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SBUX: THE QUESTION NOBODY WANTED TO ASK

I have been a SBUX bull since early 2009 and remain one today.  Yet, unfortunately, I am still not allowed to ask a question on the earnings calls.  I know there are 28 analysts that follow SBUX and there is a limited time on the call to get every question in but I was disappointed when calling in 20 minutes in advance did not yield an opportunity to ask a question.

 

The IR team did reach out to me and I look forward the conversation, but I must say I was hoping to ask my question in a public forum.  That is not to say that I doubt they would have expertly danced around the issue I planned on bringing up but I was eagerly anticipating the dialogue nonetheless.

 

Ever the optimist, I was hoping that management might look kindly upon the only sell-side analyst that has been covering the company from day one.  Then working at Morgan Stanley, I titled my initial report “Expensive and Built to Stay That Way”.  Nine months later I got cute and put a sell on the stock due to a rich valuation.  Soon after, I received a call from Howard Schultz and he told me that I did not understand the room the company had to grow.  He invited me out to Seattle to show me what he meant.  After taking him up on his offer and spending a day driving around with him, I walked away having learned a lot.  One week later I changed my rating.  So, my relationship with Starbucks has had its ups and down, but surely longevity counts for something!

 

As Schultz reminded us on the call yesterday, SBUX has come a long way since its beginnings in 1987. He said, “this week approximately 60 million customers will visit us, and that's just an unbelievable number when you consider where we have come from 1987, 11 stores, 100 employees, and today, 17,000 stores in 55 countries.”

 

I learned a very important lesson that day early in my career and it still applies today.  Howard Schultz embraced my sell rating as a challenge and, telling me “you don’t get it and let me show you why”, set about changing my mind rather than cutting me off.  I don’t think that Starbucks would cut me off for asking the question I was going to ask yesterday, but I do think that the topic it addresses will be a real concern in the coming 12 or 18 months.   

 

So, here is the thought process behind my question:

 

Starbucks has identified the single serve category as being very important to the company future growth.   While I understand the rational for going with Keurig and Green Mountain, I was surprised the company did not want to control the “last mile” into the home.  A number of people from the SEC to forensic accountants and well-known hedge fund managers have expressed serious reservations about the integrity of the company and the viability of the business model. 

 

Does Starbucks have a contingency plan in case Green Mountain cannot access the financial markets for the needed capital to execute its growth plan and deliver an adequate supply of k-cups?

 

The lack of the company ability to generate cash has been well documented and screens “UNSUSTAINABLE” in the Hedgeye Sustainability model.  The biggest red flags in the Hedgeye Sustainability model are Asset Turns and CFFO or, more importantly, the proportion of earnings yielding cash. 

 

Why would Starbucks rely on a supplier where we need to ask the question:  Is the company generating enough cash from its operating activities to continue without accessing new external sources of cash?  What if the capital markets dry up for GMCR?

 

We define CFFO as cash from operating activities less capital expenditures, less the benefits from the exercise of Employee Stock Options and adjustment for one-time gains/losses or restructuring items.  

 

Most of the companies we follow generate free-cash flow after significant investment in the growth of the core business, while other smaller, faster growing companies do not generate free-cash flow.  This is not necessarily a negative if the cash burn rate is within the limits of available resources.  To-date, the capital markets have been very generous to GMCR, but what happens when the music stops?    

 

Importantly, we are looking at the proportion of earnings yielding cash.  If GMCR reports strong revenue growth, good margins, healthy profits but those profits are accompanied by negative cash earnings yield, SBUX must be suspicious, or at least I hope they are. 

 

 

Howard Penney

Managing Director

 

Rory Green

Analyst

 

 

   


Call Him Good or Lucky, Obama Is At 50/50 On InTrade

Conclusion:  Romney looks poised to win the Republican nomination, but Obama is looking increasingly difficult to beat.


Our Macro Team was on the road this week meeting with clients on the West Coast and inevitably politics came up as part of the macro discussion.  As most macro traders know, policy and policy makers are key factors in determining the future price direction of various asset classes.  Specifically, both monetary and fiscal policy shape interest rate policy and, eventually, the price of key currencies.

 

In theUnited States, this coming year is obviously a Presidential Election year.  Barring an unforeseen development, the showdown over the Presidency will be between President Obama and former Massachusetts Governor, Mitt Romney.  Despite the media trying to make the Republican nominating process seem competitive, it is anything but competitive. 

 

According to InTrade, Romney is currently at 70.1% probability of gaining the nomination.  The rest of the field is very distant, with Perry at 11%, Gingrich at 8%, and Cain at 5%.  Interestingly, the most recent national poll of the Republican front runners suggests a slightly closer race with Romney at 25%, Cain at 23%, Perry at 14%, and Gingrich at 12%.  From our perspective, while polls can be instructive, predictive markets tend to be more accurate.  Further, the primary calendar plays very well into Romney’s strategy.

 

The early caucuses or primaries in January and February are outlined in the table below:

 

Call Him Good or Lucky, Obama Is At 50/50 On InTrade - 1. DJ

 

In aggregate, of the first ten primaries or caucuses, Romney appears poised to win six handily and in the remaining four, he is in a tight race with Herman Cain. (Incidentally, most of these polls were taken before the recent Cain sexual harassment scandal).  The key surprise could well be that Romney does better than expected in Iowa and then goes for close to a clean sweep in January and February, which would effectively end the race early.  This appears to be the scenario that is priced into the InTrade contract.

 

So, assuming this race very quickly becomes Obama versus Romney, does President Obama stand a chance?  According to a preponderance of political strategists, many pertinent economic indicators, and relevant approval polls, President Obama will be a one term President.  A few key points to consider (hat tip to Karl Rove for collecting this data):

  • No President has ever been re-elected with 74% of American saying the country is on the wrong track a year before the election;
  • No President has ever been re-elected with so few Americans, 13% according toGallup, saying they are satisfied with the way things are going;
  • No President has been re-elected with unemployment at 9% a year prior to the election; and   
  • No President has been re-elected with a job approval as low as Obama currently has.

Sounds dismal for Obama, right?  Well, not so fast.

 

According to InTrade, Obama is now at 50.5% on the contract as to whether he gets re-elected, which suggest a more than 50% probability.  As outlined in the chart below, this is off the lows of early October.  Now, clearly there is some correlation to the massive positive move in the U.S. stock market we’ve seen in October.  Nonetheless, Obama is a long ways from a sure thing as a one term President.

 

Call Him Good or Lucky, Obama Is At 50/50 On InTrade - 2. DJ

 

According the to the Real Clear Politics aggregate, Obama trails the generic Republican challenger by about +3 points.  This spread is within the margin of error and overtime has consistently indicated a slight lead for the generic Republican.  Conversely, when polled against the actual Republicans, Obama does well.  For instance, Obama has consistently outpolled Romney for the last month by either tying or beating him in every poll, and currently leads by +1.9 points.  As for the rest of the field, it isn’t even close as Obama demolishes them head-to-head.

 

So far, at least, voters seem to be siding with the devil they know, versus the devil they don’t.  In addition, there is a clear and definitive incumbency advantage for in Presidential elections as, according to a paper by David Mayhew, the incumbent has been re-elected 2/3s of the time versus 50% of the time when the there was no incumbent running.  The real risk for the Republican candidate is that the economy and stock market improve in 2012, even if only marginally.  This scenario could take a marginal Obama lead to a solid re-election.

 

Daryl G. Jones

Director of Research

 

 


RESTAURANT INDUSTRY EMPLOYMENT UPDATE

Employment data was positive for quick service and mixed for casual dining.

 

The overall jobs picture this morning was mixed this morning as the unemployment rate ticked down 10 basis points with a sequentially flat labor force participation rate but Private Payrolls for October came in at 104k versus 125k consensus and 191k prior (revised from 137k).  The revision was good news but, at the end of the day, this news still indicates – at best – that the economy is making very slow progress.

 

Employment by age shows a large uptick in employment in the 20-24 YOA bracket in October, indicating a sequential acceleration from September’s level.  This is a positive for the QSR industry which sources a lot of its customers from younger age cohorts.

 

RESTAURANT INDUSTRY EMPLOYMENT UPDATE - employment age

 

 

The second chart, below, is on a one month lag versus the chart above and shows employment growth in the full service and limited service industries.  Hiring continues to be strong on a year-over-year basis but, on the margin, employment growth in limited service restaurants showed improvement during September while full-service restaurants hiring slowed sequentially in terms of year-over-year growth.  We would need to see a continuation of this trend in October to gain more conviction of concern among restaurant operators.

 

RESTAURANT INDUSTRY EMPLOYMENT UPDATE - restaurant hiring

 

 

Howard Penney

Managing Director

 

Rory Green

Analyst

 


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NOBODY BIG IS GOING PRIVATE FOR ANY TIME SOON

We like lodging but buying HOT because you think it is going private is not a sound investment strategy.

 

 

Theflyonthewall.com recently reported that there was go private chatter related to Starwood Hotels.  No offense to HOT shareholders – lodging stocks look interesting to us too – but the chances of a large company going private in our space over the near term are very slim.  Here is why:

  • Debt markets are not available for deal leverage
    • Max leverage for super high quality stuff is 5.5x and for meat and potato, it's 4.5x
    • All the peak deals were done in the CMBS markets, which aren’t really back
  • HOT does not own enough real estate for LBO.  Blackstone was able to take Hilton private given the frothy financing environment for real estate.
    • It’s not that cheap
    • Fritz likes being public and likes his job, so we don’t think the interest is there.  There is no one on the board likely to encourage them to do it
  • CEOs are not interested in M&A.  They are chasing new Greenfield opportunities.
  • M&A deals over the last 5 quarters or shall I say lack thereof:
    • ProLogis/AMB
    • Ventas/NHP
    • Corporate properties associates ($916MM)
  • There was the Sonesta deal yesterday.  However, it's a micro cap transaction and is more of an asset sale rather than M&A since their main asset sold - Royal Sonesta Hotel Boston - accounted for 86% of the purchase price.

ACTUAL PRIVATE PAYROLL GROWTH

ACTUAL PRIVATE PAYROLL GROWTH - Jobless Stagflation Birth Death Adjustment Impact

 

In 2011 YTD, the BLS’s birth/death model has contributed +530k jobs (34.7% of the headline number). This compares to +314 (35.8% of the headline number) in the year-to-date in 2010. On a YoY basis (which you have to analyze it due to the B/D Adj. being NSA and the Private Payrolls # being SA), the U.S. lost -70k jobs in October when netting out the B/D Adj.


WMS: LOW EXPECTATIONS FOR FQ1

FQ1 was likely another weak quarter but can management convince investors they can turn it around?

 

 

We don’t think anyone has great expectations going into WMS’s print on Monday after close, despite the stock's nice recovery from $16ish lows in early October.  Buy-side whispers of a big earnings miss made their way to the sell-side after G2E and analysts took down numbers for the quarter and year.   

 

We’re still a penny below consensus for the quarter, although it’s not really about the quarter for WMS.  The performance of this stock will be determined on the Company’s ability to convince investors that the story isn’t broken and that they are on the road to recovery.  While there may be some short covering, management will likely be unsuccessful on this earnings conference call.  WMS is probably a show me stock at this point.

 

While replacements have been improving since 2008, the lack of new casinos and expansion have put overall slot market demand at all-time lows.  However, calendar 2012 should display a sharp uptick in new casinos/expansions. 

 

For FQ1, WMS likely incurred more impairment charges and needs at least another quarter to turn around the declines that they’ve been experiencing in their gaming operations install base.  As we wrote about in “G2E KEY TAKEAWAYS” on 10/06/11, we did walk away from G2E more bullish on the company over the long term.  They seem to be addressing their issues and getting back to what they do best – designing and developing good games.  However, it will likely take a couple of quarters to materialize.

 

Detail:

 

We estimate that WMS will report revenue of $180MM and adjusted EPS of $0.28.

  • We estimate product sales of $106.5MM at a 48% gross margin – impacted by some write-downs and promotional environment
    • 5,400 machine sales at $16.5k
      • 3,250 machine sales into NA – almost all replacement
    • $17MM of conversion and used game & other revenue – likely at lower than normal margins due to promotional activity
  • $73MM of gaming operations revenue at a 79% gross margin
    • We expected a sequential decline in WMS install base as well as yield pressure as WMS brings on new products at a slower pace than what’s been rolling off.  This trend should reverse towards the end of their fiscal year.
  • Other stuff:
    • R&D: $29.4MM
    • SG&A: $36.5MM
    • D&A: $21MM

Hedgeye Statistics

The total percentage of successful long and short trading signals since the inception of Real-Time Alerts in August of 2008.

  • LONG SIGNALS 80.33%
  • SHORT SIGNALS 78.51%
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