We remain bearish on MCD.
The stock has underperformed since we added it to our Best Ideas list on April 25 and will likely continue to do so. If we are right on the numbers, the situation could become worse than expected for shareholders.
MCD will report 2Q13 EPS before the market opens on July 22nd. For the quarter, the street is looking for 6% EPS growth to $1.40 on 3% revenue growth. We believe the 3% revenue target is aggressive and contend that the lack of leverage in the business model will disappoint investors looking for 6% EPS growth. In 1Q13, MCD reported 2% EPS growth on 1% revenue growth.
The company has a lot of work to do in order to improve their operational performance and we fail to see any indication that this will transpire soon. Looking forward to the 2Q13 earnings call, we expect to hear management’s recital of the (stale) tenets of the current Plan to Win strategy: “Optimize our menu, modernize the customer experience and broaden accessibility to brand McDonald’s around the world.” We believe 2Q13 results and the aforementioned message will fail to instill confidence in investors, as we do not see the current leadership coming up with ideas innovative enough to counteract the company’s current operating headwinds.
The short case we laid out back in April was predicated on MCD missing 2H13 sales numbers. We’ve always envisioned the June/July timeframe to be when our thesis begins to truly materialize. July is the time when most of the 2013 menu strategy has been implemented, effectively giving the street a better indication of how management is addressing the current issues. Looking at the three key regions, expectations are for a recovery in sales, however, we give little merit to this view given that the 2-year sales trends appear to be decelerating.
HEDGEYE – We will get a closer look at June sales trends and management’s early view on July trends when MCD reports 2Q13 results. We believe that both months will produce results below street estimates.
A quick look at MCD’s restaurant level margin will show you why the franchisee community is upset with management’s current business plan. Although the trends in restaurant level margins are less meaningful than the operating margins, they still matter. With that being said, on an annual basis, since the peak of 4Q10, MCD has given up nearly 180bps of restaurant level margins.
In contrast, enterprise operating margins have held up significantly better. On an annual basis, operating margins peaked in 1Q12 and have only declined 47bps since. Naturally, there is less volatility in operating margins, but expect sustained subpar same-store sales to inflict further pressure on margins.
Regionally, operating margins are down 110bps, 85bps and 59bps in the APMEA region, the U.S. and Europe, respectively. Given current trends, we believe MCD is vulnerable to further margin declines in both the U.S. and Europe.
HEDGEYE – We suspect that a 40bps decline in restaurant level margins will be in line with what the company will report. Furthermore, we contend that current street expectations for operating margins to hold flat in 2Q13 and to increase 40bps in 3Q13 are overly optimistic.
FOOD COST TRENDS
Since the lows in 4Q10, MCD has seen global food costs rise 132bps to an estimated 34% of overall sales in 2Q13. While McDonald’s has a very strong supply chain, it is likely that the company will continue to see their food costs rise for the foreseeable future, particularly due to its exposure to red meat. MCD benefited greatly from lower food costs in 1Q13, but we expect to see this trend reverse for the balance of 2013.
MCD has guided food inflation to be within the 1.5-2.5% range. Europe’s food inflation was up around 2.5% in 1Q13 with expectations of a comparable increase in 2Q13. Full-year food inflation for the region is estimated to be in the 2.5-3.5% range.
HEDGEYE – We’d be remiss not to note that any food inflation will have an adverse effect on the franchisee community.
LABOR COST TRENDS
In comparison to food costs, MCD had seen very stable labor cost trends over the past two years. We believe that the company will continue to face upward pressure on its labor costs for the foreseeable future.
HEDGEYE – If the company wants to regain traction on improving same-store sales it will not be accomplished using fewer workers. Labor costs are headed higher!
OTHER OPERATING TRENDS
Other operating costs were MCD’s largest source of margin decline in the U.S. in 1Q13. Overall, operating costs increased 41bps year-over-year, a trend that should persist for the remainder of 2013.
HEDGEYE – Similar to labor cost trends, MCD will experience higher costs across the P&L as management seeks to implement a more cohesive strategy to improve traffic trends.
Highlighted in the chart below, 50% of analysts rate MCD a Buy while the other 50% rate MCD a Hold.
This puts sell-side sentiment regarding the stock approaching levels not seen since 2004. Further, short interest in the stock is only 0.91% of the float.
HEDGEYE – I believe that the 2Q13 results will confirm our bearish thesis on MCD. The street may have a bearish bias on MCD, but are they bearish enough?
McDonald’s stock is up 14.4% YTD, below the 17.5% increase in the S&P 500. At 10.6x EV/EBITDA MCD is trading significantly below the QSR peer group trading at 12.3x EV/EBITDA.
HEDGEYE – McDonald's aforementioned operational issues suggest that the stock might be trading at a higher implied multiple. Valuation is not a catalyst!
This note was originally published at 8am on July 05, 2013 for Hedgeye subscribers.
“The caliphs fell, and the Caesars trembled on their throne.”
#Fireworks, love’m! But Americans need to remember what fighting for their independence means. For as long as conflicted, compromised, and centralized power remains in the hands of political plunderers, there remains a credible threat to freedom.
As I watched American Independence light up the sky last night in Connecticut, I couldn’t stop thinking why this can’t all turn out the way it always has in this country. Lincoln called it “government of the people, by the people, for the people”; not for MSNBC’s politicians.
Do we have to fight for our hard earned currency, free-markets, and economic liberty? Genghis Kahn bled for this 800 years ago inasmuch as Americans did before and after 1776. “The Mongols did not find honor in fighting: they found honor in winning.” (Genghis Kahn, pg 91)
Back to the Global Macro Grind…
Despite the US stock market’s run of the mill -3-5% correction from her all-time highs, what’s really #winning in 2013?
Shorting America’s currency and growth expectations works until it doesn’t. It worked for the last decade actually. That’s why plenty a hedge fund growth investor had the style-drift of buying Gold as politicians built the mother of all Bernanke Bubbles in bonds.
Gold and Treasuries hate growth.
If you ask Mr. and Mrs. Gold Bond for inside info on what this morning’s US Employment Report is going to look like, their answer won’t be any different than the answer their boss (Mr. Market) has been giving you since April:
So why should you pay the caliphs and consultants in Washington such a premium for that super-secret whisper on when and how Bernanke is going to taper, when you can just build a real-time market model to front-run them?
And why, by the way, is it so bad for America (not slices of the asset management business or Federal Reserve talking head speech fees) to see Gold crashing and #RatesRising?
Higher rates and crashing Gold were pro-growth signals in 1982 inasmuch as they were again in 1993. This isn’t a new concept. It’s called a cycle. Anyone who spent their days whining for a half-decade past those two dates doesn’t run real money anyway.
Kahn once said, “there is no good in anything until it is finished” … and the reality is that if you believe in economic gravity, there will be no sustained path to US growth until central planners get out of the way and let the Dollar strengthen alongside #RatesRising.
We know why there is a constituency of Bernanke believers out there who want the opposite of what most Americans should want – they get paid to believe! Follow the money:
Don’t blame me for that. It’s called a conflict of interest in what was consensus.
“I was not the author of this trouble; grant me strength to exact vengeance.” –Kahn (Genghis Kahn, pg 107)
And while vengeance may be a bad word for those who are being avenged, it’s also called #winning – USA style – for the rest of us who are promoting the only free-market path to prosperity and growth that US central planners from Bush to Obama haven’t yet tried.
Whether today’s jobs report “beats” or not, the timing remains ripe to avenge America’s Throne of Independence via #StrongDollar.
Our immediate-term Risk Ranges are:
UST 10yr 2.45-2.64%
Best of luck out there today and enjoy your liberties this weekend,
Keith R. McCullough
Chief Executive Officer
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“Never memorize something that you can look up.”
I used to have something of a photographic memory. Lately, however, a plot of my capacity for short-term recall and a YTD chart of Gold would probably be hard to distinguish.
I’d proffer that my bout with Cognitive Deflation is only transient and simply the byproduct of late nights with infants, serial overconsumption of caffeine, and serial under-consumption of exercise. At least that’s what I tell myself.
Either way, I’ve come to more closely relate to the aphoristic wisdom embedded in Einstein’s quote above.
With some beach time on the August calendar, I’m holding out hope the downtime catalyzes some needed cerebral exfoliation.
Back to the Global Macro Grind….
We have been negative on emerging market debt and equities for most of 2013 with #EmergingOutflows & #AsianContagion headlining our 2Q13 and 3Q13 Macro Investments themes calls, respectively.
The story of emerging market pain is one birthed from emergent strength in the U.S. dollar, acceleration in U.S. growth and the associated reversal in unprecedented Fed policy driving an expedited reversal in Hot Money & Yield Chase Flows out of developing economies.
We’ve presented the principal conclusions of our research and suggested positioning in recent presentations, but it’s probably worthwhile to take an illustrative, didactic tour of capital flows to understand how the cycling of capital into and out of emerging economies can work to propagate negative economic and market impacts in an archetypical scenario.
Capital Flows to Emerging Economies for 3 Principle Reasons:
1. External: “Push” flows occur for reasons external to the capital-importing economy and generally relate to relative investment attractiveness. Perhaps the simplest way to understand it is in the context of U.S. interest rates. If growth slows, policy turns easy and interest rates in the U.S. decline, investment yields available in emerging economies become relatively more attractive and capital flows accordingly. Historically, this has been the largest driver of rich-to-poor capital flows. It’s also generally the most volatile.
2. Internal: “Pull” flows are catalyzed by improving economic fundamentals, sound policy and/or trade & capital market liberalization initiatives. Pull flows provide firmer bedrock for sustained inflows.
3. Financial Globalization: Here we’d highlight the ongoing, global trend towards Financial & Capital market integration and the proliferation of conduit investment vehicles allowing broad institutional and retail access to developing economies. A secular shift in portfolio allocations towards international diversification holds positive longer term opportunity for developing economies. However, in compressed periods in which flows chase performance, it can work to amplify volatility in market prices.
It’s the potential transience of “push” and portfolio (i.e. equity & debt) flows that are of most concern to capital-importing countries, particularly given the reality of hyper-fast capital mobility.
So, what happens when the Hot Money starts to flow?
In a generalized model, the body of empirical evidence points to a number of discrete macroeconomic impacts:
1. Currency Appreciation: Absent Central Bank intervention the demand for foreign currency drives the exchange rate higher.
2. Consumption Growth: The influx of foreign capital provides for a higher level of domestic investment. This higher level of investment is generally accompanied by a decline in the domestic savings rate. Consumption rises as consumerism displaces saving.
3. Rise in the Money Supply & Inflationary Pressure: Stemming from a rise in economic activity along with any attempts by the central bank to quell the currency appreciation.
4. Widening of the Current Account Deficit: Don’t worry if you don’t remember the details about what the Current Account is. Here, it’s sufficient to understand that imports rise relative to exports generally due to an appreciating currency and rising consumption.
It’s not difficult to understand how the confluence of the above dynamics can work to drive recurrent boom and bust cycles for emerging and formerly, capital-rationed, economies. Consider how the interaction of the above factors, which initiates with a large influx of foreign capital, can work to drive a self-reinforcing cycle in both directions:
U.S. growth slows, Bernanke cuts to 0%, institutes financial repression and forces capital to search out yield. Capital flows into the EM economy causing increased investment, falling domestic savings and rising domestic consumption. Incomes rise alongside accelerating growth, driving a further increase in consumption in a positive, reflexive cycle. Further, foreign capital inflows along with diverted domestic savings provide a bid for real (i.e. housing) and speculative financial assets. Net wealth increases alongside inflating asset values. Faster growth, higher incomes, and rising net wealth all serve to increase capacity for credit. Credit expansion then serves to amplify the cycle. Everything is great, until…….
U.S growth starts to inflect to the upside, #StrongDollar starts to sniff out a Fed Policy reversal, and “push” flows begin to reverse.
When portfolio capital starts to exit, asset prices deflate and credit gets tighter, investment and consumption both decline. The currency depreciates, driving local inflation higher at the same time that aggregate demand accelerates to the downside. If demand is local and the debt is denominated in foreign currency, the debt burden on business is amplified. Declining demand in the face of a crashing currency and elevated inflation can leave policy makers handcuffed.
Thus, capital flows, this time the expedited exportation of foreign capital, catalyze a reversal of the boom cycle described above with some version of a self-reinforcing, contractionary cycle playing itself out.
Of course, country specific fundamentals, policy decisions, and monetary systems matter and understanding the prevailing risk for a particular country is more nuanced, but the generalized model described above captures the broader dynamics that tend to drive the cycle.
Further, given the large-scale proliferation of EM related investment vehicles whereby investors indiscriminately bought ‘international diversification’ without a real understanding of the underlying exposures, it’s unlikely they will be overly discriminate in their selling. Historical precedent suggests #StrongDollar driven outflows from emerging markets are protracted.
In short, we don’t think #EmergingOutflows have bottomed yet.
Hopefully the decline in my recollective ability has.
Our immediate-term Risk Ranges are now:
UST 10yr yield 2.49-2.74%
Enjoy the weekend.
Christian B. Drake
TODAY’S S&P 500 SET-UP – July 19, 2013
As we look at today's setup for the S&P 500, the range is 31 points or 1.15% downside to 1670 and 0.69% upside to 1701.
CREDIT/ECONOMIC MARKET LOOK:
MACRO DATA POINTS (Bloomberg Estimates):
WHAT TO WATCH
COMMODITY/GROWTH EXPECTATION (HEADLINES FROM BLOOMBERG)
The Hedgeye Macro Team
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