Darden Restaurants Inc. (DRI)
Despite ugly trends at its flagship brands, shaky fundamentals and management’s calculated, concerted effort to rid shareholders of their rights, we continue to believe DRI presents a strong investment opportunity due to its compelling inherent value.
That said, our long thesis is dependent on the success of activist investors Starboard Value and Barington Capital. If the activists are successful in preventing the Red Lobster spinoff and facilitating major changes at Darden, we believe there is significant upside potential. We look to Brinker International as the most recent example of a flailing company with an over-concentrated, complex portfolio to dwindle down its portfolio, refocus and create significant shareholder value. We believe this is possible with Darden, but the current management team appears unwilling to enact such change.
As we’ve said before, we believe Darden’s greatest opportunity for value creation lies within its crown jewel, Olive Garden, and to a lesser extent, Red Lobster. These two brands accounted for approximately 69% of Darden’s 3QF14 revenues despite tumultuous same-restaurant sales and traffic trends. While Darden has publicly addressed these two issues, we believe their plans (Olive Garden Brand Renaissance and Red Lobster Spinoff) are not only inadequate, but in the case of Red Lobster, value destructive.
ISS and Glass Lewis released reports last Friday recommending shareholders submit consents to Starboard in its ongoing effort to call a Special Meeting to put the Red Lobster spinoff to vote. We believe Starboard will get the majority vote and will put the right plan in place to turnaround the aforementioned chains and drive value creation.
DRI is trading at 18.18x P/E and 9.07x EV/EBITDA on a NTM basis.
Popeye’s Louisiana Kitchen, Inc. (PLKI)
PLKI has been on our Watch List as a long for quite some time and we’re now adding it to our Investment Ideas list. PLKI is an operationally sound, strategically focused company with considerable brand momentum and modern day relevance. Given the considerable growth opportunity that lies ahead, both domestically and internationally, and a stringent, calculated plan to capitalize on this, we are bullish on the stock. Popeye’s diversified revenue stream and strong, stable cash flows mitigate the risk typically found with consumer growth stocks.
There are many things we like about PLKI, notably its strong management team led by CEO Cheryl Bachelder and a group of executives who have led the brand’s turnaround beginning in 2009. Under the current leadership, Popeyes has established a laser-focused strategy and clear path for consistent shareholder value creation. Last night, news hit that CFO H. Melville Hope III will be stepping down on May 23rd to pursue other opportunities. The company has begun a search for his successor. We don't view this as a huge deal and believe the Mr. Hope is leaving the company in a strong organizational and financial position. Any sell-off related to this news could present a strong buying opportunity.
PLKI’s efficient, asset-light model, healthy margins, current initiatives and feasible, material growth opportunities give us reason to believe they can successfully generate at least 13-15% EPS growth over the long-term. As it stands, we believe street estimates for 13% EPS growth on 14% sales growth in FY14 are conservative.
In our view, barring a sector-wide correction, PLKI’s risk/reward setup is too attractive to ignore, with limited downside and notable upside. We plan to release a full report running through our thesis next week.
PLKI is trading at 25.75x P/E and 14.04x EV/EBITDA on a NTM basis.
Jack in the Box Inc. (JACK)
JACK continues to be one of our favorite longs in the quick service space as we continue to believe its long-term potential is underappreciated, particularly with respect to the future growth of Qdoba. The company’s pivot to a defensive, asset-light model has proven wise and led to significant operating margin gains. We expect recent initiatives and same-store sales gains to continue to accelerate through FY14 as JIB continues to build upon the late night and breakfast dayparts and Qdoba identifies ways to differentiate its brand and attract new customers.
JIB has been a pleasant surprise to many investors amid its recent string of success. Reimaged restaurants and resonant advertising campaigns have helped company restaurants generate higher AUVs and margins, while improving franchise profitability. The late night and breakfast dayparts have been accretive to sales and continue to present an opportunity for future growth. Menu innovation continues to be a catalyst, while tighter operations (refranchising, lower food and packaging costs) have helped sales flow through to the bottom line. Improving speed of service continues to be a major opportunity moving forward.
Qdoba continues to be an underappreciated piece of the JACK story and one that we believe should be awarded a growth multiple. The Qdoba brand is working closely with Boston Consulting Group as it continues to develop its brand positioning strategy and effectively differentiate itself in order to retain current guests and attract new guests. An important part of this repositioning effort has been closing unprofitable stores in markets with poor brand awareness. According to management, they have identified clear opportunities to reposition the Qdoba brand and set the stage for strong performance moving forward. A big part of this strategy will include product innovation and the introduction of more LTO’s to drive traffic and trial. Catering growth continues to be a bright spot at Qdoba. We expect management to open approximately 42 Qdoba restaurants system-wide in FY14.
JACK currently trades at a discount to its QSR peers despite the potential to grow operating margins by 340 bps and EPS by +25% in FY14. In addition to considerable momentum, a strong balance sheet and notable free cash flow generation, management appears ready and willing to continue buying back shares through an aggressive repurchase program which was recently raised to $260mm. Indications are this program will be completed by FY15 and should contribute meaningfully to EPS growth.
JACK is trading at 23.34x P/E and 10.20x EV/EBITDA on a NTM basis.
Krispy Kreme (KKD)
Despite selling off hard towards the end of 2013, KKD remains one of our favorite small cap growth companies. Over the past three years, the company has transformed itself into a strong regional brand and positioned itself as an asset-light business with unique global growth potential. KKD is a rapidly growing company with a strong financial profile.
KKD has plans to increase its system-wide unit count from 828 at the end of FY14 to 1,300 (400 domestic, 900 international) by the beginning of 2017. KKD international franchisees pioneered the initial development of smaller, satellite shop formats that generated stronger returns for owners. This model has translated to the U.S. and is an integral part of the company’s domestic growth model. We believe these formats will continue to resonate with the franchisee community and give them the confidence to incorporate these smaller models into their expansion plans.
Given the difficult comps, we expect KKD’s same-store sales to decline on a two-year basis in FY15. We believe the stock has already sold off on these expectations. On the other hand, we expect franchise international same-store sales to continue its upward trend and ultimately approach positive territory. Despite potentially slowing same-store sales trends, we believe KKD has leverage left in its operating model. Specifically, we believe selling higher margin beverages continues to be one of KKD’s largest opportunities. Management is taking steps, including a partnership with GMCR to sell Krispy Kreme K-Cup packs, to drive top of mind awareness and, ultimately, in-store coffee purchases.
We are also intrigued with the strong financial profile of the company. KKD has compelling unit economics, free cash flow generation and is generating strong ROIIC. Despite its ambitious growth agenda, management has been willing to return capital to shareholders through its share buyback program. KKD has approximately $50mm remaining on the current $80mm authorization. Given the brand’s recent success, we believe the company is a strong takeout candidate.
We expect KKD to generate +20% EPS growth in FY15 and FY16 and believe the current share price represents an attractive entry point.
KKD is trading at 25.14x P/E and 15.30x EV/EBITDA on a NTM basis.
Chipotle Mexican Grill, Inc. (CMG)
Chipotle Mexican Grill, with its best in class operating model, has delivered strong returns for shareholders over the majority of the last five years. Despite more than doubling in 2013, we continue to favor the stock as strong same-store sales momentum (+9.3% in 4Q13) should continue through 1H14. Chipotle continues to differentiate itself and drive consumer loyalty with its unique food and people culture.
CMG has several drivers in place (faster throughput, Sofritas, catering, GMO removal, non-traditional marketing) to help capitalize on recent momentum and enable them to deliver +15% revenue growth and +20% EPS growth in FY14 and FY15. Chipotle, at 1,500 domestic units, has ample room left for domestic expansion and an international market that is virtually untapped. Longer-term, the Shop House and Pizzeria Locale concepts remain two potentially significant growth drivers.
On the 4Q13 earnings call, management discussed a potential 3-5% price increase beginning in 3Q14 in order to help offset rising food costs, including the transition to non-GMO ingredients by the end of FY14. Management guided to food costs as a percentage of sales to be around 34.5% for FY14 before the impact of any price increase. Assuming a modest price increase, the street is currently modeling food costs at 33.6% of sales for the full year.
Despite significant same-store sales and traffic momentum, we believe margin pressure is beginning to build on CMG’s cost lines. However, a price increase could help offset this and given the loyal customer base and premium placed on high quality food, we don’t expect this to be much of an issue.
CMG is trading at 41.77x P/E and 20.97x EV/EBITDA on a NTM basis.
The Wendy’s Company (WEN)
WEN continues to take market share in the QSR space in large part due to its successful Brand Transformation, successful new products and ongoing store reimages. By repositioning the brand as “A Cut Above,” management has driven strong same-store sales momentum that should continue through FY14. Menu innovation has led to the creation of popular LTOs such as the Pretzel Pub Chicken Sandwich, the Pretzel Bacon Cheeseburger, and Bacon Portbella Melt on Brioche. Through this repositioning, WEN has established itself as a producer of high quality food at a reasonable price. In other words, they’ve found the middle ground between traditional QSRs and fast casual concepts.
In late March, Wendy’s rolled out a new mobile payment smartphone app to its entire domestic restaurant base. Not only is this a smart strategic move that fits with the brand’s repositioning, but it is a potential guest experience enhancer and transaction driver.
Same-store sales momentum and recent debt refinancing initiatives have aided cash flow generation, while WEN’s corporate optimization has helped management manage its effective tax rate. WEN already pays a respectable dividend, but management has been open to growing this and repurchasing shares when they have the cash.
We expect WEN to deliver +13% EPS growth over the next two years and continue to grow restaurant level and operating margins. WEN has high short interest (+15% of the float) and is generally disliked by the street, making it our favorite contrarian play on the long side in the restaurant space.
WEN is trading at 24.84 P/E and 10.22x EV/EBITDA on a NTM basis.
Yum! Brands, Inc. (YUM)
YUM continues to be one of our favorite longs in the big cap QSR landscape as we believe the company is well positioned to capitalize on a substantial long-term growth opportunity in China and other emerging markets. We expect easy comps, notable margin expansion and positive earnings momentum to drive performance throughout 2014. As we’ve stated before, the magnitude of this performance will depend heavily upon the trajectory of the recovery in China. While management’s guidance of 40% operating profit growth in China may be aggressive, we believe they have multiple levers at their disposal to reach at least +20% EPS growth in 2014.
We believe China concerns are overdone and the region is well on its way to recovery, despite somewhat limited visibility. YUM’s ongoing efforts through its I Commit campaign should help restore trust in the KFC brand, while a 2Q restaging and menu revamp should help establish considerable brand momentum. Furthermore, Pizza Hut casual dining and home business continue to be two strong growth opportunities. Despite near-term volatility in trends, China continues to be a significant opportunity for YUM to capitalize on a growing consumer class that is expected to double from 300mm+ in 2012 to 600mm+ by 2020.
Domestically, Taco Bell continues to take share from competitors and drive incremental sales through innovation. The chain recently launched its national breakfast rollout, supported by a strong advertising campaign. Early signs indicate that breakfast has been selling well and franchisees are supportive of the move. We believe breakfast represents a material opportunity for Taco Bell, even if they are only able to capture a small piece of the market. Taco Bell has significant brand momentum and continues to carry the domestic business. We expect to see a renewed focus at both the KFC and Pizza Hut brands as they continue to lose share to competitors.
YRI continues to be a material long-term growth opportunity as the company positions itself to capitalize on a rapidly expanding consumer class.
YUM is trading at 20.86x P/E and 11.68x EV/EBITDA on a NTM basis.
EVENTS TO WATCH:
Wednesday, April 16
- HTZ at BAML Auto Summit
Thursday, April 17
- Iowa Racing & Gaming Commission Meeting - to decide whether it will grant Cedar Crossing Casino a state gaming license, which would make the Cedar Rapids facility the 19th casino in Iowa.
- GE 1Q14 Earnings - 8:30 am Conf Call - real estate comments?
- BX 1Q14 Earnings - 11 am Conf Call PIN 149 943 55 - lodging comments & color?
- DIS - Investor Day - cruise & parks commentary?
Monday, April 21
- IGT FQ2 earnings - 5 pm Conf Call , Passcode: IGT
Monday, April 22
- Genting Singapore - Annual General Meeting
Thursday, April 24
- PENN Q1 earnings - 10 am
- HOT Q1 earnings - 10:30 am , Passcode: 12049644
- LVS Q1 earnings
- LA March revenues released
MGM - Clark County District Judge Elizabeth Gonzalez has ordered that the Harmon Tower be demolished - dismantled floor-by-floor.
TAKEAWAY: While everyone is talking about the dismantling, we wonder what MGM & City Center will rebuild on this very visible and valuable piece Las Vegas Strip real estate?
MGM - MGM Resorts International and Hakkasan Group announce formation of JV hotel Company MGM Hakkasan Hospitality
TAKEAWAY: Building hotel brands is not an easy business.
Atlantic City - rumors are circulating that Showboat will be the next casino to close in Atlantic City. Management is apparently moving players redeeming promotions to Harrah's.
TAKEAWAY: While any walk-in traffic lost (low end grinders anyway) because Revel would be even farther from the nearest open casino, at the margin, less supply is a modest positive for the adjacent Revel and all of the operators including Borgata.
Japan - (Reuters) Yumeshima, with about 170 hectares (420 acres) of land available for development, is likely to be designated as the preferred site for a casino when Osaka officials meet on April 22 to discuss possible gaming site, Governor Ichiro Matsui said
Tokyo, the other city most likely to host a casino, has yet to officially name a site for a development, although the Odaiba area in Tokyo Bay is being touted as the preferred location. Tokyo Governor Yoichi Masuzoe has yet to say whether he supports a casino in the capital.
Proponents of the initial bill expect debate to start in May, and aim to pass it before the house adjourns in June. Matsui believes casino operators will invest more than 500 billion yen ($4.91 billion) in an integrated resort in the city, adding that he was visited last week by Lawrence Ho, CEO of MPEL.
TAKEAWAY: Probabilities look better than ever
New Jersey I-Gaming - Internet gaming win was $11.9M, up 15.2% from February 2014. Borgata and party.poker generated $4.4M in online gaming revenue, up from $3.2 million the prior month, leading the New Jersey online gaming market with a 37% share.
TAKEAWAY: Slow and steady but not close to the billion dollar run rate many politicians expected. We care about Poker share and Borgata upped its share to 51%.
Massachusetts Gaming Poll - a survey by the Western New England University Polling Institute, conducted March 31 through April 7 of 477 adults, found that 59% of adults indicated they support establishing casinos in Massachusetts, while 34% were opposed and 7% were either undecided or declined to answer the question. The margin of sampling error for the survey was plus or minus 4.5 percentage points. Still, many respondents took a "not in my backyard" approach to the issue, as 55% indicated they were opposed to having a casino in their community, 42% said they supported having a casino in their community, while 3% were undecided or declined to answer the question.
TAKEAWAY: Just build the casinos!
Greece VLTs - (GamblingCompliance) Publication is reporting that progress is being made on legislation to potentially allow for 35k VLTs.
TAKEAWAY: This has been a frustrating, dragged out process for the suppliers. Even now our sources are downplaying the likelihood. Nevertheless, SGMS popped 4% on the news.
Ireland I-Gaming - A massive increase in gambling problems among young people is being linked to the rise of smartphones and tablets. According to the data, among the under-25 year old age group, as many as 90% started gambling on a handheld device.
TAKEAWAY: Why the trends in Ireland but not elsewhere?
- New yuan loans: 1.05 trillion yuan vs consensus 1 trillion
- Total social financing: 2.07 trillion yuan vs consensus 1.85 trillion, -19% YoY
TAKEAWAY: Lending was ok in March but there is still fears of a credit slowdown as China keeps an eye on shadow banking.
Hedgeye remains negative on consumer spending and believes in more inflation. Following a great call on rising housing prices, the Hedgeye Macro/Financials team is turning decidedly less positive.
TAKEAWAY: We’ve found housing prices to be the single most significant factor in driving gaming revenues over the past 20 years in virtually all gaming markets across the US.
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Client Talking Points
Nikkei bounces a whopping +0.6% after moving to oversold at -14% year-to-date. Here’s a piece of trivia: If you are -14% in a drawdown, you need to be up +16.3% from the lows to get back to break-even. #Unlikely for the new Japanese stock bulls with Yen strong versus the US Dollar.
A big whiff on the German ZEW at 43.2 for April (versus 46.6 in March) is just one of a string of less than good German economic data in the last month. The DAX is trading back below Hedgeye TREND resistance of 9391 now, too (we don’t have any European longs currently in #RTA). The rate of change in German #GrowthAccelerating is starting to slow – alongside United States and Japan. Add it to the list.
A 2.65% 10-year yield continues to signal the nasty – if 2.57% TAIL risk support snaps, watch out below. There are a lot of people who are still long US #GrowthAccelerating in the back half of 2014 – we think the consumer slows well into the third quarter (tough comps).
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Top Long Ideas
Hologic is emerging from an extremely tough period which has left investors wary of further missteps. In our view, Hologic and its new management are set to show solid growth over the next several years. We have built two survey tools to track and forecast the two critical elements that will drive this acceleration. The first survey tool measures 3-D Mammography placements every month. Recently we have detected acceleration in month over month placements. When Hologic finally receives a reimbursement code from Medicare, placements will accelerate further, perhaps even sooner. With our survey, we'll see it real time. In addition to our mammography survey. We've been running a monthly survey of OB/GYNs asking them questions to help us forecast the rest of Hologic's businesses, some of which have been faced with significant headwinds. Based on our survey, we think those headwinds are fading. If the Affordable Care Act actually manages to reduce the number of uninsured, Hologic is one of the best positioned companies.
Construction activity remains cyclically depressed, but has likely begun the long process of recovery. A large multi-year rebound in construction should provide a tailwind to OC shares that the market appears to be underestimating. Both residential and nonresidential construction in the U.S. would need to roughly double to reach post-war demographic norms. As credit returns to the market and government funded construction begins to rebound, construction markets should make steady gains in coming years, quarterly weather aside, supporting OC’s revenue and capacity utilization.
Darden is the world’s largest full service restaurant company. The company operates +2000 restaurants in the U.S. and Canada, including Olive Garden, Red Lobster, LongHorn and Capital Grille. Management has been under a firestorm of criticism for poor performance. Hedgeye's Howard Penney has been at the forefront of this activist movement since early 2013, when he first identified the potential for unleashing significant value creation for Darden shareholders. Less than a year later, it looks like Penney’s plan is coming to fruition. Penney (who thinks DRI is grossly mismanaged and in need of a major overhaul) believes activists will drive material change at Darden. This would obviously be extremely bullish for shareholders and could happen fairly soon driving shares materially higher.
Three for the Road
TWEET OF THE DAY
After yesterday's no volume bounce, the Nasdaq and Russell are still -7.7% from their YTD highs $IWM @KeithMcCullough
QUOTE OF THE DAY
"Education is what remains after one has forgotten what one has learned in school." - Albert Einstein
STAT OF THE DAY
The UK inflation rate as measured by the Consumer Prices Index (CPI) fell to 1.6% in March from 1.7% in February, according to the Office for National Statistics (ONS). It is the third consecutive month inflation has been below the Bank of England's 2% target rate, and the lowest rate since October 2009. (BBC)
“In the long history of humankind (and animal kind, too) those who learned to collaborate most effectively have prevailed.”
In his 1936 book, “The General Theory of Employment, Interest and Money”, John Maynard Keynes used the term animal spirits to “describe the instincts, proclivities and emotions that ostensibly influence and guide human behavior.” He goes on to use consumer confidence as an example of how animal spirits can be measured economically.
In our Q2 Themes presentation, we did a lot of work on the median consumer and took a detailed look at his / her income statement and balance sheet. Currently, there are a number of major headwinds for the median consumer. The obvious first one is the rampant acceleration in food costs in the year-to-date, the second is the anemic interest rate that they get on their savings, and, finally, the last headwind is the softening in the housing market.
For many average consumers, the house is in effect the balance sheet, so as home prices go up so too does net worth. The two points that bode most negatively in our models for future home prices are the dual facts that pending home sales are down -14.5% from their peak and mortgage applications for purchase are down more than -20%. Ultimately, home prices follow demand on a lag (as shown in the Chart of the Day), so we should expect that home price growth softens from here.
As it relates to the consumer, late last week the Bloomberg Consumer Confidence slipped to -31.9 from -30.0. This is well below the long run average of -16.5 and normally a number above -30 is the level at which the economy is considered to be in recovery mode. More alarmingly was the personal finance sub-index which fell to -2.9, the worst level in five months.
On a higher level, last week Michigan Consumer confidence came in at 82.6. This was better than the expected 81.0 and an increase from the prior month. So the animal spirits of consumer confidence appear to be intact . . . at least for now, but keep your eye on those home prices.
Back to the Global Macro Grind . . .
Yesterday was a slow grind in global macro land and today seems to be similar in tenor. As it relates to the pin action of stock markets, the Shanghai Composite today is -1.36%. The punditry is attributing this downward move as front running China’s GDP tomorrow, albeit the positive move in Chinese equities yesterday was considered a precursor to positive GDP, so the question of course is: which is it?
At a minimum, it seems that the government may be trying to talk down economic growth and the timing of the following report is suspect coming out one day ahead of GDP:
“Researcher with State Information Center said in Shanghai Securities News that efforts to address overcapacity, deleverage the economy and curb property bubbles could push GDP below 7%, something that would trigger massive unemployment.”
My colleague and our Asia Analyst Darius Dale had some detailed thoughts on the topic:
“In the 15 quarters since Chinese real GDP growth hit a cycle-peak of +11.9% YoY in 1Q10, Chinese economic growth has accelerated sequentially only three times. It’s basically been a straight leg down for four consecutive years – so much so that on a trailing 3Y basis, the current z-score for this series is (0.6x), which is actually up from trough of (1.6x) in 2Q12. In non-statistical speak, this implies that the “surprise factor” of Chinese #GrowthSlowing is burning off.
That isn’t to say that Chinese economic growth is not still slowing. In fact, the broad swath of high-frequency economic data points to a continued slowdown. The current risk range in our predictive tracking algorithm has probable downside to +7.3% YoY for Chinese real GDP growth here in 1Q14, which would: A) be the slowest growth rate since 1Q09; and B) imply that the Chinese economy is not taking advantage of extremely favorable base effect tailwinds – a sign that sequential momentum is indeed decelerating (as evidenced by the MAR PMI data).
One thing that investors should be aware of, however, is that Chinese policymakers are content to stand pat for now. Expectations for big stimulus has been dramatically tempered in recent weeks, most recently by Premier Li Keqiang’s prepared remarks at the Boao Forum for Asia Annual Conference. Perhaps they are storing up their fiscal and monetary “gun powder” to arrest any potential deceleration through the low +7% range in real GDP.
Or perhaps China’s intermediate-term growth trajectory isn’t really isn’t as dour as it has appeared in recent months and their superior visibility into the state-run Chinese economy leads them to believe that a large stimulus is simply not warranted. Time will tell; next up: tonight’s releases of 1Q GDP and MAR high-frequency growth data…”
The Hedgeye team will never be confused of being supportive of the interventionist nature of the world’s central bank. A key critique we often held is that as a result of activist monetary policy, the markets tend to get manipulated. We aren’t sure yet whether the Fed is more evil than those dastardly high frequency traders, but recent data on correlations emphasize our concern.
Specifically, according to ConvergEx, since 2009, the 10 industry sectors in the SP500 have averaged 85% correlation to the index. In the past thirty days, correlations have dropped markedly to 77.5%. Most interestingly though is the fact that long run correlations, before Fed intervention, have averaged 50%. (Hint: Michael Lewis, there is a book here somewhere.)
The most challenging part of dealing with central banks may be in discerning whether they mean what they say. The most recent example of course is the jawboning from ECB head Mario Draghi, who specifically indicated that the ECB was ready and willing to take monetary policy to an extreme level. The Euro, despite a down move yesterday, has by and large shrugged Draghi off and is up 0.6% on the year-to-date. Credibility anyone ?
Our immediate-term Global Macro Risk Ranges are now:
Daryl G. Jones
Director of Research
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