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Crude Oil Differentials

For October/November, water-borne light, sweet crudes (Brent, LLS, ANS) continue to trend higher against WTI, and regional crudes (Bakken, Midland, Syncrude, WCS) have traded away from WTI since mid-September. Wide differentials could persist in 4Q12, but we expect them to tighten across the board in 2013.

 

Crude Oil Differentials  - CRUDEoiltypes


JCP: War Pending in the Mall

Takeaway: Owning this name means waiting for the new stores to outweigh the old stores in quantity. Let’s hope the balance sheet lets it get there.

What Everyone Will Say: Results severely missed expectations. Comps down 26%, Internet sales down 37%, and margins off by -1237bps. Adjusted earnings showed a loss of $0.93. Management seems to have a very good sense as to where things went wrong, but not necessarily a good strategy to fix things anytime soon. The video of the new store concept looked great, and shows a transformed JC Penney into jcp, but it will take time to rollout en masse until newco outweighs the size of JC Penney.


What We Say: We did not like the stock the day Johnson started, and we don’t like it today. In fairness, this weakness was worse than even our model by a factor of 2x. We expected better, but are not surprised. Here’s are our low/highlights…

  1. We liked the fact that Johnson was more humble compared to a flat-out arrogant 2Q conference call (when he said he is missing Analysts targets, not His, just 2 quarters after spoonfeeding the Street).
  2. But unfortunately, it took the form of RJ going through his ‘Learnings’, which were really nothing more than realizations of factors that he should have known about this business before he took the job.
  3. The biggest Learning was ‘pricing’ in that when he offered lower prices, consumers responded in both traffic and conversion. When they held firm with a higher price, both metrics suffered. Sounds basic enough, huh?  unfortunately, it took a year to understand.
  4. If we were locked in a dark room and could see only one statistic about a company’s performance (aside from the stock price) it would be e-commerce sales. The simple fact that .com was down by 37% -- a sequential erosion – is just sad. One part of e-commerce is being operationally sound to handle consumer demand through a different, and more profitable, channel. But another is actually having consumers that care about the content in the first place. JCP has done a great job in driving consumers away, and it is going to take more than free haircuts to get people back shopping. It is going to take repeated positive experiences – which will take years to play out over a base of 1,100 stores.
  5. Johnson noted again how ‘this is a Journey’. We don’t want a Journey. We want a business that will take share profitably, and return capital to shareholders at a greater rate than other retailers.

JCP: War Pending in the Mall - JCP remodels

 

6.  Cash flow from operations for the year is -$655mm, JCP’s net debt to equity is sitting at historical highs of 0.67x, and we’re staring down the face of a FASB-mandated accounting change to capitalize operating leases that could inflate JCP’s balance sheet further to a point where borrowing capital to fund its transformation could become very difficult. Ultimately, JCP is likely to charge ahead, but would have to sell assets in order to do so. It’s already made the easy sales. Future ones are going to be less favorable economically.

7.  On that note, RJ stepped into dangerous waters when he started to call JCP a specialty store yet compare it to mall owners Simon, GGP, Macerich and Taubman. That was odd, to say the least. He followed up later to a question about specialty store productivity (which is $300-$400/square foot). He admitted then that jcp will be a specialty store, but with department store productivity.

 

The punchline here is that the call has not changed from last summer. Johnson is operating on a 7 (now 6) year duration. That’s when he gets paid. Wall Street largely cannot wait that long. Until then (and possibly after) we still are not sure that JCP will ever see an earnings number over $2.00. Trying to gage earnings this year is a Hail Mary. And either way you come up with a negative number. P/E valuation is meaningless. But with it its current debt burden and lack of cash, we’re looking at an EBITDA multiple near 10x. That’s just flat-out bad. At some point, this stock will look interesting as the shops gain traction, but that will be a long time from now, and until then we can point to nothing that should make it go up from $20. We think that JCP will create a massive headache for companies such as Macy’s, Gap, and Kohl’s as it takes up its product mix. The rationale is that regardless of JCP’s success, 100% of the product is being sold through. It just depends on the price, and therefore gross margin.

 

 


WEN CARDIAC ARREST

Takeaway: Looming risks facing the Wendy's system make the stock unattractive to us on the long side.

We’ve outlined our concerns about Wendy’s cash flow, given the years of intensive capex required to fix the system, since the analyst day back in January when the price tag of the turnaround ($3.7 billion) was brought to light.

 

 

Thoughts on the Quarter

 

We expect fixing the Wendy’s system to take another two years.  Years of deferred capex has turned the company’s store base from an asset into a brand liability.  It has taken CEO Emil Brolick the better part of a year to get the upgrade cycle going.  As things stand, the vast majority of the initiative remains to be done.  The company is working frantically to reimage stores in order to produce data and assure the investment and franchisee communities of the initiative’s viability. 

 

The desire to demonstrate results is a positive but, on the other hand, it also implies an accelerating pace of spending and an increasing risk of earnings misses.  Yesterday’s earnings announcement was mixed, at best, as operational metrics came in light besides same-restaurant sales.  This company, by any conventional measure, is not producing free cash flow and likely will not for the next two years.

 

The comps during 3Q have vindicated management’s recent introduction of new menu items to increase consumer appeal.  However, Brolick has emphasized the long-term importance of the asset base upgrade for gaining full credit from consumers for the upgraded menu.  Where same-restaurant sales are in the fourth quarter is the key question for investors as the company laps the introduction of the Dave’s Hot ‘N’ Juicy Cheeseburger in October 2011.  It is a strong possibility that comps are negative in 4Q with consensus expecting +1%.

 

WEN CARDIAC ARREST - wendy s earnings recap

 

 

Nothing Better To Do With Cash?

 

The biggest concern from the earnings release, for us, was the doubling of the dividend and a new $100 million share repurchase program.  The board seems to be throwing money at the stock in order to support the share price which has been flat-lining for five years now.  An owner of the stock yesterday was happy to learn that the dividend was going higher but the truth is that the company does – or should – have a better use for its cash. 

 

WEN CARDIAC ARREST - wen cardiac arrest

 

 

Near-Term Uncertainty for Franchisees

 

Management announced a franchisee incentive program to get the larger, better-financed franchisees on board with the reimage program.  As an observer, it’s difficult to know how the impact of these initiatives will play out over the near- and intermediate-term.  As management has alluded to, the transformation of the Wendy’s brand will involve substantial turnover among the franchisee base.  The journey from “mom and pop” franchisees to “mega” franchisees will, we believe, have a positive impact on the long-term health of the Wendy’s system.  It is worth bearing in mind, however, that these transitions rarely occur without a hitch. 

 

There are other factors, on the macro and micro level that are adding to franchisee blood pressure.  On the macro side, Obamacare, commodity prices, and the fiscal cliff and its myriad possible consequences from a tax and economic perspective are weighing on the minds of operators.  On the micro level, there has been some discontent among smaller franchisees at the level of investment required of them to partake in this (largely unproven) reimage initiative. 

 

While we believe management can allay the micro-level concerns, the macro issues are unknown but could be especially meaningful for a company, like Wendy's, that is in transition. Our industry contacts continue to state that the implementation of Obamacare will be a negative for the restaurant industry.  Franchisee communities which operate on thin margins, like Wendy’s, are particularly vulnerable. 

 

 

The Latent Risks of the Franchised Business Model


In June, we held a conference call with John Hamburger of the Restaurant Finance Monitor and discussed the general perception of franchised companies as stable cash flow generators and the premium multiple that investors award the stock of such companies.  Shares of BKW, DIN, DNKN, MCD, WEN, YUM & DPZ are some of the most richly valued in the restaurant space. 

 

It makes intuitive sense to award a higher multiple to the shares of franchised companies but an important caveat is the prospective health of the constituent franchisees.  Yesterday, Wendy’s stated that the impact of the healthcare overhaul will be “less than” (read: “around”) $25,000 per store.  Assuming the company-franchise mix of ownership remains as it is, we calculate that Wendy’s could be facing a $0.10 hit to earnings per share.   Given the company and franchisees’ need to reinvest in the business, it is important to look at the impact on franchisee cash flow.  The impact of this new cost may amount to as much as 18-20% of store level cash flow for a ten-unit franchisee. 

 

WEN CARDIAC ARREST - obamacare unit econ impact

 

 

The looming impact of this, and other risks, is adding a real sense of urgency to the Wendy’s reimage initiative.  For those taking a shorter-term view of the stock, accelerating spending during such an uncertain time implies a higher risk of earnings disappointments.   

 

Howard Penney

Managing Director

 

Rory Green

Analyst

 

 


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Manheim Index Under Pressure?

The Manheim Index of Used Car Values rose in October by 1% on a month-over-month basis, an improvement but is still trending negative on a year-over-year basis. As of November 1, new vehicle inventory levels have been below 60 days (on a 12-month rolling basis) for the longest period ever. Low inventory in new auto sales means there’s a strong market there, putting pressure on used car sales.

 

Manheim Index Under Pressure?  - Manheim Index vs SPX normal

 

Why do used car sales matter? Because the Manheim Index historically correlates closely to the S&P 500 and financials (XLF). Pressure on the used car market could be a harbinger for things to come in the broader market.

 

Manheim Index Under Pressure?  - Manheim Index vs XLF normal

 

Manheim Index Under Pressure?  - Manheim Vs SPX normal


TUMI: How Low Can You Go?

Tumi Holdings (TUMI) looks weak right now and with the broader market selling off, it’s tempting to jump in and buy it. It’s important to note that TUMI just fell below its critical level of support at the TREND duration; we don’t see any support until the $17 level, so if you’re able to put temptation aside, you can likely snap up TUMI at a much lower price.

 

TUMI: How Low Can You Go?  - tumi


Buying On Red

Client Talking Points

Buy 'Em

The old adage of “buy on the low, sell on the high” still rings true these days. At Hedgeye, we’re buyers when the market is tanking and people are forced to sell. Basically, you’re in one of two camps: you’re either holding a lot of cash or you’ve got a buy list with names you’re ready to pick up on market weakness. We’re in the latter camp and today, we’ll be looking to pick up a few new names. We have a process and we stick to it. Right now, our signals are suggesting we buy stocks and sell bonds, so we’re going to go forward and do just that.

 

Think back to the 2000 bubble when it popped and everything went from triple digits to single digits in a matter of weeks (or delisted entirely). Those who took out their proverbial wallet and started buying on the low did what was right and generated a profit more than likely. It’s the same thing here, courtesy of post-election cynicism that has investors all riled up.

The Name's Bonds

Skyfall and 007 aside, the recent bullish bias in bonds has been quite obvious over the last several weeks with our Growth Slowing theme building day by day. With the 10-year Treasury only offering a yield of 1.61%, we think bonds are overbought here and the time is nearing to sell ‘em like you mean it. 

Asset Allocation

CASH 55% US EQUITIES 6%
INTL EQUITIES 0% COMMODITIES 0%
FIXED INCOME 24% INTL CURRENCIES 15%

Top Long Ideas

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HCA

While political and reimbursement risk will remain near-term concerns, on the fundamental side we continue to expect accelerating outpatient growth alongside further strength in pricing as acuity improves thru 1Q13. Flu trends may provide an incremental benefit on the quarter and our expectation for a birth recovery should support patient surgery growth over the intermediate term. Supply costs should remain a source of topline & earnings upside going forward.

Three for the Road

TWEET OF THE DAY

“Becky is grilling a $JCP analyst right now on Sqwawk. Sad to see people defend a name like this.#Sinking_ship.” -@HedgeyeRetail

QUOTE OF THE DAY

“Ambition is a poor excuse for not having sense enough to be lazy.” -Edgar Bergen

STAT OF THE DAY

JC Penney Q3 Same Store Sales fall 26.1%


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