Geithner's Greenback

Poor Timmy is back on stage this morning, testifying in front of the US Government, and reminding us all that our Financial system (and those at the helm of it), have lost credibility. This guy's smugness is truly embarrassing.


In a perverse way, this is actually quite good for the REFLATION trade. As foreign sellers threaten to Break The Buck, assets will REFLATE. Dollar DOWN = everything else UP.


Geithner's Greenback - gman


Keith R. McCullough
Chief Executive Officer

MCD - Rolling out the Angus Burger?

It’s being reported today that McDonald's (MCD) is planning to introduce its Angus burger nationally this summer.   The Angus burger is a premium burger (over $4.00 in some markets) with a larger patty and higher quality beef.  The size of the burger did pose some operational challenges for some franchisees. 

The timing of the launch Angus burger is puzzling at best.  First, franchisee are burdened with the complexity of rolling out the premium coffee initiative this summer.  To successfully accomplish the premium coffee strategy, incremental labor must be added to the store.  Second, no QSR chain that is focused on selling premium product is seeing increased traffic.  Third, a successful launch of any new product requires significant advertising support.  Without a significant increase in the overall ad budget, advertising dollars will need to be shifted away from what is currently working (breakfast and the value message) to support the new burger.  We already know the company has shifted some advertising dollars to support the launch of the specialty coffee business this summer. 


MCD’s U.S. same-store sales growth remained surprisingly strong throughout 2008 despite the tough economic environment. The company states that half of this comparable sales growth has been driven by traffic with the remainder coming from increases in average check. The growth in average check in 2008 was driven solely by MCD’s 3%-4% price increase, which was partially offset by negative mix contribution in each quarter.   One obvious explanation for MCD’s negative mix in the U.S. is that customers are trading down to the Dollar Menu, which has also helped to support traffic growth. 


I recognize that the problem with an average check is you have a lot of different transactions in there. MCD’s breakfast business, which carries a lower average check, continues to grow faster than the rest of the day’s business.  This hold true with drinks too.  Last summer, the $1 sweet tea promotion was a huge success and the drip coffee is up more than 30%. 


The point to all this is that in 2008, the incremental consumer that was going to a McDonald’s was there for the “value” not “premium” products. 

MCD - Rolling out the Angus Burger? - angus


IGT spent $130 million more in 2008 on SG&A and R&D than it did in 2006, on a big slot revenue decline and flat total revenues.  Why can't IGT revert back to its 2006 cost structure?  The answer:  IGT needs a push.  We don't yet know if Patti Hart is the right person although she certainly brings a fresh and more importantly, unemotional perspective.


The following chart compares various margins for IGT, WMS, and BYI.  On the surface, it appears that IGT's margins are reasonable and the company's cost structure is not necessarily bloated.


IGT: COST CUTTING POTENTIAL - slot margin comps


However, the next chart shows that SG&A and R&D spend is up 23% and 26%, respectively, in just 2 years on a big decline in product sales. 




IGT indicated that it has already cut $115 million in costs in the past year so the obvious question is how much more is left?  Fortunately, those cuts were made at the production level and more than offset the usual margin decline associated with declining volumes.  Gross margin would've otherwise cratered with sharp decline in units.  Instead, product margins have expanded in the face of dismal sales as can be seen in the following chart.  Some of that is increased non-box sales (higher margin conversions, software, etc) and higher pricing, but also reflects the $115 million in cost cuts.  IGT's manufacturing is running at about 35% capacity, leaving a lot of margin on the table until replacement demand reaccelerates.  Since IGT owns its manufacturing plant and has made the production cuts, margins are likely to follow volume from here on out.  




It is in SG&A and R&D where the real opportunity lies but management needs to be aggressive.  We think it is reasonable to expect $100-130 million more in cost savings out of these areas:

  • $75MM gets them back to 07 levels, $130MM back to 06
  • Should take 6 quarters to achieve the cuts, seems like they know where some will come from, and are feeling their way around the others - the new CEO could expedite this
  • $15MM of the $100MM will show up this quarter, and it should be visible in SG&A and perhaps R&D
  • New R&D projects will now require demonstrable ROI
  • First round of cuts are in place and are a kind of "restructuring" - cleaning house to do things better rather than just get across a goal line

The bottom line here for IGT is that the cost cuts will offset some of the top line pain but earnings are likely going lower.  Slot sales will be abysmal with new and expansion units for the industry down 53% and 49% in calendar 2009 and 2010, respectively.  Replacement demand probably won't improve until 2H 2010 at the earliest.  The upshot for IGT is by that time the cost structure should hopefully be very lean and more appropriate for a 40% share company versus the historical 60-70%.  IGT will be in good shape in terms of flow through when replacement demand finally "normalizes".

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Deflation Day

"Only the wisest and stupidest of men never change."
Having played plenty a Canadian Junior Hockey Night cage match in the Bear's Den of Smith Falls, Ontario (instead of glass behind the end boards, they had chicken wire), I can assure you that I am definitely not the stupidest of men. Most guys who I chirp at with these morning investment missives will assure you that I am neither the wisest!
Ah, if you can't have fun playing this game, what's the point in waking up at this un-Godly hour and playing it at all! That said, even after taking my US Cash position back up to 62% on Friday, yesterday wasn't much fun for me. My Asset Allocation Model lost -1.05% on the day, largely because I got smoked out of my hole with a 12% allocation to Commodities. The Buck broke out, and it broke my bank.
When we did our Q2 Macro Trend call a few weeks back, I gave explicit levels on the US Dollar. I outlined a critical resistance line of 86.33 on the US Dollar Index as being my line in the sand. With that crystal clear in my rear view mirror now, yesterday's meltdown in everything other than yellow rocks (Gold was +2.4% on the day) was proactively predictable. Yes, we're long TIPs and sold out of our long positions in China, Canada, and Russia, but we still lost money, and that's unacceptable.
In conjunction with the 19 component CRB Commodities Index closing down -3.6% on the session, the SP500 got tagged for an even larger loss of -4.3%. Thankfully, I have shunned everything US Financials (XLF was -11% on the day), and have opted to stay away from being long any index with Financials in it (XLF, SPY, DIA, etc...). Regardless, on DEFLATION Day, I still took it on the chin with the 13% exposure I have to US Equities via the XLK and XLY (Tech and Consumer Discretionary ETFs).
So what to do from here? Well, as usual, the plan is that the plan is going to change. As market prices and the risk/reward embedded within them changes, I will. Only the bravest of men and women stepped up and bought additional US or International Equity market based exposure yesterday, and for that, if they get paid on this morning's US market open, I salute you. I think we have at least one more round of selling left in this thing.
Although I'm not sure what he'll have to say about this, I have never thought of my Dad's primary job as being brave - neither is mine. Notwithstanding that my cushy job up here in New Haven is nearly as dangerous, Dad's job as a firefighter, and mine as a stock market operator, is to proactively manage risk/reward.
I put up an intraday note to our Macro clients yesterday telling them that I was going to wait. With the SP500 breaking down through an important immediate term momentum line at 846, the 815-819 intermediate TREND base of support is now in play. Waiting may not seem brave, but neither is losing a toe for the sake of being in a hurry. If anything has held true for the last 18 months, it is that patience pays a big performance premium.
The entire way up to that 874 line in the SP500 I was rightly pressed by our clients and prospective ones as to why I wasn't choke full of US Equity exposure. On the way up to the top of a proactively predictable trading range, those questions get harder to answer. On the way down however, I rarely hear a peep...
Peeping is what people do who are trying to get a look-see on something that they probably shouldn't. When it comes to the inverse correlation of the US Dollar versus virtually everything else that's asset based on your screens, there is hardly any peeping required. Dollar UP = DEFLATION. If you need a chart to show you this more succinctly, we can send you one. For the guys and gals up in Boston last week, we called it The Green Monster.
In 1999 I worked on the "sell side" at CSFB, then I moved to the "buy side" for the next 8 or so years... and now I like to think that I am on the right side. I am in the business of being right, or being fired - and I like that. It keeps me awake.
Being long is one thing. Being wrong is completely another - and I don't need to stick around to see the reruns of how this movie went post mid-January when the US Dollar caught a bid again. If the Dollar goes up, I think everything else is simply going down.
The good news now (if you're long anything other than cash and gold that is) is that at 86.59, the US Dollar Index is overbought from an immediate term TRADE perspective. If the US Dollar fades here, it will put in another lower high, and that, on the margin, will be bullish for anything that you'd like to see REFLATE.
Just remember, what you'd like to see, and what the malfeasant of our Financial system still hope to see... may not be what you end up seeing. Peeping isn't cool, and neither is a risk management model that doesn't have the ability to change as the macro factors embedded within it do.
Best of luck out there today,


EWZ - iShares Brazil- The Bovespa is up 18.3% YTD and continues to look positive on a TREND basis. President Lula da Silva is the most economically effective of the populist Latin American leaders; on his watch policy makers have kept inflation at bay with a high rate policy and serviced debt -leading to an investment grade credit rating. Brazil has managed its interest rate to promote stimulus. The Central Bank cut 150bps to 11.25% on 3/11 and likely will cut another 100bps when it next meets on April 29th. Brazil is a major producer of commodities. We believe the country's profile matches up well with our re-flation theme: as the USD breaks down global equities and commodity prices will inflate.

XLY - SPDR Consumer Discretionary-TRADE and  TREND remain bullish for XLY.  The US economy is showing faint signs the steep plunge in economic activity that began last fall is starting to level off and things are better that toxic.  We've been saying since early January that housing will bottom in 2Q09 and that "free money" for the financial system will marginally improve the US economy in 2H09, allowing early cycle stocks to outperform.  The XLY is a great way to play the early cycle thesis.

EWA - iShares Australia-EWA has a nice dividend yield of 7.54% on the trailing 12-months.  With interest rates at 3.00% (further room to stimulate) and a $26.5BN stimulus package in place, plus a commodity based economy with proximity to China's H1 reacceleration, there are a lot of ways to win being long Australia.

XLK - SPDR Technology - Technology looks positive on a TRADE and TREND basis. Fundamentally, the sector has shown signs of stabilization over the last six+ weeks.   As the world demand environment becomes more predictable, M&A should pick up given cash rich balance sheets in this sector (despite recent doubts about an IBM/JAVA deal being done).  The other big near-term factors to watch will be 1Q09 earnings - which is typically the toughest for tech, along with 2Q09 guide.  There are also preliminary signs that technology spending could be an early beneficiary of the stimulus plan.

TIP - iShares TIPS- The iShares etf, TIP, which is 90% invested in the inflation protected sector of the US Treasury Market currently offers a compelling yield on TTM basis of 5.89%.  We believe that future inflation expectations are currently mispriced and that TIPS are a compelling way to own yield on an inflation protected basis, especially in the context of our re-flation thesis.

USO - Oil Fund-We bought more oil on 4/20 after a 9% intraday downward move. We are positive on the commodity from a TREND perspective. With the uptick of volatility in the contango, we're buying the curve with USO rather than the front month contract.  

DJP - iPath Dow Jones-AIG Commodity -With the USD breaking down we want to be long commodity re-flation. DJP broadens our asset class allocation beyond oil and gold. 

GLD - SPDR Gold-We bought more gold on 4/02. We believe gold will re-assert its bullish TREND as the yellow metal continues to be a hedge against future inflation expectations.

DVY - Dow Jones Select Dividend -We like DVY's high dividend yield of 5.85%.

VXX  - iPath VIX- The VIX is inversely correlated to the performance of US stock markets. On 4/20 the VIX shot up 15.5% intraday, an overcorrection we want to be short as we believe US indices will make higher highs and the volatility is currently overbought.

LQD  - iShares Corporate Bonds- Corporate bonds have had a huge move off their 2008 lows and we expect with the eventual rising of interest rates in the back half of 2009 that bonds will give some of that move back. Moody's estimates US corporate bond default rates to climb to 15.1% in 2009, up from a previous 2009 estimate of 10.4%.

SHY - iShares 1-3 Year Treasury Bonds- If you pull up a three year chart of 2-Year Treasuries you'll see the massive macro Trend of interest rates starting to move in the opposite direction. We call this chart the "Queen Mary" and its new-found positive slope means that America's cost of capital will start to go up, implying that access to capital will tighten. Yield is inversely correlated to bond price, so the rising yield is bearish for Treasuries.

EWU - iShares UK - We shorted the UK on 4/08. We're bearish on the country because of a number of macro factors. From a monetary standpoint we believe the Central Bank has done "too little too late" to manage the interest rate and now it is running out of room to cut. The benchmark currently stands at 0.50% after a 50bps reduction on 3/5. While the Central Bank is printing money and buying government Treasuries to help capitalize its increasingly nationalized banks, the country has a considerable ways to go to see recovery. GDP declined 1.5% in Q1 and unemployment  is on the rise.

EWL - iShares Switzerland - We shorted Switzerland on 4/07 and believe the country offers a good opportunity to get in on the short side of Western Europe, and in particular European financials.  Switzerland has nearly run out of room to cut its interest rate and due to the country's reliance on the financial sector is in a favorable trading range. Increasingly Swiss banks are being forced by governments to reveal their customers, thereby reducing the incentive of Switzerland as a tax-free haven.

UUP - U.S. Dollar Index -We believe that the US Dollar is the leading indicator for the US stock market. In the immediate term, what is bad for the US Dollar should be good for the stock market. The Euro is up versus the USD at $1.2970. The USD is up versus the Yen at 98.2010 and down versus the Pound at $1.4582 as of 6am today.

EWJ - iShares Japan -We re-shorted the Japanese equity market rally via EWJ. This is a tactical short; we expect the market there to pull back when reality sinks in over the coming weeks. Japan has experienced major GDP contraction-it dropped 3.2% in Q4 '08 on a quarterly basis, and we see no catalyst for growth to return this year. We believe the BOJ's recent program to provide $10 Billion in loans to repair banks' capital ratios and a plan to combat rising yields by buying treasuries are at best a "band aid".

XLP - SPDR Consumer Staples- Consumer Staples broke down through TREND line support, closing under the TREND line by a dime. This group is low beta and won't perform like Tech and Basic Materials do on market up days. There is a lot of currency and demand risk embedded in the P&L's of some of the large consumer staple multi-nationals; particularly in Latin America, Europe, and Japan.


Over the past five days, three firms have cut their ratings on Starbucks; two have gone from buy to hold and one from hold to sell.  All of the downgrades cited basically the same reasons; the company is going to report a lousy quarter and the McDonald's marketing machine is going to make it nearly impossible for Starbucks to survive.  This is now consensus!


What if things are not that bad? - We know from the trends in most of the consumer discretionary universe that things are "less bad" in 1Q08.  


What if the hundreds of store closures have had a positive impact on sales trends?  - 75% of the stores closed are within three miles of an existing company-operated store.


What if lower commodity prices and reduced labor expenses help to stabilize margins? - Milk prices are down about 35% year-over-year.


What if our grass roots survey is right and sales trends improved during the quarter?


What if McDonald's gourmet coffee strategy does not work?


Don't get me wrong, the issues Starbucks faces are far from trivial and McDonald's is a great competitor, but to think that Starbucks is not fixable is crazy.  There are a lot of high-end retailers that are not doing well today.  The Starbucks basic drip coffee is anything but expensive at around $1.65 for a 12oz cup.   


It has been well over a year since Starbucks first announced its initial restructuring, including slowed U.S. unit growth, store closures and a renewed focus on store-level unit economics.  Although these transformational changes all signaled a move in the right direction for the company, Starbucks' stock is still down nearly 40% in the last year as sales trends deteriorated further.  The company has since announced $500 million in costs savings in FY09 alone, which should help to offset sales weakness.  SBUX's fiscal 1Q09 results reflected these cost saving initiatives as EBIT margins improved sequentially from 4Q08 even with U.S. same-store sales declining 10% (worse than the 8% decline in 4Q08).  And, the savings are expected to accelerate throughout the year.  The stock's 21% move year-to-date reflects these improved results. 


In order to sustain continued stock price appreciation, SBUX cannot rely on cost saving initiatives alone.  Investors will expect to see a turnaround in sales to keep bidding up SBUX's stock price.  That being said, I set out to come up with a way to gauge SBUX's progress toward improving monthly sales trends, which resulted in the inception of the SBUX monthly "grass roots survey."  With Starbucks introducing its combo meals in March (the company's first attempt at a nationally promoted price point and a significant change in management strategy), I thought March would be a telling month to get started.  To that end, of the stores surveyed (representing a geographic mix across the U.S.), they are selling an average of 20 of these breakfast combo meals per day.




The survey indicates that March same-store sales on average were flat to -3%.  These numbers are so good I don't believe what I'm seeing.  Naturally, I provided a haircut to the numbers, but that would still put SBUX same-store sales at down 5-7%.  This would be a significant improvement from the trends in fiscal 1Q09 when same-store sales declined 10%.  As this is the first month of the survey, I think it is more important to focus on the numbers on a directional basis rather than looking at the absolute numbers, and directionally, these March numbers look better than what we have been seeing out of Starbucks' U.S. business.


Also of significance was that 100% of the partners surveyed commented that they thought management was taking the company in the right direction, with its new focus on combo meals and value offerings being the most consistent supporting answer, particularly in light of today's challenging economic environment and its subsequent toll on consumers.  A handful of Starbucks partners pointed out that advertising would help even more, which according to CEO Howard Schultz should be coming soon as he stated at the company's March annual meeting that the company is ready to take its gloves off and will no longer be silent regarding the false claims its competitors have made about the Starbucks brand in the past.  As I said earlier today in my post titled "BKC - What's up with Burger King...?", advertising is critical to driving incremental traffic within the mature QSR segment.  Time will tell!



Dispatches from the General: Thoughts on Obama's Foreign Policy As a Tail Risk

While we sometimes get accused of partisanship here at Research Edge, that accusation is often coming from people that are themselves, partisan.  We have a strong belief in free markets, which sometimes manifests itself in a view, but the reality is we follow politics as a means of inferring investment trends and thinking about managing risk. 


Obviously, the last few weeks have provided data points for us to contemplate the next four years under the foreign policy of an Obama administration.  While there are some similarities to Bush, and some continuations of Bush administration policies, there are also some marked differences that indicate that the future may be dramatically different than the post 9/11 era, in which the Bush Doctrine, that of pre-emption, stood paramount.


This weekend we noted with interest the front page picture on the New York Times of President Obama shaking hands with Hugo Chavez and also both Obama and Secretary Clinton's limited response to Nicaraguan President Daniel Ortega's rant against United States foreign policy.  Interestingly, oil is down almost 8% today on the back of Obama's engagement with Chavez this past weekend, which may be signaling that the implications for this action, at least in the short term, are positive from a geopolitical risk perspective.  Although clearly with all equity and commodity markets down broadly today, it is difficult to extrapolate too much into this move in oil.  Nonetheless, it is important to consider the longer term implications of Obama's foreign policy. 


We asked a father of one of Research Edge's Analysts, a retired Brigadier General, his thoughts on this weekend's events and the emergence of President Obama's foreign policy in general.   We don't necessarily endorse his thoughts, nor consider ourselves competent enough in foreign policy to adequately gauge them, but we take the former General's thoughts seriously. He is a serious man who has seen the consequences of foreign policy acted out first hand through the course of his career, sometimes at great cost. We have pasted his email response below:


"I have been enjoying the nice weather and also was traveling (as you know) this weekend - so I did not see the speech (and this news junkie has not seen any since Friday morning).  But I gather that our 'friends' have been helping our current Commander in Chief point out our deficiencies as a county.  So I just scanned the NYT online and did a search on Ortega's speech.  And we have our share of mistakes in the past.  BUT - always remember that Ortega is a Marxist, and will always be one.  And trash talk is cheap.  What really scares me is the message that total passiveness and cozying up to bullies (like Chavez and Castro) sends to the other snakes that lurk under rocks out there.  Lots of people can interpret no reaction from us as being weak.  Like it or not, I agree with the adage that other countries do not have to agree with us, but they should respect us and have a healthy fear that we will not be weak if anyone attacks us.  The old school yard bully routine.  Just take a look at Jimmy Carter's performance as Commander in Chief - Iran considered him weak and treated this country as if they had nothing to fear (as was true).  Iran only freed the hostages on inauguration day in 1981 because they assumed (correctly) that Reagan would take action; the window to maximize their position was closing.  Obama could well be walking down the same path - and not really realizing it, given his blind spots.  The unintended consequence of that is what could lead to problems.  Some group somewhere will push us; it is just a matter of where and when.  And I don't mean pirates - that is a totally local (Somalia) issue due to a failed nation state.  The key will be what the response of this administration is when someone bloodies us.  That is what you need to watch for, and what will tell everyone what to expect until 2012 at least. And then, depending upon the miscalculations on either side, we could be in one heck of a mess.  I just hope the first problem is not a spill over of drug violence from Mexico (on a larger scale than the current violence constrained to drug operatives) on a large scale - I don't think this administration has the guts to deal with that issue if it is the first one out of the chute."


Clearly, the General see's tail risk that could be that a passive foreign policy could leave the United States vulnerable.  President Obama has certainly not indicated that he will in any way act passively when the country's interests are at direct risk, and in fact acted very decisively with the Somalian pirates, but clearly his willingness to not either dress down or respond to Daniel Ortega does provide some evidence of the direction of Obama's future foreign policy positions.  As does his willingness to engage with Iran, Cuba, and Hugo Chavez in Venezuela when his predecessor was much less willing.


Daryl G. Jones
Managing Director

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