As we look at today’s set up for the S&P 500, the range is 40 points or 1.8% (1,0764) downside and 1.9% (1,116) upside.
“I like narrative storytelling as being part of a tradition, a folk tradition.”
Life imitates art and consistent with tradition, the earnings season is all about corporate storytelling and stocks trading on headlines – remember, fat fingers rule the world! So far the 2Q10 earnings season is no exception and if the trend continues, it’s going to be a long hot summer.
The S&P’s 6.0% rally since the July 4th holiday has been about the second quarter earnings season and how good the numbers are going to be despite continued signs that global growth is slowing. The signs of a renewed or intensifying economic downturn continue to mount and this will manifest in Q3, not Q2… Yes, Intel had a great quarter, but that is in the rear view now.
I realize that Alcoa’s management team had to put their best foot forward about the demand environment, but growth is slowing and they appear to be speaking out of both sides of their mouths. The quarter that AA reported was potentially a bearish indicator of what’s to come; prices up and demand down, by any other name that is stagflation. There is the potential that AA management has set themselves up for a Toll Brothers “You-Tube” moment. To recall, this is how things went for Toll Brother last quarter:
“It appears that our business has finally emerged from the tunnel and into a bit of day light.”- Bob Toll, CEO May 26, 2010.
Then three weeks later:
“In the three weeks following our earnings conference call on May 26, 2010, our per-community deposits have been running about 20% behind the comparable period in last year’s third quarter and our per-community traffic has been about 3% behind.” -Joel Rassman, TOL CFO, June 16, 2010.
No matter where you look in the USA or abroad the news continues to point to trouble ahead. Here are some data points about American Austerity at the state level that can’t be ignored:
(1) By the end of June, the backlog of unpaid bills in Illinois could exceed $5.5 billion
(2) Most of California's 240,000 state employees could see their salaries temporarily cut to the federal minimum wage.
(3) Minnesota is delaying tax refunds
(4) State tax revenues fell 12% from Sept 2008 to 2009
Who gets hurt the most by these trends? The consumer.
As I said earlier, the signs of a renewed or intensifying economic downturn continue to mount, highlighted by the weaker than expected June retail sales (June represents the second straight month of declining retails sales) and a worse than expected May trade deficit.
On a year-to-year basis, June 2010 retail sales were reported up by 4.8% from June 2009, continuing a trend of slowing annual growth, versus a revised annual May gain of 6.8% (previously 6.9%) and a revised 8.7% (previously 8.9%) annual increase in April. The annual numbers are working off the effects of the severe decline in economy last year and are somewhat meaningless.
The slowing retail sales numbers suggest that the upcoming second quarter GDP "advance" estimate due to be reported on July 30th will show the economy slowing further. The sharp deterioration in May’s trade deficit also suggests a meaningful widening in net exports, also a negative for GDP.
Sadly, the "advance" GDP number is largely a guess by the BEA. In order to maintain consistent data series, the BEA is measuring the same types of supply-side data that they first developed in the middle of the previous century. Bottom line, someone sitting in Washington is guessing how fast our economy is growing (or contracting) based on a method developed in the previous century. This is just plain wrong and is a clear indication that the government data cannot be trusted to accurately show what is happening in the real economy.
As we said on our Q3 theme call, we are below consensus for GDP growth in 2H10. Yesterday’s retail sales data and other upcoming reports should continue to be on the downside of expectations, as the fall-off in business activity begins to accelerate despite what the corporate story tellers are saying. Yesterday, the FED agreed with this call, but they still don’t have it right.
With respect to the FED forecast adjustments, the upper and lower bounds of the central tendency forecasts for 2010 GDP (Q4/Q4) were each lowered by two tenths (now 3.0% to 3.5%). The upper bound for 2011 was lowered from 4.5% to 4.2%, but the lower bound was lifted a tenth to 3.5%.
The unemployment projections for year-end were little changed (9.2% to 9.5%), as the lower bound was lifted just a tenth; although the range for 2011 was raised by two tenths to 8.3% to 8.7%. Policymakers appear to be resolved to a somewhat slower pace of labor market recovery. Similarly, core inflation forecasts drifted slightly lower for 2010 (now 0.8% to 1.0%), 2011 (0.9% to 1.3%) and even 2012 (1.0% to 1.5%).
If the “fat fingers” want to trade another negative headline based on slowing economic data, they will get a chance today - Industrial Production is due out. June industrial production is expected to be -0.1%, consensus was previously at a 0.2% gain. May was reported at a gain of 1.2% (1.3% prior to revisions). Consistent with other economic data out of Washington, until the consensus begins to catch up with the weakening reality, reporting risk continues to be to the downside of expectations.
On Friday, the Hedgeye retail team will host a conference call that will provide further evidence that demand may be on the cusp of deterioration, exacerbated by a housing double dip. To listen to that call please email for more details.
Function in disaster; finish in style
Since early 2008 we’ve singled out housing as the #1 macro driver of gaming revenues. An updated analysis shows housing and unemployment are even more critical now.
Sorry to bore you with statistics but I’m a bit of a nerd and it’s a big part of our process. Way back in early 2008, we regressed all important macro variables on gaming volumes and found that over the period from 1993 to 2007, housing was the most important driver, followed by GDP. It was an easy call then for us to be negative on gaming for most of 2008. Statistics do matter.
When we updated the regressions for Las Vegas Strip gaming volumes, we saw that correlations and R Squares have increased. Over the last 15 years, national housing prices, interest rates, and unemployment are the only three macro variables that mattered, and mattered in that order. T-stats are all close to or above 2. Surprisingly, GDP was an insignificant driver of Las Vegas Strip gaming volumes. Combined, these macro variables drove an R Square of 0.48.
The housing (wealth effect) and unemployment impacts are fairly obvious. The positive relationship between interest rates and gaming volumes may not be as intuitive to the casual observer. The average age of a LV visitor is 50 years old, and weighting age with gambling dollars would surely result in an even older demographic. Many of these gamblers live on fixed incomes so discretionary spending goes higher as interest rates move up. This phenomenon has been consistently borne out in our statistical analysis.
We also broke down the analysis into shorter periods. The impact of housing and unemployment escalated over the last five years while GDP remained insignificant. Interest rates were also insignificant during that period. The housing coefficient doubled from the 15 year regression while the unemployment coefficient went up slightly. Most importantly, the R Square actually increased to 0.69 despite fewer observations (months). Now more than ever, investors need to have a view on housing and unemployment to make real money in this sector in our opinion.
So where do we stand? We defer to the Hedgeye Macro group and our financials guru Josh Steiner. Hedgeye Macro is negative on unemployment relative to consensus and Josh has written extensively on the significant hurdles the housing market face. If we are right, Las Vegas won’t be recovering anytime soon and MGM MIRAGE will struggle to maintain its 12x EBITDA multiple and/or the consensus EBITDA projection.
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Reported a solid quarter and issued smart guidance; smart, as in very conservative Q3 but reasonable full year.
Not surprisingly, MAR reported solid Q2 results and bumped up 2010 guidance. MAR remains attractively valued, particularly on a relative basis, and is certainly the most defensive of the lodging names.
They beat our EPS estimate by a penny and beat the Street by $0.02. Adjusted EBITDA of $278MM was $3MM above our estimate and 7% ahead of the consensus. On the surface it may look like the beat was driven by stronger RevPAR and room openings. Not to take anything away from Marriott, but looking under the hood that’s not exactly correct.
By our math, the beat came from higher termination fees on the owned, leased, corporate housing and other, higher incentive fees, lower timeshare costs, and lower SG&A. At least the first three items are lower multiple drivers of value. Even so, 3Q guidance of $0.18-0.22 seems awfully low given the revised RevPAR guidance and upwardly revised room growth. Even if we use MAR’s seemingly high $155MM SG&A guidance, it seems that they should easily beat the top end of their range. Consensus heading into the release was $0.22.
Owned, leased, corporate housing and other revenue of $255MM was $6MM below our estimate but gross margin was only $1MM below our estimate.
Fee income of $287MM was $1MM ahead of our estimate. However, Management and Franchise fees were lower than our estimate with Incentive fees making up the difference. We believe Incentive fees are less valuable.
Timeshare results managed to beat our estimates and management guidance despite weak contract sales given the difficult YoY comparisons, which included 25 year anniversary promotions. Timeshare before SG&A was $8MM better than our estimate.
SG&A came in $8MM below management guidance. Oddly, the guidance for Q3 is $13MM higher than the actual Q2 quarter. As a reminder, 3Q2009 included $15MM of unfavorable impact associated with deferred comp compared with 2008 and $5MM of certain litigation expenses. At the time, MAR claimed that $130MM was a normalized number. MAR’s $155MM guidance implies 19% YoY growth which, again, seems way too high.
Looking for changes on the margin that impact operational performance
Nirvana - At the restaurant level, the company is operating smoothly. Sales and margins are headed in the right direction. On the surface this gives management the benefit of the doubt that they are not aggressively using pricing to manage the business. There is sometimes the potential, however, that a company is operating in Nirvana as a result of positive comps that are driven entirely by pricing. In that case, if customers are not coming in the door, positive same-store sales growth will not be sustainable.
Who’s got it right as of their last reported quarter? CMG, MCD, YUM U.S., YUM China, DPZ, PNRA, SBUX, CAKE, MRT and TXRH
As shown in the sigma chart below, it should be of no surprise that the companies operating in Nirvana, on average, also trade at the highest NTM EV/EBITDA multiples.
Moonlighting in Nirvana? Most of the names located in the upper right quadrant did not come as a surprise; that is, except for TXRH and MRT. In 1Q10, TXRH and MRT both reported positive comparable sales growth for the first time in about 2 years (slightly longer for TXRH).
TXRH’s full-year same-store sales guidance of flat to +1% implies that same-store sales remain relatively positive for the balance of the year (toughest comparison in 4Q10) even if trends slow somewhat on a two-year average basis, as has been the case for the casual dining industry on average in 2Q10, as measured by Malcolm Knapp. That being said, TXRH’s YOY restaurant level margin compares get more difficult in 2Q10 and even more so in the second half of the year. Lower food costs in 1Q10 were the primary driver of the significant margin growth in the quarter and management stated that food deflation will be less for the balance of the year and lowest in 2Q10. Remaining in Nirvana will be challenging; though same-store sales improved substantially in 1Q10 on a 1-year and 2-year basis and the trend in top-line may be more important to investors now.
As for MRT, the company started out 2Q10 strong with same-store sales up 6% in April and guided to +4% to +6% same-store sales for the quarter. Maintaining positive comps in 2H10, particularly in 4Q10, as comparisons get more difficult, is unlikely.
Other Nirvana Standouts:
CMG – The Company will likely put up positive comps for the balance of the year, even if top-line trends slow somewhat on a 2-year basis from the first quarter. CMG’s full-year same-store sales guidance of up mid single-digits implies steady-to-slightly better two-year trends for the remainder of the year. On a YOY basis, the company most likely posted its strongest restaurant margin growth, however, in the first quarter. Restaurant level margin will face increased pressure in the second quarter and could potentially turn negative in 2H10, pushing CMG into the “Trouble brewing” quadrant. After benefiting from favorable food and labor costs as a percentage of sales in 1Q10, management guided to modest commodity inflation in 2H10 and higher labor costs as of 2Q10 due to wage rate inflation and the lapping of labor efficiency initiatives implemented in 2Q09. Also hurting margins for the balance of the year is the expected increase in other operating costs as the company ups its marketing spend to 1.8% of sales for the full year from 1.1% in the first quarter. Specifically, management said, “we expect to de-lever this line during the rest of the year as we invest in our new marketing campaign.” Given the increased cost headwinds, remaining in Nirvana will be difficult in the second half of the year, but investors may be more focused, in this environment, on the company’s ability to maintain positive comparable sales growth.
CAKE – Like CMG, CAKE most likely posted its strongest FY10 quarter in 1Q10 from a YOY margin growth perspective as restaurant level margins get increasingly more difficult going forward, largely in 2H10. Also, like CMG, the company expects to face increased pressure from higher commodity and marketing costs in 2Q10. These increased cost pressures will likely push CAKE out of Nirvana as we trend through the year even if the company is able to maintain its positive same-store sales growth (management guided to flat to +1% growth in 2Q10 and for the full year). And, even if the company achieves its full-year guidance, it will be challenging for the company to maintain its positive comp growth in 4Q10 given the sequentially more difficult comparison.
YUM U.S. – YUM’s stronger-than-expected 2Q10 results in the U.S. enabled the company to move out of what we call the Deep Hole (negative same-store sales and YOY decline in restaurant operating profit margin) earlier than I had anticipated. I had expected this segment to begin to recover in the second half of the year as the company lapped easier comparisons, but as of 2Q10, the company is now straddling the line between Life-line (negative same-store sales and positive restaurant operating profit margin growth) and Nirvana.
YUM China – YUM continues to expect to face labor and commodity inflation in the second half of the year. Overall, as expected, China continued to operate in Nirvana during the second quarter, but will likely move into the Trouble Brewing quadrant (positive same-store sales and YOY decline in restaurant operating profit margin), and potentially, into the Deep Hole, during the back half of the year as higher food and labor costs materialize.
Deep hole - The concept is experiencing negative same-store sales and declining restaurant level margins.
They are feeling the pain: DIN, SONC, BKC, KONA, EAT, PZZA, PFCB, RRGB, CPKI, JACK, JACK, BOBE and TAST
Deep hole Standouts:
EAT – Sales will remain choppy in the near-term as consumers adjust to the significant menu changes at Chili’s and the company could remain in the Deep Hole for another reported quarter. Beginning in FY11, EAT should begin to move up and to the right on the sigma chart as margin initiatives materialize and same-store sales recover.
PFCB – PFCB has the potential to report the biggest sequential quarterly swing in same-store sales growth at the Bistro in 2Q10 as the company implemented a +1% to +2% price increase during the quarter in late May. At the same time, PFCB hopes to support average check, which declined 3.5% during 1Q10, by reducing its reliance on discounting. Although traffic was positive in 1Q10, it will be important to see if the company can sustain its recent traffic momentum at the Bistro while also increasing prices. Prior to the price increase, management stated that for most of April both the Bistro and Pei Wei experienced a roughly 200 bp improvement from 1Q10 comp trends.
Margins should improve as the company refines the Happy Hour initiative at the Bistro and improves execution. It is important to remember that the inefficiency around executing this new program, along with some other incremental discounting activities at the Bistro, cost the company about 80 bps on the COGS line and 100 bps on the labor line, or about $0.13 per share in 1Q10. I would expect restaurant level margin to decline again in 2Q10 (though to a lesser magnitude) and gradually improve during the balance of the year, pushing PFCB up and to the right in the sigma chart.
Trouble brewing - positive same-store sales and YOY decline in restaurant level margin. We recognize the trends associated with operating in both the Life-line and Trouble brewing territories as unsustainable. Typically, if a company is posting positive same-store sales and declining margins, the company is unable to leverage its positive top-line and is therefore spending too much on either growth related costs or increased discounting. Either way something has to give and it usually ends ugly.
The red flags are being raised for: BJRI and BWLD
Trouble brewing Standout:
BWLD – With same-store sales only up 0.1%, BWLD was extremely close to falling into the Deep hole in 1Q10. Same-store sales slowed 30 bps in 1Q10 on a two-year average basis and deteriorated 420 bps sequentially in April from the 1Q10 level. Given that same-store sales were down 3.7% in April, I do not expect BWLD’s sigma position to improve in 2Q10, but rather the company could fall into the Deep hole if top-line trends did not improve materially during the balance of the quarter. I would expect continued pressure on restaurant level margin in 2Q10 despite the fact that the company will benefit from lower YOY chicken wing prices after facing inflation of 17% in 1Q10 (traditional wings account for about 20% of restaurant sales).
It all comes back to sustainability, and BWLD lost it….BWLD grew too fast. New unit volumes are declining. Growth related costs will become more evident as same-store sales remain under pressure. BWLD needs to slow growth and cut costs and that does not yet appear to be in the plans.
Life-line - Negative same-store sales and YOY increase in restaurant level margins. At Hedgeye we have another term for this and it’s called “pulling the goalie.” When you are down and out (customers are not coming back), you need to do anything to make the numbers and preserve margins. The reduction in costs is not sustainable and can lead to further issues down the road. It will certainly not do much to bring the customers back in the door.
Looking for answers: DRI, RT and WEN
RT – RT’s same-store sales trends have gotten better on a one-year and two-year basis for the last five quarters. Maintaining this trend on a one-year basis will be more difficult in fiscal 4Q10. Management’s full-year comparable sales growth guidance of -1% to -2% implies a pretty wide range of results during the fourth quarter of -2.5% to +1.5%. Whether or not same-store sales turn positive (I am modeling a slightly negative comp, roughly in line with 3Q10), restaurant level margin is expected to be down in the fourth quarter, shifting RT into either the Trouble brewing quadrant or the Deep hole. Management guided to a 25 bp to 50 bp decline in full-year restaurant profit margin as a result of the company’s focus on offering compelling value and the associated negative impact of food costs. This full-year guidance implies a 25 bp to 125 bp decline in the fourth quarter.