Fake it 'til You Make It

This note was originally published at 8am on February 01, 2013 for Hedgeye subscribers.

"To be a great champion, you must believe you are the best.  If you’re not, pretend you are.”

- Muhammad Ali


Last night Big Alberta (aka Daryl Jones) gave me the late look that I was to write this Early Look, so this morning I get to take extra creative liberties and subject you all to thoughts on my sector, Energy.


It’s a difficult space to make money in when oil prices aren’t going straight up, a la 2009 and 2010. 


Oil and gas companies – particularly the producers (E&Ps) – are highly promotional, as they have to be, in order to raise capital for what has become an incredibly capital-intensive industry.  In 2012, capital expenditures from S&P500 companies in the Energy sector were 39% of the index’s total; in 2000, they were only 12% (see Chart below).  Someone’s got to foot that bill, as the companies can’t do it on their own – the free cash flow yield of that same group was 0.0% in 2012, and if you back out a few cash cows like ExxonMobil and Royal Dutch Shell, you’ll find that most producers are not self-funding.


Nevertheless, in general, market participants hold the energy sector near-and-dear to their hearts.  Investors tend to anchor on recent history, and energy was by far the best performing sector over the last decade (XLE +200%).  And the sell-side knows what pays the rent – capital raises – so it’s not too surprising that Energy has the highest percentage of “buy” ratings and lowest percentage of “sell” ratings of all S&P500 sectors.


But is the love deserved?  Most E&Ps cannot generate a return greater than their cost of capital (aka “create value”), even with real oil prices near multi-decade highs and interest rates at multi-decade lows.  We shudder to think what a serious back up in rates would do to the sector…bankruptcy cycle?


But all is not lost (can’t get too cynical on a Friday)!  Among all the wealth destruction so colorfully described by activist investors in recent letters to the shareholders of Chesapeake (Icahn), Sandridge (TPG), Murphy Oil (Loeb), and Hess (Elliott), there are legitimate franchises and investment opportunities in the sector.  Over our long-term TAIL duration, we believe that select companies highly-levered to US natural gas prices will generate the best risk-adjusted investment returns in the space.


As we hover around nominal natural gas prices last seen on a consistent basis in the 1990s, it is a non-consensus view, so it needs some defending…


1.  Because natural gas is a local commodity, market fundamentals (supply, demand, and inventories) in North America impact prices in North America.  It is a remarkably efficient commodity market, and one which we can fundamentally believe in.  If we have a warm winter, natural gas prices go down – we get that.  We can’t necessarily say the same about global oil markets.


2.  In a world characterized by slow growth and tail risk, we think natural gas is a relative safe-haven.  If China has a debt crisis or the EU collapses, we will still heat our homes and turn our lights on.  US demand for natural gas is inelastic – in 2009 it fell only 1% compared to a 3% drop in US real GDP.


3.  Natural gas will continue to take power generation market share away from coal.  We estimate the natural gas demand from the power sector was +20% y/y in 2012, largely due to coal-to-gas switching and the retirement of aging coal plants.  At least 10% of existing coal-fired capacity is likely to shut down between 2012 – 2015 due to impending emissions regulations.


4.  Demand from the industrial sector should grow above GDP as new petrochemical, chemical, fertilizer, and steel plants come take advantage of the energy cost advantage in North America relative to the rest of the world.  As one example, Italy’s M&G Group announced last month that it will build the world’s largest single-line PET plant in Corpus Christi, Texas.  M&G remarked, “This is the largest PET investment ever in the western world and probably one of the largest investments recently announced in the US in the private sector.”


5.  Price is below the marginal cost of dry gas production, which we consider to be $4.50 - $5.00/Mcf, or the price at which producers can generate a positive return on a Haynesville Shale gas well.  We do think that we have seen the last of Haynesville Shale production growth.


6.  Longer-term, we are optimistic about new sources of natural gas demand: LNG exports and natural gas as legitimate transportation fuel.  With the right R&D and policy measures, both are economic and feasible, in our view.

We’re not going to give away the shop here, so if you’d like to discuss ways to invest in the thesis send us an email at  Further, on Wednesday 2/6 we’re going to host a Black Book presentation and conference call for institutional clients on Gulfport Energy Corp. (GPOR).  There we have a very non-consensus view.  For now, we’ll just say that it’s one of the more promotional companies in the space...  Email for details on that call.


Have a great weekend,


Kevin Kaiser

Senior Analyst 


Fake it 'til You Make It - EL chart


Fake it 'til You Make It - yup

HNZ: Berkshire Buys a Little ADM

On a day where we saw Berkshire Hathaway’s appetite for global consumer brands manifest itself as a $72.50 per share bid for Heinz (HNZ), a much smaller investment, but an investment that is no less consistent with Berkshire’s investment philosophy, may have escaped investor notice.  In a 13-F filing, Berkshire Hathaway reported a 6 million share position in Archer-Daniels Midland (ADM).

With the overarching investment principle a focus on long-term value, Berkshire has also displayed an interest in infrastructure when it ventures out beyond insurance.  We believe that part of the long-term investment thesis surrounding ADM (and Bunge, BG, as well) is the capital investment that both companies have made in global, agricultural infrastructure and the likely potential future returns associated with those investments.

The assets at ADM and BG are unique and leveraged to what we view as a powerful, long-term investment thesis – feeding an expanding global population and the associated need to get the crops from where grown to where consumed.

We expect that ADM shares will get a boost from this news and continue to see upside to the mid-$30’s in the name as we move through the start of the crop year in the U.S.  Similarly, we see upside to shares of BG, despite a recent quarterly result marred by the performance of the company’s risk management operations.


STZ: Happy Endings

Constellation Brands (STZ) closed up +37.2% today after news that it won full control of the Corona and Modelo brands after Anheuser-Busch InBev tried to salvage its deal to buy Grupo Modelo that was initially blocked by the Department of Justice. Constellation brands will become the third-largest brewer and seller of beer to U.S. consumers.


Back on January 31, 2011, Hedgeye Consumer Staples Sector Head Rob Campagnino noted that STZ had the potential for further upside per the Modelo deal. Said Campagnino:


"Our view remains consistent – this transaction represents significant value to ABI, and therefore we believe that additional concessions are very likely.

While the move down is painful, we continue to see substantial value to Constellation Brands should the transaction close, an event that we continue to see as likely, though delayed."


STZ: Happy Endings - STZBIGONE

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Today we bought International Game Technology (IGT) at $16.26 a share at 9:53 AM EDT in our Real-Time Alerts. Buying back Hedgeye Gaming, Leisure and Lodging Sector Head Todd Jordan's Best Idea on red after it had a controlled correction to immediate-term TRADE support. One of our top guns on the long side.



Is Herbalife A Scam? Part II

Takeaway: Professor Anne T. Coughlan's weighs in on whether Herbalife is a scam. We also examine the differences between MLMs and pyramid schemes.

Today Hedgeye clients were treated to a private seminar with Professor Anne T. Coughlan, John L. & Helen Kellogg Professor at Northwestern University’s Kellogg School of Management.  A recognized expert in distribution channels, direct marketing and sales force management, Professor Coughlan has received awards for excellence in teaching and is a sought-after consultant in the private sector, where she counts Herbalife among her clients.  She appeared with Hedgeye in her capacity as an independent academic scholar and presented her own views on Multi Level Marketing.


Direct Selling & Multi Level Marketing

Professor Coughlan gave an overview of Direct Selling (DS), with a focus on Multi Level Marketing (MLM).


Direct Selling is well established in the retail marketplace.  Compared with traditional “bricks and mortar” retail, “e-tail,” and franchising, DS offers certain advantages to both the company and the distributor.  DS and MLM also have characteristics that make them look very different from traditional retail models.  But, cautions Professor Coughlan – different does not necessarily mean illegitimate.  Professor Coughlan described the key elements of DS, and of MLM, and contrasted the legitimate MLM structure with Pyramid Schemes.


Distribution Channels

All distribution channels address four basic issues:

  1. The combination of products and services – WHAT do consumers buy?  HOW do they buy it?  Consumers buy a product bundled with delivery services, and sometimes with post-delivery services – think of the expression “shopping experience.”
  2. The structure of the distribution channel – WHO is in the channel?  HOW are functions allocated?  WHO does the work at each step? 
  3. Compensation – HOW are people compensated? WHAT are the incentives driving added-value activities in the channel?
  4. Governance – HOW is the program implemented and overseen?  WHAT are the rules of conduct, rules for resolving conflicts and for protecting both customers and participants?  HOW are channel participants’ investment protected, while ensuring end users access to a quality product?


The MLM Company

The MLM company develops the product and performs R&D and market research.  The company administers the business: it sources product, performs quality control, and handles logistics to ensure inventory and delivery. In addition, the legitimate MLM company makes a significant investment in technology and administrative staff to effectively manage payment of compensation and incentive awards to its distributors.


The key characteristics of a legitimate MLM company include: actual product which is differentiated, usually by premium quality or scarcity.  Legitimate MLM companies make their money from selling product, not from recruiting fees; they discourage distributors from taking on large inventories, and generally allow departing distributors to sell unused product back to the company.


Advantages of the MLM Model

Individuals are attracted to MLM selling for a number of reasons.  Becoming an MLM distributor offers an aspiring businessperson an opportunity to try out their skills without incurring the cost and liability of setting up a business.   

Distributors set their own goals and success is measured by individual satisfaction, not corporate guidelines.  One reason revenues look very different among MLM distributors from the profile at a traditional retailer is that most distributors are satisfied if they can defray the cost of their own consumption of the product.  Also, many people push their sales efforts seasonally – to pay for Christmas shopping, tuition or summer camp.  


People become MLM distributors because they love the product, not to become financially successful.  This is the biggest reason for low profitability in distribution downlines.  Most distributors are satisfied with small profits and continued access to the product for their own use.  Horror stories of housewives stuck with a garage full of shampoo and deodorant do not describe the operation of a legitimate MLM company.


Companies value star salespeople, and star MLM distributors are incentivized in a fully transparent fashion.  Those few distributors who can successfully develop large downlines are the key to continued sales growth.  While outsiders may think these business leaders are getting paid “off the backs” of their downline, they work very hard mentoring and training to ensure the success of their downline distributors, adding real value to the company.  It is a rare combination to be a great salesperson AND a great recruiter AND a great trainer AND a great motivator AND a great mentor.  Sales pros who can deliver on all these front are well rewarded.


A legitimate MLM company offers the same compensation structure to every distributor, and the compensation is clearly laid out, including incentive awards and the requirements for attaining them.  Anyone can become a star.  The fact that most people do not is attributable to human nature, not to a flaw in the business model.  “The flaw,” laments Cassius to Brutus, “is not in our stars but in ourselves.”  


So What is a Pyramid Scheme?

The primary characteristic of an illegitimate pyramid scheme is that people are paid to recruit others into the pyramid.  Rather than derive revenues from the sale of product, pyramid schemes charge a registration fee, usually non-refundable.  Many pyramid schemes do not even deliver an actual product, just an “opportunity.” 


The first red flag is the compensation clause that says you get paid to recruit new distributors, even if they never sell anything.


Other red flags include a requirement to purchase large quantities of inventory, or requiring standing orders to be filled automatically, and which can not be returned if not sold.  A pyramid scheme will not make a meaningful investment a product or an organizational structure.  


How Do You Tell The Difference?

If distributors continue to use the product themselves, even if they are not making money off their own sales, Professor Coughlan says that is a strong indication a company is a legitimate MLM organization, and not a pyramid scheme.  Remember that people get involved in MLM sales for a variety of reasons, and “value” is defined very differently in MLM than in structured sales organizations.  If the company maintains R&D spending, it is a strong indicator that this is a legitimate MLM operation.  The fact of individuals being more or less financially successful should not be seen as the determining factor, says Professor Coughlan.


Bottom Line: What About Herbalife?

We remind you that Professor Coughlan works as a paid consultant to Herbalife from time to time.  Nonetheless, she was able to speak clearly about publicly available information, comparing it with financial information from similar public companies.


Professor Coughlan says, based on their public reporting, HLF’s compensation, production and distribution practices are comparable to industry norms, as are their interactions with distributors and end users.  HLF does not charge high enrollment fees, and fees are refundable if distributors opt out within 90 days.  HLF makes an ongoing investment in product design and buys back unsold inventory when distributors depart.  The company discourages “inventory loading,” where distributors take on large quantities of inventory they may not be able to sell.  HLF cites its own research showing “a lot” of end use by actual customers, i.e. buyers outside of the distribution downline. 



Professor Coughlan says, based on publicly available information, HLF is comparable to other accepted MLM companies.  The company’s compensation structure is “in the same ballpark” as other recognized companies, and the details of the compensation structure are well publicized across the distributor network.  


Like other DS organizations, HLF’s distributors are the company’s own best advertisement, and it plows excess revenues back into compensation.  Professor Coughlan says HLF’s total compensation is roughly equivalent as a percentage of revenues to the combined sales and advertising budget of major personal care companies with traditional sales forces made up of employees.


For a company that doesn’t advertise, HLF has gotten an awful lot of publicity lately – not all of it good.  Professor Coughlan’s analysis provides a valuable framework for assessing the outlook for this company.  The jury is still out, but it has just gotten an important new piece of evidence.


Watch our website for updates as Consumer Staples sector head Rob Campagnino continues to monitor developments at Herbalife.



History suggests CCL could underperform over the next month


  • The chart below shows the stock’s performance following the Carnival Splendor fire on 11/8/2010 as a comparison to the current Carnival Triumph fire. 
  • CCL underperformed for 3 weeks and it took the stock a month and a half to recover its losses vis a vis the S&P 500.  However, the stock did recover, although some of that was earnings related.
  • The publicity is much worse this time.   Normally, we would buy the negativity but this kind of hype is likely to affect bookings for a period of time – potentially more damaging during the busy wave season - that could lengthen the stock’s recovery period.



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 80.43%
  • SHORT SIGNALS 78.34%