prev

The Credit Card Trade

American Express (AXP) just can’t get its act together. After reporting its second quarter earnings, it’s clear that our macro Growth Slowing call is kicking into gear. The company reported large sequential deceleration in every growth category.

 

The company isn’t growing card volumes and instead is watching them evaporate, particularly in Europe. Taking into account that 100 basis points equates to one percentage point, look at the downward spiral that is AXP below:

 

US volumes slowed 380 bps to 8.7% YoY in 2Q vs. 12.5% in 1Q. International volumes slowed 920 bps to 3.0% YoY growth in 2Q from 12.2% YoY growth in 1Q. Right now the business is split 2/3 US and 1/3 International. As a result, overall growth slowed 570 bps to 6.7% YoY in 2Q from 12.4% last quarter.

 

Conversely, MasterCard (MA) is doing quite well. Over the last five years, MasterCard is up 157% compared with American Express’ -12%.  It’s easy to see why we’re bearish on AXP and bullish on MA.  Visa (V) is also a winner, up over 95% during the same five year period. V and MA are doing well in the broader market. The Financials SPDR (XLF) lost 55% in that five year period, too.

 

 

The Credit Card Trade  - AXPvsMA

 

 

The chart says it all. While MasterCard may be a little pricey, trading at 19x earnings, it’s golden compared to American Express’ performance and outlook.


HAVE U.S. CORPORATE EARNINGS GONE TOO FAR?

CONCLUSION: When analyzed outside the vacuum of short-termism associated with quarterly reporting, US corporate profit margins appear particularly overstretched – from both an operational and a social perspective. This has potentially dire implications for corporate earnings growth over the long term.

 

In the note below, we explore the US corporate income statement with a long-term analytical lens. But before we dig into the graphical eye candy below, we must stress that it’s important to note that a handful of the metrics below are derived from our own calculations using a combination of BEA, BLS and Bloomberg data. In the process of compiling data for this analysis, we discovered that US corporate financial statement data is particularly scant at the macro level. That said, however, we were able to find and manipulate several readily-available data series into what we feel are decent proxies for a variety of key corporate operational metrics. As always, we’ll let you be the ultimate judge of our work; refer to the appendix at the bottom of this note for more details.

 

WHERE WE ARE IN THE LONG-TERM CYCLE

 

To say that US corporations are generating net income at historic rates would indeed be a very accurate statement. In fact, the ratio of US corporate earnings to Nominal GDP at year-end 2011 was 7.3% - good for the highest level since 1930 (data going back to 1929). Using the full data set, this ratio is 1.6x standard deviations above the long-term average. Using data from the modern/post-war period, this ratio jumps to 2.2x standard deviations above the long-term average.

 

HAVE U.S. CORPORATE EARNINGS GONE TOO FAR? - 1

 

From an operational perspective, US corporations have been increasingly productive; in 2011, US corporations produced an aggregated operating margin of 33% (as a percentage of gross profits; full explanation and methodology below) – an all-time high. As a result of this, and other key drivers, cash flowed through to the bottom line at a historically-elevated ratio of 12.8% of gross profit. That’s the highest ratio since 1930. Interestingly, as the chart below shows, ratios in the 10-12% range tend to be historic inflection points for rates of earnings generation.

 

HAVE U.S. CORPORATE EARNINGS GONE TOO FAR? - 2

 

HOW DID WE GET HERE?

 

Macro Drivers: The aggregated propensity of US corporations to generate earnings has benefited greatly from several key long-term macro drivers, including favorable regulation, easy money and secular weakness in the USD exchange rate(s).

 

From a  regulatory perspective, both lower tax rates and a higher degree of tax write-offs have helped US corporations reduce their overall tax burden (27.5% in 2011) to levels unseen since prior to 1940 (with the exception of 2002). Though depreciation as a percentage of gross profits has fallen -100bps from its 2009 peak of 13.4% to 12.4% in 2011, that level of corporate write-downs is unseen outside of the Great Depression era.

 

HAVE U.S. CORPORATE EARNINGS GONE TOO FAR? - 3

 

From a cost of capital perspective, the following chart highlights the obvious relationship between US monetary policy and corporate interest payments. More specifically, net interest payments as a percentage of corporate EBIT have fallen to 10.5% in 2011 – down from a whopping 32.1% during the Paul Volcker era.

 

HAVE U.S. CORPORATE EARNINGS GONE TOO FAR? - 4

 

The following two charts highlight arguably the most important long-term trend that we think is critically important to contextualize: Weak Dollar Inflates the Inflation. The first chart highlights the strong inverse relationship between the market value of the USD and US corporations desire to chase easy revenues afforded by commodity price inflation by incrementally investing in mines, shafts and wells. Interestingly, US corporations haven’t been this addicted to US dollar debauchery since the last time we had a Federal Reserve Chairman condition market expectations for perpetual easy money (Arthur Burns). The second chart perfectly highlights this broad-based chasing of price/revenues (using commodity price data going back to 1981).

 

HAVE U.S. CORPORATE EARNINGS GONE TOO FAR? - 5

 

HAVE U.S. CORPORATE EARNINGS GONE TOO FAR? - 6

 

Micro Drivers: While the aforementioned long-term macro trends have all played an important role in helping US corporations generate earnings at historically-elevated ratios in recent years, we’d be remiss to ignore several key micro strategies that US corporations have implemented to buoy their bottom lines.

 

The first long-term trend we’d focus your attention on are the substantial cost cuts over the last ~10yrs. To that tune, US corporations have taken to paying employees less and investing less in equipment and software (as percentages of gross profit) over that duration – no doubt creating particularly lean operations in the process. At 58.7% of gross profit, the former is at an all-time low; at 13.1% of gross profit, the latter – which includes computers and software, industrial equipment and transportation equipment – has retraced to levels seen just before the DotCom Bubble.

 

HAVE U.S. CORPORATE EARNINGS GONE TOO FAR? - 7

 

Another trend on the labor front that has been fairly additive to US corporate profits is outsourcing – particularly in the manufacturing (think: Pearl River Delta) and service industries (think: Indian call centers). Over the last ~20yrs, US wage and salary payments to the rest of the world has tripled as a share of Nominal GDP.

 

HAVE U.S. CORPORATE EARNINGS GONE TOO FAR? - 8

 

Another major micro trend that US corporations have strategically pushed for and taken advantage of is economies of scale. Using BLS data for the total number of employees on nonfarm private payrolls, we were able to calculate the number of employees it takes US corporations to employ in order to generate $1B in earnings. That number has declined exponentially over time and, in 2011, reached an all-time low of 100,404 workers. While general inflation over the years has certainly played a role in this trend, the fact of the matter is that US corporations have consistently been able to squeeze out incremental profits from their existing headcount or generate new sources of earnings by acquiring human capital at perpetually slower rates.

 

HAVE U.S. CORPORATE EARNINGS GONE TOO FAR? - 9

 

The following chart, which shows the ratio of US corporations’ gross profit to their nominal labor expense per employee, is highly supportive of our previous claim. The plot essentially shows the number of turns US corporations are able to generate from their labor assets; as such, we find this to be an interesting way to measure worker productivity. Importantly, this metric reached an all-time high of 1.7x in 2011.

 

HAVE U.S. CORPORATE EARNINGS GONE TOO FAR? - 10

CRITICAL IMPLICATIONS

 

It's abundantly clear that US corporations have become quite effective at generating incremental returns for shareholders, having broadly implemented successful strategies at the micro level while also taking advantage of several noteworthy tailwinds on the macro level. That said, however, a fair amount of corporate earnings growth in recent years has come directly at the expense of the US laborer. While this is most certainly not the proper medium to discuss the morality of this trend from an ideological perspective, we will offer the following analytical thoughts on the potentially negative implications of the current setup:

 

Over the last ~30yrs, corporate executives, whose compensation is primarily determined by the value of their stock price, have increasingly paid out a smaller share of gross profits to employees in favor of boosting dividends (via making more cash available for the bottom line). This trend has correlated quite nicely with the dramatic ascension of the US equity market over that same duration.

 

HAVE U.S. CORPORATE EARNINGS GONE TOO FAR? - 11

 

As a result of increasingly heightened corporate executive pay (via dividend increases and stock market inflation), income inequality in America has widened to generational highs (data back to 1979).

 

HAVE U.S. CORPORATE EARNINGS GONE TOO FAR? - 12

 

What is perhaps misunderstood by consensus are the potential negative long-term political and economic implications of this trend. As the following chart from The Nation shows, domestic income inequality has surpassed levels unseen since just prior to the Great Depression. Interestingly enough, as the previous chart highlights, you'd have to go back to the pre and post Great Depression era to find US corporate dividend payout ratios that exceed the levels reached in recent years. While it would certainly be a stretch to say that income inequality was the dominant factor in bringing about the Great Depression, it would be equally as reckless to completely dismiss it as a contributing factor.

 

HAVE U.S. CORPORATE EARNINGS GONE TOO FAR? - US L T Income Inequality

 

Refer to our DEC 8 note titled "SPREAD RISK: THE INVESTMENT IMPLICATIONS OF WIDENING INCOME INEQUALITY" for our extended analysis of this important political topic.

 

All told, when analyzed outside the vacuum of short-termism associated with quarterly reporting, US corporate profit margins appear particularly overstretched – from both an operational and a social perspective. This has potentially dire implications for corporate earnings growth over the long term.

 

Darius Dale

Senior Analyst

 

APPENDIX: The GDP, Fixed Investment and BOP data in the charts above are rather straightforward and can be easily accessed via the BEA’s Interactive Data Tables. As mentioned before, however, we did have to make a few judgment calls to back our way into a handful of corporate operational metrics. In the following list, we attribute our calculations to their respective definitions in BEA Table 1.14: 

  • Gross Profit = Gross Value Added of Corporate Business (NOTE: while certainly not equivalent to corporate revenues, this was the closest L/T proxy for topline data we could find)
  • EBITDA = Net Operating Surplus + Consumption of Fixed Capital
  • EBIT = Net Operating Surplus
  • EBT = Corporate Profits with IVA and CCAdj
  • Earnings = Profits After Tax with IVA and CCAdj
  • Depreciation = Consumption of Fixed Capital
  • Net Interest Payments = Net Interest and Miscellaneous Payments
  • Effective Tax Rate = Taxes on Corporate Income/Corporate Profits with IVA and CCAdj 

Additionally, to the extent you’d like to conduct a similar analysis on your own, we found the following four guides helpful in getting us up to speed on the BEA’s definitions and data collection methodologies: 


MCD JUNE SALES PREVIEW

McDonald’s is releasing 2Q12 earnings before the market open on Monday morning.  Investors will be listening keenly for commentary on the global economy.  Our view is that MCD is likely to miss the Street’s expectations for sales in June. 

 

On April 24th, 2012, we wrote, “we see plenty to be concerned about” regarding McDonald’s top-line trends going forward.  Price is running at roughly 3% in the United States and 2-3% in Europe.  While the price points at McDonald’s are compelling for consumers relative to much of the competition, when we consider that Food Away from Home CPI in the U.S. is running at ~3% this year, McDonald’s may be taking less share this year on account of its price points than in years past.  The company is now pricing in line with Food Away from Home CPI whereas last year, that difference was roughly -50 basis points.  We remain unconvinced that traffic trends will be sufficient to bring the overall June comp in line with consensus for the U.S. division.

 

Callout

 

On the topic of "Growth Slowing", which Hedgeye Macro was ahead of the competition on, we want to highlight the two charts below.  We won't be calling comps on a month-to-month basis on the back of these charts, the numbers are trailing twelve month averages, but they clearly highlight how economic activity does impact the fundamental performance of the McDonald's business. 

 

MCD JUNE SALES PREVIEW - mcd growthslowing


 

Below we go through our take on what comparable restaurant sales numbers will be received as good, bad, and neutral by investors.  For comparison purposes, we have adjusted for historical calendar and trading day impacts (but not weather).

 

Compared to June 2011, June 2012 had one less Wednesday, one less Thursday, one additional Friday, and one additional Saturday.  We expect a positive calendar shift impact in McDonald’s June results.

 

U.S. – facing a difficult compare of 6.9%, including a calendar shift of between 0.2% and 0.5%, varying by area of the world:

 

We expect that MCD U.S. same-restaurant sales grew +1.0-1.5% in June.

 

GOOD: A print of higher than 2.5% would be strong results, in our view, as it would imply a sequential acceleration in the calendar-adjusted two year average trend.  Commentary across the restaurant space indicates that the operating environment for restaurant companies has been deteriorating in the United States.  While a +2% print would imply negative traffic/mix, we believe that investors are taking that as a given considering the extremely strong traffic trends posted last year as a result of the beverage line offering.

 

NEUTRAL: A print of +1.5% would be considered a neutral result as it would imply roughly flat calendar-adjusted two-year average trends on a sequential basis.  

 

BAD:  A result of less than +1.5% growth in same-restaurant sales would imply a significant slowdown in two-year average trends on a calendar-adjusted basis and would likely cause the stock to sell off further.  While we do believe that McDonald’s sales trends are slowing, we do not believe that the number will be below +1%.

 

MCD JUNE SALES PREVIEW - mcd sales preview

 

 

Europe - facing a difficult compare of +9.1%, including a calendar shift of between 0.2% and 0.5%, varying by area of the world:

 

We expect that MCD Europe same-restaurant sales declined by between -1% and -1.5% in June.

 

GOOD: A positive same-store sales number would, in our view, be positive for MCD Europe as it would imply a sequential acceleration in calendar-adjusted two-year average trends.  Other companies in the consumer space have cited lower-than-expected sales lift from the Euro 2012 soccer tournament. 

 

NEUTRAL: A print of between -1% and 0% would be considered a neutral result as it would imply two year average trends picking up slightly from trough levels in May.  Investors will be eager to see some stability in the Europe business’ trends.

 

BAD: Same-restaurant sales below -1% would imply little or no sequential improvement in calendar-adjusted two-year average trends from low levels in May. 

 

 

APMEA - facing a compare of +4.8%, including a calendar shift of between 0.2% and 0.5%, varying by area of the world:

 

We expect that MCD APMEA same-restaurant sales grew by +1% in June.

 

GOOD: Same-restaurant sales growth of more than 1% would be a strong result, in our view, because it would imply a sequential acceleration in the calendar-adjusted two-year average trend following three consecutive months of decline.  Macro concerns around China were assuaged, to a degree, by YUM meeting analyst expectations of 9.8% comps in 2Q with a 10% print. 

 

NEUTRAL: A print between 0% and 1% would be a “neutral” result as it would imply a sequential stabilization of two-year average trends.  That said, the low level of growth would remain a concern.

 

BAD: Comparable restaurant sales growth below 0% for McDonald’s APMEA division would imply a continuation of sluggish two-year average trends.

 

 

Howard Penney

Managing Director

 

Rory Green

Analyst

 


get free cartoon of the day!

Start receiving Hedgeye's Cartoon of the Day, an exclusive and humourous take on the market and the economy, delivered every morning to your inbox

By joining our email marketing list you agree to receive marketing emails from Hedgeye. You may unsubscribe at any time by clicking the unsubscribe link in one of the emails.

The Bearish Case For Oil

Yesterday, we shorted oil in the Hedgeye Virtual Portfolio. Our case is simple: the US dollar, which has been in a bullish formation since April, is about to rip higher. In turn, oil will go down and has dropped over -1.5% today, confirming our thesis.

 

It appears that pundits and analysts are worried about the situation in the Middle East. Tensions with Iran and Israel are high, the Strait of Hormuz might close,  the civil war in Syria is worsening and suicide bombers are on the loose  in Bulgaria. None of that really matters. It’s all about what the dollar does. As our CEO Keith McCullough says: “Get the dollar right and you get a lot of other things right.” We are bullish on the dollar and bearish on global growth, which continues to slow.

 

The Bearish Case For Oil  - USD BrentChart


Big Money: Valuing Sports Dollars

We all know there’s big money in sports, but do you know just how big? Manchester United, the world’s most popular sports team, has 400 million fans worldwide. There’s only ~310 million people in the US and no one outside our borders cares what Jeter and the Yankees do this season, despite being the third most valuable sports franchise.

 

 

Big Money: Valuing Sports Dollars  - Nike Endorsement Values

 

 

What this boils down to is team value. Forbes values ManU at $2.23 billion, Real Madrid at $1.88 billion and the Yankees at $1.85 billion. There’s big money in sports. We’ve plucked out five facts we think are notable in the world of valuation:

 

  1. The most notable point, by far, is that the two teams with the greatest increase in value are both in Los Angeles. The next two teams on the list are in Spain (FC Barcelona and Real Madrid). We get the California angle, but is Forbes watching what’s going on in Spain? Not so sure about that.
  2. As bullish as a $1.4bn valuation might sound for the Dodgers, the team was purchased by Guggenheim Baseball in April for $2bn which was based on an impending local TV deal that is expected to be worth nearly $3.5bn in cash and equity. Steve Forbes is probably getting several angry phone calls this week questioning valuation math.
  3. Despite the Juventus Football Club moving into a new stadium this year with a 49% increase in capacity, it fell off the top 50 list and was replaced by the Texas Rangers. Now valued at $674mm, the Rangers won the AL West only to lose in the World Series for the second straight year in game 7. Regardless, attendance reached Franchise history highs and the team struck a 20yr cable deal with Fox Sports Southwest beginning in 2014 valued at $3bn.
  4. Only 5 of the top 20 clubs are Football/Soccer.
  5. 12 of 20 are US rules (NFL) Football. There’s a  little snippet for NFL fans that hate soccer.

 

So who’s the big player in all of this? If you guessed Nike (NKE), you’d be correct. Endorsements are serious business and the company pays the big bucks ($40 million for ManU alone) to replicate uniforms for resale to the public. It is anticipated that come 2015 when Manchester United’s current deal with Nike expires, they will be looking to ink a deal worth up to £600m over 10 years, which breaks down to about $95 million annually.

 

Best of luck to ManU and their upcoming $300 million IPO. 


Get Shorty

RIA DAILY PLAYBOOK     

FOR RELEASE ON FRIDAY, JULY 20, 2012

 

CLIENT TALKING POINTS

 

THE JAPANESE DON’T LIE

While the US market is busy getting squeezed amid tepid volume and earnings, the Japanese are showing us how it’s really done. The Nikkei has continued to open post-US close with a solid gain, only to be slammed down into negative territory, closing down -1.4% this time around. The global industrial slowdown is among us and it is quite noticeable.

 

GET SHORTY

You can wax poetic all you want about particular names in stockpicking, but the reality is unless you backup your call with a timestamp, it’s just another idea. We have been short the S&P 500 since 1375 – yes it’s at 1376 now. We’re off by a point. This “rally” will not last, and please keep in mind that hope is not a risk management process.

 

LEAVING OIL BEHIND

It’s about that time. The US dollar has been in a bullish formation and we’ve been liking it since about April. We went short oil yesterday in the Hedgeye Virtual Portfolio. Yes, the US dollar is ready to rip higher. Never mind the bollocks associated with the turmoil in the Middle East, threats or suicide bombings. It simply doesn’t matter. All that talk of $200 a barrel  oil is nothing but laughable at this point.

 

 

ASSET ALLOCATION

 

Cash: Down U.S. Equities: Flat

 

Int'l Equities: Flat Commodities: Flat

 

Fixed Income: Up       Int'l Currencies: Flat

 

TOP LONG IDEAS

 

PSS WORLD MEDICAL (PSSI)

The bulk of the bad news is on the table following disappointing F2012. Rebased F2013 estimates far more reasonable, and revenues should be supported by our expectations for rising physician utilization, and in the near-term, a flu season that is shaping up as a considerable tailwind.

                             

TRADE: LONG

TREND: LONG

TAIL: NEUTRAL

 

HCA (HCA)

SS volume accelerated in 1Q12 and employment remains a tailwind to both admissions & mix. We expect acuity to stabilize and births and outpatient utilization to accelerate out of 1Q12, while supply cost management continues as a margin driver and acquisition opportunities remain a source for upside.

 

TRADE: NEUTRAL

TREND: LONG

TAIL: NEUTRAL

 

UNDER ARMOUR (UA)

The company continues to control its own destiny through investments in all the right areas. We think 30%+ top line and EPS growth for 5+ years. One of its failures, however, has been in penetrating markets outside the US. That will happen. But for now, its failure is a competitive advantage in the face of a strengthening dollar. We like it in sympathy with a LULU sell-off.

 

TRADE: LONG

TREND: LONG

TAIL: LONG

 

THREE FOR THE ROAD

 

Tweet of the Day: “Indeed it looks like a free fall abyss @ekathimerini: Greece, Portugal & Spain are staring into the same economic abyss dlvr.it/1tQPQx”        -@Nouriel

 

Quote of the Day: “When a person can no longer laugh at himself, it is time for others to laugh at him.” –Thomas Szasz

 

Stat of the Day: 4500 jobs to fill at the Solaire Manila Resort & Casino. 


the macro show

what smart investors watch to win

Hosted by Hedgeye CEO Keith McCullough at 9:00am ET, this special online broadcast offers smart investors and traders of all stripes the sharpest insights and clearest market analysis available on Wall Street.

next