“Time is what we want most, but what, alas, we use worst…”
-William Penn (1)
If only Penn – founder of what is now modern-day Pennsylvania – were alive today. Considered one of the most thoughtful, forward-thinking minds to ever grace planet earth, his works and writings partially serve as inspiration for the United States Constitution (via the “Frame of Government of Pennsylvania”), as well as the European Union (via his proposals to establish a European Parliament).
Surely he would be able to appropriately contextualize and navigate the many globally-interconnected risks associated with international trade and finance. One such key risk is the eventual advent of the Chinese yuan as a global reserve currency.
Back to the Global Macro Grind…
Yesterday, the IMF proposed extending the current SDR basket by nine months until September 30, 2016. This decision to delay any changes to the current composition of the basket is the direct result of member states’ lobbying efforts to avoid changes in the basket at the end of the calendar year to ensure continued smooth functioning of SDR-related operations.
While such operations are not necessarily worthy of mention, what we did find interesting is the IMF’s decision to NOT delay its review process of the current composition of the basket, which occurs every five years (with November 2010 being the most recent iteration). With respect to China – which has been intensely lobbying the IMF for inclusion of late – this means China’s date with destiny is going to come sooner rather than later. In fact, the review process is well underway and the results of these efforts will be revealed by year-end per IMF officials.
What does that process entail? According to the criteria for SDR inclusion (last updated in 2000), China must prove that the yuan plays a central role in the global economy. Secondly, the yuan has to be deemed “freely usable”, which means it is both “widely used” to make payments in international transactions and “widely traded” in principle exchange markets. It’s important to highlight that “freely usable” does not equal “freely convertible”; in fact, a currency can be widely used and widely traded even though it is subject to capital account restrictions (and vice versa).
As of today, the Chinese yuan is the only currency not currently in the SDR basket that meets the first criterion. Specifically, China’s exports of goods and services over the trailing 5Y period account for 11% of the world total, besting current SDR members Japan and the U.K. by 600bps and 610bps, respectively, and lagging the U.S. and Eurozone by 360bps and 820bps, respectively. This means determining whether or not the CNY is a “freely usable” currency will be at heart of this year’s discussion – the conclusion of which will determine whether or not the Chinese yuan will be granted reserve currency status in 2015.
Is the Chinese yuan “freely usable” as determined by the myriad of criteria the IMF focuses on in making this determination? Fortuitously for investors, there is no right answer. Real money is made by betting on the improbable becoming probable.
With respect to the previous question, on one hand, the CNY pales in comparison to the USD, EUR, JPY and GBP in terms of being “widely used” and “widely traded”. On the other hand, the rate-of-change across each of the following metrics suggests the yuan’s importance as an international currency has dramatically increased since the last SDR review and that this increasing importance should be considered a sustainable development.
The data presented below is in terms of share of global totals:
- Official Foreign Currency Assets: CNY = 1.1% in 2014, up from 0.7% in 2013. This compares to 63.7%, 21%, 4.1% and 3.4%, respectively, for the USD, EUR, GBP and JPY in 2014.
- International Banking Liabilities: CNY = 1.9% to 4.0% (depending on classification) in 2014. This compares to 52.1%, 29.7%, 5.4% and 2.8%, respectively, for the USD, EUR, GBP and JPY in 2014.
- International Debt Securities Outstanding: CNY = 0.6% in 1Q15, up from 0.1% in 1Q10. This compares to 43.1%, 38.5%, 9.6% and 2.0%, respectively, for the USD, EUR, GBP and JPY in 2014.
- Issuance of International Debt Securities: CNY = 1.4% in 2014, up from 0.1% in 2010. This compares to 42.1%, 37.1%, 11.6% and 1.8%, respectively, for the USD, EUR, GBP and JPY in 2014.
- Cross-Border Settlement: CNY = 1.0% in the four quarters ended 1Q15, up from 0.2% in the four quarters ended 1Q13. This compares to 41.6%, 36.6%, 4.3% and 3.3%, respectively, for the USD, EUR, GBP and JPY in the four quarters ended 1Q15.
- Trade Finance (Letters of Credit): CNY = 3.9% in the four quarters ended 1Q15, up from 1.9% in the four quarters ended 1Q13. This compares to 85.6%, 7.2%, 0.2% and 1.9%, respectively, for the USD, EUR, GBP and JPY in the four quarters ended 1Q15.
- Foreign Exchange Market Turnover: CNY = 1.1% in 2013 (the latest available annual data), up from 0.4% in 2010. This compares to 43.5%, 16.7%, 5.9% and 11.5%, respectively, for the USD, EUR, GBP and JPY in 2014.
This we do know: the burning desire for reserve currency status among Chinese authorities has perpetuated a dramatic increase in both the speed and scope of capital account and capital markets reform in China, including:
- Increasing the participation of foreign central banks and institutional investors in Chinese capital markets;
- Granting foreign entities greater freedom to issue yuan-denominated debt and/or raise equity capital in China;
- Granting domestic entities greater freedom to issue foreign currency-denominated debt and/or raise equity capital abroad;
- Further promoting the use of the yuan for international trade and settlement; and
- Liberalizing interest rates.
With respect to the aforementioned reforms:
- As of May, the PBoC has allowed 152 foreign institutional investors access to China’s $6.1T interbank bond market (far and away its largest and most critical), an increase of 34 entities in the YTD.
- As of 2Q14, foreign entities held a mere 1.9% of China’s general government gross debt securities, which is far and away the lowest share of foreign participation among the 24 emerging market economies tracked by the IMF and compares to a sample average of 35.3%. This compares to an even lowlier 1.1% of foreign participation in mainland equities.
- The current 870B yuan quota for China’s Renminbi Qualified Foreign Institutional Investor program (RQFII) – which allows international investors to purchase Chinese stocks and bonds with yuan raised offshore – accounts for a mere 2.9% of China’s general government gross debt outstanding and 2.1% of mainland equity market cap.
- Chinese individuals can only move a maximum of $50,000 per year out of the country, effectively limiting their investment options to cash, CNY bank deposits, domestic debt and equity securities, property and physical gold. Moreover, China’s stock of narrow and broad money is extremely significant as a share of world totals at 19.8% and 24.9%, respectively. For companies, overseas securities investment is currently capped at $300 million.
- The proportion of China’s trade that was settled in yuan has risen from 0.02% in 2009 to nearly 25% in 2014. Moreover, there are now 15 offshore clearing centers for the yuan around the world. Additionally, over 20 foreign central banks have signed currency swap agreements with the PBoC totaling about $430B.
- A key hurdle for interest rate liberalization in China was surmounted in May when the PBoC introduced a deposit insurance program that will fully cover deposits up to 500,000 CNY. This effectively shields Chinese households, on the margin, from any fallout resulting from increased competition for deposits that would naturally occur as a function of removing the deposit rate ceiling and follows efforts in 2013 to meaningfully lower the floor for lending rates. China currently has $19.7T in bank deposits.
In short, there are two primary reasons Chinese officials are so desperately seeking reserve currency status for the yuan:
- International portfolio rebalancing among institutional investors is likely to be overwhelmingly unidirectional. Specifically, the preponderance of capital will likely flow to China in lieu of other lower-yielding reserve currencies, at the margins. We discuss these dynamics in greater detail on slide 72 of our recent presentation titled, “Is Consensus Right On China?”. Such asset allocation adjustments will help offset the recent dramatic acceleration of capital outflows (read: the reversal of “hot money” flows) from the mainland, which accelerated to a record TTM sum of $510B as of June. Refer to slides 35-38 of the aforementioned presentation for more details.
- It would help China secure another major victory in its ongoing battle versus the U.S. for economic and political clout. Investors, politicians and businesspeople the world over who “know China” understand very well that Chinese officials are displeased with the current state of global affairs where the U.S. is the primary hegemonic power. Achieving reserve currency status would be the latest triumph in an increasingly impressive list of “wins” in the YTD, including securing support from key U.S. allies for the Beijing-led Asian Infrastructure Investment Bank (AIIB), as well as for the very topic we are discussing – reserve currency status. In fact, in spite of the recent spate of heavy-handed policy intervention in mainland equity markets, the IMF recently affirmed its support for the yuan’s inclusion into the SDR basket; it’s merely a matter of when, not if. Additionally, the IMF has taken an opposing stance to the U.S. Department of the Treasury by recently deeming the yuan to no longer be “undervalued”.
All told, we can’t stress enough how impactful China’s capital account reform measures will be to the global economy. While the reform drive will no doubt continue to be piecemeal and full of incremental quotas (Chinese officials credit the country’s closed capital account with shielding the mainland economy from the 1997-98 Asian Financial Crisis and the 2008-09 Global Financial Crisis), meaningful progress will be achieved sooner than many investors may assume.
Whether it happens in 2015 or 2020 (the U.S.’s vote could make or break China’s bid), achieving reserve currency status for the yuan is not the end game. Rather, it’s simply the beginning of a long-lasting series of tectonic shifts in and across the global economy and the financial markets that underpin it.
Is your portfolio appropriately positioned for these changes?
Our immediate-term Global Macro Risk Ranges are now:
UST 10yr Yield 2.16-2.29% (bearish)
SPX 2068-2119 (bearish)
VIX 11.88-15.24 (bullish)
USD 97.04-98.44 (bullish)
EUR/USD 1.08-1.10 (bearish)
YEN 123.34-124.99 (bearish)
Oil (WTI) 44.36-47.12 (bearish)
Gold 1075-1101 (bearish)
Keep your head on a swivel,
McDonald’s (MCD) is on the Hedgeye Restaurants Best Ideas list as a LONG.
Bottom line - getting more bullish as the dog days of summer press on.
Initiatives across the company are all starting to click. A few more things such as a national value message, further simplification and ADB need to be figured out but this ship is in gear and headed north. We still strongly believe that the inflection point will be Q3 and that 2015 will be the last time MCD trades below $100 per share.
Yesterday we spoke with McDonald’s to try to get a better read on how the turnaround is going. The feedback they are getting from investors are that people are feeling better about the business outside of the U.S., in markets like China as they lap the supplier issue. People are encouraged by the Europe segment, recognizing that France and Russia have had their issues. It is clear to all that the center piece of the turnaround will be dependent on the U.S. recovery. Coming out of this conversation we are confident in our 3Q15 inflection point and that the November 10th analyst meeting will have a lot of substance, and provide investors with a better road map for the USA recovery.
MCD admitted to the fact that they have given up share on the value offerings and that value is a pillar to MCD’s foundation and they need to defend their turf. They are encouraged that the franchisees’ thinking has evolved, from the beginning of the year when they didn’t want a national value platform to June where they approved national price point value. The $2.50 McDouble and small fries deal underperformed in the first few weeks, due to marketing and execution issues but those are being addressed and demand is improving. The current value promotion is an LTO and will be rolled off at the end of the summer; they are working on a longer-term national value offering.
Some local markets are providing more value; certain Florida locations are running $1.39 and $1.49 10 piece nuggets to combat Burger King. Seattle is going after dollar any size drinks. Bottom line, value is key to MCD’s success, and from what we heard they are well on their way to figuring out a long-term national solution, they are just not quite ready to share it publicly.
Yesterday, we learned that McDonald’s CEO, Steve Easterbrook, got up last week in front of U.S. owner and operators, urging them to basically get their act together. Saying that we restructured our entire business in less than two months but you guys cannot agree on and approve a national marketing message over the same time period.
Traditionally, McDonald’s has existed as a culture of consensus building, and that everyone needs a voice, Steve is moving away from this process and wants things done faster. The new CEO is pushing people across the organization to move with more speed and urgency. We are very encouraged by what we are hearing and believe that MCD has the right CEO in place to succeed.
THE REORGANIZATION IS CRITICAL
The reorganization of the business is going to provide a great benefit, aligning the business by like markets versus geography was a big change. By doing this, management created greater focus on the most important regions. For instance, Doug Goare, President of International Lead Markets used to be the President of Europe in which he ran 40 markets and managed roughly 100 people. Now he oversees five markets and has about three to four people supporting him. This is a big change to the business model, but now he is no longer distracted by less important markets, his time is freed up to focus on what is important to the company.
McDonald’s management isn’t settling for just $300mm in savings, they are trying to find efficiencies in the way they operate that is not customer facing, trying to minimize the impact to customers. As we called out in our MCD Black Book, we expected them to look beyond the $300mm, and they are doing exactly that which is promising to hear. We expect we will hear more about this at the November 10th analyst meeting.
THE SILVER BULLET - ALL DAY BREAKFAST (ADB)
Tests in San Francisco are encouraging and they are expanding tests to biscuit and muffin markets (mainly across the south), as they would have to offer one or the other. Obviously ADB will add greater complexity, and Steve’s goal is to have net reduction in complexity, so teams are working on different kitchen configurations to reduce the complexity. At the end of the day operators will be the ones to determine if they will move forward with ADB, but ADB continues to be the number one requested item by customers. We recently took a survey on whether people would go to MCD more often if they could get breakfast for lunch. The results were good, 33.3% of people said they would go more often, ADB looks to be the silver bullet and could catapult MCD to growth, but we don’t view it as a necessity.
PLAN FOR NOVEMBER 10TH MEETING
Management is viewing this meeting as an opportunity to provide an update on the turnaround plan, what 2016 will look like, as well as financial areas of opportunity. Additionally, a logical person would probably think that they will cover longer term growth opportunities, as they have done in the past.
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Takeaway: The formal announcement of the Wells Fargo deal gets us half way to our $1.3 trillion AUC opportunity and our $55 per share fair value.
The company announced it has formally struck a deal to distribute its retirement services through Well Fargo
2Q15 results over night were in line across the board with unchanged revenue and EBITDA guidance for the rest of the year
Fee realization rates were stable pacifying the long term contention of the Bears who fear substantial pricing declines
The setup in the stock is still asymmetrical to the upside with 25% of the float short and 40 days to cover
FNGN remains on our Best Ideas list as a Long position with a fair value of $55 per share
Financial Engines (FNGN) formalized the announcement of Wells Fargo providing their independent advisory services in their 2Q15 earnings presentation last night. While the deal had been speculated by a news outlet during the course of the quarter, the formal announcement adds a solid fundamental catalyst guided to come on stream by the "middle of 2016." It is likely however that with the formal disclosure of the deal out of the way, that FNGN sales and distribution teams are already approaching the underlying plan sponsors within the Wells network and incremental assets-under-management/contract can start to bleed into the firm's numbers (after operational testing). According to the most recent Cerruli retirement survey, assets under administration at Wells currently stand at $168 billion (this counts only 401K plans over $100 million). This would be +16% on the firm's current assets-under-contract of $1.04 trillion. Thinking about a 2 year conversion rate at 13.3% of future assets-under-contract to assets-under-management (at the firm's current realization rate and net margins), put the Wells opportunity at $0.11 in earnings per share. The firm's TTM EPS is currently $0.93, putting the full potential at +11% accretion.
The quarterly print was otherwise in line with the firm hitting adjusted earnings per share estimates and maintaining its top line and EBITDA guidance on an operational basis. The firm's slightly adjusted its top line and EBITDA guidance on an annual basis by $1 million lower (not really worth talking about) solely due to lower average market levels between the 1Q to 2Q print. Annual top line guidance is now $314-320 million from $315-321 million prior with EBITDA guidance settling at $96-100 million from $97-101 million prior. What was encouraging in the quarter, was that absolute new assets from new enrollment during 2Q again reached record levels at $6.5 billion. While a growing base of assets-under-contract assists this production, the conversion rate of AUC to AUM over a 26 month period also ticked up to 13.3% from 13.0% in 1Q15.
Decomposition of the firm's net AUM additions versus subtractions displayed another high in quarterly net enrollments at $6.5 billion (chart below is in $MM):
The 26 month enrollment rate from AUC to AUM also matched a new high at 13.3%
While external realization rate calculations (fee rates) are not that accurate, with AUM and AUC blending into the financials at different times outside of the GAAP reporting periods, investor fears of substantial fee degradation are not justified. Our calculation of the firm's quarterly realization rate remained at 28 basis point for the quarter, in line with 1Q levels and down just 1 basis point year-over-year. Generally, most bearish views on the stock have pricing assumptions declining rapidly into the mid teens which just simply isn't happening yet. We are comfortable that we have put forth a reasonable out year estimate with realization rates on AUM at 25 basis points (assuming some reasonable pricing declines).
The market internals for the stock are still way too bearish and with over 25% of the float short, we continue to see asymmetric upside. Historically, the 20% short interest level has been the buy signal in FNGN stock, which has remained the case throughout the course of this year. In addition, with trading volume having dried up over the past 90 days, the days to cover has now doubled this year to 40.2 days.
FNGN stock continues on our Best Ideas list as a Long position with fair value at $55 per share. We are valuing shares on an assets-under-contract opportunity of $1.3 trillion. With the new Wells announcement already getting us half way there, and the ongoing overly bearish market structure of the stock, we continue to see upside.
Jonathan Casteleyn, CFA, CMT
Joshua Steiner, CFA
Wendy’s (WEN) was added to our SHORT bench as a result of our LONG thesis on McDonald’s. We still believe that it might be adversely affected by the resurgence of McDonald’s, but it’s not time to go SHORT on WEN yet.
Yesterday, WEN reported 2Q15 results, for the most part outperforming consensus, but as management put it, has room to improve on their value offering. The company-owned comp was +2.4% versus consensus of +1.7%, a 150bps decline YoY. This quarter was their toughest comp of the year at +3.9%, comps get easier in the 2H of the year. Total company revenue of $489.5mm beat consensus of $486.3mm, representing a decrease of -6.5% due to refranchising efforts. Company-owned restaurant level margins increased 40bps to 18.2%, beating estimates of 18.1%. Adjusted EPS came in at $0.08 below consensus of $0.09, representing an -11% decline YoY.
Reimaged stores are having a strong impact, seeing 10-15% sales increases post completion, with 40-50% of that flowing through. Newly remodeled stores drove 170bps of the system-wide same-restaurant sales growth of 2.2%, which was above estimates of 1.6%. Management stated they are continuing to see strong results from core menu items and LTO’s. Recently introduced a refurbished chicken sandwich featuring new marinade and antibiotic free chicken, in certain test markets and hoping they can bring it system-wide. The company is notably having difficulties with price and value on some items, and working to fix it with value bundles in the $4-$6 check range.
The company continues to invest in technology to improve customer interaction. They view Mobile Order & Pay and Self-Order Kiosks as a great ways to offset wage inflation, as well as improve the quality of the food and experience for the customer. Just staying on the wage topic for a moment, management was adamant that they do not, and their franchisees do not intend to pass a majority of this increase onto customers in the form of pricing. They will work on reducing staff, reducing hours, in general getting smarter around labor management. Management went as far as to say, “these wage increase will in the end hurt the very people they are intended to help.”
The hot topic in restaurants, the REIT was broached in this call, but largely pushed to the side by management. By 2017 they anticipate receiving $170mm a year in rental revenue, which is a strong dependent revenue stream they don’t want to get rid of.
WEN increased their outlook for 2015 adjusted EBITDA to $385mm to $390mm from its prior guidance of $375mm to $390mm, representing an 8% to 9% increase compared to 2014. The company also increased their outlook for restaurant operating margins by 50bps to 17% to 17.5%. EPS estimates remained constant at $0.31 to $0.33. The planned sale of 540 domestic company-operated restaurants is on schedule, and expected to provide $400mm-$475mm in pre-tax proceeds. Additionally, the company entered into an accelerated share repurchases transaction for approximately $165mm as part of a previously approved share repurchase authorization.
We continue to think that looking out 1-3 quarters WEN sales will start to take a hit from the resurgence of McDonald’s. Until that happens this company will perform in line with expectations, comping at the 2.0% to 2.5% range. When MCD starts taking share, WEN will not be immune, it seems like the first company to get value right will win this race, our bet is on MCD.
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