RL: It Still Seems Early

Takeaway: RL is making all the right investments, and the TAIL story is a winner. But where the consensus numbers come out near-term is critical.

We were negative on RL coming out of the print in May – not because we did not like what the company was doing – quite the opposite, actually. RL was investing in IT systems, stepping up its Retail and e-commerce investments on a global scale, and preparing to take in the Chaps license from Warnaco. But these initiatives cost money, and the outward capital flow unfortunately precedes turning on the revenue spigot by at least 9-12 months. Simply put, there’s almost no way that returns can turn up when this is happening, and valuation multiples don’t expand when returns are going down. Given that RL’s multiple was sitting near peak, it made sense to us to wait to get involved until the market to freaked out over sloppy results.


The financial results played out as we thought, but the reality is that if you asked us a couple of days ago if we’d see a sell-off this quarter, we’d have said ‘probably not’.  Don’t get us wrong, the quarter itself was poor, with 4% sales growth de-levering to an 11% decline in EBIT. Comps came in down -1%, and inventory growth outstripped sales growth by a factor of 2x. Again, not return-enhancing metrics – consistent with our concern last quarter. But that said, we think that expectations were set appropriately headed into this print. 2Q guidance of lsd growth and margins down 300-350bp vs last year seemed to be the big culprit, as they suggest EPS in the range of $2.25-$2.20 vs the consensus at $2.57.   The question, therefore, is likely whether that is the real number, or if it is a sandbag.


Our sense is that financial reality is somewhere in between guidance and current estimates. We’re coming out at $2.31 for 2Q, and where the consensus lands will be critical as it relates to our near-term take on the stock. We’ll watch that in the coming days, and will be back accordingly.


Long-term, we continue to like RL in that the actions that the company is taking today should propel RL’s top line over $10bn within 3-years, push EBIT margin into the 17-18% range, and take RNOA from 24% today to 35% as asset turns increase on top of a higher margin business. Those characteristics are tough to find. But the catch, once again, is that our estimates are hovering right on top of the Street’s for the next three years (based on last night’s consensus numbers – see table below). That’s rare for us and RL. We’re usually far above. That tells us that the Street finally has it right, or we’re missing something. Either way, we don’t have the conviction to jump in at current levels – at least not while it is still in the early half of its ‘investing year’.


Ralph Lauren Investment Summary

RL: It Still Seems Early - rlfinancialsummary


RL Profitability Roadmap: Solid Outlook Over Our TAIL (3-Year) Duration

RL: It Still Seems Early - rlroadmap






RL: The Market Is Not Recognizing The Risk


Takeaway: Stocks don't go up when sales slow, costs increase, capex goes up materially and the stock is at 20x EPS. A textbook 'investing year.


Conclusion: We like what RL is doing, but the near-term financial implications will not be pretty and EBIT growth trajectory and RNOA will suffer. Even though this impact will likely be temporary, investors will need to wait until near the end of this calendar year until the risk profile improves. Until then, valuation matters.



We're surprised that RL was not down more on its 4Q print. Yes, the company overdelivered -- in typical RL fashion.  But there are enough factors that are changing negatively on the margin that we think will make  RL a good candidate for multiple compression in the sloppy quarters that lie ahead in the upcoming fiscal year.


We like this company as much as we ever have. It continually reinvests in its intellectual property to elevate the retail experience and gain share -- something that has worked for RL without fail.

Case in point…we kept a little scorecard of all the times that retailers and brands mentioned the words 'omni-channel' in press releases and earnings calls this earnings season. We stopped count at 100, and no, it did not take us long to get there. This has officially become the biggest cliché buzzword since 'supply chain' made it on to the scene 15 years ago. We swear that half of the execs talking about omni-channel don't even know what it means (if there even is a universally-understood definition). They're just following the cool kids.


Ralph is one of the cool kids.  It did not discuss 'omni-channel' once on its call or press release. Why? The reality is that it has been implementing a true omni-channel strategy for much of the past five-years…at a time when no one knew what it even was. Now RL is implementing retail and e-commerce models that others will be trying to implement in another five years. Simply put, we think that RL will continue to be a winner.  


But this is one of those years where the negatives to the story are likely to outweigh the positives. Specifically…

  1. FX will be a meaningful headwind in FY14 -- especially given RL's significant exposure to Japan.  Check out the Yen's move over the past six weeks. Not good.  FX is a $75mm hit to EBIT for the year.
  2. RL's Global SAP implementation, Korean e-commerce rollout, acceleration of retail rollout -- including NY flagship. There's another $75mm hit to EBIT this year.
  3. Capex is going from $276mm last year to up to $450mm in FY14 -- that's one of the biggest capex increases we're seeing out of anyone in retail.


In fairness to RL, it has proven to be an exceptional steward of capital in the past, and we have no reason to think that will change this year.  But the reality is that the $150mm in extra costs puts RL in a hole for 13% EBIT growth. This would be ok if we could justify solid double-digit top line growth as an offset -- but the reality is that we cannot (even if partially due to FX). So we've got slowing sales, eroding margins, and a step-up in capex. Any way we cut it, we can't justify the combination of these factors leading to any form of multiple expansion.  


MCD remains on the HEDGEYE best ideas list as a SHORT.


In order for McDonald’s to generate sustainable revenue and operating growth consistent with the company’s long-term goals, we believe MCD must make changes to its core U.S. store operations.



ROIIC, We Meet Again


Over the years, we have built a Restaurant Dashboard that tracks a number of companies and industry metrics, allowing us to consistently and constantly gauge investor sentiment and company performance.  While some metrics fall in and out of favor over time, one metric that has outlasted the test of time for every company is one of our favorites – Return on Incremental Invested Capital (ROIIC). 


Depicted in the chart below, MCD’s ROIIC has returned to levels not seen since 2002-2003, which was a period of underperformance and called for major restructuring.  We have been very critical of the direction MCD is heading since the end of 1Q13 and remain in that camp following the release of 2Q13 results.






Issues on the Horizon


Stepping back and reviewing 2Q13 results, the only solace management offered shareholders that the underperformance would not continue was two-fold, and in our opinion, relatively weak:

  1. “Throughout McDonald’s history, we’ve effectively grown both the top and the bottom lines to varying degrees across a variety of economic and competitive cycles.”
  2. “We have an iconic brand, an outstanding system of owners/operators, suppliers and employees, and superb real estate locations in nearly every market around.”

While we are in agreement with the above, these comments neglect several issues that call for immediate attention:

  1. Evidenced by an increasing number of negative articles on the company, the franchise base is very unhappy with senior management.
  2. A declining category is no plausible excuse, let alone a cause, for the current issues the company is facing.  We don’t see Wendy’s or Taco Bell complaining about a declining category.
  3. The competition in the QSR landscape has regrouped and MCD appears to be standing still.

This raises the question: How did MCD get to the point where ROIIC is currently at levels not seen since 2002-2003?  Perhaps the answer is best expressed by drawing on an analogy to Starbucks.  Using this analogy, we ultimately find that MCD needs to readjust its basic store operations.



A Tale of Two


Breaking down the business models:

  1. MCD is a food destination first and a beverage destination second.
  2. SBUX is a beverage destination first and a food destination second.

Both companies have struggled in their attempts to diversify away from their respective core competencies.  In the past, an over-emphasis on anything other than the core business has led to the underperformance of the core.  We recall a time when SBUX attempted to sell books and compact discs in an effort to diversify and these efforts ended in an unmitigated disaster.  We believe that MCD has taken the “McCafe” strategy too far too fast, while ignoring the underlying trends in the initial test markets.   For more on this thought, please review our post “MCD: An Espresso-Based Conspiracy Theory” penned earlier this year.  In short, attempting to sell Latte’s and blended ice drinks is no easy task and is obfuscating the brand image, while diverting resources away from the core business.


Another MCD versus SBUX comparison:

  1. SBUX believed that introducing TurboChef ovens to its stores would improve the consumer perception of their food.  We view the purchase of La Boulange as proof that this strategy was ineffective.
  2. MCD believed that introducing espresso machines and blenders to its stores would help make it a beverage destination.  But, in the end, consumers do not view MCD as a beverage destination, as the company has struggled to compete with SBUX and DNKN on quality.

The bottom line for us is simple: MCD needs to take a step back from their aggressive McCafe beverage strategy in the U.S.  As outsiders, it seems clear to us that the expensive McCafe equipment has simply complicated the back of the house operations.  Clearly, operators are unhappy and many of the one’s we have spoken to have indicated that it now costs more to “plug-in” the espresso machine than the sales they generate from it.


McDonald’s and the franchisee community now find themselves in a precarious situation as they face a new and growing problem.  This new equipment has failed to generate enough revenues to validate its presence in stores.  And now, many of these machines are approaching, or already surpassed, their fifth year in existence, meaning that the majority of them will either need to be repaired or replaced.  At this point in time, management must ask themselves some very important questions:

  1. Will the franchisees be willing to continue to invest in an expensive machine that slows the speed of service and does not generate incremental profitability?
  2. What percentage of McDonald’s marketing and promotion dollars have been spent promoting beverages in 2013?
  3. Did the company achieve a worthwhile ROI on the aforementioned marketing dollars spent?


Back to the Basics

MCD has faced difficult sales comparisons for years (2005-2011), yet this has never stopped them from posting positive same-store sales.  According to management, the new products are working thus far in 2013, but difficult comparisons are the reason for declining same-store sales.  In our view, the new products are not working and operational throughput issues persist. 


CMG and others are changing the landscape for fast food.  In what we would take as positive news on the margin, MCD has acknowledged that it needs to do a better job attracting millenials with fresh ingredients and variety!  Now, what changes in service style does MCD need and what will it cost?  That’s something for management to figure out, what we can surmise is the premium wraps did not adequately convey that message to the intended audience.


MCD is in need of a period where they get back to the basics of serving fresh, prepared food.  They can continue to pay lip service to being a beverage destination if they please, but the truth is they will likely never be able to compete against the concepts that successfully make a living serving beverages.



Is Thompson the Next Greenberg?

We’d be remiss to end the note without touching upon the disappointment of the dollar menu.  As you may recall, selling food for $1 was a strategy that cost Jack Greenberg (ex-CEO of MCD) his job in 2002.  Yet, the Dollar Menu was Don Thompson’s “go-to” move in 2012 through 2013, and it is turning in undesirable results.  Will Don Thompson face the same fate as Jack Greenberg or will he accept the reality of the current situation and strive to reestablish the core business?







Howard Penney

Managing Director

Morning Reads on Our Radar Screen

Takeaway: A quick look at stories on Hedgeye's radar screen.

Keith McCullough – CEO

Credit-Crisis Oracle Rajan to Head India’s Central Bank (via Bloomberg)

Yemen says it has foiled an al-Qaeda plot (via BBC)

Formula One Joins Legoland in Plan to Remake Malaysia’s South (via Bloomberg)

China fines milk powder makers $110 million for price fixing (via Reuters)


Morning Reads on Our Radar Screen - asia


Daryl Jones – Macro

The Myth of Hedge Funds as 'Myopic Activists' (via WSJ)


Jonathan Casteleyn – Financials

Manhattan Homes Under $3 Million Never Harder to Buy (via Bloomberg)


Howard Penney – Restaurants

Burger King Japan Employee Reprimanded For Lounging On Buns (via HuffPost)


Matt Hedrick – Macro

Obama Cancels Moscow Putin Summit After Snowden’s Asylum (via Bloomberg)


Josh Steiner – Financials

Washington Steps Warily on Housing (via New York Times)

Big banks warming to small businesses (via Washington Post)


Jay Van Sciver – Industrials

Artificial photosynthesis to make plants green with envy (via PHYS.ORG)

Daily Trading Ranges

20 Proprietary Risk Ranges

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UK - Carney Issues Forward Guidance

We’ve been fundamental bulls on the UK economy since releasing our June 11th European update presentation titled “Where Does Europe Go From Here”. Today’s announcement from Mark Carney, the new governor of the BOE, underlines our view that Carney will be an important catalyst (clear and transparent) to guide monetary policy (and expectations around it), which he did today in providing for the first time a framework of forward guidance on monetary policy linked to unemployment.


Carney said that the BOE will not raise interest rates or revise its asset purchase target until the unemployment rate falls to 7%. Further, he noted that 7% should be viewed as a “way-station” for the MPC to reconsider its policy stance, and not an outright target for the unemployment rate.  The BOE said that it sees the unemployment rate greater than 7.0% until at least Q3 2016 (it’s currently at 7.9%).  


Despite a tone from Carney of cautious optimism around existing spare capacity in the economy, and growth only beginning to reach historical averages, we remain bullish on UK fundamentals. Having been the first country to issue austerity to improve its fiscal balances, the economy is seeing positive inflections and momentum in the form of improvement in consumer sentiment, PMI readings, retail sales, industrial production, and housing, while the gap between wages and CPI tightens. Reductions in the savings rate may also be an indicator of improved sentiment. (The charts below show updates to these indicators).


Should the UK meet or exceed its outlook (below) to reduce inflation and accelerate growth over the next three years, we’ll remain bullish on the country’s investment prospects. Our quantitative levels suggest a healthy level of intermediate term TREND support at 6,412 on the FTSE.


UK - Carney Issues Forward Guidance - zz. levels



Bank of England Outlook:

GDP growth is stronger than in the last forecast (May).

2013 of +1.5% vs prior forecast +1.2%

2014 of +2.7% vs prior +1.9%

2015 of +2.4% vs prior +2.2%


CPI inflation is likely to remain close to 3% in the near term; by the second half of the three year forecast period the risks around the 2% inflation target are judged to be broadly balanced.


2013 +2.9%, unchanged vs prior forecast

2014 +2.4% vs prior +2.1%

2015 +2.0% vs prior +1.9%


UK - Carney Issues Forward Guidance - z. retail sales and industrial


UK - Carney Issues Forward Guidance - zz. cpi


UK - Carney Issues Forward Guidance - zz. savings rate


UK - Carney Issues Forward Guidance - zz. gdp


Matthew Hedrick

Senior Analyst

BBEP 2Q Review: Understated Maintenance Capex = Majority of DCF (Correction)

Correction: The previous version of this note incorrectly stated that we compared 3Q13 production to 2Q12 production.  That was a typo.  We are comparing 2Q13 reported production to 2Q12 reported production (year-over-year).  It's a crucial point, and we want to make sure that it is clear.  - Kevin Kaiser


BreitBurn Energy Partners (BBEP) remains a top short idea for us.  DCF is generated primarily via understated maintenance capex, as evidenced by the fact that the Company posted no organic production growth over the last twelve months, while total capex exceeded maintenance capex by ~$130MM.  This is BBEP’s most material distortion of its economic reality, and the reason why the equity is so overpriced.  We also take issue with the BBEP’s capital efficiency, leverage, calculation of non-GAAP measures, valuation, and corporate governance.


Understated Maintenance Capex


We believe that BBEP’s “maintenance capex” is significantly understated, and is responsible for nearly all of the Company’s “DCF,” despite management’s qualitative, unsubstantiated comments on the conference call yesterday (8/6/13) that suggest otherwise:


Analyst: “With respect to maintenance capex, what assurances can you give us that your maintenance capex is sufficient to maintain production, and can you provide us with some granularity or transparency about how you go about calculating that number?”


BBEP COO Mark Pease: “I think that everybody on the call knows that we define maintenance capital as the amount of investment that it takes to hold production flat, and we look at it regularly, and what we use for the basis for those calculations is our year-end reserve report . . . And we look at multiple years on that reserve report.  So, we don’t cherry pick a year and we don’t try to put the properties or projects that are more capital efficient . . .  We take our exit rate for the latest year in that reserve report and then we look at the reserve report and see how our rate varies out in the future . . . And for instance, if our base decline is 10%, and we look at the time period that production covers and it goes up 5% . . . two-thirds of the money that we spend is needed to cover that 10% base decline.  So that’s the details behind it and it’s all backed up by what we have in the reserve report . . . ”


Analyst: “And historically speaking, when you’ve done that exercise, how have your projections about the production from the dollars spent, how have those borne out versus your estimates when you’re making that maintenance capex budget.”


BBEP COO Mark Pease: “I think on the whole, they’ve been very good.  And that’s one of the things about having a bigger portfolio of projects, some projects come in better than forecast, some come in under forecast, but as a whole, the program has matched closely.”


But, according to BBEP’s actual production results, over the TTM (2Q12 – 2Q13), BBEP’s organic production growth was negative 0.3%, with total capex exceeding maintenance capex by ~$130MM.  The consequence is that, over the TTM, understated maintenance capex generated ~80% of DCF.  Management says one thing; the numbers say something entirely different.  This is BBEP’s most significant issue, and the primary reason why we believe the equity is so overpriced.


BBEP 2Q Review: Understated Maintenance Capex = Majority of DCF (Correction) - bbep edit


Timing of Equity Raise in Focus


With the amended leverage covenants referencing pro forma TTM adjusted EBITDAX (i.e. BBEP gets the Postle Field adjusted EBITDAX in full for the TTM), BBEP does not have to reduce debt as quickly as we had thought previously.  BBEP stated that it will be at 4.0x total debt/TTM pro forma adjusted EBITDAX at the end of 3Q13, implying that the Postle Field TTM adjusted EBITDAX was ~$40MM per Q.  BBEP’s leverage will continue to tick higher QoQ with calls on cash (capex + distributions) consistently exceeding cash flow by $40 - $50MM per Q (depending on go-forward capex).  The timing of the deleveraging was a popular topic on the conference call, and though management gave little hint as to what it’s thinking, perhaps the “Triggering Event” described in the Ninth Ammendment to the Second Amended and Restated Credit Agreement gives us some idea:


“’Triggering Event’ means Parent’s receipt, at any time after Ninth Amendment Closing Date, of net cash proceeds from the issuance of common units (“Equity Proceeds”), as follows: (a) the first Triggering Event means receipt of Equity Proceeds in a cumulative amount of at least $175 million, and (b) the second Triggering Event means receipt of additional Equity Proceeds such that the cumulative amount received after Ninth Amendment Closing Date equals at least $350 million. By way of example, if the Parent receives Equity Proceeds in the amount of $200 million on August 20, 2013, Equity Proceeds in the amount of $100 million on November 20, 2013 and Equity Proceeds in the amount of $50 million on February 20, 2014, the first Triggering Event will have occurred on August 20, 2013 and the second Triggering Event will have occurred on February 20, 2014.”


$350MM of equity at $18.50/unit would amount to 19MM new shares, approximately 20% dilution to existing unitholders.    


Changes to Derivatives Accounting, Adjusted EBITDAX, and Disclosure


We note several changes QoQ in BBEP’s derivatives accounting methodology, calculation of adjusted EBITDAX, average realized sales price, and the associated disclosures in the press release and 10-Q:

  • BBEP no longer has realized and unrealized gains/losses on commodity derivatives, but total gains/losses, cash settlements, and premiums paid.  This is an improvement in disclosure, however, the Company still only counts cash settlements in adjusted EBITDAX/DCF; adjusted EBITDAX/DCF is still, in our opinion, overstated by the cost basis of the derivatives that settled in the period, which amounted to 3.7% of DCF in 2Q13 and 2.5% in 1Q13.  There is another ~$28MM in future overstatement coming, as the Company paid $30MM for premiums in 2012.  Further, BBEP also paid ~$40MM cash for WLL’s in-the-money swaps, which will overstated future period adjusted EBITDAX/DCF just as paying a counterparty an option premium does.
  • BBEP no longer adds “net operating cash flow from acquisitions, effective date through closing date” to adjusted EBITDAX, and it “conformed” 2Q12 adjusted EBITDAX to exclude $1.6MM for this adjustment.  For all of 2012, the adjustment generated $19.9MM (12%) of DCF.  BBEP will likely “conform” 3Q12 adjusted EBITDA lower by $13.2MM and 4Q12 adjusted EBITDAX by $5.1MM.
  • “Average realized sales price” now “excludes the effect of commodity derivative settlements,” whereas last quarter it included them.

Disclosure has improved, but the non-GAAP measures of adjusted EBITDAX and DCF remain inflated measures of profitably due to the fact that BBEP excludes the cost basis of derivatives (both premiums paid and acquired hedges), unit based compensation, non-cash interest expense, and cash taxes from their calculation.


Why so Cryptic on the Postle Field?


BBEP’s management is reluctant to dig into the cash flows from the recently-acquired Postle Field:


Analyst: “Can you share what the cash flow just from [the Postle Field] might be versus the capital that would be needed to keep [production] flat?”


Phenomenal question.  We wanted to ask that as well.  And here’s management’s response:


COO Mark Pease: “I don’t know if we’ve disclosed that.”


CFO Jim Jackson: “We just haven’t – we have not given that level of detail on [the Postle Field] to date.”


Analyst: “Okay, thank you.”


Why not disclose that answer?  Surely they know it, and it’s a crucial information . . .  We want (need) to know how much of this new capital is going into the maintenance capex and growth capex buckets.  The fact that they don’t want to speak to this issue suggests to us that a significant portion of it will be considered growth capex, which is inappropriate, in our view.  This is likely a significant driver of the increase in future DCF coverage.


Guidance Cut or Sandbag?


Despite closing the Postle Field acquisition 15 days early, BBEP did not adjust 2H13 production guidance.  That’s an incremental 110,000 bbls of oil production for 2H13 that was not in the prior numbers.  Management noted on the call that it was not material enough to adjust guidance, but we think that it is.  It’s an extra 1,200 bbls/d in 3Q13 and 600 bbls/d in 2H13.


Profitable Growth?


After spending ~$600MM on acquisitions (before Postle) and another ~$200MM of capital expenditures over the TTM, adjusted net income per unit came in at $0.13 in 2Q13, down from $0.15 in 2Q12, and discretionary cash flow (CFFO before change in WC) per unit was $0.56 in 2Q13 vs. $0.72 in 2Q12.  Free cash flow (discretionary CF minus capex) this quarter was negative $5MM (-$0.05/unit) vs. +$28.2MM (+$0.39/unit) in 2Q12.  How ‘bout that for profitable growth?


BBEP 2Q Review: Understated Maintenance Capex = Majority of DCF (Correction) - bbep11

BBEP 2Q Review: Understated Maintenance Capex = Majority of DCF (Correction) - bbep12


Kevin Kaiser

Senior Analyst


In an effort to evaluate performance and as a follow up to our YouTube, we compare how the quarter measured up to previous management commentary and guidance




  • BETTER:  VIP hold was high at both Altira and City of Dreams but that was already in our numbers and should’ve been in the Street estimates as well. MPEL beat us everywhere on the volume side, Mass/VIP, Altira/CoD.




  • SAME:  Studio City remains on schedule and on budget with expected opening date in mid-2015
  • PREVIOUSLY:  "Studio City, our cinematically-themed mass market focused integrated casino resort, remains on track to open in mid 2015. The project remains on time and on budget with expected design and construction costs remaining at $2.04 spending for 2013 is between $800 million to $1 billion."


  • BETTER:  Mass drop increased 35% in 2Q. 
  • PREVIOUSLY:  "We continue to improve the two major signature club area on improving their service. So you'll note that in the next two quarters some improvement in this premium mass area with nice improvement as well as well as the service level that we are bringing to the property."


  • BETTER:  Favorable VIP mix and higher hold benefited margins
    • "I think the primary driver, and I think there is room, is what's happening on the gaming floor and what's happening with the mix of business. Given our success in the mass market business and that, the strength in that segment overall, we do see a potential for favorable mix shift over time, which will drive blended margin higher."
    • "First, I think, gaming floor, we continue to see a positive trend in terms of hold percentage on the floor as well as absolute revenue."
    • "I think our retail area, although it's relatively small compared to the neighbor, it's already up to a level which is quite comparable with the neighbors. So I think with this kind of improvement in our positioning in the last few quarters, it has started to pay off in terms of this non-gaming higher margin EBITDA contribution. So we hope that that trend continue and you'll see some more improvement in the next few quarters."


  • SAME:  Construction will begin by end of year.  Expected opening will be end of 2016/2017.
  • PREVIOUSLY:  “We are optimistic that we'll break ground before the end of the year.


  • SAME:   Higher wages impacted 2Q by $4MM
  • PREVIOUSLY:  "As your modeling should anticipate, as of April, it increased fairly market wide of a 5% wage rate increase in your model and that's not inconsistent with what we experienced last year as well despite incremental supply in the market, incremental staffing needs across the market. So this year, we think 5% is very manageable and one that we expect to be consistent throughout the year. But I would encourage you to flag that in your models going into the next quarter."


  • SAME:  Will open in mid-2014.  Believes the tax situation at PAGCOR will be resolved.
    • "In this quarter, our pre-opening expense of about $1.9 million. About two-thirds of that was Philippines. As that project ramps up over the course of the year into the mid single digits and then subsequent from that into 2014, but that will increase over the course of this year."
    • "Our view is that the tax situation will be resolved favorably. So no change in our expectation of ROIC."


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