Conclusion: The recent collection of hawkish monetary policy and prudent fiscal policy has Brazilian equities feeling the ill-effects of waning stimulus due to higher interest rates and budget cuts. In addition, we detail below how we are playing Global Stagflation from a Global Macro perspective.
Position: Short Brazilian Equities via the etf EWZ.
On Thursday, we shorted Brazilian equities in the Hedgeye Virtual Portfolio on the expectation that the Bovespa was indeed rallying to another intermediate-term lower-high. From a top-down perspective, a confluence of bearish factors has had us sour on Brazilian equities since early November:
Slowing Growth: The higher-frequency data in Brazil (Retail Sales, Consumer Confidence, Economic Activity Index, Trade Balance, and Industrial Production) has inflected negatively in Dec/Jan reporting.
Accelerating Inflation: Even in the face of recent rate hikes and higher reserve requirements, the official IPCA National CPI reading accelerated +10bps to a 26-month high of +6% YoY in Jan. The unofficial, more sobering FGV IGP-M CPI reading accelerated to a 26-month high as well in Jan (+11.5% YoY).
Recent news suggests Brazil may have to import crude oil to offset a mix-shift by consumers and producers away from ethanol consumption, where prices are becoming prohibitively expensive. Unfortunately, the proverbial “poison” will have to be picked: WTI crude oil prices accelerated to +17.3% YoY in Jan from +8.5% YoY in Dec.
Interconnected Risk is compounding: In what we consider a bullish long-term data point, the inexperienced President Rousseff won a major battle within the Lower House of the Brazilian Congress to increase the minimum wage to 545 reais – a +6.8% YoY increase. Opposing lawmakers had been calling for an increase to as high as 600 reais. The bill, which was passed by a vote of 361-120, now goes to the Senate floor for debate.
This decisive “win” helps Rousseff stay the course on her plan to cut spending by 50 billion reais ($30B) from the budget. This victory sets the stages for additional frugality, as over two-thirds of pension and welfare costs are indexed to the minimum wage. Every one-real increase in the minimum wage translates to a +300 million reais increase in public spending.
Rousseff, who has yet to detail where additional budget cuts will come from aside from “eliminating waste” and freezing government hires, appears to remain steadfast in her commitment to work with Central Bank President Alexandre Tombini and Finance Minister Guido Mantega to rein in inflation through a combination of tighter fiscal and monetary policy. As a result, Brazilian interest rate futures have been on the decline of late. Despite the prospect of less aggressive rate hikes, however, the outcome remains the same: less liquidity to perpetuate demand growth and chase stock prices higher.
While we are not in the camp that considers stock market performance to be indicative of a country’s long-term health, we do believe in its merits as an indicator of a country’s near-term growth/inflation trends. Both are going the wrong way for Brazil and are weighing on Brazilian equities. Also, the proactively predictable interconnected risk associated with MENA instability certainly doesn’t help either:
The March Towards Global Stagflation:
While prudent fiscal and monetary policy is not a “risk” by definition, it is a bearish factor for near-term equity market performance. As we’ve seen for the past two years, global equity market performance has been in-part driven by loose monetary policy worldwide. Now, we’re seeing emerging markets get tagged as they rein in the laxity which has helped global growth advance to its current cyclical peak.
We maintain our belief that global growth (including in the US) topped out in 4Q10, as bearish factors combine to quell the current momentum of growth: global inflation accelerating, higher interest rates and tighter monetary policy globally, global credit risk rising, US consumption growth slowing, US housing deflating… the list continues on. Consensus' current bullish sentiment is supported by lofty global growth assumptions and elevated earnings forecasts which will likely be revised down from current estimates in the coming months.
Regarding our virtual investment positions specifically, we’ll continue to watch the US dollar like a hawk for cues on the direction of global inflation (we're currently short the US Dollar via the etf UUP). While supply/demand fundamentals have certainly contributed to the current elevated prices of many commodities, we’d be remiss to ignore the medium by which they are PRICED and traded in to determine our expectations of future PRICES.
As long as Bernanke, Geithner, and Obama continue to Burn the Buck, we see no reason for commodity prices to back off meaningfully. Don’t assume slowing global growth will lead to decelerating inflation; Global Stagflation is a definite possibility and, in that scenario, not even the “flows” will protect investor portfolios. We remain short Brazilian equities (EWJ), Indian equities (IFN), Japanese equities (EWJ), Emerging Market equities (EEM), US Treasuries (SHY), and US Consumer stocks (XLP, COH, VFC, MCD; recently closed/still bearish on: XLY, TGT, SAM, and JNY) in anticipation of this scenario playing out.
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There is a difference between sharing assumptions and setting expectations. Here’s some great color we’ve picked out from some key industry players whose views are anything but similar.
One thing we find consistently surprising are managements’ comments about how “if all else fails, the consumer will absorb the cost of inflation.” In retail, that is almost never the case. Based on what the retailers, brands, and manufacturers are saying, the consumer will need to grow the size of their wallet by 3-5% on like-for-like product this year, and fork it all over to maintain peaky profit margins on so/so businesses.
What do Wal-Mart, VFC Corp and to a degree Macy’s all have in common? They’re forecasting healthy consumer spending in 2011 without meaningful margin erosion. How in the world can they do this with 87% of the year left to go and we’re two months away from the point where the highest raw material headwind the modern retail industry will hit margins?
Headed into 4Q earnings, these companies felt the need to give some context about their go-forward assumptions for FY11 – which we think is fair. But there is a difference between sharing assumptions and setting expectations. A company that shares assumptions is likely to be more pliable with any outside forces that may impact cash flow. On the contrary when optimistic expectations are set so early in a year, the risk/reward rarely ends up in a good place.
Before we dive into the new information we got today on retail, there’s one thing that’s vital to consider. There are three stages of grief as it relates to raw materials.
1) Control what you can control.
2) Workup a strategic plan as to how you think your supply chain partners will react when faced with a meaningful change in their cash flow. I’m referring to a brand like Adidas being on the lookout for how Nike plans to dramatically reinvent the ‘toning’ space (as the iPad did to Kindle).
3) In addition to the two preceding points, plan for how a supply chain partner will look to squeeze when it’s hurt in other categories.
> For example…what happens if the ‘food inflation pass through’ is maxed out and Wal-Mart needs to face a food price increase at risk of losing additional traffic?
> Why not push it through to more discretionary and highly fragmented categories like apparel and toys?
> Go out and ask a CEO of a ‘basics’ apparel company if he knowingly funded markdowns in fresh fruit. He’ll say no, and he’s not lying. He’s simply unaware.
Let’s look at some of these recent comments and assumptions, to see if we can set our own expectations.
Here are the limited comments from WMT re: apparel. Most interesting is the point about consolidating suppliers and adding back some exposure to footwear and accessories. Clearly some of the category shifts in 2010 are being unwound.
- “We posted mid-single digit negative comps in apparel. We have seen improving sales trends in men’s, ladies plus, and women’s, offset by a pull back in juniors. Customers are also buying closer to need, particularly in seasonal apparel. I’m encouraged by recent trends, as we add back assortment in key apparel categories, including shoes and accessories.”
- “Space and assortment changes are now under way to improve our merchandise presentation, particularly in apparel, sporting goods, toys and hardlines in most of our U.S. stores.”
- “Labor and higher cotton prices are affecting apparel and home categories. In softlines, we’re consolidating suppliers to improve purchasing power and leveraging our buying power with raw material suppliers. We continue to work with our suppliers to reduce inflationary pressure where possible and only pass on price increases when they cannot be avoided.”
Hedgeye: Translation…Wal-Mart is changing its assortment to maximize productivity, along with consolidating its softline vendor base. When they run out of rope, they need to ‘work with suppliers’, which basically means “get better pricing from vendors.”
Not a ton of surprises in the current quarter as they had previously pre-announced, but a surprisingly confident outlook for 2011. Keys to ’11:
- 3% same store sales guidance on top of a reported 4.6% would make this the greatest 2-year performance in over a decade.
- Management is bullish on e-commerce and continues to invest heavily in e-com infrastructure. Growth in the .com is worth about 100bps to overall comps. Allows for potential reduction in clearance over time as SKU’s can be held centrally and distributed on a DTC basis.
- Reiterated that strength in top-line is being driven by fashion-related items. This is the key to management’s belief that they can take some pricing. They will remain competitive on basics, but fashion remains the focus for the company. Traditional brands (not specific here but I’m guessing JNY, etc.) are laggards and need reinvigoration from vendors.
- Inventories well managed despite pulling inventory receipts forward to meet demand after successful post-holiday demand. Inventory growth should mimic comp store sales momentum. Sounds like there is real discipline here on the part of inventory management which is driving a cycle of better gross margins as well as reduced markdowns.
Hedgeye: Net/net, Macy’s is confident that their merchandising initiatives (My Macys, private/exclusive brands, and emphasis on fashion) will help drive a second year of LSD positive comps. If successful, this will be the single best two year sales run in the modern history of the company.
The company is guiding toward 8%-9% top line in 2011. Let me repeat… Guiding to 8%-9% top line in 2011.
- Remember that the old model called for 3-4% growth from the base business and 3-4% from acquisitions. This time, however, there is no mention of acquisitions.
- VFC did not put up organic top-line growth like this since midway through last decade.
- Guidance is based on 8% top-line with flattish margins y/y (GM down 100bps offset by SG&A leverage). Don’t you think that just MAYBE this is a little optimistic?
One of the X-factors here is the competitive dynamic between Levi’s and VFC (Lee and Wrangler). These brands are the $20-$30 mainstay at WMT. Levi’s intends to take price increases in one fell swoop. VFC will likely be more measured and gradual. Notable VFC comment:
- “In terms of 2011 for our Jeanswear America businesses, we anticipate men's single-digit growth in revenues. At the same time, unit volumes are expected to decline at a mid single-digit rate, offset by new programs in pricing...Some initial price increases have taken effect in February, with some additional increases planned as the year progresses. On the cost side, we're keeping a tight reign on expenses and reengineering products. Nevertheless, the combination of pricing and cost controls will not fully mitigate the increases in product cost, and as noted earlier by Bob, our domestic Jeanswear margins will be down this year.”
Hedgeye: In men’s, the only growth will come from whatever pricing sticks. If competitors break price, then pricing is at risk in one of the most stable and profitable businesses for VFC. Keep in mind that expectations call for pricing to largely offset unit declines in the domestic business with international growth both in Europe and Asia the key drivers of global top-line results. Overall, we’re perplexed as to why and how the company set these expectations so far out with so much uncertainty yet to come.
- “I can tell you in this environment all apparel companies are raising prices and retailers are seeing it everywhere. They’re seeing it from U.S. suppliers, Central American suppliers, Asian suppliers, and as I said, we’ve implemented price increases, some of which took effect this week. And we’ve also solidified pricing through back-to-school and you’ll see higher promotional prices and prices in the marketplace than you did the prior year.”
- “What I’m seeing is a lot of retailers be willing to push branded basics a little bit more and they are going to be a little bit more cautious for high price point, high fashion, high mark down risk items especially I think in back-to-school and leading into the holiday season.”
- “Overall, I think you’ve got a lot of people that understand that if you’re raising prices in a certain category, that volumes are going to come off. There’s a question, obviously, about how much. And as I alluding to earlier, what a lot of retailers are doing is they’re making those decisions in a lot of the apparel categories that they pre-buy which is the bulk of apparel. They are cutting units and more where they realize that they have more mark down risks. So I think what the retailers are trying to do is to make sure they don’t end up with a huge mark down exposure, for example, next holiday.”
- “So if you saw prices come down from these levels substantially we’re probably, they’re just starting to match the price increases that we’ve secured in the marketplace for back-to-school. And, as I said, if they stay at these levels you’re going to see us continue to increase price and actually the retailers fully understand that. We’ve been communicating with them on that all along and they’re hearing that from other suppliers around the world.”
Hedgeye: We know that Wal-Mart is consolidating vendors and changing up its mix. HBI did well with WMT last year – though it got a mini shot in the arm with Carter’s down and out. Will it be using its cost cuts to gain more share at WMT?
- “I think consumers, especially at the mass-market, are a little more sensitive to price – elasticity in price movement. But there’s definitely room. If I look at the way the pricing has gone in the past, I mean, you can buy, in certain cases, nine pairs of underwear in a bag. Do you need nine pairs for a week or do you need seven pairs for the week? So there’s ways to keep price points down at retail by reducing the assortments and other things, let’s say, for example that could mitigate the price increases. And that’s – we work through with the retailers.”
- We have strong sell-through from retailers in the men’s and boys’ socks categories in the quarter
- I mean, the cost in Asia has skyrocketed. I mean, T-shirt prices in Asia have gone up over $9 a dozen since last year this time. They’re just not competitive. The pricing out of China, in all categories not just our basic T-shirt category, but every – across the board everywhere are up anywhere between 15% and 25%. So what’s happening is that retailers are scrambling in general the find product. And I think it’s going to play well for people that are producing in this hemisphere, ourselves and the industry at large, to capitalize on what we think is going to be a big shift in terms of where people looking to manufacture and source their products. We have a lot of inquiries from people that are calling us now looking for product
Hedgeye: Interestingly, the perennially bullish GIL management team has one of the more lucid opinions on the retail environment. That said they are the only company we’ve heard call for a “soft landing” in cotton prices.
MPEL beats and provides a positive Q1 outlook. The reasons they missed our Street high estimate are not exactly negative.
You wouldn’t know it by the stock price but this should’ve been a good day for MPEL’s stock. They beat the Street for the second straight quarter (a big deal for the gang that couldn’t shoot straight since the IPO). More importantly, Q1 is trending above Street estimates and direct play appears to be growing as a percent of VIP which should be good for margins. Numbers look like they are going higher, again. Unfortunately, the stock market, and particularly gaming stocks, are not cooperating.
MPEL reported net of $774MM and Adjusted EBITDA of $134MM. Net revenues were in-line with our estimate while Adjusted EBITDA was 6% light - but still above consensus. The $9MM EBITDA underperformance vs. our estimate can be attributed to higher corporate expense and higher direct play (vs. our estimate) at CoD. Corporate expense was $3MM higher than our estimate due to a higher bonus accrual; the run rate should be lower. We overestimated the VIP win percentage which appeared higher per our monthly data but in reality wasn’t because direct play was higher. Going forward, higher direct play should help margins as player rebates are on average 30bps lower than junket commission rates.
City of Dreams
CoD net revenues of $489MM and adjusted EBITDA of $98MM were 3% and 12% below our estimates, respectively. Net casino revenues were $27MM below our estimate, primarily due to VIP revenues
- Direct play at CoD was 19% in 4Q210 vs. our estimate of 15% (3Q10 was 13%) resulting in RC volume that was 5% higher than our estimate, or a 66% YoY increase.
- VIP net revenues were $447MM, $13MM lower than we estimated
- The combination of lower reported net revenues and higher RC volumes resulted in us overestimating hold percentage by 20bps, resulted in a net revenue miss of $20MM vs. our original projection and an EBITDA impact of roughly $3.5MM
- Mass revenue of $126MM was $1MM below our estimate. Table volume was a bit light of our estimate while hold was better
- Slot win of $30MM was 6MM below our estimate due to lower slot handle and lower win percentage
Net non-gaming revenues were $12MM above our estimate, driven by House of Dancing Water, better RevPAR and lower promotional expenses. We believe that fixed expenses increased to $69MM at CoD compared to our estimate of $60MM and $55MM in 3Q2010.
- The company says this is because of the incremental cost of the HODW show – but you would think this would be accounted for in non-gaming expenses.
- However, the above statement doesn’t jive with the show being breakeven on its own- in which event you would have margins decrease in net non-gaming revenues, not an increase – so we assume that a lot of the costs did get captured in our fixed expense estimate. Looks like the show added about $8MM of incremental fixed expenses
Altira net revenues of $245MM and adjusted EBITDA of $46MM were 1% and 17% above our estimates, respectively.
- Gross VIP revenues were $8MM better than our estimate driven by hold that was 10bps above our estimate. Direct VIP was negligible.
- Mass table win was $3MM lower than our estimate due to weaker than estimated hold. Drop increased 98% YoY.
- We estimate that fixed costs were $18MM compared to our estimate of $21MM and our prior quarter estimate of $15MM
- Mocha slots revenues were $2MM above our estimate while EBITDA was $1MM better
Position: Long Sweden (EWD); Short Euro (FXE)
Below we include a portion of a product offering from our Financials’ team, the Weekly Risk Monitor for Financials that tracks CDS across global banks. The table below covers major banks throughout Europe and the trend week-over-week was mixed, tightening for 23 of the 39 reference entities, widening for 15, and flat for 1.
Our attention remains acutely on the health of each of the PIIGS due to their volatility and contagion effect across the continent. We have particular focus on Spanish banks given their recent widening, and high foreign exposures (4x higher than to Greek banks, or $989.8 Billion), according to the latest data from the Bank of International Settlements.
The European credit markets continue to be an important indicator of risk for us. As the chart of 10YR government bond yields below presents (and in sharp contrast to the outperformance of the equity market of the PIIGS year-to-date) yields continue to trend higher, a reflection of the risk premium to own the debt and deficit imbalances of these nations.
We remain long Sweden (EWD) and short the Euro (FXE) in the Hedgeye Portfolio with the EUR-USD trading in a range of $1.34-$1.37. From a fundamental standpoint, we continue to like countries like Sweden and Germany that demonstrate fiscal discipline, political stability, and a healthy growth profile for this year and next.
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