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Austerity’s Bite

“Everything we hear is an opinion, not a fact. Everything we see is a perspective, not the truth.”

-Marcus Aurelius

 

Austerity is the new buzz word in Europe; from newly elected UK Prime Minister David Cameron in the north to Italian PM Silvio Berlusconi in the south, the issuance of austerity measures from European governments to combat bloated fiscal imbalances seems like a near daily occurrence.

 

The word austerity comes from the Latin austerus meaning “dry, harsh, sour, tart” and was originally used to describe fruit and wine, however in economics refers to a government’s reduction in spending and/or increases in taxes to reduce a budget deficit.  Over the last weeks, European austerity packages have included such provisions as civil servant wage freezes, extensions on the age of retirement, and levies on alcohol and tobacco to an additional tax on the price of an airplane ticket. In short, governments are trimming obvious “fat” and creating revenue streams to rein in over-extended budgets.

 

Here’s a quick recap of budget deficits (as a percentage of GDP) and the notable austerity packages issued in Europe over the last months:

 

Greece – (13.6%); plans to cut €30 Billion in spending over the next three years

UK – (11.5%); £6.2 Billion (or €7 Billion) in spending cuts this year

Spain – (11.2%); €15 Billion in spending cuts and 5% reduction in public worker wage this year

Portugal – (9.4%); plans to issue measures to save €2 billion this year

Italy – (5.3%); €25 Billion in cuts over two years (*strike planned for June 25th)

Germany – (3.3%); €11.2 Billion in spending cuts for next year, or ~€85 Billion by 2014.

 

The most obvious question to ask is will these measures be enough to reduce deficits and return “health” to Europe?

 

In both the immediate and longer term the answer to this question appears to be No and a qualified No. In the near term, Europeans are taking to the streets, with strikes over austerity measures already held in Greece and Spain. While the estimated 2.5MM strikers in Spain appeared mostly harmless (a colleague likened the visual displays on TV to a pre-game World Cup party), strikes in Greece had a very ugly undertone with the death of 3 protestors.  As Keith has noted recently, austerity will equate to civil unrest:  the confluence of a government’s need to tax its people versus the public’s cry that they aren’t responsible for the government’s fiscal mismanagement, and therefore refusal to bear the brunt of the measures. We believe that deficit reduction alone won’t solve Europe’s fiscal problems.

 

In the longer term there are numerous structural and fundamental concerns related to the Eurozone. We’ve pointed out in our quarterly theme work that the investment risk related to sovereign debt default or restructuring is not limited to Greece, but will spread to Spain, France, and Italy, much larger economies than Greece with debt exposure to European banks far greater than Greece’s obligations by a factor of 4-5 times. The outcome could cause further (and greater) downward pressure on markets. 

 

Importantly, it’s worth noting that the European and IMF-led €750 trillion “loan” facility to buy up toxic debt from European countries “in need” (and return investor confidence) has failed to buoy European markets largely because ECB President Jean-Claude Trichet has not outlined just how the facility works! As a result, we’ve tracked increases in government bond yields, sovereign CDS, and equity underperformance, along with the Euro-USD that broke through our immediate term support line of $1.20-1.21 earlier this week to a low of $1.1876 on 6/7 and is down 15% YTD.

 

Further, what we have seen since the facility was announced on May 10th is strong headline risk (think comments from a Hungarian official last week of a Greece-like debt crisis in his country that sent markets plunging) and continued day-to-day volatility. Also, the separate European/IMF funded €110 Billion aid package to Greece hasn’t made a dent in performance or sentiment: the Athex is down 33% YTD and the worst performing major index in the world.

 

Could it be that the experiment of uniting disparate economies is a losing effort?

 

As we see it, there are two main threads of questions that still need to be worked through to determine the path of the Eurozone:

  1. Should European officials revise the standards of the Stability and Growth Pact, which limits members to a budget deficit no greater than 3% of the country’s GDP?  Could more malleable standards be devised (alongside an oversight body) to limit fiscal imbalances across countries, to benefit both the individual country and the Union as a whole? Conversely, is there any merit in imposing harsh budget reduction mandates (that governments may likely fail to meet) at the expense of growth?
  2. Can the Eurozone, a union of 16 disparate countries that share the Euro as a common currency and are tied to the European Central Bank for monetary policy, exist at all, if countries cannot manipulate (devalue) their currency to inflate their way out of debt or independently adjust interest rates to spur or quell growth? 

Clearly these are big questions, all of which we don’t have the answer for.  What we can count on is the continued lack of political solidarity from European leaders to proactively address the region’s ails, which is risk we’re focused on managing around. Statements yesterday from EU President Herman Van Rompuy are case in point: “And if the plan [€750 Billion loan facility] were to prove insufficient, my answer is simple: in this case, we’ll do more.” This is not leadership! 

 

If austerity is the first start to something better, we caution that weaker growth prospects are ahead for much of Europe. In the longer term, it just may be that despite the Eurozone’s intention for the whole to be stronger than the individual parts, disparate parts may remain just that, or conversely, and to quote a line from William Butler Yeats’ poem “The Second Coming”: Things fall apart; the center cannot hold.

 

We’re currently short France in our virtual portfolio via the etf EWQ and have been short Spain (EWP) this year as a way to play the weakness we see in Europe.

 

Matthew Hedrick
Analyst

 

Austerity’s Bite - EL CDS


WEN - SUM OF THE PARTS

 

On 5/19 we published a note titled, “WEN - Undervalued Yes, Where is the Opportunity?” that discussed WEN’s stock and provided a sum-of-the-parts analysis that suggested that the company’s stock was trading below its intrinsic value.

 

I said at the time, “Over the years, Trian Partners has been extremely successful at creating value from mispriced securities.  In the almost two years since creating the Wendy’s/Arby’s Group, it has now created one of those mispriced equities.  Can Trian and senior management fix WEN again?”

 

After the close yesterday, Train said in a 13D/A filing that it recently received an oral inquiry from a third party expressing interest on a preliminary basis in a potential acquisition involving WEN.  Our sum of the parts analysis from 5/19 values the WEN at $7.70.  We value the Wendy’s business at $6.30 per share and the Arby’s business at $1.40 per share.  Send me an email if you would like additional details.

 

Thus far WEN is the third company to announce some sort of value enhancing initiative.  Fist it was CKE, then CPKI and now WEN.  If you are looking for the next possible candidate I would bet on EAT...

 

Howard Penney

Managing Director


EAT – HOLDING FIRM

Despite Keith’s selling of EAT in the firm’s virtual portfolio, we remain confident in the long-term opportunities for Brinker shares. 

 

By now, many of our subscribers are aware of our unique process at Hedgeye that marries Keith’s macro and quantitative views with our company-focused fundamental perspective.  While Keith’s move here is primarily predicated on his broader view of the market, we want to reiterate that our fundamental, long-term view on Brinker shares and the company’s turnaround efforts at Chili’s remain unchanged. 

 

Specifically, Keith provided the following perspective on his move to sell EAT in the portfolio, “I'm going to take the loss here and sell the stock on an up day. Penney remains bullish for the long term here but is becoming increasingly negative on competitor balance sheets like DIN.”

 

I would agree with Keith that the MACRO environment will remain challenging in the near-term and overleveraged balance sheets will only magnify those challenges for certain restaurant companies, like DIN, but I would actually point to DIN’s balance sheet issues as a positive for Brinker.  As I outlined in my EAT Black Book, Brinker has a strong balance sheet and one primary reason I think the company will outperform in these challenging times, in the more challenging Bar and Grill segment, is that its largest competitor (DIN’s Applebee’s) does not have the financial capability to compete.  And, as I said earlier this week, I continue to believe it will be important to focus on those companies that are being proactive and creating leaner, more efficient cost structures as they will be better positioned to mitigate margin erosion in a tough sales environment.  To that end, EAT is one name that is pursuing a proactive strategy and remains a core focus name. 

 

To be clear, when I became more vocal on the reasons to own EAT, I stated that sales trends through the end of fiscal 2010 would be choppy as Chili’s attempts to decrease its reliance on aggressive discounting (and move away from “3 Courses for $20) and as customers adjust to the significant menu changes at the concept.  That being said, management’s efforts to revitalize the brand from both the retail and manufacturing sides puts the company on track to post significant margin growth at about the same time top-line trends should begin to recover, beginning in FY11; though I think the margin story will materialize even without a significant tick up in trends.

 

There seems to be a lot of confusion among investors about the timing of implementation for POS, KDS and kitchen retrofits and the subsequent 500 bp margin benefit (net 400 bps after depreciation) forecast to materialize by the end fiscal 2013, but management said very specifically at an investor conference this week, “So we do think more than half of the 500 basis points of margin improvement will be in place by the end of fiscal 2011.”  I do not think most investors were forecasting this level of growth in FY11 and management’s comment only strengthens my conviction that the street’s FY11 EPS estimate is too low.

 

Management seems confident about its potential earnings growth in the next two years.  EAT’s 5-year target to double EPS by FY15, off of the $1.40-$1.44 base, with 10%-12% EPS growth in FY13-FY15 implies 40% to 50% EPS growth from FY10 to FY12. This two-year target assumes 1% to 2% same-store sales growth, which seems achievable; though it does it rely on sequentially better 2-year trends going forward.

 

I am comfortable saying again what I wrote on April 20th, following Brinker’s fiscal 3Q10 earnings call, “I know things don’t happen in a straight line and there will be bumps in the road, but I want to be a little early on this one.  Once it gets going, it’s gone…”

 

Howard Penney

Managing Director


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Sizing Up China

“China is teeing themselves up to take over the financial world.”

-Keith McCullough, June 10th, 2010

 

Conclusion: China is starting to look interesting on the long side, as the stock market has priced in slowing economic growth.

 

Bottoms are processes, not points. With the Shanghai Composite down just over 21% YTD, it’s obvious that investors have been discounting what we are starting to see evidence of: slowing growth. At a point, however, that all gets baked into the market and bottomed-out, downward growth expectations begin to shift on the margin towards upward growth forecasts. Combined with the prospects of a simple intermediate-term mean reversion trade (China has underperformed all major equity indices YTD except Greece, Spain, and Slovakia), it’s easy to see why we’re starting to warm up to China on the long side – of course not at every price. We’ll wait for more confirmation of the Shanghai Composite’s higher-low to begin looking for an entry point.

 

For now, allow the charts below to tell the story on China and what the forward growth outlook is from here.

 

No surprise here: Chinese equity markets and Chinese demand for copper (as measured by our proprietary Hedgeye China Market Index) have been a leading indicator for growth. As our index would suggest, GDP growth peaked in 1Q10.

Sizing Up China - GDP

 

The YTD look at the Hedgeye China Market Index suggests that Chinese GDP growth will decline sequentially from its 11.9% peak in 1Q10. The markets have been pricing this in. At a point, what has been priced in will begin surprise to the upside.

Sizing Up China - HCMI

 

Chinese real estate prices were up 12.4% Y/Y in May – the first sequential deceleration in a year. It appears the peak has been established, which has been priced into the Chinese equity market for quite some time. With peak property price growth perhaps in the rear view, the next question logical question will be where will the current cycle bottom out?

Sizing Up China - Property Prices

 

To a large extent, the answer to that question will be to watch the Chinese equity markets and the price of copper. With a positive 0.78 correlation (0.61 r-squared) to property price growth for the last three years, our Hedgeye China Market Index should prove to be a reasonably reliable concurrent indicator for the growth of one of China’s main industries. If Chinese property price growth continues to sequentially decline, we expect those declines to bottom out alongside, or shortly after we’ve put in a bottom in Chinese stocks.

Sizing Up China - Property HCMI

 

Much to-do has been made about the Chinese trade numbers released overnight (Trade surplus – $19.5B in May vs. $1.7B in April; Exports up sequentially – 48.5% Y/Y in May vs. 30.5% Y/Y in April; Imports down sequentially – 48.3% Y/Y in May vs. 49.7% Y/Y in April). Members of the Manic Media appear puzzled that May could produce such large gains in exports – especially with a significantly weaker Euro. Analysis shows, however, that the May 2009’s export growth compare (-26.4% Y/Y) was the easiest “comp” on record. It appears basic math and probability analysis trumps even European sovereign debt scares, or the analytical skills of the Manic Media.

Sizing Up China - Imports Exports

 

Lastly, a sequential deceleration in import growth is just what the Chinese wanted to see. With what is widely considered an “undervalued” currency, the Chinese are prone to importing inflation. To gauge real-time, we’ve created rolled out our Hedgeye China Growth Commodities Index, which indexes the price of copper, crude oil, and aluminum to the start of the year. The chart below suggests that China indeed imported deflationary commodity prices in May and is continuing to do so in June. No surprise that China’s copper and aluminum imports were down Y/Y in May (-6.1% and -71.5% respectively).

Sizing Up China - Growth Commodities Index

 

So what does this all mean? You have a government that put the screws to its economy in order to cool growth and it appears the peaks have been established, making it less likely we’ll see more tightening in the near term and likely that perhaps equities have already discounted future slowing growth.

 

Darius Dale

Analyst


Crash or Correction? SP500 Risk Management Levels, Refreshed...

The only way to have another stock market crash is for there to be a suspension of belief that we can’t crash again. Markets don’t trade on valuation – they trade on expectations. With fleeting low volume rallies to lower-highs in the past few days, the probability of this correction becoming a crash is going up.

 

Hedgeye defines a crash as a -20% move from a measurable peak-to-trough. Since the 2008 crash, we have not had one. From the April 23rd, 2010 cycle-peak of 1217 to the June 7th closing-low of 1050, we had an expedited -13.7% correction. The crash zone from 1217 is well below the 1000 line at 974, so keep that reference point in mind. That’s the Pain Trade point for the bulls.

 

If we hadn’t seen 2010 crashes already in major global equity markets like China, Spain, and Italy, the probability for mean reversion would be lower. If our forecast for another breakdown in the US Dollar based on US sovereign deficit and debt risks weren’t concerning us, the probability for lower-lows versus 1050 would also be lower.

 

If there weren’t so many ifs in our risk management process, we are not quite sure what we would keep us busy throughout the day. If consensus was Bearish Enough, the SP500 wouldn’t be up 2% today either. From a risk management perspective, nothing of consequence has really changed here today, so we’re still a net seller on strength.

 

Our long term TAIL line of resistance is now at 1081 and has proven to be a formidable wall today. We see no downside support from here to 1037. From 1081 to 1037 = -4.1%. If that were to happen tomorrow, I think it will definitely get people’s attention and put the crash scenario in play. Lots of ifs…

 

The monthly US budget deficit for May was released at $136 BILLION DOLLARS. Add that to April’s $83 BILLION DOLLARS and I have $219 BILLION reasons to not trust that the US Government should be entrusted with my hard earned capital being put at risk. Our asset allocation to US Equities remains zero percent as a result.

KM

 

Keith R. McCullough
Chief Executive Officer

 

Crash or Correction? SP500 Risk Management Levels, Refreshed... - S P


FL: Hedgeye's Process Unleashed

Despite Keith’s selling of FL in the firm’s virtual portfolio, we remain confident in the intermediate-term opportunities for Foot Locker shares. 

 

 

By now, many of our subscribers are aware of our unique process at Hedgeye that marries Keith’s macro and quantitative views with our company-focused fundamental perspective.  Often times our best ideas are born out of the intersection of the two processes.  At other times, there can be a disconnect between us, resulting in opposing opinions.  While Keith’s move here is primarily predicated on his broader view of the market, we want to reiterate that our fundamental view on Foot Locker shares and the company’s turnaround efforts remain unchanged.  We still believe this represents one of the better stories in retail, driven by both strong athletic footwear and apparel tailwinds as well as strategic initiatives put in place by CEO, Ken Hicks and his team.

 

A second pillar of our process is transparency, which means we’re more than happy and in fact, proud to share our thought process with you in real time.  As such, here’s Keith’s perspective on why he sold his position in FL this morning:

 

“Stock between a rock and a hard place plus I am bearish on the market… market call with a stock that just broke its TREND line of 14.49 and hasn’t been able to recover it … long term TAIL of support all the way down to $11.81, so I have time to buy it back on any market weakness” - KM

 

Importantly, Keith’s selling of the FL position in the firm’s virtual portfolio does not change our key view on the opportunity for the shares, which we highlight below:

 

We continue to believe the COMBINATION of Foot Locker specific drivers such as improved apparel assortments, distinct banner segmentation, and inventory management will ultimately lead to a continued string of upside over the next several quarters.  Importantly, the company’s recent 1Q results were the first reported since Ken Hicks unveiled the company’s strategic plan on March 9th.  We remain confident that management is conservative with its forecast on both the top and bottom lines, preferring to use a still “uncertain economic” backdrop as a reason for which to be reserved. 

 

While management may be conservative, we remain aggressive both on the opportunity to see meaningful earnings upside over the next couple of years as well as the commensurate opportunity for share price appreciation.  Our estimates remain comfortably ahead of the Street for this year at $1.05 vs. $0.87.  We’d continue to use the market weakness and jitters to revisit the intermediate term opportunity.  As stated above, we suspect Keith will also be revisiting at some point as well.  

 

Eric Levine

Director 


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