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PM – Currency can be a Bear

PM is on the tape with Q1 2013 EPS of $1.29, a shortfall of $0.05 versus consensus – however, currency was a $0.07 headwind in the quarter.  Currency is now forecasted to be a $0.19 headwind for the year (versus $0.06 prior) resulting in a $0.13 downward adjustment to EPS at both the top and bottom end (now $5.55 to $5.65).  Underlying guidance remains unchanged.



PM posted a volume decline of 6.5% (against the toughest comparison of the year, +5.4%).  Volume was weaker than consensus in multiple regions – European Union (-10.1% reported versus -6.7%), Asia (-10.4% reported versus -5.4%) and Latin America and Canada (-7.5% reported versus -1.0%).  However, again, Q1 was the most difficult comparison of the year in each of those regions.  Despite the volume shortfall versus consensus, reported revenue (net of excise taxes) of $7.584 billion came in slightly better than consensus, against a very difficult comparison.  Constant currency organic revenue growth was +3.2% despite the volume print, indicating to us that the pricing architecture for 2013 is in place and intact.



Operating income declined year over year (-0.6%), currency neutral EBIT +2.9%, so the company saw negative operating leverage for the first quarter since Q4 2011 – not surprising given the volume print in the quarter.

 

What we liked:

  • Preservation of underlying operating guidance
  • Solid pricing architecture in place for 2013
  • Respectable constant currency organic revenue growth of +3.2% against a difficult comparison
  • Comparisons ease substantially through the balance of 2013

What we didn’t like:

  • EPS miss and reduction of guidance (even if for no reason other than currency)
  • Volume weakness across multiple regions versus consensus (and even versus our more bearish estimates)
  • Lack of operating leverage (first time since Q4 2011)
  • Awful FCF generation in the quarter (-32.8%, and -17.1% adjusting for currency)

It’s tough for us to be positive on a stock when EPS estimates are heading lower (regardless of the reason) and when we couple that with a firm view of continued strength in the U.S. dollar, we have a hard time getting behind PM at this point despite what we readily acknowledge as strength in the underlying business model.

 

Call with questions,

 

Rob

 

PM – Currency can be a Bear - rr. 1

 

PM – Currency can be a Bear - rr. 2

 

 

Robert Campagnino

 

Managing Director

 

HEDGEYE RISK MANAGEMENT, LLC

 

E:

 

P:

 

 

 

Matt Hedrick

Senior Analyst 

 

 


INITIAL CLAIMS: A GROWING DIVERGENCE BETWEEN PERCEPTION & REALITY

Takeaway: So far, this year is following in the footsteps of the prior three years on both a seasonally and non-seasonally adjusted basis.

Back on Track

We realize there are a lot of charts in this note, so in the interest of everyone's time we'll direct you to the two that we consider most important: the first and second.

 

The first chart shows the illusion. You can see from the bottom right series that seasonally-adjusted initial jobless claims are beginning their steady rise that will continue through August, just as they have in the prior three years. In fact, the slope of the line is steeper than what we've seen in the last three years - a negative sign. As a reminder, we think this dynamic is one of the primary contributors to the recurrent pattern we've seen in the XLF over the last three years. For more on that see our note yesterday "Beware the Ides of April?".

 

The second chart shows the reality. The reality is that non-seasonally adjusted claims are 4.0% lower than last year, which is right in-line with the trend line of improvement we've been seeing since the recovery began in early-2009. You can see that the slope of the 2013 YTD change is nearly identical with what we saw in 2012.

 

The takeaway from this is that the market still focuses on the first chart when it should be focusing on the second chart. While we recommend battening down the hatches for the immediate term, we would view weakness as a buying opportunity so long as the second chart remains on track. 

 

The Numbers

Prior to revision, initial jobless claims rose 6k to 352k from 346k WoW, as the prior week's number was revised up by 2k to 348k.

 

The headline (unrevised) number shows claims were higher by 4k WoW. Meanwhile, the 4-week rolling average of seasonally-adjusted claims rose 2.75k WoW to 361.75k.

 

The 4-week rolling average of NSA claims, which we consider a more accurate representation of the underlying labor market trend, was -4.0% lower YoY, which is roughly flat with the previous week's YoY change of -4.4%.

 

INITIAL CLAIMS: A GROWING DIVERGENCE BETWEEN PERCEPTION & REALITY - 1

 

INITIAL CLAIMS: A GROWING DIVERGENCE BETWEEN PERCEPTION & REALITY - 2

 

INITIAL CLAIMS: A GROWING DIVERGENCE BETWEEN PERCEPTION & REALITY - 3

 

INITIAL CLAIMS: A GROWING DIVERGENCE BETWEEN PERCEPTION & REALITY - 4

 

INITIAL CLAIMS: A GROWING DIVERGENCE BETWEEN PERCEPTION & REALITY - 5

 

INITIAL CLAIMS: A GROWING DIVERGENCE BETWEEN PERCEPTION & REALITY - 6

 

INITIAL CLAIMS: A GROWING DIVERGENCE BETWEEN PERCEPTION & REALITY - 7

 

INITIAL CLAIMS: A GROWING DIVERGENCE BETWEEN PERCEPTION & REALITY - 8

 

INITIAL CLAIMS: A GROWING DIVERGENCE BETWEEN PERCEPTION & REALITY - 9

 

INITIAL CLAIMS: A GROWING DIVERGENCE BETWEEN PERCEPTION & REALITY - 10

 

INITIAL CLAIMS: A GROWING DIVERGENCE BETWEEN PERCEPTION & REALITY - 11

 

INITIAL CLAIMS: A GROWING DIVERGENCE BETWEEN PERCEPTION & REALITY - 12

 

INITIAL CLAIMS: A GROWING DIVERGENCE BETWEEN PERCEPTION & REALITY - 13

 

INITIAL CLAIMS: A GROWING DIVERGENCE BETWEEN PERCEPTION & REALITY - 14

 

Yield Spreads

The 2-10 spread fell -10.6 basis points WoW to 147 bps. 2Q13TD, the 2-10 spread is averaging 153 bps, which is lower by -14 bps relative to 1Q13.

 

INITIAL CLAIMS: A GROWING DIVERGENCE BETWEEN PERCEPTION & REALITY - 15

 

INITIAL CLAIMS: A GROWING DIVERGENCE BETWEEN PERCEPTION & REALITY - 16

 

 

Joshua Steiner, CFA


CAT: Heavy Exposure

Takeaway: Looking for slower growth or small declines in resources-related capex is inconsistent with history and logic. That may be bad news for CAT.

This note was originally published April 17, 2013 at 15:00 in Industrials

CAT: Why Consensus Is Coming Our Way

 

 

Resource-related Capital Investment Cycle:  When commodities rise sharply, resources-related capital spending ramps quickly to bring on additional supply.  A subsequent flattening or decline in commodity prices can bring resource-related capital spending back to trend levels – typically not far above maintenance levels, since the industries are generally mature.  Currently, resources-related capital spending is very high following 100+ year outlier gains in many commodity prices, like iron ore, copper and gold.

 

CAT: Heavy Exposure - 1qq

 

 

Expect Very Large Declines:  Some are looking for slower growth or small declines in resources-related capital spending.  That expectation is inconsistent with history and logic.  As the chart above shows, resources-related capital spending declined 80% over a five year period following peak orders in the late 1970s.  CAT posted very large losses in the early/mid 1980s, in part as a result of this readjustment.  As the chart below shows, a return to slow output growth levels of capital spending (approximated by depreciation and amortization) would bring a ~70% decline in capital spending at large miners.  Mining is not a growth industry.  In the long-run, capital spending should be expected to approximate DD&A.

 

CAT: Heavy Exposure - 2qq

 

 

Resources Capital Equipment Is Where CAT Makes Money:  Approximately three-quarters of CAT’s 2012 operating income was derived from Resource Industries and Power Systems.  Both of those divisions are heavily exposed to resource-related capital spending.  Resource Industries counts sales of mining equipment to coal, copper, iron ore and gold mines as its largest end-markets.  Power Systems sells locomotives to mines and railroads, power generation systems to mines/resource companies and power plants, turbines to gas compression and energy extraction sites, and other end markets.  Picturing the impact of a 50% decline in resources-related capital spending (not at all unlikely in our view) on the operating income of CAT does not require much imagination.

 

CAT: Heavy Exposure - 3qq

 

 

Value Traps:  CAT, Komatsu and other diversified resource-equipment suppliers are likely to look cheap on multiples for years to come.  They will go down and investors will buy them thinking they are values, only to find that results weaken yet further.  Beware the low PE in cyclicals – it is frequently a sign of a cycle peak or decline. 

 

 


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Taking A Beating

Client Talking Points

Whipping The KOSPI

South Korea's KOSPI index is down another -1.2% overnight, which brings the index to another lower-low for the year and is -5% year-to-date. Ouch. The country has plenty of external factors going against it, ranging from Japan's debauching the Yen to Kim Jong Un crying war up north. Tech in the US is taking a beating - just look at AAPL yesterday. All this spells trouble for Korea.

Doctor Copper

The Great Commodity Bubble brought on by Federal Reserve Chairman Ben Bernanke has already taken out gold, so who's next? Doctor Copper, step right up. While gold struggles to recover this morning, copper is taking another beating, down -1.1% to $3.08/lb. This comes on the heels of a fresh six month low, so don't forget: bad can get worse.

Asset Allocation

CASH 34% US EQUITIES 20%
INTL EQUITIES 15% COMMODITIES 0%
FIXED INCOME 6% INTL CURRENCIES 25%

Top Long Ideas

Company Ticker Sector Duration
IGT

Decent earnings visibility, stabilized market share, and aggressive share repurchases should keep a floor on the stock.  Near-term earnings, potentially big orders from Oregon and South Dakota, and news of proliferating gaming domestically could provide near term catalysts for a stock that trades at only 11x EPS.  We believe that multiple is unsustainably low – and management likely agrees given the buyback – for a company with the balance sheet and strong cash flow as IGT.  Given private equity’s interest in WMS (they lost out to SGMS) – a company similar to IGT that unlike IGT generates little free cash – we wouldn’t rule out a privatizing transaction to realize the inherent value in this company.

IGT

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

"If VZ activated 4 million iPhones, that's 25% YoY growth." -@Commodity_Bull

QUOTE OF THE DAY

"It is dangerous to be sincere unless you are also stupid." -George Bernard Shaw

STAT OF THE DAY

U.S. weekly jobless claims edge up by 4000 to 352,000.


Chinese Chicken

This note was originally published at 8am on April 04, 2013 for Hedgeye subscribers.

“Chickity China the Chinese Chicken. You have a drumstick and your brain stops tickin’.”

-Barenaked Ladies (1998)

 

Thank goodness the A-Shares are closed today.

 

Ok, perhaps that is quite a bit dramatic, but we’re certainly not thrilled by the fact that the Shanghai Composite Index is down -3.8% since our Macro Team pitched Chinese equities on the long side in our 2/27 Best Ideas Presentation (underperforming the regional median equity market gain of +1.3% by 507bps).

 

The lesser analyst in me would’ve begun the note pointing to the SHCOMP’s +6.8% delta since 12/10 (when we originally introduced the idea), calling for the index to continue making higher-highs and higher-lows over the intermediate term.

 

While that remains our base case scenario – for now at least – we would be remiss to ignore what we have learned from Dr. Daniel Kahneman’s work in the then-groundbreaking field of prospect theory – specifically in that economic agents A) assign an asymmetrically greater absolute value of utility to losses then they do to gains and B) multiple gains and/or losses are accumulated to create an overall feeling about a series of transactions that extends from the most recent, not original, reference point.

 

Applying prospect theory to our bullish bias on China, the absolute value of the negative utility associated with the -3.8% delta since 2/27 is likely in excess of the positive utility associated with the +11% delta from 12/10 to 2/27. Loosely applying the above quote from our Canadian friends up north (which itself hardly makes sense even in the context of the song it is sourced from), it would be fair to say that the Chinese stock market has indeed indulged in a rather infamous “drumstick”.

 

Cutting to the chase, it was our view that Chinese authorities would delay any tightening of monetary policy and/or macroprudential regulation until well after the country’s economic recovery had been firmly entrenched – creating cover for at least 3-6 additional months of potential upside for a traditionally high-beta market. With the introduction of the early-MAR propriety curbs, the late-MAR clamp-down on wealth management products (WMPs) and the dramatic acceleration in official recognition of systemic risks in the financial sector, however, it has become quite clear to us that the aforementioned view was dead wrong.

 

No doubt these measures will have some negative impact on Chinese economic activity, which we still see as accelerating over the intermediate term. But as prospect theory would have, the negative delta from our original, fairly-subdued expectations for a Chinese economic rebound to our updated view of an even more muted acceleration likely registers the entire sequence as a negative utility event.

 

In broader terms, it’s bad when your bull case gets less bullish, at the margin. Moreover, to the extent that the bull case was consensus across the investment community, the initial delta from “positive” to “less-positive” in any fundamental thesis is often the first cue for experienced short-sellers to enter a particular market.

 

Is China a short?

 

While we don’t believe it is (at least not yet; as evidenced by Keith’s buy signal on the CAF yesterday afternoon), we would be downright slipshod to not thoroughly debate the merits of the bear case, which we did in our 3/28 note titled “IS CHINA CAREENING TOWARDS FINANCIAL CRISIS?”. To recap a few highlights:

  • Last week China Daily reported that the China's banking regulator has urged banks to pay close attention to the credit risks in key industries affected by the economic downturn and hit by overcapacity woes. Zhang Ping, Chairman of the National Development and Reform Commission recently said that the industrial sectors suffering most from overcapacity include steel, cement, electrolytic aluminum, plate glass and coal coke sectors, each of which is operating at 70-75% of total capacity. Analysts estimate the outstanding loan portfolio of those industries may amount to around 30T-40T yuan ($4.83T-$6.44T or 22.6-30.2% of total banking system assets at the end of JAN). Per the PBOC, outstanding loans to the property sector were 12.1T yuan at EOY ’12.
  • In addition to these on-balance sheet risks, China has roughly 15T yuan of off-balance sheet credit (28.8% of GDP) in the form of commercial bills, trust financing, entrusted loans, etc. that has increasingly been allocated to riskier borrowers in recent years (per various agencies, including the IMF) – many of whom which have outsized exposure to property prices, such as property developers and local gov’t financing vehicles (LGFVs). The latter entity has 636.8B yuan in bonds outstanding as of EOY ’12 (+148% YoY) and 9.3T yuan of loans outstanding (17.9% of GDP) – 20% of which are “funding projects which are largely not profitable and thus are vulnerable to [repayment] risk,” per PBOC Governor Zhou Xiaochuan.
  • The next round of interest rate liberalization should promote better real returns and improved access to credit for Chinese households and SMEs, respectively, and that may perpetuate an unwind of off-balance sheet lending activities, which, according to most sources, have been largely capitalized with the surplus savings of China’s private sector that are seeking higher real yields via Trust Products and WMPs, where average annualized yields are 37% higher than the PBOC’s benchmark 1Y household deposit rate of 3%. To the extent there are any weak hands in the WMP or trust financing sectors, a lack of new inflows, at the margins, would expose the “ponzi-scheme” nature of some products (per the words of the Xiao Gang, Chairman of the Bank of China) – specifically those that rely on short-term funds in order to invest in illiquid fixed assets and fund distributions largely with new net inflows.
  • Ultimately, the most recent WMP regulations should translate into slower (and potentially even negative) growth in the supply of credit within the shadow banking channel and to the extent any existing liabilities facing repayment risk aren’t able to be rolled over, we will start to see default rates accelerate across China’s shadow banking sector. Any spillover effects across key industries – particularly in the oversupplied construction and construction materials sectors – could adversely impact Chinese bank NPL ratios (currently at 0.95%) on a lag.

In spite of all this, we continue to hold a reasonably high degree of conviction in our bull case on China, as a core driver of the thesis (i.e. Strong Dollar) is, in fact, the same bull case for US equities we have held since late 2012 that consensus has largely ignored and/or fought all year. To sum it up in a few bullets:

  • As expected, early MAR growth data is supportive of the Chinese economy resuming its trend of broad economic acceleration (the official Manufacturing PMI accelerated to 50.9 from 50.1 and the official Non-Manufacturing PMI accelerated to 55.6 from 54.5).
  • A sequential slowing in China’s MAR CPI and PPI figures (due out 4/8) is highly probable from the Lunar New Year jump in FEB. Moreover, continued gains in the CNY (at a ~19yr high) should weigh on inflation expectations over the intermediate-to-long term as China reorients its economy, though rebalancing certainly won’t happen overnight. Amid rebalancing, the country’s import model should change (less commodities; more consumer goods), ultimately increasing the impact of currency fluctuations upon consumer prices.
  • Lastly, continued USD strength should continue weighing on the prices of internationally-traded commodities, which should ultimately allow the pace of economic activity to creep higher in China on a lag. China’s heavy industry benefits from energy and raw material deflation via margin expansion and potentially increased production, at the margins, in a backdrop of subdued credit expansion. Additionally, Chinese consumers benefit from food and energy deflation by freeing up share of wallet for more discretionary goods and services.

All told, being long of China is certainly a non-consensus position at the current juncture. In spite of fairly recent gains, the fundamental backdrop for the Chinese stock market is as convoluted as it has been in quite some time. As such, we are sticking to our process and deferring to the quant on this one.

 

Our immediate-term Risk Ranges for Gold, Oil (Brent), US Dollar, USD/JPY, UST 10yr Yield, VIX and the SP500 are now 1542-1594, 106.26-109.11, 82.55-83.46, 93.07-96.11, 1.81-1.93%, 12.31-14.54 and 1546-1576, respectively.

 

Keep your head on a swivel,

 

Darius Dale

Senior Analyst

 

Chinese Chicken - Chart of the Day

 

Chinese Chicken - Virtual Portfolio



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