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Bad(ger) Choice or Good Choice?

Takeaway: Paul Ryan won’t help with Electoral College math, but could help Romney regain an edge in the debate on the deficit and economy.

After months of speculation, presumptive Republican presidential nominee Mitt Romney selected Wisconsin Congressman Paul Ryan to be his Vice Presidential running mate this weekend.  Now that the punditry has reacted and the partisan attacks have begun, we’ll give you our perspective.


In our view, this is likely a wise choice for Romney.  This election will be about two key issues: the national debt and the economy.  Ryan is one of the most well versed politicians on both of these topics and will be able to articulate a strong case against the Obama administration.   In fact, Ryan already has a well established history of challenging the President head-to-head, in particular on the budget deficit, as emphasized in this video:




Another key advantage stemming from this choice, may relate to the law of low expectations.  In hindsight, Sarah Palin was considered a weak choice for Senator McCain.  Initially, though, Palin was received very favorably.  In fact, according to Fox News polls right before the election McCain was at 39%, Obama was at 42%, and 19% was other/don’t know.  In the same poll, shortly after Palin was announced as McCain’s running mate, McCain jumped to 45% and Obama remained at 42%.


The real time reaction from Intrade was tepid at best as the Intrade market for a Romney Presidency actually moved down initially on the Ryan announcement, though it has since moved back up.  The key critique of the Ryan selection is that he doesn’t have the ability to deliver a key state like Ohio (Portman) or Florida (Rubio).  Admittedly Wisconsin does help at 10 electoral votes, but both Ohio and Florida are more critical at 18 and 29, respectively.   Clearly Romney was thinking more about elevating the key debates rather than solving for electoral math.  Indeed, Ryan’s ability to own these debates may be critical heading into the fall.


Longer term, we think that Ryan is potentially an intriguing Vice Presidential choice to the extent his voice gets heard.  More than a year ago, we published the note below about Ryan’s proposed budget plan.  It is worth a reread as a quick refresher on his fundamental economic policies and views.  In effect, he is very focused on shrinking the federal government and narrowing the deficit.   If and when the market views these policies as realistic, they will be very dollar bullish.


Daryl G. Jones

Director of Research



 Bad(ger) Choice or Good Choice?  - chart1a


Conclusion:  Simply put, the Ryan budget dramatically reduces the size of the federal government over the long run and thus reallocates capital back to the private sector, which could be incredible bullish for economic growth in the United States.


The current budget debate in Washington is amongst the most heated and partisan we’ve seen since the beginning of the Obama administration.  On the conservative side of the equation is, of course, the Ryan budget, which was introduced two days ago by Representative Paul Ryan the Republican from Wisconsin.   Philosophically, the basis of the budget is simple; it both reduces taxes and dramatically reduces the size of the government over ten years, with a focus on restructuring the cost of healthcare.


The Congressional Budget Office, at the request of Representative Ryan, presented their analysis of his budget yesterday.   In the introductory section of the analysis, the CBO stated:


“To prevent debt from becoming unsupportable, policy makers will have to substantially restrain the growth of spending, raise revenues significantly above their historical share of GDP, or pursue some combination of those two approaches.”


In theory, the budget situation is actually that simple:  either raise taxes or cut costs, or both.  Politically, and practically of course, the solution is far from simple, but the outcome of the Ryan budget, albeit at the expense of restructuring healthcare, may provide some real long term economic advantages for the United States versus the fiscal status quo.


The key components of the Ryan budget are as follows: 

  • Healthcare – The Ryan budget would convert the current Medicare system to a system of premium support payments and would increase the age of eligibility of Medicare.  On Medicaid, the federal share of Medicaid would be converted to block grants to the states, which would grow with population and CPI-U.  The Ryan budget would repeal all components of the 2010 Patient Protection and Affordable Care Act (more commonly known as Obamacare). Finally, several limitations of punitive damages in medical malpractice would be implemented; 
  • Other spending – Under the Ryan budget, mandatory and discretionary spending, other than that for mandatory healthcare (outlined above) and social security, are cut from 12% of GDP in 2010 to 6% of GDP in 2022 (this is below pre-WW2 levels); and 
  • Revenue – Under the Ryan budget, federal government revenues grow from 15% of GDP in 2010 to 19% of GDP in 2028, and remain at that level thereafter.  For comparative purposes the long run average of federal government revenue as a percentage of GDP from 1960 – 2011 is 17.6%.   So, in essence tax receipts in Ryan’s proposed budget are slightly above the long run percentage of taxes as share of the U.S. economy and ~27% above current levels. 

Unfortunately the CBO analysis didn’t offer a comparison of the Obama budget versus the Ryan budget, but they did offer a comparison of the Ryan Budget versus their Extended-Baseline Scenario (normal scenario) and Alternative Fiscal Scenario (draconian scenario).  In the table below, we’ve also included the CBO’s most recent estimates of the Obama budget, albeit the ten year budget ends in 2021 and not 2022.  The clear take away from the ten year budget comparison below is that the Ryan budget effectively outpaces both the federal government’s current fiscal path and the proposed Obama budget in reducing the budget deficit over the next decade.


 Bad(ger) Choice or Good Choice?  - chart2


The longer term fiscal benefits of the Ryan budget are even more compelling according to the CBO.  By 2050, the federal government would be running a 4.25% budget surplus (as a percentage of GDP) under the Ryan plan versus -4% in the CBO’s normal scenario and -26% in the more draconian scenario.  


In evaluating the long term benefits of the Ryan budget from an economic perspective, we think three key factors are most relevant, which are as follows:


Long term structural debt – The most thorough analysis of the impact of long term debt is This Time is Different by Carmen Reinhart and Kenneth Rogoff.  The key take away from their analysis is that as sovereign debt balances accelerate and eventually reach the 90% debt-to-GDP level, which we have coined the Rubicon of Sovereign Debt, growth slows dramatically. 


In fact, their analysis of 2,317 observations has a statistically significant 352 observations at, or above, 90% debt as a percentage of GDP.  Collectively these observations show us that GDP growth averages at 1.7% beyond the Rubicon of Sovereign Debt, which is almost three standard deviations below the collective growth rates at lower debt levels.  The Ryan budget by 2050 has debt-as-percentage of GDP at 10% according to the CBO, while the CBO’s baseline and draconian scenario take debt-as-percentage of GDP to 90% and 344%, respectively.


Declining government spending – For starters, government spending is a large percentage of GDP (between 29% and 35% in recent years), so, in theory, cutting government spending dramatically could be a drag on the economy.  Further, and as the argument of Keynesians, higher levels of government spending or stimulus are required in periods of below average GDP growth.


To test the impact of declining government spending introduced by the Ryan budget, we analyzed real GDP change from 1960 to 2009, and year-over-year government spending changes in the same years.   Interestingly, in the five years with the slowest year-over-year growth in government spending, GDP in those years grew on average 4.74%.  Conversely, in the five years with the largest year-over-year change in government spending, GDP grew 1.10%.  The average of real GDP growth over the entire period was 3.2%.  


Now, admittedly, this is a somewhat simplistic analysis, which we will be refining further.  A key pushback is obviously that as GDP growth slows, certain entitlements naturally kick in, and vice versa.  Interestingly, if we look at one year out after the five most dramatic ramp ups in government spending, GDP growth does reaccelerate to 3.3% on average, which is just above the long run average.  While this is encouraging for Keynesians no doubt, it is still somewhat anemic growth given easy comparables.  So, while this analysis needs refinement, it does appear to lend credence to the idea that government spending does not have a comparable return to the same capital allocated to the private sector.


Long term low taxation levels - Under the Ryan budget, federal government revenues grow from 15% of GDP in 2010 to 19% of GDP in 2028, and remain at that level thereafter.  For comparative purposes, the long run average of federal government revenue as a percentage of GDP from 1960 – 2011 is 17.6%.   So, in essence, tax receipts in Ryan’s proposed budget are slightly above the long run percentage of taxes as share of the U.S. economy. While this may seem less conservative, in reality, it’s quite conservative when compared to the current alternatives. For example, by 2022 the CBO baseline estimate has government taxes at 21% of GDP, and President Obama’s budget has government revenues as a percentage of GDP at 19.3% by 2021, while Ryan has this statistic at 18.5% by 2022. 


So, the long run debate continues, are lower taxes better or worse for the economic growth?  We know where we stand on that, but if you don’t believe us, take the CBO’s word for it, which in their analysis of Representative Ryan’s budget wrote:


“To the extent that marginal tax rates on labor and capital income would be lower as a result, future output and income would be greater in the long term, all else being equal.”


To many, the Ryan budget is scary.  It dramatically attacks the long term expenditures and structural deficits of the U.S. federal governments by cutting costs to unprecedented levels.  The reality is, though, based on the fiscal history of the modern United States, this plan could be wildly bullish for the U.S. economy in the long run as it dramatically allocates capital away from the government and into private hands where it will potentially be much more efficiently allocated.


Daryl G. Jones

Managing Director 



HedgeyeRetail Visual: PETM's Latent Commodity Exposure

Takeaway: $PETM's commodity inputs on its food biz (53% of revs) are ripping due to the drought. That's not helping its intermediate-term mgn outlook.

Conclusion: We wonder if the Street is fairly considering the relationship between commodity prices and PETM’s P&L. About 53% of PETM’s business comes from food, which is also the primary traffic driver in the stores. Relevant commodity prices have been ripping, and pricing power is minimal. It might be early to short, but with margins and productivity near peak, risk/reward looks unfavorable in the intermediate term.



History shows that the change in commodity prices (corn, chicken and beef) has a fairly low correlation to comp store sales. In other words, higher input costs don’t evenly through to the consumer.  In fact, look at 2006-2008, which was the last commodity spike. Comps actually went negative. See figures 1 and 3 below.


Comps started to recover in ’08 and into ’09 when commodity prices eased. But still not to a level great enough to exceed PETM’s occupancy hurdle – which we estimate to be about 4%. Note in that same chart that despite a comp recovery, margins were still trending lower.


Commodities are up about 60% since that 2009 trough, and PETM took comps higher by relying on categories other than food (services such as grooming, adoptions, training, vet services).  Note figure 2 below which shows mix going from 57% to 52% over the course of three years. As such, the company is now sitting at a peak comp on a peak margin – at a time when relevant commodities are ripping due to the drought.


The Street has generally not taken a stand on PETM in either direction headed into Wednesday’s print. The consensus is at the high end of management’s $0.61-$0.65 guidance, short interest is around 7-8% of the float, and there’s a fairly even dispersion between Buy and Neutral ratings.


In addition, in the grand scheme of big box retail, this is a decent-enough business – as sales comps are fairly predictable and inventory is easier to manage ( fish, parakeets and hamsters die at a lesser rate than apparel inventory goes out of fashion). Furthermore, compares don’t get tough on the top line for another two quarters. So it may be early to short.


But this is one that feels like risk reward does not favor the upside over the intermediate-term.


Figure 1: There's little evidence that PETM has any pricing power.

HedgeyeRetail Visual: PETM's Latent Commodity Exposure - petm1


Figure 2: Food as a Percent of mix has fluctuated.

HedgeyeRetail Visual: PETM's Latent Commodity Exposure - petm2


Figure 3: Commodity prices have little relationship with comps

HedgeyeRetail Visual: PETM's Latent Commodity Exposure - petm3

Lower-Highs: SP500 Levels, Refreshed

Takeaway: In mid-March, the sell signals were actually less obvious.

POSITIONS: Short Industrials (XLI) and SPY


I am sure someone will try to pin this market on its high again (via rumor or “buy imbalance”) into the close – then we call all say, together, “but the market is up YTD”, at 14-15 VIX. In mid-March, the sell signals were actually less obvious.


Been there, done that.


Across our core risk management durations, here are the lines that matter to me most: 

  1. Immediate-term TRADE resistance = 1407
  2. Immediate-term TRADE support = 1397
  3. Intermediate-term TREND support = 1369 

In other words, they can keep this puppy pinned up until every last short has covered… then you don’t want to know what happens next.


Or, if you’re short SPY, maybe you do?




Keith R. McCullough
Chief Executive Officer


Lower-Highs: SP500 Levels, Refreshed - 1

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Takeaway: Demographic and macroeconomic factors dictate that being better, not bigger, generates greater returns: long $EAT, short $DRI, short $BWLD

Within the casual dining category, we have been heavily focused on three names this year: EAT, BWLD, and – more recently – DRI.  We are positive on Brinker and bearish on Buffalo Wild Wings and Darden.  Our view on these stocks is based on the companies’ respective earnings potential versus expectations as dictated by current trends and sentiment in the investment community.


Below, we offer a quick recap of our thoughts on each name:


EAT (LONG):  Brinker’s strategy over the last couple of years has been focused on “better not bigger” and this mantra has led to Chili’s transitioning from an industry-laggard to an industry-leader (versus industry benchmark Knapp Track Casual Dining Index.  This has led to strong earnings growth and, we believe that FY13 has the potential to be another 20+% EPS growth year for the company as Chili’s leverages its superior kitchen technology to roll out additional platforms with far greater efficiency than the competition.  Despite having outperformed from a price perspective, the street is still valuing EAT below its casual dining peers on an EV/EBITDA basis.







BWLD (SHORT):  Buffalo Wild Wings is a company that we have been bearish on since early 2012.  We were concerned by the possibility of a short-term pop in the stock price on 2Q EPS as Wingstop, whose comp-store sales had correlated tightly with BWLD’s (0.96), had posted strong numbers for the quarter.  All in all, our FY12 EPS estimate for $3.07 is well below the Street at $3.19 (low estimate is $3.13).  The bullish case in April, on the post-earnings sell-off, was that the conversation was set to turn from higher wing prices to lower wing prices.  At the time, we said such a stance was premature and that our view of the food processor industry and USDA data was indicative of a persistence of elevated wing costs that would pressure EPS growth in FY12.  Given our view that EPS expectations remain overly positive, we are bearish on this stock.  While the EV/EBITDA multiple has come in considerably, we believe that consensus EBITDA remains too high.


CASUAL DINING TRIFECTA - bwld eps expectations vs wing prices



DRI (SHORT)Darden is the inverse of Brinker in that it is attempting to become bigger first and better second.  Rarely, in this industry, do companies become bigger and better at the same time when running multiple chains in one portfolio.  Darden’s stock price has diverged dramatically from EPS expectations and, not expecting a reversal in revision trends any time soon (given fundamental trends at Olive Garden and Red Lobster), we would posit that the risk profile of the stock is skewed to the downside.   Our continuing concerns about Darden’s long-term outlook are centered on the company’s accelerating capital spending and declining traffic trends at its core concepts.  Email Howard for a copy of our recent Black Book on Darden which outlines out thoughts in detail.  Unless you think FY13 EPS estimates are heading dramatically higher, you should consider joining the Darden bear-camp.






General Casual Dining Thoughts


When thinking about the casual dining group and the restaurant industry more broadly, we are trying to keep two things in mind for the longer-term: demographics and consumer spending.   Given that casual dining is among the most discretionary components of the consumer economy, tracking the population growth of the demographic with the highest propensity to spend (55-65), is instructive for generating an informed view of the group over the longer term.  This age cohort's population growth, shown in the chart below, is important for casual dining because of this base of consumers' high frequency use of casual dining chains.  The quote below (from Brinker’s CFO no less) provides an insight into how exogenous tailwinds made the industry fat and happy in good times while also conditioning many industry operatives to focus too much on growth.


“It all gets back to this realization or admission of maturity in the space. What got you to win historically in casual dining was demographics in trade area and real estate. That's how you won. We all built many, many restaurants over many, many years and that's how you won. And in many ways we open the doors and they came because there were a lot of macroeconomic tailwinds who were contributing to that. I think when you realize that your space gets more mature, it puts a whole different filter on how you manage your business because you have to do it so much better.


You can't just rely on organic growth to drive improvements in your business. Now you are looking at your existing box and you're saying, how am I going to make this more profitable. And you start to get much, much closer to the consumers. I think that's the biggest realization we came to that the more mature you get, the closer you get to consumers, the more you understand how they use your brand, what really matters to them.”

– Guy Constant, Brinker CFO, 6/4/12


CASUAL DINING TRIFECTA - pop growth 55 65


Howard Penney

Managing Director


Rory Green



Takeaway: IGT a participation market share gainer among the Big 3?

IGT defying gravity 



  • A big knock on the IGT story was an unsustainably high share of participation revenue.  However, IGT's share has been consistent for 10 quarters among the Big 3.
  • Surprisingly, WMS has been a share loser recently. This would've been a shocking prediction a year ago
  • BYI's consistent gains in revenue share and unit share continue - your father's WMS?





European Banking Monitor: SMP Remains on Hold

Takeaway: Sovereign yields come in but remain elevated as Draghi elects not to reactivate the SMP last week.

Below are key European banking risk monitors, which are included as part of Josh Steiner and the Financial team's "Monday Morning Risk Monitor".  If you'd like to receive the work of the Financials team or request a trial please email .


Key Takeaways:


* European financials acted a lot like European sovereigns, both tightening week-over-week. The Draghi rally continues for now. As the SMP chart below shows, Draghi elected for yet another week to refrain from buying sovereign peripheral paper. We expect this to change in the coming weeks.



If you’d like to discuss recent developments in Europe, from the political to financial to social, please let me know and we can set up a call.


Matthew Hedrick

Senior Analyst





Security Market Program – For the 22nd straight week the ECB's secondary sovereign bond purchasing program, the Securities Market Program (SMP), purchased no sovereign paper for the latest week ended 8/10, to take the total program to €211.5 Billion.


Following President Draghi’s conference call remarks on 8/2 in which he addressed rising yields in the periphery and said that the ECB “may undertake” non-standard  measures, we continue to expect that the ECB will reactivate the SMP to buy Spanish and Italian bonds, in particular, in the coming weeks.


European Banking Monitor: SMP Remains on Hold - aaa. SMP


European Financials CDS Monitor French and Italian banks tightened, alongside the sovereigns. Spanish banks were mixed, with a few of them posting sizable widening. Overall, however, swaps throughout Europe's financial system were notably tighter. 


European Banking Monitor: SMP Remains on Hold - aaa. Banks


Euribor-OIS spread – The Euribor-OIS spread tightened by 3 bps to 28 bps. The Euribor-OIS spread (the difference between the euro interbank lending rate and overnight indexed swaps) measures bank counterparty risk in the Eurozone. The OIS is analogous to the effective Fed Funds rate in the United States.  Banks lending at the OIS do not swap principal, so counterparty risk in the OIS is minimal.  By contrast, the Euribor rate is the rate offered for unsecured interbank lending.  Thus, the spread between the two isolates counterparty risk.


European Banking Monitor: SMP Remains on Hold - aaa. Euribor


ECB Liquidity Recourse to the Deposit Facility – The ECB Liquidity Recourse to the Deposit Facility measures banks’ overnight deposits with the ECB.  Taken in conjunction with excess reserves, the ECB deposit facility measures excess liquidity in the Euro banking system.  An increase in this metric shows that banks are borrowing from the ECB.  In other words, the deposit facility measures one element of the ECB response to the crisis.  


European Banking Monitor: SMP Remains on Hold - aaa. ECB facility

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