The Economic Data calendar for the week of the 10th of June through the 14th is full of critical releases and events. Attached below is a snapshot of some (though far from all) of the headline numbers that we will be focused on.
Takeaway: Current Investing Ideas DRI, FDX, HCA, HOLX, MPEL, NSM, WWW
(Editor’s note: We added HCA and NSM as new Investing Ideas, and we will issue full Stock Reports on those two companies next week. Additionally, we have removed CAG from the Investing Ideas list.)
“Say hello to the people, Stupid.”
“Hello to the people, Stupid!”
- Edgar Bergen and Charlie McCarthy
Washington policy makers have perfected the ability to speak out of both sides of their mouth simultaneously. Like the best practitioners, they constantly wear a broad smile which effectively masks any movement, with the result that no one can tell who is actually doing the talking.
As we pointed out two weeks ago here the Fed “manages” interest rates using two primary tools: by buying and selling Treasury bonds – and now a whole lot of other stuff – in the open market, or by just talking about when they might buy or sell some Treasury bonds (or sketchier instruments). One might argue that, once the first dollar has been spent in open market operations (or more accurately, the first trillion dollars, but who’s counting…?) (Who, indeed…) it is just as effective to threaten to buy Treasury bonds as to actually purchase them. And it’s a lot cheaper.
As we have observed in the past, markets cannot go up in an environment of uncertainty. If we didn’t know better, we would assume the government purposely destabilizes the markets by putting out contradictory and confusing data, presumably as a way from keeping the brakes on to prevent asset bubbles from proliferating out of hand.
Of course, it might be that we attribute too much stealth and connivance to our government. Or too much intelligence.
The Fed is an outstanding practitioner of auto-ventriloquy, but they are hardly alone. Our Financials sector head Josh Steiner highlights the ongoing push-pull in government data with his read on this week’s Initial Unemployment Claims numbers.
For ordinary mortals such as we, it is confusing enough that the government reports both Em-ployment and Un-employment. Steiner says this week’s unemployment data continue an optical illusion that has governed perceptions of the economy for three years.
As we have mentioned in earlier notes, Steiner tracks the weekly Non Seasonally Adjusted initial jobless claims data (NSA) which he says give an accurate picture of how many people are actually filing claims. The Bureau of Labor Statistics (BLS) puts out Seasonally Adjusted (SA) claims figures to smooth for the effect of collecting data monthly. To the likes of you and me, this might seem perfectly logical – which means we likely qualify to work for the government.
Like any metric that cuts off at month end and restarts the following day, there is an artificiality to the data underlying the SA figure. It’s a bit unavoidable – portfolio managers and mutual funds are judged on annual performance, as are most business metrics in any industry. And everyone celebrates their birthday, which is otherwise no different from the day before or after. Steiner argues that the economic convention of tracking SA data has created the illusion of stagnation.
After showing steady improvement (a decline in the rate of new unemployment claims) from August of last year through February, the SA data is all but flat from March up to now. Steiner says this leveling “is expected as it is following the same trend over the past three years, owing to faulty seasonal adjustment factors in the government’s model.” In fairness to the government policy makers (we never thought we’d hear ourselves say that) statistical modeling is difficult, and it’s really hard to get seasonal factors right for exactly equal comparisons over time. Of course, this is precisely why Steiner relies on the NSA figures, which is the actual number of people filing initial unemployment claims.
“The market still cues off the SA data,” says Steiner, “so to the market’s eye, the data is beginning to stagnate.” Charting the SA data shows roughly parallel annual trends in 2009-2012, with the decline in unemployment reversing around March of every year and an increasingly dismal labor picture emerging through August. To any observer this labor market stagnation is an indicator of economic decline – just when things were starting to look better!
Unemployment plays a significant role in investors’ perceptions of the economy, and the recent stagnation in the SA labor numbers have to be a big part of what’s leaning on stock prices right now. Looking at the NSA numbers though, Steiner sees a marked drop in unemployment and a robust pattern emerging. For the first time since 2010, the rate of year-over-year change in the NSA figures clearly form a downward slope, compared with rising or rising-to-flat trends in the prior three years. In other words, the rate of improvement is accelerating.
Steiner would urge patient investors to be poised to buy market dips, to the extent they are triggered by fading confidence in the labor market recovering. The headwind from the SA figures will culminate around August and will switch back to a tailwind beginning in September, accelerating through February 2014. This could be the catalyst for a late-summer (read: election season) rally. As with every call that is based on knowing something the rest of the market doesn’t, you have to be willing to live with volatility until your vision pans out.
This brings us full circle to the notion of the Fed “jawboning” stock prices this way and that without so much as lifting a finger – or a measly $85 billion – to influence the market. And to other branches of government maintaining completely conflicting parallel stories. In other words, government auto-ventriloquy is not some exotic form of speech impediment. It turns out to be an important policy tool.
Another way to look at this is that the government is merely the government, and who are they to say which is the best way to look at the data? By putting out myriad data series all tracking essentially the same thing, the BLS and other government agencies create the perfect environment for crowd-sourcing answers to complex problems.
Some folks say the stock market is the ultimate example of the Wisdom of Crowds. Could it be that the policy ventriloquists down in Washington are no dummies?
Remember “Peak Oil”? The notion was making the rounds a few years ago that the world had run out of its readily-producible supply of oil, and that Life As We Know It would soon grind to a halt, predicated as it has been since WWII on an unending supply of cheap oil.
Oil is already no longer cheap – the US Department of Energy says that, in constant 2011 dollars, the price of gasoline rose from under $1.50 a gallon on the eve of the Arab Oil Embargo of 1974, to over $3.50 by the end of 2011. Peak Oil says oil is also no longer plentiful, because we have drilled the world down to a diminishing petroleum reserve.
Books and articles proliferated – because not many people can make money trading markets, but a whole lot of folks can make money writing about how to trade markets – predicting how dire our lives were about to turn, and how soon.
Now “Peak Oil” has not only peaked. It has flipped. Now, when folks use the term, they mean that demand for oil has peaked and the combination of fracking and newly-discovered US gas reserves will make our energy woes a thing of the past. We have no idea who will be proved right, but we again observe that it pays to speak in superlatives and paint extreme scenarios if you want to sell books about investing.
Energy prices have long been a key driver of inflation, and significant moves in energy prices tend to ripple across markets. Many portfolio managers still assume that a move in the price of oil is sufficient to move the equities markets, generally in the opposite direction. Oil Up = Inflation = Stock Market Down.
Inflation used to mean higher interest rates. In Modern Portfolio Theory (MPT) this used to be expressed in the interest rate paid on US Treasury Bonds (the “riskless asset,” perhaps another outmoded concept). Interest rate increases naturally flowed through to stock price declines, and vice versa. It is axiomatic to MPT that investors seek a higher rate of return in exchange for taking on more risk.
In 1996, the 2-year Treasury had a nominal yield of around 6.25%, while the 10-year yielded over 7.5%. There was the same arbitrage opportunity then as there is now: borrow short, and lend long and capture the spread. But who needed to finagle to get 1.25%, when you could just buy the darned things and have Uncle Sam pay you over 6% to sit?
In order to take on the added risk of being in equities, said MPT, the average investor would need to obtain a return at least 1 ½ times that of the Riskless Investment. With 2-year Treasurys yielding over 6%, this means stock market investors were looking for a return of between 9%-10% annually.
Nowadays these relationships are all out of whack. Two-year bonds yield next to nothing, and investors are looking not for equity appreciation, but for yield replacement. Meanwhile, the global central bank cabal is driving asset prices (stock markets) to further enrich the wealthy – those who do not rely on interest income to fund their meager retirements.
The yield panic is driven by a number of forces, among them pension fund managers who are required to produce a minimum target return every year (there’s that semi-artificial unit of measurement again) and who long relied on fixed income to do their heavy lifting.
Another side is individual savers who can no longer afford to retire because they live on a fixed income and need every extra smidgeon of yield. Your average corporate lawyer or Wall Street professional used to be able to sock their bonus away in muni bonds and retire in just a few years. At 5% annual interest, $2 million will get you $100,000 a year in tax-free income. No longer.
Welcome to the “New Normal.” With the Riskless Asset no longer a viable investment option – it is neither an Asset, nor Riskless – MPT theory has to do some fancy footwork to adjust. Managers hunting for yield have given rise to a range of market distortions such as the recent run-up in the distressed debt market (“junk” bonds) which got bid up so far in price, they were trading more like low-range investment grade paper until the recent rush for the exits. And now investment banks are offering exactly the same instruments that are blamed for the collapse of the global financial markets (see for example Financial Times, 6 June, “Frankenstein CDOs Twitch Back To Life”).
Getting Energized: Into this morass treads our intrepid Energy sector senior analyst Kevin Kaiser. Kaiser has managed to get a whole lot of folks riled up in recent weeks over his coverage of Linn Energy.
Kaiser has taken LINN’s financials apart and, despite loads of criticism, disdain and some good old-fashioned name-calling – from Wall Street analysts who are bullish on the stock, from money managers who own lots of it, and from the company’s own management – Kaiser keeps coming back to the conclusion that LINN is using accounting methods that may be legal, but that don’t represent the company’s financial picture in a manner consistent with the expectations of shareholders.
LINN is what’s called an “upstream oil & gas MLP.” An MLP – Master Limited Partnership – is a tax-advantaged investment vehicle that distributes its income to its shareholders, and also trades like a stock, offering constant liquidity. It is “upstream” because it focuses on acquiring oil and gas producing properties, thus getting paid at the wellhead.
Upstream MLPs got a bad rap in the 1980s when many of them borrowed heavily and bought into producing properties with short remaining life spans. Energy price volatility banged up against declining inventory, and the hedging markets in the 1980s were nowhere near as deep or complex as they are today. Upstream MLPs fell out of favor and were replaced by Midstream MLPs that piped oil and gas from the producer to distributors and users. This middleman position was seen as far safer and held sway for many years.
Now the upstream business has come back into vogue. The greater risks associated with exploration and production (E&P) are offset by higher payouts to unit-holders.
But wait, you say – if there’s more risk, how can you be sure you’ll always be able to make those bigger payments?
One of Kaiser’s major criticisms of LINN is its method of accounting for its hedging book, where it seems to be crediting itself for amounts it spends to buy swaps and options. Just this week, in response to what appears to be pressure from the SEC, LINN has disclosed the actual cash outlays to acquire put options used in their hedging program. Says Kaiser, “in the most recent quarter, 29% of Distributable Cash Flow was generated by LINN’s unique put options accounting method.” This means that, far from generating cash flow from the production of oil and gas, the company appears to be raising money by offering its partnership units in the equities market and buying hedges on its production portfolio with the proceeds – then redistributing that same cash back to unitholders.
The most conservative way to account for this would be to book the cost of acquiring the options as an expense, and to treat the resale of those options as a return of capital, which would leave the financial picture essentially flat, with the only difference being any profits from the sale of the options.
Instead, LINN’s accounting method makes these payments look almost like revenues. In the beginning of 2012 this accounted for 16% of DCF. Now it is up to 29% and counting. To the uninitiated – which certainly includes the majority of individual investors who have long been buyers of these MLPs for the yield and the perceived safety – this is starting to look like the company is increasingly in the business of recycling money, rather than producing oil and gas.
To make matters worse, Kaiser’s comparison of LINN’s operating properties with those of competitors working the same areas indicates wide discrepancies between the price LINN says they will get for their production, and the value of that production implied by comparable transactions in the same markets.
The big question for us is not even LINN. It’s the valuation of producing properties across the whole sector and the likelihood that the upstream MLP business may again fail. Because of the higher yields from upstream MLPs, they have been favorites of individual investors, especially those primarily driven by yield. This group includes largely retired people and, increasingly, the elderly. As both energy prices and the upstream MLP well reserves decline, where will the MLPs find the quarterly cash flow to continue to make payments at the same levels?
As long as MLP unitholders receive the same steady return month after month, they will not be motivated to ask questions about the companies’ operations or the health of the business model. Not even the most obvious ones – like, given fluctuations in production levels and in the price of oil and gas, how do you manage to make exactly the same payment every quarter? If that doesn’t make your antennae go up, nothing will.
Kaiser’s work points to what might be a troubled corner of the Energy sector. MLPs that continue to make high payments to unit holders should be scrutinized closely. Investors desperate for yield may to be ignoring the risks associated with robbing Peter to pay Paul.
Looking for an acceptable rate of interest on a safe fixed-income investment that you can hold for the long term? Sorry, looks like your retirement plan just peaked.
It kind of makes no sense: the stock market retreats from an uptrend and you lose money. Why is that “Correct”?
The difference between a Crash and a Correction may be very small, at least initially, but they tend to have diametrically opposite after-effects. A correction is defined as a pullback of general price levels of 10% or less, generally in a relatively short period of time, and often leading to higher prices in the future. If all those qualifiers bother you, welcome to the world of economic analysis, where events can only be clearly identified when they are already in the rear-view mirror. And as in real life, so in the markets: objects in the mirror may be larger than they appear.
A market crash is defined as a drop of between 10%-20% that usually happens relatively quickly – sometimes famously in a single day. Various protective measures have been implemented by regulators to hold the line against crashes. These include “circuit breakers” such as Trading Curbs in the stock markets, where trading in a stock may be suspended for a period of time and then re-started on the same day, and price-move limits and position-size limits in the futures markets.
Market economists generally say that corrections are inevitable – which works in favor of using a positive-sounding name for them – and that they do not create lasting negative effects. Crashes, on the other hand, are associated with recessions and with permanent wealth destruction – and in the most extreme cases, societal disruption.
One way to understand this is to say that excessive enthusiasm causes stocks to “get ahead of themselves.” You may remember Alan Greenspan’s famous locution “irrational exuberance.” If stocks in a sector tend to trade at a 15 price / earnings multiple, and one stock has gotten to a 25 P/E, then perhaps that stock needs to be “corrected.”
There are traders who buy on Momentum – which can look a lot like emotion. When a stock has advanced a certain percentage in price, these traders hop on board to capture the last X% of the price move. And there are also investors who panic. They see a stock that has risen 20% in a few days and, terrified that they have missed the boat, they pile in and their buying lifts the stock another 3%. Irrational Exuberance at work.
And then the momentum traders sell.
Which knocks the price down a quick 5%.
And then the emotion buyers panic and sell too. Next thing you know, the stock has retreated 10% from its recent high. The momentum buyers are out of it, and the emotional buyers are out, leaving only those who “should” own the stock. This includes long-term holders, value investors, fundamental or special situation investors, and those forlorn souls who can never make a decision one way or the other.
So the theory of a Correction, simply put, is that it shakes out those who “shouldn’t” own the stock now and forces the buying action to consolidate. In a bull market, these consolidations build a more stable platform for the stock to launch to a higher level. Think of it as a pit stop for a race car, an elite runner slowing a bit to take a sip of water.
Or, if you are like lots of other people, just panic next time the stocks you own go down in price, sell everything and take your losses – then react in fury when those same stocks are 10% higher three months later.
You won’t be alone.
We are pleased to announce that Senior Analysts Rory Green and Matt Hedrick will be taking over and expanding our Consumer Staples coverage. Both Rory and Matt have been at Hedgeye for over four years and have made immense contributions to our world class consumer and macro franchises.
Matt will be focused on food and beverage and Rory will be focused on home products. Similar to other verticals, their focus will be on developing intensively researched investment ideas- both longs and shorts. This duo will allow us to expand our consumer staples coverage and cover more names. They will be rolling out coverage over the next few weeks and will be upping the velocity of deep dive ideas.
On a separate note, Rob Campagnino recently left the firm. We would like to thank him for his work and wish him all the best in the future.
Daryl G. Jones
Director of Research
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.
Takeaway: At 5x EBITDA with an under leveraged balance sheet, we think DF has a conservative 20 – 30% upside from here.
Our Consumer Staples team has been touting Dean Foods (DF) for the past couple of months and although the stock has moved, we believe there remains significant value and upside in the name. Before getting into an updated valuation analysis, we wanted to tell you why we like this business (especially at 5x firm value / 2013E EBITDA).
We think DF is a compelling business for the following reasons:
That all said, DF is still a commodity company, even if a branded one, so we do need to consider that fact when evaluating the business along with the highlights above. In our view, the current valuation provides substantial downside protection and fully accounts for the commodity nature of the business.
In the table below, we provide an upside / downside analysis based on 2013E EBITDA and multiples of enterprise value / EBITDA. Currently, we think the stock is at a price in which the risk / reward is compelling. On the downside, absent a dramatic change in the milk market or poor management execution (unlikely), we think the reasonable downside is 4.5x EBITDA, or ~16% from current levels.
In terms of the upside, as noted we do acknowledge that this is a commodity company with only modest top line growth rates, but we do believe given the compelling business characteristics and high free cash flow yield reasonably justify a multiple in the 6.5X – 7.0x EBITDA range, which implies 32% - 44% upside from current levels. From our perspective, a situation in which there is 2:1 upside / downside with fundamentals trending our way is a compelling investment.
The argument for the upper end of the multiple range of course is based on the generous free cash flow nature of this business. While 2013 is a bit of an odd year given the corporate activity (notably the spin-off of WWAV), we believe that on a normalized basis DF will generate in the range of $140 - 150 million of free cash flow to the equity annually. This implies a rough 8% free cash flow yield. In combination, a 8% free cash flow yield and a debt-to-EBITDA ratio of just over 2x makes this a compelling LBO candidate. (Moreover, the debt-to-EBITDA is closer to 1x if we net out the WWAV stake.)
In addition, DF’s publicly traded debt seems to validate our view of the stability of the cash flow, and potential to add more debt to the balance sheet in a LBO type scenario, as all three tranches are trading well above par and tight versus Treasuries. In fact, 5-year DF paper is trading at only 210 basis points above comparable Treasuries.
The key pushback from many is that DF is a “value trap”, or a business in decline, so it is a cheap stock that can get cheaper. Indeed, there have been a number of publicized articles recently that highlight that per capita milk consumption has been in decline since 1970. Even if this is accurate, total volumes have shown a steady increase in recent years, which is more relevant for a market share leader like DF. In fact, in the chart below we show that total volumes have increased by 20% over the last nine years. Not stellar, but definitely the kind of growth and cash flow that gets a private equity firm licking the milk off their moustache!
Daryl G. Jones
Director of Research
Takeaway: A quick highlight reel of today's top tweets to @KeithMcCullough.
TV embarrassment to the max. You are the only one on my feed or tv this week that didn't say get long $GLD but short it.
Do you plan on wearing jorts to bed tonight? Does Mrs. Mucker approve of the look?
@PetersenRChris 3:54 PM
I don't always agree with your calls. But you've been on fire. Well done.
thanks for the GLD short. Used options made 30% this week. Have good weekend.
You and your Hedgeye crew are leading a very positive paradigm shift in accountability in the investing community. Kudos!
it takes stones to make the calls u make in the face of all this hate and you keep crushing it! Cheers
Hedgeye is kicking A$$ and taking gnomes..oops I mean names..sorry freudian slip
@ExtraDividends 9:46 AM
Am thinking @KeithMcCullough is the hottest lighting rod in Twitterdom. It’s a love/hate scenario of epic proportions.
The total percentage of successful long and short trading signals since the inception of Real-Time Alerts in August of 2008.