Takeaway: International protectionism is poised to meaningfully accelerate over the intermediate term.



  • While we view the threat of military intervention as highly improbable, we do think the heightened tension over the Senkaku (Japan)/Diaoyu (China) islands risks facilitating a string of international protectionism – which is already poised to accelerate due to recent political promises out of the Obama and Romney camps.
  • Such protectionism would have dire economic effects globally, with Japanese industrial production and US/EU consumption getting hurt the most – the former due to lower Chinese demand; the latter due to higher import price inflation.
  • Retaliatory measures, while not an acute risk, could beget broader financial market and economic contagion globally. This is a meaningful TAIL risk, given the recent rhetoric and maneuvers of international policymakers.


In recent days and weeks, the geopolitical tensions surrounding China and Japan’s territorial dispute over the Senkaku (Japan)/Diaoyu (China) islands have certainly elevated to a critical level. Currently, outraged citizens across ~85 cities in China are protesting Japanese occupation of what is viewed by the Chinese as their sovereign territory, physically damaging Japanese businesses in the process. To some extent, a fair amount of yesterday’s social unrest was a function of yesterday being the anniversary of the commencement of Japan’s 1931 occupation of China. That being said, however, the situation remains far from resolved. In fact, it appears poised to get a lot worse before it is ultimately resolved.


As a quick refresher, the following link (albeit from the Tokyo governor’s office) details the size, location and the highly controversial geopolitical history of the disputed territories, which lie squarely in the East China Sea: Interestingly, an LDP victory in Japan’s parliamentary elections (due by AUG ’13) will all-but-guarantee this territorial dispute is not resolved efficiently, as all three candidates to replace Sadakazu Tanigaki as the head of the LDP are in favor of Japan’s attempt to nationalize and develop the islands (as are 75% of Japanese voters). It's worth noting that the LDP is currently favored in polls vs. the ruling DPJ by a margin of 31% to 14%.




On the topic of conflict resolution, US Defense Secretary Leon Panetta visited China yesterday (after visiting Japan the day prior) attempting to help mediate the dispute, which comes in the wake of the recent attempt by Japan to nationalize the islands and a recent Chinese sovereign declaration of precise boundaries for the waters surrounding the islands – an act that may lead to heightened pressure to respond with military force if a Japanese vessel invades China’s “sovereign” territory. It is our view that the US would ultimately be forced to side with Japan in the event of a military conflict, given its current use of Japan as a key military base in the region – highlighted by a deal Monday for the US to build a brand-new, anti-missile radar shied on Japanese soil. For now at least, the threat of military intervention remains low.


A threat that is not improbable at the current juncture is large-scale protectionism on the international trade front. Combining their bilateral exports, China and Japan shipped each other $316.1 billion of goods last year  – which would rank their exchange of merchandise as the 34th largest country in the world! More importantly, their economic ties are even more interconnected, given the bilateral exchange of services, foreign and portfolio direct investment, as well as tourism flows. While total dollars are hard to quantify, the key takeaway here is that China and Japan are economically joined at the hip.


Japan, however, is a bit more economically joined at the hip to China than China is to it. In fact on an aggregate basis, Japan relies on Chinese demand 2.5x the rate China relies on it (China-to-Japan = $148.5B or 7.8% of total exports; Japan-to-China = $167.6B or 19.7% of total exports). Moreover, key retailers in Japan look to Chinese end markets for a meaningful portion of their global sales (Nissan at 26%, followed by Honda at 20%) and Fitch Ratings has already threatened to downgrade a host of Japanese companies should the geopolitical dispute drag on. In short, a Japan-China trade war would most likely be more impactful to the Japanese economy than it would be to the Chinese economy – especially considering that the former is more reliant on international demand for growth amid a 20yr-plus economic malaise.


Even beyond end-market protectionism, such as economically-punitive tariffs, China could enact rather destructive measures on Japanese (and global) supply chains by choking off its production and shipment of rare earths – a critical input in just about every modern piece of technological equipment, ranging from cell phones to computers to televisions to light bulbs to missiles. China, which is home to over 90% of the world’s rare earth supplies and 23% of global reserves, has already signaled that its reserves are declining and have recently commenced a round(s) of strategic buying to boost stockpiles and protect the industry from overexploitation.


To be fair to China, this latest measure is in line with their three-year trend of systematically reducing international shipments and production quotas, with a -20% production cut as recently as this AUG. To the extent this trend is accelerated in the name of protectionism, we would not be surprised to see fears of a rare earths shortage develop across the international markets. Keep an eye on the Market Vectors Rare Earths/Strategic Metals ETF (REMX) for signs of this risk; in fact, it could serve as a potential hedge for anyone with international tech exposure in their portfolio (SNE? AAPL?), as those companies would be at risk of margin erosion, on the margin. On the flip side, any potential input cost increases could be passed through to international consumers, which would likely slow consumption growth broadly. How much someone in the US or Spain can afford to pay for an iPhone 5 remains to be seen…




Jumping ship, we briefly wanted to touch on what we see as growing risk that the US and China are headed down a similar path of protectionism, as China’s manufacturing prowess at the expense of the US laborer has become an increasingly hot topic on the US presidential election campaign trail. To that tune, President Obama and Presidential hopeful Mitt Romney exchanged rhetorical blows earlier in the week on the US’s bilateral trade with China. While both candidates appear to be blowing a fair amount of political smoke, we’d be remiss to ignore their aggressive tone towards China and any potential implications of tighter US trade policy towards the Asian manufacturing giant.


Per Bloomberg: “The economy returned to the forefront of the presidential campaign as the U.S. today filed a challenge at the World Trade Organization accusing China of illegally subsidizing exports of automobiles and auto parts. It was the administration’s second complaint related to the auto industry since Obama began his re- election campaign. The aid amounted to at least $1 billion between 2009 and 2011 and benefited as much as 60 percent of Chinese car-parts exports, according to the U.S. The subsidies put U.S. component manufacturers at a competitive disadvantage, which encourages the outsourcing of car-parts production to China, the U.S. said. The U.S. announced the complaint 50 days before the Nov. 6 presidential election and 15 days before early voting starts in Ohio. The state has 54,200 residents employed by the car-parts industry and 12.4 percent of the state’s total employment related to the auto sector.”


From our purview, Obama is clearly elevating China’s “unfair” trade policies on his political agenda – likely to dodge pre-election heat from pro-business supporters that claim he hasn’t done enough during his first term in office to protect American corporations from having to outsource labor costs in order to remain competitive. As it stands, we anticipate that a large portion of Obama’s tough talk will die down after the election (assuming his likely victory); conversely, a Romney victory would accelerate protectionist measures aimed at unwinding China’s competitive advantages, given his repeated claim to label China as a currency manipulator (and thereby invoking highly-punitive measures against China) on his first day in office.


In the short-run, meaningful anti-China trade measures are likely to lead to higher US consumer and producer price inflation, as increased cross-border transactional costs get passed through to US consumers and businesses. To the extent China retaliates with measures of its own, we could see US businesses like YUM and NKE that have a large [and growing] Chinese footprint suffer on their respective top-lines.


Stay tuned – as if the next 3-6 months weren’t going to be eventful enough!


Darius Dale

Senior Analyst


Revenue diversity is fine but has it gone too far?


  • Non-gaming (room, food & beverage, and entertainment) revenues accounted for 62% of total Strip revenues in Fiscal Year 2011 (ending June 2011), far higher than its 49% proportion seen 15 years ago
  • Vegas operators e.g. MGM, CZR, STN, have been more dependent on hotel revenue growth.  Unfortunately, Vegas REVPAR growth is trending negative in Q3 compared with a 15.4% growth rate in 2011, as it has become difficult to push rates higher.
  • Our big issue continues to be that fewer young people are playing slots and slots are the highest margin revenue stream in Vegas



The Healthcare Nightmare

Takeaway: Romney's against the ACA and will repeal it if elected while Obama believes this is for the greater good of our nation. Voters will decide.

President Obama successfully got his Affordable Care Act through Congress much to the chagrin of Republicans. Now it’s time to examine what that means for Medicare spending going forward. Hedgeye Healthcare Sector Head Tom Tobin discussed entitlement reform, spending and each candidate’s opinion on ACA during today’s client call discussing the 2012 presidential election.


It should come as no surprise that Mitt Romney is heavily against the Affordable Care Act, calling it a “$2 trillion entitlement we don’t want and certainly can’t afford.” He has noted that should he become president, he’ll repeal the act.



The Healthcare Nightmare - TOBIN uninsured



Looking at the above chart, you can see that uninsured Americans are generally younger and aren’t big consumers of medical services. Medical services consumption increases with age, with those over 55 making up the lion’s share of expenditures. The CBO currently estimates that 11 million people will be added to Medicare and 19 million to private insurers due to the ACA. The act increases total medical spending by between +3.1%* to +6.7%.


Someone has to pay for this and you can easily see why Romney is against having taxpayers foot the bill. Obama believes that the ACA is for the greater good. Votes are likely to choose a candidate based on their current medical and financial situation. It’s one more factor that gives us reason to believe the election is too close to call.



The Healthcare Nightmare - TOBIN election

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Election Economics

Takeaway: This election is simply too close to call. Economic data favors Romney while state polling data favors Obama.

On today’s client call discussing the upcoming presidential election, Hedgeye Director of Research Daryl Jones focused on the role economic data will play with regard to each candidate. Current battleground state polls show Obama ahead in every state save for North Carolina and no Republican has ever won an election without winning Ohio, which is cause for concern for the Romney camp. But the caveat to state polling data could be economic studies which tell a different tale.



Election Economics - JONES election



Two University of Colorado professors, one from Boulder and one from Denver, have put together an

Electoral College forecast model to predict who will win the 2012 presidential election and the result is

bad news for Barack Obama. The model, which uses economic indicators from all 50 states, shows 320 electoral votes for Romney and 218 for Obama, pointing to a Mitt Romney victory in 2012.


This kind of Electoral College model developed by the team of Bickers and Berry is the only one of its kind to include more than one state-level measure of economic conditions -- both national unemployment rates as well as per capita income. We are of the opinion that this election is too close to call; if you go with state polling, it’s a win for Obama. Those who agree with Bickers and Berry see Romney winning in November.


Takeaway: $TXRH is facing significant headwinds from here

After doing a better-than-bad job on Texas Roadhouse in 2011, we did not have a view on the stock coming into 1Q12 earnings and missed a sizeable pop in the share price.  On the category more broadly, we have held a cautious-to-negative view since our 4/20/12 note, “CASUAL DINING CAUTION”.


Category View


Over the intermediate-to-long term, our bearish stance is dictated by slowing demographic trends and a difficult macroeconomic outlook.  Casual dining has not underperformed the market since our 4/20 note but we believe the heightened volatility in the group has been worth avoiding.  On the positive side, Brinker, a long-time favorite of ours, has managed to sustain a relatively smooth upward trajectory over the same time period and remains our favorite stock in casual dining.





While our caution on casual dining was a couple of months premature, we remain bearish today as several factors are serving as headwinds for the group.  We detail those factors below.


Demographics:  Before he exchanged un-pleasantries with his shareholders, CEO Clarence Otis spoke about Darden and casual dining’s position within the restaurant industry.  The declining number of baby boomers with high levels of disposable income, and the headwind that that represents for restaurant chains that are not adapting to the preferences of the increasingly Millennial-dominated consumer base.  This is a negative for all companies in casual dining that are supporting concepts that are struggling to stay relevant.


Labor Market:  The U.S. economy is, from a growth perspective, on life support as Federal Reserve interventions continue amidst much-less-than-satisfactory jobs growth. 


Gasoline Prices: Gasoline prices are above 2008 levels and 16% higher than they were on June 30th. We believe that this poses a significant risk to continued growth in the economy.  Given the discretionary nature of expenditure at casual dining restaurants, the corollary to this is a negative view on the category’s share of the consumer’s wallet.



Casual Dining Conclusion: As the group deals with adverse demographic and macroeconomic factors in the near-, intermediate-, and long-term, investors will likely seek out companies that are taking share and differentiating themselves from the herd in what has become a heavily-oversupplied industry.



Texas Roadhouse


Specific to Texas Roadhouse, beyond the issues facing the category, we see the following issues as important for investors:

  1. Food Inflation
  2. Highly Competitive Sub-Category
  3. New Unit Volumes and Returns

At this point we would advise clients to avoid TXRH on the long side.  The charts and text below elaborate on our thoughts specific to the company.


Earnings Revisions and Sales Trends:


We do not expect earnings estimates to rise from here as beef inflation accelerates and same-restaurant sales bump up against difficult weather compares.  Bloomin’ Brands coming public (and putting Outback Steakhouse’s best foot forward) is increasing discounting at a time when the Restaurant Value Spread (CPI Food at Home less CPI Food Away From Home) is negative and declining further, lessening the pricing power of restaurants within the food complex. 


TXRH: WHERE TO FROM HERE? - TXRH price estimates fy12 fy13





Capital Spending Accelerating Far In Excess of Sales Growth


One of the red flags in our assessment of the sustainability of Texas Roadhouse’s growth trajectory is a sustained period of capital expenditure growth unaccompanied by commensurate sales growth.  In 2011, the company took a decision to restart unit growth and the company has now seen capital spending grow faster than revenues for six straight quarters.  Importantly, as of last quarter management is saying that the new units are not performing as well as the broader unit base.  On the 2Q call, Texas Roadhouse CFO Price Cooper said, “While our newer restaurants continue to open strong, as they move through the honeymoon period and their sales normalize, their base is slightly less than existing restaurants.”  We believe that there is risk to the stock’s multiple if returns decline.


TXRH: WHERE TO FROM HERE? - txrh capex sales growth



The Stock Price Should Trend In-line with Returns


The net result of the bifurcation between capital spending growth and sales growth is declining returns on incremental invested capital.  Our view is that, from a shareholder perspective, tying unit growth to a more conservative expectation of sales growth and returning surplus cash to shareholders would be a more attractive strategy.


TXRH: WHERE TO FROM HERE? - txrh roiic



Accelerating Food Costs Are Presenting a Challenge For Margins


There is a no relief in sight for the company when it comes to higher beef prices.  Over the past couple of quarters, the company has been able to manage labor costs, but slowing sales and industry headwinds are likely to exacerbate the impact of rising food costs.  Our expectation from here is for restaurant level margins to decline under pressure from rising input costs and a difficult top line environment. 





Beef is a significant driver of input cost inflation for TXRH.  In March, the company had the following to say: 


Now, the not-so-good stuff-food inflation up approximately 8%. That's primarily beef driven and most of you probably are aware of that. There has been significant inflation in the beef markets, live cattle markets. I suspect that'll be little a bit continued in 2013 until herds get rebuilt of cattle, so we may have to bear with that for a while and we will.


We expect beef prices to remain elevated as herd sizes are depleted and will likely take several years to rebuild.  From a pricing standpoint, for a couple of reasons, we believe it may be difficult for Texas Roadhouse to take additional pricing to protect margin.  First, competition in the steak category is fierce with Outback in the public arena once again and non-traditional competitors like Chili’s launching steak at their restaurants.  Secondly, while Texas Roadhouse likely does not compete with grocery as directly as some other casual diners, the Restaurant Value Spread (CPI FAH less CPI FAFH) is indicating that traffic in casual dining, as measured by Malcolm Knapp, is likely to decelerate over the next six months or so.  For TXRH, the chart below seems to indicate that a sequential slowing of comps is possible as consumers encounter less inflation in the grocery aisle than at the restaurant.





The Stock’s Valution is Cheap, Probably for a Reason


TXRH is being touted as “cheap” by some in the investment community but, as is the risk with valuation, estimates may be overly bullish as sales slow and inflation accelerates.


TXRH: WHERE TO FROM HERE? - casual dining valuation TXRH



Howard Penney

Managing Director


Rory Green



Financials And Presidents

Takeaway: Clinton takes the cake, with financials growing +366% over his two terms.

 Today, Hedgeye held an election call with Director of Research Daryl Jones, Financials Sector Head Josh Steiner and Healthcare Sector Head Tom Tobin to discuss different aspects and metrics of the upcoming 2012 election. Steiner examined the different returns in the financials sector over each different presidential administration. Here’s what we found:


-During Reagan’s two terms, financials grew 354%

-During Bush’s (H.W.) term, financials grew 96%

-During Clinton’s two terms, financials grew 366%

-During Bush’s (W) two terms, financials fell -74%

-Thus far, during President Obama’s first term, financials have grown 109%



Financials And Presidents - STEINER election

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