“The world is changing very fast. Big will not beat small anymore. It will be the fast beating the slow.”
A friend of mine in Connecticut just sent me that quote. Like most of us on the East Coast, he’s up and at it early this morning. Risk happened fast. Now it’s time to slap on a pair of jeans, fire up our generators, and take on the day.
In The Signal And The Noise, Nate Silver calls out what physicist Didier Sornette alludes to as the “fight between order and disorder” (page 368). That fight isn’t new. However, through chaos theory, we are beginning to understand it more clearly.
Not unlike the world and its weather, I think about the Global Macro marketplace as one of interconnected factors that are colliding within a complex system. “Complex systems like this can at once seem very predictable and very unpredictable… they periodically undergo violent and highly non-linear phase changes from orderly to chaotic and back again.” (Silver, page 369)
Back to the Global Macro Grind…
For most things Big Beta, October was gnarly. We won’t know what the fallout looks like on the buy-side until it’s old news. But the new news is that buying high-beta stocks and/or commodities at the Bernanke Top of September 14th, 2012 left a mark.
That’s not to say there weren’t what perma-bull marketing pundits tried to sell you yesterday morning as a “hurricane Sandy buying opportunity.” You just need to be selective about what you buy and when.
In the US stock market alone, look at the S&P Sector performance divergences for October 2012:
- SP500 = -2.0%
- Financials (XLF) = +2.0%
- Utilities (XLU) = +1.4%
- Basic Materials (XLB) = -2.1%
- Technology (XLK) = -6.3%
Markets rarely make perfect sense to me but, from a research perspective, these Sector divergences did.
- SP500 = bearish TRADE and TREND, so pervasive weakness into month-end made sense
- Financials = that’s the 1st Sector you buy if you think Romney wins (his closing the gap was enough, for starters)
- Utilities = that’s the low-beta trade that we recommended downshifting to last month; we’re still long it
- Basic Materials = get the Dollar right (Romney momentum = anti Bernanke momentum), you get commodities right
- Technology = Growth and #EarningsSlowing (our Top Macro Theme for Q412) matters, in the end
Where to from here? Let’s start with the Hedgeye Asset Allocation Model:
- Cash = 58%
- Fixed Income = 21% (Treasuries, Treasury Curve Flatteners, German Bunds – we still like them all during #GrowthSlowing)
- International FX = 15% (Strong US Dollar, stick with it unless it becomes clear that Obama is going to win)
- US Equities = 6% (Utilities and Financials we think continue to work; buy them on red)
- International Equities = 0% (with markets like Russia moving back into crash mode (-19.1% since March) we’re in no hurry)
- Commodities = 0% (we’ve been calling it Bernanke’s Bubble since March – sticking with it)
The asset allocation model isn’t for everyone. It’s actually for me. It’s how I think about my own money and what I am willing to put at risk at a given time and price. Since I own a lot of Hedgeye stock, my Cash position is overstated. This is meant to be a product whereby I can signal when/where I’d be adding to or subtracting from big liquid asset classes, on the margin.
The most important principle in my decision making process is uncertainty. I embrace it every minute of the day and reserve the right to change my mind, fast. That’s not for everyone. And I get that. I also get that, sometimes, it’s better than being slow.
After all, that’s what Rupert Murdoch is alluding to in the aforementioned quote inasmuch as the world’s largest sovereign governments have been reminding you of, almost daily, for the last 5 years. While Too Big To Move can be a problem for you when you have an 80 foot tree hanging on power lines across your driveway, you still need to be fast to adapt and change.
Our immediate-term risk ranges for Gold, Oil (Brent), US Dollar, EUR/USD, UST 10yr Yield, Technology (XLK), AAPL, and the SP500 are now $1, $107.41-109.09, $79.56-80.39, $1.28-1.30, 1.70-1.75%, $28.29-29.44, $586-616, and 1, respectively.
Best of luck out there today,
Keith R. McCullough
Chief Executive Officer
Takeaway: Consensus BKW US & Canada same-restaurant sales estimates are very aggressive and Burger King's system remains "Too Big To Fix".
Burger King’s 3Q12 earnings per share beat consensus estimates by $0.02 but the myriad adjustments and one-time items muddied the waters. The company has been cutting its way to improved profitability but history tells us that this, as a sole driver, is unsustainable.
The performance in sales trends is what carries most weight for the Burger King investment thesis. On that metric, the outlook is uncertain. In the U.S., two-year average trends accelerated by 100 basis points, sequentially, from 2Q12 to 3Q12. The U.S. constitutes almost 60% of the store-base. As the charts below highlight, consensus is expecting a sharp acceleration in trends during the first half of 2013. Holding current two-year trends level suggests negative same-restaurant sales trends for 1H13.
Same-store sales slowed on a two-year average basis in Latin America and the Caribbean and Asia Pacific (18% of the store base); flat in Europe, the Middle East and Africa.
Outlook for Burger King
The overall BK strategy, according to management, is based on 4 pillars: Image, Menu, Marketing Communications, and Operations. Below, we outline some thoughts on these initiatives and the progress that was made on each during the third quarter.
Remodeling the store base is the core focus of the “Image” initiative. There was some good news in the quarter. The number of Burger King stores in the USA needing to be remodeled is shrinking, but it needs to continue shrinking. At the end of 3Q12, the system wide units had declined by 1% year-over-year and 0.2% sequentially. Also, management announced that they received new commitments to re-image more than 350 restaurants in the United States and are on track to reach our target of having 40% of the US and Canada system on a modern image within three years.
The bad news, from our perspective, is that they did not disclose how many units were remodeled during the quarter. The company outlined plans suggesting that almost 3,000 restaurants will be converted over the next three years. The implication is that the Burger King system, in the United States and Canada, needs $350 million in capital every year for the next three years in order to complete the re-image program.
During the earnings call, management stated that its “analysis of remodels completed to date continues to reflect an average sales uplift of 10% to 15%, providing an attractive return to franchisees.” Whether or not that target is achieved, even post-reimage Burger King store volume would be significantly below the competition.
Hedgeye Conclusion: We still believe that Burger King is “too big to fix”.
Management stated that it is “seeing tangible results from the strategy to balance targeted promotions in premium limited time offerings. This strategy is designed to shift our consumer profile and product mix, which we believe is key to driving positive, profitable growth for the BK system in the long-term … A key element of our strategy is to broaden the appeal of our advertising and bring a more diverse customer mix back into our restaurants. We saw further evidence of results on this front in our consumer segmentation data, which shows us that the change in marketing strategy has been successful and Burger King's mix of both women and customers age 50 or older increased.”
Hedgeye Conclusion: Changing the menu at this point, and focusing significant amounts of resources and energy on it, is putting the cart before the horse. It may require some attention to a degree, but is not going to lead Burger King to where shareholders want it to be. Emil Brolick, at a lunch hosted by WEN at the outset of his tenure as CEO, stressed the importance of improving his company’s asset base over menu items for sustained market share gains. We do not know any other QSR companies targeting customers 50 years of age and older and we think there is a reason why others are not focused on that demographic.
Management stated: “Our television advertising is increasingly focused on taste, which we think is a key differentiator for Burger King due to our flame-broiled grilling platform. This quarter, we used our advertising focused on limited time chicken offerings to create awareness around our broader chicken platform, including the Chicken Parmesan Sandwich, our new Popcorn Chicken, as well as wraps.”
Hedgeye Conclusion: Burger King stepped up media spending in 2Q and 3Q to unsustainable levels. We will see if the investment yields positive returns over the next few quarters but the current level of media spending will not continue.
Management stated: “Speed of service slowed marginally with the introduction of our new products in early Q2 but has improved in the subsequent months, as coaches and crews in the restaurants accumulated experience with the new platforms and product builds. Our average speed of service is likely to remain somewhat higher than some of our peers due to our made-to-order service model, but we still have more work to do to reduce wait times and improve training in connection with the new product roll-outs.”
Hedgeye Conclusion: Burger King’s service standards were significantly below the competitors before the introduction of new menu items. Now, it seems, relative performance on those metrics is getting worse. Adding complexity to the menu will likely impair any progress on this front.
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Takeaway: While the strategic and financial implications make a ton of sense – we see further upside from here.
After nearly a decade of speculation, the timing finally aligned for PVH to capitalize on WRC’s operating shortfalls through 1H. With a business over-indexed to Europe and WRC in search of a transformative deal, Manny Chirico (CEO) moved in earlier this summer sealing a deal just 8-months into Helen McCluskey’s tenure. The reality is that a combined PVH/WRC makes sense and initial accretion projections are likely conservative. This is a win/win for both as the 22% increase in aggregate market cap today suggests, but we see further upside with $10 in FY14 EPS on the horizon.
- Based on our estimates, Calvin Klein accounted for ~70% of WRC’s revenue base and ~80% of total EBIT. With the transaction valuing WRC at ~$2.9Bn and assuming a 5x EBITDA multiple for WRC’s Heritage businesses(Chaps, Speedo, and intimate brands Olga and Warner’s), the deal implies PVH paid a ~9.5x multiple for the CK business on FY12E estimates and under 8.5x FY13E pre synergies. This isn’t exactly a steal, but if you believe that WRC’s numbers are depressed, then it is attractive enough for a brand that has grown at a +13% CAGR at retail since it was acquired by PVH in 2003 and is expected to grow +8%-10% over the next 5-years.
- At risk of stating the obvious for a deal so widely expected, the strategic fit here makes sense given that WRC is PVH’s biggest licensee. Layer WRC’s core business over PVH’s infrastructure while complimenting each company’s regional strengths – PVH in NA and Europe, WRC in Latin America and Asia. Not to be overlooked is the ability for PVH to control the presentation of CK in its entirety at retail, which should help reignite a struggling ~$700mm CK Jeans franchise.
- With $100mm in costs targeted for elimination over the next 3-years as well as MSD-HSD revenue growth, PVH is looking to grow operating margins by nearly 50-75bps over each of the next 3-years.
- With $1.00 in EPS accretion by 2015 likely conservative, investors will start looking at FY14 EPS approaching $10.00. With margin expansion under the combined entity expected to drive a high-teens earnings growth rate over the next 3-years, we think multiple expansion is likely. However, even if we simply take the upper end of PVH’s historical EPS multiple over the last decade of 16x, we’re looking at a $160 stock over the next 12-24 months suggesting a 20%+ annual return even after today’s 18% move.
- Targeting early 2013 for closing the transaction.
Additional Highlights from the Call:
- WRC operating teams expected to stay on to operate various brands with headcount reductions expected to be primarily in back office
- PVH expects to pay debt down by $400mm/yr over the next 4yrs – focused on delivering as they did post Tommy deal
- Looking to finance the deal with a $4.324Bn financing commitment in the form of both bank financing and unsecured notes
- PVH will have more favorable leverage ratio post WRC deal (3.4x) than 2yrs ago when it bought Tommy (3.6x) – goal to get back down below 2.5x
- With this deal PVH hurdles RL in retail second only to VFC in revenues
- Deal shifts ~$100mm in WRC royalty revs to owned leaving a ~$170mm royalty base going forward
- Plan to leverage Tommy’s European expertise to drive stronger CK apparel presence in Europe beyond today’s $1Bn in revs
- Tommy growth opportunities via WRC’s Asia/Latin America presence upside to today’s plan – but don’t want to risk significant growth opportunity for CK by integrating Tommy too early (3-5yrs out)
- Operate a $200mm Tommy business in Latin America today and $600mm Tommy business in through licensing
partners that present an opportunity to integrate in the future
- PVH assuming Chaps license (RL) does note continue re its accretion assumptions – currently in discussions with RL about this now
- ‘no intention of selling it at this point’ – re strength of Speedo business.
- Though ~$400mm+ PVH could get for Heritage business could help toward delivering if need be
- WRC’s store growth plans under review. Underwear stores work, but would like to put underwear and jeans under same roof
In an effort to evaluate performance and as a follow up to our YouTube, we compare how the quarter measured up to previous management commentary and guidance
- Same: EBITDA fell short of expectations but could've been worse. Management commentary was very similar to that following Q2
- MIXED: Net revenues declined 4.1% YoY in 3Q due to lower casino revenues, largely resulting from a decline in trips. Property EBITDA grew 12% YoY due to decreased property operating expenses resulting from cost savings initiatives and lower property tax assessments.
- "The Atlantic City region, as you're well aware, has been challenged for a number of years and continues to be challenged. However, the growth decline in that region has started to mitigate and, as we move forward with the annualization of Aqueduct and the annualization of Revel, we would expect that to continue to improve."
- "Our margins at Atlantic City are under tremendous pressure as revenues continue to decline. Many of the properties there operate unprofitably for reasons that are very hard to understand. And so, we continue to look at all manners of adjustment we can make to try to keep our operating expenses as low as possible."
- MIXED: While net revenues were slightly higher, property EBITDA fell 5% YoY because of the increase in property operating expenses. Also, CZR estimates that the negative impact caused by Project Linq construction activities reduced EBITDA by ~$5-10 million. Spend per trip increased 7.8%, due primarily to strength in the international high-end segment. Promotional allowances were also higher.
- PREVIOUSLY: "It's one of the challenges in this business, we're still facing the same number of guests, we're servicing the same number of visitors, putting them to bed, waking them up, parking their cars and alike, but the amount of revenue we enjoy is a bit diminished from that. And there is no reason that I can see in the immediate future that would suggest the general macroeconomic conditions that have led to that results are going to be much different."
- SAME: Horseshoe Cincinnati is planned to open Spring 2013
- PREVIOUSLY: "Horseshoe Cincinnati is well under construction. That's going to open at the end of the first quarter or early into the second quarter."
LAS VEGAS ROOM RENOVATION
- SAME: The renovation of Imperial Palace was estimated to have reduced net revenues by approximately $10 million to $15 million. CZR expects meaningful ADR improvement when all the renovations are done.
- PREVIOUSLY: "We are going to renovate a large number of rooms next year in Las Vegas. If you were to ask, where we've cut back on maintenance capital for the last few years, it's really been in Las Vegas and it's primarily been in the room renovation category. So next year, we're planning to do a significant number of rooms, probably touching nearly all of the properties themselves. There will be a significant renovation at Caesars Palace of 550 rooms."
- SAME: Harrah's Baltimore is proceeding with plans to open a gaming facility in Baltimore in the middle of 2014.
- PREVIOUSLY: "The State of Maryland's Video Lottery Facility Location Commission granted a license to our consortium, paving the way for us to begin building Harrah's Baltimore, which will feature 3,750 VLTs. The consortiums are beginning to seek necessary permit and construction is likely to begin in 2013 with an opening targeted for the second quarter of 2014."
HARRAH'S ST. LOUIS CLOSING DATE
- SAME: CZR expects to close the acquisition in 4Q.
- PREVIOUSLY: "We also announced that sale of Harrah's St. Louis, which we expect to close by the end of year."
GROUP CONVENTION BUSINESS
- SAME: 4Q won't see much difference from 3Q but CZR is encouraged by 2013 and 2014 trends.
- PREVIOUSLY: "I think the general trend remains favorable.... I doubt that much of that is going to change in the remainder of this year, but I think as we look forward to 2013, I think it's likely to be a little bit more encouraging."
CZR 3Q CONF CALL NOTES
"Thanks primarily to growth in our interactive operations and a continued emphasis on expense reductions, we achieved about the same net revenues and Adjusted EBITDA as in the third quarter of 2011, despite more competitive markets and the challenges posed by the continuing weakness of the U.S. economy. Reflecting the sluggish economic conditions, customer visitation declined in all regions and spend per trip declined in several regions. However, Las Vegas saw a nearly 8% increase in per trip customer spending and Iowa-Missouri and Louisiana-Mississippi experienced modest increases in spend per trip."
- Gary Loveman, Caesars Entertainment chairman, chief executive officer and president
CONF CALL NOTES
- AC properties are closed but none of them have suffered material damage. Hope to reopen in the next several days.
- PA reopened this morning
- They do not expect to exceed their deductible insurance
- Will convert Bill's Gamblin' Hall and Saloon property into a boutique lifestyle hotel
- Pursuing a plan to attract more mid-week meeting business by constructing a convention center. Will seek financing from the city.
- Enhancing their Caesars.com website to help with online bookings
- Very active in using social media as a marketing tool and are expanding mobile applications onsite
- Horseshoe Cleveland: welcomed over 2MM members since opening
- MA: preparing their JV bid with Suffolk Downs
- Focused on gaming legalization in several states
- LV: Cash ADR decreased by 2.2% with occupancy in the mid-90s
- AC: Benefited from lower property taxes and margin improvements through cost saving initiatives
- 250 rooms that were out of service at their Biloxi property that have recently reopened
- Booked estimates of the St Louis divestiture. The prior estimate needed to be adjusted and they booked the adjustment this Q. The Region would still have been slightly EBITDA positive without the adjustment.
- Group business in 4Q12 in LV? Doesn't think that they will see a large difference in the 4Q vs. 3Q
- They are looking to sell the golf course in Macau; any proceeds need to go to CEOC.
- Capex guidance: $520-560MM for 2012. 2013 will have higher capex than 2012 - a lot in Las Vegas
- Cash outlays for Baltimore will not be significant
- High end strength in LV on the international side but promotional expenses were also higher. Generally, reinvestment in the high end international are higher than other players, but in this quarter the two are not correlated.
- Managed category increase is due to Cleveland. Employees are CZR's employees - they book revenue and expenses there and will have the same treatment for the other Ohio properties.
- Did hold have any meaningful impact on the quarter? No.
- They are trying to staff much more efficiently to compliment demand patterns
- Experienced $50.8MM of cost savings in the Q and identified $204.3MM of future cost savings (marketing efficiencies, tax strategies)
- Did not buy back any debt in the quarter
- Expect an increase in ADRs post room renovations in LV
- Feel like they are close to a CFO hire
- Have nothing to announce on the London Clubs
HIGHLIGHTS FROM THE RELEASE
- Trips across all regions decreased in the third quarter of 2012 when compared with the same period in 2011, resulting in a decline of 4.9% on a consolidated basis, due mainly to economic and competitive pressures as well as hurricane-related property closures in the Louisiana/Mississippi region in August 2012. The overall increase in spend per trip in the third quarter of 2012 was attributable to a large increase in the Las Vegas region due primarily to strength in the international high-end segment, as well as modest increases in the Iowa/Missouri and Louisiana/Mississippi regions
- In August 2012, we issued $750 million in new debt due 2020, with proceeds used to refinance debt maturing in 2014 and 2015 and to increase liquidity. In conjunction with this transaction, which closed in October, we extended the maturity of approximately $958 million of term loans from 2015 to 2018 and beyond, and repaid approximately $479 million of term loans under our credit facilities.
- Challenging macro conditions and new competitors negatively impacted some of their regional results. Our consortium with Rock Gaming and others is proceeding with plans to open a gaming facility in Baltimore in the middle of 2014, and we will apply for a license to build a full-scale gaming-destination resort in Boston in an alliance with Suffolk Downs. We've also begun booking meetings and conventions for the spring 2013 opening of the new $450 million. Horseshoe Cincinnati being developed by Rock Ohio Caesars LLC, a joint venture in which we have a 20% ownership interest."
- "During this quarter, we expect to complete the previously announced sale of Harrah's St. Louis for $610MM and plan to use the proceeds from the sale to reinvest in our core properties and invest in growth opportunities. One example is our anticipated renovation and rebranding of the Imperial Palace, which we are renaming The Quad. We expect to upgrade significant portions of that property, including the casino, public spaces and guest rooms. The reconfiguration of the casino and its entrances will enable direct access from the Linq and make the Quad what we believe to be one of the most easily accessible casinos on the Strip."
- "Increased casino revenues were mostly offset by decreases in food and beverage and other revenues combined with higher promotional allowances."
- "Revenues rose slightly, despite the negative impact on results caused by Project Linq construction activities, including the closure of O'Shea's casino in May 2012, the closure of several retail outlets at Harrah's Las Vegas and the ongoing renovation of the Imperial Palace, which the Company estimates to have reduced net revenues by approximately $10 million to $15 million."
- "Trips were relatively flat, while spend per trip increased 7.8%, due primarily to strength in the international high-end segment."
- "Hotel revenues in the region were relatively flat.... due in part to the 662 additional Octavius Tower rooms, offset by a decrease in cash average daily room rates...and a decrease in total occupancy."
- Revenues decreased "due mainly to lower casino revenues, largely resulting from a decline in trips. Trips by lodgers and non-lodgers declined 4.5% and 5.1%, respectively...due mainly to new competition in the region. Spend per trip for lodgers and non-lodger decreased 2.8% and 4.1%, respectively."
- "Expects the market to continue to be challenged by local and regional competition."
- "Property EBITDA increased ....due mainly to decreased property operating expenses resulting from cost savings initiatives and lower property tax assessments"
- "Revenues were negatively impacted by the closures of two casinos in the region as a result of Hurricane Isaac in August 2012, which contributed to a 6.2% decline in trips."
- "Loss from operations was $183MM... non-cash intangible asset impairment charges of $176.0 million, as well as a non-cash tangible asset impairment charge of $13.0 million and a $20.2 million charge for exit activities related to the halted development project in Biloxi, Mississippi."
- "Estimates that the negative impact of Hurricane Isaac on its income from operations and Property EBITDA was approximately $4 million"
- Revenues declined "due mainly to a decline in casino revenues resulting from new competition in the Kansas City market"
- "Income from operations and Property EBITDA increased... due mainly to a reduction in property operating expenses resulting from the refinement of estimates of costs remaining in the discontinued operations of the Harrah's St. Louis casino as a result of the imminent closing of the transaction."
- IL/ IN:
- "2012 net revenues... increased slightly. Spend per trip declined while increased competitive pressures in the region resulted in fewer trips, despite the reopening earlier this year of the bridge that allows direct access by customers to the Company's Southern Indiana property, which closure affected the property starting in early September 2011."
- "Income from operations for the third quarter of 2012 increased... due mainly to higher revenues together with reduced property operating expenses as a result of cost savings initiatives. The increase in Property EBITDA reflects higher revenues and reduced property operating expenses"
- Other Nevada:
- 3Q net revenues decreased ... "due mainly to a decline in casino revenues. Trips to the properties in the region, as well as spend per trip, declined... due to local competitive pressures, and the Company expects the market to continue to be challenged."
- "There was a loss from operations of $75.2 million..... due mainly to non-cash intangible asset impairment charges of $103.0 million."
- "Property EBITDA decreased slightly... due mainly to the income impact of lower revenues, partly offset by reduced property operating expenses."
- Managed, International & Other
- "Net revenues ....increased.. 40.3%... due primarily to higher revenues associated with the Company's growing interactive operations. Net revenue increases were also attributable to the opening of a new managed casino, Horseshoe Cleveland, which began operations in May 2012, including an increase in reimbursable expenses for Horseshoe Cleveland that is presented on a gross revenue basis, thus resulting in an increase in net revenues and an equally offsetting increase in operating expenses."
- "Loss from operations increased.... due mainly to non-cash intangible asset impairment charges of $124.0 million... and increased corporate expenses. Increases in corporate expenses were attributable to the consolidation of certain functions at corporate, and increased stock-based compensation expense."
- "Interest expense, net of interest capitalized, increased by $65.4 million, or 14.5%... due primarily to higher interest rates as a result of extending the maturities of the Company's debt combined with higher debt balances compared with the year-ago quarter, and a $66.2 million decrease in mark-to-market gains on derivatives resulting from $6.2 million of gains in 2012 compared with gains of $72.4 million in 2011, partially offset by $33.9 million of lower amortization of deferred losses in accumulated other comprehensive loss.
- Capitalized interest in 3Q: $9.5MM
"The effective tax rate benefit for the quarter ended September 30, 2012 and September 30, 2011, was 30.8% and 29.6%, respectively. The reason for the increase in the quarterly rate at September 30, 2012 is that the negative impact to the 2012 rate, which is primarily caused by nondeductible goodwill impairments, was relatively less than the negative impact to the 2011 rate, which was primarily caused by nondeductible foreign losses and nondeductible losses on company-owned life insurance policies"
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