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Feeling Strange

“Is it not strange that desire should so many years outlive performance?”

-William Shakespeare


This morning’s global macro risk management setup feels as strange as it has since September of 2007.


As most market historians will recall, the S&P 500’s run from Labor Day of 2007 until the first week of October 2007 was the final countdown to get out. That’s not to say that the shorts who pressed the August of 2007 lows didn’t get run over in September of 2007 by the way. I, for one, got crushed.


I’m not one to say that market history repeats, but I am a big believer that patterns of market behavior rhyme. Think about both the absurdity of the prices paid by Private Equity and LBO firms in 2007 and then rewind the quality of yesterday’s “rumor mill” about everybody buying everybody. The sad reality of our business is that the hopes and desires of low quality market players trying to make a living on rumors is many years outlived by actual performance.


The performance of the S&P 500 from September 4th – October 8th of 2007 was +4.3%. The month-to-date performance of the S&P 500 for September of 2010 is +4.7%. You can tell me what parts of the “M&A” rumor mill is driving this low-volume rally to lower-highs. I can tell you that it’s not insignificant.


I can also tell you that there are significant and strange developments occurring across global markets this morning. Remember, managing the risk associated with a rally in US Equities requires analyzing the multi-factor and multi-duration price action that’s driving this globally interconnected ecosystem. The best I can do this morning is summarize how strange this is all feeling by major geography.


Before I dig in geographically, it’s worth mentioning that there is one major factor governing news-flow worldwide right now – professional politicians fundamentally believing that they are the arbitrators of all our desires. Strange.


1.       Asia


Other than Japanese equities crashing again (Nikkei 225 down -20% from its April peak) and few in the Manic Media acknowledging that Japan is a much larger long term issue than Greece, isn’t the following comment from Japan’s Finance Minister, Yoshihko Noda, this morning strange?


“I feel strange that China can buy Japanese government bonds while Japan can’t buy theirs.”


Capitalistic note to bureaucratic self: the world’s largest creditor can buy whatever they damn well please. You, Captain Debtor Nation, shouldn’t feel strange at all now that you have compromised and constrained your economic system with systemically impairing levels of leverage.


By the way, this is how a spokesman at China’s Foreign Ministry, replied in Beijing today. “We will decide whether or not to buy one country’s bonds according to our own needs.” There’s nothing strange about that.


2.       Europe


Watching Bloomberg TV’s Andrea Catherwood interview Greece’s Director General of Public Debt Management Agency, Petros Christodoulou, this morning was beyond strange. Never mind what a professional politician is doing with a title that long, what in God’s good name do market participants expect him to say about Greece’s debt?


In Q2 of this year, we introduced a Hedgeye Macro Theme called “The Sovereign Debt Dichotomy.” The long term cycle work on the sovereign debt default cycle was backed by Reinhart & Rogoff and our core thesis remains long term as cycles like these are. The bottom line is that sovereign debtor nations will be forced into restructuring or default at different points in time for the balance of the next 3 years. They won’t all happen at once!


Is it strange that Denmark (up +22% YTD) is trading up +0.79% this morning and Greece (down -28% YTD) is trading down again after getting clocked yesterday? Is it strange that Petros “rules out restructuring”? or is it just strange that a professional politician like this actually matters to markets?


3.       USA


Price action in US Equities is definitely improving. I can call that strange – I certainly did in 2007! But strange can remain longer than a short seller can remain solvent. Learning from my mistakes and evolving the risk management process is where I’m focused on improving.


Both the weekly ABC/Washington Post Consumer confidence (-43 vs -45) and MBA Mortgage Application (+6.3% week-over-week) reports were better than expected yesterday. For the two big things that matter for US economic growth (consumer spending and housing), there should be nothing strange about the fact that the only moves I made in the Hedgeye Portfolio yesterday were buys and covers. As facts change, I need to.


While these data points appear strange in the immediate term, they are real. It’s also important to Distinguish Our Immediate Term Duration from the Intermediate Term bearish TRENDs we continue to forecast in both US consumer spending and housing.


While I don’t think it’s strange that the US market won’t focus on something like Harrisburgh, PA defaulting on its September 15th payment until they actually miss the payment, it’s sometimes strange to just think about these things out loud from the fishbowl that is my office in New Haven, CT.


Whether its in CT, IL, or AZ, these states and the municipalities that they house are going to be feeling more and more strange as they march down the Road To Perdition that many European states have already trekked. Will Illinois be the next Greece?  Will the US Federal Government be forced to bail out municipalities and states like the EU had to with Greece, Spain, and Portugal?


If China is selling US Treasuries and buying Japanese Government Bonds, where will we get the money? There should be nothing strange about asking yourself these risk management questions.


My immediate term support and resistance levels for the SP500 are now 1086 and 1107, respectively. If 1086 can hold, I’ll continue to be far less aggressive with my shorts this September than I was in 2007. This Time Is Different.


Best of luck out there today,



Keith R. McCullough
Chief Executive Officer


Feeling Strange - 1


The Macau Metro Monitor, September 9th 2010



A spokesperson for the Ministry of Community Development, Youth and Sports (MCYS) said, "We're investigating the provision of free transport by the IR operators. The IR operators will not be allowed to target the local market or provide incentives in any form for Singaporeans to patronise the casinos."  But RWS spokesman Robin Goh said the free services are the result of feedback and "the age-old perception that Sentosa was too far and inaccessible ... " The shuttle buses deliver about 2,500 people per day to the resort, and in surveys of passengers, more than 60% of them indicate they are not going to the casino, but to Universal Studios or "others", said Mr Goh.


The free shuttle of RWS are available at two spots in the Central Business District as well as 12 HDB town centres, including Ang Mo Kio, Jurong East, Tampines and Bedok.  MBS's free shuttle runs between the resort and Changi Airport and hotels in the Marina Bay area.  MBS recently introduced premium bus services to Orchard Road, the Central Business District and Chinatown.


Higher commissions may be driving the junket switch from the Peninsula to Cotai, but that doesn’t explain the Mass shift.



The following charts show monthly market share of Mass revenue, VIP revenue, and Rolling Chip volume generated on the Cotai Strip as a percentage of total Macau.  It is clear that Cotai has been gaining share sequentially throughout most of this year in all three categories.  The gains cannot be attributable to new supply since City of Dreams opened on June 1st, 2009.  The other major new supply actually opened off Cotai:  Wynn Encore, L’Arc, and Oceanus. 


The Cotai bears (mostly Wynn bulls) will point out that City of Dreams has probably been more generous in recent months with their junket commission rate and we would agree.  That certainly would pull VIP revenue away from the Peninsula since that is where most of that type of revenue is generated.  However, a higher junket commission rate at CoD does not explain the Mass shift.  The Cotai gains in Mass revenues have been as strong as the VIP shifts.  With more entertainment options and bigger facilities, could it be that Cotai is becoming the “in” place to congregate for the lucrative Mass customer?


We also included Wynn’s market share in each segment.  Wynn has lost a little Mass share this year, especially in August and we think in September thus far.  What’s surprising is that despite the opening of Encore in April, VIP and RC share has stayed fairly constant, after normalizing for the obvious hold volatility.  We would’ve expected better.







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PVH: The Ultimate Consensus Long?

PVH: The Ultimate Consensus Long?


PVH is a consensus long. Period. The interesting thing is that the Tommy deal structurally makes sense, but the narrative behind how, why and when is not pretty by any means. While the world loves PVH, bears might have to wait another 3-quarters until the $300mm cookie jar is empty for some thesis validation.


This is one of those consensus longs that bugs me so many levels, but to fight the tape on a name that has a $300mm cookie jar to fuel earnings over the next year is a tough one. I love how management says that the Tommy Hilfiger deal will be $0.30-$0.35ps (10-12%) accretive, but this excludes $3.21 per share in integration costs. So let me get this straight… they’re going to INCLUDE the revenue and operating profit on the base business – but will EXCLUDE the costs to realize it. The only thing that’s worse is that the Street is taking the bait.


The irony here is that I actually think that the combination makes sense. It gives PVH significantly greater exposure to Europe – where the Tommy brand has always been exceptionally strong (despite its roller coaster ride in the US), and further diversifies PVH away from its legacy dress shirt business – which might be dominant with 46% share in department stores, but it is a price taker in a commodity category. Now the legacy biz is down to 10% of sales and 8% of EBIT vs. 23% and 22%, respectively last year (and over 75% before Calvin).


But as much as I can justify the deal, let’s not forget the fact that PVH NEEDED this. This is not Manny’s first rodeo. He saw what was coming. PVH is capping off a period where CK drove the business and then – like most other companies in retail – relied on extremely tight inventory management pushing peaky gross margins. Tack on a 4% decline in G&A due to corporate workforce cuts (400 positions at about $40mm) and write downs at Geoffrey Beane, and PVH realized 7% EBIT growth last year on a 4% sales decline.


Now, the company begins to go up against extremely tough compares on the gross margin and SG&A lines, and must rely on sales. But without the consumer showing up en masse, the company needs a PVH-specific product driver for the core business – and it would have needed to have been investing in that for the past 2-years. Either that, or it could have simply gone out and bought growth – a la Tommy.


The icing on the cake is a complete reclassification of the reporting segments. In all fairness, this is likely the proper thing to do as GAAP accounting states the company must report in a way that it runs its business – and the business structure has changed. But the reality is that the reclassification clouds the water as it relates to understanding the real trajectory of each of PVH’s units.


This note sounds like sour grapes. That’s not intended. I call the narrative for what it is, and will model it accordingly. Keith will guide with timing and sizing on either side. For now, this is a ‘Do Nothing’ stock -- though I have a fundamental bias to the downside 2-3 quarters out.



FYI: An interesting comment from management on the call about inventories. Good perspective. Sounds like the lynchpin is whether the department stores are correct in modeling 2-4% comp store sales.


I guess I'll speak on inventory levels at retail. I think the retailers -- we went through nine months starting in the third quarter of last year where retailers were chasing inventory consistently from suppliers and because of the availability of production piece goods, in that time frame you were able to react quicker. There was production availability. You were able to get it in. You were able to do what was necessary, fly goods, do whatever. There was transportation available. As demand really started to dramatically improve in the fourth quarter of last year, coming into 2010, clearly production started to fill up. You know all the stories about all the transportation issues. We were very clear with our retail partners. If you want goods, it's going to be very difficult to chase in the second half of 2010. You're going to have to get the orders. So the retailers were forced to really get ahead of the sales trend and they're buying into whatever their planned comps are. We're seeing that in our business and right now I would say to you inventories are in good position. We're in excellent shape at retail. The sales plans with our key customers seem to be running ahead. Clearly inventory's in good shape and they've bought into their 2% or 4% comp store increase depending whatever it is, the retailers have basically bought into that.



The chart was extracted from a note dubbed "HOPE FADING BUT ON ITS HOLD UNTIL DECEMBER" issued to Risk Manager Subscribers earlier today, September 8, 2010.




The chart below details where the unemployment rate would be if the labor force participation rate was at its ten-year average level of 66.1%; for the year-to-date, it has been averaging 64.8%.  This implies that many folks are losing heart and dropping out of the job hunt.



CHART: HOPE FADING... - chart1


Easy comparisons and a beneficial cost environment should translate into strong fiscal 1Q11 results.


Darden is scheduled to report its fiscal 1Q11 earnings after the market close on September 21st.  The company is lapping extremely easy blended same-store sales comparisons in the first half of the year of -5.3% and -4.7% in 1Q10 and 2Q10, respectively.  Of the three larger concepts, the comparisons are particularly easy at Red Lobster as comps declined 7.9% and 8.4% in 1Q10 and 2Q10, respectively. 


These easier comparisons should allow Darden to report positive comps during 1Q11 even if trends slow slightly on a two-year average basis.  That being said, given the current macroeconomic backdrop, I continue to think the company’s full-year same-store sales guidance of +2% to +3% could prove aggressive.  Lower food costs in 1H11, lower YOY labor costs as a percentage of sales, expected incremental cost savings initiatives of $10 to $15 million and accelerated share repurchase during fiscal 2011 leave me less concerned about the company’s ability to achieve its 14% to 17% EPS growth target.


For reference, casual dining same-store sales trends on a two-year average basis, as measured by Malcolm Knapp, slowed about 50 bps through the first two months of Darden’s fiscal 1Q11 (June and July) from the prior quarter.  Darden’s reported results will provide the first real glimpse of casual dining trends in August and insight into whether or not the industry was able to sustain the sequentially better results from July on a two-year average basis after posting declines for the prior three months.


Increased leverage from positive same-store sales growth, combined with the expected beneficial cost environment, should lift margins during the first quarter and for the entire first half of the year.  The company guided to continued food costs favorability during fiscal 1H11 but expects costs to level out during the second half of the year.  To that end, management has good visibility on its food costs through the first half of the year as it has contracted most of its commodity needs through December.


Also helping YOY margin growth during fiscal 2011 is the fact that the company is lapping significantly higher labor expenses as a percentage of sales from fiscal 2010, largely in the first half of the year.  Management attributed these higher labor costs in fiscal 2010 to sales deleveraging, increased benefit costs, wage rate inflation and higher manager bonuses.  For fiscal 2011, the company guided to lower labor costs as a percentage of sales and I would expect the biggest YOY benefit to come during 1H11.


Darden’s cash flow story remains intact.  The company recently increased its quarterly dividend 28% to $0.32 per share and expects to repurchase about $300 to $350 million of shares during FY11, up from $85 million in FY10. 


Howard Penney

Managing Director


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