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Confidence and Cowardice

"Whether you think you can or think you can't - you are right. "

-Henry Ford


Like all mornings, today we are waking up to many more global macro risks than what's happening in Greek bonds or how much snow some people have in their Connecticut driveway. While many of us can be distracted by our own personal issues, it's important to remember that global markets wait for no one.


I am certainly not suggesting that European sovereign debt issues don't matter any more. We have been calling out the percolating risks in Greek and Spanish credit default swaps for 3 months. These risks are no longer new. They are simply becoming understood. This is progress.


Each day we are tasked with re-rating global macro risk. Since these risks are constantly being re-priced on a marked-to-market basis, we let real-time prices rule over our emotions. I can't imagine being called a PIG (Portugal, Italy, Greece) by the US media every day enthuses Europeans. Nor does China laughing at our Treasury Secretary make Americans smile. The art of risk management is just checking all our emotional baggage at the door.


From a real-time risk manager's perspective, this morning I see the following three topics as most influential on markets:


1. Chinese Economic Data

2. US Monetary Policy

3. Sovereign Debt


I'm not going to draw a box around my head and think inside of it, so I won't consider these risk factors with any particular weight of importance. Rather, like any good student of complexity theory, I'll consider them in the aggregate. What deep simplicity can I deduce from the most recent data points on my macro screens?


1. Chinese Economic Data


The data reported overnight had a little bit of something for everyone. The Chinese stock market closed flat on the session (down -8.9% YTD) reflecting how mixed the economic data flushed out. On one hand, Chinese loan growth for January was a moonshot to the upside (1.39 Trillion Yuan - thats a lot of Yuans!). On the other hand, money supply growth (M2) dropped again, sequentially, by -170 basis points (month-over-month) to +26% year-over-year. It's important to remember that money supply growth in China peaked in November of 2009 at +29.7% y/y. Since we called for this easy money chart to rollover at the begining of 2010, I'll call this inline with what we were expecting.


On the inflation front, China had higher than expected PPI (producer prices) and lower than expected CPI (consumer prices). Again, a little something for everyone, but the media seems to be more focussed on the CPI report so let's grind through that. Consumer prices in China have been moving up into the right for the last 6 months and slowed, sequentially, this month to +1.5% y/y inflation versus last month's cycle-high of +1.9% y/y. On the margin, this is less hawkish, sequentially. On an absolute basis, it still means the Chinese will to continue to tighten.


2. US Monetary Policy


Expectations for interest rate policy in America becoming Japanese (a perpetual return on the citizenry's savings accounts of zero) took a shot in the arm yesterday with Ben Bernanke changing his rhetoric on rates. I understand what a lot of perpetually dovish market pundits are going to say about this - these people are proactively predictable. The reality is that changes on the margin are what matter most in navigating global macro risk - and Bernanke made a significant change yesterday.


He Who Thought He Saw Depression is obviously seeing the economic data for what it is at this point. The US is running +5.7% GDP growth, +2.7% CPI inflation, +4.4% PPI inflation, and the unemployment rate is rolling over. So, He Who May Now See The Light (still Bernanke here), signalled to the market yesterday that the US will be raising the Discount Rate "before long."


The Discount Rate is not the Fed Funds rate. We get that - and so do the bankers who have been chowing down on the Piggy Banker Spread (the bankers get to borrow at the discount rate - you don't). As a reminder, the Discount Rate was cut to zero (ok, maybe not 0.00%, but 0.50%) in December of 2008 because Bernanke was forecasting the potential of the next Great Depression, no growth, and no inflation. Obviously the man works for the government rather than an asset manager because his economic forecasts are routinely wrong. So here we are now with the data rolling in, forcing him to be rhetorically "data dependent."


3. Sovereign Debt


Expectations here are what they are - climbing the wall of worry. The worst thing about the manic media's analysis of it all is the paralysis of their scope. Sovereign Debt is a global macro risk that is going to be here for the next decade, not the next New York minute. This is the long term TAIL risk that Global Politicization has given birth to. Piling debt upon debt upon debt is reactive policy that political cowards continue to disguise as short term confidence.


Altogether, Confidence and Cowardice is what all 3 of these factors sum to. That's the deep simplicity of living in today's globally interconnected and, sadly, politicized marketplace. The Chinese politicians are confident, tightening at their own pace, on their own terms. The American and European politicians are being cowards, tip toeing around raising interest rates because they are scared of their stock market going down.


Who has the Confidence to sell on up days? Who has the Cowardice to live in political fear of the down days? Who have we become when we have become so confident that cowards can never fail?


My immediate term suppport and resistance lines for the SP500 are now 1045 and 1076, respectively.


Best of luck out there today,






XLK – SPDR Technology — We bought back Tech after a healthy 2-day pullback on 1/7/10.


UUP – PowerShares US Dollar Index Fund — We bought the USD Fund on 1/4/10 as an explicit way to represent our Q1 2010 Macro Theme that we have labeled Buck Breakout (we were bearish on the USD in ’09).


EWG - iShares Germany — We added to our position in Germany on 2/4/10 on the bullish intermediate term TREND thesis Matt Hedrick maintains on Germany. We are short Russia and, from a European exposure perspective, like being long the lower beta DAX against the higher beta RTSI as well.  

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 mispriced and that TIPS are a efficient way to own yield on an inflation protected basis.



CAF – Morgan Stanley ChinaThe Chinese Ox Remains In A Box. We shorted CAF on 2/10/10 ahead of another inflationary report that registered China’s CPI at +1.5% in January Y/Y, and PPI at +4.3% Y/Y.


RSX – Market Vectors Russia We shorted Russia on 2/9/10 and maintain our intermediate term TREND bearish view on the price of oil.


XLP – SPDR Consumer Staples The Consumer Staples sector finally broke both our TRADE and TREND lines on 2/8/10. Given how many investors own these stocks because it was a "way to play the weak US Dollar" last year, we have ourselves another way to profit from a Buck Breakout with this short position.


EWW – iShares Mexico Mexico short is a solid compliment to our concerns about sovereign debt risks and our bearish intermediate term view on oil.


EWJ – iShares Japan We re-shorted Japan on 2/2/10 after the Nikkei’s up move of +1.6%. Japan's sovereign debt problems make Greece's look benign.


IEF – iShares 7-10 Year Treasury One of our Macro Themes for Q1 of 2010 is "Rate Run-up". Our bearish view on US Treasuries is implied.

R3: WMT: The Rut of Consistency


February 11, 2010


In the near-term there is little to suggest that Wal-Mart shares are anything more than still stuck in a narrow range.  Even with what appears to be a flurry of recent organizational and strategic changes, the company’s performance remains relegated to a simple two factor equation- traffic and pricing.





After another year of lackluster share price performance, it seems that the Street is looking for reasons to own Wal-Mart in 2010.  The shares have been subject to two upgrades in the past two weeks, so there is sure to be something going on here, right?  Well, on the surface it looks like there’s been more activity at the largest company on earth in the new year than we’ve seen in a while.  Let’s take a look at some of the company’s recent announcements:


  • Formation of a global sourcing initiative with Li & Fung. The arrangement begins with $2 billion worth of goods, which is not much at all considering WMT is on pace to deliver north of $405 billion in revenues this past year.  The larger initiative also calls for an increase in focus on direct imports and global sourcing.  Haven’t we heard about this at almost every analyst day over the  past five years?
  • Sam’s Club store closings (10 stores, 1,500 employees), outsourcing of demonstration employees (10,000), and the elimination of new business representatives at the clubs.  Hmm, another pseudo-restructuring at Sam’s Club.  But will this finally be the move that closes the productivity gap with Costco? Not a chance.
  • New operations structure for Wal-Mart U.S which consolidates Real Estate, Operations, and Logistics under one leadership team to foster more value for customers, growth for associates, and returns for shareholders.  We’re missing how this one will actually work.  The memo on this topic was the longest, but also the lightest on real details.
  • Realignment of merchandising categories. Alignment of Store Planning with Customer Experience Teams.  This makes the most sense, but after the Store of the Community was unveiled we thought the marriage of what the customers want and what Wal-Mart sells were already one in the same.  Looks like there will always be work to be done here.
  • Integration of Puerto Rican operations into Wal-Mart and Sam’s Club U.S.  Definitely a cost savings measure but it probably is a rounding error given the law of large numbers here.


So what do all these moves, changes, and dense employee memos really mean?  They need to do something (anything?) given that U.S same-store sales have been negative for what is likely to be 3 quarters in a row and EBIT margins have been in an extremely narrow range of 40 bps over the past 6 years.  Stability is what makes this a staple in the truest sense, but it certainly doesn’t make for an exciting investment opportunity, LONG or SHORT.  Yes, earnings have been growing over the same time frame, but at a decreasing rate for each subsequent year.  Wal-Mart’s historical stock performance coincides with its financial results.  The share price performance over following durations is: YTD -0.22%  , 1YR +11.76% , 5YR -0.24%, and 10YR -5.29%.  So in other words, an investment in Wal-Mart has basically been like holding cash.  


After some digging into the model, it’s seems clear that even with all these organizational and strategic maneuvers, Wal-Mart is still relegated to a simple two-factor equation.  Traffic and pricing.  Both are fairly easy to decipher in the near term.  With the economy in its current state, there is no question that Wal-Mart has benefitted from a traffic boost.  But in the absence of a measurable change in the economic backdrop to the downside, the traffic outlook looks status quo at best.  We have simply passed the peak, based on what we know today, in the year over year growth in consumers trading down to deeper discount retailing.  There is no question that the payroll cycle is still as pronounced as ever, but with unemployment no longer getting worse and even food stamp usage growing at a lesser rate (see yesterday’s post “SNAP Participation Growth Slowing” for more detail), Wal-Mart’s incremental traffic opportunities appear harder to come by. 


That brings us to pricing.  The Holy Grail that investors keep pointing to is inflation.  Yes, we are seeing signs of inflation in food and consumables.  Costco confirmed this on their recent sales call, but simple math also suggests that 2010 will be inflationary for consumables.  After all, we are coming off of the most deflationary period in food and consumables in modern history.  With that said, what is Wal-Mart going to do with an inflationary trend?  If we read the tea leaves and look at the subtleties of the company’s recent memos, “lower prices” remain the cornerstone of Wal-Mart’s efforts. 


While bullish investors may be putting on long trades in Safeway and Kroger because of the mighty inflation, Wal-Mart is probably going to spoil the party.  Roll-backs will continue, forever.  All of the efforts to lower cost of goods are not solely aimed at boosting the gross margin line.  Yes, there may eventually be some benefits to consolidating SKU’s and finally building a global sourcing organization, but reinvestment in price to drive market share still appears to be a top priority.  It’s embedded in the culture and this is one thing that is highly, highly unlikely to change.


As a result, in the near-term there is little to suggest that the company’s fundamentals and share price are anything more than still stuck in a narrow range.  To meaningfully break this cycle of monotony, we would have to see a few key things: 1) merchandising efforts actually work and drive a mix shift back towards discretionary goods, which in turn drives average ticket and margins higher, 2) a meaningful pick up in contribution from international at higher EBIT margins (unlikely as the non-U.S units collectively remain in growth mode) and 3) an acceleration in traffic (share) growth as a result of all of the above-mentioned efforts combined.  In theory, achieving this short list is what management needs to do to get out of the rut of consistency.  In reality, the hope of inflation as a savior and reliance on merchandising changes to drive margins higher are likely to be disappointing to those looking at 2010 as a breakout year for the largest company on the planet.


R3: WMT: The Rut of Consistency - 1




  • After a very strong boot season, JNY management indicated that they expect the category to remain strong throughout the Spring/Summer and into Fall 2010. As a reminder, history suggests that it’s very unlikely to see two “very strong” boot seasons in a row, especially since cold weather typically acts as a boost to the upside for boots. However, it is notable that Nine West has returned to Nordstrom in all doors- clearly a vote of confidence from the most important footwear retailer in the U.S.
  • What do you get when you cross Crocs with Converse Chuck Taylor All-Stars or Clark’s Wallabees? Native Shoes. Check them out here: http://nativeshoes.com/. Clearly there is still a chance to actually make injected-molded footwear look cool…
  • Despite the growth in the use of email as a marketing tool, especially by retailers, a new study by Return Path suggests not all emails are reaching recipients. The new study shows that 20% of email in the U.S and Canada is not making it into the inbox. Approximately 3% is going to straight into a “junk” folder, while the remainder is “going missing”.




Gap Inc. Shuffles Leadership - Gap Inc. is resetting its top ranks in an effort to correct prolonged product issues at the Gap division, sustain momentum at Old Navy and possibly bring the chain overseas, WWD has learned. The moves also identify Gap’s future leaders. In the biggest change, Pam Wallack will become president of Gap adult and body, filling a slot vacant for 18 months since the departure of Gary Muto, who is president of Loft. Those duties were being handled by Marka Hansen, president of Gap North America, and other executives. Wallack, who was running Gap kids and baby businesses for the past five years, will report to Hansen.  Succeeding Wallack as head of Gap kids and baby businesses is Mark Breitbard, who since last year has been Old Navy’s chief merchandising and creative officer. Previously, he was president of Levi Strauss & Co.’s retail division and senior vice president and general manager at Abercrombie & Fitch Co., but he held merchandising jobs at Gap, Old Navy and Banana Republic from 1997 to 2005. <wwd.com>


Steven Madden Buys Big Buddha Handbags - Steven Madden Inc. has acquired Big Buddha Inc., the better-priced accessories line founded by Jeremy Bassan. Madden purchased the firm for $11 million in cash plus certain earn-out provisions that are based on financial performance through 2013. Bassan said he will stay on to oversee the line, which will move from its Santa Cruz, Calif., headquarters to Madden’s facility in Long Island City, N.Y. “We’ve bought the bags for our stores in the past and they’ve been fantastic, and we love that it’s a young company with tremendous value,” founder Steve Madden said. “We want to help with their distribution both domestically and internationally, and the bags really fit in with what we’re doing.” Since its 2003 inception, Big Buddha has produced better-priced accessories for department stores and online retailers, such as Dillard’s and Piperlime.com. In 2009, Big Buddha had net sales of $13 million.  <wwd.com>


Gildan Activewear to Open Distribution Center in South Carolina - Gildan Activewear will locate a new distribution center on Clements Ferry Road in Charlston, SC, with operations expected to begin in the next few weeks. Gildan expects to hire about 250 people this year for the new facility. Gildan has purchased the former Mikasa building, which is located in the city of Charleston and in Berkeley County. "This state-of-the-art facility will be utilized to support the company's strategic initiative to become a major full-line supplier of basic family apparel for national mass-market retailers," Glenn Chamandy, Gildan president and CEO, said in a statement that the S.C. Department of Commerce released today. <sportsonesource.com>


LaCrosse Footwear Plans New Danner Factory - LaCrosse Footwear, Inc.  plans to move into a new Danner factory in Portland, Oregon. The new Danner facility will be located in an industrial building approximately one mile from the company's corporate headquarters. The new factory will be approximately 59,000 square feet, representing twice the square footage of the company's existing Portland-based factory which is being replaced. The new facility's lease is scheduled to begin during the second quarter of 2010 for a term of approximately five years, with options to extend the lease for up to 15 more years. DP Partners is serving as the developer for the project. LaCrosse expects to begin production in the new facility in the third quarter of 2010. During 2010, the company expects total capital expenditures to be approximately $8 to $9 million, which includes leasehold improvements and machinery for the new factory facility. During the transition period from the current factory to the new facility, the company plans for certain one-time costs of approximately $0.5 million, which are expected to be included in its operating expenses in the second and third quarters of 2010.  <sportsonesource.com>


Harry and David shakes up the CEO suite and brings in an outsider - Harry and David has named Steven J. Heyer as its next chairman and CEO to replace president and CEO Bill Williams who has left the company. Heyer joins Harry and David, which owns and operates HarryandDavid.com, Wolfermans.com and HoneyBell.com, from Avra Kehdabra Animation LLC, a computer animation studio. Prior to co-founding Avra Kehdabra, Heyer also served as chief executive officer of Starwood Hotels & Resorts Worldwide Inc. and as president and chief operating officer of Turner Broadcasting System Inc.  <internetretailer.com>


C.P. Company Sold To FGF Industry SpA - The owners of Sportswear Company SpA have sold their C.P. Company division to FGF Industry SpA, the company owned by designer-entrepreneur Enzo Fusco, who produces and distributes Blauer USA, BPD, Design by Enzo Fusco and Sweet Years. Sportswear Company, owned by siblings Carlo and Cristina Rivetti, retains ownership of its Stone Island brand. The operational handover will take effect with the spring 2011 collection. WWD first reported that C.P. Company was on the block last month. Founded in 1975 by Italian designer Massimo Osti, C.P. Company built a cult following with its military-inspired silhouettes and customized textile treatments. Last spring, Rivetti appointed Wallace Faulds, a deputy of John Galliano, as its designer. The brand shows in Milan. <wwd.com>


Sports apparel and home improvement brands climb the buzz charts - Amazon.com Inc. continues its run as the most talked-about retailer on the social web for the fifth consecutive month, according to the monthly Zeta Buzz Top 25 Retail Standings Index, a measurement of online retail chatter conducted by digital marketing firm and social media monitoring service provider Zeta Interactive exclusively for Internet Retailer. The brands showing the most positive movement in the rankings since last month were the Home Depot (+9), Lowe’s (+7) and Nike (+6). The brands with the most negative movement were Barnes & Noble (-11), GameStop (-7) and Old Navy (-6). There were five retail brands new to the Top 25 list this month: Costco, Walgreens, Staples, Dick’s Sporting Goods and Adidas. Five retailers dropped out of the Top 25 rankings this month: H&M, Aeropostale, J.C. Penney, Radio Shack and Toys ‘R’ Us. “Retailers in the sports apparel and home improvement industries experienced the biggest buzz increases—a sign that post-holiday fitness resolutions and improvements around the house are top of mind for consumers,” says Zeta Interactive CEO Al DiGuido. <internetretailer.com>

The M3: Resorts World Opening Sunday, Nagacorp Targets Chinese Gamblers, Macau-Tokyo Air Agreement



The Resorts World casino-resort is set to open on Chinese New Year, Feb 14 at an auspicious time of 12:18pm. Genting also plans to open its Universal Studios theme park by early March. Feb. 14, 15, and 16 are national holidays in Singapore for Chinese New Year.



China Morning Post, The Standard


President Chen Lipkeong would like to form a JV with at least two Macau casino operators. He believes Cambodia's attractive effective tax rate (2% vs 14% in Macau) would promote interest in a partnership. Nagacorp plans to expand the number of gaming machines at its NagaWorld casino resort in Phnom Penh to 1000 from 738 this year. 




Macau and Japan have signed a new air agreement that allows designated airlines to make regular flights to all destinations in Japan, including Tokyo, beginning this coming March.  

Daily Trading Ranges

20 Proprietary Risk Ranges

Daily Trading Ranges is designed to help you understand where you’re buying and selling within the risk range and help you make better sales at the top end of the range and purchases at the low end.


"Hope is not the conviction that something will turn out well but the certainty that something makes sense, regardless of how it turns out”

-Vaclav Havel


HOPE is not an investment process, but I HOPE the EU and Ben Bernanke get it right.  As Keith McCullough posted yesterday he thought the prepared statement was “refreshingly objective” in saying the Federal Reserve will raise the discount rate “before long.”  This is an explicit change in the Fed’s language; a change we thought should have come in January. 


The two dominant MACRO factors at work yesterday were the fiscal challenges in Europe and Ben Bernanke testimony that wasn’t.  On the lack of conviction on how this is going to end, the S&P 500 finished lower by 0.22% on very light volume.   Although, the light volume is likely more a function of the East Coast snowstorm.


In our multi-factor model, the VIX was the only factor that suggested a continued benefit from the RISK AVERSION trade.  The VIX closed down 2.3% to 25.40, but is still bullish on TRADE and TREND. The Hedgeye Risk Management models have the following levels for VIX – buy Trade (22.40) and Sell Trade (28.34). 


The favorable risk implications are emanating from increased expectations for some kind of Euro/German rescue package for Greece and other troubled European nations.  Greek Prime Minister George Papandreou is on the tape saying he does not need help, but has apparently hammered out an aid package.  The Dollar index (DXY) gained some strength yesterday finishing up 0.21%.    The Hedgeye Risk Management models have levels for DXY at – buy Trade (79.69) and sell Trade (80.67). 


Yesterday, the Consumer Discretionary (XLY) underperformed the S&P 500 and broke TREND, leaving Healthcare as the only sector positive on TREND.  Although it should be noted that the XLV was the second worst performing sector yesterday, declining 0.6% 


The only sector up on the day was Financials (XLF).  The money center banks bounced yesterday from the benefited of the RISK AVERSION trade; the two standouts were BAC and JPM.  Outside of the banks, the asset managers outperformed too.


The strength in the DXY and earnings miss put pressure on the Materials (XLB), the worst performing sector yesterday.  The XLB declined 0.7% yesterday, with the weakness focused on the steel sector. ArcelorMittal announced below consensus Q1 EBITDA guidance, as higher shipments will be offset by lower ASPs and increased costs.  Ah yes inflation!


As we look at today’s set up, the range for the S&P 500 is 31 points or 2.1% (1,045) downside and 0.74% (1,076) upside.  Equity futures are currently trading above fair value in a follow through to yesterday's late day bounce and the EU support of Greece. 


Copper climbed the most in almost three months in London as lending increased in China and employers added jobs in Australia, improving the demand outlook.  The Hedgeye Risk Management Quant models have the following levels for COPPER – Buy Trade (2.82) and Sell Trade (3.14).


The correlation for gold continues - gold is trading lower on the back of a stronger dollar.  The Hedgeye Risk Management models have the following levels for GOLD – Buy Trade (1,044) and Sell Trade (1,111).


The International Energy Agency raised its forecast for global oil demand this year as developing countries need more crude to fuel their economies.  Oil has traded higher for the last three day and looks to be up again today.  The Hedgeye Risk Management models have the following levels for OIL – Buy Trade (70.11) and Sell Trade (77.26).


Howard Penney

Managing Director














Li Ning: Lighting a Match in a Dry Forest

When we hosted our call in early January discussing our Top 10 ‘Predictable Unpredictables’ (events that we assign a better than 60% chance of happening, but the consensus is not focused on) for the global softlines supply chain for 2010, we discussed the Chinese Import factor.  We’re not even through February and we’re already getting confirmation.


What kind of risk? (for those of you that did not participate in our call).  No, it’s not COGS. The consensus finally caught up to that one. Yes, we did discuss changes in the free trade environment in Asia, and the dollar falling out of favor with Asian factories. That’s definitely a concern. But the risk I’m referring to here is Chinese content/brands transplanting themselves onto US soil. Yes, Reebok has all but gone away, and Adidas is weakening. But a brand like Li Ning or Anta could come along and gain a couple of points of share of the $20bn athletic footwear market at the drop of a hat.


Well folks, Li Ning has just opened its first US showroom in Sneaker Valley – otherwise known as Portland, OR – where just about every viable player in the US athletic market has established a presence to attempt to raid Nike’s talent.


Li Ning is launching a press event on Monday focused around the launch of the ‘BD Doom’ game shoe, which is designed for LA Clippers’ star Baron Davis.  As a point of reference, other Li Ning NBA athletes include Shaq, Jose Calderon (Raptors) and Hasheem Thabeet (Grizzlies).


As a sidenote, this is either really good timing, or really bad timing for Li Ning. Nike is going on offense again, and the BD launch surrounds an athlete who is at a critical and questionable tipping point.


No one would accuse Davis of being in good form these days. And with Mike Dunleavy stepping down as the Clippers’ coach last week, Davis lost his last ‘loser’ excuse on a coach who is a control freak.


In his own words “I got to go out and get back to being my old self now. [Interim] Coach Kim is going to allow me to be a little bit freer and play off instincts. So, I just got to get back to that mentality. From there, I think everything else will take care of itself.”


You better, BD. Li Ning is betting on you.


Regardless of Davis fate, this move by Li Ning won’t be the last. I actually think that this is very good for the industry. The ONLY time the US athletic footwear industry could be accused of being healthy is when there was someone stepping up to challenge Nike. Under Armour will do so in 2010, and some foreign content will keep Nike on edge. That’s when it performs the best. All these things add up to better product, and better comps for retail. It turns out to be less about market share and more about growing the market. As I’ve been saying, I have a high degree of confidence that we’ll finally return to growth in the footwear market in 2010.


Li Ning: Lighting a Match in a Dry Forest - shoe


Li Ning: Lighting a Match in a Dry Forest - shoe2


Chipotle is scheduled to report 4Q09 earnings after the close tomorrow, and based on the company’s recent track record (as shown in the chart below), it will likely beat street estimates.  I am modeling EPS of $0.84 versus the street at $0.81.  If my number is right, this outperformance would not come even close to the 26% earnings upside in 3Q09, but as the chart below also shows, this earnings beat was still not enough to get investors excited as the stock traded down 8% the following day.


CMG – WHERE TO FROM HERE? - CMG eps vs estimates


Investors have become accustomed to better-than-expected earnings, so what has mattered more is the trend in top-line numbers.  In 3Q09, the 150 bp sequential slowdown in 2-year average trends helps to explain why the stock performed so poorly.  To that end, we could see the stock trade higher on Friday as my estimates assume +2.3% same-store sales growth, better than the street’s +1.4% estimate.  Going forward, however, I would expect comparable store sales trends to get worse as we move through 2010, even if traffic trends on a 2-year average basis get less bad, which should influence CMG’s stock performance.


Throughout the third quarter, CMG’s EBIT margins have improved on a YOY basis in 2009, with the company operating at peak margins during 2Q09 and 3Q09 of 15.1% and 14.5%, respectively.  The company’s return on incremental invested capital has also moved higher in 2009.  These peak margins and returns are also reflected in CMG’s peak multiple.  The company is currently trading at nearly 11x on a NTM EV/EBITDA basis relative to the QSR average of 8x.


I have previously said that a restaurant company’s stock price performance is often highly correlated to the direction of returns and as the second chart below shows, this has been true for CMG.  The current direction of returns often impacts if a stock will move higher or lower and CMG’s trajectory of returns as of 3Q09 puts CMG in a seemingly favorable position.  So the most important question is whether the next leg is up or down and as I see it, CMG’s peak margins and returns are likely to roll over. 


CMG – WHERE TO FROM HERE? - CMG ebit margin 3Q09




In 4Q08, CMG rolled out a 6% incremental price increase, which helped to leverage the company’s P&L at a time when traffic was negative and deteriorating further on a 2-year average basis.  The 6% pricing impact from 3Q09 will come down in 4Q09 to +2.5% as we lap the 4Q08 price increase.  The company will have flat pricing as of January 1 and as of the last earnings call, did not expect to take any pricing in 2010 until management saw an uptick in consumer spending. 


My +2.3% same-store sales estimate for 4Q09 assumes some improvement in traffic trends on a 2-year basis (most likely the primary difference between my higher same-store sales estimate and that of the street’s) as we have seen sequentially better numbers in the fourth quarter from those restaurant concepts that attract higher income consumers.  Even so, EBIT margins should begin to roll over in 4Q09 from the peak levels earlier in the year.  I am expecting continued YOY margin growth but of a lesser magnitude than in the prior three quarters.  Some of this sequential decline in margins is explained by the fact that the fourth quarter typically results in lower margin and also the company is opening considerably more restaurants during the quarter, which implies higher preopening expenses and increased inefficiencies on the labor line.  The roll off in pricing also removes some of the leverage in the model and will have a bigger impact in 1Q10 when I would expect margins to begin to decline on a YOY basis.


Also impacting margins in 2010 is the fact that the company is forecasting low single digit food and labor cost inflation after getting significant leverage on both these expense lines in 2009.  In describing the gives and takes in its operating model, management stated on its last earnings call, “The way to think about it is in a perfect world if there was zero inflation and you had zero comps, our margins would hold up exactly as they are today. If you have a little bit of inflation - let's say it's 1% inflation across the board, across labor, across food, across everything - that would hit your margin for about 70 basis points; 2% inflation across everything would hit you for about 140 basis points.”  As I just said, management is not expecting zero inflation, but is expecting flat comps and the resulting impact on margins is obvious.  To be fair, management’s comp guidance assumes no improvement in consumer spending, so it might be somewhat conservative, and a lot will depend on whether management changes its stance on pricing in 2010. But, as I see it, operating margins are coming down in 2010.


Declining margins never bode well for returns and in my opinion, nor will the company’s new real estate strategy.  In 2010, CMG currently plans to open 120-130 new restaurants, even with the expected level of openings in 2009.  However, due to the “recent pressure on developers and the corresponding reduction in number of new developments currently available for [CMG] to buy or lease” (as cited by the company), CMG is now pursuing a new real estate strategy.  In the past, the company only opened restaurants in what it deemed “tier 1” trade areas.  Going forward, management plans to still open about two-thirds of its new units in these “tier 1” areas, but due to the limited number of opportunities, it will also pursue what it is calling “A model sites,” which it says are “tier two trade areas which still have attractive demographics typically characterized by lower occupancy costs and develop for a substantially lower investment cost.”


This new strategy will put pressure on new unit AUVs as the A model sites are expected to generate about $1.1 million in sales volumes, which is below the company’s average opening range of $1.350 million to $1.4 million.  In the past, CMG has built two-thirds of its new sites in proven markets, which yields opening volumes above its average new unit volumes and one-third in new and developing markets, which come in below average at $1.1M.


For 2010, CMG is planning to build 25% of its new openings as A model locations.  Initially, CMG said it will build these A models in proven markets, which means these relatively lower AUV new builds will take away from the higher volumes typically generated in proven markets.


Tier 2 sites are still expected to achieve cash on cash returns in the mid 30% range because the lower development, occupancy and operating costs will offset the lower expected sales volumes.  These new “A model sites” will not pose a problem should they generate the expected returns, but it always concerns me when a restaurant operator appears to be compromising its real estate decisions in order to maintain growth.  The fact that the company said it will pursue as many tier 1 locations as it can implies that they are still the preferred sites.  To that end, the tier 2 locations signal less discipline on the part of the company for the sake of maintaining growth.  These types of compromised real estate decisions often lead to declining returns.  And, increasing penetration of proven markets could put the company at risk of cannibalizing sales going forward.  That would not be a new story for a restaurant company.


Howard Penney

Managing Director

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

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