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Persistent Illusions

This note was originally published at 8am on March 22, 2013 for Hedgeye subscribers.

“Reality is merely an illusion, albeit a very persistent one.”

-Albert Einstein


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:


The illusions:

  • 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.

The reality:

  • 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 $1594-1620, $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 1542-1565, respectively.


Enjoy your weekends.


Keep your head up and stick on the ice,


Daryl G. Jones

Director of Research


Persistent Illusions - Chart of the Day


Persistent Illusions - Virtual Portfolio


The Macau Metro Monitor, April 5, 2013




Macau need not be worried about four confirmed human deaths on the mainland linked to a strain of bird influenza known as H7N9, said the government. And the outbreak has no impact on the decision to open the Gongbei border for two hours longer during the three days of the Ching Ming holiday, added Alexis Tam Chong Weng, head of the Chief Executive’s office.  “For the [H7N9] ‘flu this time, there is still not any case recorded in Macau,” Mr Tam told a press conference on Wednesday. “The cases are currently limited to the northern region of China so I think there will be no problem for us to open longer hours in the border in these three days.”



China has begun a mass slaughter of poultry at a market in Shanghai, after a new bird flu virus was detected there.  The H7N9 virus, a form of avian flu not before seen in humans, was discovered in pigeons being sold in the market.  Six people have now died from the virus, Chinese officials say.


It is not yet known how people are catching the disease, although the WHO says there is currently no evidence of human-to-human transmission.  The virus was discovered in pigeon samples in Huhuai market in western Shanghai, Chinese media said.  There have been 14 confirmed infections so far in eastern China, including in Shanghai and Zhejiang province.



The Taiwanese government is proposing a 13% tax on gross gaming revenue for potential casinos built on its outlying islands.  In Macau, casinos pay a 39% effective tax on gross gaming revenue.



CHART OF THE DAY: In #StrongDollar, We Trust


CHART OF THE DAY: In #StrongDollar, We Trust - Chart of the Day

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In #StrongDollar, We Trust

“Kennedy Pledges He Will Maintain Value of Dollar”

-New York Times, 1960


As William Silber points out in Volcker – The Triumph of Persistence, that’s what JFK was rolling with 2 weeks before the 1960 US Presidential Election. It was a pro-growth campaign about American progress. A #StrongDollar has always symbolized that.


After LBJ, Nixon, and Carter spent 15 years devaluing the Dollar, this progressive conservative American mantra lost its place in the vernacular of what Hayek called the Political Economy. Why? Currencies and the central bankers that manipulate them get politicized.


After watching Bernanke devalue the Dollar as aggressively as any Fed Chairman since Arthur Burns (1970s), now you are watching the Japanese take a page out of his un-American playbook. That’s not a partisan comment either. Long-time Democrats will recall Kennedy’s thoughts about the US Dollar and monetary policy were crystal clear:


Price stability belongs on the social contract. We give the government the right to print money because we trust our elected officials not abuse that right, not to debase the currency by inflating… Failure to maintain those promises undermines trust in America. And trust is everything.” (Volcker, pg 53)


The world no longer trusts the Japanese.


Back to the Global Macro Grind


But do Americans trust President Obama and Ben Bernanke? Does Wall Street? Do we trust that if the US unemployment rate continues to surprise on the downside in 2013 that these politicians will get out of our hard earned currency’s way?


Today is a big day on that score. While it’s tough to get comfortable with a number that the US government effectively makes up, we’re confident that the market is confident that Bernanke is somehow confident betting the entire bond bubble farm on one made-up number.


To be balanced, if there’s one thing we are overly confident in, it’s that Bernanke’s growth forecasts will continue to be wrong. We think both US employment and consumption growth surprises to the upside during #StrongDollar periods like the one you are seeing now.


Does the market like this? Which market? First, let’s look at what USD Correlation Risk is telling us on a 1-month duration: 

  1. US Dollar vs SP500 = +0.84
  2. US Dollar vs Brent Oil = -0.71 

Hooowah! Al Pacino couldn’t have said it better. Like taking a flyer in a Ferrari for free, American Consumers absolutely love #StrongDollar, Down Oil. Basic Materials and Energy stocks, not so much.


Commodity-linked country stocks markets don’t like it either:

  1. Russia – RTSI down again this morning and down -13.3% since January 28th 2013
  2. Brazil – Bovespa is a big commodity index, and continues to be just nasty YTD (-10.3%) 

For Commodities overall, the last 2 months have been flat out nasty:

  1. Rubber -21.1%
  2. Silver -15.2%
  3. Corn -14.2%
  4. Copper -10.9%
  5. Platinum -10.7%
  6. Wheat -9.0%
  7. Brent Oil -7.9%
  8. Soybeans -7.8%
  9. Lean Hogs -7.4%
  10. Gold -7.4%

So, I guess if you are really long commodities, being long Gold right now would be your outperformer!


Long-time market history fans know that Gold has been annihilated, multiple times, during #StrongDollar periods. Until Nixon and Connolly (his politically compromised Treasury Secretary – the guy who rode in the car with JFK during the assassination) figured out how to Burn The Buck for political victory (1971), US Dollar strength (particularly in the 2nd half of 1969) crushed the Gold bugs.


But this is much larger than #AngryBugs at this point. This is really the first opportunity since Q1 of 2009 where #StrongDollar Commodity Deflation has provided a real-time Tax Cut to American Consumers of food and oil.


The Fed’s Bill Dudley would disagree with me on this, but I don’t think you can eat platinum or rubber. That said, producers who need such things to make what we consume will pay less for their inputs, if pervasive Dollar strength continues.


So, again – I call on the great market minds in Washington D.C. to do what’s right and:

  1. End the most dovish Fed policy in US history
  2. Continue with the shift toward conservatism in fiscal policy
  3. Spread the love about #StrongDollar’s benefits (Obama, Yes You Can!)

Especially at the pump and at our dinner tables, we can trust that a lot more than we’ve trusted the #PoliticalClass under any of the Nixon, Carter, Bush II, or Obama regimes. “And trust is everything.”


Our immediate-term Risk Range for Gold, Oil (Brent), US Dollar, USD/YEN, UST 10yr Yield, VIX, and the SP500 are now $1, $105.68-108.93, $82.52-83.41, 94.04-96.35, 1.76-1.92%, 12.31-14.61, and 1, respectively.


Best of luck out there today,



Keith R. McCullough
Chief Executive Officer


In #StrongDollar, We Trust - Chart of the Day


In #StrongDollar, We Trust - Virtual Portfolio


TODAY’S S&P 500 SET-UP – April 5, 2013

As we look at today's setup for the S&P 500, the range is 25 points or 0.70% downside to 1549 and 0.90% upside to 1574.     










  • YIELD CURVE: 1.53 from 1.54
  • VIX closed at 13.89 1 day percent change of -2.25%

MACRO DATA POINTS (Bloomberg Estimates):

  • 8:30am: Trade Balance, Feb., est. -$44.6b (prior -$44.4b)
  • 8:30am: Nonfarm Payrolls Change, March, est. 190k (pr 236k)
  • 8:30am: Unemployment Rate, March, est. 7.7% (prior 7.7%)
  • 1:30pm: Baker Hughes rig count
  • 2:30pm: Philadelphia Fed vice president Nason speaks
  • 3pm: Consumer Credit, Feb., est. $15b (prior $16.15b)


    • CFTC holds closed meeting on surveillance and enforcement matters, 10am
    • Talks resume on Iran’s nuclear weapons program in Kazakhstan


  • Payrolls in U.S. probably rose in March as demand picked up
  • Blackstone said to sidestep Michael Dell’s role in buyout talks
  • Soros joins Gross in warning Kuroda plan risks rout in yen
  • BP to ask judge to halt some oil spill settlement payments
  • Olam to discontinue legal action against Muddy Waters, Block
  • Euro-area Feb. retail sales fell less than est. from Jan.
  • German Feb. factory orders may rise from Jan.: survey
  • Grohe owners said to mull IPO, sale of bathroom fixtures maker
  • Banks warn stricter securitization rules risk credit drought
  • North Korea regime uncertain, maintains stability: South Korea
  • Japan considers shooting down North Korea missile: Sankei
  • U.S. budget, Bernanke, China, Masters: Wk Ahead April 6-13


  • WTI Set for Biggest Weekly Drop Since September Amid Iran Talks
  • Gold Traders Split With Bullion Nearing Bear Market: Commodities
  • Soybeans Fall for Third Day as Bird Flu in China May Hurt Demand
  • Platinum to Slump as Europe Car Sales Tumble: Chart of the Day
  • Copper Swings on Chile Export Curbs and Signs Economies Struggle
  • Cocoa Falls a 3rd Day as Rain May Help Crop; Sugar Also Declines
  • SGX to Introduce Iron Ore Futures as Investors Bet on China
  • Russian Grain Crop Seen by Rusagrotrans Up 28% in Coming Season
  • Le Fracking for Geothermal Heat Draws Ire of French Oil: Energy
  • Coal Strike Looms as Workers Protest Stake Sale: Corporate India
  • Meat Industry Renames Beef, Pork Cuts Before U.S. Grill Season
  • RIN Ethanol Price Risk Remains Skewed to Upside, Goldman Says
  • Aluminum Premiums Reach Record as Warehouse Releases Limited
  • Gold Trades Near 10-Month Low in London on Recovery Outlook






















The Hedgeye Macro Team











HedgeyeRetail Best Ideas

Takeaway: Here's our incremental thinking on our Retail Best Ideas. NKE, RH, FNP, KORS, JCP(what?). DKS, GES, UA, LULU, M, CRI. Then there's our bench

Here’s an overview of incremental thoughts on our Retail Best ideas.


The Retail Group Call: The out-of-consensus call here is to be bullish on retail. But with margins at peak, capex up by 30-40%, and SG&A up by 30-50bp the rate of sales, we need confidence in a given company’s ability to drive top line growth through its model to keep returns headed higher. We think that Retail will increasingly be a game of haves and have not’s in 2013 – and capital efficiency/deployment will be the biggest theme.



Nike (NKE): The consensus view is that the company just put up a great quarter, and now the story is over. But the reality is that it proved that it can continue to drive results in its core US market, while we’re now seeing a recovery in China, Europe and Emerging Markets. Also don’t forget that Gross Margins, which have been an Achilles Heel for over two years, are improving sequentially. Inventories look cleaner than they have in 10 quarters. It is doing this with a disproportionately small amount of working capital and capex, which carries big weight with us. Consensus estimates are still too low.


Restoration Hardware (RH):  The Street has left this one for dead.  But the reality is that RH is seeing an inflection point in its square footage growth by way of rolling out its new Design Galleries – which are 3x the size of its current stores. While bigger stores is usually the swan song for a retailer, in the furniture space is critical. RH has only been able to showcase 25% of its product, and now it is changing its model to show the consumer a dramatically greater portion of its product line, as well as launch new categories like kitchen, bath, flooring, kids, art, etc…. The punchline is that this is a volatile name, but you’ve got square footage growth, productivity improvement from new categories, and a call option on a sustained recovery in housing.  


Fifth & Pacific (FNP): The stock is hitting multi-year highs, but that doesn’t mean that it can’t hit new multi-year highs. The new wrinkle of a likely sale of Lucky along with Juicy Coture is a big positive – as much as we a) like the current momentum at Lucky and b) cringe at selling Juicy at t he bottom. FNP has already gone from being a debt-laden, low margin, low asset turning portfolio of bad brands to being one of the best growth stories in retail. Getting rid of these brands would strip FNP of its debt, which would only make the story that much more attractive. We’re modeling Kate EBITDA to nearly triple to $300mm by 2015. That more than 50% ahead of consensus. Until that’s recognized, the ‘FNP is too expensive’ argument holds little water with us.


Michael Kors (KORS):  Yet another expensive stock, but one where we think we’re looking at 40-50% earnings growth – and expectations that are about 20% too low through 2015. In short, we think that KORS and COH will flip flop as it relates to margins, with KORS accelerating to the low 30s and COH slipping to the mid-20s. We’re modeling another 175 stores added globally on top of 30% wholesale growth. Both of those are very realistic. As it relates to comps, we concede that the productivity numbers are getting stratospheric -- $1,700 today on a trajectory to $2,400 over three years. Though we’ll be looking at moderating growth thereafter, we’ll also be looking at a company that turns its assets 12x annually on top of 22% tax-adjusted EBIT margins. That would make it one of the highest retailers in retail – ever. 25x a $4.00 EPS number in 2015 is hardly a stretch in that scenario. At a minimum, shorts beware.


JC Penney (JCP): Ok…here comes the accountability thunder.

After being short JCP from the Ackman/Johnson $40 ‘$9-$12 in earnings power’ hype, we pulled a 180 at $19 earlier this year. To say that our ‘about-face‘ was the wrong call would be an understatement.


While it’s very tempting to support it here, we simply can’t for anyone with a near-term horizon. We have three primary concerns. 1) First off, we’re at a loss of ($0.91) for the quarter, versus the Street at a loss of ($0.68). We were below-consensus last quarter too, and made the mistake in thinking that it was ‘in the stock’. The timing of the Vornado sale did not help, but clearly, it’s tough to be bullish on a name like this ahead of a miss.  2) The Martha Stewart trial is coming to a head and we’ll see fireworks on or around April 8. It is near impossible to get an edge on which way this will go. 3) The calls for Ron Johnson to be fired scare us. For most companies, we could see how this would make sense. But the company can’t financially afford to change direction under anyone else, and if RJ is out of the equation there’s the risk of major vendors backing out. If the lobbying for him being fired is successful, we’d short every share we could find. The punchline here is that there’s no reason this stock can’t drift lower near-term.


While it’s obvious that a lot of this uncertainty is what’s driving the stock down so hard, the reality is that the better risk-management call would be to support it once a) 1H earnings is past, and b) we have clarity that RJ is keeping his job – even if it means getting involved at a higher price.


If this story is really going to work, getting back in at $19 as opposed to $14/$15 won’t make much of a difference for someone with a 1+year duration. But if the company misses even our bearish estimate in 1Q and/or the research call changes (its ability to roll-out higher productivity shops), we’ll cut bait…fast.



Dick’s (DKS): DKS might be a best in breed, but it’s a bad breed. DKS is low margin, low asset-turning, and subsequently low return. We only like to get involved with DKS on the long side as a rental, and that’s when we can bank on comps in the 5% range or better. Today, we’ve got 1-2% comps, and the only safety there is that the golf business (Golf Galaxy – about 22% of total) is doing well because Tiger is back. The current run rate is not enough to leverage occupancy, which is not comforting given that a) margins are at peak and b) management admitted that it has underspent in its omni-channel growth strategy and needs to play catch up (#$$$). We might be ok with that for an above average retailer, but keep in mind that this is a company that faces stiff web competition from other retailers and even the brands that sell in its stores. The companies that are winning today are the ones that spent on ‘omni-channel’ way back when no one even knew what the heck ‘omni-channel’ was. Too little, too late. We think that DKS is a value trap.


Guess? (GES): The Guess? brand is stalling globally, the executive suite has a revolving door, and the only real bull case revolves around this being cheap on a more ‘normal’ earnings base of $3+ that it earned over each of the past two years. That’s a pipe dream. Even management’s guidance of $1.70-$1.90 is optimistic at best, and if it gets there it will be through cutting costs that arguably be reallocated to other areas of the business. One thing that’s important to consider is that 2/3 of GES’ business is causing the problem – and that’s North America Retail, and Europe. The company is blaming the economy – again. The company needs to understand – as we do – that investors absolutely have zero tolerance for a management team that does not have a process to drive its business in the face of a downturn in the economy.  In the end, we think we’ll need to see new blood in the executive rank at GES who will then need to fight for – and win – the right to reinvest capital into the business to better stratify the brand and build an omnichannel strategy accordingly. We’d definitely put GES in the bottom quartile with its abilities in those areas. Until then, it too, is a value-trap in the mid-$20s.


UnderArmour (UA): We continue to think that UA will join the band of companies in the retail supply chain that is stepping up capital investment this year – both in capex and in SG&A. Growth in Footwear and International are both absolutely critical to UA’s aggregate top line. When that happens, we think that revenue and EBIT growth will diverge. If we’re wrong, then we think it is a matter of time until the top line slows, which would be even more damaging to UA’s multiple.  We still think that this is an exceptional brand, but simply think that it belongs to a company that needs to go through some growing pains before it could deliver upon the expectations currently embedded in the stock.  We think it’s more likely than not that earnings growth gets pushed out by a year sometime in 2H, and that investors should take advantage of this on or just after the 1Q print.


Lululemon (LULU): We rarely make a multiple call, but this is about as close as we get. LULU owns one of the most powerful brands in apparel, and few would debate that. That’s implicit in the company’s sales trajectory, 27% margins, 125% ROIC, and ultimately, its 30x multiple. Unfortunately, its ‘wardrobe malfunction’ that threatened one of its most important products, it begs the question as to whether there’s enough infrastructure at LULU to ensure quality control at a level that is consistent with a company that is going to double in size to $3bn over 3-years.  Keep in mind – in order of magnitude of this blunder is like Nike finding out that all its Jordan’s are defective. We know that costs are going up to some extent. But will they only impact margins by 1%, or take them to 25%, 20%, 15%? We can speculate, but the reality is that we simply don’t know, and the market won’t know either for a 1 to 2-year time period. This kind of uncertainty does not give us confidence that a multiple starting with a 3 – or perhaps even a 2, is bankable until sales and margins reaccelerate.


Macy’s (M): We simply don’t like how this story is packaged. Macy’s is a lousy secular story with no unit growth that is at peak margins and just had a breakout year that temporarily pushed returns above its cost of capital.  It has a major competitor that is coming back online after a disastrous year, and it will impact the competitive landscape whether JCP succeeds or fails in hitting its own goals.  By saying ‘a major competitor coming back online’ we mean that JCP probably won’t comp down another 30% this year (even if you’re a JCP bear you probably agree with this). That’s the magnitude Macy’s needs to see in order to face a similar competitive set as last year. On the margin front, management already noted that additional gross margin improvement is unlikely, and that we’ll need to see future margin growth coming from SG&A leverage. We’d be much more comfortable paying up for M if we could bank on Gross Margins. But banking on sales and SG&A leverage for a department store? Not quite. And let’s not forget that it’s got financial leverage. We think the downside/upside here is 2 to 1.


Carter’s (CRI): CRI has been an outstanding story, and it’s one where we’ve gotten the research call wrong on the short side. That said, we’re keeping it on this list because it fits so well with our capital allocation theme as we struggle to find another company that is spending more capital for an incremental return that is already embedded in consensus estimates. In other words, there’s extremely little room for error. We started to see product pricing show slight signs of weakness two quarters ago. Then last quarter comps weakened in US Carter’s stores. At the same time SG&A was up 40%, and the company noted that capex was going up from $85mm in 2012 to $200mm in 2013. The Street is modeling margins of 14.4% 3-years out, and we’re hard-pressed to think that we see anything higher (in fact we can’t find comparable businesses that do much better). With the stock at $59, we’re looking at 17.8x, 15.5x, and 12.4x earnings using 2013, 14 and 15 consensus estimates, which assume that CRI grows margins by 330bps over that time period. If we’re wrong on this one, we think it will be the time period over which CRI hits these goals – not that it will surpass the absolute margin levels.  

investing ideas

Risk Managed Long Term Investing for Pros

Hedgeye CEO Keith McCullough handpicks the “best of the best” long and short ideas delivered to him by our team of over 30 research analysts across myriad sectors.