After reviewing numerous quarterly reports and conference calls, it’s becoming clearer to me that the industrial economy remains in a recession. Consumer businesses are doing better relatively, but in my opinion, their results are not as strong as some of earnings game “winners” suggest. Today I reviewed the quarterly results of four consumer companies – two earnings game winners and two losers. The two earnings game winners were moderate to higher-end consumer companies that are more likely to benefit from record high stock prices. While the two losers have a consumer base with limited exposure to asset inflation.
One of the losers is a restaurant everyone knows and most likely has reviewed, McDonald’s. Normally I don’t spend a lot of time on large cap stocks, but their earnings release caught my attention. They lost the earnings estimate game by reporting $1.25 per share vs. expectations of $1.39 per share. In my opinion, the more important operating measurement was U.S. comparable sales, which only increased 1.8%. Management blamed lower than expected sales results on softening industry trends. But what really caught my attention was discussed on the conference call. Management noted, “In the US, second-quarter pricing year over year was up about 3%, compared with food away from home inflation of 2.6%.” With pricing up 3% and comps 1.8%, one can infer that traffic trends were negative.
McDonald’s customers are not exactly “loving it” in today’s economic environment. McDonald’s operating results are a good example of what happens when price increases meet stagnant wages. It’s also a good example of the disconnect between what I read on conference regarding price increases, or inflation, and what we’re constantly told by the Federal Reserve – that inflation is too low. I’m not seeing it Janet. McDonald’s quarter does not shout deflation, but instead it’s what I’d expect to see during periods of stagflation.
Management touched on industry conditions and the economy after an analyst commented on the “huge deceleration” within the restaurant industry. On the industry slowdown management said, “…well clearly — it’s been fairly well documented on the consumer slowdown across most consumer segments, to be honest with you, through this second quarter.” On the economy management noted, “I think generally there’s just a broader level of uncertainty in consumers’ minds at the moment, both trying to gauge their financial security going forward, whether through elections or through global events. People are certainly mindful of an unsettled world. And when people are uncertain, when families are uncertain, caution starts to prevail and they start to hold back on spend.” Pretty generic comments, but I thought it was noteworthy nonetheless. I’m a little skeptical of the election uncertainty excuse. It’s been used frequently this quarter. Does Trump or Clinton really impact your decision to order a Big Mac?
After reading McDonald’s conference call I wanted to read some good news, so I picked up Panera’s quarterly earnings report. Scrolling through the headlines I noticed Jim Cramer called it a blowout quarter, so I enthusiastically began to learn more. Panera won the earnings game by reporting $1.78 vs. its $1.75 estimate. The same-store comps I read in the headlines were an impressive +4.2%. However, after reading further, I discovered those comps were for company-owned stores alone. Franchise-operated same-store comps only increased 0.6%. Combined, system-wide same-store comps were up +2.3%, far from the blowout quarter Mr. Cramer claimed. And here’s the kicker when it comes to the company-owned comps of +4.2%. The growth came from transaction growth of only 0.4%, while average check growth was 3.8%. While slightly positive (a little better than MCD), traffic growth was weak as most of the comp growth came from price increases.
If inflation associated with dining out is running between 3-4%, it’s not surprising traffic growth is struggling at McDonald’s and Panera. Is the restaurant industry’s weak traffic trends in Q2 inflation related? After eating out for lunch and dinner today (I’m on the road again) and paying through the nose for mediocre fare, I think it’s highly likely! In fact after dinner tonight, I stopped by the grocery store and bought a less expensive and healthier option for lunch tomorrow.
Rent-A-Center was another consumer stock loser, as it missed earnings estimates considerably. Earnings per share were $0.19 vs. $0.43 and sales declined -8.1%. Same store comps were -4.9%. No way to spin this one pretty and management didn’t try. Poor results were attributed to issues with its point of sales system, weakness in oil markets (Texas 10% of sales), the reset of its smart phone category, and declining computer and tablet sales. Management was extremely disappointed. Investors were as well, driving its stock down 18%. In my opinion, Rent-A-Center’s customer base remains under stress and I’m not expecting an immediate turnaround.
For companies with aggressive buyback programs and above average dividends, please take note. Rent-A-Center bought back $200 million of stock in 2013 at much higher prices. Also, between 2013 and 2015 it paid out approximately $150 million in dividends. During this period it took on debt to help fund these shareholder friendly initiatives. It’s always tempting to reward shareholders when times are good, but sometimes it’s better to shore up the balance sheet for a rainy day. That day is now for Rent-A-Center. With $636 million in net debt, I’m sure they’d like to have some of that cash back.
Lastly, we’ll end with an earnings game winner, Tempur Sealy International, Inc. (TPX). Tempur Sealy squashed earnings estimates as it reported $0.92 vs. the $0.68 estimate. However, GAAP EPS was less impressive at $0.35 vs. $0.34. To understand the difference between the adjusted non-GAAP and GAAP earnings all one needs to do is comb through the 18 footnotes at the end of their earnings report. I did. One thing that stood out was $4.2 million in annual meeting costs in 2015. Nice. I’d like to have attended that one!
Temper Sealy adjusted non-GAAP earnings benefited significantly from higher adjusted gross margins of 40%. Margins improved due to operational improvements, pricing and mix. There’s that “pricing” comment again. If we’re having all of this deflation, why are there so many comments related to higher pricing on conference calls? By the way, Astec Industries, which we discussed yesterday, noted on their call that they are watching rising steel prices closely (more price increases). In any event, back to Temper Sealy. How much of their growth was pricing and mix? While sales were up 5.2%, management noted units sold only increased +2%.
Despite the slow unit growth, investors apparently loved the quarter and drove Tempur Sealy’s stock up 17%. I would have expected stronger organic growth given the stock’s large jump. Even Tempur’s management tempered (sorry) their enthusiasm by providing low single-digit sales growth guidance for the year. Management noted the worldwide economy is doing “just o.k.” and they pointed to some headwinds such as the election, international events, and currency. Management described the economy as having a 1.5% to 2% GDP feel. However, their best description of the economy was, “feels good, feels weak, feels good, feels weak”. That’s more accurate and clear than most economists!
In conclusion, a mixed earnings picture from four consumer companies. I found comments on pricing, traffic, and unit sales very interesting. The moral of the story is you can raise prices if your customers are benefiting from asset inflation and can afford to pay a 40% gross margin on a $5,000 mattress. However, if your customers’ spending decisions are largely dependent on fixed wages, raising prices may backfire and turn customer traffic or units sold negative.
Lastly, given the sharp rise in stock prices, I was surprised by the actual top line results of the companies that won the earnings estimate game. In my opinion, revenue growth did not appear overwhelming, especially after pulling out the effect of price increases. So goes the earnings estimate game, where actual results and real data points take a back seat to the “achievement” of jumping over spoon-fed earnings estimates.