DF –Trends Are Moving in DF’s Favor

The bad news is that there are a handful of issues that continue to overshadow DF’s underlying market opportunities. First, the company has been plagued by commodity cost volatility, particularly as it relates to milk, butterfat, diesel, natural gas and resin costs. In 3Q alone, non-milk costs increased over $13 million from 2Q. Second, Horizon Organic continues to put pressure on WhiteWave-Morningstar segment profitability as industry oversupply has led to declining retail prices at the same time raw organic milk prices have climbed significantly. Third, recessionary headwinds combined with historically high commodity prices have put increased stress on the fluid milk industry, which is driving market price volatility. Fourth, DF is a highly leveraged company at a time when investors are frightened by illiquidity.
  • The good news is that most of these issues are abating and even turning favorable. As it relates to DF’s key commodity inputs, costs have already started to come down. In 3Q, milk prices were down 12% YOY but still up 7% sequentially from 2Q. For fourth quarter-to-date, milk prices have declined 24% YOY. The company’s diesel, natural gas and resin costs also all declined sequentially in October from 3Q levels. Higher butter prices (up 13% in the quarter) contributed to the 4% profit decline at the WhiteWave-Morningstar segment. DF utilizes a pass-through pricing mechanism as butter prices change on a monthly basis, but if prices increase rapidly it can create a pricing lag effect so the company was unable to keep pace with the significant increases in butter prices. Management sees these prices stabilizing in November and December and rolling over so Morningstar’s profitability should benefit from lower costs. As management stated, “We're finally catching up with a trend that's coming to an end. So, classic Class 2 butter fat pricing dynamic. Right? Typically, you don't see a march up of 10 consecutive months like we've had this year, but the trend is ending and we've been pricing against the trend and doing our best to anticipate the trend. So we believe that you'll see Morningstar move back into a more profitable posture as the trend ends.” Although management expects its key input costs to be favorable on a YOY basis, they stressed that their current FY09 EPS guidance of approximately $1.40 is based on conservative commodity cost assumptions due the recent volatility experienced.
  • In addition to higher butter costs, Horizon Organic also negatively impacted WhiteWave-Morningstar profitability in 3Q as industry organic milk retail prices have not kept pace with rising raw organic milk costs. In 3Q, Horizon Organic’s retail pricing increased 11.8% YOY on top of the 4.9% increase in 2Q (follows 4 quarters of pricing declines). DF also saw private label prices increase during the quarter but by about half of the magnitude taken by the branded players. On a positive note, management sees industry supply growth slowing significantly over the next 6 months which should boost prices over time, but they have not planned for any meaningful rebound from Horizon Organic in FY09. Like the company’s other commodity inputs, management does expect raw organic milk costs to begin to rollover as feed costs abate which should benefit Horizon Organic’s profitability despite the less than favorable retail pricing environment. Despite the challenges at Horizon Organic, the company expects stronger results for WhiteWave-Morningstar going forward, beginning with a return to profitability in the fourth quarter.
  • As it relates to the competitive fluid milk environment, DF continues to gain volume share (up 3.2% in the quarter relative to the industry’s 1.3% increase). This 3.2% volume increase (200 bps from acquisitions) compares to its competitors’ estimated 0.2% volume growth in 3Q. DF is seeing increased competitive pricing as the industry pushes to sell increased volumes in today’s recessionary environment. In the short-term, this increases management’s lack of visibility and cautious stance. Management indicated that based on current retail pricing combined with current commodity cost pressures that many of its competitors are struggling and are not earning their cost of capital. This type of environment over time can lead to two outcomes (or a mix there of): some of these competitors will go away and/or the industry will have to return its focus to building margins by increasing prices. Both of these outcomes will work to DF’s favor. Struggling competitors will provide DF with the opportunity to grow its market share and a returned focus to industry profitability will also boost DF’s profitability.
  • Although DF’s financial leverage is concerning, relative to other conference calls I have listened to recently, the Q&A session was not bombarded by questions regarding DF’s current debt to EBITDA levels and covenants, which leads me to believe that investors are not extremely concerned. The company has generated $75-$100 million in free cash flow in each of its last 3 quarters and expects to achieve $75 million plus in 4Q, which management believes will allow DF to close out the year at a debt to EBITDA ratio of below 5.25x relative to its covenant of 5.75x. By the end of 2009, the company expects this number to fall to 4.5x (relative to its covenant step-down to 5x). Management stated that it is comfortable that it will remain half a turn ahead of its covenant step-down.

Headline Of The Day: "The New Reality" bites!

Our friends at Street Account hit us with this today, "JPMorgan Chase has closed its proprietary trading desk" -- Financial News ...

This is great news for the US financial industry. The compromised, conflicted, and constrained "Berlin Walls" of "Investment Banking Inc." continue to fall, one by one.

Running a prop desk on the other side of your client businesses just won't make sense to anyone with a pulse and a ‘You Tube’. The transparency and accountability pants are going to finally be worn in this business. Today, is another great day for the “New Reality” of American Capitalism.



India’s markets rally but the data remains overwhelmingly negative

Stocks rallied in India today for the fifth consecutive session, fueled by the central bank’s surprise rate cut and reserve requirement reduction, with financials in particular rebounding from earlier lows. Comments from the minister of finance indicated that the Reserve may open 100 billion INR credit lines to both National Housing Bank and Small Industries Development Bank to increase flows for mortgages and small companies -adding to bullish public sentiment. Meanwhile the rupee was up on heavy US Dollar selling by banks.

We expect this relief buying to lose steam as rapidly as it arrived when domestic Indian investors (who are largely funding this rally, despite some media reports that foreign buyers have started to dip their toe in the water again) shift their attention from inflation to dimming growth prospects.

Trade data for September, released yesterday, is hardly encouraging. Export numbers reached their lowest growth Rate since November 2005 while trade deficit figures, despite coming in better than 3 out of 4 prior months due to declining commodity prices, still represents a 133.37% increase over the same month last year.

The current administration’s public stance is that, although a slowdown is now a foregone conclusion, GDP growth should maintain above 7% annually –enough to sustain job growth. This is wishful thinking. In a nation attempting to balance socialism with a stratified society where 25% of the total population subsists below the poverty line, job growth is critical for any party wishing to maintain power. This leaves Singh & co. little choice but to keep promoting a rosy picture before next year’s election.

One part of the government’s narrative -that the diversification of India’s export markets towards greater trade with OPEC nations and emerging Asia will insulate GDP growth from the slowdown in the EU and US, while at the same time heralding cheaper commodity prices as an inflation fix, sounds like suspiciously circular logic.

We continue to take a negative view on India’s short-term and intermediate-term prospects as the combination of a cooling global economy with short-sighted government policies stand to continue weighing heavily on the “I” in “BRIC”.

Andrew Barber

Hedgeye Statistics

The total percentage of successful long and short trading signals since the inception of Real-Time Alerts in August of 2008.

  • LONG SIGNALS 80.46%
  • SHORT SIGNALS 78.35%


Everyday hundreds of millions of people around the world wake up and drink a cup or two of coffee in the morning. It’s a habit for some and will remain that way forever. Starbucks is a brand that has relevance in our society and can satisfy the habits of millions. How many times have someone said to you let’s meet at Starbucks and get a cup of coffee? It happened to me yesterday! At Research Edge we think the timing is great to start a consumer fund with a 3-5 year investment horizon. There are some incredible opportunities given the debacle in consumer names. Starbucks would be one of the names we would put in that portfolio. Don’t misunderstand my positive tone has nothing to do the quality of the quarter to be reported on November 10th. A lot has changed since the last time the company gave guidance to the street.
  • Starbucks still faces significant headwinds as it adjusts to the global consumer macro issues. Since the company last gave guidance for 2009, consumer sentiment is falling and spending has slowed. The company current expectations are for same-store sales to grow 2-3% for fiscal 2009, with no pricing. This appears to be aggressive given the current trends in consumer spending. Every company is facing theses issues and Starbucks is better positioned than most to deal with them. To the degree that smaller competitors can’t survive, Starbucks’ opportunities grow.
  • In the short run, two big negative commodity factors have swung positive for the company. Over the past couple of weeks, we have posted extensively on the decline in both milk and coffee prices. While they will not provide any significant benefit to the company in its fiscal fourth quarter reported on November 10, lower commodity prices will have a positive impact in the first quarter of fiscal 2009 (higher dairy costs resulted in a negative $0.02 impact to EPS in fiscal 1Q08).
  • Another short term issue includes consumer demand at the company’s core U.S. store base. Last week, CEO Howard Schultz made the following comments to reporters at a company leadership conference in New Orleans; "The downturn continued in the fourth quarter, and we did see a slight improvement in the first weeks of Q1 ... which might suggest that Starbucks may have hit bottom in terms of negative transactions in our fourth quarter.” If I had 3-5 year investment horizon, SBUX would be on the top 10 list of consumer stocks to buy….. But, why did Howard need to be this vocal about business trends? I don’t see any upside at this point...
  • I believe Howard is also seeing the benefits of the company’s efforts to slow store growth and close underperforming stores. The shrinking of the U.S. asset base (closing stores and rationalizing the U.S. infrastructure) will eliminate cannibalization and close underperforming stores, which will help to improve same-store sales trends.
  • For most consumer companies there is not much that can be done to offset the macro environment. Therefore given today's turbulent investment environment, cash and the redeployment of cash flows will be a critical factor in determining future levels of valuation and, therefore, stock price performance. A cash flow sustainability analysis suggests that managing cash flow properly will allow any given company to outperform its peer group over a sustainable period of time. A key component to sustainable, consistent growth and a premium valuation is the proper balance between cash reinvested into the business and cash returned to shareholders. We all know that Starbucks had tipped the scales too far in favor of growth. What is not clear is how the capital allocation decisions made in fiscal 2008 will impact 2009. Our model suggests one outcome, but the reality of the reported numbers will not be evident for 3-6 months. Over the next two years SBUX will likely generate about $1.2 billion in free cash flow, but this number could move higher because I think FY09 capital spending still has the potential to come down further. To date, management has not spoken about what they intend to do with this cash. In all likelihood the company will pay a dividend for the first time in the company’s history. The divided could be anything from $0.15 to $0.25 per share. At the high end it would provide shareholders 2% yield, helping to put a floor on the stock.
  • Lastly, the investment community is so sure that MCD will put SBUX out of business, or at least significantly erode the profitability of SBUX’s business model. I’m confident that the MCD coffee program is not working – there is clear evidence that MCD is way behind on its store conversion schedule and they are still tinkering with the recipe. SBUX is the cheapest global restaurant company I follow (6.5x NTM EV/EBITDA) with great cash flows and global opportunities, but patience pays.

Point Counterpoint: GES, LIZ, RL, SKX, COLM, CROX

Here’s the latest intersection between Keith’s factor models, and my fundamental models. Combining the two has improved our team’s batting average. Lots of opportunity out there…

KEITH: GES lined up to be knocked down again. From here to 25.96 it’s a short. Any catalysts?
BRIAN: Yes. When the company comes out with earnings in another month, it will take down numbers.

KEITH: LIZ has a lot of work to do, but if it can hold 7.32, it has a prayer.
BRIAN: A lot of work to do indeed. But we’re going to start to see more of that work payoff over the next 2 quarters. The P&L is a mess, but people are looking through capex and sg&a cuts. Cash trajectory looks good to me.

KEITH: SKX failed right where it should have (13.48); it will see $11, soon, if the fundamental river card shows.
BRIAN: Let me be clear on this one… I think margins are going close to zero. But I’m not sure we’ll see Keith’s fundamental river card before year end.

BRIAN: My gut (and my math) gets me to a beat on the quarter, and if there is a guide down, it should not be by much. For a global power brand like RL that is coming off a period of investing in both its P&L and balance sheet while many competitors have been doing the opposite, I like its competitive positioning at 6x EBITDA.
KEITH: Stock was a buy at 38 on the prospect of a beat on the Q… not at 48.
Editor’s (Brian’s) Note: The key factor here in our differing view is duration mismatch.

KEITH: COLM holding 35.76 looks like a long.
BRIAN: I agree on the fundamentals here. Not rosy by any means, especially with Spring backlog so weak. But COLM is 3-quarters into a period of SG&A investment that I have been waiting for five years to see. The company is finally investing in its content. Don’t underestimate how that could reverse the trajectory of a flailing top line.

KEITH: CROX has 29% of the shares held short, and is now a long provided it can hold 2.48. Up another 26% Tuesday. Someone knows something …
BRIAN: If someone knows something imminent, it’s not me. Imminently, earnings/cash flow is a black hole. CROX should have reported yesterday, but they have not even announced their reporting date. Fundamentally, I like the idea of a take-out. Enterprise value of $232mm, and regardless of the ‘fad-factor’ of its core product, I think Crocs is a brand, not a product. Someone larger will own this company within a year. My bet rests with Skechers, which can buy CROX with its cash on hand. The duration of a call on this one is the biggest question in my mind.

Confucius Says...

“And remember, no matter where you go, there you are…”

This is one of the simplest, yet most relevant quotes in my investment notebooks. In a word, I call it accountability. Hide from it at your own risk. There’s a new sheriff in this town of global market leadership – her name is ‘You Tube’… and she will hunt you down.

The transparent drama of political life in this country will finally find an apex tonight. Obama will likely be accepting a rock-star victory at a reception in Grant Park in Chicago, Illinois, while the “Straight Talk Express” will be chalking up another Presidential race loss… this time, at the Biltmore in Phoenix, Arizona.

The paths of these two men provide a metaphor for where the United States has been vs. where it’s going. Grant Park is 319 acres of open air which hosts America’s mosh pits at Lollapalooza, whereas the Biltmore is one of our citizenry’s sites of haute couture, Cartier watches, and Cindy marrying the “Maverick” back in 1980. “No matter where you go… there you are.”

Much to the chagrin of the bears who are running around pitching my 9 month old “Macro” thesis’, we’ve been all “bulled up” as of late. We’ve been using Obama’s pending election, credit spreads narrowing, and earning’s season ending, as a trifecta of catalysts for a new beginning. No matter how good or bad a year you are having in this market, you have to have your feet on the floor this morning, proactively managing towards tomorrow. People don’t care about your October anymore. They want to know where you are today, and where you are going next. “No matter where you go… there you are.”

So where to next, “Mr. Mucker”? While it’s nice to be called “Mr.” these days, I do still enjoy the odd crackberry addict firing off at me, calling me names. It inspires me to work harder. So let’s strap on the analyst pants and get back to the notebooks. First, for context, let’s go through the math. Since our “Buy’em” Early Look note from 10/27 (, the S&P500 has rallied from 848 to 966 (up +14%), Volatility (VIX) has plummeted from 80 to 53.68 (down -33%), International stock markets have been squeezed for anywhere from +15-30% moves, the US Dollar has lost -3% from its peak, and international currencies have stopped going down. “No matter where you go… there you are.”

Context is always critical when attempting to proactively predict markets and/or the tail risks implied therein. Respect history, or it will teach you lessons the hard way. With the aforementioned bullish macro backdrop, you have to face the facts this morning and look towards a less dark future. Obama’s win is the obvious catalyst that global stock markets have started to discount, but the less obvious ones are A) that the yield curve continues to steepen and B) inflation readings continue to dampen. This combination is a powerful one. It gives countries from Asia to Europe the objective facts needed to join hands and cut rates. The Reserve Bank of Australia cut rates this morning by another 75 basis points to 5.25%, and on Thursday, both the ECB and the Bank of England will be cutting them again as well. Don’t be short that calendar.

In yesterday’s Federal Reserve Senior Loan Officer Survey, the simpleton’s conclusion should have been more of what we have been calling for the past 9 months – access to credit continues to tighten as cost of capital continues to rise. No, “Heli-Ben” dropping money from the heavens hasn’t done a darn thing for 30 year mortgage rates other than inflate them. No, Paulson’s Biltmore Club collaboration for “Investment Banking Inc.” hasn’t helped one corporate borrower who needs long term debt financing – 10 year Treasury yields are testing 4% this morning - they are breaking out!

No, this won’t make sense to all of the “hedgie” freedom fighters who said they “don’t do Macro”… nor will it help my 60% position that I still have parked in US cash. Cutting rates to zero doesn’t inspire one to save anything. Cutting rates to zero ultimately means you can only RAISE them next! That’s why long rates are headed higher as short one’s nosedive. This, all together, is outstanding news for what we have labeled as a Research Edge Investment Theme for 2009 – “The New Reality.”

“The New Reality” is that yesterday’s Wall Street is going away. They can house it alongside the horse and the buggy whip at the Biltmore museum. Bush’s administration will be gone. Paulson’s team will be too. This is great for those looking for new beginnings. This is great for Americans who are liquid long cash. Borrow short, lend long. Charge those in need of leverage a healthy premium. Rinse and repeat. “And remember, no matter where you go, there you are.”

Our immediate term target for the S&P500 is now 990. A close above that level gets my allocation to US cash under 50%. A failure, and close below that level re-sharpens my bear claws.

Have a great day,

Long ETFs

JO – iPath Coffee – Arabica futures declined on ICE on further anticipated index investment outflows. Vietnam Coffee and Cacao Association warned producers face major bottleneck unless banks open credit lines to wholesalers.

EWG – iShares Germany – Eurozone PPI was reported for September at +7.9Y/Y, lower than expected on declining oil costs. BMW traded up 8% after guiding for ``clearly positive'' earnings after production cutbacks.

FXI – iShares China – CSI 300 index declined over 1.5% as basic material and energy companies guided lower on falling global commodity prices. China’s top tin producers announced significant capacity cuts as demand slackens.

VYM – Vanguard High Dividend Yield ETF – Depository Trust & Clearing Corp. will publish details of the top 1,000 credit default swaps today after 5PM, under regulatory pressure. Information will include gross and net contracts outstanding as well as trading volume.

Short ETFs

UUP – U.S. Dollar Index – The Euro rose against the dollar today on declining money market borrowing cost, anticipated rate cut from the ECB in 2 days further increasing liquidity.

EWU – iShares United Kingdom – Apparel retailer Marks & Spencer up over 10% after reporting smaller than expected loss, continued dividend. RBS declined 9% on write-down’s, declined to forecast full year results.

IFN – The India Fund – SENSEX and the Rupee rose for fifth consecutive day. Finance Ministry reports that the Reserve Bank may open 100 billion INR credit lines to the National Housing Bank and Small Industries Development Bank to increase flows for mortgages and small companies.

Keith R. McCullough
CEO & Chief Investment Officer

Early Look

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