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YUM - until the cows come home

Will growing “until the cows come home” come back to bite em in the butt?


I want to be clear:  Yum will continue to grow in China for years and years.  What I’m focused on is the rate at which Yum is growing in China.


On the surface, it does not follow that a country where the economy is growing by 10% and consumer confidence is on the rise, that concepts like KFC would be having problems.  I have been told many times by senior management at YUM that taking a traditional U.S. restaurant analyst approach to analyzing China business is just wrong.  Call me stubborn, but here I go.


I’m trying to understand why Yum’s same-store sales in China have been coming down on a 2-year average basis throughout 2009 (and guided to come down again in 2010) when the MACRO backdrop is seemingly so positive.  Why are the issues that KFC faces in China any different from any other country in the world?  We see three major issues facing YUM in China: increased competition, over-building, and deteriorating brand perception among consumers due to health-related isses such as obesity.


As the chart below indicates, macro factors are providing somewhat of a tailwind.  Overall consumer confidence is improving (though not reflected in sentiment towards fast food) and GDP is growing, yet YUM’s China same-store sales have gone in the opposite direction.


YUM - until the cows come home - yumchinapod1


COMPETITION - Our contacts on the ground in China suggest that in the older, more mature cities where KFC has been for years there is significantly more local competition from smaller local players that can compete effectively on price.   Not to mention that McDonald’s has made great strides in increasing its pressence in those cities as well.  We have also heard that because the KFC brand is now much better known in China, when KFC opens in newer cities it has what I call the “Cheesecake” problem.  The new units are so big and glamorous that they operate at peak volumes and then subsequently, struggle to  grow same-store sales thirteen months later.  This is not a bad problem to have until a chain begins to canabilize sales by increasing capacity in order to achieve economies of scale.


It is interesting to take our propietary comments in the context of what we heard from McDonald’s management on its most recent earnings call.  “I think on an overall basis the pricing relationships in China in the quick service restaurant industry are in an interesting dilemma because of who you are competing against which is a very low price menu on the street from the non sort of chain restaurants and food available. We are not necessarily discounting but what we are doing is getting our price right in relationship to the economic time that we find ourselves in which is an ongoing pricing relationship as compared to a discounting of our food.  And it moves up and down the scale depending on where we find ourselves in the consumer spending. As we’ve said, I think the environment of China which basically fell off a cliff after the 2008 Beijing Olympics. We’ve adjusted accordingly along the way to be relevant with our consumers and it’s worked well for us.”

MCD’s comments highlight that despite improving consumer confidence, YUM is not the only QSR player in China facing a slowdown in demand.  The defining factor for YUM, however, is that the company is more leveraged to performance in China as management likes to point out that it continues to widen its lead in the Western QSR category with its approximately 1,700 KFC units in Mainland China relative to MCD’s 1,150 units.  In 2009, MCD cut back on growth in China in response to what it called a marketplace that was not growing while YUM maintained the pace of growth it had outlined at the beginning of the year (500 new units).


SUSTAINABILITY - Sustainability issues are looking to be a big red flag in China.  The issues stem not from growth alone, but rather from the company’s rate of growth.  For the past three years, YUM has raised its level of capital spending in China (forecast to grow another 9% in 2010) to roughly 10% of sales in 2009.  Over the same timeframe, operating margins in China have declined to close to 16%, based on my estimates, from nearly 18% in 2006.  And, return on incremental invested capital (ROIIC) has come down every year since 2006, albeit from a very impressive level.  In 2009, ROIIC should come in just better than 30%, but that compares to nearly 50% in 2007 and about 45% in 2008.  Based on my numbers, both margins and ROIIC will continue down on their current trajectory in 2010.  Focusing too much on same-store sales and on the fact that 2-year average trends will continune to come down in 2010 may be the U.S. centric way of analyzing trends in China (as management likes to talk about system sales growth), but I can’t disregard declining margins and returns.


YUM - until the cows come home - yumchinaroiic


YUM’s mentality in China is to grow “until the cows come home” - no matter what.  When a majority of management’s compensation is dependant on “system-wide sales” growth and comps are negative, the only way to get a bonus it to grow units.  Over the past four years YUM has taken its total number of units in China from about 2,300 in 2005 to almost 4,000 today , with the company first talking about canabilization in 3Q05.  At the time, CEO David Novak was quoted as saying that the company was cannibilizing units because four years previously, in 2001, “we thought we were starting to see some potential cannibilization in China and…we put the pedal to the metal and look at the business we’ve built”. 


While YUM has taken down its total capital spending in 2009, it is forecast to grow its spending in China by about 9%.  This 9% rate of growth expected in both 2009 and 2010 is toned down from the 40%-plus growth in the prior two years, but it appears that current trends should dictate further slowing in the coming years. 


The likelihood of YUM slowing growth in China any time soon is low as management has publicly stated, “We could drop our sales 20%-25% and open restaurants until the cows come home - so that's what we plan on doing.”  I contend that if the issues of over capacity are real and YUM maintains an accelerated pace of growth, it will exacerbate the problem. 


Think SBUX!


YUM - until the cows come home - yumchinacapex


CONSUMER PERCEPTION - In the late 90’s and early 2000’s, McDonald’s had a major problem in the U.K. dealing with consumer perception, particularly around health related issues.   Based on recent performance by both YUM and MCD in China, it appears that QSR in general is facing some consumer backlash in China.  Concerns about obesity preoccupy Chinese citizens and authorities alike and an awareness campaign has been launched by the government to highlight the dangers of fast food with vivid images of children playing among oversize food laced with glass and scorpions.  The article, posted on france24.com, was entitled, “China scaring kids out of fast food chains”.


YUM - until the cows come home - yumchart4


Obesity is a growing concern in China, and it is clear that the association between U.S.-style fast food and child-safety is being emphasized by the government. 


YUM - until the cows come home - yumchart5


Even if consumer confidence and GPD numbers are rising, there appears to be some MACRO related issues at play in China, too, as McDonald’s made perfectly clear on its 4Q09 earnings call.  


 “Now China, although their economy is improving and we delivered an increase in comp sales and guest counts in December, we expect it will still be sometime before consumers regain confidence and are willing to spend more.”  NOTE: this contradicts a study that we referred to earlier in this post.

MCD’s management also went on to say - “Regarding China, a couple of things, yes we did report positive sales and guest count movement in December.   You won’t see that in January though because we have the shift of the Chinese New Year so last year that was in January and this year it will be in February so by comparison that will be a little bit choppy.   But, we’re optimistic in what we’re seeing with the trends. We’ve talked about China in the south, and the central and the north so we saw all three of those areas improving in December and are kind of cautiously optimistic as the consumer starts to spend a little bit of money there that we will then be able to get a little bit more out of price and get a little more traffic moving there so that’s a perspective for you.”

Another potentially important MACRO focus-point is the urban youth of China.  While I have been advised by YUM’s management not to apply American logic to Chinese scenarios, I would hazard a guess that younger people are a somewhat important demographic for fast-food chains.  A telling piece on France24.com entitled “Beijing graduates crammed into slums like ‘ants’” shows the harsh reality for graduates living in urban China.  It is clear that these graduates are not frequenting western fast-food chains.  


The photo (shown below) is followed by a comment by one such graduate living in Beijing, “This is a place to eat.  It’s cheaper than in the rest of Beijing.  But people only eat out for breakfast – the rest of the time we cook in our bedrooms.”  Local players, whether operating out of premises or off the street, are providing formidable competition for YUM. 


YUM - until the cows come home - chinateen



MPEL missed by even more than we thought but the story was not Q4.  Rather, market share and EBITDA rebounded in January and if the trend continues, 1Q2010 results will handily beat the street.




MPEL missed our revenue number by only $6MM or 1.5%, but missed our EBITDA which was roughly 50% below consensus by a mile. The miss was everywhere with the exception of CoD, which is where the potential value of MPEL really lies.  We knew that hold would be bad, in fact, we had correctly estimated hold % at 2.4%.  So what happened this quarter?  While MPEL doesn’t give you the exact breakdown between CoD and Altira, we always try to piece together the numbers given the data.  Below are the details.


City of Dreams

  • CoD revenues were $5MM below our estimate of $243MM but EBITDA at $22MM was spot in line with our expectations
  • Not unlike the Venetian Macau, now that CoD has been open for a few quarters they are realigning their gaming floor to match demand (ie. removing supply).  In Q4, average tables were reduced by 22 and average slot machines were 38 lower than 3Q09
  • RC volume and VIP win was higher than we estimated as a result of higher direct VIP play.  We estimate that direct VIP was 19% of total RC vs. our prior estimate of 12%.  Given the higher profitability of this segment, it is an encouraging trend.
  • Mass win, estimated at $75MM was about $1MM light of our estimate.  We think that hold at CoD was a little better than the 17.5% average hold on Mass
  • Slot handle was $59MM better than our estimate, but this was offset by lower win % of 5.4% vs our estimate of 6% hold. Net net, slot win was $1MM better than we estimated
  • Net casino revenues were $5MM below our estimate, while non-gaming and promotional expenses were in line with our estimates.  The miss on revenues was made up by lower fixed costs and lower expenses on non-gaming revenues.



  • Altira revenues were $5MM below our estimate of $138MM and EBITDA missed our estimate of -$6MM by $8MM
  • In the quarter, average tables were reduced by 16 vs. 3Q09
  • We suspect that slightly better table results at Altira were more than offset by higher discounts & promotional expenses.  Normally we estimate “discounts & other” at .83% of RC for this property, however, this quarter that ratio ticked up to .96% of RC volume
  • Net casino revenues were $5MM below our estimate, while non-gaming and promotional expenses were in line with our estimates.  The miss on revenues was further exasperated by higher costs – some of which were temporary and associated with the switch away form AMA




  • Given the strong January results, and the likelihood of strong February, we raised our EBITDA estimate for 1Q2010 to $95MM on estimated revenues of $583MM
    • CoD:  $330MM of revenue and $60MM of revenues
    • Altira:  $227MM of revenue and $28MM of EBITDA
    • Mocha Slots:  $27MM of revenue and $7MM of EBITDA
  • For FY2010 we are estimating $2.25BN of revenues and $350MM of EBITDA
    • CoD:  $1.3BN of revenue and $268MM of EBITDA
    • Altira:  $825MM of revenue and $85MM of EBITDA
    • Mocha Slots:  $103MM of revenue and $27MM of EBITDA

Risk Management Time: SP500 Levels, Refreshed

Paul Volcker is reminding the willfully blind on the Senate Banking Committee right now that they live and operate in a Bubble of US Politics. His basic message is that everyone at Investment Banking Inc knows exactly what prop trading is, and that it shouldn’t be back-stopped by the government.


In the end, I think the Volcker Rule makes the American Financial System a less volatile and less cyclical place to transact. So, I support Volcker’s basic demand here – get London on board and get it done. That’s my long term (TAIL) view.


For the immediate term TRADE and intermediate term TREND in the SP500, the answer is less clear. I have basically been selling the entire way up this week, and now the SP500 is jumping above what I call the Shark Line (the 1099 line). A close above that line gives my short position in the SP500 pain until 1116, where I plan on shorting it again. All we are doing here is making a series of lower-highs.


A close below 1099 puts 1071 in play on the downside.  



Keith R. McCullough
Chief Executive Officer


Risk Management Time: SP500 Levels, Refreshed - sp22

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Brazil Update: Lula's Health

Since he just started reading the local Brazilian press for us in real-time (in Portuguese), Moshe Silver’s Hedgeyes have recently revealed the following risk management takeaways:


1. Brazil’s central bank just released for 90-day comment period a proposal to regulate bankers’ compensation, based on Group of 20 principles accepted last year.  Purpose of the proposed new rules will be to align bankers’ compensation with impact of risk exposure they take on.


2. Lula has been pushing for his right-hand Cabinet Chief, Ms. Dilma Rousseff – a former anti-government guerrilla during the military dictatorship – to become his hand-picked successor.  She has now formally accepted, which means she will stand for her party’s nomination during their convention this month.  Lula, who can’t run again now, has made his choice plain.  Her reported surge in popularity in the last few days maybe “inside information” function of her formally saying she wants the job. 


3. Lula was hospitalized for emergency high blood pressure episode on 28 January.  His doctors were monitoring him during the day on the 27th.  The Brazilian market was down that day – maybe a leading indicator from Lula’s doctors’? concern for his health?


Rousseff is still being treated for cancer that first surfaced in the press a few years ago.  She says it’s in remission, but obviously this would be a bad time for both Lula and his hand-picked successor to have severe health crises.


With all of this “news” in the rear-view, it’s easier to understand why the intermediate term TREND line for the Brazilian Bovespa is under assault. That line of support = 66,624. All the while, the long term TAIL of support for Brazilian equities remains intact down at 55,406. We have outlined these risk management levels and durations for you in the chart below.


Moshe and Keith


Brazil Update: Lula's Health - bovespa


Short Natty

Position: Short natural gas via the etf UNG


In the last few days, we’ve laid out a few shorts in the commodity world.  We shorted the XLE, which comprises the major U.S. based energy producers, and yesterday we shorted UNG, the natural gas etf.  The thesis behind both of these positions is slightly different as oil is driven by global drivers, while natural gas is a localized, North American market.


Despite the fact that Punxutawney Phil saw his shadow this morning, which, according to the urban legend, means we will experience six more weeks of winter, winter is basically in the rear view mirror, and sequentially demand for natural gas should decline seasonally as it usually does.  This year the seasonal impact will be particularly pronounced as we’ve just experienced one of the more seasonally cold winters in reason history.  That, too, has become consensus.  As we wrote on January 11th:


“Cold weather is good for the price of Natural Gas, we definitely get that.  We also get that the idea of cold weather is becoming a solidly consensus notion.  Consider the following headlines that are currently posted on the drudgereport.com:

  • Cold Stuns Floridians, causes deaths elsewhere;
  • Arctic air has invaded the south;
  • Cold kills 100,000 tropical fish in S Florida;
  • Chill Map;
  • Cold snap death toll rises across Europe;
  • Global cooling may set in for 20 – 30 years; and
  • Feds: December was 14th coldest in 115 years.”

As of now, there is less winter in front of us than behind us, so natural gas should begin building inventory as demand naturally declines.


Currently, inventory in the U.S. is still well above normal levels.  According to the most recent natural gas update from the DOE:


“Working gas in storage was 2,521 Bcf as of Friday, January 22, 2010, according to EIA estimates. This represents a net decline of 86 Bcf from the previous week. Stocks were 120 Bcf higher than last year at this time and 87 Bcf above the 5-year average of 2,434 Bcf.”


While natural gas did see a weekly decline in the most recent numbers, inventory levels are still very high and the price of natural gas is still roughly ~15% higher than it was a year ago. With higher inventory and higher price, something has to give.


The recent increase in the price of natural gas that we’ve seen as of late has been leading to an increase in drilling activity as well, which is negative for future price in a time when both inventory and production are still high.  According to the Baker Hughes rig count, they see an addition of 36 rigs to the fleet in the United States and 35 rigs to the fleet in Canada week-over-week.   On a year-over-year basis, the United States rig count is still down on a year-over-year basis, though Canada, which is a major producer and exporter to the United States of natural gas, is up by 99 rigs.


Below we’ve outlined a chart with our current levels on UNG, the natural gas etf.



Daryl G. Jones
Managing Director


Short Natty - natty


RL: A Huge Beat HAS TO Happen

RL: A Huge Beat HAS TO Happen


Tomorrow’s print should show that RL will earn ’11 EPS a year early. The sentiment suggests that the market knows this. But RL remains in bullish TRADE and TREND with upside to $86.11... not a short yet per KM’s risk management models.


It’s been a while since my confidence on a name has been so birfurcated heading into an event as I am with RL’s 3Q (Dec) EPS.  On one hand, RL will absolutely blow away the number tomorrow. We’re modeling $1.28 vs. the Street at a buck. Similarly, our 4Q estimate is $0.96 vs the Street at $0.79.  Top line is turning on the margin (helped in part by newly consolidated Asia business), both revenue and margin compares are increasingly easy, and capital intensity is easing. When all is said and done, RL should earn the Mar’11 Street estimate a full year early and make people look to $5.50-$5.75 in EPS power in Mar ’11.


So what’s not to like about that? Hardly anything. In fact, RL is one of the poster children for a company that invested in its P&L and balance sheet over the past two years when the world was falling apart. Yes, it took it on the chin with margins, but now will enter harvesting mode and show outsized growth in revs, earnings, cash flow and returns.


With names like this, we’re increasingly not valuation-centric. Why? They DESERVE to be expensive. A global brand name with a bullet-proof balance sheet and a proven track record for executing a simultaneous top and bottom line-driven mid-teens EBIT growth rate and 20%+ RNOA?


What do you pay for that? History shows us that RL is a typical ‘feast or famine’ apparel company in that when times are tough it is valued as a lowly apparel brand, but when it is beating expectations it is quickly valued as a luxury brand. Today we’re looking at the latter. If I take my estimate – which is a moonshot above the consensus, it suggests about 17-18x p/e, or about 15x on March ’11 numbers. This also equates to about 8x an above consensus number 2-years out.


Is this justifyable? I think so. But with more Buy ratings than anytime since June 2007 (8 Buys, 6 Holds, 0 Sells), short interest resting at the lowest level since Dec/07 and having just come down precipitously over the past six months (now at 6%), and with management as net sellers above $80, it’s pretty darn tough for me to justify adding to any position here. Even though we’re expecting a monsterous beat, we’d like to see it be a more controversial one to play on the long side.


But before getting cute on the short side, keep in mind that the positive fundamentals will be there, and Keith’s models suggest that RL remains in bullish TRADE and TREND with upside to $86.11.


-Brian McGough



RL: A Huge Beat HAS TO Happen - rl1


RL: A Huge Beat HAS TO Happen - rl2


RL: A Huge Beat HAS TO Happen - rl3



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The total percentage of successful long and short trading signals since the inception of Real-Time Alerts in August of 2008.

  • LONG SIGNALS 80.46%
  • SHORT SIGNALS 78.35%