The Economic Data calendar for the week of the 24th of June through the 28th 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.
We no longer see Darden as one of the most attractive longs in the space as soft traffic and confusing statements from the management team make it difficult to remain behind the stock. We are removing it from our Best Ideas list as of today. Given today's results and conference call, we can no longer defend the long case.
On today’s evidence, we believe that Darden’s shares have further to fall. We adopted a bullish stance on DRI in March having been bearish on the stock since July 2012. The bull case was comprised of two scenarios, either of which was sufficient, in March, to boost the stock considerably from the depressed levels it was trading at. The first was an improving economy, which implied accelerating Knapp Track comps that would most likely imply a sequential acceleration in Darden’s comps. The second was the possibility of an activist emerging to shake up management and take advantage of what we saw as a company whose equity was trading below the value of the sum of its parts. Following the earnings release and conference call today, we believe neither scenario is likely from here. The stock has appreciated handsomely since the lows of the year and we believe that management is entrenched in the company and the fundamental performance of the company suggests that further downward revisions of FY14 earnings are in play. While we have called out the deficit of leadership in Orlando, as well as the activist thesis that we see as attractive to those active in the space, it seems as though change will not be as forthcoming as we previously thought.
The primary takeaway from the quarter is that traffic trends at Olive Garden and Red Lobster remain soft and management seems to have little in its arsenal to rectify that situation. CEO Clarence Otis stated that traffic is the ultimate measure of brand health and blamed Darden’s weak comps on the macro economy, even offering a U.S. GDP growth estimate for 2013.
The company lowered FY14 EPS growth expectations and Blended “Big Three” same-restaurant sales guidance for the next four quarters.
Big Promises from the Top
Darden’s leadership deficit continues to grow. We were surprised to hear Clarence Otis tout the company’s positive traffic growth on CNBC this morning. While the company did register positive traffic, the traffic comparison was favorable and the two-year average trend at each of the “Big Three” concepts tells a distinctly different tale to what Otis was communicating. The sequential deceleration in two-year average trends in May, despite an easier compare, suggests that the underlying trend weakened into the end of the fiscal year.
Capital Intensity a Key Point
While the capital intensity of Darden’s business model has been decreasing, what is more relevant for a restaurant company is the relationship between capex growth and EBITDA growth. In this instance, we see, below, that Darden’s EBITDA growth is decelerating precipitously. Guiding to higher FY14 cash flow from operations on lower net income is raising the bar too high, in our view.
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Takeaway: What we do not want is for Ben Bernanke to back off what he said. We need him to taper.
The only good thing that’s happened this week from a global macro fundamental research perspective (which is different than the quantitative signaling perspective) is of course that the US Dollar has recaptured its trend line of support.
That line is 81.11. The corollary to that line for the Yen versus the Dollar is 96.18. Watch those lines very closely.
This is a good thing. It breaks down the oil price. And it keeps commodity deflation in play.
Obviously YTD the best place to be has been short commodities, long consumption. The CRB Index is down about 5.5% YTD versus the S&P 500 which is up about 12%.
By the way, what we’re having right now is a correction in equities, not a crash. What would provide additional support for just a correction instead of a crash would be #StrongDollar.
What we do not want is for Ben Bernanke to back off what he said. We need him to taper. The only thing that will keep the Dollar up is tapering.
Our Central-Planning Fed Overlords need to get out of these ridiculous programs and eliminate these ridiculous expectations that we’re going to have ridiculously low, zero percent interest rates for the rest of your life.
(Editor's Note: This commentary comes from from Hedgeye CEO Keith McCullough's morning conference call. If you would like to learn more, please click here.)
Conclusion: Domestic Consumption should be 'okay' (not great) for 2Q13 with the low savings rate and historically low PCE inflation continuing to help offset ongoing, modest growth in wage inflation and disposable personal income. Government furloughs beginning in July along with the potential for a further shift towards part-time/temp employment related to Obamacare hours worked thresholds is likely to constrain the upside in personal income in 3Q.
The domestic Labor market, Housing and Confidence data all continue to accelerate – even the economic wet blanket that has been the March-May manufacturing data is showing some life with the latest Empire and Phili Fed reports. Still, wage inflation remains subdued and real wage growth, while looking increasingly better, is still not exciting on an absolute basis and is benefitting, in large part, from abnormally lower inflation.
So, with the market remaining in FOMC myopia hangover mode, what’s the current read-through for consumption from the conflation of the above fundamental factors?
Broadly speaking, the drivers of Consumption aren’t overly complicated. In short, consumer spending growth is hostage to (the growth in) income, the marginal propensity to consume or save that income, and the net change in household credit.
Asset reflation/appreciation and the wealth effect matter, but they are largely indirect impacts - higher net worth doesn’t mystically transubstantiate itself into consumption – the incremental benefit to consumption has to come via a behavior shift such that households hold fewer non-housing related assets than they would otherwise have held. Empirically, this manifests as a decline in the savings rate and/or an increase in debt levels.
Below we take a summary look at each of the primary consumption drivers:
Income and Savings: Together, growth in disposable income and the change in the savings rate explain most of the change in nominal consumption growth. Over the last 30 years, the multiple regression between PCE growth vs. Disposable Income growth and the change in the Savings rate produces an R^2 of 0.94. Under the following assumptions, the regression equation suggests y/y real consumption growth of 2.6% for 2Q13.
Sequestration: The furloughing of ~ 750K federal employees will begin in July. There are currently 2.75M federal employees, which represents 2.0% of the NFP workforce. A continuation of current trends in Federal government employment growth alongside a 20% paycut for ~27% of the Federal workforce equates to a 7.2% decline in aggregate pre-tax income YoY. Stated different, the collective impact of the furloughs and employment growth at the federal level should equate to a ~7% decline in income for 2% of the total workforce as we move through 3Q.
State & Local government employment growth went positive in May for the first time in 5 years. Continued, positive job growth at the state/local level could serve as an offset to accelerating declines in federal employment and income growth. Collectively, Federal, State, & Local government employment currently represents 16.1% of total payrolls. Layering on an assumption of modest, but accelerating state & local gov’t employment growth to the furlough and employment related pressure at the Federal level, the net impact is ~1.2% negative aggregate income growth for 16% of the employment base.
In short, negative income growth for 16% of the workforce will serve to constrain the potential for acceleration in personal disposable income growth, and aggregate consumption growth by extension, in 3Q13.
Household Balance Sheet: The 2Q13 Fed Flow of Funds data reflected an acceleration in household net worth, largely on the back of accelerating home values and new highs in equities and other financial assets. On a nominal basis, net wealth is 5.2% above the 2007 peak. Adjusting for inflation and the growth in households, household net wealth remains ~7.6% below peak levels.
Net-net, the household balance sheet recovery remains ongoing and should remain supportive of household capacity for credit expansion. Further, the LTM appreciation in home values should be supportive of some measure of the wealth effect (+25-40bps net impact to GDP by our estimate). While an expedited back-up in mortgage rates would be serve as a headwind to transaction volumes in the more immediate term, current affordability (even with the rate backup) and supply/demand dynamics coupled with the positive labor market trends and the giffen nature of housing, we continue to see further intermediate and longer-term upside for housing.
Credit: The latest Federal Reserve data reflects a $19B sequential decline in total household debt in 1Q13 with Y/Y growth in total debt recovering further towards the zero line. The Fed’s 2Q13 Senior Loan officer survey showed bank credit standards continued to ease while business and consumer loan demand, particularly for real estate and auto loans, showed further sequential improvement.
So, while broader credit trends are favorable and a positive change in the flow of net new household credit would provide an incremental tailwind to consumption growth, thus far, credit has had a muted to dampening impact on consumption as the larger deleveraging trend has continued to predominate. Over the more immediate term, we’re not anticipating a change in credit to serve as a material driver of household consumption growth.
In sum, ‘okay’ is probably the right adjective in describing the outlook for consumption growth over the intermediate term. Policy headwinds certainly exist but the labor market, housing, and confidence all continue to stream roll ahead alongside #StrongDollar upside for consumption.
Given the global macro alternative’s – you don’t want to be long bonds, commodities, EU or EM debt, equity, or currencies, or anything Japan – is “okay” good enough to increase gross exposure to domestic equities with an eye towards easy comps and a diminishing fiscal drag in 2014?
The answer is yes…but at a price. As Keith highlighted in today’s S&P500 update note: “For a few weeks I have been saying ‘get out of the way’ – and for the 1st time this year I am saying stay out of the way (for now).”
Enjoy the weekend,
Christian B. Drake
Takeaway: For a few weeks I have been saying ‘get out of the way’ – and for the 1st time this year I am saying stay out of the way (for now).
POSITION: 5 LONGS, 4 SHORTS @Hedgeye
This is not good. Both PRICE and VOLATILITY are now confirming yesterday’s VOLUME signal. In my 3-factor model, that’s all I need to stay out of the way. If the TREND line of 1589 remains broken, there is not intermediate-term support to 1503.
Many of you will ask why I am using 1589 now (instead of 1583). That’s the right question. And the answer is that I’ve had to tweak my implied volatility assumption for a breakout in intermediate-term US Equity (front-month) volatility above my 18.98 VIX TREND line.
Across our core risk management durations, here are the levels that matter to me most:
In other words, for a few weeks I have been saying ‘get out of the way’ – and for the 1st time this year I am saying stay out of the way (for now). That’s new for me. For 6 months you’ve been used to seeing me buy corrections. Thanks Ben.
I am price, volume, and volatility data dependent. This is my plan (for now). And the plan is that the plan is always changing.
Enjoy your weekend,
Keith R. McCullough
Chief Executive Officer
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