Conclusion: Stagflation looks poised to accelerate in India alongside a reduction in the central bank’s credibility.
Position: We remain bearish on Indian equities and bearish on Indian rupee-denominated debt for the intermediate-term TREND. Bearish on the Indian rupee (INR) for the intermediate-term TREND (vs. SGD, CNY, GBP, EUR, and CAD).
Through a series of what we described along the way as “glaring monetary and fiscal policy missteps”, India has managed to accomplish what few countries are able to do in having us be outright bearish on all three of their major liquid asset classes. The laundry list of bad policy actions in India is both long and hard to defend to anyone who possesses a Global Macro process to interpret them in their entirety:
- Early 2010: Indian Prime Minister Manmohan Singh welcomes more potentially-destabilizing and inflationary capital inflows by increasing the overseas investment cap on Indian government and corporate bonds by +$5B and +$30B each;
- June 2010: Indian Government allows fuel prices to be market-determined for the first time since December 2003. At the time, India’s basket of crude oil was $74.3/bbl.;
- November 2010: The Reserve Bank of India (RBI) stepped up its daily lending to Indian banks, relaxed a ruling that requires them to invest in government bonds, and began holding additional money-market auctions and open-market purchases of government bonds (QE) to help increase liquidity in its “cash-strapped” banking system;
- November 2010: RBI goes on hold citing “transitory commodity inflation” and their overly-benign March 2011 WPI forecast of +5% YoY as a reason to delay further tightening (for reference, actual March 2011 WPI came in at +9% YoY and the central bank’s March 2011 WPI forecast was upwardly revised FOUR times to +8% YoY in the four months leading up the actual report);
- February 2011: Finance Minister Pranab Mukherjee unveils the FY12 budget, which is full of sales tax hikes and symbolic, but not meaningful, income tax deductions. In addition, the revenue projections are based on +9.25% YoY GDP growth, which is higher than the government’s official estimate of +8.6% YoY and the central bank’s estimate of +8%, which was revised down today from +8.6% YoY.
- March 2011: Indian Government increases fuel prices to reflect a basket of crude oil at $110.70/bbl.
The net result of these policy blunders is that inflation is up and to the right in India; for this reason, we remain bearish on rupee-denominated debt. Absent a very significant pullback in commodity prices (which would more than likely manifest itself across all risk assets due to the overwhelming US Dollar Correlation Risk Bernanke has imposed on global markets), we are likely to continue to see inflation in India make higher-highs over the intermediate-term TREND. After many months of resisting and trying to extend and pretend on inflation risk, the Reserve Bank of India finally capitulated, today admitting that inflation is anything but “transitory” in India:
“The inflation rate will remain close to the March 2011 level over the first half of 2011-12, before declining… These projections factor in an upward revision of petrol and diesel prices.”
-RBI Governor Duvuuri Subbarao
This defeated commentary was provided alongside India’s first +50bps hike of the current tightening cycle, after eight +25bps hikes since March of 2010. As we’ve called out in our recent work, their actions leading up to today’s accelerated rate hike have put them at risk of losing credibility; now that credibility is officially being eroded alongside the market cap of the SENSEX, which plunged (-2.4%) today and closed down (-9.6%) YTD as the worst performing major equity market globally. At one point, the BSE SENSEX 30 Index was down (-16.9%) from its cycle peak on November 5th to its February 2nd bottom. Indian equities remain broken from a TRADE & TREND perspective and we will look to re-short them on strength in the Virtual Portfolio.
Interestingly, the RBI did provide an update to their economic assessment with this latest rate hike and prepared remarks – an update that matches bearish Hedgeye estimates (at least directionally, that is). Accordingly, they affirmed our call that Growth Slows as Inflation Accelerates by rhetorically committing to tackling inflation and its associated expectations – even at the expense of growth:
“Current elevated rates of inflation pose significant risks to future growth. Bringing them down, therefore, even at the cost of some growth in the short-run, should take precedence.”
-RBI Governor Duvuuri Subbarao
As inflation ramps up in the coming months, we expect India’s consumption growth to deflate, its GDP Deflator to inflate, and the central bank to continue hiking interest rates in an aggressive manner, which would likely constrain credit expansion and industrial production growth in coming quarters as well. As such, we see an air pocket developing below India’s Manufacturing PMI, which is currently at a five-month high of 58.
Shifting gears a bit, as point of clarification, we typically don’t want to be short currencies that are aggressively tightening monetary policy, as India looks poised to do. We do, however, feel comfortable taking such risk given our out-of-consensus calls for: a) India to miss its fiscal deficit reduction target (likely by a wide margin); and b) Bernanke’s Indefinitely Dovish monetary policy to continue fueling cross-asset correlation risk, which would likely result in a broad-based de-risking of institutional portfolios in the event of a US Currency Crash. Historically, the Indian rupee has traded in lockstep with Indian equities, suggesting that the general appetite for risk has been the dominant factor driving the currency. The backdrop of slowing growth, accelerating inflation, and aggressive tightening of monetary policy do not support any incremental tolerance of risk towards Indian assets.
Make no mistake; The Trifecta is not something investors with exposure to India should take lightly given, given just how quickly international capital can drain from Indian assets. If we’ve learned anything from 2008, it’s that the “flows” works both ways, and when they turn, they can turn hard and fast. Keep in mind that the 2008-09 crash in Indian equity markets was aided by a (-$12.9B) outflow of international capital in 2008. Last year, Indian equities saw a +$29.4B inflow, which was followed by a +$919M inflow YTD. Them be a lot of redemptions potentially waiting to happen…
All told, we’ll be looking to express these ideas in our Virtual Portfolio in the coming weeks and recommend you do the same in yours.
Appendix: Within my coverage areas (Asia, Latin America, and Munis), Indian equities, rupee-denominated debt, and the Indian rupee itself remain three of my least favorite investment opportunities. Our Global Macro process allowed us to turn appropriately bearish on them in early November, and the same process continues to flag further downside in all three areas. With a major sell-side institution coming out today as incrementally bearish on Indian growth and incrementally bullish on Indian inflation, the question becomes, “Is this all priced in?” Our answer is a resounding “NO”; the street is not yet Bearish Enough on India. The reports below will detail why (email us for copies):
India’s Two Big Problems (11/9/10): We expect inflation to continue to be a major headwind for the Indian economy and we see further tightening on the horizon. In addition, the potential for destabilizing withdrawals of foreign investment has breached its 2007 highs, which suggest Indian equities could experience major declines should global markets come under pressure.
India’s Two Factor Squeeze (1/6/11): We remain cautious on Indian equities as growth looks to slow due to a cash shortage and additional monetary policy tightening on the horizon. Further, we see inflation as a much larger headwind in India than we feel is currently priced into its equity market.
Top Emerging Market Short Ideas: Indian Equities (1/26/11): If you agree with our October call that EM assets will come under pressure and remain that way over the intermediate-term TREND, then you’re likely looking for short ideas. If so, we think Indian equities are among the top short ideas in this space, supported by the fundamental backdrop of slowing growth, accelerating inflation and interconnected risk compounding.
Falling Like a BRICk: Is India the Next Egypt?: (2/3/11): Inflation in India continues to come in hot, increasing the likelihood of Egyptian-style social unrest in the world’s second-largest country (population). Moreover, slowing growth, accelerating inflation, tighter monetary policy, and an erosion of financial liquidity continues to make Indian equities one of our top short ideas.
The “Flows” Are Reversing For India Equities (2/15/11): Slowing growth and accelerating inflation indeed have interconnected risk compounding in India as the “flows” are currently working against its equity market(s).
India: Missing Where It Matters Most (2/28/11): Finance Minister Mukherjee’s budget failed to adequately address the #1 issue facing the Indian economy – inflation. As a result, our bearish stance on Indian equities continues unabated. Further, we don’t see India meeting its FY12 deficit reduction target as a likely outcome.
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Over the past three years CBOU has been the second best performing restaurant stock behind GMCR, up 270%. The stock powered ahead 30% in 2010, but has languished 6.5% do far this year. The underperformance can be attributed to the significant increase in coffee costs and the challenges it presents. Absent a significant increase in same-store sales the company will be hard-pressed to report any meaningful upside to EPS given the 27% surge in coffee prices year-to-date.
CURRENT GUIDENCE: During the 4Q call management maintained guidance for 2011, despite the fact that commodity prices have gone up. Those aspects are: consolidated sales growth of approximately 7% to 9%, driven by 3% to 5% comparable coffeehouse sales, approximately 10 new store openings coming in the latter half of the year, commercial sales growth in the mid-teens to 20%, capital expenditures of $13 million to $15 million, skewed more towards the back half of the year. EPS guidance is (untaxed and fully diluted) $0.58 to $0.62, or approximately 26% to 35% growth over 2010. On a fully taxed basis, our EPS guidance translates to $0.35 to $0.37.
SALES TRENDS QUESTION: The Q4 comp of 3.5%, could you give some detail on how much of that was related to check versus traffic, and perhaps could you comment on whether you think the snowstorms in the Minneapolis area in December might have hurt that figure and by how much?
ANSWER: Yeah, so for the year, clearly traffic and ticket have been driving our comp store sales. We've talked in the past that the launch of oatmeal has added 1%. We were expecting our sandwich platform to add 2% on an annualized basis. Specific to the fourth quarter, we launched it across half of the systems, so that certainly helped us. And a lot of the other activity that we've done around ticket has helped us drive – and yet the snowstorm had some impacts.
And so as we look forward, we continue to expect our food platform roll-out will – in the first quarter, we launched another tranche of stores on our morning breakfast sandwiches. We're working on lunch. We have other initiatives being teed up, all of which we see as both ticket and traffic-driving initiatives.
COFFEE COSTS: coffee commodity costs are expected to increase approximately 25% on a full year basis with a higher proportion of the increase being realized from deliveries in the back half of the year. (Coffee prices increased another 10.4% in 1Q11).
PRICING: We anticipate covering this commodity cost to increase through a variety of pricing actions across our lines of business and markets in line with our industry peers, as well as other cost reduction efforts.
QUESTION: Could you give us a sense for how much pricing you need to take across the business to cover the type of inflation that you might see, and maybe talk a little bit about how you plan to approach that in the various segments?
ANSWER: Well, the way we look at it is for every 10%, sorry, increases in the C market, we can offset that by roughly a 1% change in overall pricing across the system. So as we look at our different lines of business, obviously specific to commodity costs on the commercial side of the businesses, coffee is a bigger percentage of the overall COGS mix. So we're looking at pricing increases in line with some of the peers that have announced. And on the retail, the coffeehouse side, coffee is not as big a part of the mix in the overall COGS. So we did take some price in the end of last year. On the retail side, we're phasing in some pricing across some of the other lines of business within commercial, and we're taking a phased approach, effectively really following what the industry is doing.
Here is a look at BAGL’s inflation outlook as of the company’s most recent earnings call on March 3rd.
BAGL is not a name I follow closely but, having observed a trend so far this earnings season, of companies missing on margins while meeting or exceeding top-line expectations, I decided that it would be informative to take stock of the inflation guidance for names that are due to report soon. In general, the trend so far this earnings season has been for companies to raise their prior inflation guidance.
It will come as no surprise, wheat costs are important for BAGL and are locked for the first half of the year. Wheat represents 10% of the total commodity basket. The trajectory of wheat prices as we head towards the second half will largely dictate the inflation that the company faces and the commissary margins at BAGL in 2H11. Coffee costs are also significant for the company, comprising of 8% of the mix. Coffee is 100% locked for the year.
I believe that 2-3% overall commodity inflation guidance is more than likely conservative and will likely be revised higher.
Below, I have included some dialogue from the earnings call from March 3rd:
“And as I said, it's all about transaction growth and that's what we concern ourselves most about day-in and day-out, is ensuring that we continue to get that turnaround in transactions, clearly as we take pricing to hold margins in a time where commodity inflation's going up”
Question: In terms of the commodities for next year, have you locked in any of the second half 2011 wheat contracts? And if so, do you have any commentary on that? And then in terms of other commodities, you mentioned wheat and coffee, but do you have any updates on maybe some of the other commodities, where they're trending, and what you're expecting for the year?
Answer: Yeah. Manny did mention that we did lock-in wheat only for the first half, and the reason for that is we – because in our work with our external team that helps us with our wheat buy – they're really indicating and we really feel that, that in the back half of the year that there's some opportunity I guess, in wheat prices weakening, if you will. So, it's the only reason we haven't locked deeper into the year than we have right now, but we do have the opportunity. So, we're covered on the upside and have the opportunity to lock-in at any time assuming that we feel that current estimates aren't where they – where we're expecting them to go.
The second piece – keeping in mind that wheat still only represents 10% of our total commodity purchase and that's an important piece for everyone to keep in mind as they think about our business trends. Overall, we're saying that our commodities will be in the – still in that kind of 2% to 3% range and that's an important element to know. And while there's been some short-term pressure on produce, as you all know, even that is in items that we think will work through quite quickly. Things like tomatoes and lettuce and some other items, because it's such a short growing season that we'll be back into the new fresh produce very quickly. So, we're working through that side of it. So, overall, as I said, 2% to 3% range and on a national basis, and we continue to monitor it very closely.
Question: I was curious in terms of on the commissary side, last time wheat prices went up, commissary margins came under some pressure. Just curious what sort of guidance you might be able to provide us on how to think about that?
Answer: Well, it's a really good question. It's one of the things I hadn't mentioned, and I meant to bring up. As we look at this cost team that we've pulled together, in addition to the packaging and inventory management and truckload, commissary is also another area, Bart, that we have – are really focusing on. So, well, last time, it did do that. We're, I would say, on top of the game, and we think that there's some efficiencies there, some good learnings that we've had. And I feel that that's an area that we can tighten up this year, and it might be another area for upside opportunity for us on a cost side as we sort of go through the year.
Question: And do you expect that 2% to 3% to be higher in the first half of '11 or the second half, or spread evenly throughout?
Answer: We have it spread evenly through the year. Although on the second half, we do have – expect dairy to be a little bit better than in the first half. So, but for all intents and purposes, it's mostly even throughout the whole year.
In preparation for MGM’s Q1 earnings release tomorrow, we’ve put together the pertinent forward looking commentary from MGM’s Q4 earnings call.
- “2010 for the city, visitor growth was about 3% and for this year, the LVCVA is predicting another 3% increase. We think there is upside to those numbers based on increased scheduled flights into Las Vegas, a stronger convention calendar, and the early booking pace that we are seeing already this year, particularly in the year for the year.”
- "We saw increased spending across all of our Strip properties in January with a 17% tick-up in net non-casino revenues. Looking at it for the full year, we have approximately 1.6 million convention room nights on the books, which is a double-digit increase from the same time leading into last year."
- "In January, for example, we were up 33% in inquiries and 150% in bookings in our incentive business, as compared to the prior year. So we’re on a good pace for 2011, and we expect to see our overall casino mix to be about 14%."
- "And we have good experience as to what happens when our convention business grows. We saw that in last October. We’re seeing it right now and the convention mix helps us drive much better revenue, and reason why we believe REVPAR will be up all year in 2011 for our company."
- “On the casino side, we continue to see strength in the international play. In fact, we had another all-time record in the city and for our Strip properties in 2010, including Aria, in terms of international volume…. We’re in the tail end of Chinese New Year’s, and we’ve seen very strong volumes here in Las Vegas… We flew about 15% more customers into Las Vegas this year than last. All of our suite product has been fully occupied through the whole period, with high-volume and high-value guests.”
- “In January… we were able to improve our convention mix by four percentage points, and that all came out of the leisure segment…. convention segment has an average $50 to $70 ADR premium over our leisure segment.”
- “We saw increased spending across all of our Strip properties in January with a 17% tick-up in net non-casino revenues.”
- “We’re up in the teens in REVPAR in January, largely due to a very good convention calendar.”
- “January was a great month for CityCenter, all around the campus with strong profitability in every element of the business.”
- “Aria continues to experience exceptionally strong rate of play in baccarat. Year-to-date, through December, Aria has captured 23% of the Las Vegas Strip’s baccarat market share.”
- “January 2011 REVPAR at Aria was the highest since opening, and exceeded expectations.”
- “In conjunction with the opening of Cosmopolitan, and the adjacent pedestrian bridge just off the CityCenter’s footprint, we’ve seen a noticeable increase in foot traffic.”
- Guidance for 1Q2011:
- “Stock compensation expense… is estimated to be …$9 million to $10 million.”
- “Depreciation expense… is estimated to be in a range of $160 million to $165 million.”
- “We still believe… we’ll be able to have good pricing strength going into the second quarter as well.”
- [Strip RevPAR] “We’ll be up, as Dan said, double-digit in the quarter.”
- Q: “Dan, you had mentioned that you’re expecting first quarter 2011 REVPAR to be up 10% or so, including the resort fees. If we were to exclude resort fees, could you help us out with that year-over-year change would be?”
- A: “Excluding resort fees, we would expect it to be up at least in the high single-digits as a percentage.”
- A: “At least. Like 7% or 8% or something”
- "Convention forecast for Aria is about 14.5% for convention."
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