How to Be Positioned For a #LateCycle Slowdown

How to Be Positioned For a #LateCycle Slowdown - late cycle


In a recent note to subscribers, Hedgeye CEO Keith McCullough reiterated our #SlowerForLonger (growth) theme and explained how investors should play slowing economic growth:


"If we’re still right on #LateCycle GDP Slowing, easiest move is to short the Financials (XLF, KRE, JPM) and buy Utilities and Treasuries (XLU, TLT, etc.) – this is the 8th or 9th time in 2015 they’ve “rallied” the 2yr to 0.75% and failed."


Incidentally, our macro analysts Christian Drake and Darius Dale sent a detailed note to institutional subscribers Thursday afternoon providing additional context on why we believe things are going to get worse on the economic front and providing an update on how to be positioned. 


Here's the headline and takeaway:

How to Be Positioned For a #LateCycle Slowdown - darius christian note


Here's how that setup worked out in 3Q:


LONGS: Utilities (up +4.4%) and Treasury Bonds (10Y Yield down -32bps):


SHORTS: S&P 500 (down -6.9%), Financials (down -7.2%) and High Yield Credit (Yields up +148bps and OAS up +154bps, on average)


How to Be Positioned For a #LateCycle Slowdown - z 56


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October 30, 2015

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Income, Eurozone and Inflation Carnage

Client Talking Points


We’ll get the aggregate household income & spending figures for SEPT this morning.  Decelerating growth in aggregate hours and flat wage growth in the Sept employment report should translate into a reported deceleration in aggregate income growth.  The 2nd derivative trend in income drives the capacity for consumption growth and the implication for a modern consumption economy is straightforward: lower income growth = lower consumption growth (holding savings rate & credit growth steady). Consumption growth peaked in 1Q15 and with payroll trends slowing and harder income & growth comps in the coming quarters, the probability of a material re-acceleration in household spending growth continues to trend lower.   


Eurozone CPI jumped a whole 10 basis points to 0.0% in OCT year-over-year, yet remains at a far cry from the ECB’s 2.0% inflation target.  As ECB head Mario Draghi talks up the prospect of increasing the Bank’s QE purchasing program, expect the EUR/USD to fall in kind. Our GIP model continues to signal the Eurozone in QUAD 3, equating to growth slowing and inflation accelerating.  


We’re 2/3rds of the way through S&P earnings season and the carnage in Energy, Materials, and Industrials continues. Energy, materials, and industrials Sales have comped -33%, -17%, and -6% respectively. Earnings growth is down -62%, -20%, and +0.70%. It’s not just the smaller, leveraged names getting hit. Royal Dutch Shell on Wednesday reported a Net Loss of -$7.4Bn vs +$4.5Bn Q3 2014. They took a $-7.9Bn write-down for a halted project in Alaska, but even backing that out they were barely profitable. Strong USD deflation feedback loop à lower commodity prices means lower cash flows, which equals more leverage, especially for those international names with USD denominated debt and weaker currencies. Remember that Debt due is nominal.


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Asset Allocation


Top Long Ideas

Company Ticker Sector Duration

What week it was for MCD shareholders! Shares finished the week up 7.3%. We have been saying all along that the third quarter of 2015 would be the inflection point for the McDonald’s (MCD) turnaround. After this print, it appears that the heartache is finally over at McDonald’s, as this quarter marks the first good quarter the company has had in two years.


From here, the upside in the stock price lies with the growth of All Day Breakfast, additional G&A cuts, national value offering implementation, reimaging of restaurants, commodity deflation, especially in beef and increased operational efficiencies, among others. In addition, the REIT is a potential driver of incremental value but not crucial to the long-term success of this call. With Steve Easterbrook at the helm we are confident this company will be better managed than it has been in a long time.


RH unveiled a full floor of Modern product in their New York Flatiron store this week. The new concept sits on the first floor of the 21k sq. ft. store and marks the 3rd property in RH’s fleet (along with Denver and Atlanta) to carry the new product line.


Fundamentally and financially, we’re about to see growth at RH go on a multi-year tear. We think this stock is headed to $300 over the next 2-3 years. We’ve been patient for the catalyst calendar to begin, and the waiting is finally over.


As devaluation and global currency war jockeying from central bankers around the world continues, the acknowledgement of growth slowing continues to push yields lower. The long-bond was up on Thursday, after the ECB meeting, despite an easing-fueled rip in equities. The bond market doesn’t believe in the growth storytelling and we expect it to continue.


Remember that Down Euro Devaluation is a global TIGHTENING event because the world’s biggest asset price #deflation risk is that the world’s inflation expectations (commodities, debt, etc.) are DENOMINATED IN DOLLARS. That has implications for gold (risk to being long), but we want to get through the Fed meeting and GDP data next week before we pivot on a gold view. Stay tuned.

Three for the Road


REPLAY: An Inside Look at Healthcare Earnings with Hedgeye's Tom Tobin… @HedgeyeHC



Happiness is not a state to arrive at, but a manner of traveling.

Margaret Lee Runbeck


72% of all Halloween candy bought this year will be chocolate, according to CashNetUSA.

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Takeaway: Do your job because everyone is watching all of the time.


Growth at Valeant accelerated when they bought Philidor in the fall of 2014. When we saw the 3Q result, it was confusing.  How could a business with little to no internal investment see growth break out to mid teens from low single digits over night?  Now we know, and now the payors know.  The payors who are in the process of reviewing their claims data and writing new claims edits and will be likely scrutinizing every claim for a Valeant product from now on. 







I don't have to be a super smart hedge fund guy to see Valeant and the cast of rogues for what it is.  As an industry, we should all be ashamed that malignancies like Valeant, Bill Ackman, Pearson, and their deformed brain-child Philidor were allowed to flourish even for a brief period of time.  


Either Pershing knew that Valeant had Philidor in their back pocket and how the company was driving growth, and should not be trusted with managing money... or they didn't know, and can't do their job.  It is more true because everyone is looking all of the time.  


Most people getting up to go to work this morning don't have the slightest clue who any of these rich guys are.  But to everyone who didn't do their job; the reporters who stand idly by warming their ratings, clicks, and views by the media fire storm, the sellside and their "buy" ratings, the buyside that didn't do their own research, Valeant is a loud and clear warning.  How you behave and the quality and integrity of your work when no one is looking is not an anachronism. Do your job because everyone is watching all of the time.



Thomas Tobin
Managing Director 



Andrew Freedman



The Macro Show Replay | October 30, 2015




The good news is that EAT is operating from a position of strength.  The company has a strong brand in Chili’s; strong margins and significant free cash flow.  The bad news is that industry sales have slowed; the competition has regrouped and now Chili’s needs to regain some traffic!  I suspect that the biggest change in industry dynamics over the last six months has been Olive Garden performing better.  While they might not be a direct competitor, Olive Garden can move the needle on industry sales when the chain generates positive sales and traffic.  That being said, depending on how Chili’s responds, it could be a negative for DRI and the improving Olive Garden.  DRI is currently on the Hedgeye Restaurants SHORT bench.


The casual dining space is under significant pressure right now.  The Restaurant MACRO environment is unfavorable as all of the following factors are slowing on the margin:

  • Payroll’s
  • Personal consumption expenditures
  • Consumer confidence
  • Industry sales trends  


A theme we are now hearing during the 3Q earnings season is an increase in the competitive (discounting) activity as the bigger brands are fighting for the incremental consumer.  All of this is starting to be reflected in lower multiples for the casual dining space overall.


Currently, EATs EV/NTM EBITDA is trading at a 10% discount to the current industry average of 8.4x.  Clearly some bad news is priced in to the stock, but it’s unclear what the financial outcome of managements shift in strategy will be.  Right now estimates for the balance of FY16 look aggressive, given current sales trends.


We have no position in EAT currently so we are waiting and watching!  





Globally, our business delivered comp sales of positive 4.8% during the quarter, driven by effective marketing platforms and regional marketing co-ops and aided by a favorable Ramadan shift. We opened six additional restaurants during the quarter, including a new market entry into Tunisia, which marks our 31st country for the Chili's brand and demonstrates the strength and relevance of Chili's across the globe.


SELF INFLICTED WOUNDS - Continuing from last quarter there was some sales softness through the transition to the My Chili's Rewards program. “The shift from our direct marketing program to loyalty hasn't performed as strongly as expected. And we're now adjusting the mix of loyalty and direct marketing to optimize the investment.”


“We were challenged with a couple of macro factors, both within our industry and in the broader economy.” 


MACRO FACTORS - Persistently low oil prices and the appreciation of the dollar, means greater challenges within oil markets and border towns.  “There have been pockets of softness within those regions for a while, but the top-line challenges expanded during the quarter across Texas, Oklahoma, Arkansas and Louisiana, home to about 30% of our restaurants.  And it's unusual for us to see that much regional variability.”


INDUSTRY FACTORS - The battle for market share continues to intensify. “We saw increasingly aggressive discounting and deal rates still at five-year highs. This intense level of promotional activity resulted in some competitors taking share during the quarter.”


EAT IS GOING TO FIGHT BACK - Over the last six months, we stayed consistently focused on our long-term strategies and have refrained from engaging in heavy promotional activity. We've built a solid foundation with our strategic work on food, service and atmosphere, as well as the digital guest experience. And the good news is we've achieved the margin strength to enable us now to take a much more aggressive approach to turn the tide on sales and traffic in the near-term while we maintain the health and sustainability of our brands over the long-term.



LUNCH - First, we're reigniting our lunch business with the same intensity we had five years ago when we reinvented that day part. We're introducing new products with more compelling price points and linking that new value proposition to technology like Ziosk, NoWait and our mobile app, so guests can now set their own pace that meets their needs at lunch.


DINNER – “At dinner, we're messaging both value and new news with the launch of our Prime Rib Fajitas and the introduction of bottomless chips and salsa with any fajita purchase. And we're testing big ideas that lean into value and further differentiate Chili's as a Fresh Tex, Fresh Mex brand.”


HAPPY HOUR – “We're also reinvigorating our happy hour business with the launch of a national program that offers more aggressive appetizer pricing and drink specials, like a $5 Presidente Margarita.”


MARKETING – “And finally, we're ramping up support with local and regional marketing efforts to strengthen our competitive position and drive traffic in our oil and border town regions.”


TECHNOLOGY – “This rewards program is part of our overall digital guest experience, a crucial strategy to help us learn from and communicate more effectively with our guests. We're also optimizing our technology investment to drive top-line in the near-term. As I mentioned, the My Chili's Rewards program isn't generating the incremental traffic that we need the program to deliver, but there is tremendous acceptance and engagement from our guests in the program, which are critical as we work to drive the incrementality. We've signed up over 3.7 million members so far. More than 16% of our checks include loyalty transactions, and we know from the data that our rewards program members rate the brand even higher in terms of experience and they're much more likely to return than the average Chili's guest.”


MAGGIANO’S - Maggiano's, experienced some unexpected softness in their banquet business, resulting in negative sales for the quarter, but as we approach the busy holiday season, we are confident Maggiano's sales will rebound.


SAME STORE SALES - Total company-owned comp restaurant sales decreased 1.6%, driven by a 2.1% decline in traffic and a negative 1.4% change in mix, partially offset by a 1.9% increase in price.


MARGINS - Now, turning to margins, our restaurant management teams continue to operate the business effectively, with overall restaurant operating margin improving 10 basis points to 14.6%. This performance reflects solid margin expansion in our base business, partially offset by the mix impact of the Pepper Dining restaurants. Excluding Pepper Dining, our restaurant operating margin improved 50 basis points, driven by a 40 basis point decrease in cost of sales and a 10 basis point decrease in restaurant expense. Restaurant labor expense was flat for the quarter.


COGS - First quarter cost of sales improved 40 basis points, reflecting 40 basis points of favorable menu pricing and 20 basis points of favorable commodity pricing, partially offset by 20 basis points of negative mix. Commodity pricing primarily benefited from lower avocado, cheese, and seafood costs, partially offset by higher steak, fajita beef, and poultry costs when compared to prior year. Restaurant expense improved 10 basis points, mainly driven by a shift in advertising to My Chili's Rewards support, partially offset by deleverage and the timing of repair and maintenance expenses and other costs.


LABOR - While the restaurant labor expense line was flat to prior year, it included the impact of increased wage rates of approximately 2%. Depreciation expense increased $3.6 million to $39 million in Q1. This reflects our investment in key capital initiatives such as the nearly completed re-image program and the acquired restaurants. In addition, general and administrative expenses were $33 million, a $0.5 million increase versus prior year, primarily due to the loss of transition services income previously received from franchise Pepper Dining. This level of spend is below our planned rate of expense and reflects cost management efforts to offset top-line challenges.


CAPITAL ALLOCATION - Capital expenditures for the quarter were $24 million. During the quarter, we repurchased 900,000 shares for $51 million and we ended the quarter with $66 million of cash on our balance sheet. Since the end of the first quarter, we purchased an additional 328,000 shares for $17 million, leaving an outstanding authorization of about $550 million. This includes the additional authorization of $250 million approved by our board in August. We also raised our quarterly dividend to $0.32 per share, representing a 14% increase over prior year.



  • We are reaffirming our full year earnings per diluted share guidance range of $3.55 to $3.65
  • We now expect revenue growth for the fiscal year to increase 10% to 12% compared to prior guidance range of 12% to 14%.
  • Comp sales guidance for company-owned restaurants is now expected to be in the range of down 0.5% to down 1.5% compared to the prior range of up 1.5% to 2%. We expect second quarter comp sales to be below first quarter levels, third quarter close to flat, and we expect positive growth in the fourth quarter.
  • Reported operating margin is unchanged from our original guidance of flat to down 25 basis points. Excluding the impact of Pepper Dining, our restaurant operating margin is also unchanged from our original guidance of up 25 to 50 basis points.
  • We now expect overall commodity inflation of less than 1% for the current fiscal year versus prior expectations of up approximately 2%. This reflects favorability from beef, partially offset by higher produce costs. Currently, 97% of our commodities are contracted through the end of calendar 2015, 86% through the end of fiscal Q3, and 71% are contracted through the end of fiscal 2016.
  • Depreciation expense is now forecast to increase $10 million to $12 million year-over-year, a reduction from our prior guidance of $12 million to $15 million increase.
  • Our anticipated increase in G&A expense in fiscal year 2016 is now expected to be $3 million to $6 million, down from prior guidance of $10 million to $12 million.
  • We expect weighted average share count to be between 59 million and 61 million, due to a lower average share price for buybacks compared to prior guidance of 60 million to 62 million.



“So if you were to look at the map and the black box data regionally, you would see that the whole industry is a little more challenged in Texas than in other parts of the country right now.”


“No, really you guys have been asking us the question for quite a few calls actually, if we've been seeing softness. And while there had been some pockets, it had been fairly isolated into really kind of those very specific smaller oil towns. And what we're seeing now is a broader kind of impact, if you will, to the larger geography. And it's moving. It's moved into some bigger locales.”


“So on the comp sensitivity, 100 basis points would be around $0.10 to $0.12”


“And so as we look at our situation right now, we've given up too much traffic. We need to get the traffic patterns changed. And that's what we're focused on and that's what those initiatives we've talked about are really all kind of geared for. We think there's opportunity to take some check where it's possible and to continue to grow it, but, for the most part, we're focused on turning the traffic pattern around.”


Please call or e-mail with any questions.


Howard Penney

Managing Director


Shayne Laidlaw





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