Investing Ideas Updates:
The latest comments from our Sector Heads on their high-conviction stock ideas.
NSM – Financials sector head Josh Steiner says Nationstar Mortgage Holdings continues to move higher on dual tailwinds. The first tailwind is Bernanke’s incrementally dovish comments that he isn’t in any hurry to begin tapering the Fed’s QE asset purchase program. The second tailwind is comments made by both JPMorgan and Wells Fargo on this week’s 2Q13 earnings conference calls about wanting to sell some of their mortgage servicing books.
Bernanke’s dovish comments put downward pressure on long-term interest rates, including mortgage rates. This improves the outlook for mortgage refinancing volume, which is a core business for NSM. But Steiner points out that while a substantial portion of NSM’s earnings come from mortgage origination, most of which is refinancing-driven, most of NSM’s refinancing business isn’t traditional refinancing at all, it’s HARP refinancing, a point Steiner believes is largely unrecognized by investors. Refinancing under the federal HARP program entails borrowers who are underwater on their mortgages and cannot refinance through conventional means because their loan-to-value ratios are too high to meet traditional underwriting criteria. HARP refi volume is less rate-sensitive than traditional refi volume because borrowers have no other options and are typically at rates well above current market rates.
JPMorgan and Wells Fargo’s comments about selling a portion of their servicing book is good news for NSM. There are three primary companies in a position to acquire the bulk of those servicing assets, NSM, Ocwen (OCN) and Walters (WAC). Historically, the purchase of bulk servicing assets from large banks has been very accretive for these companies. Case in point, when NSM bought $215 billion in servicing UPB from Bank of America at the start of 2013, they raised their 2014 EPS guidance to $5.60-6.50 from $3.30-3.80.
TRADE: In the short-term the market will trade NSM inversely to long-term interest rates.
TREND: Over the intermediate term, we expect 2Q earnings to be beat Street expectations when the company reports in mid-August , which should be a positive catalyst for the stock to move higher.
TAIL: In the long-term, there is still a tremendous opportunity for non-bank servicers like NSM to roll-up the servicing business. NSM is well positioned to be a prime beneficiary. We continue to think consensus earnings estimates remain too low for 2013/2014.
MD – Health Care sector head Tom Tobin says his Recovering Birth Trends thesis looks on track, which should buoy Mednax’ business going forward. Tobin and his team have launched a monthly OB/GYN practice survey which should aid greatly as Tobin continues to verify and fine-tune his birth trends forecast. Of particular interest for MD, with their broad range of neo-natal and related services, the survey will ask physicians about pregnancies and births in the most recent month.
Beyond live birth counts, Tobin is also looking at overall patient volumes to model broader trends in physician visits. Tobin says the OB/GYN practice is more economically sensitive than other practice areas to fluctuations in patient traffic among the commercial (working-age) populations. Nationally, 71% of OB/GYN volume are patients under the age of 65, the highest percentage of any medical specialty. This means the survey can also assist in verifying broader trends in healthcare consumption since the commercial market is often the swing factor.
HCA – Health Care sector head Tom Tobin says JNJ’s strong quarterly results support his bullish thesis on Hospitals, and bode well for HCA Corp. JNJ’s results indicate ongoing strength in baby care, and improvements in orthopedics, and surgical and specialty surgery care.
This week HCA pre-announced Q2 results that are ahead of consensus EBITDA estimates. This may have been a tactical parry to the recent pre-announcement of softening admissions trends by THC, whose business overlaps in 70% of HCA’s footprint. HCA’s stronger pre-announcement says the weakness seen at THC is not an industry-wide phenomenon. Tobin says “our macro indicators have continued to point to a 2Q13 acceleration, contrary to the many sell-side surveys suggesting otherwise.” As the largest public hospital operator, HCA’s beat provides evidence that the sector is recovering from Q1 weakness.
HOLX – Based on Health Care sector head Tobin’s new OB/GYN survey, patient volume appears to be stable to improving. HOLX preannounced 2Q EPS results that were slightly ahead of consensus; suggesting that the secular decline in Pap tests from the new Cervical Cancer Screening Guidelines issued last year are not an obstacle the company cannot overcome. Pap tests will continue to remain a headwind, but HPV testing remains underutilized and should help mitigate the Pap headwind.
Tobin’s new monthly survey of OB/GYN practices suggests patient volume is improving in July, which agrees with his thesis for rising physician patient traffic in 2013. While HOLX is facing intermediate headwinds, Tobin believes they are manageable, and less important than the longer-term tailwinds from its mammography business and the ACA Insurance Expansion in 2014.
FDX – Industrials sector head Jay Van Sciver says FedEx’s quarterly financials, released this week, held no great surprises. Says Van Sciver, “Looking through a full 10-K and deciding there is nothing of interest is somewhat harder than finding new interesting disclosures.” There was discussion around the ongoing restructuring – the previous “independent contractors” and “owner-operators” has largely been replaced by “independent small businesses,” which may mark progress in reconceptualizing FDX’s Ground model.
Accounting changes that may hit FDX, such as the proposed requirement to include operating leases as liabilities, and the EU Emissions Trading System, would impact FDX’s competition equally. The report manages expectations to the more modest side for the timing of profitability in the Express segment – prudent in a long-term restructuring program – while sounding a bit more positive about the Freight business. Recasting pension assumptions allowed for a $190 million change in pension expense for next year, which Van Sciver “should more than offset the postal contract headwind.”
For coming developments, Van Sciver continues to believe an acquisition of TNT makes a lot of sense for FDX, and he looks for the International Domestic segment of Express to be broken out as a separate item, which he expects will happen as that business ramps beyond $2 billion in revenues.
SBUX – Trading Starbucks today, it’s all about the duration, according to Restaurant sector head Howard Penney.
INTERMEDIATE TERM (the next 3 months or more)
We remain positive on the intermediate-term TREND for Starbucks as the company should continue to post stable revenue growth thanks to strong growth potential in international markets as well as the ongoing expansion of its CPG business. If the US employment picture continues to improve, that would give investors further confidence in Starbucks achieving its targets.
LONG-TERM (the next 3 years or less)
The long-term TAIL for Starbucks is attractive; the company has plenty of white space to grow through several channels and geographies with ample expertise and capital to execute its strategies. The company must retain focus on the core business and we believe that management is acutely aware of this following their prior (‘07/’08) experience.
NKE – Nike was added to Investing Ideas this week. We will send out a report next week.
MPEL – Gaming, lodging and leisure sector head Todd Jordan has no update on Melco Crown this week.
WWW – Retail sector head Brian McGough has no update on Wolverine Worldwide this week.
Macro Theme of the Week – Hedgeye’s Q3 Macro Themes Call
This week Hedgeye presented its Q3 2013 Macro Themes call for institutional clients, introducing the three major themes our Macro team has identified as significant drivers of investment strategy for the current quarter.
As a review, our Q2 Macro themes were:
- #StrongDollar – The Dollar continues to reverse what has been a forty-year slide. Renewed strength in the currency keeps pushing ahead despite Bernanke’s policy statements designed to weaken the Buck.
- #GrowthAccelerating – Hedgeye has tracked significant growth in a number of key sectors, including declining unemployment, strength in the housing market, and an upturn in the birth rate, reversing a forty-year decline and leading to a boost in new household formation.
- #EmergingOutflows – The BRICs are BROKEN, even “stable” countries like Turkey are in the grip of unrest. The US is once again the safe haven.
The Macro View
Macro trends are sensitive to government policy. When governments meddle in the financial markets, they compress natural market and economic cycles. This causes volatility to spike – free money for short-term high-frequency traders (especially those who get economic news a few seconds early), and a trigger for waves of nausea for the individual investor.
But while high-frequency traders focus on specific economic numbers, scalping a few pennies on a short-term lift in Financial stocks when the Fed looks dovish, Hedgeye’s broad Macro work focuses on rates of change in the economy. A public statement from Ben Bernanke may provide shot term profits for algorithmic traders, but it’s not a signpost to America’s economic future. Nor is it anything the individual investor can rely on.
Our analysis focuses on rates of change – we look at the slope of the line, the cumulative rate of change over time in key economic indicators. If you track rates of change, you will see where the growth comes from – or fails to come from. If you know where the growth is in the economy, you can position yourself to succeed as a long-term investor.
Hedgeye’s Macro Themes for Q3 2013:
Our themes are simple. The dollar has been strengthening. Meanwhile housing, employment and consumption have all been surprising to the upside – not major blow-out numbers, but the slope of the line is definitely in the direction of Growth. In this environment, Fed “tapering” is a pathetically weak dog wagged by a potent tail: interest rates are rising, the Dollar doesn’t want to go down, and growth has taken root in key areas of the economy.
Throughout the Middle Ages, the most educated people in Europe were convinced the sun rotated around the earth. Today we chuckle derisively at how they could reject proofs from the likes of Copernicus and Galileo. In the face of real signs of accelerating growth, Bernanke is behaving like the Defender of the Faith, as though he had the authority to direct gravity. He needs to have his King Canute moment and publicly allow the sea to wash over him. We’re convinced the waves are about to break.
Here we offer the first of our three Macro Themes, Rates Rising.
‘POP!’ goes the bubble as interest rates start to rise, reversing the most asymmetrical set of relationships on our Macro screen. The gradual decline in rates that has prevailed for forty years is turning. Like the Queen Mary, it turns ponderously – so slowly that at times you can’t tell it’s reversing course. As the slope for interest rates turns up, so much that has been tied to declining rates will unravel. Hedgeye continues to emphasize this on our bearish call on commodities.
Keith went out on a Macro limb and said we are not likely to see the 2012 lows on ten-year bond yields again. Not soon, and maybe not ever. With longer-term historical rates averaging over 6%, there’s more than four hundred basis points – over four full percentage points – for rates to reflate as the 40-year bonds bubble pops without entering the historical Danger Zone for inflation. Hedgeye expects the bond bubble to melt over the coming 3-5 years.
What’s an Investor to Do?
Keith digs into the historical record and shows that rising interest rates are not the enemy of economic growth. To the contrary, historically there is a high coincidence of rising bond yields during periods of high economic growth. Mr. Bernanke’s fear mongering notwithstanding, there’s no reason to believe it has to be any different today.
In a growth environment, as characterized by rising 10-year bond yields and a strengthening Dollar, Consumer Discretionary and Financial stocks tend to perform well, along with Industrials and, to a lesser extent, Energy. Yield plays – notably Utilities – are at a disadvantage, as increases in current yields are offset by declines in the price of the stocks.
But Growth isn’t Good News yet, as too many major investors have large portfolios based on declining rates – and short-term traders are enamored of the volatility created by Fed uncertainty.
To us, the problem continues to be political. Wall Street boasts many of Washington’s biggest donors, money managers and bankers whose largesse in recent years has come from the built-in guaranteed profits of declining rates, as they repeatedly locked in the spread between 10-year Treasurys and 2-years. Like the Fed, a lot of these folks hold an awful lot of fixed income paper – Treasurys, but also corporate, and even mortgages – all of which will decline in price as rates climb. Unlike the Fed, they can’t print their own money to remain liquid. Write-downs on these bond portfolios could get ugly. Even if managed right, it won’t be easy to get out of billions of dollars’ worth of bonds without getting spanked.
So Bernanke keeps the myth alive, the sun continues to revolve around the earth, and the house of cards stands firm as the Inchcape Rock. Until it doesn’t. Meanwhile, volatility in your portfolio will likely be the order of the day. That, and uncertainty about the future.
You weren’t planning on retiring any time soon…?
Sector Spotlight – Industrials: Does a Dead CAT Bounce?
Hedgeye Industrials sector head Jay Van Sciver has the hot hand in this oh-so hot month of July.
Last week as rumors swirled around FedEx, Van Sciver ran a well-attended Flash Call laying out the case for an activist investor to get involved. This week, famed short seller James Chanos told an investor conference that he is short CAT, saying the company is vulnerable to weakening commodity prices, and questioning the company’s accounting practices. Van Sciver, who has done a mountain of work on CAT, swung into action and presented clear support for the Short case.
Mined Over Matter
Van Sciver is a seasoned Industrials sector investor and analyst. This puts him in the unusual position of being a Wall Street professional whose memory extends beyond last night’s dinner at Nobu. Industrials tends to be very long-cycle sector, and investors need to pay attention to key features of the group as it evolves over decades. It’s not enough to look at quarterly reports of the individual companies.
For starters, Van Sciver says Mining Capital Equipment, the segment that delivers about one-quarter of CAT’s profits, is not really an “industry.” It’s a bubble within the heavy equipment sector, built on the back of the commodities bubble that fueled the Emerging Markets boom.
As the commodity-fueled EM bubble evaporates, Mining Capital Equipment will retreat to its historic position as a subset of heavy industrial equipment. With all the enthusiasm among EM portfolio managers, the entire mining group never had more than 100 customers worldwide.
Investors shouldn’t mistake a Bubble for a “New Paradigm,” cautions Van Sciver, the capital equipment sector has not changed much over the years. Iron ore mining goes back to approximately 1300 BCE – which is why we call it the Iron Age. Sort of the ultimate “mature industry.” Advances in technology have made it easier to extract larger quantities of ore, and to do it faster. But if China isn’t buying, your ore either sits on cargo ships (which is where Brazilian company Vale has parked large chunks of its inventory) or it stays in the ground, and no technological advance will change that.
Addressing CAT’s other major drivers of profits, Heavy Construction provides about another 25% of profits, but is a very low-margin business. And it’s very hard to – you should excuse the expression – carve out a niche in this highly fragmented industry. Oil & Gas, accounting for about another 15%-20% of profits, is not significantly different from mining. CAT invested heavily to add capacity as high energy prices drove a multi-year increase in capital spending, all of which may prove unsustainable if, as Hedgeye forecasts, the Dollar continues to strengthen and energy prices decline.
CAT’s Basic Business
The Resources Capital Expenditures (“capex”) cycle is long and volatile, affecting companies like CAT that sell to resources companies. Coming off a major bubble, global commodity prices are now in trouble. In an industry where margins do not stay high for long, CAT is ill-prepared for a downturn.
CAT has resources-related exposure beyond mining. The company sells a range of power products – drilling equipment, locomotives, pumps, nat gas compressors – all of which are primarily used in resources-based industries. In the commodities capex cycle, spending goes up as commodities prices rise. In order for spending to plummet, prices don’t have to hit new lows, they just have to flatten, making the next incremental dollar of capex spending unprofitable.
Recent booms in commodity prices and commodity capex spending are the biggest in 100 years of data representing outlier price and spending moves. Again, not a New Paradigm, but rather the prelude to Mean Reversion. Van Sciver says we are already in the down slope of this cycle which could see mining capex decline by as much as 70% before it stabilizes.
The recent capex blip is likely the result of a combination of factors including a lack of capacity investment through the 1990’s, a commodities bubble, government easy money policies, and attraction to the “sector” as investors looked for new ways to invest in Emerging Markets. It is not realistic to expect any of this capital spending to be sustainable.
Other segments reflect similar weakness. Global coal prices are down, and high energy prices will not be sustainable as the Dollar continues to strengthen. The same holds for the gold market, one of CAT’s largest markets. Already down some 25% from its highs, if the yellow metal loses its investment luster, “look out below” says Van Sciver.
In 2011, CAT made two sizeable investments in an apparent bid to block potential new entrants from the market. They acquired mining equipment maker Bucyrus-Erie, and they purchased Chinese mining equipment maker ERA – a billion dollar deal that turned out to be a fraud.
Raising similar questions about CAT’s accounting as those aired by short seller Chanos, Van Sciver shows that the Bucyrus deal included $8.5 billion of “intangibles” – on a total $7.5 billion transaction price. Capital equipment deals should be “tangible-intensive.” From an accounting perspective, Intangibles and Goodwill don’t depreciate, which saves CAT from having to charge amortization and depreciation against future earnings. This looks good with pencil and paper, but this accounting move does not create actual profits.
“Acquisitive companies frequently rely on the topline growth and earnings boost that large acquisitions can provide,” observes Van Sciver. Translation: what does management do when they can no longer earn money in their basic business? But when you are in an industry that has peaked, and is sliding fast, and when you are paying top price – at the top of the cycle – to buy your competition in order to add their revenue stream to your own, it is only a matter of time before both the top- and bottom-line numbers will simply go away.
This may already be happening. Van Sciver says free cash flow has “nosedived” relative to reported profits, a sign that there may be accounting irregularities.
Who’s Gonna Sell All This Stuff?
CAT has a “close relationship” with its dealer network. How close? CAT finances the purchase of these dealerships, then finances both their dealers’ inventory and their receivables. What may have looked like a brilliant way to capture all the revenue flow from the upswing in capex now looks like a game of corporate Russian Roulette with the cylinder fully loaded.
CAT is facing excess manufacturing capacity and excess inventory, which continues to balloon as sales continue to drop. Production has not been cut, which enables CAT to report improving manufacturing margins – a questionable practice that continues to turn out more equipment the company won’t be able to sell.
And even before CAT itself takes its lumps, their dealer network is stuck with excess inventory. Inventory that is financed by CAT. In a whole industry sector that invested in bloated capacity as commodity prices rose, the knock-on effect of CAT’s dealers possibly going out of business could be staggering. As CAT’s orders continue to decline the company points to improving Orders as Per Cent of Sales figures. With sales down over 17%, it’s not surprising, leaving one to wonder who management thinks is buying this story.
By the Numbers
Van Sciver believes Wall Street analysts’ earnings projections for CAT are unrealistically high. By which measure CAT’s own guidance looks completely out of touch with reality.
Consensus estimates have CAT earning $7.92 next year, and $9.15 in 2015. CAT provides no guidance at all for next year. Asked about next year, CAT corporate controller and head of Investor Relations says “That’s a really hard question to answer at this juncture. I mean, certainly we don’t have an outlook for 2014.”
For the following year, 2015, CAT’s own guidance is $12-$18 – as high as twice Street consensus. Van Sciver says so much of reported profit is either manufactured – no depreciation charges to goodwill – or unsustainable as sales continue to slip, that CAT will have difficulty earning even half of the bottom of their guidance range.
One of These Sectors is Not Like the Other
Finally, Van Sciver points to one of the curious characteristics of his sector. Some investors continue to say CAT is “cheap,” looking at its low P/E ratio. Van Sciver says the Industrials sector is characterized by relatively short cycles of high profitability, punctuated by occasional oases of stability in a wilderness of volatility. The time to buy Industrials companies is when they are losing money, which means they will have P/E’s approaching infinity. That’s when these companies are bottoming. Low P/Es point to unsustainable earnings.
Think of the market’s logic: the market will pay an expanding multiple for a company with strong growth prospects. The lower P/E is the market’s way of saying there’s no more growth at this point in the cycle. Lower P/Es on Industrials mean the stocks could be in for a teeth-rattling decline.
Van Sciver says CAT is an outright short. He believes the company can not achieve anywhere near its own earnings guidance – and even analyst projections will prove wildly over-optimistic. There’s the added spice of possibly murky accounting – Chanos calls CAT’s accounting “questionable” and “overly aggressive” – and the looming specter of further possible dislocations across the EM, where CAT relies on inflated commodity prices to buoy its revenues. If Egypt closes the Suez, the price of oil will go up – but oil companies won’t buy more drilling equipment. If civil war breaks out in a major iron producing nation, the price of iron ore will rise – but mining companies won’t buy more equipment.
Van Sciver believes the protracted erosion of the global commodities complex could have companies in this sector facing revenue declines of as much as 70%. When that happens, all the Creative Accounting in the world won’t hide the fact that no one is buying your products.
Sorry, looks like this CAT is out of its bag.
Investing Term – Housing Starts
Housing Starts records the number of “Housing Units” – privately owned new residences – on which construction has actually begun in a month. Housing Units include single-family homes – houses, but also condos and “townhouses” – and apartment houses with more than five apartments, with each apartment counted as a separate Unit.
There are a range of measures of residential construction used in economic forecasting.
The National Association of Home Builders publishes a monthly Housing Market Index (NAHB HMI, if you want to stay current with industry jargon) survey that measures builders’ confidence in the outlook for new home construction. The HMI is a telephone survey of builders nationwide that asks for their outlook on current conditions, future expectations, and their take on local buyer foot traffic. Economists also look at the Census Bureau’s monthly Building Permits survey, an undifferentiated report that lumps together speculative developers and non-speculative builders.
The Commerce Department reports monthly on Housing Completions of privately-owned Housing Units, a measure of the economy’s ability to follow through with spending plans. If Completions fall below their corresponding Starts, it may signal loss of jobs, assets, or confidence in the economy causing projects to be abandoned before they are finished.
The Census Bureau has statistics going back to 1976 showing that single Housing Units are generally started within one month after the permit is issued, and multiple Unit buildings generally within two months of the permit. The average time from Start to Completion runs at around six months for single Units, with owner-built Units taking closer to 10 months on average. Multiple Unit buildings and apartment buildings take longer, with larger apartment buildings taking about a year from Start to Completion.
This means that interruptions between Starts and Completions could signal economic disruptions, while Permits running ahead of Starts indicates economic optimism.
Hedgeye’s Financials sector head Josh Steiner was ahead of the curve with his “housing going parabolic” call in the fourth quarter of 2012. Steiner emphasizes that housing is what economists call a “Giffen Good” – like the stock market, the higher prices go, the more people rush in to buy. Similarly, the current rise in long-term interest rates should not act as a drag on housing. There could be a spate of panic homebuying as rates get up to 5%, and bankers will be more motivated to push both refinancings and new mortgages at 5% than at 3%. Steiner notes that major lenders have already started to lower their lending standards for mortgages, which will bring more potential buyers into the pool. This is good news for housing – and certainly good news for the banks – though it begs the question of whether we really learned anything at all from the financial crisis that, from most folks’ perspective, we are still suffering with. (For the record, the answer is No. In case you didn’t know, now you know.)
This week’s reported Housing Starts were down 9.9% from the prior month. But note the biggest chunk of that was a 26% drop in multifamily housing, a sector that is notoriously choppy and that may be bumping up against saturation after private equity funds bought up billions of dollars’ worth of apartment units at distressed prices.
Hedgeye’s growth thesis remains on track and with it, the outlook for homebuying. Steiner says this week’s Initial Jobless Claims number shows that the core positive employment trend remains very strong and Health Care sector head Tom Tobin sees the upward trend in the US birthrate continue, all of which presages increased household formation. In fact, Steiner published research this week showing that the rate of new household formation in June was the fastest rate we have seen since the beginning of the year.
More people, with more jobs, making more babies. They all need places to live.