MNST Q4 – Where do we go from here?

Coming into this evening’s earnings release, we had concerns that the company would disappoint versus consensus – those concerns were validated.  We like the category and we like the company, and we want to like the stock, but we still need to see 1H ’13 consensus come down a shade(2%).  Ultimately, we continue to believe that MNST’s superior growth profile isn’t being appropriately valued, in part because of ongoing regulatory overhang and in part because of weakness in the energy drink category in the U.S.

MNST reported Q4 results this evening, falling short of consensus on both the top and bottom line.  Revenue growth was 15.0% (versus 17.6% contemplated by consensus) while reported EPS of $0.39 was $0.02 light of consensus.


What we liked in the quarter (the good)

  • Sequential improvement in revenue growth versus a more difficult (420 bps) one year comp
  • Sequential improvement in EPS growth versus a more difficult (930 bps) one year comp
  • Sequential mitigation in gross margin declines against a marginally easier comp
  • Continued share gains by MNST in the energy drink category
  • Sustained strength in international sales (+29.6%)
  • Aggressive share repurchase by the company in the quarter

What we didn’t like in the quarter (the bad)

  • Continued year over year declines in the price per case (fourth consecutive quarter)
  • Weakness in the broader energy drink category

What else (the ugly)

  • Very difficult one and two year comps in 1H 2013
  • Pending adjustments coming out of this release, we remain below consensus for 1H ‘13

We continue to like the longer-term prospects for the energy drink category in general and MNST specifically, but this quarter’s results are precisely the reason we haven’t been as vocal as we have been in other situations – we prefer to see a clear path to EPS upside before we get excited about a name.


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Best Ideas: Bank of America

Bank of America (BAC) has substantially cleaned up its legacy mortgage exposures and the remaining costs associated with its housing exposure are finally quantifiable .  As housing improves at an accelerating rate, the bank’s credit quality will continue to improve, adding to the bottom line.  Finally, risks emanating from the housing bubble and the financial crisis are largely either behind the company, or baked into the stock price.  Steiner sees BAC as the best play on strong housing among the major financial institutions. 


As the financials sector emerges from crisis mode, BAC stock remains highly  volatile.  Investors tend to use price volatility as an indicator of a company’s fundamental stability.  Steiner believes observers are discounting key ratios that are standard factors in the analysis of financial companies, based on a fundamental misunderstanding of current risks.

The banks hold more tangible capital today than they have in many years – in some cases, more than they ever held.  Paradoxically, the market is using historical cost-of-capital calculations at a time when the whole risk profile of the sector has changed.  Banks – BAC in particular – hold lots of capital.  Tangible equity capital – not “risk-weighted capital” – is hard to manipulate.  


Investors remain focused on the risks of leverage – the excesses that brought down the system.  But Steiner points out, capital is the inverse of leverage.  High levels of capital equals low levels of risk.  Steiner says the market continues to charge a high-risk cost of capital at a time when risk is lower than it has been in many years.


Steiner believes the decline in volatility will dramatically reduce BAC’s cost of capital computation.  Investors should also see a significant improvement in the bank’s margins and, as volatility declines, will change the way they account for risk.  Steiner thinks this Best Idea has the potential to return 100% over the next one to two years.


Today we sold our iShares Dow Jones US Home Construction ETF (ITB) position at $22.55 a share at 10:48 AM EDT in our Real-Time Alerts. We originally bought ITB at $22.17 a share on February 20, 2013. After an outstanding week of US Housing data, booking our 6th consecutive gain on the long side in ITB on an immediate-term TRADE overbought signal. We remain Bullish on #HousingsHammer.


TRADE OF THE DAY: ITB - image001

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CRI: Eye On Capital Intensity

Takeaway: We liked the CRI print, but we don’t like the change we’re seeing in capital intensity. The movements are severe and could impact returns.

Conclusion: There were puts and takes in the CRI quarter, but the major standout to us is the change that we’re seeing in the capital intensity of the model. The colossal rise in capex and spike in SG&A ups the ante for the well-telegraphed ‘14% EBIT Margin’ bull case we need to see come to fruition in order to prevent a decline in returns. If this happens we think you’ve got 16-17x $4.25 in EPS in 2015, or a 8-10% annualized return on a number that you have to wait 3-years to see. If our concerns about pricing spreads and high cost/low return of international growth play out, we think CRI has downside to about 13x on $3.00, or $15 downside over the next year. Capital deployment shorts don’t play out overnight, but at a minim we’d avoid the long side of this name. There are far better places to be in our opinion.



Obviously the market doesn’t like the CRI print today, and we agree. But we think we don’t like it for different reasons. The stock started to trade down just as CEO Casey mentioned that 1Q to date showed negative comps in Carter’s stores. While that’s not good, we think a bigger negative was the change in tone regarding capital allocation and margin makeup.


Harvesting Is Over: We think CRI is entering a meaningfully different stage in its investment cycle. The way we see it, it just made its second international acquisition in 18 months, it is bringing its product sourcing from 20% of total today to 50% in 5-years, it just took SG&A up 40% in the latest quarter on top of a 14% sales growth rate, and management noted that GM upside (ie pricing better than costs – something it has sparse control over) will need to happen in order to offset higher planned costs. Furthermore, capex in the coming year is slated to be $200mm. As a frame of reference, this is 4x the rate of Carter’s D&A, and it has never spent even half that much in a given year (even as a % of revenue) in all the years it has been public.


Don’t get us wrong. We like when companies spend money – at least those who prove to be good stewards of capital and drive returns higher through share subsequent share gain or margin improvement. But CRI is simply unproven in that regard. We’re not saying that it will fail. But rather that you need to believe that it will succeed in order to buy the stock here.


The ‘14% margins due to direct sourcing’ bull case is very well telegraphed. If we assume that the company gets there within 3-years, we’re looking at about $4.25 in earnings power. That’s a great lift over the $2.86 it printed last year and $3.28 it is guiding towards in 2013. But with the stock at $55, you’re paying 12-13x a best-case earnings number that may or may not happen in 3-years.


In the interim, there are some puts and takes.

International is clearly growing, US Carter’s retail is still putting up mid-teens square footage growth, and is growing nicely – up to 18% of store sales in this quarter vs 11% last year. The new DC should keep this heading higher.


On the flip side, we remain concerned about more normalized product costs and increased competition by both retail partners and competing brands alike. In addition, while International is nice, it’s definitely not a slam dunk.


a)      Bonnie Togs comping down only 2-quarters after it is included in the comp base.

b)      The new dual-brand stores in Canada are launching, but are not proven yet.  

c)       Just after CRI anniversaries the Canada acquisition, it’s investing capital in the last place we want to see incremental money put to work – Japan. For a luxury brand (like Kate Spade, Kors, or Ralph) perhaps that makes sense, but not for a kids mass apparel maker. Also, keep in mind that the dominant brand for CRI in Japan is Osh Kosh, which it has a hard enough time growing in the US nevermind Japan. The opportunity is for the for Carters brand, but Japanese Moms are not US moms. It will cost money to build that opportunity. 

Have Stocks Conquered Commodities?

Since we moved in to #GrowthStabilizing territory in mid-November of 2012, we've been a proponent of the long US stocks/short commodities game plan as the great commodity bubble created by the Federal Reserve deflates. Over the last three months, the S&P 500 has gained +7% while the CRB Commodities Index has dropped -1.1%. 


Have Stocks Conquered Commodities? - CRB SPX


We would not short Darden today, as our short thesis that we first outlined in July has become common knowledge, but we retain a bearish bias.  It is possible to construct a valuation/earnings case for 8-20%of downside but, for want of catalysts, we would not be taking a short position today.  With the emergence of a catalyst, we may become more vocal on the short side of DRI but for now we are covering our short position in the Hedgeye Restaurants Position Monitor.


Our rationale:

  1. The company has announced that earnings over the next 5 quarters will be disappointing
  2. SRS are likely to see a sequential uptick in 3QFY13
  3. The company has reduced capital spending enough to cover the dividend

Our bearish bias remains due to capital spending plans that remain overly aggressive and the fact that Darden’s most important asset – The Olive Garden – is a long way from being fixed.  



Summary of Our Thoughts on the Darden Meeting


The theme for the meeting, “Operating Successfully in a New Era”, was the first indication that this presentation would be somewhat detached from reality.  Several of the statements from management surprised us but most striking was the company only now stating that the change in the casual dining industry has been structural, not cyclical.  Darden has the largest system in casual dining.  Its national competitors have been recognizing the structural nature of the shift in casual dining customers’ habits for several years.  The demographic changes that we have written about are among the most obvious indications that the go-go days are over for casual dining.



Core Brands Remain the Problem


We believe that management has been tone deaf to consumer trends.  That may sound like an exaggeration but the two charts, below, speak to that argument.  An objectivity-damaging trust in internal customer satisfaction results rather than actual traffic trends is one factor we inferred from the presentation content.  The fact that the “Darden i-Tracker” is implying a consumer perception diametrically opposite to the trend in same-restaurant traffic growth perhaps calls into question the relevance of the internally generated metric.


The charts below show that, by the metrics that matter, Olive Garden and Red Lobster need a lot of work.  What’s more, management wasn’t forthcoming with many details on the Olive Garden turnaround; the technology segment of the Analyst Meeting was longer in duration that the Olive Garden segment. 


DRI: EASY YARDS ARE OVER - dri big 2 gap to knapp traffic



Sacrificing Growth to Keep the Dividend


The company pointed out that cash flow had to be managed more conservatively to support the dividend.

  • The current dividend is currently running at roughly $263mm on an annual basis
  • Free Cash Flow is anticipated to be $245-265 million in FY13
  • Mgmt has a policy of raising the dividend each year with a target of 50% payout ratio
  • The roughly $125 million cut in cap ex will eliminate that funding gap for the dividend


Cutting CapEx at Olive Garden

  • Cutting back CapEx from $700-$725 million in FY 2013 to $600-$650 million in FY 2014
  • OG new units scaled back from about 35 to 15 and
  • OG remodels put off until late FY14
  • LH openings from 40+ to 35-40



Olive Garden


The company’s most important business unit had the shortest presentation.  The new President, Dave George, is still settling into his role and impressed us with his observations and perspectives.  There were two major takeaways from the Olive Garden segment:

  • Remodels are being stopped and new unit openings are being slowed likely until sometime in FY14
  • Details of Tuscan remodel being tweaked, logo being updated
  • No new initiatives were announced



Red Lobster


Inconsistency has plagued Red Lobster over the last few years as promotions have failed to deliver steady results.  The Bar Harbor remodel program has been yielding some positive results for traffic but it seems that the turnaround at Red Lobster will take some time.  





Management’s claim that limiting price increases to 1% will help drive incremental traffic growth seems to contradict recent Knapp Track, Gap-to-Knapp, and company data.  The underperformance of Olive Garden and Red Lobster in recent years would suggest that management’s understanding of its customers may not be acute enough to make such a claim.

The theory goes:

  • Management said “we are trying to target the check to the guest that need the relief” but how?
  • They said they are just now building the technology to have the ability know the consumer better, so how can they have target messaging now?
  • This technology will not be in place until late in FY 2014



Truth Hurts


We were a little perturbed by a statement from CEO Clarence Otis, at the end of the second day, that the company’s traffic problem is only a year old.  The data (charts earlier in this post) show otherwise and we believe this Analyst Meeting exposed a degree of detachment between Darden’s CEO and the nuts and bolts of the company’s operations. 





Howard Penney

Managing Director


Rory Green

Senior Analyst






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