The Economic Data calendar for the week of the 4th of March through the 8th of March is full of critical releases and events. Attached below is a snapshot of some (though far from all) of the headline numbers that we will be focused on.
Takeaway: Pensions are in dire need of proper reform. Time will tell if America's pension systems can fix themselves before a massive crisis erupts.
Hedgeye’s Industrials Sector Head Jay Van Sciver hosted an expert call yesterday with David R. Godofsky, head of the employee benefits practice at the law firm of Alston & Bird. A Fellow of the Society of Actuaries, Mr. Godofsky has decades of experience in all areas of corporate benefits and compensation. His talk yesterday was titled “Pension Funding and Accounting: The Pension Pendulum.”
Mr. Godofsky’s analysis demonstrates how the nation’s pension plans have been yanked back and forth as Congress repeatedly tries to fix what is wrong with pension funding requirements – then rushes to fix what they got wrong the last time. Companies struggle to keep their balance while adjusting their pension funding practices to conform to the latest changes.
The Employee Retirement Income Security Act (ERISA) took effect in 1976, creating federal funding requirements and government insurance for private sector pensions. This first swing of the pendulum set funding requirements, giving companies 30 years to meet unfunded liabilities and setting rates for contributions.
ERISA was put under IRS jurisdiction, and the agency pressed companies not to fund their plans quickly, in order to maintain tax revenues. The convergence of a long time horizon, unrealistically low funding requirements, and IRS pressure to keep contributions low, led to low balances backing very large pension liabilities.
This was compounded by moral hazard with the introduction of federal pension insurance. Even today there is very little restriction on what companies can promise in terms of pension benefits – and federal insurance is on the hook. Godofsky says the vast majority of insurance claims come from collectively bargained plans, where both management and the union know the government will backstop whatever they agree to.
After ERISA was in place, Congress introduced funding caps and a 50% excise tax on withdrawals from overfunded plans, and Congress has kept the pendulum swinging ever since. Successive new rules keep trying to strike a balance between beefing up contributions to protect employees, and avoiding excessive corporate tax deductions.
One change, adopted in 1987, was to use actual bond rates as the investment return assumption. Companies realized they could issue their own bonds at rates below the assumed rate of return. They used the proceeds to buy stock in the pension plans, and booked the difference in interest rate payments as a profit. Through the “magic” of this paradigm, companies could consider their pensions fully funded when there was actually a significant asset shortfall.
So Congress changed the assumptions again, requiring contributions to be calculated on the assumption that all investment assets are equivalent. Except, as Godofsky points out, they are only equivalent today. Their values will diverge in 30 years. Or in ten years. Or by tomorrow. Companies could no longer create assets using borrowed cash.
Even though funding assumptions were now based on bond rates, between 40%-60% of all pension money is invested in stocks, which did what they were supposed to do: outperform bonds. This created a large number of overfunded plans. The companies can’t just withdraw the excess, because of the 50% tax hit. But they can get creative.
Some companies deal with excess pension assets by offering extra pension payments in lieu of current compensation. Or a company with an overfunded pension can sell a division to a company with an underfunded plan. The buyer also takes on a piece of the seller’s excess funding, paying for it in an inflated purchase price for the operating unit. There are also legal ways to give special pension bonuses to a select group of senior management employees without having to grant equal treatment to others.
The bottom line, says Godofsky, is that the 50% excise tax is never actually paid, and these measures also reduce payroll and other tax revenues. And all this still doesn’t prevent companies going out of business and defaulting on plans, increasing the burden on an already distressed pension insurance program.
Congress whipped the pendulum back the other way with the 2006 Pension Protection Act which exacerbates economic cycles by requiring companies to maintain funding levels. Companies are forced to pump cash into plans in down markets, taking away resources they could use for business expansion or job creation.
What’s The Next Swing?
Godofsky believes funding assumptions will continue to be a source of tension. Accountants believe pensions should invest in fixed income, because pension liabilities look like fixed income. Meanwhile, pension managers will continue to be about 50% in equities, because portfolio theory says stocks outperform bonds over the long term. This tension is not likely to be resolved.
Godofsky sees crises brewing in multi-employer plans, and in public sector plans, especially at the municipal level.
One thing that appears certain is that Congress will continue to meddle. It’s what they’re good at. As Godofsky’s Rule states: the pendulum never stops in the middle.
BKW remains a short in the Hedgeye Restaurants Position monitory.
Two areas continue to concern us within the Burger King business:
The bullish thesis hinges on 2012 same-restaurant sales demonstrating that the strategies BKW has been pursuing are effective. We disagree. A slowdown in early 2013, that we believe is underway at BKW, will shake the prevalent belief that the Burger King turnaround is a done deal.
Carrols Restaurant Group (TAST), a franchisee of Burger King and is seeing February SRS tracking -4% to -5%, including average check of 3-4%, implying traffic down between 7% and 9%. TAST management is still guiding to a 2-4% comp for FY13. We do not expect this guidance to be achieved.
Longer-term, we are skeptical that management’s goal of having 40% of the system remodeled over the next three years will be met. The current sales lift from remodeled stores within the Carrols system is running at 8-10%, below what BKW has guided to: 10-20%. This disappointing sales lift should increase skepticism in the long-term viability of the remodel program.
Don’t take our word for it, Carrols management said the following: “We would hope to remodel at an aggressive pace, but recognize that we may need to temper this, based on how the year progresses.”
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Hedgeye issues some negative comments on the airline sector (via Seeking Alpha)
4 S&P 500 Dividend Stocks With Troubling Accounting Signals (via Seeking Alpha)
Kass: The Buck Stops Here (via The Street)
5 Homebuilders Currently Undervalued By EPS Trends (via Seeking Alpha)
5 High-Growth Restaurant Stocks With Encouraging Inventory Trends (via Seeking Alpha)
Why More Than 8% Unemployment Could Lie Ahead (via CNBC)
This note was originally published February 28, 2013 at 11:19 in Restaurants
Our bullish stance on Brinker (EAT) remains firmly in place as the Investor & Analyst Conference was starkly different in tone to the unsettling Darden Analyst Meeting the couple of days prior. Here are our summary thoughts on EAT:
We believe that Brinker is well poised to deliver on its stated goals and remains one of our favorite names in the restaurant space. The company is offering investors a differentiated focus on returns with a clear capital allocation strategy. EAT is one of our favorite names in the restaurant space, even after this past three years.
Takeaway: We continue to think Strong Dollar = Strong America and believe the USD can continue to win in 3 ways.
Summary: 3 Ways the USD Wins
“Why is broad commodity deflation a bullish setup?” – we’ve been fielding some version of that question with greater frequency over the last few weeks as market prices have continued to offer positive confirmation of our strong dollar - strong consumption view, a key underpinning of our #GrowthStabilizing investment theme.
Below we provide a summary recap of our view on the dollar-growth connection, our bullish view on the dollar and why we think there is further upside in the immediate/intermediate term.
The Strong Dollar = Strong America mantra continues to anchor our view on sustainable, real GDP growth both domestically and globally. Central to the view is the fact that a stronger dollar drives commodity & energy deflation, serving as a real-time tax cut to consumers and an input cost reduction for business with a flow-through benefit to earnings on a lag.
Because most global commodity transactions settle in dollars, the USD-Commodity Price relationship is rather direct, and the impacts of commodity deflation are felt globally as share of wallet occupied by food and energy declines. The cost deflation and purchasing power impacts are further pronounced for economies with some measure of a currency peg to the U.S. Dollar – fundamentally, we continue to like Hong Kong, China, and Singapore, in part, for that reason.
Persistent central bank policy intervention with the explicit goal of devaluing the currency to drive (financial) asset price re-flation has been a discrete headwind to sustainable dollar strength over the last five years. Investors, on balance, have bought into the policy regime with a primary follow-on effect being that equity and commodity price correlations to the dollar have been strongly and inversely correlated over that same time.
While policy initiatives supported equity valuations (via lower discount rates & a lower dollar) and provided some measure of economic stimulation, commodities and inflation hedge assets generally outperformed other asset classes. With repeated rounds of easing, the investor response became pavlovian with commodity and energy price inflation and lower real, inflation adjusted growth on the other side of those policy initiatives.
As we’ve stated repeatedly, big government policy intervention and the perpetuation of the temporal, Dollar Down --> commodity Inflation Up --> Real Growth down, dynamic has served to:
1. Shorten Economic Cycles, and
2. Amplify Market Volatility.
As a result, we’ve been beholden to compressed economic oscillations and fleeting, episodic periods of growth, while real, sustainable, demand growth has remained elusive.
Can we break the cycle as Bernanke's last Bubble (commodities) deflates?
With QE-infinity on the table, the capacity & appetite for further Fed balance sheet acceleration declining, and domestic growth stabilizing, the potential to break free of the prevailing, policy-inflation-growth cycle that has characterized the better part of the last five years is increasing – with the prospects for sustained USD appreciation gaining concomitantly.
Indeed, at present, intermediate term dollar correlations to the S&P500 are positive while holding negative across the larger commodity basket. Dollar Up, Stocks Up, Commodities Down is the relationship dynamic we’d like to continue to see perpetuate itself with respect to sustainable end demand.
Mother Nature likes redundant systems and we feel comfortable taking an anti-fragile cue from one whose traversed a global cycle or two. Currently, we think the strong dollar thesis can win in 3 ways.
THE FACTORS & HOW TO POSITION:
1. Fiscal Consolidation: After a multi-decade run of debt financed consumption and federal profligacy, Sequestration, or any manner of fiscal restraint & consolidation, on the fiscal policy side is dollar favorable on the margin. Further, given the diminishing return of fed policy action and the reduced appetite for further QE initiatives, QE now appears rearview as a discrete bearish catalyst for the dollar in the near-term.
2. Taro Aso being Taro Aso: We’ve detailed our Short Yen case via our #QUADRILL-YEN 1Q13 Investment theme and on our recent best ideas call (email us if you would like a copy of the presentations). In short, with the dovish actors in place (Aso/Kuroda), the political will supportive, and the appetite there for increasingly aggressive policy initiatives we think the Yen is poised to return to ¥100+ per USD. A weak Yen with an explicit and comparatively dovish policy outlook for Japan vs the U.S. is supportive of dollar strength.
3. U.S. Growth Stabilizing: Economic fundamentals are USD supportive, on balance, with Housing, Labor Market & Manufacturing activity data all stable to improving. Further Economic weakness across G7 economies, particularly across the EU, UK & Japan, should support a relative bid for the dollar in the immediate/intermediate term as well.
4. Quant: The USD remains bullish and is breaking out from a quantitative perspective. TRADE & TREND Support sit lower at $80.65 and $80.12, respectively.
Christian B. Drake
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