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RESTAURANT SIGMAS – MOVERS AND SHAKERS

Back in July, we decided to map out where the restaurant companies were in terms of their positions on the SIGMA chart.  Changes in top-line growth and margin expansion/contraction clearly illustrate key operational trends in each company.  Tracking these changes as the quarters roll over, and the different valuation multiples that are assigned companies as trends change, offers valuable insight.

 

All restaurant companies want to live in Nirvana, with same-store sales positive and margins growing on a year-over-year basis.  Not all of the restaurant companies in Nirvana are there for the same reasons; some companies may be lapping easy comparisons, driving comps entirely by pricing or thanks to a temporary but very favorable cost environment.  In these cases, such companies will not sustain their positions in the Nirvana quadrant. 

 

The following companies are currently enjoying positive same-store sales and margin growth as of the most recently reported quarter: CMG, MCD, YUM US, YUM China, BJRI, DPZ, PNRA, SBUX, TXRH, CAKE, RT and MRT.  All of these companies, with the exception of YUM US and BJRI, were operating in Nirvana territory before the most recent quarter was reported. 

 

As I did in July, I would like to bring to your attention a few names that I think may be “moonlighting in Nirvana”.  YUM China, TXRH, MRT, CAKE and RT are the five names I would highlight as being particularly vulnerable to a move from Nirvana in the second half of 2010 (or by fiscal 2Q11, in RT’s case). 

 

YUM continues to expect to face labor and commodity inflation in China during the second half of the year.  Overall, as expected, China continued to operate in Nirvana during the second quarter, but will likely move into the Trouble Brewing quadrant (positive same-store sales and YOY decline in restaurant operating profit margin), and potentially, into the Deep Hole, during the back half of the year as higher food and labor costs materialize.

 

TXRH is guiding to same-store sales of +1% for the remainder of the year which implies a relatively stable two-year average trend.   Food deflation is set to provide a sequentially more favorably environment than in 2Q but not as much as the company enjoyed in 1Q.  That being said, YOY comparisons from both a cost of sales and restaurant-level margin perspective are set to become more difficult in the back half of the year.

 

My concern for MRT is primarily top-line related.  While there is a certain amount of risk in their beef costs only being 20% contracted for 2010, given the 14% increase in Live Cattle prices YTD, I believe that the steep increase in sequential comps from 1H to 2H09 will make it difficult for MRT to maintain positive comps, particularly in 4Q10.

 

CAKE could also face pressure going forward due to an average check problem; customers have been trading down to small plate and snack items.  In an effort to maintain comps going forward the company implemented a 1% effective menu price increase in August.  Same-store sales and margin comparisons become decidedly more difficult, for CAKE, in 2H10.

 

RT’s outlook for their next quarter (1QFY11) is quite positive; same-store sales could improve again on a one-year and two-year basis and restaurant-level margins should increase year-over-year.   However, as I wrote in my recent note “RT: IMPROVING BUT THINGS SHOULD SLOW”, momentum will likely slow from there for RT.  Same-store sales, by my reckoning, will come under pressure for the balance of FY11 with margins likely following suit due to higher food costs as a percentage of sales and more difficult comparisons come to bear on the bottom line.   RT could possibly be heading for the Deep hole in 2QFY11.

 

Other Nirvana standouts:

 

CMG: CMG is largely unlocked from a commodity perspective and this could impact margins adversely in the second half of 2010.  Further increased costs on the labor, other operating cost (higher marketing) and G&A lines could further impair CMG from maintaining positive margin growth in the back half of this year.  Investors may be less concerned about this increased margin pressure if the company is able to maintain its sales momentum from the second quarter.

 

 

The Deep hole quadrant is inhabited by companies experiencing negative same-store sales and declining restaurant level margins.  

 

The following companies are currently suffering: SONC, DIN, BKC, WEN, EAT, CPKI, KONA, JACK and RRGB.  The trouble about the Deep hole quadrant in this current environment is that there is no “magic bullet” that can solve the issues that have led the company there.  Sometimes there are plans that management initiates that are margin accretive and build sustainable top-line momentum, but these strategies require a patient management team (resisting the temptation to take short cuts to print good numbers) and several quarters to implement.  McDonald’s “Plan to Win” is one example of an effective strategy that has changed that company. 

 

For the QSR names in the list above, MCD is the main problem.  They continue to knock the cover off the ball – I estimate a +7% comp in August – and it is hurting BKC, WEN, SONC and JACK.  For these names, I would not expect much movement from the Deep hole over the next few quarters and I believe that will be reflected in their valuations.  Compounding the impact of MCD’s outperformance, JACK’s geographic issues augment the macro headwinds.  Their overexposure to California and young Hispanic males (high unemployment cohort), in particular, has been pressing their stock for some time.

 

Other Deep hole standouts:

 

EAT: We expect the top-line to be volatile in the near-term as the customer familiarizes itself with the new menu.  Following the most recent quarter’s earnings, I am marginally less confident in Brinker’s ability to meet earnings expectations over the next two quarters (1H11).  I do expect, however, the company to see a material YOY improvement in restaurant-level margin in FY11, despite near-term sales volatility.   Having extensively researched the operational initiatives and changes being undertaken by the firm to increase margins and customer satisfaction, I see the potential for a strong turnaround for Brinker.  I remain confident in the direction of the company but believe that the turn in fundamentals is further out than previously thought.

 

 

Trouble Brewing:  We believe that the trends associated with the Trouble brewing and Life-line quadrants are unsustainable.  Companies usually find themselves in either territory in a transitional phase.  Typically, if a company is posting positive same-store sales and declining year-over-year margins, the company is not leveraging the positive top-line and is spending too much on growth-related costs or increasing discounting.  Whatever the reason, it usually spells trouble.

PFCB is currently situated in this quadrant.  On a sales-weighted basis, its concepts are running same-store sales of +0.8%.  Having taken price in May, for the first time in two years, and improved operational performance during the first half of the year, the company could see top-line strength persist if traffic can hold up (as of the date of the most recent earnings call, 7/28, traffic had been positive for five months).  I expect a gradual improvement in restaurant-level margins in the second half of the year for PFCB.   

 

PFCB is facing easy comparisons in 3Q10 on many fronts.  At the same time, trends are getting better at the Bistro, which should make for a strong third quarter.  PFCB could move up and to the right into the Nirvana quadrant during the back half of the year after starting out the year in the deep hole.

 

 

The Life-line quadrant is usually populated by companies that have “pulled the goalie”.  When customers are not coming through the doors, sometimes companies cut costs in order to maintain bottom-line numbers in the absence of top-line strength.  This clearly is an unsustainable situation.  In other cases, such as 2Q for BWLD, a shift in commodity margins can boost margins and add to profitability even in a difficult top-line environment.

 

The following companies are in the Life-line territory currently seeing restaurant-level margins increasing year-over-year but same-store sales declining: BWLD and DRI.  BWLD is likely going to experience year-over-year restaurant level operating margin expansion over the next number of quarters.  This is largely due to the 31% decline in chicken wing prices since the YTD peak in January.  The company is in the process of closing underperforming, lower volume stores but it is likely going to take some time. 

 

RESTAURANT SIGMAS – MOVERS AND SHAKERS - sigma chart restaurants 92

 

Howard Penney

Managing Director


EARLY LOOK: Corner Banging

This note was originally published at 8am this morning, September 3, 2010. INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK (published by 8am every trading day) and PORTFOLIO IDEAS in real-time.

 

 

__________________________________

 

“Twenty years from now you will be more disappointed by the things that you didn't do than by the ones you did do. So throw off the bowlines. Sail away from the safe harbor. Catch the trade winds in your sails. Explore. Dream. Discover.”
-Mark Twain

 

EARLY LOOK: Corner Banging - chart1

 

 

On Tuesday, Keith comes back from vacation.  I’ll be honest, setting aside the fact that Keith and I have been friends for upwards of 15 years and I like having him around, wearing his jersey in the mornings is not easy.  I’m all about hard work, but, seriously, you try preparing for a 20-minute conference and writing a strategy note all by 8:30 am every day.  I’m starting to understand why some of his morning notes make him sound a bit a grumpy, this isn’t easy!
 
If you didn’t know, corner banging is a sailing term.  It basically means to sail all the way to one side of a race course in search of a strategic advantage.  If you bang the corner, you either win big, or you lose big.  That’s it.  For those of you who have been reading our notes for the last couple years, it is likely quite clear that we are not corner bangers.  If we’ve said it once, we’ve said it many times: we are Risk Managers.  In fact, the term is so common around our office, we even added it to the name of our company, Hedgeye Risk Management.
 
Managing risk isn’t about being short or just having a high allocation of capital to cash, but rather preparing and contemplating events that could happen and impact our portfolios.  As we look forward over the next couple of months, one specific event that jump out in our minds is the midterm elections.  There is potential that the Republicans, who are expected to do well, which could have an impact on whether the Bush tax cuts are extended.  It is our belief that the idea of the Bush tax cuts being extended is not currently priced into the market.
 
The Bush tax cuts are meaningful. To highlight this point, in the bullet points below we compare what would happen to certain tax rates if the Bush tax cuts are not extended:

  • Short term capital gains would go from 35% to 39.6%;
  • Long term capital gains would go from 15% to 20%;
  • Qualified divided taxes would go from 15% to 39.6%;
  • Non-qualified dividend taxes would go from 25% to 39.6%; and
  • Wage taxes in the top bracket would go from 35% to 39.6%.

 

On a very basic level, an increase in divided taxes should decrease the value of those companies that pay dividends, all else being equal.
 
On September 7th at 230pm, Keith and I will be hosting a call with Karl Rove to discuss the midterms with the title, “Could The Midterm Election Be A Major Stock Market Catalyst?”  Karl, as many of you know, is known as “the Architect” for putting together the successful Gubernatorial and Presidential campaigns for George W. Bush.  Now let’s be clear, we get that Mr. Rove is a Republican and that many of you may be athwartship (a sailing term that means at right angles) politically with Karl, but this is not a political call.  This is about sitting down with one of the premier political analysts in the country and having a Big Boy Talk with him. The point is to try and determine whether the midterms will indeed be a catalyst.  If you are a current subscriber or would like to trial our service and participate in the call, please email us at sales@hedgeye.com.
 
As former long time Speaker of the House famously said: “All politics is local.” Typically this is indeed true, so while we can presume to know what is going on from our perches in Manhattan, Boston, New Haven, or wherever we may be, bringing in a man who has studied elections in this country on a county by county level is sure to help make sure our sails are directed toward the wind.  Currently, the Republicans clearly have the wind behind their sails.
 
To begin with, President Obama’s approval ratings are quite low.  According to the Real Clear politics poll average, 46.4% of those polled approve of the job President Obama is doing and 47.8% of those polled disapprove.  So, in aggregate, less than half of the country approves President Obama and more disapprove than approve.  Interestingly, in the Rasmussen Daily Tracking poll (which we have highlighted below with a picture of Hedgeye’s own sailor, Zach “The Hammer” Brown), President Obama has improved over the last month or so.  His current approval index is -13 (which is the difference between Strongly Approve and Strongly Disapprove), which is an improvement off his all time low on May 26th, 2010 of -22.  Despite this improvement, the point is President Obama’s approval rating is low, which won’t bode well for the Democrats.

 

 

 

EARLY LOOK: Corner Banging - chart2

 

 
The other important point to consider is that there is substantial dissatisfaction with politicians these days.  In fact, congressional approval is as low as it’s ever been, so the concept of incumbency advantage is likely going to be less impactful than typical this election.  As I wrote back in May:
 
“As many studies note, incumbents typically win re-election 90% of the time.  These early data points are noteworthy and mark the beginning of perhaps a serious shift by voters away from incumbency. This idea is also supported in recent polls.  Specifically, a recent ABC News-Washington Post poll indicated that nearly six in 10 respondents they’re not likely to vote for their current representatives to Congress.”
 
A backlash against incumbents naturally hurts the Democrats because they hold more seats.
 
As we survey the Electoral Ocean in front of us this is what the polls looks like in terms of the shift of power according to the poll averages at Real Clear Politics:

  • Republicans to pick up 8 seats in the Senate but the Democrats will retain control at 51 to 49;
  • Republicans will win 206 seats in the House, the Democrats will win 194 seats and 35 seats are a tossup currently; and
  • The Republicans will pick up 8 governor seats to hold a 32 to 18 seat advantage.

 

The potential for major Republican victory in the fall is realistic, and we need every advantage we can get to ensure we fully understand the probabilities.  Keith and I hope you will join us on Tuesday.
 
As you head into the long weekend with your friends and family, I’ll leave you with one more quote from Mark Twain:
 
“Denial ain’t just a river in Egypt.”
 
Enjoy the weekend.
 
Yours in risk management,
 
Daryl G. Jones


THE DAILY OUTLOOK

TODAY’S S&P 500 SET-UP - September 3, 2010

As we look at today’s set up for the S&P 500, the range is 30 points or 2.7% (1,061) downside and 0.01% (1,091) upside. 

Equity futures are trading flat to higher as the market awaits key US non-farm payroll data later. Today's macro highlights include: Aug Nonfarm Payrolls, Aug Unemployment Rate, Aug Private Nonfarm Payrolls, and Aug ISM Non-Manufacturing Index.

  • Arcsight (ARST) didn’t mention sale in 1Q earnings after WSJ last week reported co. is on the auction block
  • Esterline Technologies (ESL) boosted 2010 EPS forecast to $3.85-$3.95 from $3.45-$3.65, vs est. $3.60
  • Finisar (FNSR) forecast 2Q rev. $215m-$230m vs est. $206.1m
  • H&R Block (HRB) reported 4Q loss per share of $0.36 vs estimate of a loss of $0.41
  • Krispy Kreme Doughnuts (KKD) forecast FY11 operating income ex charges $13m-$17m, up from prev. guidance $11m-$15m
  • Quicksilver (ZQK) reported 3Q rev. $441.5m vs estimate $443.7m
  • SeaChange International (SEAC) CUTS FY rev. forecast to $215m-$220m from $225m-$235m
  • Sunoco (SUN) said former GM CEO Frederick A. Henderson has joined the company as a senior VP
  • Take-Two Interactive Software (TTWO) boosts FY adj. EPS forecast to $0.60-$0.70, from loss $0.10-$0.30, vs estimate $0.20 loss
  • Ulta Salon Cosmetics & Fragrance (ULTA) forecast 3Q adj. EPS $0.20-$0.22c vs estimate $0.17
  • U.S. Airways Group (LCC) said August passenger rev. per available seat mile increased estimate 15%

PERFORMANCE

  • One day: Dow +0.49%, S&P +0.91%, Nasdaq +1.06%, Russell 2000 +1.16%
  • Month-to-date: Dow +3.05%, S&P +3.89%, Nasdaq +4.07%, Russell +5.02%
  • Quarter-to-date: Dow +5.59%, S&P +5.76%, Nasdaq +4.30%, Russell +3.74%
  • Year-to-date: Dow (1.04%), S&P (2.24%), Nasdaq (3.05%), Russell +1.10%

EQUITY SENTIMENT:

  • ADVANCE/DECLINE LINE: 1228 (-1005)
  • VOLUME: NYSE - 960.71 (-19%) - volume drying up ahead of the jobs report
  • SECTOR PERFORMANCE: All sectors up XLU
  • MARKET LEADING/LAGGING STOCKS YESTERDAY: Nordstrom +8.05%, Goodyear Tire +6.30% and LTD Brands +6.10%/Abercrombie -3.88%, Tyson -3.32% and Total Systems -3.30%
  • VIX: 23.19 -2.93% - down 15.3% in past week - YTD PERFORMANCE - +7.0%         
  • SPX PUT/CALL RATIO: 1.32 from 1.21  

CREDIT/ECONOMIC MARKET LOOK:

  • TED SPREAD: 16.91 +0.249 (1.495%)
  •  3-MONTH T-BILL YIELD .14% +.01%
  • YIELD CURVE: 2.13 from 2.08

COMMODITY/GROWTH EXPECTATION:

  • CRB: 271.15 +0.98%
  • Oil: 75.02 +1.50% - a 2 day rally looks to end today
  • COPPER: 349.55 +0.52% - Dr C ragging ahead again
  • GOLD: 1,250 -0.36% - up 4 of the last 5 days

CURRENCIES:

  • EURO: 1.2808 +0.09% - looking at a 4 day rally
  • DOLLAR: 82.463 -0.07% - looking to be down for the last 3 days

OVERSEAS MARKETS:

ASIA

  • Nikkei +0.57%; Shanghai Composite (0.01%)
  • Most Asian markets ended higher or flat fuelled on the day. Technology stocks in the region outperformed tracking Nasdaq’s rise yesterday.

 

EUROPE

  • FTSE 100: +0.25%; DAX +0.31%; CAC 40: +0.40%
  • Major European indices are trading flat ahead of US non-farm payroll data later today. Technology stocks are higher in the region tracking gains by their peers in Asia earlier and on the Nasdaq yesterday. Food & Beverages and Autos are among the worst performing sectors this morning in Europe.
  • UK Aug Services PMI 51.3 vs consensus 52.9 and prior 53.1
  • EuroZone Aug Final Services PMI 55.9 vs preliminary 55.6
  • EuroZone Aug Final Composite PMI 56.2 vs preliminary 56.1
  • Germany Aug Final Services PMI 57.2 vs preliminary 58.5
  • France Aug Final Services PMI 60.4 vs preliminary 59.9
  • Eurozone July Retail Sales +1.1% y/y vs consensus +0.6% and prior revised +1.2% from +0.4% 
Howard Penney
Managing Director

THE DAILY OUTLOOK - S P

 

THE DAILY OUTLOOK - VIX

 

THE DAILY OUTLOOK - DOLLAR

 

THE DAILY OUTLOOK - OIL

 

THE DAILY OUTLOOK - GOLD

 

THE DAILY OUTLOOK - COPPER


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R3: Earl, Cotton, TBL, Choo, UA, and GES

R3: REQUIRED RETAIL READING

September 3, 2010

 

Nothing like a hurricane to take the “wind” out of a retailer’s sales.  Expect those with weakness in September to blame Earl come next sales day. 

 

RESEARCH ANECDOTES

 

- Quicksilver noted that trends picked up meaningfully towards of the end of August and into early September following a weaker performance in June and July. Sales improvement coincides with the timing of back-to-school. Interestingly, similar trends are being observed in non-U.S. markets as well.

 

- As Dockers tries to reinvent the brand it has collaborated with NY based designer Steven Alan on a co-branded, higher end line. The products will be made available at Barney’s New York and at Steven Alan’s namesake boutiques, with pants priced at $128 to $148. More importantly expect a PR blitz to make its way through the fashion community. How this translates into sales of $40 khakis at Kohl’s is still unclear, but the effort is certainly noted.

 

- In one of the more rare transitions of a children’s product into the adult world, Silly Bandz may be destined for a second life. It turns out that the rubber bracelets (which come in a million shapes and colors) are now being used on the dating scene in Manhattan as a sign of flirtation. In other words, men and women are exchanging these rubber bracelets at bars as part of the dating process. Talk about a way to kill a brand (and a product).

 

 

OUR TAKE ON OVERNIGHT NEWS 

 

US Apparel Companies Turn Up the Heat on Bangladesh - U.S. retailers and apparel companies are taking a proactive stance against reports of police and government repression of garment workers and arrests of union activists in Bangladesh. The American Apparel & Footwear Association sent a letter to Bangladesh’s ambassador to the U.S., Akramul Qader, on Wednesday, expressing its concerns about the reports. The Bangladesh government moved to increase the country’s minimum wage in the garment industry in July, following months of widespread violent protests by workers and their union, but the protests have continued amidst widespread reports of worker repression and intimidation and union arrests. <wwd.com/business-news>

Hedgeye Retail’s Take:  The bottom line on rising prices out of this region and potential supply-chain disruptions in the interim are still unchanged.  It’s highly unlikely (while politically correct) that the AAFA puts this major political issue to rest for the Bangladeshis.

 

Hurricane Earl Causes Difficulties for Retailers - U.S. retailers in Hurricane Earl’s projected path were already feeling the effects of the storm before the first drop of rain or gust of wind. Retailers from the Carolinas to Massachusetts are missing out on sales this weekend especially because its the last big weekend of back-to-school. Stores noticed the first drop-off in sales on Wednesday, when recreational parks in the area were closed and travelers began to leave town.  <wwd.com/footwear-news>

Hedgeye Retail’s Take:  Take note come September sales day when retailers cite Earl as a reason for weaker sales.  As of now, this storm will likely have minimal impact on retailing as it is expected to move offshore quite quickly and is not anticipated to hover over any major metro areas.  Yes, the final summer weekend in Cape Cod, Nantucket, and Martha’s Vineyard could be impacted.  Not good for Murray’s.

 

Steve Madden Looks To Capitalize on Betsey Johnson's Credit Issues - Betsey Johnson’s credit headache could prove to be Steve Madden’s designer brand opportunity. In papers filed with the Securities and Exchange Commission late Thursday, Steven Madden Ltd. said it had taken over a $48.8 mm loan to Johnson’s firm, Betsey Johnson LLC, that is currently in default. If Johnson can’t repay the loan by Aug. 20, 2012, Madden would end up owning the brand — and could even seize the personal assets of Johnson and her chief executive officer, Chantal Bacon. There are 66 Betsey Johnson boutiques and plans call for the chain to expand to 100 stores by 2012, according to the designer’s Web site. Madden already holds a license for handbags, small leather goods, belts and umbrellas under the Betsey Johnson and Betseyville trademarks. <wwd.com/business-news>

Hedgeye Retail’s Take:  Looks like a fairly smart move as the company continues to acquire beyond the core shoe biz.  Both a real estate and brand play, this may ultimately prove to be a savvy investment.

 

More on Jimmy Choo Possible IPO - Jimmy Choo isn’t for sale at the moment, but that isn’t preventing investment banks from sniffing around. Industry sources said banks eager to drum up new business have been approaching the footwear and accessories firm, which this year is expected to post revenues of 150 million pounds, or $231 million, at current exchange. TowerBrook principals narrowed down the list and asked only Goldman Sachs and Morgan Stanley to prepare pitches with a view to becoming strategic advisers on future options for the company. <wwd.com/business-news>

Hedgeye Retail’s Take:  With momentum in the higher-end luxury retail segment hitting a pause recently, we wonder how quickly Goldman and Morgan can prepare their pitches.  If a roadshow does materialize, be prepared for a lesson in how Choo can morph into a “lifestyle” brand as well as a global retailer.

 

Timberland Steps Up Marketing on Green Products - The Timberland Company is escalating its green marketing activities with the launch of its biggest and most environmentally-focused marketing campaign yet -- Nature Needs Heroes. Launching globally over the next several weeks, the campaign showcases Timberland's Earthkeepers collection. Made with materials like recycled rubber and recycled PET (one and a half plastic bottles are used in each pair of Earthkeepers boots), Earthkeepers product is one of the company's leading and fastest growing product collections. <sportsonesource.com>

Hedgeye Retail’s Take:  While the overall business may still be under pressure, the company’s efforts in the area of sustainability and the environment clearly add credibility and authenticity to the brand.  Consumers are beginning to embrace social responsibility in a meaningful way and Timberland has been an early adopter of such efforts.

 

Under Armour Focuses on Women - Under Armour is determined to strike a chord with female athletes—many of whom have been buying the brand, but aren’t that emotionally attached to it. The company has kicked off a campaign that includes a Facebook page dedicated to women’s performance apparel. The target demographic is a female consumer who “trains in Under Armour, but doesn’t really know about the brand other than [that] it’s her boyfriend’s brand," said Adrienne Lofton, senior marketing director of Under Armour’s women’s business. The campaign, which is part the brand’s “Protect This House. I Will” campaign, includes a star-studded lineup of athletes. There is Lindsey Vonn, an Olympic gold medalist downhill skier; soccer sensation Lauren Cheney; and track and field runner Monica Hargrove. One 60-second spot (now on YouTube) takes viewers through the grueling, day-to-day training these female athletes go through to be on top of their game. Vonn lifts weights and balances herself atop a yoga ball, for instance, while Cheney collides with a player in the soccer field. <brandweek.com>

Hedgeye Retail’s Take:  Recall that UA hired a separate agency and team of marketing and merchandising execs to focus exclusively on the female consumer.  It appears that the early byproducts of these efforts are now beginning to trickle out.  Women’s continues to be a huge, untapped opportunity for the brand.

 

First Kidswear Store Signals UK Retail Assault By Guess - US denim brand and retailer Guess is to open standalone stores for its kidswear range and Guess by Marciano sub-brand as it gears up for rapid retail expansion in the UK. <drapersonline.com>

Hedgeye Retail’s Take:  Similar to the US, kids retail appears to be the concept du-jour.  Unfortunately, higher price points will put a lid on ultimate kids expansion, unless of course the concept is planning to take prices lower. 

 

Social Networking Doubles Among Boomers and Seniors - Social media usage has nearly reached saturation among younger adults, and its highest growth rates are now coming from internet users ages 65 and up, who have doubled their usage of social networking sites in the past year. The mass appeal is causing ad dollars to flow, but could it cost sites like Facebook their cool factor? <emarketer.com>

Hedgeye Retail’s Take:  While this is certainly noteworthy, we wonder if the adoption curve for social networking in the 65+ category is any different from other youth-perceived tech products.  Either way, the broader the audience online, the less relevant TV and Radio become.

 

R3: Earl, Cotton, TBL, Choo, UA, and GES - 1

 

Visa and MasterCard Show Increased Transaction Activity in E-Commerce - More than 12% of Visa's global transaction volume comes from the web, and because its growing faster than other channels Visa has stepped up their focus.  That sharper focus is evident by a series of moves in 2010 from both Visa and its main rival, MasterCard Worldwide, which does not break out its e-commerce volume. Here's what they've done this year:

— In March, Visa announced plans for an online social shopping service and electronic wallet called Rightcliq.

— MasterCard soon afterward unveiled MasterCard Marketplace, featuring discount offers from online retailers.

— Later that month, MasterCard created a new research and development unit called MasterCard Labs to speed new payment products to market. Its first initiative, announced in May and called Open APIs, is designed to make it easier for mobile and web developers to integrate MasterCard payments into their applications.

— Visa in April announced it was paying $2 billion for CyberSource Corp., a major provider of fraud prevention and payment processing services to online retailers.

— MasterCard last month announced plans to pay $520 million for U.K.-based payment processor DataCash Group plc, calling it a move to strengthen its position in e-commerce.

What all this will mean for web and mobile retailers is still coming into focus, as these initiatives are so new. But experts agree that the Visa/CyberSource combination could bring valuable new services to retailers and that MasterCard's Open APIs puts it in the thick of fast-changing developments in mobile payments.  <internetretailer.com>

Hedgeye Retail’s Take:  Fishing where the fish are.  The real innovation here however, will come when the traditional credit card is no longer needed to transact online or from a mobile device.  One click payment (like Paypal) and wireless payments seem closer to a widespread reality than ever before.  However, security and privacy concerns remain a key factor in holding back mass adoption.

 


Corner Banging

“Twenty years from now you will be more disappointed by the things that you didn't do than by the ones you did do. So throw off the bowlines. Sail away from the safe harbor. Catch the trade winds in your sails. Explore. Dream. Discover.” 

-Mark Twain

 

On Tuesday, Keith comes back from vacation.  I’ll be honest, setting aside the fact that Keith and I have been friends for upwards of 15 years and I like having him around, wearing his jersey in the mornings is not easy.  I’m all about hard work, but, seriously, you try preparing for a 20-minute conference and writing a strategy note all by 8:30 am every day.  I’m starting to understand why some of his morning notes make him sound a bit a grumpy, this isn’t easy!

 

If you didn’t know, corner banging is a sailing term.  It basically means to sail all the way to one side of a race course in search of a strategic advantage.  If you bang the corner, you either win big, or you lose big.  That’s it.  For those of you who have been reading our notes for the last couple years, it is likely quite clear that we are not corner bangers.  If we’ve said it once, we’ve said it many times: we are Risk Managers.  In fact, the term is so common around our office, we even added it to the name of our company, Hedgeye Risk Management.

 

Managing risk isn’t about being short or just having a high allocation of capital to cash, but rather preparing and contemplating events that could happen and impact our portfolios.  As we look forward over the next couple of months, one specific event that jump out in our minds is the midterm elections.  There is potential that the Republicans, who are expected to do well, which could have an impact on whether the Bush tax cuts are extended.  It is our belief that the idea of the Bush tax cuts being extended is not currently priced into the market.

 

The Bush tax cuts are meaningful. To highlight this point, in the bullet points below we compare what would happen to certain tax rates if the Bush tax cuts are not extended:

  • Short term capital gains would go from 35% to 39.6%;
  • Long term capital gains would go from 15% to 20%;
  • Qualified divided taxes would go from 15% to 39.6%;
  • Non-qualified dividend taxes would go from 25% to 39.6%; and
  • Wage taxes in the top bracket would go from 35% to 39.6%.

On a very basic level, an increase in divided taxes should decrease the value of those companies that pay dividends, all else being equal.

 

On September 7th at 230pm, Keith and I will be hosting a call with Karl Rove to discuss the midterms with the title, “Could The Midterm Election Be A Major Stock Market Catalyst?”  Karl, as many of you know, is known as “the Architect” for putting together the successful Gubernatorial and Presidential campaigns for George W. Bush.  Now let’s be clear, we get that Mr. Rove is a Republican and that many of you may be athwartship (a sailing term that means at right angles) politically with Karl, but this is not a political call.  This is about sitting down with one of the premier political analysts in the country and having a Big Boy Talk with him. The point is to try and determine whether the midterms will indeed be a catalyst.  If you are a current subscriber or would like to trial our service and participate in the call, please email us at .

 

As former long time Speaker of the House famously said: “All politics is local.” Typically this is indeed true, so while we can presume to know what is going on from our perches in Manhattan, Boston, New Haven, or wherever we may be, bringing in a man who has studied elections in this country on a county by county level is sure to help make sure our sails are directed toward the wind.  Currently, the Republicans clearly have the wind behind their sails.

 

To begin with, President Obama’s approval ratings are quite low.  According to the Real Clear politics poll average, 46.4% of those polled approve of the job President Obama is doing and 47.8% of those polled disapprove.  So, in aggregate, less than half of the country approves President Obama and more disapprove than approve.  Interestingly, in the Rasmussen Daily Tracking poll (which we have highlighted below with a picture of Hedgeye’s own sailor, Zach “The Hammer” Brown), President Obama has improved over the last month or so.  His current approval index is -13 (which is the difference between Strongly Approve and Strongly Disapprove), which is an improvement off his all time low on May 26th, 2010 of -22.  Despite this improvement, the point is President Obama’s approval rating is low, which won’t bode well for the Democrats.

 

The other important point to consider is that there is substantial dissatisfaction with politicians these days.  In fact, congressional approval is as low as it’s ever been, so the concept of incumbency advantage is likely going to be less impactful than typical this election.  As I wrote back in May:

 

“As many studies note, incumbents typically win re-election 90% of the time.  These early data points are noteworthy and mark the beginning of perhaps a serious shift by voters away from incumbency. This idea is also supported in recent polls.  Specifically, a recent ABC News-Washington Post poll indicated that nearly six in 10 respondents they’re not likely to vote for their current representatives to Congress.” 

 

A backlash against incumbents naturally hurts the Democrats because they hold more seats.

 

As we survey the Electoral Ocean in front of us this is what the polls looks like in terms of the shift of power according to the poll averages at Real Clear Politics:

  • Republicans to pick up 8 seats in the Senate but the Democrats will retain control at 51 to 49;
  • Republicans will win 206 seats in the House, the Democrats will win 194 seats and 35 seats are a tossup currently; and
  • The Republicans will pick up 8 governor seats to hold a 32 to 18 seat advantage.

The potential for major Republican victory in the fall is realistic, and we need every advantage we can get to ensure we fully understand the probabilities.  Keith and I hope you will join us on Tuesday.

 

As you head into the long weekend with your friends and family, I’ll leave you with one more quote from Mark Twain:

 

“Denial ain’t just a river in Egypt.”

 

Enjoy the weekend.

 

Yours in risk management,

 

Daryl G. Jones

 

Corner Banging - hammer1


U.S. Treasury Debt... Wouldn't Touch It With a Ten Foot Pole

Conclusion: Analyzing the latest quarterly presentation of the Treasury Borrowing Advisory Committee leads to some pretty negative takeaways as it relates to the fiscal health of the U.S.

 

Position: Short the U.S. dollar (UUP); Short 1-3 year U.S. Treasuries (SHY)

 

Below is a collection of select charts we pulled from the Department of the Treasury’s latest quarterly presentation to the Treasury Borrowing Advisory Committee. Needless to say, all is not well in our Hedgeyes, which is evident in the analysis below. We continue to remain short the short end of the yield curve and the U.S. dollar to express our bearish conviction regarding the U.S. government’s fiscal health and the negative long term economic outlook domestically.

 

After having tax revenues trending well below the historical recovery average since the end of the recession, we’ve finally eclipsed the average four quarters into the recovery. Unfortunately, that’s comes just as the Bush tax cuts may be extended while employment is deteriorating and both consumer spending and housing appear to exhibit significant downside over the next 3-4 quarters.

 

 U.S. Treasury Debt... Wouldn't Touch It With a Ten Foot Pole - 1

 

Much of the growth in tax revenue have been driven by corporate tax receipts, which look to slow absent an effective tax hike in the upcoming period of slow growth and depressed top line growth. Many companies have been pulling margins levers to drive earnings growth in recent quarters so a tax hike could be disastrous for earnings going forward, as these companies don’t have much left to cut.

 

 U.S. Treasury Debt... Wouldn't Touch It With a Ten Foot Pole - 2

 

If the federal government eats the marginal loss in revenues, they will need to borrow more to fund a larger deficit on the margin. Based on the deficit projections from our Hedgeye models, their estimates for borrowing (i.e. Piling Debt Upon Debt) over the next two years are far too low.

 

 U.S. Treasury Debt... Wouldn't Touch It With a Ten Foot Pole - 3

 

With yields on the long end of the curve near historic lows, the average maturity of U.S. Treasury debt outstanding has continued to increase as the Treasury issues more long-dated paper. Currently, the average maturity is right at the 30-year average of 58 months, or 16 months above the 30-year minimum and 13 months below the 30-year maximum. Should this up-trend continue, U.S. Treasury holders in aggregate will be increasingly subject to further duration risk – which is noteworthy given the fiscal health of the country (see: PIIGS 2010).

 

 U.S. Treasury Debt... Wouldn't Touch It With a Ten Foot Pole - 4

 

The percentage of debt maturing in the near-term is at historic lows on a 20-year basis. Even still, roughly 31% of treasuries ($4.1 trillion) need to be refinanced in the next 12 months. Adding that with a consensus minimum of $950 billion in financing needs in FY11 leaves us with 38.2% of treasury debt needing to be financed in the next 16 months. Accounting for Hedgeye’s worst case scenario of $1.93 trillion in financing needs for FY11 takes the magic number up to 45.6%.  This occurs at a time when it will likely become more difficult for the United States to roll over short term debt due to burgeoning fiscal issues.

 

 U.S. Treasury Debt... Wouldn't Touch It With a Ten Foot Pole - 5

 

A chart that really jumped out to us was their interest expense projections. Under baseline OMB scenarios (which we have shown in our previous  work to assume above-trend growth and below-trend expenditures), the federal budget’s interest expense will jump to nearly 4% of GDP in just ten years – a near 275bps increase from today’s ratio of ~1.25%! This is not surprising given the upward direction of the average maturity of public debt outstanding. A domestic interest expense near 4% of GDP is well above the historic average for the previous 60 years and this rise will naturally present significant trouble for the fiscal health of the United States over the next decade – especially considering the current direction of entitlement and healthcare spending. Either taxes will have to ramp up significantly in the next 5-10 years or the U.S. will continue to have to Pile MORE Debt Upon Debt to fund its deficits. Either result is negative for future economic growth domestically.

 

 U.S. Treasury Debt... Wouldn't Touch It With a Ten Foot Pole - 6

 

The next chart highlights a pretty interesting conundrum the U.S. federal government is in regarding the direction of interest expenses. When compared to many of its Western European and Japanese counterparts, we see the weighted average maturity of U.S. Treasury debt outstanding is below the group average. This means that the Department of the Treasury has room to take advantage of depressed yields at the long end of the curve and issue more long-dated securities, further increasing the interest rate burden on the federal government P&L.  Should the U.S. remain a group laggard and/or reduce its average maturity profile, it will leave itself more exposed to market sentiment and a potential crisis of confidence in U.S. Treasury debt. China has been selling U.S. Treasuries and should any other major holder (i.e. Japan, U.S. commercial banks, U.S. pension and hedge funds, etc.) follow suit, the U.S. government could potentially face a substantial refinancing crisis if rates on the short end of the curve back up meaningfully.

 

 U.S. Treasury Debt... Wouldn't Touch It With a Ten Foot Pole - 7

 

The last chart we want to highlight shows U.S. Treasury issuance will continue to dominate the debt supply landscape over the next couple of years, further crowding out private sector investment. Not much else to say here other than the fact that we are likely to face below trend GDP growth from a lack of private investment as long as the grey bar continues to dominate the chart below.

 

 U.S. Treasury Debt... Wouldn't Touch It With a Ten Foot Pole - 8

 

All told, we continue to remain short the short end of the yield curve and the U.S. dollar to express our bearish conviction regarding the U.S. government’s fiscal health and the negative long term economic outlook. The federal government’s aggressive baseline projections highlight some pretty negative trends and the more conservative Hedgeye models suggest even more downside as it relates to the intermediate-to-long-term fiscal heath of the U.S.

 

Darius Dale

Analyst


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