Ok, so Vietnam is not on your list of countries that you watch on a daily basis – we do.  The big news today is not the Citi (C) debacle but what is happening in Asia—there were big breakdowns in the TRADE lines in the equity markets of Vietnam, China and Hong Kong.


Last night Vietnam was down 1.6% and is now down 30.5% over the past month.  That is a stock market CRASH!  Also last night, Hong Kong broke its TREND line of 21,557, declining 1.2%. The next question is, why?   We see the reason being China. Not only did the Shanghai A-Shares get smoked last night trading down 2.3%, but also broke its TRADE line, an important momentum line that has not been violated in quite some time. 


We continue to make the call that China is going to slow down from an economic data point perspective in 1Q10.  It should also be on your radar screen that we’ve seen a big divergence in the property stocks in China, which have underperformed the local index by nearly 1000 bps.  Our take-away from this is that the property bubble appears to be popping in China, just like the financial “bubble” is popping here in the US.  The XLF has underperformed the S&P 500 by 990 bps over the past three months.


We continue to harp on the fact that China is going to restrict loan growth in the property sector because of “bubble” fears. 


With the Japanese market declining for the past three months, there is not much in Asia that looks positive right now.   



Keith R. McCullough
Chief Executive Officer




HOUSING – A Bottoming Process

It was recently reported that November housing starts rose month-to-month by 8.9%.  October’s starts were revised so as to show a 10.1% decline, after initially having been reported down by 10.6%. The year-to-year change was down by 12.4% in November, following a revised annual contraction of 30.9% in October.   


As seen in the chart below, since December 2008, housing starts have been bouncing along the bottom at historically low levels.  In November housing starts were reported at 574,000 versus the 3-month moving average of 564,000.  Over the past 6 months housing starts have averaged 576,000.  Since June 2009, all monthly readings have been within the normal range of monthly volatility around the 6 month average. 


To describe the housing market in a "recovery" phase based on housing starts is a slight over statement.  No matter how you look at it, housing starts remain well below any levels seen since the end of World War II.


Howard Penney

Managing Director


HOUSING – A Bottoming Process - starts1


HOUSING – A Bottoming Process - starts2

Mind the Covert Deal Activity

Overnight, there have been a number of statements (and speculation) about a number of deals in retail and consumer. Most are small and seemingly inconsequential. But looked at in aggregate, it supports our view that M&A activity in retail will pick up meaningfully in 2010.


  1. Delta Apparel buying Art Gun Technologies, a maker of technology needed to customize patterns and colors on garments.
  2. A SPAC is stepping up to buy Fashion Box, the owner of “Replay”, “We Are Replay” and “Replay & Sons” (no kidding) denim brands.
  3. Emerisque – who recently bought Hartmarx, said in a public statement that it is stepping up its acquisition efforts meaningfully – but apparently is subscribing to the Ackman-esque model (remember when he justified losing money on Target by saying that he uses a 50-year model?) and distancing itself from financial buyers that are now pained with the task of unloading similar deals that were done 3-4 years ago at peak margins and valuations.
  4. Also some non-retail deals worth noting

       a) Apollo buying Cedar Fair for $700mm.

       b) Boyd/Station
       c) Jarden broadens its portfolio of eclectic assets with the acquisition of Mapa Spontex.
       d) Sally Beauty Supplies buys Sinelco – a beauty supply distributor in Europe.


A notable trend is that since the Dollar General and Rue 21 deals, the IPO part of our ‘Banker Bonanza’ call has dried up. But the M&A portion appears to be picking up steam. The evolution into 2010 should be when both are humming simultaneously.

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I was not a big believer that restaurant stocks would post strong performance in 4Q09 when comparisons “were easy” – demand is just not there.  While many analysts have suggested that the decline in capacity was a net positive for the industry, the decline in visits has been enough to offset it (and then some) so there is really no net improvement in trends for the industry. 


In 2008, the restaurant industry faced both declining demand and historically high input costs (the double-edged sword).  The big story in 2009 has been that margins have benefitted from dramatically lower food costs and a rationalization of individual business models, despite no recovery in top-line trends.  In 2010, I am not yet a believer of the demand-recovery story and the cost cutting story will be in the rear view mirror, as will the lower food cost story.  In that respect, the underlying themes in 2010 may not be too different from 2008; though the magnitude of commodity inflation may not be as great and the decline in demand not as surprising.


Demand Trends

I see no real shift in 2010 in the consumption-led recession that the restaurant industry faces.  Employment issues, access to credit and increased savings (or debt reduction efforts by consumers) will continue to put incremental pressure on traffic trends and average check. 


According to NPD's CREST data, traffic declined across all restaurant segments for the quarter ending September 2009. Total industry traffic declined 4% YOY in 3Q09.  By segment, visits to QSR declined 4% and Casual Dining visits were down 5%.


Casual dining same-store sales growth, as measured by Malcolm Knapp, continues to get worse on a 2-year average basis as we move through 2009 (outside of July, when operators, on average, posted their biggest declines year-to-date).  QSR demand trends have fallen off more significantly in recent months, leading JACK management to say in a presentation last week that it now appears that consumers are trading out of the restaurant segment rather than trading down to QSR.


Margin Trends

I have been saying for some time now that the trajectory of margins in 2009 is not sustainable without a pick-up in top-line trends.  As you can see in the charts below, both QSR and casual dining margins have moved higher in 2009 after declining for most of 2008 for QSR and for a much longer period of time for casual dining.  Specifically, 1Q09 marked the first time the casual dining operators on average grew margins since 3Q04.  The two food cost charts below also show that both the QSR and casual dining sectors have benefitted tremendously from favorable YOY commodity costs in 2009 as food costs combined with labor costs account for about 60% of restaurant companies’ operating expenses. 


Although food costs as a percentage of sales have continued to move lower on a YOY basis, the trend for food costs is already moving higher as evidenced by the CRB Food Stuff Index (also shown below), which bottomed in 2Q09.  For the casual dining names on average, the change in food costs as a percentage of sales on a 2-year average basis appears to have already bottomed in 2Q09; though costs are still coming down YOY. 


The decline in absolute commodity costs, however, is not the only factor to consider when looking at food costs as a percentage of sales.  Also impacting these numbers is the prevalence of industry discounting.  Without such discounting, these food costs as a percentage of sales would likely be lower.  I would argue that lower food costs in 2009 have afforded restaurant companies the opportunity to take promotional activity to a new level in a desperate move to stave off traffic losses.  The real question in 2010 is what the impact on margins will be if this discounting continues when food costs move higher.  And, if rising costs force companies to rethink their discounting tactics, what will happen to demand?


I maintain that margins will again be the big story in 2010; though I do not expect them to move in the same direction as 2009.  Demand will remain soft and food costs are likely to move higher.  And, the commodity headwind in 2010 will only complicate the fact that most companies will be lapping the bulk of cost saving initiatives they took in late 2008/early 2009.










Food Costs Trends

When it comes down to understanding the dirty details on food costs, the timing is slightly different for each individual company due to long-term contracts.  Regardless of the timing and length of contracts by company, it does not change the fact that we will be hearing about higher food costs in 1Q10. 


Beginning in 2010, the dagger in the back of the restaurant industry could result from declining food production and a more rational food processing industry.  In November, global food costs jumped 7%; the most since February 2008.  So far in 2009, farm price inflation has lagged behind prices for copper, gold and oil.  The big MACRO question is will the global economic recovery, especially in emerging markets, spur an increase in demand for food and thus, drive commodity prices higher?


In an inflationary environment, the agricultural commodities and related stocks will be the biggest beneficiaries.  On the margin, restaurant companies will be the biggest losers; the marginal restaurant concepts will be hit the hardest.  I’m thinking about smaller companies in the very crowded Bar and Grill segment, like RT and CHUX, who do not have the same level of purchasing power as that of their larger competitors.   


As a result of the combined impact of lower herd sizes and low inventories in a number of grains markets, the prospect of food inflation in 2010 cannot be ruled out. 


Pork and Poultry processors are reducing herd size

After two-years of losing money, pork farmers have cut the herd size to the smallest level since the USDA started collecting data in 1964.  As a result, wholesale-pork prices are up 27% this year.  While this may already seem dramatic, the CEO of Smithfield Foods believes that “further liquidation is needed." 2010 projections include another 4% cut to herd size.  As an aside, I’m not naive to the fact that Smithfield Foods has a big economic incentive to convince competitors to reduce production.


The same holds true for the poultry industry.  In 2009, broiler production decreased for the first time since 1975; the USDA is estimating a 3% decline in 2009.  Currently, the USDA is forecasting a 1% production increase in 2010.  However, there is a chance that production could decline again in 2010 for the following reasons:  (1) the continuation of volatility in feed costs, (2) uncertainty of maintaining exports to the two largest markets - China and Russia, (3) a sluggish economic recovery in the United States and globally, and (4) continued reluctance on the part of banks to lend money.


The key segment to watch in 2010 is wholesale chicken wing prices.   Currently, wing prices surpass boneless/skinless breast meat prices.  The ever-growing consumer demand for buffalo-style wings is putting increased pressure on a relatively fixed supply of wings.  As the boneless wings trend continues, it will help ease the price pressure on bone-in wings while adding marginally to the demand for breast meat.  I continue to be very cautious on BWLD going into 2010.


Milk Supplies are tight

In 2010, higher milk and cheese prices are almost a given.  In 2009, dairy farmers have been reducing their herd size, too.  Currently, domestic dairy production is down 8.2% in 2009.  According to the USDA, the price of nonfat dry milk, used in baking products and baby formula, will rise to an average of $1.275 a pound next year from 92 cents, and cheese will increase 28%.  Also, the USDA thinks processed and fluid milk will jump 31% to $16.75 per 100 pound.    


Corn prices and Federal mandates

Corn prices began to decline in 2008 when it became apparent that flooding in the Midwest had not devastated the corn crop and that farmers would harvest another large crop in 2009.  Fast forward to today and the USDA is projecting that the US will need more corn in the coming months than will be harvested; the implications are that we are beginning to draw down on reserve stocks.  The likelihood that we could face a repeat of 2008 increases as the federal mandate for corn-based ethanol keeps increasing. 




RESTAURANTS 2010 – REMEMBER THE DOUBLE-EDGED SWORD - Wheat current vs forecast

FL: The Footlocker Wish List

Foot Locker remains one of our top ‘bench’ ideas headed into 2010. No, the timing still is not right, but the fundamental story should begin to align – for the first time in a long while. There’s still a wall of silence from FL on its strategy. Here’s our initial wish list.


On our 4Q theme conference call (if you missed it, let us know and we’ll get you the slides/replay), we mentioned that we were warming up to Footlocker.  We still are. And while we definitely don’t have all the answers on this one, we continue to dig deeper in an attempt to figure out the potential for a turnaround.  Importantly, there seems to be a fair level of interest (and intrigue) with our focus here.  Not because Foot Locker is a screaming buy at this very moment, but because it has fallen off of so many people’s radar screens over the past couple of years.


In absence of answers, we do have plenty of questions.  And based on the FL-related inquiries hitting my inbox, so do you.  I’m get the same simple question from anyone who is even remotely interested in understanding what’s going on at Footlocker.  What can they possibly do to fix this business?  Not having done a ‘double secret one-on-one’ we have no special “insight” into recently hired Ken Hicks’ game plan, but here’s an initial wish list for what should be key to improving the future of the chain:


  • Right-size the store base and optimize the portfolio by brand.  With 8 sub-brands (Footlocker, Footlocker International, Lady Footlocker, Kids Footlocker, Footaction, Champs, CCS, and Eastbay) there is ample opportunity to put the right stores in the right place.  Historically, the focus has been overly centered on the total portfolio and a modest amount of store closings in any given year.  Recall that past management was very much in favor of “addition by subtraction”, which resulted in a 3-4% per annum reduction in square footage over the 2007-2008 period.  Many conference calls of yesteryear touted the 50bps annual benefit the company could achieve by simply closing stores. Closing a large amount of stores may or may not be the right answer. After all, one might argue that mass store closures would take away some of the leverage FL has with vendors and landlords as an 800lb gorilla.  But with a 30+ point margin spread between the least profitable and most profitable stores, doing the analysis is a start.


FL: The Footlocker Wish List - fl store growth


  • Focus on the product.  Sounds simple, but it’s not.  When 60+% of your merchandise comes from one vendor (Nike ranges from 44% to 78% of total sales depending on the nameplate), it seems to me that this is a “buy” and not a “sell” mentality.  Ken Hicks brings a substantial amount of experience to the table in areas of sourcing, branded apparel and footwear, large chain store operations (Payless), and private label/exclusive brand development.  All of these areas are key to the future of Footlocker in my view.  Better brand balance (less Nike, more of everything/anything else), improved product mix utilizing apparel to drive higher gross profits, and increased use of exclusive product offerings to drive pricing power and differentiation should all be considered.  The days of trying to cross sell 5 for $20 tees with marquee Nike’s must come to an end.


FL: The Footlocker Wish List - nike footlocker


  • Europe probably doesn’t need as much fixing.  The non-US operations are in a different state at this point.  The brand is better positioned overseas, with product more skewed towards the premium level. Competition is more confined to local and regional players and the business exists outside the “mall”.  Quite simply, if it ain’t broke don’t fix it.  The US needs the most attention and at this point shareholders should recognize where the low hanging fruit exists.


  • This is not a financial engineering/restructuring.  With $438 million in cash and $138 million in long-term debt, there isn’t much to worry about here when it comes to liquidity.  Yes, the company has over $4 billion in operating lease commitments (that Wall Street loves to forget about) but that’s the price of admission when you operate in a mall.  An important consideration is that Foot Locker has among the shortest implied lease duration of most mall retailers. Not a bad place to be when the commercial real estate market is crashing and setting up for rate resets. The real focus here is on productivity and on profitability.  Both of which are achievable with the current balance sheet.  Are the stores tired? Yes, and maybe refreshing the in-store experience is part of the plan.  If it is, I don’t see it being at the top of the list or requiring substantial amounts of capital.


  • Seeds planted for limited, but some growth.  In the near to intermediate term I would be surprised to hear much about growth.  This is clearly a margin recovery story.  EBIT margins are likely to end the year below 3%, but were in the low 7% range from ’03-’06.   With a strong and well capitalized e-commerce platform, a growing International business, and the seeds planted for a new concept in CCS there will at some point be an opportunity for Footlocker to use its cash flow for new projects.  It just won’t be anytime soon.


So what’s next?  Hicks is expected to unveil his plan in the Spring, with the reporting of 4Q results.  We won’t be surprised when some combination of the abovementioned strategies will be employed to begin the turnaround.  Neither should you.  The question here is not what ideas will be communicated but rather if and how well they can be executed.  For us, the change in leadership alone is likely to be biggest single factor in the process.  At least to start.  No one needs to be buddies with Ken Hicks or get that exclusive early access to recognize that this company needs a new strategy, implemented by a new leader.  The old rules of bigger is better no longer apply.  Collaboration with Nike and Under Armour and Adidas and others will be key to this new focus.  Bullying suppliers and being overly reliant on one brand is no longer an option. 


It’s time to start paying attention to Footlocker as it remains one of the few retailers with a sizeable revenue base and a reason to exist, that has not benefitted from cost cutting and inventory cuts like the rest of retail. 


You’ll be hearing a lot more from us on this name headed into ’10.


Eric Levine


The End Of History

“What we may be witnessing is not just the end of the Cold War, or the passing of a particular period of postwar history, but the end of history as such…”
-Francis Fukuyama

It is impossible to separate a strong Macro process from having Edge on the state of the US Healthcare System. Here’s a look from Tom Tobin (Research Edge Healthcare Sector Head) as to how the two come together.

The disconnect between the politics of Washington D.C. and the economics of Wall St. are well known.  It is like a bad marriage of two co-dependent and borderline personalities.  On the one hand the banker identifies with the hand of God, He-eth who enables the creation of capital and the attending prosperity it brings to “the people.” Meanwhile politicians call bankers names like fat cats, and slander them with accusations of ripping tax payers off with free money government bailouts.  Politicians for themselves invoke the spirit of Jimmy Stewart’s Mr. Smith when they speak of their own role in the History of Man.  The banker remains silent in the argument at this point, at least publicly, and just tries to figure out who he has to pay to get favorable language in the next round of regulation.  All the while, the kids in the back seat are the American Public who rightly assumes they are getting taken for a ride by both.  Over the long term, the noise and bluster is just that, noise and bluster.

Politics is a process of seeking the advantage on the margin, the P&L consisting largely of intangibles, such as political capital and favors to call in.  But it leaves an outsider constantly grasping at their real motivation.  Personally, I hope the answer to the parlor game on the Left of “what Joe Lieberman got paid to kill the Public Plan” is more than a junket to play golf in Scotland.  At least on Wall St., your P&L is measured in dollars, the ultimate truth serum.  That is of course, you didn’t cheat to get there. 

For a time, President Obama held the mantle of renewal and rebirth for American politics.  Unfortunately, at least for the 45% of Americans currently registering their disapproval, that is no longer true.  There was a time when 80% of Americans approved of their newly elected President, so that must have included at least a few Republicans, and maybe a few who did not understand the question, or both.  When Americans loved him we were in a state of crisis, the next great Depression was upon us, and they were scared. 

Like Fukuyama’s End of History, President Obama promised an end of history in Washington D.C.  Transparency and Accountability would reign over the lobbyists, fat cat bankers, unjust wars, no-bid contracts, and tax cuts for the rich, putting the reins of power in the hands of the commoner.  But the bitter truth is Transparency and Accountability has been noticeably absent as the rhetoric has soared above the fray on high minded clouds, while the politics of the possible on the ground ended in school yard taunts.

Whether it is the Burning Buck and crisis-level Fed Fund rates, Swine Flu, Afghanistan, or Health Reform I, the speeches, while inspiring, have found their targets to be elusive.  The problems facing Healthcare are well known; Medicare will go broke in 2017 despite, or more likely because of, private market subsidization of the government who chronically underpays providers, uses a political process to set prices, and gets robbed daily.  The predictable outcome, which has been evolving over decades, has been spiraling healthcare inflation, and a swelling population of the uninsured.  With or without the subsidies outlined in Health Reform I, insurance premiums will be $20,000 per year for a family of four by the time Health Reform hits in 2014.   Either it was because nobody could ask the question, or wanted to hear the answer, but the most obvious question was never asked, which is “why is healthcare is so expensive?” The answer, of course, can be found where the costs are, at the hospital (31% of spending) and in physician offices (21% of spending).   

Now that the process is near complete, it seems the American taxpayer doesn’t have the right guy on speed-dial. The Obama team cut deals with the American Medical Association, who represent doctors and whose membership is dominated by high cost specialists (70%), and the American Hospital Association, even before the question of cost and quality were even discussed. This was an early sign that President Obama’s view of Transparency and Accountability were open to interpretation.

But things evolve and that is the key variable that Fukuyama forgot to contemplate in his end of history thesis.  Maybe if he had reviewed Darwin, or the modern updates of evolutionary theory, he would have found that evolution is a process that happens on the margin.  The end of communism was a triumph of western liberal democracy, but it did not happen the day the Berlin Wall came down, nor was the aftermath completely written.  Young men and women dying today in Afghanistan is our sad inheritance of that victory. 

Complex systems (markets and politics) and the organisms that populate them (bankers and politicians) have the power to passively and stably self organize.  This stability requires more than just one isolated event to define a new trend.  Joe Lieberman is not a lone gunman.  In this or any era, I don’t think “the people” particularly care about politics day to day.  Whether President Obama likes or not, a continuous state of crisis is unsustainable.  Even crisis can become commonplace.  The Marxist-Leninists saw themselves as “liberators” of the proletariat, and we know how that disconnect ended.

Tom Tobin
Managing Director
Healthcare Sector Head

VXX – iPath S&P500 Volatility For a TRADE we bought some protection at the market's YTD highs by buying volatility on 12/14.

EWZ – iShares Brazil As Greece and Dubai were blowing up, we took our Asset Allocation on International Equities to zero.  On 12/8 we started buying back exposure via our favorite country, Brazil, with the etf trading down on the day. We remain bullish on Brazil’s commodity complex and believe the country’s management of its interest rate policy has promoted stimulus.

XLK – SPDR Technology We bought back our position in Tech on 11/20. Rebecca Runkle has an innovation story in Mobility and Team Macro has an M&A story in our Q4 Theme, the “Banker Bonanza”. We’re bullish on XLK on TREND (3 Months or more).

GLD – SPDR Gold We bought back our long standing bullish position on gold on a down day on 9/14 with the threat of US centric stagflation heightening.   

CYB – WisdomTree Dreyfus Chinese Yuan
The Yuan is a managed floating currency that trades inside a 0.5% band around the official PBOC mark versus a FX basket. Not quite pegged, not truly floating; the speculative interest in the Yuan/USD forward market has increased dramatically in recent years. We trade the ETN CYB to take exposure to this managed currency in a managed economy hoping to manage our risk as the stimulus led recovery in China dominates global trade.

TIP – iShares TIPS The iShares etf, TIP, which is 90% invested in the inflation protected sector of the US Treasury Market currently offers a compelling yield. We believe that future inflation expectations are currently mispriced and that TIPS are a efficient way to own yield on an inflation protected basis, especially in the context of our re-flation thesis.

EWJ – iShares Japan While a sweeping victory for the Democratic Party of Japan has ended over 50 years of rule by the LDP bringing some hope to voters; the new leadership  appears, if anything, to have a less developed recovery plan than their predecessors. We view Japan as something of a Ponzi Economy -with a population maintaining very high savings rate whose nest eggs allow the government to borrow at ultra low interest levels in order to execute stimulus programs designed to encourage people to save less. This cycle of internal public debt accumulation (now hovering at close to 200% of GDP) is anchored to a vicious demographic curve that leaves the Japanese economy in the long-term position of a man treading water with a bowling ball in his hands.

XLI – SPDR Industrials We shorted Industrials again on 11/9 on the up move as the US market made a lower-high.  This is the best way for us to be short the hope of a V-shaped recovery.   

XLY – SPDR Consumer Discretionary We shorted Howard Penney’s view on Consumer Discretionary stocks on 10/30 and 12/2.

SHY – iShares 1-3 Year Treasury Bonds  If you pull up a three year chart of 2-Year Treasuries you'll see the massive macro Trend of interest rates starting to move in the opposite direction. We call this chart the "Queen Mary" and its new-found positive slope means that America's cost of capital will start to go up, implying that access to capital will tighten. Yields are going to continue to make higher-highs and higher lows until consensus gets realistic.

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