“It’s like there’s a bunch of guys that are making it up as they go along… They talk about transparency and what they present is opacity, programs that don’t make sense, or are not yet fully laid out. This only increases the already high level of uncertainty and anxiety.”
-Anna Schwartz (co-author with Milton Friedman of “A Monetary History of the United States”)

For those of you who read Barron’s on the weekend, you’ll recall that quote from the 93 year old Anna Schwarz take on the US Treasury’s performance to date. She doesn’t carry a crackberry. She doesn’t hang with the “hedgies.” She reads, and thinks…

That cover of Barron’s was titled “More Pain” (with a bear taking a chainsaw to a bull’s head), and the #1 headline on Bloomberg this morning reads “Stocks plunge worldwide, US futures drop.” Suffice to say we are going to have ourselves a good old fashioned accountability check in the coming months. At least I don’t have to sound like I have an axe to grind anymore. People are figuring this all out… who did what and when… Facts are stubborn little critters aren’t they?

If you flip through Barron’s quickly, you won’t miss the full page inserts from Barclays and Merrill Lynch that read “Tax-Loss Harvesting” and “Support – Merrill really delivers on that promise.” Really? Do they “really” deliver? That’s a fascinating interpretation of their performance in 2008. That’s about as believable as John McCain sounds when he plays the theme song of Rocky and tells the 100 or so people at a rally in Ohio that he has Obama “right where he wants him”… or better yet, the Morgan Stanley advertising insert (Barron’s, 10/27/08, page 14) calling themselves “World Wise!”

After missing that this global economy is cyclical and that leverage can work both ways, I don’t need to ‘YouTube’ these firms and voices anymore. Like any man or woman who is guilty, they’ll show it off to you themselves – just give them and the lawyers time. Much to the chagrin of “Investment Banking Inc’s” conflicted and compromised business models of Christmas bonuses past, this truth will be told now. As Martin Luther King said, “a lie cannot live.” All of those finger pointers will be mailed mirrors. We might even order up some baby blue Tiffany bows for them, just to remind them of how good all that money smelled.

Global stock markets smell again this morning, badly – just how I like them. This week we will have both “Heli-Ben” cutting rates and month end performance marks for everyone who is still in this game. Winners and losers are emerging. The losers will tell everyone that it’s not their fault, “it’s the market”. That’s how the accountability rules on this Street used to work, so don’t expect anything less come Friday. I’m not sure how the math worked last year at October end, with the S&P 500 44% higher. I don’t recall PM’s sending incentive fees back to their investors with a note admitting that “it’s the market.” But heh, who’s keeping track of history…

Asian markets are marking some of the most expeditious declines in world history. Overnight, Hong Kong closed down the most since the Tiananmen Square crisis, losing -12.7% in one fell swoop. Philippino stocks lost -12.3%, and stocks in Thailand got tagged for another -10.5% loss. South Korean stocks actually closed up 0.82%, and that’s largely because the government cut interest rates by 75 basis points to 4.25%. Greenspan taught the world how to react to manias, just cut rates and never mind the leverage bubbles that will be born out of the process. By the time that occurs, everyone can throw up their hands and say “we’re shocked”…

The Shanghai Composite Index and the Hang Sang Index have lost -72% and -65%, respectively, since this same week of last year. The only thing that’s “shocking” about this is what you’ll find on the ‘You Tube’ rewinds from whoever it is you’d like to Google this morning. What did they say, and when? As appropriately, the question you should be asking yourself this morning is what are they doing now in anticipation of October 2009? Our answer is quite simple, buying stocks. We buy things in 3’s here at Research Edge. If we see our prices in FXI (China) or EWH (Hong Kong) this morning, we’ll be buying them, for the 3rd time. Importantly, we just started buying into these macro ideas in October of 2008. We were short them at this time last year.

Our ‘Hedgeye Asset Allocation’ model has the following exposures this morning: US Cash 75%, Canadian Cash 3%, Gold 3%, and Global Equities 19%. The US side of our equity exposure is only 6%, and we have expressed that with more of our “cash is king” theme, buying the Vanguard High Dividend Yield Fund (VYM). Otherwise, we bought Australia (EWA) on Friday, adding it to our equity ETF exposure in Germany (EWG), China (FXI), and Hong Kong (EWH). This puts us in a tactically sound position to be buying into any US market weakness as PM’s mark down positions into what was nothing short of a horrifying month for those who weren’t in cash.

For the month alone, the S&P 500 is down 24.8% to date. For 2008 to date, it’s down -40.3%, and since the October 2007 “it’s global this time” high of 1562, the S&P500 has lost 44% of its value. To borrow Morgan Stanley’s “World Wise” tag line, it pays to respect history and context here. The only worse peak to trough decline in the US market was during the Great Depression. If you or whoever is managing your money cannot find value here, I don’t think you or they ever will.

We have an S&P 500 downside target buy zone of 857.76 today. As the math changes, we will. If you ever want to be a capitalist, now would be a great time to start. Be your own process. Beat your own path. In a year from now, I’ll be reminding you of this note. I am Keith McCullough, and I support this message.

Best of luck out there this week,

Calling All CEOs: Watch the Rupee

The Rupee hit all-time peak and trough all in the same year vs. the dollar. Here’s an overview of winners and losers. But the bigger issue is which CEOs will lead zigging when everyone else zags.

The rupee is off 21.3% from highs hit earlier this year. It’s not the decline that matters to me as much as the rate of change. Think of it this way, the Rupee hit all-time peak and trough all in the same year vs the dollar.

Whenever evaluating FX changes in this business, one must always net out the sourcing change vs. the revenue translation change. The good news here is that most companies have failed miserably in any effort to grow in India.

On the cost side, there are clear opportunities to up the proportion of product sourced in India. Only 3-4% of our apparel and 0.5% of US-consumed footwear is sourced in India. To be clear, there are structural reasons why this is so low, the least of which are logistics and receptivity towards foreign direct investment. But if an Indian government that increasingly needs to bow to a populist positioning opts to lower the barriers for the US to tap into Indian labor and apparel sourcing capacity, then we could be looking at a net positive for the industry by sometime in 2010.

As it relates to revenue…
… there are few companies that have any presence at all. Interestingly enough, one of the top brands in India is Reebok – after years of Reebok endorsing the National Cricket team. This is one of the few brands where there is, in fact, a positive delta between Indian-denominated revenue and costs. We’re talking less than 3% for Adidas/Reebok, but there is exposure nonetheless.

As it relates to Nike, presence in India was fairly limited until Nike outbid Adidas and Reebok in 2005 for the contract to outfit the Indian National Cricket team. To those that do not know, Cricket is to India what Hockey is to Canada, Football (soccer) is to Europe, and Baseball/Football is/are to the US. Nike bid 1.97bn rupee in ’05 for this deal, which then equated to US$430mm over 5 years. The cost since escalated to $490mm, and with the recent correction in the Rupee, we’re now looking at $380mm. Why is this good? Mark my words, there is no way Nike is within shooting distance of making money on this endorsement contract. When total cost comes down more than total revenue, that’s generally a good thing.

VF acquired a 60% interest in a newly formed joint venture with India’s Arvind Mills to design, market and distribute VF- branded products in India for a total cost of approximately $33 million – or about 1x revenue. This largely covered its Lee and Wrangler subsidiaries. This business is not hugely accretive to the P&L, but it does in fact run at a profit. This is likely a topic VFC calls out in the coming quarters as an area for weakness.

Other specific call outs… Arvind is a key manufacturer and licensee to Phillips-Van Heusen, VF Corp, Tommy Hilfiger, and Cherokee Inc. Arvind has been manufacturing and distributing Phillip-Van Heusen’s Arrow brand in since their agreement in March 2008. Arrow was a 65 million dollar brand for PVH, 12.3% of PVH’s wholesale dress furnishings segment and 2.6% of total net sales in 2007. Arvind is one of nine Cherokee licensees and represents about 0.5% of total revenue.

The last, and by far the most important point to me is how CEO’s view India as a strategic risk vs. opportunity. Any time we see emerging markets blow up, the second tier players with no real strategy or reason for being run for the hills, write down assets, and find other geographies to ‘fish where the fish are.’ Case in point – check out the sheer number of companies that decided it was a good idea to invest in China over the past year AFTER a massive run in the currency (see our 9/18 post The Race To China).

But the winners will take that opportunity to invest capital despite near term pain to establish dominance to be in the pole position for when the market turns. This is what Nike did in Brazil, Argentina, and Mexico 5-years ago. It was #3 in those markets, and when they blew up, it invested and now it is #1 by a wide margin. Same goes for both Nike and Adidas in China.

This is an opportunity for CEOs to show some backbone and show that they really believe in their Brand and opportunity to execute.

Not All Comp Packages Are Created Equal

Let’s look at how executives in the apparel industry paid themselves last year relative to performance. I wonder if the volatility in their own comp will mirror that of their stakeholders in ’08?

Tough year, huh? Yes, this is the year where many on Wall Street have a massive question mark around 1) whether or not they will have a paycheck, and 2) to the extent they get one, how big will it actually be? In that context, let’s take a little look at how much money executives in the apparel industry paid themselves last year relative to performance. I wonder if the volatility in their own comp will mirror that of their stakeholders.

The analysis below simplistically looks at two factors. 1) Percent of EBIT that goes towards executive comp, and 2) incremental change in EBIT versus incremental change in comp i.e. are they both moving in the same direction? Here are some stand outs with each.

EBIT Percentage. Yes, I realize that there are many more relevant factors than simply looking at EBIT – including ROIC and other key balance sheet factors. But a quick compare and contrast is pretty mind numbing… 1) Should comp for the top officer really equate to 8% of EBIT for Warnaco, Guess, Ralph Lauren? 2) PVH, Timberland, and Quiksilver are far more balanced.

Incremental Comp vs Incremental EBIT. No consistency here whatsoever. 20 out of 47 executives saw comp move in the same direction as EBIT last year. At least half of those that saw comp growth less than growth in EBIT are the ones with the most egregious comp packages (GES, WRC, RL). The results below speak for themselves.


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As of this week the Lehman emerging markets bond index was down over 28% for the year, with the Latin America and European sub indices each down by an even larger percentage. Pummeled by falling commodity prices and without the ability to borrow any more from external markets, the emerging economies are in dire straits and the potential for default by one or more of them has become very real.

Two countries that our customers have asked us about repeatedly this week are Argentina and Russia. The prospect of default by either is significant: after years of misguided policy Argentina’s government is genuinely broke, while Russia’s potential for reneging on its obligations may be motivated by politics as much as its balance sheet.

Argentina: Sinking Fast

Compared with the other major Latin American economies there are relatively few tranches of Argentine US dollar denominated debt, most of which was issued in the wake of the default through rolling existing bonds. Despite this, external debt still hovered at just under 50% of GDP in the first quarter.

Raising money in international markets has been difficult for Argentina’s leaders since they still have not fully settled with creditors in the 19 country Paris club –their primary new foreign creditor in recent years has been the Venezuela Government (with Comrade Chavez demanding yields as high as 15%). Early in September President Kirchner announced that she intended to attempt a settlement on the $6.7 billion remaining in defaulted debt at the expense of the nation’s foreign currency reserves, but by then the credit markets had already shut down completely. This leaves her with only the home market left to turn to as she seeks to salvage her ambitious public works programs.

The private pension funds that are currently being eyed for nationalization are among the primary holders of Peso denominated Argentine debt, as well as banks and other financial institutions. Many of the bonds held by domestic holders have yields linked to inflation, which has become a source of controversy since the present administration and its predecessor adopted a policy of publishing fake, artificially low CPI numbers to stave off additional interest obligations. This policy of lying contributed to additional tension between Argentina and the IMF, helping to make the chances of international aid even more remote.

In short, the policy restructuring of domestic debt and nationalization of pensions that the government has embarked on seem likely to undo all the progress made by the Argentine economy over the past 5 years within a few short months.

The Peso’s plunge and skyrocketing yields (see chart below) indicate that foreign traders have largely factored a restructuring of some type in already. At this stage, the impact of a default will for the most part only be felt by the Argentinians themselves and their immediate neighbors.

Russia: Wounded Bear

In comparison to Argentina, the Russian debt situation is infinitely more complex and greater in scope.

In recent years the Eurobond and other international markets were increasingly significant providers of liquidity for the Russian economy until the one two punch of the Georgia incursion and the banking crisis effectively closed those windows. As such, the current bailout plans being sponsored by the Russian government has been financed domestically –with domestic Ruble debt there up over 10% YTD as of the end of September. With the freefall of both the Ruble and oil continuing to pick up speed, the Kremlin has adopted a consistently more aggressive tone.

If you read our work regularly you know that we view the economic crisis facing Russia and its political allies as a very serious issue that could have a destabilizing impact on global politics. Putin & Co. have a record of seizing private assets whenever it suits them, this does not bode well for creditors –the current turmoil could prove to be an irresistible opportunity to take Russia back into bankruptcy and rebuild it according to their vision.

One clear loser in any Russian debt restructure would be EU unity. A passive response by large economies there with more skin in the game will be perceived as appeasement by their newer Eastern partners who retain a profound distrust of their former overlords.

We will be keeping our eye on Russia and Argentina closely for the foreseeable future. Unlike some well known market pundits however we will not be making any investments there; assets could not possibly be “cheap” enough for us to want to own them in a nation so poorly managed as either.

Andrew Barber


We've been bearish on natural gas since the late spring and our supply / demand model for natural gas is showing an inventory build in 2009E that will be greater than expected when we first turned bearish. Obviously, though, the price of natural gas has corrected rather dramatically and a good deal of bad news is priced into the equities and the commodity. That said, as we look into 2009, there is potential for real supply / demand imbalances.

On the supply side, YTD production is up y-o-y 8%. While we are starting to see producers cut back on drilling (Chesapeake's recent announcement for one), production will not stop on a dime. The production ramp we are on this year is well above trend line and any historical norm (the producers got greedy). The growth in production has not lead to a build in inventory, so far, because demand has averaged +4% y-o-y and imports (LNG and Canada) have been down y-o-y. Low LNG imports are finally lapped in November of this year, so in the last couple of months of this year and into next year comparisons favor a building of inventory.

Demand has been robust YTD at up +4%. Currently, the EIA is estimating growth of +1.9% in consumption in 2009E. We have a hard time seeing that happening given the current economic environment. In recent history, natural gas has rarely seen much more than GDP growth y-o-y and, in fact, in tough economic times has seen y-o-y declines, such as in 2001 when natural gas consumption was down more than -4% y-o-y. In 2001, this was primarily driven by an almost 10% y-o-y decline in industrial consumption, which is not an unlikely scenario for 2009 in our opinion.

In terms of inventory, as of October 10th, we are 3% above the 5-year average, which is certainly not overly bearish. That said, we will likely see continued building of inventory into year end and in early 2009, which could take the slightly above average inventory number to well above average.

So as we look out the next 6 - 12 months, we are fairly bearish on supply and demand and our model shows a more meaningful build than consensus. Obviously a good deal of bad news is priced in already and we wouldn't recommend shorting the equities down here. But in terms of the actual price of the commodity, it is hard for us to get bullish until we can rule our forecast for an inventory build.

On the positive side, we don't want to downplay Chesapeake and its peers cutting cap-ex budgets for drilling. This is a bullish sign, but we just need to see some evidence of production beginning to decline, as a result of these actions, before we can get bullish on the fundamentals.

Daryl G. Jones
Managing Director

CBRL – Changes to management’s compensation metrics in 2009

In the CBRL’s proxy filed last week, the compensation committee changed the key financial metrics for management’s compensation. According to the proxy “We seek to align the interests of the named executives Named Executive Officers with those of our shareholders by evaluating executive performance on the basis of key financial measurements which that we believe closely correlate to both near-term and long-term shareholder value, including increases in operating profit, revenue growth and operating margin.“ In 2008 the key metrics included operating profit, revenue growth and return on investment.

Why would management not want to include ROI in 2009? One thought would be to make it easier for management to get a bonus since they did not hit the key metrics in 2008

For management to get a bonus in 2009 total revenue are to increase approximately 4.5% to 5.5% over 2008 and operating income margin to be approximately 6.0% to 6.3% compared with 6.3% in 2008. All of this translates to operating income growth of approximately 6.4% in 2009.

Currently, the Reuters estimate for revenues growth is 3%, flat EBITDA and earnings declining slightly.

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