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DFRG | WORKING THRU THE STAGES OF GRIEF | GOING LONG

This call is likely going to be six months early, but now is the time to go LONG DFRG.

 

The LONG DFRG thesis is centered on management doing the right thing.  Management needs to right size the company with significant changes to its growth/operating strategy that will significantly improve profitability.  This will take time but it’s a critical step to building a stronger company.

 

The plan that the DFRG management team needs to execute has been done many times before by some of the industry’s largest and most successful companies.  The following is our theory about the operational cycle that many companies in the restaurant industry tend to go through. Typically, when a concept gets in trouble, the management team’s decision-making process has followed a certain pattern.  A company’s stock becomes a buy when the cycle is complete.

 

THE SYMPTOM - OVERCONFIDENCE AND IRRATIONAL EXPECTATIONS— A concept loses its operational integrity when unit growth exceeds the company’s capacity to manage that growth.  Also, a concept can lose its value proposition when management raises prices too aggressively or lowers the quality of the food, leading to a decline in customer counts.

 

Most management teams are unwilling to acknowledge the issues and try to grow through the mistakes, which usually make the issues more difficult and costly to fix.  The grieving process looks something like this:

 

STAGE 1 – SETTING THE GROUND WORK — In an effort to meet aggressive unit growth targets, management makes bad real estate decisions.  Management knows from the beginning that any given sight is questionable, but opens it regardless.  From the store opening, it takes about 6-12 months (depending on the size of the company) for the street to see it in the numbers.  For more mature companies, that raise prices aggressively, it is a two years process before consumers catch on and begin to frequent the concept less often. Traffic begins to decline and management usually begins to blame the weather or another external event.

 

At this stage the best SHORT stories are created!

 

STAGE 2 – THE DENIAL — Depending on the situation, denial can take many forms.  Unfortunately, bad real estate site selection is hard to explain away, but it usually comes in the form of lack of brand awareness.  In an effort to avoid the inevitable and appease the street, management begins to accelerate growth through the form of new unit acceleration in core markets.  More mature companies will look to the acquisition of new brands as a way of maintaining a growth story.  Unfortunately, the core business continues to deteriorate alongside a decline in ROIIC (return on incremental invested capital).

 

STAGE 3 – THE PANIC — As the numbers become self-evident, the fast money crowd begins to circle, pushing management to disclose more details.  In the beginning, the sell-side takes it easy on management, allowing for any initial strategy to play out.  Depending on how bad things look, management talks about a number of changes to operations and may respond by slowing new unit growth, although often not by enough. The core business continues to decline, as senior management begins to replace the operating team. Simultaneously, management concludes that the advertising agency is not creative enough and the search for a new agency begins.

 

STAGE 4 – DEPRESSION — Now it really gets ugly.  At this point one of two things can happen.  First, management can reduce labor at underperforming units to improve profitability, or second, management sacrifices margins to increase customer counts by implementing a deep discounting strategy. It then becomes clear that major changes need to be made across the enterprise.

 

STAGE 5 – THE UPWARD TURN AND HOPE — Management decides to close stores, stop growth and or stops discounting to improve profitability.  The next move is to attack the middle of the P&L to improve profitability.

 

At this stage the stock becomes washed out and the sell-side has abandoned the company.  It also becomes very hard for the buy-side to pull the trigger and buy the stock.  At this stage I like to go LONG! 

 

Having acknowledged the need to close stores and slow the growth rate of The Grille, we view DFRG as emerging from depression.  To that end, DFRG has announced the first steps to improving the broken company:

 

  1. Closing unprofitable stores
  2. Slowing unit growth
  3. Increase focus on existing assets

 

What we are missing from the DFRG story are the details behind what level of profitability (the improvement in EBITDA) will be coming from the store closings.  Despite management acknowledging the issues, the stock has been beaten to a pulp, down ~30% over the last three months. We are starting to feel that at 6x EV / NTM EBITDA all the bad news has been priced into the name.

 

Unfortunately, the company’s strongest brand, The Double Eagle, is seeing slowing sales trends due to market volatility and the associated decline in banquet business. As for the changes within their control, this is exactly what we want them to be doing, and we believe that they will get the Grille concept running smoothly.

 

From a sum-of-the-parts analysis the stock is significantly undervalued (see table below) as it probably should be given the current fundamentals.  That being said, six months from now, hope will turn into optimism and the stock will be a lot higher!

 

DFRG | WORKING THRU THE STAGES OF GRIEF | GOING LONG - CHART 1 SOTP

DFRG | WORKING THRU THE STAGES OF GRIEF | GOING LONG - CHART 2

DFRG | WORKING THRU THE STAGES OF GRIEF | GOING LONG - CHART 3

DFRG | WORKING THRU THE STAGES OF GRIEF | GOING LONG - CHART 4

 

Please call or e-mail with any questions.

 

Howard Penney

Managing Director

 

Shayne Laidlaw

Analyst

 


P: Fool's Gold (Web IV)

Takeaway: The Register partially ruled in favor P. All this means is that P hasn't drowned yet; it's just treading water in the middle of the ocean.

KEY POINTS

  1. Fool's Gold: The Register ruled in favor of P regarding whether the Merlin deal is admissible.  But this is not a preliminary victory for P.  All this means is that the P-Merlin deal isn't getting thrown out, not the Register is endorsing the agreement.  That decision now falls back to the CRB judges to rule on the probative value of the P-Merlin deal as a benchmark.  The other ruling that came from the Register is that the judges are allowed to consider the Pureplay Agreement as evidence to determine its impact on existing market agreements.  In summary, the Merlin agreement is in, but will be tested for statutory influence. 
  2. P May Have Already Lost: The fact that the CRB judges were compelled to ask the Register whether it should throw out P-Merlin to begin with suggests that the judges already have reservations about the probative value of the P-Merlin deal as a valid benchmark.  Note that P conceded multiple times in its Response to the judges questions that P-Merlin was influenced by the Pureplay agreement, which it is also called the "prevailing statutory rate” that it was able to achieve a "discount off" of.  All the judges in every Webcaster proceeding leading into this one were clear that the willing buyer/seller standard is to assume no statutory influence (including the Web III Remand, which are the same judges presiding over Web IV).   

 

We will be hosting a two-part event this Thursday to discuss both the bull and bear cases regarding Web IV.

  1. P: Webcaster IV = Powder Keg (12pm EDT) – Our bearish thesis discussing the implications of the Web IV outcome on P’s business model.
  2. Speaker Series: David Oxenford, Counsel to Webcasting Companies (2pm EDT) – Fire-Side Chat on the relevant Web IV statutes and the Services' arguments.

 

In the interim, let us know if you have any questions or would like to discuss further.

 

Hesham Shaaban, CFA


@HedgeyeInternet 


McCullough: DAX Support Is ‘Gone. Shot. Dead.’

 

The German stock market (DAX) crash was a hot topic on The Macro Show earlier this morning. Here’s a brief excerpt of Hedgeye CEO Keith McCullough weighing in with some of his latest thoughts.

 

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

 

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EHS | Predictable Surprises & Delicate Balances

Takeaway: EHS took an unsurprising step back in August, but supply remains tight and 1st time buyers are slowly returning to the market.

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. 

 

EHS | Predictable Surprises & Delicate Balances - Compendium 092115 

 

Today's Focus: August Existing Home Sales

EHS | AS EXPECTED:  EHS declined -4.8% sequentially in August, the first decline in four months and largest since January.  While the magnitude of decline was a bit steep (the month-to-month numbers are noisy) the decline was not unexpected.  Relative softness in PHS in both June and July along with flat-to-down trends in Purchase Applications have signaled a soft existing number for over a month.  Interestingly, unless we get a sizeable negative revision or notable decline in Pending Sales for August (data due out next Monday, 9/28), the setup for EHS reverses with the risk shifting to the upside for Sept/Oct (see 1st chart below). 

 

Inventory & Price:  Units of inventory rose +1.3% MoM in August to 2.29 mm and with sales declining, inventory on a month-supply basis rose to 5.18 months – representing the 1st month in three above 5-mo but holding below the traditional balanced market level of 6-mo for a 36th consecutive month.  Ongoing supply tightness in the 90% of the market that is EHS remains supportive of improving HPI trends and the acceleration in price growth observed across the CoreLogic and FHFA price series in recent months.  Again, improving 2nd derivative trends in HPI augurs positively for housing related equities given the strong contemporaneous relationship between the two. 

 

1st-time buyers:  First-time buyers rose to 32% of the market in August, up from 28% in July and equal to the 3-year highs recorded May.  The share gain in August was a function of a decline in both cash and investor sales, a modest retreat in non-1st time conventional buyers and accelerating demand within the cohort itself.  Sales to 1st-time buyers rose +8.8% MoM and accelerated to +17.2% YoY (vs +6.3% prior).  So long as the labor/income fundamentals continue to improve across the 20-35YOA demographic, rising headship rates and single-family purchase demand should manifest on a moderate lag.   Mean reversion back to 40% market share remains the primary catalyst for taking EHS back over the 6.0 mm mark. 

 

Supply Redux:  A Delicate Balance

Because closed sales activity is well-telegraphed by prior month PHS, the inventory data sit as the primary figures of import in the EHS release and the lone (official) real-time read on the supply side of the existing market. 

 

Supply, Demand, and Price remain in a delicate three way dance towards normalization and, from an inventory-centric perspective, there are a number of leading factors posited as underpinning the supply stagnation in housing. 

 

Each are valid to some greater or lesser extent and their collective influence will continue to anchor the inventory environment in the existing market over the medium-term.  We summarily review each, in turn, below.   

 

  • Low Rates:  Low rates locked in during the post-crisis period remain a disincentive to selling/moving and an inertial headwind to rising inventory.
  • Demographics:  Top heavy demographics with Boomers (which are a significant % of the homeownership base) entering the peri-retirement period will weigh on housing turnover broadly.  Aging in place remains an emergent trend and moving-out will not become an outsized driver of supply for another decade when the Boomer bulge starts moving beyond 80 YOA. 
  • Equity:  If Boomers are dragging on inventory and Millennial demand is just beginning to percolate,  what’s left?  Mostly Gen X’ers.  Those aged ~35-50 represent a significant source of potential supply in the form of trade-up buying.  A meaningful percentage in this group, however,  remain in negative or near-negative equity positions, serving as weight to both entry level supply and mid/upper market demand. 

 

Rising prices are likely to spur supply as negative and near-negative equity positions turn increasingly positive and capacity for trade-up purchases improves.  Rising prices, however, can constrain affordability for new buyers and for 1st time buyers specifically – with the latter representing the lower rung in housing’s ladder and the primary liquidity source for trade-up buyers.  

 

The dynamics underpinning the supply environment are many-fold with the path to market balance a delicate one to tread.  Realistically, the least disruptive path to balance on the supply side – without a cratering in demand – probably, and simply, remains time.  Measured HPI alongside ongoing recovery in household incomes would provide for further emergence of 1st-time buyer demand in conjunction with crawling improvement in housing equity positions for prime trade-up buyers. 

 

 

EHS | Predictable Surprises & Delicate Balances - EHS vs PHS

 

EHS | Predictable Surprises & Delicate Balances - EHS Mo Supply

 

EHS | Predictable Surprises & Delicate Balances - 1st time buyer sales

 

EHS | Predictable Surprises & Delicate Balances - EHS Units   YoY

 

EHS | Predictable Surprises & Delicate Balances - EHS HPI regional YoY

 

EHS | Predictable Surprises & Delicate Balances - EHS Inventory Units

 

EHS | Predictable Surprises & Delicate Balances - EHS regional YoY

 

 

 

About Existing Home Sales:

The National Association of Realtors’ Existing Home Sales index measures the number of closed resales of homes, townhomes, condominiums, and co-ops. Existing home sales do not take into account the sale of newly constructed homes. Existing home sales account for 85-95% of all home sales (new home sales account for the remainder). Therefore, increases in existing home sales tend to signify increasing consumer confidence in the market. Additionally, Existing Home Sales is a lagging series, as it measures the closing of homes that were pending home sales between 1 and 2 months earlier.

 

Frequency:

The NAR’s Existing Home Sales index is published between the 20th and the 22nd of each month. The index covers data from the prior month.

 

 

  

Joshua Steiner, CFA

 

Christian B. Drake


Retail Callouts (9/21): Holiday Margin Pressure - Wages & Free Shipping

Takeaway: KSS is most at risk as holiday hiring heats up, and holiday shipping standard is likely to be FREE.

Holiday Margin Pressure - Wages & Free Shipping, KSS Most At Risk

 

M, TGT, WMT, and KSS announced hiring plans for the Holiday selling season over the past week and everyone with the exception of KSS announced flat to down seasonal hiring plans. That makes sense given that employees are now at the $9.00 minimum wage hurdle.

 

We think this year's Holiday period will be extremely competitive. And not for the typical reasons like promotions. Our analysis suggests that KSS is most at risk to the wage pressure dynamics due to its low pay for entry level positions relative to competitors (according to GlassDoor it paid 4% and 8% below TGT and WMT, before the announced wage increases). Consider the following...

Retail Callouts (9/21): Holiday Margin Pressure - Wages & Free Shipping - 9 21 chart1

 

1) The current unemployment rate at 5.1% is down 100bps from the same time last year. At the same time two of the three biggest employers in the sector (WMT & TGT) took up the minimum starting salary to $9.00 and more have followed suit. To us that means that a) demand is higher for a more scarce resource and b) the price to acquire those employees just got more expensive. Neither is a positive for SG&A.

2) We’ve already heard that UPS and FDX are having trouble staffing for the Holiday surge. That will make it more difficult for retailers to stock online fulfillment centers (or at least more expensive). WMT and TGT may be safe because the base rate is 20% and 40% higher respectively  already. But for KSS and M who are preparing for the holiday surge it will cause some headaches that we don't think have been addressed yet.

Retail Callouts (9/21): Holiday Margin Pressure - Wages & Free Shipping - 9 21 chart2

 

3) The other big issue is ‘free shipping’. Target went ‘free shipping’ last holiday, and earlier this year cut its free shipping threshold in half to $25. We suspect that it will go Free again this holiday, and we would not be surprised in the least to see several other retailers use this as an offensive weapon. Unfortunately, for almost everybody except the bullet-proof content-owners of the world (i.e. Nike) such a move will be dilutive to margins. Even worse news is that if they don’t play ball, then there’s risk to the top line (i.e. if either KSS or JCP opts-in to the free-shipping game, they both lose). We still think that by the end of FY16, all of retail will be 100% Free Shipping, 100% of the Time. 

 

M - Macy's plans to hire 85,000 employees for holiday season, down from 86,000 last year.  12,000 of the employees will be for DTC fulfillment centers.

(http://investors.macysinc.com/phoenix.zhtml?c=84477&p=irol-newsArticle&ID=2089116)

 

M - Macy's unveils millennial floor in Herald square store called One Below.  The floor "blends technology with fashion and food" and is meant to attract the millennial customer, a goal of Macy's since 2012.

(http://wwd.com/retail-news/department-stores/macys-millennial-floor-herald-square-one-below-10231538/)

 

Reuters reporting that Petco is exploring a merger with PetSmart.  Petco filed for IPO last month looking for a valuation of $5bn-$6bn.

(http://www.reuters.com/article/2015/09/18/us-petco-m-a-petsmart-idUSKCN0RI23A20150918)

 

HD - Home Depot opening a third e-commerce fulfillment center, located in Troy, Ohio.  Center will employ 500 workers.

(http://www.chainstoreage.com/article/home-depot-builds-physical-omnichannel-infrastructure)

 

Ikea is building a new Seattle store of 406,000 sqft to replace the current 398,000 sqft store built in 1979.  New Store to open spring 2017.

(http://www.chainstoreage.com/article/ikea-going-bigger-seattle)

 

New balance opened up its new 250,000 sqft headquarters in Boston Landing development, with last group of its total 708 employees moving in last week.  New Balance outgrew its old HQ, which was about 100 yards away.

(http://footwearnews.com/2015/focus/athletic-outdoor/new-balance-boston-headquarters-bruins-151824/)

 

TGT - Target CEO Brian Cornell is joining Board of Yum

(http://wwd.com/business-news/human-resources/brian-cornell-on-yum-brands-board-10231505/)


Fund Flows | The Best Offense is a Good Defense

Takeaway: Widespread withdrawals in the 5 days ending September 9th erased last week's inflow into equity funds with stock ETFs also losing.

This note was originally published September 17, 2015. If you would like more information on how you can subscribe to our institutional research please email sales@hedgeye.com.

Investment Company Institute Mutual Fund Data and ETF Money Flow:

China's downward revised GDP and consternation over the upcoming FOMC meeting contributed to defensive reallocations in the 5-day period ending September 9th. Investors allocated +$3.3 billion to fixed income ETFs while withdrawing funds from all other asset classes. The spread between total fixed income products and total equity products was highly defensive with an $18.7 billion skew to fixed income, well below the average +$1.6 billion 52-week average benefiting equities. In specific ETF callouts, the S&P 500 SPDR SPY lost -$10.1 billion or a -5% net redemption while the long Treasury TLT gained +$255 million or +4% NAV gain.

 

Finally, defensive posturing continues to hurt domestic equity funds. The asset class lost -$3.0 billion to redemptions last week, erasing the prior week's inflow and bringing the year-to-date outflow to -$109.2 billion. T. Rowe Price (TROW) stock continues to be our Short/Avoid proxy on these trends. (See our TROW report HERE.)


Fund Flows | The Best Offense is a Good Defense - z cast 1


In the most recent 5-day period ending September 9th, total equity mutual funds put up net outflows of -$3.2 billion, trailing the year-to-date weekly average outflow of -$273 million and the 2014 average inflow of +$620 million. The outflow was composed of international stock fund withdrawals of -$237 million and domestic stock fund withdrawals of -$3.0 billion. International equity funds have had positive flows in 46 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 outflows of -$2.4 billion, trailing the year-to-date weekly average inflow of +$551 million and the 2014 average inflow of +$926 million. The outflow was composed of tax-free or municipal bond funds withdrawals of -$191 million and taxable bond funds withdrawals of -$2.2 billion.


Equity ETFs had net redemptions of -$14.7 billion, trailing the year-to-date weekly average inflow of +$1.5 billion and the 2014 average inflow of +$3.2 billion. Fixed income ETFs had net inflows of +$3.3 billion, outpacing the year-to-date weekly average inflow of +$1.1 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:


Fund Flows | The Best Offense is a Good Defense - ICI2


Fund Flows | The Best Offense is a Good Defense - ICI3


Fund Flows | The Best Offense is a Good Defense - ICI4


Fund Flows | The Best Offense is a Good Defense - ICI5


Fund Flows | The Best Offense is a Good Defense - ICI6



Cumulative Annual Flow in Millions by Mutual Fund Product: Chart data is the cumulative fund flow from the ICI mutual fund survey for each year starting with 2008.

 

Fund Flows | The Best Offense is a Good Defense - ICI12


Fund Flows | The Best Offense is a Good Defense - ICI13


Fund Flows | The Best Offense is a Good Defense - ICI14


Fund Flows | The Best Offense is a Good Defense - ICI15


Fund Flows | The Best Offense is a Good Defense - ICI16



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:


Fund Flows | The Best Offense is a Good Defense - ICI7


Fund Flows | The Best Offense is a Good Defense - ICI8



Sector and Asset Class Weekly ETF and Year-to-Date Results: In a defensive move, investors withdrew -$10.1 billion or -5% from the S&P 500 SPY ETF and contributed +$255 million or +4% to the long treasury TLT.


Fund Flows | The Best Offense is a Good Defense - ICI9



Cumulative Annual Flow in Millions within Equity and Fixed Income Exchange Traded Funds: Chart data is the cumulative fund flow from Bloomberg's ETF database for each year starting with 2013.


Fund Flows | The Best Offense is a Good Defense - ICI17


Fund Flows | The Best Offense is a Good Defense - ICI18



Net Results:

The net of total equity mutual fund and ETF flows against total bond mutual fund and ETF flows totaled a negative -$18.7 billion spread for the week (-$17.9 billion of total equity outflow net of the +$854 million 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 +$1.6 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 -$18.7 billion (negative numbers imply more positive money flow to bonds for the week.)

  

Fund Flows | The Best Offense is a Good Defense - ICI10



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:


Fund Flows | The Best Offense is a Good Defense - ICI11 



Jonathan Casteleyn, CFA, CMT 

203-562-6500 

jcasteleyn@hedgeye.com 


Joshua Steiner, CFA

203-562-6500

jsteiner@hedgeye.com







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