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Sell Some: SP500 Levels, Refreshed

Takeaway: Every time this US stock market corrects we get a whole new bear case and each bear case is different than the one prior.

This note was originally published June 10, 2013 at 11:02 in Macro

POSITIONS: 6 LONGS, 5 SHORTS @Hedgeye

 

Sell Some: SP500 Levels, Refreshed - bullbear

 

Ok, I sold more than some. I actually sold ½ my long positions this morning. But not because I am all beared up or anything like that – it’s just process. We bought the oversold signal well last week < 1601, and now the SP500 is 50 handles higher!

 

I usually don’t use exclamation marks but, this year deserves one. Every time this US stock market corrects we get a whole new bear case. Each bear case is different than the one prior, but it feels equally as tough to buck up and buyem when you should.

 

Across our core risk management durations, here are the lines that matter to me most:

 

  1. Immediate-term TRADE overbought = 1662
  2. Immediate-term TRADE support = 1624
  3. Intermediate-term TREND support = 1583

 

In other words, now we’re just trying to manage the risk of the intermediate-term TREND range (1582-1662). If you want to think about where I’d be as a % of a full intermediate-term TREND position in US Stocks, I went to 97% of my max allocation last week.

 

If we test 1583 again this summer, I’ll probably do that again.

 

Keep moving out there,

KM

 

Keith R. McCullough
Chief Executive Officer

 

Sell Some: SP500 Levels, Refreshed - SPX


Twitter Exchange of the Day

Takeaway: We love it when we help our clients make money. A case of free beer for the effort? Icing on the cake.

Twitter Exchange of the Day - hein

 

Any questions?

@KeithMcCullough 3:50 PM

 

did the case of beer I sent to 111 whitney arrive last Friday?

@CFRamseyer 3:53 PM

 

was that you? I don't think it had a name on it!

@KeithMcCullough 3:54 PM

 

yes it was. Thx for $9k from late thurs thru fri close

@CFRamseyer 3:55 PM


Trade of the Day: XLF

Takeaway: We sold the Financials (XLF) at 9:59AM at $20.03.

We bought the Financials right as it was about to v-bottom. Not a time to get piggy. Book the tidy 3.2% risk-managed gain. That's the TRADE. We remain bullish on the Financials from a TREND perspective.

 

Trade of the Day: XLF - XLF

 


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SBUX: WELL CAFFEINATED

Takeaway: Despite SBUX trading at the high end of its historical consensus forward earnings and cash flow multiples, we believe there's more upside.

This note was originally published June 06, 2013 at 22:40 in Restaurants

Our CEO Keith McCullough likes to frame sentiment as being bullish, bearish, or not enough of one or the other. The investment community is not bullish enough on Starbucks. The bear case does not scare us when it comes to Starbucks. We decided to run through some bull and bear points to refresh clients on our thesis.

 

SBUX: WELL CAFFEINATED - sbux

 

Summary


We remain bullish on Starbucks at current levels. Despite the stock trading at the high end of its historical consensus forward earnings and cash flow multiples, we believe more upside is in store. Bullish factors we are focused on include rapid unit growth in China, expansion into new segments of the global food and beverage industry, and a commodity tailwind that only seems to be getting stronger.

 

Below, we go through the bear and bull cases for SBUX and offer our thoughts on each sub-point.

 

 

Performance

 

Starbucks has been a favorite name of ours for virtually all of the last four years. Aside from a period in 3Q12, when our research process suggested a more cautious stance was necessary, we have been bullish on the stock as it has taken share from competitors in existing businesses and grown its touch points in tangent areas of the food and beverage industries. Despite strong outperformance and plenty of bearish arguments to the contrary, we are reiterating our bullish stance today as we believe that the investment community is bullish, but not bullish enough, at this price.

 

As the quantitative levels, below, indicate, SBUX is in bullish formation with the immediate-term risk range at $62.63-$64.56 and TREND level support at $59.57.

 

SBUX: WELL CAFFEINATED - sbux levels 66

 

 

Bear Case: Valuation, Sentiment, Portfolio Pitfall, Personnel Changes, EMEA, Brewer Growing Pains

 

Valuation

 

Valuation is a factor we consider when formulating all investment theses but is not, in itself, a thesis. It’s impossible to know if Starbucks’ stock is cheap or expensive at current levels unless one knows the forward earnings of the company. What would make the stock cheap to us is if the future growth potential of the company was being overestimated by the investment community. We do not believe that it is.

 

SBUX: WELL CAFFEINATED - sbux valuation cahnge

 

SBUX: WELL CAFFEINATED - sbux eeg FY13

 

 

Sentiment

 

The investment community has become more bullish on Starbucks over the past year as the stock price has risen and visibility on the company’s future growth strategies has increased. Casual dining has seen sentiment rise more than quick service as investors have sought exposure to more discretionary niches of the consumer space. We believe that the stock has further to run over the intermediate TREND and long-term TAIL durations. Our CEO Keith McCullough likes to frame sentiment as being bullish, bearish, or not enough of one or the other. The investment community is not bullish enough on Starbucks.

 

SBUX: WELL CAFFEINATED - sbux sentiment historical

 

 

Portfolio Pitfalls & Growing Pains

 

The history of the restaurant industry is littered with anecdotes of management teams that thought they could grow forever at an ever-increasing rate. Executive compensation structures more closely tied to unit growth targets than returns typified the folly of so many quick service and casual dining companies. Many companies have reaped the negative rewards of growing too fast and/or adding too many concepts to the company’s structure.

 

With respect to growth, Starbucks has not been perfect throughout its history. Between 2005 and 2009, Starbucks almost doubled its number of locations, to almost 17,000. In 2007, Howard Schultz flagged changes in the consumer experience to then-CEO Jim Donald as counter-productive initiatives.  Examples included “flavor-locked packaging” and complicated espresso machines that eroded the degree to which visiting Starbucks resonated with consumers.

 

Perhaps the most acute risk we see in Starbucks’ future trajectory is the growing number of ventures under the auspices of the current management team. We expressed this on 6/5/12 in a note titled “ONE MOVE TOO MANY?”, writing  that the company seemed to be embarking on an investment phase implied added risk to the share price. Managing five concepts, we wrote, seemed to be a departure from the returns-focused strategy had added value to the company in recent years.

The best argument against the idea that Starbucks will begin to destroy value by overstretching its shareholders’ capital is the current management team’s leadership.  Schultz’ emphasis on discipline and rigor in his team’s approach to making capital allocation decisions differs greatly from other, less effective, executives in the industry.

 

 

Executive Changes

 

As Starbucks becomes larger, and a greater number of individuals assume leadership positions, the potential for executives to leave to pursue alternative paths could increase. Michelle Gass leaving the company for Kohl’s Corp. is a blow, with CEO Howard Schultz having praised her impact on several key areas of the business including a key role in the turnaround of 2008/2009.

 

What Gass’ departure means for the stock is difficult to know. The pessimist may infer that her departure represents, in part, a lack of confidence in Starbucks’ future trajectory as she had, just one month ago, been called back from her role leading the EMEA division to work in an undefined leadership role under Schultz focusing on making the “pieces” of Starbucks work together, according to The Wall Street Journal. Gass worked for Stabucks for 16 years and, in time, may have been a candidate to assume a leadership role in the company’s C-Suite.

 

We believe that Gass’ departure from the company is a negative but, given her focus on the EMEA division over the past couple of years, it is clear that the company has many other talented individuals that have helped drive important areas of the enterprise forward. If we were to speculate, we would guess that the incentive of almost $10 million over the next four years likely had more of an impact than unease in her role at Starbucks.

 

 

EMEA

 

The weakness of Europe’s economies poses a risk to all global companies but we believe that Starbucks is relatively well-prepared to weather the storm. The company derives a very small proportion of its earnings, or less than 2% of total consolidated operating income, from EMEA which offers shareholders peace of mind as Europe continues to struggle to find economic momentum. Even with such a low degree of exposure, the company is taking a proactive approach to mitigating the risk of further economic turbulence in EMEA by increasing the proportion of licensed to company-owned stores.

 

SBUX: WELL CAFFEINATED - sbux emea pod1

 

SBUX: WELL CAFFEINATED - yum mcd sbux opinc

 

 

Bull Case: Strong Dollar, Growth Runway, Commodity Costs, Mgmt Team, ROIIC

 

Strong Dollar, Strong America, Strong Consumption

 

In November 2012, our Macro team turned positive on U.S. growth, which is 71% consumption, as the strengthening U.S. Dollar gave consumers a food and energy price cut. With the U.S. economy continuing to improve, we believe that Starbucks is one of the best ways to play a strengthening consumer. Jobless Claims, in particular, are an important metric for Starbucks’ Americas business as, in the most basic terms possible, more people going to work translates very closely into more people buying coffee as part of their daily routine.

 

SBUX: WELL CAFFEINATED - sbux americas pod1

 

 

Growth Runway

 

The strength of Starbucks’ Americas retail business is well-appreciated. Additional growth over the long-term TAIL will be largely driven by other segments of the business such as CPG, China, India, K-Cups, single-serve, home brewers, tea ($40 billion category), juice, and food among others. With management aiming to double the China unit count to 1,500 from 700 by the end of 2015 and viewing the CPG business as potentially becoming as large as the U.S. retail business, we believe that Starbucks is far from the end of the growth phase of its maturity curve.

 

 

Coffee Costs

 

Favorable coffee costs, coinciding with strong top-line growth, have resulted in strong earnings and cash flow generation. This tailwind is likely to continue through the end of the year and beyond, with management expecting a $100 million tailwind from coffee in 2014.

 

SBUX: WELL CAFFEINATED - coffee chart

 

 

Management Team

 

This is not a quantifiable factor but for anyone that has been following the restaurant space for any significant period of time, it is evident that a management team’s aptitude is often evident in their communications with the investor communities. Starbucks, over the last five or six years, has demonstrated a consistency in its message and its commitment to prudent growth that has set is apart from most of its competitors. Starbucks’ brand is one of the best-recognized in the world as the company has taken proactive steps to build an industry-leading loyalty program and an unrivalled social media presence, which has manifested in strong organic growth.

 

 

ROIIC

 

Last, but certainly not least, the ROIIC metric indicates that management is walking the walk. This chart is a key component of our process on all restaurant names – particularly those growing units – and Starbucks is better than most at sustaining a disciplined approach to expanding its business operations.

 

SBUX: WELL CAFFEINATED - sbux roiic

 

 

Howard Penney

Managing Director

HPenney@hedgeye.com

646.455.0992

 

Rory Green

Analyst

RGreen@hedgeye.com

646.455.0992

 


CHART DU JOUR: CORE LV METRICS IMPROVING

Slot volume is the metric we watch closely - and growth is accelerating 

 

  • Nevada numbers are out and slot handle gained 1% YoY in April, with the 3-month rolling trend on track to break out to the upside this summer
  • We believe May will start off a string of growth months for Vegas slot volume
  • Due to unfavorable demographics, we still believe the long-term trend is negative. However, better near-term results should boost sentiment.
  • MGM is the obvious trade on the long side on the data.  MGM's strong Macau ramp should also contribute to higher near-term estimates.

CHART DU JOUR: CORE LV METRICS IMPROVING - vegas  1


IS CHINA PREPARING FOR SYSTEMIC FINANCIAL RISK?

Takeaway: Recent policy developments call attention to the systemic risks facing China’s banking system. Additionally, MAY growth data came in soft.

SUMMARY BULLETS:

 

  • The pending introduction of a nationwide deposit insurance scheme and proactive regulations for dealing with commercial bank failures calls attention to the systemic risks facing China’s banking system. When taken in context with the outlook for interest rate liberalization and a bubbly property market, we are left continuing to hold a far-less-than-sanguine view of Chinese financials.
  • As a reminder, we’ll be hosting a flash conference call this Wednesday at 11AM EST to discuss Chinese financial system risks in greater detail, having added CHIX (Global X China Financials ETF) to our Best Ideas list on the short side. We look forward to your participation and questions then.
  • The sluggish MAY growth figures are in line with what we saw out of China’s recent PMI readings on both the manufacturing and non-manufacturing fronts and we continue to warn of A) incremental tightening (macroprudential or blunt instrument, if necessary) to stem rampant property price appreciation and B) a 2H13 slowdown in Chinese growth as conditions for credit growth deteriorate.
  • While certainly hard to know for sure, it is our view that much of the equity market upside stemming from positive sentiment surrounding the various avenues for reform (economic, financial, fiscal and social) was priced in during the recent rally.
  • For our latest thoughts on the Chinese economy and its banking system, please refer to the research notes hyperlinked at the bottom of this note.

 

PBOC, CBRC RAISING EYEBROWS (OURS AT LEAST)

This morning, we learned that the PBOC was out confirming that a deposit insurance system is ready to be launched after gathering much-needed political consensus. According to the central bank, the insurance system will help "increase the flexibility of commercial banks in terms of financial business innovation and risk control". Moreover, China’s regulation on the standardization of commercial bank bankruptcy – which has been deliberated on for five years – is expected to be submitted to the State Council in 2H13.

 

So let’s get this straight: Chinese authorities are A) implementing a deposit insurance scheme and B) finalizing regulations to facilitate commercial bank bankruptcies. Are we missing something or is Beijing preparing for some meaningful banking system headwinds over the intermediate-to-long-term?

 

In the context of the PBOC likely scrapping the deposit rate ceiling over the intermediate term, there have been concerns that smaller banks would be uncompetitive in a competing cost-of-funds environment. They would ultimately lose deposits and creditor faith as their ability to generate earnings growth declined amid slower or potentially negative financing growth.

 

The commensurate tightening of interbank liquidity is something we’ve been keeping an eye on; last week there was a rumor of a mid-sized bank failing to repay an interbank loan. Expect more to come on that front as we inch closer to the implementation of interest rate liberalization in China. Consensus has been celebrating/bidding up headlines on that front in the YTD, but we continue to hold a far less sanguine view:

 

  • On scrapping the lending rate floor (current minimum = 70% of the benchmark): Consensus expects this to increase the supply of credit to SMEs by lowering the cost of funds for SOEs and allowing risk-based credit allocation to flourish. We think there is risk that SOEs just demand cheaper financing from the banks and that SMEs continue to get crowded out in the absence of regulatory quotas.
  • On scrapping the deposit rate ceiling (current maximum = 110% of the benchmark): Consensus expects this to increase the return on household savings deposits (as do we), but fails to see the dangers of crowding out small-to-mid-sized lenders out of the market for deposits. Moreover, this would be an enormous blow to the systemic financial repression that underpins China’s investment economy (~46-47% of GDP) and higher real rates of return in safer, traditional savings deposits would slow the supply of yield-chasing funds to Trusts and WMPs – potentially exacerbating any liquidity constraints in those credit markets.
  • On doing both at the same time: We’re not sure what consensus thinks here, but it’s obvious to us that lowering lending rates and increasing deposit rates at the same time will inevitably result in NIM compression – something that can only be offset from an earnings perspective by accelerating credit growth. In the context of subdued GDP targets, the Party’s economic rebalancing agenda, a bubbly housing market and an inevitable and potentially dramatic rise in NPLs over the long-term, a meaningful, sustained increase in credit growth appears unlikely.

 

IS CHINA PREPARING FOR SYSTEMIC FINANCIAL RISK? - 1

 

As a reminder, we’ll be hosting a flash conference call this Wednesday at 11AM EST to discuss Chinese financial system risks in greater detail, having added CHIX (Global X China Financials ETF) to our Best Ideas list on the short side. We look forward to your participation and questions then.

 

  • Toll Free Number:
  • Direct Dial Number:
  • Conference Code: 663556#
  • Materials: CLICK HERE (slides will download one hour prior to the call)

 

RATTY MAY DATA

This weekend brought us some pretty ratty growth data out of China for the month of MAY. Perhaps the largest callout would be export growth slowing from +14.7% YoY in APR to +1% YoY in MAY, which is what we were calling for post the regulatory crackdown on fake invoicing. Back in line with reality, the MAY export growth figures may arouse global growth fears (exports to the US slowed to -1.6% YoY; exports to the EU slowed to -9.7% YoY).

 

IS CHINA PREPARING FOR SYSTEMIC FINANCIAL RISK? - 2

 

In the context of slower capital flows stemming from a reduction in “fexports” (i.e. fake exports) and tighter interbank liquidity, the MAY credit growth data was also pretty subdued: total social financing growth slowed to +CNY1.19 trillion MoM from +CNY1.75 trillion prior as new loans ticked down to +CNY667.4 billion MoM from +CNY792.9 billion prior. That is unsupportive for fixed assets investment and industrial production growth, the both of which ticked down marginally.

 

IS CHINA PREPARING FOR SYSTEMIC FINANCIAL RISK? - 3

 

IS CHINA PREPARING FOR SYSTEMIC FINANCIAL RISK? - 4

 

IS CHINA PREPARING FOR SYSTEMIC FINANCIAL RISK? - 5

 

All told, the sluggish MAY growth figures are in line with what we saw out of China’s recent PMI readings on both the manufacturing and non-manufacturing fronts and we continue to warn of A) incremental tightening (macroprudential or blunt instrument, if necessary) to stem rampant property price appreciation and B) a 2H13 slowdown in Chinese growth as conditions for credit growth deteriorate.

 

While certainly hard to know for sure, it is our view that much of the equity market upside stemming from positive sentiment surrounding the various avenues for reform (economic, financial, fiscal and social) was priced in during the recent rally.

 

For our latest thoughts on the Chinese economy and its banking system, please refer to the research notes hyperlinked at the bottom of this note.

 

Darius Dale

Senior Analyst

 

  • IS THE RECENT RALLY IN CHINESE EQUITIES SUSTAINABLE? (5/17): We do not think the recent strength in the Chinese equity market is sustainable, as China’s 2H13 growth outlook appears dicey at best.
  • WHY IS CHINA GOOSING ITS EXPORT FIGURES AND HOW MUCH LONGER WILL IT CONTINUE? (5/8): Chinese firms are goosing exports to drive incremental liquidity into the banking system – a phenomenon that appears set to slow from here.
  • TWO CHINAS? (5/1): Financial system headwinds continue to outweigh consumption tailwinds within the Chinese economy.
  • REPLAY: Will China Break? (4/30): The Party’s use of state owned banks to drive economic growth through fixed asset investment has left the financial system loaded with bad assets.  The bad assets mirror bad investments in the real economy.  They also can limit the ability of Chinese banks to make new loans.  Following the financial crisis, the Chinese government pushed too hard on the FAI growth lever, building infrastructure projects “for the next 10 years.” It has also left the banking sector choked with bad debts that may limit future lending.  Those factors should slow Chinese FAI growth and slower Chinese FAI growth should be negative for commodity prices and resource-related profits, all else equal.
  • CAN CHINA AVOID FINANCIAL CRISIS? (4/26): The risk of a Chinese financial crisis is heightened to the extent that financial sector reforms are not appropriately managed.
  • REPLAY: EMERGING MARKET CRISES (4/23): We currently see a pervasive level of risk across the emerging market space at the country level and have quantified which countries are most vulnerable. China is particularly vulnerable to experiencing a financial crisis.
  • IS CHINA CAREENING TOWARDS FINANCIAL CRISIS? (3/28): Systemic risks are present across China’s financial sector – as is the political will and fiscal firepower needed to avert a crisis.

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