This note was originally published at 8am on February 18, 2015 for Hedgeye subscribers.
“Shallow men believe in luck or in circumstance. Strong men believe in cause and effect.”
-Ralph Waldo Emerson
If you are human, when the global macro market correlations go against your position, you undoubtedly classify them as spurious. After all, they don’t fit your thesis, so how else can they be classified?
In reality, when we think of spurious correlations, we think of things that have no business or rationale in being correlated. We’ll give you a few examples:
Suffice it to say, not all correlations are created equal.
In yesterday’s Early Look, Keith highlighted the fact that some of our macro views that are highly correlated have been going against us for the last week or so – dollar down, oil up, Euro up, Russia up, Greece up, Brazil up . . . and the list goes on. Versus say mozzarella and engineering degrees, these assets, even if we disagree with their recent price direction, have a lot more business being correlated.
Certainly, almost every asset and asset class has a price, but what we have seen in February remains a counter TREND move. In our view, the underlying fundamental circumstance of global #deflation and slowing growth remains intact.
Back to the Global Macro Grind...
Speaking of spurious, the most interesting central banking comments of the day award has to go to Bank of Japan Governor Kuroda, who indicated he will potentially act if the drop in the price of oil continues to hurt his outlook for inflation and general price levels (read: his inflation statistics). Since the Bank of Japan has bought almost every other asset available globally, perhaps the next move will be to lever up and buy oil futures!
On the topic of oil and counter trend moves, oil continues to be one of the more hotly contested asset classes globally. After a decline of epic proportions, WTI is now up about 10% in the last month and this is, admittedly, on contract volume that is up about 61% versus the 3-month average. Certainly, declining rig count in the U.S. and some level of short covering has helped, but what of production and future supply? Interestingly, Wood Mackezie in a recent report noted the following per a Bloomberg article:
“. . . that of 2,222 oil fields surveyed worldwide, only 1.6 percent would have negative cash flow at $40 a barrel. That suggests there won't be a lot of chickening out at $40. Keep in mind that the marginal cost for efficient U.S. shale-oil producers is about $10 to $20 a barrel in the Permian Basin in Texas and about the same for oil produced in the Persian Gulf.”
In Chart of the Day, we highlight weekly U.S. oil production in the U.S. going back to 1983 (as long as the data has been kept). As you can see, weekly oil production in the U.S. hit its highest level in more than 32-years last week. If Wood Mackenzie is correct, it seems we may not be done with #DrillBabyDrill just yet.
Inasmuch as oil bears want the bottom to be in for WTI, the chart is very telling. Not only is oil production at a 32+ year high in the U.S., it is growing some 10% year-over-year. Unfortunately, again for oil bulls, on the demand side, the outlook is not overly robust either, with U.S. oil demand at a more than 12-year low (as a % of GDP).
The nearest term catalyst for oil markets may well be in the April / May time frame in the U.S. Based on projections of current production, it is expected that Cushing, and other U.S. repositories, may be at full capacity by then. In theory, this may force producers to dump near term supplies on to the market at seriously discounted prices. #Contango, anyone?
Switching commodity gears slightly, at 11am ET this morning, we will be hosting a call with Keith Barnett the Head of Fundamental Analysis from Asset Risk Management (http://asset-risk.com/author/kbarnett/ ) on the outlook for natural gas prices (he will also discuss oil). If you don’t already have it and would like to get the dial in for the call, please email email@example.com. The key topics Barnett will discuss include:
We hope you can join the call.
Our immediate-term Global Macro Risk Ranges are now:
UST 10yr Yield 1.70-2.18%
Oil (WTI) 48.37-54.02
Keep your head up and stick on the ice,
Daryl G. Jones
Director of Research
Given Panera’s dual-class shareholder structure, the company might not be in the line of sight of an activist. With that being said, we believe Chairman of the Board and Chief Executive Officer Ron Shaich should take a page or two from our playbook and go activist on his own company!
Two former restaurant CEOs turned activist that we admire are Doug Brooks of EAT and Linda Lang of JACK. Both stocks are up approximately 201% and 461%, respectively, since these CEOs originally laid out (EAT in 2010; JACK in 2005) fundamental changes to their business models in order to enhance performance and drive shareholder returns. While these CEOs had to make very difficult decisions at the time, the rewards have been vindicating. Thanks to their strategic moves, Brinker and Jack in the Box are now two of the best run restaurant companies in the space today.
Dear Mr. Shaich,
I believe that you have a significant opportunity to restructure your company and, in the process, make your shareholders a lot of money. At the same time, you will solidify your place as being one of the greatest, and most respected, CEOs in the restaurant industry.
Change is inevitable. In fact, since you first started Panera, consumer tastes, behavior, and technology have all changed drastically – rendering parts of the Panera model outdated. It’s time to become an activist CEO and reinvent the company. What I’m going to write probably won’t sit well with you, and you will be inclined to immediately dismiss it, but I ask that you think long and hard about the suggestions forthcoming. Ultimately, I believe they will make Panera an even stronger company.
Panera is a fantastic company, but it has a distinct opportunity to become greater, bigger, and more profitable than ever before. To be clear, the best way forward today is vastly different from the ways of the past. Importantly, my thoughts are in line with your stated belief that Panera’s success is dependent on your ability to create “long-term concept differentiation.” Consumer behavior and tastes are evolving, and the changes you are currently making to your food policy are just the beginning.
Along those same lines, the company must address the secular decline in per capita consumption of bread. While Panera’s identity is rooted in handcrafted artisan bread, consumer attitudes about bread have changed since you first started the concept. I don’t think it’s a stretch to say that you’re not getting credit from the consumer by owning all the assets associated with serving this artisan bread. Does owning the bakery chain supply chain generate a strong return on assets? I don’t know, but I doubt it. This leads me to my first suggestion:
1. Sell off non-core assets
Panera currently produces and distributes fresh dough through a leased fleet of temperature controlled trucks owned and operated by the company. According to the most recent filing, as of December, 30, 2014, you had 224 trucks leased. In addition, as of the same date, you had 24 fresh dough facilities, 22 of which were company-owned, including one located in Ontario, Canada. We suspect this asset may be particularly inefficient considering it only supports 15 bakery-cafes located within that market.
As you’ve previously stated, the “essence” of Panera begins with artisan bread: “Bread is our passion, soul, and expertise, and serves as the platform that makes our other entire food special.” While this may be important, this line of thinking may not properly reflect pronounced changes in consumer behavior. Specifically, consumers have been consuming less bread, as per capita consumption of this food has been declining since 2000. More importantly, absolute sales of bread in your stores only make up five to seven percent of sales.
Panera is the last remaining, vertically integrated public restaurant company that we know of. Companies have argued for years that vertical integration is a competitive advantage. Of course, in some cases, this is merely corporate speak. Every vertically integrated company needs to decide whether they are operating more, or less, efficiently than they could be. Jack in the Box was the last restaurant company to do so, when it rightfully decided to sell off its non-core distribution business. The stock is up approximately 265% since this time.
Frankly, I don’t think distributing tuna, cream cheese, and certain produce to substantially all of your company-owned and franchise-operated stores gives Panera any competitive advantage.
Moreover, it seems as though the ownership of your supply chain actually limits the company’s future growth opportunities and creates inefficiencies on the P&L. You already use other independent distributors to distribute some of your “proprietary sweet goods” and other materials to bakery-cafes. Why not sell off your non-core assets and use independent distributors to distribute all of your products? You could than redeploy this excess capital back into the business or return it to shareholders. This leads me to my second suggestion:
2. Slowdown the rollout of Panera 2.0 and begin molding a concept of the future
I sincerely appreciate the level of detail you provided in the 4Q14 earnings release regarding Panera 2.0. However, I don’t believe you accomplished what you had intended to, because the inconsistency of the results led to a lot of confusion. I also appreciate that Panera 2.0 is part of broader set of initiatives designed to make your restaurants more competitive, but there can be much more done to improve the efficiency of the box. None of the initiatives laid out address improving pain points that exist in the back of house or eliminating menu items that are difficult to prepare and simply don’t have the customer sell through. In addition, it may be time to rethink the part of the box that is dedicated to selling bread. Should we be thinking about Panera 3.0? The structural changes that are needed at the core concept lead me to my third suggestion:
3. Slow unit growth and cut capital spending
It’s not possible to focus the company and its resources on Panera 2.0, or Panera in general, when you are accelerating unit growth. There are a significant amount of unnecessary “growth” resources in place at Panera at a time when the box is in need of a major transformation. Is this sending shareholders the wrong message? Given the size and scale of Panera 2.0, why aren’t all of the firm’s resources going into it? It’s also difficult to maximize profitability when you are spending G&A on unnecessary resources, which leads to my fourth suggestion:
4. Cut excessive G&A spending
Looking at comparable companies, your G&A seems to be much higher than needed – but this should come as no surprise. Today, Panera is a vertically integrated restaurant company that is growing units at an inefficient pace. Both of these can be easily remediated by thinking differently about the business model. Every major restaurant company that has faced similar issues in the past has decided to streamline its structure and improve the operations of its existing asset base. Panera has not addressed these issues which, in part, play into my fifth suggestion:
5. Aggressively refranchise stores
Refranchising will immediately help eliminate some unnecessary G&A. While the majority of players in the restaurant space have transitioned closer toward asset-light models, Panera has taken the opposite approach. Over the last four years, the percentage of company-owned stores has increased from 42% to 49%. I understand these acquisitions were accretive to earnings at the time, but you now have a bigger problem on your hands. As you know, you are the one responsible for investing shareholder capital to fix them. Currently, your franchisees only operate approximately 51% of Panera’s bakery-cafes. Given that these franchisees are well-capitalized (35 franchise groups operating approximately 27 bakery-cafes each), selling stores probably won’t be a challenge. Even if current franchisees are out of the question, Panera is a highly desirable concept which, given the amount of liquidity in the market place, makes it likely that there are a number of potential buyers available.
Lastly we will be publishing our detailed thoughts in the coming weeks. We believe that changes to your current business model will significantly enhance the margins, returns and overall earnings power of the company. We put the base line earnings power of the company between $8-10 per share and the implied stock price between $240-$300
I hope that you will consider some of my suggestions.
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Takeaway: China’s Elite drives BABA’s GMV. BABA's user growth moving forward will come from a much weaker consumer; a double-edged sword for its GMV.
Editor's note: Hedgeye Internet & Media analyst Hesham Shabaan has basically been the only bear on Alibaba and has been highlighting the major risks to the BABA story since 10/21/14. Since then, we've witnessed the validation of his bearish thesis within BABA’s quarterly earnings with the emergence of a new concerning trend that landed BABA on our Best Ideas list as a Short on February 11. We are hosting a special call outlining the bear case on BABA this Thursday March 5th at 1pm. Ping firstname.lastname@example.org for full access. The note below was originally published on November 26, 2014.
We hosted a call last week laying out our BEAR case on BABA, and the key metric we're tracking to time the short opportunity (contact us for the deck and replay). We're going to publish a series of short notes detailing the salient points from the call. This is the first, and maybe the most important.
The average consumer on BABA’s China Retail sites spends roughly ¥6.5K annually (~USD $1.1K). In the chart below, you can see the distribution of China’s internet users by income (red columns) and what BABA's average GMV would represent as percentage of their incomes (orange columns). In short, BABA’s GMV would be a prohibitively large amount for most consumers in China; especially since BABA can’t sell’s everything.
The other thing to consider is BABA’s cohort commentary on its F2Q15 earnings call, which we have pasted below.
BABA F2Q15 Earnings Call (Maggie Wu): “Let me share with you some color on this average spending per buyer. As I said that the longer customers stay with us, the more they're going to spend annually on our platform. I'll give you an example”
The amounts spent by those on the platform for more than 5 years are just jaw-dropping when you consider the income distribution of China’s internet users. If we compare these metrics to the first chart above, only 5% to 14% of China's internet population at most could afford to spend ¥15K-¥30K annually; let alone BABA's ¥6.5K average GMV.
The obvious takeaway is that BABA’s GMV is currently hostage to the whims of its upper class consumers. What’s more concerning is that GMV growth moving forward will be driven primarily by new consumers with considerably less to spend. In turn, new user growth will come with disproportionately lower GMV growth since average GMV is facing decline; turning what was a growth driver into a headwind.
We illustrate this dynamic in our China GMV Market Model, which is driven by user growth and e-commerce spending projections (both by income cohort); the former being the more important driver. As new lower-income consumers join the BABA platform, they will grow in proportion to BABA’s total users; driving down both average income and average spending of its user base.
Note that roughly 85% of BABA’s revenues are linked to its GMV, which our model suggests is heading for sharply decelerating growth through F2017.
We will be publishing a follow-up note with more detail on the impact of our GMV projections on BABA's business model. In the interim, see link below for broader summary of our bearish thesis, or let us know if you would like to see our BABA deck.
BABA: Leaning Short, But...
10/21/14 07:02 AM EDT
Hesham Shaaban, CFA
Here is the replay of today's edition of The Macro Show, featuring live and interactive commentary from Hedgeye CEO Keith McCullough.