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YUM – CHINA, NOT WITHOUT ISSUES

YUM needs its Holy Grail, China, to save the day in Q1, which could be a challenge.  YUM is facing difficult comparisons and although economic news out of China has improved on a sequential basis in March, overall trends in Q1 were less than favorable.

 

In 4Q08, we learned that same-store sales trends in China slowed considerably in December as YUM had reported that quarter-to-date comparable sales were up 4% through November 30, but closed out the quarter only up 1% (a timing shift in December hurt by 1%). YUM was lapping a difficult 17% comparison in the fourth quarter but this slowdown was worse than expectations.   Also, EBIT margins declined in China in 4Q08 (down 190 basis points) as a result of continued commodity and labor inflation.

Looking to 1Q09, I expect YUM to face similar challenges as YOY commodity pressures will be more severe in 1Q09 and the company is lapping 12% same-store sales growth and 33% operating profit growth.

And the news from China is not all that good.  The slide in December retail sales trends looks to have continued into January and February, but March suggests some consumer resilience.    

YUM – CHINA, NOT WITHOUT ISSUES - China Retail Sales

The Chinese Government is doing what they can to get consumers to spend again.  As you can see from the chart below, credit is flowing rapidly in China creating positive momentum.  Yesterday, China reported an 11.2% year-over-year increase in urban disposable income for 1Q09 (the rural population realized 8.6% cash income growth in the same period) and the CPI declined by 1.2% Y/Y for March – the second sequential negative growth month.  YUM needs government stimulus to motivate Chinese shoppers to increase their willingness to spend for the balance of 2009 in order to hit its 15%-20% operating profit growth goal in China.

YUM – CHINA, NOT WITHOUT ISSUES - China Liquidity

 


CANARIES & COAL MINES

The market for coal in China suggests buyers are anticipating a big increase in power demand

 

At -4.6%, Chinese PPI for March arrived at the lowest year-over-year change in a decade as contracting demand for exports and lower commodity prices impacted the cost of doing business.

 

CANARIES & COAL MINES   - che1

One core commodity component that has still seen double digit inflation levels is coal. Since becoming a net importer last year the PPI breakout has remained in double digits despite global price declines with February data (the most recent available) registering at 18.3% Y/Y.

 

March imports registered at the highest level in two years, and the divergence between spot prices in China have held at price levels significantly higher than global averages since the end of last year, with some data showing a 50% premium to European and South American prices.

 

CANARIES & COAL MINES   - che2

 

CANARIES & COAL MINES   - che3

 

Chinese coal producers’ experienced significant setbacks last year with massive snow storms and the Sichuan earthquake interrupting operations and transportation, while at the same time government programs to modernize the industry and close antiquated, unsafe mines have trimmed capacity. The persistent demand for Thermal coal in the face of the Q4/Q1 Industrial production slowdown and sequential Y/Y declines in reported electric power production over the same period however, would appear to be more than enough to offset these capacity setbacks.  This continued rapid demand expansion suggest something that may be significant for our thesis:  stockpiling by utilities in expectation for rapidly increased electricity demand for the remainder of 2009 as a stimulus fed recovery picks up steam.

 

We remain bullish on the ability of China to kick start internal demand with the stimulus measures adopted and will continue to monitor all factors looking for more data to support or challenge our thesis.

 

Andrew Barber
Director


MACAU: A SUMMER OF TOUGH COMPARISONS

As can be seen in the following chart, Macau year-over-year comparisons have been extremely difficult due to primarily to the flood of credit that boosted the Rolling Chip (RC) segment in the first half of last year.  The Mass Market comparisons, while difficult on the surface, were boosted by the opening of The Venetian, which obviously remains open.

MACAU: A SUMMER OF TOUGH COMPARISONS - macau comps

We remain unperturbed about the tough comparisons.  September is not that far off.  Visa restrictions may already have been loosened and most certainly will be when the new CE takes over in November.  For those of you looking for a nearer term catalyst, the June event calendar looks favorable including:

·         The opening of Crown’s City of Dreams in early June

·         G2E on June 2-4

·         The International Indian Film Academy (IIFA) Awards on June 11-13th – “Bollywood” is a big deal these days.


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ONE SIZE DOESN’T FILL ALL

Back in the day, it was easy to compare the EV/EBITDA valuations of fundamentally similar companies.  EV/EBITDA is now failing as a useful valuation metric due to disparate credit issues.  A low and sustainable cost of capital is a valuable asset versus debt with a near-term maturity or a likely covenant breach.  Yet, even if estimates are adjusted for refinancing, the impact won’t show up in the standard EV/EBITDA calculation.

We can blame the markets, dumb financial management, the government, and so on.  Pick your scapegoat but the credit environment has changed dramatically in the last 6-9 months.  The easy money era is over and companies can no longer financially engineer returns.  Consider: 

·         For more leveraged companies, credit spreads have blown out from several hundred basis points to several thousand basis points

·         For less leveraged companies, bonds have gone from trading in the mid single digit yields to high teen yields

·         The CMBS market has largely become inaccessible

·         Banks have a much smaller appetite for risk, even at generous spreads, as they seek to shore  up their balances sheet

·         Underwriting future cash flow or giving credit for non-income producing assets is a rarity

·         Loan-to-Value (LTV’s) are down from 75% to 50%, with much more conservative assumptions on the “V” portion

·         Leverage covenant tolerance is down from 7.0-8.0x to 5.0x

·         Senior leverage tolerance is down from 5.0x to under 3.5x

·         LIBOR floors are the new future - say goodbye to sub 5% all in rates

Prospective or distressed borrowers are facing very large mark-ups in interest cost when they refinance or issue fresh debt.  For companies that rely heavily on bank debt, the mark up will be particularly ugly, as new credit facilities will not only be materially more expensive, but also a lot smaller, forcing these companies to tap the high yield market.  Even when fundamentals stabilize and begin to recover, companies may not get any cash flow benefit, as much of the EBITDA improvements will be eaten away by higher interest costs.  Therefore, simply applying historical EBITDA multiples will not capture the new reality of higher capital costs.

Unlike EBITDA, FCF accounts for differences in capital structure, and therefore we believe it is more appropriate to apply a multiple to FCF when thinking about valuation for leveraged sectors such as Gaming & Lodging.  Of course, fundamentals, stability, and growth can justify disparate multiples as they’ve always done.  Now, cost of capital can vary significantly across similarly leveraged and fundamentally exposed companies.  FCF yields and multiples do a better job of capsulizing that important metric.


Poland Seeks Alternative Energy and Snubs Russia

Poland’s state-owned gas company signed a 20-year deal to buy liquefied natural gas (LNG) from Qatar, a deal which will send a clear message to Moscow and the rest of Europe that it is not dependent on Russian energy alone.

 

The deal is landmark for both Poland and Europe due to the inaction of EU states to attain alternative natural gas flows outside of Russia, especially since Russia’s repeated regional shut-offs, including the most recent one over New Year’s due to contract disputes with Ukraine. This year the Nabucco project, a potential pipeline from Turkey (via the Balkans) to Europe made headlines but lacked funding; the only concrete resolutions to come from the European community include green energy projects and increased funding for wind turbines and hydro-electric  technology. 

 

Poland’s deal highlights the advantages of LNG technology. LNG gas takes up about 1/6oo the volume of natural gas, making it efficient to transport by ship to circumvent Russian pipeline delivery. Till this point Europe has been adverse to LNG technology due to the massive infrastructure start-up costs and time associated with building LNG terminals (where LNG is stored and regasified) versus the cost benefit of piped Russian gas. 

 

The political significance of the deal, which pigtails our post (“Feeding The Ox 2”) on China’s announced $10 Billion minority stake in Kazakhstan’s state-owned oil company, is immense. Again, Russia stands to lose on the deal, both strategically and competitively. Yet Poland relies on Russia for some two-thirds of its gas (EU average 42%) and the projected deal would only supply the country with one-tenth of its annual consumption, and Poland won’t be buying gas from Qatar until 2014.

 

For Poland, arguable the one Eastern European country to make the largest capitalistic strides while cementing its western (EU) orientation since the Fall of the Berlin Wall, has a long history of antagonism and distrust for Russia—this is nothing new. This Qatari deal, along with Poland’s announcement to build an LNG terminal more than three years ago and pipeline project to Norway, does not mean that Poland is energy independent from Russia. It is however a bold political move, one Putin & Co. will interpret as a slap in the face, and may be the catalyst for European nations to limit their dependence on Russia energy and make alternative gas solutions a reality.

 

Matthew Hedrick
Analyst

 

Poland Seeks Alternative Energy and Snubs Russia - LNGPHO


INTERPRETING CHINESE DATA

GDP was uninspiring, but much of the March data suggests that things are back on track


At 6.1% Y/Y, Q1 GDP was disappointing to many - but also inside the expectations of every rational observer.  With exports down by 20% Y/Y, this contraction is unsurprising if unwelcome.

 

INTERPRETING CHINESE DATA - cee1

 

Industrial production data for March showed a Y/Y increase of 8.3% with western industrials registering growth of 11.8% Y/Y vs. 5.2% for central regions and 3.7% for the export dependent eastern coastal regions.   While production has remained resilient, profits contracted sharply with NBS reporting a 37.3% Y/Y decline for large enterprises despite the respite provided to refiners by falling oil prices.

 

INTERPRETING CHINESE DATA - cee2

 

Critically, the sequential improvement in retail sales for March suggests real consumer resilience as the increasing credit and liquidity we discussed on Monday ( “Gushing “), combined with a 11.2% Y/Y real increase in urban disposable income for the quarter (the rural population realized 8.6% cash income growth in the same period) and  CPI which declined by 1.2% Y/Y for March –the second sequential negative growth month, Chinese shoppers appear to be willing to spend.

 

INTERPRETING CHINESE DATA - cee3

 

For our macro view, perhaps the most important data point release last night was fixed investments which clearly demonstrated that increasing  stimulus juice is hitting the OX’s  bloodstream at 28.5% Y/Y up from 26.5% in Feb.  This continuing growth (particularly felt in the central and western regions) continues to support our thematic conviction in reflation driven by proximity to the “customer” as the stimulus measure adopted by Beijing continues to improve prospects for pragmatic commodity centric economies.

 

With Q1 headline data Inside the low of the anticipated range, but signs of life in March data the market’s reaction is divided as both the glass half-full and half-empty camps see support for their thesis. From our perspective, although the numbers are far from pretty, there is a clear indication that the Chinese economy has begun to find its legs.

 


Andrew Barber
Director


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