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THE FEROCIOUS AUGUST BEAR RAID

The bear raid in U.S. equities took its toll with a cumulative decline of 71 basis points over the last four days (#SarcasmAlert). We’ve been harping on this all year, but as the U.S. economy continues to transition from stabilizing to accelerating with labor and confidence hitting levels not seen since 2007, U.S. equities will continue to find a bid on any sell-off.

 

The longer term supporting bid in U.S. equities is, of course, the theme that our financials team has been focused with their recent launch on asset managers, which is the current (and we expect continued) outflows from fixed income assets as interest rates grind higher. 

 

This will only accelerate if U.S. economic data continues to come in strong.

 

THE FEROCIOUS AUGUST BEAR RAID - Bear Raid With closeup


Insight: JPM 2Q EARNINGS

Takeaway: This note argues why the current criticisms of JPMorgan's 2Q earnings quality seem misplaced. We also take a refreshed look at fair value.

This note was originally published July 12, 2013 at 12:11 in Financials

Insight: JPM 2Q EARNINGS - jpm 

(Editor's note: Hedgeye's Institutional Clients range from the country's largest mutual funds to the world's top hedge funds. For more information on Hedgeye's Institutional Research product offerings, please click here.)

 

Lateral Plays

 

JPM read throughs. We see Capital One (COF) as a clear winner when they report 2Q next week. The card results from JPM confirm our perception of accelerating underlying improvement in credit quality in the unsecured market. Also, the enormous Q/Q improvements in residential RE credit quality trends bode well for BofA (BAC) when they report next week.

 

 

Results Are Stronger Than They Appear

JPMorgan reported a strong second quarter (all things considered), a blueprint for how we expect the rest of earnings season to progress. That said, there are many size-able adjustments that bulls and bears alike can find plenty to like or take issue with in this report. Here's our take.

 

The printed number was $1.60 vs. the Street at $1.44. There’s lots of adjustments here, so let’s dig in.

 

  • First, the company posted a whopper of a reserve release at $1.356bn, or 23 cents per share. Consensus was looking for $1.26bn, or 21 cents per share . As such, that delta only accounts for 2 cents vs. Street numbers.
  • Second, the company posted a DVA benefit of 6 cents or $355mn from spreads widening. This is a tough one to make apples to apples adjustments to because, while we know there's a DVA benefit in the consensus estimate, we don't know how large it is. 
  • Third, they posted a 9 cent ($600mn pretax) charge for boosting litigation reserves.

Net, net we get to $1.60 less 2 cents (reserve release delta vs consensus) less 6 cents (DVA) = $1.52. Finally, if we give them the 9 cents in litigation reserve they pop back up to $1.61, and, if not, they stay at $1.52. Either way, they seem well ahead of the $1.44 estimate. Also, recall that the $1.44 already included some degree of DVA tailwind, so the true apples to apples number is likely stronger still.

 

Moving past the adjustments, here is a quick summary of some of the other notable items we spotted this quarter: 

  • NIM down 17 bps QoQ to 2.20% from 2.37%. Much of the decline was attributable to the company boosting cash levels by over $100 billion to meet LCR requirements. The interesting takeaway is that while NIM was down 7.2% Q/Q, Net Interest Income was down a much more benign 1.8% Q/Q. Also, taking a step back, if we look at the 7-quarter trend, we find that NII has been falling at trend-line rate of $202mn per quarter (Q/Q). This quarter's sequential decline of $208mn was essentially right in line with that trend. We're not cheering this as good news, but it is an important context factor relative to what appears to be horrible sequential performance in the NIM. Also, it's worth noting that the forward outlook is for stabilizing NIM in the back half and for NII to be sequentially higher in 3Q vs 2Q. For reference, in the last 7 quarters, NII has only advanced Q/Q once (4Q12).
  • Loan growth was negative 50 bps Q/Q. The outlook is for loan growth to begin to accelerate in the back half of the year as the company is reporting seeing early signs of a modest resurgence in loan demand.
  • Non-interest income was again strong this quarter, even after adjusting for DVA benefits. Clearly the Investment Banking business delivered stronger than expected results and Mortgage Banking held steadier than expected under the circumstances. Looking forward, the company clearly tempered expectations on the mortgage side, indicating that the current rate environment would lead to a 30-40% reduction in mortgage volume over the back half of the year. 
  • Efficiency was up Q/Q, rising to 61.1% from 59.7%, but is continuing its trend-line improvement since the start of last year. Looking back over the last 7 quarters, the company has driven efficiency lower by 1% per quarter (Q/Q). 
  • Credit quality was impressively strong this quarter. Supporting the massive reserve release, the company’s NPAs and NPLs were down, 4 and 9 bps, respectively. Meanwhile, coverage remained at 199% of NPLs in spite of the drawdown (flat with last 4 quarters).
  • Tangible book value per share advanced this quarter to $40.04 from $39.54 last quarter, and, importantly, has grown 12.1% in the last 12 months. This is in spite the London Whale fiasco. This quarter, the company posted a 13% return on equity and a 17% return on tangible equity.
  • Leverage Ratio - Yesterday's fanfare over the new supplementary leverage ratio requirements looks like it won't be a terribly big event for JPMorgan. To put things in context, the company is currently at a 4.7% leverage ratio under the new framework with a BHC requirement to get to 5% by 1Q18. They are generating a 16-17% return on tangible capital right now. If we gross up their capital base by 6% (5.0% / 4.7% = 106%), we find that that potential return on tangible equity compresses by roughly 100 bps, i.e. from 17% to 16%. On a fair value model for banks, a 100 bps compression in potential ROTE equates to roughly an 8% reduction in multiple to tangible book value. 8% of JPMorgan's $40 TBVPS = $3. However, based on the company's 16-17% ROTE, we estimate fair value is actually closer to 2x tangible book value (on a straight P/TBVPS : ROTE model (y = 9.4098x + 0.492) and on an EVA model (+3.2%) we estimate fair value is 1.73x TBVPS (y = 8.2686x + 1.4679), or $70-80 per share. So a $3 reduction in potential fair value seems de minimis relative to $15-25 upside.
  • Capital Return - The dividend was increased to 38 cents (2.7% yield) from 30 cents (2.2%) and the outlook for buyback remains unchanged.

The charts below look at the trends in net interest income, tangible book value growth vs. price and returns, the current relationship of return on tangible capital to price/tangible book value (good), the current relationship between EVA and price to tangible book value (better), the current upside/downside to fair value by bank based on our EVA model, and, finally, the 2Q earnings snapshot.

 

Insight: JPM 2Q EARNINGS - jpm 2

 

Insight: JPM 2Q EARNINGS - josh1

 

Insight: JPM 2Q EARNINGS - simple scatter

 

Insight: JPM 2Q EARNINGS - eva scatter

 

Insight: JPM 2Q EARNINGS - cheap cheap

 

Insight: JPM 2Q EARNINGS - jpm earnings

 

Joshua Steiner, CFA

203-562-6500

jsteiner@hedgeye.com

 

Jonathan Casteleyn, CFA, CMT

203-562-6500

jcasteleyn@hedgeye.com

 


JACK: STRATEGIC INITIATIVES ON TRACK

Following the release of 3Q13 results, we continue to believe that the long-term potential of JACK is underappreciated, particularly with respect to the future growth of Qdoba.  The company’s recent initiatives only enhance this view.

 


3Q13 Results


JACK reported 3Q13 adjusted EPS $0.03 above consensus along with a top line miss (-3.71%) that was in line with industry softness.  Company sales trends for the quarter were mixed as same-store sales for Jack in the Box fell short of expectations (+1.2% versus +1.8% consensus), while same-store sales for Qdoba came in above expectations (+0.5% versus -0.1% consensus).

 

 

Strategic Initiatives


In June 2013, upon completion of a strategic market review led by newcomer Tim Casey, the company announced plans to close 67 of its company-operated Qdoba restaurants.  We responded positively to this announcement in our note, “Jack: Right-Sizing The Qdoba Ship,” when we wrote:

 

                “The upside in JACK, as we have often written, is in the multiple assigned to the Qdoba business.  To the extent that it occurs, future upside to earnings is obviously also a positive.”


We continue to stand by this, and believe that CEO Linda Lang’s assertion that the closures are expected to result in higher future earnings, AUV’s, restaurant operating margin, cash flow and ROIC, will come to fruition.  To date, the company has closed 62 underperforming Qdoba locations, transferred 3 to a franchisee and will close the remaining 2 when their leases expire at the end of the year.

 

As for Jack in the Box’s refranchising strategy, they intend to sell 29 additional restaurants by the end of FY13 and an additional 60 by the end of FY14.  Upon completion, the company’s goal is to have between 80-85% of Jack in the Box locations franchised, which similar to the closure of Qdoba stores, should have a positive impact on financial performance.

 

 

JACK: STRATEGIC INITIATIVES ON TRACK - JACK OP MARGIN

 

 

Change at the Top


The company also announced this week that CEO Linda Lang plans to retire as of Jan. 1, 2014, and will be replaced by current President and COO, Leonard Comma.  We expect this transition to be seamless, as Leonard is well-respected within the industry and, in our view, fully capable of leading JACK in its future endeavors.

 

 

Potential Upside


In our view, the company’s aggressive move to restructure Qdoba is likely to improve the brand’s profitability and should provide investors with the confidence to assign the brand a growth multiple.  Due to this renewed growth profile, we see approximately 25% potential upside in the stock over the next 2-3 years.  Below we offer some more thoughts on 3Q13 results:

 

 

What We Liked

  • Strong strategic plays in refranchising and restructuring by Jack in the Box and Qdoba, respectively
  • Jack in the Box 3Q traffic improved sequentially from 2Q
  • Raised full-year restaurant operating margin guidance to 17-17.5%
  • Qdoba closures expected to add $0.15-$0.16 to FY13 EPS from continuing operations
  • Raised full-year operating EPS guidance to $1.72-$1.78
  • The company has $84.7m remaining in its stock buyback program that expires in Nov. 2014 and an additional $100m authorized for stock buybacks that expires in Nov. 2015

 

What We Didn’t Like

  • Jack in the Box company same-store sales were down in July
  • Scaled back full-year guidance for new Qdoba restaurants from 70-75 to 65-70
  • Qdoba margins decreased 270 bps to 20.6% in 3Q, driven by a combination of sales deleverage, commodity inflation, product mix changes and increased staffing levels
  • Competitive environment – seeing deep discounting from some casual diners as well as strong value plays by other QSRs

 

JACK: STRATEGIC INITIATIVES ON TRACK - JACKK CO SSS

 

JACK: STRATEGIC INITIATIVES ON TRACK - JACK FR SSS

 

JACK: STRATEGIC INITIATIVES ON TRACK - Qdoba SSS

 

 

 

Howard Penney

Managing Director

 


Early Look

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Client Talking Points

CHINA

A big macro day in China with Chinese CPI coming in at +2.7%, PPI declining for the 17th straight month down -2.3% year-over-year, and retail sales up a solid +13.2% year-over-year.  That last data point continues to be supportive of our view that Chinese GDP is in a phase transition from an export led economy with a focus on infrastructure build out, to a consumption driven economy, with a lower aggregate growth rate.

JAPAN

This Sunday we will get preliminary GDP numbers from Japan and this will be the focus of many global macro investors. The main event in global macro this year has been the rapid decline and volatility of the Yen.  In turn, this has supported strength in the U.S. dollar, which has implications across asset classes with varying degrees of correlations. We aren’t going to attempt to tell you where the number will come in.  That said, we continue to have conviction that regardless of any short term data, the Japanese will have to continue to stimulate, and aggressively so, in order to get anywhere in the zip code of their long run inflation target of 2% and nominal growth of 3%. To get to these targets, the Japanese policy makers will require a whole lot of “Control P” (printing), which makes the long run bear case on the yen very compelling.

SPY

The ferocious bear raid in U.S. equities took its toll with a cumulative decline of 71 basis points over the last four days (#SarcasmAlert). We’ve been harping on this all year, but as the U.S. economy continues to transition from stabilizing to accelerating with labor and confidence hitting levels not seen since 2007, U.S. equities will continue to find a bid on any sell off. The longer term supporting bid in U.S. equities is, of course, the theme that our financials team has been focused with their recent launch on asset managers, which is the current, and we expect continued, outflows from fixed income assets as interest rates grind higher.  This will only accelerate if U.S. economic data continues to come in strong.

Asset Allocation

CASH 33% US EQUITIES 26%
INTL EQUITIES 19% COMMODITIES 0%
FIXED INCOME 0% INTL CURRENCIES 22%

Top Long Ideas

Company Ticker Sector Duration
WWW

WWW is one of the best managed and most consistent companies in retail. We’re rarely fans of acquisitions, but the recent addition of Sperry, Saucony, Keds and Stride Rite (known as PLG) gives WWW a multi-year platform from which to grow. We think that the prevailing bearish view is very backward looking and leaves out a big piece of the WWW story, which is that integration of these brands into the WWW portfolio will allow the former PLG group to achieve what it could not under its former owner (most notably – international growth, and leverage a more diverse selling infrastructure in the US). Furthermore it will grow without needing to add the capital we’d otherwise expect as a stand-alone company – especially given WWW’s consolidation from four divisions into three -- which improves asset turns and financial returns.

MPEL

Gaming, Leisure & Lodging sector head Todd Jordan says Melco International Entertainment stands to benefit from a major new European casino rollout.  An MPEL controlling entity, Melco International Development, is eyeing participation in a US$1 billion gaming project in Barcelona.  The new project, to be called “BCN World,” will start with a single resort with 1,100 hotel beds, a casino, and a theater.  Longer term, the objective is for BCN World to have six resorts.  The first property is scheduled to open for business in 2016. 

HCA

Health Care sector head Tom Tobin has identified a number of tailwinds in the near and longer term that act as tailwinds to the hospital industry, and HCA in particular. This includes: Utilization, Maternity Trends as well as Pent-Up Demand and Acuity. The demographic shift towards more health care – driven by a gradually improving economy, improving employment trends, and accelerating new household formation and births – is a meaningful Macro factor and likely to lead to improving revenue and volume trends moving forward.  Near-term market mayhem should not hamper this  trend, even if it means slightly higher borrowing costs for hospitals down the road. 

Three for the Road

TWEET OF THE DAY

George Clooney knows more about retail than Bill Ackman. $JCP

@JeffMacke

QUOTE OF THE DAY

Shallow men believe in luck. Strong men believe in cause and effect.

- Ralph Waldo Emerson

STAT OF THE DAY

Japan's finance ministry released data Friday showing that the country's debt burden has topped 1 quadrillion yen for the first time. If you want to get specific, Japan's central government debt at the end of June was 1,008,628,100,000,000 yen. (CNNMoney)



Grind It Out

“Success is stumbling from failure with no loss of enthusiasm.”

-Winston Churchill

 

Four years ago, Keith, myself and Todd Jordan, our Managing Director of our Gaming, Lodging & Leisure team, embarked on a journey in which many people predicted we had little chance of succeeding at. With the support of our colleagues at Hedgeye, we entered the process to purchase the Phoenix Coyotes, a bankrupt NHL franchise.  Our proposal to purchase the team was seemingly received well (as you might imagine Keith played the lead role in that meeting!) and enabled us to become the key contender to own the team.

 

Our analysis of the situation in Phoenix was vintage Hedgeye. We started with a macro perspective that it was likely the ideal time to buy a distressed asset in the Phoenix region as housing was literally in free fall.  Our view was that housing would ultimately revert to the mean, and thus home prices would see a strong recovery, which would then drive discretionary spending on things like sporting tickets.  In the Chart of the Day, we show the improvement in home prices in Phoenix since that period.

 

We then took a hard look at the financials of the team (hat tip to our colleague Anna Massion for some good work here), we found a business that was bloated on the cost side with some easy pro-forma cost reductions.  On the revenue side, we developed a plan for steady revenue growth with the unique idea of playing five games in another market (think the Buffalo Bills playing in Toronto).  Even though we came to agreement with the NHL on the parameters of a purchase via a letter of intent, the deal ultimately fell through as we were unable to agree to terms on an arena lease.

 

At that point, we chalked it up as a loss, but a win on the learning side, and watched over the last couple of years as various other groups attempted, yet failed, to purchase the franchise.  With the advent of the new collective bargaining agreement in 2013, which from our view created a very compelling economic situation for smaller market NHL teams, we decided to revisit the opportunity, almost three and half years after first looking at the team.

 

Over the course of the last few months, we and our partner Anthony LeBlanc were able to put together a very intriguing financing package with a major hedge fund as the lender. With Anthony’s guidance, an arena lease was negotiated that exemplifies a true public / private partnership.  And finally we found a lead equity investor in my friend George Gosbee from Calgary, who is now the Governor of the franchise, and closed the transaction earlier this week.

 

For Hedgeye and our partners, the deal was a true lesson in perseverance and teamwork.  Quitting at any point would have been easy, but ultimately we persevered and put the puck in the net.  While we are quite excited about the prospects for NHL hockey in Phoenix, I will ease the minds of any NHL hockey fans out there . . .  despite owning a small piece of the team, you can be rest assured Keith and I won’t be getting on the ice any time soon!

 

Switching back to the global macro grind, we have a slew of data out this morning.  It was a big macro day in China, in particular with Chinese CPI coming in at +2.7%, PPI declining for the 17th straight month down -2.3% y-o-y, and retail sales up a solid +13.2% y-o-y.  That last data point continues to be supportive of our view that Chinese GDP is in a phase transition from an export led economy with a focus on infrastructure build out, to a consumption driven economy, with a lower aggregate growth rate.

 

This Sunday we will be getting preliminary GDP numbers from Japan and this will undoubtedly be the focus of many global macro investors. The main event in global macro this year has clearly been the rapid decline and volatility of the Yen.  In turn, this has supported strength in the U.S. dollar, which has implications across asset classes with varying degrees of correlations. 

 

We have a lot of things at Hedgeye, but a crystal ball is not one of them, so we aren’t going to attempt to tell you where the number will come in.  That said, we continue to have conviction that regardless of any short term data, the Japanese will have to continue to stimulate, and aggressively so, in order to get anywhere in the zip code of their long run inflation target of 2% and nominal growth of 3%. To get to these targets, the Japanese policy makers will require a whole lot of “Control P” (printing), which makes the long run bear case on the yen very compelling.

 

Back in the U.S., the ferocious bear raid in U.S. equities (to quote my colleague Christian Drake) took its toll with a cumulative decline of 71 basis points over the last four days (#SarcasmAlert). We’ve been harping on this all year, but as the U.S. economy continues to transition from stabilizing to accelerating with labor and confidence hitting levels not seen since 2007, U.S. equities will continue to find a bid on any sell off.

 

The longer term supporting bid in U.S. equities is, of course, the theme that our financials team has been focused with their recent launch on asset managers, which is the current, and we expect continued, outflows from fixed income assets as interest rates grind higher.  This will only accelerate if U.S. economic data continues to come in strong.

 

Our immediate-term Risk Ranges are now as follows:

 

UST 10yr Yield 2.57-2.73%

SPX 1

DAX 8

VIX 11.62-13.94

Yen 96.16-98.71

Copper 3.05-3.25

 

Have a great weekend with your friends and families!

 

Keep your head up and stick on the ice,

 

Daryl G. Jones

 

Grind It Out - Chart of the Day

 

Grind It Out - Virtual Portfolio


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