Despite the stronger dollar over the past week, the commodities that we monitor generally gained with the exception of pork, rice, and coffee.
McDonald’s COO, Don Thompson, speaking at the UBS Global Consumer Conference, had the following to say about grocery inflation and its impact on McDonald’s business: “I think the projection for 2012 is for the grocery store prices, the food at home to moderate a little bit in the maybe 4% to 5%, 3% to 4% range and food away from home to be more like 2% to 3%. So that gap is closing but the projections are still for the grocery stores to be a little higher. If that means for us, our back store cost won't increase as much, that's a good thing.”
As our chart below illustrates, the spread between food at home CPI and food away from home CPI has been narrowing over the past four months. If the trend over the last four months were to continue, assuming the average rate of narrowing since the spread stopped widening, by the end of the second quarter the spread would be closed. While this is not a foregone conclusion, it is important to note that – on the margin – the gap has been closing and offering less of a competitive advantage to restaurants versus grocery stores.
SUPPLY & DEMAND
The USDA’s Wheat Outlook report is projecting world wheat production in ‘11/12 2011/2012 world wheat production is up 1.1 million tons this month to 694.0 million, further raising the historical record. In Australia, 2011/12 production is up 1.2 million tons to 29.5 million this month, and up 1.6 million tons on the previous year’s record.
Record production and stocks have stimulated trade. Iran is negotiating grain purchases with Russia, Pakistan, and India using letters of credit denominated in rubles and rupees to bypass Western banking sanctions. Globally, export forecasts have been increased for countries including Australia, Brazil, Kazakhstan, and the U.S.
The USDA said that 922k farms raised cattle last year, 13k fewer than in 2010. The USDA has lowered its forecast for 2012 beef production by 80 million pounds and raised its forecast for fed cattle prices by $2.50/cwt.
The Texas AgriLife Extension Service is beginning a statewide educational initiative focusing on rebuilding cattle herds within the state. Dr. Ron Gill, AgriLife Extension livestock specialist said, “…The historic drought of 2011 dramatically accentuated that trend [declining herd sizes]. The state’s cattle industry and affiliated trade and service companies are the second largest economic driver in the state, bringing in billions of dollars to the state economy. With the cowherd at such a critically low level, Texas will start to lose infrastructure if cow numbers do not increase soon.”
The World Agricultural Supply and Demand Estimates from the USDA indicated that beef supplies will shrink further this year and imports will pick up, but not enough to account for lower production and continues strong exports, according to USDA projections.
Beef exports in January were even in volume versus a year ago but increased in value by 14%. Philip Seng, president of U.S. Meat Export Federation (USMEF), said that “there are opportunities to expand the presence of U.S. red meat by exploring new market niches as well as increasing access with several key trading partners.”
Egg sets placements continue to contract at around the same rate, at -5.4% for the six-week moving average, according to the Broiler Hatchery report released by the USDA today. This implies that supply will remain tight as the industry looks for more favorable business conditions before expanding production.
RECENT COMPANY COMMENTARY
Beef: Most companies are expecting beef cost inflation to be up mid-to-high single digits versus last year
TXRH: We expect approximately 8% food inflation in 2012, primarily due to higher beef costs…on the beef side we do have fixed price – pricing arrangements in effect for over 90% of our beef costs in 2012.
CBRL: To the continued pressure on ground beef prices and other commodities partly offset by lower average dairy and produce prices, along with benefits from our supply chain initiatives, we expect cost of sales to increase 60 basis points to 80 basis points over 2011 to near 26% in 2012.
RUTH: We project 2012 beef inflation to be between 5% and 8%. We currently have purchase agreements for beef representing approximately 30% of our needs through August of 2012, which represents an approximate 7% premium compared to the prior years.
CMG: While we're cautiously optimistic we'll see more reasonable prices in 2012 for avocados, dairy and produce, we expect these benefits will be more than offset by higher costs for our beef, chicken, rice and beans. Beef costs will be especially challenging due to protracted supply shortages, despite recent reductions in grain prices.
MCD: As we look at our guidance for 2012, we've built another mid-teens increase for beef, expecting that the dynamics in the marketplaces that we see, and are expecting, will continue.
DRI: U.S. beef production will continue decline though over the next 24 months, placing continued upward pressure on beef prices because of the slow economic recovery hamburger and value oriented beef, cattle beef are in high demand and can be priced accordingly by the packers. At Darden we purchased mainly tenderloins and other premium steakcuts, while we expect pricing for our beef products to increase by 12% our pricing has been tempered by consumers' resistance to record higher retail prices for premium stakes and the resulting shift to value oriented cuts and as you can see beef is approximately 14% of our cost basket … We have 75% of our beef requirements contracted for fiscal 2012 and 40% of the June to December usage under contract for fiscal 2013.
SONC: One item to note is that we recently locked in our beef contract for calendar year 2012… given the potential for beef costs going even higher, which there are a lot of reports out there that speculate that could happen, that we chose to go with making this more of a known quantity here, and the idea of having a set price for the next 12 months, we feel like would be good for our business, adds some predictability to the business.
Coffee: Prices are now down -32% versus last year
PEET: We expect 2012 coffee costs to rise 12% instead of last year's 42%.
SBUX: We've taken advantage of the recent declines in the C-price to lock in more of our coffee needs for fiscal 2013. We now have six months of our fiscal 2013 requirements secured at costs moderately favorable to 2012.
Dairy: CAKE, DPZ, PZZA, TXRH and others could benefit from favorable cheese costs this year
TXRH: The volatility around that 8% estimate for food cost inflation would really be driven by produce and dairy. Those are of the biggest components that we float around the market, and that's about 15% to 20% of our total cost of sales.
CMG: While we're cautiously optimistic we'll see more reasonable prices in 2012 for avocados, dairy and produce, we expect these benefits will be more than offset by higher costs for our beef, chicken, rice and beans.
With Buffalo Wild Wings’ stock up 32.5% year-to-date, our negative research stance heading into the 4Q11 EPS print has definitely left a scar. We are also not going into hiding because the facts indicate that some important questions need to be answered by Buffalo Wild Wings to sustain its stock price at current levels. Besides the more specific issues facing the company, the macro environment for restaurant stocks is generally positive – for now. Here we run through our updated thoughts on the stock.
Our view of Buffalo Wild Wings’ 4Q11 results was that, while the top line numbers were impressive, it was disconcerting that margins did not expand despite the fact that elevated wing prices were yet to impact the P&L. On its own, this fact would likely have been enough to prompt skepticism among investors but – unfortunately for our research call – the 1Q12 to-date (as of 2/7) same-store sales number, at 12.9% at company locations, superseded any margin-related concerns.
The stock has settled in at around $90 and the EV/EBITDA (NTM) multiple has expanded to 10x. We are less than convinced that this current price level is sustainable over the intermediate term TREND and see significant risk to the downside if the company does not execute to perfection over the next two quarters. The Street, it seems, shares this view; despite the impressive 1Q guidance and the implied same-store sales trends, FY12 EPS estimates did not move significantly. Estimates for 1Q12, appropriately, were revised sharply higher but it seems that analysts are waiting to see how the rest of the year plays out (chart1, 2). Our view is that costs will play a more significant role in 2Q and 3Q than consensus is allowing for.
Here are some points we are currently focused on:
- The sequential move in comparable-restaurant sales from 8.9% in 4Q11 to 12.9% for the first five weeks of 1Q12 benefitted by 3% from the impact of gift cards and also, we estimate 2-3% of favorable weather impact. Our estimate for the real current run-rate of comps is 7%. Gift cards may not have as much of a favorable impact on the full quarter comp versus January’s but we still expect a significant boost from gift cards and weather for 1Q12 comps.
- The Street obviously gave the company a pass on flat margins in 4Q, despite a stronger-than-expected top line, due to the 12.9% 1Q12 to-date same-store sales number released coincidentally. 4Q11 was a poor quality quarter for BWLD given the lack of flow through on strong comps and the fact that the tax rate was lower than expected. Unless the company can keep disclosing quarter-to-date comps far in excess of expectations, the lack of leverage in the business model will be a concern for investors. Without gift card and weather benefits, especially in the event that the broader employment outlook softens the stock price could move lower. Tougher top line compares are coming in 2Q and 3Q for BWLD and we believe investors will be seeking reassurance from management that the momentum in sales is continuing into April when 1Q EPS is reported (chart 3).
- We are hearing from some franchisees that sales softened in the second half of February. Gas prices (up 6% in the two weeks from 2/15) are thought to have been a factor.
- Chicken prices continue to head higher. While chicken wings led the way, other cuts are now following; breast, leg, and full bird prices are all gaining as elevated beef prices push food service toward chicken products. This demand for chicken is a bullish indicator for wing prices. Additionally, as the processors continue to struggle, supply remains constrained (chart 4).
- Sanderson's Farm (SAFM) is up 14% over the past month on the improved outlook for chicken prices.
- In order to manage inflation and meet EPS expectations, management will likely need to cut costs and/or raise prices. Both of these strategies could ultimately have a negative impact on the top line. Cutting G&A costs is not without its risks for a "growth" restaurant company given the likelihood that it might impact revenue growth down the road. Additionally, as we learned on the 2Q11 EPS earnings call, expanding the concept's geographical reach - a key component of the growth story - requires significant G&A investment.
- Management mentioned the possibility of acquiring or developing a second concept. This is generally a huge drain on company resources and can require significant investment. We would be initially skeptical of this notion but obviously will reserve judgment until such a time that management might disclose more detail. Our initial concern is founded upon the fact that BWLD is not generating much cash flow (after growth-related expenses). The company’s net CFFO-to-net income ratio has been barely positive over the last year (chart 5). If margins contract in 2Q and 3Q, that only heightens our negative view of BWLD acquiring an additional concept; the company would have to lever up to acquire a second concept of significant scale.
- AT 10x EV/EBITDA, BWLD looks very expensive for a company with a checkered past of inconsistent operating performance.
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We don’t like VRA headed into the Q4 print, or coming out of it. It’s next to impossible for us to make a valuation call in this tape. But our model is 20% below Street expectations next year, which pretty much speaks for itself.
TRADE (3-weeks or Less)
We’re at $0.44 vs. the Street at $0.47E for Q4. We expect the shortfall to come from lower margins despite the likelihood of sales coming in above the upper end of guidance.
- Current expectations for a rebound in gross margins implies the impact of a timing shift in sourcing costs and opportunistic sale of retired inventory were one-time events and does not appear to reflect the current promotional climate or VRA’s exposure to cotton.
TREND (3-months or More)
Comps have been driven by pattern proliferation and additional category expansion over the last two years and are starting to slow putting greater emphasis on store growth to drive the top-line driving higher costs.
- Managing the inventory/sales growth spread will remain challenging in the 1H with sales slowing at the same time retailers get increasingly cautious on inventory.
- Top-line trends are already starting to roll. The top end of Q4 guidance implies a significant deceleration in both the 1yr and 2yr trends. We expect this trend to continue with mid 20%s revenue growth over the last two years slowing to a low-teens rate over the next two as retail and e-commerce growth offsets a decline in wholesale sales.
- In addition, our sense is that VRA is getting more aggressive with the terms it’s offering wholesale accounts to encourage earlier receipts. This tactic might work to drive sales over the near-term, but it’s not sustainable. Particularly given the profile and size of 25%-50% of VRA’s wholesale accounts, which simply don’t have the capacity to store excess inventory.
- Perhaps this is already happening. Management addressed concerns about product showing up at Costco on a recent conference call essentially revealing that while they don’t sell directly to Costco, a large wholesale account had flushed excess inventory through the discount channel. There is nothing to keep this from this happening again. It may be through smaller channels (think flash sale sites), but the evidence of over inventoried product inevitably comes to roost.
TAIL (3-years or Less)
VRA risks overextending the brand in pursuit of additional category expansion. At the same time, the company is looking to expand internationally into Japan and double the size of its DC which requires incremental investment.
- Square footage growth can come, but at a price we think is grossly underappreciated when it comes to VRA’s business model. Unlike the other brands, VRA is sold not through department stores (with the exception of a few Dillard’s locations), but rather through small independent retailers where VRA often drives and accounts for a meaningful percentage of sales at each wholesale account. Its network of 3,400+ small independent retailers is far more sensitive to the competitive threat of company-owned retail stores opening nearby than typical brands that are distributed in department stores that are far less reliant on any one vendor.
- Despite efforts to expand its product offering (e.g. rolling luggage), VRA is more constrained than the other brands in its ability to drive meaningful category growth limiting store productivity potential. This has been reflected in a material deceleration in comps to HSD with little to suggest a material reacceleration is likely.
- Over the last three years, SG&A leverage has accounted for 9 pts of margin expansion, which is now likely to shift in the other direction and suggests VRA was over earning in its first year as a public company. We expect this shift to result in a 2pt margin swing as a 1.5pt tailwind turns into a 0.5pt headwind this year (F13). (see table below)
- Over each of the last two years, VRA has kept Advertising, Marketing and Product Development flat to down. This is the line that accounts for new product initiatives for a brand that’s starved for expansion ideas – not good. We think VRA is going to be forced to take this line higher over the next few years. We are modeling this line up +10% and along with continued growth in selling expense expect SG&A deleverage for the first time in four years.
The stock appears to be baking in the kind of growth that we’d associate with the possibility of another department store partnership. We prefer to value what we see in front of us and that’s a brand challenged to grow with operating margins already over 20%. We are shaking out at $1.55 and $1.61 in EPS for F12 and F13 respectively 20% below Street expectations next year (F13). With the stock trading at 22x and 12.5x consensus F12 EPS and EBITDA estimates, this is not reflected in the stock here at $37. Nor is the structural risk in VRA’s wholesale accounts once it starts rolling out owned retail stores more aggressively.
THE HEDGEYE BREAKFAST MONITOR
Interesting story on Bloomberg today: Asian Buyers Buoy New-Home Demand in California’s Orange County. Asian buyers, many paying, cash are boosting the local economy in Southern California, particularly in Orange County. This could be providing some boost to PFCB, CAKE, BJRI and other restaurant companies with exposure to the area.
Commentary from CEO Keith McCullough
If your portfolio is 50% long SPY and 50% long AAPL, you are all set – Bonds, Gold, Currencies all getting crushed:
- STOCKS – fascinating, but maybe not surprising, that the lowest “quality” countries in the world are leading the upside this morn (Japan +1.5%, Greece +2.6%, Romania +1.5%). China and Hong Kong closed down -2.6% and -0.2% post the “stress test” squeeze into the US market close. We should hang out up here in the nosebleed seats, until we don’t – new SPX range = 1.
- BONDS – kaboom! 2-yr US Treasury yields are only up about +33% in 10 days, so there’s really no Global Macro interconnected risk w/ this Bernanke pancake plan, is there? Only if you are long anything Bonds, Gold, or FX – 10yr absolutely ripped after it crossed my 2.03% line. This is one of the biggest off-sides 1-day moves I’ve ever seen in Global Asset Class attribution.
- CURRENCIES – so the Japanese Yen is crashing (down -9.1% in 2 months) and now the Euro is back into a Bearish Formation. The best news we have here, but only for Americans, is that Strong Dollar is potentially back (until Qe4 whispers come on a 50bps SPY down move). But the globally interconnected risk to a sustained strong dollar (Gold hammered) is tangibly evident.
I have a 0% asset allocation to Commodities and Int’l FX. I finally re-shorted SPY at 1388 yesterday. I’ll definitely be trading these new ranges of risk. Being long VIX 14-15 has worked until it hasn’t – then this whole thing flips, violently, again. Long live the “Price Stability.”
MCD: McDonald’s COO Don Thompson said this morning that about 20% of U.S. restaurants are remodeled and that most European stores will be remodeled by the end of the year. U.S. remodeling is set to ramp up which, we believe, will pressure Wendy’s as it struggles to fix its asset base.
SONC: Sonic is tinkering with its marketing strategy as it adds new menu items to boost sales and new drive-in prototype to reduce franchise costs, according to NRN.com
NOTABLE PERFORMANCE ON ACCELERATING VOLUME:
COSI: Cosi gained 8.4% on accelerating volume yesterday.
CBOU: Caribou was the only stock in QSR that posted a decline yesterday.
CAKE: Cheesecake Factory’s move to introduce “Small Plates and Snacks” was mentioned in a story by the LA Times about customers’ increasing preference for “grazing” through smaller servings instead of sitting down to longer, more expensive meals.
The Macau Metro Monitor, March 14, 2012
LAS VEGAS SANDS FACES $375 MILLION SUIT BY FORMER MACAU PARTNER NY Times
A filing submitted to a court in Macau in January by Asian American Entertainment, an estranged former partner of LVS controlled by the Taiwanese businessman Shi Sheng Hao, who also goes by the name Marshall Hao, alleges LVS of improperly breaking off a 2001 agreement to bid for a Macau casino license and seeks compensation of 3 billion patacas, or more than US$375MM.
In October 2001, LVS signed a letter of intent to team up with Asian American in bidding for a casino license. Hao had recruited financial support from China Development Industrial Bank, a Taiwanese lender that had agreed to underwrite the joint bid. Asian American submitted a formal offer to the government of Macau in December 2001 on behalf of itself and Venetian Venture Development, a subsidiary of LVS.
Asian American’s suit alleges that Venetian Venture Development violated the terms of their bidding agreement in early 2002 by going behind its back to seek a rival bidding partner. When results of the tender process were announced by the government on Feb. 8 of that year, LVS had won — not in partnership with Asian American, but with Galaxy of Hong Kong.
Asian American had previously filed a breach of contract suit against Sands in 2007 in US federal court in Nevada, but that case was dismissed by the court in 2010. In that 2007 suit, LVS had argued that Nevada had no jurisdiction over the case and that Asian American’s claims were void because of the statute of limitations. But on appeal, a higher court allowed some of Asian American’s claims to go ahead, sending the matter back to the lower court in 2009. The matter was ultimately thrown out by the lower court after Asian American failed to retain lawyers to press the case — effectively giving up.
It is unclear why the company has chosen to take up the case again now, in Macau. Under Macau’s laws, LVS has two months to respond to Asian American’s suit. Based on the timing of most civil cases, the matter would be unlikely to go to trial before 2013.
MACAU PACKAGE TOURS AND HOTEL OCCUPANCY RATE FOR JANUARY 2012
Visitor arrivals in package tours surged by 43.6% YoY to 634,993 in January 2012, attributable to the Lunar New Year holidays. Visitors from Mainland China (424,234) increased by 34.1%, with 176,498 from Guangdong Province. Moreover, visitors from Taiwan (60,273); Hong Kong (41,877); and the Republic of Korea (34,428) soared by 151.5%, 139.0% and 43.2% respectively YoY. The average length of stay increased by 0.02 night to 1.5 nights.
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