• run with the bulls

    get your first month

    of hedgeye free


The dollar, less almighty: Big investors see possible long-term currency weakness

Forget patriotism. Dump the dollar, go long the loonie.


CAKE reported 1Q earnings after the close Wednesday, announcing diluted EPS of $0.34 versus consensus at $0.33 and guidance of $0.29 to $0.33. 


The Cheesecake Factory reported 1Q earnings after the close Wednesday and, while the results were in line or slightly above expectations, the commodity outlook – and the question of company’s ability to pass it along to consumers – is causing uncertainty.  This uncertainty weighed on the stock Thursday as CAKE traded down 3.9%. 


Comparable restaurant sales came in at +1.6%, or +2.4% excluding weather, which implies a sequential increase in two-year average trends of 220 basis points.  The street was expecting comps to come in at +1.2%.  Exiting the quarter, CAKE had +1.4% of price on the menu.  Grand Lux did experience negative comps during the quarter, coming in at -3.8%, but management attributed that weakness to a difficult compare (+4.0%) versus 1Q10 and volatility in sales at the Las Vegas locations. 





In terms of ROP Margin, CAKE’s performance was less reassuring.  Cost of sales increased 70 basis points year-over-year.  With 60% of its food cost basket contracted, management anticipates inflation of approximately 3.5% for 2011.  The prior guidance was for inflation of 3% in the food basket.  Tellingly, management now forecasts the commodity impact on EPS for 2011 to be $0.11 from $0.05 prior.  Along the lines of my post on CAKE in February, titled “CAKE – PUNT AND HOPE”, management is betting the ranch on food inflation falling off a cliff in the back half of the year.  While that may happen, on a year-over-year basis, it is less than certain and does not jive with much of the agriculture news at present which point to disappointing harvests in grains and produce and increasing feed costs supporting protein prices.  Despite having protein costs locked, to the extent CAKE has to renegotiate contracts with suppliers in 2011, the overall cost of its commodity basket could increase further than the general rate of food inflation.   The company is guiding to 2.5% inflation in 2H11, with 1.5% in 4Q11, as compared to 4.5% inflation in 1H11. 


In order to address this inflation, management maintained that pricing would be taken, if necessary, to absorb cost pressure.  As I stated before, price was +1.4% at the quarter’s end and, with 0.7% in price rolling off the menu at the end of summer, the company anticipates taking 0.7% in the 2011 summer menu change to maintain the 1.4% price.  Management also underlined its willingness to take price closer to 2% with that menu change if the commodity environment required it.  G&A/labor efficiencies will also contribute to offsetting inflation, according to the company.





EPS guidance was raised at the low end, from $1.55-$1.70 to $1.58 to $1.70 (full year consensus EPS is $1.65), despite the incremental $0.06 of pressure from food costs that management is expecting.  This full-year earnings guidance is based on a comparable restaurant sales forecast of 1.5-3.0%.  For the second quarter, EPS guidance is at $0.39 to $0.41, which is below the street at $0.44 and will result in a shift in EPS from 2Q to 2H, absent a reduction in full year consensus expectations.  I would not be shocked if 3Q inflation, which could well be as bad as, or worse than, 2Q, prompts an additional shift in EPS expectations to 4Q!  Whether or not CAKE has sufficient pricing power to absorb the coming inflation will be the key question from here.  I do not believe that CAKE has the ability to price its way through the inflationary period ahead.  There is a significant risk of full-year EPS being reduced from here, especially given the lop-sided sentiment around the stock of late.


CAKE – EXTEND AND PRETEND - sell side rating chart cake



Howard Penney

Managing Director

Daily Trading Ranges

20 Proprietary Risk Ranges

Daily Trading Ranges is designed to help you understand where you’re buying and selling within the risk range and help you make better sales at the top end of the range and purchases at the low end.

Underestimating Leadership?

This note was originally published at 8am on April 19, 2011. INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK (published by 8am every trading day) and PORTFOLIO IDEAS in real-time.

“I suppose leadership at one time meant muscles; but today it means getting along with people.”
-Mohandas K. Gandhi


Yesterday, the ratings agency Standard & Poor’s downgraded their view of U.S. government debt from “AAA” stable to “AAA” negative for the first time since the attack on Pearl Harbor.  The implication of this new rating is that there is now a 33% chance that the S&P downgrades U.S. government debt in the next two years.  To be clear, our view of ratings agencies hasn’t changed—they are lagging indicators at best. 


In this instance, though, Standard & Poor’s did provide insight on the current political debate in Washington.  The basis of their call is that they believe it unlikely that the politicians in Washington will come to an agreement on a budget plan that will narrow the deficit over the long term.   This is the point we made in our Q2 Theme call last Friday, so of course we agree.


On the Republican side of the debate is the budget proposed by Congressman Paul Ryan from Wisconsin whose key tenets are to cut taxes, cap the size of Medicare and Medicaid, and to dramatically slash discretionary spending.  Conversely, the budget plan presented by President Obama raises taxes on the rich, cuts discretionary spending somewhat, and takes a hatchet to defense spending.  These are meaningfully substantive and philosophical differences with very little common ground as a starting point for negotiation.    


The reaction from the Obama Administration to the rating change from Standard & Poor’s was interesting.  The White House effectively dismissed the action, while the Treasury Department doubled down on the politicians in Washington.  In fact, according to Assistant Treasury Secretary Mary Miller, Standard & Poor’s revised outlook “underestimates” the nation’s leadership.  I’m not sure exactly what Ms. Miller thinks is being underestimated about the politicians in Washington, but fair enough.


I used the quote above from Ghandi to underscore the core of leadership, which is getting things done in conjunction with your perceived adversaries.  Unfortunately, many of our perceived leaders have failed the nation on this front in the last week.  President Obama failed us by turning a prime time speech about his deficit reduction plan into a campaign speech that alienated Republicans, including Congressman Paul Ryan who was stoically watching the speech live.  While Tea Party leader, and Presidential hopeful, Congressperson Michelle Bachman, failed us by once again bringing up the tired old questions about President Obama’s place of birth last weekend, rather than focusing on the critical deficit issues facing the nation.


If Standard & Poor’s action yesterday did anything, it brought the lack of political leadership to solve the deficit issue completely into the mainstream.  Not surprisingly, stock market operators cast their votes appropriately.  While the SP500 closed above our TREND line of 1,302, it did so barely at 1,305 and it is still trading below the TRADE line of 1,319.  Volume also confirmed this vote as it accelerated 28.8% on the NYSE week-over-week.  Volatility did the same with the VIX up 11%.


From a sector study perspective, financials became the first of the primary SP500 sectors to break down with yesterday’s market action.  On some level, this is likely the early anticipation of the ending of quantitative easing, which removes the politicization of the short end of the yield curve and hurts the lucrative business of borrowing short and lending long.  As we’ve posted below in The Chart of the Day, the spread between 2s and 10s is at a near all-time high in spread.  (As a way to play this reversion to the mean, we are long the etf FLAT in the Hedgeye Virtual Portfolio, which is a Treasury curve flattener position.)


Our Financials Sector Head Josh Steiner also provided some color as a rationale for yesterday’s quantitative breakdown in the sector:


“Mortgage-related costs are on the rise and managements are being more open about the accelerating deterioration of fundamentals in that business. Bank of America stated on their call that multiple charges taken in the quarter were tied to ongoing home price deterioration. MSR write-downs at other banks are an additional indication of ongoing deterioration in that business, as JPMorgan highlighted with their $1.1 billion write-down.


While most companies are beating on the bottom line it is largely being driven by credit-related improvement, but this is illusory. Most of that credit improvement comes from reserve release, specifically in the credit card business. For instance, JPMorgan’s card services provision was $226 million in 1Q11 as compared with $1.6 billion in 3Q10. One might assume that credit losses had fallen to $226 million, but in reality net charge-offs were $2.2billion in 1Q11. In other words, the company released $2 billion in reserves (defined as the difference between losses and provisions).


This reserve releasing has been substantially propping up earnings for the last several quarters, but will be coming to an end in the next few quarters as delinquencies in that business are nearing their trough.


The catch? The banks have been using reserve release from their card operations to offset growing pressure and recurring “one-time” charges in their mortgage business. Reserve release in cards will end in the next few quarters but mortgage-related weakness will persist for much longer.


Bigger picture, the industry continues to face an environment of little to no loan growth, rising margin pressure, falling non-interest income and, in 2Q11, significantly rising FDIC deposit insurance premiums for most of the large banks. From a macro standpoint, the start of the Consumer Financial Protection Bureau on July 1, 2011 will coincide with the end of QE2 on June 30, 2011, both of which are likely to be incremental headwinds for the sector.”


Needless to say, Josh isn’t overestimating the future stock performance leadership of the financial sector. 

Broadly, we will see this week which bell weather companies will lead, follow, or get out of the way as earnings seasons kicks off in full force.  Today, Goldman (this morning), Intel, IBM, and Yahoo all report earnings.


One last leadership quote today from the venerable Nobel Laureate Paul Krugman, who said this about the Standard & Poor’s ratings change:


“That said, it’s worth remembering that S&P downgraded Japan in 2002… Japanese bonds became known as the “trade of death”, because people kept betting on an interest rate rise, and it kept not happening. So, no big deal.”


So according to Dr. Krugman, emulating Japanese fiscal and monetary policy is no “big deal”.  I’m no Nobel laureate and my PH.D is from the School of Hard Knocks, but even I know that becoming Japanese economically IS a big deal. 


Keep your head up and stick on the ice,


Daryl G. Jones

Managing Director


Underestimating Leadership? - Chart of the Day


Underestimating Leadership? - Virtual Portfolio


As it turned out, IGT was more than just the safe play



"Our second quarter results reflect the advances we are making towards moving IGT to a position of greater financial strength.  We continue to demonstrate the leverage in our operating model with strong performance in profit margins.  Although we remain in a challenging environment, the near and long-term outlooks for the Company are improving and we look forward to reporting our progress in coming quarters."

- Patti Hart, President and CEO of IGT




  • Revenues: $492MM and EPS of $0.23
  • Guidance raise:
    • $0.84-$0.90 (excluding the 4 cents favorable impact from certain adjustments)
  • Games Ops:
    • Revenue per unit: $53.62; $3.24 increase sequentially and $2.66 increase YoY
    • Install base: 57,100; 400 sequential increase
    • "Improvement in per unit yields offset a lower installed base compared to the prior year, down largely due to removals from Alabama charitable bingo facilities and conversions of leased games to for-sale units in Mexico."
  • Product Sales:
    • 10,200 recognized unit sales
      • NA: 5.7k; International: 4.5k
    • 10,000 units shipped
      • NA: 5.3k (1.5k new and 3.8k replacement) ; International: 4.7k (2.3k new; 2.4k replacement)
    • ASP: $13.4k
    • "The Company recognized 10% more units in North America while International units were down 12% year over year."
    • "The increase in gross margin resulted from improvements to both the geographic and product sales mix combined with product cost efficiencies, such as lower obsolescence and rework costs."
  • "On April 18, 2011, IGT executed $250 million notional value interest rate swaps that terminate on June 15, 2019, which effectively exchange the remaining fixed interest payments on our 7.5% Bonds due 2019 for variable rate interest payments based on six-month LIBOR plus 409 basis points set in arrears with payments due on June 15 and Dec. 15 of each year"


  • Visibility remains limited and they continue to expect macroeconomic pressure in the second half. Expect that their current trends of modest growth to continue for the balance of the year and into next year
  • Feel very optimistic about their international prospects
  • Had a higher mix of mega-jackpot games in the quarter
  • Game ops yields should continue their moderate improvement assuming normal seasonal trends continue
  • 82% of their games are variable fee in game ops
  • NA ASP increases are reflective of the competitive environment
  • Expect ASPs to rebound modestly from this quarter's levels but for margins to remain under pressure for the rest of the year, mostly due to mix
  • SG&A increased due to i-gaming initiatives and higher incentive comp. Expect SG&A to increase modestly for the remainder of the year.
  • New $750MM facility replaced their existing facility providing a lower borrowing rate and extended term. Their interest expense will be $13.5MM annually as a result.  The swap will save another $7MM of interest expense.
  • Their new facility will allow them to:
    • invest in their interactive space
    • enhance their international game distribution
    • enhance their content offering
  • 500 Centerstage games on order
  • Have over 33% of their install base on their new G33 platform
  • Expect their international unit sales to keep pace with their NA sales for the balance of the year. Expect game ops placements internationally to remain strong.
  • Still see a big opportunity in i-gaming internationally
  • Game operations G33 box is allowing them to deploy games in just a few hours at a lower cost to them. Placements of G33 boxes increased 16% to date and they have 3,000 more boxes in order
  • Centerstage is performing well. Sex in the City is performing well. Dark Knight, Hangover, Ghost busters all scheduled to be released soon.
  • Overall coin-in was down 4% YoY but up 15% on a per machine basis
  • They are still very much in a promotional environment for replacement units.  To help offset these promotions, they have continued to reduce their production costs but simplified their products and processes.
  • Increases in their IP revenue also contributed to their margins this quarters
  • Systems revenues have grown in the high single digit range YTD.


  • WAP mix in their install base?
    • Have seen their WAP base stabilize and improve recently
    • New content is the biggest drive to the improvement but the return to normal seasonal trends is helping
  • Gun Lake was the most notable new shipment
  • Margins in product sales will be around 52% domestically for the remainder of the year
  • Working to keep their R&D expenditures flat. Redeployed their systems workforce to China earlier this year which is helping them keep costs down.
  • Any changes in NA pricing throughout the quarter?
    • ASPs that they experienced were a combination of mix and promotional activities.  MLD was only 37% of their mix.  There were 1500 units that slipped from lease ops to for sale at very low ASPs (Mexico). Hence they expect a pick up in ASPs for the balance of the year.
    • They are seeing some of their competitors price aggressively, but feel like their promotional activity is reasonable
  • Their spending on i-gaming internationally isn't a big portion of their spend. Going forward, they will link their spend on i-gaming with the growth in the revenue from that business. They will likely spend more on R&D next year.
  • Guidance raise is due more to margin expansion and cost control vs. revenue growth
  • They increased their resources in their China R&D center from their US center to reduce costs
  • Working on more localized theme product to grow share in Asia. Also making sure that their systems products are appropriate for that market. Expect their Asia group to gain share in 2012.
  • Going forward they will move more of their R&D dollars to online and applications
  • Don't think that there is that much elasticity to lowering prices
  • Expect MLD's as a % of sales to be up in the back half
  • Replacement sales? At the low end of their guidance, they assume that things remain flattish and at the high end that there is some modest pick up as well as some improvement in game ops.
  • Will focus on taking share on the slot side in Asia instead of focusing on electronic table games


MCD reported 1Q results this morning and, while the initial glance was encouraging, the upward revision in the firm’s FY11 commodity inflation outlook is weighing heavily on the stock.


MCD is an impressive organization that creates value for its shareholders, jobs for the economy, and serves billions of people globally.  I have been bearish on the stock since December and released a Black Book to that effect in January.  While March comps in the U.S. exceeded my expectations, as well at consensus, concerns about margin sustainability – concurrent with a likely slowdown in comparable restaurant sales growth – are coming to the forefront. 


MCD reported global comparable restaurant sales growth of 3.6% for 1Q11.  The March numbers showed strength in the U.S. with comps coming in at +3.0% versus consensus at 1.7%.  MCD took a 1% price increase in early March and will likely take more this year.  Europe, in spite of austerity measures being implemented across the continent, saw comparable restaurant sales growth of 4.9% in March (consensus +3.2%) and 5.7% in the quarter.  The company also took a 1% price increase in the first quarter.  APMEA was slowed somewhat by the impact of the disaster in Japan as March comparable restaurant sales eked out a 0.5% gain year-over-year (+2.0% consensus), rounding out 3.2% growth for the first quarter. 









While comps exceeded expectations, on aggregate, restaurant level margins declining for the first quarter since 1Q09 (prior to that it had been 3Q05!) was what generated the most attention.   With compares becoming more difficult as the summer progresses, gaining leverage over operating costs will be difficult.  In addition, management raised its FY11 guidance for its food cost basket from +2 to 2.5% in the U.S. and +3.5 to 4.5% in Europe.  It seems almost certain that a significant price increase will be necessary to absorb this inflation.  While MCD pointed to its track record of not having raised prices since last 2009, it is important to note that commodity costs were deflating until recently for MCD; a price increase will be necessary at some point in 2011.  As the chart below shows, the decline in margins brings MCD out of the “Nirvana” quadrant – positive comps and margins – for the first time since 1Q09.





On the ability to “manage through an inflationary environment”, management assumed a defensive tone on the call, referencing 2008 as an example of the company successfully navigating an inflationary environment.  While this is true, I believe the point I made regarding the overdependence on beverages is applicable in this instance.  Frappes and smoothies in 2Q and 3Q proved to be high-margin items for MCD and, coupled with year-over-year commodity favorability, were highly accretive to the company’s bottom line.  Furthermore, the beverages were highly effective sales drivers.  Per our MCD Black Book, we estimate that frappes and smoothies counted for 5.7% and 5.9% of the 2Q and 3Q10 comps, respectively.  For reference, 2Q and 3Q10 comps for the MCD U.S. business were 3.7% and 5.3%.  If our estimates are correct, MCD U.S. excluding frappes and smoothies, declined on a same-store sales basis in 2Q and 3Q10.  The initiatives being rolled out this summer, namely strawberry lemonade and an additional flavor of smoothie, have big shoes to fill. 


The MCD franchise system is more robust than any other in the business.  However, as was pointed out on the earnings call, it is easy to keep a franchisee happy with growing market share and increasing margins.  It will be interesting to see how franchisees will react to the ever-expanding menu and increasing commodity costs, all the while attempting to maintain the low prices that corporate aligns the brand with. 


The sentiment around this stock shows just how high expectations are for the stock.  These expectations are difficult to meet and, in 2Q and 3Q of 2011, McDonald’s has a tough few months ahead of it.  Guest counts, long the lifeblood of the company’s comparable sales growth, are likely to be negatively impacted by any steep price increases.  Inflation looks like it is almost certainly going to require a steep price increase on the part of the company.  This is certainly the most interesting period for this stock in the last seven years.





Howard Penney

Managing Director