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SHORT SMALL-CAP BURGER CHAINS | QUICK SERVICE CAN’T AFFORD $15 MINIMUM WAGE

We remain SHORT small-cap hamburger chains SONC, WEN and JACK.  Expectations (and valuations) for those companies are not aligned with reality.  SONC gave us a look at what happens to high-expectation stocks with even a slight miss and guidance that suggest 2-year sales trends will slow significantly. (Click HERE for our recent note on SONC)

 

Part of our LONG thesis on MCD, includes that the company will not be ceding anymore market share, especially with the “value” based customer.  It’s our belief that all three domestic chains have benefited from MCD being a poorly managed company.

 

We specifically did not mention Restaurant Brands International (QSR) on this list because of the global nature of the Burger King business and the strong Tim Hortons brand.  That being said the Burger King’s business in the U.S. will also be negatively impacted by a stronger McDonald’s.  We also see the Burger King system having a very difficult time adjusting to higher minimum wage.  The combination of low average unit volumes, excessive discounting and significantly higher debt levels at the franchisee level are all significant impediments to future profitability.

 

We are now adding QSR to the short bench, with an eye on taking it to the next level.

 

SHORT SMALL-CAP BURGER CHAINS | QUICK SERVICE CAN’T AFFORD $15 MINIMUM WAGE  - CHART 1 15 min

 

WHAT $15 MINIMUM WAGE MEANS FOR QUICK SERVICE RESTAURANTS

The move to $15 minimum wage will be a crushing blow to small independent Quick Service Restaurant (from this point forward, QSR will pertain to Quick Service Restaurant) operators and will be a negative for “asset light” franchisor stocks.

 

This note is not a political statement about what a “fair wage” is, it’s just math.  And math is simple.  To be blunt, without major structural changes, most small independent QSR operators will go bankrupt at $15 minimum wage.  To avoid bankruptcy, the options are limited.  Operators can raise prices and risk a decline in traffic and or the more likely scenario is to cut labor too drastically to maintain profitability.

 

The bottom line is that the QSR industry already operates on low margins and can’t afford to see labor costs increase by 50% or more. 

 

As the CEO of CKE Restaurant, Andy Puzder's, says “if you increase wages in such a ‘draconian fashion,’ it takes away from the ability of businesses to absorb the increase in pricing and forces them to use labor more efficiently or resort to automation, resulting in the loss of jobs.”

 

You can read Mr. Puzder’s WSJ op-ed piece HERE

 

In the table below we run thru a hypothetical (but close to reality) scenario analysis of a typical QSR restaurant doing average unit volumes of $1.2 million, $1.4 million and $1.6 million.  As you can see in the table on the left, the industry already operates under very thin margins.

 

On the right side of the slide, is the impact on profitability of taking minimum wage up to $15 per hour.  What this analysis does not contemplate is the Andy Puzder scenario of pricing a significant reduction in the number of jobs and the impact of new technology (automation) on profitability.

 

SHORT SMALL-CAP BURGER CHAINS | QUICK SERVICE CAN’T AFFORD $15 MINIMUM WAGE  - CHART 2 15 min

 

We did a separate analysis for MCD since it has average unit volumes significantly higher than other competitors.  Even MCD is not immune from a significant decline in profitability and franchisees only cover the royalties by a modest amount.

 

SHORT SMALL-CAP BURGER CHAINS | QUICK SERVICE CAN’T AFFORD $15 MINIMUM WAGE  - CHART 3 15 min

 

While this is devastating personally for crew workers and franchisees, the franchisors are not immune to the impact.  Given significantly higher labor costs, a store averaging $1.4 million would need to increase volumes by 55% to $2.175MM in order to return the labor margin back to where it started.  Since this is impossible to do, operators will be required to seek alternative strategies to run the restaurant. 

 

As we see it the impact is twofold.  First, marginally profitable stores will be closed, and second, even the profitable stores will not be able to pay the required royalties.

 

Bottom line, at $15 minimum wage, the TAIL thesis for being short the high multiple, highly leveraged, “asset light” darling restaurant stock becomes very clear.  First, the recurring cash flows (royalty payments) begin to dry up.  Then, over time massive leverage on the balance sheet of these companies becomes the noose around the neck and they will probably have to deal with franchisees going bankrupt. If $15 minimum wage becomes a reality, the descent is just beginning for these stocks, and it will be an ugly landing.

   

Please call or e-mail with any questions.

 

Howard Penney

Managing Director

 

Shayne Laidlaw

Analyst

 

 


REPLAY | Railroad Black Book @ 1PM

watch thE replay below

 

 

OVERVIEW

 

There have only been a few buying opportunities for Class 1 Railroad shares over the last decade, and we think the current sell-off will be another.  Rails have underperformed significantly since late 2014, with Norfolk Southern giving back nearly a decade of relative outperformance.

 

 

HIGHLIGHTS

  • A Long View of The US Railroad Industry:  Does industry performance have room for further gains?
  • Mistaken for Commodity Plays:  Volumes just haven’t grown commodity-wise in the past decade, and correlations with CRB are negative.  
  • Speed:  Rail speeds got clobbered last year.  Slower speeds pull costs onto the rails and slow revenue generation.  Rails are speeding up now, and that cost/revenue should come back out.
  • Valuation:  Reasonable range DCF, between different railroads and relative to historical metrics 

Builder Confidence | Boom Goes the Dynamite

Takeaway: Builder confidence in September records a new post-crisis high of 62, but remains well below the prior cycle highs of 71, 78 and 72.

Our Hedgeye Housing Compendium table (below) aspires to present the state of the housing market in a visually-friendly format that takes about 30 seconds to consume.

 

Builder Confidence | Boom Goes the Dynamite - Compendium 091615

 

Today's Focus: September NAHB HMI (Builder Confidence Survey) & Mortgage Apps

 

Builder Confidence:  New Highs | Builder Confidence made another post-crisis high in September with the HMI rising +1pt to 62, marking the strongest reading since October 2005. 

 

Across the Sub-indices, 6M Expectations dipped -2 pts sequentially while Current Sales and Current Traffic both rose +2pts.  Geographically,  builder optimism in the West was flat MoM while the South, Midwest and Northeast all recorded gains sequentially. 

 

Builder vs Consumer Confidence: Given the low base of new construction activity, continued low rates, ongoing labor market improvement and the steady gains observed across Pending, Existing and New Homes sales YTD, the sustained build of positive sentiment is not particularly surprising.  Under the hood, the decline in 6M Expectations in September accords with the steep drop observed across the same category in the University of Michigan’s preliminary September reading (see confidence table below) although the headline HMI doesn’t appear to be impacted by the global turmoil and equity market correction that seemingly weighed on the broader measure of consumer confidence.   

 

The divergence is interesting given the tendency for builder confidence to lead both Consumer Confidence and broader macro inflections over recent cycles.   Any emergent bifurcation between the two confidence measures could also be reflecting the divergent short-to-medium term paths being tread by housing and the larger economic cycle.  As we’ve highlighted (see: Resi Construction & the Cycle), while we’re late or mid-late cycle more broadly, we’re probably somewhere closer to early-mid or mid cycle in housing itself given the significantly lagged recovery in the sector.  

 

With respect to NAHB commentary around the September data: 

 

NAHB Chairman Tom Woods commented: 

"The HMI shows that single-family housing is making solid progress ….However, our members continue to tell us that they are concerned about the availability of lots and labor.”

 

NAHB Chief Economist David Crowe added

"NAHB is projecting about 1.1 million total housing starts this year ..Today's report is consistent with our forecast, and barring any unexpected jolts, we expect housing to keep moving forward at a steady, modest rate through the end of the year.”

 

 

Purchase Applications: Mostly Noise | Purchase application demand fell -4.2% in the latest week while decelerating to +15.9% YoY.  Given that it was a holiday shortened week and the holiday was shifted relative to last year, the noise level in this week’s data is substantial.  The prevailing read-though on the trend in the data remains largely unchanged, however.  Purchase demand remains lower by ~1% QoQ in 3Q while reported year-over-year growth remains (& should remain) solid as compares remain easy through the balance of 2H.   

 

Monetary policy and the flow through impact to rates will likely remain the largest externality for housing in the nearer-term.  Beyond any nearer-term volatility associated with the attempt at policy normalization, our macro call on both growth and inflation remains slower-and-lower-for-longer and would view a flattening of the curve and flat-to-lower long-term rates as an increasingly likely by-product of a sustained attempt at tightening.   

 

(h/t to Brian Collins for today's note title inspiration)

 

Builder Confidence | Boom Goes the Dynamite - NAHB LT

 

Builder Confidence | Boom Goes the Dynamite - Confidence table

 

Builder Confidence | Boom Goes the Dynamite - NAHB Indicators

 

Builder Confidence | Boom Goes the Dynamite - NAHB Regional

 

Builder Confidence | Boom Goes the Dynamite - Builder vs Cons Conf

 

Builder Confidence | Boom Goes the Dynamite - Purchase   Refi YoY

 

Builder Confidence | Boom Goes the Dynamite - Purchase 2013v14v15

 

Builder Confidence | Boom Goes the Dynamite - Purchase Index   YoY qtrly

 

Builder Confidence | Boom Goes the Dynamite - Purchase LT

 

Builder Confidence | Boom Goes the Dynamite - 30Y FRM

 

 

About the NAHB HMI:

The Housing Market Index (HMI) is based on a monthly survey of NAHB members designed to take the pulse of the single-family housing market. The monthly survey has been conducted for 30 years. The survey asks respondents to rate market conditions for the sale of new homes at the present time and in the next 6 months as well as the traffic of prospective buyers of new homes. The HMI is a weighted average of separate diffusion indices for these three key single-family series. The HMI can range from 0 to 100, where a value over 50 implies conditions are, on average, improving, a value below 50 implies conditions are worsening, and an index value of 50 indicates that the housing market is neither improving nor worsening.

 

About MBA Mortgage Applications:

The Mortgage Bankers’ Association’s mortgage applications index covers more than 75% of mortgage applications originated through retail and consumer direct channels. It does not include loans delivered through wholesale broker and correspondent channels. The MBA mortgage purchase applications index is considered a leading indicator of single-family home sales and construction. Moreover, it is the only housing index that is released on a weekly basis. 

 

Frequency:

The MBA Purchase Apps index is released every Wednesday morning at 7 am EST.

 

 

Joshua Steiner, CFA

 

Christian B. Drake

 


Attention Students...

Get The Macro Show and the Early Look now for only $29.95/month – a savings of 57% – with the Hedgeye Student Discount! In addition to those daily macro insights, you'll receive exclusive content tailor-made to augment what you learn in the classroom. Must be a current college or university student to qualify.

Why Housing May Be Set To Outperform The Broader Market

 

In today’s edition of The Macro Show, Hedgeye analysts Christian Drake and Josh Steiner discussed our (contrarian) call that while the broader U.S. economy is in a late-cycle slowdown, housing remains early to mid-cycle and why we expect the housing sector to be a major relative outperformer vs. the rest of the market.

 

Subscribe to The Macro Show today for access to this and all other episodes. 

 

Subscribe to Hedgeye on YouTube for all of our free video content.


We're Keeping Our Exposure Low

After six tries in as many months, the UST 2YR yield ripped through 0.75% resistance to 0.82%.

 

What does it mean?

 

Moreover, what did it mean when it ripped to this same level in October 2011 (see chart below), before crashing to 0.16%? Looked like a big asset allocation move to me.

 

German and Swiss 10s are at their 1-month highs as well.

 

We're keeping our exposure low heading into this very risky Fed event day. Reacting at extremes? It has not worked.

 

We're Keeping Our Exposure Low - z sod

 

**If you like what you see here, we're 99.98% certain that we have an investing product that will suit (and surpass) your needs. Click here to learn more.


CHART OF THE DAY: Confused? Stick With What You Know

Editor's Note: The chart and brief excerpt below are from today's Early Look written by Hedgeye CEO Keith McCullough. For more information on how you can subscribe click here.

 

CHART OF THE DAY: Confused? Stick With What You Know - z zod 09.16.15 chart

 

...And, while I can assure you that I’m more confused today than I was on Friday (in terms of how this all plays out in the very immediate-term), I’m still as confident as I can be in both the gift of life and staying true to our process.


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