Double Bubble Trouble

This note was originally published at 8am on February 27, 2014 for Hedgeye subscribers.

“Double, double toil and trouble. Fire burn, and cauldron bubble.”

-William Shakespeare


They say Shakespeare wrote Macbeth sometime between 1603-1607. But my contacts tell me he could have written it in 2007. The prescience of his dark tragedy would have been a big call for CNBC.


But, from an economic forecasting and risk management perspective, what has really changed since late 2007? On mute, I can still see the same old broken sources telling me that the future slopes of growth and inflation are going to be what they were in the prior twelve months. Huh?


It’s brilliant really. To get paid to forecast the weather on a 6-12 month lag, that is.


All the while, the anti-consensus fires begin to burn as the next macro risk starts to bubble. What do I think right now? I think that US inflation can absolutely double in 2014; double, double, cut US GDP in half, and there will be trouble.


Double Bubble Trouble - bub


Back to the Global Macro Grind


Turning bearish might sound like it comes right out of Scene 1 of Macbeth. I’m in my dark man-cave, I’m wearing jorts beside a boiling cauldron and three witches. Thunder strikes as my arthritic hockey knuckles pound the keyboard. “Thrice the brinded cat hath mew’d!”


Seriously. Let’s get real here. All the boys know that my first creative writing paper in the English department @Yale was given back to me with the word “ungradable.” While I may have only had upside from there, I have no business writing you poetry this morning.


Back to the call. If I boil down our entire US macro view right now to “inflation doubles, and growth gets cut in half” what does that mean? 

  1. #InflationAccelerating – US Consumer Price Inflation (headline) goes from 1% y/y to 2%
  2. #GrowthSlowing – US GDP growth gets cut in half from our #GrowthAccelerating call high of +4.12% in Q314

So easy a Mucker can do it.


I’ve been on the road seeing some really smart and really successful customers of ours in NYC and Connecticut for the last few days and the feedback to our call is:

  1. “You’re the only strategist hammering on #InflationAccelerating right now”
  2. “When do you think it will matter?”

While I think it will matter a lot more as the year progresses, we are quickly approaching the ides of March… and with the US stock market still down for the YTD, I’d argue it already matters. It already matters.


Gold is ripping (up again this morning to +11% YTD), and plenty of bonds (and/or stocks that look like bonds; Utilities +7% YTD) are crushing consumption growth stocks too. That’s where this call really matters – from both a sector and investment style perspective.


To be clear, my being bearish on inflation’s impact on the slope of US growth expectations doesn’t mean I am universally bearish on every asset class you can buy.  My asset allocation model is basically the opposite of what it was on this day in February of 2013:

  1. Long Commodities
  2. Long Foreign Currencies vs the US Dollar
  3. Long Fixed Income
  4. Net Long European Equities
  5. Net Short Japanese Equities
  6. Net Short US Equities

As you know, I’m big on process. So you shouldn’t be surprised about my re-positioning. As we move towards what we call “Quadrant 3” in our GIP (Growth, Inflation, Policy) risk management process, all I’m doing here is what the playbook tells me to do.


Any monkey can be long something. Over 90% of #OldWall ratings aren’t sell. So when I whip up the bearish brew, I get that people care more about how that might taste than telling them to buy Twitter (we still think you should be short that btw).


So when I say I’m “Net Short US Equities”, there are a few explicit positions you can see on that front:

  1. More US equity SHORTS than LONGS in #RealTimeAlerts
  2. Short Consumer and Financials (XLY, XLP, and XLF) vs long Healthcare and Energy (XLV and XLE)

If you think it’s a low-stress life to be publicly publishing my research team’s Best Short Ideas in a market that is just coming off its all-time highs, think again. The venom we’ve received (from non-customers) on short ideas like Kinder Morgan (KMI) and Nationstar (NSM) is real.


But I like it.


“Swelter’d venom sleeping got,

Boil thou first i’ the charmed pot”


Ah, the poetry of it all. I’m looking forward to seeing how the market reacts to its first big slowdown in US GDP tomorrow morning.


Our immediate-term Macro Risk Ranges are now (our Daily Top 12 ranges are in our Daily Trading Range product). We’ll be hosting a Flash Call on Brazil at 11AM EST today. Please ping if you’d like access.


UST 10yr 2.64-2.80%

SPX 1825-1852

Nikkei 14260-15164

EUR/USD 1.36-1.38

Brent 108.18-110.69

Gold 1321-1351


Best of luck out there today,



Keith R. McCullough
Chief Executive Officer


Double Bubble Trouble - UNITED STATES


Double Bubble Trouble - Virtual Portfolio

March 13, 2014

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Mushrooms can tolerate some light, but they thrive best in the dark while they grow in composted manure.  If you are being “mushroomed,” you are likely being left in the dark and fed a steady diet of offal.  I hope this is not an accurate metaphor for Darden’s independent Directors.

With that being said, I must ask a simple question: Are Darden's independent Directors being “mushroomed” and left in the dark by management?


I ask this because, from where I sit, I see a disconnect between what management is telling shareholders and reality.


During my tenure as an analyst, I have been both complementary and critical of Darden.  My first priority is, and has always been, to look out for the shareholders of any company I follow.  While I am not always right, I have built an honest and respectable track record.  Admittedly, my opinions can be very critical at times.  This is, without a doubt, the most difficult part of my job.


For the past year, I have been rather critical of Darden’s performance and the overall direction of the company; I’m not alone in this.  I have encountered numerous Darden shareholders who are bewildered and frustrated by the direction in which management has taken this company.  I firmly believe that Darden is now at a critical juncture in its existence, and I am concerned that management may be withholding the critical concerns of Darden’s less vocal shareholders from the Board.  Management wants shareholders to believe they have overwhelming support in their “value creation plan.”  From what I have seen, this is far from the truth.


As an analyst covering Darden, I frequently hear from institutional shareholders who have grown frustrated over the wall of silence that has been built around the company.  It is this wall that has allowed the poor decision making of management to persist with impunity.


The recent cancellation of the company’s analyst day is an obvious case in point – and note that the open analyst day has just been replaced by a “sell-side” analyst day (to which I was not invited), which presumably will allow management to cozy up to more cooperative members of the analyst community.  I believe holding an open dialogue with shareholders is a sound business practice.  I also believe the Board has a fiduciary obligation to fully weigh shareholder concerns before signing off on decisions that will materially affect the company’s future.


I encourage you to hold conversations with current shareholders to gain an unfiltered perspective and understanding of their current mindset.  To be clear, I think it is more than reasonable to assume Staboard will be successful in gathering the appropriate votes needed to call a Special Meeting and prevent the Red Lobster spinoff.  A number of institutional shareholders are very frustrated over their inability to communicate with the company.  None of them has indicated to me which side they are inclined to take in this dispute, but if Starboard is successful, you will face a much different situation than you currently do. 


It should also be noted that the SEC, under the leadership of its new chair, Mary Jo White, has placed renewed emphasis on issues of corporate governance, the proxy process, and shareholder participation in corporate decision-making.  Given the chain of events that I believe will unfold in the coming months, it would behoove you to be proactive and meet with these shareholders.




Looking back to earnings call commentary regarding Red Lobster since 4QF11, the brand appeared to be performing well.  That is until 3QF13, when the positive impact of the remodels began to diminish.  By 4QF13, the company began aggressively discounting in a desperate attempt to drive traffic.  These efforts failed, as declining traffic persisted and aggressive discounting efforts led to sales declines and margin contraction.  As management quickly learned, discounting never leads to increased profitability.  Needless to say, the Red Lobster brand has been treading downhill since.


We’ve identified, in our previously published Brand Life Cycle, discounting as a Stage 2 Panic condition.  We have found that management teams tend to follow a certain pattern in their decision making process when a concept gets in trouble.  Stage 2 Panic, as we’ve identified, tends to prelude the initiation of the healing process.  After sacrificing margins by implementing a deep discounting program fails to drive customer counts, management tends to realize they need to make major changes across the enterprise.


Red Lobster’s extreme discounting in 4QF14 led to a significant, sustained decline in the chain’s profitability.  In 1HF14, Red Lobster restaurant level margins and operating profits declined 2.6% and 85% respectively.  These numbers gave management no choice but to respond to activist pressure.



“After a slow start to fiscal 2011, Red Lobster has regained profitable same-restaurant sales momentum by optimizing their promotion strategy to feature craveable dishes at specific price points versus starting-at price points.” (Drew Madsen, 4QF11 earnings call)



“We are also pleased with the results of our refined promotion strategy during the first quarter, especially at Red Lobster and LongHorn. Our earnings shortfall compared to our internal expectations during the quarter was primarily driven by soft guest counts at Olive Garden and a search for affordability by our guests across all brands, generating a negative menu mix that was due in part to more check management than normal.” (Drew Madsen, 1QF12 earnings call)



“Red Lobster same restaurant sales increased 6.8% during the second quarter, 620 basis points above the full service restaurant industry benchmark. Red Lobster has delivered competitively superior same restaurant sales since October last year when they began emphasizing craveable, new seafood dishes and price certainty in their promotions. And that momentum continued during the second quarter.” (Drew Madsen, 2QF12 earnings call)


“Red Lobster same-restaurant sales increased 6% during the third quarter, 340 basis points above the full service restaurant industry benchmark. Red Lobster has delivered competitively superior same-restaurant sales since October of 2010 when they began emphasizing craveable new seafood dishes and price certainty in their promotions, and that momentum continued during the third quarter.” (Drew Madsen, 3QF12 earnings call)


“This growth was fueled by strong results at Red Lobster.” (Clarence Otis, 4QF12 earnings call)


“Red Lobster same-restaurant sales declined 2.6% during the first quarter, although operating profit increased on both a percentage and absolute dollar basis, due in part to lower seafood costs.  As you recall, last year during the first quarter, Red Lobster delivered same-restaurant sales growth of 10.7% behind the introduction of their Four Course Seafood Feast promotion.  And we’re pleased that Red Lobster was able to hold on to the large majority of last year’s growth this quarter and deliver a same-restaurant sales increase of slightly more than 8% on a two-year basis.” (Drew Madsen, 1QF13 earnings call)


LongHorn has completed a remodel of their existing restaurant base and Red Lobster will be approximately 75% complete with their remodel program by the end of this fiscal year. Both programs have significantly elevated brand perceptions among all guests and contributed to value-creating guest count growth.” (Drew Madsen, 2QF13 earnings call)



“On a blended same-restaurant sales basis the results for Red Lobster, Olive Garden and LongHorn Steakhouse declined 4.6% in the third quarter. In contrast, our Specialty Restaurant Group saw continued same-restaurant sales gains of 2.3% on a blended basis.” (Brad Richmond, 3QF13 earnings call)


“Second, we began to more aggressively address affordability in our core menus. And that included launching, with some heavy media support, a new Red Lobster core menu that has a significant affordability component, and then also accelerating introduction of new more affordable core menu offerings at both Olive Garden and LongHorn Steakhouse.” (Clarence Otis, 4Q13 earnings call)


Looking at Red Lobster’s financials, the numbers are much worse than management has led analysts to believe over the past five years.  An 85% decline in operating profits to-date in 1HF14 would be a staggering number for any company, let alone one with a relatively new asset base. 


These financials reveal just how poorly Red Lobster has been managed since FY09:

  • Food costs are up 100 bps
  • Labor costs are down 100 bps
  • Restaurant expenses are down 100 bps
  • Restaurant level margins are up 50 bps
  • Operating margins are down 200 bps

The 150 bps spread between the decline in restaurant level margins and operating margins speaks directly to the inefficiencies of the Darden business model.  Even worse, a vast majority of operating margin contraction was driven by a 150 bps increase on an inflated G&A line.  G&A currently stands at 11.3% for Red Lobster, well above the 9.9% Darden average.  This trend continues to worsen, as G&A was up 80 bps in 1HF14 vs 1HF13.  Management has no cost control!




These numbers look so out of line that we are now questioning if it is a misprint.  If they are indeed accurate, we may have underestimated how much G&A there is to cut in the entire Darden portfolio.


From FY09 to FY13, Red Lobster spent approximately $716.5 million in capex.  We estimate that only $60 million of this was used to develop new units.  This suggests that management spent over $650 million on upgrading the Red Lobster asset base.  A majority of the Bar Harbor remodels occurred between FY11-FY14.  During this time, management consistently assured outsiders that remodeled restaurants were maintaining a sales increase of 4% to 5%, which implies these stores surpassed the stated return on investment hurdle.


From FY09 to 1HF14, same-store sales have declined in 41 of 69 (59.4%) months and traffic has declined in 49 of 69 (71%) months.  From FY11 to FY13, same-store sales have declined in 11 of 24 (46%) months and traffic has declined in 13 of 24 (54%) months.  These trends negatively affected the P&L as EBITDA declined 8.5% from FY09-1H14, suggesting that the remodel and efforts to revive Red Lobster were unsuccessful.


Despite all of this, there is some good news!  Red Lobster’s assets are not in need of a significant upgrade.  The brand, if run properly, also has the ability to generate a significant amount of free cash flow.  The wild card will always be sales and traffic volatility, but a strong management team and a calculated, purposeful menu and promotional strategy could mitigate this effect.


We believe Red Lobster has a valuable asset base that makes Darden’s overall real estate portfolio materially more attractive than it would be without it.  We fear management’s current plan to spinoff Red Lobster is reactionary and lacking integrity.  They haven’t given a plan to stabilize and turnaround Red Lobster, but merely an excuse to cast off the struggling chain.




Howard Penney

Managing Director


Fred Masotta


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Operations driven quarter. BYD, you can do this too.



  • Graton - continues to gain momentum with each passing week
  • Closed on $2bn debt refi 
  • Revenue challenge is that customers were less willing to spend
  • LV Strip continue to show evidence of recovery
  • Strip:  Visitor room nights were flat; gaming volumes grew
  • Favorable population trends in LV locals market should continue in 2014
  • $8 bn invested in LV city projects, highest since 2007-2008
  • New developments should benefit Red Rock 
  • Mobile sports gaming:  signups exceeded expectations.  
  • Fertitta Interactive:  online gaming has gotten off to a slow start but are optimistic; payment process impediments e.g. Visa
  • 2013 capex:  $86MM
  • 2014 capex guidance:  $110-120MM
  • Have improved leverage ratio by 3 turns since restructuring in June 2011 
  • Consolidated cash:  $138MM


Q & A

  • Locals market:  no material improvement from last couple of quarters
    • Good trend in visitation but seeing low spend per visit
  • Still have room for cost improvement
  • LV promotional environment:  stable last couple of quarters 
  • Graton will report annual results in a few weeks
  • Ex Red Rock, $80-85MM maintenance capex run rate
  • 2014 excess FCF:  focus is to pay down debt and delever
  • Online DE/NJ interstate compact:  helpful but not game changer
  • Promotional spending as a % of revenues declining:  maximizing marketing $$; diligent and disciplined
  • Graton:  $46MM receivables left, will be paid back to Stations at some point in 2014
  • $48MM in interest reserve
  • North Fork referendum will happen
  • Broad-based strength across Las Vegas valley

Real Conversations: Keith Talks to Top Chief Investment Officer

Streaming Music the Amazon Way

Takeaway: Whatever Amazon does, customer attrition is critical.

Editor's Note: Below is a brief, complimentary excerpt from Hedgeye Retail analysis. For more information on our services, click here.

Amazon Working on Music-Streaming Service


Streaming Music the Amazon Way - 3 12 2014 3 21 21 PM

  • " Inc. is hoping to offer an on-demand music-streaming service to customers of its Amazon Prime program, but it may limit how much a person can listen to any given song, according to people familiar with the matter."
  • "The Seattle-based company has held negotiations with record companies and music publishers seeking to license their music for the planned service, but it remains far apart from some record companies on financial terms, these people said."
  • "The music service is one of several new features that Amazon may add as it raises the price of Prime to as much as $119 a year."

Takeaway from Hedgeye’s Brian McGough:

Here’s the deal. Amazon’s (AMZN) world continues to revolve around its Prime service in the same way Costco’s membership-only warehouse club revolves around its membership fee. Costco loses money excluding its fee, and Amazon loses money regardless.


Perhaps a boost in customers subscribing to Prime would put Amazon solidly into the black. Because, in truth, $119/year represents a 50% increase from current levels.


But you have to keep your customers. Attrition is critical. Simple as that.


To us, this move just sounds risky.

Connect to Hedgeye.