Keith added to our RL short today in the Hedgeye virtual portfolio with the stock overbought relative to his model on an immediate-term TRADE basis.
Here is a comprehensive view of top line trends in the QSR category heading into earnings season. Commodity costs are elevated; investors get that. How companies handle that and maintain comps will be the key differentiator over the balance of the year.
In the quick service space, traffic has been the prize operators have aimed for over the past number of years. Some, like CMG, have had tremendous success in driving guest counts while others, like WEN, have struggled in that regard over the last couple of years. Below, we go through several key names in the QSR space in terms of where they stand from a comparable sales growth perspective as we roll towards earnings season kicking off.
Chipotle has blown away expectations for a number of quarters now. Management struck a more cautious tone on the most recent earnings conference call of February 20th, but the company is likely to report another solid quarter of comparable restaurant sales growth on July 19th. Over the past three quarters, the company has produced double-digit comp growth. The concept has been wildly popular but, expectations surrounding top line growth have moderated somewhat. During the first quarter, CMG comparable restaurant sales grew 12.4% (11.4% excluding the impact of a BOGO promotion). This represented an acceleration in two-year average trends of 105 basis points (55 basis points excluding the impact of the BOGO promotion). Despite this robust growth, restaurant-level margins contracted in 2Q which has led management to make the decision to raise prices further. Labor pressure related to the federal immigration authorities’ probes into CMG’s hiring practices has also impacted margins.
In light of the strong performance during 1Q, management raised its guidance for comp growth from low single-digit to mid-single digit. On the February 20th earnings call, management said that it would hold off any further increase in price until the third quarter to properly assess food inflation and the reaction of its customers, particularly in California, to prior price increases. News emerged over the past few days that the company has raised prices $0.50 at its New York chains, with lines (according to the Wall Street Journal, still “out the door”) and plans to raise prices in the next few weeks at its stores in the Northeast and Southeast, with changes in other markets to follow.
While New York City’s customers may absorb the price increase with little impact on frequency of visits, it remains to be seen if the broader store base will react in a similar manner. The company needs to maintain transaction counts to meet investor expectations in the back half of the year.
Hedgeye: CMG is going to once again post a strong quarter.
I continue to believe that the COSI turnaround story is on track, despite what the weakness in the stock, of late, might be suggesting. In 1Q11 COSI reported a 3% in same-store sales, implying that 2-year trends declined from a -0.3% to -0.7%. All of our visits and checks suggest that the company can post 3-4% same store sales in 2Q11.
Hedgeye: COSI (the stock) has struggled of late, but the sales trends are telling a different story. I believe there will be incremental positive news when the company reports the quarter.
Domino’s Pizza’s management team has carried out an impressive turnaround over the past 18 months. The introduction of a new pizza was well-received in early 2010, with a massive increase in comparable restaurant sales growth coinciding with the new product and the accompanying advertising campaign. The company has remained focused on driving comp growth by other initiatives also. For instance, the company has rolled out an impressive online ordering system that accounted for 25% of sales in the first quarter, according to the most recent earnings call.
Hedgeye: Management is guiding to domestic company comparable-restaurant sales of +1 to +3%. The mid-point of this range implies two-year average trends of 5.2%, a sequential deceleration of 105 bps from 1Q11. All indication are that DPZ will meet or exceed current guidance.
Jack in the Box has seen comparable restaurant sales recover over the last couple of quarters but lags the QSR group on this metric. Management is guiding to what I believe is an achievable range of +2 to 4% comparable restaurant sales growth during the third quarter. The mid-point of this range implies two-year average trends of -3.2%, a sequential acceleration of 70 basis points. I believe that this is within reach for Jack in the Box. The mid-point of management’s guidance range for Qdoba comparable restaurant sales, of +4 to 6%, would represent a sequential acceleration in two-year average trends of 20 basis points to +4.8%.
California and Texas have been soft markets for JACK over the past couple of years but, encouragingly, that there has been a recent bounce-back in comps in both markets. In fact, according to management commentary during the most recent earnings call, “California and Texas both continue to have positive same-store sales and California was our best performing market on a two-year basis.” Together, the Lone Star and Golden states make up 57% of the company’s total store base.
Hedgeye: Given the improving MACRO environment JACK has a chance to beat consensus environment.
MCD sales have been strong thus far this year but, as we highlighted in our “MCD – HORSESHOES AND HANDGRENADES” on June 8th, the change of tone between the April and May press releases was telling. April’s U.S. results were, according to the company, driven by McCafé, beverages, breakfast, and featured core products. May’s U.S. sales commentary, however, did not mention core products or McCafé.
The crux of my bearish thesis on MCD, that originated in the latter stages of 2010 and was published in a black book in mid-January, was that McDonald’s has become over-dependent on beverages to drive sales. The risk to this strategy, as I see it, is that it is not sustainable and I expect to see MCD struggle to match the beverage sales of 2010 this year. With any drink for $1 at MCD this summer, it seems that management is maintaining its loyalty to the idea of driving guest counts but average check is likely to suffer and my bottom line, that MCD’s core business is declining, remains intact. My view here is specific to MCD’s domestic business which accounts for ~46% of the company’s overall operating income.
Hedgeye: It appears the MCD is having a strong June in the U.S., which could imply acceleration in 2-year trends. With 2Q11 sales trends likely to will be in line with consensus, what will 3Q11 trends bring given the extremely difficult comparisons?
Panera Bread has seen tremendous growth over the last few years, as have other fast casual concepts, and the past couple of quarters have been especially impressive. Despite weather impacting the first quarter, comparable restaurant sales grew +3.3% versus a +10% comp, implying a 40 basis point sequential acceleration in two-year average trends.
As of the date of the most recent earnings call, April 27th, reported 2Q to-date comparable restaurant sales growth was +5.3%. The guidance range provided for the same date was +5 to 6%, the mid-point of which would suggest acceleration in two-year average trends of 90 basis points.
Hedgeye: PNRA recently launched its first national advertising campaign, which should provide a lift to the current trends.
Starbucks’ stock has been on an incredible run and, with prices rising, some investors I have spoken with are wondering when to pile in on the short side. I am certainly not there; I think the company has further avenues for growth available. Growth for Starbucks, going forward, is expected to come primarily from its CPG business and China. Unless you are bearish on the aggregate of these two factors, I think it is difficult to build a credible short thesis.
In terms of guidance, management expects revenue growth for the full year to be driven by mid single-digit comp growth. I remain positive on Starbucks’ future business prospects and believe that the company is taking the right steps to grow market share, whether it is developing mobile payment apps for Android and i-Phone smart phones or taking control of its distribution channels to protect the brand’s equity. I expect a strong quarter from Starbucks from a sales perspective, but coffee costs rising does pose a concern.
Hedgeye: Intra-quarter, our in-store analysis suggested that SSS were double digits during the Frappuccino promotion. I expect SBUX to have another strong quarter.
Sonic’s comparable restaurant sales growth has been impressive of late, with the premium six-inch hot dog promotion driving traffic across all day parts. Customer satisfaction scores have improved and the value initiatives have been resonating with consumers. On June 22nd, however, it was interesting to hear management describe a slowing in trends over “the past few weeks” during an earnings conference call. The company was reluctant to shed light on the magnitude, or any other specifics, regarding the slowdown.
Going forward, management is basing its hopes of bringing back incremental traffic on promotions including a BAJA hotdog and a new line of shakes. Despite the fact that value offerings were highlighted as being responsible for driving traffic in the third fiscal quarter, the company felt comfortable adding 0.5% of price to the menu in early June. The company now has 2% of price on the menu which will not begin to roll off until next April.
Hedgeye: SONC is relying on the “hotdog” to boost SSS from the May/June slowdown. This will be a close call.
Wendy’s is a stock that I like over the longer term but, as I highlighted in a post on June 16th, “WEN - INTERMEDIATE TERM ISSUES BUT THE LONG TERM STILL LOOKS GOOD”, there are some intermediate term issues that bear keeping in mind. Net net, I like WEN as a standalone concept, near-term issues aside.
On the positive side:
On the negative side:
Hegdeye: WEN will not see a meaningful pick up in SSS until 4Q11, at the earliest.
YUM’s U.S. business is stagnating and management is not forthcoming with any earth-shattering solutions. That is not to suggest they should have a “silver bullet”; their KFC, Taco Bell, and Pizza Hut concepts are in a tough place in the domestic market. However, China and YRI remain major growth engines for YUM and, as I’ve said before, without a bearish view on China, I would not advise investors to be bearish on YUM.
Hedgeye: YUM USA is a disaster, with all three concepts seeing comps down between 3-7%. YUM China is likely to post its second straight quarter of double digit SSS.
Positions in Europe: Long Germany (EWG); Short Spain (EWP)
The Finance Ministry in Athens is on fire, what’s next?
As we mentioned in our research earlier in the week, we believe the backing for PM Papandreou’s PASOK party in the confidence vote last Tuesday was THE critical hurdle to clear to pass the government’s newest €78 Billion austerity package. The probability of its passage was also largely confirmed by the strong performance of European equity markets over the last two days and gains in the EUR-USD cross. However, we warn that Troika’s (EU, ECB, IMF) desire to avoid a strict restructuring of Greek debt in favor of near-term bailout band-aids and debt concessions will only extend the country’s larger fiscal imbalances, and therefore downside uncertainty for those institutions and investors holding Greek debt.
Today’s vote to pass austerity opens the door widely for similar approval of a second bill tomorrow that authorizes implementation of the measures. Critically, the passage assures Greece receives its next bailout tranche of €12 Billion from the IMF on July 3rd (from its first bailout of €110 Billion in May 2010), as the Greek government has stated that it only has funds until mid-July to support government salaries, pensions, and maturing debt obligations. In the chart below we show the monthly principal and interest payments over the next months. Further, passage assures the ball will be put in motion for talks on a second bailout worth an estimated €70-120 Billion. Such discussion will take place at the next EU Finance Ministers’ Meeting on July 5-6th and 11-12th.
But to what end with these bailout and austerity packages?
We’re less than optimistic that austerity will have much impact on the country’s fiscal imbalances and that the devil is in the details. Of the planned €28 Billion of spending cuts and tax hikes and €50 billion of private assets sales through 2015, Greece may be able to reach a deal that broadly agrees with Troika’s deficit reduction demands, while specific terms of the deal are back-loaded towards 2014/15.
While this is only a hypothetical, such a tactic could be used to appease both Troika and the Greek populous. But ultimately it bodes poorly for any material change in the budget debt and deficit, but then again given Greece’s poor prospects to grow any revenue with such a deflated growth profile (GDP contracted -4.4% in 2010 and is forecast to fall -3.8% this year), using smoke and mirrors by either party to reach any form of intermediate support should come as no great surprise.
Further, subsidizing Greece extends the uncertainty of all banks, central banks and private individuals, which hold nearly half a trillion dollars (or €340 Billion) of Greek debt. France has floated the idea of French banks reinvesting 70% of their maturing debt Greek bonds, with 50% allocated to new Greek debt that would be maturing in 5 years to be rolled over to a maturity of 30 years and another 20% directed to a zero coupon fund of “high quality securities”. The Germans have also floated similar ideas in response (meetings being held today), yet clearly there are numerous unknowns surrounding this proposal, including interest rates on the debt, and ultimately where this Greek soap opera will take us over the next month, quarter, and years ahead.
While we worry about Greece, we’re equally concerned about rising risk premiums across the rest of the periphery, especially for Italy and Spain, two countries with outsized government debts, and much larger GDPs (and exposure to throughout European institutions) than Greece, Portugal, or Ireland.
Interestingly the spread of 10 government yields from Italy and Spain over German bunds has reached record highs over the last days, a flag to monitor as the media is focused squarely on Greece.
A second chart to note is the CHF-USD cross which continues to make higher highs. Here we’ve pulled the chart back 10 years to show this serious move. We recommended a long position in the pair on 6/2/2011 and continue to support that view as the uncertainty in European sovereign debt contagion sees no end in sight.
Regarding the EUR-USD cross, we expect the pair to trade in a tight band between $1.41 and $1.45, largely supported by Troika’s backstop to prevent default of any Eurozone member nations and weakness in the USD vis-à-vis political indecision on the US debt ceiling debate.
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Notable news items and price action from the restaurant space as well as our fundamental view on select names.
Crop conditions don’t seem to be improving in the U.S. The States is the biggest exporter of corn and soybeans. U.S. corn was rated 68% good or excellent as of June 26, down from 73% a year earlier. 65% of soybeans earned the good or excellent designation, down from 67% a year ago, according to USDA data.
The federal government’s Energy Independence and Security Act has created inelasticity in corn markets. Supply shocks are tending to push prices higher than they might be in a typical supply/demand system, according to an energy policy specialist quoted by cattlenetwork.com.
“If it ain’t broke, don’t fix it”
-Bert Lance, former OMB Director under President Carter
The current Debt Ceiling Debate ongoing in Washington, DC has largely gone unnoticed by investors. The conventional wisdom appears to regard the daily back and forth between Democrats and Republicans with only passing interest. As the Sector Head for Healthcare here at Hedgeye, what may be a curious side show to many, has deep implications for investment decisions today.
Many news stories have struggled to understand Wall St.’s complacency toward the debt ceiling debate. On the one hand, and in the face of warnings from Secretary of Treasury Geithner, who has made multiple statements regarding the “economic catastrophe” that follows if Congress fails to raise the government’s ability to borrow above $14.3T by August 2nd, there has yet to be the US equivalent of the Greek CDS chart. Senator John Boehner, the Republican Majority Leader in the Senate, called the August 2nd deadline “an artificial date created by the Treasury secretary.” It may just be that we’ve seen this movie before and all know the ending.
Republicans and Democrats have staked out their respective Debt Ceiling positions by centering on Medicare. It makes sense to focus on Medicare. Medicare spending is the fastest growing and single largest (54%) outlay within Health and Human Services (HHS), the federal department which consumes the largest percentage of federal outlays (23%). To put this in context, Defense (16%) and Treasury (14%) are number 2 and 3, respectively. The Congressional Budget Office (CBO), in their more reasonable ‘Alternative Fiscal Scenario’ outlined in their ‘Long Term Budget Outlook’, chart the widening gap between federal income and outlays due entirely to accelerating growth in Medicare spending.
The current Debt Ceiling debate has been decades in the making as government outlays for Medicare and Medicaid have grown substantially since 1960. Indeed, over the life of available data (since 1960) we’ve witnessed a discrete, secular cost shift away from the individual consumer towards their employer and increasingly towards federal & state sources. National Health Expenditure data from the Center for Medicare Studies, the agency that administers Medicare and Medicaid, show government sourced dollars have grown from ~20% of total spending to 49%, while Private sources, which include out-of-pocket and Private Health Insurance, have gradually shifted from ~75% to 51% over that same timeframe . Moreover, Out-of-Pocket expense as a percentage of Total Private Sources has declined from 47% to 12% over the same time period.
Despite the rapid growth in total medical spending, the Healthcare Economy in the United States by many measures and opinions is broken. The cliché is to state that we spend far more per capita ($7,290) than any other developed nation ($3,700) yet regularly rank poorly for statistics such as life expectancy (42nd), level of health (72nd), and health system performance (37th), at least according to the World Health Organization. The rebuttal is that the US healthcare system is better than any in the world, provided the patient carries health insurance and can pay. But even here, Americans look unfavorably on their health insurance carriers. According to a December 2010 Gallup survey, 56% percent of those surveyed thought the health insurers as fair or poor at providing their service. Poor health outcomes is the routine reality for the upwards of 50M people not lucky enough to have health insurance to complain about. For all the money spent, these statistics suggest we could do better as a country with the dollars spent.
The Affordable Care Act (ACA), also know widely as Health Reform, attempted to correct many of the issues listed above; by expanding insurance coverage, building tools to control costs, and cutting the federal deficit by $143B over ten years. Unfortunately, the fix may actually be making the problem worse.
The ACA expands coverage by expanding Medicaid by raising the poverty limit to qualify, offering tax credits to small firms to offer health insurance, and providing subsidies to individuals and families to purchase their own insurance on an Insurance Exchange. It saves money by encouraging the formation of Accountable Care organizations, provider groups who will share in the savings they generate while providing care audited for quality. The ACA, according the CBO, cuts the federal deficit by lowering Medicare outlays, particularly to private insurance companies who offer Medicare Advantage.
Since President Obama signed the ACA into law many of the underlying assumptions are coming undone. The ACA “froze” the benefit level states offered under Medicaid, but in recent months, and as states grapple with peak budget shortfalls in 2012, they are looking to cut Medicaid expenses, their second highest expense. In the last few days, both Democrats and Republicans have publicly contemplated allowing the states to lower eligibility and provider rates under Medicaid. ACA looks likely to expand Medicaid coverage from a much lower run rate.
Additionally, 1433 companies (representing 3.5M insured lives) have sought and received waivers from HHS to avoid complying with ACA insurance rules. The Obama Administration has since stopped granting waivers.
Accountable Care Organizations were touted as capable of reducing costs and increasing quality, but this plan too has faltered. After a steady stream of providers formed ACOs prior to the proposed rules offered to govern them, the concept has run up against the reality of foregoing revenue while incurring costs to comply with the rules set to govern them. At this point, even the 5M lives estimated by the CBO to be cared for in an ACO appears aggressive.
Recently, the news has turned to a discussion of the Insurance Exchanges, slated to begin offering insurance in 2014, corporate tax credits for offering insurance and the number of people who already have insurance through their job. McKinsey conducted a controversial survey of employers which suggests a significant percentage of employers (30%+) stop offering health insurance for their employees and pay the smaller penalty set out in the ACA. A larger than expected coverage drop will increase the government cost of subsidizing health insurance through the planned subsidies. The CBO currently expects 1M out of a total population of 163M to lose employer health insurance.
Douglas Holtz-Eakin went further with his estimates and calculated the penalty-insurance cost gap would induce employers to drop an additional 38M workers from employer sponsored plans and onto Insurance Exchanges. This is in addition to the number and subsidy cost of Insurance Exchange participants the CBO estimates, 19M and $450B over 10 years. With an additional 38M lives, the Insurance Exchange Hotltz-Eakin estimates the subsidy cost will rise to $1.4T, driving the ACA deep into the red. We have invited Douglas Holtz-Eakin to speak on a call with our clients July 13, and I am looking forward to learning more about his analysis.
The Insurance Exchanges should not present a significant problem as long as the transfer from employer plans to the Insurance Exchanges is 100% efficient. Similar to the corporate penalty-cost of insurance spread, the individual mandate that compels purchase of health insurance has a very low penalty that starts at $95 for individuals in 2014. Assuming that just 5% of young healthy employees, who are high margin since they don’t incur many costs, decide to pay the penalty, this leaves a higher cost population behind. Those that remain will have to pay higher premiums, drawing more subsidies per member, raising the deficit impact, and inducing more individuals to forego insurance, and so on.
While the Debt Ceiling debate goes largely unnoticed today, and may yet be pushed to another day, the day of reckoning approaches for the Health Economy. Government, corporate, and individual pressures to contain costs will eventually lead to slower growth and margin pressure. Medicare and Medicaid will need to be cut, the penalties and taxes raised to corporations and individuals, and more aggressive cost control measures put in place. In the interconnected Health Economy, the ensuing revenue and margin pressures will pose a challenge to everyone; it’s just a question of when.
Managing Director, Healthcare
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