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Takeaway: The key to a safe “landing of the [growth] plane” is an expedited, well-implemented deregulation of FDI and portfolio flows.



  • Conflicting signals from Chinese officials have made it difficult to handicap China’s TREND & TAIL GIP outlook(s) in recent months. We offer our latest thoughts in the note below.
  • We are decidedly back to analyzing China with a sanguine lens and are increasingly of the view that it probably warrants playing China alone (i.e. not via consensus ancillary “China plays”) on the long side with respect to the intermediate-term TREND.
  • With respect to the long-term TAIL, we still would like to see concrete implementation of capital account and FX reforms, as well as more safeguards put in place to limit the risk of a broadly destructive transition to a fully liberalized financial system (email us if you’d like to receive a walk-though of the specifics and a recent collection of confirming evidence).
  • It could be over a year before we have meaningful clarity on the latter, so our best solution for clients at the current juncture is to overweight “new China” (i.e. consumption and deregulation) while underweighting (or shorting) “old China” (i.e. the concomitant bubbles in credit and fixed assets investment), as highlighted in the chart below.


At the bare minimum, 2013 has been a weird year to be involved in China – either directly through Chinese equity exposure or indirectly through consensus ancillary plays like EM assets, commodities, and the currencies of commodity-producing nations.


While we consider it a huge victory for our team to have kept our clients out of or on the short side of those ancillary plays all year (and prior), that is certainly not to say we’ve nailed China or anything to that nature.


In the following table, we highlight the absolute bloodbath that has occurred across the commodity complex since we first introduced our structurally negative view on commodities back in APR ’11 as part of our Deflating the Inflation quarterly macro theme. We’ve obviously followed that up with numerous notes and presentations over the past couple of years, so please email us if you’re not yet familiar with our long-held bearish bias on the commodity complex and we’ll be happy to forward you the relevant materials.




Going back to not nailing China, we’ve been keen to change our stance on China multiple times in the YTD (% changes reflect the performance of the Shanghai Composite Index over the respective duration):



The predominant reason we’ve changed our tune on China so many times this year has been due to policy inflections that have materially altered (or complicated) our rolling-thee-to-six-month forward expectations for the Chinese economy. Amid this ~3M long period of admittedly-unattractive neutrality, we’ve analyzed China in both a positive and negative light, highlighting both the key opportunities and risks to China’s long-term GIP outlook along the way:


Sanguine tone:


Pessimistic tone:


We are decidedly back to analyzing China with a sanguine lens and are increasingly of the view that it probably warrants playing China alone (i.e. not via consensus ancillary “China plays”) on the long side with respect to the intermediate-term TREND.


With respect to the long-term TAIL, we still would like to see concrete implementation of capital account and FX reforms, as well as more safeguards put in place to limit the risk of a broadly destructive transition to a fully liberalized financial system (email us if you’d like to receive a walk-though of the specifics and a recent collection of confirming evidence).


It could be over a year before we have meaningful clarity on the latter, so our best solution for clients at the current juncture is to overweight “new China” (i.e. consumption and deregulation) while underweighting (or shorting) “old China” (i.e. the concomitant bubbles in credit and fixed assets investment), as highlighted in the chart below:




Going back to the intermediate-term TREND outlook, we think China has the opportunity to surprise consensus growth expectations to the upside into and potentially through 2014, after what is likely to be a brief dip into Quad #3 here in 4Q13:








Moreover, we think China has the potential to continue distancing itself from the carnage that has become the emerging markets space. It will seek to accomplish this by enticing international capital flows (both FDI and portfolio) away from beleaguered EM economies, at the margins, through a combination of strengthening the CNY and promoting its use internationally, as well as through incremental deregulation and investor-friendly incentives.




Below is a compendium of data points we’ve come across in the past couple of weeks that support this view:


  • Reuters noted that the PBoC said China will begin rolling out financial liberalization reforms in the Shanghai free-trade zone within three months. PBoC Shanghai chief Zhang Xin said the reforms would be launched within three months, evaluated after six months and formal policies would be fully implemented by the end of a year. He added the policies will serve as models for other regions as they move to create their own FTZs. (StreetAccount)
  • Xinhuanet noted that Zhang Xiaoqiang, deputy head of the National Development and Reform Commission, said China will simplify its foreign investment approval process in order to introduce a registration-based system for foreign investment projects. Zhang said that the government will further enhance the role of foreign investment in its market-oriented economic development. (StreetAccount)
  • Reuters reported that the yuan overtook the euro in October to become the second-most used currency in trade finance. SWIFT said the market share of yuan usage in trade finance grew to 8.66% in Oct, up from 1.89% in January 2012. The yuan now ranks second behind the US dollar, which has a share of 81.1%. (StreetAccount)
  • Dim Sum bond issuance has accelerated to the fastest pace since June 2012 as China’s pledge to move toward yuan convertibility boosts demand for the currency. Sales reached 27 billion yuan ($4.4 billion) in November, almost five times as much as October’s 5.8 billion yuan, according to data compiled by Bloomberg. Yuan savings in Hong Kong rose the most since April 2011 to a record 782 billion yuan in October. (Bloomberg)
  • The WSJ noted that foreign real estate developers eager to capitalize on rising consumption in China are increasingly raising funds to invest in warehouses and shopping malls. Data from PERE showed developers and their subsidiaries have raised $3.5B for China projects so far this year, eclipsing the $2.2B raised in all of 2012 and just shy of the $4B raised by private-equity and other fund managers. (StreetAccount)
  • Xinhuanet noted that Zhou Xiaochuan said China should increase the qualification and quota of QDII and QFII investors to help them with their activities. He added that administrative approval procedures for QDII and QFII qualification and quotas shall be eliminated "when conditions are ripe". (StreetAccount)


All told, we still think China has a lot of credit bubble-related skeletons in its closet that will increasingly become a headwind to Chinese economic growth over the long-term TAIL. For the time being, however, we think Chinese officials are putting the right policies in place to offset those headwinds, at the margins.


Please feel free to email us with any follow-up questions.




Darius Dale

Associate: Macro Team

[video] McGough on Black Friday Sales, $JCP

[video] Macro Notebook 12/4: $VIX, $SPY, DAX

Early Look

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Relied upon by big institutional and individual investors across the world, this granular morning newsletter distills the latest and most vital market developments and insures that you are always in the know.


Please join us for an in-depth look at the upcoming Hilton (HLT) IPO with a conference call on Tuesday, December 10th at 2:00pm EST.  HLT IPO will be the largest lodging IPO and the 3rd largest IPO of the year.




  • HLT stock should trade well
    • NAV supports at least a $22/share valuation
    • High end of the offer range implies an EV/EBITDA ratio in line with the comp set
    • HLT is just one of many Blackstone portfolio companies that it will look to bring public over the next 12-24 months- including LaQuinta which is likely coming in January 2014
    • Blackstone will make a hefty profit on the IPO, so there is plenty of pie to pass around
    • Once the lock-up expires, Blackstone will be back to the secondary market with more stock - they will own ~80% of the company post IPO, so they have a lot riding on the stock trading well
    • Leveraged balance sheet but plenty of FCF generation will allow HLT to get to 3.5x by the end of 2015 without counting on proceeds from asset sales


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Best Idea: Short Potbelly $PBPB

Takeaway: PBPB's a single daypart, low margin, low return restaurant company w/ declining traffic & little competitive advantage over its competition.

Editor's note: This piece was originally published November 19, 2013 at 09:31 by Hedgeye Managing Director Howard Penney. For more information on how you can subscribe to our research click here.


We are adding PBPB to the Hedgeye Best Ideas list as a SHORT.

Best Idea: Short Potbelly $PBPB - sandwich


Chipotle redefined the quick-service industry with its innovative operating model, Panera created the bakery café segment and Noodles catapulted into the fragmented Asian fast casual category.  All three are unique concepts that have, in a sense, redefined their respective categories. 


At the heart of it, Potbelly is a single daypart, low margin, low return sub shop with declining traffic and little competitive advantage over its most basic competitors.  Admittedly, these are not quite the qualities we’d expect to find in a company that is trading at a P/E of 84.3x and 21.7x EV/EBITDA on a NTM basis.  But, this is precisely what we have here.  


To be clear, we believe Potbelly is a solid company with a strong management team, but it should not be trading at a premium multiple to its aforementioned peers.


With that being said, we would not be surprised to see PBPB decline by 30-40% over the next twelve months.

As we wrote last week, in aggregate, the current valuations seen across the casual dining sector are shockingly high.  In fact, we have no problem referring to them as bubble-like and we’ve found this extends beyond the depths of casual dining stocks to several newly minted “growth” restaurant stocks.  Our CEO, Keith McCullough, did a nice job contextualizing these bubbles in this brief excerpt from yesterday’s Early Look titled “Weird Bubbles”:



From a US stock market “Style Factor” perspective, check out the score:

  • LOW YIELD (i.e. GROWTH) stocks = +40.4% YTD
  • Top 25% EPS GROWERS (by SP500 quartile) = +37.2% YTD
  • HIGH BETA stocks = +35.8% YTD


From a pure “Style Factor” perspective, PBPB fits the bill of a “growth” restaurant stock.  Let’s consider management’s aggressive guidance:

  • New unit growth of 10%+ for a “long period of time”
  • Low-single digit same-store sales growth
  • At least 20% annual adjusted EBITDA growth
  • At least 20% annual net income growth
  • At least a 25% return on invested capital, as measured by the second full-year profit of new shops
  • Shop margins above 20%

At its core, Potbelly is a local sandwich chain competing in the most competitive segment of the restaurant industry – the sandwich segment.  Although many people like to refer to it as the newest fast casual concept, the reality is it’s only at the “intersection between the fast casual and sandwich categories.”  Needless to say, Potbelly’s operating model, while solid, is nothing close to jaw-dropping.



Peer Group Operating Model Comparison

  • Potbelly’s average unit volumes are low.
  • Food costs are in-line with Panera’s.  There is very little room to move lower without downgrading to lower quality food.
  • The company appears to be very efficient, with labor costs running at 27.96%.
  • Other operating expenses are also very low, which could be the difference-maker in maintaining 20% store-level margins over the long haul.
  • Excluding IPO expenses, Potbelly’s G&A costs are running closer to 8%, which puts it fairly in-line with its competitive set.
  • Even after adjusting for lower G&A costs, operating margins remain low and will require sales leverage for any further upside.

Best Idea: Short Potbelly $PBPB - hwp1



Same-Store Sales

Management’s long-term guidance of “low-single digit same-store sales” implies that they believe, or want us to believe, they have the ability to take price in order to consistently drive average check higher.  In fiscal 2012, Potbelly’s average check was $7, which, on the surface, appears to be in-line with other fast casual operators.  With average check already at this level, relying on price as the primary driver of future profitability is a risky proposition.  Needless to say, we haven’t seen anything recently that would suggest this rate of same-store sales growth will come from traffic gains.  Potbelly has seen traffic decline for at least the past 3 quarters and expectations are for this trend to continue into the first half of 2014.


Best Idea: Short Potbelly $PBPB - chart2



Average Unit Volumes

The Potbelly mission is to be “the best place for lunch.”  While a strong focus on lunch is important, restaurant companies that generate the best returns operate across multiple dayparts and, in turn, generate higher average unit volumes.  Depicted in the chart below, at $1.1 million, Potbelly’s average unit volumes are below all of its primary public peer competitors.  Given the inherent unit economics of a Potbelly shop, we find the company’s premium multiple very difficult to justify even with the “growth” story as a backdrop.


Best Idea: Short Potbelly $PBPB - chart3    



Restaurant Level Margins

Given the rapid projected growth rate of the company, PBPB will be facing downward pressure on restaurant level margins for the foreseeable future.  On average, new Potbelly shops will open up with shop level profit margins in the high-single digit or low-double digit range.  It will require nearly flawless execution on store openings to avoid being stymied by incremental margin pressure.


Best Idea: Short Potbelly $PBPB - Chart4



Low Returns

Relative to its competitive peer set, PBPB generates a very low return on assets.


Best Idea: Short Potbelly $PBPB - chart5



Strong Balance Sheet and Cash Flow

PBPB is expected to have $48.87 million of cash and short-term equivalents on its balance sheet at the end of 2013 and is expected to generate approximately $7.8 million in free cash flow after allocating $31.16 million to capital expenditures in 2014.  The company has not formally announced what it will do with its excess cash, but we can safely presume they will use it to fuel their self-funding model and accelerate new unit growth in the second half of 2014 and 2015.




Per our comments earlier and the visuals from the charts below, PBPB is a very expensive stock that we, at the very minimum, find quite unattractive from a valuation standpoint.


Best Idea: Short Potbelly $PBPB - second to last


Best Idea: Short Potbelly $PBPB - last




As it stands, PBPB’s operating model has little room for error.  To justify the current multiple, it needs to be clear that there is significant upside from current consensus EPS estimates.  We don’t anticipate this coming to fruition and, with short interest comprising 15% of the float, it appears as though we are not the only ones.




Howard Penney

Managing Director





What's New Today in Retail (12/4)

Takeaway: WMT.com and JCP stand alone w/ POS sales updates. H&M attacking LULU? Shareholder looks to oust Jeffries from ANF. Un-American Eagle.



Hedgeye Black Friday Consumer Survey: Focus on JCP.  We'll be conducting a follow-up to our prior consumer survey (which helped us call a JCP beat and KSS miss) following Black Friday weekend and Cyber Monday. We'll have results next week, and will have an updated presentation accordingly. If you are interested in our results, please email sales@hedgeye.com, or .


ARO - Earnings Call: Wednesday (12/4) 4:15 pm

GES - Earnings Call: Wednesday (12/4) 4:30 pm

WTSL - Earnings Call: Wednesday (12/4) 5:00 pm

FRAN - Earnings Call: Thursday (12/5) 8:30 am

SKX - Analyst and Investor Meeting: Thursday (12/5) 9:30 am

HBI - ISI Group Consumer Holiday Conference: Thursday (12/5) 9:30 am

DG - Earnings Call: Thursday (12/5) 10:00 am




Weekly Athletic Footwear Data


What's New Today in Retail (12/4) - chart1 12 4

What's New Today in Retail (12/4) - chart2 12 4

What's New Today in Retail (12/4) - chart3 12 4







  • "J. C. Penney Company, Inc. today provided a preliminary update on the Company's performance for the fiscal month ending November 30, 2013. During that period, which includes the important Thanksgiving weekend, the Company's comparable store sales grew 10.1 percent over last year. The Company also noted that its e-commerce sales through jcp.com continued to be strong, running well ahead of last year, consistent with last month's trend."


Takeaway: See our note "JCP The Bear Case Lacks Intellectual Honesty"


WMT - Walmart.com Has its Best Sales Day Ever on Cyber Monday 2013



  • "Walmart today announced that Cyber Monday 2013 was the biggest online sales day in its history. The five-day period from Thanksgiving to Cyber Monday is the highest five-day stretch in online sales for the retailer to date, and Walmart.com processed more than 1 billion page views during that period."


Takeaway: It's kind of funny…every retailer will cherry pick the highlights and report them to the world. The bad news gets stifled. At least Wal-Mart had SOMETHING good to say -- even though it had nothing to do with store sales over Black Friday weekend. JCP had good news. So far, crickets from the rest of US retail.


ANF - Engaged Capital Tells Abercrombie: Replace CEO



  • "Engaged Capital said in a letter to the Abercrombie board that it should start looking for a replacement for chairman and chief executive Michael Jeffries, whose employment contract expires Feb. 1."
  • "The hedge-fund firm, which said it owns about 0.5% of Abercrombie's stock, also said the sale of Abercrombie to a private-equity buyer 'may represent the best option for shareholders.'"
  • "Abercrombie on Tuesday said it welcomed 'input from all shareholders' and that it had held 'extensive discussions' with many shareholders, including Engaged Capital, over the past several months."


Takeaway: We hope they succeed. We've been tempted to get involved with ANF over the years, but the fact that Jeffries is still CEO has repeatedly held us back. It's rare to see one person destroy significant equity value at a company, but that's the one area where Jeffries has succeeded.


HMB - H&M Sport to Compete in Activewear



  • "The Swedish high-street retailer will reveal today that it is launching H&M Sport, an expanded concept with a new visual identity, on Jan. 2 in all its markets worldwide."
  • "Dedicated areas in selected stores will feature activewear and accessories including windproof and water-repellent running jackets; warm-up tops and trousers for working out; comfortable garments for yoga; tennis shorts, and protective fleece jackets for outdoor activities."
  • "H&M signaled its intention to deepen its sportswear offering earlier this year when it said it would dress Sweden’s athletes for the Winter Olympics and Paralympics in Sochi, Russia, next year and the Summer Olympics and Paralympics in Rio de Janeiro in 2016."


What's New Today in Retail (12/4) - chart5 12 4


Takeaway: So many retailers are hopping on the Athletic bandwagon. Heck, you can buy yoga apparel at Whole Foods now. Nike and UnderArmour have been dealing with this for a long time. But Lululemon better keep an eye on the price gap between its Down Dawgs and what the H&M's of the world are offering.


SHLD - Filing Reveals Edward Lampert's Stake in Sears



  • "Edward Lampert, Sears Holdings Corp.’s chairman and chief executive officer, pared his stake in the company over the last few months and no longer controls the majority of its shares, but the pruning job was relatively modest."
  • "In a regulatory filing Tuesday, Lampert and his various investment vehicles, including ESL Partners LP, were listed as owning 51.6 million shares of Sears stock, 48.4 percent outstanding. That’s down from the 58.9 million shares, or 55.4 percent, listed in March. The reduction was caused by distributions to ESL investors."


Takeaway: Perhaps this is a complete non-event if it was simply a distribution to ESL Investors. But if there was any part that was driven by his desire to downside his stake, then it would be catastrophic to SHLD. In fairness, Lampert is savvy enough to not let that happen.


AEO - American Eagle Inks Overseas Deals



  • "American Eagle Outfitters Inc. is expanding its presence in the Americas and in Asia-Pacific. The teen retailer has signed three new licensing agreements for stores that are set to begin opening in time for back-to-school in 2014."
  • "According to Simon Nankervis, senior vice president for the Americas and global licensing, one agreement is with Grupo David Enterprises. That contract covers Venezuela, the Caribbean Islands and, in Central America, the countries of Panama, Costa Rica, Honduras, Guatemala, El Salvador, Nicaragua and Belize."
  • "A separate agreement was signed with Grupo Comercializadoras for Colombia. In Asia-Pacific, the retailer signed an agreement with Pacifica Lifestyle Co. for stores in Thailand."
  • "All agreements are for two, five-year tranches. Each agreement also allows the licensing partner to open aerie concept shops-in-shop or side-by-side stores...While many of the stores in the U.S. are about 7,000 square feet, Nankervis said those overseas range on average from 4,000 square feet to over 7,000 square feet, depending on location and availability of real estate."


Takeaway: American Eagle is doing the unthinkable -- taking the 'American' Eagle brand outside of America. Let's face it, the US isn't too popular on the world stage. If AEO can make this work, they definitely tack on another leg of growth to the story.


Burton - Burton Unveils U.S. Olympic Snowboard Look



  • "When the 2014 Winter Olympics take place in Sochi, Russia, Feb. 7 to 23, the U.S. snowboarding team will be sporting Burton. The Vermont-based brand unveiled the original men’s and women’s designs at its flagship here Tuesday night."


What's New Today in Retail (12/4) - chart4 12 4


Takeaway: Out of any sport in the games, the apparel that gets the greatest focus is arguably snowboarding. Burton was the first and remains the premier snowboarding brand. Though it's surprising that one of the bigger brands with deeper pockets has not stepped up and bid away the deal.


NKE - Nike starts waterfree fabric dyeing facility in Taiwan



  • "NIKE, Inc. celebrated the opening of a waterfree dyeing facility featuring high-tech equipment to eliminate the use of water and process chemicals from fabric dyeing at its Taiwanese contract manufacturer Far Eastern New Century Corp."
  • "NIKE, Inc. has named this sustainable innovation 'ColorDry' to highlight the environmental benefits and unprecedented coloring achieved with the technology."




Visa’s Black Friday weekend online sales up 30%



What's New Today in Retail (12/4) - chart6 12 4


New Rules to Dictate Spending Habits of China Officials



  • "In what could be a further blow to luxury consumption in China, the nation’s leadership is deepening its pledge to crack down on corruption and ostentation with the release of new rules outlining how officials should avoid extravagant spending on activities ranging from overseas travel to the purchase of new vehicles."
  • "With 12 chapters outlining 65 rules on how to manage funds and employ more transparent spending, the document, released last week, is extensive and is causing analysts to question whether the antigraft campaign that began nearly a year ago under the new administration of President Xi Jinping will continue to have a far-reaching impact on China’s luxury sector. Spending on luxury products has historically been bolstered by the purchase of expensive gifts between officials and business associates as bribes."


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