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Will We See 6.5% Unemployment in 2013?

Takeaway: It won’t take extraordinary improvement in the factors that drive the unemployment rate to take it below 7% by year-end 2013

As global macro data continues to confirm that growth is stabilizing, we’ve been discussing the possibility of seeing a 6-handle in the unemployment rate in 2013.   With Bernanke offering an explicit employment target of 6.5% for a cessation in QE initiatives, a significant decline in unemployment over the NTM may augur higher yields as the bond market attempts to front-run a prospective Fed exit.  


With market expectations for rates likely to follow the slope in unemployment rather than the actual realization of a 6.5% unemployment rate, we attempted to put some math around how the principal variables driving the Unemployment rate would have to trend for Unemployment to breach the 7% threshold over the next twelve months.  Below we include a quick review of the variables driving the unemployment rate, the summary conclusions, and some other considerations as it relates to the go forward dynamics likely to directionally impact unemployment.   


Of course, Bernanke could effectively hold the exit timeline hostage by again changing the rules mid-game and attaching conditions that a the sub-6.5% unemployment rate be accompanied by a “normalized Labor Force Participation Rate” or a “sustained, negligible output gap”.  We’ve ignored this potentiality here as its largely unmodelable and because the bond market could well move ahead of the Federal Reserve realizing their growth forecast batting average isn’t going to improve from 0%.  


Note that rather than attempting to provide an explicit year-end or 7% unemployment target date, the broader goal of this risk management exercise is to frame up the variable dynamics and quantify the magnitude of change in the relevant unemployment rate drivers necessary to take unemployment below 7.0% and towards 6.5% over the NTM.  Certainly, any number of variable assumptions and scenario iterations can be contemplated.  If you’d like to observe the impact of your own growth and participation rate assumptions on the unemployment rate timeline you can link to the associated model here >> Unemployment Rate Variable Analysis_HEDGEYE



UNEMPLOYMENT 101 - THE VARIABLES:  Below is a summary review of the variables that drive the unemployment rate.  Here, we’ve broken them down into the Input and the Dependent variables based on how we model them.   


Independent/Input Variable Description:

  1. Civilian Non-institutional Population Growth (CNP): The CNP represents persons 16 years of age and older residing in the 50 States and the District of Columbia who are not inmates of institutions, such as penal and mental facilities, and homes for the aged, and who are not on active duty in the Armed Forces.
  2. Employment Growth:  Growth in Employed workers as measured by the BLS Household (CPS) Survey.
  3. Labor Force Participation Rate (LFPR):  Represents the Civilian labor Force as a percentage of the Civilian Non-institutional Population.  Equal to the sum of employed & unemployed workers. 


Dependent Variables:

4. Total Labor Force:  The Civilian Labor force is a product of the Civilian Non-institutional Population & the labor force participation rate

5. Unemployed Workers:   The total number of unemployed workers is the difference between the Labor Force and total employed workers. 


Unemployment Rate = the number of unemployed workers as a % of the Total Labor Force (i.e. the sum of employed and unemployed workers)


So, assumptions need to be made for the growth in the Civilian Non-institutional Population (CNP),  growth in the number of Employed Workers and the Labor Force Participation Rate (LFPR).  The Total Labor Force and the Total Number of Unemployed become a function of the three input variables and the direction in the unemployment rate is determined by the participation rate and the delta between CNP growth and growth in the employed.    



The CONCLUSION:  Can we get 2 out of 3?

In the chart below we provide a timeline view of the 2013 Unemployment Rate under a selection of scenarios.  Obviously, any number of iterations can be envisaged with respect to growth rates and interaction between the principle drivers of the unemployment rate but, in general, 2 of the 3 variables need to trend positively with respect to the unemployment rate for a move to 7% and below to be a 2013 event.  


It’s notable that the NTM moves don’t have to be extraordinary for this to occur.  For example, scenarios in which Employment growth accelerates 30bps (2Y basis) on average in 2013 and CNP growth declines linearly to the historical average over the NTM or the Labor Force Participation rate continues to decline at the 3Y CAGR both result in a move to/below the 7% unemployment level in 4Q13. 


If, however, positive acceleration occurs in just a single variable while the other two flat-line or trend negatively, the timeline for <7.0% unemployment extends significantly.  For example, if employment accelerates 50bps (2Y basis) on average in 2013 while Labor force participation remains static at the current level and CNP growth holds at the current rate, the implied unemployment rate would reach a 2013 low of 7.3% in December. 


In terms of thinking about the directional trend in the relevant variables – with housing continuing to accelerate, the domestic jobs data continuing to trend positively and our #growthstabilzing theme extending itself, we could make a credible case for seeing a modest acceleration in employment growth.  Given that growth in the civilian non-institutional population generally tracks population growth in the 16YOA+ cohort over the longer term and that volatility in active duty military status should be more subdued going forward, the assumption that CNP growth decelerates towards population growth probably represents the baseline case. 


The Labor Force participation rate, and the structural and behavorial psychology dynamics underpinning it, remains the largest wildcard.   The consensus logic goes that in a typical recovery, economic growth and employment growth drive renewed worker interest in employment in a reflexive fashion.  Discouraged workers, who are not currently seeking employment and are not included in the Labor force totals, again begin to actively seek employment.  To the extent that growth in workers coming back to actively look for work outpaces actual employment gains, the unemployment rate is negatively impacted despite the improved economic conditions/outlook.  Here, the transient increase in the unemployment rate would belie a positive economic inflection.


The current situation is complicated by the fact  that despite the ongoing, albeit tepid employment recovery, the resurgence in job seeking, which typifies the back end of business cycle slowdowns, has yet to materialize and the LFPR continues to slide.  Whether this behavioral dynamic continues and to the extent that structural unemployment/length of unemployment is a contributing factor remains an unknown.    Also unknown is the extent to which protracted fiscal policy uncertainty (Health Law, Fiscal Cliff, Budget Control Act/Sequestration, etc) has dragged on employer hiring decisions.  Regardless of the outstanding questions, labor force participation will continue as the real wild-card variable to watch relative to its impact on the unemployment rate.


Will We See 6.5% Unemployment in 2013? - Unemployment Scenario Analysis


Will We See 6.5% Unemployment in 2013? - 16YOA Population Growth


Other Considerations:

  • Annual Benchmark Revision:  the Census Bureau applies an annual population control adjustment to the Civilian Non-institutional Population alongside the January release every year.  Historically, the magnitude of the January adjustment has ranged from tens to hundreds of thousands or even millions of individuals.  An outsized revision to the January 2013 data could shift the unemployment variable dynamics from their current trend.
  • Employment – Growth Connection:  The historical frequency distribution for Employment and growth suggests we’d need to see #growthstabilizing transition to growth accelerating for a concurrent acceleration in employment to manifest.  While employment growth could run ahead of economic growth at the onset of a recovery, historically, employment growth >2% is typically associated with real GDP growth north of 3%.  We show the historical relationship between real GDP Growth  and y/y employment growth as measured by the BLS’s Household Survey below. 
  • Energy/Commodity Inflation:  In our 1Q13 themes call we highlighted the top 3 risks to #growthstabilizing as 1. Rising Oil Prices 2. Japan & 3. Earnings Slowing.  As it relates to risk #1 - as of this morning, both Brent and WTIC have re-captured their respective long-term TAIL risk lines of $92.04 and $111.48 support.  A continued reflation in oil and commodity prices broadly represents a real time tax on consumers, an input cost related margin drag on business, and a material headwind to growth accelerating from here.  


Will We See 6.5% Unemployment in 2013? - Employmet vs GDP Growth


Will We See 6.5% Unemployment in 2013? - Employmet vs GDP Frequency Distribution



Christian B. Drake

Senior Analyst 


Visitors Down In Macau?

Visitor arrivals in Macau declined 2.0% year-over-year for December 2012 to 2,495,851. For the entire year of 2012, visitor arrivals increased a tad by 0.3% year-over-year to 28,082,292. Visitors from Mainland China increased slightly by nearly 1% to 1,495,316 for the same time period. The more visitors, the better the hold for the casino operators like LVS, WYNN and MPEL.


Visitors Down In Macau? - visitation1

Heinz Wants to have its cake and eat it too

The press release from Heinz (HNZ) this morning is reasonably straight forward, but doesn't sit well with us – it reads more like a commercial than a financial release (“Foodstar has delivered excellent results and has performed well beyond our expectations since joining Heinz.”)  The meat of the release is that HNZ owes an incremental $60 million earn-out payment related to its acquisition of the Foodstar business in China back in November of 2010 – the original purchase price was $165 million.  The earn-out will be treated as an extraordinary item, resulting in a $0.04 charge in the upcoming quarter.

Just to review, Heinz made this comment regarding Foodstar at a conference back in September of 2011:


“Approaching $150 million in FY12 expected net sales.”


Shortly after making the acquisition (February 24, 2011), HNZ commented


“Expecting >$100 million sales in FY12.”


Today, HNZ said:


“The business has grown to well over $200 million in sales.”


So it seems that sales have approximately doubled since the purchase, while the purchase price has gone up by approximately 40% - good stuff.  We have a couple of issues, however.

  1. As mentioned, the press release is highly promotional
  2. Why is the incremental cost treated as extraordinary?

It appears to us that HNZ wants to have its cake and eat it too - get the benefit on the top line and to EPS, but have the cost broken out as an item.  To be clear, the accounting treatment is correct, but it just doesn’t sit well with us, nor does the highly promotional nature of the press release. Keeping with the food metaphors, it seems like the company is positioning itself for a free lunch.


Bottom line, HNZ remains one of our least preferred name in staples.


Call with questions.


- Rob

Robert  Campagnino

Managing Director





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IGT: Still On The Top

After reporting solid fiscal Q1 earnings, International Game Technology (IGT) remains one of our top long ideas in gaming. Our full fiscal 2013 estimate goes from $1.26 to $1.30; we believe our thesis on IGT remains intact: strong EPS grwoth, stabilized market share, better capital deployment (which will lead to a higher return on investment) and a cheap valuation.


IGT: Still On The Top - IGT

MCD: An Espresso-Based Conspiracy Theory

The Street believes that we are close to an inflection point and that McDonald’s sales trends will bounce right back.  If you were reading only the today’s headlines from the McDonald’s 4Q12 earnings release, there are some signs of hope. 


However, with USA same-restaurant sales up 0.3% in 4Q12 and company operating margins down 150bps it would appear that there are other operational issues rooted deeper in the company results.  Global same-restaurant sales trends are expected to be negative in January.  If US trends are also negative, domestic company margins may compress further in 1Q13. 


The real key to driving sustainable top line sales and margin improvement will be running efficient stores.  We continue believe that management needs to address some operational issues that are having a negative impact on store-level margins.  The following note goes through the rationale behind our contention that operational changes need to take place for the US business to get back on track.



Historical Context


McCafé was first launched in Melbourne, Australia in 1993.  It reflected a growing consumer trend toward espresso-based coffees.  In the USA, Starbucks was changing the coffee landscape in the USA, educating the consumer about higher quality coffee and espresso-based drinks.  Bringing McCafé to the USA was the brainchild of Charlie Bell (an Aussie) who was brought in to be CEO following the death of Jim Cantalupo.  Sadly, Mr. Bell died in January 2005 shortly after being appointed as the first non-American to lead the company. 


McDonald’s first started testing McCafé domestically in the Chicago area in May 2001.  The program was designed to take on the growing competitive threat of Starbucks and, later in the decade, the potential incursion of Tim Hortons.  The Starbucks impact went well beyond the coffee and brought to life the theory of the “third place” or “a café” setting.  It was a place to a have a pastry and read the paper or, as it now turns out, connect to the internet. 


In the 2001-2003 timeframe, McDonald’s saw the new Starbucks business model as one factor in its own same-restaurant sales declines.  Complicating matters for McDonald’s was the company trying to open 1,000 units per year in the United States alone.  The focus was on unit growth and not unit productivity.


In 2003, the Plan-to-Win was unveiled but it was not until 2005 that management began upgrading its drip coffee by using higher quality beans, filtered water, and better-tasting cream.  After two years, drip coffee sales were surging, giving management the confidence to upgrade their hot-drinks menu.  Beginning in 2006, management began to put forth the argument that the success of the drip-coffee business gave the company credibility to expand into espresso-based drinks.  McDonald’s shift in focus from being a fast food concept to more of a beverage concept was underway.


The greatest successes in McDonald’s history, like the Egg McMuffin, have stemmed from franchisee initiatives while some of the biggest disappointments, like Arch Deluxe, have been driven by Oakbrook.  In the case of the complete beverage strategy, it was driven by Oakbrook; franchisees had little to do with the shift in focus.


Strategically, I can see the reason for management wanting to drive the sales of higher margin beverages but, absent almost-prohibitive investment, McDonald’s will likely never become a beverage destination over a sustained period of time.  The DNA of the company lends itself to executing on food, as Starbucks’ lends itself to executing on beverages.  Unfortunately for McDonald’s the capital thus far-committed to shifting toward beverages has come at a significant cost. 



Early Test Markets


In 2007-2008, the company expanded the McCafé test in Chicago into Kansas City.  The original strategy called for McDonald’s to spend $100,000 per store, incorporating separate McCafés in each restaurant that could serve a new line of espresso-based products and assorted baked goods.  The strategy also included expanding the drive-thru to ameliorate though-put issues.  In the end, the construction costs exceeded the budgets and, more importantly, the level of consumer acceptance was not meeting expectations. 


So, for the first time in McDonald's history "testing" became irrelevant because the test markets did not go well, the franchisees said "we don't want this, take it out."  Instead, the Oak Brook based initiative went national in 2009 with a roll out strategy that was changed had to be altered from its original form.


Late in 2008, I documented that the company was clearly behind plan in converting restaurants to McCafés in order to nationally promote the product by mid-2009.  In the US, the company was running behind schedule and a lack of enthusiasm among franchisees to absorb rising costs posed a problem for Oakbrook.  In the end, the decision was taken to abandon the plan for a separate “McCafé” within the store, as was the prototype developed in other markets, and move forward with espresso machines being integrated behind the existing front counters. 


Does MCD Know Its Audience?


Selling expensive beverages at McDonald’s in the USA has always been a curious notion, given the brand’s perception among consumers as a value chain. 


Why did McDonald’s take the decision to proceed with the rollout in 2009/2010? Why was there no slowdown?  It seems that the reason behind this decision was the business plan at the time calling for phase II of the “beverage strategy”: cold drinks.  After four years of upgrading the menu and successful new product introductions, management needed to drive traffic and beverage sales were deemed the way forward. 


Back in 2008, a McDonald’s executive was quoted as saying, about the company’s beverage strategy, “That's the great part about McDonald's is that we are actually offering affordable luxuries, so for us we know our customers are looking for those affordable luxuries."  Are “affordable luxuries” going to resonate with the consumer in 2013?  Longer-term acceptance of the McDonald’s as a beverage destination is key to the success of this strategy and a return on the considerable capital investment that has supported it. 


We’re now told that the expensive and complicated espresso machines behind the counter only serve a handful of espresso drinks per day.  The espresso machine is separate from the machine that produces the traditional drip coffee, of which McDonald’s sells a large amount, and is a piece of equipment that requires regular maintenance.  Additionally, the shaved-ice drinks (smoothies and frappes) have no connection with the espresso machine.  Below are some thoughts from the franchisee community on the subject of the expensive drinks machines:

  • History has proven that the more complicated a piece of equipment is the shorter it's [sic] lifetime in a MCD restaurant.
  • The machines were installed in 2008 and early 2009.  What will happen when the machines need replacing? Will franchisees refuse to spend the $15,000 plus to replace them to continue to sell a few drinks a day?
  • The maintenance required for the machine is huge and may end up 'out of control'. We all bought Cadillac’s but at GM, 16 year olds don't do the oil changes.

The most important operational dilemma that senior management faces is the level of media spending that has, and continues to be dedicated to beverages.  We believe investors will increasingly question the allocation of marketing dollars.  Should those media dollars be re-allocated to helping grow other parts of the business? Then what does that say about the potential for beverage trends actions?  Lastly, what are the implications to corporate margins as beverage transactions slow and incremental maintenance expenses?


A core tenet of the Plan to Win, established under Jim Cantalupo, was something called “simplification” which applied to the menu and kitchen operations.  Over time, the tension between the desire to drive traffic and simplification led to an expanding menu including a significant number of beverages varieties.  Franchisees are finding the menu too large and kitchens are far from the streamlined centers of operation that the Plan to Win envisaged.  Service times in the lobby and drive-thrus are likely to suffer if the back of the house has become disorganized due to the expansion of the menu.  Given the ownership that individuals within the McDonald’s organization take of different menu items and/or initiatives, it is unlikely that a menu item cull is forthcoming.   If anything, the complications of the four-wall operation at McDonald’s could be getting worse.



Howard Penney

Managing Director


Rory Green

Senior Analyst




Quick Look at Unilever Results

Unilever (ULVR LN) is up over 3% in European trading this morning, after releasing full-year and Q4 results.  Underlying sales growth (excluding the impact of exchange rates, acquisitions and disposals) was 7.8% with strength in Personal Care (+11.5%, 4.0% price, 7.2% volume) and Home Care (+10.4%, 3.1% price, 7.0% volume).  Foods were a laggard at +1.3% underlying sales growth with price contributing 1.4%.

These results represent a sequential acceleration in underlying sales growth (+6.0% in Q2 and +6.1% in Q3) and represent strength on strength as the comparable result in Q4 2011 was a +6.6%.


We would like to highlight a couple of items from these results.

  1. Unilever is a transformed company, with the transformation beginning with the appointment of Paul Polman as CEO, formerly of Nestle
  2. Unilever is what PG should aspire to be in terms of growth and investment in brands
  3. Personal and Home Care results are favorable on the margin for PG
  4. Food results still struggle to find a balance between price and volume growth

It's been fun to watch the transformation of Unilever over the years from a sluggish, inexpensive staples name to a global growth company.  If anyone suggests that the jockey doesn't matter in a horse race, point them toward Unilever.

Kind regards,




Robert  Campagnino

Managing Director




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