CAKE reported stronger than expected earnings of $0.31 per share versus the street’s $0.25 per share estimate and management’s guidance of $0.23-$0.25 per share.  Same-store sales turned positive in the quarter at both Cheesecake Factory and the Grand Lux Café with blended same-store sales coming in +2.8% (better than management’s guidance of flat to +1%, including a 1% expected benefit from increased gift card redemptions).  This better comparable sales result implies a 370 bp acceleration in sequential 2-year average trends from the prior quarter, which the company attributed to continued improvements in traffic trends.  Operating margin improved about 250 bps YOY during the quarter.


Management does not provide guidance until the conference call, but based on these better than expected results, it would seem that the current full-year outlook for $1.16-$1.24 per share in earnings and -1% to flat same-store sales growth is going higher.  Based on the 1Q10 earnings beat, we would expect FY10 EPS guidance to move to at least $1.22-$1.30 (the street is already at $1.27).


The stock is initially indicating lower….Remember when less bad was good.  Based on 1Q10 earnings to date, the new question is how good is good?



Howard Penney

Managing Director


Keith just shorted CMG in the portfolio.  Read on for his quantitative levels and a note outlining my thoughts on the name.


The chart below shows Keith's quantitative view on CMG at its closing price. 




Chipotle joined the party after the close yesterday.  The outlook for the company is strong and price action is reflecting that.  Longer term, there are many factors to consider.


Yesterday’s earnings were, as is the standard this quarter, above expectations for Chipotle.  The comparable sales increase for 1Q of +4.3% was mainly driven by traffic; there has been no price taken in the past twelve months.  Looking at the top-line, the outlook is strong.  On a year-over-year basis, the next few quarters should not be difficult for sales and management said as much on the earnings call, raising their guidance for comparable store sales for the year, “based on improved traffic trends, we’re raising our comp guidance from flat to an expected comp increase of mid single-digits for the full year.”




What will really be interesting will be how margins play out going forward.  Specifically, regarding commodity inflation, management stated that inflation outlook for the year is relatively benign and the company only has a few small items contracted for the remainder of the year such as rice, soy oil, corn, and tortillas.  Historically the cheese has been locked in but, in line with the company’s high standards for ingredients, it is now moving supply to more pasture-raised dairy.   The spot market in cheese was also, to management, “more attractive”.  Judging by data from the Bureau of Labor Statistics, the outlook for PPI index for cheese is less-than-benign.  At current levels, year-over-year inflation in PPI for “Natural, processed, and imitation cheese” would be 7.4% year-over-year, on average, over the next six months.  The move by CMG to buy on the spot market increases the potential for quarter-to-quarter volatility. 


In terms of the interaction between grain prices and margins, the chart below shows Restaurant Operating Margins, the CRB Grains Futures Sub-Index, and the CRB Livestock Futures Sub Index.  It is clear that the deflationary period of late 2008 and 2009 has helped Chipotle to achieve a higher level of operating margin.  In the past quarter, the uptick in sales clearly aided leverage over fixed costs.  Whether the company can prudently manage costs in the inflationary periods that we believe are ahead, will be a highly pertinent factor in the intermediate term.




In terms of Return on Incremental Invested Capital, Chipotle is at elevated levels.  As they continue into new markets, geographies, and different types of stores, it will also be important to monitor this metric.








Proud that during the toughest times, company has maintained standards and service.  As the economy improves, more people visiting Chipotle

  • First European restaurant is opening in London
  • Found good local ingredients
  • Taking a fresh look at many aspects of the brand

New advertising

  • Pointing out where CMG’s food comes from
  • High quality, building awareness will build loyalty

One area of focus is the team

  • High performing people culture
    • Difficult to articulate but clear that the culture is a factor in driving sales, margins, earnings
    • Hiring elite managers and providing incentives for managers to perform and reach “restauranteur” level
    • Helping managers understand their role in the overall vision in changing the way people think about fast food
    • Special people culture and people are helping the company achieve the goal



New units

  • 700k average development cost for 5 new untis this quarter
  • They are performing well initially
  • On par with traditional new restaurants despite lower opening and investment costs
  • New “A” model units have appeal for CMG
    • Same experience
    • Lower costs

“A” model

  • Providing the best customer experience possible
  • Growing CMG responsibly
  • Increasing shareholder value

1Q results

  • Tough consumer environment is improving somewhat
  • Efforts have paid off, new and existing customers coming back more frequently
  • Unemployment still high, cautious for 2010
  • We won’t stray from strategy
    • People
    • Quality
    • Growing
    • Did all this while strengthening business model


Highlights for quarter

  • Revenue increased 15.6% to $409.7m
  • Diluted EPS of $1.19 (vs $0.96 est)
  • Comp store sales increased 4.3%
  • Restaurant level operating margin was 26.1%
    • Increase of 260 bps
    • Labor efficiencies and comps drove margin expansion
    • Food costs dropped 80 bps
      • Rice, avocados, cheese
      • Net income was $37.8 million, increase of 49.1%
      • Diluted earnings per share was $1.19, increase of 52.6%
      • Other operating costs decreased
        • Lower promotional and insurance expenses
        • G&A declined due in part to increase in stock based comp
        • Opening 20 new restaurants in quarter



  • Raising guidance for comps from flat to up mid-single digit
  • 2H food inflation
    • Increased commodity costs and consumer demand
    • Little or no labor leverage going further
    • Marketing at 1.8% for the full year
    • No G&A leverage for the rest of 2010
      • Holding conference…22m for 2010
      • Opening 120-130 new units in 2010. 25% of those will be “A” models
      • Better positioned than ever to add to shareholder value




Q: Store productivity …thoughput in busier markets…can you update us on throughput?


A: We took our eye off this ball over the past couple of years.  Throughput fell off coming into the recession.  TCs were lower. Especially at peak hours, less business customers at lunch.  They fell more than they should have, though.  Over the past couple of years we’ve scheduled better, labor-wise. 



Q: Can you talk about comps through quarter and this present quarter so far?


A: In February we were starting to see momentum building in traffic but weather hit that trend in traffic turning.  We’re cautious with guidance because this is a new found trend, unemployment is still high, and consumer confidence has improved but not that much.  What we saw in March has continued into April.

Once weather is bad we get a couple of over performance for a couple of days when it clears up so we don’t think weather was overly material.



Q: Will commodity inflation in 2H make you consider taking pricing?


A: Seems manageable based on what we know today.  Not anticipating taking any price. Seeing food inflation in low single digit range.  For the year, wouldn’t expect menu price increases.  If things change, we can, but won’t rush.



Q: Growth outlook?


A: in terms of development outlook, two years ago, 70% of restaurants were new developments.  Last year it fell off and now it’s around a third.  No pick up in new developments yet. There is a substantial lead time.  The “A” model strategy tends to go into tier 2 locations and existing real estate.  We’re feeling positive about the “A” model strategy.  Looking to find as many good locations as we can in 2011 and beyond.  This year after the 3Q release we’ll have more concrete details on 2011 unit growth.



Q: Anything in human resources that would make you hesitate in the growth? Or is it real estate?


A: HR is not a problem.  We have a good ratio of leaders to stores. Restauranteur growth has been steady. 



Q: What kind of competition are you seeing in premium convenient segment and where are you taking market from?


A: It seems like all the news has been positive recently. Seems like consumer is out spending again.  We did the best we could while consumers were more timid, and made sure they had the best experience possible. 



Q: London team set up?


A: It will be consistent with how it was done in Toronto.  Restaurant employees are the only people working there…in London there will be a restauranteur opening the restaurant.  There will be two other restauranteurs at the same level that will help with sourcing, hiring, training.  That’s unusual but given the success of Toronto, we feel that it is the way forward in London.  Germany and France are on longer term radar screen.  Sending more talent to London initially.  We think it will be easier to find natural food in Europe – there is no RBGH diary in Europe, whereas in the US we have to look for food with integrity. 


Sourcing…everything will be cooked from scratch in that restaurant.  Going to be able to buy from small suppliers if needed. 


The design in London was approached as a chance to do something new – quite like the new ones in NYC. 



Q: Clarify marking spend and let us know how broad it will be. How many markets will use radio?


A: Rolling out in 30 major markets.  About half of those will have a strong campaign.  Marking came in at 1.1% for quarter because new marketing campaign is being rolled out now.  Should see marketing budget at 1.75% for year.  Marketing now is radio, billboards…radio just started so don’t know what the effect is as yet.  Marketing is designed to highlight food with integrity but making message clearer to raise awareness of food with awareness and taste.



Q: Kids’ menu?


A: rolled out in some markets…plan on rolling out the rest of the country throughout the year. June 1st will see another tranche.  The teams need to be trained adequately.  2% to 3% of transactions are for kids in the markets so far, without any marketing so far, it has ticked up.  Kids menu is priced slightly higher.



Q: Is some of that business incremental?


A: That’s tricky to see right now.



Q: What is your read on restaurant margin differential between “A” model and traditional?


A: It’s really early, we don’t know what the difference would be.  If you’re talking about comparable volume, they have opened at typical volume.  IF that continues, “A” models will be higher for sure.  Too early to tell at this point.  Sometime next year we’ll being to open “A” models in new and developing markets.  We don’t like new market margins for traditional units.  We anticipate “A” models performing better in this respect in new and developing markets.



Q: How do we stand on development of the new units? Backend weighted? Can you tell us where the 25% of “A” models in existing markets will be going in?


A: 120 to 130 this year. Heavily weighted towards 2H.  “A” models will be opening throughout that time. 4 next quarter and 12 in the next, 8 in the next, perhaps.   They’re going into proven markets…where we’ve been for a long time.  Most markets are proven markets.  Denver, DC, Dallas, Houston, Chicago, Phoenix…reduced risk of not having success.



Q: Marketing expense…1.8% of sales is for full year…is that evenly going to be expense now for quarters or did 2Q have a few weeks where it wasn’t jacked up?


A: Can’t commit to it being even for the remainder. Remaining flexible.  If it were even it would be around 2%. 



Q: Average Check?


A: Check was stable.  It was perhaps slightly up.  Nothing material.  Driven by the group size being a little bigger. More group sales, more fax orders, more online. Generally higher check. 



Q: Marketing…a year ago the new menu test…is any of the new advertising spend aimed towards educating the guest or is that for the restauranteurs and employees to do now?


A: There are aspects we like, the kids meal is a success in markets so far.  Trying to organize the markets in different ways. 



Q: Commodity – what was deflation in 1Q? What items are you seeing moving up? What do you have contracted for the year?


A: 80 bps deflation, net. Rice contracted through three quarters, soy, corn, tortillas for full year. That’s it. Not able to lock in much of ingredients. Cheese has been historically locked but we’re changing that, moving towards pasture raised dairy. Spot market was more attractive for cheese also.



Q: Are the stores you opening in the downturn ramping? Comment geographically?


A: comp is broadbased. Only spot that was lagging a bit was Texas, who entered the recession late.  Also returning to the comp trends that we saw before recession – new restaurants are comping well and older markets are positive. Comp guidance assumes no menu price increase.



Howard Penney

Managing Director


Starbucks continues to surprise to the upside.  The rate of improvement will slow, but margin growth should continue to materialize from here.


Yesterday, MCD reported stronger-than-expected 1Q10 earnings and the best quarterly U.S. restaurant level margin in nearly 16 years.  Following those results, I posted MCD’s stock chart, which showed it trading at an all-time high and highlighted that there seems to be some investor concern about where the stock and margins go from here.  After the close yesterday, SBUX followed up with another quarter of crazy good numbers.  With SBUX’s share price more than doubling in the last year alone and the company reporting record 2Q operating margins in both the U.S. and internationally, my first inclination was to ask the same question about SBUX:  where to from here?  Call me gullible, but I seem to believe management when it says the “best days are ahead” and that the U.S. business “has not seen its peak.”  Apparently, I am not alone as the stock is up 6% today, in contrast to MCD’s muted response yesterday.  To be clear, SBUX’s rate of improvement will have to slow (full disclosure: I feared this two quarters ago), but I am now convinced margin growth will continue to materialize.


SBUX is not MCD…

To start, SBUX is not trading at an all-time high; though it has had an impressive 275% move higher since its recent November 2008 low.  MCD is consistent.  I was concerned with the company’s decision to add the McCafe beverage platform because I feared the company would lose sight of its core business.  With March same-store sales up 4.2% in the U.S., the company seems to be charging forward with few issues.  The company will continue to refine its business, allowing it to better execute, but I question what the next layer of growth will be for MCD, particularly in the U.S.  I do not have the same concerns for SBUX. 








SBUX seems to have a lot of momentum right now when it comes to potential sales layers.  Additionally, these new avenues of growth will leverage the company’s existing retail store base but also extend beyond it. 


Within the retail store base:

  • Company transformation – the back-to-basics strategy has enabled the company to improve its customer satisfaction metrics, which has been directly correlated to the company’s improved traffic – Sharing best practices globally
  • My Starbuck Rewards – the recently launched rewards program is driving increased frequency with card reloads up 45% YOY in the second quarter
  • U.S. VIA – management would not break out VIA’s contribution to the 7% same-store sales growth in the U.S., but did say that VIA was an important driver of the 5% increase in average check – VIA is now expected to be slightly positive to profit in FY10 (had said profit neutral)
  • International VIA – the product has been rolled out in Canada, the U.K. and most recently, Japan and has exceed management expectations in each segment.  VIA will be launched in additional markets throughout the year
  • Remodels – over the next 12-18 months, SBUX will begin an “aggressive phase of existing store remodels and refurbishments in the U.S”


Within the CPG channel:

  • Management continues to believe that both VIA and SBC have the potential to become billion dollar brands for SBUX
  • VIA – the brand’s distribution will be greatly increased to more than 30,000 points of distribution by the end of 3Q10 supported by a nationwide U.S. advertising and marketing campaign, both print and broadcast
  • Regarding VIA, management looks “forward to offering new form factors and other innovations in the very near term for all things VIA.”  Management was fairly cryptic about what those other form factors could be but it was clear that it is heavily focused on the at-home market.  Specifically, management stated, “We’re certainly well aware as the leading specialty coffee brand of what’s going on around single serve and specifically at-home and have had a watchful eye on what Green Mountain and Keurig have been able to do and they’ve done a fantastic job. We’re looking at this in two ways. One, we think that VIA has an interesting opportunity to position itself in a way against what Keurig is doing at home because there’s no waste, there’s no cost of equipment and you can take VIA anywhere. And the quality of the coffee is significantly better and we’re going to have multiple SKUs and form factors that will create a portfolio of product. However, I think the market needs to stay tuned that we have every intention of understanding what single serve can be. And we’re not going to sit back and just watch Green Mountain and Keurig march their way into 20 to 30% household penetration without Starbucks not doing anything. So just stay tuned.”
  • Increasing CPG capabilities globally – recently entered the RTD coffee category in Europe and launched Starbucks Double Shot in the U.K. grocery and convenience channels
  • SBC – by the end of the year, the company will have expanded SBC points of distribution to 30,000 from 3,000


SBUX’s ability to identify new sales layers has been impressive, but like anything else, execution will be important.  Focusing on the core business has been a significant driver of the company’s recent success in the U.S. and it will be necessary to monitor whether SBUX can maintain this focus while executing these new growth initiatives.


Near-term issues:  As I stated earlier, SBUX’s rate of improvement will slow in the back half of the year as the company will begin to lap more difficult same-store sales and margin comparison from last year.  Based on the company’s full-year margin guidance, margins will continue to improve in the back half of the year but at a moderating pace from 1H10.  Keep in mind that margins in the third quarter will be further pressured by the increased investment behind the VIA launch , which will add an incremental $0.05 per share of marketing expense in 2H10 versus 2H09, which will fall primarily in the third quarter.  Management stated that 4Q margin should be higher than the 3Q level. 


As management indicated on its call yesterday, same-store sales in the U.S. improved through 2Q10 sequentially on a 1-year basis for five quarters and on a 2-year basis for four quarters.  Although I am expecting two-year average trends to continue to get better, it will be a lot more difficult for the company to maintain its trend of posting sequentially better numbers on a 1-year basis in the next two quarters.  I was surprised that the company was able to post a sequentially better number on a 1-year basis during the second quarter, but investors cannot count on too many more of these surprises.  To that end, management’s full-year mid-single-digit comparable store sales growth does not assume that same-store sales come in better than 7% in the back half of the year.


We included Keith McCullough’s risk management TRADE (immediate) and TREND (intermediate) levels in the chart below:




Howard Penney

Managing Director

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This indispensable trading tool is based on a risk management signaling process Hedgeye CEO Keith McCullough developed during his years as a hedge fund manager and continues to refine. Nearly every trading day, you’ll receive Keith’s latest signals - buy, sell, short or cover.


PNK should beat the consensus Q1 estimate and 2010 probably needs to go higher. The stock has had a great run but management seems to be making all the right moves.



Q1 should look much better than Q4’s kitchen sink.  We have our own theories on why Q4 was so ugly but that’s yesterday’s news.  Top line in Q1 will not look strong but margins should be much improved.  This is not exactly ground breaking commentary, however.  The stock is up 66% since we highlighted the potentially strong quarter and positive catalysts in our 3/1/10 note, “PNK: Is the Worst Over?”  However, 2010 consensus EBITDA of $179 million looks low, so there still might be some gas in the tank.


For Q1, we are projecting $45.8 million of EBITDA, about $5 million ahead of the Street.  We think the main risk to our number will be if the company wants to be conservative with a new CEO at the helm.  For the year, we are at $188 million versus the Street at $179 million.  On the conference call, look for some important commentary on the cost side.  Here is our analysis:


How much can PNK really save?

  • In 2009, PNK spent $12.1MM maintaining the AC land
    • “In late 2008, we decided to suspend substantially all development activities in Atlantic City indefinitely.  The continuing pre-opening and development costs include property taxes and other costs associated with ownership of the land.” 
  • Getting rid of the airplane and consolidating the 3 offices will save them another $2.5MM/year 
  • They renegotiated their insurance policy – saving another $1MM 
  • Marketing expenses may be the largest saving for PNK, particularly in Louisiana – another benefit from jettisoning Dan Lee 

If we are right on the cost savings (without factoring in marketing cost reductions), PNK would have up to $15 million in potential cost savings this year plus marketing reductions.  We are not sure if the AC costs will be shown in discontinued operations until they sell the property.  If you add $22 millilon in net River City contribution (net of Lumiere Place cannibalization) plus the cost savings to the $173 million in EBITDA from last year, it's easy to see why we think the Street's 2010 estimate of $179 million looks conservative to us, even with degredation at the other properties.



Q2 2010 Themes: Sovereign Debt Dichotomy

As we look at the macroeconomic environment ahead what’s certain is that investor fears associated with sovereign debt default (globally) will persist. Greece, a poster child of years of government budget mismanagement and excesses, has been the obsession of the media, yet even countries with historically top credit ratings (US, UK, and Japan) are beginning to feel the spotlight as they too are among the proverbial debt bloated “PIIGS”. We’d point you to Reinhart and Rogoff’s book “This Time is Different”, for a thorough analysis of eight centuries of global sovereign default, and note that the current cycle of sovereign default is just ramping up, and we believe will last far longer than most expect. What’s clear is that certain countries are “sitting” better than others from a fiscal balance sheet perspective, countries we’d also expect to outperform their deeper debt-laden peers as we look out to 2010, a theme we’ve named the Sovereign Debt Dichotomy.


Q2 2010 Themes: Sovereign Debt Dichotomy - m1


With this dichotomy to play out across asset classes, in summation we’ve positioned ourselves in our model portfolio to take advantage of owning High Grade versus High Yield. We’ve represented this conviction through owning low beta sectors like Healthcare (XLV) to countries with more fiscally conservative balance sheets like Germany (EWG). Conversely we’ve shorted Municipal Bonds (MUB) and High Yield Corporate Bonds (HYG) - to take advantage of yields pushing higher as obligations mount- to shorting countries like Spain (EWP) with looming sovereign debt issues and glaring negative fundamentals that could stretch over the TAIL (3 years or less) duration. We’ve also seen carry-over to a weakness in the Euro versus the USD, which we’ve taken advantage of by shorting the Euro via the etf FXE.


As an example of our Sovereign Debt Dichotomy theme and the divergence of economic performance across countries, below we lay out our case for investing long in Germany and short in Spain.





Position: we initiated a long position in Germany via the etf EWG in our model portfolio on 4/7/10.


The anchor of our bullish case for Germany remains the fiscal conservatism of German Chancellor Angela Merkel and her government, and improving trends across fundamentals, especially exports. 



Fiscal Conservatism


Germany’s budget deficit stands at 3.5% of GDP, a clear differentiating factor compared to the low double digit budget deficit figures witnessed in countries like Greece, Spain, Ireland, and the UK (chart). We see this as an extreme advantage, especially as the cost of capital looks to rise for European states over the medium term. 


Q2 2010 Themes: Sovereign Debt Dichotomy - m2


A recent example of Germany’s fiscal conservatism can be seen in Merkel’s initial decision to support a unilateral IMF-led campaign to aid Greece. Although the position was heavily chastised by the European community, it was really a pragmatic decision born out of her fiscally conservatism:  not only did she not want to reach into German coffers to fund Greece’s debts, but also by suggesting that Greece continue to work to clean up its own “house” (budget deficit) before monies were placed on the table, Merkel attempted to not diminish the incentive of the Greek government to issue austerity measures to shave its imbalances. 


As we now know, Europe has agreed to provide a three year €30 Billion loan to Greece at favorable rates (estimated at 5% or 200bps below current market prices for Greek debt) and the IMF guaranteed to kicked in an additional €15 Billion should Greece need (or request) the loan. In our opinion, we believe the loan is imminent.  In any case, Germany’s position on Greece—which differed from her European colleagues such as French President Sarkozy and ECB President Trichet—is representative of a cultural aversion to debt, from personal consumption at the individual level up to spending at the governmental level. We believe it is this conservatism which will benefit the country’s growth prospects over this year and beyond.


First and foremost, the German economy offers competitive growth and safety.  And as Germany differentiates itself from the sovereign debt crisis brewing across certain states in Europe, and globally, we believe Germany is in a favorable position as it will not have to sacrifice growth to correct a leveraged balance sheet (or default), as the credit market remains relatively stable despite Germany’s pending contribution to Greece. Below we offer some of the fundamentals we track that confirm an improving economic trend that we expect to continue.



Fundamental Strength


  • Exports rose +5.1% in February month-over-month. The chart below shows an improving trend in exports, up +9.4% in February Y/Y, with favorable comparisons for the months ahead as global demand melts higher. Additionally, carry-over weakness in the Euro versus the USD should be a net positive for the export-led economy. We guide to trading the Euro between $1.33 - $1.35 with TREND (3 months or more) resistance at $1.39 and TAIL (3 years or less) resistance at $1.42.

Q2 2010 Themes: Sovereign Debt Dichotomy - m3


  • German Factory Orders rose +24.5% in Feb. Y/Y; while certainly a moonshot of a number, we note the comparison was off the trough a year earlier of -38.0%. January also saw a sizable annual improvement (+20.6%) versus -36.8% in Feb. ‘09.  Orders are confirming an intermediate positive trend.
  • A stable inflationary environment for consumers and producers continues with CPI at +1.1% in Mar. Y/Y and PPI at -1.5% in Mar. Y/Y. Additionally German Manufacturing and Services PMI surveys shows improvement over recent months.
  • Unemployment currently stands at 8.0% and the unemployment rate has held steady for the last months.  Despite the persistent fear of rising unemployment that we’re seeing across many European countries, the stability in the number has helped to boost consumer and business confidence; credit should be given to the successes of the short-term work agreements (Kurzarbeit) subsidized by Merkel’s government.

Q2 2010 Themes: Sovereign Debt Dichotomy - m4





Position: we initiated a short position in Spain via the etf EWP on 4/9/10 and covered it on 4/21 for a trade. Our negative bias continues.


In contrast to Germany we see significant downside risk for Spain over the medium to longer term, including such structural and fundamental issues as: 1.) the aftermath of the housing bubble and high unemployment, 2.) the banking situation, especially its savings and loan banks, or Cajas, and 3.) its debt payment schedule ahead.



Housing: From Boom to Bust


Our bearish outlook on Spain is heavily underpinned by the structural weakness in the housing market and the rise in the country’s unemployment rate. With the bursting of a decade-long housing bubble beginning in 2007, Spain has lost a main driver of the country’s previous economic growth and sent many of the same people that were employed by the construction industry to fuel the housing boom into unemployment. At just shy of 20%, Spain’s unemployment rate alone is astronomical compared to the Eurozone average of 10%. The carry-over effects of a high unemployment rate (more generally) have and will lead to reduced government revenue and erosion of personal consumption, coupled with the severe wealth destruction caused by the depreciation of housing prices, are all factors we believe will provide a headwind to economic growth.


A recent report from Morgan Stanley suggests that housing prices have declined by 11% from their peak in 1Q08 and the construction sector is down 32% from its peak in 4Q07. Interestingly, the report cites that house prices fell some 20% peak to trough in the UK and -25% in Ireland, inferring that downside potential of another 10% from here remains, an assessment that we’d largely agree with. Further, it’s clear that inventory of unsold homes remains extraordinarily high.  MS tags the number of unsold homes at 1.5 million (or half the number of homes built over the last 5 years) and Banco Santander notes that repossessed properties are currently selling at 20%- to-30% discount to market prices.


Q2 2010 Themes: Sovereign Debt Dichotomy - m5


While an environment of low interest rates has push down mortgage rates and helped to alleviate the collapse in the housing market, and a weaker Euro (for now) has favored exports, we believe further downward pressure remains as Spain works through its high unemployment and negative drag of housing prices. 



Banks: Hostage to the Cajas


The cajas, or the nearly 50 savings and loan banks across Spain, remain a critical puzzle piece to the future direction of Spain. You’ll note that the cajas, which control about half the deposits and loans in the Spanish banking system, were the main lenders to real-estate developers and the construction industry, contributing some €175 Billion to fuel the housing boom. Therefore with the pop of the bubble, the mainly municipally controlled cajas saw their bad loans rise at an unprecedented speed and level.


Now the Bank of Spain is pushing through measures to clean up these bad loans, a process in which some cajas will be recapitalized, merged, or allowed to fail.  Morgan Stanley suggested that the cajas need “€43 Billion in new capital to plug the hole in their balance sheets from a quickly growing pool of defaults.” Further MS estimates that €76 Billion will be needed over the next 3 years.


If we take these numbers as in the area code of capital required, Spain will have to issue more debt this year. Already Spain has sold €28.2 Billion in bonds this year, one-third of its planned issuance according to the government. While Spain did set up a bailout fund last June, known as the Fund for Orderly Bank Restructuring (FROB), to prop up the banking sector, the FROB with reserves of €12 billion is set to expire in June when the restructuring of the banks was meant to be completed by the government. It’s worth note however, that due to the strict conditions set on the FROB by the EU, there have only been 11 mergers and only 1 caja has drawn on the FROB.


So the limitations of the FROB and the delay from the Spanish government to restructure its banks and cajas are a negative; the road ahead, which could possibly include working with the EU for assistance, is unclear and therefore will likely be interpreted negatively by the market. In any case, the success of the government’s bond issuances to fund the banks (and budget deficit) this year will be crucial. As debt obligations mount, and more attention is cast on the other PIIGS, we could foresee bond yields moving higher. (Note in the chart below that yields spiked for most of the PIIGS in January and February as uncertainty over Greece escalated).    


Considering the headwinds for Spain’s financial industry, we’re comfortable on the short side of Spain via EWP, an etf composed 40% of financials. Of total holdings, 22% is composed of Banco Santander and 6% in Banco Bilbao Vizcaya Argenta, Spain’s largest and second largest banks, respectively.


Q2 2010 Themes: Sovereign Debt Dichotomy - m6



Budget: Delaying Reality


While Spain’s government debt to GDP ratio of 55% looks healthy compared to Greece’s at over 100%, Spain’s hefty Federal budget deficit remains an outstanding risk.  At 11.2% of GDP as of 2009, the government has said it plans to reduce its budget deficit to 9.5% this year and is on track to meet demands by the European Commission to reduce the deficit to 3% by 2013, a level stipulated for all members of the Eurozone according to the European Growth and Stability Pact.


While Spain is not an anomaly in violating the 3% threshold this year and last, it stands only in the company of Greece, Ireland, and the UK in reaching double digit budget deficit numbers. To reduce the deficit, Spain has called for belt tightening in the form of an increase to the value added tax of 200bps to 18% in July, the end to its €400 tax rebate to low-income households, and higher tax rates to dividend, interest and capital gains that began this year.


Still, the risk remains that while these measures are positive, Spain does not plan to issue its Austerity Package (that aims at cutting spending by more than 2.5% of GDP) until next year, which may be too late. Further, in the near term similar fears as those associated with Greece’s balance sheet problems could domino to Spain (and other peripheral countries) which would cause severe downward pressure on its capital markets.





As we look at potential investment risks of the Sovereign Debt Dichotomy in 2010, we want to own High Grade versus High Debt. We believe owning Germany and shorting Spain is one way to express this theme. While median predictions for Spain’s GDP is +0.4% this year and 1.1% next, we wouldn’t be surprised to see Spain underperform based on the structural and fundamental headwinds, the main being: further downward pressure in housing prices, high unemployment, the challenges of restructuring and capitalizing its banks, in particular the cajas, and debt risk associated with an extended budget balance.


Conversely, we believe the fiscal conservatism of the German balance sheet will help propel the economy as its exports gains steam from a weaker Euro and global demand picks up. The chart below shows our intermediate term TREND (3 months or more) lines for the German DAX and Spanish IBEX 35, and the dichotomy embedded therein. 


Q2 2010 Themes: Sovereign Debt Dichotomy - m7


Already we’ve seen Spanish GDP contract for the past 6 consecutive quarters (Q/Q), currently at -0.15% as of Q4 Q/Q or -3.1% Y/Y, and we expect to see it continue to underperform Germany, which like its neighbor France, officially exited its recession in Q209. YTD the DAX is outperforming the IBEX by almost 1,300bps.


With sovereign default risks in Greece still not in the rear view despite the loan guarantee from the Europeans and IMF (note the chart below of Greek 5YR CDS), we’re positioning ourselves to take advantage of the existing dichotomies we see among global economies. 


Q2 2010 Themes: Sovereign Debt Dichotomy - m8


Matthew Hedrick



COLM: Turning the Corner

It shouldn’t be too much of a surprise with Outdoor Outerwear up 17% YTD according to weekly SportScan data, that this has been a key driver of Columbia’s recent uptick in top-line trends as well as a tailwind for the company’s shares.  In light of improving consumer spending, easing top-line and margin compares over the next 2 quarters, positive trends through Q1 particularly in footwear (~20% of sales – see charts below), and the anniversary of close-out sales that significantly weighed on margins (200bps+), we expect the company to come in at $0.25 – ahead of consensus at $0.21.  Both better top-line and gross margins are key sources of upside. Sources of additional strength could also come from the company’s recent efforts in its direct-to-consumer business, an effort which includes a 20% increase in retail doors since last year and the launch of ecommerce last summer.


We also note that this is one of the few names in apparel/retail that face 5 straight quarters of favorable margin compares beginning now, when most others have only one or two quarters of easy compares remaining.  With EBIT margins halved over the last 2-years, we expect to start seeing the benefit of the company’s re-investment efforts in 2010. We believe tonight’s results will mark the first quarter of margin expansion in the last 10, which may also prove to be a key turning point for company and the shares.


See below for the detailed puts and takes on the quarter:


COLM: Turning the Corner - COLM Q1 Table 1 4 10

COLM: Turning the Corner - COLM Q1 Table 2 4 10


COLM: Turning the Corner - COLM FW Trends 4 10


COLM: Turning the Corner - COLM APP Trends 4 10


COLM: Turning the Corner - COLM S 4 10



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