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Hedgeye Best Ideas: Starbucks (SBUX)

Thank you for the feedback last week related to the revised format we're considering for the Hedgeye Hot Sheets (to be renamed Hedgeye Best Ideas). For those who have not responded, please take a moment to review the revised format of the stock report and let us know what you think. For a preview of the email, please click here.

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Starbucks is the premier roaster, marketer, and retailer of specialty coffee in the world, operating in more than 50 countries. The company sells drip brewed coffee, espresso-based hot drinks, tea, cold drinks, a variety of food items, as well as mugs and similar products.

As of October 2, 2011, there are more than 17,000 Starbucks locations across the globe, 53% company-owned. During fiscal 2011, company-operated stores accounted for 82% of total net revenues. Risk factors for Starbucks' business include costs for commodities that can only be partially hedged, such as fluid milk and high quality Arabica coffee, labor costs such as increased health care costs, and other variables beyond management's control. Trading Starbucks today, it's all about the duration.

 

 

INTERMEDIATE TERM (the next 3 months or more)

We are positive on the intermediate-term for Starbucks as the company should continue to post stable revenue growth thanks to the ongoing expansion of its CPG business, alongside other drivers mentioned above. If the US employment picture continues to improve, that would give investors further confidence in Starbucks achieving its targets.

 

LONG-TERM (the next 3 years or less)

The long-term TAIL for Starbucks is attractive; the company has plenty of white space to grow through several channels and geographies with ample expertise and capital to execute its strategies. The company must retain focus on the core business and, we believe that managemet is acutely aware of this following prior ('07/'08) experience.

 

 

Hedgeye Best Ideas: Starbucks (SBUX) - he bi SBUX chart

 

 

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Jobless Claims: Hidden Improvement

This week’s jobless claims numbers appeared to deteriorate significantly week-over-week but in reality, they actually improved slightly. The perception is that initial jobless claims rose 38k to 368k from 330k week-over-week. While poor in performance, we’re actually right back to where we were 3 weeks ago. In March, we’ll see the strength in the labor market cool off and give way to weakness as April progresses to August.

 

Jobless Claims: Hidden Improvement - 1 normal

 

So where’s the hidden gem? The positive ray of hope? Rolling NSA (non-seasonally adjusted) claims. They improved year-over-year by -4.8% this week versus last week’s -4.3% change. The more negative the number, the better as we're measuring the year-over-year change in jobless claims. The seasonality distortion that we’re beginning to experience is perfectly normal; the labor market is not about to fall off a cliff or anything just yet. 

 

Jobless Claims: Hidden Improvement - 2 normal


JOBLESS CLAIMS - ARE WE MOVING IN THE RIGHT DIRECTION AGAIN?

Takeaway: Don't believe what you read. While claims appeared to deteriorate significantly WoW, they actually improved slightly. Here's why.

A Quick Walk Through What's Really Happening & What the Market Thinks is Happening ...

Let's start with the perception of what's happening. The perception is that initial jobless claims rose 38k to 368k from 330k WoW. This is being regarded as bad, which is not a surprise. First, let's put this morning's headline number in context. As we flagged two weeks ago, we're simply seeing the reversal of very poorly adjusted number from two weeks prior. Two weeks ago claims dropped by 37k, their largest one week drop since the same week last year. Last year's drop of 46k was followed by a 23k bounce, which was in turn followed by a 4-week drop of 20-25k. This year, we saw claims drop 37k two weeks ago, drop a further 5k last week and this morning rise by 38k. In other words, we're right back where we started 3 weeks ago; actually, we're still 4k lower. Initial claims should trend steadily lower from here over the next four weeks as the final phase of Lehman's Ghost kicks into the seasonal adjustment factors. Thereafter, beginning in March, we'll begin to see the strength in the labor market cool off, and ultimately give way to weakness as April progresses to August.

 

Now, let's take a look at what's really happening. Rolling NSA claims improved year-over-year by -4.8% this week, that's an improvement vs. the prior week's -4.3% change. This may not sound significant, but it is because it marks an inflection from what had been two straight weeks of deterioration. Remember that a more negative number is better, as we're measuring the YoY change in jobless claims. This series has consistently been the best read on the underlying labor market condition. Bear in mind that tomorrow's payroll report suffers from the same seasonality problems as jobless claims. Tomorrow's report, by the way, should be very solid (partly because it's benefiting from an imaginary tailwind).

 

Given this dynamic, we continue to expect Financials to push higher through February and likely into March (high beta, value names continuing to lead the way), though as the labor data cools in March/April we expect to see the same pullback we've seen over the last three years. However, we think this year's pullback will be smaller than in years past, partly because Lehman's effect is shrinking, but also because the housing data should partially offset the perception of weakening labor dynamics.

 

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Yield Spreads, Meanwhile, Are Solidly Improving

The 2-10 spread rose 13.7 basis points WoW to 172 bps. 1Q13TD, the 2-10 spread is averaging 162 bps, which is higher by 20 bps relative to 4Q12.

 

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Joshua Steiner, CFA


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SGMS ACQUISITION OF WMS CONF CALL NOTES

Borrow cheaply, buy cash flow and profitability at a reasonable multiple, utilize NOLs - worked for PNK and should work for SGMS.

 


"The acquisition of WMS is transformational for Scientific Games, enabling us to offer a complete portfolio of lottery and gaming products and services to both new and existing customers around the world.  We expect to combine our game content, technology, operational capabilities and respective geographic footprints to create an enterprise poised to capitalize on significant growth opportunities around the globe." 

 

-A. Lorne Weil, Scientific Games' Chairman and Chief Executive Officer

 

 

CONF CALL NOTES

  • Opportunity of a lifetime for both companies
  • Faster growth of their business has been outside the US but for structural reasons all of their interest expense and most of their operating expenses are inside the US. Therefore their EPS has lagged revenue growth.  They have racked up a huge NOL inside the US. 
  • WMS is almost a mirror image of their situation - 75% of WMS's business comes from within the US and they have a pristine balance sheet. Also have a large tax bill in the US
  • The merger will give them huge EPS growth and a significant number of investors care about P/E multiples. So at last they will look attractive on that valuation basis. This acquisition will allow them to reap huge cash flow savings as a result of utilizing their NOL.
  • Feel confident that SGMS's existing international footprint can help WMS cross sell their products. 
  • Feel that there will be more expansion by the lotteries (internationally) into traditional slot related product. 
  • Greek lottery is expected to create a national network of thousands of machines and SGMS is partners with OPAP, so that puts them in a unique position
  • The financial engineering rationale isn't the only reason for this acquisition. They have a lot of industrial logic.  They have virtually no competitive overlap between the WMS & SGMS businesses. However, the businesses are complementary.
  • Think that there is a huge revenue synergy from being able to cross sell each other products and create new products, systems and services that neither company is currently offering to the market
  • Think that that there is an opportunity for cost savings since they are both in the business of manufacturing, designing, acquiring 3rd party content, and expanding into the online world... therefore, there should be cost syngeries and scale benefit here.
  • The two companies have a high degree of cultural compatibility (that's a little scary...)
  • Need regulatory and government approvals to complete the transaction
  • SGMS: 
    • 50% of their revenue comes from their instant ticket business
    • 25% is from their traditional lottery systems business
    • 25% from providing machines and systems supplying to VLT markets with just a few devices per location vs. casino operators
  • In IL they are going to be providing the monitoring system for VLTs
  • Feel like WMS's business is on the verge of a turnaround 
  • Like WMS's game server intergration business and will complement their similar business. Together they can have a leading business.
  • Both companies are leaders in using licensed brands to promote their respective products. Have a few brands where they overlap and can help each other acquire developing content.
  • Thinks that the lottery distribution channel will be a huge opportunity for WMS
  • Feel like the US economy is in the beginning of a recovery, albeit perhaps a slow one.
  • Combined leverage with no synergies will be 5x on an LTM basis and 4.4x with synergies compared with current leverage of 4.0x

Q&A 

  • WMS is the best possible partner for SGMS with no close second.  
  • Integration with WMS: Expect to have 2 operating sectors with a lottery one and a gaming one
    • Regarding Barcrest: They will intergrate Global Draw with Barcrest and move that over into the "gaming sector"
    • They intend to keep the WMS brand and the senior management team to continue to manage the gaming sector - including whatever SGMS has
  • Term loan that they will use to finance the deal has a 7-year term and they will have a $300MM R/C
  • Do not believe that they will have to exit any businesses as a result of the combination
  • There are a number of lottery jurisdictions that are either run by a private operator like OPAP, where WMS's content can help them on the VLT side
  • Wouldn't characterize that WMS is in the midst of a turnaround, nor would WMS
    • huh?
  • Competitive implication of this combination is not likely to help the other gaming suppliers
  • The interactive opportunity? Thinks it's a big opportunity given SGMS's view that online gaming will proliferate through the government/lottery channel vs. federal legislation in the US. Their relationships with lotteries and foreign governments and WMS's content and efforts in that arena could be hugely synergistic.

 

HIGHLIGHTS FROM THE RELEASE

  • SGMS and WMS have "entered into a definitive agreement under which Scientific Games has agreed to acquire WMS for $26.00 in cash per common share or approximately $1.5 billion." 
    • Includes assumption of $85MM of debt and $55MM of cash
    • Price translates to a 6,0x TTM EBITDA multiple (looks low but this is just because WMS's cash flow conversion is terrible. They have always had a low multiple)
    • Acquisition is subject to WMS shareholder approval
    • Expected closing by end of 2013
    • SGMS has committed financing 
  • The combined company will have revenue of approximately $1.6BM and EBITDA of $579MM based on TTM results ended September 30. 
  • The transaction was unanimously approved by both company Boards
  • "We view this transaction as the next logical and strategic step in offering continued innovation in gaming. Shareholders will enjoy a meaningful premium for their shares and employees will have expanded career opportunities as part of a larger, broader and more diverse organization"
  • "Scientific Games expects to achieve synergies through revenue growth, shared costs and larger scale, as well as by monetizing its significant U.S. tax attributes. The combined company will also be able to efficiently utilize shared manufacturing, engineering, software, field maintenance and customer service to drive growth and cost savings"
  • Other reasons for the combination: 
    • Complementing businesses leveraging core competencies
      • "Scientific Games and WMS will draw on each organization's core strengths to broaden offerings, bring gaming products to new sectors and geographies, accelerate key growth initiatives and offer enhanced capabilities, systems, field service and content. Scientific Games' strong global footprint, including its position in server-based gaming, should help accelerate WMS' international development initiatives."
    • Diversification of revenues
    •  Strengthened position in interactive gaming
      • "The combined iLottery/iGaming platform and content will significantly expand the scope of the combined company's interactive products.  WMS has a well-developed iGaming platform, including social and mobile gaming, while Scientific Games has an advanced platform for iLottery, sports book and loyalty/rewards. Scientific Games expects significant opportunities to cross-sell these products to the companies' respective customers"

The Game Of Risk

Client Talking Points

Play The Hand You’re Dealt

The market is very much like a poker game at a casino: you have to play the hand you’re dealt. Monday and Tuesday of this week, we bought US equities. Yesterday, we sold ‘em. Today, we’ll follow the risk and the range combined with our fundamental research to make a decision on what we’re going to do. This recent bull market is so driven to continue going up and to the right that the Chicago PMI numbers out today may not even make a dent in the SPX. It’s important to keep an eye on other asset classes, too.

 

If bonds and gold keep declining and stocks keep going up, we’ve got the growth the market is looking for. Throw in $130 a barrel oil and now you have a problem as global consumption growth stalls. It all revolves around The People of this great country. If gas prices are $6 a gallon and bread and milk cost $10 combined at the grocery store, they will not be going out and buying shoes, iPhones and other goods.

Housing Recovery

We continue to see recovery in the housing market with data point after data point coming out each week that signals that the recovery is underway. Inventory is falling, prices are going up, people are taking out mortgages and buying homes; things are good. This recovery may soon trickle over to the regional banks who are involved with housing. Hedgeye Financials Sector Head Josh Steiner put out a note on TCF Financial (TCB) yesterday summed up by this:

 

"TCB remains a favorite long idea of ours on an ongoing housing recovery which is just starting to have a powerful influence on fundamentals."

 

Asset Allocation

CASH 56% US EQUITIES 10%
INTL EQUITIES 10% COMMODITIES 0%
FIXED INCOME 0% INTL CURRENCIES 24%

Top Long Ideas

Company Ticker Sector Duration
ASCA

We believe ASCA will receive a higher bid from another gaming competitor. Our valuation puts ASCA’s worth closer to $40.

FDX

With FedEx Express margins at a 30+ year low and 4-7 percentage points behind competitors, the opportunity for effective cost reductions appears significant. FedEx Ground is using its structural advantages to take market share from UPS. FDX competes in a highly consolidated industry with rational pricing. Both the Ground and Express divisions could be separately worth more than FDX’s current market value, in our view.

HOLX

HOLX remains one of our favorite longer-term fundamental growth companies given growing penetration of its 3D Tomo platform and high leverage to the 2014 Insurance Expansion from the Affordable Care Act.

Three for the Road

TWEET OF THE DAY

“One theme I'm noticing in earnings this season... "performed well despite challenging times" has replaced hand-wringing.” -@HerbGreenberg

QUOTE OF THE DAY

“Physicists like to think that all you have to do is say, these are the conditions, now what happens next?” -Richard P. Feynman

STAT OF THE DAY

U.S. consumer spending rose 0.2% in December as incomes jumped 2.6%, most in eight years.


HLF: Expert Call Today @ 10:30

Takeaway: Today's conference call featuring multi-level marketing expert Dr. Jon M. Taylor will explore key topics surrounding HLF.


Call: Thursday, January 31, 2013 at 10:30am EST 


If you would like to receive the dial-in information for this call please email .



The Hedgeye Consumer Staples Team, led by Rob Campagnino, will be hosting an expert conference call entitled "An Expert's Opinion on Multi-Level Marketing, Pyramid Schemes and Herbalife" on Thursday, January 31st, at 10:30am EST featuring multi-level marketing expert Dr. Jon M. Taylor. 


KEY TOPICS WILL INCLUDE

  • What is a pyramid scheme?
  • Contextualizing Herbalife (HLF) and its peers within the history of multi-level marketing
  • What is the likelihood that the FTC will take significant action against HLF?
  • If in fact HLF is a pyramid scheme, as Ackman claims, how long can it continue its growth pattern before collapsing?

 

ABOUT DR. JON M. TAYLOR

Dr. Taylor has dedicated a majority of his career to researching multi-level marketing (MLM) and its impact on consumers. He has authored books and numerous analytical reports on profitability, viability, ethics and abuses of "product-based pyramid schemes" including The Network Marketing Game and The Case (for and) Against Multi-level Marketing. Through his research Dr. Taylor developed tools for evaluating MLMs and their profitability (or lack thereof).  


His Five-step Do-it-Yourself Evaluation of MLM Programs is an interactive program for visitors to his website - www.mlm-thteruth.com. His research has been confirmed by the analysis of over 400 MLMs and feedback from thousands of consumers. Dr. Taylor received an MBA degree from BYU and a Ph.D. in Applied Psychology from the University of Utah. He is currently President of the Consumer Awareness Institute and President of the Jon Taylor & Co., Inc.


Please contact to obtain the dial-in information for this call and a copy of the presentation, or to learn more about our research.

 

 

ABOUT ROB CAMPAGNINO
Rob has nearly 20 years experience in the industry and within the last 5 years on the buy side at some of the top hedge funds in the business, including Pioneerpath, Diamondback Capital, and Searock Capital. Prior, he was a senior equity analyst at Prudential Securities where he was consistently Institutional Investor ranked. Before Prudential he was at Sanford Bernstein as an equity research associate covering food, beverage, and retail. He began his career as a strategic consultant with PricewaterhouseCoopers. Rob has a MBA from Columbia and BA in Economics from Duke.



 


Daily Trading Ranges

20 Proprietary Risk Ranges

Daily Trading Ranges is designed to help you understand where you’re buying and selling within the risk range and help you make better sales at the top end of the range and purchases at the low end.

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