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HOUSING – ACTING RATIONALLY

 

If you take a classic economist's view on the recent Commerce Department figures on housing you are missing the point on the housing recovery story.  An old school economist will tell you that the decline in home building will continue to act as a drag on investment and overall output in the economy in 2009. 

 

In sharp contrast to that view, ours is that the only way the economy is going to get back on a growth trajectory is for the U.S. to work through the excesses of the past-and that means housing inventory. 

 

According to the Commerce Department, housing starts declined 13% to an annual rate of 458,000, which was led by a 46% decline in multifamily starts.  Also, building permits, a sign of future construction, fell 3.3% to a record low pace of 494,000.  On this news the futures sold off immediately, a classic reaction to a traditional government statistic.  It was almost like the traders in the futures pits are reacting to headlines without perspective.  Intraday, those pre-market losses were recovered and those who shorted the opening lows are once again feeling shame.

 

Given the supply of unsold homes and the number of homes in foreclosure, is it any surprise that builders broke ground on the fewest homes on record in April?  If you are a builder this is bad news, which is why we don't think the best way to play a housing recovery is to buy home building stocks.  As an aside, the insider selling at Toll Brothers Inc has been massive!  Since March 16th the Toll Brothers have collectively sold $45 million worth of stock. 

 

If you are Home Depot or any of the second derivative housing names you are indifferent at this point to the housing start number.  Right now the second derivative names are looking for the increase in housing turn over, so we can work through the supply of homes.  This is the first step in the housing recovery story!  The growth in big ticket items will come later!    On May 5th, the National Association of Realtors said the Pending Home Sales Index, (a forward-looking indicator based on contracts signed) increased in March by 3.2% to 84.6 from 82.0 in February.  Importantly, the index is 1.1% higher than in March 2008.

 

What has been occurring over the last two months could be the leading edge of a turn in the housing market.  As we said in our 4/24/09 post - HOUSING - Which way is up? -  affordability is at a 40-year high when looking at median home prices, mortgage rates, monthly mortgage payment, and median family income.   

 

As we work through supply, the decline in home prices will slow! Not until then will homebuilders start to build more homes.  Chances are when this happens the S&P 500 will be few hundred points higher!

 

Howard W. Penney

Managing Director

 

HOUSING – ACTING RATIONALLY - starts


KONA – HOLD OUT FOR A HIGHER PRICE


For the second time in as many years Mill Road has made a bid for Kona Grill (KONA). The first offer in March 2008 was at $10.75 a share. On Monday, Mill Road offered $4.60 a share, up from the May 15 closing price of $2.29.


Based on where KONA is now trading relative to other casual dining companies and my EBITDA estimate for 2010, I would take nothing less than $5.50


In documents filed with the SEC Mill Road said: "The recent departure of the company's chairman and CEO has placed Kona at a crossroads. The company and its employees are facing a very difficult operating environment for restaurants without the leadership and vision that a permanent CEO should provide. ... We strongly believe that Kona has a significantly better chance of successfully addressing the competitive, leadership and capital issues as a private company."


It was not too long ago that senior management at OSI Partners Inc. made the same statement about being a private company. Given the trouble they are in, I don't think they would make that statement today!


More to come!

 


IGT: A TALL PEAK OF EARNINGS

In our 4/21/09 note "IGT: PLENTY OF EARNINGS POWER FOR PATIENT INVESTORS", we highlighted recurring earnings power of $1.40-$1.50 assuming normalized replacement demand of 35,000 machines annually. 

 

Since that analysis, we've also reached the conclusion that pent up demand, especially for Reel Spinners, could lead to a V-shaped recovery, much to the benefit of IGT.  Assuming 38% of the 950,000 slot machines in North America are Reel Spinners and they are replaced in an accelerated cycle over three years, IGT could sell almost 60,000 Reel Spinners annually with a 60% share.  Throw in another 15,000 Video Reels (33% share) and IGT would be selling 75,000 machines annually over a three year V-shaped recovery scenario.  Per my complex math, 75,000 is a lot more than normalized 35,000, which is a lot more than our 2010 projection of 15,500.

 

IGT: A TALL PEAK OF EARNINGS  - IGT NA REPLACEMENT DEMAND

 

At 75,000 replacements, IGT could generate north of $2 per share in EPS for a few years, more than double our 2010 estimate of $0.94.  Not bad for a $15 stock.


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CMG: A CLASSIC PATTERN DEVELOPS!


Chipotle, like every restaurant company is currently "over earning" which is not a bad thing, just a function of the times. By "over earning" I mean the rate of pricing running through the P&L is far out stripping the rate of inflation the company is seeing, so margins are exploding. For CMG this will continue for at least one to two more quarters, depending on traffic trends and how the new menu initiatives perform.

 

Given how young the Chipotle concept is, there is not a lot of history to understand how consumers will view the concept in a recession. Fortunately, senior management has bought themselves some time and margin to adjust to the new reality; consumers are not flocking to the concept as they once did on the past.

 

In 2007, Chipotle was enjoying rapid growth with little or no advertising expense. Much of the growth was driven by word of mouth and CEO Steven Ells justified the scant spending on advertising in March 2007, saying, "Advertising is not believable." Fast forward to today and Chipotle's traffic was down 4.5% in 1Q09 and the company is launching its first advertising campaign.

 

Ells and his team have come up with mychipotle.com as a centerpiece for an advertising campaign seeking to bring the credibility of word of mouth promotion to a wider range of people. The aim is to get more people into Chipotle. I'm sure we will hear how successful mychipotle.com site is, but I'm skeptical that it will translate into increased traffic.

 

While I have no doubt that social media advertising is powerful and could possibly benefit CMG in the future, value is a key theme today. Clearly, the concepts declining traffic trends are down partly in response to the 8.5% price increase implemented last year. In the short run, the menu price increase certainly helped margins, but may create some difficulties should traffic not pick up significantly in 2010.

 

By the time we reach 2010, the Chipotle concept will have little or no pricing flexibility and at some point variable costs and lower price points on the menu will impact margin. At the same time, the company will have opened over 250 stores at lower margins or 25% of the store base. There will continue to be a "portfolio" impact on the overall margin structure of the company.

 

The following are some of the key issues the company faces. CMG clearly has a number of significant issues to overcome, but nothing is terminal. The comparisons in 2Q09 are difficult, but the "over earning" status suggests that it might not be that difficult to compare against. In this scenario, the 19% short interest is a bullish signal.

 


MENU CHANGES

 

By design the Chipotle menu is simple and easy to execute as it displays the individual ingredients, and leaves it up to the customer to mix and match. The company research suggests that this design leads to a perception of limited variety and discourages experimentation. More to the point, the concepts price points are not flexible enough to provide choices for families with kids. In order to broaden the appeal of the concept, the company is testing a new menu that includes new entree options, several featured items, new, smaller, lower priced options, and a complete kid's menu. Without a broad based communication strategy to communicate the menu changes and drive incremental customer traffic, the risk that the concept sees a lower average check from current customers is high.

 

Can they introduce value and maintain margins; that thought is inconsistent in the restaurant industry!

 

CMG:  A CLASSIC PATTERN DEVELOPS! - cmgpod1

 

MARKETING

 

Chipotle new marketing campaign is called My Chipotle and is designed to engage directly with Chipotle's current customer base. The idea is build on the traditional word-of-mouth strategy. The new campaign will be using radio, print, outdoor and a website called mychipotle.com. The intent is for the concepts customer to become part of the ongoing My Chipotle advertising campaign. The new strategy appears to be directed at the concepts existing heavy users and not drawing in new customers.

 

As a percentage of sales, Chipotle spent 2.2% in 1Q08, 2.5% in 2Q08, 1% in 3Q08 and 0.7% in 4Q08. In. Overall for 2008, CMG spent 1.75% of sales on marketing. In 2009, advertising should remain at 1.75%, with 1Q09 spending 2009 at 1%, advertising is expected to accelerate for the balance of 2009 putting pressure on margins in 2H09.

 

SAME STORE SALES

 

Chipotle took a very aggressive approach to pricing in 2H08 and given the decline in overall restaurant traffic, it's hard to quantify how much of the decline in traffic is in response to higher prices. In 2009, the price increases taken last year will result in an effective increase of about 6% for the full year with effective pricing of around 6% for 2Q09 and 3Q09 and less than 3% in 4Q09. Currently, guidance is for same-store sales to be in the low single digits for 2009. In 2Q09, CMG will lose a day as a result of being closed on Easter and it will lap a 2% menu price increased from last year.

 

A critical issue going forward will be management expectations for its new marketing initiatives and the impact on traffic. I would not be surprised to see management be overly optimistic about the potential impact for the increase in customer counts. It's unlikely to see a significant improvement in same-store sales from current levels.

 

CMG:  A CLASSIC PATTERN DEVELOPS! - cmgpod2

 


NEW STORES/LOWER RETURNS - A RESTAURANT INDUSTRY CLASSIC!

 

This is where one of my biggest concerns lies when looking at CMG. I don't know one restaurant company that has been able to overcome the "portfolio impact" on margins and returns from opening stores with lower average unit volumes.

 

Total capital expenditures in 2008 were $152 million; declining to $140 million in 2009, of which $120 million relates to the construction of new stores. In 2008, CMG spent, on average, $916,000 to build a new store - up from $880,000 in 2007. This is due to opening a larger portion of the restaurants in urban locations being partially offset by a decline in the percentage of free-standing restaurant openings and smaller square foot per store. In 2009, development costs are expected to remain the same as 2008.

 

Here is the problem; CMG new growth is coming from building new stores with lower average unit volumes that cost more to build! This trend will not reverse as they have built out all the best return sites. Also weighing on future performance is the company ability to pick only A/B sites; right now there is room for error in site selection.

 

Going forward, incremental growth provides a diminishing return. Over time while the company may be able to grow total EPS, but the multiple on the EPS will contract providing very little upside to the stock price.

 

Another classic pattern will be for the investment community singularly focused on the performance of the existing store base relative to the new stores being opened. The company reported its first decline in system-wide AUVs in 1Q09 as more new stores are annualizing at $1.35 million to $1.4 million are brought into the comp base. Currently the system average is about $1.7 million. In 1Q09 I calculate new store average unit volumes at $1.26 million versus $1.40 million in 1Q08, down 10%. This compares to management stated number of $1.350 million to $1.4 million. I know that the new store performance is not a new issue, but it's one that should not be over looked.

 

Over the past year CMG has been opening lower volume stores; as a result, the company's return on incremental invested capital has declined from 26% in March 2008 to 17% in 1Q09. While this metric has improved from the low of 12% in 4Q09 the trend will decline given the company current strategy.

 

Toward the end of 2009, I would not be surprised to see the company accelerate unit development in an effort to maintain a growth multiple!


CMG:  A CLASSIC PATTERN DEVELOPS! - cmg3

 


Are You Down With O-P-E-C? “Yah You Know Me”

 

The Energy Information Administration ("EIA") prints a weekly piece which is entitled, "This Week In Petroleum", which offers a broad view of what has happened in the last 7-days in the petroleum markets, with a particular focus on the United States.  In the most recent version, which was publicized last Wednesday at 1pm, as it is every week, it had an interesting note relating to surplus capacity in OPEC, which was as follows:

 

"The members of the Organization of Petroleum Exporting Countries (OPEC) generally hold almost all of the world's available surplus crude oil production capacity, providing them with the ability to alter production levels to influence global oil prices and manage market conditions. Saudi Arabia and other Persian Gulf countries usually hold the bulk of available surplus production capacity, with Saudi Arabia stating it wants to maintain 1.5 to 2 million barrels per day of surplus capacity. In contrast, non-OPEC countries generally produce at capacity and tend to have surplus capacity only when oil prices are so low that marginal production is unprofitable and is shut-in."

 

While there is a great deal of speculation as to what was driving the rampant rise in oil prices into the summer of 2008 (Was it the financial speculators? Was it the evil-doer short sellers?), the fact of the matter remains that based on the measurable data, "oil producers were operating at 98 to 99 percent of capacity".  As the global oil market began operating closer and closer to capacity, it became even more susceptible to marginal changes in supply, such as those related to geo-political risk.  Currently, OPEC is operating at about 4 million barrels per day of surplus capacity versus the 30-year low of 1 million barrels of surplus capacity in Q3 2008.  The current level of surplus capacity is comparable to the level that was maintained for much late 1990s and early 2000s, when oil was at a much lower level even on an inflation adjusted basis.

 

This spike in OPEC capacity correlates with an increase in U.S. Crude Oil Days of Supply, which has been solidly above 25 days of supply since mid-March, which is a level not last seen since 1995 / 1996.  This chart is outlined below.  Clearly the major spike up in days supply has been a drop off in demand due to the recession and increasing unemployment, though there has been a sizable increase in domestic production on a y-o-y basis as well.  In fact, from February to the week ending May 8th, 2008 domestic oil production in the U.S. has been up on average 5.7%. In aggregate for the year-to-date, the U.S. has produced ~4.163MM more barrels than the year before, which while not insignificant is still less than 10% of the 44.8MM build-up in oil stock we have seen y-o-y.  Thus even if domestic production dropped back to levels from a year ago, we would still have had a surplus of oil domestically.

 

Are You Down With O-P-E-C? “Yah You Know Me” - crude

 

Despite these negative fundamentals, Oil is up ~33% in US$ year-to-date and we see a positive quantitative set up going forward.  In fact, we see the TREND upside line at $77.09 versus the TREND support line at $47.94.  Based on the current price of oil at ~$59 / barrel, we see a compelling risk / reward of $11 downside and $18 upside, with our TRADE support at $53.84.

 

The price of oil appears to be signaling one of two things:  either demand will at some point in the near future accelerate or that there is a geo-political event on the horizon that will reduce supply.  

 

In 2007, many corporate management teams responded the following way when we asked them about their macro view: "We have no crystal ball."  In this case,  we really do not have a crystal ball, but one thing we have learned in our careers is that price is a leading indicator and historically reported fundamentals are, by their very nature, a lagging indicator.  As always, price rules.

 

Daryl G. Jones
Managing Director


SKS Quick Read

SKS reported -$0.04 for the quarter vs. the Street at -$0.26.  On the surface it looks like a huge beat driven by much better gross margins and huge expense cuts.  However, a huge clearance event was pushed out into 2Q, which positively benefited the quarter by about $0.05.  Net, net still a better number but 2Q will be hit on the gross margin line by the clearance shift.

 

Inventory not well controlled relative to sales, which has been a consistent issue here.  Total inventory down only 7.3% vs. sales down 27%.  They talk about getting inventories more in line by 3Q, but they are not suggesting huge cuts here but rather more gradual pruning.  

 

As for trends in the quarter, all regions, categories, geographies, and channels were weak.  Notably the NYC flagship was worse than the overall average of down 27.6%.  This confirms other anecdotal commentary that the NYC market is still very soft.

 

Eric Levine


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