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CONSTERNATION IN BRAZIL

Takeaway: The outlook for Brazilian financial markets is confusing, to say the least.

SUMMARY BULLETS: 

  • With the exception of the Brazilian real, which we maintain our bearish bias on (vs. the USD), the TREND-duration outlooks for Brazilian equities and BRL-denominated debt is rather binary in each case.
  • Expectations for further monetary easing out of the Brazilian central bank are completely muted, creating a binary scenario whereby rising inflation expectations beget tightening expectations or accelerating global growth concerns beget incremental easing from here.
  • We continue to see heightening risk that inflation does not converge to the mid-point of the central bank’s target over the intermediate term, as guided to by officials. 

To say that Brazilian policymakers are giving investors the run-around would among the more aggressive understatements of the year. We too were on the less-desirable side of a few noteworthy shifts in policy expectations in recent months: 

  • 5/3: WHAT THE HECK IS GOING ON IN BRAZIL?: An expectation that Brazilian policymakers would limit further downside in the BRL made bullish on Brazilian equities with respect to the TREND duration;
  • 5/31: WAIT ON BRAZIL: An outlook for continued Big Government Intervention was a key factor in our decision to withdraw our bullish bias on Brazilian equities and the Brazilian real with respect to the TREND duration; and
  • 7/30: IS BRAZIL IN A BOX?: Growing inflationary concerns amid muted expectations for a policy response made us bearish on Brazilian equities, the Brazilian real and Brazilian real-denominated debt with respect to the TREND duration.   

At Hedgeye, we are no strangers to keeping score – even when it goes against us: from 5/3 to 5/31, the Bovespa dropped -12.3% in the face of our bullish bias. Leaving behind that misfire, the index is largely flat from 7/30 to present; the real has declined -0.5% vs. the USD and Brazil’s 10yr sovereign debt yield has backed up a modest +5bps over that same time frame. Looking ahead, we continue to expect more downside in the BRL relative to the USD over the intermediate term, though we no longer hold high conviction in our bearish bias on Brazilian equities and BRL-denominated debt. In the sections below, we update our thoughts on each asset class.

 

BRAZILIAN REAL (BRL)

With last night’s unanimous decision to reduce the SELIC Rate -50bps to a new all-time low of 7.5%, exactly what we said would happen is happening in Brazil – specifically in that the central bank is completely looking past the recent pickup in inflation and continuing on with its easy monetary policy. Looking ahead, their lack of prudence/vigilance is likely to continue weighing on expectations for Brazilian real interest rates over the intermediate-term TREND – likely a critical headwind for the BRL (vs. the USD) with respect to that duration.

 

CONSTERNATION IN BRAZIL - 1

 

CONSTERNATION IN BRAZIL - 2

 

Moreover, investors should continue to anticipate help from the powers that be: “Brazil’s government will continue to take action to weaken the real in benefit of local manufacturers,” per Finance Minister Guido Mantega in a statement from yesterday. Ironically, Mantega’s “beggar-thy-neighbor” policies have done little promote Brazilian exports (-5.6% YoY in JUL) or manufacturing activity (PMI = 48.7 in JUL), while at the same time completely sticking Brazilian manufacturers with COGS inflation (+7.2% YoY in JUL from +6.6% in JUN). The obvious risk here is that Mantega is emboldened to do more of what hasn’t worked – particularly as economic concerns in China – Brazil’s largest export market – continue to weigh heavily on prices for one of Brazil’s key export products.

 

CONSTERNATION IN BRAZIL - 3

 

CONSTERNATION IN BRAZIL - 4

 

BRAZILIAN EQUITIES (BOVESPA INDEX)

On our proprietary GIP factoring alone, Brazilian equities look almost as attractive as they did to us back in early MAY – particularly from a growth perspective, where our models continue to point to a back-half ramp in real GDP. Of course a lot has happened since then, especially on the fiscal policy front, including the recent extension of the IPI tax cut though OCT, increase in home buying subsidies, decrease in minimum mortgage down payments, increase in State-level debt ceilings, the introduction of a $66B/30yr infrastructure investment program (with 59.7% coming in the first 5yrs) and an incremental R$1.5 billion capital injection in Caixa Economica. And that’s just for the month of AUG!

 

CONSTERNATION IN BRAZIL - BRAZIL

 

Needless to say, it remains to be seen whether or not the Brazilian government’s aggressive year-long stimulus efforts will provide the intended boost to growth without spurring a measured ramp in inflation. We continue to see that as the key question to debate regarding Brazilian equity exposure over the TREND and TAIL durations. As we outline in our 75-page presentation titled, “THE ROADMAP TO INVESTING IN BRAZIL” (AUG ’11), Brazil remains an economy at risk of a sustained and material spike in inflation – a conclusion only enhanced by the BRL’s -22.3% YoY decline. QE3-inspired commodity inflation also remains a heightened risk to the Brazilian econmy with respect to the intermediate term.

 

Net-net-net, we wash out largely neutral on Brazilian equities from here (TREND), fully understanding the merits of the both the bull and bear case. In instances like these, we typically defer to the market to do the concluding for us – though, given our below-consensus expectations for global growth over intermediate term, we don’t necessarily find it prudent to be long of Brazilian equities at the current juncture.

 

BRAZILIAN SOVEREIGN DEBT

Upon cutting the SELIC to 7.5%, Brazil’s central bank subtly signaled to the market that they were at/very near the end of their monetary easing cycle by inserting the word “maximum” in their statement, which did not appear in previous iterations:

 

“Considering the cumulative and delayed effect of policy action implemented until now, which are partially reflected in the ongoing economic recovery, the Copom considers that if the prospective scenario were to allow for an additional adjustment in the monetary conditions, this move should be carried out with maximum parsimony.”

 

Looking to Brazil’s interest rate swaps market, OIS are now essentially pricing in no further reductions in the SELIC over the NTM. To the extent that scenario plays out amid a positive inflection in Brazilian growth and a continued ramp in NTM inflation expectations, we could see selling pressure on both the short and long ends of Brazil’s sovereign debt curve.  Additionally, QE3-inspired commodity inflation could actually perpetuate tightening expectations in the Brazilian bond market, much in the way QE2 did.

 

CONSTERNATION IN BRAZIL - 6

 

On the flip side, our top-down view on global growth suggests that Tombini and Co. might not necessarily be done cutting rates in the current cycle, contrary to market expectations. Moreover, we anticipate that as Brazil’s consumer credit metrics – a lagging indicator – continue to deteriorate over the near term, pressure from Rousseff and Mantega upon Tombini to resume monetary easing is likely to reaccelerate. Rousseff in particular, is likely to continue pursuing such means of populism amid her current heavyweight bout with Brazil’s public labor unions as she seeks to slow growth in public pensions and public worker salaries, which combine to represent a whopping 65% of federal expenditures.

 

CONSTERNATION IN BRAZIL - 7

 

All told, the outlook for Brazilian financial markets is confusing, to say the least. With the exception of the Brazilian real, the TREND-duration outlooks for Brazilian equities and BRL-denominated debt is rather binary in each case.

 

Darius Dale

Senior Analyst


Expert Call with Jim Rickards Summary: Tipping Points, Bullish On the Euro, and Dollar Policy

Takeaway: In a recent conference call we hosted, Jim Rickards outlined a bull case for the Euro - $FXE.

Outlined below are the key highlights from our recent conference call with Jim Rickards.  While we don’t necessarily share all of his views, we definitely found him to be very thoughtful and his perspectives insightful.  A key non-consensus perspective he has is a bullish view on the Euro.

 

The replay is below:

James Rickards Expert Call

 

Summary of Jim Rickards’ Hedgeye Call, 8/29/2012


A)     Philosophical View of Chaos Theory


Rickards introduces his topic of “Currency Wars, Capital Markets & Geopolitics” by saying that capital markets are a complex system, grounded in complexity theory. To solve for this complexity one needs to know the dynamics of the system and determine a methodology for the system. While it may not be possible to have 100% accuracy in making predictions, what’s key is to get the method right and isolate larger significant factors to draw inferences and reach probable outcomes which lead to the most accurate forecast.

 

Unfortunately, a lot of economic and policy advisors, people on the Board of Governors, Federal Reserve staff economists, and people in the Treasury (to name a few) are using the wrong methods. They’re stuck with the thinking of Keynesianism and monetarism, which are simply the wrong tools for evaluation. Our job is to identify and utilize the right tools so that we can understand capital markets.

 

Capital markets are complex systems and there are four characteristics that govern them:

  1. Diversity – you need a lot of agents or participants and they need to be diverse from each other.
  2. Connectedness – how are the agents arranged, so that they can observe and perceive one another to figure out what the others are doing, or not?
  3. Interaction – if I do something does that affect what other people do, or vise versa?
  4. Adaptation – based on the experience do I adapt, do I learn?

Clearly capital markets fit all of these characteristics closely: Diversity (bulls and bears; fear and greed; long term vs short term; people operating using different currencies); Connectedness (Bloomberg screens, CNBC, Twitter, etc.); Interaction (buyers and sellers trading for instance over $1 Trillion in FX daily and Billions of shares on NYSE); Adaptation (funds close or adapt to the macroeconomic environment). 

 

Complex systems however are not limited to the capital markets and can be seen in catastrophic events such as forest fires, earthquakes, and power grid failures, to name a few.

 

And what you get out of these systems are a couple of power tools:

  1. The Critical State – when the players in the system are arranged in such a way that they’re vulnerable to some kind of a collapse, what physicists call a phase transition (ex. Boiling water turns into steam).
  2. Emergent Properties – the whole is greater than the sum of its parts. That is to say, things come out of the system that one would not infer based on knowing all the pieces in the system -- what Nassim Taleb would call Black Swans.

The point is that we can put together highly predictable models and although we may not be able to name a Black Sway or exactly pin-point a collapse, we can come close in understanding the magnitude and narrow the timing of events based on our understanding of the scale of the system. Again, we will never have all the information to solve a problem, but a powerful way to solve a problem is to get one big thing right and draw inferences and hypotheses from it to narrow down a set of possible outcomes.

 

 

B)      Obama’s US Dollar Policy

 

The starting point is that the US wants a cheaper dollar. In fact, it is a stated policy of the Obama administration to double exports in five years, which can only truly happen with a weaker dollar.

 

Bernanke and Geithner, with support from the White House, are out to cheapen the USD. However, this doesn’t mean that they’ll get a cheaper dollar because they want one -- the dollar has shown periods of strength over the last two years partly due to the fear trade coming out of Europe and changes in the Chinese policy stance.

 

Taking account of the recent political climate to reduce government spending and reflecting back to explicit comments from President Obama in his State of the Union address on January 2010 in which he outlined an Export Initiative policy to double US exports in 5 years, it’s clear that this administration (and its advisors) believe net exports are the only way to drive the economy.

 

While exports may be a much smaller part of the economy than say Germany, if you double exports that leads to a 1% - 1.5% increase in GDP, which could put growth towards 3%.

 

However, the only way to double exports is to trash the USD, so that is implicit in the President’s policy. Drawing inferences from two rounds of QE that have not resulted in the USD going down a lot, then you can expect that some level of QE3 is coming on September 13th to cheapen the USD.  

 

 

C)      Acceleration of the Money Velocity May be the Key Catalyst that Leads to a Tipping Point in Inflation

 

The Fed controls money supply, and although we saw huge spikes in money supply growth from the QE1 and QE2 programs, over these same periods the velocity of money collapsed.  (This of course bucks the assumption held by economists that the velocity of money holds constant).  In fact, velocity is something the Fed cannot control and if velocity is crashing so is GDP unless you can get some inflation in the mix.  So the Fed is now very determined to attempt to change velocity but this is something that is a behavioral phenomenon. For example, if people are worried about their job they’re going to reduce spending and let their money sit in the bank. Conversely, if people are optimistic they’ll spend more freely and maybe take their friends out to dinner.  

 

There are two ways the Fed is going about trying to manipulate velocity. First, it will try to create negative real rates (that is to say to get inflation rates higher than nominal rates), which is a huge incentive to a borrower. Second, it will attempt to deliver an inflationary shock to scare people into spending money.  While Bernanke may say he is targeting 2% inflation, what he really wants is closer to 4%. Essentially, Bernanke is setting a target (an expectation) which he’ll then beat to change expectations and create the shock to change behavior, and spark, for example, a consumer buying a new refrigerator now before rates move higher.

 

Keep in mind the Fed wants to get to 5% nominal growth. While under ideal conditions this could be achieved with 1% inflation and 4% real growth, under current conditions Bernanke is willing to take 4% inflation and 1% real growth.

 

And of course the easiest way to get more inflation (to get 5% nominal growth that is imperative to pay off nominal debt) is to cheapen your currency.  The only problem we [all] should have with this policy to import inflation via currency debasement is that the Fed thinks it is playing in a linear world (like the impact of turning the dial on a thermostat to the room’s temperature); the Fed is actually playing with a nuclear reactor, in which dialing up or down the reactor can result in a catastrophic meltdown.

 

 

D)     Contrarian View of the EUR/USD

 

Rickards has been bullish on the EUR/USD for a long time, and ruled against those that think the EUR is going to parity or even $1.15.  Over the longer term, he remains firmly of the opinion that no country is leaving the Euro, no country will be kicked out of the Euro, and that new countries will join the Euro over time (for example Hungary, Iceland, Scotland, and others).

 

Specific reasons for this bullish view are represented by a triangle of the three major currencies: USD, EUR, and YUAN. Rickards already stipulated that the US wants a cheaper dollar. China has been under enormous pressure to appreciate the Yuan versus the dollar, but the Chinese don’t want to have the Yuan appreciate versus the USD and the EUR and be the biggest loser in the Currency Wars. Because it is a zero sum game and the USD is going to be depreciated and the Yuan is going to be capped or pushed lower, there’s no other way than for the EUR to appreciate. And you can’t have a cheaper EUR than the USD because the US has a bigger printing press!

Further bull cases for the EUR:

  1. Germany realizes that it must have slightly higher inflation rates to compensate for low to negative rates in the peripheral countries. To do this, Germany will increase its unit labor costs (which historically have been much lower than the periphery’s) which should help to balance out inflation/deflation across the region and spur the common currency.
  2. China desperately wants to diversify away from dollars and is looking to invest heavily in Europe (after the storm clouds clear from the sovereign debt and banking crisis).
  3. Huge cohort of youths, especially in the periphery, are hungry for work (especially for a first job) and will take entry level jobs at advantageous costs for companies.
  4. Europe has taken its austerity and will emerge stronger and ahead of the US, which has yet to take its austerity medicine.
  5. The IMF can print via STRs to bailout Europe/restore confidence, if needed.

 

 

E)      The Four Horsemen of the USD Apocalypse vs the Upside in Gold

 

Since 1980 the US has not been on a gold standard, but a dollar standard. In the last 10 years the USD has declined from 70% of reserve currencies to 60%, which still provides a tremendous anchor for global currencies to be pegged to.  It would be a very unanchored world if reserve currencies were split say 40% USD, 40% EUR, and a remaining 20% mix of Swiss Francs (CHF) and other currencies. 

 

But, under a scenario in which you get a collapse of economies, countries may be forced to a gold standard. And this would have drastic price appreciation consequences. Looking at gold prices based on global monetary aggregates, an ounce of gold (based on M2 money supply metrics) could be worth as much as $44K!

 

 

Matthew Hedrick

Senior Analyst

 


JOBLESS CLAIMS: MORE GOOD THAN BAD WITH A TAILWIND SET TO KICK IN

Takeaway: Most of the news on the labor front is positive with a big tailwind set to kick in, but there are a few storm clouds on the horizon.

Big Picture - Where Are We With Respect to Employment?

The good news: jobless claims are still below the threshold level of 385-400k that we've identified as the break even point for the unemployment rate. Below that threshold, the unemployment rate falls and vice versa. Also, on a year-over-year basis, rolling non-seasonally-adjusted jobless claims are still improving, down 7.8% YoY this past week. These two reference points suggest that the health of the labor market is intact. Further, we are on the cusp of the seasonal adjustment factor headwind becoming a tailwind. Recall that the Lehman-based distortion reaches its maximum headwind in August/early September, and begins to unwind thereafter, reaching its peak tailwind by late February.

 

The bad news: the year-over-year change in the rolling NSA series compressed this past week to 7.8% improvement, down from 8.0% improvement in the prior week. More importantly, this measure is slowly but steadily converging toward zero suggesting the economic recovery is running out of steam. Also, the current disequilibrium between rolling SA claims and the S&P 500 suggests fair value on the market of 1,352, or roughly 4% lower than where it's trading presently.

 

The Numbers

Initial jobless claims rose 2k to 374k last week, but were flat after a 2k upward revision to the prior week's data. Rolling claims rose 1.5k WoW to 370k. 

 

JOBLESS CLAIMS: MORE GOOD THAN BAD WITH A TAILWIND SET TO KICK IN - Raw

 

JOBLESS CLAIMS: MORE GOOD THAN BAD WITH A TAILWIND SET TO KICK IN - Rolling

 

JOBLESS CLAIMS: MORE GOOD THAN BAD WITH A TAILWIND SET TO KICK IN - NSA

 

JOBLESS CLAIMS: MORE GOOD THAN BAD WITH A TAILWIND SET TO KICK IN - Rolling NSA

 

JOBLESS CLAIMS: MORE GOOD THAN BAD WITH A TAILWIND SET TO KICK IN - S P

 

JOBLESS CLAIMS: MORE GOOD THAN BAD WITH A TAILWIND SET TO KICK IN - Fed and Claims

 

JOBLESS CLAIMS: MORE GOOD THAN BAD WITH A TAILWIND SET TO KICK IN - NSA YoY

 

Yield Spreads - More Margin Pressure

The yield spread compressed last week by 5 bps, pushing the 2-10 spread to 137 bps from 142 bps the week prior. Ten year yields fell 4 bps to 165 bps from 169 bps. Currently, the 3Q12 yield spread is down 18 bps QoQ thus far in the third quarter.

 

JOBLESS CLAIMS: MORE GOOD THAN BAD WITH A TAILWIND SET TO KICK IN - 2 10

 

JOBLESS CLAIMS: MORE GOOD THAN BAD WITH A TAILWIND SET TO KICK IN - 2 10 QOQ

 

Financial Subsector Performance

The table below shows the stock performance of each financial subsector over multiple durations. 

 

JOBLESS CLAIMS: MORE GOOD THAN BAD WITH A TAILWIND SET TO KICK IN - Subsector Performance Graph

 

JOBLESS CLAIMS: MORE GOOD THAN BAD WITH A TAILWIND SET TO KICK IN - Companies

 

Joshua Steiner, CFA

 

Robert Belsky

 

Having trouble viewing the charts in this email?  Please click the link at the bottom of the note to view in your browser.  


the macro show

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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.

Another Dollar Holler

ANOTHER DOLLAR HOLLER

 

 

CLIENT TALKING POINTS

 

ANOTHER DOLLAR HOLLER

Time for another Dollar Holler as reality starts to set in for those who have been busy smoking the Bernanke peace pipe. There is most likely no further easing coming down the pipe at the Fed’s Jackson Hole meeting and you know what that means? Well if you’ve been paying attention to the market, you certainly would. Gold is heading lower, the US dollar is back in bullish business and commodity prices are set to deflate somewhat. You can’t just keep the QE bandwagon going forever, so now people are starting to holler at that dollar and Paul Ryan is loving it. Furthermore, a Washington Post article pulled an anti-Hilsenrath and basically suggested all we mentioned above, adding fuel to the fire.

 

 

TALKING TO JIM RICKARDS

For those of you who didn’t get a chance to dial-in to the call yesterday, our expert call with Jim Rickards was fascinating to say the least. Rickards touched on myriad topics ranging from chaos theory to countries in crisis reverting back to the gold standard to China buying the Euro. It was a privilege to be able to get so deep into the brain of a man as diverse as he is. Luckily, we live-tweeted the call and then put up a post highlighting the best points that Jim mentioned. You should check it out this morning if you haven’t already – this is the kind of stuff that gets your brain’s cogs turning.

 

URL: http://app.hedgeye.com/unlocked_content/22860-our-expert-call-with-jim-rickards

 

 

SPREAD RISK

The market may or may not have a boiling point. That’s more of a subjective call in terms of what your trading and investing strategy is. But in the big macro picture, there are a few relationships that are important to pay attention to. Measuring this spread risk in the market can help you make your next move accordingly. Keith highlighted three relationships in this morning’s Early Look we think are worth reiterating:

 

1.                    The long-term spread between Money Supply (rising as they print money) and Velocity of Money (falling, fast)

2.                    The long-term spread between the US Dollar and the CRB Commodities Index

3.                    The long-term spread between the SP500 priced nominally versus priced in Gold

 

_______________________________________________________

 

ASSET ALLOCATION

 

Cash:                  Flat

 

U.S. Equities:   Flat

 

Int'l Equities:   Flat   

 

Commodities: Flat

 

Fixed Income:  Flat

 

Int'l Currencies: Flat  

 

 

_______________________________________________________

 

TOP LONG IDEAS

 

NIKE INC (NKE)

Nike’s challenges are well-telegraphed. But the reality is that its top line is extremely strong, and the Olympics has just given Nike all the ammo it needs to marry product with marketing and grow in the 10% range for the next 2 years. With margin pressures easing, and Cole Haan and Umbro soon to be divested, the model is getting more focused and profitable.

  • TRADE:  LONG
  • TREND:  LONG
  • TAIL:      LONG            

 

FIFTH & PACIFIC COMPANIES (FNP)

The former Liz Claiborne (LIZ) is on the path to prosperity. There’s a fantastic growth story with FNP. The Kate Spade brand is growing at an almost unprecedented clip. Save for Juicy Couture, the company has brands performing strongly throughout its entire portfolio. We’re bullish on FNP for all three durations: TRADE, TREND and TAIL.

  • TRADE:  LONG
  • TREND:  LONG
  • TAIL:      LONG

 

LAS VEGAS SANDS (LVS)

LVS finally reached and has maintained its 20% Macau gaming share, thanks to Sands Cotai Central (SCC). With SCC continuing to ramp up, we expect that level to hold and maybe, even improve. Macau sentiment has reached a yearly low but we see improvement ahead.

  • TRADE:  LONG
  • TREND:  NEUTRAL
  • TAIL:      NEUTRAL

  

_______________________________________________________

 

THREE FOR THE ROAD

 

TWEET OF THE DAY

“Handlesblatt claims Weidmann may threaten to resign if ECB bond buying plan goes ahead and/or he does not get German govt support” -@OwenCallan

 

 

QUOTE OF THE DAY

“A wise man gets more use from his enemies than a fool from his friends.”– Baltasar Gracian

                   

 

STAT OF THE DAY

$3.1 billion. The price Scotiabank is paying to gobble up ING’s Canadian business.

 

 

 


DRI: EXPECTATIONS ARE THE ROOT OF ALL HEARTACHE

Takeaway: "Growth" remains the religion of choice at $DRI. The trends are not sustainable and something's got to give

Darden’s Annual Report arrived this past weekend and made for some great reading.  The primary takeaway for us was that the “growth” ethos at Darden is as entrenched as ever.  Against a backdrop of sustained traffic declines, it is jarring to read the following sentence: “Our brands have strong individual and collective growth profiles”.   We think management is setting itself up to miss expectations.

 

If you have read our Darden Black Book you are aware of our conviction that the continued acceleration of Darden’s new unit growth over the past couple of years has served to mask evidence of a secular decline in the company’s two most important brands.  The Letter to Shareholders in the Annual Report contains no evidence of management slowing growth any time soon.  Management’s growth targets are bold to say the least.  How they get there while maintaining the financial health of the company remains to be seen.

 

This is not the first time we’ve held a view on a stock that is diametrically opposite to that of management.  MCD and SBUX were two names I went against the grain on in 2002 and 2006, respectively.  Of course, we’ve been wrong before but feel strongly about our thesis on Darden.  Conversations with clients and industry experts, without exception, have increased our confidence in our thesis.  This thesis is not going to play out today or tomorrow; we are aware that we are early on this one. 

 

 

It’s Not The Economy

 

Darden’s annual report suggests that management sees the economy as the biggest issue facing the company and, furthermore, sees weakness in trends at its core brands as being transitory in nature.  The longer-term view, as defined by the data, suggests an altogether different story.  On a very basic level, we believe that companies acknowledging their issues are generally more apt to arrive at solutions.  The traffic trends at Olive Garden and Red Lobster clearly are demanding action of management.  The economy is undoubtedly a factor but the poor performance of the “Big Two” versus the Knapp Track casual dining benchmark is a clear indication that the company’s sluggish traffic trends are not entirely attributable to the macroeconomic environment.  The data points that we are pointing to – traffic trends – as a primary reference for our thesis are indicative of, at least in part, self-inflicted wounds. 

 

DRI: EXPECTATIONS ARE THE ROOT OF ALL HEARTACHE - OG RL comps details

 

 

If the company has become dependent on growth as a drug for all ailments, the Annual Report suggests that management does not seem to have freed itself from the “denial” stage of its addiction.  Stating that the “core brands remain highly relevant to restaurant consumers” can be supported by pointing to the average unit volumes at Red Lobster and Olive Garden as being some of the strongest in the industry.  We believe this statement to be misguided, however, when considering same-restaurant sales trends – a far more relevant metric when assessing relevance to the consumer:

  1. Red Lobster’s two-year average same-restaurant sales have declined over 10 of the last 16 quarters
  2. Olive Garden’s two-year average same-restaurant sales have declined over 8 of the last 16 quarters.

Red Lobster’s positive traffic trends in FY12 were driven largely by aggressive discounting while Olive Garden’s most recent data is deeply concerning.  The charts below illustrate the cumulative price and traffic trends for Olive Garden and Red Lobster relative to FY08.  Price has been taken steadily while traffic has generally trended lower with the exception of brief spurts into positive territory driven by LTO discounting.  Our concern is that the core brands of Darden, whether deemed relevant or not by management, are losing appeal for consumers as time goes by. 

 

The remedy for what ails Olive Garden, a system with 430 restaurants in need of remodeling, is not going to materialize imminently.  We believe that more dramatic measures may be needed to boost the competitiveness of the “Big Two”. 

 

DRI: EXPECTATIONS ARE THE ROOT OF ALL HEARTACHE - OG RL cum traffic

 

 

What’s Consistent About Darden’s Margins?

 

The Darden Annual Report states, “our success will be driven by strong total sales growth and consistent margin expansion as we leverage our collective experience and an increasingly efficient support platform.”  We would like to address this quote in two parts. 

 

First: “consistent margin expansion”.

 

Darden’s EBIT margins are consistent in their absolute level but they are not expanding.  Contributing to Darden’s strong EBIT margins are the company’s restaurant level margins which were 23% in FY12.  Darden stands alone among the companies we follow in terms of its margins but we find it difficult to believe that significant expansion in that metric is likely from here given the reality of Olive Garden and Red Lobster’s traffic trends.

 

The outlook for margins is far more important than what is in the rear-view mirror and we contend that the need to improve the relative value proposition at Olive Garden and, to a lesser extent, Red Lobster is likely to lead to an easing in pricing trends.  Maintaining restaurant operating margins under this scenario will likely be difficult.  At the Analyst Meeting in February, management was vocal about lower menu prices improving traffic and allowing Darden to leverage G&A, thereby offsetting the restaurant operating margin decline and even expanding EBIT margins.

 

Second: “our success will be driven by strong total sales growth”.

 

Total sales growth has been strong but rather than focus on total sales or average unit volumes, we focus on traffic and comparable-sales trends as true indicators of top-line health.  Leveraging the balance sheet to buy top line growth is not a winning strategy, particularly for a stock whose ownership seeks stability and yield.  Traffic trends are expected to decline in FY13.

 

 

Operating Cash Flow Targets a Little Rich

 

Darden is projecting a doubling of its operating cash flow over the next five years despite its best-in-industry margins being at peak levels with traffic trends slowing.  This is a lofty goal when we consider that operating cash flow has declined 1% since 2008.  How does the company get there?

 

DRI: EXPECTATIONS ARE THE ROOT OF ALL HEARTACHE - dri operating cash flow

 

 

The chart, above, taken from the company’s Annual Report, shows that the company is guiding to operating cash flow doubling to $1.4-1.6 billion by FY17.  The company is also guiding to sales of $11.5-12.5 billion in the same year.  Looking at operating cash flow margin over the last five years, it seems that FY17 will have to be a very good year for the company to hit its implied target of 12.5%.  Over the past five years only once, in FY10, with 12.7%, did the company achieve or better the operating cash flow margin that is implied by the FY17 estimates.  FY10, it is also worth remembering, saw food and beverage costs decline 6.8% in what was the only year of the last five during which this cost declined for Darden.

 

In order to double its operating cash flow over the next five years, the company will require a sizeable recovery in sales at its two largest brands.  At a minimum, we believe that Olive Garden is two years away from a sales recovery beginning.  Over the past five years, from FY08 through FY12, the company has spent $2.6 billion to generate an incremental $242 million in EBITDA. 

 

 

Big Promises

 

The company has made the following commitments to its shareholders for the period ending FY17.

  1. SRS of 2-4% with 1-2% in FY13
  2. 500 new stores or ~$3.4 billion in capex (Hedgeye estimate)
  3. 2x operating cash flow to $1.5 billion
  4. Cumulative dividends and share repurchases of $3.2 billion

We believe these are tall orders, individually and collectively, for the company to deliver.  We will address these targets below:

 

Same-restaurant sales of 2.4% are dependent, according to management, on “normal” economic conditions (whatever that means).  Historically, the company has had pricing of 2-3% included in its comps but we believe that the primary brands’ pricing power will be diminished going forward.  Traffic in the casual dining industry declined 40 basis points in 2011 and 90 basis points over the last twelve months, according to Malcolm Knapp’s Casual Dining Same-Restaurant Sales Index. 

 

New restaurant growth is a key focus for Darden and the company has sufficient cash flow to grow 500 units over the next five years.  The more salient question is whether or not the company should allocate that capital to 500 new units over the next five years.  We believe the company should slow growth given decelerating Returns on Incremental Invested Capital.

 

Operating cash flow is unlikely to double in five years given the current run-rate of capital spending.  We anticipate roughly $3.4 billion of capex between now and the end of FY17.  As we highlighted earlier, operating cash flow margins need to expand significantly (300 bps) from FY12 to FY17 in order for operating cash flow targets to be made, assuming the sales guidance comes to fruition.

 

Returning cash to shareholders is a key Darden selling point.  The 3.8% dividend yield is highly appealing to investors and, since FY08, the company has raised the dividend 150% while EPS has grown 31%.  More importantly, the operating cash flow of the company has declined 1%, from $767 million to $762 million, between FY08 and FY12.  In order to pay the dividend and accomplish other capital-intensive goals, the company has burned through $689 million in cash.  In FY12, dividend and capital spending accounted for 113% of operating cash flow.  As a result, adjusted debt/EBITDA at the beginning of FY13 was 62% (prior to the recent acquisition), leaving the company little room to maneuver from an operational perspective and raising the stakes should margins decline.  The company’s long-term goal of returning $3.2 billion in cash to shareholders is dependent on expanding operating margins.  If this does not materialize, either the dividend or capex will need to be cut.

 

DRI: EXPECTATIONS ARE THE ROOT OF ALL HEARTACHE - DRI unsustainable

 

 

Conclusion


Senior management at DRI has a very ambitious 5-year plan, where there is very little room for error.  As we see it for management to accomplish this 5-year plan the following must happen:

  1. RL and OG need to improve traffic trends ASAP with no margin degradation.
  2. The company needs to leverage 2-4% same-store sales with little pricing
  3. Enterprise wide cost cutting is must
  4. Real estate site selection must be perfect and new unit sales trends must be above average
  5. Margin expansion is a must and there is little room for food or labor inflation (the impact of the new heath care will likely be inflationary)
  6. The company must overcome significant macro/demographic headwinds
  7. Darden must protect share against some rejuvenated competitors in EAT and BLMN
  8. Margins must be maintained as increased leverage is going to limit the operating flexibility of the company

We believe that Darden could, even while achieving its cash flow targets, burn through between $550-650 million in cash between FY13 and FY17.  The current path for Darden looks to be fraught with risk and largely unsustainable in its current form.

 

 

Howard Penney

Managing Director

 

Rory Green

Analyst

 

 


Follow The Lightning

This note was originally published at 8am on August 16, 2012 for Hedgeye subscribers.

“I follow the lightning, And draw near to the place that it strikes.”

-Navajo Chant

 

Now I know that a lot of our clients want to talk about what consensus versus contrarian thinking is, in this no-volume marketplace, but I’m thinking they’d have a tough time advising their kids to go hard core contrarian like the early 19th century Navajos did.

 

Admittedly, I am developing a Darwinian confirmation bias in my reading list this summer as I delve into more Native American history with a book I started reading this week titled Blood and Thunder – “The epic story of Kit Carson and the Conquest of the American West.”

 

Whether it was the ability of the Navajo and Comanche tribes to adapt and survive the late 18th and early 19th centuries, or it’s what you are staring at on your screen this performance chasing morning, our goals remain common in human nature; evolve or die.

 

Back to the Global Macro Grind

 

Buy stocks or bonds?

 

Rarely can I time that question as critically as I’ll timestamp it this morning. Yes, these are the thralls of August. But Mr Macro Market couldn’t care less about our summer vacations. Timing matters right here and now, big time.

 

Timing was especially important in answering this same basic asset allocation question in the middle of March 2012 (see Darius Dale’s Chart of the Day): 

  1. Stocks wouldn’t go down
  2. Bonds wouldn’t go up
  3. Volatility went away 

In fact, by the time the VIX hit 14.26 on March 26th (the Russell2000 topped for 2012 on the same day at 846, +5.2% higher than where it is today), there was a massive consensus (both buy and sell side)  that “growth was back” and “earnings are great.”

 

Fast forward to June… and US stocks were gasping for air in the middle of a double-digit drawdown (Russell2000 and SP500 down -13% and -10% from their late March highs) as US Treasuries put on a massive move to the upside (10yr yield dropped -42%, from 2.4% to 1.4%).

 

What drove the correct answer to the stocks vs bonds question?

 

Global #GrowthSlowing. Period.

 

What will get you to the correct answer for the next 1-3 months, from here?

 

Follow The Lightning.

 

The most abysmal volume and volatility readings I have ever recorded in my US Equity model aside, there are 2 basic realities that both bulls and bears have to deal with this morning: 

  1. US stocks are making both intermediate and long-term lower-highs
  2. US bonds are making both intermediate and long-term higher-lows 

In other words, if you believe Growth is going to improve from here, you buy stocks. If you’re more confident (like we and the data are) on #GrowthSlowing, you buy bonds.

 

Our predictive tracking algorithm (the one that called for #GrowthSlowing when few did in March), which is a multi-factor, multi-duration model, is telling us that this is a fairly straightforward call to make because:

 

A)     Oil prices are up +32% (Brent) from the June low (that slows growth)

B)      Corporate Revenue growth’s slope is as weak as it has been, globally, since Q308

C)      Chinese Growth continues to surprise on the downside

 

Chinese what? Yes, while I suppose you could say that China’s Foreign Direct Investment (FDI) print this morning of -9% year-over-year was better than India’s Export growth tanking to -15% year-over-year earlier this week, we highly suggest you take China’s word for it:

 

“In the second half, China’s foreign trade and export situation will be more grim, there will be more difficulties, harder tasks, and the pressure of achieving the full-year target will be bigger…” –China Ministry of Commerce (this morning)

 

Now, before you zap me with the bull counterpoint (for stocks) to this (rate cuts, stimuli, bailouts, etc.), just remember that doing more of the same will only keep food/energy prices higher (and growth slower) for longer. That’s bullish for bonds, longer term. And our long-term TAIL risk line for growth (bond yields) remains intact at 1.94% on the US Treasury 10yr.

 

My immediate-term support and resistance ranges for Gold, Oil (Brent), US Dollar, EUR/USD, 10yr UST Yield, and the SP500 are now $1601-1612, $111.69-116.21, $82.34-82.97, $1.22-1.24, 1.56-1.82%, and 1391-1410, respectively.

 

Best of luck out there today,

KM

 

Keith R. McCullough
Chief Executive Officer

 

Follow The Lightning - Chart of the Day

 

Follow The Lightning - Virtual Portfolio


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 80.65%
  • SHORT SIGNALS 78.63%
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