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R3: Keep the Beemer, Risk the House


April 9, 2010





It’s obvious that a confluence of half-dozen factors came together to drive yesterday’s solid results. But consider the underlying change in behavior around mortgage defaults. A recent study raises some good points that we think could explain away $67bn in annual PCE.


If there’s one head-scratcher that came from yesterday’s strong sales numbers, it is the extent to which the consumer is actually improving, and what underlying factors are really driving higher retail sales.  Was the 9% comp (highest in 11 years) due to a) higher tax refunds, b) holiday shift, c) weather, d) penned up demand as consumers had not bought Spring apparel in 23 months, e) a wealth effect from higher equity prices, or simply f) a rebound in the economy. My sense is that we can spend all week trying to quantify precisely how much of these factors are contributing to sales strength (which we are doing, by the way). But there’s another theory that Allison Kaptur on Josh Steiner’s Financials team brought to my attention this morning that is tough to ignore.


It is from an article written by Paul Jackson of HousingWire.com. The crux of the argument is that consumers who are either in default – or on the brink -- are simply spending their mortgage payments on something other than their home. He states the following…

  • “We’ve got 7.4 million non-current loans in this country, according to data source Lender Processing Services, Inc.”
  • “The average age of a loan in foreclosure is now 410 days delinquent, after all, according to LPS; and that’s just the average. Many delinquent borrowers are able to stay in their homes for even longer than that.”
  • Data is clear that “Americans are now more likely to stop paying their mortgage first relative to other debts, meaning that they will continue to pay their credit cards, auto leases and other financial commitments.”

While this is purely anecdotal, Jackson highlights a HAMPlicant case study whereby the applicant had an $1,880 monthly payment on their mortgage they’d defaulted on, yet their bank statements for the past 30 days included the following expenses:

  • visits to the tanning salon
  • visits to the nail spa
  • some kind of gourmet produce market
  • various liquor stores
  • A DirecTV bill that involved some serious premium programming or pay-per-view events
  • Over $1,700 in retail purchases, including: Best Buy, Baby Gap, Brookstone, Old Navy, Bed, Bath & Beyond, Home Depot, Macy’s, Pac Sun, Urban Outfitters, Sears, Staples, and Footlocker

If just half of the current 7.4 million currently delinquent mortgages are ‘spending their mortgage’ and we assume a $1,500 average monthly mortgage payment – we get about $67bn in higher annualized discretionary spend – or about 1.4% growth.


-Brian McGough




  • Pier One is one of the most successful large retail chains at negotiating rent rate reductions. Over the past two years, the company has successfully reduced rents on 350 stores (over 1/3 of the chain) resulting in an average reduction in rates of 23%. Management still believes there is opportunity for additional stores to be adjusted. Over 2009, the savings resulted in a $6 million improvement in SG&A and $10 million in cash savings.


  • A study released by Kline and Company suggests that sales nail polish are coming off a banner year, despite the historical view that lipstick sales benefit when the economy suffers. The “lipstick theory” was based on the idea that women will spend on lipstick as a way to improve their appearance given the low price point of the product. With overall cosmetic sales down 0.8% for 2009, nail polish bucked the trend with a 14.3% increase. The new “nail polish theory” suggests that women have curtailed spending on manicures in favor of doing their own. Oddly, lipstick sales were down 5.3% last year, suggesting there was some sort of trade-off between the two categories.


  • Cult favorite Brazilian flip-flop maker has entered the market for traditional footwear. Havianas recently launched a small collection of sneakers and espadrilles at Harrods in London. It’s still too early to know when the moderately priced ($55/pair) footwear will make its way stateside.





R3: Keep the Beemer, Risk the House - Calendar 





Consumers to Aid U.S. Economic Rebound as Unemployment Drops, Survey Shows - Consumers are emerging from a two- year hibernation to play a more active role in the U.S. recovery as unemployment recedes, according to economists surveyed by Bloomberg News. <bloomberg.com/news>


Consumers Praise Private Label Brands - Respondents to a 23-country survey largely agreed that store brands are at least as good as national brands in many respects. Released yesterday by Ipsos Marketing the Consumer Goods poll (conducted last November through this January) found 89% of respondents saying store brands are "the same as or better than" national brands when it comes to "providing a good value for the money." But it's not just that they're seen as a bargain. Large majorities of respondent also said store brands are at least the equal of national brands in "offering products that meet my needs" (87%), "offering products that are good for the family" (86%), "offering food products that taste good" (81%) and "offering home products that work well" (81%). <brandweek.com>


UK Fashion Industry Calls for Clarity on Party Policies as Election Approaches - Fashion industry leaders have called for the three main political parties to clarify their plans to stabilise the economy and consumer confidence and give transparent information on issues such as National Insurance (NI), VAT and business rates ahead of the general election on May 6. <drapersonline.com>


India: Government Cancels Yarn Export Duty Concessions - Indian government has withdrawn the 7.61% concession of cotton yarn exports under the Duty Entitlement Pass Book (DEPB) scheme to control prices of textile products.  Knitwear exporters have been protesting against the unusual hike in cotton yarn prices, which have increased by nearly 30% in the last few months, while garment exporters have been badly hit by the slowdown in global markets. <fashionnetasia.com>


R3: Keep the Beemer, Risk the House - cotton


EU: Euro-Zone Retail Dipped in February - Retail sales in the 16 countries of the Euro-Zone fell once again in February, indicating that consumer spending will remain weak due to a slow economic recovery, according to the European Union's statistics agency Eurostat. The retail sales figure dropped by 0.6% from the previous month unexpectedly. That was the second straight drop this year and undermines hopes that the eurozone economy is poised for a solid return to growth in the first quarter of 2010 after stagnating in the last three months of 2009. <fashionnetasia.com>


China Signs Free Trade with Costa Rica - China has signed a free trade agreement (FTA) with Costa Rica, paving the way to lift almost all tariffs on Chinese textiles, chemicals and machinery to the Central American nation. When the agreement takes effect, 90% of commodities will be tariff free within a few years. China is Costa Rica's second biggest commercial partner after the United States, while Costa Rica is the Asian nation's ninth largest trade partner in Latin America. <fashionnetasia.com>


Seven & I, Fast Retailing Rise After Forecasting Higher Earnings on Demand - Seven & I Holdings Co. and Fast Retailing Co., Japan’s biggest retailers by market value, advanced in Tokyo trading after forecasting higher earnings amid signs consumer spending is recovering.  <bloomberg.com/news>


J. Crew to introduce Warehouse Collaboration - J. Crew will have something to offer the most diehard of denim aficionados next month. The retailer has collaborated with Japanese selvedge denim label Warehouse on an exclusive men’s style that will sell for $300 on its Web site, and at its Men’s Shop and Liquor Store locations here. The style’s name, Lot 484 jean by Warehouse for J. Crew, is a nod to the address of the Men’s Shop at 484 Broadway. <wwd.com/markets-news>


The iPad Impact - With its sleek design and game-changing visual capabilities, Apple’s newly released iPad could be just what the fashion industry always wanted. “The screen real estate is perfect for what we do,” said Jag Bath, VP of product management for Gilt Groupe, which launched an iPad app last week, in the days leading up to the device’s debut on April 3. Other companies seem to be enjoying the benefits as well. Both eBay and Gap launched apps earlier this month, as did several fashion magazines, including Interview and GQ. <wwd.com/footwear-news>


R3: Keep the Beemer, Risk the House - ipad


Timberland Is a Little Greener - The Timberland Company announced that it has achieved a significant reduction of greenhouse gas emissions. The company successfully reduced its emissions by 36% in 2009 over its 2006 baseline coming from Timberland owned and operated facilities and employee air travel. Timberland is on pace to reach its goal of a 50% emissions reduction by the end of 2010. <sportsonesource.com>


Cotton Inc. Unveils New Ads - Cotton Incorporated is looking to link consumers’ associations to cotton with high fashion in the next evolution of its “The Fabric of My Life” campaign. The original Fabric of Our Lives campaign from the Nineties was successful in getting consumers to recognize how cotton was a crucial and desirable fiber in everything from socks to jeans to towels. For the last several years, the message has shifted to presenting cotton as a fiber equally suited to designer apparel. <wwd.com/markets-news>


The S&P 500 finished higher on Thursday after selling off in early trading.  The market can go down but it will not stay down.  Each move down is followed by a rebound, and each move higher is a BETA shift up.  The best performing sectors yesterday were the high beta XLY, XLE and XLF.  The underperformers yesterday were XLU, XLV and XLP. On the MACRO front, U.S. stocks rose for the seventh time in nine days as strong retails sales more than offset any fears triggered by concern over Greece’s debt crisis.


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”.


As head into next week’s earning season, the corporate calendar looks to be a bright spot, as most retailers reported stronger-than-expected March same-store sales. The retail sector extended its outperformance vs. the broader market on the news. The S&P retail Index advanced 1.3% yesterday and is up 3.2% for the past week.  The Thomson Reuters same-store sales index rose 9.1% in March vs. final consensus expectations for a 6.3% gain, marking the seventh consecutive positive reading. The Street Account beat/miss ratio improved to 83%/17% in March from 79%/21% in February and marked only the second 80+% reading since they began tracking the figures closely nearly five years ago.


Yesterday, the Financials (XLF) was a big driver to the upside in the market, the banking group leading the way; the BKX was up 1.0% on the day. 


The increased M&A speculation in the airline industry offered additional support for market stocks yesterday and the Transports +1.4% outperformed the broader market.  The bulk of the upside leadership came from the airlines, with the XAL +3.3%. The group was underpinned by renewed consolidation speculation following reports that UAL Corp. and Us Airways are in advanced merger talks.


Technology (XLK) was unable to keep pace, just slighting underperforming the S&P 500.  Storage-related names were among the worst performers as CML bombed after guiding Q1 revenue below the Street.  The Semis also took it on the chin with the SOX declining 1.4%.   


Healthcare (XLV) can’t get out of its own way, declining again for the fourth straight day.  Managed care was a laggard again today with the HMO down 1% yesterday and down 2.2% over the past week.  The pharmacy group also struggled with the IHE down 0.4% yesterday.


In early trading, crude oil is looking lower for a second day in New York after a report showed U.S. crude inventories increased more than forecasted last week. 


In early trading, gold is looking to decline on the back of a stronger dollar.


In early trading, copper fell in London for a second day, extending a decline from a 20-month high, on concern that recent advances were not supported by demand from China. 


In early trading, equity futures are trading above fair value in a continuation of yesterday’s late-session recovery which saw a reversal from earlier losses, which were helped by stronger-than-expected retail sales and in reaction to comments from ECB President Trichet. Today's macro agenda is thin with only Wholesale Inventories scheduled for 10:00 ET.  As we look at today’s set up the range for the S&P 500 is 16 points or 0.7% (1,178) downside and 0.6% (1,194) upside. 


Howard Penney

Managing Director

Reality's Illusions

“Reality is merely an illusion, albeit a very persistent one.”

-Albert Einstein


Today’s reality is that American and European governments are Keynesian. That is, they believe that government spending is the answer to growth, and that government’s heavy hand doesn’t perpetuate the unemployment they whine about or the inflation that they aren’t allowed to talk about.


Retiring Fed Head, Donald Kohn, made comments in San Francisco last night that summarize the illusion that he needs to create: “I expect unemployment to come down only slowly from its current elevated level”… and… “inflation will remain low for a while.”


Now, let’s set aside that Kohn has been at the Fed forever and missed seeing any of this mess coming since he joined the Fed’s Board of Governors in 2002, and consider the reality of this two-factor Fear Mongering Fed Model that he and his always dovish friends, Janet Yellen and Bill Dudley, have recently echoed:

  1. Unemployment: At +9.7%, it's high. Anyone with an internet connection gets that. It’s also the most lagging economic indicator we have, and it’s rolling over sequentially versus its peak where some at the Fed were forecasting the Great Depression.
  2. Inflation: Headline inflation (CPI) rolled over in February on a month-over-month basis to +2.1% year-over-year (yes, even the calculation that they have changed 9x since '96 to numb it down is up), and is setting up to shoot up again, sequentially, in March.

Yes, there are forecasts embedded in my considerations. This is what people who manage risk proactively call “making a call” before something happens and you can hold me accountable to it (March CPI will be reported next Wednesday). Reality’s Illusion is that Washington group-thinkers still thinks that “core” inflation is benign, because the Fed model is a reactive one that’s based on yesterday as opposed to today and tomorrow.


I talked to the Chairman of MFS and author of “Too Big To Save”, Bob Pozen, about this last night on Bloomberg TV. I asked Bob if the real problem with the Fed and the said leadership of American finance is whether or not the Fed operates with an ideology rather than a proactive risk management process. He said yes. Coming from a leader who is marked-to-market every day by his clients, the answer here was not surprising.


I understand that 2008 seems like forever ago, but the realities of what created this crisis are not illusions. In 2008, on the topic of ideology versus empirical process, Rep. Henry Waxman asked Alan Greenspan, “do you feel that your ideology pushed you to make decisions that you wish you had not made?”


Greenspan: “Well, remember that what an ideology is, is a conceptual framework with the way people deal with reality. Everyone has one. You have to – to exist, you need an ideology. The question is whether it is accurate or not. And what I am saying to you is that I found a flaw.”


So there you have it Mr. Bernanke and Mr. Kohn. What have you learned from the crisis and why are we still managing go-forward market risks based on a failed ideology? Markets change and so do facts; what do you do Sirs?


The reality is that Glenn Stevens at the Reserve Bank of Australia, Albert Einstein, and Darwin for that matter, would never sign off on individuals garnering so much political power that they allow their ideologies as to a way something “should” work override the data. It’s lunacy.


A persistent illusion that Keynesian economics is the written gospel of God is what brought us the inflation of the 1970s, and for whatever reason now all the Keynesians out there think “it’s different this time” because they can print moneys from the heavens. Food in India may indeed by falling from Ben’s helicopters right now, but its +18% more expensive than it was last year!


While the US Federal Reserve and European Central Bank mark their ideologies to their political models, the inflation data continues to roll in. And yes, inflation is marked-to-market.


Anyone who needs to put gas in their car or food in their children’s mouths around this good world get that, but now were even seeing inflation spikes on conflicted government data.


While I am still forecasting here, I’m also staring down the latest data on my sheets from this morning’s global macro run:

  1. British Producer Prices (input prices, as in the price of things someone needs to pay to make something they want to sell) were up +10.1% year-over-year for the month of March. That was the highest reading since May of 2008, when Bernanke didn’t think $150/oil was inflationary.
  2. Oil prices are trading in a Bullish Formation (bullish across all 3 of our risk management durations: TRADE, TREND, and TAIL) at $86.16; that’s up +12-21% from the WTIC oil price that was imputed into the February CPI and PPI reports don’t forget.
  3. The US Dollar Index continues to make a series of higher-highs and higher-lows at the same time as US Treasury yields continue to make a series of higher-highs and higher-lows.

Suggesting that the both Mr. Bond Market and Mr. Currency Market have this wrong alongside Dr. Copper (who is trading up at $3.61/lbs this morning; up +26% from the February lows that the Fed is straight-lining as their “benign inflation” assumption), and that the Fed’s flawed ideology is right, is something for analysts far braver than I to accept as an illusion that will be this debt laden world’s long term reality.


My immediate term support and resistance lines for the SP500 are now 1178 and 1194, respectively.


Best of luck out there today,



Reality's Illusions - Greenspan


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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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