The Economic Data calendar for the week of the 6th of September through the 10th of September is full of critical releases and events. Attached below is a snapshot of some (though far from all) of the headline numbers that we will be focused on.
Conclusion: The combination of today’s employment report and the ISM Non-Manufacturing Index spell incremental trouble for the U.S. economy. We have conviction that growth will continue to slow based largely on a jobless and deleveraging consumer, downward pressure on housing prices, and a burgeoning federal debt burden.
Position: Short the S&P 500 (SPY).
This morning’s employment report was well received by the market (up around 1% today). This is largely due to the fact that private payrolls “beat” consensus estimates, climbing 67k vs. 40k (Bloomberg Consensus).
Akin to a bad company beating low earnings expectations, this morning’s employment report does not pass the test of analytical rigor. Diving deeper into the “model” we see that private payrolls growth (while up 67k MoM) slowed sequentially. In MACRO, everything that matters happens on the margin, and, on the margin, this is sequential deterioration.
Analyzing the industry-specific reports, we see that employment at service providers fell 54k MoM. While a sequential improvement, it is important to note that today’s ISM Non-Manufacturing Employment Index came in at 48.2 for the month of August, offering no near-term signs of reprieve in this sector. Employment in the retail industry fell by 4,900 bodies and employment in the construction sector grew 19k MoM. We hope (understanding full well that hope isn’t and investment process) that this addition of labor isn’t busy adding more supply to a housing market that is very much in disequilibrium from a supply/demand standpoint. Research from Josh Steiner, our Managing Director of Financials, suggests we are due for a ~20% correction in housing prices over the next 12 months based on current inventory levels – absent major government intervention.
The deltas in federal government employment continue to be distorted by the unwinding of Census hiring, so we’ll just leave the (-121k) MoM decline alone. We will, however, point out that State & local governments continue to shed jobs (down 10k MoM) and the austerity measures currently being undertaken across the country will weigh on GDP growth going forward. YTD, State & local governments have shed 135,000 jobs and without meaningful intervention by the federal government (or a pickup in tax revenues, which we feel is unlikely based on where we think GDP is headed), this trend will continue because of their budget balancing mandate.
Today’s unemployment report is similar to the trend we saw in the 2Q earnings season whereby companies beat on earnings but missing on the top line. The positive market reaction to the private payrolls “beat” is overshadowing the sequential uptick in the unemployment rate (9.6% vs. 9.5% in July), which is a miss in our eyes – regardless of consensus expectations. The end result is simply that less people that want jobs have them. Underemployment, which measures part-time workers who’d prefer full-time employment and people who want to work but have given up looking, also worsened sequentially (16.7% vs. 16.5% in July). Needless to say, the employment situation in America is not conducive for a pickup in growth, given that ~70% of our economy is consumer spending.
The last chart we want to highlight comes from another survey; the ISM Non-Manufacturing Index for August “missed” estimates, falling off the table sequentially (51.5 vs. 54.3 in July vs. consensus expectations of 53.2). The survey, which covers about 90% of the economy, is now 150bps away from signaling a contraction. The three components of the index we watch all declined sequentially: New Orders dropped to 52.4 from 56.7; Backlog of Orders dropped to 50.5 from 52; and Employment dropped into contraction at 48.2 vs. 50.9 in July.
All told, the combination of today’s employment report and the ISM Non-Manufacturing Index spell incremental trouble for the U.S. economy. We have conviction that growth will continue to slow based largely on a jobless and deleveraging consumer, downward pressure on housing prices, and a burgeoning federal debt burden. On July 1st as part of our American Austerity theme, we published our initial estimate for 3Q GDP, which was 1.7%. That will be revised lower in the coming weeks.
We remain short the S&P 500 via the etf SPY with an immediate term TRADE downside target of 1061.
Enjoy the long weekend with your family and friends.
Once per year, the BLS benchmarks its payroll estimates against state unemployment insurance filings, which last year saw a significant drop in the previously-reported payroll employment levels.
In the benchmark revision for the year beginning March 2009 (printed in 2010), the net effect of the BLS revision was an upward adjustment to the number of jobs losses during the recession of 900,000 jobs. When the BLS first announced the massive 2009 benchmark revision, in effect the statement indicated that the underlying assumptions to the Birth-Death Model were missing certain jobs losses and it is not a reliable indicator. The BLS’s model assumes that jobs created by start-up companies have more than offset jobs lost by companies going out of business. So for the BLS this becomes their equivalent of a fudge factor; the ability to make the employment situation appear better than it really is. We will be following up with a more in depth analysis of this effect early next week.
So far this year, the model has created an average of 53,000 jobs per month, including 115,000 jobs this month. In this economy, it is interesting that the bias has been positive and not negative! While there is no shortage of misinformation being broadcast through the media, the government seems to be a fully engaged participant.
With the September payroll numbers, the BLS is scheduled to publish its initial estimate of the benchmark revision for March 2010; once again we are likely to learn that the BLS got it wrong again and hundreds of thousands of people lost their jobs that we did not know about.
Knowing how flawed the Birth/Death model is flawed, backing out the 115,000 of addition jobs this month, the non-farm payroll number would be closer to -169,000; worse than consensus and acceleration from last month's loss of -131,000.
We just bought the TLT exchange-traded fund. If the hope that unemployment is meaningfully improving and housing is stabilizing, we’ll be a buyer of the long end of the bond market on associated weakness.
Housing is not improving and unemployment situation is not either.
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Wynn Encore Macau has been open over four months. While still preliminary, we took a look at the incremental revenues and EBITDA from the new property.
How is Encore doing? Based on the first four months of data – admittedly preliminary – we’d definitively say that Encore is doing, well, okay. We look at the Encore contribution in two ways: 1) by calculating the incremental market share gain and deriving an estimate of EBITDA and 2) calculating the incremental EBITDA from Q1 (pre-Encore) to Q2 (post-Encore) and adjusting for the hold differential.
In Q2, Wynn generated $216m in EBITDA versus $181m in Q1. After adjusting for the fact that Encore was only open for 72 days in the quarter and hold percentage was significantly higher in Q2 and Q1, we calculate the annualized incremental EBITDA from Encore was $83 million. Encore cost $600 million to build so the ROI per this method was a respectable 14%.
The second methodology yields a lower ROI of 11%. Given the market growth from Q1 to Q2, we decided to look at the Wynn Macau VIP market share following the opening of MPEL’s City of Dreams on June 1, 2009 but before the April 21st opening of Encore (June 2009 through March 2010 period) and compare it to the May-August period (post Encore). We are focusing on VIP because Encore did not add any Mass tables. In fact, according to the numbers, Encore added nothing to Wynn’s Mass share. The 2.2% increase in market share would generate approximately $64 million in annualized incremental EBITDA per our math. See the chart below.
So the jury is still out on Encore. However, Wynn’s post Q2 market share has been substandard and trending lower. I guess we’ll just have to wait and see.
Conclusion: European PMI Services fell or substantially slowed in August, which is line with our forecast for a negative inflection in the August data from Europe. We continue to expect a decline in consumption across Europe post the exuberance of the World Cup and in response to the enactment of austerity measures that should induce individual belt-tightening and hamper confidence. The British Pound is one European currency that’s taken a notable dive alongside headline data, down -3.4% over the last month.
Of the countries reporting, here are the PMI Services numbers in August versus July:
The German, French, and British economies are anchoring points in our analysis. The negative move in August PMI (German PMI Manufacturing released on Wednesday was unchanged in August, while the UK fell to 54.3 from 56.9) bodes poorly for the region, especially due to the fact that Germany, France and the UK are often the largest trading partners with other EU member states.
Back in July, we decided to map out where the restaurant companies were in terms of their positions on the SIGMA chart. Changes in top-line growth and margin expansion/contraction clearly illustrate key operational trends in each company. Tracking these changes as the quarters roll over, and the different valuation multiples that are assigned companies as trends change, offers valuable insight.
All restaurant companies want to live in Nirvana, with same-store sales positive and margins growing on a year-over-year basis. Not all of the restaurant companies in Nirvana are there for the same reasons; some companies may be lapping easy comparisons, driving comps entirely by pricing or thanks to a temporary but very favorable cost environment. In these cases, such companies will not sustain their positions in the Nirvana quadrant.
The following companies are currently enjoying positive same-store sales and margin growth as of the most recently reported quarter: CMG, MCD, YUM US, YUM China, BJRI, DPZ, PNRA, SBUX, TXRH, CAKE, RT and MRT. All of these companies, with the exception of YUM US and BJRI, were operating in Nirvana territory before the most recent quarter was reported.
As I did in July, I would like to bring to your attention a few names that I think may be “moonlighting in Nirvana”. YUM China, TXRH, MRT, CAKE and RT are the five names I would highlight as being particularly vulnerable to a move from Nirvana in the second half of 2010 (or by fiscal 2Q11, in RT’s case).
YUM continues to expect to face labor and commodity inflation in China during 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.
TXRH is guiding to same-store sales of +1% for the remainder of the year which implies a relatively stable two-year average trend. Food deflation is set to provide a sequentially more favorably environment than in 2Q but not as much as the company enjoyed in 1Q. That being said, YOY comparisons from both a cost of sales and restaurant-level margin perspective are set to become more difficult in the back half of the year.
My concern for MRT is primarily top-line related. While there is a certain amount of risk in their beef costs only being 20% contracted for 2010, given the 14% increase in Live Cattle prices YTD, I believe that the steep increase in sequential comps from 1H to 2H09 will make it difficult for MRT to maintain positive comps, particularly in 4Q10.
CAKE could also face pressure going forward due to an average check problem; customers have been trading down to small plate and snack items. In an effort to maintain comps going forward the company implemented a 1% effective menu price increase in August. Same-store sales and margin comparisons become decidedly more difficult, for CAKE, in 2H10.
RT’s outlook for their next quarter (1QFY11) is quite positive; same-store sales could improve again on a one-year and two-year basis and restaurant-level margins should increase year-over-year. However, as I wrote in my recent note “RT: IMPROVING BUT THINGS SHOULD SLOW”, momentum will likely slow from there for RT. Same-store sales, by my reckoning, will come under pressure for the balance of FY11 with margins likely following suit due to higher food costs as a percentage of sales and more difficult comparisons come to bear on the bottom line. RT could possibly be heading for the Deep hole in 2QFY11.
Other Nirvana standouts:
CMG: CMG is largely unlocked from a commodity perspective and this could impact margins adversely in the second half of 2010. Further increased costs on the labor, other operating cost (higher marketing) and G&A lines could further impair CMG from maintaining positive margin growth in the back half of this year. Investors may be less concerned about this increased margin pressure if the company is able to maintain its sales momentum from the second quarter.
The Deep hole quadrant is inhabited by companies experiencing negative same-store sales and declining restaurant level margins.
The following companies are currently suffering: SONC, DIN, BKC, WEN, EAT, CPKI, KONA, JACK and RRGB. The trouble about the Deep hole quadrant in this current environment is that there is no “magic bullet” that can solve the issues that have led the company there. Sometimes there are plans that management initiates that are margin accretive and build sustainable top-line momentum, but these strategies require a patient management team (resisting the temptation to take short cuts to print good numbers) and several quarters to implement. McDonald’s “Plan to Win” is one example of an effective strategy that has changed that company.
For the QSR names in the list above, MCD is the main problem. They continue to knock the cover off the ball – I estimate a +7% comp in August – and it is hurting BKC, WEN, SONC and JACK. For these names, I would not expect much movement from the Deep hole over the next few quarters and I believe that will be reflected in their valuations. Compounding the impact of MCD’s outperformance, JACK’s geographic issues augment the macro headwinds. Their overexposure to California and young Hispanic males (high unemployment cohort), in particular, has been pressing their stock for some time.
Other Deep hole standouts:
EAT: We expect the top-line to be volatile in the near-term as the customer familiarizes itself with the new menu. Following the most recent quarter’s earnings, I am marginally less confident in Brinker’s ability to meet earnings expectations over the next two quarters (1H11). I do expect, however, the company to see a material YOY improvement in restaurant-level margin in FY11, despite near-term sales volatility. Having extensively researched the operational initiatives and changes being undertaken by the firm to increase margins and customer satisfaction, I see the potential for a strong turnaround for Brinker. I remain confident in the direction of the company but believe that the turn in fundamentals is further out than previously thought.
Trouble Brewing: We believe that the trends associated with the Trouble brewing and Life-line quadrants are unsustainable. Companies usually find themselves in either territory in a transitional phase. Typically, if a company is posting positive same-store sales and declining year-over-year margins, the company is not leveraging the positive top-line and is spending too much on growth-related costs or increasing discounting. Whatever the reason, it usually spells trouble.
PFCB is currently situated in this quadrant. On a sales-weighted basis, its concepts are running same-store sales of +0.8%. Having taken price in May, for the first time in two years, and improved operational performance during the first half of the year, the company could see top-line strength persist if traffic can hold up (as of the date of the most recent earnings call, 7/28, traffic had been positive for five months). I expect a gradual improvement in restaurant-level margins in the second half of the year for PFCB.
PFCB is facing easy comparisons in 3Q10 on many fronts. At the same time, trends are getting better at the Bistro, which should make for a strong third quarter. PFCB could move up and to the right into the Nirvana quadrant during the back half of the year after starting out the year in the deep hole.
The Life-line quadrant is usually populated by companies that have “pulled the goalie”. When customers are not coming through the doors, sometimes companies cut costs in order to maintain bottom-line numbers in the absence of top-line strength. This clearly is an unsustainable situation. In other cases, such as 2Q for BWLD, a shift in commodity margins can boost margins and add to profitability even in a difficult top-line environment.
The following companies are in the Life-line territory currently seeing restaurant-level margins increasing year-over-year but same-store sales declining: BWLD and DRI. BWLD is likely going to experience year-over-year restaurant level operating margin expansion over the next number of quarters. This is largely due to the 31% decline in chicken wing prices since the YTD peak in January. The company is in the process of closing underperforming, lower volume stores but it is likely going to take some time.
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