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Bulls (Still) on Parade

Here's a look at the epic move in the S&P 500 since we first made our call to go long U.S. equities. Stick with the game plan that's working. Get long growth, short fear.

 

Bulls (Still) on Parade - SPX YTD

 

To be sure, we are plenty bearish, on plenty of things, the things that are actually going down. But here's the point: bears have been mauled and have missed the move in equities for the better part of the year. Meanwhile, as money continues to flow from the bond market to avoid losses, equities will be waiting with open arms to receive this capital exodus.


BRAZIL AND MEXICO DEBATE THE “FLOWS VS. FUNDAMENTAL” ARGUMENT IN EMERGING MARKETS

Takeaway: The flows should continue to dominate (and influence) the fundamentals across many EM economies and asset classes.

SUMMARY BULLETS:

 

  • Without being overly simplistic about our #EmergingOutflows thesis (there’s a cumulative 183 slides of research accompanying two presentations backing our views), we think a protracted tightening of global credit conditions driven by sustained USD appreciation and a back-up in US interest rates will weigh on growth in EM fixed investment (via negative inflections in portfolio and FDI flows) and on growth in EM consumption (via a negative inflection in purchasing power as EM FX reverts to the mean).
  • It should be noted that domestic housing TRENDS, labor market TRENDS, credit TRENDS (both on the consumer and commercial fronts) and birth TRENDS all continue to support our bullish bias on the USD and US interest rates with respect to the long-term TAIL duration (email us to acquire a compendium of the relevant research notes).
  • Over the past three weeks, Brazil’s Bovespa Index has been outperforming on a rebound in commodity speculation, registering a +0.91 correlation to the CRB Index and a +0.86 correlation to the XLB SPDR (Materials Sector); those figures compare to its -0.35 correlation to the SPX. A widely-celebrated economic stabilization in China and a marginally less hawkish monetary policy outlook are also factors that have been recently supportive of Brazilian equities.
  • Flipping over to Mexico, the Dow Jones Mexico Stock Index has been outperforming for more idiosyncratic reasons,  registering a -0.71 correlation to the country’s 2Y sovereign yield and a -0.75 correlation to the country’s 10Y sovereign yield as investor capital has plowed back into the Mexican economy ahead of speculation that policymakers would unveil their first steps to open up the country’s decayed energy sector to private investment for the first time since it was nationalized back in 1938.
  • All that being said, however, we continue to think that as long as the core drivers of our #EmergingOutflows thesis remain intact, the flows should continue to dominate (and influence) the fundamentals across many emerging market economies – including Brazil and Mexico.
  • Moreover, both Brazilian and Mexican equities are within striking distance of bumping up against TREND resistance according to our quantitative models, so we are of the view that it’s actually a good spot to either A) book gains if you’ve played these immediate-term relief rallies on the long side; or B) short them if, like us, you’ve been patiently waiting for better entry prices from which to play our #EmergingOutflows thesis.

 

THE TREND IS YOUR FRIEND IN GLOBAL MACRO

When we last updated clients on our #EmergingOutflows thesis in a 7/19 note titled: “SEPARATING THE FOREST FROM THE TREES IN EMERGING MARKETS”, we plainly stated the following in the conclusion of the note:

 

“Various EM asset classes could bounce another +5-10% from here to their respective TREND lines of resistance without signaling any shift in our interpretation of the fundamentals.”

 

Well, unfortunately for value buyers of emerging markets, EM asset classes couldn’t even do that (% change in price since 7/19)!:

 

  • MSCI EM Equity Index: +0.8%
  • JPM EM FX Index: -0.5%
  • iShares JPM EM USD Debt Fund (EMB): -2.4%
  • Market Vectors EM Local Currency Bond Fund (EMLC): -2.1%

 

Two countries have, however, been able to stage semi-valiant relief rallies: Brazil (Bovespa Index up +6.2% since then) and Mexico (Dow Jones Mexico Stock Index up +4.8% since then). The aforementioned equity market gains compare to a regional median delta of +3.9%.

 

Obviously with our structural bear thesis across EM asset classes still very much intact, we think these dead-cat bounces are to be eventually faded.

 

In fact, both Brazilian and Mexican equities are within striking distance of bumping up against TREND resistance according to our quantitative models, so we are of the view that it’s actually a good spot to either A) book gains if you’ve played these immediate-term relief rallies on the long side; or B) short them if, like us, you’ve been patiently waiting for better entry prices from which to play our #EmergingOutflows thesis.

 

BRAZIL AND MEXICO DEBATE THE “FLOWS VS. FUNDAMENTAL” ARGUMENT IN EMERGING MARKETS - BOVESPA

 

BRAZIL AND MEXICO DEBATE THE “FLOWS VS. FUNDAMENTAL” ARGUMENT IN EMERGING MARKETS - MXDOW

 

Without being overly simplistic about our #EmergingOutflows thesis (there’s a cumulative 183 slides of research accompanying two presentations backing our views), we think a protracted tightening of global credit conditions driven by sustained USD appreciation and a back-up in US interest rates will weigh on growth in EM fixed investment (via negative inflections in portfolio and FDI flows) and on growth in EM consumption (via a negative inflection in purchasing power as EM FX reverts to the mean).

 

BRAZIL AND MEXICO DEBATE THE “FLOWS VS. FUNDAMENTAL” ARGUMENT IN EMERGING MARKETS - DXY

 

BRAZIL AND MEXICO DEBATE THE “FLOWS VS. FUNDAMENTAL” ARGUMENT IN EMERGING MARKETS - UST 10Y

 

It should be noted that domestic housing TRENDS, labor market TRENDS, credit TRENDS (both on the consumer and commercial fronts) and birth TRENDS all continue to support our bullish bias on the USD and US interest rates with respect to the long-term TAIL duration (email us to acquire a compendium of the relevant research notes).

 

From an intermediate-term perspective, however, the one major caveat to our thesis is the recent run-up in crude oil prices (Brent’s +7.1% run-up over the past 3M is aided by a -2% decline in the DXY over that time frame) that will undoubtedly serve as a headwind to domestic consumption growth here in 3Q.

 

BRAZIL AND MEXICO DEBATE THE “FLOWS VS. FUNDAMENTAL” ARGUMENT IN EMERGING MARKETS - OIL

 

We don’t have a high degree of conviction in any call on crude oil from here as it has decoupled dramatically from the rest of the commodity complex in recent months. That said, however, we continue to do work behind-the-scenes on why oil prices can go a lot lower from here over the long-term TAIL, but we aren’t yet ready to present those findings. Stay tuned.

 

“NOT SO FAST” SAYS BRAZIL

Over the past three weeks, Brazil’s Bovespa Index has been outperforming on a rebound in commodity speculation, registering a +0.91 correlation to the CRB Index and a +0.86 correlation to the XLB SPDR (Materials Sector); those figures compare to its -0.35 correlation to the SPX.

 

Additionally, China’s JUL growth data did not disappoint and showed exactly what the Politburo said they were going to deliver: economic stabilization. Recall that China is far and away Brazil’s largest export market at 17%. On the margin, economic stabilization in China is supportive of Brazil’s manufacturing sector, which, oddly enough, showed renewed weakness per the most recent data: Brazil’s Manufacturing PMI ticked down to 48.5 in JUL from 50.4 prior.

 

BRAZIL AND MEXICO DEBATE THE “FLOWS VS. FUNDAMENTAL” ARGUMENT IN EMERGING MARKETS - 6

 

Lastly, a slightly less hawkish monetary policy outlook has been supportive of Brazilian equities as well. The country’s benchmark IPCA CPI ticked down to a 5M-low in JUL (+6.3% YoY) and is now back inside BCB’s 4.5% +/- 200bps target range. More importantly, the IGP-M CPI which leads the official IPCA series by 1-2 quarters ticked down to a 13M-low of +5.2% YoY in JUL.

 

BRAZIL AND MEXICO DEBATE THE “FLOWS VS. FUNDAMENTAL” ARGUMENT IN EMERGING MARKETS - 7

 

That, coupled with the fact that BCB is now supporting the BRL by selling USD’s in the face of dollar declines, is supportive of the view that they may want to use the exchange rate to fight inflation going forward. The spread between 1Y OIS and the benchmark SELIC rate has tightened from a YTD high of 186bps back in late-JUN to “only” 104bps as of today (i.e. the swaps market sees less tightening, at the margins). Brazil’s fixed income market has exhibited a similar delta: 1Y sovereign yields are now trading at a 100bps spread to the SELIC, down from a YTD high of 137bps at the beginning of JUL.

 

BRAZIL AND MEXICO DEBATE THE “FLOWS VS. FUNDAMENTAL” ARGUMENT IN EMERGING MARKETS - 8

 

All that being said, however, we wouldn’t fight the tape here if the Bovespa breaks out above its TREND line; Brazil’s idiosyncratic GIP outlook is, in fact, supportive of continued strength in the country’s equity market for the time being – provided the BRL stabilizes around current levels (to date it’s been absolutely smoked, having declined just inside of -15% vs. the USD over the past 6M). 

 

BRAZIL AND MEXICO DEBATE THE “FLOWS VS. FUNDAMENTAL” ARGUMENT IN EMERGING MARKETS - BRAZIL

 

BRAZIL AND MEXICO DEBATE THE “FLOWS VS. FUNDAMENTAL” ARGUMENT IN EMERGING MARKETS - BRL USD YoY vs. HRM Commodity Basket YoY

 

As outlined above though, that’s not a call we expect to have to make at the current juncture, as the flows should continue to dominate (and influence) the fundamentals across many emerging market economies.

 

MEXICO CHIMES IN WITH A STARK “NO WAY, JOSE”

Flipping over to Mexico, the Dow Jones Mexico Stock Index has been outperforming for more idiosyncratic reasons,  registering a -0.71 correlation to the country’s 2Y sovereign yield and a -0.75 correlation to the country’s 10Y sovereign yield as investor capital has plowed back into the Mexican economy ahead of speculation that policymakers would unveil their first steps to open up the country’s decayed energy sector to private investment for the first time since it was nationalized back in 1938.

 

The latest on this front are the PRI and PAN’s recent proposals to the Mexican parliament. The PAN, which is the larger of the two main opposition parties in Mexico, kicked things off with a plan to allow for concessions and a framework for [eventually] partially divesting the government of its stake in the state-owned Petroleos Mexicanos (Pemex).

 

The ruling PRI’s plan was met with less enthusiasm from investors. Rather than outright concessions, where private companies take ownership of their share of oil at the well head, President Nieto opted for a profit-sharing model with private servicers getting a cost reimbursement and a pre-negotiated share of the net income.

 

The PRD might pose a challenge to any comprehensive overhaul, as both Jesus Zambrano (PRD president) and Andres Manuel Lopez Obrador (PRD’s former presidential candidate who came in 2nd to President Nieto in last year’s election) recently affirmed their intention to publically oppose anything that resembles privatization.

 

With the Pact for Mexico still intact and the PRI in a bargaining mood per party president Cesar Comacho, however, it looks like some form of this potentially game-changing legislation in Mexico’s energy sector will eventually be ratified.

 

If, however, the PRD can’t come to terms with amending the constitution, the PRI and PAN, along with the PRI-allied Green Party, control more than the two-thirds vote required to pass a constitutional change in both the lower house and Senate and could successfully pass the legislation regardless of the PRD opposition to the extent they can work out their – albeit not insignificant – differences.

 

Recall that Mexican crude oil production has been in secular decline since peaking in 2004 at 3.83Mbpd; JUL’s 2.48Mbpd production rate represents both an 18Y-low and a -35.2% peak-to-present decline). Needless to say, anything Mexican policymakers can do to get a jump-start on domestic energy production will be positive, at the margins, for Mexican economic growth and the country’s current account dynamics (Mexico’s latest crude oil exports-to-production ratio is ~44%).

 

BRAZIL AND MEXICO DEBATE THE “FLOWS VS. FUNDAMENTAL” ARGUMENT IN EMERGING MARKETS - 11

 

On the flip side, taxes and royalties from Pemex fund about 34% of Mexico’s public budget (Pemex paid roughly 55% of its $127B in revenue in taxes last year), so less direct taxation of Mexico’s oil and gas “industry” would have to be offset by credible reforms backing Nieto’s drive to broaden the country’s tax base.

 

To this tune, Mexico’s latest sovereign revenue/GDP ratio of 23.6% is well below the EM average of 30.7% and the G-7 average of 40.1%. If Nieto is unsuccessful in his drive, the country’s fiscal position will deteriorate, at the margins. To note, Mexico’s 2012 sovereign budget balance/GDP ratio of -2.5% (i.e. squarely in deficit territory) was -1.2 standard deviations below the trailing 10Y mean.

 

BRAZIL AND MEXICO DEBATE THE “FLOWS VS. FUNDAMENTAL” ARGUMENT IN EMERGING MARKETS - 12

 

BRAZIL AND MEXICO DEBATE THE “FLOWS VS. FUNDAMENTAL” ARGUMENT IN EMERGING MARKETS - 13

 

All in, we like economic reforms that are capitalist in nature as they tend to be positive for economic growth over the long run. Moreover, Mexico screens exceptionally well on our EM Crisis Risk Model, so, all things being equal, holders of peso-denominated financial assets have a considerably lower degree of tail risk to incorporate into their fundamental views.

 

BRAZIL AND MEXICO DEBATE THE “FLOWS VS. FUNDAMENTAL” ARGUMENT IN EMERGING MARKETS - Hedgeye Macro EM Crisis Risk Model Summary Table

 

All that being said, however, we continue to think that as long as the core drivers of our #EmergingOutflows thesis remain intact, the flows should continue to dominate (and influence) the fundamentals across many emerging market economies – including Mexico.

 

AND THE WINNER IS…

A decade of dramatic outperformance in emerging market asset classes has trained investors to eye country-specific fundamentals as idiosyncratic drivers of any one country’s currency or capital markets. In this scenario, it’s easy to see why the reporters at Bloomberg, Reuters, WSJ, etc. search for idiosyncratic reasons why XYZ country/asset class is appreciating and lose sight of the core top-down factors determining the direction of the flows.

 

In the midst of a potential phase change like this, however, investors would be better served paying attention to what’s going on “underneath the hood”:

 

BRAZIL AND MEXICO DEBATE THE “FLOWS VS. FUNDAMENTAL” ARGUMENT IN EMERGING MARKETS - 15

 

BRAZIL AND MEXICO DEBATE THE “FLOWS VS. FUNDAMENTAL” ARGUMENT IN EMERGING MARKETS - 16

 

Indeed, there remains an entire class of investors on the buyside that have never really seen EMs (or commodities) decline in price on a sustained basis – myself included! Don't get caught offsides thinking certain assets are cheap way up here (pull up just about any ~10Y chart of anything-EM and you'll know exactly what we mean).

 

Darius Dale

Senior Analyst


Retail Sales & Business Confidence: Solid Start to 3Q13

Conclusion:  Today’s Retail Sales and Small Business Confidence numbers were solid, extending the trend of broad improvement observed across the balance of the domestic macro over the last two quarters and offering some positive confirmation of the early 3Q13 strength signaled by the Labor Market and ISM figures for July.    

 

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U.S. MACRO -  Solid Start to 3Q13:   The Labor Market (initial claims) continued to show accelerating improvement in July while the ISM manufacturing and services surveys reflected a broad recovery off the lackluster activity that characterized the April-June period. 

 

As can be seen in the Economic Indicator Summary Table below, 3Q13 has started off solid with the preponderance of growth/activity indicators released thus far showing improvement on both a TRADE & TREND basis.  On balance, the July Macro releases have come in ahead of expectations according the Citi and Bloomberg Economic Surprise Indices.  

 

Retail Sales & Business Confidence: Solid Start to 3Q13  - US Indicator Summary 2

 

Retail Sales & Business Confidence: Solid Start to 3Q13  - Economic Suprise Index 

 

RETAIL SALES:  Monthly Retail sales are volatile, subject to notoriously large revision, and reported in nominal dollars but, still, it’s hard to ignore a component responsible for roughly a third and a quarter of PCE and GDP, respectively.   

 

The first read on consumer spending in 3Q13 came in healthy with July Retail sales ex-Autos accelerating to 0.5% MoM (vs. 0.1% in June) while Sales excluding Autos & Gas accelerated to +0.4% MoM (vs. 0.0% in June).   

 

On a year-over-year basis, growth slowed modestly across each of the primary aggregates with Total Retail Sales, Sales ex-Autos, and Sales ex-Auto’s and Gas slowing 50bps, 30bps, and 40bps, respectively.  On a 2Y basis, however, all three measures accelerated modestly in July. 

 

All in, not a game changer or positioning catalyst, but a positive update for consumer spending to start the third quarter.   

 

We’ll be interested to see the Personal Income data for July (8/30 Release) and the impact of the furloughing of federal workers on aggregate disposable income growth – which has been treading water at a lackluster  ~+2% YoY.   As a reminder, we expect income growth for federal workers (~2% of the total workforce) to grow approx -7% over the balance of the fiscal year due to the combination of  furloughs and employment declines.  The impacts, while moderate, should constrain the upside in disposable income growth and consumer spending in 3Q13.  

 

Retail Sales & Business Confidence: Solid Start to 3Q13  - Retail Sales Table July

 

Retail Sales & Business Confidence: Solid Start to 3Q13  - Retail Sales

 

NFIB Small Business Optimism:  The NFIB Small Business Optimism Index climbed to 94.1 in July from 93.5 in June.  Under the hood, the outlook for general business conditions deteriorated sequentially although (somewhat incongruously) hiring plans, sales expectations, and job openings all advanced. 

 

The directional TREND in the consumer and business confidence metrics provides a better read on sentiment than any one data point in isolation and the larger trend in small business confidence remains positive and in agreement with the ongoing advance in the lead measures of consumer confidence.  

 

Retail Sales & Business Confidence: Solid Start to 3Q13  - NFIB Table

 

Retail Sales & Business Confidence: Solid Start to 3Q13  - NFIB Optimism

 

 

With labor, credit, and confidence trends all showing ongoing improvement and with a diminishing fiscal drag and easier comps as we annualize sequestration and the tax law changes into 2014, the growth dynamics for the U.S. economy,  and prospects for the U.S. Dollar and U.S equities remains favorable.  Consumption growth faces some constraints in the near term and congress will likely re-emerge as a negative catalyst in some form in the coming weeks, but, fundamentally the data continues to support a constructive outlook for domestic growth

 

 

Christian B. Drake

Senior Analyst 

 

 


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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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