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THE HOUSE OF UNINTENDED CONSEQUENCES

We continue to see some pretty spectacular moves in agricultural commodities, which have been triggered by adverse weather events around the world that have caused production shortfalls.  At the same time the free monies policies of the Federal Reserve are leading to increased speculation in commodity markets.  This is similar to the scenario that unfolded in 2007 when the Federal Reserve began to cut rates and flood the system with liquidity in response to the subprime crisis.

 

The unlimited supply of money (including derivatives) created by the Fiat Fools can dwarf the limited supply of hard commodities.  We are seeing that occur right now with the price of food stuffs, as represented by the CRB Foodstuffs Index, reaching new highs in terms of year-over-year growth. 

 

How is this consistent with the Federal Reserve dual mandate of full employment and price stability?

 

The unintended consequence here is that the restaurant industry is going to feel margin pressure in the not-too-distant future.  The last time corn was at $6, Casual Dining margins were over 200 basis points lower than they were in 2Q10!  Additionally, news that the EPA is expected to sign off on higher concentrations of ethanol in gasoline for newer vehicles, raising the maximum blend from 10% to 15%, is further supportive of corn prices.

 

Consumers on Main Street might get the complexities of derivative markets, but they do understand the ramifications of paying higher prices food and gas.

 

THE HOUSE OF UNINTENDED CONSEQUENCES - crb foodstuffs vs cd lag

 

Howard Penney

Managing Director

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Contract For America: Even Slower Growth Ahead?

Conclusion: Careful analysis of State & Local Government fiscal headwinds suggests that a Republican takeover of Congress may lead to decisive spending cuts, which could negatively impact U.S. economic growth in the intermediate term. Furthermore, State and Local Government’s FY11 revenue projections are very out of line with economic reality, which suggests further cuts are on the way.

 

Position: We remain bearish on Muni bonds for the intermediate term TREND.

 

It’s certainly no secret that State & Local Governments are facing tremendous pressure to balance their budgets and their cuts have been a drag on the economy over the past couple of years.  What is not at all baked into consensus GDP forecasts, however, is the likelihood that these measures accelerate meaningfully over the next 2-6 quarters.

 

In FY110 States faced a $191 billion budget shortfall that is estimated to decline to a $160B shortfall in FY11 (which began July 1st and ends June 30, 2011 for all but four states) according to the latest reports from the Center on Budget and Policy Priorities and the National Conference of State Legislatures. The marginal improvement is based on projections of an aggregated +4% YoY increase in tax receipts. All told, of the 47 States surveyed, 40 States expect total tax collections to have positive YoY growth in FY11 and another 6 expect flat growth in the same period. Only one State budget has forecasted a YoY decline in tax collections in FY11 (Alaska b/c of declining crude oil-related revenues).

 

Contract For America: Even Slower Growth Ahead? - 1

 

On a more granular level, we see that 35 of the applicable 43 States are baking in YoY growth in Personal Income Taxes (~34% of State tax collections) ranging from +1% to >10% in FY11. This forecast likely does not consider the damaging effects of the lingering stagnation in the job market. Since the start of the current fiscal year, unemployment has hovered 9.6% and adjusting for the 20-year average labor force participation rate, unemployment nationally is somewhere closer to 11.5%. Total Nonfarm payrolls have declined by a net 218k in the three months since the start of FY11. That compares with a total loss of 221k payrolls in all of FY10! Furthermore, we contend the transfer to real income growth from government-sponsored income growth will be challenging.

 

Contract For America: Even Slower Growth Ahead? - 2

 

Contract For America: Even Slower Growth Ahead? - 3

 

Contract For America: Even Slower Growth Ahead? - 4

 

Of an applicable 45 States, 34 States expect YoY growth in Sales Tax Receipts (~32% of State tax collections) ranging from 1 to >10% in FY11. Another 5 states expect flat Sales Tax receipts YoY, with only 4 forecasting declines in their budgets. Notably, West Virginia anticipates a (-5.3%) decline in Sales Tax Receipts in FY11 due to pulling forward $228 million of FY11 tax collections into FY10. Robbing Peter to pay Paul as they say…

 

We can all but guarantee you that no State budget has the Hedgeye Macro Team’s 4Q10 Theme Consumption Cannonball embedded in their revenue forecasts. Simply put, we expect discretionary spending to go negative to the tune of down 5-6% for each of the next 2-3 quarters starting in 4Q10. Layer on the deteriorating consumer confidence, rising taxes, and Housing Headwinds contributing to a rising savings rate as a result of net worth erosion and it’s almost a certainty that State Sales Tax Receipts will lag in FY11 and potentially into FY12 as well. 34-39 States will be painfully surprised to the downside in this category.

 

Contract For America: Even Slower Growth Ahead? - 5

 

Contract For America: Even Slower Growth Ahead? - 6

 

Regarding Corporate Income Taxes (less than 6% of State tax collections) 34 of an applicable 46 States are forecasting YoY growth in that category in FY11. Twenty-five States project the increase to be greater than 5% and 18 are projecting double-digit growth. At 39.2%, the United States has the second highest combined corporate income tax rate in the developed world behind none other than Japan. The key takeaway here is that there is little room for tax hikes to meet these robust projections. Corporate earnings have to be extraordinary for States to even sniff the area code of FY11 budget forecasts. It is all but a foregone conclusion that earnings in the XLY, XLP, and XLF will suffer over the next 2-3 quarters because of the Consumption Cannonball, accelerating commodity inflation, and yield curve compression. Where will the tax receipt growth come from?

 

Contract For America: Even Slower Growth Ahead? - 7

 

Our bearish forecast for State Tax Receipts in FY11 does assume that States no longer have the headroom they once did to raise tax rates based on two consecutive years of hikes and the likelihood that a portion of the Bush Tax Cuts will expire on the Federal level. In 2009, roughly half of the States raised taxes to tune of a $28.6 billion increase in tax collections. In 2010, the net increase from tax hikes was only $3 billion. All told, 30 States have already raised tax rates to some degree in the previous two years. Consumers are severely cash strapped and living on Uncle Sam’s dime, so further tax hikes from here have the potential to negatively impact U.S. GDP growth going forward.

 

Contract For America: Even Slower Growth Ahead? - 8

 

All told, State’s FY11 budget revenue forecasts are very out of line with the current macroeconomic setup. Of course, the economy could always surprise to the upside, but hope is not an investment process we subscribe to at Hedgeye. As the math suggests in the table below, State tax receipts are extremely pro-cyclical so, as the economy goes, so goes State budgets.

 

Contract For America: Even Slower Growth Ahead? - 9

 

Currently, only six States are reporting mid-year budget shortfalls for FY11. We expect that number to increase substantially over the next 3-6 months, which suggest incremental budget cuts are on the way. Last month’s (-83k) decline in State & Local Government payrolls was far and away the largest monthly decline since the start of The Great Recession. Based on our projection for State & Local Government revenue collections to come in substantially lower than initially forecasted in FY11, we see September’s layoffs as a sign of things to come, rather than the “blip on the radar” status assigned to it by many market participants.

 

Contract For America: Even Slower Growth Ahead? - 10

 

Unfortunately for the U.S. economy, reprieve for State budgets is quickly eroding. According to NASBO, State’s rainy day funds are a mere $36.6 billion down 47% from the 2006 high of $69 billion. As a percentage of expenditures, State’s year-end balances are a mere 2.2% when factoring out Texas and Alaska (66% of the total). In FY10, the remaining 48 States combined to have the lowest balance ratio since 1992!

 

The prospects for further federal government aid seem even bleaker given the increasing likelihood of a Republican majority in Congress. According to the Center of Budget and Policy Priorities, States have only a remaining $6 billion in American Recovery and Reinvestment Act funds left to patch the FY12 budget gap of an estimated $140 billion. Incremental funding from H.R. 1586, the August 2010 Jobs Bill, buoys State spending on Medicaid only through June 2011 and adds only $10 billion to the State Fiscal Stabilization Fund.

 

Contract For America: Even Slower Growth Ahead? - 11

 

If State & Local government revenues come in in-line with our bearish estimates, where will the much needed additional funding come from as States are forced into mid-year budget rebalancing and as they prepare FY12 budgets? Likely not from the federal government, given the Republican Party’s momentum in the latest polls.

 

In short, House Minority Leader John Boehner’s words yesterday tell the story much quicker than I have:

 

“[If the Republicans win a majority] you’ll see us every single week move bills that will cut spending.”

 

Look out below.

 

While remain bearish on the long term trajectory of the U.S.’s debt and deficit ratios, we do understand the near term impact of pulling away government funding, which has been propping up the economy over the last several quarters. The chart below says it all.

 

Darius Dale

Analyst

 

Contract For America: Even Slower Growth Ahead? - 12


The New NFL: (N)ike (F)oot (L)ocker

The NFL license is officially heading to Beaverton for the start of the 2012 season and we believe this has larger implications than the obvious impact it will have on Nike.   Recall that back in March we laid out a thesis on Foot Locker that included both financial and strategic opportunities. One of our key beliefs was that CEO Hicks and his team would begin to forge exclusive partnerships and distribution arrangements aimed at driving more full priced selling, less discounting, and higher gross margins.  Much like the company’s efforts to partner Champs with the NBA and Adidas, we now believe that an NFL/Nike/FL partnership is in the works. 

 

In fact, we would not be surprised to see FL leverage its existing real estate to strategically develop a House of Hoops type effort centered on the NFL.  Given the broad scope of the NFL license, which includes on-field, sideline, baselayer, and sportswear it is probable that a FL/NKE collaboration could effectively merchandise a full NFL retail experience as both a shop-in-shop and a freestanding effort.  Clearly FL’s 2,700+ store base in the U.S offers a substantial competitive advantage in targeting specific regional team preferences.  With 32 NFL franchises, there is ample opportunity to segment the store portfolio to very precise demographics.  In fact, we note that Nike’s analyst meeting in May focused on the company’s capabilities in using sophisticated analytics to map, target, and identify local product and merchandising opportunities in the U.S down to the Street or shopping venue level.  We suspect this will be a key part of identifying which locations are optimal for a NFL focused store or shop-in-shop.

 

While timing is still over a year away, we believe we will be hearing more about this strategy as both companies continue to develop a plan to maximize the sizable NFL opportunity.  Realistically,  details will be scant for some time as the existing license remains in Reebok’s hand for one last season.  As a league, the NFL remains the holy grail of all domestic professional sports.  TV viewership and league profits are coming off of a record season last year and are expected to surpass peak levels yet again.  So far through four games this year, 150 million people have tuned in to watch at least part of a game up from 146.1 million last year.  We believe this could be a meaningful opportunity for FL and one that is just part of the differentiation and store segmentation strategy that is key to ultimately driving EBIT margins past prior peak levels of 7.6%. 

 

Eric Levine

Director


Hedgeye Statistics

The total percentage of successful long and short trading signals since the inception of Real-Time Alerts in August of 2008.

  • LONG SIGNALS 80.33%
  • SHORT SIGNALS 78.51%

HST 3Q2010 CONF CALL: "NOTES"

With no surprise to anyone, HST beat consensus through good cost controls. However, 4Q guidance is at the low end of expectations with top end just touching consensus. Here are our notes from the conference call.

 

 

HIGHTLIGHTS FROM THE RELEASE

  • "The increase in RevPAR was significantly affected by the improvement in average room rate for transient business of 6.8% combined with an increase in transient demand of 1.8%.  Group demand increased 7.9%, combined with a 1.3% increase in rate. For year-to-date 2010, comparable hotel RevPAR increased 5.6%."
  • "Comparable hotel adjusted operating profit margins for the third quarter of 2010 increased 150 basis points, despite a $5 million, or 50 basis point, decline in revenues from attrition and cancellation fees compared to 2009."
  • "During the third quarter the Company completed the acquisition of three, high-quality hotel assets in New York, Chicago and London for a total investment of approximately $430 million, including assumed consolidated debt of $166 million."
    • HST will use $121MM of cash to defease the mortgage assumed on the W New York-Union Square
  • "Subsequent to quarter end, the Company acquired the 245-room JW Marriott Hotel Rio de Janeiro, Brazil for approximately $48 million."
  • "During the third quarter of 2010, the Company issued 7.4 million shares of common stock at an average price of $14.08 for net proceeds of approximately $103.5 million."
  • FY 2010 guidance changes:
    • Lowered comparable revenue guidance by $84 to $106MM
    • Lowered comparable expense guidance by $77MM to $85MM (so lower revenues but better cost controls)
    • Increased Corporate & Other expenses by $5MM
    • Tightened FFO guidance (up 1 penny on the low end and lowered by 1 penny on the top end)

 

CONF CALL NOTES

  • Ancillary revenues increased 1.6% and comparable F&B increased 6% YoY
  • YTD comparable F&B grew 4.3%
  • Improvement in RevPAR has continued to shift towards rate and business mix has continued to improve
  • Would expect to see continuing strength in rate as mix improves towards better rated business
  • Group revenues increased by 9%, driven by a 1% increase in rate and an 8% increase in room nights.  Demand was driven by luxury corporate and association business
  • Booking cycle continues to be very short.  Group booking activity is up 6% for 4Q compared to last year. 
  • As they look out to 2011, their booking pace is up slightly
  • Acquisition price on the 4 assets they recently bought represent a 14x multiple on 2010 EBITDA and were at a 40% discount to replacement cost
  • Outlook for the rest of the year:
    • Improvement in RevPAR was offset in a more cautionary outlook on F&B and ancillary revenue
    • FFO was impacted by debt repayment and acquisition costs
  • 2011 guidance will be given on their next call in February
  • New Orleans and Orlando were the best performing markets
    • New Orleans RevPAR was up 28.3% (8.3% ADR & and 12pts of occupancy). The hotel benefited from a significant increase in group room nights and contract business related to the Gulf oil spill clean up.  For 4Q, expect the property to underperform the rest of the portfolio due to less city wide business.
    • Orlando RevPAR was up 26.7% (all Occ driven).  Group demand particularly association business increased significantly.  Expect underperformance in the 4Q due to lower levels of group business and the start of the rooms’ renovation at the hotel
  • Chicago RevPAR was up 14.2% (occupancy +3% & ADR +9.4%) despite 2 less citywide events; they benefited from more corporate business. Expect Chicago to perform in-line in 4Q.
  • Boston RevPAR was up 14.5% (ADR +6.9%; Occ +5.8%). Outperformance was driven by a 30% increase in group and citywide room nights. Expect the hotel to underperform in 4Q due to fewer city-wide room nights and ballroom renovation.
  • NY RevPAR +12.9% (driven by 12.4% increase in ADR). Reached nearly 91% occupancy, Expect NY to have a very good 4Q despite room renovations.
  • Hawaii finally recovered. RevPAR +11.8% (ADR was up 8.3%) due to increased air capacity and better group demand.  Expect to outperform in 4Q.
  • Denver RevPAR +11.8% (occupancy +7.2%).  Expect them to outperform in 4Q.
  • San Fran: RevPAR up 11% (ADR up 3.9% and Occ +5.3%). Expected to perform in-line in 4Q
  • San Antonio RevPAR fell 7% (6.6% decline in occupancy).  The poor performance was due to lower transient and group demand. Expect hotels to rebound in 4Q and outperform the portfolio due to a substantial increase in group and citywide demand.
  • Phoenix RevPAR declined over 9.8%. Expect these hotels to continue to underperform the portfolio due to continuing renovations
  • San Diego is expected to significantly outperform in the 4Q
  • European JV RevPAR was up 10.3% -  in constant Euros
  • Rooms flowthrough was excellent at over 80%
  • F&B flowthrough was worse than expected due to more cautious group spend
  • Unallocated costs increased 7% - all due to variable expenses. Utility increased 6.2% due to higher utility usage costs due to weather, property taxes decreased 1%, and insurance decreased 20%
  • In the 3rd Quarter, they terminated their sublease of the HPT hotels due to a default of their tenant. They will terminate the residence in properties on Dec 31, 2010.  They will also terminate the lease on the 53 courtyards effective Dec 2012.
  • W Union Square mortgage is $115MM

Q&A

  • Expect that roughly 1/3 of their hotels will be paying incentive fees by year end.  Don't expect anywhere close to 2/3rds to be paying by end of 2011.
  • Corporate rate negotiations? Doesn't have anything to really add to Arne's comments.  Still very early. Some early customers that renegotiated came in at high single digit rate.
  • Broadly speaking they are more focused on the coasts than the middle of the country for ownership. 
  • Groups are meeting again, but are being more cautious on what they spend on F&B especially during breaks. So group spending per customer is down a little. On the ancillary revenue, they aren't seeing as much spending on spa and golf.  Given the occupancy increases, they were hoping to see more growth on that side. They also hope that at some point they will begin to be able to start charging for meeting rooms - which have good margins.  Have only been able to do so in limited markets.
  • Have looked at the JW Marriott in Rio a few years ago but there were some title issues that needed to be resolved.  Still suspect that the majority of the assets that they are looking at will be domestic. 
  • Expect that 2011 wage increases will trend above CPI by a percent or two. Have had some pressure on the wage area as bonuses come back in this year, but next year the increase shouldn't be as material year over year since it's not off of a zero base.
  • Things aren't moderating, comps are just getting a little more difficult. They also have some renovations in Nov & Dec - when business levels are usually lower and therefore disruption isn't as great.
  • September was up 9% for them. Booking pace continues to follow the same pattern of strong close in bookings. Supply is also moderating which helps.
  • Despite the fact that GDP is weaker, corporate earnings and results are trending stronger than expecting, which is good for spending. They expect corporate investment to be up in 2011 over 2010.
  • 80% flowthrough on room revenues is as good as it gets really
  • International exposure for them is roughly 7-8%.  In the future if they feel like they can successfully invest abroad, then they may increase exposure there.
  • If rates were to increase, they still believe that pricing will hold up since increased rates means that business is also better. Also while rates are lower it's also harder to get leverage.  Cap rates should trend up as the anticipated growth rate moderates. Also over time, pricing on assets and replacement cost tends to converge.
  • Thoughts on development? Would be surprised if they saw progress on new full service development over the next 12 months.  Think that 2005-2006 is a good proxy for growth. Luxury development will be even tougher since in the past, hotels were subsidized by condos. Do expect growth in limited service.
  • Expect occupancy to also be up next year, but rate growth should play an increasingly larger role. While mix shift has helped, they have also been getting increases in rate.

Sports Apparel: Very Positive Trend Confirmation

The past two weeks of sports apparel sales were down. We’d been waiting for a third week to call it a trend. It didn’t happen. The sports apparel channel staged a meaningful rebound in the latest week.

 

Sports Apparel: Very Positive Trend Confirmation - AppFW Table 10 13 10

 

Sports Apparel: Very Positive Trend Confirmation - AppFW Chan 2yr 10 13 10

 

 Sports Apparel: Very Positive Trend Confirmation - AppFW Chan 10 13 10

 


Eye On Asia: The Good, The Bad, and The Ugly

Conclusion: The bevy of economic data out of Asia over the last 48 hours makes us question the legs behind the bullish rally in many Asian equity markets. In addition, the data grows increasingly supportive of the relative underperformance of Japanese equities.

 

Positions: Long Chinese Yuan (CYB); Short Japanese Equities (EWJ); Short Japanese yen (FXY); Short Indian Equities (INP); Short Emerging Market Equities (FFD)

 

There has been a slew of economic data coming out of Asia over the last 48 hours – some good, some bad, and some ugly. Rather than belabor the point(s) with excessive prose, we’ll just highlight the meaningful deltas and inflection points in the call-outs and charts below.

 

The Good 

  • Japan’s Machine Orders grew in August to +10.1% MoM from +8.8% in July. This is the largest monthly increase since December and, while stale, this data point is serving to pare back concern regarding the frailty of Japan’s economic recovery.
  • Malaysia’s Industrial Production accelerated in August to +4% YoY from +3.2% in July.
  • Australia’s Consumer Confidence inflected in October, accelerating +3.3% to 117 from a (-5%) drop in September.
  • Australia’s Business Confidence Conditions Gauge (hiring, sales, and profits) rose in August to 7 from 5 in July.
  • Hong Kong’s introduced a rent-to-buy program for foreigners looking to buy property. This is an incremental measure to combat surging housing prices that have increased nearly 50% since 2009. 

Eye On Asia: The Good, The Bad, and The Ugly - 1

 

Eye On Asia: The Good, The Bad, and The Ugly - 2

 

The Bad

 

  • China’s Export and Import growth slowed in September, which, on the margin, highlights a deceleration in Chinese and global demand. Exports slowed to +25.1% YoY from +34.4% in August; Imports slowed to +24.1% YoY from 35.2% in August. This lends further support to the claim that inflating commodity prices globally are more the result of dollar debasement than any other factor.
  • China’s central bank temporarily raised reserve requirements 50bps for six large commercial banks to rein in excess liquidity and fight inflation. The current levels are 17% for the largest lenders and 15% for smaller institutions. This latest move is in response to China’s accelerating inflation, which hit a 22-month high in August. Central Bank Governor Zhou Xiaochuan also recently said it may take two years for the inflation rate to fall below 3%, which is a firm stance against a potential interest rate hike and global calls for expedited yuan appreciation.
  • Malaysia’s Export growth decelerated in August to +10.6% YoY from +13.5% in July.
  • Dai-ichi Life Insurance Co., Japan’s second largest-insurer, plans to boost its holdings of JGBs in lieu of Japanese equities. The Nikkei, which is down (-11%) YTD, may come under substantial incremental pressure should more Japanese insurance companies and pension funds follow suit.
  • Australia’s headline Business Confidence declined in August to 10 from 11 in July. 

Eye On Asia: The Good, The Bad, and The Ugly - 3

 

Eye On Asia: The Good, The Bad, and The Ugly - 4

 

The Ugly 

  • Japan’s public pension fund plans to expand its investments to include emerging market equities next summer. This marks the beginning of the end in terms of Japan’s reliance on domestic demand for JGB financing (~95%). As of 2008, 61% percent of JGBs were financed directly or indirectly from the funds of Japanese households. With this tailwind becoming a headwind over the long term, how will JGBs attract foreign buyers with such low yields going forward? Refer to the long term call outlined in the Japan’s Jugular section in Hedgeye’s 4Q Macro Themes presentation for more details.
  • Japan’s Consumer Confidence dropped in August to 41.2 from 42.4 in July. One of the key tenets to our Japan’s Jugular intermediate term call is that yen strength bodes poorly for Japan’s domestic economy, which is levered to exports as the main driver of growth. With exports slowing, we expect the side-effects (rising joblessness, declining consumer and business confidence, etc.) to be a major drag on that economy over the next 3-6 months.
  • Korea’s PPI accelerated in September to +4% YoY from +3.1% in August.
  • India’s Industrial Production decelerated in August to a 15-month low: +5.6% from a revised +15.2% increase in July.  The slowdown in industrial output may weigh on the central bank’s decision to continue rate hikes to fight India’s rampant inflation going forward. 

Eye On Asia: The Good, The Bad, and The Ugly - 5

 

Eye On Asia: The Good, The Bad, and The Ugly - 6

 

The Murky 

  • China’s FX Reserves grew to a record $2.65 trillion in September from the prior $2.45 trillion, adding concern that the U.S. will accelerate protectionist litigation through Congress. This morning, Senate Finance Committee Chairman Max Baucus went on record saying a bill that would “punish” China for its undervalued yuan is likely to get past the Senate and onto President Barak Obama’s desk.
  • The MSCI Emerging Market’s Index historical volatility closed at 12.1 last week – the lowest levels since July 2007. In our models, depressed volatility could potentially be a contra indicator and a signal to sell. Looking back historically, we see the measure increased off its lows to 27 just prior to the EM Index peak in October 2007.
  • Thailand will remove a 15% tax exception on foreign income from domestic bonds in an attempt to stem gains in the baht. This is just another action amid a growing list of steps taken by foreign central banks to combat excessive currency gains amid Fed-sponsored dollar debasement. QE may be good for a near-term equity rally, but the dollar’s decline is restricting export competitiveness and stoking inflation globally. Exports account for roughly 70% of Thailand’s GDP. 

While we continue to be favorably disposed to Asian countries with strong growth profiles like China, Singapore, and Indonesia, we would be remiss to join in on the rally and decoupling talk now. We are likely buyers on pullbacks provided these markets hold important quant lines of support in the event of a dollar breakout. That, however, remains the biggest “if” in all of global macro investing right now.

 

For now, we are content to wait and watch.

 

Darius Dale

Analyst


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20 Proprietary Risk Ranges

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