Conclusion: The math would suggest it is prudent to fade bullish manufacturing and export data at these prices, given their low predictive value for economic growth. Growth Slowing remains our fundamental outlook for the U.S. economy over the intermediate term.
Position: Long L/T U.S. Treasury Bonds (ETF: TLT).
But manufacturing is strong, right? Right.
Long before today’s ISM Manufacturing beat (76 years ago to be exact), John Maynard Keynes published The General Theory of Employment, Interest and Money. In that seminal work, Keynes laid the foundation for many economists after him to justify currency debasement in order to stimulate an economy’s manufacturing and export sectors in the pursuit of higher rates of GDP and employment growth.
Fast forward to 2012, we are entrenched in what Jim Rickards has labeled “Currency Wars” (also the title of his new book), whereby countries all over the world are pursing expansionary fiscal and monetary policy with the goal (stated or obfuscated) of having the cheapest currency. In few places is this more prevalent than the U.S., where the political agenda continues to be focused on stimulating manufacturing and export growth.
As we’ve seen with the resilience of the manufacturing sector in both the ISM survey and in the monthly employment figures, Obama and Bernanke are getting exactly what they want:
Unfortunately, their “victory” comes largely at the expense of domestic purchasing power and economic/financial market stability (refer to our 2Q12 Macro Themes presentation for more details). Perhaps more importantly, it should be duly noted that stimulating manufacturing and export growth in the U.S. is as good of a real world example of “focusing on the trees in lieu of the forest” as we can find. Manufacturing value added represents only 12.3% of the U.S. economy – down from 20.8% just over 30yrs ago. Additionally, that 12.3% is well below the OECD average of 16.1%.
Turning to exports, outbound shipments have averaged just 13.4% of the U.S. economy over the last four quarters – hardly comparable to the 70.7% share garnered by PCE.
Perhaps these data points explain why manufacturing has had little predictive value in determining U.S. growth. In the analysis below, we regressed the QoQ % change of the quarterly average of the ISM Manufacturing Report on Business with U.S. Real GDP QoQ SAAR – in concurrent fashion and with a one-quarter lag. Needless to say, the fit isn’t tight at all; we’d argue that this is because manufacturing doesn’t move the needle on the slope of U.S. growth. Manufacturing does, however, move the needle on the slope of consensus storytelling about the U.S. economy – as evidenced by today’s melt-up.
As such, we are sticking with our process and siding with the Treasury bond market rather than what we see as a topping equity market, as the former continues to trade in line with our call for slowing domestic growth. Our quantitative risk management levels on 10yr yields are included in the chart below.
Domino’s Pizza posted a soft quarter, missing on sales as we were expecting. From here, for now, we are neutral on the stock given the large correction on the news. DPZ missed EPS expectations of $0.49 by 2 cents. International comps also fell short while domestic comps were an unequivocal bomb versus the Street.
Our view of today’s print is that this was more a function of slowing pizza trends than any self-inflicted wounds from the company. That said, we believe that Pizza Hut’s dinner box and other promotional items from competitors may have taken share from Domino’s as the company’s promotions focused on non-pizza side items. In what seems to be a strategy to drive unit economics to a place where franchisees feel more of an incentive to help grow the unit count, management’s marketing strategy seems aimed at higher margin items likeac the Cheesy Bites (4Q) and Parmesan Bread Bites (1Q). The company said, “Our focus is on helping our franchisees generate strong store profits and to turn those profits into new stores so that our domestic store growth rate improves.”
- Top line may have been impacted from marketing focus on side items. Pizza promotions better driver of traffic.
- Weather was not a significant factor.
- Technology continues to drive sales; 30% of orders were digital (versus a year ago) in the U.S. and 7% of total orders were made from a mobile device. The recently launched Android app accounted for 1% of orders in the quarter.
- International store growth remains strong and management offered encouraging commentary on weaker stores being “weeded out” of the system.
- 2% system comps (2.1% franchise, 1.6% company) for the domestic business was spun as being in the long term guidance range, which is it, but even bears were not anticipating such a weak comp.
- Promotion of the side item was effective in raising awareness of these items and driving margin higher.
- Operating margin increased year-over-year from 28.7% to 29.8% as a result of a change in the mix of revenues attributable to fewer company-owned stores and increased franchise revenues. Franchised domestic same-store sales gained 2.1% while domestic comps were up 1.6%.
- Food costs: -140 bps as cheese block prices for 1Q were $1.52 versus $1.69 a year ago
- Labor costs: -110 bps
- Occupancy: -80 bps
- Insurance and Other: +40 bps
- Store level unit growth is not expected to be a factor for the company in the near term. Over the medium term, raising store level profits is crucial to getting that drive back.
- Europe remains a concern with well-broadcast economic issues persisting. Management seems satisfied with how it is holding up but it is a potential worry.
- Stronger franchisees have been growing by buying stores that are not performing as well, or are even distressed, and as that trend eases there should continue to be fewer closures.
- Food basket inflation for the year is expected to be between 1-2% (unch).
- 35-40% of the company’s intended purchases for 2012 are locked in.
- The marketing message will be more evenly balanced between promoting check and traffic over the remainder of the year. Artisan pizza is a focus this quarter as well as early week carry out special and other side items.
- G&A is currently trending lower but the company expects higher G&A versus 2011 for the full year.
Other Points of Interest
- Technology has been a tremendous driver of business for Domino’s and will continue to be. However, in terms of the competitive advantage that it has offered the company versus competitors, we believe that that is waning rapidly as Papa John’s, Pizza Hut, and even smaller chains invest in their own digital ordering capabilities. Management described technology as the “biggest leveragable competitive advantage” both domestically and internationally.
- There are now more Domino’s stores outside the U.S. than within the U.S.
- Gas prices, for Domino’s, have the greatest impact on the company’s business through the effect on long term commodity prices.
- We expect sentiment around this name to turn marginally more bearish. A lot of the questions on the call seemed to lead management toward positive statements but management did not bite. According to Bloomberg there are currently no sell ratings for DPZ.
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Let's face it. No one has ever HAD TO look at either WWW or PSS. Now we're left with the same high-quality leadership at WWW, but at a significantly larger company. This story has legs.
With WWW trading down on the news of the PSS/WWW deal, we see it as a buying opportunity. While WWW paid $1.32Bn the PLG business (10x EBITDA) at the higher end of expectations, the accretion to next year’s EPS after 1x costs are absorbed is attractive and appears conservative.
- For starters, WWW is assuming MSD-HSD sales growth for the PLG group over the next few years, which we think is very conservative.
- Over the last two-years, this business has grown in the high-teens and we think this business could and should grow in the low-to-mid-double-digit range reflecting ~12% growth at wholesale and ~6% growth at retail. Even if we were to assume that the retail business (primarily Stride Rite) remains flat, we’re still looking at +9%-10% revenue growth here. These are not heroic assumptions and reflect a slowdown from current growth rates as reflected in the table below. We can't imagine that WWW management, which we view as the small cap footwear equivalent of VF Corp (i.e. very good) would buy into a permanently lower-growth story with no plans to leverage existing platforms.
- With 90% of PLG’s revenues generated domestically, WWW should be able to leverage existing distribution channels that it’s established to drive PLG growth with 1/3 of sales coming from overseas. This is expertise Sperry lacked under its prior structure, which should drive continued growth at wholesale.
- At Saucony, athletic footwear continues to outpace the industry particularly running. We see little reason this brand should grow less than 10% in 2012. The traction it has gained among elite runners over the past three years can't be given back easily.
- As for Stride Rite and Keds, if WWW can get these brands to grow at a MSD rate, we think the PLG business could grow in the teens.
- In addition, total PLG operating margins were 6.9% in 2010 and while F11 margins came in at 3.6% due primarily to retail store underperformance, we think this business could run at a HSD margin or higher with the drag on retail removed.
- Included in these assumptions is $16mm in incremental amortization offset by the initial impact of $8mm in identified synergies, which will start to be realized in F13 as reflected in the table below the full benefit of which should be realized by F14.
- Further, given the scale of WWW’s supply chain and operating team, we’d expect additional SG&A leverage opportunity.
- Our biggest concern is all the IFs just mentioned. WWW has proven to be extremely astute at integrating new content, turning around existing brands, and growing brands that already have relevance with the consumer. This, however, is a short cruise into uncharted waters, to say the least. WWW is acquiring four brands with over $1Bn in revenue -- equal to 65% of its existing size. The saving grace is that Matt Rubel did them a favor by consolidating back office for PLG under one roof, which makes it a cleaner sweep with lower risk for WWW.
- WWW will be taking on approximately $1.275Bn in debt in the form of $900mm in term loans and a $375mm notes offering at LIBOR + 200-300 suggesting ~$50mm in interest expense and a net debt/EBITDA ratio of 4.2x. The company expects to get that down to 2.2x by the end of F14 suggesting ~$250mm in annual debt reduction and ~$40mm in interest expense as reflected in our table below. Additional considerations include a 25% tax rate and ~49mm shares outstanding.
WWW has historically traded around 14x forward earnings. With earnings of approximately $2.75 this year and ~$3.00 in F13. At 14x this year’s EPS we think there is only $1-3 of the deal currently reflected in the stock. We think EPS accretion could be closer to $0.50 in F13 compared to the range of $0.25-$0.40 suggested and could be up to $1.00 in incremental EPS in F14 vs. a suggested range of $0.50-$0.70, which is worth at least $6-$8 in value today. This implies a $45-$47 stock 10%-15% above current levels with additional upside from PLG 2-3 years out. Given the synergies available and what appears to be conservative growth assumptions for the PLG brand over the next several years, we like $4 in earnings power at this price.
In preparation for ASCA's FQ1 2012 earnings release Wednesday morning, we’ve put together the recent pertinent forward looking company commentary.
Youtube from FQ4 2011 conference call
- "Because we almost immediately fell below 5.5 times earlier in the year, once we file our certificate with the banks, we'll be lowering the add-on for our revolver by 25 basis points. So, we're basically staring out this year at an interest rate on the revolver at a lower level than when the facility was put in place last April."
- "As we've stated in previous earnings releases, the Blanchette Bridge which is the interstate bridge by our St. Charles facility is now starting to receive some preliminary work with minor intermittent lane and highway ramp closures. We had said early in previous call that we thought the actual bridge westbound span would be closed either maybe in March or April. The state now announced it will be around November of 2012 before the bridge is actually completely closed for the construction work – obviously this will create some inconvenience for up to a year with our guests. However, there are several different routes that can be taken by our guests to access Ameristar St. Charles. So, we believe that despite some of the interruption there will be some negative impact to revenues that we'll be able to manage the situation and it is temporary."
- "Our Q1 2012 estimate for non-cash stock-based compensation expense will be between $4.5 million and $5 million. For the entire year the rate should be somewhere around $14.8 million to $15.8 million. We expect our blended tax rate to get back to normal for the first quarter and for the year with those rates being approximately 43% and 44%."
- "On the capital spend side, for the first quarter we are looking at $31 million to $36 million number but that number does include the $16 million purchase of land in Springfield. So the run rate will be back to what our normal run rate is which should be somewhere between $15 million and $20 million on the normal maintenance CapEx."
- "Total capital expenditures for the year should be somewhere between $85 million and $90 million including the land purchase in Massachusetts. Net interest expense in Q1 is expected to be approximately $27 million. Non-cash interest expense is expected to be approximately $1.4 million. For the year, we anticipate interest expense to be between $103.5 million and $108.5 million, flat year-over-year due to expected debt repayments and the add-on reduction offset by what we believe will probably be some slight increase in LIBOR throughout the year."
- "Q1 corporate expenses are increasing slightly. We expect the range to be $12.5 million to $13 million for the quarter and $52 million to $53 million for the year. This excludes the corporate portion of stock-based comp. We expect to generate significant cash flows that will allow us the flexibility to pay down debt again this year and the first quarter range to be between $20 million to $25 million and for the year somewhere between $155 million and $165 million."
- "Obviously the number of outstanding shares bounced around this year with the stock buyback and we had multiple numbers during the year. Going forward, the number should range between $34 million and approximately $35 million and diluted weighted average shares starting now at about $34 million for the first quarter."
- [Promotional spending] "And all I could say is – if I were you, I wouldn't expect any surprises."
- "I think we're seeing a decent degree of stabilization. There are some very short-term trend lines that give us some hope for optimism, but they're too short to give us confidence in them getting there. The farm economies are doing pretty well."
- "Watch the savings rate, that's an indicator that we think is pretty important to have and understand how the economy is going to be moving for the next few months."
- [Margin flowthrough] "It will continue to be strong. We anticipate margin flow through, obviously when you take into the component taxes and our promotional spend, of around 50% or a little bit greater than 50% in most markets depending on the tax rate."
- "As we start to see some lift out of the economy, I think you will see extraordinarily tight control on the variable cost increases that will drive a very high flow through rate."
- [Bridge closure impact] "There are two other major bridges across the Missouri River within a couple of miles of the property, one to the North and one to the South. So, as Tom said, orange cones were going to create some impact to us. But there is a very sizeable population that lives on the St. Charles County side of the river as well as a substantial portion that lives on the St. Louis County side of the river.So, for some of those people that are going to our competitor in Maryland Heights that live in the St. Charles side of the river, they are going to have a more a difficult time getting over there and may well shift some of their allegiance to Ameristar. So, I think it's going to be a short-term situation, it's going to be a manageable situation, but it's not going to have the zero impact."
- [Market share growth in East Chicago] "I think it's sustainable."
POSITIONS: Short Industrials (XLI), Basic Materials (XLB), and Energy (XLE)
I just sold my long Utilities (XLU) position which has effectively gone straight up in the last month, so that makes me short 3 Sectors in the SP500. Fortunately, we covered our SPY position yesterday on red.
Where would I consider re-shorting SPY on green?
- Immediate-term TRADE overbought = 1412
- Immediate-term TRADE support = 1391
- Intermediate-term TREND support = 1359
In other words, shorting the SPY at a lower YTD high is definitely interesting on the way up here, but its more interesting to be short the aforementioned pro-cyclical Sectors provided that Growth Slowing remains our call.
Today’s ISM number (54.8 vs 53.4 last mth) was the only legitimate beat we’ve seen in our model in a month, so don’t expect me to change everything based on 1 data point. That would just look as emotional as the tape does right now on short covering.
Up next is jobs, jobs, jobs (ADP, Jobless Claims, and Unemployment). So we will have to see about that.
Keith R. McCullough
Chief Executive Officer
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