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MCD: You Deserve A Short Today

Takeaway: McDonald’s squeezes profits to gain market share. A gambit that may pay off – or not. For not it’s “Little Mac."

“Little Mac”?  The Case for Shorting McDonald’s

Restaurants sector head Howard Penney adds his Short call on McDonald’s (MCD) to Hedgeye’s Best Ideas with an institutional conference call titled “MCD: Flying Too Close To The Sun.”

 

With over 34,000 locations worldwide, MCD is the world’s largest restaurants company – both by sales and by market capitalization.  Some 80% of MCD outlets are franchised – mostly in the US – and Penney argues that this has had a negative impact on planning.  While MCD has made a very visible push in recent years to expand in Asia, the Pacific region, the Middle East and Africa (“APMEA”) – with special focus on China – the US remains its biggest market and, says Penney, it’s Achilles’ Heel (Icarus, Deadalus, Achilles… it may be appropriate that a presentation that questions a major company’s fundamental growth story is full of references to mythology!)

 

Where Do They Make Their Money?

MCD’s most significant source of revenues is in Europe.  Over 39% of the company’s revenues come from Europe, versus 32% from the US – and 23% from APMEA (including China).  Penney points out that the majority of European stores are company owned.  Even though the ongoing Euro-Zone crisis is taking its toll, Europe, with a high percentage of company-owned stores, remains more profitable than the US, with its high percentage of franchised locations. Management is focusing its growth plans on the APMEA markets, but Penney points out that the combination of weak economic conditions in the Euro-Zone, and low profit margins in the US – which together combine for 80% of MCD’s earnings power – will drive disappointing differences between analyst projections of earnings per share and actual reported earnings over the next few years.

 

What Do The Numbers Look Like?

Analyst expectations have already been trimmed, with consensus for 2013 EPS at around $5.80.  But Penney sees global same-store sales growth declining – he thinks growth rates worldwide could end the year nearly flat, which should drag earnings estimates significantly lower.  Nobody likes a downside surprise.  

 

Except, that is, a short seller.

 

With 41% of stores, and just over 40% of sales revenues, the US represents by far the largest sales and unit base for the company.  But put those figures alongside the earnings numbers we quote above and you see that the US provides over 40% of global sales, but only 32% of earnings.  Europe, by contrast, represents 39% of earnings, on only 28% of sales.  And Europe is weakening.

 

What’s Wrong?

Penney says MCD’s management has gotten itself into an unrealistic position, looking to be both the low-priced and the premium-profit leader.  The company has positioned itself in the US as a super-discounter over the last decade.  But “Dollar Meals” don’t return big profits – ask any frustrated franchisee.  In their latest earnings call, the CFO acknowledged MCD “expects margins to be pressured throughout 2013.”  Translation: Heads up: we’re heading down!

 

Here are another couple of key takeaways from the CFO’s presentation:

 

“Our business model is built around growing comparable sales to a level where we can realize margin leverage.”  

 

Translation: if we can sell a whole lot more stuff at really low prices, sooner or later we’ll realize economies of scale and our profit margins will go up a little.

 

“In this environment, where you continue to have the cost pressures, so commodities will be up, labor rates are going up, et cetera, and yet you have soft economics, declining to flat eating out markets, that battle for market share becomes so critical to the long-term health of the business, that we’re willing to sacrifice a little bit of margin to maintain that traffic and grow the market share.”  

 

Translation: but right now, we have to take our already-tiny profit margins down even further in order to gain market share.  That “little bit of margin” we are willing to sacrifice – but hey, we only have a little bit in the first place – oops… there goes the profit margin.

 

You Don’t Get A Break Today

Penney points to a number of factors underpinning his bearish case.

 

At the macro level, US consumers are feeling better and spending more, and are less dependent on cheap prices.  Europe, meanwhile, just keeps getting worse.

 

At the company level, MCD same store sales are deteriorating globally, while the company suffers from “self-inflicted wounds.”  Two key examples are an unacceptable level of operating complexity, and an inability to field new ideas.

 

With only tiny profit margins on the majority of their menu, speed and efficiency at mealtimes become critical.  Every store has to run at top efficiency to speed diners through between the critical 11:30AM-1:00PM lunch hour.  As one example of poor planning, Penney points to the freestanding beverage stations, which customers enjoy, but which make the back-of-house operation much more complex, because staff must repeatedly stop serving customers to go out and service the machines.  When a discounter, which is already operating at near-maximum capacity, has to slow down its throughput to tend to an unnecessary machine… well, you get the picture.

 

And Penney says senior management seems surprisingly uninterested in very specific issues raised by franchisees.  MCD management have their game plan which they expect all locations to implement, while they continue to push for new-store growth outside the US and Europe.  This means that, while MCD goes through the expense of expanding in new markets, they are not getting incremental benefit out of their highest-revenue and highest-profit generating regions.  Management appears to be building a more profitable company-owned base of overseas stores on the back of – and at the expense of – its US franchisees.  This can lead to alienation of MCD’s most important revenue base.

 

Conclusion

Penney expects MCD to disappoint in Q3, and likely also in Q4 of this year, leading to analysts downgrading the stock and pushing prices lower.

 

MCD’s ongoing focus on “value” (i.e. cheap prices) continues to destroy profit margins and cash flow – and to frustrate franchisees in its biggest market.  Penney says the only way out now is the highly unlikely success of a “magic bullet” – a premium product that everybody loves.  But MCD has defined itself as a “value” chain.  After so many years at the low end of the price range, they will have a very hard time trying to introduce a premium offering.

 

Add to that the recent surge in their closest competition.  Wendy’s (WEN) is now being run by an outstanding operator / innovator.  Taco Bell, says Penney, “is on fire” with popular new product offerings and an on-target marketing campaign.  Even Burger King (BKW) – a company Penney went bearish on earlier this year (See BKW report HERE___) has gotten itself organized enough to present a marginal headwind for MCD.

 

“Don’t get me wrong,” says Penney.  “MCD is a great company.  It’s a financially strong global company, and they will probably raise the dividend again.”  But a range of near- and intermediate-term problems that will lead to earnings disappointments.  Penney thinks the market will not be forgiving, at least over the next two quarters.  

 


Morning Reads From Our Sector Heads

Todd Jordan (GLL):

 

Survey shows visitors gamble less (via USA Today)

 

Rob Campagnino (Consumer Staples):

 

GrainCorp agrees to ADM’s sweetened A$3bn offer (via FT)

 

Josh Steiner (Financials):

 

US regulators urge quick Libor replacement (via FT)

 

Drop in Borrowing Squeezes Banks (via WSJ)

 

Bernanke Says Alternatives to Libor Being Considered (via Bloomberg)

 

Brian McGough (Retail):

 

George Soros Buys Into J.C. Penney (via WWD)

 

Matthew Hedrick (Europe):

 

Spain Slashes "Growth" Outlook, Projects Higher Deficit, Delays Deficit Reduction (via Zerohedge)

 

Kevin Kaiser (Energy):

 

Ras Tanura Oil-Tanker Capacity Seen Falling 13% in Latest Week (via Bloomberg)

 

Jay Van Sciver (Industrials):

 

KBR Announces First Quarter 2013 Results (via KBR)


America Grows

Client Talking Points

Strength In Housing

The housing market continues to impress investors with its recovery. We're seeing a combination of positive indicators that indicate demand is on the rise. Home prices are rising, volumes are up, mortgage demand has increased thanks to ultra-low rates (the 15-year fixed-rate is at an all-time low) and inventory isn't bloated. Put all these together and you have true economic recovery that makes the US housing market one of the most attractive investments out there.

Employment Stabilizing

Talking heads on news programs may indicate otherwise, but the employment situation in the United States is doing quite well. The latest initial jobless claims numbers prove that we're seeing sequential improvement on a month-over-month basis. Both seasonally adjusted and non-seasonally adjusted claims show an improving trend in the labor market. Jobs, along with housing, all fit into the consumption game. Consumers are working hard, buying homes and hitting the grocery store and gas pump and spending money. Consumption is the key to global growth and right now, things are looking up.

Asset Allocation

CASH 23% US EQUITIES 25%
INTL EQUITIES 18% COMMODITIES 0%
FIXED INCOME 6% INTL CURRENCIES 28%

Top Long Ideas

Company Ticker Sector Duration
IGT

Decent earnings visibility, stabilized market share, and aggressive share repurchases should keep a floor on the stock.  Near-term earnings, potentially big orders from Oregon and South Dakota, and news of proliferating gaming domestically could provide near term catalysts for a stock that trades at only 11x EPS.  We believe that multiple is unsustainably low – and management likely agrees given the buyback – for a company with the balance sheet and strong cash flow as IGT.  Given private equity’s interest in WMS (they lost out to SGMS) – a company similar to IGT that unlike IGT generates little free cash – we wouldn’t rule out a privatizing transaction to realize the inherent value in this company. 

WWW

WWW is one of the best managed and most consistent companies in retail. We’re rarely fans of acquisitions, but the recent addition of Sperry, Saucony, Keds and Stride Rite (known as PLG) gives WWW a multi-year platform from which to grow. 

FDX

With FedEx Express margins at a 30+ year low and 4-7 percentage points behind competitors, the opportunity for effective cost reductions appears significant. FedEx Ground is using its structural advantages to take market share from UPS. FDX competes in a highly consolidated industry with rational pricing. Both the Ground and Express divisions could be separately worth more than FDX’s current market value, in our view.

Three for the Road

TWEET OF THE DAY

"Whoa, Burger King a whopper (20%) of div increase. However... "comp sales growth was not up to our expectations..." Which trumps which? $BKW" -@herbgreenberg

QUOTE OF THE DAY

"Instead of giving a politician the keys to the city, it might be better to change the locks." -Doug Larson

STAT OF THE DAY

Economy in US expanded 2.5% in Q1 compared with 3% projected growth.


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THE HEDGEYE DAILY OUTLOOK

April 26, 2013                                                                                                  

 

 

SECTOR PERFORMANCE


THE HEDGEYE DAILY OUTLOOK - 1A

 

THE HEDGEYE DAILY OUTLOOK - 2

 

EQUITY SENTIMENT:


THE HEDGEYE DAILY OUTLOOK - 10


CREDIT/ECONOMIC MARKET LOOK:

  • YIELD CURVE: 1.46 from 1.48
  • VIX closed at 13.62 1 day percent change of 0.07%

MACRO DATA POINTS (Bloomberg Estimates):

  • 8:30am: GDP, 1Q, est. 3.0% (prior 0.4%)
  • 8:30am: Personal Consumption, 1Q, est. 2.8% (prior 1.8%)
  • 8:30am: GDP Price Index, 1Q, est. 1.3% (prior 1%)
  • 8:30am: Core PCE, 1Q, est. 1.1% (prior 1%)
  • 9:55am: U. of Mich Conf, April final, est. 73.5 (prior 72.3)
  • 11am: Fed to purchase $2.75b-$3.5b notes in 2020-2023 sector
  • 1pm: Baker Hughes rig count

GOVERNMENT:

    • President Obama hosts Jordan’s King Abdullah at White House
    • 9:30am: House Science, Space and Technology panel meets to review federal hydraulic fracturing research
    • 10:30am: House Foreign Affairs panel holds hearing on Islamist extremism in Chechnya

WHAT TO WATCH

  • Archer-Daniels-Midland wins GrainCorp board approval for bid
  • Boeing 787 poised to resume flights in Japan after approval
  • UPS ends Teamsters strike risk w/new contract before deadline
  • Samsung sold a third of smartphones as iPhone growth slows
  • Economic growth in U.S. probably picked up in 1Q
  • Yahoo’s Amoroso resigns as chairman, plans to leave board
  • U.K. banks said to be rattled by regulator silence on capital
  • Schneiderman won’t seek damages from Ex-AIG CEO Greenberg
  • Google’s Motorola royalty demand to Microsoft cut by judge
  • EA must face fraud claim by man seeking “Madden” royalties
  • Dell gets Silver Lake investor cheers in rare feat w/PC talk
  • Empire State Building IPO plan nears pivotal test in court
  • Senate passes last-ditch bill to end controller furloughs
  • Online sales-tax measure advances to May 6 vote in Senate
  • Carlyle joins Pantheon with new offices in Colombia, Peru
  • ECB, Fed, Facebook, Buffett, Derby: Week Ahead April 27-May 4

EARNINGS:

    • Autolive (ALV) 6am, $1.21
    • Corporate Office Properties (OFC) 6am, $0.41
    • Covidien (COV) 6am, $1.09 - Preview
    • Tyco International (TYC) 6am, $0.39
    • Barnes Group (B) 6:30am, $0.44
    • Goodyear Tire & Rubber (GT) 6:30am, $0.30
    • ImmunoGen (IMGN) 6:30am, $(0.16)
    • Aon (AON) 6:30am, $1.10
    • American Electric Power (AEP) 6:57am, $0.81
    • Brookfield Office Properties (BPO CN) 7am, $0.26 - Preview
    • Simon Property Group (SPG) 7am, $2.01 - Preview
    • National Oilwell Varco (NOV) 7am, $1.36
    • LifePoint Hospitals (LPNT) 7am, $0.79
    • Alliance Resource Partners (ARLP) 7am, $1.34
    • DTE Energy (DTE) 7am, $1.07
    • Digital Realty Trust (DLR) 7am, $1.18
    • Alliance Holdings (AHGP) 7am, $0.83
    • Burger King Worldwide (BKW) 7am, $0.17
    • VF Corp (VFC) 7am, $2.19 - Preview
    • WisdomTree Investments (WETF) 7am, $0.06
    • DR Horton (DHI) 7am, $0.19 - Preview
    • LyondellBasell (LYB) 7am, $1.45
    • Ventas (VTR) 7:01am, $1.00
    • Chevron (CVX) 7:30am, $3.07 - Preview
    • HMS Holdings (HMSY) 7:30am, $0.18
    • FLIR Systems (FLIR) 7:30am, $0.36
    • FirstService (FSV CN) 7:30am, $(0.03)
    • Moog (MOG/A) 7:50am, $0.78
    • Lazard (LAZ) 8am, $0.31
    • GNC Holdings (GNC) 8am, $0.72
    • Itron (ITRI) 8am, $0.45
    • Medical Properties Trust (MPW) 8:30am, $0.26
    • Capital Power (CPX CN) 8:30am, C$0.40
    • TransCanada (TRP CN) 8:30am, C$0.54
    • Forum Energy Technologies (FET) Bef-mkt, $0.33
    • AbbVie (ABBV) Bef-mkt, $0.67 - Preview

COMMODITY/GROWTH EXPECTATION (HEADLINES FROM BLOOMBERG)

  • Gold Buyers Throng Indian Stores for Second Week on Rally
  • Gold Traders Most Bullish in Month as Buying Surges: Commodities
  • Trafigura Said to Hire Former TNK-BP Trader Kollek in Moscow
  • Corn Traders Least Bullish Since September on Drier U.S. Outlook
  • Copper Falls as Stocks Keep Expanding Before Holiday in China
  • Coffee Falls to Lowest Since January on Supply View; Sugar Rises
  • Gold Extends Gains in New York on Signs of More Metal Purchases
  • Coal Slump Seen Ending on Deal at Four-Year Low: Energy Markets
  • Corn May Fall 36% on Record World Production: Chart of the Day
  • Boeing Supplier Says Aircraft ‘Brightest’ Market for Aluminum
  • Oil May Gain Next Week on Projected ECB Rate Cut, Survey Shows
  • Highest-Paid Workforce Driving Shell Offshore Australia: Energy
  • European Power Trading Falls a Second Year as Banks Drop Out
  • Gold Imports by China Seen Jumping as Price Slump Lures Buyers

THE HEDGEYE DAILY OUTLOOK - 5

 

CURRENCIES


THE HEDGEYE DAILY OUTLOOK - 6

 

GLOBAL PERFORMANCE

 

THE HEDGEYE DAILY OUTLOOK - 3

 

THE HEDGEYE DAILY OUTLOOK - 4

 

EUROPEAN MARKETS

THE HEDGEYE DAILY OUTLOOK - 7A

 

ASIAN MARKETS


THE HEDGEYE DAILY OUTLOOK - 8

 

MIDDLE EAST


THE HEDGEYE DAILY OUTLOOK - 9

 

 

The Hedgeye Macro Team

 

 

 

 

 

 

 

 

 

 



#Losing

“Losing on the other hand, really does say something about who you are. Among other things it measures: do you blame others, or do you own the loss? Do you analyze your failure, or just complain about bad luck?”

-Lance Armstrong

 

Yesterday, I started off the Early Look with the title #Winning and today I chose its antonym as the title.  It is rarely enjoyable to lose, or think about losing, especially in investing and business, but the reality is that we probably learn more from our mistakes than we do from our victories.

 

 Lance Armstrong is now considered by many to be one of the biggest losers of our generation after being one of the biggest winners with his unprecedented string of Tour de France victories.  In the most recent news, the Justice Department has filed a suit for $100MM against Armstrong and Tailwind Sports under the False Claims Act on behalf of the U.S. Postal Service (yes, it does beg the questions as to why the USPS was sponsoring cycling!). Time will tell what, if anything, Armstrong has learned from his failures and mistakes.

 

To be fair, it is natural to over react to mistakes (although I don’t think Armstrong is guilty of this) and I’ve certainly noticed this with myself and my colleagues at times.  The immediate reaction to a loss is often a willingness to quit a strategy. In reality, the reaction to a loss should be to analyze it, learn from it, and focus on improving the results.

 

The more interesting point on not learning and moving on from mistakes is that we basically inhibit ourselves from creating new ideas and opportunities.  As Po Bronson and Ashley Merriman write in “Top Dog: The Science of Winning and Losing”:

 

“By definition, new ideas can’t come from a playing-not-to-lose mindset, where the inhibition system is hyperactive. Creativity requires disinhibition: it requires turning off the internal censors in order to allow brainstorming and idea generation. Neuroscience has shown that in the very moment when a new idea sparks to life in the brain, the prevention system is turned off.”

 

So, in effect, if you can’t actually forget about your past mistakes and become uninhibited, you will chemically impair your ability to generate new and innovative ideas.

 

Forgetting about mistakes is certainly not easy, especially when the reminders are very present.  In the Chart of the Day, we’ve highlighted the three worst performing major global asset classes in the year-to-date: Peruvian equities, the Japanese Yen, and gold.  The irony of the last two is that when central bankers are aggressively printing money, like the Japanese central bank is, gold is not supposed to go down.  Of course, if unilateral money printing leads to U.S. dollar strength, the case for gold obviously becomes less compelling.  It should be no surprise that in U.S dollar terms the Yen is down almost the same percentage as gold this year.

 

The larger risk to gold is that we actually get to a place in which the U.S. Federal Reserve begins to tighten policy.  Certainly some slackness remains in the U.S. economy and inflation appears largely in check, but as my colleague and our U.S. economist Christian Drake pointed out yesterday in a note, we are starting to see potential that economic growth in the U.S. may accelerate based on:

 

1)      Housing – The housing recovery continues on the parabolic recovery that we outlined at the start of the year. Specifically, mortgage purchase applications recently registered a YTD high, median home prices of existing homes for existing home sales rose 11.8% (the highest level since November 2005), and inventory of existing home remains basically at its trough (down 17% in the last 12 months); and

 

2)      Employment -This week’s Initial Jobless Claims data was again positive with both the SA and NSA series showing sharp sequential improvement.   We consider the 4-week rolling average in NSA claims to be the more accurate representation of the underlying labor market trend and on that metric, the trend improved 250bps week-over-week as the year-over-year change in 4-wk rolling claims went to -6.3% Y/Y from -3.8% Y/Y the week prior.  So, despite initial sequester related impacts beginning in April and the seasonal distortion in the seasonally adjusted data shifting to a headwind, labor market trends continue to show steady improvement.

 

Despite what some of the talking heads might have you believe, in an economy that is 70% consumption, a strong U.S. dollar (the currency with which we consume), an improving housing market (the consumer’s balance sheet), and stabilizing employment, are all very supportive factors of improving economic growth.

 

I’m going to end this morning in the winner category.  If you haven’t been watching European sovereign yields, you should be focused on them as a measure of global tail risk.  Since the freak-out highs in yields perpetuated by the Cyprus dysfunction, yields in the 10-year sovereign bonds of Italy, Spain, and Portugal have recovered to some of the lowest levels we’ve seen since the beginning of the European sovereign debt crisis began.  In fact, it won’t be long before Italian 10-year yields starts with a three handle . . . I mean, who would’ve thunk!

 

Our immediate-term Risk Ranges for Gold, Oil (Brent), US Dollar, USD/YEN, UST 10yr Yield, VIX, and the SP500 are now $1, $97.31-103.34, $82.55-83.44, 97.45-101.36, 1.70-1.76%, 11.33-14.89, and 1, respectively.

 

Keep your head up and stick on the ice,               

                                                                                               

Daryl G. Jones

Director of Research

 

#Losing - Chart of the Day

 

#Losing - Virtual Portfolio


Daily Trading Ranges

20 Proprietary Risk Ranges

Daily Trading Ranges is designed to help you understand where you’re buying and selling within the risk range and help you make better sales at the top end of the range and purchases at the low end.

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