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IN CASE YOU FORGOT!

The federal minimum wage will rise to $6.55 an hour on July 24th, the second of three annual 70-cent increases passed by Congress last May. With housing markets collapsing, financial markets in disarray and the economy looking at a consumption recession, the increase in minimum wages could complicate a challenging environment.

Raising the minimum wage over the next two years regardless of changes in economic conditions could accelerate inflationary pressures. In addition to increased labor inflation, restaurants and retailers are among the sectors impacted the most by rising commodity prices and slower consumers spending. If companies try to raise prices to offset minimum wage hikes, on top of current pricing trends, they run the risk of lower guest counts.

This Bull Isn't Spanish

This bull is Asian. This bull is Small Cap. This Bull is Short Interest – This bull is a stock picker!

This is a bull shark ripping the underbelly of everything complacent and consensus. The last thing you want to be short out there in these trading waters this morning is a high short interest Chinese internet company like say, Baidu.com (BIDU -trading +13%). Realizing that you’re smarter than everyone else didn’t pay you staying short the US Financials this past week, nor is it going to pay your “fundamental” short Amazon (AMZN) or Qualcomm (QCOM) bets this morning (they’re trading +8% and +10% respectively). If you’re short a trifecta ticket with Chipotle (CMG), Sketchers (SKX), and Ryland (RYL) – you’re a winner!

CMG and SKX are trading down -12% and -13% pre-open, respectively, and yes they have high short interest – but that factor gets wiped aside on alpha day, so be careful out there – some of these bulls are not like the others. I have to give some Obama knuckles to my partners, Brian McGough and Howard Penney, for nailing these two shorts in their portals. Great job, Gentlemen.

I know this has to be a frustrating month for some, if not for many. I’ve been bearish on the market’s “Trend” for 9 months, but I’m having another good month riding this bull “Trade”; lucky me, I guess. Understanding where we go next continues to weigh to the bullish side of an extended “Trade” higher, and as depressing as my notes may have been in months past, it is only too ironic that I am depressing the shorts with these key strokes. This is a complex market system of interconnected factors. They change daily, and they must be respected.

In the last 72 hours we’ve been issued macro facts that are outright bullish. Most of these factors center around deflating an inflation bubble. You can find these facts littered all over the world. They’re fairly straightforward too. So let’s go through a list of 9 bullish factors, for starters:

1. Oil broke my support level of 126.16
2. CRB Commodities Index broke my support level of $428
3. US Dollar recovered from crisis zone, through my resistance level of 72.61
4. US Treasury 10 year yields rallied through my resistance level of 4.05%
5. Brazil raises interest rates overnight to 13%, and remains hawkish
6. US Federal Reserve rhetoric changes to explicitly hawkish after Plosser and Bernanke comments
7. Canadian and Brazilian stock markets continue to break down (Food and Oil inflation proxies)
8. Russian, Norwegian, and Middle Eastern equities (Energy inflation proxies) continue to break down
9. Asian currencies and stock markets strengthen in tandem

The facts have changed, and unless these levels reverse in unison, there is no reason to be short this bull shark. That does not mean I want to buy everything. That certainly does not mean I want to run out and buy US Financials after they have ripped the shorts for a +30% 6 day move. It means, I don’t want to be long commodities (including Gold); and it means I want to be picking stocks, assets, and country’s that fit the macro short squeeze profile. Vietnam reported the 1st of global inflation numbers we will see for July, and it was the 1st sequential deceleration since guess when – October 2007. I am looking for CPI and PPI July inflation reports to decelerate, globally.

China traded up +2.6% overnight to 3053 on the Shanghai Index. As I said yesterday, that’s a contrarian macro “Trade” that I think works. Conversely, a country that’s levered to the Euro pinned up at 1.57, and hostage to their own balance sheet malaise like Spain is, should be avoided like the bubonic plague. Spain reported a whopper of an unemployment number this morning at +10.4% year over year, and Spain’s stock market is trading down -1.1% as a result, taking its cumulative losses from October 2007 to -26%.

This bull is a “Trade” that can run for longer than some “wanna be” short sellers can remain solvent. This bull isn’t Spanish. This bull needs to be understood.

*Full Disclosure: I am long FXI.
KM



SKX: Management Needs to be Schooled

This quarter is a great example as to why SKX has been on my ‘avoid like the plague’ list. I’ve been getting a lot of pushback on this one because it looks so dang cheap. But appearances can be deceiving – especially when a 4-year positive fashion cycle and an 8-year ‘easy-money’ supply chain collided to lift margins near peak levels of 8-9%. Now we’re seeing SKX invest in the wrong initiatives at the wrong part of the cycle. People get hung up on the conference call about the impact of American Idol endorsements, and Cali Gear sales (Crocs knock-off). At the same time SKX is pushing hard to grow when the market for its product is changing for the worse and margins are taking a hit. Quite frankly, I could care less about the David Cook endorsement right now. Skechers is trying really hard to grow, and the real question for me is whether it should simply change its colors -- pull back on capex and working capital, boost margins, and flat-line sales. Ordinarily that’s really bad for a small cap growth company’s multiple. But at 6.5x EBITDA, the risk of multiple contraction would be pretty slim. In fact, I’d argue for multiple expansion given the ensuing cash flow stability. Instead, SKX is taking the aggressive path and is trying to grow when it shouldn’t, and is therefore likely to take margins another 3+ points lower over 2 years. That means that the stock looks cheap today at $23.74, and will look expensive in 12 months at $15.

I always pause and consider the contrarian case when I have so many reasons to be negative on a name. But there really were not many positive factors coming from this quarter. Here’s a couple worth pointing out.

1. The quality of earnings was abysmal. Sales +1%, EBIT -8%. The way I am doing the math, FX helped the top line by about 3.8-4% (management danced around the question and did not provide an answer on the call). Assuming a 25% flow-through rate, this helped EPS by about $0.04, pegging real EPS decline of about 15%.

2. While I’m on the topic of International, I still do not understand why this company should grow internationally!! It is a knock off company. Real aspirational brands work overseas. When brands don’t matter, then it’s speed to market, local consumer expertise, and low cost production that does matter. Perhaps with the exception of speed to market, I don’t think that Skechers excels at any of those things. The real challenge is that SKX falls squarely into the bucket of a company that has not managed through an unfavorable FX cycle. I challenge anyone to find me a company in retail that came out of its first negative FX swing with flying colors. I’ll dare not ask the question as to whether this management team is conservatively assuming that Big Ben will play some offense, take rates higher, and get the dollar to reverse course.

3. It’s clear from my sources as well management’s comments that the ‘low profile’ shoes that drove SKX’s business are seeing impact from what I think is a sustainable long-term downtrend (my 6/4 SKX post).

4. Bad debt exposure heading higher. With disproportionate exposure to troubled mid-tier retailers vis/vis its share of the total market, I think that the hits we’re seeing from Goody’s and Shoe Pavilion will only be the beginning. I guess a bigger question is why SKX is increasingly showing up as a large creditor (with Goody’s being the best example). That probably points back to the fashion shift and the need for SKX to find non-traditional channels for its wares.

5. I love watching the progression of how a management handles their respective business in different market environments. SKX is a textbook example of an organization that simply does not learn from its mistakes – specifically as it relates to inventory/margin trade-off. Check out my little Sales/GM/Inventory analysis. The vertical axis measures sales growth less inventory growth (i.e. a higher number is better) and the X axis measures the yy change in Gross Margin. Plotting SKX’s path over 2+ years is simply classic.

The narrative sounds something like this…
a. 1Q06-2Q06: “Business is solid. We’re on trend and margins are up. Life is good. Let’s order more stuff.”
b. 3Q-6-1Q07: Ok margins are still decent, but inventory is building. We’re gonna hang on under the assumption that we can sell this built-up inventory at a respectable margin.”
c. 2Q07: “We were wrong. Inventories are still too high, and now margins are down Ouch!”
d. 3Q07: “Ok, we messed up. Let’s clear the inventory – even if at an undesirable margin.”
e. 4Q07-1Q08: “We’re geniuses. Problem solved, and now we’re back on trend. Let’s up our growth plans again.”
f. 2Q08: “Uh oh. Inventory building and we’re back to where we started.”
A classic example of how not to trade off the income statement and balance sheet in retail -- courtesy of SKX execution. See color above.

Hedgeye Statistics

The total percentage of successful long and short trading signals since the inception of Real-Time Alerts in August of 2008.

  • LONG SIGNALS 80.32%
  • SHORT SIGNALS 78.49%

PFCB – Taking the Right Steps in Today’s Environment

According to NPD data, the supper daypart, which represents 31% of eating out occasions, has declined the most, down 1% in the March-May 2008 time period relative to up 1% for both the morning meal and lunch dayparts. This help explains PFCB’s worse than expected same-store sales results in 2Q as dinner makes up 67% of revenues at the Bistro and 57% of revenues at Pei Wei. During 1Q08, the Bistro experienced positive daypart activity during the week at both dinner and lunch and positive weekend dinner trends. In 2Q08, dinner trends during the week turned negative, leaving dinners during the weekend as the only positive daypart.
  • PFCB’s same-store sales results were also impacted rather severely by the company’s geographic exposure to Arizona, California, Florida and Nevada, which accounted for 84% of the Bistro’s total comparable sales decline, and same-store sales declines in these four states worsened sequentially from 1Q08. Pei Wei experienced considerable weakness in its Phoenix, Las Vegas, Southern California and Dallas markets. These four regions represent 41% of the concept’s comparable units and were down more than 7% in the quarter after being down 6% in 1Q08.
  • Despite weakening top-line results, the company is taking the right steps to manage the parts of the business it can control. Although the company is facing higher commodity costs, management stated that it does not expect to increase prices at either of its concepts over the next 6 to 18 months as the risk to traffic trends and customers’ overall value perception is too great. With traffic down in the 6%-7% range at the Bistro and negative at Pei Wei, I would agree that raising prices in this economic environment would be detrimental to both concepts.
  • Additionally, the company announced that it is significantly slowing its new unit growth in FY09 and plans to open 12-14 Bistros (down from the expected 17 in FY08) and 6-10 Pei Wei restaurants (down from 25 in FY08). I would be happy to see the company stop its expansion of the Pei Wei concept all together until it can generate the necessary returns, but cutting the concept’s FY09 growth by more than 60% is a step in the right direction and management is focused on improving Pei Wei margins by 200-250 bps off of 2007 levels. I was surprised and encouraged to hear management say (in response to a question) that they are currently evaluating the existing Pei Wei locations and would consider closing some locations if they determine any sites don’t have the potential to get where they want them to get. Management was clear in saying, however, that no such units have been identified as of yet. As a result of this slowed FY09 development, capital expenditures are expected to come down in FY08 (now expecting to spend $80-$90 million versus prior guidance of $105 to $115 million), which will generate increased free cash flow in the current year. This capital spending number will come down even further in FY09.
  • As it relates to things management can control, the 70 bp YOY decline in labor expenses at the Bistro is somewhat concerning as such declines in labor expense can be a red flag for a company trying to protect margins at the expense of the customer experience. Management attributed the year-over-year decline to improved efficiency and scheduling in the back of the house and said that the magnitude of the decline is not necessarily sustainable, which is encouraging.

US Financials (XLF): Down Today, In An Up Tape

I talked about being net long for the market “Trade” this morning, but also said don’t chase Luskin and Gartman into the bear trap called Financials. The XLF closed down -0.13% today, and is starting to look as tired as Dick Fuld must be of trying to define what a “Level 3 Asset” is.

Provided that the XLF doesn’t close higher than 23.78, the negative “Trend” in this sector will remain firmly entrenched. The US Financial Industry needs a full makeover, not a 5 day rally. Sell high, Cover Low.
KM
(chart courtesy of stockcharts.com)

Hershey (HSY): Giving The Shorts Something to Think About...

This stock's sentiment reminds me of that which used to be Budweiser's (BUD). One day, someone with Euros changed that negativity, and you know where BUD is now. I know, I know - but The Hershey Trust "will never bend". Some hedge funds have fun IM’ing one another with their narrative fallacies.

HSY reported a better than bad quarter today, and closed up +5.4% on solid volume. Short interest is vibrant at 11% of the float. If you're short it, and you think you have a unique thesis, you don't anymore (or a catalyst, for that matter).

If the stock can hold today's gains, you can buy it using a $36.17 stop loss. You'll get paid a 3.2% dividend to wait this turnaround out in the meantime.

See Howard Penney's notes for more.
KM
(chart courtesy of StockCharts.com)

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