Bullish Fundamental Of The Day: That Big Ole Chinese Ox!

The Ox is waking up…

As Keith Noted in our Early Look note, China released seasonally adjusted PMI for January of 45.3 versus 41.2 reported in December and, importantly, significantly above the November low of 38.8. Although any number under 50 represents a contraction, the positive delta here is significant -particularly when taken in context with modestly rising indicator levels in recent weeks like base metal prices and shipping rates.

Positive industrial data points are signaling that the Ox is waking up. Unemployment however, particularly job losses by rural migrants who labored in consumer goods manufacturing spaces that will likely never return to previous output levels, is a lagging factor that will likely continue to rise in coming months. The rising jobless numbers will keep public pressure on Beijing as the second wave of the stimulus program works through the system. The major infrastructure projects which are slated to commence in Q2 should relive some of that pressure, but the topic will be a continuing source of negative headlines until then. We are expecting this bad news and have factored it into our thesis.

We remain bullish on the Chinese Ox and will be following all data points both from within China and from its major trading partners as we continually test our convictions.

Andrew Barber


I have not written about sustainability in a very long time. Two years ago, nearly my entire investment thesis for the restaurant industry was centered on the sustainability of a company’s growth model. Needless to say, back then, many restaurant companies were growing well beyond their means. There is now clear evidence that YUM has pushed the growth model too hard and the strain of that growth is starting to emerge.

YUM is growing too fast, especially in China!

For YUM, 40% of senior management compensation is keyed off of growth in system wide sales and new units, which are effectively one in the same. Another 50% of their compensation is driven off of EPS growth. I believe, therefore, that they have a compromised disposition toward growth. If you don’t grow, you don’t get paid! As a result capital spending needs to go up every year in order to hit growth targets. Since 2005, YUM capital spending has grown by nearly 60%.

YUM’s 2007 proxy was the first proxy in which the company laid out a table that showed the performance targets and the weightings used to determine management compensation. This implies that the philosophy was in place for 2006. So guess what happened in 2007? You got it – there was a dramatic increase in capital spending (up 21% in 2007 from up nearly 1% in 2006) and new unit development. In 2005 and 2006 YUM’s international system (China and YRI) built 1,189 and 1,181 units respectively. In 2007, (year 2 of the new compensation structure) the YUM built 1,358 new stores in China and YRI. In 2008, YUM grew its international restaurant base by nearly 1,500 stores and total capital spending grew by 26%.

YUM’s capital spending reflected as a percentage of revenues was 8.3% for fiscal 2008, up from 7.1% and 6.4% in 2007 and 2006, respectively. I know that there will be more than a handful of people who will disagree with me, especially the company, but there is a direct correlation between management’s compensation structure and the company’s growth trajectory. Importantly, this is going to end badly for the company.

People outside the U.S. use QSR restaurants differently than they do in the U.S. In most countries around the world, especially less developed countries, QSR restaurants are used more like a casual dining and special occasion restaurant. Global economies around the world are slowing at the same time YUM has elevated its level of unit development.

4Q Results:

At first glance, YUM’s 4Q results looked strong with revenues up 8% for the full year and earnings growing nearly 14%. This growth continues to be fueled, however, largely by unit growth (up nearly 3% for the full year) and share repurchases. The company spent $1.6 billion to purchase 47 million shares, reducing its full-year diluted share count by 9%. This continued aggressive spending does not come without cost as the company outspent its cash generated from operations on capital spending needs in the fourth quarter, which is not a sustainable trend. This is the first quarter that YUM’s net CFFO/net income turned negative since 4Q05. With the company’s capital spending increasing 26% year-over-year, the company had to increase its borrowings to fund its share repurchases.

The company has said that it will suspend its share repurchase program at least in the first half of 2009 in order to build liquidity, which is encouraging, but it expects to maintain a similar level of capital spending of about $900 million. At its analyst meeting on December 10, 2008, YUM management said that it expected to spend $900 million in FY08 and that number ended up being $935 million so I would not be surprised to see the FY09 number move higher as well as YUM has become addicted to spending with capital spending growth exceeding sales growth by nearly 18% in FY08 and 12% in 2007 (again, not sustainable).

Same-store sales trends in China slowed considerably in December as YUM had reported that quarter-to-date comparable sales were up 4% through November 30, but closed out the quarter only up 1% (a timing shift in December hurt by 1%). YUM was lapping a difficult 17% comparison in the fourth quarter but this slowdown was worse than expectations. EBIT margins declined again in China in the fourth quarter (down 190 basis points) as a result of continued commodity and labor inflation. YUM expects to face similar challenges in 1Q09 as YOY commodity pressures will be more severe in 1H09 and the company is lapping 13% same-store sales growth and 35% operating profit growth in the first half of the year. Despite these challenges, YUM is maintaining its FY09 unit growth targets in China. Management did acknowledge that the pace of new unit openings has inevitably led to some sales transfer between units and cannibalization, but that the overall sales lift warrants the openings. New unit growth at the expense of sales cannibalization is typically a sign of bad things to come.

One bright spot in the quarter was the 7.7% operating profit growth in the U.S. The U.S. results were helped by the company’s refranchising efforts. Although U.S. operating profit still declined 6% for the full year, this sequential improvement and positive YOY U.S. restaurant and EBIT margins in the quarter was encouraging as the U.S. continues to be the largest contributor to total company operating profit representing about 40% of segment operating profit. These positive results, however, are expected to reverse in the first quarter. The first quarter will be made more difficult by the fact that the company does not expect to fully realize the financial benefits of its G&A restructuring until 2Q. Additionally, YUM is expecting to turnaround its KFC business in FY09 but this turnaround relies on the success of its Kentucky Grilled Chicken launch, which is also a 2Q event. Management said that U.S. sales trends have started the year below its initial expectations and that there is now more downside risk to its estimate of a mid-single digit decline in U.S. operating profit in 1Q.

Apparel Data Check: Bad End to January

Sales in January decelerated/declined sequentially right up until the very end. It’s all about share. UA is holding its own. Nike getting better – though not in the channel I want to see.

No improvement to athletic apparel trends over the past week. In fact, the 3-week trend continues to erode with the only saving grace being a double digit (11%) boost in average selling price. Hardly enough, however, to offset a 16% decline in unit sales. This price point trend is partially driven by a relatively clean channel, but moreso due to a shift in mix toward higher-priced outerwear vs. last year.

While no brand is out of the woods, UnderArmour’s share is holding its meaningful bounce over the past four weeks of about +300bp vs. last year.

Nike’s share is improving on the margin, which is nice to see. Though it is important to point out that the lion’s share of growth is coming from Family Retailers (the Kohl’s of the world) as opposed to more traditional Sports retailers.

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America: Was November The Low?

America: Was November The Low?

It certainly was across all of the quantified metrics that I have in my notebooks. Historical facts are hard to fight.

Today’s market strength is based on this reality - the easiest leading indicator for momentum traders to understand is the most obvious one that they have to abide by – price. The US stock market is not trading on valuation, it’s trading on price momentum.

Inclusive of today’s +1.25% move in the SP500, the US stock market is trading +12.9% higher than the November low. The chart below shows what matters most to the USA’s GDP (non-manufacturing growth), and it too looks to have bottomed in November. This morning’s non-manufacturing ISM reading of 42.9 is what it is now, a historical fact.

On top of these economic readings, we had a better a much better ADP payroll number reported for January (vs. last month) at 522,000 vs. 659,000 in December, and we also had an improvement in the weekly ABC/Washington Post consumer confidence reading. Add these facts to yesterday’s pending home sales (December report), and you have a handful of metrics to wrestle with that are much better than where we were in America during the October/November Liquidity Crisis.

At the November lows, both America and the world stopped. Now, albeit with a cautionary yellow light, economic traffic is at least moving again.

Keith R. McCullough
CEO & Chief Investment Officer

The Barking Lot

“One dog barks because it sees something; a hundred dogs bark because they heard the first dog bark.”
-Chinese Proverb

Thank God for Chinese proverbs and the cash on their balance sheet. As consensus continues to doubt China’s economic resolve, the Shanghai Stock Exchange continues to run the consensus short sellers right over.

When this week’s cover of The Economist is titled “Asia’s Shock”, the notion that being short China is a unique concept renders itself quite reckless. The Chinese own the two things that American investment bankers need most, cash and liquidity. They are putting that cash to work, surgically via stimulus, and seeing some impressive results. Last night, stocks in China added another +2.3%, taking their 3-day Year of the Ox move to +5.8%, and putting the Chinese stock market up +15.5% for 2009 to date. Yes, as the great Tim Russert would say, “This is BIG.”

Why is it big? Could there be fundamentals supporting McCullough’s China barking? Aren’t the Chinese making up the numbers like Madoff did? These are all questions that inquiring momentum chasers would now like to know the answer to…

Everything in global macro that really matters happens on the margin. The delta in the Chinese PMI report last night improved significantly. China printed a real time manufacturing reading for January of 45.3 versus 41.2 reported in December and, importantly, significantly above the November lows. China’s central bank governor, Zhou, followed up with comments to the world’s media that the $586B stimulus plan is proving to have “initial positive results.” Indeed, Mr. Zhou, indeed…

This Chinese re-acceleration is not a surprise to us. We have been calling for both a sequential and seasonal lift in Q1 (versus Q4’s lows) for China for some time now. Greenspan and Clinton taught China this “go to” fiscal/monetary dance move – should that move work for America and no one else? Of course not – that’s silly. The reality is quite simply that this is one of the largest domestic stimulus plans in economic history – and it will have an impact!

Cutting rates, cutting taxes, and infusing stimulus is not the trifecta that an investor should be shorting AFTER a stock market has crashed. However fleeting the fundamentalists believe the “re-flation” trade may be, stocks can go up, a lot longer than the short seller can remain solvent. We know this - we have learned that lesson the hard way. We also know that being one of a hundred economic dogs barking about the same negativity is as dangerous a place to be as when they were chasing each other’s tails in the land of positivity.

Stocks in Brazil seem to be starting to discount that the government could start to provide aggressive economic stimulus as well. Brazil’s stock market raced +2.8% higher yesterday, taking the Bovespa Index to 39,746, and +5.8% for 2009 to date. While Brazil is underperforming the Chinese gold medalists, they are “re-flating” just the same.

Back to America, the question remains – can the US stock market continue to “re-flate” from her November lows? So far, at every opportunity to be proven wrong, The New Reality bulls have run the bears right over on that front. After yesterday’s +1.6% move, the SP500 is now trading +11.4% from that November “Liquidity Crisis” low of 752.

Impressively, this US portfolio “re-flation” has occurred with some of the horse and buggy whip US Financials all but going away. Can the US stock market continue to make higher lows without the financials? Yesterday it certainly did. In the face of a great move in Consumer Discretionary and Healthcare, the XLF (SP Financials Sector) was down another -1.8%.

The reality is that once you take stocks to zero (and make no mistake, Obama will let more banks go there), the mathematical probability of putting higher lows in an index containing those zeroes goes UP. While it may be entertaining for the manic media to keep you abreast of the daily malfeasance of investment banking executives, they represent less than 5% of the SP500 at this point. Been there, done that – let’s get on with the capitalism show before the Chinese really leave us behind.

I continue to worry that the Chinese will leave some Americans behind – mostly because they should. Some of the broken handshakes that our bankers issued to Chinese officials will never be forgotten. This is partly why the US Bond market is shaking right now (we are short US corporate bonds via the LQD etf; see our virtual portfolio at, and yields continue to push higher. When the largest US customer of Treasuries stops buying American, and invests their cash savings at home, it affects the math!

In a roundabout way, this is great for the next generation of American capitalists. Those who haven’t been barking with the dogs in the crowd – those who haven’t levered themselves up and own both their own liquidity and duration of their investments. As the bond market goes down, and the US yield curve steepens, that good ole fashion American industry of borrowing short and lending long starts to work again – if I am the only dog barking up that big ole oak tree of capitalism, I’m cool with that.

Into the US market’s weakness earlier this week I moved my position in US Cash back down to 79%. I know, call me wild and crazy getting all invested and stuff… patience will continue to pay dividends – unlevered returns on cash will remain king of The Barking Lot.

Best of luck out there today.

The Barking Lot - etfs020409


Wynn Resorts held a spot conference call to outline a cost reduction program that will save the company $75-100MM annually. Salary reductions and hourly cutbacks in Las Vegas will drive the majority of the savings. Management wouldn’t comment specifically on earnings other than to say that there will be a lot of “non-recurring” expenses.

The value added of this call to investors is limited. Why not at least provide some preliminary operating numbers? One explanation could be that they are still working their way through what expenses to classify as non-recurring versus being included in operating EBITDA. Starwood recently reported a quarter with over $350 million in “non-recurring” expenses that will no doubt benefit margins in future periods. WYNN definitely laid the groundwork for some big charges.

Margins are the wild card for Q4 and 2009. We are pretty sure the top line will be well below formal estimates as will true EBITDA. Street consensus revenue estimates of $737MM and $3.50bn for Q4 2008 and full year 2009, respectively, are probably each too high by about 10%. This is not a new call for us. We wrote about a potential earnings shortfall back in our 12/10/08 post, “NOV MACAU MARKET SHARE ANALYSIS”, and again in our 1/9/09 post, “WYNN: IT’S NOT JUST Q4 I’M WORRIED ABOUT”. After last night’s call, our call will now be the consensus call.

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