R3: Cotton’s Ugly Head


March 10, 2010


In 2H US retail needs to bank on a stronger consumer – we all know that. But now the ‘Cotton Factor’ is rearing its ugly head. Prices over $0.80/lb today impact margins 9+ months out. Mind your modeling assumptions. Not all companies are created equal.





2H US retail needs to bank on a stronger consumer – we all know that. But now the ‘Cotton Factor’ is rearing its ugly head. Prices over $0.80/lb today impact margins 9+ months out. Mind your modeling assumptions. Not all companies are created equal. 


Many retailers and manufacturers are expecting sourcing costs to rise over the second half of the year due to a confluence of factors.  While tougher comparisons against last year’s substantial cost declines is one reason, below the surface there are additional factors looming.  On the obvious side of things, fuel and subsequent freight costs are up.  On the less obvious side of things are material cost inflation.  Take a look at the recent spike in cotton since the new year:


Global production remains stressed and at historically low levels with the U.S. cotton crop estimated at 12.0mm bales (3% below 2008 levels) and India’s output under pressure because of drought conditions.  Furthermore, the big move last week came after China stated its 2009 crop fell by 14.6% last year. With U.S. stockpiles low and China (world’s largest consumer) continuing to run a substantial deficit, prices continue to head higher as exports increase.  A recent statement from India’s textile ministry highlighted that exporters have sought permits to ship 3x more cotton in February compared to the same time last year.  Additionally, concerns over supply shortages beyond April are also contributing to further tightening in the global market.


As cotton prices test the prior highs of early 2008, current factors suggest that we are likely to see demand continue to outstrip supply in the near-term and prices may still be moving higher from here.


This is when you need to give credit to those companies that have defendable positioning in the supply chain (NKE, RL, UA, WMT, etc…), and questioning 9-12 month modeling assumptions for those who lack any semblance of pricing power (JNY, GIL, HBI, VFC, GIII, etc…).


R3: Cotton’s Ugly Head - Cotton Futures Chart




  • Dick’s Sporting Goods management noted that it expects to see product costs increase over the second half of 2010, but that it hasn’t been able to fully quantify the impact at this point. On its private label and direct sourced product, management expects to pass on higher costs leaving gross margins unaffected. 
  • Kroger management believes the promotional environment remains very aggressive, but it is no longer getting more aggressive. As a result, management believes the environment is now a little more predictable. 
  • Despite a recent pick up in same store sales at Neiman Marcus, management is not planning any meaningful store growth in the near to intermediate term. With the exception of one new store opening in Spring 2012, the pipeline is essentially empty at this time. 
  • Collective Brands management noted that the J. Crew/Sperry relationship has been a win-win for both parties. As a result, management believes the opportunity for its Keds/Gap partnership this Spring and Summer is also promising. If successful, this could be the beginning of a long awaited turnaround for the Keds brand. 
  • American Eagle is clearly bullish on denim. Management attributes the 8% increase in inventory at cost per foot to the increased penetration of denim in its product mix. It is also noted the “strong demand” for AE denim is the main reason for the inventory investment. This represents one of the more noticeable inventory investments across the specialty landscape. 




Foot Locker to Increase Apparel Emphasis, Expand Globally - Apparel — both private label and branded — will be a primary focus for Foot Locker Inc. over the next five years as it strives to significantly increase sales and profitability. Calling it his “coming-out party,” chief executive officer Ken Hicks, who joined the company from J.C. Penney Co. Inc. in August, laid out Foot Locker’s plan to become “the leading global retailer of athletically inspired shoes and apparel” at an analysts’ meeting at the firm’s headquarters on 34th Street in New York on Tuesday morning. The goal, executives said, is to increase sales to $6 billion from $4.9 billion in 2009; raise sales per square foot on average to $400 from $333; increase the earnings before interest and taxes profit rate to 8 percent of sales from 2.6 percent; elevate the net income margin to 5 percent of sales from 1.8 percent, and boost inventory turnover to 3 times from 2.2 times last year. Gross margins are projected to increase to between 30 percent and 31 percent of sales from 27.7 percent, while sales, general and administrative expenses are expected to fall to 20 percent to 21 percent of sales from 22.6 percent. The main drivers of these improvements are creating differentiation among the company’s divisions, which include 3,500 stores under the Foot Locker, Lady Foot Locker, Kids Foot Locker, Footaction, Champs Sports and Eastbay names; enhancing the apparel and footwear assortments, and aggressively pursuing growth opportunities both domestically and overseas.  <>


Madonna, Iconix Form Fashion Joint Venture MG Icon LLC - Madonna and Iconix Brand Group Inc. are ready to cause a commotion and dress you up at retail. The pop icon and the brand management firm will today reveal the formation of a joint venture called MG Icon LLC, which will bring multiple fashion-related projects to retail racks across America and around the world. The first initiatives under the agreement are a juniors’ line called Material Girl, which will launch exclusively at Macy’s in August. MG Icon is also close to announcing a collaboration with a designer label for a co-branded eyewear collection. “Joining forces with Iconix to bring my fashion ideas to consumers is very exciting for me,” said Madonna. WWD first reported on Feb. 16 that Madonna was in talks to launch the Material Girl collection with Iconix and Macy’s. MG Icon will be 50 percent owned by Iconix and 50 percent by Madonna and Guy Oseary, her longtime manager and the “G” in the joint venture’s name. MG Icon will develop a range of fashion-related business projects, including the creation of new brands, the acquisition of existing labels and the exploration of opportunities within the portfolio of 21 brands that Iconix and its other joint ventures already own, said Neil Cole, chairman and chief executive officer of Iconix. <>


Target Gets Set for Liberty - The Target + Liberty of London collection will be in full bloom Sunday in most Target stores. But first, the 300-item line with Liberty’s microflorals and explosive blossom prints splashed over apparel for women, men, girls and infants, as well as home products, bedding, garden tools, stationery, candles and bicycles, will be unveiled at a 5,285-square-foot pop-up shop here. The Target + Liberty of London Experience at 1095 Sixth Avenue near Bryant Park, features an indoor garden with 12,500 live flowers, green foliage covering the cash wrap and digital projections of 12 Liberty prints onto larger than life size products such as a giant tea cup and enormous umbrella, create a sensory experience. The pop-up shop is open today from 11 a.m. to 8 p.m., and Thursday through Saturday, 9 a.m. to 8 p.m.  <>


L.L. Bean will launch its new line and web site next week - Outdoor apparel and gear retailer L.L. Bean on Monday will launch L.L. Bean Signature, a contemporary apparel and accessories line along with a dedicated e-commerce site and catalog. L.L. Bean already has launched a dedicated Facebook fan page for the brand. The page, which offers fans a preview of the line’s spring collection, had 883 fans as of 1 p.m. EST. The retailer began making limited quantities of seven items from the line available on the L.L. Bean Signature web site on Jan. 19. All the items sold out within three days. <>


Container Imports to Grow 17% in First Half - Import cargo volume at the nation’s major retail container ports is expected to rise 13% this month compared with the same month a year ago, and double-digit increases are expected to continue through the summer as the U.S. economy begins in improve, according to the monthly Global Port Tracker report released today by the National Retail Federation and Hackett Associates. “These numbers show that retailers continue to anticipate improvements in the U.S. economy,” NRF VP for supply chain and customs policy Jonathan Gold said. “This is very different from the past two years when merchants were continually cutting their imports in an effort to manage inventory.” U.S. ports handled 1.08 million Twenty-foot Equivalent Units (TEU) in January, the latest month for which actual numbers are available. That was down just under 1% from December as imports wound down after the holiday season, but up 2% from January 2009. It was also the second month in a row to show a year-over-year improvement after December broke a 28-month streak of year-over-year monthly declines. One TEU is one 20-foot cargo container or its equivalent. <


“A rising tide lifts all boats…”


SONC was the best performing stock on big volume yesterday only because the “group” was rallying (SONC has significantly underperformed the QSR group over the last 6 months).  Or maybe someone knew an analyst upgrade was coming this morning.    


Today, we learned that SONC guides Q2 system-wide same-store sales to a decline of 12-14%.  SONC attributed the decline to “unusually cold winter weather conditions combined with a decline in consumer spending in Sonic's core markets.”  Same-store sales at partner drive-ins declined approximately 15% for the same period.  There is no mention that management tried to gauge the consumer with aggressive pricing a few years ago and trends have never fully recovered since, particularly at partner drive-ins.  Time for a management change?


BKC missed by a wide margin yesterday and it moved higher too.  


Yesterday, YUM got a “vision” upgrade and a better multiple applied, in part to its US business.  The issues that BKC and SONC are seeing are not limited to those concepts.  YUM’s US business is one of the worst positioned of the large cap restaurant companies.  Taco Bell is ok, but KFC and Pizza Hut are in secular decline. 


On the full-service side, RT moved higher on better sales trends despite the weather.  Although a nearly 10% move seems extreme, short covering was likely a significant factor.  At 7.3x NTM EV/EBITDA, there does not appear to be much upside from these levels for RT. 



Howard Penney

Managing Director





I struggle with the timing on this one. WMS is probably best positioned to capitalize on the tremendous long-term potential of this sector but there is a wall of worry surrounding the near term.



From a fundamental perspective, the long-term outlook for the slot guys is bordering on incredible.  We think we are at the bottom of a multi-year (five?) cycle.  Not only should replacements trough this year in the mid 40k range – down from the peak of around 120k in 2004 - but new markets will start to contribute meaningfully in 2011 and beyond.  Normalizing replacement demand would alone boost WMS’s EPS by around 50%.  The news on new markets should continue to flow.  The states have never been in worse fiscal shape and precedent says they aren’t cutting spending.  They need revenues.


However, what's on investor's minds currently is the near-term earnings picture.  Maybe it’s in the stocks.  As of late, this group has badly underperformed.  We actually think WMS will make the quarter, although it may not be of the highest quality.  At this point, that could be good enough.  The stock trades at 17x our forward twelve month estimate, despite potential 25% EPS growth over a 3-5 year period.  The current valuation is attractive on a historical basis as well as can be seen below.


WMS: NOW OR LATER? - wms forward pe


So what could go wrong?  It’s all about timing.  For this reason I brought in the quantitative/charting specialist, Keith McCullough.  Keith says “WMS is building a base and finally climbing above its TRADE line = 38.37”.  Sounds good.  As long as the wall of worry doesn’t go any higher we should be fine.


So why WMS over the other guys:

  • WMS is capturing an increasing percentage of replacement demand which is poised to accelerate – normalizing replacements results in a 50% increase to EPS
  • WMS is the most forward looking supplier – "Transmissive Reels", Episodic gaming, portal applications, player recognition, etc.
  • We think WMS is just scratching the surface on market share gains in the Gaming Ops segment which is potentially a bigger and more profitable opportunity than ship share gains
  • WMS is entering Class II which is already material for IGT and BYI
  • There are more new markets for WMS:  Mexico and Australia to name the two biggest
  • Chicks dig WMS slots - Content is King

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Motivated Illusions

“A man must learn to understand the motives of human beings, their illusions, and their sufferings.”

-Albert Einstein


One basic risk management premise that we operate with here at Hedgeye is that people lie. I know that sounds a little harsh, but it is what it is. The truth about lying is that people do it.


Some people don’t know they aren’t telling the truth. Some people don’t know what they don’t know. Some people wake up every morning and get paid to be willfully blind. The power of combining groupthink with compensation has unlimited potential, and the risk embedded therein works both ways.


Rather than create a list of liars this morning, I’ll take my queue from the college campus my office sits on and make this basic risk management lesson sound more academic. I’ll label these global macro risks Motivated Illusions:


1. Greece


Motivate Illusion: One of the top headlines on Bloomberg this morning is “Greek Financial Crisis Is Over, Rest of Euro Region Is Safe, Prodi Says.” Now this comment from the former head of the European Commission, combined with Greece’s Prime Minister telling Washington groupthinkers yesterday that Greece has been the victim of “unprincipled speculators and malicious rumors” is what it is – over the top.


Reality: After their one-week global storytelling road-show that spammed us from Germany, to France, to the USA ends, Greece will be selling another 10 BILLION Euros in debt to the marketplace. Piling debt, upon debt, upon debt is what a country who has lived through generations of serial default does. Watch what they do, not what they say...


2. China


Motivated Illusion: China isn’t going to continue to tighten monetary policy, raise the value of its currency, or raise interest rates any further.


Reality: That’s a Western view held by debtor countries that cannot afford to lose their flailing hopes that levered up Chinese demand is going to save their deficit spending. Overnight, China reported a +46% year-over-year export growth number for the month of February. That’s up huge versus an already big January export growth rate of +21%. While the entire political leadership of the Western world tries to remind you that this is still the great depression and we have no global inflation, you can read tomorrow’s pending Chinese inflation report for what it will be to the Chinese – inflationary.


3. US Federal Funds Rate


Motivated Illusion: Ben Bernanke is going to keep rates of return on his citizenry’s hard earned savings accounts (or fixed incomes) at ZERO percent in perpetuity. There is no inflation because the narrow calculation that the government has changed 9 times since 1996 doesn’t say there is any…


Reality: If we haven’t recognized that massive credit issuance and sovereign debt and currency crises, globally, haven’t led to 8 centuries of predictable inflation, please go back and re-read Reinhart & Rogoff’s “This Time is Different.” Apparently some of the boys at the Fed have been doing the required reading. Charles Evans (Fed head of Chicago) gave a speech last night and didn’t use the phrase “exceptional and extended” when talking about prospective monetary policy. Instead he said the Fed would keep rates low “for some time” and when asked after the speech what “exceptional and extended” means, he said “3 to 4 FOMC meetings.”


Call Goldman Sachs esteemed Fed forecasters this morning and ask them if that was the duration and definition they thought Bernanke’s Fed was using in defining “extended and exceptional” when Goldman laid out their forecast that the Fed was on hold until they get their 2011 bonuses. Depending on their answer, I’ll tell you who is storytelling. By the way, the FOMC meetings are 8 times a year, and by Q2 the clock on “3-4 meetings” runs out.


Markets don’t lie; people do. The score on all 3 of these Motivated Illusions is right up there this morning for all participants in this game to see:

  1. Despite rallying +2% early this morning on people hoping Prodi isn’t lying, Greek stocks have lost over -27% of their value since October 14, 2009.
  2. Despite having some of the best GDP and export growth stats in the world so far in 2010, China closed down another -0.66% overnight (down -7% YTD), because local investors realize that growth like this will be met with higher interest rates and/or an appreciated Chinese Yuan.
  3. Despite interest rate doves hoping government bonds higher, global interest rates continue to make a series of higher-lows and higher-highs.

At a point, reality gets recognized by the investors who win or lose every season by discerning who is motivated to elude them. As reality sets into Mr. Macro Market’s prices, consensus becomes the direction of those prices… and the game of trying to figure out who doesn’t know what they don’t know goes on.


My immediate term support and resistance lines for the SP500 are now 1122 and 1149, respectively. On yesterday’s rally in both US Tech and Volatility, I sold out of both my XLK and VXX positions, and I bought US Healthcare (XLV) on the pullback.


Best of luck out there today,





XLV – SPDR Healthcare — Healthcare was down again on 3/9/10 in the face of “Obamacare” inspired fear. While we fear we may be early here, it’s better than fearing fear itself.


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).

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.



SPY – SPDR S&P500We moved to neutral (from bearish) on the S&P500 on the week of February 22. At 1139, for the immediate term TRADE, we’ll go back to bearish. This market is finally overbought. We shorted SPY on 3/5/10.  


EWP – iShares SpainThe etf bounced on 3/3/10 in part from a strong day from Banco Santander, the fund’s largest holding in the Financials-heavy (43.8%) etf. We shorted Spain for a TRADE again on 3/5 as every sovereign debt risk has a time and price to be short of. We have a bearish bias on the country; massive unemployment, public and private debt leverage, and a failed housing market remain fundamental concerns. 


IWM – iShares Russell 2000With the Russell 2000 finally overbought from an immediate term TRADE perspective on 3/1/10 and added to it on 3/2; we got the entry price that the risk manager makes a sale on strength. 


GLD – SPDR Gold We re-shorted Gold on this dead cat bounce on 2/11/10. We remain bullish on a Buck Breakout and bearish on Gold for Q1 of 2010, as a result. 


XLP – SPDR Consumer Staples Another capitulation squeeze is in full motion for the short sellers of everything "consumer". Shorting green as inflation starts to creep into the system again.


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

US STRATEGY – Financials Charge

The S&P 500 finished slightly higher by 0.17% yesterday, on a 25% improvement in volume.  Notably, the advance-decline line deteriorated by 149 to 371.  In our sector study it was surprising to see that 5 of the 9 sectors we track declined on the day.


For the second day this week, there were no big MACRO data points to help drive any one theme.  The RISK AVERSION saw some signs of life with the dollar up by 0.2% and commodities flat to slightly higher.  This dynamic seemed to weigh the most on commodity equities, particularly Energy (XLE) and Materials (XLB).  The Hedgeye Risk Management models have levels for the Dollar Index (DXY) at:  buy Trade (80.21) and sell Trade (80.87). 


The VIX traded slightly higher over the past two day but continues be broken on all three durations - TRADE, TREND and TAIL.  The Hedgeye Risk Management models have levels for the volatility Index (VIX) at:  buy Trade (17.08) and sell Trade (18.72).  Yesterday we sold our position in the VXX. 


For the past three day the Financials (XLF) has been one of the best performing sectors and yesterday was no exception.  Within the XLF, banking led the way, with the BKX +0.6%; the regionals were mixed with some renewed focus on capital needs.  Credit-card and credit/risk-sensitive mortgage insurers were also stronger on the day.


Yesterday, we sold out position in Technology (XLK). The XLK has been leading the market higher this week, and now it’s finally immediate term overbought. Yesterday, both tech and telecom outperformed the broader market.  The semis finished down slightly with the SOX down 0.2%; TXN was a drag following its mid-quarter update. Software was a bright spot with the S&P Software Index +0.7%.


Surprisingly, consumer stocks lagged the broader market yesterday.  In the Consumer Discretionary (XLY) retail snapped a three-day winning streak with the S&P Retail Index 0.5%.  On the positive side restaurants largely extended their outperformance despite weaker-than-expected Jan/Feb same-store sales out of BKC. 


Yesterday the Materials (XLB) finished lower for a second straight day.  The strong dollar can take most of the blame.  CF, X and FCX were the three worst performing name in the sector. 


As we wake up today, equity futures are trading above fair value ahead of another light day for corporate and MACRO data points.  As we look at today’s set up the range for the S&P 500 is 27 points or 1.8% (1,122) downside and 0.4% (1,149) upside. 


Copper gained for a second day after China’s imports of the metal rose 10% in February, adding to confidence that the economic recovery is gaining momentum.  In early trading copper is trading lower after declining slightly yesterday.  The Hedgeye Risk Management Quant models have the following levels for COPPER – Buy Trade (3.36) and Sell Trade (3.50).


Gold is slightly higher in early trading, after trading flat yesterday.   The Hedgeye Risk Management models have the following levels for GOLD – Buy Trade (1,105) and Sell Trade (1,145).


In early trading, oil is trading little changed as analysts forecast rising crude supplies in the U.S.  The Hedgeye Risk Management models have the following levels for OIL – Buy Trade (80.24) and Sell Trade (82.69).


Howard Penney

Managing Director


US STRATEGY – Financials Charge - sp1


US STRATEGY – Financials Charge - usd2


US STRATEGY – Financials Charge - vix3


US STRATEGY – Financials Charge - oil4


US STRATEGY – Financials Charge - gold5


US STRATEGY – Financials Charge - copper6



PFCB notes on Mr. Vivian’s ad lib presentation:


Pei Wei is what people are looking at most closely

  • 12-18 months ago it was suggested that PFCB abandon the concept
  • Mistakes corrected
  • Last 6 quarters have shown improvement in operations
  • Comfortable putting capital down to work
  • 3-4 new Pei Wei units this year, 10-15 in 2011, and a number larger than that in 2012 (maybe 20-25)
  • More next year (existing markets except Chicago)


Pei Wei had positive traffic last year

  • The expectation is that comps will be positive this year
  • Pei Wei unit potential is around 500 units


Currently all units are company-owned.  The company is not against using partners to grow this concept but management wanted to first make certain that they could make money with Pei Wei.  PFCB would be more open now to having those conversations (not currently having any conversations with potential partners for Pei Wei).



  • Very good concept
  • Struggling over the last couple of years to grow traffic but that is beginning to change
  • Looks like we’re going to be moving into positive territory as we move out of this year
  • If we’re negative this year, negative first half, positive second half
  • Business is slowly improving, when you dial out weather


190 Bistros, PFCB thinks 250 is the right number

  • First priority with cash is to build restaurants
  • Likely they will build ten or so too many and then have to find the right number


Bistro universe is shrinking so opportunities are less apparent



How do you evaluate returns at the unit level, when does it not make sense?

  • ROIC
  • investor relations page has a return on invested capital section with the returns of each year (‘07, ‘08 and ‘09)
  • Capitalizing lease, 30% return is PFCB’s aim
  • Last year, Bistro was 36% and Pei Wei was 28%



Q: Ever considered international expansion?

A: Yes. Three agreements outside of USA – Mexico, Middle East, and The Philippines.  Partners will likely open other international locations also.  PFCB is not committing any capital to international expansion.

Actually get a call a week from Asia for to expand there…



Q: Dividend…

A: Progressive dividend…rather than initiate a fixed dividend, we thought it made more sense to fix payout ratio and let dividend float. Better results will aid shareholders.  Ratio fixed @ 45% of Net Income.  Investor responses to the dividend announcement: He has been told that PFCB is the #2 in restaurant group in terms of payout


He has also heard that people are saying that the initiation of the dividend signals that PFCB’s growth is coming to an end. Bert’s response to that comment is that PFCB is producing a lot of cash…bistro is self sufficient. Pei Wei is nearing self sufficiency. Both concepts will soon be able to fund their own growth. Both international growth and the frozen food venture are not requiring any capital.


The right amount of cash on the balance sheet is $40/50mm so anything above that we are going to figure out how to best return it to shareholders.



Q: Unit economics of Pei Wei?

A: Cost $750k – 800k cash (recently took $50K out of the cost). Including lease obligations, it is about $1.4M-$1.5m, all in. Excluding a small group of under achieving units, Pei Wei generates about $37K-$38K per wk in sales



Q: Maturity curve?

A: Bistro reaches maturity in about 18-24 months.  Pei Wei hits the curve quicker. It is an easier model from an operational standpoint so maturity should be approximately 12-18 months.


PFCB extended a $10m line of credit to Sam Fox for True Foods Kitchen restaurants to build 3-5 restaurants. The agreement includes some provisions to allow PFCB to convert its loan to equity, but that decision is still a couple years away.




Howard Penney

Managing Director



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.