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November 18, 2014

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MCD: An Activist's Dream? Not So Fast.

With the news of a large activist buying into MCD, we find it prudent to ask, “Will shareholders be saved?” 


We think it’s going to be a long road.  The last activist that was involved in MCD was successful, but not because they had an impact on management thought process. 


What did Pershing see in late 2005?

  • A concept squarely in the midst of a significant turnaround that resulted in over 110 months of positive global same-store sales growth
  • MCD had a market cap of $42 billion and $20 billion in system-wide sales
  • A real estate portfolio that was undervalued by $16 billion ($30 billion versus Pershing Square’s $46 billion estimate)
  • A stock that was unnecessarily trading at a discount to its peers
  • Three different businesses: franchise operations, company-owned operations and real estate


What did Pershing propose?

  • Spin 65% of the McOpCo stores
  • Spin out the real estate
  • Use the proceeds and increase leverage to repurchase stock


What was McDonald’s response?

  • They called it a mere exercise in financial engineering
  • Claimed they had a unique business model
  • Suggested it would disrupt the relationships it had with customers, franchisees and suppliers
  • Management said friction costs would make a REIT cost prohibitive
  • Pointed to potential unintended consequences
  • Feared it would lose its “A” credit rating


In the end, the company never implemented any of Pershing's bold plans.  Pershing's investment in MCD was successful, not because of the their ideas, but because the business was going in the right direction. 


Here we are, ten years later, with another activist prepared to potentially knock on the door of MCD.  In some ways, it’s a very different McDonald’s this time around.  In others, it’s the same old story. 


Last week, Jana Partners took a stake in MCD by accumulating 1.042 million shares, inclusive of calls.  According to the investment manager’s website, “Jana typically applies a fundamental value discipline to identify undervalued companies that have one or more specific catalysts to unlock value.  Jana can be the instrument for value creation by becoming an actively engaged shareholder.”


We understand why an activist would be attracted to MCD today:

  • McDonald’s needs to undergo a significant restructuring
  • McDonald's has approximately 6,500 company-operated restaurants that could be re-franchised
  • Global same-store sales are declining and have been for quite some time
  • The stock has under-performed the SPX by 14.5% over the past year
  • Chipotle has grown from approximately 440 restaurants in 2005 to approximately 1,785 restaurants today and is leading a significant shift in consumer eating patterns. 
  • McDonald's must be pushed to aggressively adapt to the changes in the market place 


The activist playbook in the restaurant space is generally confined to a couple of key moves.  Get control of the board and do one, or all, of the following:

  • Sell real-estate
  • Cut SG&A
  • Sell company-owned stores
  • Sell other non-core assets
  • Increase leverage and repurchase stock


In the case of MCD, we believe it will be very difficult to achieve any of these moves. 


First, we don’t think the board is ready to give up on CEO Don Thompson (for now, at least). Second, selling real-estate will never happen at MCD; there is a chance, however, that the company sells some McOpCo stores.  All told, we believe the latter is too small of a change and would not move the needle on profitability.  Third, McDonald’s doesn’t have any non-core assets.  And, fourth, we believe it is unlikely management will increase leverage because they like their credit rating where it is.  This would likely be a unwise move, to be frank, because increasing leverage in a declining sales and margin environment is unlikely to create shareholder value.


Now, either Jana’s investment is just the beginning of a bigger position or they are making the call on a short-term improvement in the operating performance of the company. 


We’re not sure what the play is here. 


What we are sure of is that McDonald’s is unlikely to see a notable, short-term improvement in trends and that Jana’s position is too small to agitate for change.  The truth is, none of the typical moves in the activist playbook will generate much value in this environment. 


The biggest upside in MCD will come from fixing the core operations.  With no disrespect to Jana, there is likely little they can do in this regard.  If they did come up with a silver bullet it would take 12-18 months for it to be approved and executed.  Lastly, we doubt the franchisee base will look kindly upon a hedge fund telling them how to run their business.    


For this reason, we still think there is risk to the numbers in 2015 and remain bearish on MCD.  We normally side with activists in the restaurant space, but we don’t see how one can make money in MCD right now. 


Feel free to call, or email, with questions.


Howard Penney

Managing Director


Fred Masotta


Write It Down

This note was originally published at 8am on November 04, 2014 for Hedgeye subscribers.

“Write down, therefore, what you have seen, and what is happening, and what will happen afterwards.”

-Revelation 1:19


No, I’m not going all religious on you this morning. That’s the opening volley from Jim Rickards in his recent book, The Death of Money. For those of you who missed it, I had a Real Conversation @HedgeyeTV with Rickards earlier in the year that you can watch here.


Do you write it down? What is “it”? And what do you do when something macro is happening that hasn’t happened for a very long period of time (like #deflation)? Once market expectations go through a phase transition from inflation policies to deflation, what will happen afterwards?


I’ve been writing down real-time market quotes, data, research, etc. in my notebook for 15 years and I have only seen versions of what I have been writing down for the last 10 months 2x: October 2007 and October 2008. Neither were bullish historical reference points and neither were the same.


Write It Down - 3


Back to the Global Macro Grind


To review, what is #Quad4 Deflation? In our risk management process (rate of change) it’s when the second derivatives in both growth and inflation are slowing, at the same time. These signals are both non-linear, and dynamic.


“There has been no episode of persistent deflation in the United States since the period from 1927-1933; as a result, Americans have practically no living memory of deflation.” (The Death of Money, pg 9)


I was in LA yesterday (San Francisco today) and, to a degree, I think that’s why we’ve been getting so many moments of silence in one-on-one Institutional Investor meetings as of late. It’s really hard for objective risk managers to absorb a scenario they’ve really never had to deal with.


“Objective”? Yes, as in this is what the market told you about #Deflation expectations yesterday:


  1. US Dollar up +0.3% to +8.8% YTD
  2. WTI Crude Oil down -2.8% to #crashing -20.5% YTD
  3. Energy Stocks (XLE) down -1.6% to -2.8% YTD
  4. Basic Material Stocks (XLB) -0.7% to +3.9% YTD
  5. Healthcare Stocks (XLV) +0.1% to +21.5%% YTD


In other words, in stark contrast to the Dollar Up, Rates Up #Quad1 signal we gave you to be long of everything big beta US growth in 2013, this Dollar Up (going to cash), Down Rates, #Deflation move is nasty for most things that lose their pricing power.


Healthcare (XLV) and Utilities (XLU) are two of the sectors that don’t get decimated by #deflation as fast as a levered-long-crude-oil-hedgie-dude (or an upstream E&P MLP dude who depends on the “dividend” that is decided by the price of the other dude’s oil inflation expectations).


I know, #dude!


That’s why the objective investor who has been writing down the sector returns for the SP500 in 2014 has noted the following RELATIVE YTD performance:


  1. Healthcare (XLV) +12.3% YTD
  2. Utilities (XLU) +11.4% YTD
  3. Technology (XLK) +4.7% YTD


  1. Basic Materials (XLB) -5.2% YTD
  2. Consumer Discretionary (XLY) -7.3% YTD
  3. Energy (XLE) -12.0% YTD


Yep, if all you did was express either our early-cycle slowdown calls for #ConsumerSlowing and #HousingSlowdown from the beginning of the year and/or our #Quad4 deflation call, in your S&P Sector asset allocations, you’ve crushed it.


If all that mattered to the American Consumer was “gas prices” (it actually represents only 6.4% of the median consumer’s budget) all of these rosy “surveys” you’ve been reading would have been right. Instead, in relative and sector performance terms, those narrative fallacies got you killed.


But, but, the ISM number was great yesterday. Yep, just great, another survey!


In other news, Industrials (XLI) closed down on the day on that ISM manufacturing report. I wonder if that’s because the non-survey data (US Retail Sales, Consumer Spending, Durable Goods, Construction Spending, and New Home Sales), all recently SLOWED, in actual rate of change terms!


Moving along…


If only everyone who writes in this business was forced to actually write this stuff down, every single day, consensus might be as concerned about the big beta #bubble in levered-long-and-illiquid US equity inflation expectations as I am.


But what is your catalyst, Keith?


  1. What I have been writing to you all year is already happening
  2. What I have seen (on the mid-October Russell and Bond Yield Lows) has not been forgotten
  3. What is most probable to happen next is more of the same


If everything that was in #crash mode on October 13-14th were to crash, literally, tomorrow… I’d write it down too – and “it” would be something that should not come as a surprise to anyone.


Our immediate-term Global Macro Risk Ranges are now:


UST 10yr Yield 2.21-2.37%

SPX 1967-2033

RUT 1086-1181

Italy’s MIB Index 18912-20099

Yen 109.27-113.66

WTI Oil 76.41-80.94


Best of luck out there today,



Keith R. McCullough
Chief Executive Officer


Write It Down - 11.04.14 Chart

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Takeaway: Lots of positive buzz on elements on Quantum, particularly the WiFi. But the 'Quantumizing' of the existing fleet will be costly.

Management commentary on board Quantum



Chairman Fain, CEO

  • Fuel:  20% better on ships pre-2006 vs post 2006 on $ per APCD
  • 85% guests using smart online registration process; boarding process on ship was less than 10 minutes.
  • O3B technology:  
    • Connectivity is 450x faster (fastest in the industry)
    • 8 orbiting satellites beaming on Quantum
    • Will be on Allure shortly and will be implemented across the fleet, particularly Caribbean-focused ships
      • Will be a very expensive investment 
      • Currently charging less on new WiFi product than older version of internet on other ships
    • RCL has exclusive contract with O3B in the cruise industry for a long period of time
  • Energy usage:  10-12% more efficient than their competition
    • Additional ~2.5% energy improvement expected in 2014
  • Advanced Emission Purification (AEP):  takes out sulfur; Mein Schiff III is the 1st cruise ship built with an AEP system already installed
  • Oasis 3 :  20% more efficient than Oasis 
  • Newer ships:  25% higher revenue, 20% lower costs, 3.5x higher EBITDA
  • ROI opportunities:  Best thing to add are staterooms; staterooms cost less to build on newer ships. 
  • Customers who book onboard activities in advance spend more onboard $ on the ship.  The pre-cruise planner has worked well.
  • Revenue breakdown:  Have gone from 20% non-US to 50% non-US


Jason Liberty, CFO

  • Solid liquidity
  • Net debt/EBITDA improved by ~50% over last 5 yrs
  • ROIC up 110 bps YoY
  • Moderate capacity growth:  
    • 2 Quantum Class
    • 2 Oasis Class
    • No order for 2017
    • Sold 5 ships in past 6 years
  • Continued double yield growth for Europe and China for end of 2014
  • Quantum demand exceeding expectation
  • 2015 
    • Yield growth: higher than 2014 yield growth
    • Fuel consumption down 2.5% for 2015


Q & A

  • Dollar strength vs lower fuel prices have neutralizing effects.  Will look into revising fuel hedging program but will also keep an eye on how much stronger the dollar gets.
  • Share buyback vs buying back debt:  
    • Being investment-grade credit is very important to RCL
    • Weighted cost of debt:  3.5%
    • Not much tax shield
  • Travel agents vs direct bookings:
    • Quantum has gotten better publicity than any other ship
    • Travel agents critical to attracting 1st time cruisers
    • More and more cruisers are buying directly thanks to internet resources
    • RCL direct bookings cost:  less than the 12-15% of revenues
  • Quantum to China
    • More significant costs
        • Marketing expenditures on grand welcome for Quantum
        • Chic will be transformed into traditional Chinese restaurant
        • Rice will be cooked in large woks -- more expensive products
        • Expanding casino
          • More table games; few slots
          • 2 private gaming rooms
        • Johnny Rockets will be converted to Kung Fu Panda noodle shop
        • Why Quantum didn't consider Southwest China on their itineraries and not just Korea/Japan?
          • For tax reasons and also less port charges.  
          • The trips are short (4-5 days), so not enough time to visit other places
        • Commissions paid to Chinese agents:  similar to US
    • Ships are almost exclusively Mainland Chinese guests  
    • A little more family/multi-generational 
    • 1/3 crew will be Chinese
    • Booking online in China is very low
  • Supply in Caribbean:  have seen stress in Q1 2015
  • Supply stress also in Australia/New Zealand
  • Not focused on macroeconomic trends in Europe
  • Ships that burn MGO fuel have lower ROIC e.g. Millennium, Meridian  
  • Double-Double targets have incorporated much of the additional capex needed to upgrade existing fleet.

Cartoon of the Day: Burn Your Currency. Fall Into Recession. Repeat.

Cartoon of the Day: Burn Your Currency. Fall Into Recession. Repeat. - Abenomics cartoon 11.17.2014

Behold the beauty of Abenomics - a failed #CurrencyBurning central plan that promises more of what doesn't work. In related news, Japan just fell into recession. 



ICI Fund Flow Survey: Return to Normality

Editor's note: This complimentary research was originally published November 13, 2014 at 07:33 in Financials. For more information on our services click here.

After a two month slide, taxable bonds rebounded posting their first subscription in 8 weeks.


Investment Company Institute Mutual Fund Data and ETF Money Flow:


After an exciting month of October whereby over $36 billion alone spilled out from the taxable bond fund category, the latest ICI survey relayed some stability with a $5.0 billion inflow by investors, the first subscription since the week ending September 10th. A post-mortem of the beneficiaries of the October snap redemption shows that broadly bond ETFs hoovered up the most "money in motion," with several select Total Return Funds including the Metropolitan West Total Return Fund (a unit of TCW), BlackRock's flagship fund, and Jeff Gundlach's DoubleLine substantially improving assets-under-management in the month. Interestingly, but not a surprise to us, the Janus Uncontrained Bond Fund, had a very modest benefit and as a result we remain skeptical of the resulting market cap improvement of that company without the support of new assets-under-management (read our JNS research here).


ICI Fund Flow Survey: Return to Normality - ICI chart12


In other survey data, U.S. equity mutual funds put up another worrisome $1.7 billion redemption making it 25 of the past 28 weeks with outflows. We continue to recommend underweight or short positions to those managers with outsized U.S. equities exposure (read our research here). Passive fund flows via ETFs continue to be substantial with a year-to-date high of $17.7 billion into total equity ETFs last week and another inflow into bond ETFs, the 6th straight week of fixed income subscriptions. The blood letting continued specifically in the Materials Sector SPDR with another 19% of assets-under-management alone coming out of that product over the past 5 days. Conversely there has been strength in Utilities (XLU) and the 20+ Treasury ETF (TLT) products with respective inflows improving AUM by 7% and 8% during the week.


ICI Fund Flow Survey: Return to Normality - ici1



In the most recent 5 day period ending November 5th, total equity mutual funds put up net outflows with $302 million coming out of the category according to the Investment Company Institute. The composition of the outflow was squarely the result of domestic stock fund redemptions as a $1.7 billion loss more than nullified the $1.4 billion which came into international stock funds. The two equity categories have been polar opposites all year with international stock funds having had inflow in 43 of the past 44 weeks, versus domestic trends which have been very soft with inflow in just 15 weeks of the 44 weeks thus far year-to-date. The running year-to-date weekly average for all equity fund flow continues to decline and now settles at a $1.1 billion inflow, now well below the $3.0 billion weekly average inflow from 2013. 


Fixed income mutual funds napped their drawdown schedule of the past 5 weeks putting up inflows in both the taxable bond fund category and also in tax-free munis. Taxable fixed income netted a fresh $5.0 billion in investor money with municipal bond funds putting up a $399 million inflow, making it 42 of 44 weeks with positive subscriptions in tax-free bonds. The 2014 weekly average for fixed income mutual funds now stands at a $985 million weekly inflow, an improvement from 2013's weekly average outflow of $1.5 billion, but still a far cry from the $5.8 billion weekly average inflow from 2012 (our view of the blow off top in bond fund inflow). 


ETF results were very strong during the week with substantial inflows in equity funds and decent subscriptions into passive fixed income products. Equity ETFs put up a 2014 year-to-date high subscription with a $17.7 billion inflow which made the $564 million inflow into passive bond products look very modest. The 2014 weekly averages are now a $2.1 billion weekly inflow for equity ETFs and a $1.1 billion weekly inflow for fixed income ETFs. 


Mutual fund flow data is collected weekly from the Investment Company Institute (ICI) and represents a survey of 95% of the investment management industry's mutual fund assets. Mutual fund data largely reflects the actions of retail investors. Exchange traded fund (ETF) information is extracted from Bloomberg and is matched to the same weekly reporting schedule as the ICI mutual fund data. According to industry leader Blackrock (BLK), U.S. ETF participation is 60% institutional investors and 40% retail investors.   


Most Recent 12 Week Flow in Millions by Mutual Fund Product: Chart data is the most recent 12 weeks from the ICI mutual fund survey and includes the running weekly year-to-date average for 2014 and the weekly quarter-to-date average for 4Q 2014:


ICI Fund Flow Survey: Return to Normality - ICI chart2


ICI Fund Flow Survey: Return to Normality - ICI chart3


ICI Fund Flow Survey: Return to Normality - ICI chart4


ICI Fund Flow Survey: Return to Normality - ICI chart5


ICI Fund Flow Survey: Return to Normality - ICI chart6



Most Recent 12 Week Flow Within Equity and Fixed Income Exchange Traded Funds: Chart data is the most recent 12 weeks from Bloomberg's ETF database (matched to the Wednesday to Wednesday reporting format of the ICI) and the running weekly year-to-date average for 2014 and the weekly quarter-to-date average for 4Q 2014. The third table are the results of the weekly flows into and out of the major market and sector SPDRs:


ICI Fund Flow Survey: Return to Normality - ICI chart7


ICI Fund Flow Survey: Return to Normality - ICI chart8


Sector and Asset Class Weekly ETF and Year-to-Date Results: In specific callouts, the blood letting continued in the Materials Sector SPDR with another 19% of assets-under-management alone coming out of that product over the past 5 days. Conversely, the Utilities (XLU) and 20+ Treasury ETF (TLT) had respective inflows of 7% and 8% during the week.


ICI Fund Flow Survey: Return to Normality - ICI chart9



Net Results:


The net of total equity mutual fund and ETF trends against total bond mutual fund and ETF flows totaled a positive $11.4 billion spread for the week ($17.4 billion of total equity inflow versus the $6.0 billion inflow within fixed income; positive numbers imply greater money flow to stocks; negative numbers imply greater money flow to bonds). The 52 week moving average has been $2.9 billion (more positive money flow to equities), with a 52 week high of $17.7 billion (more positive money flow to equities) and a 52 week low of -$37.5 billion (negative numbers imply more positive money flow to bonds for the week). 



ICI Fund Flow Survey: Return to Normality - ICI chart10


Exposures: The weekly data herein is important for the public asset managers with trends in mutual funds and ETFs impacting the companies with the following estimated revenue impact:


ICI Fund Flow Survey: Return to Normality - ICI chart11 




Jonathan Casteleyn, CFA, CMT 




Joshua Steiner, CFA




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