Keith shorted WMT in Hedgeye’s virtual portfolio with the view that inflation will become an increasing headwind for the company’s topline as well as for margins. Independent of inflation, we’re already pre-disposed to be short WMT based the internal challenges the company faces to drive its domestic same store sales towards the first increase in seven quarters.
The situation surrounding Wal-Mart’s internal execution in areas such as apparel and overall category management is nothing new. Too much selection? Not enough selection? Brands? Basics? Management is hyper focused on turning things around, yet numerous strategy changes over the past year have yielded little in the way of tangible results. We do not see a meaningful and credible plan at this current time that suggest domestic sales can outperform an increasingly challenging backdrop for the company’s core consumer. In fact, the company entered 2011 with total inventories up 11% against a 2.5% increase in sales. Clearly not the “clean” start that instills confidence in the wake of rising costs and substantial volatility at the gas pump.
We remain concerned with the following near-term challenges:
- Management’s message now says the US goal of positive same store sales will “take time”. The CEO acknowledged that issues facing sales (and their customers) were bigger than they “initially expected”. Traffic is still a drag and likely to remain so given the law of large numbers that puts 1 in 3 Americans at a Wal-Mart each week.
- The company cut capex by $1 billion for this year, after slightly raising it at the October analyst day. While this is noteworthy because it shows some discipline towards capital preservation, we put the amount of the cut in perspective. At today’s share price, WMT can buy an additional 19 million shares which represents a mere .005% of shares outstanding.
- Inventories are high no matter how you slice it heading into this year. Total inventories were up 11%, total sales up 2.4% at year end. With a negative comp headwind, inventory pressure is likely to persist through the first half of the year leaving little chance for margin expansion. From a timing perspective, this then rolls into the second half of the year which is the most uncertain time from an inflation and price elasticity standpoint.
- The current four point plan aimed at fixing the US business is centered on price leadership, broad assortments, improved remodels, and focus on multi-channel. None of this is revolutionary, but rather basic blocking and tackling. Details surrounding these plans are also scant, at least as of 4Q reporting. The first point of the plan is most telling however. In order to maintain price leadership in a the wake of rising costs, we suspect WMT will be as aggressive as ever to protect its market share. At best, this caps margin improvement in the near to intermediate term.
What’s the chance that LVS gets prosecuted?
LVS shares continue to be pressured by the potential ramifications of the SEC/DoJ investigation into the company’s compliance with the Foreign Corrupt Practices Act (FCPA). As Adelson wonders how much more hair and money he will lose over this matter, we checked in on stats from some of the past high-profile FCPA cases.
In 2010, there were 23 FCPA investigations that resulted in enforcement actions. This translates into a roughly 20% hit rate. 48%, 28%, and 18% of estimated ongoing FCPA investigations resulted in prosecution in 2007, 2008, and 2009, respectively. The number of cases have more than tripled since 2007.
As the table below shows, the settlement payments for the largest FCPA cases have risen significantly since 2008. The penalty multiple placed on the alleged illegal money varies widely, although the guideline for 2010 was around 2x. Moreover, many senior management members, including CEOs, are serving prison sentences. We’re not saying Adelson is going to jail but as we wrote in LVS: IT’S NOT JUST ABOUT THE FINE (3/2/11), we believe the FCPA fine for LVS could be high, and more importantly could have deeper ramifications (e.g. forced exit from NV,PA; lost opportunities in new markets).
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Conclusion: Price momentum is slowing in copper. The industrial metal is now bearish on TRADE duration and that has our attention. The fundamentals – supply and demand – confirm the price breakdown; thus, we do not see the pullback in copper as a buying opportunity
China consumes ~40% of the world’s refined copper – 4x as much as the U.S. Historically, copper prices and Chinese growth have been positively correlated. However, just as at a point higher oil prices are bad for economic growth, so are higher copper prices. The chart below illustrates this point. The Chinese stock market and the price of copper closely mirrored each other for the first half of 2010. But when copper crossed over $4.00/lb in October 2010, the two diverged meaningfully. At a point reflation becomes inflation, and inflation hampers growth.
The method through which higher prices stymie growth is lower demand. Consumption of copper in China peaked in early 2010, and has trended down since:
As consumption slows, inventories build. Here is what that looks like in China:
What about the developed world? After China, the largest consumers of refined copper are the US, Germany, and Japan. Here’s what consumption of copper looks like in those countries:
Obviously, developed economies cannot be relied upon to pick up the slack for a marginal slowdown in Chinese copper consumption. And recently copper inventories at the largest copper warehouse in the world – the London Metal Exchange – have built aggressively. When China slows, copper inventories build:
Lending to the inventory builds, copper production (mining) is strong, increasing 7% in 2010 year-over-year:
Inflationary pressures (copper included) have forced the Chinese to tighten monetary policy, leading to slower growth. Slower growth has led to a decline in copper consumption, though we have to not seen the impact of that feed through to the price of copper until very recently. We contend that copper traded away from the supply – demand fundamentals beginning in late 2010, and simply inflated. After all, the correlation between the USD and the price of copper is -0.80 over the last year.
If inflationary pressures subside and copper returns to the fundamentals, lower demand and higher supply will take the metal lower. We will be watching the TREND line of support ($4.25/lb.) closely. If that line breaks, look out below.
Conclusion: We’ve recently been reading Jonathan Alter’s book, “The Promise: President Obama, Year One”, which is a thoughtful overview of President Obama’s first year in office. We’ll leave a scorecard of that year to the punditry and historians, but one interesting take away from the book was the management hierarchy within the Obama White House.
Our friend Karl Rove has loudly criticized the power structure within the White House based on the number of staff, which by his count is almost 3x the number of people that were in the Bush White House. In his view, the Obama structure is very political and laden with academics. While this could be true, Alter provides a slightly different perspective of the current White House staff.
According to Alter, President Obama took a memo from his staffers on a trip to visit his ailing Grandmother in Hawaii in late October of 2008. The topic of the memo was who was to report to whom in the White House. As Alter wrote:
“Under one flowchart, a dozen senior staff would report directly to the President. This was the way disorganized Democrats always seemed to do it, going back to JFK and Jimmy Carter. Clinton followed the pattern and it contributed to the “college bull session” nature of his early tenure. Obama chose Pete’s other chart, the one labeled “collaborative hierarchy.” This centralized all power in the Chief of Staff’s office so that there was no confusion on lines of authority. The new Chief of Staff would have much more power on paper than many of his predecessors.”
So despite the highly populated White House, President Obama actually has theoretically set up a management structure that is quite focused with the Chief of Staff as the real power broker in the White House.
The other key decision was obviously related to the type of person that should be the Chief of Staff. President Obama veered away from having a full principal (according to Alter, this is a powerful elected representative or someone of cabinet rank) as Chief of Staff, and instead selected Rahm Emanuel who was considered half principal, half staff.
The new Chief of Staff, Bill Daley, actually diverges quite widely from the half principal model as he is, in fact, a former cabinet member as Secretary of Commerce under President Clinton and also a senior executive at many corporations, including the former President of SBC Communications. In effect, we now have a White House that has established the role for a powerful Chief of Staff, and a Chief of Staff who is very powerful. Therefore, in evaluating future decisions of the White House, it will be important to understand the background and influence of Daley.
Daley is a lawyer by training and has been either on the Board of, or worked for: Boeing, Merck, Boston Properties, JPMorgan, and SBC Communications. He was also President Clinton’s advisor on NAFTA. In sum, he certainly appears to be pro-business and an advocate of free trade. Interestingly, and perhaps not surprisingly, the appointment of Daley has seen mixed reviews from President Obama’s base. Per Wikipedia:
“Daley's appointment was "vociferously condemned" by "leading progressive voices" including MoveOn.org, Rachel Maddow and Keith Olbermann of MSNBC, while being enthusiastically supported by JPMorgan Chairman and CEO Jamie Dimon (who first suggested Daley), the Chamber of Commerce, the Third Way, and Karl Rove. The choice was questioned due to the fact that "Daley was an outspoken opponent — in public — of two of Obama's most prominent legislative items: health care reform and the financial regulation bill's consumer protection agency."
The key danger we potentially see is that Daley may be too much of a principal to be effective in this management role, which may require as much in the way of logistics as actual decision making. The other potential issue of course is hubris. As we reviewed this past Sunday’s morning political shows, this is the key risk that jumps out at us from the early versions of The Daley Show.
On Meet the Press this Sunday, David Gregory started his conversation with Bill Daley talking about the price of oil and uncertainty in the Middle East. To say he was less than on his game, might be an understatement. He seemed rattled by some of Gregory’s questions and his answers were often full of platitudes, which showed a limited understanding of core issues.
The one response that intrigued us was when Daley responded in the affirmative that President Obama would consider tapping the Strategic Petroleum Reserve (SPR) to offset rising oil prices. While on the margin this might have an impact, the issue is not supply, so increasing supply actually has limited benefit. In fact, currently crude stockpiles in the U.S. are 1.4% over year ago levels, which is also above the prior five year range. So, the U.S. is solidly supplied with oil.
Given this, if the White House does tap the SPR, oil prices might go higher. For starters, the SPR only holds ~724MM barrels, so at full U.S. consumption there is only ~34 days of supply, or roughly 2 months supply if we just account for covering imports. The point being that the SPR does not have a lot of supply and should likely only be used in a period of real extremes. If not, the risk is that tapping the SPR could signal to the market that oil is more scarce than reality. It is likely no surprise, as a result, that the oil price has effectively not budged since Daley’s statement.
As you think about the coming months and years of the Obama Presidency, stay tuned to the Daley Show. Our Hedgeyes will be focused on it.
Sonic is trading higher today on preannounced comps from yesterday and a sell-side upgrade this morning.
Yesterday, Sonic management indicated that sales for both company-owned drive-ins and the system were positive for the second fiscal quarter ended February 28, 2011. The company estimates that system-wide sales for the quarter (2QFY11) increased by between 1% and 1.5% (company-operated stores up 2.2%). While this is encouraging in that it is a positive number – the first since 2QFY08 – I would think it imprudent to chase this stock today.
I struck a fairly positive tone when penning my last note on SONC titled, “SONC: LESS BAD IS GOOD”, on January 5th. While I did state that the company was “not out of the woods” from a top line perspective, I was certainly becoming more positive on the margin. The Street’s bearish sentiment on the name also made the name more attractive. The system-wide comp for this quarter, assuming it falls at the midpoint of the estimate range provided by management, will imply deterioration in two-year average trends from 1QFY11 of 150 basis points.
The reality is that over two months have passed since my aforementioned post on Sonic and much has transpired since then. Coincident and lagging indicators, like employment and personal consumption, have shown some improvement and/or stabilization. Commodities have increased greatly in the last two months, however, and I believe greater sales growth than +1%-+1.5% (versus a -13.2% year prior) will be required to absorb such cost inflation.
Guidance provided following results in January for FY11 top-line trends was suitably vague; management stated that “sequentially improving same-store sales throughout the fiscal year” would be based on “sales-building initiatives”. While 2Q’s preannouncement certainly meets guidance from a one-year standpoint, the two year number is concerning because clearly the compare was easy and they become more difficult going forward, but also because commodity costs – as shown in the charts below – are through the roof. For reference, to simply maintain, not improve, the 2QFY11 level of comp growth in 3QFY11 on a one-year basis, it would imply about a 350 basis point acceleration in two-year average system-wide comp trends. To me, this seems aggressive.
Like a lot of restaurant companies, I feel that SONC is understating the real inflation numbers it is going to see. The company previously guided to between 1% and 2% commodity inflation for the year and, while the majority of their basket items are hedged for the year, the company is purchasing beef on a short term basis.
Regarding beef prices management stated that it expects, following mid-single digit gains in 1QFY11, “to see kind of a comparable year-over-year increase, maybe even flattening out in the third [fiscal] quarter”. Beef prices have, although volatile, made higher highs and lower lows since early January. Since the earnings call, beef prices are up 4%.
Of course, commodity costs impact SONC’s operations in more ways than one. Gasoline prices are up over 14% since the earnings call for 1QFY11 earnings was held. This is obviously relevant for all QSR chains but given that SONC’s system is exclusively drive-in, the company is particularly exposed to gas price inflation. The company will have approximately 0.5% of price on their menu in 2Q and 3Q; considering the cost of gasoline as part of the cost of a trip to SONC, I am confident that additional price won’t be well-received by the Sonic customer. I think it is unlikely traffic will come to the rescue either – 2QFY11 comps flattered to deceive.
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