Keith's Macro Notebook 3/27: USD | Oil | Japan


Hedgeye Macro Analyst Ben Ryan shares the top three things in CEO Keith McCullough's macro notebook this morning.

INSTANT INSIGHT: Currency Wars, Strong Dollar & Oil

Editor's Note: This is an excerpt from CEO Keith McCullough's morning research today. Click here for more information on how you can become a subscriber.

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INSTANT INSIGHT: Currency Wars, Strong Dollar & Oil - ben ryan oil


So, they tested the patience of the crowded Euro and Yen short positions... but all lines of @Hedgeye resistance for those majors in the #CurrencyWar held as the U.S. Dollar Index held all lines of support.


There's no support for the Euro to 1.05 and Yen 121.61 vs USD.


On a related note, Oil...


It doesn’t like #StrongDollar, but we like shorting Oil and levered E&P equity schemes on that (ping to see how our energy analyst Kevin Kaiser is positioning our customers on the long/short side of this).


WTI failed at the top-end of yesterday’s risk range and has no real support to $41.93.


(No, that’s not a typo.)

MCD: Putting the Activist Thesis to the Test

The basic premise of wanting to be long MCD is a good one; but for us, it comes down to a matter of timing.  From where we sit, with an abundance of unknowns, it’s still too early.


McDonald’s is a great company with strong margins, significant free cash flow, and unmatched global scale.  It’s an iconic brand, but its image is tarnished and in need of a major overhaul that can only be led by an overhaul of the menu and the food it serves.  This is precisely why the company is trading at $97 today.  Despite this, there is one shareholder that thinks the stock is worth $169.  We love the bold thinking, but it’s unlikely to happen anytime soon.


Three of the top fifteen shareholders that own MCD can be classified as activists.  Given that the new CEO has taken the initiative to classify himself as an internal activist, or a constructive agitator, will the company be better managed?


We’re working under the assumption that these shareholders are directing the company to pull some levers to create shareholder value.  This was confirmed by yesterday’s meet and greet with management in NYC.


Glenview Capital Management recently put forward a very aggressive case for what MCD can do to unlock value.  No matter what they put forward, turning this company around will ultimately come down to fixing its operations.  Importantly, this is the part of the story that cannot and should not be influenced by an activist.  It will also force the CEO to make difficult, strategic decisions that will be disruptive to how the company operates today.


The Glenview (and consensus) bull thesis goes something like this:



Glenview Capital Management: “McDonald’s same-store sales turned negative due to strategic misdirection, operational inefficiencies and disenfranchised franchisee.  We believe that each one of these is a solvable problem and our proprietary research in the channel and conversations with management suggest they are already being addressed, which should allow for a return to positive same-store sales.”


Hedgeye: We agree MCD can be fixed operationally.  The bigger question is how long it will take and what will it take to return to positive same-store sales?  How deep are the operational issues?  Will management address the health of its franchisees?  Our proprietary check into McDonald’s franchisees suggests that these issues are much deeper than most think.  The bigger issue revolves around how much blood management can extract from the proverbial stone.  At this point, the franchise system is not seeing “renewed enthusiasm” in the field and, in fact, franchisees are still very concerned about what the recovery will look like.  Consumer perception of the brand remains a huge issue.


Verdict: Glenview target price reduced by $11.  There is little evidence of a turnaround.  At the very least, it will not manifest into increased profitability until late 2016.



Glenview Capital Management: “The bull case says that MCD can cut $500 million of the $2.5 billion in SG&A spending.” 


Hedgeye: Once again, we agree that MCD is a bloated company relative to its peer group and there is a significant opportunity to cut costs.  Given the current management team and construct of the Board of Directors, MCD likely won’t come close to realizing the potential G&A cuts.  This type of change would require running the company with a significantly different mentality than anyone at McDonald’s is used to.  For this reason, we don’t believe this is in the cards anytime soon.  Additionally, a sizeable part of any G&A savings will need to be reinvested in the business to help improve assets and the quality of the food.


Verdict: Glenview target price reduced by $11.



Glenview Capital Management: “Refranchising has a minimal impact on EPS when consummated in a rent-adjusted leverage neutral basis, but the improved quality of the less capital intensive and more stable earnings stream has been consistently and appropriately rewarded in the market via improved valuation. Multiple case studies point to both an immediate recognition upon announcement as well as overtime as the plan is executed, and McDonald’s stagnant franchise mix over the past five years has contributed to a valuation that was at the high end of its peers five years ago but now ranks as the cheapest in the group as others have capitalized on the opportunity while McDonalds has not.”


Hedgeye: Management has disclosed their intentions on refranchising, a position we believe they are unlikely to shift from.  The premise of the thesis here is that refranchising will lead to a higher multiple, given the more asset-light nature of the business.  For the most part, MCD U.S. is already an asset-light business model and, unfortunately, it’s not the right time for MCD to be refranchising its company-operated store base.  The company needs the store base right now, because it needs to prove to franchisees that the investments they are making to improve operations will result in the intended lift in sales and profitability.  It’s clear from our discussions with the McDonald’s franchise community that the system is very reluctant to incur incremental costs to fix the asset base until management proves the ROI.  Lastly, even the new CEO will have a difficult time getting the Board to approve this radical change in direction for the company.


Verdict: Glenview target price reduced by $14.



Glenview Capital Management: “With accommodating credit markets providing access to generationally low interest rates, as evidenced by McDonald’s 30 year debt yielding slightly below 4% pre-tax or 2.6% after tax, we believe McDonald’s could return approximately 25% of the market cap to shareholders through the end of 2016 while still maintaining an investment grade rating and as much as 50% of the market cap if they choose to match the leverage levels of burger peers, QSR and WEN.”


Hedgeye: The potential for balance sheet optimization can be lumped into the same category as SG&A cuts and refranchising.  All three are real opportunities, but all three are highly unlikely given the current Board of Directors.  We don’t believe the new CEO and current Board will leverage the company to the degree that other asset-light companies have done.  That’s simply not the McDonald’s way.  It would represent a major shift in thinking at the company and there are no signs it will move in this direction.


Verdict: Glenview target price reduced by $12.



Glenview Capital Management: “Given that REITs are trading at almost 20x EBITDA, we do not believe this is reflected in McDonald’s current 12x EBITDA valuation, and we believe management efforts to monetize or illuminate this could unlock at least $20 billion of value.”


Hedgeye: We believe this entire topic of McDonald’s potential real estate opportunity is overblown and, on some level, flawed.  The Glenview letter is short on details and ignores some very important issues.  If those doing the analysis spent more time studying McDonald’s business model, they would better understand how the real estate and franchise sides of the business work together.


First, it appears that people believe McDonald’s is charging below market rents to franchisees.  This is simply not true – actual rent payments are far above market rates.  This would not be allowed under a publicly traded REIT.  If MCD gets a significant chunk of their revenues from rent paid by franchisees, how will a REIT further monetize real estate?  Raise the rent to franchisees?  They can’t.


Second, many properties are already encumbered by the franchise agreements in place at each and every location.  McDonald’s has no power to modify or force a renegotiation of these terms.  They can certainly sell the underlying properties into a REIT, but we fail to see how they can monetize this without charging higher rent.  And if they sell this underlying property, McDonald’s is still responsible to the franchisee for the remainder of the franchise term.  They can sell or assign their rights, but not their responsibilities.


The dirty little secret that no one talks about is ongoing rumors that there is a “secret MCREIT” that MCD set up with six of their suppliers 20 years ago.  According to industry insiders, the suppliers bought real estate and leased it back to MCD with zero transparency to shareholders.  How much of the leased land and buildings are already owned by this “secret MCREIT?”


Verdict: Glenview target price reduced by $25.



Our target price is closer to $96, a far cry from the $169 target put forth by Glenview Capital Management.  We see downside/upside potential to $83/$112 per share, respectively.


MCD: Putting the Activist Thesis to the Test - 1

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Crowdfunding: The SEC’s Big Push for the Little Guy

By Moshe Silver


The SEC finally issued the Crowdfunding rules required under the 2012 JOBS Act (“Jumpstart Our Business Startups.”  Who knew Congress could be so cute, so inventive…?)  Release 2015-49 says the new Rules “provide investors with more investment choices.”  The new rule updates and expands the old Regulation A, which permits public equity sales of up to only $5 million.  It raises that cap to $50 million and cuts lots of additional red tape.  Showing they are every bit as witty as Congress, the SEC calls the expanded Reg A “Reg A+,” and it’s already scoring high with the Crowdfunding community.


Crowdfunding: The SEC’s Big Push for the Little Guy - 23


This tenfold expansion of the public offering rule could be seen as long overdue – the $5 million cap has been in place for a long time.  The radical part of Reg A+ is something Congress didn’t mandate, but that the Commission threw in themselves.


Under Reg A+, issuers will no longer have to register their offering in every state in which investors reside.  These procedures are called the “Blue Sky” laws, made famous in a 1917 Supreme Court opinion describing flim-flam artists offering “speculative schemes which have no more basis than so many feet of blue sky.”  The blue sky laws are one of the state securities regulators’ main sources of leverage, giving them the ability to prevent a security from being sold to residents of their state.


Under the old rules, a company wishing to raise up to $5 million in ten states had to go through eleven registrations: one for the SEC, and one in each state.  This is obviously incredibly time consuming and runs up attorney fees.  And while it has prevented serious frauds, there are famous cases of offerings that didn’t make it through the blue sky process.  For example, Apple Computer’s IPO was not permitted to trade in Massachusetts because regulators thought it too risky, while Salomon Bros had to re-do the first-ever offering of asset-backed securities at the last minute over blue sky issues.  Under Reg A+, anyone can invest, and the stock will be registered and transferrable immediately.  Unlike now, issuers will be able to advertise, and it appears that the old restriction on numbers of shareholders will be lifted.


Thus, it looks like small companies could advertise their offerings online direct to investors and raise $50 million in $100 increments.


Among the obvious pitfalls of these offerings are the likelihood of illiquid investments, and the apparent lack of investor protections when suitability requirements are relaxed and issuers are free to flog their wares with far less oversight that what is required of the average mutual fund offering. 


There remain significant moving parts to work out, but chair White’s announcement really gets the Crowdfunding ball rolling.  Two years ago, former SEC chair Arthur Levitt called for caution, warning that without strong SEC oversight, Crowdfunding could become a mechanism for fleecing the average investor.  Needless to say, state regulators are up in arms over a central-government power grab that, they claim, makes it impossible for them to prudently protect their citizens. 


Some thoughts:


  • Arthur Levitt is one of our heroes – the man who made the investment markets safe for the Little Guy.  His words should be heeded, and heeded carefully, and we’re eager to hear his thoughts now. 
  • State regulators tend to stay in their jobs for the long haul, unlike the SEC where a larger percentage move on to jobs in the private sector.  When they are good, state regulators have a fingertip-fine sense of what goes on on their watch.  And unlike the SEC, if you don’t like your state regulator, you can move to another state. 
  • From a States-versus-Washington point of view, it strikes us as odd that folks screaming bloody murder that we’re being “nanny-stated” to death by programs such as universal healthcare that try to share some of the toys evenly, are only too happy to see the state’s own nanny – in the imposing person of Mary Jo White – wade into the nursery and take the toys away.


One thing is for certain: this will unleash a massive wave of creativity as Wall Street and the entrepreneurial community come up with new ways to raise money, distribute securities and, by creating new forms of exchanges, provide liquidity for their investors.  There will be tremendous opportunities for both companies and private investors, and this new initiative could come close to actually achieving its public policy objective of providing real benefit for the economy and for the markets.  Fortunes will be made and –for sure – lost, and there will also be excesses, dumb mistakes and a few serious frauds.


It’s a brave new crowded world.  Keep your wits about you.


Moshe Silver is a Managing Director at Hedgeye Risk Management and author of Fixing a Broken Wall Street.

Back to Business for #StrongDollar

Client Talking Points


They tested the patience of the crowded Euro and Yen short positions, but all lines of @Hedgeye resistance for those majors in the Currency War held as the U.S. Dollar Index held all lines of support – no support for the Euro to 1.05 and Yen 121.61 vs USD.


Oil doesn’t like #StrongDollar, but we like shorting Oil and levered E&P equity schemes on that – WTI failed at the top-end of yesterday’s risk range and has no real support to $41.93 – that’s not a typo.


No typos in the terrible Japanese economic data either (which is perversely the catalyst to be long the Nikkei) – Household Spending and Retail Sales are down -2.9% year-over-year and -1.8% year-over-year, respectively, in FEB with 0.0% year-over-year inflation (ex-Tax) – they’re going to need moarrr central planning #cowbell.

Asset Allocation


Top Long Ideas

Company Ticker Sector Duration

No typos in the terrible Japanese economic data either (which is perversely the catalyst to be long Nikkei) – Household Spending and Retail Sales are down -2.9% year-over-year and -1.8% year-over-year, respectively, in FEB with 0.0% year-over-year inflation (ex-Tax) – they’re going to need moarrr central planning #cowbell.


iShares U.S. Home Construction ETF (ITB) is a great way to play our long housing call, U.S. #HousingAccelerating remains 1 of the Top 3 Global Macro Themes in the Hedgeye Institutional Themes deck right now. Builder Confidence retreated for a 3rd consecutive month in March and New Home Starts in February saw their biggest month-over-month decline since January 2007.  We think the underlying reality is more sanguine with the preponderance of the weakness in the reported February data largely attributable to weather.


While labor supply constraints may serve as a drag to builder confidence, presumably it is rising demand trends that are driving tighter conditions in the resi employment market.  All else equal, we’d view improving demand as a net positive.  On the New Construction side, while the sharp drop in Housing Starts captured most of the headlines, we believe the real story was in the 3% gain in permits. We'd expect to see a big rebound in the next two months in housing starts as the data plays catch-up to the thaw.


Low-volatility Long Bonds (TLT) have plenty of room to run. Late-Cycle Economic Indicators are still deteriorating on a TRENDING Basis (Manufacturing, CapEX, inflation) while consumption driven numbers have improved. Most of the #Deflation trades bounced to something less-than-terrible (both absolute and relative) for 2015, whereas the real alpha trending in macro markets continues to play to the lower-rates-for-longer camp’s advantage.

Three for the Road


Spent all night vetting and revetting $RH. Bottom line...math doesn't lie. This name has a tremendous setup for FY 2015.



You’ve got to play your game.

-Andrew Miller


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CHART OF THE DAY: Stick With The Hedgeye Process

CHART OF THE DAY: Stick With The Hedgeye Process - 03.27.15 chart


This chart was featured in today's Morning Newsletter written by Hedgeye CEO Keith McCullough. For more information on how you can subscribe click here.

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