“For unless man were to be like God and know everything, it his better that he should know nothing.”
The Gap in the Curtain (1932) is a novel by John Buchanan that speaks to the human desire for certainty, and the dangers its quest can bring.
In a London country house, five party-goers partake in an experiment that allows them a glance at a newspaper that will be printed exactly one year in the future. The rest of the book tells the story of how that information affected each of their lives over the next year.
One man reads of a business merger, spends the next year painstakingly traveling the world buying every share of the to-be-acquired company he can find, only to find that the business combination he read of was one nearly out of bankruptcy… Another character reads his own obituary and dies of a heart attack the night before it prints; he does not live long enough to read the correction the paper issues on the following day for the typo…
This exchange from Core Laboratories’ (CLB) earnings call yesterday reminded me of the novel:
Analyst: “So, what’s your prediction, where is oil going from here?”
David Demshur, CEO of CLB: “Don’t have a clue, my friend.”
I sympathize with the analyst’s question – wouldn’t that be nice to know! – but, more so, I appreciated Demshur’s candid answer.
Gold is going to $2,000… Oil will spike to $200/bbl… My price target for the S&P500 at year-end 2013 is 1,458…
Wall Street loves making declarative statements. I used to think that I had to make them too – I was scared to say “I don’t know,” as if I should have the answers to so many inherently unknowable questions. But after several humbling experiences early in my career – i.e. being wrong – I have “resigned from the professional undertaking of coin-flipping,” to quote one of my favorite risk managers and thinkers, Hugh Hendry.
Sure, I have my biases – commodity prices tend to mean revert, oil lower (possibly a lot lower), Peyto Exploration (PEY.CN) higher (possibly a lot higher), LINN Energy (LINE, LNCO) and EV Energy Partners (EVEP) lower – but really I try to let the market tell me what to do (embrace uncertainty and our complexity-based models) and make solid risk-adjusted investment decisions given those signals.
Our playbook since the beginning of the year has been long USD and US consumption-oriented sectors, and short commodities and commodity beta. Our Macro Team reviewed our #StrongDollar theme on our 2Q13 Macro Call on Tuesday – we’re bullish on the USD due to:
- All-time low interest rates with the prospect of a hike;
- Cessation of QE initiatives;
- Improving housing and employment picture;
- Addressing all-time highs in sovereign debt and deficit ratios;
- USD solidified as world reserve currency at the expense of a weaker Yen and Euro.
From there we think that a #StrongDollar deflates commodity inflation and takes commodity-levered sectors (XLE and XLB) lower with it. If you don’t think I should paint a broad brush across “commodities,” tell me why gold and oil have a +0.92 correlation since ’09 (see Chart of the Day). We think it’s the same “inflation hedge” trade that’s now unwinding…
Today, the risk management signals across the “financialized” commodity complex are still not good:
- Gold is bearish TREND (needs to recover: $1,681)
- Copper is bearish TREND ($3.58)
- Brent Crude is bearish TREND ($110.54)
- WTI Crude is bearish TREND ($93.88)
- Energy Stocks (XLE) are bearish TREND ($76.87)
So as our fundamental #StrongDollar theme plays out, and oil and energy stocks begin to break down across our core TREND duration, we want to be underweight energy, looking for energy stocks to sell/short, and know that our energy long ideas have to be really tight (imminent catalysts or special situations) or levered mostly to natural gas prices (bullish TREND).
Two stocks that I think are worth selling are LINN Energy (LINE, LINCO) and EV Energy Partners (EVEP). I wanted to hit on this in this note because these stocks are hugely popular among retail investors, which are attracted to that juicy yield (LINE 8%, EVEP 6.5%). It’s kind of funny – any time Keith or I tweet about LINE/LNCO we get borderline hate-mail in return! But how much cash a company pays out to its shareholders says nothing of the intrinsic value of the business – and these stocks are hugely overvalued, and their distributions sustained with capital raises. The distributions paid are inconsistent with the economics of the businesses, and we think it ends in tears. Hedgeye subscribers, do not be left holding the bag!
Our immediate-term Risk Ranges for Gold, Oil (Brent), US Dollar, USD/YEN, EUR/USD, UST10yr Yield, VIX, and the SP500 are now $1, $96.72-102.27, $81.95-83.11, 96.63-101.57, $1.29-1.31, 1.68-1.76%, 14.27-18.68, and 1, respectively.
Have a great weekend,
TODAY’S S&P 500 SET-UP – April 19, 2013
As we look at today's setup for the S&P 500, the range is 24 points or 0.56% downside to 1533 and 1.00% upside to 1557.
CREDIT/ECONOMIC MARKET LOOK:
- YIELD CURVE: 1.48 from 1.46
- VIX closed at 17.56 1 day percent change of 6.36%
MACRO DATA POINTS (Bloomberg Estimates):
- G-20 meeting of finance ministers, central bankers, Washington
- 7:30am: ECB’s Weidmann, Germany’s Schaeuble hold press breakfast in Washington
- 11am: Fed to purchase $1.25b-$1.75b in 2036-2043 sector
- 12pm: Fed’s Stein speaks in Charlotte, N.C.
- 1pm: Baker Hughes rig count
- IMF/World Bank officially begin three-day spring meetings
- 10am: Senate Judiciary Cmte holds hearing on immigration laws, w/ Homeland Security Sec Janet Napolitano
- 2pm: State Dept releases 2012 Human Rights Reports
WHAT TO WATCH
- Schaeuble says G-20 must honor deficit-cutting commitments
- Blackstone is said to pull out of bidding for Dell
- Softbank not planning higher Sprint bid, company executive says
- Lenovo said to be in talks to buy IBM low-end server unit
- FAA said ready to end Boeing 787 grounding as fix approved
- U.S. bank profits disappoint most in 3 yrs as revenue falls
- Fisker said to spend $660K on each $103K plug-in car built
- Banker groups sue Treasury, IRS over account reporting rule
- Viacom copyright suit against Google’s YouTube again dismissed
- J.C. Penney’s operating chief joins talent head in departing
- Pilot Corp. suspected of fraud in diesel rebates, FBI agent says
- Humana fires law firm tied to alleged leak of Medicare decision
- Toyota said to reveal plans to begin production of Lexus in U.S.
- GDP, Apple, Exxon, BOJ, Iron Man 3: Week Ahead April 20-27
- One Boston marathon bombing suspect dead, Federal official says
- Schlumberger (SLB) 6am, $0.98 - Preview
- Baker Hughes (BHI) 6am, $0.62 - Preview
- SunTrust Banks (STI) 6am, $0.61
- General Electric (GE) 6:30am, $0.35 - Preview
- Laboratory Corp of America (LH) 6:45am, $1.77
- Honeywell International (HON) 7am, $1.14 - Preview
- Genuine Parts (GPC) 7am, $0.98
- Under Armour (UA) 7am, $0.03
- Interpublic Group (IPG) 7am, ($0.13)
- First Horizon National (FHN) 7am, $0.17
- Kimberly-Clark (KMB) 7:15am, $1.34 - Preview
- First Niagara Financial (FNFG) 7:15am, $0.17
- State Street (STT) 7:21am, $0.93
- Rockwell Collins (COL) 7:30am, $1.17
- Manpower (MAN) 7:30am, $0.45
- McDonald’s (MCD) 7:58am, $1.27 - Preview
- TCF Financial (TCB) 8am, $0.19
- Kansas City Southern (KSU) 8:01am, $0.88 - Preview
COMMODITY/GROWTH EXPECTATION (HEADLINES FROM BLOOMBERG)
- Gold Gaining as Physical Demand Said to Be ‘Extraordinary’
- Gold Traders Split on Outlook as Asian Jewelers Buy: Commodities
- U.S. Wheat Faces Damage Threat as Plains See Another Freeze
- Copper Set for Biggest Weekly Drop in 16 Months on Demand View
- Palm Oil Posts Fourth Weekly Decline on Biofuel Demand Concern
- WTI Crude Advances for a Second Day to Pare Third Weekly Decline
- Cocoa Climbs After North America Grindings Gain; Sugar Declines
- Monsoon Seen Normal in South Asia Set to Boost India Growth
- Carbon-Intensive Investors Risk $6 Trillion ‘Bubble,’ Study Says
- Crude May Fall on Weaker Economy as Output Gains, Survey Shows
- California Power Facing Biggest Test Since Enron: Energy Markets
- Biggest LBO Collapse Seen as Boon to Texas Power Market: Energy
- Nickel Surplus Seen Bigger by Macquarie Than Forecast Last Month
- Rebar Rises to Pare Weekly Loss, Supported by Iron Ore, Demand
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Takeaway: Several near-term risks were mitigated this qtr. In addition, we're taking up our 'already high' long-term growth forecast. 2 yrs = $60.
RH’s $0.02 ps beat far understates the significance of the company’s earnings report. After running the numbers and listening to the call, we walked away with the following thoughts:
1) Confirmation that this management team is executing on one of the most intriguing business opportunities in retail. Comping 26% on top of a 22% in the same quarter last year, and that’s before the launch of new businesses like Tableware and Objects of Curiosity.
2) Not only is the Design Gallery pipeline robust, but management seemed to have a (borderline odd) epiphany that it could open significantly larger stores with far more favorable rent structures than previously anticipated. Given that increased furniture sales will put a natural damper on margins over time, lower occupancy hurdles are a nice offset.
3) We made a rather significant change to our model, in that we took the average size of a Design Gallery up from 25,000 square feet to nearly 35,000 over the next three years. The Boston store, for example, is nearly 50,000 square feet. With a weighted average of 35k sq feet and our estimate of 15 Galleries by the end of 2015, it gets us to weighted average square footage growth of 15% by that time period. The interesting element here is that bears (and even common logic) will say that current comp trends will roll, and over 2-3 years we’ll be looking at a stabilization in sales/square foot trends. With that being the case, the acceleration in square footage still drives 15-20% top line growth through this model. We think that’s the biggest part of this story that people are missing.
4) Find us a company that is taking UP expectations for both revenue and earnings for the upcoming quarter and year. It would have been easy enough for them to give initial guidance right in line with existing estimates. #confidence.
5) De-risking Sentiment. Like it or not, sentiment is a major factor with this stock. We’ve been positive on the name since the IPO, and when we bring it up with investors it’s pretty clear to us that it’s not too far from JCP as it relates to being hated. The two most common reasons. 1) There’s not enough float. 2) The company is probably going to do a secondary (that probably explains why 1.4mm shares of the 4.2mm float is short). That’s ironic when you think about it. Half the people don’t like the lack of float, and the other half don’t like the one event that could fix the ‘small float’ problem.
Regardless, there are three things that happened this quarter that we think de-risk sentiment and improves ownership characteristics for RH.
- First, simple as it may be, the fact that RH finally ended what may be the longest quiet period in modern retail history is a positive. Other retailers are getting ready to report 1Q in 3-4 weeks, and RH is just getting out its 4Q numbers. It’s been a black hole of info, and it has not helped sentiment one bit. That’s over.
- IPO-related charges are out finally known, booked, and out of the way. They made financial modeling a bear – and now that’s no longer an issue.
- While we usually could care less about company guidance, the fact that RH issued quarterly and annual guidance is a massive positive for a levered and newly public company like this.
The reality is that so many people have had zero appetite for the name given such little float, funky accounting, no guidance, and such a huge delay in the earnings report. The 4Q print ameliorated many of these concerns.
In the end, this remains one of our favorite longs. Its so rare to find a defendable high-end brand with such an obvious, yet fixable, distribution problem. Having stores that are only large enough to showcase 20-25% of the company’s product is like having a fleet of Ferraris and only a two-car garage. This is the one instance in retail where bigger stores is not only a positive, but it is a necessity. As these stores grow, the company can scale into new categories (kitchen, kids, art, flooring, art, collectibles, textiles, etc…), and subdivide existing ones to drive productivity.
We think that the earnings guidance of $1.29-$1.37 for the year will prove conservative by at least 10%, and ultimately this is a company with $3 in earnings power over 3-years. If that’s right, we’re looking at over a 20% CAGR in EPS, which makes 20x $3 in the realm of possibility. Granted, that is by the end of 2014, so there’s some time to go. But until people start to realize this potential, we’re not concerned about the stock being expensive.
Takeaway: Today's move shows an strong grasp of old news. Valuing Ground & Express separately shows the restructuring call option in FDX shares.
FDX: Is Canada Always on Top or Just America’s Hat?
The FDX downgrade this morning shows an excellent grasp of old news. In mature, cyclical industries, if one is buying on good news and strong data, one is probably making a mistake from a longer-term perspective. It is precisely the weak margins at FedEx Express that got us interested in the shares last November.
We think FDX can improve its Express margin over the next few years, in much the way DHL recently did and to a level near what UPS has. We also think that investors will price the expectation for continued margin improvement into FDX shares should the restructuring show progress. We believe FDX’s market price currently reflects only the value of FedEx Ground. Each FDX share provides a free call option on the success of the FedEx Express restructuring, in our view. That is an option we want. If we are wrong, and we could be, the downside looks limited from current levels.
- Product Trade Down: The mix shift to lower cost products has been going on for quite some time. It is good they finally noticed. As we pointed out in our November 2012 Express & Courier Services deck, the cycle in high value transports relates to economy-wide inventory levels. Slack inventories slow shipping, since no one pays to express goods that are already sitting in inventory. Express services peaked in ~2005 amid the tightest inventories of the post-war period, and we believe it is at or near a trough now (hence the title of our deck “When Will Then Be Now? Soon”).
- Mix Shift Only Small Part of It: The reality is that DHL and UPS are more profitable than FedEx in Express sevices with the current mix. FedEx has company specific issues, which we believe are addressable. DHL has already completed a successful restructuring from a much worse margin position than FedEx Express is in currently. We do not see a structural reason that FDX cannot match competitors’ margins.
- Mix Shift Makes Targets Harder? Since the $1.7 billion in cost reductions are to be measured against this year’s run rate, mix shifts are in the base for the cost reductions. Mix shifts probably lower the bar for gains, which everyone already knows, but do not make them harder to achieve. If mix rebounds, however, it would actually make it easier to achieve the targets.
- Mix Trend is Here to Stay? If that is the case, then all packages eventually end up in the SmartPost channel. That isn’t going to happen and faster delivery does add value. Extrapolating the mix-shift trend is a facile approach that does not consider the origins of the shift. Factors like fuel prices and ocean freight rates have actually been abating. Inventories may well tighten from current levels in North America, where consumption-oriented economic activity appears to be improving.
- International Express: It is not news that FedEx Express needs to restructure its aircraft fleet. It is a key component of the restructuring plan. Removing excess capacity is a good thing. There is nothing wrong with redeploying 777s if they are more profitably operated in a different channel. If the late pick-up service offerings do not make money, they can be put aside until demand supports the product offering.
- Domestic Express: This fixation on FDX’s two networks vs. UPS’ one network is odd to us. FDX has a separate Ground network, in part so it can use independent contractors to dramatically reduce labor costs and take market share from unionized UPS for 12+ consecutive years. FedEx Express is flying archaic aircraft and needs to rationalize capacity, facilities and labor. That is not a 1 vs. 2 network issue, but it is the point of the restructuring and a component of our long thesis. It is not as though UPS is delivering an overnight package from Boston to Seattle through its ground network and FedEx Express is barred from operating trucks.
- Risks in USPS Airlift Contract: That UPS is bidding against FDX for the USPS air contract has been known for at least several quarters. We even discussed it with the former head of the Postal Regulatory Commission last November here. The contract was put out in July of last year, with the bid packages received around October. UPS already has about 10% of the USPS airlift revenue (see USPS supplier table below). The intertwining of the postal service and FDX/UPS is complex and there is a history of bad blood between the post office and UPS. In government contracting, if a supplier is doing a good job, they are likely to keep most or all of a contract. Otherwise, it can be more work and scrutiny for government employees. That said, we do expect UPS to get a larger share of the contract and expect margins on the contract to come down. We also expect an announcement pretty soon. But the revenue at risk is likely less than 3% of FedEx Express’s total. We do not think it is worth much attention relative to a prospective $1.7 billion margin expansion opportunity.
- Fixed Cost Reallocation – WTF? The complete loss of the USPS contract would obviously be a negative, but the full cost of that lost revenue would not be broadly reallocated to the rest of the Express division. A quick perusal of the FY2002 10K for FedEx should ease any anxiety since 1) profit didn’t jump by a huge quantity as >$1 billion in costs were suddenly spread out over the USPS revenue and 2) the costs are identified as incremental salaries, fuel costs and other, mostly variable, factors. Sure, there could be a charge associated with a partial or complete contract loss, but, in our view, the notion that there could be an ongoing $1.00 to $3.00/share loss associated with cost reallocation should not be presented and borders on moronic.
- Who Cares If They Cut $1.5 Billion Instead of $1.7 Billion? Currently, FedEx Express’ value is not in the share price at all, in our view, as the FDX valuation can be explained by FedEx Ground alone. If FedEx Express generated a couple of billion in operating income, shares of FDX would be revalued significantly, in our view. Not that we value the company this way, but FDX currently trades at an EV/Sales of 0.64 while UPS trades at 1.53. We believe the primary difference is that UPS’ Express revenue is vastly more profitable than FedEx’s. That does not have to be so.
- Why Would FedEx Lower Their Longer-term Guidance Targets? FedEx has not reported a single quarter since the restructuring was expected to generate cost benefits. Further, restructuring is a multi-year affair. Forecasting a management reduction in targets based on something that has not started, especially from a position of inferior knowledge relative to company insiders and competitors, is, well, pretty aggressive. The targets seem achievable to us, since DHL just did it and UPS already has it. A discussion of competitors’ margins is notably excluded.
- Where Do They Get These Multiples? Why a 4.5 EV/EBITDA? Who takes these valuations seriously? The use of an aggregate, narrative fitting multiple is particularly tedious when a discourse on the disadvantages of FDX’s separate Ground and Express networks is followed by a failure to value them separately.
- More Noise, Better Opportunity: There is no new news on FedEx, but the shares are cheaper. A single post-restructuring quarter has yet to be reported, but the street seems to have already decided the restructuring is a failure. Will they change their minds if the restructuring is working by year-end, upgrading the shares at higher prices? Haven't we seen that movie?
- Our Take: We think that FDX shares trade for what FedEx Ground is worth, leaving a free option on the upside produced by a successful FedEx Express restructuring imbedded in the shares. The restructuring is a multi-year process, but one that is likely to succeed since management is focused on it, a competitor just did it and the industry structure supports it. We think many have misread the Express cycle – loving FDX in 2005 at the peak and shunning it now (at a lower price) near a cycle trough in 2013. In short, we think FDX is a straight-forward long, but apparently one that requires a strong stomach for both broker research reports and market volatility.
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