KO Takes It on the Chin

Takeaway: Coke takes it on the chin, but there may be room for optimism.

This note was originally published July 16, 2013 at 14:17 in Consumer Staples

KO is trading down today as volume results for Q2 2013 came in below expectations (globally +1% vs +4% last quarter) with the company citing a challenged macro environment (U.S., Europe, Asia, and Latin America), social unrest, and poor weather conditions (wet and cold across multiple regions) that impacted consumer spending and demand. North America, which is ~ 44% of sales, saw volume down a disappointing -1% in the quarter.  


Performance was hit by tough Q2 comps given the especially good weather in 1H last year: Pacific volumes were +2% vs +10% last year; Brazil’s volume was even cycling +6% a year ago; and India’s volume grew +1% versus a +20% comp.


The company cited optimism around a turnaround in 2H for its key international markets (China, Brazil, Russia, Mexico, and India) on improvement in the macro environment, continued marketing support of its brands, weather improvements (India performs historically stronger in the back half), and its systems execution.


While we expect many of the forces dragging on confidence and demand to remain in the back half of the year,  including  high unemployment (especially in southern Europe), social unrest, and inflation, we like that the back half quarters of 2013 are lapping much easier comparisons year-over-year.  On the top line, the Q3 2012 comp is +0.8% versus this quarter’s +2.8%. Gross margin was pretty consistent throughout last year, however the operating margin gets easier in the final two quarters of last year (+23.6% and +21.7%, respectively) versus +26.1% this quarter.


The stock is currently trading above its intraday lows at around $40.45. Our quantitative levels suggest that KO has an intermediate term price TREND line of support at $40.14.


KO Takes It on the Chin - hed


What we liked:

  • EPS inline with consensus at $0.63
  • Outperformance of still beverages, volume +6%  vs sparkling 0%
  • Packaged water volume up +6% and energy drinks +5%
  • Russia volume +11% with a strong marketing calendar tied to the 2014 Sochi Winter Olympics
  • COGS decreased -5%
  • Eurasia and Africa volume up 9% (benefitting from Aujan partnership)
  • New guidance on the effective tax rate of 23.0% for 2013 vs last quarter’s estimate of 23.5%

What we didn’t like:

  • Net Revenues were down -2.6%  in the quarter and missed estimates ($12.75B vs $12.96B)
  • Operating income fell -1.5% in the quarter
  • Europe volume -4% (vs -4% in Q1 2013) on colder weather and flooding in Germany and central Europe


Matthew Hedrick

Senior Analyst

Behold the US Bull

Client Talking Points


Bears are not sleeping well. US stocks notching new all time-highs. (All-time is a long time.) S&P 500 up +18.4% year-to-date. Russell up even more +23.7% year-to-date. It's the seventh consecutive day where all 9 Sectors in our Hedgeye S&P Sector risk model are bullish on both TRADE (3 weeks or less) and TREND (3 months or more) durations. In other words, even the sectors we don't like like Utilities (XLU) and Basic Materials (XLB) aren't shortable, yet. Immediate-term Risk Range for SPX is 1670 - 1701. Bottom line? Buy US Stocks on red; Sell Treasuries on green – rinse and repeat.


It's still Japan (bullish) vs China (bearish). Nikkei was down -1.5% overnight to 14,589. But it did hold our 14,448 line of support. Japan was down for the first day in five. We are keeping a close eye on the Nikkei. It's getting interesting there. Meanwhile, Chinese stocks continued to get rocked. China is down 3.7% in the last 3 days. Beijing is a certified gong show right now; its not where you want to be putting your capital. Liquidity trap anyone?

Asset Allocation


Top Long Ideas

Company Ticker Sector Duration

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. We think that the prevailing bearish view is very backward looking and leaves out a big piece of the WWW story, which is that integration of these brands into the WWW portfolio will allow the former PLG group to achieve what it could not under its former owner (most notably – international growth, and leverage a more diverse selling infrastructure in the US). Furthermore it will grow without needing to add the capital we’d otherwise expect as a stand-alone company – especially given WWW’s consolidation from four divisions into three -- which improves asset turns and financial returns.


Gaming, Leisure & Lodging sector head Todd Jordan says Melco International Entertainment stands to benefit from a major new European casino rollout.  An MPEL controlling entity, Melco International Development, is eyeing participation in a US$1 billion gaming project in Barcelona.  The new project, to be called “BCN World,” will start with a single resort with 1,100 hotel beds, a casino, and a theater.  Longer term, the objective is for BCN World to have six resorts.  The first property is scheduled to open for business in 2016. 


Health Care sector head Tom Tobin has identified a number of tailwinds in the near and longer term that act as tailwinds to the hospital industry, and HCA in particular. This includes: Utilization, Maternity Trends as well as Pent-Up Demand and Acuity. The demographic shift towards more health care – driven by a gradually improving economy, improving employment trends, and accelerating new household formation and births – is a meaningful Macro factor and likely to lead to improving revenue and volume trends moving forward.  Near-term market mayhem should not hamper this  trend, even if it means slightly higher borrowing costs for hospitals down the road. 

Three for the Road


US Equity Fund Flows (ex-ETFs) ripped the perma 2013 bears another new one last wk, +$3.7B inflows w/w



“Detroit has been working its way to a level of insolvency for decades, continuing to borrow, continuing to defer pension payments, continuing not to pay its bills on time, continuing a deepening insolvency -- $18 billion.” - Kevyn Orr, Detroit's emergency manager (Bloomberg)


The AAA daily tracking of gas prices rose another penny Thursday to $3.66 for a gallon of self-serve regular, the 11th straight day of rising prices. Gas is up nearly 20 cents a gallon, or about 6%, during that period. (CNN)


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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.










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.






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 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!







Howard Penney

Managing Director


America's Throne

This note was originally published at 8am on July 05, 2013 for Hedgeye subscribers.

“The caliphs fell, and the Caesars trembled on their throne.”

-Edward Gibbon


#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?

  1. Short Fear
  2. Short #GrowthSlowing
  3. Short Gold, Treasuries, etc.

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:

  1. Gold and Silver -1.2 and -3.2%, respectively, this morning – and both continue to #crash (Gold -26% YTD)
  2. 10yr US Treasury Yields are testing 3-month highs again this morning, backing up to 2.54%

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:

  1. They run levered-long Gold funds
  2. They have (levered) net long Treasury Bond positions
  3. They earn fees and/or advertising revenues to promote slow-growth and/or fear

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%

SPX 1602-1634

VIX 14.93-17.59

USD 82.72-84.04

Euro 1.28-1.30

Gold 1183-1264


Best of luck out there today and enjoy your liberties this weekend,



Keith R. McCullough
Chief Executive Officer


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