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European Banking Monitor: Broad Improvement

Below are key European banking risk monitors, which are included as part of Josh Steiner and the Financial team's "Monday Morning Risk Monitor".  If you'd like to receive the work of the Financials team or request a trial please email .

 

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European Financial CDS - Last week saw large improvements in French, Greek, Italian, and Spanish swaps. In fact, the only company that saw swaps rise was Sberbank of Russia, where swaps backed up another 14 bps to 238 bps. Sberbank swaps have become increasingly tethered to the outlook for oil prices.

 

European Banking Monitor: Broad Improvement - ww. banks

 

Sovereign CDS – Last week saw another across-the-board tightening in sovereign credit default swaps. Spain, Italy and Portugal led the improvement with declines of 15 bps, 12 bps and 11 bps, respectively. Ireland and France followed with 8 bps and 5 bps. The U.S., Germany and Japan were all tighter by 1-2 bps. 

 

European Banking Monitor: Broad Improvement - ww. cds 1

 

European Banking Monitor: Broad Improvement - ww. cds 2

 

European Banking Monitor: Broad Improvement - ww. cds 3

 

Euribor-OIS Spread – The Euribor-OIS spread (the difference between the euro interbank lending rate and overnight indexed swaps) measures bank counterparty risk in the Eurozone. The OIS is analogous to the effective Fed Funds rate in the United States.  Banks lending at the OIS do not swap principal, so counterparty risk in the OIS is minimal.  By contrast, the Euribor rate is the rate offered for unsecured interbank lending.  Thus, the spread between the two isolates counterparty risk. The Euribor-OIS spread widened by 1 bps to 13 bps.

 

European Banking Monitor: Broad Improvement - ww. euribor


Bullish: SP500 Levels, Refreshed

Takeaway: Bears will be bitter.

POSITIONS: 5 LONGS, 2 SHORTS @Hedgeye

 

These market corrections are huge. I opened the day net short (4 LONGS, 5 SHORTS) because Friday’s close was immediate-term TRADE overbought. SPY dropped a whopping -0.35%, then rallied back to its all-time high on another bullish #GrowthAccelerating data point.

 

ISM non-manufacturing (i.e. the bulk of the US economy) accelerated to 56.0 in JUL vs 52.2 in JUN and some of the components within the report ripped (New Orders 57.7 vs 50.8 last month, and Business Acvivity 60.4! vs 51.7 last month). Bears will be bitter.

 

Across our core risk management durations, here are the lines that matter to me most:

 

  1. Immediate-term TRADE resistance= 1714
  2. Immediate-term TRADE support = 1693
  3. Intermediate-term TREND support = 1630

 

Higher-lows, higher-highs, and accelerating US growth data looks just about right. Don’t forget that’s what Gold and Bonds have been discounting now all year. Growth as a style factor within equities is ripping too (Top25 EPS growers in our SP500 model = +7.3% m/m and +26.8% YTD).

 

Don’t fight the data – and keep moving out there,

KM

 

Bullish: SP500 Levels, Refreshed - SPX


E-Cigs: What’s Big Tobacco Saying?

Takeaway: A brief review of Big Tobacco’s Q2 earnings call commentary on electronic cigarettes.

This note was originally published July 30, 2013 at 12:44 in Consumer Staples

Below we’ve collected Big Tobacco’s Q2 earnings call commentary on electronic cigarettes. A common thread among the big four (LO, RAI, MO, PM) is excitement to participate in the category, focused investment behind it, but cautious optimism on the runway for e-cigs as a category and general uncertainty on just how the FDA will regulate e-cigs in the future.

 

E-Cigs: What’s Big Tobacco Saying? - ecig

 

LO led the group in terms of bullish sentiment on claims of strong incidence of repeat trialing (conversion) of e-cigs, whereas the others suggested conversion rates still remain low or that it’s too early to measure results. 

 

Big Tobacco’s push into e-cigs began last year, and of the big four, LO was the first out of the gate purchasing Blu last April. As we show in the table below, both RAI and MO are launching their e-cig versions this month and next month, while PM commented that it may have ambitions to get in the market in 2016/17. 

 

E-Cigs: What’s Big Tobacco Saying? - hedpic

 

Lorillard’s e-cig Blu holds the number one dollar share of the total e-cig market at ~40% followed by NJOY (private) at ~30%. Across the xAOC channel (= all channels excluding convenience), the leading brands include: Blu (44.5%), FIN (20.6% share), Mistic (11.7% share), and NJOY (10.8% share).

 

U.S. e-cigs sales were projected at $150MM in 2011, $500MM in 2012 ($300MM across retail channels and $200MM over the internet), and are estimated to be around $1-2B in 2013. Currently e-cigs represent 1% or less of the portfolio of any Big Tobacco company, however we think there is a huge runway for converters in the $90B annual tobacco industry and believe e-cigs may be the first truly new consumer product in the markets in many years. They offer a compelling alternative to traditional cigarettes and offer the consumer a much different experience than a nicotine patch or gum.

 

The involvement of Big Tobacco in the category should continue to lend credibility to e-cigs and accelerate growth; we expect e-cigs to be margin-enhancing to the combined cigarette category for Big Tobacco and 2014 to be a breakout year for them, having tested the waters in 2013.

 

 

LO:


E-cigs were a hot topic on the call. LO reported that Blu achieved net sales of $57MM in the quarter with over a 40% retail market share. In the quarter it added its e-cigs to 30K retailers to bring its total to 110K retailers.

 

LO said Blu’s topline grew year-over-year, but was flat sequentially due to the rollout of its new rechargeable kit. LO only sold rechargeable Blu units in 2 of the 3 months out of the quarter as it took one month to draw-down inventory of its old model before the June 24th launch of its new model to replace the older version.

 

LO, unlike RAI or PM, was very bullish in its commentary on repeat purchases of its e-cig, and confident that although the new rechargeable kit is sold at break-even for the company, the razor-razor blade model of the kit-cartridge will prove profitable.  As of Q1 2013 (no update on the call), disposables accounted for 51% of its e-cig sales. We believe the company will be pushing to expand its more profitable rechargeable business at the expense of less profitable disposables, and we think the new rechargeable is a catalyst for this shift, and should be margin enhancing as distribution and investment behind the brand expand.

 

Feedback according to CEO Murray Kessler on e-cigs from retailers is very positive given the opportunity for higher margins versus other tobacco offerings.  On who is switching to e-cigs, Kessler offered up it’s typically users of less tar cigarettes. He added, this is another reason why he expects less cannibalization with its full-flavored menthols or even its new Newport non-menthol Golds.  

 

 

RAI:


The company looks to continue to invest in its e-cig brand Vuse in the back half. It opened its earnings call by underling that it’s excited that Vuse is expanding into its first major market, Colorado. In the Q&A, the company noted that Vuse will grow to have a commanding presence in the e-cig market, already out in 500 retail stores in the first week, with a flavor profile it calls superior to its competitors.

 

On industry trends, it claims it’s too early to talk about the consumer response, but said retailers are extremely positive. It noted that while e-cigs have strong trialing, so far the conversion rate is low. RAI also said that while its products may have product displays at retail locations that are available to the customer, the actual product is located behind the counter and access is clerk-assisted.

 


MO:


Responding to questions if E-cig have any impact on cigarette volumes this quarter, management gave no color beyond that e-cigs are having some impact. It noted that they’re thinking about what the size is now and what it can be down the road and there is a lot that has yet to be resolved: what the regulatory structure could be, and depending on that, the impact on the size of the category. Further they’re not sure about what excise taxes may be.

 

On playing catch-up to LO with its MarkTen, the CEO said we're still in the early days in the e-vapor category, and he’s confident that MarkTen will be a strong player in the category.  He added that MO’s strategy remains to maximize the core business while taking appropriate steps forward with innovation. He said, in e-vapor category we want to learn our way in.

 

On marketing plans for MarkTen the CEO noted that because the products contain nicotine, they’ll put appropriate warnings on the product, which it will bear despite the fact that it is not currently regulated by the FDA. It’s target audience is adult smokers and vaporers, and noted that the company will take the appropriate steps so that the product doesn’t reach an unintended audience.

 

 

PM:


In the Q&A there were a couple questions on E-cigs. CFO Olczak kept his words brief but said that the market is difficult to estimate, and he doesn’t think it is more than 1% of the industry, which itself might be a high estimate. He believes demand and interest overall is much stronger in the U.S. than in Europe and that what’s distinguishing the category is its lower price points versus traditional cigs, and that the taste profiles don’t compare. He cannot size up if the category will be one with staying power, or one that is a fad. Finally, he hinted that PM could get involved in the market in 2016/17.

 

Matthew Hedrick
Senior Analyst 


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Morning Reads on Our Radar Screen

Takeaway: Here's a quick look at stories on Hedgeye's radar screen.

Keith McCullough – CEO

Health food fight ramps up as Ackman hits Soros over Herbalife (via NY Post)

Treasuries Are World’s Worst-Performing Bonds (via Bloomberg)

Sri Lanka Opens $500 Million Port Terminal Built by China (via Bloomberg)

World's first lab-grown burger to be cooked and eaten (via BBC)

 

Morning Reads on Our Radar Screen - earth1

 

Daryl Jones – Macro

Shale Explorers Outperforming International Oil Titans (via Bloomberg)

U.K.'s services PMI jumps to 60.2 in July (via MarketWatch)

 

Josh Steiner – Financials

#RatesRising 30-Year Mortgage Rates Have Spent 3 Weeks Between 4.3-4.4% (JS note: Our outlook remains higher highs & higher lows … via Bloomberg)

 

Jonathan Casteleyn – Financials

Treasuries Proving Safer Than AAA Two Years After S&P Cut (JC note: I don't think Treasuries are safe but a positively sloped yield curve is one of the most important economic tenets  via Bloomberg)

Bond Salesman Who Wasn’t Reveals RBS Human Errors (via Bloomberg)

 

Matt Hedrick – Macro

Merkel Challenger Says Alienated Voters Are Key to Unseating Her (via Bloomberg)


MONDAY MORNING RISK MONITOR: GOLDILOCKS

Takeaway: Both the short and intermediate term FIG setups remain favorable with very few watch areas currrently.

Key Takeaways:

Last week was another ho-hum week from a risk monitoring standpoint. US financial credit default swaps were essentially unchanged. European financial swaps were broadly improved (average -14 bps). High yield rates were nominally higher (+5 bps), TED spread was nominally lower (-1 bp), Euribor-OIS was wider by 1 bp and the Shifon Index tightened by 30 bps. All this points to a broad-based calm globally. 

 

On a short term basis, the only risk measure that deteriorated was Muni CDS, which rose 4 bps to 95 bps, reflecting modestly higher default expectations as investors re-review pension statuses nationally. On an intermediate term basis, we continue to see a lot of positives. Note the preponderance of green in the middle columns (MoM) of our summary table below. 

 

Financial Risk Monitor Summary

 • Short-term(WoW): Positive / 5 of 13 improved / 3 out of 13 worsened / 5 of 13 unchanged

 • Intermediate-term(WoW): Positive / 6 of 13 improved / 3 out of 13 worsened / 4 of 13 unchanged

 • Long-term(WoW): Positive / 7 of 13 improved / 2 out of 13 worsened / 4 of 13 unchanged

 

MONDAY MORNING RISK MONITOR: GOLDILOCKS - 15

 

1. American Financial CDS -  The biggest movers last week were the mortgage insurers, MTG and RDN, which saw swaps tighten 33 bps and 20 bps, respectively, to 416 bps and 377 bps. Overall, swaps tightened for roughly half (15 out of 27) of domestic financial institutions. 

 

Tightened the most WoW: MTG, RDN, GNW

Widened the most WoW: AXP, MBI, ALL

Tightened the most WoW: MTG, RDN, GNW

Widened the most/ tightened the least MoM: AGO, MBI, MMC

 

MONDAY MORNING RISK MONITOR: GOLDILOCKS - 1

 

2. European Financial CDS - Last week saw large improvements in French, Greek, Italian, and Spanish swaps. In fact, the only company that saw swaps rise was Sberbank of Russia, where swaps backed up another 14 bps to 238 bps. Sberbank swaps have become increasingly tethered to the outlook for oil prices.

 

MONDAY MORNING RISK MONITOR: GOLDILOCKS - 2

 

3. Asian Financial CDS - Indian banks were notably wider last week, rising 11 - 19 bps across the group. Swaps in Chinese banks were tighter, while Japanese banks were flat to mixed. 

 

MONDAY MORNING RISK MONITOR: GOLDILOCKS - 17

 

4. Sovereign CDS – Last week saw another across-the-board tightening in sovereign credit default swaps. Spain, Italy and Portugal led the improvement with declines of 15 bps, 12 bps and 11 bps, respectively. Ireland and France followed with 8 bps and 5 bps. The U.S., Germany and Japan were all tighter by 1-2 bps. 

 

MONDAY MORNING RISK MONITOR: GOLDILOCKS - 18

 

MONDAY MORNING RISK MONITOR: GOLDILOCKS - 3

 

MONDAY MORNING RISK MONITOR: GOLDILOCKS - 4

 

5. High Yield (YTM) Monitor – High Yield rates rose 5.5 bps last week, ending the week at 6.23% versus 6.17% the prior week.

 

MONDAY MORNING RISK MONITOR: GOLDILOCKS - 5

 

6. Leveraged Loan Index Monitor – The Leveraged Loan Index rose 0.6 points last week, ending at 1805.85.

 

MONDAY MORNING RISK MONITOR: GOLDILOCKS - 6

 

7. TED Spread Monitor – The TED spread fell 1.3 basis points last week, ending the week at 23.4 bps this week versus last week’s print of 24.7 bps.

 

MONDAY MORNING RISK MONITOR: GOLDILOCKS - 7

 

8. CRB Commodity Price Index – The CRB index fell -1.4%, ending the week at 284 versus 288 the prior week. As compared with the prior month, commodity prices have increased 0.7% We generally regard changes in commodity prices on the margin as having meaningful future consumption implications.

 

MONDAY MORNING RISK MONITOR: GOLDILOCKS - 8

 

9. Euribor-OIS Spread – The Euribor-OIS spread (the difference between the euro interbank lending rate and overnight indexed swaps) measures bank counterparty risk in the Eurozone. The OIS is analogous to the effective Fed Funds rate in the United States.  Banks lending at the OIS do not swap principal, so counterparty risk in the OIS is minimal.  By contrast, the Euribor rate is the rate offered for unsecured interbank lending.  Thus, the spread between the two isolates counterparty risk. The Euribor-OIS spread widened by 1 bps to 13 bps.

 

MONDAY MORNING RISK MONITOR: GOLDILOCKS - 9

 

10. Chinese Interbank Rate (Shifon Index) –  The Shifon Index fell 30 basis points last week, ending the week at 3.25% this week versus last week’s print of 3.55%. The Shifon Index measures Chinese banks’ overnight lending rates to one another, a gauge of systemic stress in the Chinese banking system.

 

MONDAY MORNING RISK MONITOR: GOLDILOCKS - 10

 

11. Markit MCDX Index Monitor – The Markit MCDX is a measure of municipal credit default swaps. We believe this index is a useful indicator of pressure in state and local governments. Markit publishes index values daily on six 5-year tenor baskets including 50 reference entities each. Each basket includes a diversified pool of revenue and GO bonds from a broad array of states. We track the 16-V1. Last week spreads widened 4 bps, ending the week at 95.3 bps versus 91.1 bps the prior week.

 

MONDAY MORNING RISK MONITOR: GOLDILOCKS - 11

 

12. Chinese Steel – Steel prices in China fell 0.7% last week, or 23 yuan/ton, to 3447 yuan/ton. We use Chinese steel rebar prices to gauge Chinese construction activity, and, by extension, the health of the Chinese economy.

 

MONDAY MORNING RISK MONITOR: GOLDILOCKS - 12

 

13. 2-10 Spread – Last week the 2-10 spread widened to 230 bps, 5 bps wider than a week ago. We track the 2-10 spread as an indicator of bank margin pressure.

 

MONDAY MORNING RISK MONITOR: GOLDILOCKS - 13

 

14. XLF Macro Quantitative Setup – Our Macro team’s quantitative setup in the XLF shows 0.9% upside to TRADE resistance and 1.2% downside to TRADE support.

 

MONDAY MORNING RISK MONITOR: GOLDILOCKS - 14

 

Joshua Steiner, CFA

 

Jonathan Casteleyn, CFA, CMT

 


CAT: Incorrectly Impaired Red Flag? (10-Q Review)

Summary

 

Filing a 10-Q at 4:30PM on a Friday is a mistake for a company that has recently been said to have “accounting issues” by one of the world’s best known and most diligent short sellers.  Regardless of the content, a Monday morning filing would have been less provocative.  We have looked through to see what CAT may have been hoping to deemphasize. 

 

The disclosure that jumps out is that CAT had “incorrectly” reported impaired loans and finance leases at CAT Financial. Even the most ardent CAT optimist has to acknowledge that there have been issues with due diligence at CAT (e.g. Siwei).  “Incorrectly” disclosing impaired loans and finance leases may add to the perceived lack of management attention.  Having investors focused on a new red flag at CAT Financial is unlikely to be positive; cash has poured into receivables in recent years to support equipment sales, growing the unit’s infrequently discussed $35 billion in assets.

 

We also note additional language that disagrees with the history of resources related capital spending.  When commodity prices stall or decline, resources-related capital spending should return to maintenance-like levels over time.  CAT’s language suggests that they do not believe that the decline in Resource Industries sales is part of a return to normal levels of demand, not a departure from them.

 

There are other odds and ends, the key aspects of which we think can be gleaned from the quarter’s press release and earnings call.  It is not as though CAT reported an unexpectedly strong quarter.

 

 

Incorrectly Reported Impairments

 

Here is the new disclosure:

 

“During the second quarter of 2013, we changed the classification of certain loans and finance leases previously reported as impaired.  While these loans and finance leases had been incorrectly reported as impaired, the related allowance for these loans and finance leases was appropriately measured; therefore, this change had no impact on the Allowance for credit losses.  The impact of incorrectly reporting these loans and finance leases as impaired was not considered material to previously issued financial statements; however, prior period impaired loan and finance lease balances reported in Notes 4 and 8 have been revised.” – CAT and CAT Financials’ 2Q 2013 10-Qs

 

At first, the disclosure does not look all that interesting.  The impaired items were previously overstated and the accruals are reported to have been accurate.  However, the magnitude of the incorrect reporting and the lack of corrected historical replacement financials are of some interest.  Consider the table below:

 

CAT:  Incorrectly Impaired Red Flag? (10-Q Review) - cat1

 

 

This new disclosure raises questions, at least for us.  Did CAT’s management not realize that the disclosed Recorded Investment In Impaired Loans and Finance Leases With An Allowance was being incorrectly reported by ~30%-50% for at least a year?  Did CAT change the methodology to identify impaired loans to reduce the current reported balance and, presumably, those going forward?  Is this a red flag indicating further incorrect disclosures at CAT Financial or efforts to manage something?  We are pretty sure that CAT management does not want to be asked those kinds of questions following Siwei, Chanos and recent guidance cuts.

 

We do not want to make a mountain out of a mole hill, but context usually matters and these issues are often not isolated to a single item.  At the very least, we would have preferred some background on the cause of the incorrectly reported values.

 

 

What is “Normal”

 

We continue to think that the boom in resources-related capital spending was a deviation from historical norms and that recent declines are just a step back toward them.  CAT disagrees, judging by other comments and this disclosure on an anticipated cyclical recovery.

 

“Due to the substantial decline in Resource Industries' sales and the uncertainty around when cyclical recovery will resume, we have taken substantial action to adjust production levels and to reduce costs.” – CAT 2Q 2013 10-Q

 

This differing view may matter going forward in Power Systems, where many expect the stall in energy prices to have a different impact on energy-related capital spending (Power Systems) from that of stalled metals prices on mining capital spending (Resource Industries).  But we note that Power Systems is also under pressure:

 

“The lower sales were mainly due to decreases in electric power and industrial petroleum applications.”  – CAT 2Q 2013 10-Q

 

 

 

 


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