PSS: Math

Here’s a great example of why estimates ≠ expectations. Let’s step back, YouTube ourselves, re-evaluate, and decide where to go from here. Math is math… Bottom line is to up our exposure.




Don’t you love when a company grows earnings by over 40%, beats estimates by 13%, and yet the stock still goes down meaningfully on the print? Unfortunately, there’s a difference between estimates and expectations, and as we often say here at Hedgeye, “Expectations are the root of all heartache” (borrowed from Shakespeare).


Make no mistake; the company missed both my estimates and expectations this quarter. I was at $0.88 cents (17% above the Street) and thought they could print something starting with a 9. The key variable was sales comps vs. Inventory.  Simply put, PSS missed the comp – printing -1.2% -- in an environment where people are scared spitless about anything surrounding the consumer. They smoked expectations on their wholesale business, which is not only higher margin but also less asset intensive and higher ROIC, but that does not have quite the offsetting dramatic flair in the headline that a comp miss does.


Ok McGough, you’ve liked this name for a while. Solid story last year, it’s been a dog since the start of 2010, and now they miss the comp. Have you overstayed your welcome? Are you succumbing to ‘thesis morph’?  Time to bail on this name and move on to greener pastures?


After going through the model ad nauseum last night and this morning, the answer is ‘No.’ I liked it 2 days ago, and I like it today – but at a better price. Yes, there are question marks that exist today that did not exist for me last week. But I am comfortable with the answers I’ve come up with.


Let’s dig…


1)      Why’d they miss the comp?  Am I happy about this? No, and there’s no excuses here for missing. A real company in this space needs to grow comp – especially one with no square footage growth. But I’m not as miffed as to why they missed. Simply put, the biggest driver was not having enough product to fill consumer demand.  Mind you, that’s one of the primary reason that gross margins were up 241bps. Ideally, they’d have managed the business to drive a few points of comp and around 100bps+ of GM% improvement. That’d look prettier, but would ultimately leave us with a similar result on the P&L.  This ability to manage the business better is something that PSS will need to show more of.


2)      What’s coming down the pike? PSS is going heavy on the toning category – with nearly 3x the inventory in 2H than 1H. The price point is nearly 2x the average price of the base Payless shoe, and let’s face it…regardless of how ridiculous this product is in my humble opinion (get fit while wearing them to do round trips from couch to fridge and back to score bon bons and beer) it is a hot trend. Competing product is selling around $80 (Reebok Easy Tones), $100 (Skechers Shape Ups) and $200+ (MBT).  A Payless offering under $30 will probably get noticed, as will several wholesale initiatives. 


3)      P&L Trends in 2010. At the same time they have this push; they’ll have a corresponding marketing push and will be going up against their easiest comp of the year. In fact, there’s no reason why we should not see avg ticket grow sequentially over the course of this year. This highlights the biggest binary risk/opportunity. We know the product is coming in. We know the trend is hot. We know the price point is meaningfully below anything else on the market. We know they’ll promote accordingly. But if this falls flat on its face, then there’s top line, GM and Inventory risk all rolled into one. If it works, then we get the opposite. The current stock price and consensus estimates discount something closer to the bear-case.


4)      That brings me to our estimates. Without making heroic assumptions, we’re coming out at $0.58, $2.00, and $2.50 for the upcoming quarter, this year, and next year, respectively. Over those time periods it represents 100%, 52% and 26% earnings growth, and 26%, 15%, and 25% above consensus, respectively.


5)      Don’t forget the long term story. This is a business that I like on a multi-year basis. It is at the center of a multitude of Macro cross currents, and just happens to have a CEO who I think has one of the best Macro processes in retail. The company owns both content and distribution – which will increasingly be important – and is the low cost/price provider of footwear with large scale distribution at a time when its main competitor – Wal-Mart – is downsizing its shoe business. Multiyear investment that have come to a head and structural changes in business alignment at PSS will allow the company to grind its average price higher over the next several years, which should unlock incremental margin dollars on what has been a perennially low-margin, highly-levered, no growth concept. As the fundamental story plays out, so will the earnings, the perception, the valuation, and ultimately the stock.


6)      Cash flow??? It’s rare to hear the words ‘Cash Flow’ in conjunction with PSS, but the reality is that the company has its’ net debt down to $417mm, or 33% of total capital. That’s the best position since the closure of the (horrifically ill-timed) Stride-Rite acquisition. But this is a company that should completely fund its working capital and capex needs, and still generate close to $360mm in free cash over the next 2 years. In effect, it should be nearly debt-free by the end of 2011.  I’ll have a tough time justifying that it should hang onto its ‘junky levered retail’ discount as that plays out.


7)      That brings me to valuation. Those who know me can count on one hand the number times I’ve dedicated any of my typing capacity to anything valuation-related unless it is break-up or M&A-related. That’s not because it does not matter, but because of our view that fundamentals will almost always trump valuation. Some cheap stocks should be cheaper, and some expensive stocks should be more expensive. But in the context of everything outlined above, consider the following valuation stats on FY10/11 using today’s stock price:

  1. PE: 9.8x/7.8x
  2. EV/EBITDA: 4.6x/3.8x
  3. FCF Yield: 14%/16.5%



Take nothing on its looks; take everything on evidence. There's no better rule.
-Charles Dickens, Great Expectations


How many times have you heard that “expectations are the root of all heartache?”  Well, here it is one more time.   


Looking ahead to the Nonfarm Payrolls number to be reported on Friday, the expectation is high for a strong print.  A Bloomberg Survey is looking for a BIG uptick to 515,000 jobs from 290,000 last month.  We have noted  the spread between what the economists were saying and reality since 2008 and 2009, when nobody saw the recession coming.  What are the chances they get it right this time? 


Yes, May is the peak for census hiring and there have been a number of press reports that the Obama Administration is double counting the numbers, but this looks a little out of line.


Howard Penney

Managing Director


FRIDAY'S JOBS REPORT - GREAT EXPECTATIONS - nonfarm payrolls annotated





"While we believe the economic condition of our customers improved as the fiscal year progressed, we believe the effect of an economic recovery on the gaming business will be slow and steady. As a result, we continue to trim costs where possible, improve our marketing efforts and elevate the guest experience to improve the competitive positioning of each of our properties."

- Virginia McDowell, President and COO



  • Depreciation and amortization expense is expected to be approximately $85 million to $87 million.
  • The Company expects cash income taxes pertaining to FY 2011 operations to be less than $5 million which primarily represents state income taxes.
  • Interest expense is expected to be approximately $89 million to $92 million, net of capitalized interest.
  • Total Corporate expenses for FY 2011 are expected to be approximately $46 million including approximately $8.5 million in non-cash stock compensation expense.
  • Maintenance capital expenditures for FY 2011 are expected to be approximately $45 million to $48 million, including conversion of approximately 2,500 slot machines to the Bally's slot system technology.


  • Retail sales increased sequentially in 5 of the casinos
  • Little visibility of economic recovery
  • Adjusted EPS is 24 cents/share vs. 18 cents/share in 4Q FY 2009
  • Strive to bring cash level down from $90 MM to current levels
  • 6.9x leverage ratio
  • $110MM available in credit facility before busting a covenant; 300 MM undrawn
  • $6 MM capex in 4Q 2010


  • Tax rollback in Pompano, FL- goes down by 15%
  • $400MM swapped out debt - most expires at end of 2011 with one long-term expiring at end of 2011
  • Station auction participation?
    • No
  • Florida properties:
    • have introduced penny slots in recent years
    • will take a couple of million dollars to reinvest in marketing program - to reintroduce customers to property
  • Gaming in Texas?  Thinks nothing happens until 2011.  Racino is a more likely possibility than a full-fledged casino.
  • Ameristar Black Hawk ramping:
    • doesn't think Riveria has any impact on Ameristar
    • hotel occupancy stabilized in Black Hawk.... retail expansion have driven customers to Ameristar
  • Rainbow
    • will rebrand to Lady Luck; will cost a couple of million
  • 35% effective tax rate in Florida - could be marginally higher.
  • Like the current cash level of $68MM-- though $75 MM is normal run rate.
  • Promotion environment:
    • facing pressure in Lake Charles
    • Biloxi--highly promotional environment
    • Quad cities-- tough as well
  • Depreciation decline forecast for 2011:
    • Assets getting to end of useful life; Pompano and Waterloo assets, specifically.
  • Stock compensation in 4Q 2010: $1.7 MM
  • South Florida economy seemed to have recovered: direct competition with Sugar Creek;
    • menu changes at many of the restaurants and television campaigns driving retail sales.
    • customer confidence improving "a little"
  • Credit amendment:
    • ISLE can invest in private equity projects that can leverage management fees
  • Quarterly interest coverage:
    • How close to covenant?
      • leverage: 6.9x; covenant is 7.5x.
  • Biloxi oil spill effect?
    • Nothing yet
    • BP marketing campaign to increase tourism in gulf coast area
    • Postponed the property's biggest event-- Bill Fish Tournament--to August; if oil spill doesn't improve, may cancel this event
  • Discontinued operations?
    • A little from Europe and a little from Bahamas in FY 2010
    • In FY 2011, discontinued operations will involve a little of Blue Chip from Europe
  • Davenport license:
    • nothing substantive has occurred
    • would be compensated for losing the contract if ISLE sells its property
  • Missouri 13th license:
    • interested but need to know more details
  • Gaming visitation trends:
    • For full year, visitation increased 3%; 4Q 2010 visitation is down slightly YoY.

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Housing Continues to Stumble ... Fade Any Strength from Today's Pending Home Sales Print


We've been beating the drum that home sales post the tax credit expiration would be anemic. This morning we get further confirmation. The MBA Mortgage Purchase Application Index, a leading indicator for home sales activity, continued its slide. The index declined 4.1% from last week bringing the decline since April to 28.8%. The decline for the entire month of May is 18% vs the month of April. The last two weeks of data have represented the lowest level of purchase activity since April 1997. For reference, the conforming 30-Year fixed mortgage rate in April 1997 was 8.14%. The rate averaged 4.95% in May 2010. Imagine what purchase activity would look like today without a 4-handle on the 30-year mortgage.





Yesterday the Mortgage Insurance industry association, MICA, released its monthly data for April. Two months ago the improvement in the cures/defaults ratio got investors extremely bullish on the mortgage insurers and housing in general. There was an underappreciated degree of seasonality tailwind embedded in the February data. From this point going forward we'll be on the back side of that tailwind. In other words, it's going to be a headwind from here.





One caveat of note. Later this morning we'll get pending home sales, which should be quite strong, possibly extremely strong. April saw a tremendous amount of demand pull forward ahead of the tax credit expiration and this morning's pending home sales data for April should reflect that. This is a lagging indicator, however, so we would be sellers of any pending home sales-related strength.


As a reminder, here are the banks most exposed to residential real estate as a percentage of their loan portfolio. These percentages include residential first lien, second lien, HELOC and 1-4 construction loans.





Joshua Steiner, CFA


Allison Kaptur


Chinese Ox Still Boxed In

Unveiled in early January, our Chinese Ox in a Box 1Q10 theme called for an economic slowdown in China. We seen just that in the equity markets, reflected by the Shanghai Composite and Hang Seng posting YTD declines of -22% and -11%, respectively. Much of the negative equity performance has been the result of government tightening to dampen inflation pressures and cool an overheating property market, which, for the most part, have been priced in. Still, concerns regarding the Eurozone’s fiscal and debt crisis, a domestic property bubble on the verge of rapid collapse, domestic wage issues, and international pressure are negatively impacting growth outlooks even beyond what we’ve seen in the numbers thus far. If yesterday’s PMI release was any indication (alongside copper breaching its long term TAIL line of support $3.03/lb), the Chinese Ox could very well be boxed in for quite some time going forward.


Below is a quick summary of recent developments from the last week which are additive to the current bear case for China. While we certainly aren’t recommending you join the “short everything China” trade now, we do think the latest developments out of China suggest further downside risk.



5/25 – More tightening in the property market:

  • Shanghai to introduce property tax trial next month
    • Estimates of an annual tax of 1.5%
    • Prices for new homes dropped 16% in Shanghai for the week ended May 23rd
  • Ronnie Chan, chairman of Hang Lung Properties said residential real estate prices in the mainland could fall by 20% - 30%  from current levels
    • Real estate investment is 12% of Chinese GDP at most recent readings

5/27 – Liquidity drying up:

  • China’s benchmark money-market rate rose 24bps to 2.4% - the highest levels since Feb. 12th
    • Prompted China to offer higher yields on short term bills @ auction (up 4bps to 1.49%)

5/28 – Domestic investors seeking returns forced to chase IPOs, which are now in a bubble:

  • Chinese IPOs beating Chinese benchmark indices by an average of 33 points in their first month of trading – best in the world YTD
    • Chinese IPOs raised $25B YTD due to many Chinese individuals being restricted from Int’l markets
    • P/E of Chinese IPOs: 46x vs. Shanghai Composite (16x) vs. Shenzhen-listed securities (23x)
    • Chinese IPOs gained an average of 32% in the first month of trading

6/1 – PMI slowing sequentially; property development and transactions eroding sequentially; domestic consumption slowing sequentially; battle over wages continue; China continues to get called out for “cheating”; and China increases its efforts to add liquidity to a financial system that has been drying on the heels of tightening in the property market and news out of the Eurozone:

  • PMI 53.9 in May vs. 55.7 in April vs. 54.5 consensus
  • HSBC PMI 52.7 in May – the lowest in a year
    • HSBC Index more weighted toward smaller, privately-owned businesses (400 manufacturing companies)
  • PMI components            
    • Output 58.2 in May vs. 59.1 in April
    • New Orders 54.8 in May vs. 59.3 in April
    • Export Orders 53.8 in May vs. 72.6 in April
    • Input Price Index 58.9 in May vs. 72.6 in April
  • Official PMI typically declines sequentially in May (3 of last  4 years) – seasonal adjustment factor off?
  • Property sales falling sequentially in May (M/M)
    • Beijing down roughly 70%
    • Shanghai around 70%
    • Shenzhen near 62%
  • Developers are postponing project launch dates and are waiting to see market developments and government policies before launching new projects
    • Shanghai – only 46 of a scheduled 96 developments were put on sale in May
  • Transactions for new homes in Shanghai fell 56% for the month through May 16 (M/M)
  • Secondhand home transactions in Beijing down 70% M/M in May
  • Hong Kong retail sales down sequentially to up 16.8% Y/Y in April vs. up 19% Y/Y in March
    • Retail sales volume down sequentially to up 12.4% in April vs. up 17.3% in March
    • Visitation up 18% Y/Y in April (1.7M)
  • Passenger car sales down sequentially - up 25% Y/Y in May vs.  Up 34% Y/Y in April
    • Has risen each month since Feb 2009 after gov’t lowered the tax on small vehicles to 5% from 10% in Jan. of ‘09
      • The tax was increased by 250bps this year to 7.5%
    • May 2010 is the most sluggish pace of growth since March 2009
    • Stockpile of vehicles up sequentially by 64,900 units in May
  • Honda Motor Co. production in China will remain halted at least through June 3rd as striking workers rejected a 24% pay increase to 1,910 yuan per month (looking for 2,000-2,500 per month)
    • Production of up to 3,000 cars per day has been lost since its auto assembly factories shut down last week
      • May 17 – plant in Foshan, Guangdong closed
      • May 24 – 2 plants closed in Guangzhou, Guangdong
      • May 26 – 2 plants in Guangzhou and Wuhau, Hubei
    • First time a strike has stopped Honda’s local auto production
    • Scuffles broke out between workers and staff from the government-backed trade union yesterday
      • Some workers sent to the hospital for treatment
  • Trade unions and employers appear to be reporting a growing number of work stoppages in China, although there are no official numbers, according to the International Labor Organization in Beijing
    • Hon Hai Group (assembler of iPhones) said last week it may raise wages 20% amidst a probe into the companies working conditions after the deaths of 10 people this year at their Shenzhen factory
      • Police treating as suicides
  • John Clarke, Head of EU delegation to WTO said today that “China uses a weak currency, export incentives, and subsidies to bolster its economy”… “the EU has seen some worrisome signals of stagnation in China’s efforts to revamp its economy”… “[EU] companies have reported a worsening of the [Chinese] business climate”
    • China March trade to EU up 25% Y/Y ($21.45B) – setting up for reported figures to slow sequentially in April and May
    • EU is largest recipient of Chinese exports in March (19.1%) vs. US (17.2%)
  • WTO judges are probing complaints by the EU, US, and Mexico against Chinese restrictions on exports of raw materials
    • Duties on coke, zinc, bauxite, magnesium, manganese, silicon carbide, yellow phosphorus
      • Used in steel, aluminum, automotive, and chemicals production
    • China claims taxes aimed at easing overproduction and pollution
    • WTO remarked that “export restraints tend to reduce export volumes of the targeted products and direct supplies to the domestic market, leading to downward pressure on the domestic prices of these products”
  • China’s Central Bank sold 1Y bills at 2.0096% vs. 1.9264% last week
    • Sold 15B yuan of 1Y bills
  • China’s Central Bank also raised rates on 3-month bills for second straight auction on May 27
  • China has added a net 145B yuan of cash into the financial system last week – the 2nd weekly injection of the last month after draining cash each week in April and March

6/2: Employers giving in to wage demands; liquidity drying up further; China may finally address restrictive residential system that has been marginally inhibiting to growth – a sign that the government may begin to pull out all the stops to avoid a full economic collapse:

  • Honda reopened a parts plant in China
    • Most of the parts factory’s 1,900 workers accepted an offer this week for a pay raise to 1,910 yuan ($280) a month (24%)
  • Hon Hai Group will raise worker salaries at least 30% after series of suicides
    • Workers with a monthly wage of 900 yuan per month will be paid 1,200 yuan effective immediately
  • 7-day repurchase rate rose 8bps to 3.28% - the highest since Oct. 2008 (19 month high) vs. 1.56% (12/31/09) vs. 0.96% (6/1/09)
  • Bank of China Ltd. (third largest lender by market value) started selling convertible bonds today
    • Plans to raise 40B yuan ($5.9B) according to a May 30 statement
  • China may gradually implement a residence permit system in 10 cities that may relax the Hukou rules, according to the South China Morning Post, which cited a State Council document

Chinese Ox Still Boxed In - SSEC



The balance of the year could prove difficult from a cost perspective.  The consumer comeback that casual dining management teams have touted may also be running on fumes.


Casual dining sales slowed in April and we are hearing that May’s numbers are not showing stronger trends.  Officially in April, the Malcolm Knapp data showed that two-year trends slowed sequentially from March. 


The trends in April and May suggest that the rate of change in improvement in sales trends is slowing just when the industry needs it most.  As you will see in the following charts, the industry benefited from declining food prices in 2009.  Labor costs were also somewhat benign as turnover rates slowed in the recession.


As we get closer to the outlook for 2011 (Q2/Q3 conference calls), higher food costs will dominate the headlines.  In addition, if the jobs picture really improves it’s only a matter of time before we hear about higher labor costs.  In an economy that is creating jobs, there is an increased incentive to quit and walk away from a lower-paying job (think restaurant server/cooks) increases and the restaurant industry will pay the price. 


There is also a case to be made that the improvement we have seen in sales trends is somewhat artificial, or said another way, it’s the SQUATTERS’ INCOME impact.  A New York Times article entitled “Owners Stop Paying Mortgages, and Stop Fretting” details just one example of unsustainable consumer spending patterns.  The article describes how for some homeowners that chose to halt mortgage payments, foreclosure has allowed them to “stabilize the family business.  Go to Outback occasionally for a steak.  Take their gas-guzzling airboat out for the weekend.  Visit the Hard Rock Casino.”  One individual stated, “instead of the house dragging us down, it’s become a life raft. It’s really been a blessing.”


Additionally, as our Hedgeye Risk Management BLACKBOOK on the consumer (released yesterday) illustrates, the consumer is facing a myriad of other headwinds.  For a copy of this BLACKBOOK, please email


From a cost perspective, restaurant companies face difficult comparisons over the next few quarters.  As the first chart below shows, average food costs as a percentage of sales for casual dining decreased significantly through the first three quarters of 2009.  While the first quarter saw further year-over-decline in food cost margin, the compares become increasingly difficult through the third quarter.  Some restaurant companies have indicated that costs have been trending higher than was expected at the outset of the year.  Two components that were cited specifically by management teams during the recent earnings calls were alcohol (MSSR) and chicken (RT).


While most companies are under long-term contracts for beef, as new contracts are negotiated, nearly every company will be paying higher prices in 2011.


Some companies that are looking vulnerable coming into the 2Q earnings season are CAKE, RT, TXRH and to a lesser extent DRI. 




In terms of labor costs, 2Q will likely bring significant labor cost year-over-year growth to the casual dining space.  Many companies saw year-over-year labor cost inflation in 1Q10.  DRI, PFCB, KONA, and RRGB had labor costs jump 95 bps, 116 bps, 133 bps, and 137 bps, respectively.  MRT saw deflation of 123 bps in labor costs.




Examining the EBIT margin trends in casual dining paints a vivid picture; the category is facing increasingly difficult margin compares for the rest of the year.  1Q10 was the last easy comp and many companies operating at peak margins will find it difficult to sustain those levels.  Those that jump out for me include CAKE, MRT, and TXRH. 




CASUAL DINING – THE SQUATTERS’ INCOME IMPACT - food cost margins cd names


Howard Penney

Managing Director

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