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YUM: BUY THE CONTROVERSY

We continue to be buyers of the negative headlines in China.

 

 

July Sales Disappoint...

 

YUM is trading down following yesterday’s release of July comps for the China Division.  While it is important to see the China Division return to positive same-store sales, we believe how they get there is more important than when.  YUM’s management continues to warn investors that the Chinese business will be spotty, but expects same-store to turn positive in 4Q.  At this point, we believe management may be regretting guiding to a 4Q13 recovery in China comparable sales.

 

YUM estimates that same-store sales in July were down -13% in the China Division versus expectations of a -4% decline (StreetAccount), with KFC down -16% and Pizza Hut up +3%.  We were secretly hoping for the company to come off the long standing expectation of a 4Q13 recovery to positive same-store sales.  After two consecutive months of sequential improvements (in May and June), expectations have risen for a continued sequential improvement in comparable sales trends moving forward.  The difficulty in projecting these trends comes in the face of conflicting macro data points in China, but, the continued easing of Avian flu issues and very easy comparisons will certainly benefit the reported results for the balance of the year.

 

Attempting to parse the macro environment in China and its implied impact is a significant challenge, but the underlying tone of the more discretionary +3% same-store sales at Pizza Hut certainly raises a red flag.  Perhaps even more so than the KFC numbers, as it is obvious the brand is still seeing the lingering effects of December poultry issues and other supplier concerns.

 

 

Buy the Dip

 

With the reality of a soft top-line now common knowledge, we believe the real driver of sentiment moving forward will be the slope of the line in the margins of the China Division.  China margins held up better than expected in 1H13, despite significant declines in traffic and mix, as YUM benefitted from lower food costs and improved labor productivity.  We expect margins in 2H13 and 2014 to improve concurrently with an improvement in same-store sales.  The company has previously acknowledged that they need mid-single digit same-store sales growth in China in order to fully offset inflation, and we believe a continued internal focus on margin management will lead to better than expected earnings in 4Q13 and 2014.

 

Buying into negative news is never an easy task, but YUM’s management team has proven over time that this is the right course of action to take.

 

 

YUM: BUY THE CONTROVERSY - YUM SEQ

 

 

 

Howard Penney

Managing Director

 


The Queen Mary of Macro Trends

Takeaway: The seismic shift in interest rates will certainly be one of the most critical factors over the coming quarters and years.

(Editor's note: The excerpt below is from this morning's "Morning Newsletter." For more information on how you can become a subscriber, click here.)

 

The Queen Mary of macro trends has inflected– We often use the analogy of the Queen Mary turning to describe the long term trend in interest rates.   The Queen Mary, of course, is the massive ocean super liner that dominated transatlantic voyage before the jet age.  Like any vehicle that is more than 300 meters in length, turning the Queen Mary was no easy task and not without its implications.

 

The Queen Mary of Macro Trends - 10Y Treasury

 

This analogy is appropriate for interest rates as they have literally been in decline for the last 30 years since peaking in the early 1980s.  This long term decline has enabled any business that depends on borrowing money to fund its business to have a steadily declining cost of capital.  In addition, this has made bonds a compelling asset class with a long term underlying bid to price.

 

In our models in Q2, yields inflected notably and broke out above our TRADE, TREND and TAIL levels.  In fact, as shown in the Chart of the Day, 10-year yields had their largest percentage increase quarter-over-quarter in more than a decade.  Even though 10-year yields have broken out, they remain well below the mean yield since 1989 of 5.21%.

 

As volatility in an asset class increases, so too does the expected loss and/or return.   According to Merrill Lynch’s MOVE index, bond volatility has almost doubled in the last quarter and is at two year highs.  Meanwhile duration is at close to all-time highs.  My colleague Jonathan Casteleyn of our financials team highlighted this in his recent presentation on asset managers (ping sales@hedgeye.com if you haven’t seen it yet), but based on current duration a roughly 100 basis point move in yields equates to a 8.9% loss on the 10-year treasury.

 

In part we are already starting to see the sort of generational losses in bonds that we should expect from the dynamics outlined above.  Specifically, the Barclay’s Aggregate Bond Index is set for its first loss in 14-years and only third loss since 1990.  While gentleman may prefer bonds, they don’t prefer losses.

 

The reality in markets is that there is rarely "One Thing" that dominates, but the seismic shift in interest rates will certainly be one of the most critical factors over the coming quarters and years.  As money flows from the bond market to avoid losses, equities will be awaiting with open arms.

 


EVEP 2Q13 Review: Bumping Up Against Debt Covenant

Summary Bullets:

  • Short EVEP remains a Hedgeye Best Idea (added 4/26/13 at $47.00/unit);
  • 2Q13 results were in-line, no change to 2H13 guidance, an uninteresting quarter operationally;
  • 1st Utica acreage monetization was NOT a positive surprise;
  • EVEP is pushing up against its total leverage covenant and likely needs to issue equity in the next six months;
  • EVEP is now capitalizing a material amount of interest, and maintenance capex is likely understated; both items are "artificially" boosting DCF.

 

2Q13 results in-line……Adjusted EIBTDA came in at $52.6MM vs. $55.6MM consensus, and DCF of $0.61/unit (0.80x coverage) was in-line.  For the quarter, we have clean EPU of $0.13, FCF of -$0.96/unit, CF of $0.93/unit, and open EBITDAX of $42.4MM.  EVEP maintained 2H13 guidance.  Operationally, it was an uninteresting quarter.   

 

Utica acreage sale #1 was NOT a positive surprise……EVEP popped 9% on Friday morning as, in our view, investors mistakenly extrapolated EVEP’s sale of 4,345 net acres in Guernsey, Noble, and Belmont counties for $56MM, or $12,900/acre, over its entire package for sale.  This is by far EVEP’s best Utica acreage, and the price tag is neither surprising nor indicative of potential prices for its other acreage packages.  We were modeling $20k/acre for the Guernsey acreage.  In late June 2013, Eclipse Resources acquired ~49k net acres in the core of the Utica (Guernsey/Belmont/Noble/Monroe counties) from The Oxford Oil Company at a price between $10k - $15k/acre (exact terms not disclosed).  Prospectivity of the play varies across EVEP’s acreage, and the acreage sold was largely in the “core of the core.”   We assume that EVEP monetizes 45,000 net acres in the wet gas window of the Utica for $205MM (~$4,500/acre), including the package already sold, between now and the end of 1Q14.  The big piece is the 11,000 net acres in Carroll County (mostly in the NW corner of Carroll County).  We model $5k/acre, though with CHK dominating Carroll County Utica leasehold, it’s more difficult to handicap.   

 

Total leverage covenant is a problem……EVEP ended 2Q13 just inside its total debt to adjusted EBITDAX covenant of 4.25x.  We estimate that EVEP has to come up with ~$150MM of cash before the end of 3Q13 to stay compliant with that covenant.  The first Utica acreage sale for $56MM has them in need of another ~$100MM cash before quarter-end.  It will likely come in the form of either additional Utica acreage sales and/or an equity raise.  The situation does not improve from there, as EVEP will again be bumping up against the total leverage covenant in 4Q13.  Bottom line – unless EVEP can manage a large asset-for-equity deal, we believe that a ~$200 - $250MM secondary needs to happen within the next 6 months.  Either way, equity is needed to remedy a stretched capital structure and liquidity position ($520MM drawn on the $710MM borrowing base).

 

EVEP capitalized 17% of interest expense in 2Q13……EVEP started capitalizing interest in 4Q12 when it began investing heavily in its unconsolidated midstream affiliates (UEO and Cardinal).  In 2Q13, EVEP capitalized $2.4MM of interest, which was 17% of total interest paid and 9% of DCF.  EVEP is certainly permitted (under FASB Statement No. 34) to capitalize the interest associated with the midstream build-out, but we consider it somewhat aggressive as capitalizing interest increases DCF, which is the key metric for an MLP like EVEP, and the metric most use to value the equity.  It doesn’t sit right with us to see a serial capital raiser capitalizing a material amount of interest paid.  If EVEP expensed this interest paid, and deducted all GAAP interest expense from DCF, then DCF would have been $23.1MM, for 0.71 coverage, vs. reported $26.1MM and 0.80 covereage.

 

EVEP 2Q13 Review: Bumping Up Against Debt Covenant  - evep1      

 

Maintenance capex remains below 2012 trend……Maintenance capex in 2Q13 came in at $14.7MM, or $0.94/Mcfe produced.  This was 48% of total capex, $30.7MM, and is roughly half of the DD&A rate, $1.76/Mcfe.  The maintenance capex rate of $0.94/Mcfe suggests that EVEP is one of the most efficient E&Ps with the drill bit in North America, though its annual reserve replacement statistics paint a different picture, such as its $4.49/Mcfe Drill Bit F&D Cost (excluding revisions) in 2012.  EVEP’s maintenance capex took a curious step change lower in 1Q13, coming in at $13.6MM, falling 29% QoQ, and coinciding with the Company’s drop in DCF and distribution coverage.  Maintenance capex remains below 2012 trend by $4 – 5MM, which is ~17% of DCF.  We believe that EVEP’s maintenance capex is understated, and as a result its DCF overstated.     

 

Don’t worry, be happy……EVEP’s Executive Chairman John Walker said this on the 2Q13 conference call: “I want to thank those analysts who took the time to really understand EVEP and the Utica play, as well as our investors who hung in there as our unit price fell into the low 30’s. I wish that we or myself personally, at EnerVest and EVEP could have bought units as the price declined, but we've had restrictions on buying or selling EVEP units since last year because of our ongoing negotiations. Again thank you very much.”  No comment necessary. 

 

 

Kevin Kaiser

Senior Analyst


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Morning Reads on Our Radar Screen

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

Jay Van Sciver – Industrials

AMR-US Airways Deal Blocked by U.S. in Antitrust Suit (via Bloomberg)

 

Morning Reads on Our Radar Screen - 4488

 

Brian McGough – Retail

Ackman quits J.C. Penney board three years into turnaround push (via Reuters)

 

Josh Steiner – Financials

The many legal millstones weighing down JPMorgan (via AZCentral.com)

A.G. Schneiderman Sues Western Sky Financial And Cashcall For Illegal Loans Over Internet (via New York Attorney General Office)

 

Keith McCullough – CEO

Yet another US #GrowthAccelerating data pt for July > U.S. July Small-Business Optimism Index Rises to 94.1 (via Dow Jones)

Xinjiang violence: Two sentenced to death in China (via BBC)

 

Daryl Jones – Macro

LINN Energy not worth more than $18.00, Barron's says (via the fly on the wall)

 

Jonathan Casteleyn – Financials

Public Pensions Up 12% Get Most in 2 Years as Stocks Soar (via Bloomberg)

 

Matt Hedrick – Macro

Irish Banks Chasing Defaulters Who Sleep Well at Night (via Bloomberg)


Gentlemen Prefer Bonds?

Client Talking Points

UST 10YR

Get this: 10-year yields had their largest percentage increase quarter-over-quarter in more than a decade.  And while 10-year yields have broken out, they remain well below the mean yield since 1989 of 5.21%. Meanwhile, the Barclay’s Aggregate Bond Index is set for its first loss in 14-years and only third loss since 1990.  We are already starting to see generational losses in bonds. So while gentleman may prefer bonds, they don’t prefer losses. Our immediate-term Risk Ranges for UST 10YR is 2.57-2.74%.

SPY

Stick with the game plan that's working. Long growth, short fear. Look, we're bearish on plenty of things that are actually going down - but U.S. stock bears have been mauled and have missed this epic move in equities for the better part of the year. As money continues to flow from the bond market to avoid losses, equities will be awaiting the capital exodus with open arms. Our immediate-term Risk Range for the S&P 500 is 1680-1714. 

Asset Allocation

CASH 33% US EQUITIES 25%
INTL EQUITIES 20% 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

Cumulative construction shortfall since start of 2011 is ~3 million. Imbalance is supportive of both rising home prices and financials $XLF. @HedgeyeFIG

QUOTE OF THE DAY

“An economist is an expert who will know tomorrow why the things he predicted yesterday didn't happen today.” - Laurence J. Peter

STAT OF THE DAY

Is Best Buy the best comeback stock story of 2013? BBY up +158% in 2013 after falling -49% in 2012.



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