If You're Going to Dance with the Devil, Make Sure You Pick the Music...
There are some investor meetings that can be boring and many times you walk away saying to myself “why did I even waste my time; I did not learn anything.” But this meeting was different and I decided to sit in the front row. Maybe it was because Nelson Peltz was going to say a few words and I wanted to make sure I got a good look.
History may not repeat, but it certainly does rhyme; I have made this call a least a dozen times in my career and two of them in the last two years (SBUX in 2009 and EAT in 2010). Senior management is finally getting down to doing what should have been done two years ago – letting the Wendy’s brand thrive on its own.
Wendy’s is following the classical rinse and repeat process of successful restaurant turnaround stories: simplify operations by shedding any surplus, dilutive brands that are distracting management and focus on executing the core business to the highest level possible. Today’s investor meeting shed plenty of light on the progress WEN is making on this path and, while some question marks remain, I was convinced that the painful lesson of the Arby’s merger has been fully absorbed by management and they are now poised for significant growth over the longer term. The presentation, in its totality, put forth a frank account of the errors that WEN had made in terms of operations and a convincing list of steps it is now taking to turn around the concept.
The meeting obviously kicked off with Wendy’s new breakfast, supplied by Wendy’s, and the team was quick to tell the audience about the new rollout. According to management, the day part has the potential to add $150,000 to the concept’s $2.4 million in average unit volumes. The immediate success of breakfast is not critical, to the degree that management does not build in a significant expectation on what it will add to same-store sales growth. They will only have it in 1,000 stores by the end of next year and only 2/3 of the system will be able to execute it.
The most critical element to the turnaround is management’s plan to upgrade the menu to enhance the quality of its offerings. This new menu strategy focuses on introducing new products that compete with some of the more premium products and brands in the QSR segment. The company has rolled out new “natural cut” French fries that rival the style of those available at Five Guys. Additionally, the company will be rolling out a new hamburger called the “golden burger” which is expected to compete with the quality offered at In-N-Out Burger, Five Guys and other premium prices products. The new burger will be rolled out nationally during the second half of 2011. They will also follow up in the coming months with a new chicken sandwich to compete with Chick-fil-A.
While unit growth is not currently a focus it remains another vehicle through which management aims to grow the top line. WEN announced a new partnership in Argentina with Desarollo y Gestion (D&G), to open 50 franchise stores. Other opportunities are being pursued in Brazil, China, and Japan, and management is optimistic about the prospects in all three markets. Interestingly, while WEN expects earnings exposure to international markets to increase, it also plans on opening 1,000 new stores on top of the current ~6,000 unit restaurant base.
Aiming for operational excellence was a key theme of the presentation and management outlined how it can have the obvious benefit on margins but also on top line trends. One fine example is the drive-through window. WEN detailed the significant uptick in sales seen as operational creases were ironed out and speed-of-service times were reduced. I’m assuming it is for Wendy’s in the U.S., but management said that 67% of sales are made at the pickup window.
Management is also using a pricing model to best calculate stores where there is room for pricing versus those stores where a price increase would likely result in a drop off in traffic. Remodels are another strategy that the company is following to support sales; 75 remodels are scheduled for 2011.
The presentation elaborated briefly on the current standing of the share repurchase program, which was, of course, interrupted because of the filing of a 13-D by Trian, WEN’s largest shareholder. For this reason, it was explained, there were no stock repurchases in the fourth quarter. The current intention is for repurchases to resume as soon as possible.
In terms of outlook, management reiterated the guidance disclosed in yesterday’s preannouncement of 4Q and FY2010 earnings. For 2011, the company outlook expects same-store sales growth of 1-3% at Wendy’s North America company-operated restaurants and an improvement of 30 to 60 basis points in Wendy’s company-operated margins. Capex is projected to be $145 million. Unit development is expected to include 20 company stores in North America, 45 franchise stores, and approximately 50 international franchise stores. From a cash flow perspective, the company aims to produce annual EBITDA growth of 10-15%, beginning in 2012. Commodity inflation is projected to be around 2-3% for the company with beef costs impacting on approximately a one-month lag basis. Chicken is contracted out on an annual basis and will offset some of the inflation beef is causing in the commodity basket presently.
While focusing on simplifying the menu and the process (Burgers, Fries, Cokes), the chain is also focusing on simplifying the marketing strategy. Using the namesake of the brand and daughter of the founder, Wendy Thomas, in select advertising is just one of the initiatives management is using to heighten WEN’s profile among QSR customers of which, according to the presentation, 60 million visit QSR restaurants 4 or 5 times per week in the U.S.
The most positive and all-important take away from this investor day was the resounding “yes” management gave to me in response to my question about whether or not this definitively meant that Wendy’s, as a concept, would now be given sole attention of management and room to breathe. The response was important and the benefits obvious. Management teams across the space are generally better served focusing on a few simple operational tasks and executing on them clinically. The sale of Arby’s allows WEN to forget about trying to right the wrongs of Arby’s and invest capital and management time into Wendy’s. Of course, from a dollar perspective, the reduction of corporate G&A to support a single brand is also a positive. Beyond that, focusing on the core menu will also yield benefits. Hamburgers, fries, salads, value, and chicken comprise 70% of total sales for WEN. That is a slice of the pie worth getting right.
As with all turnarounds there is always the X-factor. The X-factor in this case is the implication(s) this has for the employees and the franchise system. You generally see most people be revitalized by the new initiatives and the stores tend to see a higher level of execution and the turnaround progresses. This is why when the ball starts rolling it goes further and lasts longer than most expect it to. This was clearly evident in the most recent quarter that SBUX reported.
We will have more details around valuation in the coming days.
There’s very little to punish UA for here. UA is giving the bulls all they need to keep the faith that this company will double over 3-years. But cash flow is eroding on the margin. That’s caused some pain in the past. Put your risk management hats on.
You gotta hand it to these guys...seriously. They crushed expectations, and it was not because they set crushable guidance over lackluster performance. This thing legitamently reaccelerated its top line to 36% (and by 12,000bps sequentially on a 2-yr run rate). EBIT grew 31% and EPS by 34%. Yes folks, that’s organic. It’s not because of one of these poor quality acquisitions that are blanketing the market, FX, or stripping the cost structure clean in anticipation of being LBO’d. UA is the real deal. That’s not real news to us, as it was one of our top names last year. But we hopped off early on 10/26 (see our note, UA: The Gap is Gone) at about $48 – content at a 2-bagger in six months at a time when 1) the consensus estimates moved up to our level, 2) we started to see headwinds on athlete endorsement costs, and 3) UA was in the heat of launching it’s first real cotton product at a time when cotton costs were up three standard deviations from the mean. We were wrong.
One thing that has changed in the market, and in retail in particular, is the premium people are willing to pay for organic growth. In retail, that’s UA, URBN, LULU. Levine and I are often asked about these three in the same sentence. One thing to consider is that UA’s model is far more exportable, and can appear to a larger audience globally. Let’s face some facts, they’ve blown it thus far going international. But UA is sticking its nose into a global duopoly (Nike and Adidas) where the primary channel would love nothing more that great quality product from a high-end US brand. Also, find me anyone that would take the other side of the debate that UA could add another $400mm in footwear sales over 2-3 years on top of a billion dollar apparel business.
So what are our thoughts with the stock near $60? Pretty much unchanged. The company has got great product momentum, and along with Nike, Footlocker, Dick’s, Sports Authority, and Hibbett, we should see both the space and this company materially outperform into 2011. If you want to short on valuation, then be our guest. But it’s probably gonna hurt. I heard people say “sorry, it’s too expensive for me” at $20, $30, $40, and $50. Why not $70?
One thing to consider is that the biggest moves in this stock over time have happened at peak/trough cash cycles. Think about it some of the BIG calls on UA in the past.
Therein lies the Bear Case:
“Top line growth is astounding today. But the cash cycle is weakening on the margin. Growth in company stores is accelerating, which means higher capex and working capital. The company already guided to top line growth of 25-27%, which is above its long term range. Heck, maybe that means its true intention is for 30%+ growth. But otherwise why raise expectations at the very start of what is going to be one of the years in retail with more pin action than we’ve seen in a while. If operating margins OR asset turns peak and roll (like our SIGMA shows yellow flags of doing) then the other will have to accelerate just as much in the other direction in order to offset erosion in RNOA. That will be a painful day to hold UA.”
When we net it all out, we think that the Bull case will prevail, but certainly at a heightened level of risk relative to where this name was for most of last year. We think this is a ‘do nothing’ stock right now. What’s funny is that ‘do nothing’ is actually positive on a relative basis compared to the rest of retail.
Review of the Quarter
Revenue Growth: Revenue growth was impressive up +36%, but more impressive was the fact that it came from every category – including footwear. New product introductions will continue to be the primary growth driver including the company’s new Charged Cotton shirt (end of Q1) and additional footwear introductions on top of a full year of basketball sales. Very few companies in retail can come close to posting this type of sustainable top-line growth.
Direct-to-Consumer: Plans are accelerating here with management now expecting to add 25 stores in 2011 up from ~20 last quarter off a base of only 54 stores. With sales per store averaging ~$5mm per annum, Direct sales have quickly become a major growth driver accounting for 10% of growth in 2010 and is likely to drive a similar if not accelerated rate in 2011 with the majority of stores entering years 2 and 3 becoming increasingly more productive.
Margin Pressure(s): It’s no surprise that gross margins will face increasing pressure over the next 12-months, but higher investment spending is clearly in the plan for 2011 masking the margin expansion opportunity that comes from 20%+ top-line growth near-term. As such, guidance implies 10-50bps of EBIT margin expansion in 2011, which appears optimistic if not at the expense of lower marketing spend at year end. In addition to higher sourcing and labor costs in the 2H, the company will also be challenged by mix shift as footwear continues to grow particularly in Q2 offset in part by higher DTC revenues as well.
Inventories: With 45% growth on a 36% increase in revenues and further growth expected in the 1H, inventory risk remains a concern near-term. While the majority of growth is due to investments in core auto replenishment inventory, the reality is that at these levels the company is at a considerable risk if sales don’t materialize as expected. It’s also worth noting that aged inventory is half the size at year end compared to last year suggesting product is more current and would be easier to liquidate if need be.
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Conclusions: As we noted a week ago, the Jasmine Revolution has the potential to go global, and it has. This week we’ve seen massive protests in Egypt, the world’s 27th largest economy. The Egyptian stock market is down 16% in the last three days.
On January 20th in an Early Look (some of this data is replayed below), we discussed the idea that Tunisian protests could represent a tipping point for civil unrest in emerging markets. These protests, or what is now being called the Jasmine Revolution, began on December 17th with the self-immolation of Mohammed Bouazizi (after police confiscated his unlicensed food stand) and ended on January 14th with current President Ben Ali fleeing the country for Saudi Arabia. In the last week, we have seen protests accelerate in emerging markets, and this may just be the beginning.
Tunisia had seen steady economic growth from 1999 to 2008 with average annual GDP growth of 4.9%, until a deceleration in 2009 to 3.1%. The natural outcome of a deceleration in economic growth is a freeing up of capacity in the economy. In Tunisia, almost 50% of the economy is driven by services, which is effectively “people” power.
So, as the economy in Tunisia has slowed, unemployment has picked up to 14.1%. In conjunction with slowing growth and high unemployment, we have also seen basic commodity prices accelerate in the last year – copper up 24%, tin up 58%, wheat up 68%, cotton up 131%, and palm oil up 53%, to name a few. In economic parlance, this combination of accelerating inflation, slow growth, and high unemployment is called Jobless Stagflation.
In democracies with longstanding institutions of law and government, Jobless Stagflation often leads to protest and change, similar to the change we saw in the recent midterm elections in the United States, where the Republican Party gained control of the House of Representatives. The people demanded change in the United States and they went to the polls to get it. In nations like Tunisia, this mechanism for change (free and open elections) does not exist, so the people went to the streets and demanded it.
Civil unrest as an outlet for protest against the government exacerbated when the population is youthful. As healthcare broadly improved in these Africa and the Middle East in the late 1960s, birth rates went up dramatically. Currently, it is estimated that around 65% of the regional population is under the age of 30.
In the Early Look last week, we posited the rhetorical question: could the Jasmine Revolution become a primary export of Tunisia? The evidence early seems to suggest that the Jasmine Revolution is already spreading across the region; the most supportive evidence is coming from Egypt.
Over the last three days, there have been massive protests in Egypt against the autocratic regime of President Hosni Mubarak. These protests are being driven by economic concerns, primarily spiraling costs of living (read: inflation). As the costs go up, the underemployed and underpaid youthful population naturally vents, and in an autocratic regime they have no outlet other than, at least in their minds, to take to the streets. No doubt the successful revolution in Tunisian was a catalyst for the Egyptian revolts; the success of overthrowing the Tunisian government has emboldened protestors across the region. To wit, protests are occurring and growing in Yemen and Jordan as well.
Unlike Tunisia, Egypt is a country that matters on the global economic stage; it’s the 27th largest economy in the world with a GDP of $470BN (2009). As well, the markets are signaling that there is more to come in Egypt, as the stock market there has reached its lowest level since July 2010, falling 16% in the last two days. Further, credit default swaps, insurance on Egyptian government debt, have surged 15% in the last week.
The powder keg of high unemployment, youthful citizens, rising inflation, and limited democratic institutions are endemic to Africa and the Middle East. Tunisia appears to be the flint that lit the powder keg. As protests continue over the coming days and weeks, we expect the mantra “We are all Tunisians now” to expand across the region, as the Jasmine Revolution becomes Tunisia’s top export.
Daryl G. Jones
Conclusion: From a secular perspective, Japan’s economy continues to implode. The acceleration of that implosion towards the Keynesian endgame is arguably the largest TAIL risk to the global economy.
Position: Bearish on Japanese Equities; Bearish on the Japanese yen; Bullish on Japanese CDS.
This morning, Standard & Poor’s came out with yet another lagging downgrade that seems to have caught the US financial media’s attention. By cutting Japan’s credit rating to AA-, Standard & Poor’s reminded us all what we already knew:
Japan’s economy is imploding in slow motion. Slowly, but surely, Japan is reaching the Keynesian endgame.
For the sake of not making too much of a deal about a late downgrade, we’ll spare you with the details on why we feel this way. Please refer to our 4Q10 Key Macro Theme of Japan’s Jugular for the work behind our implicit downgrade of Japan’s credit, currency and equity market. The presentation, originally published on October 5th, can be accessed here:
Replay Podcast (starts around 9th minute): https://www.hedgeye.com/feed_items/9746
[To access the podcast, you may have to copy/paste the link into the URL of your browser.]
Slides (12-34): http://docs.hedgeye.com/Q4%202010%20THEMES.pdf
Two alarming datapoints that hit our screens over the past couple of weeks were Japan’s widening central government budget deficit and subsequent burgeoning debt issuance. According to the Japan’s Finance Ministry, Japan’s budget deficit is forecast to grow to ¥51.8 trillion yen (~$630B) in FY13 and ¥54.2 trillion yen (~$660) in FY14. [For reference, FY13 starts April 1, 2012.]
When put into the context of a ratio, Japan could be running a PIIGS-like ~11%-12% deficit to GDP in a little over a year. Looking closer to this upcoming fiscal year, which begins on April 1st, Japan’s relentless acceleration in deficit spending has Japan’s Finance Ministry upping its projected debt burden +5.8% YoY to 997.7 trillion yen, or roughly 215-220% of GDP.
Japan bulls point to the fact 90% of Japanese government debt is financed through its domestic population of savers, making it less likely to experience a dangerous back up in yields or default. As we’ve shown in the aforementioned presentation, that tailwind is rotating on the margin towards becoming a headwind as a result of unfavorable demographics. We saw signs of this trend starting last year, with Japan’s largest pension funds selling assets and joining the global search for yield to meet payout obligations.
This will only accelerate over the next 20-30 years, with the next ten likely being a real wake up call for global investors. Currently, the ratio of retirees to working-age Japanese is equal to 35.5%. In just ten years time, that ratio will be equal to 48%. In a society notorious for luxurious pension packages, going from a 3-to-1 base in potential contributors to a near 2-to-1 base in a matter of just ten years means the domestic demand for JGBs bulls consistently refer to will decline by nearly 1/3rd.
All told, we foresee a major supply/demand imbalance for Japanese government debt and, in our opinion, this imbalance is one of the largest long-term TAIL risks to the global economy. But don’t take our word for it:
“The financial state of our nation is becoming increasingly severe. Fiscal management that depends excessively on bond issuance is becoming too difficult.” – Japan’s Finance Minister Yoshihiko Noda, January 24, 2011
“The government must fix its finances to avoid a debt crisis that could trigger a global depression.” – Japan’s Vice Finance Minister Fumihiko Igarashi, January 2011
Obviously, we think it pays to pay attention here.
Position: Short Italy (EWI); Short Euro (FXE)
Conclusion: Our current short positions in the Hedgeye Virtual Portfolio of Italy via the etf (EWI) and the Euro (FXE) are working against us as Europe gets a confidence boost from Asian debt demand, positive speculation on a future bailout package for the region, and increased sentiment from ECB President Trichet to fight inflation (ie raise rates) which is supportive for the common currency.
We see this development potentially continuing to play out in the immediate-term, however over the intermediate-term TREND our negative outlook on Europe, especially for the countries with high fiscal imbalances (Italy, Spain, and Portugal), remains intact; the credit market and recent fundaments provide supporting evidence. Our TRADE (3 weeks or less) range on the EUR-USD of $1.35-$1.37.
Don’t Fight these Forces, Near-Term
As an update on our recent work on Europe, it’s clear that European equities (especially the PIIGS) and the EUR versus major currencies (particularly the USD) are getting a sizable near-term boost. While our thesis remains intact that the region’s debt imbalances will weigh to the downside on capital market performance over the next 3-5 years, recent strength in European equities and the common currency can’t be ignored, and we think they’re primarily a function of:
1. A pledge by Japan and China to buy European debt in the first half of January:
- And Asian investors followed through on their promises – in the first auction from the European Financial Stability Facility (rated AAA) on January 25th of €5 Billion 5-year bonds @ 2.89% the Japanese government bought 20% of the issue, with Asian investors snapping up a full 38%. The auction drew considerable demand at €44.5 Billion!
2. Bullish speculation on a “comprehensive package” to tackle Europe’s sovereign debt crisis:
- European Ministers have said that a package to revise the EFSF and map out a permanent mechanism to replace it in 2013 and tighten fiscal rules should be decided on by late March when the European Summit convenes.
- Proposals for this package include:
3. Hawkish commentary from ECB President Jean-Claude Trichet:
- Following the ECB rate decision on 1/13 and in recent interviews at Davos, Trichet is signaling to the market that he 1.) Recognizes rising inflation (particularly in commodities), and is 2.) Determined (as ever) to maintain price stability over the “medium term” to address these pressures. This position diverges greatly from Bernanke’s stance in the US!
- In a separate note we’ll be addressing the timing of an ECB rate hike, however the chart below of the 2YR German Note provides a telling inflection that a hike in the near-term is being priced in. The yield is up a full +50bps since the end of last year.
Here’s the equity performance of the PIIGS since 1/10:
Beware: Long-Term, Sovereign Debt Issues Persist
Over the long term we see significant headwinds from the developing sovereign debt crisis in Europe. We think this “crisis” has a tail of 3-5 years. We don’t see politicians allowing for the failure of the Eurozone member states or the Euro, however what’s clear is that the long road to tighten up the fiscal imbalance of member countries, and construct frameworks to more effectively govern the unequal economies joined under monetary policy and currency will be a great challenge.
We’re not of the opinion that governments across the region will be able to meet their debt and deficit reduction targets over the next 2-4 years. One clear signal we’ve witnessed for the last year is a trend of rising credit yields for the PIIGS despite bailouts in Greece and Ireland. We think Portugal, Spain, and Italy are next on the block.
As the chart above demonstrates, rising yields put increased pressure on the sovereigns as they issue new debt, and so begins the viscous cycle of nations chasing yields higher to capture demand to meet future obligations. We’ve seen, using Greece and Ireland as examples, that a yield of 7% or above is a critical inflection line -- in both cases after the line was violated to the upside, a bailout came in mere weeks.
While we applaud the concurrent austerity programs throughout Europe to suppress spending and increase revenue vis-à-vis tax hikes, slower growth (and therefore less revenue) should follow, another headwind for fiscally imbalanced countries (and their equity markets) that have sizable debt obligations due this year and next (see chart).
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