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MCD: MIGHTY WINGS OR MIGHTY DISASTER?

Takeaway: MCD remains on the Hedgeye Best Ideas list as a short.

This note was originally published October 02, 2013 at 12:35 in Restaurants

McDonald's remains on the Hedgeye Best Ideas list as a short.

MCD: MIGHTY WINGS OR MIGHTY DISASTER? - mwing 

To be clear, we believe MCD has a secular top line issue and not a cyclical one.  That said, we don’t believe management is willing to acknowledge this.  So far in 2013, the new product pipeline has failed to stimulate incremental customer traffic and new products, such as Mighty Wings, seem like a desperate attempt to hide from reality.

 

We posted a note a couple of weeks ago titled, “MCD: A Pending Mighty Disaster,” in which we stated that MCD’s decision to sell wings this fall could be disastrous for the company.  Given current trends, we have no reason to back off this negative bias.

 

We have three main issues with the current MCD menu strategy:

  • Mighty Wings will not enhance the McDonald’s brand (Premium Wraps have not helped either)!
  • Both new products (Mighty Wings and Premium Wraps) have slow service times.
  • Adding new products to an already complex menu is the wrong direction for the company to go.

We also have two main issues with the Mighty Wings promotion:

 

Mighty Wings Are Too Expensive 

For the smallest portion, you are paying a dollar per mighty wing.  

 

McDonald’s Mighty Wings are available in three portion sizes. There is a 3-piece for $2.99, a 5-piece for $4.79 and a 10-piece for $8.99.  Across the pricing spectrum, this is equivalent to paying $0.99, $0.96, and $0.90 per wing, respectively.

 

Inconsistent Product From McDonald's

We are hearing that frequent visitors of McDonald’s are not used to the bone-in chicken wings product.  While bone-in chicken wings are standard fast food options for restaurants that specialize in fried chicken – for example, KFC and Popeyes – it does not seem to fit well with the rest of McDonald’s products.

 

Summary

This whole situation is all too reminiscent of the period from 1998-2002, when we witnessed the sad decline of a mismanaged McDonald’s brand.  During that time, the company was focused on unit growth and cost reduction rather than driving high margin, top line sales.

 

As the image of the brand began deteriorating, management failed to invest in the brand and customer experience.  Rather, they turned to monthly promotional tactics in order to drive short-term sales at the expense of brand equity and margins.  This strategy did not end well for either the company or investors and we’d be surprised if this time was any different.

 

MCD: MIGHTY WINGS OR MIGHTY DISASTER? - penney1

 

We continue to believe there is a disconnect between investors’ expectations and the company’s fundamentals.  As long as this remains the case, we are looking for more underperformance versus both peer consumer and S&P 500 benchmarks.

 

 

Howard Penney

Managing Director

HPenney@hedgeye.com

 

 


BEIJING: BACK IN BLACK

Takeaway: We're beginning to nibble in China.

China showed solid follow through overnight after Friday’s China #GrowthStabilizing data for Q313 and September. The Shanghai Composite led Asian Equities higher closing up +1.6%. It's back-in-black in China year-to-date. We're starting to allocate capital to it in the Hedgeye Asset Allocation Models.

 

So, the Chinese and the rest of the world continued to exist despite the fear-mongering and dysfunction in DC. Imagine that. Bottom line: If China bases here on the growth curve, an acceleration in 2014 could be next. 

 

Click image to enlarge.

BEIJING: BACK IN BLACK - dale1

BEIJING: BACK IN BLACK - china22


EAT: EARNINGS PREVIEW

We continue to believe EAT is one of the best managed companies in the restaurant space.  Following the earnings report on 10/23, we will be hosting a call with the CFO, Guy Constant, on Friday, October 25th at 12pm.

 

We believe Brinker’s macro commentary from last quarter still applies.  This is a very difficult operating environment for many restaurant companies and we expect to see slightly diminished margins given current sales trends.  Looking back to 4Q:

  • EAT continued to see a fairly lethargic category and the macroeconomic environment was not as strong as they had expected.
  • The restaurant industry was not recovering as quickly as they had expected.
  • In 4Q, the company was negatively affected by the deep discounting of their peers.
  • Management decided not to match this aggressive discounting and remained committed to their Plan to Win strategy.
  • Company-owned same-restaurant sales were down slightly for the quarter.

In 1Q14, EAT’s Chili’s brand is up against its most difficult comparison of the year at +2.8%.  In our opinion, the current Consensus Metrix estimate of -0.4% for Chili’s appears to be aggressive, as this would represent a 40 bps acceleration to +1.2% in the two-year trend.  Given what we know about current industry trends, EAT is unlikely to significantly beat sales estimates.  In 4Q12, Chili’s company-owned same-restaurant sales and traffic were down -0.6% and -2.1%, respectively.  Depending on where same-restaurant end up for 1Q14, management may need to address the current full-year guidance of 1-1.2% same-restaurant sales growth.

 

EAT: EARNINGS PREVIEW - EA

 

 

During the quarter, the company decided it will roll out tabletop tablets to all U.S. company-owned restaurants by the middle of next year.  Franchisees have been given the option to include the devices in their locations.  These devices are all-encompassing, as they can take menu orders, accept credit cards, let customers play games and more.  In our opinion, this should enhance the customer experience at a manageable cost, as the installation costs are minute compared to the returns they will generate.  We view this announcement as a positive, and believe Brinker is well-positioned, particularly compared to other casual dining chains, to take advantage of a changing consumer landscape.  However, we do not expect to see the tabletop rollout have a material impact on sales until the second half of next year.

 

Looking past the near-term sales pressure, the company business model remains in good shape.  In our opinion, food costs is one segment of the P&L that could come in better than expected.  Guidance is for this line to improve in 1Q14. Consensus Metrix estimates indicate the street is looking for a 20 bps improvement in the quarter, which we believe may be too conservative.  The company will also continue to benefit from new operating initiatives, which will result in continued labor and efficiency gains, specifically in the first half of FY14.  We are expecting restaurant level margins to improve 80 bps y/y in 1Q14.

 

EAT: EARNINGS PREVIEW - EAT OPERATING

 

EAT: EARNINGS PREVIEW - EAT RLM

 

EAT: EARNINGS PREVIEW - EAT LABOR

 

EAT: EARNINGS PREVIEW - EAT FOOD

 

EAT: EARNINGS PREVIEW - EAT ITGER OP

 

 

The bottom line is, we aren’t expecting to learn anything shockingly new when EAT reports on 10/23 and we do not know how the stock will react.  Short interest has been coming down over the past month and the sell-side has been becoming more bearish of late.  In our view, the recent incremental bearish bias toward EAT is simply a byproduct of the current industry conditions as opposed to anything company specific.  The excessive discounting from DRI is hurting everyone in the industry, but particularly EAT.  With that being said, Brinker would be one of the biggest beneficiaries from our dismantling Darden thesis, if it played out.

 

EAT: EARNINGS PREVIEW - EAT SAHREs

 

 

Despite the difficult operating environment, EAT remains financially robust.  In 4Q13, the company passed the $1 billion share repurchase mark since its fiscal 1Q10.  Over the same period, management reduced the share base by nearly 33%.  Looking out over the next 12 twelve months, we expect EAT to repurchase another $250 million in stock, effectively reducing the share base by another 7%.

 

 

 

Howard Penney

Managing Director

 


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MCD: ENTERING STAGE 1 PANIC?

Takeaway: In our opinion, management remains unwilling to accept the reality of the situation: MCD is in need of structural changes.

MCD remains on the Hedgeye Best Ideas list as a SHORT.

 

In this note, we offer our take on MCD’s current downward trajectory.  The company reported disappointing 3Q13 results and management appears disconnected from, or at least unwilling to accept, the reality that structural changes must be made.


Setting the stage:

  • MCD has now experienced declining traffic for the better part of the year.
  • The company continues to blame the macro environment for declining sales, while insisting that its LTOs are “hitting internal goals.”
  • Management says it doesn't having pricing flexibility, yet it has already raised prices +2.6% this year.
  • MCD lost the head of its U.S. business, the head of its German business, and its U.S. Chief Marketing Officer.
  • Over the last two quarters, the company has slightly lowered its new unit growth rate.
  • ROIIC is in decline.
  • MCD is aggressively pushing the dollar menu.

In our opinion, this is the second time in the last 10 years that the company must accept the need for structural change to their business model.  The company appears to be transitioning from Stage 2 Denial into Stage 1 Panic.  The core business continues to deteriorate, members of the operating team are being replaced, and management plans to slightly slow its new unit growth rate.  If today’s call was any indication, management remains far away from the Healing Process.  To refresh, when a concept gets in trouble, the management team’s decision-making process typically follows a pattern similar to this:

  • Overconfidence – The concept loses its value proposition when management raises prices too aggressively or lowers the quality of food.
  • Stage 1 Denial – Consumers catch on and begin to frequent the concept less often.  Traffic begins to decline and management usually begins to blame the weather or another external event.
  • Stage 2 Denial – In an effort to avoid the inevitable and appease the street, management begins to accelerate growth through the form of new unit acceleration or the acquisition of new brands.  Normally, the core business continues to deteriorate alongside a decline in ROIIC (return on incremental invested capital).
  • Stage 1 Panic – Analysts begin to catch on and management responds by slowing new unit growth, although often not by enough.  The core business continues to decline, as senior management begins to replace the operating team.  Simultaneously, the search for a new advertising agency begins.
  • Stage 2 Panic – Now it really begins to get ugly, as management sacrifices margins to increase customer counts by implementing a deep discounting strategy.  It then becomes clear that major changes need to be made across the enterprise.
  • The Healing Process – Management decides to stop growth and attack the middle of the P&L.

We won’t bore you with the details of the call or the press release, but, to summarize, MCD’s 3Q13 results, as well as their 4Q13 outlook, were uninspiring and consistent with our bearish thesis. 

 

Rapidly decelerating sales trends continue to suggest that management must respond with a viable plan to improve operational efficiencies and spur long-term, sustainable sales growth.  Until this happens, MCD is likely to remain a short.

 

MCD: ENTERING STAGE 1 PANIC? - MCD GLOBAL

 

 

 

Howard Penney

Managing Director

 


European Banking Monitor: Onward & Upward

Below are key European banking risk monitors, which are included as part of Josh Steiner and the Financial team's "Monday Morning Risk Monitor".  If you'd like to receive the work of the Financials team or request a trial please email .

 

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European Financial CDS - Europe continues to dazzle. Only two EU financials widened last week, RBS (+1 bp) and Banco Popular (+19 bps). The rest of Europe was notably tighter. This continues a theme that's been in place for some time now. In fact, looking at the MoM trend, the mean/median change in EU financial CDS is tighter by 31/8 bps, respectively. 

 

European Banking Monitor: Onward & Upward - zz. bank cds

 

Sovereign CDS – Sovereign swaps were tighter around the globe last week with the sole exception of the US, where swaps were flat at 34 bps. The real takeaway is the MoM change, particularly in Europe. Consistent with our 4Q13 macro theme of #EuroBulls, Portugal, Spain and Italy are tighter MoM by 136 bps, 35 bps and 33 bps, respectively. 

 

European Banking Monitor: Onward & Upward - z. sov1

 

European Banking Monitor: Onward & Upward - z sov2

 

European Banking Monitor: Onward & Upward - z. sov3

 

Euribor-OIS Spread – The Euribor-OIS spread was unchanged last week at 12 bps. The Euribor-OIS spread (the difference between the euro interbank lending rate and overnight indexed swaps) measures bank counterparty risk in the Eurozone. The OIS is analogous to the effective Fed Funds rate in the United States.  Banks lending at the OIS do not swap principal, so counterparty risk in the OIS is minimal.  By contrast, the Euribor rate is the rate offered for unsecured interbank lending.  Thus, the spread between the two isolates counterparty risk. 

 

European Banking Monitor: Onward & Upward - z. euribor



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