Today's Crisis Management Wish List...

Here is my Crisis of Credibility wish list (all prices that I’d like to see before I invest my 64% position in Cash):

1. SP500 intraday test of the 752 line
2. VIX intraday test of the 50.82-52.93 range
3. US Dollar Index test of the 88 level
4. Gold taking a good hard look at $1000/oz
5. XLF (Financials ETF) test the $6.83 line
6. One more sell side analyst say Citigroup is going to zero

Keith R. McCullough
CEO & Chief Investment Officer


I read two articles yesterday that provided a rather conflicting picture of how casual dining companies and some QSR players are trying to gain market share in today’s environment. One was published by Nation’s Restaurant News and focused on how casual dining restaurants are offering discounts to drive traffic in this difficult environment. Specifically, the article highlights that both T.G.I. Friday’s and Ruby Tuesday launched promotions this week with coupons good for a free entrée with the purchase of another one. This is obviously not good for margins (casual dining EBIT margins on average have declined by more than 150 bps in each of the last four quarters through 3Q08), and the debate over whether discounting to drive sales is good for business in not a new one. I found this article interesting, largely because I came across it right after reading another article on that talked about how QSR players, Burger King and Jack in the Box, specifically, are currently targeting casual dining market share dollars by offering more premium products.

Although these higher priced items have the potential to boost QSR margins at a time when most QSR players are focused on discounting and promoting value, the fact that these new menu offerings are being pushed aggressively at the same time casual dining restaurants are providing “buy one get one free” coupons among its other value items leads me to believe that this might be the exact wrong time for QSR companies to focus on premium offerings. The article states that the lines between a QSR and casual dining product are starting to blur as QSR companies offer higher priced, higher quality products. This may be true, but the lines are starting to blur from a pricing standpoint as well, however, as casual dining companies desperately try to lure customers back into their restaurants. So then the question remains, where is the better value?

The article cites BKC’s CEO John Chidsey as saying “For someone who was having a premium burger at an Applebee's or a Chili's that's paying $9 to $11 dollars and can come to Burger King for a Steakhouse Extra Thick burger and pay $5 to $6 dollars, that's value to them.” Looking at both Applebee’s and Chili’s menus, I found that you can buy a hamburger for $7.49 and $6.79, respectively. You can buy Ruby Tuesday’s classic burger for only $5.99. Based on these prices, BKC’s Steakhouse burger does not seem to offer the same type of value because although people have less money to spend today, there is still value in going out to dinner, sitting down and having your food brought to you.

This QSR premium offering strategy will be made more difficult by both Wendy’s and Sonic’s recent aggressive push to drive sales with more value-priced menu items. Additionally, NPD data shows that QSR deal traffic growth has really picked up since early 2008 and has been steadily increasing as a percent of total traffic since mid 2007.

CKR is another QSR player that is trying to drive sales at higher price points. For CKR, however, this is not a new strategy. Instead, the company continues to sell premium priced items and has said it refuses to discount despite the moves by its competitors. CKR is in a different position than BKC or JACK because it is not choosing now to more aggressively push into the premium segment but is attempting to maintain and grow its share within the premium segment. For reference, Carl’s Jr.’s average check has been north of $6 since FY06 and has exceeded $7 in each of the last two quarters. Just this week, CKR said at an investor conference that its same-store sales have not held up as well as some of its competitors who have discounted more, primarily MCD, BKC and YUM, but management is working to protect both its margins and brand for the long-term.

Bone or Bust

If it’s not going bust, then you gotta buy the bone!

If you have zero tolerance for miniscule-cap, highly volatile stocks with high risk/reward, then don’t bother looking at the chart below. But the reality is that so many consumer names – especially in retail – are trading at or near a bone. In other words, bordering on unworthy of any equity value whatsoever. The question with these names is quite simple. Is it going bust? If not then it is probably not going to stay near a buck for too long. Remember that we’re coming off a year where the average analyst/PM on the buy side was not allowed to like these poor-quality, highly-levered and risky names. They’re the kind of names where you get a golf clap from your PM if you’re right, but get fired if you’re wrong. I’m not condoning that by any means (it’s the opposite of the process we have at Research Edge between Keith and the Analysts), but it exists nonetheless.

My favorite name in this group of Bones is LIZ. Ok, at $2.50 it’s not really a bone. But in my mind anything under $3 is fair game. I’m increasingly confident that LIZ will not breach a covenant, will cut capex to a greater extent than most people give it credit for, and will start to show meaningful margin improvement after a multi-year slide starting in 2Q as it cuts away the fattest cost structure in all of apparel. Quiksilver is a close second. Cost cuts on an inefficient platform will help, with a call option of monetizing its core brands with a break-up of the company. It was driven down initially due to horrible performance associated with its ski/hardgoods business. But that’s gone, seasonality is back to normal, and balance sheet risk is slowly but surely being mitigated.

If you want any more details on our thought process here, or factors behind timing and sizing, please contact Jen Kane at .

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 80.43%
  • SHORT SIGNALS 78.34%

UA: Running Trends Bucking Bad Sentiment

Sentiment is so overwhelmingly bearish on Under Armour—including the common view that the Running footwear launch is ‘average at best.’ I won’t walk you through my thesis on UA’s approach to building this business again (check out several posts on the topic over the past few month), but I remain meaningfully more constructive – both short term and long term.

I won’t judge this launch on data from such a short time period, but we now have three weeks, which is a level that is becoming more relevant to me. A few takeaways – 1) Average price point has not budged off of $93. 2) Cross training market share has not suffered. 3) Interesting to note in the second chart that prior launches consistently made higher highs on the 1-year anniversary (counter to the view that UA launches well, but then fizzles).

Aye Carumba!: Mexican Tail Risk

In a November 11th 2008 note entitled, “Mexican Short Thesis: Oil Production”, we laid out the core tenet of our short thesis, which was based on declining national oil production in Mexico. We stated that:

“To this day, PEMEX owns and operates all of Mexican oil production and is a meaningful contributor to the Mexican economy. In 2007, Mexican oil exports contributed 10% of Mexican export revenue. PEMEX pays out over 60% of its revenue to the Mexican state in the way of royalties and taxes. In aggregate, PEMEX contributes almost 40% of the federal government’s budget. Despite record oil prices over the last few years, the Company has a substantial debt balance estimated at over $42.5BN as the vast majority of profits have gone to the government rather than to pay down debt, let alone investing in the business.

The Mexican government’s dependence on revenue from Pemex is a major issue for two reasons. First, oil is a commodity and as we have seen over the last five months the price of any commodity can change quickly. While the inherent long term value of Pemex’s reserve base does not change, the royalties and taxies paid to the government can be very volatile. Second, and more importantly, is that Pemex crude oil production has been in decline since 2004 and is down 10% ytd.”

Since then, the iShares Mexico etf, EWW, is down ~14.7% and Mexican Peso Currency Shares etf, FXM, is down 10.8%.

While the oil issue outlined above continues to be a core component of our thesis, a lunch we had yesterday with a Yale professor who in a former life was a Chief of Staff at the State Department and is a close confidante with the likes of Henry Kissinger, highlighted another key risk. We asked him what was the singles largest sleeper in terms of potential geo-political risk and his unequivocal answer was Mexico, due to the burgeoning power of the regional drug lords.

With a domestic economy that is under serious duress and a governmental income statement that is declining dramatically y-o-y, as outlined in the chart below, due to downward trending oil prices and domestic production, the drug lords have only been empowered.

In aggregate since December 2006, it is estimated that over 40,000 troops have been deployed against Mexican drug cartels. Over that time period, it is also estimated that there have been more than 8,000 fatalities associated with the drug war. News reports from south of the border over the last week suggest that the battle between Mexican drug lords and the government is turning into a veritable civil war.

In the past week, there has been a wave of street demonstrations and border crossing obstructions to protest the involvement of the military. These protests have shut down border crossings in Reynosa, Nuevo Laredo, Maramoros and Ciudad Juarez. They have also shut down part of the industrial hub Monterey.

According to the New York Times:

“Without providing evidence, the Mexican authorities say they see the hidden hand of traffickers in the splashy events, which have included men, women and children, some of whom cover their faces as they wave placards and denounce President Felipe Calderón’s decision to deploy more than 40,000 soldiers to combat a booming drug trade.”

These protests along with more brazen attacks on police and army officials highlight the growing power of these drug lords, which coincides with the declining economic power of the Mexican government due to its dependence on oil.

The emergence of a full blown civil war in Mexico is a risk that is moving from the tail into the normal distribution with every passing day.

Daryl G. Jones
Managing Director


If you’ve been following our work you know that we are bearish on Russia (forgive the pun). Russia’s stock market is down 12% this week and confirmed a new low with its close today at 549.21, 22bps below its October 24th low.

There are a few more data points out today that confirm more pain is ahead for the energy-levered economy:

-Russia’s unemployment rose to 8.1% in January, the highest since March 2005 and disposable income fell 6.7%
-January industrial output declined by 16%
-Average monthly wages fell by an annual 9.1% in January to ~$418 (the biggest drop since August 1999)

Russia forecast a 2009 contraction of 2.2% yesterday, which we believe may be a conservative estimate. We continue to follow the political gesturing from President Medvedev and PM Putin and the fluctuation in the ruble, which has depreciated 3.6% versus the dollar this week and is down 22% YTD.

Yesterday China lent Russia $25 Billion in exchange for larger supplies of crude oil. Should the Ruble continue to slide against major currencies, Russia’s debt will continue to compound. With capital investment in Russia down 15.5% in January M/M Russia can only hope for a re-flation in commodity prices. Russian leaders would be wise to get to the bottom of an apparent sinking of a Chinese merchant ship leaving the port of Nakhodka last week by their navy –violence is bad for business no matter how much the price of oil rebounds.

Matthew Hedrick

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