Lorri: “So how does it feel to be the oldest rookie in the last 30 years?”
Jimmy: “I don't know... I'm tired.”
-Rachel Griffiths and Dennis Quaid in The Rookie
Alongside “Invincible” (starring Mark Wahlberg and Greg Kinnear in 2006), “The Rookie” (Dennis Quaid and Rachel Griffiths in 2002) is one of my favorite ‘true story’ Disney movies of the last decade.
I’m an athlete, so these are my confirmation biases. I get it. And I’m proud of it. While trading markets may not be a full contact sport, there’s definitely a score and the non-athletes in the game are some of the most competitive people I have ever played with and/or against.
There are plenty of Rookie Trader mistakes that people make in this business. I am certain that I have made all of them, multiple times. Most of the time, that’s the only way a risk manager can mature in this business – by learning with live ammo.
Currently, we have a Rookie Trader learning on the job as he trades America’s balance sheet. Like Jimmy Morris did, he has some of the credentials to play in the Big Leagues. He’s one of the oldest rookies we’ve put in the game. And, if you didn’t notice, on Wednesday in front of Congress, he looks tired.
Tired and old is hardly a bad thing. I’ll still put the original Thunder Bay Bear (my Dad) up against any young buck who wants to try to hold up a retaining wall (we might just have to jack him up with some coffee first!). But tired, old, and inexperienced is not the kind of trader I want at the helm of my firm or family’s future.
Every week the Federal Reserve issues its version of transparency and shows us both the size and components of the Fed’s balance sheet. In the last 2 weeks, this is what Ben Bernanke has been doing – buying bonds, aggressively:
Yes, I am capitalizing the B’s and T’s so that you can hear me now…
Over the same 2-week period, this is what the US Treasury Bond market was doing:
So… what does this mean? drum-roll … The Rookie Trader at the helm of the US Federal Reserve is committing one of the cardinal sins of risk management – he’s getting bigger and more aggressive on the way down!
Again, remember that The Ber-nank’s promise of perpetually low interest rates and that the Quantitative Guessing II (QG2) is the elixir of Big Government Intervention life has A) never been tried before, B) no risk management scenarios in the case that the trade goes against him, and C) no one to tap him on the shoulder and stop him from trading.
When I was given my first book to trade in 2002 (at our hedge fund we called it a “carve-out”), I had 2 bosses and an entire trading desk overseeing everything I did. Stop losses, shoulder taps, personal embarrassment – there were plenty of governors managing my mellon. But this guy has none.
No real-time accountability. No modern day risk management system to stop him out. Nothing.
And this he’s betting with $25-31 BILLION DOLLARS a week!
To put those Burning Bucks in context for you… and yes I realize our entire culture and country is numb to what a US Dollar is worth anymore… pressing a one-way bet with $30 BILLION Dollars a week would be the equivalent of 3 Steve Cohens taking all of their capital and having them all buy the same security, at the same time, with no hedges and no other positions…
Welcome to Centrally Planned America 2.0. with the Rookie Trader starring as your Almighty Central Planner.
In other news this morning, as US interest rates continue to push higher (2-year yields are now up +166% since Bernanke made his QG2 promises of “low interest rates and price stability” at Jackson Hole), I see nothing but price volatility.
1. Pepsi (PEP) – a $100 BILLION snack and beverage company cut its EPS targets for 2011, and the stock hit a fresh 3 month low on big volume. Management cited soaring commodity costs and uncertainty about when the said US economic recovery will actually be felt by consumers.
2. Bunge (BG) – a $10 BILLION agribusiness and food service company said it would no longer issue earnings guidance because volatility in the commodity markets have made forecasting increasingly difficult.
3. Bolivia – a country with 11 million people saw its President, Evo Morales, pull himself from all public appearances as food riots have erupted across the country and Bolivian miners, who are evidently upset, are starting to throw sticks of dynamite at government people.
I know, who cares about Egypt, India, and Bolivia? The Rookie Trader says US Monetary Policy gone bad has nothing to do with what’s happening anywhere in the world, including his home team’s bond market.
My immediate term support and resistance levels for the SP500 are now 1311 and 1334, respectively.
Best of luck out there today and have a great weekend,
Keith R. McCullough
Chief Executive Officer
TODAY’S S&P 500 SET-UP - February 11, 2011
Equity futures are trading below fair value as events in Egypt send investors into defensive mode; safe haven trades are a consequence of the current political uncertainty with dollar assets in demand and the price of oil rising back above $87.00 per barrel. As we look at today’s set up for the S&P 500, the range is 23 points or -0.82% downside to 1311 and +0.92% upside to 1334.
MACRO DATA POINTS:
EARNINGS/WHAT TO WATCH:
As has been the case throughout much of the week, high-profile drivers remained few and far between, particularly with another fairly quiet day on the economic calendar. Nevertheless, we have day 4 of perfect = 9 of 9 sectors positive on TRADE and 9 of 9 sectors positive on TREND.
CREDIT/ECONOMIC MARKET LOOK:
Treasuries were back on the defensive yesterday after snapping a seven-day losing streak on Wednesday.
Australian dollar falls below parity with dollar as Reserve Bank Governor Glenn Stevens says policy makers judged it was “sensible” to keep interest rates on hold.
Hedgeye CEO Keith McCullough handpicks the “best of the best” long and short ideas delivered to him by our team of over 30 research analysts across myriad sectors.
CAKE reported earnings for 4Q10 after the close, announcing revenues of $416.7 million versus $400.6 million for the same period one year prior. Earnings came in at $0.36 versus the Street at $0.35. This was a low quality quarter, however, with the tax rate coming in at 23.8% due primarily to a higher manufacturing tax deduction on the significant increase in the production of bakery products. Bakery sales were a bright spot for CAKE this quarter, surprising management, coming in at $31.9 million, or up 22.3% on last year. Of course, this level is unsustainable and management said as much during its commentary, stating that Bakery sales should remain at approximately 5% of sales.
Turning to the company’s costs, cost of sales increased to 26.3% of revenue for 4Q10 compared to 25.3% of revenue for 4Q09. This increase was attributed to higher bakery sales as well as continued pressure from dairy costs, as expected. Labor costs were a major help to earnings during 4Q, ending up at 30.8% of revenue for the fourth quarter, down 120 basis points from 32% in the prior year. Of this, management stated that perhaps 30 bps was due to improved management of labor while approximately 90 bps was due to two unusual items: lower equity compensation and a benefit from the Federal Hire Act, which resulted in lower FICA costs. The 90 bps was split fairly evenly between these two factors.
G&A expenses decreased 60 bps to 5.9% of revenues due to lower bonus accruals and depreciation was 4.3% of revenues versus 4.8% a year prior. This favorability was due to sales leverage and an impairment charge in 4Q09. In addition, net interest expense was $1.5 million versus $5.4 million a year ago; a $2.2 million expense to unwind an interest rate collar a year prior, as well as a higher debt balance, resulted in this year-over-year decline.
Clearly this quarter, by happenstance, several factors fell into place for CAKE. Operating margins improved by 90 bps year-over-year to 7.4%.
Outlook was obviously the primary interest, given that comps had been preannounced in January. For 1Q11, diluted EPS guidance was given as $0.29 to $0.33. Full-year 2011 guidance was reiterated at $1.55 to $1.70, based on a comparable store sales projection of 1-to-3%. Clearly the implication here is that management is hoping for a pickup in earnings power after the first quarter. The first quarter, management said, is being impacted by record snowstorms in the Midwest and Northeast as well as elevated food costs. Dairy sales have continued to skyrocket since January 1st and, quarter-to-date, management estimates that weather has cost CAKE 1% from a comp perspective.
Management is forecasting food inflation of 4% in the front half of the year followed by 3% in the second half. Since management first gave FY11 guidance in October, their outlook for food costs alone has risen by “at least” $0.05. Nevertheless, management unconvincingly stated that by “actively managing our cost structure, including ongoing improvements in labor productivity and tight G&A controls”, the company will absorb these costs. In my experience, a nearby penny is worth a distant dollar – I certainly was less than convinced by management’s assurance.
Firstly, their comparable-restaurant sales guidance may prove difficult. While mix is trending less negative than it did for the first three quarters of 2009, the compares facing top line trends step up meaningfully from 1Q onward.
The company is implementing a 0.7% menu price increase in their winter 2011 menu change, lapping a 0.6% menu price increase from the winter of 2010. This will leave 1.4% pricing on the menu by the end of the year. With only 60% of its food basket on contract, it seems that the company may have to ponder taking additional pricing. Management knows from experience that The Cheesecake Factory’s customer is fairly price sensitive, hence the average check problems that have hurt the top line for the last number of quarters.
Secondly, the cost outlook is less-than-positive. As of now, dairy, cheese, and fresh fish are not contracted. Rather than proactively passing costs along to the consumer, unsurprisingly, management stated that it would prefer to be a follower than a leader in this regard. Depending on how spot markets behave throughout the year, some competitors may be better insulated from food inflation than CAKE; the company may have difficulty waiting for other chains to blink first.
It is instructive to bear in mind that, for CAKE, as management stated at the Cowen Conference, “every 1% increase in annual comparable sales is about an incremental $0.08 in earnings per share, based on 40% flow through, although many times we have been able to achieve a flow through better than 40%.”
The labor cost initiatives intended to make up the $0.05 of food costs (from what management knows of the quarter so far) may also prove a stretch. Management stated that the magnitude of labor savings in 2011 will depend on what comps are; “At the higher end of our range, we should be able to sustain some improvement in the labor line. At the lower end, it’s going to be a little more challenging.” Given the difficult comps ahead from a top-line perspective, exposure to food inflation and management’s revealing hesitancy to proactively raise prices, I believe that the outlook for 2011 is decidedly negative for CAKE.
What P/E multiple would you pay for a restaurant company with the following characteristics?
(1) 5-yr EPS growth of 18-20% (13% unit growth, 4% SSS and some margin expansion?)
(2) Consumer loyalty that cyclical (otherwise management would have raised menu prices)
(3) Little pricing power (management implied that last night)
(4) Significant margin volatility due to significant commodity exposure (read the rest of this note)
Pick from the following:
(A) 20x earnings
(B) 25x earnings
(C) 30x earnings
(D) 35x earnings
This brackets the valuation of CMG at some where between $120 and $210 per share, with stock having closed at $256 (and trading up at $275). Yes, you can accuse me of having a BEARISH view of CMG, but I also feel like I’m being rational in a market that is irrational. Right now I have CMG earning $6.00 in 2011 below the $6.66 consensus estimate. I’m the bearish one so I’m going to use 25x as an appropriate multiple to value CMG - that puts $100+ downside to CMG.
Read the balance of this note and you tell me that the current 42x multiple is justified.
CMG once again beat street expectations, reporting 4Q10 earnings of $1.47 per share and 12.6% comp growth relative to the street’s $1.31 per share and 9.9% same-store sales growth estimates, respectively. With restaurant-level margins up over 140 bps to nearly 26%, and operating margins up 240 bps YOY, it is hard to poke any holes in the company’s fourth quarter results.
CMG maintained its reported FY11 guidance to open 135 to 145 new restaurants and for low single-digit comp growth, but outside of that, all of management’s commentary around its outlook for this year was decidedly bearish. In short, same-store sales comparisons, and more specifically, traffic comparisons, get increasingly more difficult as we progress through the year, inflationary headwinds will put real pressure on margins and labor costs will creep higher as a result of the recent immigration inspection in Minnesota, which could ultimately affect additional markets.
Same-store sales growth
During the fourth quarter, CMG successfully lapped its first quarter of slightly positive traffic growth reported in 4Q09 after lapping five quarters of traffic declines. The traffic comparison turns significantly more positive in 1Q11 to about 4% and jumps to double-digit growth in the second half of the year. Given that the company is currently not planning any menu price increase for the first half of the year and menu mix has only been a minor driver of comp growth in recent quarters, the sharp uptick in traffic comparisons will likely cause comp growth to slow, particularly in the second half of the year, to closer to 3% from the double-digit growth reported in 2H10.
On the earnings call, management announced a loyalty program based on rewarding “our best customers for their knowledge and understanding of Chipotle, rather than simply rewarding visits as most loyalty programs do”. While CMG’s intentions may be admirable, to ‘educate people about “Food With Integrity”’, I am skeptical that this initiative will prove incremental to comparable sales and traffic growth when it is rolled out in April.
During the first quarter, a tougher comparison will not be the only hurdle; however, as management said that although comps held up well in 4Q10, “it's been pretty volatile so far in 2011 with extreme weather throughout much of the country.” Given this volatility, I am currently modeling 6% same-store sales growth during 1Q11, which implies about a 200 bp deceleration in two-year average trends. For the remainder of the year, I am modeling flat two-year trends with the fourth quarter because management did specify that, outside of the weather impact, there does not appear to be any change to underlying trends. But again, flat two-year average trends imply a significant slowdown in comp trends on a one-year basis (pictured below).
CMG sounded decidedly more negative today regarding its commodity cost outlook for 2011 relative to the company’s 3Q10 earnings call when it said it could face low-to mid-single digit cost inflation. During the fourth quarter, food costs as a percentage of sales increased nearly 100 bps to 31% and that is with comps up 12.6%. Now, management is saying that, using that 31% of sales level as a starting point, overall food cost inflation will climb to mid-single digits during the year. This new guidance does not even include the expected 200 bps of pressure that the company could face in the coming months as a result of recent freezes in Mexico and Florida that have impacted the supply and cost of tomatoes, green peppers and tomatillos.
After hearing this outlook, I assumed management’s next comment would be that it has already or will soon be implementing a price increase to offset this margin pressure. That was not the case. Instead, the company said it will not take any price for the next two quarters until it sees how the commodity environment pans out and how consumers react to its competitors’ price increases. I understand management’s caution around taking price in this economic environment, particularly since traffic growth has been the primary driver of CMG’s comp growth.
Increasing prices could likely be detrimental to traffic growth, but without pricing, CMG’s margins will take a hit, and likely a big hit, specifically during the first half of the year until we see how the situation in Mexico and Florida shakes out. Rising corn prices are also a major concern. Specifically, management stated, “reports of continuing or even worsening supply shortages of corn will only add to inflationary pressure on the meats that we serve.” To that end, management continues to think it has pricing power and will decide whether a price increase is necessary during the second half of the year. We could easily see food costs as a percentage of sales up 200-300 bps in the first half of the year.
Labor cost pressure
As a result of the recent Minnesota immigration inspection, CMG has had to hire and train hundreds of new employees, which management called “disruptive.” CMG has 50 restaurants in Minnesota and the company has had to train new employees in nearly all of them, which adds up to 20% to 30% more crew hours in those restaurants. At the company level, these increased labor hours in Minnesota alone are expected to add 20 to 30 bps of extra costs to the labor expense line, which should then level off over the next few months. But, this might not be the extent of the damage because the company has already received a similar notice of inspection for all of its restaurants in Virginia and Washington D.C. and I would not be surprised to see more markets added to the list.
During the 3Q10 conference call, management provided an insightful comment pertaining to the company’s ability to sustain margins going forward; “so long as we continue to see some comp growth – and we typically need something mid-single digit, generally with normal inflation [to hold margins]”. Given that the inflation picture has worsened and they are now guiding to low-single digit comps, margin contraction, not expansion, seems more likely.
Timing the 2011 Headwinds:
1Q11: Experiencing “volatile” trends quarter-to-date, could face an additional 200 bps of commodity pressure on top of the already climbing commodity costs (would not be surprised to see food costs as a percentage of sales up 200-300 bps YOY), expecting at least 20-30 bps of incremental pressure on the labor line as a result of the immigration inspection in Minnesota, no price increases…I am expecting the biggest YOY restaurant-level margin decline in 1Q11 (down about 300 bps).
2Q11: Lapping a more difficult 8.7% comp relative to 4.3% in 1Q11, facing continued commodity pressure (would not be surprised to see food costs as a percentage of sales up 200-300 bps YOY) and likely additional costs associated with an expanded immigration situation, no price increases
2H11: Lapping double digit comp and traffic increases, commodity pressures will be an issue; though they may mitigate somewhat as the year progresses, company may implement a price increase if necessary
Blockbuster quarter in Macau. Even after normalizing the unexpectedly high Mass hold, the beat was still huge.
CONF CALL NOTES:
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