“Reality is merely an illusion, albeit a very persistent one.”
This has been an entertaining week at Hedgeye. For those that have been reading the Early Look or following us on Twitter, you have noticed that we have been having some fun with a few of the old guard of Wall Street research. One friend of Hedgeye actually wrote in and called Keith and myself: grumpy young men.
Candidly, that is probably more truth than illusion. To be fair, though, getting up early and grinding hard throughout the week probably does rightfully make a guy or gal grumpy. There is no doubt many of our subscribers can relate to this as well. While we have the pressure of running a profitable business and making 50+ employees happy, the pressure that many of you have associated with the fiduciary responsibility of managing money is also no illusion.
Speaking of illusions, our Energy Analyst Kevin Kaiser actually identified a great one this week in the cash flow statement of a company called Linn Energy (LINE). LINE is an upstream MLP, so in effect they use the tax advantage of a MLP structure to pay out large distributions. This is fine for predictable and mature businesses. Unfortunately, neither of those traits fit LINE.
In fact, LINE is an oil and natural gas producer. So not only is it not a mature to slightly growing business, it is actually a business with natural decline rates that requires meaningful capital expenditures to maintain the cash flow stream. In the Chart of the Day, we’ve included a slide from the presentation that looks at distributions paid from 2006 to 2012.
In that time period, LINE paid $2.2 billion in distributions. Strangely, in the same period the company only generated $1.7 billion in cash flow from operations. Moreover, if we look at free cash flow, which we define as cash flow from operations less capital expenditures, LINE generated a negative -$1.0 billion in cash flow. Despite these cash flow deltas, LINE management has done a decent job pulling rabbits out of the proverbial cash flow hat and paying distributions, largely from financing cash flow.
So, as Kaiser summed up about the company at the end of his presentation:
- LINN’s assets are mature oil and gas fields with low decline rates;
- LINN’s cash flows are stable because of its hedging strategy;
- LINN generates sufficient cash flow to pay and grow its distribution;
- With an 8% yield, LINN is an attractive fixed-income alternative; and
- LINN is creative and innovative.
- LINN’s base decline is 20 - 25% per year;
- LINN’s cash flows are overstated because of its hedging strategy;
- LINN does not generate any FCF, and must raise additional capital to pay its distribution;
- LINN equity is more than 50% overvalued today; and
- LINN is financially creative and innovative.
If Houdini were a hedge fund manager, he would likely be all over this company!
In the global macro world this week, the primary illusion has been in regards to the cash in Cypriot bank accounts. Is it there? Will it stay? How much will the government take? Coming in to the week, many pundits predicted that the arbitrary decision to “tax” money in bank accounts in Cyprus would lead to a run on the banks across the peripheral countries in Europe. Much to the chagrin of alarmists, this hasn’t happened.
Of course, this is not to say that the EU decision to try and force a bank levy on Cyprus makes any sense. The larger risk is not that the EU will do try to this in Greece, Portugal, or Spain next, but rather that the illusion is created that they will. A run on banks across the peripheries is literally a worst case scenario for the EU. Unfortunately, investor and depositor confidence erodes very quickly with seemingly arbitrary decisions.
The latest news flow suggests that the Cyprus situation will continue into next week. Russians have a large amount of capital in the Cypriot banking system, but Cypriot Finance Minister Michael Sarris spent all week in Russia and returned with his hat in hand and no bailout monies. The European Central bank has also said that effective this coming Monday they will cut off liquidity lines unless Cyprus gets a deal in place. So yes, the illusion that ECB officials have the situation under control is alive and well.
As for the Cypriots, well as of this morning the statement the government was supposed to issue is now more than 60 minutes late, but according to Twitter they are working on it. As for the average Cypriot, their bank withdrawals from ATMs are limited to literally a couple hundred Euros. Talk about dysfunction!
The slow and steady recovery of U.S. economic activity continues to be solidly in the category of non-illusions. The key data point we received this week was in the way of non-seasonally adjusted jobless claims, which declined by -7.5% year-over-year for the week. In aggregate, the improvement in jobless claims is starting to mirror 2012.
Our Financials Sector Head Josh Steiner has noted many times, improving jobless claims are one of the best leading indicators for housing trends, credit quality, and loan growth. Even as the dysfunction in Europe percolates, the U.S. economy stabilizing is no illusion. This is a key reason U.S. equities remain one of our favorite global asset classes.
Our immediate-term Risk Ranges for Gold, Oil (Brent), Copper, US Dollar, USD/YEN, UST 10yr Yield, VIX, and the SP500 are now $1, $107.01-108.99, $3.39-3.49, $82.23-83.39, 94.12-97.08, 1.89-1.98%; 10.73-14.74, and 1, respectively.
Enjoy your weekends.
Keep your head up and stick on the ice,
Daryl G. Jones
Director of Research
TODAY’S S&P 500 SET-UP – March 22, 2013
As we look at today's setup for the S&P 500, the range is 23 points or 0.25% downside to 1542 and 1.24% upside to 1565.
CREDIT/ECONOMIC MARKET LOOK:
- YIELD CURVE: 1.67 from 1.67
- VIX closed at 13.99 1 day percent change of 10.42%
MACRO DATA POINTS (Bloomberg Estimates):
- 11am: Fed to purchase $3b-$3.75b notes 2018-2020 range
- 12pm: Revisions to Fed’s industrial production data
- 1pm: Baker Hughes rig count
- Obama to meet w/ King Abdullah II of Jordan
- 7:30am: Fed Gov. Sarah Bloom Raskin, CFPB Director Richard Cordray, FDIC Chairman Martin Gruenberg speak at Natl Community Reinvestment Coalition conf.
WHAT TO WATCH
- BlackBerry Z10’s U.S. debut marks biggest test of comeback
- Dell go-shop period for other offers expires today
- FCC Chairman Julius Genachowski said to be leaving agency
- Cyprus lawmakers to debate bailout bill as deadline looms
- Euro area said to weigh closing Cyprus banks, asset freeze
- Boeing faulted by 787 investigators for battery fix comments
- Samsung said to be in talks to sell Liquavista to Amazon
- Sharp extends deadline for 2nd Qualcomm payment to June 28
- Citigroup says pay plan holders rejected helped keep Corbat
- Life sale said to shift to strategies; some buyout firms exit
- German business confidence unexpectedly drops from 10-mo. high
- Australia probes pricing by Apple, other tech cos.
- Goldman Sachs raises U.S., Japan growth forecasts
- Deutsche Bank, Goldman miss $129m fee in Evonik IPO snub
- U.S. Spending, Supreme Court, BRICS, AMR: Wk Ahead March 23-30
- Tiffany (TIF) 6:59am, $1.36
- Stella-Jones (SJ CN) 7am, C$0.93
- Darden Restaurants (DRI) 7am, $1.01
COMMODITY/GROWTH EXPECTATION (HEADLINES FROM BLOOMBERG)
- Brent Crude Set for Second Weekly Drop to Shrink Premium to WTI
- Gold Seen Extending Rebound as Cyprus Revives Bulls: Commodities
- Biggest Crisis Since 2008 Looms for South African Mines: Energy
- Gold Falls From 3-Week High as ETP Drop Overshadows Cyprus Woes
- Palm Oil Heads for Weekly Gain as Inventories Seen Declining
- Industrial Metals Advance as Economies in U.S., China Improve
- Rubber Declines for Second Week on Yen, Europe Debt Concerns
- China Soybean Imports Seen Lower Than USDA Forecast Amid Delays
- Copper Fees Climb in Shanghai as Metal Seen Moving to Malaysia
- Rebar Declines as Demand Seen Curbed by Slowing Chinese Economy
- Diesel Best Returns in Two Years Waning on China: Energy Markets
- Brazil Gold Allure Puts Australia’s Beadell in Play: Real M&A
- Traders Cut Paulson Gold Favorite on Liquidity: Chart of the Day
- Mistry Sees Palm Rally Through May on Ringgit, Reserves Drop
The Hedgeye Macro Team
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This note was originally published at 8am on March 08, 2013 for Hedgeye subscribers.
“The dramatic modernization of the Asian economies ranks alongside the Renaissance and the Industrial revolution as one of the most important developments in economic history.”
Candidly, over time I have found myself disagreeing with a lot of what Larry Summers has said publicly. That said, the above quote definitely resonates with me. As I touched on earlier this week, the story of development in Asia over the last twenty years, and in particular in China, is really unprecedented in economic history.
In North America over the last few decades the Renaissance Men, for lack of a better word, have been the private equity firms and hedge funds partners that have generated outsized returns and been paid handsomely. Like any Renaissance, though, this one too will end. This end is evidenced by some recent studies that highlight hedge funds returns are correlated to the SP500 with a more than 0.9 r-squared. If true, this renaissance may be ending sooner than many expect.
With such a tight R-squared, an emerging risk is actually how much each hedge fund owns of a particular stock. Many quantitative managers have actually gone on to categorize this as “hedge fund risk”. In effect, this equates to the amount of stock outstanding that is in the hands of a series of hedge fund managers. So if a lot of the stock is held with hedge fund managers, then the hedge fund risk is high.
So speaking of Renaissance men, Hedgeye has a few, but perhaps the most legitimate one is our own Matt Hedrick, who covers European equities. Matt hits our internal team with an update on Europe every morning and today his key points were limited. This is actually positive because what it means is there is a not a lot going on in European and her sovereign debt crisis.
In fact, in the Chart of the Day we highlight this by showing Spanish 2 and 10 year yields over the last year. The fact is that credit risk in Europe has been steadily declining. As the chart shows, Spanish yields are well of their peak, but not only that, they are also below the levels of a year ago. The key take-away from this is that while Europe sill matters, it only matters to a point as European credit risk, broadly, has improved.
With peripheral yields improving, we are also seeing an improvement in capital flowing back to certain countries.
Specifically, in Italy private sector deposits were up 7.7% year-over-year in the last month. While this is not a number that is going gangbusters per se, what it does show is that capital is coming back to the certain at-risk sovereigns in the Euro-zone. This ultimately is a positive for broader credit risk in the EU.
On the flip side, some of the European data was less than positive night-over-night. For instance, German industrial production declined -1.5% from last year. This is an acceleration from December, which declined -0.5%. Are these freak out type numbers? No, but they are indicative of a European economy that continues to struggle in its recovery.
I often quote my colleague and Hedgeye Financials Sector Head Josh Steiner in the Early Look. Once again I want to highlight a big call he made yesterday in a note titled, “BAC, C, MS - LONG THE BIG CAP BETA RENORMALIZATION TRADE”. As Josh wrote:
“There’s a paradox in global U.S. banks right now, and that is that they hold more capital today than they’ve held in a very long time. We show this in a chart below, which looks at Bank of America. The red line shows BofA’s tangible equity ratio going back ten years. You can see on the right hand y-axis that capital fell steadily from the high fives in 2003 to a low of 3% in the belly of the crisis and has since risen to around 7%. Capital ratios are much higher on a regulatory basis, but we like tangible equity for its simplicity – in other words, unlike risk-weighted capital measures, it’s more difficult for banks to manipulate this ratio in their favor. The point is that capital levels are very high today and, in fact, are still headed still higher for the foreseeable future (we'll know how much more after the close). The second line on this chart shows Bank of America’s rolling one year beta going back ten years. The takeaway here is that it has risen from its tight range around 0.8 from 2003 through 2007 to around 2 today (1.93 as of this morning). Capital is the inverse of leverage, and leverage is risk. High capital equates to low risk. Now let’s use beta as our proxy for cost of capital, and by the transitive property we find that the the market is charging the highest cost of capital at a time when the risk is, in fact, lowest. This is clearly paradoxical, and a dynamic we don’t think will last.”
So to summarize: capital ratios for large U.S. banks are improving and these stocks are poised to continue to lead the U.S. equity rally. While I enjoy having a few drinks with my colleague Josh, I’m not sure he (or me for that matter) is a Renaissance man, but what he is definitely is very accurate in terms of his view of the U.S. banking system. If you’d like more of his thoughts, please email firstname.lastname@example.org.
As you all head into the weekend, I wanted to leave you with one last quote, which is related to a quote from the Early Look earlier this week:
“Marxism is like a classical building that followed the Renaissance; beautiful in its way, but incapable of growth.”
Our immediate-term Risk Ranges for Gold, Oil (Brent), US Dollar, USD/YEN, UST 10yr Yield, VIX, and the SP500 are now $1559-1585, $109.07-111.73, $81.98-82.54, 92.11-95.81, 1.94-2.04%, 11.67-14.91, and 1519-1558, respectively.
Keep your head up and stick on the ice,
Daryl G. Jones
Director of Research
The Macau Metro Monitor, March 22, 2013
FEBRUARY VISITOR ARRIVALS DSEC
Attributed to Lunar New Year, visitor arrivals increased by 11.5% YoY to 2,376,840. Mainland visitors totaled 1,508,599 (+17.4% YoY) with 754,692 traveling to Macau under the Individual Visit Scheme. The average length of stay of visitors stood at 0.9 day.
SANDS 'TO APPLY' FOR COTAI CENTRAL COMPLETION EXTENSION Macau Business
LVS says it “expects to apply” to the Macau government for an extension of the May 2014 deadline it was set by the government for completing Sands Cotai Central casino resort on Cotai. This will be the third time it has asked for more time for its Cotai project. Sands included the deadline news in its 2012 annual report published yesterday.
The government originally gave the company a May 2014 deadline – 48 months from the date the relevant Cotai land concession became effective – to complete Sands Cotai Central. The property is expected to cost at least US$4.2 billion (MOP33.58 billion) when finished.
MGM CHINA CEO SAYS 2013 VIP MARKET TO GROW UP TO 10% Macau Business
MGM China’s CEO Grant Bowie expects Macau’s 2013 VIP market to grow by between 8-10%. Bowie forecasts mass-market casino revenue to grow in the “mid to high teens” on a percentage basis. He added that March casino revenue is “pretty solid”.
Takeaway: Nike delivered on everything we needed to see to keep pounding the table, and then some.
There are three things we were looking for in Nike’s quarter; proof that 1) Nike is gaining share/driving consumer demand across its portfolio, 2) Gross Margins are improving at a rate well ahead of consensus expectations, and 3) that it is achieving these things with disproportionately less capital invested in its business (ie driving returns higher).
Well, Nike showed us every one of these, topped our EPS estimated by a penny, and blew out the Street by $0.06ps. No changes to our above-consensus EPS estimates our thesis. Nike remains a top pick.
Some important points:
North America En Fuego. As it relates to demand, we saw North America sales up 18%, which was on top of a 17% growth rate last year. Importantly, futures were up 11% despite being up at a colossal rate of 22% this quarter last year. Think about it like this -- try to find another company with 45% share in its category that is growing its top line at a mid-teens rate while improving margins and lessening capital intensity along the way. Let us know what you find, we think you’ll come up dry.
China has definitely bottomed. Don’t let management’s caution fool you. They specifically made it a point to keep estimates grounded and said that that they still have a lot of wood to chop. But futures going from -6% and -5% over the past two quarters to +4% in 3Q is proof positive that this business has at least found bottom, and is likely trending higher once again.
Inventories still improving – driving better margins. Though pricing and easing raw materials costs helped gross margins, the spread between inventory and sales growth is getting better and will continue to drive gross margins higher. This is probably best evidenced by our SIGMA chart, where it shows Nike making a big move into the upper right quadrant of this analysis. Over time, triangulating margins with capital efficiency explains away 92% of stock moves in retail. Translation – it matters.
We think that the spread between inventories and margins will continue to diverge well into FY14
Here’s our previously-published comments on our expectations for 3Q.
NKE: Ahead of the Print
We think that the Q is in good shape, but if there are any fireworks we’re confident enough in our thesis to support the name.
Conclusion: Our analysis suggests that Nike’s quarter is in good shape. But let’s face it, Nike always manages to light off a firework or two. If that happens to be case on Thursday, we’re confident enough in our underlying thesis that we’d support any weakness.
Will the quarter be a blowout? Not exactly. We’re modeling $0.72 vs the Street at $0.67. Nice upside -- but not huge. We’re about in line with the Street on the top line at about 11%, but we’re 50bp higher on the gross margin line. We think that’s fair given the easing product costs flowing through the P&L as well as 2Q ending with the most favorable inventory position in nine quarters.
Futures: As it relates to futures, bears are calling me with the expected ‘futures are decelerating’ concerns. The company is going against a 22% North American futures number in this quarter, and +18% globally. It doesn’t take a genius to figure out that this is a ridiculously tough quarter to comp. On a 2-year run rate, a 7% North American or 5% Global futures number suggests an even underlying trend. We think Nike comes in 2-3 points above those levels. On a go-forward basis, keep in mind that after this quarter, we started to see China drop off precipitously. Beginning next quarter, we expect any slowdown in growth in North America to be offset by a rebound in China and an uptick in Western Europe (NKE is about to anniversary the latest downturn there, and FL recently noted a stabilization in Europe).
Sentiment is Flat-Out Bad: Lastly, we need to acknowledge sentiment and valuation. We agree that the stock isn’t cheap at 17x earnings. But let’s not forget that sentiment on Nike remains quite bad. Our sentiment monitor, which is based on both sell-side recommendations, short interest and insider trading activity, suggests that Nike is more hated today than almost any time over the past 10-years.
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