In this brief excerpt from today's edition of The Macro Show, Hedgeye CEO Keith McCullough answers a subscriber’s question on how much merit to give sell-side consensus estimates. Keith explains that our job as risk managers is to front run the consensus circus act and move ahead of the herd to get paid.
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Takeaway: RL - New Vetting Book. Call to be held Monday June 8th, 1:00 pm. RH - Management Incentivized to Deliver
RETAIL IDEA LIST
RL - RALPH LAUREN IDEA VETTING BOOK -- JUNE 8
Why We’re Doing This Now
Our next Idea Vetting Book will be on Monday, June 8th, and the topic will be Ralph Lauren. This is hardly a new name for us -- having covered it for the better part of two decades. But we can't remember a time when there was more opacity in the model, less investor confidence in the Brand, or in management’s ability to execute on this story. Ultimately we think there are critical questions to answer over both short-term and long-term durations, and we think we have the tools, insight, and historical perspective to more fully flesh out the debate.
Remember that Mr. Lauren in 75 years old, and is the sixth oldest CEO in the S&P. But his next layer of executives have only been at the company for an average of 3-5 years, which is very young for a company like this. It's no surprise then that the company just finished 'an investing year' and then promptly started another one.
Importantly, Mr. Lauren has 81.5% of the voting power at RL. He owns the Board outright, and details around its long-term strategic plan (presuming there is one) are extremely scant. In addition to reviewing some of the near-term puts and takes for Ralph, we're also going to review some of the bigger strategic options facing the company (whether RL knows it or not).
More details to come.
RH - Management Incentivized to Deliver
We received some questions about RH's proxy statement (filed last Thurs) -- which is no surprise as people seem to be obsessed with everything and anything related to Gary Friedman, and his compensation is no exception. According to this years proxy statement the RH CEO didn't take a pay bump for the 2nd straight year, but the top end of his achievable bonus scale climbed by 25%.
The way his bonus payout is structured, Freidman would take home a fixed percentage of his base pay dependent on the RH's performance. 'On plan' equates to a bonus equal to 100% of his annual salary. At 2x the current internal plan the payout climbs to 250% of the annual salary. Meaning if the company beats its internal pre-tax EBIT plans (around $200mm) by a factor of 2, Friedman could take home a total of $4.375mm this year ($1.25mm base + $3.125mm in incentives). At face value, that seems like a pretty cheap deal for shareholders, and it is.
But it also outlines what happens when a CEO is compensated in stock in the early years. Freidman owns a 6% stake in RH, currently worth $212mm. At 2x the top of end of RH's current guidance, that would equate to $6.00 in earnings power. Apply a 30x multiple and we are talking an additional $200mm added to Friedman's net worth in 2015. $6.00 is more than a little bit ambitious for this year, but we like that the incentive is there.
If RH wins, then Friedman wins, and shareholders win.
Still our top name in all of Retail.
EVENTS TO WATCH
DLTR, FDO - Dollar Tree, Inc. Reaches Agreement to Sell 330 Family Dollar Stores to Sycamore Partners Contingent on Completion of Family Dollar Merger
AMZN - Amazon Offers Limited Free Shipping on Same-Day Delivery Orders
W - Wayfair names new CTO
Takeaway: Investors moved defensively last week, making net withdrawals from all equity products and shoring up cash in money market funds.
This note was originally published May 28, 2015 at 07:13. For more information on Hedgeye's wide array of smart investment products click here.
Investment Company Institute Mutual Fund Data and ETF Money Flow:
Fund flows were defensive in the 5-day period ending May 20th with total net equity products in outflow. Investors instead moved to the sidelines with +$20.6 billion of cash being added to money market funds last week. There were some pockets of strength with international equity mandates experiencing their second largest inflow in 2015 of +$4.3 billion. However, this was not enough to balance out the -$5.4 billion withdrawal from domestic equity funds. Investors have now pulled -$38.6 billion from domestic equity funds so far in 2015 versus +$11.6 billion in contributions over the same period last year.
In the most recent 5-day period ending May 20th, total equity mutual funds put up net outflows of -$1.1 billion, trailing the year-to-date weekly average inflow of +$713 million and the 2014 average inflow of +$620 million. The outflow was composed of international stock fund contributions of +$4.3 billion and domestic stock fund withdrawals of -$5.4 billion. International equity funds have had positive flows in 48 of the last 52 weeks while domestic equity funds have had only 10 weeks of positive flows over the same time period.
Fixed income mutual funds put up net inflows of +$2.0 billion, trailing the year-to-date weekly average inflow of +$2.3 billion but outpacing the 2014 average inflow of +$929 million. The inflow was composed of tax-free or municipal bond funds withdrawals of -$138 million and taxable bond funds contributions of +$2.1 billion.
Equity ETFs had net subscriptions of +$1.0 billion, trailing the year-to-date weekly average inflow of +$1.6 billion and the 2014 average inflow of +$3.2 billion. Fixed income ETFs had net outflows of -$632 million, trailing the year-to-date weekly average inflow of +$1.2 billion and the 2014 average inflow of +$1.0 billion.
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 weekly average for 2014 and the weekly year-to-date average for 2015:
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), the weekly average for 2014, and the weekly year-to-date average for 2015. In the third table are the results of the weekly flows into and out of the major market and sector SPDRs:
Sector and Asset Class Weekly ETF and Year-to-Date Results: In sector SPDR callouts, the long treasury TLT ETF saw somewhat of a recovery after a string of withdrawals. Investors contributed +$253 million or +5% to the fund.
The net of total equity mutual fund and ETF flows against total bond mutual fund and ETF flows totaled a negative -$1.4 billion spread for the week (-$59 million of total equity outflow net of the +$1.4 billion inflow to fixed income; positive numbers imply greater money flow to stocks; negative numbers imply greater money flow to bonds). The 52-week moving average is +$1.4 billion (more positive money flow to equities) with a 52-week high of +$27.9 billion (more positive money flow to equities) and a 52-week low of -$13.1 billion (negative numbers imply more positive money flow to bonds for the week.)
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:
Jonathan Casteleyn, CFA, CMT
Joshua Steiner, CFA
Takeaway: By 2016, it will be clear that MCD will be well on its way to reasserting itself as the dominate company that it is.
I’m going to go out on a limb and say that 2015 could be the last year MCD will trade below $100.
I wish I had crystal ball that would tell me what quarter it will be clear that MCD is no longer a broken company. What I do know, is that the issues the company faces are not terminal. I now see enough changes on the margin to suggest that the worst is behind us, and it will not be long before MCD is in a better place operationally and the stock behaves accordingly.
It’s time to be LONG MCD!
Fixing McDonald’s operationally will take time. To date, it’s been tough to piece together what the turnaround will look like. At the time CEO, Steve Easterbrook unveiled his plan there was little incremental news about how the business was going to be fixed operationally. The financial engineering aspects will only take a stock so far before it runs out of steam. Therefore, understanding how an operationally led turnaround will unfold is critical to make a longer-term commitment to being LONG MCD.
By 2016, it will be clear that MCD will be well on its way to reasserting itself as the dominate company that it is. McDonald’s CEO, Steve Easterbrook, calls his new vision for McDonald’s “modern and progressive burger company delivering a contemporary customer experience.” We are a long way from that goal but the seeds are in place.
Returning MCD to sustainable growth must be centered on structural changes to the operating model and a recommitment to regaining the trust and loyalty of customers. This can only be done at the local level; local management and franchisees working together to deliver a McDonald’s experience consistent with what made the company great in the first place.
Steve Easterbrook’s holistic focus on making MCD a better company:
- Understanding and correcting the mistakes of the past.
- Be more agile in responding to customers evolving taste preferences and needs.
- Make quicker decisions and spread global insights faster to drive incremental growth.
- Change the way MCD makes decisions.
- Identify and focus the organization to better support the most significant global markets that will drive growth overall.
Without acknowledging and correcting the mistakes of the past, MCD will never be fixed. I believe this is partly why Don Thompson is no longer CEO of the company. We continue to see incremental evidence that CEO, Steve Easterbrook, is willing to make the difficult decision to move the business forward.
Traditionally, MCD is big organization that is slow to adapt to changes in the marketplace and is facing a slow bleed if it did not change accordingly. Thankfully, times are changing. It takes a long time to turn a company like McDonalds around, but it can be done. Steve Easterbrook’s plan is bubbling to the surface gradually, but as more details are made public the strategy is looking more like a plan to win.
NEW STRUCTURE WILL CREATE NEW ENERGY FROM WITHIN
McDonald’s new structure is focused on four segments: U.S., International Lead Markets, High Growth Markets and Foundational Markets. This new structure will eliminate some bureaucracy and allows MCD to compete harder and more efficiently in market where the company generates a majority of its operating profits.
Some of the potential benefits from the new corporate structure are:
- It will free up management, giving them time to tackle critical elements of the turnaround.
- Accelerate the time it takes to fix the fundamentals of the business.
- Raise the bar on performance and set new hurdles to enhance expectations and improve profitability.
- Improving customer experience by delivering on fundamental core strengths of Quality, Service, Cleanliness and Value.
The new structure will concentrate senior management’s time and resources on those markets that are going to deliver the most meaningful improvement to profitability and improve overall returns. The focus of the new plan will be on 14 key markets in the first three segments, which deliver more than 90% of global operating income.
The critical elements of the new structure and new mandate within the realigned operating segments will be:
- Focus on shrinking the menu.
- Enhancing core menu items.
- Creating excitement around the new menu news including on premium items.
- Allow for increased returns on each marketing dollar.
- Transformation of the customer service experience.
INITIATIVES TO IMPROVE THE U.S. SEGMENT
While it’s early in the process, operationally MCD is taking the right steps to stabilize the decline in guest counts in the U.S. On top of the increased regional focus, there are fewer layers of bureaucracy and stronger accountability. The new operational initiatives will focus on the core menu items. Today, 40% of the sales in a McDonald’s restaurant come from the core menu and the strategy will focus bringing the core business back to life.
Some of the operational improvements that will enhance the focus on the core menu items include:
- Rolling out new training programs to improve order accuracy and reduce complaints.
- Working to improve the speed of drive-thru’s (70% of sales in the U.S.).
- Testing a simplified drive-through menu board that cuts the number of items by 50% to the core menu items.
- A new value proposition this summer that's designed to drive incremental customer visits.
- Focusing on the freshness and quality of the food (sirloin burgers and artisan chicken).
- Toasting the buns for longer to deliver hotter sandwiches.
- Changing the way they grill the beefs so the patties come off juicier.
- A new and improved marketing calendar.
- Balancing the overall marketing spend at a local and national level.
- MCD will launch a mobile app in 3Q15 – Steve Easterbrook stated, “I can tell you product mix by restaurant in 30 minute increments, what I can't tell you is who we're selling it to.” Technology will help this.
- MCD is testing all-day breakfast.
- Taking on the opportunity to offer more regional favorites.
Critical to improving transaction counts in the U.S. will be shrinking the menu. An overly complex menu means you're serving fewer of a greater number of things, and over an extended period of time that equation starts to break down and hurts overall performance. What you are left with are slower-moving menu items, which means you have a lot of slower-moving SKUs which slows down transactions and creates inefficiency in the supply chain. Shrinking the menu will mean the food will taste better, reducing costs at the same time.
The most important sign that significant changes are coming to operations was Mr. Easterbrook’s comments about the growth drivers the company initiated 2010-2012. It was important for The CEO to acknowledge that the McCafe coffee beverage platform has not a long-term growth driver for the company. He said “The reality is you tend to get diminishing returns from them over time, they’re kind of just baked into your baseline, and you need new incremental growth drivers. And probably one of the criticisms we have of ourselves in the business is we didn’t see the tailing of those growth platforms early enough to start to generate the growth platforms of the future.”
Unwinding some of the McCafe complexity will lead to improved store performance.
INTERNATIONAL LEAD MARKETS
At roughly 40% of the operating profits, the International Lead Markets is an important segment for MCD. The good news is that the performance of the segment is better than that of the U.S.
- Germany is showing early signs of a turnaround as negative comparable sales trends have moderated the last two quarters.
- Implementing more targeted and integrated value strategy with Germany's value reset project.
- Enhancing the appeal of premium products with the successful launch of Bacon Clubhouse featuring locally sourced products.
- France is maintaining market share despite tough economic headwinds and weak consumer confidence.
- France is benefiting from ongoing service enhancements, with table service now offered in more than a third of French restaurants.
- 90% of the restaurants in France have self-order kiosks.
- Australia is progressing and gaining momentum.
- Canada is adding side-by-side drive-thru’s to more restaurants. By the end of 2015 approximately two-thirds of Canada will benefit from these enhancements.
- The UK remains very strong despite a growing and more aggressive competitive environment.
FINANCIALLY ACCOUNTABLE ― REFRANCHISING
Over the 3-4 years (likely sooner), McDonald’s plans to move from 81% franchise store base to about 90% franchised globally. This suggests that MCD will refranchise about 3,500 restaurants by the end of fiscal 2018. Importantly, in some international markets MCD will be exiting the entire company-operated store base, moving to a 100% franchise structure.
The business benefits to MCD are obvious, a more stable, predictable revenue and cash flow streams, and the ability to unleash certain markets to the best franchisees. What MCD will not be doing is going to a 99% franchised model. MCD will always have a strong store base that will allow the company to test new products and operating methods.
G&A CUTS & OTHER
MCD has announced that it intends to cut $300 million in costs, most of which will be realized by the end of 2017. While this is a good start there is more that the company can do to streamline operations. I suspect that the new shareholder base will be pressing the company to do more.
MCD has also announced that it expects to return $8 billion to $9 billion to shareholders in FY15 through a combination of dividends and share repurchases. As a result, by 2016 the company will have returned close to $20 billion to shareholders between 2014 and 2016.
MCD’s balance sheet is conservatively managed with a target ratio of 1.5x net debt to EBITDA. The company is currently running at 1.4x but will be higher at the end of this fiscal year given the recently announced share repurchase program. There is clearly room for the company to take on more leverage and increase shareholder value.
Global Same-Store Sales Growth has bottomed out.
The stock has underperformed on a 1, 3, and 5 years basis.
The sell-side is very bearish on MCD and rightly so.
EPS estimates are bottoming out.
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