The Economic Data calendar for the week of the 12th of November through the 16th is full of critical releases and events. Attached below is a snapshot of some (though far from all) of the headline numbers that we will be focused on.
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Takeaway: We are once again short the yen and remain bearish on the JPY in light of Japan’s deteriorating cyclical and structural GIP outlooks.
Yesterday, a very astute client of ours pinged us with a question on the morning call asking about tail risk within the Japanese sovereign debt market in light of yesterday’s bombed-out SEP current account data, which, like Japan’s SEP trade balance, narrowed to an all-time low on a monthly basis:
Our answer was that the client was 100% correct to callout the awful current account data point, as Japan’s significant loss of international competitiveness due to secular yen appreciation (JPY up over +50% vs. the USD over the last 10yrs) will remain a headwind to Japanese GROWTH over the intermediate term – especially in light of the erosion of export demand stemming from the geopolitical dispute with China. That is but one more domino among a series of economic and political catalysts that we think will drive the Bank of Japan to ease monetary POLICY like it never has before – literally, as a foreign asset purchase program remain a critical tail risk for the JPY. In support of our view that the BOJ is poised to accelerate its balance sheet expansion in a potentially unprecedented way over the intermediate term are the latest trends in implied volatility in the JGB futures market, which recently dropped to the lowest since 2002 (1.27%).
Regarding the BOJ, in its latest meeting (OCT 31), the BOJ announced its first back-to-back monthly stimulus expansion since 2003, increasing its revolving Asset Purchase Program by ¥11 trillion to ¥66 trillion and introducing an “unlimited” credit program for Japanese banks. We doubt Japanese banks will respond to this easing of liquidity conditions with a commensurate expansion of their balance sheets. Net interest margins at Japanese banks are at decade-plus lows (~140bps) as the average interest rate on new loans continues to track the 10yr nominal JGB yield lower.
We continue to view these latest easing measures as mere precursors to the real fireworks, likely beginning around mid-2013, shortly after current BOJ governor Masaaki Shirakawa steps down from his post; he’ll likely be replaced by an incrementally dovish puppet of whichever party controls the Diet – more on this later. For now, Japan is likely to continue edging towards recession as companies like Sharp, Panasonic and Toshiba continue to scramble for ways to cut costs amid material profit erosion. To say corporate credit risk in Japan has undergone a demonstrably negative phase change with the JPY consistently trading just shy of post-war highs would be an understatement.
Leading and concurrent indicators in Japan continue to support our bleak cyclical expectations for Japanese GROWTH – expectations that continue to be driven lower by de facto protectionism emanating from the Senkaku/Diaoyu Islands dispute, which has weighed on both Japanese exports and industrial production in recent months. The latest developments on that front is that Japan is now seeking to revise its military cooperation pact with the US amid fears of China’s increasing military presence in the region (especially after Hu’s incredibly hawkish foreign policy speech yesterday).
Meanwhile the Japanese bond market – with the 5yr breakeven rate at/near all-time highs and the yield premium to take on additional duration risk widening – continues to support our hawkish structural expectations for Japanese INFLATION:
Interestingly, we continue to point to Shirakawa’s term expiration as one of the key catalysts for an acceleration of monetary easing by the BOJ, as the Milton Friedman-trained economist has been somewhat of a human dam, shielding the the BOJ board at the margins from the bi-partisan will [to inflate] of Japan’s two dominant political parties – the DPJ and LDP.
The primary reason we have been so focused on Japan’s looming government shutdown is that the LDP was previously using a brinksmanship tactic on the outstanding deficit financing bill (covering ~40% of FY12 expenditures), only agreeing to negotiate in exchange for a promise of early elections – likely sometime before year-end. The LDP, which would be likely to regain control of Diet as it has been heavily favored in the latest polls vs. the DPJ, has been outspoken in favor of hiking the BOJ’s long-term inflation target +200bps to +3% (and with it, the pace and scope of BOJ balance sheet expansion).
Turning back to Japan’s debt ceiling showdown, we’ve received some directionally positive news on this front this week. Japan’s three main parties (the DPJ, LDP and New Komeito Party) agreed to approve the deficit financing legislation in the Lower House on NOV 15 after the previous impasse slowed public expenditures enough to begin causing increasing disruptions in funding at the regional and local levels. LDP chief Shinzo Abe even gave his blessing to the local media, though promising to forge ahead with his party’s demands:
“It might be called a sunshine policy, but we will continue to press our demands… We are allowing Mr. Noda a chance to keep his end of the promise.”
In addition to recent weakness across Global Macro markets, this latest news has been very positive for the JPY with respect to the TRADE duration, giving us a new opportunity to re-short a favorite TREND and TAIL thesis within the FX market. Our quantitative risk management levels on the CurrencyShares Japanese Yen Trust etf “FXY” are included in the chart below. Do not, however, disrespect what the former of the previous two catalysts could do as it relates to further JPY strength from here (email us for more details) and we would look to re-short the FXY at TREND resistance if it manages to recapture its TRADE line.
All that being said, we were never of the view that Japanese government would actually shutdown; nor did we expect a near-term Japanese sovereign default (a view supported by the continued tightening of Japanese sovereign CDS). Instead we fully anticipated a deal being struck with early parliamentary elections being the ultimate outcome. We still believe this is the base case scenario, though chatter from senior officials within the DPJ suggest a that the current redistricting process may delay dissolution of the Diet even further. Still, Noda is out recently affirming his AUG promise to call elections in the “near term” (by law, they must be called by AUG ’13) and we think Noda might just be trying to buy himself and the DPJ a bit more time to potentially regain some lost momentum in the polls.
Regardless of the actual timing of the election (DEC or early 2013), a potential recession is unlikely to sit well with the Japanese populace and we would expect the LDP to maintain its advantage among Japanese voters over the intermediate term – making them Japan’s “new” ruling party (they were in power for over a generation before the DPJ won in 2009). As we mentioned before, that event would be overtly bearish for the JPY – a currency that is already struggling with gaggle of cyclical headwinds.
With respect to the long-term TAIL duration, at the present moment we think Japan faces material risk of a currency crisis (as loosely defined by a peak-to-trough move of -20% vs. the USD). During that decline, we would expect to see some reflation among Japanese equities as the exporters and industrials reap the obvious benefits of an FX tailwind. We think that beta risk is to be eventually faded however, as the JGB market may start to aggressively price in the confluence of rising inflation expectations and capital flight.
Ultimately, we continue to view these steps as the most probable functional mechanisms for a Japanese sovereign debt crisis and, as we highlighted on our MAR 2 presentation titled, “JAPAN’S DEBT, DEFICIT AND DEMOGRAPHIC RECKONING”, mere storytelling about Japan’s fiscal imbalances simply will not suffice to nail the timing of the “Widowmaker Trade”. It will pay to focus on the specific catalysts going forward, as well as any other globally interconnected risks that may impact marginal demand for the JPY and JGBs (such as US monetary and fiscal POLICY).
For those of you looking to establish a position here or generally interested in understanding the foreign exchange and global financial market risk embedded in our thesis, we encourage you to review the notes below. As always, we are available to dialogue further; simply email us and we’ll set up a call.
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For October/November, water-borne light, sweet crudes (Brent, LLS, ANS) continue to trend higher against WTI, and regional crudes (Bakken, Midland, Syncrude, WCS) have traded away from WTI since mid-September. Wide differentials could persist in 4Q12, but we expect them to tighten across the board in 2013.
Takeaway: Owning this name means waiting for the new stores to outweigh the old stores in quantity. Let’s hope the balance sheet lets it get there.
What Everyone Will Say: Results severely missed expectations. Comps down 26%, Internet sales down 37%, and margins off by -1237bps. Adjusted earnings showed a loss of $0.93. Management seems to have a very good sense as to where things went wrong, but not necessarily a good strategy to fix things anytime soon. The video of the new store concept looked great, and shows a transformed JC Penney into jcp, but it will take time to rollout en masse until newco outweighs the size of JC Penney.
What We Say: We did not like the stock the day Johnson started, and we don’t like it today. In fairness, this weakness was worse than even our model by a factor of 2x. We expected better, but are not surprised. Here’s are our low/highlights…
6. Cash flow from operations for the year is -$655mm, JCP’s net debt to equity is sitting at historical highs of 0.67x, and we’re staring down the face of a FASB-mandated accounting change to capitalize operating leases that could inflate JCP’s balance sheet further to a point where borrowing capital to fund its transformation could become very difficult. Ultimately, JCP is likely to charge ahead, but would have to sell assets in order to do so. It’s already made the easy sales. Future ones are going to be less favorable economically.
7. On that note, RJ stepped into dangerous waters when he started to call JCP a specialty store yet compare it to mall owners Simon, GGP, Macerich and Taubman. That was odd, to say the least. He followed up later to a question about specialty store productivity (which is $300-$400/square foot). He admitted then that jcp will be a specialty store, but with department store productivity.
The punchline here is that the call has not changed from last summer. Johnson is operating on a 7 (now 6) year duration. That’s when he gets paid. Wall Street largely cannot wait that long. Until then (and possibly after) we still are not sure that JCP will ever see an earnings number over $2.00. Trying to gage earnings this year is a Hail Mary. And either way you come up with a negative number. P/E valuation is meaningless. But with it its current debt burden and lack of cash, we’re looking at an EBITDA multiple near 10x. That’s just flat-out bad. At some point, this stock will look interesting as the shops gain traction, but that will be a long time from now, and until then we can point to nothing that should make it go up from $20. We think that JCP will create a massive headache for companies such as Macy’s, Gap, and Kohl’s as it takes up its product mix. The rationale is that regardless of JCP’s success, 100% of the product is being sold through. It just depends on the price, and therefore gross margin.
Takeaway: Looming risks facing the Wendy's system make the stock unattractive to us on the long side.
We’ve outlined our concerns about Wendy’s cash flow, given the years of intensive capex required to fix the system, since the analyst day back in January when the price tag of the turnaround ($3.7 billion) was brought to light.
Thoughts on the Quarter
We expect fixing the Wendy’s system to take another two years. Years of deferred capex has turned the company’s store base from an asset into a brand liability. It has taken CEO Emil Brolick the better part of a year to get the upgrade cycle going. As things stand, the vast majority of the initiative remains to be done. The company is working frantically to reimage stores in order to produce data and assure the investment and franchisee communities of the initiative’s viability.
The desire to demonstrate results is a positive but, on the other hand, it also implies an accelerating pace of spending and an increasing risk of earnings misses. Yesterday’s earnings announcement was mixed, at best, as operational metrics came in light besides same-restaurant sales. This company, by any conventional measure, is not producing free cash flow and likely will not for the next two years.
The comps during 3Q have vindicated management’s recent introduction of new menu items to increase consumer appeal. However, Brolick has emphasized the long-term importance of the asset base upgrade for gaining full credit from consumers for the upgraded menu. Where same-restaurant sales are in the fourth quarter is the key question for investors as the company laps the introduction of the Dave’s Hot ‘N’ Juicy Cheeseburger in October 2011. It is a strong possibility that comps are negative in 4Q with consensus expecting +1%.
Nothing Better To Do With Cash?
The biggest concern from the earnings release, for us, was the doubling of the dividend and a new $100 million share repurchase program. The board seems to be throwing money at the stock in order to support the share price which has been flat-lining for five years now. An owner of the stock yesterday was happy to learn that the dividend was going higher but the truth is that the company does – or should – have a better use for its cash.
Near-Term Uncertainty for Franchisees
Management announced a franchisee incentive program to get the larger, better-financed franchisees on board with the reimage program. As an observer, it’s difficult to know how the impact of these initiatives will play out over the near- and intermediate-term. As management has alluded to, the transformation of the Wendy’s brand will involve substantial turnover among the franchisee base. The journey from “mom and pop” franchisees to “mega” franchisees will, we believe, have a positive impact on the long-term health of the Wendy’s system. It is worth bearing in mind, however, that these transitions rarely occur without a hitch.
There are other factors, on the macro and micro level that are adding to franchisee blood pressure. On the macro side, Obamacare, commodity prices, and the fiscal cliff and its myriad possible consequences from a tax and economic perspective are weighing on the minds of operators. On the micro level, there has been some discontent among smaller franchisees at the level of investment required of them to partake in this (largely unproven) reimage initiative.
While we believe management can allay the micro-level concerns, the macro issues are unknown but could be especially meaningful for a company, like Wendy's, that is in transition. Our industry contacts continue to state that the implementation of Obamacare will be a negative for the restaurant industry. Franchisee communities which operate on thin margins, like Wendy’s, are particularly vulnerable.
The Latent Risks of the Franchised Business Model
In June, we held a conference call with John Hamburger of the Restaurant Finance Monitor and discussed the general perception of franchised companies as stable cash flow generators and the premium multiple that investors award the stock of such companies. Shares of BKW, DIN, DNKN, MCD, WEN, YUM & DPZ are some of the most richly valued in the restaurant space.
It makes intuitive sense to award a higher multiple to the shares of franchised companies but an important caveat is the prospective health of the constituent franchisees. Yesterday, Wendy’s stated that the impact of the healthcare overhaul will be “less than” (read: “around”) $25,000 per store. Assuming the company-franchise mix of ownership remains as it is, we calculate that Wendy’s could be facing a $0.10 hit to earnings per share. Given the company and franchisees’ need to reinvest in the business, it is important to look at the impact on franchisee cash flow. The impact of this new cost may amount to as much as 18-20% of store level cash flow for a ten-unit franchisee.
The looming impact of this, and other risks, is adding a real sense of urgency to the Wendy’s reimage initiative. For those taking a shorter-term view of the stock, accelerating spending during such an uncertain time implies a higher risk of earnings disappointments.
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