Peet’s reported strong results of Q2 EPS $0.38 vs consensus of $0.32; revenues also beat expectations of $90.6M and consensus of $88.7M. PEET has been a favorite name of mine since late 2010.
The following are my top ten takeaways from the quarter.
- The company raised full year EPS guidance "toward the higher end" of prior $1.43-1.50 range versus consensus of $1.46 and full-year revenues growth of +10-12% versus prior guidance +8-10%.
- Peet ‘s is rolling out a new product entry into the largest segment of the specialty coffee category in grocery stores with the debut of two new medium-roast coffees (1/3 of sales in the category) in ground and whole bean form: Peet’s Café Solano and Peet’s Café Domingo. It is expected that the new line will be available in about 80% of the company’s existing store base before the end of this calendar year.
- Management does not expect cannibalization from the new products; new products will be sold at the same margin.
- Grocery grew 30% in Q2, lapping 29% growth in Q2 last year and up from 22% growth in 1Q11 and is now 70% bigger than it was two years ago.
- Grocery to accelerate growth in 2H11 on the back of the new products.
- The company will be selling product in 1,000 new stores in 2H.
- Significant expansion in the TGT stores; management is expecting to double the number of target stores distributing Peet's Coffee to about 900 by the end of 4Q.
- Gross margins declined -290bps in the quarter on 37% higher coffee costs in 2Q. Coffee inflation for the year is projected to be +40% so gross margins will be down 200-300 basis points versus the second quarter in 3Q and 4Q.
- There was no significant change in pricing quarter to quarter. In 2Q, there was a full quarter impact of the grocery price increase taken in February 2011.
- PEET is one of the best small cap growth stories in the restaurant space. Valuation is rich but there is a premium for well run companies that are seeing 8-10% secular growth.
POSITION: no position SPY; short XLF
I am getting a lot of questions about levels here. To be clear, the 200-day Moving Monkey is not a risk management line. It’s a one-factor (point and click simple moving average) where we can all observe proactively predictable behavior.
Across our risk management durations (TRADE/TREND/TAIL), here are the lines that matter:
- Long-term TAIL of resistance = 1377
- Intermediate-term TREND resistance = 1319
- Immediate-term TRADE range = 1
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PEET’s is one of those rare small cap companies that is well managed and operates within a strong category. Its current valuation partially reflects the coffee bubble that is being priced into several names within the coffee space. PEET takes the prize for the company with the highest inflation rate at 40%. During the past quarter coffee prices have declined almost 20% during 2Q11. It is likely that gross margins erosion peaked this quarter and should mitigate going forward barring a spike in coffee prices.
The following comments are the forward looking statements from the 1Q11 earnings call which took place on 05.03.2011 as well as our take on certain topics.
GROCERY TOP-LINE: “Looking forward we have good momentum in our grocery business. We have strong base plans in place, very good visibility on the new distribution we expect and some things later in the year that we expect to have a meaningful impact on our business.”
“Grocery growth of 22% in the first quarter on top of last year's 39% growth in the first quarter was strong and reflects the overall health of this business, the strength of the brand and superior execution capability of our DSD system.”
HEDGEYE: The growth in grocery was achieved despite the price increase not being in effect for the full quarter. The overwhelming majority of the company’s growth came from existing store distribution. Late in the first quarter, Peet’s added “200 to 300” targeted stores. The company was at roughly 9,000 at the end of 2010 and plans to add 1,000 to 1,500 in 2011 and maintains that it has “very good visibility” on that target. As the DSD business is expanded, we expect a significant boost to margins given the degree of operating leverage in this business model.
RETAIL TOP-LINE: Retail sales grew 4% in the quarter, all from existing stores.
HEDGEYE: Going forward, Peet’s has a number of top-line and efficiency initiatives coming through that should maintain or improve on retail performance notwithstanding rising coffee costs. By the end of 2Q11, a new labor and time management system will be rolled out which will enable the company to more effectively schedule labor needs.
OTHER TOP-LINE: Foodservice and office business grew 11% in 1Q11 and lowest rate of growth this year given the timing of new licensed locations, and the fact that a price increase in early January spurred some stronger orders back in December of 2010.
HEDGEYE: The rate of growth in 1Q11 will be the low point of 2011 and I expect trends to accelerate in 2H11.
MARGIN TRENDS: “In the specialty segment margins should continue to improve”… “In 2011 have turned the corner and are starting to see the operating leverage as put more volume on the existing DSD system” … “In 1Q11 G&A expenses improved 10 basis points over last year and there should continue is leveraging this line item for the rest of the year.”
HEDGEYE: In terms of the expenses the company can control, we think it has managed them well. The quotes above and tone of the conference call showed confidence in their ability to gain on the margin line though operating leverage.
COFFEE COSTS: “Coffee has gone from 15% inflation when we set our plan back in November of 2010 to 30% at our last call on February to over 40% now in May as the market has breached $3. Higher coffee costs will begin to significantly impact gross margins in the second quarter. In fact, the largest quarter-to quarter jump will occur between the first and second quarter. In Q1, our hedging benefits limited our coffee increase to 14% higher than last year. We began locking in more expensive coffee in the fourth quarter of last year and first quarter of this year and we'll start using that coffee this quarter.”
“Were expecting our full-year inflation to be around 40% in coffee costs”
“As a result, whereas gross margins were down only 40 basis points in Q1, we expect gross margins to be down in the 300 to 400 basis point range for the balance of the year.”
“Net-net we will be able to offset most of the short term coffee cost issues we have with operating expense savings and leverage of other costs, but we will continue to invest in areas for longer-term business benefit, and therefore, not expect to offset the full amount this year.”
HEDGEYE: Coffee is the big wild card for this company but, in our view, the company is doing all the right things to reap significant benefits if/when coffee costs mitigate.
A decent quarter doesn't matter in this market environment
"Our business performed well in the second quarter, showing solid growth in earnings, stronger occupancy levels and increased average rates in multiple segments and regions. We are building on that momentum with three recently announced transactions -- two acquisitions and the formation of a joint venture -- that will expand our select service presence, heighten awareness of our successful brands among both guests and owners and strengthen our select service development capabilities, thereby enhancing our ability to attract third party capital to fuel our growth in this attractive segment in North America and internationally."
- Mark S. Hoplamazian, president and chief executive officer of Hyatt Hotels
HIGHLIGHTS FROM THE RELEASE
- Adjusted EBITDA of $151MM and Adjusted EPS of $0.27
- "Comparable owned and leased hotels RevPAR increased 5.9% (3.3% excluding the effect of currency)"
- "Comparable North American full-service RevPAR increased 5.0% (4.7% excluding the effect of currency)"
- "Comparable North American select-service RevPAR increased 9.6%"
- "Comparable International RevPAR increased 9.9% (2.5% excluding the effect of currency)"
- "Opened five properties during the second quarter of 2011 including three owned extended-stay hotels purchased during the second quarter of 2011 for approximately $77 million" and sold 8 hotels to a JV which it owns 40% for $110MM
- Owned & leased Adjusted EBITDA was negatively impacted by approx $10MM due to renovations and RevPAR was negatively impacted by approximately 500bps
- As of June 30th, Hyatt had 150 (35k rooms) executed hotel management and franchise contracts - 70% of which are located outside of North America
- 2Q Capex of $72MM
- Debt: $770MM; Cash: $875MM; Short term investments: $520MM
- 2011 Guidance:
- Capex: $380 - $400MM
- D&A: $285 - $295MM
- Interest expense: $50 - $55MM
- 15 hotel openings excluding the acquisition announced in July
CONF CALL NOTES
- Rate growth was due to continued mix shift and pricing power that resulted from higher occupancy
- Saw higher interest from potential owners in their brands this quarter
- There has been limited financing in hotel development available - so therefore they have used some of their own cash to fund growth in these brands (select service)
- Acquired through a foreclosure process--3 hotels in California--and will complete renovations at the hotels.
- During the quarter, they formed a JV with Noble to develop select service hotels and has a strong track record in developing hotels through multiple cycles. Own 40% and invested $30MM - think that they can develop 6-8 hotels
- Lodgeworks acquisition comes with the branded management rights. Majority of the hotels are located in high barrier to entry markets and the hotels are in good condition. Their extended stay product will grow by 40% as a result of this acquisition. The full service hotels will benefit from their reservation systems and rebranding efforts. They like the extended stay segment.
- 2012 Adjusted EBITDA will be approximately $50MM from this acquisition and expect that EBITDA will grow further as a result of rebranding and access to Hyatt's reservation system. 2 hotels are still under construction and several are less than 2 years old and are still ramping. Many of the markets have limited new supply coming online over the next few years
- Lower effective tax rate helped their EPS - benefited from a $12MM reversal from a charge in their international division
- Smaller asset base in 2011 vs. 2010 due to asset sales over the last 12 months - roughly 3,000 less rooms (12 hotels) impacted owned and leased results
- Timing of the Easter holiday negatively impacted results
- Group business booked in the quarter for the quarter was up 7%. Easter holiday negatively impacted group business.
- Transient rate benefited from a shift to corporate
- Saw an increase in food and beverage and other revenues for the first time in a while
- RevPAR was negatively impacted by Japan and North Africa and tough Shanghai comps. Excluding these 3 regions, local currency RevPAR gains would have been 11%.
- No plans for future share repurchases at this time
- Guidance doesn't include Lodgeworks but only the 2 they have closed. Noble borrowed $65MM - their net proceeds were $90MM
- Expect to fund $770MM of the Lodgeworks purchase in cash next quarter with the balance funded at a later date
- Less than a 100bps and less than a $5MM impact from renovations in 3Q, after that their renovations will have a positive impact
- They believe they will be able to significantly improve the EBITDA production capacity of their acquisition
- See an expansion of more Select Service opportunities and some increase in Full Service as well on the acquisition front
- Expect to open 15 properties ex Lodgeworks this year - have 8 left to open in the 2H of the year
- Don't feel like there are any markets that they are over concentrated in. The Noble $30MM investment will be funded and drawn over time
- Still focused on cost controls.
- Decreased paper utilization
- Keeping food costs in check - inventory management to reduce spoilage and turnover
- Why do they like Extended Stay?
- Gold passport membership levels are the highest in their Select Service which has a lot of managed corporate accounts
- Feel like they have a dedicated customer base
- Expect to expand these brands into emerging markets like India - Summerfield Suites are being built adjacent to IT center. Feel that these brands have international growth potential
- Lodgeworks assets are largely up to Hyatt Select Service brand standards so there is minimal investment required. Woodfin requires more capex. They would consider eventually selling these assets and retaining management contracts
- Lodgeworks team has a long track record of raising development financing. They will likely participate in some new development activity with them in the future.
- Group side overall trends - up 3% largely driven by rates. Business booked in the Q for the Q was up 13%. Business booked for 2012 has 8% higher ADRs. Corporate and association business (70% of group) was also up. Booking windows continue to be short. However, the business that they are booking is coming in at decent rates.
- Business in China ex Shanghai is up in the teens. Europe is a mixed bag.
- Transient business was up 6% as a combination of rate and occupancy.
- Leisure (10-15% of NA) ended the quarter on a strong note. June was up 10%. So far no impact of gas prices. Overall think that the trends are reasonable and they are cautiously optimistic.
- Plan to remain investment grade - which is about 3.5x. Have a R/C that they are in the process of renewing now. Still have capacity to fund more growth
- Bought back the shares given the overhang of the shares. There is no plan on stock repurchases.
- Thoughts on effective tax rate through year end? Reversed valuation allowance on an international asset based on improving results. Best to use a 35-40% tax rate.
- 2Q impact from Japan and ME was $1.7MM - evenly split. Think it will be about $5MM impact for the year.
Conclusion: It seems that the politicians in Washington have their victory on the debt ceiling debate, a victory for whom remains the question. Assuming this deal is passed, it will do very little to alleviate the bleak fiscal outlook of the United States.
Subject to passage by the Senate, the politicians in Washington have reached a compromise on the debt ceiling. Despite the best fear mongering by both parties and many of the talking heads on TV, the credit markets, both Treasury yields and credit defaults swaps, have been consistently signaling that a U.S. debt default was highly unlikely. The derivative impact of the fear mongering is that a deal is being pushed through, but the deal will not truly address deficit issues and continues to leave the door wide open for a potential ratings downgrade.
Based on the details we can discern from various sources, the Republicans will effectively get most of their deal, while President Obama will get the debt ceiling extended past the 2012 election. The key points of the bill that were passed by the House 269 – 161 last night include:
- The debt ceiling can be increased by up to $2.4 trillion. This increase will come in two tranches of $900 billion and a second tranche of up to $1.5 trillion. The second tranche could be halted if Congress approves a joint resolution of disapproval;
- The bill implements the $917 billion in discretionary spending cuts that were in the bill passed by the House last week, but these cuts are now split between “security” and “non-security”;
- The top leaders in both chambers will appoint three members each to a twelve person committee (six Democrats and six Republicans) who will be charged with coming up with $1.2 trillion in additional cuts. The committee will report by November 23rdand a Congressional vote on their proposed cuts will be implemented by December 23rd; and
- New cuts will automatically go into effect if Congress doesn’t act on the super committee recommendations to ensure that the cuts reach $1.2 trillion.
Keynesian economist and Nobel laureate Paul Krugman voiced his concern about this bill in the New York Times on Sunday with his emphasis that “there will be big spending cuts”. We are not sure whether Dr. Krugman has a calculator in either his Upper West Side apartment or hallowed Ivy League office, but nothing could be further from the truth.
In the short term, according to the most recent scoring by the Congressional Budget Office, the impact of this bill is minimal with a mere $21 billion in cuts in fiscal 2012 and $42 billion in cuts in 2013. In the Early Look last Friday, we called this the Congressional Comb-over. That is, while the amount of cuts to the deficit and the amount that the debt ceiling will be extended are roughly equal, they are on two very different time frames. As noted, in the short term, the bill literally does nothing to alleviate the deficit and if the ratings agencies are being intellectually honest, this bill should not meaningfully change the creditworthiness of U.S. government debt.
Moreover, it is important to understand that the proposed spending cuts come off of the Congressional Budget Office baseline. Based on the current CBO baseline, as represented in “An Analysis of the President’s Budget Proposal For Fiscal Year 2012”, total debt held by the public will increase from ~ $10.4 trillion in 2011 to ~ $20.8 trillion in 2021. Therefore, the baseline projections will still add over $8 trillion in debt to the U.S. balance sheet over the next decade AFTER the proposed cuts. As Senator Rand Paul wrote in an open letter stating why he won’t vote for this deal:
“This deal, even if all targets are met and the Super Committee wields its mandate - results in a BEST case scenario of still adding more than $7 trillion more in debt over the next 10 years. That is sickening.”
In the intermediate term, the more critical issue impacting the U.S. deficit is the domestic outlook for economic growth. Hedgeye has been on the low end of U.S. GDP estimates for the majority of the year, and consensus growth forecasts for 2H are still nearly twice that of ours. The actual reported numbers have supported our contrarian stance, coming in at 0.4% on a quarter-over-quarter SA basis in Q1 2011 and 1.3% in Q2 2011 (advance estimate – which may also wind up being ~80% too high after future revisions!). There are many issues with slow growth, but the key one that is not currently being contemplated is its impact on the federal deficit.
From a bigger picture perspective, the deficit projections provided by the CBO, which are the basis on which the spending cuts are predicated, are highly questionable based on a number of the imbedded economic assumptions, in particular GDP growth. According to the CBO’s January 2011 publication, “The Budget and Economic Outlook: Fiscal Years 2011 to 2021”:
“All told, if growth of real GDP each year was 0.1 percentage point lower than is assumed in CBO’s baseline, annual deficits would be larger by amounts that would climb to $68 billion in 2021. The cumulative deficit for 2011 through 2021 would rise by $310 billion.”
In its economic projections, the CBO assumes 2.9% real annualized GDP growth from 2011 to 2021. Interestingly, that is a noted acceleration from the last ten years, which produced an average annual rate of 1.7% real GDP growth. If the next ten years produce comparable growth to the prior ten years, which is reasonable for an economy that is at 90%+ debt-to-GDP, the incremental deficit in that period over the CBO baseline would be $3.7 trillion, upping Rand Paul’s $7 trillion figure to a whopping $10.7 trillion in additional deficits added to the U.S. balance sheet through 2021. And that, my friends, is a lot of billions.
Daryl G. Jones
Director of Research
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