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What Exactly Did CAG BUY - Opportunity or Albatross?

Takeaway: We see CAG as a relatively inexpensive name that has additional upside to earnings.

CAG recently announced the acquisition of RAH for $90 per share in cash.  The transaction transforms CAG into the largest private label food manufacturer in North America.  Private label grows faster (about 2x the growth of branded in the United States over the past decade), but is much more volatile in terms of top line trends and margins.  RAH competes in a number of center of the store categories – cereal, pasta, snacks, sauces, etc.  We get two major points of pushback with respect to our positive view on CAG and the transaction:

  1. Does private label and branded under the same roof work? It didn’t when RAH tried to manage the branded cereal business at Post.
  2. The branded portfolio at CAG remains unimpressive

In response to the first point, it certainly didn’t work with RAH and POST, but CAG has already been doing it reasonably well within its existing portfolio.  The key is very little overlap in terms of categories, which is/was the case for the base business at CAG and is the case with the combined business as well.

 

The last point regarding the branded portfolio isn’t wholly unreasonable and has been our concern surrounding CAG for a number of years.  However, the portfolio has been streamlined and improved via acquisitions and divestitures and, more importantly, management has been increasingly focused on providing consistent support to the brands.  Bottom line, the portfolio isn’t great, but certainly improved.

 

Finally, over a long enough period of time, the jockeys (management) in the race matter as opposed to just the horses (brands).  Management can tear down or build brand equity, and we are a believer in the jockey (CEO Gary Rodkin) at the reins of the combined CAG-RAH.

 

Accretive to the top line


As mentioned above, private label has grown at about 2x the rate of branded products over the course of the last ten years.  Over that time, we have seen substantial improvement in the quality of private label offerings, to the point where private label brands, in some cases, compete at a near-premium price point.  Retailers want private label as a foil to the branded manufacturers.  While we believe that consumers prefer brands, we also think they want value as well, which is where private label comes in.

 

We also think that the organic growth profile at RAH is underappreciated for a couple of reasons.  First, as a serial (not cereal) acquirer it was at times difficult to parse out the organic growth profile.  Additionally, as a cereal acquirer (referring to POST this time), the poor performance and all around bad idea of that deal clouded numbers for a good bit.  On an organic basis, since 2005, RAH has grown its top line at an average of 4.9% - with a low of -0.2% in 2010 and a high of +12.1% in 2008.  So, as mentioned previously, there is some volatility on the top line.  When factoring in acquisitions (excluding POST), RAH’s top line grew at an average of 14.7% over the same period.

 

Keep in mind that private label remains a highly fragment industry, and the same type of consolidation opportunities that were available to RAH will be available to the combined entity as well, to the benefit of the top line.

 

Targeting $225 million in synergies by Year 4


Cost synergies are approximately 5% of the revenue of the company being acquired, within the range (5-7%) we have seen for other staples transactions, but at the lower end of the range.  We believe that there is upside to this number – moving closer to synergies representing 6% of RAH revenues garners another $45 million in cost savings, a number that we don’t find unreasonable given the likely conservatism on the part of management at this early stage and what we have seen from past transactions.

 

Bear in mind that the projected synergies are incremental to the cost savings programs that were in place at both RAH and CAG, so we see significant income statement flexibility in the coming years.

 

The impact of commodities is magnified in both directions for private label


Higher input costs are a significant issue for private label manufacturers as private label has less income statement flexibility than branded product as there is no advertising or marketing expense that can be cut to preserve EBIT margins in the face of gross margin pressures.  Further, to the extent that private label manufacturers raise prices to offset commodity increases, gross margins can be negatively impacted by manufacturing inefficiencies and fixed cost absorption as a result of lower volumes.

 

RAH has had an issue with raw material and freight cost increases in spades over the years – in fiscal 2012 alone, commodities and freight added $313.2 million to the company’s cost structure.  All but $72.6 million of that was covered by pricing actions, but the magnitude of the impact is staggering in relation to the total EBIT for RAH in 2012 - $358.7 million excluding the Post results in Q1.

 

Our firm view is that commodity prices will moderate as that asset bubble bursts or slowly deflates.  If that is the case, private label manufacturers will have substantial flexibility with respect to margins or pricing, which could lead to share gain opportunities and increased volume.  Increased volume should lead to improved fixed cost absorption and gross margin gains.

 

Bottom line is that as much as commodities hurt on the way up, there is as much gain to be had on the way down.  This is true for both RAH and the base business at CAG – CAG’s consumer foods business experienced double digit inflation in fiscal 2012, some relief from that is part of the reason that our EPS forecast for CAG is $0.08 ahead of consensus for the 2013.

 

CAG +RAH


The combined entity will have $18.2 billion in revenue, and should be able to grow top line in the 3-5% range, including 1 pt. from private label acquisitions.  We estimate that the transaction could be between $0.15 - $0.20 accretive, conservatively, in the first year, excluding incremental amortization of intangibles that is above our pay grade to calculate.  We assume an interest rate of just below 4% for the acquisition debt, as CAG refinances and exchanges the existing RAH debt that it assumes.  RAH’s weighted average interest rate is currently over 6%.  For the sake of simplicity, we assume a steady run rate on synergies, using our higher number of $270 million by the fourth full fiscal year after the transaction closes ($67.5 million per year or about $0.10 per share, per year).  So, synergies alone could provide 4% EPS growth.  We estimate that deleveraging could provide another 1.5 pts to EPS growth or likely closer to 1.0 pts as we net out share creep from exercises as the company has suspended its share repurchase program.  Bottom line, the combined business could deliver 8-10% EPS growth without the benefit of any margin expansion associated with a more benign commodity cost environment – looking out to fiscal 2015 for CAG, we can see an EPS number in the $2.75 range.  Recall that RAH’s issues with commodities represented over a $300 million headwind last year.  Assuming even a $20 million recovery, that is another $0.03 to $0.04 of earnings.  Looking at the average group multiple of 13-14X ’15 EPS, we can see a stock price in the upper $30s over time.

 

Solid Management + Synergies + Lower Commodities + Better Top line


We see CAG as a relatively inexpensive name (13.8x calendar 2013 EPS versus the packaged food group trading at 17.6x) that has additional upside to earnings on a standalone basis as well as a transformative acquisition that is scheduled to close during calendar Q1 2013 that should provide investors a path to a higher EPS profile through accretion and synergies.

 

 

Robert  Campagnino

Managing Director

HEDGEYE RISK MANAGEMENT, LLC

 

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Do You Believe? S&P 500 Levels, Refreshed

Takeaway: My sense is enough people missed the biggest up week for stocks in a year for me to believe just about anything.

This note was originally published January 07, 2013 at 11:33 in Macro

POSITIONS: 11 LONGS, 8 SHORTS

 

Stocks got immediate-term overbought as bonds got oversold on Friday. Immediate-term TRADE overbought is as overbought does, so just be smart where you make those gross and net exposure decisions. Timing matters.

 

Do you believe we make a higher-high versus 1466? Or, maybe a better question, did you believe that we could test 1466 before we did? My sense is enough people missed the biggest up week for stocks in a year for me to believe just about anything.

 

Across our core risk management durations, here are the lines that matter to me most:

 

  1. Immediate-term TRADE overbought = 1482
  2. Immediate-term TRADE support = 1439
  3. Intermediate-term TREND support = 1419

 

In other words, the SP500 could drop 20 handles from today’s intraday low as fast as it could tack on another 20 from here. What do you do with that? I say you keep moving and risk manage this tape with a bullish bias until the research factors (#GrowthStabilizing) and/or risk signals change.

 

KM

 

Keith R. McCullough
Chief Executive Officer

 

Do You Believe? S&P 500 Levels, Refreshed - SPX


FNP: Tory Burch Deal Reminds Us of Value

Takeaway: Tory Burch transaction underscores just how undervalued FNP is headed into ICR event.

The transaction in the private luxury brand Tory Burch – one of FNP’s closest comps – at year-end serves as the latest reminder of just how undervalued FNP is at current levels. We’ve written a fair amount about the favorable setup headed into ICR and our view hasn’t changed. Consider the following:

  • Tory Burch Transaction – a Valuation Reminder: The capital gains tax increase proved the final straw. After years of speculation, Chris Burch (Tory’s ex-husband) finally sold the majority of his ownership a 25% stake in the company for ~$813mm (he kept 3.3%) suggesting a $3.25Bn valuation for the brand. According to estimates on Burch's top-line, this would suggest a multiple north of 4x and ~3x 2012 and 2013 sales respectively. This lands right between FNP’s two public company peers with KORS at 5.5x and COH at 3.5x 2012 sales and at the low-end of 2013 multiples. FNP on the other hand trades at less than 2x 2013 Kate Spade sales alone (not including Lucky or Juicy Couture) – a 45% discount to the peer average.

For several reasons, Tory Burch is a better comp to Kate with both brands at an early stage in their life cycles. For starters, both concepts are closing in on 100 stores and generate ~20% of sales overseas. One of the key differences is profitability. Burch’s operating margin is reportedly similar to KORS in the mid 20s and below COH in the low 30s. However, Kate Spade margins are lower at ~11% including corporate expenses and ~15% without substantially below peer levels reflecting investments to grow the brand. Mind you, this is not because of any factor
aside from that Kate is simply investing in the areas that matter to fuel future growth. It could print 2x the current margin rate in a heartbeat, but then we’d have to question the sustainability of its growth trajectory. We don’t question that for a minute with Kate.

 

We’re modeling Kate Spade sales approaching $800mm in 2013 and exceeding $1Bn in 2014 and expect profitability to continue to move upward toward the 20% level over the next 2-3 years. Assuming a 3x multiple of next year’s sales for Kate Spade alone that would imply a valuation close to a $2.5Bn for the brand – over 50% higher than the entire value of FNP today.

  • Expected Pre-ICR Update: We expect the company to provide an updated brand outlook ahead of next week’s ICR conference (Jan 16th-17th) most likely later this week. While the recent hire of a CEO at Juicy reduces the likelihood of an early divestiture announcement, we expect the focus in Miami to be on the company’s commitment to materially accelerating square footage growth at Kate and Lucky (see our note “FNP: Juicing Kate” on 10/25), profitability growth (particularly at Kate), and the upcoming Kate Spade investor day likely in 1H 2013.

While we can easily get to $180mm in adjusted EBITDA in FY13, we wouldn’t be surprised to see the company come in a bit lower on its initial outlook in an effort to re-establish forecasting credibility. In fact, we’d prefer it. Recall at this time last year, the company lowered its outlook less than a quarter after resetting expectations on the sale of assets in October.

 

In addition, we wouldn’t be surprised to see a positive pre-announcement out of first-timer KORS as well into the event. Particularly in light of JWN highlighting handbag strength at the high-end over the holidays and based on how the company has managed expectations historically.

  • Hosting FNP Dinner Jan 16th: We will be hosting a dinner with the management (CEO Bill McComb, CFO/COO George Carrara, and SVP of Finance Bob Vill) on the night of Wednesday the 16th. Clients who are interested can contact .

 

FNP: Tory Burch Deal Reminds Us of Value - FNP TBurch Valn 2

 




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RANKING THE G3 CURRENCIES

Takeaway: Our analysis points to further upside in the USD vs. peer currencies over the intermediate term.

SUMMARY CONCLUSIONS:

 

  • In the note below, we analyze a series of quantitative RISK MANAGEMENT and fundamental RESEARCH factors to rate each of the G3 currencies with an eye for expected performance over the intermediate-term TREND. Those factors include:
    • The market setup relative to our proprietary quantitative RISK MANAGEMENT levels;
    • Our propriety GROWTH/INFLATION/POLICY outlook for each country/region;
    • Sentiment via Bloomberg CFTC net length data;
    • Expectations for monetary POLICY via 2YR OIS spreads;
    • Sell-side expectations via 2013 Bloomberg consensus forecasts for each currency; and
    • The outlook for fiscal POLICY across each geography.
  • All told, our comprehensive analysis of G3 currency fundamentals and market indicators suggests the USD (via the DXY) is poised to trade marginally higher vs. the EUR throughout 2013 and demonstrably higher vs. the JPY over that same duration.
  • Importantly, broad USD strength vs. these two peer currencies should continue to auger negatively for global inflation expectations and market prices for inflation hedge assets, such as gold and TIPS.

 

METHODOLOGY

We assign 1pt if a particular factor screens bullish, (1pt) if the factor screens bearish and 0pts if the factor is inconclusive for each of the aforementioned factors across each currency – with the exception of our quantitative overlay. For the latter, the magnitude of scoring is both amplified and unique:

 

  • 1pt for bullish TRADE/(1pt) for bearish TRADE;
  • 2pts for bullish TREND/(2pts) for bearish TREND; and
  • 3pts for bullish TAIL/(3pts) for bearish TAIL.

 

As a point of process, PRICE, VOLUME and VOLATILITY signals tend to dominate our interpretation of fundamentals for a particular security or asset class, as well as our expectations for future PRICES; for this reason, we assign a greater weight to our quantitative overlay relative to the other factors.

 

Lastly, it should be duly noted that while we analyze each factor on an absolute basis by the signal(s) it is currently projecting, the overall analysis is one that is relative in nature – just like the currency crosses themselves. As such, investors should not interpret the final scores of this exercise as anything other than how each currency currently stacks up against the other two with respect to this comprehensive analysis.

 

QUANTITATIVE OVERLAY

On our quantitative factoring, the USD (via the DXY) is trading right at our immediate-term TRADE line of 80.24 and is bullish TREND and TAIL for a total of +5pts:

 

RANKING THE G3 CURRENCIES - 1

 

On our quantitative factoring, the EUR is trading right at our immediate-term TRADE line of $1.31 vs. the USD and bullish TREND and TAIL for a total of +5pts:

 

RANKING THE G3 CURRENCIES - 2

 

On our quantitative factoring, the JPY is bearish TRADE, TREND, and TAIL vs. the USD for a total of -6pts:

 

RANKING THE G3 CURRENCIES - 3

 

GROWTH/INFLATION/POLICY OUTLOOK

Those familiar with our fundamental RESEARCH process are likely aware of our G/I/P analysis. While this process is used primarily to front-run short-cycle deltas in a particular country and/or region’s economic fundamentals, we have added a new overlay that allows us to view those deltas on a full-year basis as well. For more details on the associated methodology, please refer to our 1/3 note titled: “SIZING UP ASIA & LATIN AMERICA FOR 2013”.

 

From a full-year 2013 perspective, the US economy appears poised to register a trip to Quad #1 on our G/I/P screen – specifically, GROWTH is likely to accelerate YoY, while INFLATION is likely to decelerate (+1pt):

 

RANKING THE G3 CURRENCIES - UNITED STATES

 

From a full-year 2013 perspective, the Eurozone economy appears poised to register a trip to Quad #1 on our G/I/P screen – specifically, GROWTH is likely to accelerate YoY, while INFLATION is likely to decelerate (+1pt):

 

RANKING THE G3 CURRENCIES - EUROZONE

 

From a full-year 2013 perspective, the Japanese economy appears poised to register a trip to Quad #3 on our G/I/P screen – specifically, GROWTH is likely to decelerate YoY, while INFLATION is likely to accelerate (-1pt):

 

RANKING THE G3 CURRENCIES - JAPAN

 

CFTC DATA

We use CFTC reporting of net futures and options contracts to gauge market sentiment and positioning for particular currencies or asset classes. Additionally, while it is common for market participants to focus on the non-commercial (i.e. speculators) data in lieu of the commercial (i.e. hedgers) data, we prefer to combine the two data sets to form a more holistic view of the market.

 

On our amalgamated look, the market is positioned net long of the US Dollar Index to the tune of 786 combined contracts for a z-score of 1.72. As it relates to market prices, this data series has a lagging relationship to the DXY, forming cycle peaks as the z-score breaks through 0 to the upside and forming cycle bottoms as the z-score breaks through 0 on the downside.

 

The current reading of 1.72 suggests we’ve either recently begun a phase change with regards to the market’s position (which was net short for much of the past three years) or there is further weakness to come. While we are inclined to believe the former view, historic data supports the latter conclusion, for now, for a score of -1pt:

 

RANKING THE G3 CURRENCIES - 7

 

On our amalgamated look, the market is positioned net short of the EUR to the tune of -2,346 combined contracts for a z-score of -2.44. As it relates to market prices, this data series has held a contrarian relationship with the EUR/USD cross since MAR ’09, after having held a coincident relationship for much of the 5-7 years prior to then.

 

As such, the current reading of -2.44 suggests the EUR is poised for further upside vs. the USD with respect to the intermediate term for a score of +1pt:

 

RANKING THE G3 CURRENCIES - 8

 

On our amalgamated look, the market is positioned net long of the JPY to the tune of 44,732 combined contracts for a z-score of 1.33. As it relates to market prices, this data series has held a contrarian relationship with the JPY/USD cross since mid-2007, after having held a coincident relationship for much of the two years prior to then.

 

As such, the current reading of 1.33 suggests the JPY is poised to give back some of its recent correction vs. the USD with respect to the intermediate term for a score of +1pt:

 

RANKING THE G3 CURRENCIES - 9

 

OIS SPREADS

We find that fluctuations in the spread of two countries and/or regions’ interest rates can often be a powerful driver of currency crosses. Moreover, we use 2YR overnight index swaps (OIS) to gauge where market expectations for said rates are.

 

For the USD (via DXY), we formed a weighted average of 2YR OIS for the six currencies that comprise the US Dollar Index by their respective weights in the index, then subtracting that figure from 2YR USD OIS rates to form a basis point spread. The current spread of -17bps suggests the DXY should be tracking roughly +3-4% higher in the ~83 range for a score of +1pt:

 

RANKING THE G3 CURRENCIES - 10

 

The +4bps spread between EUR and USD 2YR OIS rates is supportive of a much lower EUR/USD cross in the area code of ~$1.23. That’s roughly -6% lower than the current price of $1.31 per USD for a score of -1pt:

 

RANKING THE G3 CURRENCIES - 11

 

The +17bps spread between USD and JPY 2YR OIS rates is supportive of a much lower USD/JPY cross in the area code of ~¥82. That’s roughly +7% stronger than the current price of ¥87.69 per USD for a score of +1pt:

 

RANKING THE G3 CURRENCIES - 12

 

CONSENSUS EXPECTATIONS

Anchoring our expectations in and around consensus forecasts is not something we are ever inclined to do at Hedgeye. That said, however, because global moneycenter banks tend to dominate transactions in the FX market globally through a variety of trade and investment finance, hedging strategies and/or general flows of capital (i.e. repatriation of corporate overseas income, etc.), we would be remiss to discount their influence on market exchange rates.

 

In a similar fashion to how we constructed the weighted average 2YR OIS rate for the US Dollar Index constituent currencies, we have also constructed a weighted average Bloomberg Consensus 2013 year-end forecast for the US Dollar Index by amalgamating the Bloomberg Consensus 2013 year-end forecasts for each of the six constituent currencies according to their respective weights in the index.

 

On the metric, the sell-side expects the US Dollar Index to end the year roughly +2% higher at 82.10 for a score of +1pt:

 

RANKING THE G3 CURRENCIES - 13

 

The sell-side expects the EUR to end the year roughly -3% lower at $1.27 per USD for a score of -1pt:

 

RANKING THE G3 CURRENCIES - 14

 

The sell-side expects the JPY to end the year roughly flat at ¥88 per USD for a score of 0pts:

 

RANKING THE G3 CURRENCIES - 15

 

FISCAL POLICY OUTLOOK 

While typically slow-moving in nature, relative deltas in fiscal POLICY can have demonstrable effects on currency crosses when expectations for critical metrics (i.e. deficit/GDP, debt/GDP, sovereign debt issuance, etc.) are exceeded or unmet. As a result, we think currency investors should be very focused on what is likely to be an eventful 2013 with regards to G3 fiscal POLICY – particularly in both Japan and the US.

 

It would be an understatement to suggest that the domestic fiscal POLICY outlook is a bit unclear at the current juncture. While it is certainly fair to argue that hopes for any meaningful fiscal reform in the US were, at best, punted to ~MAR 1st via the introduction of the American Taxpayer Relief Act of 2012, it is not unreasonable to hold out hope for further progress.

 

The upcoming reform process is likely to be as messy as ever, but it does appear the GOP has enough political leverage (i.e. Debt Ceiling) to force Obama to play ball with regards to meaningful entitlement reform and/or tax code restructuring. Unfortunately for global investors, the world will once again be forced to watch the how proverbial “sausage” is made – if any is made at all. As an aside, any short-term bout of global risk aversion in the days and weeks leading up to and through any official breach of the Debt Ceiling would likely prove positive for the DXY via TIC inflows.

 

For a deeper discussion of the US’s fiscal POLICY outlook, please refer to our 1/7 note titled: “CLIFF JUMPING 101… TAKEAWAYS FROM PASSAGE OF THE AMERICAN TAXPAYER RELIEF ACT OF 2012”. All in, we assign the US a score of “TBD”/0pts in the fiscal POLICY department.

 

Flipping over to the Eurozone, after ~two years of European fiscal POLICY dominating global financial markets from a headline risk perspective, 2013 appears rather boring on a relative basis – both relative to what investors have likely become accustomed to receiving from Europe and relative to the US (above) and Japan (below).

 

From Matt Hedrick, our head of European fundamental research:

 

“Fiscally the Eurozone remains anchored, at least rhetorically, under Draghi’s accommodative ECB policy stance to keep rates low and use its bond purchasing program (OMT) if requested by a member nation. 2013 is setting up to look a lot like 2012 in which countries muddle through the impact of previously issued austerity packages.”

 

All in, we think a lack of fiscal deterioration in Europe is at least worth 0pts – and possibly 1pt if Draghi & Co. can help indebted sovereigns reduce their structural balances by via a lower cost of capital. For now, we think a score of 0pts is warranted for the Eurozone’s 2013 fiscal POLICY outlook.

 

Turning to Japan, Japan’s new Prime Minster Shinzo Abe and his Finance Minister Taro Aso appear poised to accelerate public expenditures and sovereign debt issuance beyond previous expectations set by the outgoing DPJ. The latest news on this front is the announcement of a ¥12 trillion supplementary stimulus budget and the accompanying debt issuance needed to finance these expenditures.

 

For a deeper discussion of Japan’s fiscal POLICY outlook, please refer to our 12/26 note titled: “JAPAN TO LOOSEN FISCAL POLICY AS WELL”. All in, we assign Japan a score of -1pt in the fiscal POLICY department.

 

RANKING THE G3 CURRENCIES - 16

 

RANKING THE G3 CURRENCIES - 17

 

FINAL TALLY AND KEY TAKEAWAYS

The cumulative score/rank for each currency is as follows:

 

  1. USD (via the DXY): 7
  2. EUR: 5
  3. JPY: -6

 

Our comprehensive analysis of G3 currency fundamentals suggests the USD (via the DXY) is poised to trade marginally higher vs. the EUR throughout 2013 and demonstrably higher vs. the JPY over that same duration. Importantly, broad USD strength vs. these two peer currencies should continue to auger negatively for global inflation expectations and market prices for inflation hedge assets, such as gold and TIPS.

 

Darius Dale

Senior Analyst


Gold In Bearish Formation

Gold has been selling off since September when it hit $1900/oz. As we move from "growth slowing" to "growth stabilizing," both commodities and gold have continued to deflate. From a long-term perspective, we think the gold bubble has already popped. From a quantitative setup, gold is in a bearish formation; we’ll short gold (GLD) and gold miners (GDX) as long as our models tell us to do. Across our core risk management durations in Gold, here are the lines that matter to us most:

 

1.       Intermediate-term TREND resistance = 1699

2.       Long-term TAIL resistance = 1671

3.       Immediate-term TRADE resistance = 1665

 

Gold In Bearish Formation - gold


Improvement In Europe

Following the fiscal cliff resolution in the United States, credit default swaps (CDS) on European banks are tightening across the board save for Greece. Italian and Spanish banks were the most improved, while German and French banks were close behind. Additionally, the Basel Committee has imposed a four-year delay for European banks to improve their liquidity requirements, which would have tied up a large amount of capital at financial institutions. This is an additional tailwind in the near-term for European banks.

 

Improvement In Europe - 33  banks normal

 

Improvement In Europe - image001


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 80.64%
  • SHORT SIGNALS 78.61%
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