"Feel like a broke down engine, aint got no driving wheel"
-Blind Willie McTell
The World Bank's annual Global Development Finance report issued yesterday provided a grim assessment of the near term situation including estimates of a 2.9% decline in global output, a 10% contraction in world trade and a projected decline in private capital flows from $707 billion last year to $363 billion for 2009. It wasn't the bad news in the report for this year that really spooked investors however, but rather the diminished expectations for recovery in 2010 -with a new global GDP growth forecast of just 2% and a predicted contraction for the developing world, excluding China and India. In short, the World Bank's annual report failed to identify any catalyst that could drive growth rates to pre-crisis levels over the next 24 months. Not a "V" recovery on the horizon, not even a "W" recovery, just a great big capital L for the next several years.
For our portfolio, yesterday was an unwelcome stress test as our commodity, energy and international long positions were pummeled by waves of selling. Yesterday's broad market action felt like an inflection point when short term consensus shifted focus from inflationary to deflationary concerns and the safety trade returned in a concentrated form: with treasuries and the Dollar as the only safe haven left for the timid.
While the market reaction to the World Bank's conclusions caught us off guard, we expected their argument. With conservative estimates drawn from rear view mirror observations, the data they released was hard to challenge but their conclusions were not. We are not joining this dash for the exits trying to stay ahead of a cyclical asset class shift, but rather are remaining firm in our convictions that the fundamental facts have not changed, and are as comfortable with our strategic convictions now as we were in January -before the 60% and 30% rise in the Shanghai Composite and the Bovespa respectively made our Q1 call consensus.
Chinese data continues to support our thesis. With Q1 GDP still registering above 6% growth, Industrial production levels rising back towards double digits, imports of base metals and coal showing resilience, new ground breaking daily on infrastructure projects and domestic consumption for durable goods from cars to laptops -Chinese internal demand measures continue to expand across the board. This weekend Premier Jiabao pledged to continue to pump more liquidity into the system, showing that Beijing continues to be willing to put their money where their mouth is and take risks to drive internal demand expansion.
A fresh report released by the National Bureau of Statistics, written by Guo Tongxin, even tackles the omnipresent concerns over Chinese data quality, presenting greater transparency of the inner workings of Beijing's accounting process -not a fix by a long shot, but a promising start. And, by the way, while the Chinese may make up their numbers, so do we!
Make no mistake: Chinese demand can't save the whole world on its own, but like the proverbial butterfly wings that drive hurricanes a thousand miles away, demand from "The Client" continues to be felt throughout the global supply chain.
Not that we dismissed all of the World Bank's conclusions entirely. The argument for a longer recovery period for weaker emerging economies seemed spot on to us -as long time readers know we have never bought into the emerging markets craze and have remained skeptical of the prophets of profit who espouse "frontier economies" from Ghana to Kazakhstan.
We diverge from their thesis on demand from the "developed portion of the developing world" if you will. As such, we continue to see growth prospects that can jump start global demand in the major Asian economies ex-Japan, combined with the smaller markets that stretch along the supply chain connecting them all the way back to commodity producers like Australia -which has thus far managed to avoid recession, and Brazil -which although challenged by commodity dependence continues to navigate the choppy waters with pragmatic leaders and significant room for policy loosening. Furthermore, since all of this will occur inside a central bank sponsored free money vacuum, we expect this resurgent demand will drive inflationary pockets inside the global commodity matrix and drive rates higher ahead of policy shifts during the fourth quarter of this year.
As such, we won't be anchoring on one report from the World Bank. While our longs hurt us yesterday, our shorts made us money and we have better things to do than sit and sing the blues.
"Feel like a broke down engine, aint got no driving wheel"
The level of discounting is truly amazing and it's everywhere!
(1) The McDonald's Family Restaurants of Greater Baltimore are proud to offer customers a FREE McMuffin or Biscuit breakfast sandwich with the purchase of any McCafé Coffee from June 22 - 28, 2009.
(2) McDonald's restaurants are giving their Southwest Florida customers some financial relief Thursday as they can purchase a second Big Mac sandwich for 25 cents after buying the first one at regular price. The offer is valid from lunch to midnight.
How are BKC and WEN going to get same-store sales in this environment?
Historically, gas prices have been a highly significant driver of same store regional gaming revenues. We have expounded upon this relationship in our 06/29/08 note, "GAS PRICES AND THE ECONOMY DO MATTER", and several other posts since then, including "REGIONALS: DISCERNING A TREND" (06/18/2009). For regional gamers, every 1% y-o-y change in gas prices results in an inverse 0.15% change in same store gaming revenues, holding all other factors constant. In thinking about organic growth in regional revenues, it is necessary to focus on the trend in gas prices.
Despite the estimated benefit from the significant y-o-y drop in gas prices in 2009, same store revenues for the regional gamers have been negative in every month since January. The 40% decline in gas prices through May 2009 may be masking worse fundamentals than the numbers are suggesting. So the question is to what degree were the less bad numbers we saw come out of regional gaming a result of the nose dive in gas prices?
According to our calculations, the 40% y-o-y decrease in gas prices through May 2009 has had a 6% positive impact on same store gaming revenues. YTD same store gaming revenues through May 2009 declined by 3%, implying that if not for the gas tailwind, gaming revenues could have been down 9%. Note the chart below.
Looking at spot prices today at $2.72 implies a 30% y-o-y decline in gas prices in 3Q09, resulting in an estimated 4% positive impact on same store gaming revenues. However, the tailwind turns into a potential headwind in the fourth quarter of this year, as the y-o-y comparison for gas prices turns negative, leaving the regional numbers to reflect a more true demand level without the mask of the fuel benefit.
As can be seen in the chart below, gas prices have spiked dramatically in the last two months. It remains to be seen what the "sticker shock" impact will have resulting from the sequential change in gas.
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The restaurant business is a cash business, and a large number of publicly traded companies generate a significant amount of cash each year. Therefore, any analysis of a restaurant company should revolve around the company's cash flows and how management spends it. The restaurant industry's 10 largest companies have reached such a size and maturity that their cash-generating capabilities have surpassed $13 billion. In the current restaurant environment, the redeployment of cash flows is an important factor in stock price performance and thus valuation. Properly managing cash flow will allow any restaurant stock to outperform its peer group over a sustainable period of time. A key component to sustainable, consistent growth and a premium valuation, therefore, is the proper balance between cash reinvested into the business and cash returned to shareholders.
A restaurant company with strong, sustainable trends will maintain a proper balance between debt and equity and will pursue a prudent level of unit growth (growth capital expenditures) while keeping up with maintenance capital requirements. At the same time, the company also must recognize the importance of keeping the concept relevant to the consumer. This puts a premium on initiatives within the four walls of the restaurant to drive incremental customer visits, which is critical to the overall health and perception of the concept. If the company has any cash left over, returning it to shareholders should be a top priority.
A common mistake that restaurant companies continue to make involves taking an overly optimistic view of a given concept's long-term prospects, which leads to excessive capital expenditures and ultimately erodes shareholder value. The point is, what might appear good for a company (or a stock) in the short term might not always benefit the company in the long term.
On the other hand, we have seen companies slow new unit growth in order to focus on their core business. This decision also has significant implications for shareholders, as a company will likely see a significant increase in its operating performance and its return on incremental invested capital as a result of increased sales and margins at existing restaurants combined with investing less capital in unprofitable stores in a mature business.
We have witnessed, more often than not, companies maintain an accelerated rate of new unit growth, putting significant pressure on the organization. That pressure comes in three primary forms. First, the company's real estate division might be pressured to find quality locations and invariably will compromise its standards in order to satisfy management guidance driven by a desire to meet Wall Street's performance projections. After two to three years of compromises, sales in the new units will begin to suffer and the company will miss its targeted return hurdles. Another part of the new unit underperformance can be attributed to the fact that the company cannot hire enough qualified managers and/or lacks the time to properly train them. Third, it is also possible the concept cannot survive in the highly competitive restaurant industry.
Most mature restaurant companies have enough operating cash to fund unit growth beyond their means. This fact implies that the prudent companies have cash left over to allow for incremental EPS growth from some sort of financial engineering, which leaves the board members of the leading restaurant companies with some very difficult decisions to make. These decisions range from the need to provide growth for the company's employees to maximizing value for shareholders. Unfortunately, these options do not always go hand in hand.
As I said before, over the long-term we are most focused on the rate at which companies deploy new capital in the business. We have developed a framework to help measure how senior management of any given company is deploying shareholders' capital. This approach is even more important in difficult times. In today's uncertain environment, most people do not want to touch a stock until there is better visibility on the top line. Unfortunately, easy comparisons do not necessarily mean results will improve in 12 months, as we have seen.
We acknowledge that same-store sales growth is a significant indicator of a concept's health, which affects the potential opportunity for growing total sales through new unit openings. The important components of computing same-store sales are broken down in transaction-level metrics: pricing, mix, and traffic trends.Typically, we find that the company with the highest multiple usually has the strongest same-store sales trends and nothing else seems to matter, leading us to believe that "best in class" restaurant companies do not receive premium valuations. Although same-store sales trends are important, investors must consider other factors when valuing a restaurant stock and determining whether a restaurant company is "best in class."
We have a number of measures that we consider when looking at a restaurant company, but four that are more important. Most of the criteria do not provide good or bad news in isolation. Instead, they lead us to ask questions in hopes of discovering in what direction a company is heading. Given that the restaurant business is typically a cash business, we do not focus on revenue (except for same-store sales, which are the most important indicator of a concept's health). Instead, we have centered our efforts on how management spends its cash flow. Specifically, we are focused on cash flow from operations, operating margins, and capital expenditures. Importantly, we look at these numbers not in isolation, but in how they relate to other parts of a company's financials and to other companies in the industry.
Cash flow from operations (CFFO). Is the company generating enough cash from its operating activities to continue without accessing new external sources of cash? We define CFFO as cash from operating activities less capital expenditures, less the benefits from the exercise of employee stock options and adjustment for one-time gains/losses or restructuring items. Most of the larger restaurant companies we follow generate free cash flow after significant investment in the growth of the core business. Some of the smaller companies we follow do not generate free cash flow. The lack of free cash flow is not necessarily a negative, as long as the company burns cash within the limits of its available resources.
Net CFFO/Net Income. Importantly, we are looking at the proportion of earnings yielding cash. This higher ratio relative to the industry can indicate more conservative accounting, signaling a sustainable level of income. At a minimum, we believe that a mature restaurant company should have a CFFO/net income ratio of 0.6 or better. Any ratio that is nearly flat or negative raises a big red flag for future returns.
Operating margins. In the restaurant industry, operating margins measure a company's cost efficiency relative to the revenues generated within the four walls of the restaurant. Generally, margins that are declining because of slowing sales trends tend to be more important than a one-time step up in costs. High margins with stable or declining revenue growth should be examined carefully. Importantly, we are looking for margin differences relative to competitors with similar box (store size) economics. Is the trend in margins consistent with other competitors in the industry?
Capital expenditures to depreciation ratio (CE/DR). This ratio can measure whether or not management is conservative in its accounting policies relative to others in the industry. In addition, it is an indicator of the company's annual cash cost of capacity. In general, the small-cap restaurant companies' CE/DR is high because of the significant amount of new assets put into the ground each year to sustain growth.
We will follow up in the next couple of days with more company-specific comments.
As the U.S. market and commodities futures previewed this morning, the stock market is having a rough start to the week with the SP500 down -2.70% and the Nasdaq down -2.95%, currently. The internals of the market are noteworthy in that there is a bifurcation of sector performance. The XLU (utilities), XLP (consumer staples), and XLV (healthcare) are outperforming. On the other hand, XLB (materials), XLE (energy), and XLF (financials) are vastly underperforming. Performances for all nine sectors of the S&P is outlined in the chart below, but the average performance for the top 3 sectors currently is -0.72% versus the average performance of the bottom 3 sectors which is -4.44%, with the delta between the two groups at 372 basis points.
Many media outlets will point to the World Bank cutting global growth estimates last night and increased geo-political pressures with Iran and North Korea as the key culprit behind today's equity market declines.
In reality, the US Dollar continues to be the primary driver of asset class returns.
The U.S. Dollar Index is currently +0.58% intraday and as we've been hammering on for most this year, dollar up equals stocks and commodities down. While declining growth estimates by the World Bank may have some sticker shock, most investors realize that those projections are more lagging than leading. As it relates to foreign policy concerns, if they were the key driver to the market today, one would rationally expect either gold or oil to be up due to a flight to safety, but both are down -1.6% and -3.9%, respectively.
While Mr. Market seems to be acting irrationally today, one needs to look no further than the quote on the US Dollar Index to explain today's price action. If you were locked in a dark room and could only have one quote to trade this market, it would continue to be US Dollar Index.
Daryl G. Jones
As we discussed on our morning call today, confidence in President Obama appears to be breaking to the downside. The most recent Rasmussen Daily Presidential Tracking Poll measured -3, which is the worst reading since Obama became President. This poll measures the differences between strongly approve and strongly disapprove, and for the first time more people strongly disapprove of the way the President is doing his job. In the chart below, we've outlined the Rasmussen Poll since its inception for Obama, and it highlights the negative trend in Obama's approval rating.
A key shift relates to greater time away from the Bush administration. As a point in fact, another Rasmussen poll indicates that 54% of those polled still blame President Bush and his administration for the economic woes. While this is a large number, it is noteworthy for the fact that this number is down from 62%, from a month ago. The implication being that, and whether he deserves it or not, this is starting to be branded as President Obama's economy as there is a direct correlation between Obama's popularity declining and people blaming Bush less for current economic woes.
The other area that seems to be hurting President Obama is foreign affairs. As we noted in the Early Look today, President Obama is taking a very different tact than his predecessor on foreign policy and so far positive results have been limited. As a frame of reference, the current top three headlines on the drudgereport.com are as follows:
- - Iran's Revolutionary Guards Say They Will Crush Any Protests...
- - NKorea threatens to harm USA if attacked...
- - Al Qaeda says would use Pakistani nukes on USA...
Obviously Matt Drudge is right leaning, but the above headlines highlight the serious international issues currently facing President Obama. Once again, while President Obama is certainly not to blame for these international threats, he is now in the driver's seat for dealing with them and as these issues manifest the news flow more extensively, they will likely continue to negatively impact the President's approval rating.
The Gallup Daily Presidential Approval poll from yesterday mirrored the findings in the Rasmussen poll. In the Gallup poll, President Obama's approval is at 57%, which is the lowest approval of his presidency based on this poll. In a number of other instances, Obama has fallen to below 60% in approval for a three day period, but has always quickly recovered to above 60%. Therefore, his approval rating over the coming days will be a real test as to whether the honeymoon approval rating is really over.
In aggregate, and not surprisingly, President Obama seems to be holding his approval with Democrats, but according to Gallup:
"The latest decline in Obama's approval score, to 58%, results from a drop in approval among political independents as well as among Republicans. Democrats remain as highly supportive of the president as ever. Obama's approval rating was 60% from June 13-15, at which time 88% of Democrats, 60% of independents, and 25% of Republicans approved of the job he was doing. In the June 16-18 polling, Democrats' approval of him stands at 92% -- up slightly -- whereas approval is down among both independents (by seven points) and Republicans (by four points)."
Most interestingly, the independents that moved to Obama in hoards during the presidential election last fall, now seem to be seriously wavering. While on the other hand, Obama's support among his own party is as strong as ever. So what is happening among the independents? The best place to find that answer may come from New Hampshire. In the New Hampshire Union Leader this morning, which is the largest paper in New Hampshire, there was an editorial sharply critical of Obama's health care plan, and specifically the disconnect between Obama saying there will be no additional spending for his plan and the Congressional Budget Office suggesting that current proposals would dramatically increase spending.
According to the New Hampshire Union Leader:
"For health care reform to "not add to the federal deficit over the next decade," every penny of new taxpayer spending on health care reform would have to be paid for by either a tax increase or a spending cut somewhere else. We're talking about roughly $1 trillion in spending -- all paid for. But remember, we already have a $1.8 trillion deficit this year. Every penny spent on health care reform is a penny not spent to pay down the existing deficit. So in reality, health care reform will at the very least perpetuate existing deficits even if it doesn't expand them.
While having solidarity among his party is powerful, in a country where only ~ 40% of adults identify themselves as Democrats, Obama has to continue to appeal to independents and if the New Hampshire Union Leader is any proxy, he is losing them.
Daryl G. Jones