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Picture Day

“Think of me like Yoda, but instead of being little and green, I wear suits and I’m awesome. I’m your bro — I’m Broda!”

-Keith McCullough


I’m not going to try to weave that recent #Tweetshow gem from Keith above into some sort of missive theme.  It just makes me laugh.


Let’s start somewhere else.


Back in school the bullies used to wait until Picture Day to punch a kid in the face.  Risk Management in Central CT starts early. 


Yesterday could probably be considered an investor picture day and the market delivered a bevy of black eyes to the perma #EOW contingent.


In related End of World and Recency Bias news, it’s now August and for the better part of the last 5 months, the ‘Sell in May’ mantra has been iteratively thesis drifting towards an un-convicted call to ‘Sell in September’ alongside another crescendo in congressional budgetary and debt ceiling discord. 


September, incidentally, also happens to be when the seasonal distortion present in the reported econ data flips from a headwind to a tailwind - serving to (optically) amplify any positive underlying economic trend. 


Hearing implied volatility in ‘sell in December & go away’ calls is ripping!


Back to the Global Macro Grind……

For much of 1H13, our pro-domestic growth call was buttressed by some positive redundancy.   That is, with our model signaling for the slope of U.S. growth to accelerate out of 4Q12, we had a bullish absolute call for domestic, consumer-centric equities. 


With most of Europe Bearish TRADE & TREND, an expectation for slowing EM growth, and upside to troughed out expectations for U.S. growth, we also had a relative call supporting a long bias to domestic exposure. 


In essence, even if U.S. growth turned out to be “okay” instead of very good, we were still taking a high probability swing at positive absolute performance.  


As it happened, our conviction in the strength of the relative call was tested more acutely as we transitioned out of 1Q.  A quick review of the last few months will be helpful in understanding how our view has evolved to where it is today. 


As we moved through 2Q, it become apparent that consumption growth, while remaining healthily positive, would not accelerate sequentially.  In part, this was not unexpected. 


Fiscal policy impacts generally hit on some short lag and the 1Q13 comparison was artificially difficult as consumer spending in 1Q benefited from the special dividend deluge and compensation pull-forward that occurred in December 2012 ahead of impending fiscal cliff related tax law changes. 


With the savings rate rising in 2Q and disposable personal income growth largely flat, divining the slope of sequential consumption growth just became simple math. 


Further, with federal employment growth running at approx -2% YoY and furloughs for ~700K+ federal employees beginning in July – which, in tandem, equates to ~7% reduction in income for ~2% of the workforce – upside to disposable income growth would likely be constrained in 3Q13 as well. 


Would a modest deceleration in consumption matter from a market perspective? – becomes the simple, but nontrivial investment question. 


As we highlighted yesterday, when re-evaluating positioning, it’s often helpful to start by detaching yourself from the myopia of trying to contextualize every market tick and, from a broader perspective, remember how this whole reflexive economic thing works.  Archetypically,


Rising spending drives income and employment higher which, in turn, drives consumption and confidence higher in a virtuous, self-reinforcing cycle.  Credit serves to amplify the cycle with credit expansion following pro-cyclically as loan demand and creditworthiness both increase alongside rising incomes and higher household net wealth. 


In short, if the TREND slope of improvement across the balance of key macro drivers (employment, consumption, credit, confidence) remains positive, and if the forward research view and risk management signals are still aligned, the path of least market resistance and the highest probability call is to stick with the TREND  - particularly if you don’t have a discrete catalyst for a reversal. 


So, how are the aforementioned macro metrics #TRENDing?


Labor market trends remain positive with Initial Claims continuing to register accelerating improvement while employment growth as measured by the BLS’s Establishment and Household Survey’s both remain positive. 


Confidence readings across the primary surveys continue to make new 5Y highs and are finally beginning to break out of their post recession channel.


Business and Residential Investment growth has accelerated in each of the last two quarters. 


On the credit side, banks are finally beginning to report positive loan growth, Commercial & Residential Real Estate loan demand continues to improve and credit standards across commercial and consumer loan categories continues to ease.


Consumption has shown a discrete acceleration, but faces some well advertised, nearer-term headwinds.  If labor market trends remain positive, does the market look past middling consumer spending growth over the next few months with an eye towards a diminishing fiscal drag and easy compares as we annualize the sequestration and the tax law changes in early 2014?  That’s an increasingly probable risk for the consensus #EOW bear crowd to manage.


Now, Is Congress a discrete negative catalyst?  As our Healthcare Sector Head, Tom Tobin would say; you can never underestimate congress’s ability to create a crisis so they can subsequently save us from it.  Congressional risk may rise, on the margin, but this iteration is likely to be mostly noise so long as the fundamental trends remain positive.


Is #RatesRising a catalyst?   We have a hundred page slide deck and a 60 min presentation on why we don’t think a return to interest rate normalcy is a threat to growth or market performance.  (ping if you’d like a copy)


Is today’s Employment Report a discrete catalyst?  Yes, but not really.  We don’t have any particular edge on the NFP number, but given the ongoing strength in the jobless claims data it’s more likely than not we print something close to consensus at 185K.


So, now that I’ve peppered you with bullish jabs for the last 800 words, I’ll remind you that we’re not bullish on everything at every price.   In fact, we moved to net neutral into yesterday’s close  (5 longs, 5 shorts) as almost everything pro-growth, domestic consumption (XLY, XLF, $USD) signaled immediate term overbought.  


But we’ll take our long exposure higher again on the signal so long as the TREND slope of improvement in the Macro data remains positive.  At present,….


“Your Friend, the Trend Remains”  - Broda


Our immediate-term Risk Ranges are now as follows:


UST 10yr 2.60-2.78%


Nikkei 14101-15095

VIX 11.96-13.74

USD 81.62-82.87

Gold 1


80o and sunny on tap for the weekend.  Enjoy. 


Christian B. Drake

Senior Analyst 


Picture Day - 10Y vs GDP  PCE  SPX


Picture Day - virtual portfolio 8 2

The Most Over-Valued E&P in North America Is…?

Answer: Kinder Morgan CO2 Company, L.P. (or at least one of the most over-valued...)


Kinder Morgan CO2 Company, L.P. is a subsidiary of Kinder Morgan Energy Partners, L.P. (KMP) that the Kinder Morgan faithful don’t want to talk much about. But the segment is crucial, as it generates 26% of KMP’s total earnings before DD&A and certain items (and the GP’s take), and nearly all of those cash flows flow to the DCF line due to the fact that KMP considers 97% of the capital expenditures in the segment to be “expansion capital” – which, as MLP investors know, are not deducted from DCF; “sustaining capital” is deducted from DCF.  


Between 2010 – 2012, for its CO2 segment, KMP reported $34MM of sustaining capital and $1,230MM of expansion capital, despite no material volume growth in its E&P or CO2 businesses, and aggregate DD&A of $1,329MM. If KMP considered all of the CO2 capital expenditures between 2010 – 2012 to be sustaining capex, which we think is appropriate considering there was no aggregate growth in the segment, then KMP’s total DCF would have been ~26% lower than reported.


We estimate that the CO2 segment currently generates ~1/3 of KMP’s total DCF after the GP's take, despite only representing 7% of total assets. 


The Most Over-Valued E&P in North America Is…? - km1b


This may not be lost on seasoned MLP investors. But there seems to be a lot of interest in this contentious topic lately, as we’ve gotten several questions and comments on it over the last few months. The general view out there on it is something like, ‘It makes no sense, but it is what it is. It’s Kinder Morgan. They do what they want.’  Some have even suggested to us that the SEC won’t do anything about LINN Energy’s (LINE, LNCO) blatantly understated “maintenance capex” (and, as a result, its overstated DCF) because ‘they won’t want to make Kinder Morgan mad.’  But in our view, the fact that KMP does this is indefensible and misleading (as it creates a wide gap between DCF and free cash flow, which most retail investors incorrectly assume are synonymous), and it’s worthy of discussion.  The KMP CO2 segment's expansion capital is funded primarily via equity and debt financing – but with no volume growth, the return on that incremental invested capital will be zero excluding the impact of price. These capital raises finance the distribution payment, not growth, and KMP’s CO2 segment is running to stand still...though it is a cash cow for the GP!


“We define sustaining capital expenditures as capital expenditures which do not increase the capacity of an asset.” - KMP 10-K, page 73.


That is purposefully cryptic. How is KMP defining “the capacity of an asset?” It clearly has nothing to do with the top line, i.e. volume growth.


KM CO2 is really two businesses – a EOR (enhanced oil recovery) E&P; and CO2 production, transportation, and marketing.  The E&P assets generate the majority of the segment's EBITDA.


In 2012 Kinder Morgan was the 5th largest oil producer (gross) in the state of Texas. It’s three oil fields are CO2 floods in the Permian Basin – SACROC, Yates, and Katz/Eastern Shelf. Net to KMP in 2012, production was 39,107 boe/d (90% oil). As of YE12, KMP had 89 MMboe of proved reserves, of which 57 MMboe (64%) were proved developed. The YE12 PV-10 of the E&P assets was $2.7B.


Production and proved developed reserves have been flat-to-down in recent years, with SACROC production flat, Yates in decline, and Katz – where production has disappointed – growing off of a low base to offset some of the aggregate decline. The 2010 – 2012 E&P production CAGR was -3%, and KMP only replaced 92% and 91% of proved developed reserves in 2011 and 2012, respectively. There is no material growth in the E&P segment. KMP has incurred $1,009MM in E&P development costs over the last 3 years, and nearly all of it was considered expansion capital, despite production and reserves declining. Sorry, but, THIS MAKES NO SENSE.


The Most Over-Valued E&P in North America Is…? - kmp graph


Growth in production from KMP’s natural gas plants (from 4,117 boe/d in 2009 to 5,717 boe/d in 2012, a 12% CAGR) has offset some off the E&P decline, but total oil, NGLs and natural gas production still declined at a -2% CAGR over the last three years. And KMP’s CO2 production has remained flat around 1.2 – 1.3 Bcf/d.


The Most Over-Valued E&P in North America Is…? - km3


If we want to think of sustaining capital for the E&P assets as the capital required to keep production and reserves flat (the definition most E&P MLPs use and abuse), let’s try and figure out what that might actually cost KMP today. Annual production over the last two years has come in ~14 MMboe. If KMP replaced 100% of those proved developed producing reserves with the drill bit, what would it cost?  We think that the best way to do this is to look at KMP’s PUD conversion cost, because that is really the heart of KMP’s EOR operation. How much does it cost KMP to move a PUD barrel into the proved developed category?


Here are the relevant disclosures from the 2010, 2011, and 2012 10-K’s:


“During 2010...we incurred $248.0 million in capital costs which resulted in the development of 10.0 million barrels of crude oil and 1.3 million barrels of natural gas liquids and their transfer from the proved undeveloped category to the proved developed category.”


“For 2011, we incurred $372.8 million in capital costs, and in prior years, we incurred $43.6 million in capital costs related to the Katz field unit. Combined, these capital investments resulted in the development of 7.3 million barrels of crude oil and 0.9 million barrels of natural gas liquids and their transfer from the proved undeveloped category to the proved developed category. We also developed 3.0 million barrels of crude oil and 0.0 million barrels of natural gas liquids reserves with the development of the Katz (Strawn) unit CO2 flood where the produced gas containing natural gas liquids is injected with the CO2.”


“For 2012, we incurred $353 million in capital costs, and this capital investment resulted in the development of 6.0 million barrels of crude oil and 1.8 million barrels of natural gas liquids and their transfer from the proved undeveloped category to the proved developed category.”


The Most Over-Valued E&P in North America Is…? - km4


Some comments:


• For scope, Denbury Resources' (DNR) PUD Conversion cost in 2012 was $21.60/boe, and it is a higher cost EOR player.  KMP's 2012 PUD conversion cost of $45/boe is very poor.


• The trend in capital efficiency is negative, likely due to activations on the fringes of SACROC and Yates, and disappointing results/cost overruns at Katz.


• The 2010 PUD conversion costs are low because of a large positive performance revision at Yates; the 2011 and 2012 combined PUD conversion costs were $45.38/boe and $33.15/boe excluding and including PD performance revisions, respectively.


• $33.15/boe x 14MM boe = $464MM of annual capital required to keep the proved developed reserve base flat.


The non-E&P CO2 segment assets (CO2 production, transportation, and marketing) will have organic growth going forward, as KMP plans to ramp production from ~1.2 Bcf/d currently to 1.7 Bcf/d by 2017. That is the main driver of the 2013 capex increase (+$200MM total before the recent acquisition).  But still, this segment should have some sustaining capex allocated to it. DD&A on these assets are ~$50MM/year, in line with the non-E&P capital expenditures in 2010 and 2011, which resulted in no production growth. Thus, ~$50MM/year is, in our view, a fair number for sustaining capex for the CO2-only assets.


Putting the two pieces together, we argue that sustaining capex on the entire segment should be between $400MM - $500MM per year (and growing), versus the 2013 guidance of $17MM. Of course, that’s never going to happen unless a regulator makes it happen, as it would shave off more than a $1.00/unit of annual KMP DCF.


On valuation…


In 1H13, KMP’s CO2 segment generated $691MM of earnings before DD&A and certain items; if we annualize that and allocate the segment $80MM of annual corporate G&A, then it will do ~1.3B of EBITDA in 2013, or 26% of the consensus EBITDA estimate for all of KMP before the GP’s take, $5.0B. But most of that EBITDA is flowing directly to the DCF line because no material sustaining capex is deducted. So with KMP in the 50/50 IDR split, the GP takes ~46% of the total distributions, and, by our estimates, the CO2 segment alone will generate ~$700MM of DCF net to KMP in 2013 (~1/3 of total DCF).  With KMP yielding 6.45% 2013e DCF, the market is valuing this asset net to KMP at ~$11B.


Compare this to the YE12 PV-10 of the E&P assets of $2.7B, and the book value of the entire CO2 segment as of 6/30/13 of $2.8B (we estimate that this is $1.4B E&P and $1.4B non-E&P).  And, recall, the GP’s take is over 46% of the distributions, so the value net to KMP is roughly half of those figures.  If KMP were to sell the segment and distribute the proceeds, we have a hard time believing that it would amount to more than $3 - 4B after the GP's take. 


The point is that the CO2 segment inside KMP is massively overvalued, largely due to understated sustaining capex and the failure of the market to recognize that it's a depleting asset (and valuing it with a yield target).  But is it a moot point?  Well, it has been for years, and Kinder Morgan will never sell or spin the segment.  But, if you own KMI/KMP, you should at least know about this; and if your content to just 'play the game,' so be it.


On the recent E&P acquisition...


"In June [2013], KMP acquired the Goldsmith Landreth San Andres Unit in West Texas from Legado Resources for approximately $285 million. Goldsmith includes more the 6,000 acres in Ector County and is in the early stages of a CO2 flood development. The unit currently produces approximately 1,250 bpd of oil and is projected to peak at approximately 10,000 bpd in about 10 years. Also of importance, as part of the transaction KMP obtained a long-term CO2 supply contract with volumes growing to 150 MMcf/d over the next few years." - KMP 2Q13 Press Release


This acquisition is not surprising to us, even the big multiple of $228,000/boe/d.  After all, the purchase price and all future capital expenditures are excluded from DCF, financed at the KMP level, and KMI will take ~50% of all future cash flows.  A no-brainer for the GP.  Really, as long as the market lets KMI/KMP get away with it, KMI supporters should push for as many CO2 segment acquisitions as possible.  


There must be a great deal of cognitive dissonance that comes with owning (or shorting!) KMI/KMP...


Kevin Kaiser

Senior Analyst

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Kellogg – A Challenged Outlook in 2H 2013

Kellogg raised a number of red flags in its earning call this morning. The stock traded down -1.1% today versus SPX +1.2% alongside the company reducing its FY sales estimate to 5% (prior 7%) and reducing its FY EPS range to account for a  $0.09 FX headwind (prior $0.02). Despite beating consensus EPS in the quarter ($1.00 vs $0.97) revenues were lighter than expected (+6.9% versus +9.9%) with weakness in key categories and geographies.


Today K broke its TRADE line of support at $65.96 (to become its new level of resistance) and TREND resistance is at $64.37. We would not be buyers of this stock just on today's weakness.


Kellogg – A Challenged Outlook in 2H 2013 - VV.K


We’re optimistic that the Pringles acquisition can help fuel returns in 2H (Q2 revenues without the Pringles acquisition were down -0.5% on the quarter), however the weakness seen in the U.S. business (sales of $2.44B vs consensus $2.56B, or -1.6%) and continued weakness in the cereal segment, signal that K has taken its eye off the ball and will need the coming quarters to realign its marketing spend and innovation to get back on track. 


Matthew Hedrick

Senior Analyst


While not as material as PNK's, BYD’s “non-recurring” charges have been a mainstay exclusion from Adjusted EBITDA.


  • BYD’s quarterly GAAP operating expenses excluded from Adjusted EBITDA have been consistent and sometimes material
  • As a percent of company reported Adjusted EBITDA, excluded expenses have represented 1-10%
  • While not as egregious as PNK's, BYD’s reported Adjusted EBITDA should probably be adjusted again – downward.  Shall we call it ‘Adjusted’ Adjusted EBITDA’?



In an effort to evaluate performance and as a follow up to our YouTube, we compare how the quarter measured up to previous management commentary and guidance




  • MAR hit their guidance for Q2 but quality was low.  RevPAR came in at the low end of guidance.  Going forward, Group and DC remain the laggards.




  • SAME:  Reiterates the 'steady as you go' theme.  Comparable systemwide US REVPAR increased 5.2% in 2Q, at the low end of its 5-7% guidance.
    • "As we look at the U.S., we think it's steady as you go, good growth environment."
    • "We would expect North America to be the stronger of the continents out there."


  • SAME:  2Q REVPAR was 1%.  France/Russia led the strength.  London will have difficult comps in 3Q due to the Olympics but they're optimistic on 4Q given much easier comps.
    • "We get about 10% of our fees out of Europe. It's still flat. The economies in Western Europe, Germany, France, some of those countries, obviously still have some structural issues to get through. Southern Europe, Spain, Portugal, Italy, suffering with high unemployment, so I think Europe's going to be kind of flat for a while."
    • "One area in Europe that is doing well is Eastern Europe, Russia, the 'stans', Georgia, those areas with the natural resources, commodities, continue to drive well and especially Russia seems to be doing well right now."


  • SAME:  REVPAR rose only 1% but MAR gained 6% in market share.  2H 2013 have will easier comps.
  • PREVIOUSLY:  "China, same thing, growing middle class, growing business community, so a lot of new travel that's taking place in that part of the world. We think it'll be choppy, but over the long-term it's a great place."


  • WORSE:  Group revenues are up only 2% in 2014.  They have 50% of the MAR brand business booked for 2014.
    • "In fact, they were up significantly in the first quarter, the pace for 2014, and we saw big movement in the year for 2014 bookings.  On the shorter horizon, though, on what we call, in the year for the year, that short-term bookings, as we said in the first quarter, we are seeing a little hesitancy at corporate America pulling the trigger on those."
    • "For 2014, we'll probably have 40%, 45% of the group business on the books I would think. And so we're building that book and obviously by the time we get to the end of year we should be something closer to 70%, actually we could be 50%-ish now, maybe low 50% for the total business for 2014 that's already on the books."


  • WORSE:  Remains a challenging environment.  % of group business coming from DC has declined from 5% to 2% for 2013. 
    • "On DC, in referring to the government, I guess, DC obviously feels sequestration more than others. But it hasn't been a big mover. I think the government, quite frankly, started cutting costs and stopped traveling or slowed down their travel pretty dramatically in 2012...I think we talked in the first quarter that it's going to cost us 60 basis points to 70 basis points. That hasn't changed. We still see that probably holding up. I think DC, it's interesting as you look at DC, it kind of leveled off. And it's holding its own."


  • BETTER:  Transient REVPAR gained 6% in 2Q and the positive trends have continued. 
  • PREVIOUSLY:  "Transient business was very strong, particularly nonqualified or retail-rated business as we eliminated discounts, pushed business into higher rated categories and raised rates."


  • SAME:  Strong incentive fee growth in the US offset flat incentive fees internationally.   
  • PREVIOUSLY:  "Incentive fees exceeded our expectations, largely due to strong performance among our full-service hotels in the U.S., particularly in New York and Florida."


  • BETTER:   Termination fees of $13MM added 2 cents to the bottom line.
  • PREVIOUSLY:  "We expect lower year-over-year termination and residential branding fees and higher pre-opening costs."



  • SAME:  Due to the delay in Obamacare, MAR is forecasting high single digit increases for healthcare costs for 2014 and a doubling of that rate in 2015. 
  • PREVIOUSLY:  "When you look into 2014, certainly ObamaCare is the biggest new potential wrinkle in the cost profile. Our estimates today for the managed portfolio in the United States is about $60 million to $100 million, and that would be, oh, I don't know, maybe about half of a point, so a 50 basis point impact on margins....obviously these are system costs that will ultimately be borne by the hotel. We will pick up a share of that through incentive fees for the managed portfolio. We don't know what the number would be for the franchise portfolio, but in terms of number of rooms, the franchise portfolio is about the same as the managed portfolio in the United States, so the numbers could be around the same order of magnitude."


  • BETTER:  Expects 100-150bps improvement in margins for 2013
  • PREVIOUSLY:  "We're more likely to see inflation go up than vice versa, and that will have some modest impact. On the other hand, with each passing year, more of the REVPAR growth comes from rates, and obviously a REVPAR coming through rate is better for margins then REVPAR coming through occupancy. And I think, guys, it's way too early to be giving guidance for 2014 and 2015, but I think our expectations would be that we will net-net see margin growth above 100 basis points in each of those years."

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