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12/6/17
Hedge Fund Telemetry "Talk Your Book" Trade Idea Series

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Buy Side Analyst - Short Restraurants Thematic Idea

Intro:  The Hedge Fund Telemetry "Talk Your Book" Series features hedge fund managers, analysts, and traders demonstrating their investment process with actionable ideas.  I love it because it digs into the genesis for the idea (sometimes an idea comes from doing work on another company - like this thematic idea did) and follows up with further evidence including a little macro.  Today's report is from a super smart buy side analyst based in San Francisco.  I believe you will appreciate his detailed look at the risks with the restaurant sector, especially if the economy gets weak.  He focuses on Jack In The Box and Cheesecake Factory as the best short ideas.  This analyst chose to remain anonymous as he would be open to career opportunities. If you would like to speak with him about career opportunities, please email me and we can arrange a call or meeting.  

Idea: Short Restaurants
Bio:  Buy side analyst in San Francisco, open to opportunities.
Background: This piece came around after covering Starbucks for a potential long idea for the fund I work for.  After realizing the weakening underlying fundamentals and traffic trends for Starbucks, I concluded the street was way too optimistic and their price targets were way too high with many targets in the $70’s.  Specifically trends in store traffic were the alarm that went off and led me to look at the industry as whole.  The street was expecting 8-10% annual revenue growth at the time which is now down to 5% for FY2017 and -0.20%YoY in the most recent quarter.  Starbucks raised prices twice in the last 18 months which offset the declining traffic trends. Once the price increases rolled off without a corresponding traffic increase, the comparable sales number was headed lower.  New Store sales growth was also declining and went negative in the most recent quarter.  I put my price target at $55 for Starbucks last November (which is where it roughly trades now) and moved my PT down to $50 currently.  Shorting Starbucks is a difficult endeavor mainly due to a very large buyback program and the fact the company is a Wall Street favorite.


Time Horizon
: Until the next recession or until meaningful improvements in restaurant traffic and comp sales.  Industry wide declining traffic and comparable sales is a leading indicator of a recession.
Vehicle: Short stock, hedge with options
Risk-Reward: Price Targets Discussed at the end of this piece. 
This piece focuses on a secondary effect of the retail apocalypse and examines some underlying causes of retail weakness.  The restaurant sector is suffering from several headwinds and an inability of consumers to splurge on meals away from home.  Admittedly I have been short several of the names discussed for a while and even though they have performed well there is more room to profit as we head towards the next recession.  Most analysts and pundits on TV will have you believe Amazon is eating everyone’s lunch and no one can keep up.  There is truth to this but underlying trends are a major factor in where and how people spend their money. What really drives consumption is real disposable income growth which recently is growing at a paltry 1.2% YoY and real disposable income per capita is only growing at 0.56% YoY. When people have disposable income they tend to eat out more and buy the clothes they probably don’t need


Income growth has been a major sticking point for the Fed and one reason they let extreme policy run for so long.  The Fed in doing so has ignored the other side of the equation, the real cost of living.  Shelter is the largest component of expenditures for the average American and Shelter CPI has been running above 3% nationally for almost three years.  If you live by a major city the rate is much higher.  As a result, rent as a percentage of income (chart below) has moved drastically higher in major cities crowding out what used to be discretionary spending.  Another implication of high rents is saving for a down payment, or saving in general (more on this later), is very difficult and is evidenced by decade low home ownership rates. Other skyrocketing costs such as healthcare and education have exacerbated the squeeze on incomes.


If income growth is slow and costs are rising, naturally the last place to get the money is out of savings or on credit.  Large moves down in the savings rate correspond to a lagged increase in consumption as shown below.  The savings rate has declined to 3.1%, a level not seen since the housing bubble years and correspondingly PCE has increased.  Considering most of the saving occurs at higher income levels, it is safe to say the bottom 50% are living pay check to pay check or have negative cash flow.


Lastly, credit has been used extensively this cycle to supplement income.  Consumer credit has grown much faster than incomes which over the long run cannot be sustained and credit growth is slowing.  These two series have to converge either through higher incomes or lower credit balances.


 
The Risks With The US Restaurant Sector 
 
 So if consumers are going to spend less going forward, naturally we want to figure out where the cracks will emerge.  Retail has already been obliterated and the risk-reward for shorting many names is poor at this point.  Another sector that gets less attention and has been deteriorating is restaurants, both full services and Quick Service (QSR).  Although several names have declined already the risk reward remains favorable as fundamentals have deteriorated at an accelerating pace. Restaurant traffic has been declining and restaurants have increased prices as an offset to keep comparable sales flat to slightly down.  Restaurants are now realizing less pricing power as consumers hit their limits and comparable sales are declining industry wide.  Promotional activity has picked up industry wide supporting this thesis as they battle for consumers wallets.


Headwinds
1) Food Inflation differential for Food-at-Home vs Food-Away-From-Home still favors food at home on a relative basis.  Consumers will naturally eat where it’s more economical.  Restaurants regularly raise their prices or reduce portion sizes to keep margins. Now that food inflation is picking up restaurants will be forced to raise prices further and sacrifice volume or restaurant margins will be lower going forward.  Sysco (SYY), who distributes food, said in their most recent earnings report food inflation was running at 3.8% YoY, a cost SYY usually passes through to their customers.


2)  A second pressure on margins is wage inflation.  Wage inflation at the low end, since most restaurant workers earn minimum or near minimum wage, are a major cost for restaurants.  A reason wage growth looks better in 2017 is due to a huge round of minimum wage increases that were passed entering the year.  The following table shows scheduled minimum wage increases for several states and the average increase was 9.6% in 2017.  In addition, 11 states have mandated minimum wage increases that are indexed to CPI.  While CPI has remained around the Fed’s 2% target, CPI has crept up over the past 12 months. (Source: State websites)


Further evidence the low end of wages is responsible for much of the recent rise is shown in the following chart of average hourly earnings for restaurant jobs vs all employees.  Taking a similar measure of wages in the lowest quintile of earners shows the exact same pattern of minimum wage increases accounting for higher growth than total workers. (Source: BLS)


 It all depends on the restaurant and where they are geographically exposed, but Starbucks for example will face 6% annual wage increases across 40% of their stores in the U.S.  Starbucks already pays most hourly employees above minimum wage, but they will have to raise wages if they wish to keep that cushion. Depending on the restaurant chain and number of hourly employees per store, wage inflation represents 20bps to 50bps of operating margin headwind annually.
                Lastly, promotional intensity in the industry has increased substantially as companies battle for share of consumer wallets. Declining comparable sales industry wide has accelerated discounting. A similar dynamic took place leading up to the 2008/09 recession. Companies have noted the pressures on earnings calls:
Jack FQ3 Earnings call
                “At Jack in the Box, although we experienced some improvement from Q2, all of our transaction loss in Q3 was attributable to checks under $5. The competitive environment was dominated during the quarter by aggressive discounting throughout the industry.”
Jack FQ4 Earnings call
                “What we've typically said is, we're not going to jump into the fray on some of the aggressive discounting, we're going to ride it out, and when our competitors slowdown on that value emphasis, we'll bounce back. ……….But, there's been this sort of value-oriented discount drug that has permeated the industry in the last 18 months that doesn't seem to want to go away”
PZZA Q2 Earning Call
                Analyst: “I know it's highly promotional earlier this year, or are you seeing an improvement in trends more recently that gives you some confidence in getting to those 2% to 4% numbers for the year?
                CFO: “I don't think we're seeing any kind of differences in the competitive environment the first half of the year compared to what we're seeing in real time now, and don't anticipate any real shift in the competitive promotional environment for the duration of 2017.”
As a result, operating and restaurant margins for many restaurants have already peaked as shown in the following chart. 


As you can see from the following chart comparable sales for restaurants are declining at the same time as their margins are being squeezed.  Most of these names missed consensus estimates on comparable sales in the most recent quarter.


Other names that have higher comps but are still deteriorating are Starbucks, Papa Johns and Darden Restuarants. These names have higher valuations due to better fundamentals but have a larger downside if things get progressively worse.


 
The Risks With Jack In The Box and Cheesecake Factory
 
Out of these names I have several short positions but the names I like the most are JACK, BWLD and CAKE.  Restaurant chains grow through growing sales in existing stores and adding new stores. These companies are cutting Capex which supports lower growth rates going forward.  The following are not exhaustive summaries of each company’s fundamentals and both are conducting buybacks and may have activists/PE interested in the companies.

BWLD: (After originally writing this piece, BWLD received a takeout offer.  I covered 25% of my position near $103 but kept 75% which was just closed for a profit around $142, unfortunately a much smaller profit than expected) BWLD has declining comparable sales (-2.3%), declining cash flow (Q3 was down 33% YoY and Capex was cut in half), declining operating income (-13% YoY), shrinking margins and declining return on assets.  Cutting capex will slow new store growth and further pressure top line growth as comp sales are negative and new store growth accounts for over 100% of sales growth.  Inflation is especially acute for the food items (chicken wings inflation +25% in the most recent quarter) they buy and BWLD is already cutting hours and portion sizes to offset the squeeze. BWLD excluded the weeks around the hurricanes when they reported comparable sales for Q3 which were still down over 2%.  BWLD has missed sales expectations 11 quarters in a row and comparable sales have missed 8 out of the last 11 quarters. BWLD has been using up more cash than they take in from operations (chart below) between buybacks and capex.  They have been supplementing cash flow with debt issuance over the past year.  Profitability is not great at an ROIC of 9% LTM.  BWLD trades at a premium to the market at 24x price to 2017 earnings.  Leverage is not crazy at Net Debt + Operating Leases to EBITDAR of 2.7x.  Relative strength percentile is bottom of the barrel at 13 before the merger news.


Jack: Jack in the Box (JITB) is following McDonald’s model of refranchising the majority of their restaurants with now a goal of 95% of restaurants being franchised.  Moving to an asset light model in this case is more so masking problems the chain is having.  Jack in the Box also owns the Qdoba Mexican food chain which was driving much of JITB’s growth.  Qdoba’s performance took a 180 and is now the weakest part of their business.  Qdoba had a -4% comp in FQ4 and operating margin came in at 1.8% for FQ4, down from double digits a year ago.  JITB management is now exploring strategic opportunities for Qdoba, essentially shedding their old growth driver.  Sell side analysts are fixated on the Qdoba sale and are looking past the deterioration in the overall business. Regardless, Jack in the Box chain is also experiencing declining comps and traffic has fallen off a cliff declining mid-single digits for the last three quarters. 



Margins for both Jack in the Box and Qdoba are declining on sales deleveraging, wage inflation of nearly 7% and commodity cost inflation of over 3%.  On the most recent earnings call management called out minimum wage increases on Los Angeles moving from $10.50 an hour to $12.00 an hour, an increase of 14%. 


JITB admitted they will have to undergo major renovations to their restaurants as many locations are over 40 yrs old.  JITB franchisees are all signed up for the remodel program and some cost will be shared through lease agreement changes where JITB is the landlord.  JITB has essentially pushed the majority of the costs onto their franchisees who will bear the burden for the remodel and franchisee capital will be cut thin for opening new locations over the next two years. Comparable sales at the franchise level are also declining (-0.7%) at a time they will be burning cash on remodels.
Lastly, JACK is another example of a company issuing debt to finance buybacks, a strategy that impairs your balance sheet over the long term.  The following shows LTM cash from operations and expenditures on buybacks, dividends and capex.  The second chart shows LTM net cash flow (after above expenditures) and the debt supplement.



As a result, leverage for Jack in the Box has increased as debt increased to over $1B from $350M on 2013.  2019 is a big year for JACK as all its debt comes due.  Net debt to EBITDA has doubled from roughly 1.5x to 3.3x over that time period and cash on hand has fallen to roughly $7M. Including operating leases puts leverage much higher, over 7.0x, but much of this liability has been moved to the franchisee. The sale of Qdoba could change the leverage picture but selling a deteriorating business probably won’t fetch a high multiple.  JACK also trades at a premium to the market at 26x FY2017 earnings. Admittedly my short position is small as a result of the ongoing sale of Qdoba and any positive reaction a sale may produce.
CAKE: Cheesecake factory is a helpless bystander of declining mall traffic as most of their locations are in or very close to malls. E-commerce as a percentage of total sales is only increasing which means fewer mall visits and fewer visits to restaurants in those malls.


According to ShopperTrak, traffic is still declining on the busiest shopping week of the year.  The decline has moderated on Black Friday, but the days around Black Friday are still seeing declines. 


As a result CAKE has declining sales (-0.5% YoY) and declining comparable sales (-2.3% YoY).  Restaurant margins are shrinking (-230bps YoY in Q3) on sales deleverage and as labor costs increased 160bps YoY. Management expects labor inflation of 5% in 2018 and food inflation of over 3% which will surely pressure margins. When asked about pricing for next year, management expects to raise prices 2.5%.  Operating income is expected to decline -20% for 2017 and operating cash flow has declined -17% over LTM. EPS has been mostly maintained (-8% for 2017E) on a lower tax rate (20% vs 27% YA) and share buybacks. Considering more sales are moving online every day the decline of mall foot traffic will become more acute over time and will further pressure growth. 


As a result of lower cash flow, CAKE is cutting back capex and the rate of store openings which is further depressing top line growth. Management only expects to open 4 to 6 restaurants in 2018 and a couple licensed stores overseas.


CAKE’s gift card liabilities are down 24% since the beginning of the year, another sign of lower demand. They have missed comparable sales estimates 7 out of the last 11 quarters and sales estimates the last 9 out of 11 quarters.  CAKE sports reasonable leverage of Net Debt + Operating Leases to EBITDAR of 3.1x.  Relative strength percentile is low as well at 19.  This is more my opinion, but Cheesecake Factory has a terrible offering in terms of quality for the price point.
Here is a summary of the short trades I have on in the restaurant space and downside targets.  I generally don’t let losers move against me more than 7-8% and protect profits with options hedges or I trim my positions.  Another company on my watch list is Brinker (EAT), which admittedly I missed and is one of the weakest names in the space.


One thing to think about is these shorts have been working when the economy is “good” and when the market has been incredibly strong.  I’m not calling for a pullback or an economic downturn immediately although I think both are long overdue, but if the market does turn these laggards should lead the market down.
 
 
 
 
 

CONFIDENTIALITY NOTE: This message is for the named person's use only. It may contain confidential, proprietary or legally privileged material. No confidentiality or privilege is waived by any accidental or unintentional transmission. If you receive this message in error, please immediately delete it and all copies of it from your system, destroy any hard copies and notify the sender. You must not, directly or indirectly, use, disclose, distribute, print or copy any part of this message if you are not the intended recipient. Hedge Fund Telemetry LLC. cannot guarantee the confidentiality of the material transmitted; therefore, information of a sensitive or confidential nature should not be transmitted. The information is subject to change without notice and Hedge Fund Telemetry LLC has no obligation to provide any updates or changes. Hedge Fund Telemetry LLC is providing this data for informational purposes and does not believe that it is sufficient to base an investment decision on. This information should not be regarded as a solicitation or recommendation of any particular security or to engage in any trading strategy.  This is simply a study by a buy side analyst demonstrating his work and process.  This is for educational purposes only.  



 
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CONFIDENTIALITY NOTE: This message is for the named person's use only. It may contain confidential, proprietary or legally privileged material. No confidentiality or privilege is waived by any accidental or unintentional transmission. If you receive this message in error, please immediately delete it and all copies of it from your system, destroy any hard copies and notify the sender. You must not, directly or indirectly, use, disclose, distribute, print or copy any part of this message if you are not the intended recipient. Hedge Fund Telemetry LLC. cannot guarantee the confidentiality of the material transmitted; therefore, information of a sensitive or confidential nature should not be transmitted. The information is subject to change without notice and Hedge Fund Telemetry LLC has no obligation to provide any updates or changes. Hedge Fund Telemetry LLC is providing this data for informational purposes and does not believe that it is sufficient to base an investment decision on. This information should not be regarded as a solicitation or recommendation of any particular security or to engage in any trading strategy.