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Takeaway: We are pulling back on our bearish stance ahead of $DNKN's 3Q print on 10/25.
We had a candid conversation with the top brass at Dunkin’ Brands yesterday. Given the timing of the call, and the fact that we have not been positive on the name, we took the call as a bullish sign in and of itself. The details were reassuring and several grey areas were clarified to our satisfaction.
Dunkin’ reaching out to us to schedule a call eight days before the company reports its 3Q earnings was surprising. If you have kept abreast of our writing on Dunkin’ over the past year, we have been critical of the company’s ability to execute on the long-term domestic growth projections that whipped up such excitement as the company came public. On top of that, we have been skeptical of actual same-store sales results meeting expectations in the back half of 2012. Same-store sales are not nearly as important for Dunkin’s profitability as unit growth, given the franchised nature of its business model, but comps do seem important from an investor sentiment standpoint. Below, we address these two aspects of the Dunkin’ story and update our thoughts.
We have consistently voiced our concern about what we perceived as a lack of disclosure, on management’s part, around the company’s new store pipeline. As was explained to us yesterday, in what we thought was a very transparent manner, the company’s future unit growth is partly stemming from existing franchisees. In 2012, 60% of new unit growth is accounted for by existing franchisees. Management explained to us the difficulty they have in calculating the backlog because of the undefined nature of existing franchisee commitments. Many franchisees are seeking to growth their businesses but, given the high level of concentration in existing markets, are looking west for that opportunity.
We have been concerned about 2H12 trends from a headline perspective as expectations are for a V-Bottom in two-year average trends through year end. We argued that even holding two-year average trends flat was likely overly bullish. We still believe that a same-store sales miss is possible but see the investments in technology and strong performance of recent food items at Dunkin’ as strong positives. We have seen with DPZ and SBUX that technology can have a significant impact on through-put, transactions, and both employee and customer-satisfaction.
The overall tone from management was very bullish. The entire senior management team was on the call to directly convey the message and extend an invitation to us to meet with them in person to dig deeper into store-level returns and the company’s growth outlook. We will be taking management up on the offer as soon as time permits.
For now, ahead of the 3Q print, we are pulling back on our bearish stance on Dunkin’. Concerns remain, but we believe that the positive aspects of this story are sufficient to warrant the current valuation.
Takeaway: $MCD is facing difficult top-line compares through February. Despite the attractive 4% yield, we are staying on the sidelines - for now.
McDonald’s reports its 3Q results on Thursday before the market open. The sales results, and outlook, will likely drive the stock price reaction. Global growth slowing is a significant headwind for McDonald’s. We believe that September same-restaurant sales in the US grew in line, or slightly ahead of, what consensus is expecting.
Plenty Becoming Concerned About “Plenty To Be Concerned About”
The sell-side has gradually become less bullish on MCD since April 23rd, when we highlighted our concerns about the macro environment and lack of a new product pipeline in the US that could maintain sales momentum through the summer. We wrote that there was “plenty to be concerned about” for MCD going forward and saw JACK as a better long idea at the time. Six months later, we believe that we are nearing a point where MCD becomes attractive on the long side, but would reiterate our call to remaining on the sidelines through this print and for the time being.
We expect further negative revisions to McDonald's earnings estimates as several headwinds come into view. Difficult compares in the US for 4Q and 1Q, driven by strong underlying performance and favorable weather, and continuing macro headwinds in Europe, are the primary pillars of the bear case. We believe that there could come a point where, from a US sales perspective, consensus becomes too bearish. In general, McDonald’s finds a way to translate economic growth in the US into consistent sales and profit growth in its business by virtue of its omnipresence throughout the country and management’s continuing investment in the product pipeline and asset base. As the chart below indicates, industrial production has led the general trend of MCD US comparable sales growth over the last few years. This is not useful from a quarter-to-quarter perspective, but we use this metric when considering consensus expectations 6-12 months in the future. In conjunction with other analysis, we using this chart to ascertain if and when consensus becomes too bearish on McDonald’s trends.
Below we go through what we would view as good, bad, or neutral comparable restaurant sales numbers for McDonald’s three regions in September. For comparison purposes, we have adjusted for historical calendar and trading day impacts (but not weather).
Compared to September 2011, September 2012 has one less Thursday, one less Friday, one additional Saturday, and on additional Sunday. We expect this to have a positive impact on September’s headline numbers. On average, we expect the impact to be in the region of 1.5%.
United States – facing a compare of 5% including a calendar shift of +0.4% to +1.2%, varying by area of the world:
GOOD: A print above 3.0% would be received as a strong result by investors as it would imply calendar-adjusted two-year average trends in line with August. Additionally, following negative traffic in August with a sequential improvement to flat-to-positive guest counts would be encouraging. We are anticipating a print of 2.5-3.0% for McDonald’s US business in September.
NEUTRAL: Same-restaurant sales growth of 1.5-2.5% would be received as neutral by investors as it would imply roughly flat calendar-adjusted same-restaurant sales and traffic growth versus August. Consensus estimates misrepresent the true expectations of the sell-side, in our view, due to consistent outliers to the downside month after month. We think investors are anticipating a print of 2.5% versus 2.1% Consensus Metrix.
BAD: A headline comp of less than 1.5% same-restaurant sales growth would be negative for MCD, especially given that the company is taking roughly 3% price in the US.
Europe – facing a compare of 6.9% including a calendar shift of +0.4% to +1.2%, varying by area of the world:
GOOD: A print of more than 1% would be received as a strong result by investors as it would imply acceleration in calendar-adjusted same-restaurant sales growth from August to September. We expect continuing strength in Russia, the UK and France but, even in the event of an upside surprise versus consensus, we expect investors to proceed with caution where Europe is concerned. We expect a print of between 0-0.5% for McDonald’s Europe business in September.
NEUTRAL: A print of 0-1% would be a neutral result for Europe as it would imply trends roughly in line with expectations and would provide some reassurance of MCD’s ability to take share on an ongoing basis.
BAD: Negative growth in Europe for the month of September would imply the second such disappointment of 3Q. McDonald’s has not printed two negative months in the same quarter in Europe for 29 quarters.
APMEA – facing a compare of 6.8% including a calendar shift of +0.4% to +1.2%, varying by area of the world:
GOOD: Same-restaurants sales growth of 1.5% or more would be received as a good result as it would imply an acceleration in calendar-adjusted two-year average trends versus August. With the backdrop of negativity on China’s economic outlook, an acceleration in trends into the end of 3Q could be encouraging. We are anticipating a print of 1.0% for McDonald’s APMEA business in September.
NEUTRAL: A print between 0.5% and 1.5% would be considered neutral for investors as it would be roughly in line with consensus, per Consensus Metrix.
BAD: Below 0.5% would imply continuing weakness in calendar-adjusted two-year average trends.
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United Continental (UAL) faces margin pressure going forward into 2013 if it doesn’t do something about the pricing of airfares. The airline has seen fuel costs increase +8% year-over-year to $3.44/gallon for September of 2012 as well as a +6.5% increase in salary plus related costs year-over-year for Q2 2012. UAL has yet to pass many of these costs on to the consumer via ticket prices, which will ultimately put pressure on 2013 EPS estimates. With UAL facing a more competitive American Airlines, you can see why our Industrials coverage remains bearish on UAL.
Takeaway: Less than 3 trading days ago (after 6 consecutive down days), no one wanted to buyem. Now +2.3% higher, no one wants to sellem.
POSITIONS: Long Utilities (XLU), Short Industrials (XLI)
Less than 3 trading days ago (after 6 consecutive down days), no one wanted to buyem. Now +2.3% higher, no one wants to sellem.
Across my core risk management durations, here are the lines that matter to me most:
In other words, the risk range is widening – and that’s not a good thing, particularly if the VIX holds 14 for the umpteenth time in the last 5 years. If you ask anyone who is long Tech how the market feels (-3% for OCT), they see the risk more clearly.
Risk tends to be more clear in the rear-view,
Keith R. McCullough
Chief Executive Officer
On an apples-to-apples basis, we think we are below the Street.
Our Q3 EBITDA and EPS projection is $187 million (excluding pre-opening and Maryland lobbying expenditures) and $0.57, respectively. PENN management had previously guided to $0.55 which included pre-opening expense (estimated at $0.08) but excluded Maryland. On an apples-to-apples basis to management’s guidance, our estimate is $0.49. We believe consensus is somewhere below the guidance but above our estimate – again, on an apples-to-apples basis.
The whisper number is probably a slight miss. We’re not sure how much of a catalyst a slight miss would be so guidance may be the focus. We’re generally negative on domestic gaming. Recent results adjusted for seasonality have been on a sequential downturn. In other words, gaming revenue for the last three months have fallen below what the sequential trend, adjusted for seasonality, would’ve suggested. Even if PENN maintains Q4 guidance, that guidance would be at risk, in our opinion.
Of course, PENN management has done a fantastic job with margins so that cost side will be the wild card. We think most of the heavy lifting on cost cutting has been completed and it should be all about demand going forward.
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