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CAN CHINA AVOID FINANCIAL CRISIS?

Takeaway: The risk of a Chinese financial crisis is heightened to the extent that financial sector reforms are not appropriately managed.

SUMMARY BULLETS:

 

  • In yesterday’s Politburo Standing Committee (PSC) meeting, China’s executive leadership mapped out guidelines to address a slew of structural ailments that were brightly highlighted in China’s disappointing 1Q growth statistics. Indeed, a “lack of growth momentum” was identified as the most serious challenge to the Chinese economy.
  • Ironically to us, there was hardly a mention of China’s domestic financial sector risks in the official transcript, though recent commentary by PBOC Governor Zhou Xiaochuan which highlighted his call for urgency on the reform front suggests that financial sector risks are, in fact, the elephant in the room: “China has to make economic reform its top priority,” he said.
  • All told, we continue to see elevated risk of a Chinese financial crisis – however one may materialize – and destabilizing capital outflows over the long-term TAIL (3yrs or less) – IF financial sector reforms and capital account liberalization are not appropriately managed by the powers that be.
  • To follow up on our deep-dive presentation on this very topic from this past Tuesday’s call on the upcoming cycle of emerging market crises, we’ll be hosting a conference call on Monday morning (4/29) at 11am EST featuring Carl Walter of Stanford's Walter H. Shorenstein Asia-Pacific Research Center. On the call, we will examine the key risks currently embedded across China's financial system and assess the probability of a Chinese financial crisis in light of the Chinese Communist Party's financial sector reform agenda. Email if you’re interested in attending or would like to be earmarked to receive the replay materials.

 

In yesterday’s Politburo Standing Committee (PSC) meeting, China’s executive leadership mapped out guidelines to address a slew of structural ailments that were brightly highlighted in China’s disappointing 1Q growth statistics: slowing GDP and consumption growth amid accelerating growth in credit and fixed assets investment. China’s first APR growth data point leaves much to be desired in the way of a meaningful rebound:

 

  • APR MNI Business Sentiment Indicator: 58.5 vs. 59.3 (APR flash) vs. 58.2 (MAR)
    • New Orders: 58.2 vs. 59 (APR flash) vs. 54.8 (MAR)
    • Production: 57.3 vs. 57.8 (APR flash) vs. 55.2 (MAR)

 

Indeed, a “lack of growth momentum” was identified as the most serious challenge to the Chinese economy – partly affected by slow global growth (exacerbated by “liquidity in some developed economies”) and a broad-based lack of sustained investor confidence due to Europe’s sovereign debt crises.

 

Ironically to us, there was hardly a mention of China’s domestic financial sector risks in the official transcript, though recent commentary by PBOC Governor Zhou Xiaochuan which highlighted his call for urgency on the reform front suggests that financial sector risks are, in fact, the elephant in the room: “China has to make economic reform its top priority,” he said.

 

NOTE: This is very much in line with what we have identified in our recent work on China – specifically in that the clock is ticking rather loudly for China’s unsustainable economic growth/public official wealth accumulation model…

 

What’s perhaps most interesting is that Chinese leaders remained committed to stringent macroprudential policies in the face of an obvious growth slowdown. As we have been saying for the past ~3 years: it’s because they architected the aforementioned growth slowdown! Indeed, they remain reluctant to hit the “go” button on large-scale stimulus, instead opting for further growth-negative policies, such as curbing the expansion of resource-intensive industries – many of which are rife with overcapacity. To this point, Chinese banks have already begun tightening loans to the iron and steel industries amid fear of rising NPLs.

 

CAN CHINA AVOID FINANCIAL CRISIS? - 2

 

All told, we continue to see elevated risk of a Chinese financial crisis – however one may materialize – and destabilizing capital outflows over the long-term TAIL (3yrs or less) – IF financial sector reforms and capital account liberalization are not appropriately managed by the powers that be (PSC, PBOC, MOF, CBRC, CSRC, NDRC, etc.). Indeed, the next round of reforms will be a sizeable team effort across all of China’s major regulatory and strategic planning agencies.

 

To follow up on our deep-dive presentation on this very topic from this past Tuesday’s call on the upcoming cycle of emerging market crises, we’ll be hosting a conference call on Monday morning (4/29) at 11am EST featuring Carl Walter of Stanford's Walter H. Shorenstein Asia-Pacific Research Center.

 

Carl is arguably the world’s preeminent expert on the Chinese financial system, having lived and worked in Beijing from 1991 to 2011, first as an investment banker involved in the earliest SOE restructurings and overseas public listings, then as chief operation officer of China's first joint venture investment bank, China International Capital Corporation. Over the last ten years he was JPMorgan's China chief operating officer as well as chief executive officer of its China banking subsidiary. Walter is also the co-author of Red Capitalism: The Fragile Financial Foundations of China's Extraordinary Rise (2012) and Privatizing China: Inside China's Stock Markets (2005).

 

On the call, we will examine the key risks currently embedded across China's financial system and assess the probability of a Chinese financial crisis in light of the Chinese Communist Party's financial sector reform agenda. Email if you’re interested in attending or would like to be earmarked to receive the replay materials.

 

Have a great weekend,

 

Darius Dale

Senior Analyst

 

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CAN CHINA AVOID FINANCIAL CRISIS? - 1

 

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1Q13 GDP - Consumption Acceleration

Takeaway: 1Q13 GDP offered positive confirmation of our 1Q13 theme for domestic consumption #GrowthStabilizing. We still like the theme.

This morning’s advance GDP estimate for 1Q13 came in at 2.5% vs expectations for 3.0%.  Belying the headline miss were some positive under the hood dynamics relative to our view on domestic consumption.  Consumer Spending growth accelerated for a third consecutive quarter, growing 3.2% sequentially vs expectations for 2.5%, and contributing +2.24 to the Total GDP figure on the quarter. Investment grew 12.3% q/q alongside some inventory build and continued strength in Residential and NonResidential Fixed Investment.  Government Spending showed some unsurprising weakness, declining 4.1% Q/Q with National Defense leading the decline with Gross Investment and Consumption Expenditures down 30.3% and 8.3%, respectively.  To summarize:

 

C:  Consumer coming in stronger than expected printing 3.2% vs. expectations for 2.8%.  Contributing +2.24 to total GDP.

I: Investment up +12.3% Q/Q and contributing 1.56 to Total GDP.  Inventories, Residential & Nonresidential Investment all positive contributions.

G:  Down 4.1% Q/Q  on the back of -7.0% in 4Q12.  Contributing -0.8 to total GDP

E:  Net exports contributing -0.5 to total GDP as growth in imports outran export growth.

 

Inflation:  Core PCE remained subdued at +1.2% which continues to lend itself to steady-as-she-goes monetary policy.   While we think employment could surprise on the upside over the NTM and Fed board commentary has been incrementally hawkish, with sequester related fiscal drag uncertainty unlikely to ebb through 3Q,  inflation below target of 2.0% and the “transiently tolerable” 2.5%, employment growth still modest, and a significant output gap remaining, we don’t hold expectations for a material policy inflection over the intermediate term. 

 

GIP Model:  On the fundamental side, 1Q13 GDP growth agreed with our Growth/Inflation/Policy (GIP) model estimate which called for accelerating growth and decelerating inflation and a move to Quadrant 1.  Simply put, if you are modeling the national economy as you would a company, Quad 1 (Accelerating Growth, Decelerating Inflation) equates to accelerating topline growth alongside margin expansion – You want to be long that.  Our early estimate for 2Q has the U.S. holding in Quad 1.   

 

In short, today’s GDP release offered positive confirmation of our 1Q13 theme for domestic consumption #GrowthStabilizing.  While its (still) hard to pin a bullish secular thesis on peak margins, a low single digit and declining savings rate, and a positive spread on spending growth vs. income growth alongside already zero bound interest rates, in the near-term, the game plan remains much the same as its been YTD.  Housing and Labor market trends remain positive for domestic consumption while declining government deficit spending, a benign domestic monetary policy outlook, a bearish setup for the Yen, and a weak growth/dovish policy outlook for the EU should all continue to support $USD strength and ongoing commodity deflation.

 

1Q13 GDP - Consumption Acceleration - GDP Chart

 

1Q13 GDP - Consumption Acceleration - U.S. Pods 042513

 

1Q13 GDP - Consumption Acceleration - GDP Summary 042513 1Q13 

 

Christian B. Drake

Senior Analyst 


Growth Accelerating: More Jobs

Housing is just one piece of the macroeconomic puzzle in the United States. The labor market is the other key driver of economic improvement and lately, things are looking up. This week's initial jobless claims numbers show improvement on both a seasonally adjusted and non-seasonally adjusted (NSA) basis. 

 

Growth Accelerating: More Jobs - JOBLESSCLAIMS1

 

We consider the 4-week rolling average in non-seasonally adjusted claims to be the more accurate representation of the underlying labor market trend and on that metric, the trend improved 2.5% week-over-week as the year-over-year change in 4-week rolling claims went from -6.3% year-over-year from -3.8% year-over-year the week prior. The headline number fell 13,000 to 339,000 week-over-week versus the prior week’s unrevised number while the 4-week rolling average in seasonally adjusted claims dropped 4,500 week-over-week to 358K. Remember: when the numbers fall, that's a positive for the economy because it shows a drop in the number of people who are jobless and filing claims.

 

Growth Accelerating: More Jobs - JOBLESSCLAIMS2


Hedgeye Statistics

The total percentage of successful long and short trading signals since the inception of Real-Time Alerts in August of 2008.

  • LONG SIGNALS 80.28%
  • SHORT SIGNALS 78.51%

SBUX STILL TOP DOG

Starbucks is the best-run company that we follow and the long-term TAIL seems unlimited. The company’s geographical reach and size is highly impressive. Even more impressive is the performance of the Americas business, given its size and maturity.

 

We maintain a positive view of Starbucks as an effective way to play improving US consumption.  While sell-side analysts this morning are correct that the global macro outlook is challenging, it is important to know where SBUX has its exposure.  The U.S. is what will drive beats and misses in the near term, despite much unit growth being focused in China/Asia-Pacific. ~88% of company stores and ~85% of licensed stores within the "Americas" division are located in the United States.

 

SBUX STILL TOP DOG - yum mcd sbux opinc

 

 

The Good

 

Last night, Starbucks reported global same-store sales growth of 6% (13th consecutive quarter above 5%).  Same-stores sales in the Americas division grew 6% (including 5% traffic). Total revenue growth of 11% produced a 180 bps increase in operating margin and a 20% increase in EPS. 

 

Americas:

  • Revenues + 10% yy
  • SRS two-yr comp sequentially declined 100 bps
  • Operating Income +22%
  • Operating Margin +220 bps to 21.1% (highest 2Q ever)

SBUX STILL TOP DOG - sbux americas pod1

 

 

EMEA:

  • Revenues unch’d, operating margin unch’d
  • -2% 2QFY13 comps implies 2-yr  comps negative
  • Emphasis is on improving profitability by refranchising (“sold to you!”)
  • Applying Americas “learnings” not trumping macro

SBUX STILL TOP DOG - sbux emea pod1

 

 

CAP:

  • Revenues grew 22%
  • Comps at +8% came in light vs consensus
  • Operating margin down -710 bps on investment spending on China growth

SBUX STILL TOP DOG - sbux cap pod1

 

 

The Less-Good: Expectations, Food

 

The only slight negative stemming from what was, overall, a bullish conference call was management reigning in expectations for 2H13, but upping the official guidance. During the call management guided for 3QFY13 EPS of $0.50-0.53 and 4QFY13 EPS of $0.54-0.57, versus consensus of $0.54 and $0.57, respectively. The coffee cost tailwinds should continue well into FY15 now, offsetting continued investments in growth-related initiatives. 

 

Food remains Starbucks’ Achilles’ heel.  The acquisition of La Boulange is a long way from being branded a “success”.  As of yesterday, there were 439 stores carrying La Boulange products, including all stores in the San Francisco Bay Area.  The company is planning a rollout of La Boulange pastries in the Pacific Northwest including Seattle in June, then will expand to cities including Los Angeles and Chicago, followed later in the year by New York and Boston. The company is on track to have La Boulange products in all of our U.S. company operated stores by the end of 2014.

 

 

Howard Penney

Managing Director

 

Rory Green

Senior Analyst


Short EVEP: New "Best Idea"

We are adding short EV Energy Partners (EVEP) to our "Best Ideas List."  We will give a presentation/conference call on Thursday, May 2nd, at 1pm EST, to walk through the thesis in depth.  Clients will receive the materials and dial-in information shortly before the call.  

 

THESIS:

  • EV Energy Partners (EVEP) is an upstream MLP that most analysts value using an arbitrary yield target, rather than considering the intrinsic value of the assets (present value of future free cash flows).  As we have found with LINN Energy (LINE, LNCO), this can create a severe mispricing of the security.
  • EVEP has overpromised and under-delivered with respect to a monetization of its Utica acreage package.  We expect that the sale will continue to disappoint expectations with respect to price and timing.
  • While analysts and investors have been laser-focused on EVEP’s Utica sale for the last 24 months, the value of the core asset base (Barnett Shale and conventional fields) has eroded to the point where the latest after-tax PV-10 of $867MM barely exceeds EVEP’s net debt of $852MM.
  • Financially, EVEP is in bad shape, and it’s set to get worse.  We believe that EVEP will have to do at least one of the following in 2013: raise equity; take on additional debt (despite being over-levered at 5x 2013 open EBITDA); use any Utica proceeds to fund capex and/or the distribution (instead of acquiring additional assets); cut the distribution.
  • We believe that fair value for EVEP is ~$18 - 27/unit (40 - 60% downside from the current price).

 

ABOUT EVEP:

 

EV Energy Partners (EVEP) is a $2.0B market cap upstream MLP with producing assets in the Barnett Shale (59% of 1P reserves); multiple legacy, conventional plays like the Austin Chalk and Knox; undeveloped acreage in the Utica Shale (for sale); and a nascent midstream business. 

 

E&P private equity firms EnerVest and EnCap created EVEP in 2006 shortly after LINN Energy (LINE, LNCO) went public.  EnerVest (71.25%), EnCap (23.75%), and EV Investors (5%) own 100% of EVEP’s General Partner (GP), “EV Energy GP,”   and all incentive distribution rights (IDRs).  All EVEP board members are either directly affiliated with EnerVest or were appointed by EnerVest or EnCap.

 

EnerVest’s operating base includes ~3 Tcfe of 1P reserves and ~550 Mmcfe/d of production; EnerVest operates 93% of EVEP’s assets.

 

In typical E&P MLP form, EVEP acquires low decline assets with a high percentage of PDP reserves; since 2006 the Company has completed $1.9B of acquisitions - the two largest coming in 4Q10 and 4Q11 in the Barnett Shale ($700MM combined).  EVEP often acquires assets from EnerVest and/or EnCap-sponsored companies (“drop downs”), or from unaffiliated parties (Encana, Petrohawk, Range Resources, EXCO, Anadarko) alongside EnerVest.

 

At YE12, EVEP had 905 Bcfe of 1P reserves (76% developed, 67% gas, 24% NGLs, and 9% oil) with an after-tax PV-10 of $867MM.  In 2012 EVEP produced 163 Mmcfe/d (71% gas, 18% NGLs, 11% oil), and has guided 2013 production to -1% y/y on E&P spending of ~$100MM.  

 

EVEP has ~170,000 net acres prospective for the Utica Shale, and has been trying to monetize ~104,000 of them since 1Q12; so far, it’s been an unsuccessful effort.  EVEP has now broken that package into 13 separate packages (by county) to attract more interest.  We believe that the majority of EVEP’s Utica acreage that is for sale is in the “oil window,” (or west of it) where Chesapeake, Anadarko, Consol, and Devon have had limited success to date.  Monetizing this acreage and then completing a 10-31 exchange with EnerVest for producing assets is EVEP’s main priority.

 

EVEP owns minority stakes in two Utica midstream companies, “Utica East Ohio” and “Cardinal Gas Services.”  EVEP is set to invest $335 - $395MM into these companies over the next 5 years, with $230 - $250MM in 2013 alone.  These assets are expected to generate ~$65MM of annual EBITDA net to EVEP by 2016/2017.

 

Kevin Kaiser

Senior Analyst



MCD: You Deserve A Short Today

Takeaway: McDonald’s squeezes profits to gain market share. A gambit that may pay off – or not. For not it’s “Little Mac."

“Little Mac”?  The Case for Shorting McDonald’s

Restaurants sector head Howard Penney adds his Short call on McDonald’s (MCD) to Hedgeye’s Best Ideas with an institutional conference call titled “MCD: Flying Too Close To The Sun.”

 

With over 34,000 locations worldwide, MCD is the world’s largest restaurants company – both by sales and by market capitalization.  Some 80% of MCD outlets are franchised – mostly in the US – and Penney argues that this has had a negative impact on planning.  While MCD has made a very visible push in recent years to expand in Asia, the Pacific region, the Middle East and Africa (“APMEA”) – with special focus on China – the US remains its biggest market and, says Penney, it’s Achilles’ Heel (Icarus, Deadalus, Achilles… it may be appropriate that a presentation that questions a major company’s fundamental growth story is full of references to mythology!)

 

Where Do They Make Their Money?

MCD’s most significant source of revenues is in Europe.  Over 39% of the company’s revenues come from Europe, versus 32% from the US – and 23% from APMEA (including China).  Penney points out that the majority of European stores are company owned.  Even though the ongoing Euro-Zone crisis is taking its toll, Europe, with a high percentage of company-owned stores, remains more profitable than the US, with its high percentage of franchised locations. Management is focusing its growth plans on the APMEA markets, but Penney points out that the combination of weak economic conditions in the Euro-Zone, and low profit margins in the US – which together combine for 80% of MCD’s earnings power – will drive disappointing differences between analyst projections of earnings per share and actual reported earnings over the next few years.

 

What Do The Numbers Look Like?

Analyst expectations have already been trimmed, with consensus for 2013 EPS at around $5.80.  But Penney sees global same-store sales growth declining – he thinks growth rates worldwide could end the year nearly flat, which should drag earnings estimates significantly lower.  Nobody likes a downside surprise.  

 

Except, that is, a short seller.

 

With 41% of stores, and just over 40% of sales revenues, the US represents by far the largest sales and unit base for the company.  But put those figures alongside the earnings numbers we quote above and you see that the US provides over 40% of global sales, but only 32% of earnings.  Europe, by contrast, represents 39% of earnings, on only 28% of sales.  And Europe is weakening.

 

What’s Wrong?

Penney says MCD’s management has gotten itself into an unrealistic position, looking to be both the low-priced and the premium-profit leader.  The company has positioned itself in the US as a super-discounter over the last decade.  But “Dollar Meals” don’t return big profits – ask any frustrated franchisee.  In their latest earnings call, the CFO acknowledged MCD “expects margins to be pressured throughout 2013.”  Translation: Heads up: we’re heading down!

 

Here are another couple of key takeaways from the CFO’s presentation:

 

“Our business model is built around growing comparable sales to a level where we can realize margin leverage.”  

 

Translation: if we can sell a whole lot more stuff at really low prices, sooner or later we’ll realize economies of scale and our profit margins will go up a little.

 

“In this environment, where you continue to have the cost pressures, so commodities will be up, labor rates are going up, et cetera, and yet you have soft economics, declining to flat eating out markets, that battle for market share becomes so critical to the long-term health of the business, that we’re willing to sacrifice a little bit of margin to maintain that traffic and grow the market share.”  

 

Translation: but right now, we have to take our already-tiny profit margins down even further in order to gain market share.  That “little bit of margin” we are willing to sacrifice – but hey, we only have a little bit in the first place – oops… there goes the profit margin.

 

You Don’t Get A Break Today

Penney points to a number of factors underpinning his bearish case.

 

At the macro level, US consumers are feeling better and spending more, and are less dependent on cheap prices.  Europe, meanwhile, just keeps getting worse.

 

At the company level, MCD same store sales are deteriorating globally, while the company suffers from “self-inflicted wounds.”  Two key examples are an unacceptable level of operating complexity, and an inability to field new ideas.

 

With only tiny profit margins on the majority of their menu, speed and efficiency at mealtimes become critical.  Every store has to run at top efficiency to speed diners through between the critical 11:30AM-1:00PM lunch hour.  As one example of poor planning, Penney points to the freestanding beverage stations, which customers enjoy, but which make the back-of-house operation much more complex, because staff must repeatedly stop serving customers to go out and service the machines.  When a discounter, which is already operating at near-maximum capacity, has to slow down its throughput to tend to an unnecessary machine… well, you get the picture.

 

And Penney says senior management seems surprisingly uninterested in very specific issues raised by franchisees.  MCD management have their game plan which they expect all locations to implement, while they continue to push for new-store growth outside the US and Europe.  This means that, while MCD goes through the expense of expanding in new markets, they are not getting incremental benefit out of their highest-revenue and highest-profit generating regions.  Management appears to be building a more profitable company-owned base of overseas stores on the back of – and at the expense of – its US franchisees.  This can lead to alienation of MCD’s most important revenue base.

 

Conclusion

Penney expects MCD to disappoint in Q3, and likely also in Q4 of this year, leading to analysts downgrading the stock and pushing prices lower.

 

MCD’s ongoing focus on “value” (i.e. cheap prices) continues to destroy profit margins and cash flow – and to frustrate franchisees in its biggest market.  Penney says the only way out now is the highly unlikely success of a “magic bullet” – a premium product that everybody loves.  But MCD has defined itself as a “value” chain.  After so many years at the low end of the price range, they will have a very hard time trying to introduce a premium offering.

 

Add to that the recent surge in their closest competition.  Wendy’s (WEN) is now being run by an outstanding operator / innovator.  Taco Bell, says Penney, “is on fire” with popular new product offerings and an on-target marketing campaign.  Even Burger King (BKW) – a company Penney went bearish on earlier this year (See BKW report HERE___) has gotten itself organized enough to present a marginal headwind for MCD.

 

“Don’t get me wrong,” says Penney.  “MCD is a great company.  It’s a financially strong global company, and they will probably raise the dividend again.”  But a range of near- and intermediate-term problems that will lead to earnings disappointments.  Penney thinks the market will not be forgiving, at least over the next two quarters.  

 


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