• run with the bulls

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Conclusion: I walked away from a recent meeting with management with a very clear impression that things are mending and the consensus is taking the “wait and see” approach.   


As measured by our Casual Dining sentiment monitor, EAT is at the bottom of the pack.  As I told this to Brinker’s CFO, Guy Constant, I noted that all the great concepts in the restaurant space have been there at one time or another: MCD, SBUX, WEN and DRI to name a few.


His response was that the sentiment around Brinker’s stock is like a “badge of honor.”  I thought this was a positive indication, given the context, of how this CFO thinks.


A major component of the EAT thesis I outlined in my Black Book earlier this year was the company’s focus on operations with the aim of expanding margins and improving the guest experience.  Soft sales trends in recent quarters are adding a sense of urgency to improve both the front and back of the house from an operational perspective.  The 187 bps improvement in restaurant level operating margins in the past quarter was evidence that those efforts are taking hold.


The Street’s wait-and-see approach is clearly focused on the top line.  There is some evidence of improvement in September, with Chili’s same-store sales declining only 0.8% when adjusting for the one week calendar shift that resulted from the fact that fiscal 2010 was a 53-week year relative to 52 weeks is fiscal 2011.  The real evidence will be seen when we turn the calendar and begin to focus on the second half of Brinker’s fiscal year 2011.


As we head into 2HFY11, an acceleration of the sales will be evident for the following reasons:


(1)    Chili’s is lapping the introduction of menu changes that caused sales to decline last year

(2)    “2 for $20” is to become permanent menu item; this will be incremental to sales in 2HFY11

(3)    In January, Chili’s will be rolling out a new lunch menu focused on gaining traction in a day part that has been challenging for the company.


By the time sales trends start to improve (3Q of FY11), management expects to have fully implemented the margin initiatives across the entire Chili’s system.  The prospect of a combination of improved sales flowing through a more streamlined restaurant suggests that Brinker should begin to enjoy positive sales trends in conjunction with positive operating margin growth.  On a quarterly basis, I track the operating status of companies depending on their sales and margin growth and divide the space into four quadrants.  The top right of the chart – what I call “Nirvana” – is where I see Brinker in 2HFY11.  As an aside, my last examination of the “Nirvana” group indicated that, on average, companies operating at that level trade at approximately 9.5x NTM EV/EBITDA. 


Currently trading at 6.1x EV/EBITDA, EAT is trading at a multiple just slightly above RRGB at 5.9x.  The difference between the companies, and their respective prospects, couldn’t be any more clear.  RRGB’s management team has no control over their business trends.  Additionally, EAT is trading at a discount (on an NTM EV/EBITDA basis) to RUTH, CPKI, MRT and RT, all of which lack the size, scale, and brand presence that Chili’s has.  The strength of Brinker’s balance sheet and their cash flow generation are two other strong differentiators.  I am not surprised that Brinker’s CFO relished the company’s lowly standing in the sentiment stakes; he knows that the only way is straight up.


EAT - A BADGE OF HONOR - eatsent


EAT - A BADGE OF HONOR - eat matrix


Howard Penney

Managing Director


Management strikes out in attempting to pitch a 14x multiple deal at an 8-10x valuation.



A bird in the hand is worth two in the bush, or so the medieval phrase goes.  Unfortunately, Caesars’ management wants you to buy $3.32 billion worth of EBITDA in the bush versus the $1.77 billion of actual EBITDA in the hand.  With significant negative free cash flow and 11.5x leveraged, where do I sign up?  We call ball four on this deal so the prudent thing would be to take a walk. 


At the midpoint of the $15-17 offering range, the valuation looks to be around 14x 2011 EV/EBITDA.  We use the face value of the debt rather than book value which is over a $3 billion difference and a 1.8x EBITDA turn. 


This must be a Macau stock, right?  We think there should be close to zero value ascribed to Macau.  What about other development opportunities and hidden assets?  Even if they could find the money, Japan would be a long shot for them, and Texas, PA, and Ohio would cannibalize existing CZR properties.  Finally, while we do think World Series of Poker has brand equity, internet gaming in the US just took a major step backward with the Republicans taking over the House.


While we do agree that current EBITDA levels are close to trough, there is a lot of Kool-Aid to drink for one to believe in $1 billion in incremental recovery EBITDA.  Here is the Kool-Aid recovery scenario:



JCP: Is Bad Actually Good?

Conclusion: A low quality quarter from JCP might actually add support to those in the Ackman camp.  Importantly, this quarter did little to change our mind that JCP is still facing fundamental challenges near and longer term.


From a fundamental perspective, JCP’s 3Q results did little to change our view on being short the shares.  The quarter was driven by two key factors, a slight miss on original topline plans offset by a measurable and unexpected level of SG&A savings.   Clearly not the quality quarter management and anti-activist investors were looking for.  But, with the company under the watchful eye of Ackmanism, the worse the business and its prospects become, the more challenging it becomes for management to fight the company’s largest shareholder. 


Overall there were a couple of key takeaways coming out of the quarter:


  • Inventories remain higher than they should be given the current run rate of sales.  On a 0.2% increase in 3Q revenues, inventories ended the quarter up 6.2%.  Weak outerwear sales at the end of October are partially to blame for part of the inventory build, but we still see some risk here if expected same stores of 3-4% over 4Q fail to materialize.  Either way, JCP remains the only player in the moderate department store space running inventories meaningfully ahead of sales growth.
  • Expense savings saved the quarter on a slightly weaker than planned comp.  SG&A dollars were expected to grow 2% but actually came in down 3.8%.  While this flexibility is noteworthy on a short-term basis, it did result in a $50 million after-tax swing in earnings (all things being equal) or about $0.21 per share.  Absent similar cost cuts, which we believe are counter to actually improving the JCP customer experience, there is minimal longer-term opportunity to continue to manage expenses down on an absolute basis.  Furthermore, the addition of the “growth brands division” will likely put pressure on the expense line as infrastructure, personnel, and marketing will require incremental investment.
  • Management’s announcement that the company has formed a “growth brands division” to pursue new concepts and additional growth vehicles is not exactly what capital preservationists and those looking for enhanced shareholder value are looking for.  The fact is JC Penney is not a growth company, nor are there any successful examples of a department store operator incubating, managing, and growing a successful specialty concept.   As reported in the Wall Street Journal yesterday and confirmed today, JCP will be developing an off-mall, big and tall concept as well as focusing on a younger consumer with an eye towards e-commerce growth.  Even more interesting is that these initiatives fall under the company’s 5 year plan to add $5 billion in incremental revenues but yet there was no mention of such plans when the original plan was unveiled in the Spring.  Bottom line, off-mall full line stores haven’t really moved the needle for the enterprise and it’s unlikely a specialty concept will either.
  • The issue of rising cotton and sourcing costs is nothing new but management noted that they are now encountering some factories which are not accepting orders due to input cost uncertainty.  While these orders primarily center around goods to be manufactured for Fall ’11 delivery, the data point is noteworthy. If this becomes a more widespread stalemate between manufacturers and suppliers, there will likely be capacity constraints come next year.  For now, this is something to watch.

JCP: Is Bad Actually Good? - jcp


Eric Levine


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The Week Ahead

The Economic Data calendar for the week of the 15th of November through the 19th is full of critical releases and events.  Attached below is a snapshot of some (though far from all) of the headline numbers that we will be focused on.


The Week Ahead - cal1

The Week Ahead - cal2


On the Road

This note was originally published at 8am this morning, November 12, 2010. INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK (published by 8am every trading day) and PORTFOLIO IDEAS in real-time.

"Behind us lay the whole of America and everything Dean and I had previously known about life, and life on the road. We had finally found the magic land at the end of the road and we never dreamed the extent of the magic."

-Jack Kerouac, On the Road


Jean-Louis Kerouac, or Jack as he was more popularly known, was the leader of the beat generation and is one of the most well known American novelists of the last half decade.  I recently took a break from my weekend readings of the Economist, Barron’s, Grant Interest Rate Observer, and other similar publications that make my girlfriend go to sleep, to reread Kerouac’s classic, On the Road.


I think it is fair to say that most type “A” investor types operate in stark contrast to the beat generation, and in particular to the writing style of Mr. Kerouac.  In 1950, Kerouac outlined The Essentials of Spontaneous Prose, which was an overview of his style of writing - a style which emphasized the unplanned spewing forth of ideas, emotions, experiences and so forth.


Our CEO Keith McCullough wrote his own book, which came out earlier this year, titled, Diary of a Hedge Fund Manager.   Far from being the spontaneous prose of a beat, the book is a well thought-out overview of the last decade of Keith’s journey in the world of Hedge Funds.  As one reviewer wrote:


“In telling his story, McCullough may end up inspiring a whole new generation of Wall Street achievers and innovators. He may also succeed in tipping a few sacred cows and instilling new paradigms for investing before all is said and done.”


Admittedly, I may be a little biased as I appear in the book via my nickname Jonesy a few times, but I would recommend you consider it as a stocking stuffer in the upcoming holiday season for that emerging fund manager in your family. ( http://www.amazon.com/Diary-Hedge-Fund-Manager-Bottom/dp/0470529725 )


Coincident to reading Kerouac’s book, I was literally on the road this week.  I flew out to Colorado Springs to participate in a bi-annual forum with a subscriber of ours, Huntley Thatcher Ellsworth Advisors (http://www.hteadvisers.com/). Aside from being very innovative in the ETF field, twice a year the folks at HTE get up in front of their clients, put on the accountability pants, and talk about what they got right, what they got wrong, and what’s next.  At the forum, I gave a presentation titled, “Should U.S. Debt Be Rated Junk Status?” and then participated in Q&A. An interesting question that came up a number of times from the audience was: should we own gold?


As we think about gold, it is pretty simple.  If the dollar continues to get debased, gold will go higher.  So longer term, it is likely an asset you want to own if you believe the dollar is going lower.  That fact is, if there weren’t monetary value in gold stock, the U.S. Federal Reserve wouldn’t be sitting on over 8,000 tonnes of gold and not selling it.  In the short term, we aren’t long gold and have highlighted a key reason in the chart of the day below, which shows the dramatic increase in the price of gold over the past few months juxtaposed against a recent front page New York Times article, “In Anxious Times, Investors Seek Cover in Gold.” If newspaper and magazine covers aren’t the best contrarian indicators, they are close. 


Another topic we discussed was the implications of Quantitative Easing, the monetary policy more popularly known at Hedgeye as Quantitative Guessing.  Our view is that QE will lead to inflation, without the commensurate pickup in economic activity. While we can debate whether we are seeing inflation in the U.S., globally we are seeing it.  In fact, yesterday Chinese CPI accelerated dramatically.  As Darius Dale wrote to our subscribers yesterday:


“Chinese October inflation numbers came in white hot this morning.  CPI accelerated to a 25-month high of 4.4% Y/Y and PPI also quickened substantially to 5% Y/Y.”


Chinese inflation will lead to one thing, Chinese tightening. If you don’t think that has global growth implications, then you haven’t turned on your Bloomberg terminal yet this morning. In the anticipation of tightening, Chinese equities are down more than 5% and the commodity complex is getting taken behind the barn and shot. Copper is down 2%. Silver is down 2%. Cotton is down 3.6%. Sugar is down 3.4%. It seems we may not have to guess as to the implications of Quantitative Guessing much longer.


My last road trip to Colorado Springs was about 15-years ago when Keith and I were members of the Yale Hockey team.  (Keith was a little quicker and I had a little more hair back then.)  We were playing Air Force in a two game series.  As I recall, Keith was suspended for the weekend and we were swept by Air Force. (Keith would likely suggest there was something to that correlation.)  Ironically, the Yale hockey team is back in Colorado Springs this weekend taking on Air Force and Colorado College.  Much has changed in the last 15-years, including the fact that Yale is now ranked 3rd in the country.  Let’s hope the Bulldogs find the “magic land at the end of the road” this weekend.


Keep your head up and stick on the ice,


Daryl G. Jones

Managing Director


On the Road - 1


Conclusion: 3Q10 was a terrible quarter for WEN and I don’t think it will get a whole lot better through the fourth quarter, despite Arby’s October performance, with the food cost outlook unfavorable and management guiding to the low end of their reaffirmed EBITDA growth guidance range for 2010.


Topline trends in the third quarter were disappointing for WEN, to say the least.  For the Wendy’s concept, company same-store sales came in at -3.1% versus -0.2% consensus.  This implies a two-year average same-store sales decline of -2.3% versus the -2.1% two-year average trend in 2Q.  As far as remedies for their soft trends at Wendy’s, management was not forthcoming with much detail. 


The strategy at Wendy’s is clearly in dire need of improvement but today's earnings call did not offer much reassurance that a solution is forthcoming.  QSR management teams across the board are highlighting the value proposition as being a major driver of traffic and it is clear that Wendy’s is falling short in that regard.  The “biggest” negative of Wendy’s sales performance during the quarter was, according to management, the area of value transactions.  There are many questions to be answered as to how the company is being run and what – specifically – can be done to improve the outlook.  The January Investor Day, we were told, will add much clarity to their strategy. However, assuming that the projected rollout of their breakfast program remains scheduled for late 2011, it seems that Wendy’s stands little chance of gaining significant market share any time soon.  In addition, taking market share in the breakfast day part may also prove difficult, but I will withhold judgment until further details are disclosed. 


Arby’s trends in the third quarter were equally disappointing, printing a decline in company same-store sales of 9.5% versus -6.5% consensus.  This result implied a sequential slowdown in two-year trends to -8% in 3Q from -7.3% in the second quarter.  On the plus side, Arby’s’ performance in October was much improved from the third quarter at +5.5% growth in same-store sales.  This was largely due to an increase in transaction counts (double-digit growth) and the impact of national advertising (albeit against October 2009 which also had national advertising). 


Management stressed that October’s success was “not just about advertising” but it was about “many things that we have had in our turnaround plan”.  Management expects sales to soften for the remainder of 4Q at Arby’s as the chain moves from the national advertising it enjoyed in October, to local advertising in November and December.


Costs are certainly not working in WEN’s favor either; cost of sales as a percentage of sales increased by 222 bps on a year-over-year basis and I expect a similar increase in the fourth quarter given another difficult comparison from 4Q09 and the outlook for beef.  As management highlighted, beef costs are not showing much sign of abating any time soon, “I actually think we may have one more quarter where it’s actually a little worse from where I sit today.  And then hopefully, I don’t think we are going to see any significant declines in the first half of the year, but hopefully it will stabilize in 2011”.  This fairly clear-cut outlook, combined with the company’s focus on premium products (fresh, never-frozen beef at Wendy’s and whole muscle Angus roast beef at Arby’s), indicates that the impact of commodity costs will likely be negative for the next three quarters, if not longer.


The outlook for Wendy’s/Arby’s is uncertain.  Management was reluctant to provide much granularity in there forward looking statements, pointing instead to the Analyst Day as the date when all will be revealed.  I am not expecting any silver bullet to be revealed at this event.  From an outsider’s point of view, all signs point to the Captain and being in distress.  Operational difficulties are being compounded by what seems to be a lack of communication between Trian and management.  A very interesting comment from today’s earnings call went as follows:


“As many of you know, Trian, our largest shareholder has a schedule 13D on file with the SEC, which indicated that it received an inquiry from a third-party expressing interest in a potential acquisition involving the company. And that Trian was considering this inquiry as well as alternatives with respect to its investment in this company. Because of this disclosure, we refrained from buying stock during the quarter.


We have asked Trian to bring us to ahead as promptly as practicable, so that we as a company can continue to focus on ways to enhance shareholder value including through commencing share repurchases under our stock repurchase program as legal and market conditions permit.”


There is a clear tone of frustration embedded in the quote above and it does not bode well for the company.  I wrote a post entitled “WEN – UNDERVALUED YES, WHERE IS THE OPPORTUNITY?” in June 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. 


However, as the CEO of Hedgeye Risk Management, Keith McCullough, is so fond of saying, “A bargain that remains a bargain -- is no bargain”.  A last comment (or lack thereof) that I would like to highlight is management’s reluctance to give any indication as to the FY11 outlook, even with respect to a directional improvement from the -5% in EBITDA growth the company is now projecting for 2010.  The general lack of guidance and confidence in management’s tone is certainly a worry and it is reflected in the data.  A look at the chart below tells you all you need to know.  WEN is in a deep hole, and I don’t see them coming out next quarter.


WEN: MAYDAY! MAYDAY! - wen sigma


Howard Penney

Managing Director

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