“Energy itself can neither be created nor destroyed, though its many forms can change.”
That’s pretty much the first law of thermodynamics. The second law is that there is a price that gets paid when forms of energy change – it’s called entropy.
“Entropy is also a measure of the disorder (or randomness) of a system… some of these basic thermodynamic ideas date back to 1824, when a young French army officer, Sadi Carnot, sought to understand the rudimentary elements of an ordinary steam engine… engines work because of a temperature difference…” (Cosmic Evolution, pg 17)
In market speak, you might insert words for entropy like “rip” or “meltdown” – but, to me at least, it’s all about the same thing – rates of change. And for those of us who aren’t on the Federal Reserve’s inside information leak-list, I guess that’s the best we can do. Think for ourselves and do our own work in a transparent and accountable way.
Back to the Global Macro Grind…
“Literally, thermodynamics means movement of heat” (Chaisson). That’s why I call my rants on Twitter #TweetHeat. And oh were the #PTCs (Professional Top Callers) feeling it yesterday.
No matter what your market views have been for 2013, here we are – at all-time closing highs for the SP500 (+11.3% YTD at 1587). Consumption stocks continue to lead the charge (Healthcare (XLV) +18.82%, Consumer Discretionary (XLY) +13.13%) and Commodities continue to get hammered.
To review our non-consensus bull case for US Growth (and US Consumption Equities):
- #StrongDollar continues to make a series of higher-lows and higher-highs (vs its 40yr low in 2011)
- #CommodityDeflation continues to make a series of lower-highs and lower-lows (vs their 40yr high in 2011)
- US Consumption Growth occurs when the real purchasing power of the US currency rises
Pretty simple really. Wouldn’t it be nice if the President of the United States (either Bush or Obama) A) understood these basic concepts and/or B) had financial advisors who made these fundamentals crystal clear to them instead of focusing on leaking whispers about their spurious economic policy conclusions to the #OldWall?
Sadly, Margaret Thatcher passed away this week. She taught Ronald Reagan a lot about the real purchasing power of a currency and the real impact a political leader can have with her people (trust) by calling out all the conflicted and compromised bureaucrats. She was a patriot. God rest her soul.
We made some sales yesterday (I don’t like buying on green), but what would really get me to change my economic and market views?
- If Bernanke debauched the Dollar again
What would happen if Obama let that happen?
- Dollar Down = Commodities Up
- Commodities Up = Food and Gas Prices Up
- Food and Gas Prices Up = US Consumption Growth Down
Again, it’s not that complicated. Really.
What is complicated is comprehending A) Bernanke’s “transparency” model (leaking information selectively? #embarrassing) and B) how he has the “best inflation track record of any central banker since World War II” (that’s what he whined to Senator Bob Corker, under oath, earlier this year after Corker called him the biggest dove in modern history).
Bernanke has been wrong on this growth forecasts at least 70-80% of the time since he took over at the Fed in 2006. Remember, he got the job with his thesis of the “Great Moderation” (he was talking about volatility, after it hit generational lows). Not that he wants to talk about that anymore (his Fed has overseen the Greatest Volatility in US market history).
Maybe we should call his legacy The Great Transparency? Nah. Maybe Obama should put Bernanke on trial. Give the man his fair share already. Please have him explain (with someone who isn’t a market moron asking the questions):
A) How leaking information selectively = #transparency
B) How the all-time lows in the US Dollar (2011) = #trust
C) How the all-time highs in Commodities (2011) = #accountability
To be balanced, the all-time highs for Food Prices (globally) didn’t happen until 2012 (Gold and the CRB index topped in 2011). So there’s still a fighting chance that Bernanke’s final rip to all-time bubble highs comes in either his reputation amongst people who get paid to believe him or in the US Bond market.
Q: (in this order) Housing, Commodities, Gold, Food, Treasuries, and now US Stocks (again). He Who Saw No Inflation at the all-time highs in all of those prices – what does he really see? Or like any un-elected and un-accountable central planner with a confirmation bias, does he see what he wants to see?
What he’s hiding from you is what you really don’t trust. And you shouldn’t. Fortunately, the other side of his storytelling doesn’t cease to exist. The popping of his Commodity Bubble is becoming self evident. That’s a real-time Tax Cut. That’s good. So will be the inevitable leak that you are no longer getting 0% on your hard earned savings account.
Our immediate-term Risk Ranges for Gold, Oil (Brent), Copper, US Dollar, USD/YEN, USD/EUR, UST10yr Yield, VIX and the SP500 are now $1, $102.39-107.38, $3.29-3.45, $82.24-83.34, 97.62-101.63, $1.27-1.31, 1.71-1.88%, 12.04-14.41, and 1, respectively.
Best of luck out there today,
Keith R. McCullough
Chief Executive Officer
This note was originally published at 8am on March 28, 2013 for Hedgeye subscribers.
“Paris is now become a furnace of politics.”
In the beginning, Thomas Jefferson fell in love with France. Eventually, he started falling out of love with some of her socialized parts. The aforementioned quote came from a letter he wrote to a friend in 1788 and went on to add that “all the world is run politically mad. Men, women, children talk of nothing else.” (Thomas Jefferson: The Art of Power, page 215)
Only 225 years later, free-market capitalists living in Paris probably still feel the same. Jefferson’s timing was, as usual, prescient. On July 14, 1789, The People stormed the Bastille Saint Aintone and the French Revolution went full throttle. All the while, George Washington was officially named the 1st President of the United States.
Imagine Americans were paralyzed by France’s politics then inasmuch as our global crisis-seeking media is now? That’s no way to live. There’s always a crisis somewhere in this world. There’s a crisis developing for those calling for a US crisis too.
Back to the Global Macro Grind…
Put another way, there is a crisis in the crisis. And, no, I am not saying that you shouldn’t be shorting countries whose economies have been socialized and compromised by modern Marxist regimes. If you are bearish on Italy, just short Italy.
Quantitatively speaking, Fear’s Furnace appears to be alive and well in Europe. Consider the following signals:
- The Euro remains in a Bearish Formation (Bearish across all 3 of our core durations: TRADE, TREND, and TAIL)
- Germany’s DAX just broke its immediate-term TRADE line of 7865 support (this week); TREND support = 7695
- Italy’s MIB Index (-6% YTD) has been bearish TRADE and TREND for over a month now (Italian CDS now > 300 too)
So that’s bad – for them. But is everything that’s bad for them bad for you? Hopefully you aren’t reading this letter from Milan. But if you are, A) I hope it’s from vacation and B) that great cup of coffee you are drinking is going to get more expensive before you finish it.
In Euros, that is.
When your currency starts to get torched by politicians, you probably should start freaking out. If people really start freaking-out about Europe, what they are going to do with their fiat moneys next is more of what they are already doing – buying American:
- European investors will buy US Dollars
- European investors will buy US Stocks
- European investors will buy US Treasuries
And while the last part of that is something I probably need to risk manage more aggressively now (the fund flow bid to US Treasuries), the first two parts of that (#StrongDollar, Strong US Equities) is more of what we continue to like anyway.
The reason why this is confusing consensus is that for the last 3 years, this is not the way that the Global Macro market worked. To review: 2010-2012 was the US Dollar Debauchery period of The Ben Bernank (i.e. the period where the entire capital market world learned to just front-run the poor guy’s Policies to Inflate).
Today, the marginal debaucherer of currency is Japan – and the to-be Bernanked (cutting rates to zero) zone is Europe. That, in turn, puts further downward pressure on Euros and Yens relative to Dollars – and puts purchasing power in the back pockets of Americans.
Or non, mes amis? Not so cool for those using the old correlation playbook of 2010-2012 either:
- Dollar Up = Stocks and Commodities Down, globally
- Dollar Down = Stocks and Commodities Up, globally
That’s when the game was less hard. Remember, “get the Dollar right and you’ll get a lot of other things right”? That’s still right, but in a completely different way:
- Dollar Up = US and Asian Stocks Up
- Dollar Up = Brazilian, Russian, and Emerging Market Stocks Down
- Dollar Down = Commodities and Basic Materials Stocks Up
I know. Up, Down – all around. This is enough to make a man mad. Just be thankful you aren’t trying to trade S&P futures on what some French dude down on the Eastern edge of Paris was whispering to the Old Media’s twitterati , circa 1789.
Our immediate-term Risk Ranges for Gold, Oil (Brent), US Dollar, EUR/USD, UST10yr Yield, VIX, and the SP500 are now $1591-1617, $106.75-110.48, $82.79-83.66, $1.27-1.29, 1.84-1.96%, 11.31-14.29, and 1554-1568, respectively.
Happy Easter Weekend to you and your families,
Keith R. McCullough
Chief Executive Officer
The Macau Metro Monitor, April 11, 2013
CHINA'S NEW YUAN LOANS RISE SHARPLY WSJ
Banks made 1.06 trillion Chinese yuan ($171 billion) of net new loans in March, up from 620 billon yuan in February and well above expectations, despite pressure from the central bank to hold the line on lending.
HEALTH BUREAU INSPECTION 28 CASINOS FAIL TO MEET AIR QUALITY STANDARDS Macau Daily Times
The Health Bureau has released the results of the first test on the air quality inside Macau casinos four months after the implementation of the partial smoking ban in gaming venues. But laboratory examinations show only 16 of the 44 gaming venues meet the full requirements and the other 28 venues all recorded one or more forms of pollutants above the tolerable level. These casinos will have to take improvement measures or risk having their smoking-area reduced.
Laboratory tests show only two concessionaires met all the air quality requirements (the Venetian’s four casinos and MGM Grand’s one casino). The other four concessionaires have a total of 11 casinos that passed all six tests, but their remaining 28 casinos have failed at least one of the six tests.
Sixteen of the 28 gaming venues found to have sub-standard air quality are operated by SJM, eight by Melco Crown, three by Galaxy and one by Wynn.
If air quality meets the required standards, the casinos will be allowed to continue operating the same size of smoking-area; otherwise they may risk a reduction of that area.
Trading the Dean Foods (DF) Stub
The value of DF right now is composed of two items:
- The value of the dairy business that constitutes DF’s operations (Fresh Dairy Direct, mostly fluid milk)
- DF’s economic interest in Whitewave Foods (WWAV)
On October 31, 2012 WWAV completed an IPO of 23 million shares of Class A common stock (IPO price of $17/share) – prior to that offering, WWAV operated as a wholly owned subsidiary of Dean Foods (DF). DF owns 150 million shares of WWAV Class B common stock, representing 86.7% of the economic interest in WWAV and 98.5% of the voting interest.
Back in February, DF announced that it would spin-off additional shares of WWAV (tax-free) in May of this year (following the April 23rd expiration of the lockup period of the WWAV IPO underwriting agreement), retaining a 19.9% interest in the company. Ultimately, DF plans to monetize/spin the remainder of its ownership interest at some point in the future.
Different Businesses, Different Growth Profiles
Whitewave Foods is a faster growing business with 40% of its sales in U.S./European plant-based food and beverages (soy, almond) – a very much on trend category with respect to health and wellness. Another 24% of the company’s sales are in North American premium dairy (organic, and the like, again, on trend) with the balance (36%) in North American coffee creamers and other beverages. Taken together, Whitewave is in a position to grow revenues in the 7-9% range and garner a premium multiple as a branded staples company. Currently, WWAV is trading at 22.9x ’13 EPS.
The Fresh Dairy Direct business, on the other hand is a zero to low-growth commodity/private label business that manufactures just about everything in your supermarket’s dairy case – milk (74% of the business), ice cream, creamers, etc. The per capita decline in milk consumption in the U.S. is a multi-decade trend, and despite the importance of the category to consumers and retailers, it is a low-margin, low ROIC business with significant commodity exposure.
The long-term growth profile at WWAV is clearly superior to that of DF, but what is the implied valuation of the Fresh Dairy Direct Business (the DF “stub”) currently?
DF less WWAV
The current enterprise value of the Fresh Dairy Direct Business at DF is approximately $3.223 billion. Net debt (excluding the debt at WWAV consolidated on DF’s balance sheet) is approximately $2.312 billion and the equity value of DF (less the value of the 86.7% ownership interest in WWAV) is $911.4 million. The $911.4 million equity value represents a per share value of approximately $4.89 per share. The stub has traded in the range of $3 per share to $5 per share since the WWAV IPO.
Let’s get this out of the way to start – we have never been a big fan of the fluid milk business at DF. As mentioned above, the category is in secular decline and it is a low margin, low ROIC business with those low margins significantly exposed to commodities. Additionally, EBIT will decline this year due to the loss of a significant customer. With that as our admittedly unpleasant backdrop, let’s talk about what can work for the company going forward.
To begin with, even with the decline in the base business in 2013, we are forecasting $0.45 per share in FCF in 2013 ($410 million in EBITDA), so the stub is trading right around 10x FCF (7.9x EV/EBITDA) – and we are forecasting that the FCF per share can grow to nearly $1.00 in 2016 even assuming no growth in the base business. The company is in a position to reduce corporate costs (stranded overhead from being a larger organization prior to the spin) from $183 million to $120 million over the next four years (the 2013 EBIT base is $256.6 million). Further, CAPEX should decline from the projected $150-$175 million level this year to approximately $125 by 2016. Finally, interest expense of nearly $100 million in 2013 should slowly decline as the company pays down debt. Combined, these factors can contribute to close to 6% EBIT growth and double-digit growth in FCF absent any top-line growth or margin expansion.
The concern with any commodity sensitive business is margins, and even if DF sees a repeat of 2011 (a period where management cited “irrational competition”), the non-operating items can shield the FCF to the point where our upside may be reduced or eliminated, but we still see the $0.40- $0.50 per share as sustainable.
With respect to commodities, DF has leverage to lower corn prices (consistent with our macro team's view) as milk prices are linked to corn prices. The drought in New Zealand has caused cheese prices outside the U.S. to rise and may lift U.S. milk and cheese prices as the year progresses (negative for DF), but by and large, the outlook for milk prices for the balance of 2013 (as indicated by the cost curve below) remains benign.
How to play it?
DF probably doesn’t make much sense for long-only buyers today – as shown above, the bulk of the value of DF is in WWAV’s value, and WWAV can simply be purchased on its own. The value of the fluid milk asset lies in the DF stub, but from a long-only perspective that value can be realized in one of two ways – DF stock rises disproportionately relative to WWAV to appropriately reflect what we consider to be a “correct” multiple for the fresh dairy direct business (simply being long DF makes sense in this case) or WWAV’s share price declines as DF’s share price stays the same (or declines less, relatively), expanding the implied value of the asset. In the latter case, an investor would have been absolutely correct in the thesis and either lost money or failed to profit from the trade. As it currently stands, buying DF standalone to get the fluid milk asset is like buying a box of cigars to get the box – there is a better way to do it.
Investors can buy DF and short 0.806 shares of WWAV (about 100 shares for every 125 of DF owned) – recall that DF will spin out a portion of its ownership of WWAV, retaining a 19.9% interest - 34.4 million shares of its current ownership position of 150 million, so DF will distribute 115.6 million shares of WWAV to DF’s 186.1 million shares outstanding, or 0.62 shares for every share of DF held. The net result is that a portion of the short position will be covered on the distribution, and presumably the value of the remaining stub can expand to more appropriately reflect its value over time and the prospect that we see for FCF and EBITDA growth. Alternatively, investors can short only the amount that will be covered on the distribution. In that case, holders of DF subsequent to the distribution will still be able to participate in WWAV’s superior growth profile through DF’s remaining 19.9% interest.
Finally, we have spoken recently about the demand for small and mid-cap staples names within the context of our analysis of PF and MKC. We expect that DF will see money flows subsequent to the distribution as the long-only buyers that we mentioned as being disinterested in getting shares of WWAV now become interested in DF on its own. Also, highly-levered, slower growth assets have been in the market’s sweet spot of late, and DF certainly qualifies in both regards.
We believe that, over time, the DF stub can trade at 12-14x our 2014 FCF estimate of approximately $0.60 per share, or close to $8 per share. On the downside, the business isn’t great (as explained above), and it is small cap without tremendous liquidity. However, in a staples world where virtually everything has a consistent bid and has worked, the DF stub is like a new issue, and we saw what happened with PF.
Call with questions,
HEDGEYE RISK MANAGEMENT, LLC
Today we sold our position in the iShares Russell 2000 Index ETF (IWM) at $93.00 a share at 10:26 AM in our Real-Time Alerts. We originally bought IWM on 4/1/13 at $92.92 a share and #timestamped it in our Real-Time Alerts. With the S&P 500 at the top end of our immediate-term TRADE risk range, we'll sell some beta up here so that we can buy it back again on the next pullback.
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