such, the prospects for the large banks finally achieving escape velocity out of their March 2009 to February 2011 price/tangible book value ranges is unlikely over the next year.


As a final point, it’s worth pointing out where we are in this current cycle. It certainly looks as though 6/4/12 was a possible major turning point. From our vantage point the most glaring difference between this year and the last two years is the level of recorded fear. In both 2010 and 2011 the VIX exceeded 45 briefly and traded for some time above 30. So far in 2012 the VIX has only exceeded 25 on a few days and hasn’t exceeded 30 at all. Considering this emerging LIBOR scandal and that the problems in Europe seem larger today than what we faced in 2011 or 2010, it strikes us as counterintuitive that the market would be less afraid today.


Our immediate-term support and resistance ranges for Gold, Oil (Brent), US Dollar, EUR/USD, Germany’s DAX, and the SP500 are now $1593-1615, $92.99-98.53, $81.41-82.31, $1.23-1.27, 6284-6581, and 1337-1373, respectively.


Josh Steiner, CFA
Managing Director


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