A Pairs Idea for the Uncertain World of Deleveraging: McDonald's and Whirlpool

 |  Includes: MCD, SBUX, WHR
by: Daniel Moser

Ask any economist how to describe the current economy in the United States and surely most of them will include something about a plague of debt reduction. A rather interesting article in the Economist is about this very topic. As they explain, "DEBT reduction, or deleveraging as it is known in the inelegant argot of economists, is a painful process. Growth suffers as consumers and firms, let alone governments, try to reduce their debts. Countries which experienced the biggest asset busts, such as America, Britain and Spain, have had the most disappointing recoveries. And the pain will continue: a careful look at the numbers suggests that the process of deleveraging has barely begun."

Despite the fact that the overall economy is terribly sluggish, if one chooses to utilize some degree of creative license and some relatively inexpensive resources (aka the FT, The Economist, Seeking Alpha, etc.), it is possible to find some possible winners and losers as we travel through this difficult period.

With that in mind, two short articles in this past weekend's Financial Times provide an excellent portrait of the economic climate in the United States. The combination of the two stories point out the overall weakness that is still present in the U.S. and in Europe. The first story is about McDonald's (NYSE:MCD), which hit a record price on July 22nd. According to the article McDonald's is hitting on all cylinders with some the following highlights:

  • Top line revenue was up 16 percent.
  • Net income was up 29 percent.
  • Successfully passing through cost increases with limited impact on sales.
  • U.S. drink sales rising 29 percent.

The U.S. was the slowest growing region with growth up 4 percent year over year. This is still substantially faster than overall GDP growth-which is terrific when you think about such a mature company. The company is growing fastest in Asia and the Middle East with sales rising 25 percent and while European sale were a bit slower than Asia it is still compelling growth at 21 percent.

Overall, McDonald's is poised to perform quite well as the deleveraging period in the developed world (particularly the U.S.) continues to be a plague on the economic climate. As people look for ways to get calories cheaper they will continue to supplement their diets with companies that offer greater values (not accounting for health) relative to the more premium brands such as Starbucks (NASDAQ:SBUX), etc. The company has demonstrated their ability to deliver robust performance during this extraordinarily difficult period.

What makes MCD an even more interesting play is that, in the event of an inflationary climate, which numerous super intelligent people believe is in store for the U.S., MCD is has proven quite capable of passing through the vast majority of cost increases that their business can be exposed to periodically. An excellent case in point is occurring this year as “grocery store prices are rising faster than restaurant menu prices” which according to the CEO provides MCD “more room to raise prices this year.” All of this provides some anecdotal evidence that MCD can manage their business in both the economic scenario currently unfolding (deleveraging) and the rising inflationary climate that some believe is in the not too distant future.

While McDonald's has been able to navigate the current environment, not all companies are faring quite as well, which turns U.S. to the next short article in the Financial Times. As it turns out it has been rather difficult for producers of washing machines and other household appliances. There are a number of less than favorable trends that are creating quite a few headwinds for companies such as Whirlpool (NYSE:WHR). According to the article, “Whirlpool is now forecasting raw material and oil related cost of between $450 and $500 million dollars, more than double the company estimates in early February.” While these rising input costs are putting a real squeeze on operating margins, what makes matters worse is that the developed world (particularly the U.S.) is in the midst of an ongoing balance sheet recession/deleveraging cycle. As the article notes, “meanwhile, consumer demand in developed markets remains weak as families chose to pay down debt, the housing construction market is still in the doldrums and competition is fierce. That makes raising prices a struggle.”

As though these macro trends are not hard enough for Whirlpool, there is more than ample potential for matters to get worse before they get better. “At the same time the withdrawal of U.S. government stimulus spending, which included certain incentive programs to encourage the sale of energy efficient appliances, has only added to the pressures on sales volumes.” It seems challenging to build a bullish case for any industry that relies on consumer debt as well as government stimulus to do particularly well. Until the consumer balance sheet is sufficiently restored, it will be tough times for Whirlpool and the like.

Just how long can the doldrums last? Well, the Economist article cited "a new analysis by the McKinsey Global Institute suggests that over the past year or so total debt levels, measured relative to GDP, have stabilised and, in some rich countries, started to inch down. But if history is a guide, there is still a long way to go. The ratio of total debt to GDP in both America and Britain has fallen by just over 10 percentage points from its peak — a fraction of the scale of debt reduction in a typical deleveraging period." The unfortunate reality of the current scenario is that things could take far longer than the typical deleveraging periods in the past. Such forecasts are typically based on a comparison of the asset bubble buildips of the past ( which preceded a balance sheet recession) with the asset bubble buildup preceding the current recession.

While "the McKinsey analysis suggests that economies usually stagnate, or even shrink, early in the overall debt-reduction process" perhaps a little luck will play out and we can get some decent fiscal policies that will prevent the economy from shrinking as balance sheets are slowly restored. But until we get more clarity on fiscal policy, maybe some renewed improvements in business confidence, I won't be holding my breath.

Thus a pairs strategy of going long MCD and short WHR is poised to reward an investor as the U.S. (and other developed economies) continue to muddle through this deleveraging/balance sheet recession.

Good luck and thanks for reading.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.