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MCD - The Hambuglar Strikes

MCD is scheduled to report 3Q09 earnings on Thursday, October 22 before the market opens.  From a revenue standpoint, I think current street estimates are too bullish, and I would not be surprised to see MCD report earnings that fall a penny short of the $1.11 consensus estimate. 


As I have said before, however, the tax rate and nonoperating income/expense line, which includes gains and losses on company investments, are extremely volatile quarter to quarter and difficult to forecast so there could easily be a penny of upside/downside from such items relative to my expectations. 


From a stock performance perspective, I think investors will be more focused on recent sales trends (MCD will be reporting September comparable sales numbers by segment as well) than earnings, unless of course, it is a huge miss/beat, which is not likely.  When MCD reported in line 2Q09 earnings, the stock still traded down 4.6% on the day because the company also reported below trend June same-store sales results. 


To that end, I think September same-store sales growth could come in below expectations with the U.S. posting a +1% number, which would point to continued deceleration in 2-year average monthly trends (a +3.3% number or better is needed for 2-year average trends to be even with or better on a sequential basis).  I am expecting September 2-year average trends in both Europe and APMEA to remain about even with August, which implies about 10% and 3.5% growth, respectively. Based on these assumptions, 3Q09 comparable sales growth will have decelerated on a 1-year basis and 2-year basis in two out MCD’s three geographic segments.  I am looking for 1.8% same-store sales growth in the U.S. (vs. +3.5% in 2Q09), +1.7% in APMEA (vs. +4.4% in 2Q09) and +6.9% in Europe (in line with last quarter). 


Traffic in the U.S should be helped in the quarter by the increased number of promotions MCD has offered, particularly around McCafe and the Angus burger.  The obvious downside to that is the impact on average check and U.S. margins.  It will be difficult for the company to sustain its last two quarters of 50 bp YOY U.S. restaurant margin growth with this level of promotional activity though the margin comparisons continue to be easy with YOY restaurant margins down 20 bps in 3Q08 and down 60 bps in 3Q07. 


Other things to consider in the quarter that will help to offset top-line weakness include the YOY easing of commodity costs and currency in the second half of the year.  Specifically, management guidance stated that in the U.S. its basket of goods should increase 3%-3.5% for the full-year, which implies about a 1% increase in the back half of the year.  In Europe, the company’s revised outlook assumes commodity costs increase 3%-3.5% as well, resulting in relatively flat costs in 2H09.  On a consolidated basis, food costs as a percent of sales should decrease YOY (even with the increased discounting in the quarter), marking the first time this number has come down in 6 quarters.  The magnitude of this YOY favorability will become even greater in the fourth quarter as food costs as a percent of sales in 4Q08 were up 170 bps YOY (vs. up 90 bps in 3Q08).


Relative to MCD’s currency guidance, the company said that based on current rates at that time that the negative impact of currency translation would decrease to about $0.04 in the second half of the year (-$0.06 in 3Q turning into a $0.02 tailwind in 4Q) from the negative $0.17 per share impact in 1H09.  Looking at rates now, this expected $0.02 benefit in 4Q09 could move higher. 


There are still reasons to love MCD.  Proving that MCD is a cash machine, the company recently announced a 10% increase in its quarterly cash dividend and stated that it expects to end the year near the high end of its three-year, $15 billion to $17 billion total cash return target.  At first glance, this 10% quarterly increase seemed low to me relative to the 33% increase last year, but on a full-year basis, MCD’s dividend will be up 26% in 2009 versus up 8% in 2008.  MCD has enough free cash flow to even trump that $17 billion target through increased share repurchases to help provide the financial engineering to make the numbers. 


MCD - The Hambuglar Strikes - MCD 3Q09 stock price

Hybrids Impact on Oil Demand

We released our Oil Black Book in September and our two key underlying themes related to flat lining production globally and the fact that increased investment does not seem to be growing production.  While these are the important facts relating to supply, on the demand side we do need to seriously start considering the impact of more fuel efficient vehicles, particularly in the United States.


The United States uses roughly 20% of the world’s oil and roughly 50% of that is used for gasoline for cars.  As a result, any real change in gasoline usage for transportation in the United States will impact global supply and demand dynamics directly.  We wrote the following in our Black Book:


“In aggregate, oil accounts for almost 95% of all transportation energy around the globe. This is the single most substantial area for potential demand alleviation as fuel intensive transportation methods begin to be gradually displaced by more economical modes of transportation. As an example, Fisker Automotive is expected to introduce a car shortly that will get upwards of 65 miles per gallon. Tesla, GM and Nissan also are in the midst of introducing cars that may get upwards of 100 miles per gallon, although it is not yet clear that these cars will see wide spread use as the mpg calculations are based on limited daily use. Nonetheless, this advancement could lead to a dramatic increase in average miles per gallon which is currently estimated to be in the ~24 mpg range in the United States.”


The reality is that based on hybrid vehicle technology, the MPG in the United States has the potential to change dramatically over the coming years.  Estimates suggest that globally, hybrid sales are still barely over 1% of all vehicle sales.  In a scenario, whereby hybrids reach 5, 10 and even 15% of vehicle sales in the United States that would have a meaningful impact on average MPG, and overall demand for oil.  In the table below, we have outlined a scenario where the base of cars becomes increasingly more hybrid and operate at a MPG of 50, which is comparable to a 2010 Prius. Let’s take a look at the rough math:


Hybrids Impact on Oil Demand - hybrid table


The punch line is that as hybrids continue to take market share, we can and will see a dramatic decline in oil demand in the United States as it relates to gasoline use.  At a point when 15% of all vehicles are hybrid, MPG will increase by 16.3%, so vehicles will be that much more efficient.   The implication is that, all else being equal, 50% of American demand for oil will decrease by 16%+ when hybrids are penetrated to 15% since 50% of oil used in the U.S. is turned into motor gasoline.


To put this in a frame of reference, gasoline demand over the past ten years from October 1999 to October 2009 has only increased by 8.3%, so to the extent that some of the general estimates relating to hybrids are accurate, namely that 20% of all car sales by 2020 will be hybrids, we could potentially see a dramatic decline in gasoline demand in the U.S. that offsets natural organic growth in demand.  In fact, over the last decade, we would have actually seen a net decline of demand of ~8%.  Keep your eyes on the hybrids!



Daryl G. Jones
Managing Director 



Eurozone Deflation Holds Steady

Position: Long Germany via EWG


We’ve had our EYE on Eurozone inflation and forecast to see mild inflationary numbers into year-end and next. Today Eurostat released Eurozone CPI at -0.3% in September year-over-year, with monthly inflation at 0.0%. While still deflationary on an annual basis, and down from -0.2% in August, we expect a slight uptick in inflation over the intermediate term, buffered by a strong Euro. 


As always, divergences in inflationary/deflationary numbers reflect structural issues on an individual country basis within the framework of the Eurozone, and will remain a political football for the ECB when it considers raising interest rates. As of yet, there’s been little rhetoric on the WHEN, however Trichet has recently signaled displeasure with a strong Euro (now bordering on the $1.50 mark) as it erodes the competitiveness of Eurozone exports.


September inflation data shows a clear divergence among countries:  Ireland and Portugal are experiencing the most deflation, at -3.0% and -1.8%, respectfully. The two largest economies in the region, Germany and France, stood at -0.5% and -0.4%, near the region’s average, while Malta and Finland topped the inflation charts at +0.8% and +1.1%. As before, we continue to believe that structural issues that weighed on certain countries into the downturn will encourage and prolong deflation, and therefore recovery, as we move out on duration.


The major components driving annual CPI deflationary were Energy (no big surprise) and Transport costs, down -11% and -3.7%, while Food and Housing saw declines of 1.3% and 1.6% respectively.  Due to tax and duties, Alcohol and Tobacco saw strong inflationary pressures at +4.4% annually.


Alongside inflation we’re beginning to see upward revisions for GDP growth across the Eurozone. Importantly, Germany was revised up to 1.2% in 2010 (from a recent IMF prediction of +0.3%), with Chancellor Merkel stating that even average growth of about 1% would only show that Germany is “slowly emerging from the trough.”  Yet, she also stressed in a recent speech that Germany’s industrial base shall help the economy outpace many of its peers, a point we agree with. Further, the Bank of Italy said the country emerged from recession in Q3, expanding 1% Q/Q. Cited for stepping up manufacturing, Italy’s push from a Q2 GDP of -0.5% is bullish for an economy that is heavily dependent on trade with the Europe.


As economies melt up, we expect inflation to follow at a relatively stable rate across the region.  We continue to like Germany, including its low inflation environment as it encourages consumer consumption.



Matthew Hedrick



Eurozone Deflation Holds Steady - EACPISEP


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This note is to share our tactical insights into the ETF and options markets. ETFs and options have unique risks and may not be suitable for all investors.  Please consult with a qualified investment professional before investing in these instruments. 


During our quarterly strategy call earlier today, we received questions about the use of leveraged ETF products.


We do not like leveraged ETFs for overnight positions. The structure which allows theses products to be created, by definition, limits the correlation to the underlying security, commodity or index to intraday moves.  For investors who have an intermediate or long term directional conviction, and who wish to leverage their position, options on a non leveraged equivalent ETF or on the underlying index may be a viable alternative.


Some basics: purchasing an option limits the potential loss in the position to the price paid, selling an option without an offset in the underlying investment will expose an investor to a potential loss of either the entire underlying (selling a naked put) or an infinite amount (selling a naked call). In other words, if you haven’t used options before, read the educational literature on the CBOE’s website thoroughly and actually read the information your broker provides rather than just clicking “I accept” before you start trading.  We would encourage you to make sure your broker actually understands how these instruments work – sadly, not all do – before you entrust your capital to their advice. I can’t stress this enough (I have spent the majority of my adult life trading derivatives and have as many gruesome stories about accidents as a career EMT).


The crux of this matter is that purchasing an option contract that is out-of-the-money (above the underlying price for calls, below the underlying price for puts) provides a significant amount of leverage and can pay off handsomely with a big movement in price. The value of one of these “lottery tickets” evaporates rapidly however as the time to expiration erodes or the underlying price moves in the wrong direction, presenting a great deal of risk. Purchasing an option that is near the current price or even actually “in-the-money” will provide a lower risk of erosion based on time or price action, but the absolute dollar cost will be more significant and the potential payoff profile will be more limited than that of an out-of-the-money contract if there is a big move in the underlying.


Options can be a useful investment tool (provided that you do your homework first) but they may not present the tactical flexibility a shorter term investment requires. For an investor looking to capture a directional movement of a few days to a week, a directional position in an unleveraged ETF may well provide more maneuverability than an option position, while providing true (if unleveraged) performance tracking the underlying.


The only time a leveraged product that resets daily makes sense is when it is being employed intraday.  Your broker may not be able to explain this to you, because financial professionals are not required to be knowledgeable about ETFs, even if they invest their clients’ money in them.  Now more than ever, buyer beware.



Andrew Barber



Quick Take on Safeway

SWY reported $0.31 vs. Street at $0.29.  Slightly weaker identical store sales at -3% vs. Street at -2.6%.  In digging through the margins and expenses, it looks like gross margin while still down slightly, came in better than expected.


Guidance of $1.70-$1.90 for the year and $1.1-$1.3 billion in FCF are both unchanged.  Street is at $1.74.  Noticeably absent from the press release is any comment on the sales outlook (normally identical store sales guidance is provided ex-fuel).  It’s likely they will address this on the conference call at 11am, but I’d take this as a sign that sales trends remain unpredictable (or maybe even getting worse?). 


Bottom line, a slightly better quarter on margins but still a challenging topline.  The market is going to be excited about this headline beat (merely because they did not miss again) but overall nothing has changed materially enough here in my view.  Key to the commentary on the call will be any insight into deflation/inflation, which is the most important topic for those bullish on the grocers. 


As it pertains to KR (a name we have been short), there is nothing out of this initial release that suggests the market has changed materially or will change materially in the next few months.  More to come after the call at 11AM…


Quick Take on Safeway - SWY SIGMA


H&M comps are still down significantly on top of easy compares with little sequential improvement from the plunge in August caused by shortage of clearance/markdown inventory after the company’s “summer sale” left inventories too lean.  Sales did grow by 1% from new stores but this sales growth is the third worst month over the last 5 years (last month’s sales growth was the worst).  This is the first time I have seen H&M come out on their monthly sales update and blame the recession and the weather: “Sales were affected by the recession and unusually warm weather in September in most of H&M’s markets. Sales were satisfactory where the weather conditions were more normal.” The only commentary on sales from their monthly releases has discussed calendar shifts, not excuses.











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