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AMID RECESSION FEARS, COULD GLOBAL GROWTH SURPRISE TO THE UPSIDE OVER THE INTERMEDIATE TERM?

Takeaway: Commodity deflation has provided and may continue to provide a stimulus to the still-fragile global economy.

SUMMARY BULLETS:

 

  • From the right PRICE, pending our quantitative signals, you could see a positive revision(s) to our global GROWTH  expectations with respect to the intermediate-term TREND, as further deflation of food, energy and raw materials prices provides an economic stimulus via disinflation in actual consumer and producer prices.
  • You’re seeing this potential GROWTH pickup confirmed across a large swath of PMI readings (we track 31 in total). Broadly speaking, the service sector continues to outperform manufacturing, as it has done since mid-2011. We portend this is largely a function of the decline in commodity prices over that period (consumption tailwind and commodity-related capex declines).
  • Aside from the necessary PRICE, VOLUME and VOLATILITY signals, what would get us really bullish on “risk assets” from here? More of the same. The less global financial markets have to react to the conflicted and compromised whims Bernanke, Geithner, Obama, Pelosi and Boehner, the more we are likely to see further upside in the USD and further downside across the commodities complex.
  • Additionally, “VIX-15” and an asymmetrically stretched bull/bear sentiment spread (in favor of the bulls) remain key contrarian indicators to intellectually wrestle with at the current juncture. Investors are broadly bullish and/or complacent, so it’s likely that some degree of improving global economic fundamentals is priced in.
  • In grossly uncertain times like these, it’s best to double-down on your process (assuming it is effective); in that light, we will continue to manage the risk of the ranges across a variety of securities and asset classes, with an keen eye for potential breakouts in light of the aforementioned global economic scenario.

 

Be it Deflating the Inflation (2Q11), Bernanke’s Bubbles (2Q12) or Bubble #3 (4Q11), we have been consistently and appropriately making bearish cyclical calls on the commodities complex over the past 18-24 months, with the latter theme extending our view to the TAIL duration as well. For the record, the CRB Index is down -17.7% since the start of 2Q11 and down another -4.3% quarter-to-date.

 

From the right PRICE, pending our quantitative signals, you could see a positive revision(s) to our global GROWTH  expectations with respect to the intermediate-term TREND, as further deflation of food, energy and raw materials prices provides an economic stimulus via disinflation in actual consumer and producer prices.

 

AMID RECESSION FEARS, COULD GLOBAL GROWTH SURPRISE TO THE UPSIDE OVER THE INTERMEDIATE TERM? - 1

 

Additionally, it just so happens that our baseline GIP model (driven by predictive tracking algorithms) is now pointing to a directionally positive economic environment over the intermediate term as new global GROWTH data has rolled in over the past few weeks.

 

AMID RECESSION FEARS, COULD GLOBAL GROWTH SURPRISE TO THE UPSIDE OVER THE INTERMEDIATE TERM? - 2

 

You’re seeing this potential GROWTH pickup confirmed across a large swath of PMI readings (we track 31 in total). For the month of NOV, the median PMI reading came in at 51.4, up from 50.4 in OCT; the median sequential delta for the month came in at +0.5 percentage points. Broadly speaking, the service sector continues to outperform manufacturing, as it has done since mid-2011. We portend this is largely a function of the decline in commodity prices over that period (consumption tailwind and commodity-related capex declines).

 

AMID RECESSION FEARS, COULD GLOBAL GROWTH SURPRISE TO THE UPSIDE OVER THE INTERMEDIATE TERM? - 3

 

AMID RECESSION FEARS, COULD GLOBAL GROWTH SURPRISE TO THE UPSIDE OVER THE INTERMEDIATE TERM? - 4

 

Aside from the necessary PRICE, VOLUME and VOLATILITY signals, what would get us really bullish on “risk assets” from here? More of the same. The less global financial markets have to react to the conflicted and compromised whims Bernanke, Geithner, Obama, Pelosi and Boehner, the more we are likely to see further upside in the USD and further downside across the commodities complex.

 

That’s a better, more sustainable bull case than the current one which largely consists of corporate management teams [potentially] levering up to pay “special dividends” and mass layoffs.

 

That being said, it remains to be seen whether or not an arrest of central planning is possible – especially with the Keynesian Cliff (Fiscal Cliff and Debt Ceiling domestically) hanging in the balance. For our latest deep-dive thoughts on this topic, please refer to our 11/16 note titled: “DEBT CEILING UPDATE: WILL SANTA’S SACK BE FILLED WITH COAL?”.

 

Additionally, “VIX-15” and an asymmetrically stretched bull/bear sentiment spread (in favor of the bulls) remain key contrarian indicators to intellectually wrestle with at the current juncture. Investors are broadly bullish and/or complacent, so it’s likely that some degree of improving global economic fundamentals is priced in.

 

In grossly uncertain times like these, it’s best to double-down on your process (assuming it is effective); in that light, we will continue to manage the risk of the ranges across a variety of securities and asset classes, with an keen eye for potential breakouts in light of the aforementioned global economic scenario.

 

Darius Dale

Senior Analyst


CAT Idea Alert: It Hasn’t Started, So It Isn’t Over

Takeaway: $CAT's recent results still reflect big *increases* in mining capital investment. Investors are not looking through what they haven't seen.

CAT Idea Alert:  It Hasn’t Started, So It Isn’t Over

 


Levels:  Long-term TAIL resistance = 89.74; TRADE support = 85.79

 

We have highlighted a number of the reasons that we are bearish on CAT’s share price.   Some investors may think that the worst is over, but capital equipment cycles tend to be multi-year affairs.  The resource investment down-cycle hasn’t even started yet for CAT, in our view.

 

  • Mining Capex:  While the pending declines in mining capital investment have just started to enter guidance, they have not entered CAT’s reported results yet.  Miners like Fortescue (Capex of $3.7 billion in 1H 2012 vs. $1.2 billion in 1H 2012) and Vale (Capex of BRL 10.7 billion in 3Q 2012 vs. BRL 6.1 billion in 3Q 2011) are still reporting massive increases in capital expenditures.  Caterpillar has not reported a single quarter reflecting lower mining capital expenditures since the financial crisis, even though the miners have started to discuss the cuts.  Instead, CAT’s results still reflect big mining investment increases. 
  • Chinese Metal Demand:  Chinese fixed asset investment has been a big driver of mine expansions.  Local construction related commodity prices suggest that party is over for now.

CAT Idea Alert:  It Hasn’t Started, So It Isn’t Over - 11

 

 

  • Inventories High, Capacity High:  CAT dealers and CAT BOTH have too much inventory, and not by a small amount.  Depending on where demand shakes out, the two probably have $5-$7 billion in excess inventory.  CAT has not reported a quarter in which inventories have corrected, yet, and reducing inventories is likely to pressure results.  The company will also need to rationalize capacity, which has not happened yet, and will likely also depress results, too, in our view.
  • Coal CapEx Cuts:  We have not seen coal capital expenditures down this year, although it looks like the cuts will bite this quarter.  Coal is a major end-market for CAT and prices have been under pressure globally.

CAT Idea Alert:  It Hasn’t Started, So It Isn’t Over - 12

 

 

  • VERY Early:  We believe we are just at the beginning of the correction in resources capital investment.  CAT has yet to report a single quarter with the expected declines, so it is probably safe to assume that it isn’t “over.”  Investors extrapolating results from recent quarters (by using P/Es, for example) are making a mistake, in our view.  Investors are unlikely to “look through” what we expect to be a very long period of adjustment to inventories, capacity and end-markets with any clarity.  

 

 


Manheim Index Gets A Boost

The Manheim Index of used car values tends to closely correlate to the S&P 500 and right now we're seeing upside in both indices. The Manheim Index rose 0.6% month-over-month in November to 122.6 but declined on a year-over-year basis by 1%. 

 

Hurricane Sandy played a role in the November numbers by reducing supply and increasing demand for used cars, which is expected to continue into December and part of early 2013. Interestingly, Manheim co-integrates with the labor market. A generally improving labor market means more people need cars to get to work and most cars on the road are…wait for it….used. This is one reason why we're so interested in the decline in Manheim over the last few months. It seems to be a contradictory data point compared with what the other labor market series are telling us.

 

Manheim Index Gets A Boost - CACC vs Manheim

 

Manheim Index Gets A Boost - Manheim vs S P


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JCP: Fake Estate

Takeaway: The ‘Real’ Estate angle with JC Penney is overhyped. A transaction could provide near-term relief, but may ultimately prove problematic.

Just about any development that gives the investment community ‘hope’ in JCP these days gets the stock rallying. That’s exactly what happened yesterday with a newly formed REIT structure out of Loblaw – Canada’s largest food retailer. But one consideration people should keep in mind is that if JCP creates a REIT, it may not be able to make its rent.

 

After five years of starving its store base of capital and pushing out leases to preserve cash flow, we’re left asking what levers the company has left to pull if sales and profitability growth fail to materialize. The most obvious option is to leverage the company’s real estate assets, a strategy that Bill Ackman & Co. have considerable experience with. Here’s an option JCP could consider to unlock its real estate value:


REIT Option: Back in January 2011, Dillard’s announced its intent to form a REIT in order to “enhance its liquidity” by transferring “real properties” that are currently owned and lease back the properties under triple net leases. Given an improved environment and recent transactions in the REIT sector, this strategy is likely under consideration for other retailers as well in an effort to unlock real estate value.


Loblaw’s announcement is similar to Dillards in that it is planning to spin off roughly 70% of its property assets worth more than $7Bn into a REIT. The funds from the transaction will be reinvested in the operating business. With cash flow from operations YTD down -$655mm and net debt-to-equity at historical highs at 0.67x, the probability of JCP pursuing this option is still low, but increasing on the margin.


Since the formation of a REIT provides the greatest benefit for retailers that own a substantial percent of their real estate, we’ve looked at the likely candidates (see chart below).  Both Macy’s (55%) and Nordstrom (46%) own a greater portion of their store base compared to JCP, but even with 39% of its real estate owned, this is an option for Penney’s to consider.

 

JCP: Fake Estate - JCP RE

 

JCP currently owns approximately 39% of its real estate, or 44.6 million sq. ft. Based on current rent and cap rates, we estimate JCP’s potential REIT value at $1.85Bn-$2.55Bn, or $8.25-$11.50 per share. 

 

JCP: Fake Estate - JCP REIT

 

While forming a REIT is not likely, one thing to keep in mind that Steven Roth is on JCP’s board. While Loblaw’s announcement may have roused speculation in the start of a potential trend, recall that Roth was one of the first to execute such a strategy when he bought Alexander’s out of bankruptcy in 1993 and converted it to a REIT. Roth has “been there and done that” before.


Here’s an obvious but big consideration.


Also, this 39% that is owned carries very low cost on the land. Yes, the company is depreciating the property (some of which is fully depreciated). But if it created a REIT, it would actually have to start paying market rent on this property. Funds from a transaction would provide operating cash and cushion initially, but rent expense could ultimately prove problematic for JCP over time.


In a perfect world, the 39% of JCP’s stores that are owned will be the 400 stores that are not going to be converted into the new format. After all, keeping the old format in these stores will default them to a very high cost infrastructure.  But that’s a very fat chance of perfect overlap. In fact, it makes the most sense to run a chain of only 700 stores – so they logistically and structurally only have to serve stores that are converted. Otherwise these remaining assets will do nothing but weigh down the core.


MCD BOTTOMING PROCESS

We believe the bottoming process in McDonald’s will take longer than some are anticipating.  This morning’s upgrade is pushing the stock higher but we see reasons to avoid McDonald’s on the long side for now.

 

Reasons to Become More Constructive:

 

The Yield: This is the #1 reason we hear for people to get bullish on MCD.  While we agree that the 3.47% yield is attractive, we believe that buying MCD here for anything more than a short-term TRADE is fraught with risk.  Consensus is expecting a “hockey-stick” recovery in earnings growth that we do not expect to materialize

 

Sentiment Has Reset:  There is an argument to be made that consensus has become too bearish on the immediate-term TRADE but we believe that mistakes on MCD’s part, yet to be acknowledged by management, will continue to hamper same-restaurant sales growth in the important US market.

 

MCD BOTTOMING PROCESS - mcd macro usa

 

 

Compares Will Begin To Ease Post-1Q13:  Several weeks ago, we were eyeing this thesis as a potential reason to get long MCD in late FY12/early FY13.   We have come to the conclusion that there are self-inflicted wounds impacting McDonald’s sales performance that management has not yet owned up to.  The aggressive move to value has not been effective and we do not believe it will be effective next year, despite easing compares.  Stiffer competition in the QSR segment in the US makes forecasting FY13 comps difficult.  For instance, yesterday at the YUM Analyst Day, we learned that Taco Bell is increasing its target rating points (TRPs) by 44% year-over-year as it transitions to an exclusively nation-wide marketing strategy (no regional advertising).

 

 

Reasons to Look Elsewhere:

 

MCD Not the Restaurant Cockroach: We read an interesting paper recently on the long-term resilience of “cockroach” portfolios that yield stable returns through economic cycles.  There is a perception that MCD is the “safety trade” in restaurants.   We would argue, from an operating income perspective, that YUM is more attractive in this regard given its geographical diversification and best-in-class growth profile. 

 

MCD BOTTOMING PROCESS - yum mcd sbux opinc

 

 

Valuation Is Not A Catalyst:  Valuation is being cited as one reason to get long MCD but, on the contrary, we would argue that it remains a reason to look elsewhere.  The Street is valuing the stock at 15.3x FY13 EPS and, while this is not a rich multiple historically, we would take issue with the Street’s earnings estimate.  Our FY13 EPS estimate of $5.29 implies a much less attractive multiple of 16.8x.  Ultimately,

 

 

MCD November Sales Preview

 

McDonald’s reports November sales on Monday morning before the market open.  Consensus is calling for a sequential acceleration in two-year average trends in November. 

 

Below we go through what we would view as good, bad, or neutral comparable restaurant sales numbers for McDonald’s three regions in November.  For comparison purposes, we have adjusted for historical calendar and trading day impacts (but not weather).

 

Compared to November 2011, November 2012 had one additional Thursday, one additional Friday, one less Tuesday, and one less Wednesday.  We expect this to have a modestly positive impact on the headline numbers for November although some negative impact will be felt in the U.S. from Sandy. 

 

MCD BOTTOMING PROCESS - MCD srs cons hedgeye

 

 

United States – facing a compare of 6.5%, including a calendar shift of 0.3%, varying by area of the world:

 

GOOD: A positive print would be received as a strong result as, on a calendar-adjusted basis, it would imply acceleration in two-year average trends from October.  In October, performance in the U.S. was negatively impacted, according to management, by “modest consumer demand and heightened competitive activity offset the impact of local Dollar Menu advertising, the Monopoly promotion, and the recent launch of the Cheddar Bacon Onion premium sandwiches.”  We believe that the heightened competitive activity in QSR is likely to ramp further over the coming months and quarters.

 

NEUTRAL:  A print between -1% and 0% would imply calendar-adjusted two year average trends roughly flat versus October.  While the first chart of this post implies an over-bearishness on the part of consensus, self-inflicted wounds on MCD’s part lead us to conclude that slower same-restaurant sales growth is possible from here.

 

BAD:  Same-restaurant sales growth less than -1% would imply a sequential deceleration in two-year average trends in the U.S. from what was a disappointing month in October.  We would expect the stock to react negatively to this print. 

 

MCD BOTTOMING PROCESS - mcd us sss

 

 

Europe – facing a compare of 6.5%, including a calendar shift of 0.3%, varying by area of the world:

 

GOOD:  A positive print would be received as a strong result as, on a calendar-adjusted basis, it would imply acceleration in two-year average trends from October.  Performance in Europe was hampered by economic uncertainty in November that has continued, if not worsened, in November.  This morning, the Bundesbank slashed a percentage point off its forecast for economic growth in Germany next year.  We expect broad-based sluggishness to persist in Europe for MCD.

 

NEUTRAL: A print between -1% and flat would be received as neutral by investors as it would imply calendar-adjusted two year average trends roughly flat versus October. 

 

BAD:  Less than -1% same-restaurant sales growth would imply, on a calendar-adjusted basis, trough two-year average trends for the year in Europe. 

 

MCD BOTTOMING PROCESS - mcd eu sss

 

 

APMEA – facing a compare of 8.1%, including a calendar shift of 0.3%, varying by area of the world:

 

GOOD:  A print of -0.5% or better in APMEA would be a positive result for MCD.  We are not expecting much from APMEA this month given the worse-than-expected commentary from YUM on its China business.

 

NEUTRAL:  A print between -1.5% and -0.5% would be received as neutral by investors as it would imply calendar-adjusted two year average trends roughly flat versus October. 

 

BAD:  Same-restaurant sales growth slower than -1.5% in November would imply sequential deceleration in two-year average trends in APMEA and would likely be received negatively by investors.

 

MCD BOTTOMING PROCESS - mcd apmea sss

 

 

Howard Penney

Managing Director

 

Rory Green

Analyst

 

 

 


Vegas Strip Surprise Data

Las Vegas Strip gaming revenue rose 3.6% in October on a year-over-year basis. The upside exceeded expectations and was due in large part to higher slot hold. Since September ended on a Sunday, due to an accounting policy, ~$50 million in slot revenue was carried into October; hence, a higher than normal hold rate (8.1%) resulted. With the Vegas gaming market still in a depressed state, future data is expected to remain weak.

 

Vegas Strip Surprise Data - SLOT666


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