“Never have I seen a country so utterly unprepared for war and so soft.”
-Field Marshall John Dill
In one of the more poorly timed British central command comments during WWII, that’s what the Chief of the Imperial General Staff, Sir John Greer Dill, had to say about America just before December 1941 (The Last Lion, page 421).
Japan, of course, attacked the US at Pearl Harbor on December 7th, 1941. And, after President Roosevelt told Winston Churchill that “we are all in the same boat now”, America all of a sudden didn’t seem so “soft” anymore.
In his memoirs Churchill explained that he was quite happy about the whole turn of events. On the night of the Japanese attack he “slept the sleep of the saved and thankful” (page 423).
Back to the Global Macro Grind…
After watching Notre Dame’s defense last night, I am still pretty sure that soft is as soft does. That’s also one of the Top 3 Global Macro Risks to being really long US Equities here: Soft Earnings.
Given our view of Global #GrowthStabilizing, that might confuse come people – but it shouldn’t. Veteran Risk Managers know that earnings are a lagging indicator, while growth is a leading one.
That doesn’t mean that #EarningsSlowing won’t matter. We introduced that Global Macro Theme in October of 2012, right before the worst US corporate earnings season since 2006. It too, didn’t matter, until it did.
One of the core takeaways from that theme was that this isn’t a ‘one-off’ where we’ll have 1 quarter of down earnings then straight back up again. That’s because US corporate margins are coming off all-time peaks. All-time is a long time.
I think #EarningsSlowing will matter, but so will the timing it:
- Alcoa (AA) and Monsanto (MON) kick off Earning Season tonight, but they aren’t driving the boat; Financials (XLF) are
- Financials Earnings Season starts on Friday, and we expect both Housing and Yield Spread to make that Sector bullish
- The biggest sector with #EarningsSlowing risk remains Tech (XLK); we don’t get those reports for a few more weeks
Yes, there’s a big difference between buying US stocks with the SP500 at 1400 and levering up long at a 5-yr closing high (1466). So be mindful of that. Be sector selective and stock specific.
Back to the Top 3 Global Macro Risks to being long overbought beta (Equities) here:
- Japanese Policy To Inflate
- Rising Oil Prices
The 3rd risk in my Top 3 is the most trivial. Oil’s price, volume, and volatility is measurable within our TRADE/TREND/TAIL process, so as time/price changes, my fundamental research view of how that factor impacts our growth model does.
A far less obvious risk remains what could happen to Japan if they pull an Argentina in 2013. I think this old (but new) bureaucrat they have brought back as Japan’s Finance Minister is crazy. That’s not a typo – plenty of politicians are crazy. Especially Keynesian ones.
Last night Taro Aso (great name for the history books if he rips his country a new one) said Japan is going to print money and buy ESM debt (as in European Bonds) in order to devalue the Japanese Yen further. We’ll walk through what that means as Japan blows through their 44 TRILLION Yen debt issuance ceiling on our Q1 Macro Themes Call (January 15th). Key word score: Quadrill-Yen.
Away from all of that, there’s nothing to worry about out there…
“During the first week of December (1941), Churchill regularly telephoned Bletchley to ask about the disposition of the Japanese Combined Fleet (Kido Butai)… Each time Churchill asked, the Bletchley reply remained the same: No intelligence was forthcoming. The Japanese navy had vanished.” (The Last Lion, page 416)
I am sure some dude in Spain, Taro Aso, and Obama’s latest son-of-Summers US Treasury bureaucrat (Jack Lew) have all central economic command under control. Full debt printing and deficit spending ahead.
Our immediate-term Risk Ranges for Gold, Oil (Brent), Copper, US Dollar, EUR/USD, UST 10yr Yield, and the SP500 are now, $1, $110.19-113.06, $3.63-3.75, $79.99-80.49, 1.30-1.31, 1.84-1.96%, and 1, respectively.
Best of luck out there today,
Keith R. McCullough
Chief Executive Officer
Here we provide you with hold adjusted property EBITDA estimates. With the exception of Wynn, all Hedgeye estimates exceed consensus.
Overall, VIP hold in Q4 was a little above normal which contributed to our property-level EBITDA estimates summing 1% higher than our hold adjusted estimates. Galaxy was the biggest beneficiary of lady luck which boosted EBITDA an estimated $13 million (+3%). On the other side was MPEL where EBITDA was dragged down by an estimated $11 million (-4%).
Interestingly, MPEL should still post the biggest Q4 beat of the season, even after the hold drag. We’re estimating Q4 property EBITDA and hold adjusted property EBITDA of $279 and $290 million, respectively, well above what we believe consensus to be at $238 million. There will be no qualifying MPEL’s results this quarter. They will be outstanding. For the market, excluding SJM for which we don’t have an estimate, we’re projecting EBITDA of $1.748 billion, well above consensus of $1.592 billion. Wynn is the only operator projected to miss consensus on an actual or adjusted basis. All others are projected to exceed consensus by 10% or more.
On a year over year basis after adjusting for VIP hold in both periods, Macau EBITDA (excluding SJM) is projected to increase 19% YoY. With the opening of Sands Cotai Central, Sands China (LVS) leads the growth race while Wynn should be the only operator experiencing a down quarter. Galaxy should post significantly higher EBITDA (+39% vs the market at 19%) despite Galaxy Macau being open in both quarters.
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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:
- Does private label and branded under the same roof work? It didn’t when RAH tried to manage the branded cereal business at Post.
- 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.
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.
HEDGEYE RISK MANAGEMENT, LLC
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:
- Immediate-term TRADE overbought = 1482
- Immediate-term TRADE support = 1439
- 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.
Keith R. McCullough
Chief Executive Officer
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 .
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