Looking Below the Surface

Looking Below the Surface


This morning March same store sales were released with results that unanimously exceeded expectations across the board.  While results in aggregate were amongst the strongest we’ve seen in years, inevitably there were several anomalies that stood out when we looked below the surface.  A few interesting points:


- While the Easter shift positively benefitted almost every retailer by 200-500 bps, Costco was the only one to report that Easter was actually a negative for the month.  Because the company is actually closed on Easter, the month had one less selling day this year vs. last.  As a result, Costco will benefit in April while the rest of the retail universe bears the negative impact of the shift.


- Costco and BJ’s Wholesale both noted that TV sales were weak during the month. Costco cited weakness due to both deflation and negative unit sales.


- GPS comments were clearly focused on its success with recent merchandising initiatives, with management going the extra mile to explain that they saw underlying strength excluding the Easter shift.  Interestingly, the company also noted that it will no longer comment on merchandising margin performance on a monthly basis.  This comes as a result of the company’s key focus being on same store sales and topline growth now that margin driving efforts are largely complete.  Clearly a shift from defense to offense.


- American Eagle Outfitters noted that tops priced under $20 were among the best performing categories in the store.  Clearly value remains top of mind amongst the teen customer base.  This was also evident in the strength we saw at ARO, and the lack of strength at Abercrombie and Fitch (even with gift card promos).


- “Conversion” was the buzzword of the day, with many retailers citing this as a key reason for strength.  Traffic was up, but “conversion” was even stronger.


- JC Penney noted that its home categories were the weakest in the store and online.  This is counter to trends we have seen out of TJX, ROST, KSS, BBBY, and WSM.  Historically home has been a key category for JCP, but market share losses are becoming more evident as the overall health of the category appears to be consistently improving.


- Nordstrom noted that March marked the 7th consecutive month in a row of increased year over year traffic.  It also posted one of the largest same store sales increases in department store history, with a 16.8% increase!


- Kohl’s stands out for the company’s geographic and merchandise consistency.  All regions posted at least a high teens increase, while all categories registered a comp increase of 19% or more.  


- Ross Stores noted that shoes and home remain the company’s best performing categories, with both increasing by 20% for the month.  Dresses were also strong, increasing in the teens.


- Target’s commentary on strong apparel sales, up mid teens, is a large part of the reason behind the company revising earnings upwards by $0.10. Interestingly, the new guidance of $0.84 will take Q1 earnings to the highest non-holiday EPS ever recorded in company history.  The prior peak was $0.82 back in 2Q08.


- Finally, it’s worth noting that ANF was one of the few companies that did not meet expectations for the month.  We continue to wonder if management’s decision to severely cut back on inventory is now meaningfully holding back sales.  Recall that management took markdowns on Spring goods before they even hit the floor (as well as diverted them to outlets) because they were unhappy with certain product.


Eric Levine



Looking Below the Surface - 1 year


Looking Below the Surface - 2 Year


ECB on Hold, Greece Isn’t

Position: Long Germany (EWG); Short Euro (FXE)


Following the European Central Bank’s decision today to keep its main interest rate on hold at 1%, ECB President Jean-Claude Trichet held his usual follow-up press conference. Notably, the media pressed him in the Q&A session to explain the economic conditions (parameters) that will initiate the EU and IMF to inject funding for Greece, or conversely the market conditions that should initiate the Greek government to request capital. In typical Trichet fashion he was tight-lipped on such questions, but did express that “a default is not an issue for Greece”.


So what did we learn from today’s ECB release?

  • The ECB has decided to keep the minimum credit threshold for marketable and non-marketable assets in the Eurosystem collateral framework at investment-grade level (i.e. BBB-/Baa3) beyond the end of 2010, except in the case of asset-backed securities (ABSs).
  • As of 1 January 2011, a schedule of graduated valuation haircuts to the assets rated in the BBB+ to BBB- range (or equivalent), which will be announced at the ECB meeting in July 2010.
  • This graduated haircut schedule will replace the uniform haircut add-on of 5% that is currently applied to these assets.
  • Marketable debt instruments denominated in currencies other than the euro, i.e. the US dollar, the pound sterling and the Japanese yen, and issued in the euro area will no longer be eligible as collateral as from 1 January 2011.

One main take-away here is that with Greece’s sovereign debt rated at BBB+ by Standard & Poor’s and Fitch Ratings, further ratings downgrades will put in jeopardy Greece’s ability to borrow from the bank as stricter collateral obligations are imposed.  We’ll know more about this latter point when the ECB presents its schedule for haircuts in July, but considering Trichet’s determination of the European community to assist Greece (or other PIIGS), it wouldn’t surprise us if exceptions were made to said measures.


The recent spikes in Greek bond yields, rising Greek CDS prices, and a plunge in the Athex equity market have furthered investor doubts that Greece can meet its debt obligations. The chart below shows the recent spike in the 10YR Yield and the lower chart gives historical perspective on the Greek spread over the risk-free 10YR German Bund.  As Greece looks to issue more debt in the coming weeks, rising current yields will put upward pressure on future rates; as we’ve said numerous times, kicking the debt “can” further down the road does not end well.  For now, without EU policy to deal with sovereign debt issues of its member states, this game of “wait and see” from Trichet and EU leaders will prolong the underperformance of Greek bond and stock markets.


Matthew Hedrick



ECB on Hold, Greece Isn’t - chart



Apparently another bidder has emerged for the assets of CKE Restaurants.


For those following the saga, I’m putting my stamp on what I think is a fair price for the company.  If I was a shareholder I  would be extremely disappointed in THL Partners’ offer of $11.05 for CKR.  A more appropriate price is closer to $15.


While a sum of the parts analysis is never an exact science, I believe my assumptions are very conservative in valuing the cash flows of the company’s two brands.  I also believe that the company was mismanaged and there are a number of opportunities to make the company more profitable.


First, the current management team has an inflated view of what it is worth.  For the last three years, the senior executives were some of the best paid in the industry running two of the smaller chains.  That being said, there are a number of ways for the company to reduce G&A.    


Second, we think there is an opportunity to enhance shareholder value by focusing on restaurant operations. While I appreciate the legacy issues surrounding the distribution business, the economics of the distribution model more than justify the company exiting the business.  Today, running a franchise restaurant company has never been more challenging; the challenges are even more complicated when management’s time is consumed with managing a distribution business and a restaurant company at the same time.  After analyzing other distribution companies, it would suggest that the economics of running the distribution business are under pressure and CKR could be well served by letting bigger, more efficient companies manage the business. 


CKR has justified retaining its warehouse and distribution operations for its Carl’s Jr. system because it allows the company to more effectively manage its food costs, provide adequate quantities of food and supplies, generate revenues from franchisees, and provide better service to its restaurants in California and some adjacent states.  Although these motives for keeping the business may all be true, we do not think they trump the potential cost savings that could be realized from outsourcing such operations. 


Hardee’s distribution business is based primarily on equipment sales to franchisees and actually generated slightly negative profits over the past five years and this does not take into account the G&A expenses associated with operating the business. 


It will be interesting to see where things shake out…..


Howard Penney

Managing Director




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Strip gaming revenues increased 33% and it was all Baccarat. Baccarat volume and win were up 131% and 255%, respectively, thanks to CNY and a lot of luck. Slot revenue declined 9%.



Owing to the timing of Chinese New Year (CNY) and good luck on the tables, the Strip posted a 33% YoY increase in gaming revenues in February 2010.  As we wrote about a few weeks ago, we thought growth would be positive but this is much better than expected.  Of the $141 million positive variance from last year, $82 million was driven by higher Baccarat drop which increased 131%.  Baccarat win increased 255% partly due to the higher drop and partly due to a higher hold percentage - the Baccarat tables held at a 17.0% clip versus 11.1% last year.  Normal hold percentage is 12-13%.  The good Baccarat luck contributed about $65 million to the variance.  Slot revenues actually declined for the month by 8.5% all due to lower hold percentage.  The table below breaks down the YoY variance in millions of dollars.




While the February numbers were outstanding, a little caution is in order.  Revenues were down 23% last year so the comp was easy.  CNY fell into February of this year versus January of last year which helped Baccarat volume.  Baccarat volume and hold percentage can be very volatile and no doubt the strength on the Strip is mirroring the VIP strength in Macau.  It is unclear how sustainable these volumes are. 

The End of Quantitative Easing, As We Know It

 “It’s the end of the world as we know it and I feel fine.”



R.E.M. is an iconic American rock band that was founded by Michael Stipe in 1980.  While the band is not known for its thoughts on monetary policy, the line quoted above from their song, “The End of the World Was We Know It”, provides a good metaphor for the Federal Reserve’s recent decision to halt quantitative easing.


While many market observers expected this planned ending of policy to lead to an increase in interest rates, particularly for mortgages, we have seen only a marginal change in rates.  In fact, over the last three weeks 30-year fixed mortgage rates have only increased marginally from 5.05% to 5.25%.  In essence, the quantitative easing world has ended, but those still borrowing via mortgages “feel fine”. 


To its credit, the Federal Reserve did an effective job at prepping the market for the end of this policy, so new buyers stepped in and the mortgage market has remained stable.


Backing up for a second, though, what exactly is quantitative easing? 


Central Banks have basically two key tools to implement monetary policy:  interest rates and reserve requirements.  By lowering interest rates, central banks can stimulate money supply by making borrowing rates more reasonable to borrowers and the margins from lending more compelling to lenders.  On the reserve front, the central bank can alter the reserve requirements, which is the ratio of cash a bank must hold compared to customer deposits. Any increase in reserve requirements will limit a bank’s ability to lend, or vice versa.


In the scenario where the interbank interest rate is zero and reserve ratios have been maxed out, central banks can initiate another form of policy: quantitative easing.  In simple terms, central banks will begin to purchase financial assets from banks through open market operations.   So the central banks print money to buy assets from banks, which increases the excess reserves on the balance sheet of banks. 


Quantitative easing was used by the Bank of Japan in the early 2000s in an attempt to offset deflation with limited results.  In November of 2008, the United States implemented their first ever policy of quantitative easing.  The policy had two aspects to it.  First, the Federal Reserve indicated they would purchase direct obligations of Fannie Mae, Freddie Mac, and the Federal Home Loan Banks.  Second, the Federal Reserve indicated they would purchase mortgage back securities.


The objective of this program according to the Federal Reserve was to, “reduce the cost and increase the availability of credit for the purchase of houses, which in turn should support housing markets and foster improved conditions in financial markets more generally.”  In effect, as credit markets ground to halt in late 2008, the Federal Reserve had to take the extraordinary and unprecedented measure of quantitative easing to offset the potential risk of deflation.


While the program started on a smaller scale with $500 billion of mortgage backed debt, the program was increased in March of 2009.  As the program ended on March 31, 2010, the Federal Reserve had purchased $1.2 trillion of mortgage-backed debt from banks and $200 billion of direct obligation debt of Fannie Mae and Freddie Mac, for total purchases of $1.4 trillion.  As a result of these actions, the Federal Reserve now owns almost 25% of the stock of mortgage-backed securities.


In the chart below, we have charted the increase of excess reserves on bank balance sheets.  The current amount of excess reserves is estimated to be around $1.2 trillion.  Assuming that these excess reserves were turned into loans at a 10:1 ratio, the increase in money supply into the system would be $12 trillion.  This is larger than the current amount of outstanding mortgages in the United States!


The reality is simply this: we have no idea what the consequences of this quantitative easing policy action will be.  It is an unprecedented move that, in time, will have to be unwound.  If the unwinding is natural, which would involve banks reducing their excess reserves to a more normal level, the inflationary impacts on the U.S. economy could be extraordinary.


At this point, I’m not going to predict the “end of the world as we know it” due to this massive increase in excess reserves, but this policy will have to be unwound at some point.  Either the Federal Reserve will have to pay competitive interest rates on these reserves so as to discourage loans, or the banks will begin to lend.  And lend.  And lend.


I can promise you this, if the $1.2 trillion in reserves starts to make its way into the economy, money supply will increase dramatically, and with it, inflation.  While there is increasing discussion of inflationary pressures, very few people are currently considering the unintended consequences of quantitative easing.


Daryl G. Jones

Managing Director


The End of Quantitative Easing, As We Know It - Excess Reserves


Following a spate of upgrades, restaurant stocks shot up yesterday on high volume in a down market.  We’ll see if today brings more of the same.


Volume on upmoves has been harder to come by in this space recently.  However, it is clear that some names continue to work well.  CBRL, PNRA, and (to a lesser extent) CMG and RUTH maintained their consistent performance on high volume.  KONA released preliminary  results this morning, exceeding topline expectations.  March comparable store sales were positive for the first time since early 2008.


While retail sales data have been strong for retailers such as Nordstrom, and the restaurant sector was upgraded yesterday, I am not convinced of the sustainability of this upward move.  While RT’s results showed stronger-than-preannounced trends and management described the commodity environment as “benign”, it is clear that restaurant companies have far less margin-boosting levers to pull relative to the retailers.  RT beat the numbers but momentum is clearly slowing.  We believe that momentum will slow further as we look towards the summer months.  RT opened down 3.3% following yesterday’s results.  See our note published this morning for further thoughts. 


Looking at the table below, it is notable that the full-service companies had a strong day yesterday.  The Street seems to believe that the restaurant recovery will continue for some time, but I’m not in that camp…


TALES OF THE TAPE - stock 4.7



TALES OF THE TAPE - commodity 4.7



Howard Penney

Managing Director



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