prev

She's Absurd

This note was originally published at 8am on August 08, 2013 for Hedgeye subscribers.

“So I hope you can accept nature as She is – absurd.”

-Richard Feynman

 

That’s what one of America’s great physicists, Richard Feynman, had to say about how quantum mechanics explains life. I think it describes markets well too. It “describes nature as absurd from the point of view of common sense. “ (American Prometheus, pg 79)

 

What Do You Care What Other People Think?” Good question. That was also the title of the book Feynman published in the year of his death (1988). It’s a question that I’d love to hear almost everyone in this profession answer out loud.

 

Yesterday, I asked you if the latest bear market correction was going to be 1%, 2%, or 5%. In case you care what consensus thinks, not one of you answered 1% (which means it’ll probably be 1%). Yesterday’s -0.4% drop in the SP500, put the 2-day correction from her all-time high at -1.1%. #Absurd

 

Back to the Global Macro Grind

 

I know, the absurdity of challenging perceived wisdoms in one of the last professions that has been forced to face the fiddle of accountability. If you don’t want to see any of it, turn Twitter off and watch the channel the rest of us have on mute.

 

To review reality (2013 YTD):

  1. Consensus came into 2013 long slow growth, Gold, and Bonds
  2. Consensus is now selling slow growth, Gold, and Bonds, but too scared to buy growth

But not just any kind of growth – our nature is to not buy “expensive” looking growth. Absurdly, in a growth investor’s market, expensive gets more expensive (Tesla, TSLA +18% pre-market).

 

“Oh, so you’re telling me growth is back Mucker? Ok, then I’m going to go buy an Emerging Market”

 

No.

 

As you can see in Darius Dale’s Chart of The Day, Emerging Market Growth is SLOWING as the slope of US and Japanese Growth is ACCELERATING (and large components of European growth is STABILIZING).

 

Just model the slopes of lines. Simple is as simpleton does from Thunder Bay, Ontario. In our GIP (Growth, Inflation, Policy) model here @Hedgeye, the G and I (Growth and Inflation) are doing 1 of 3 things from a slope perspective:

  1. SLOWING
  2. STABILIZING
  3. ACCELERATING

And that’s just about it.

 

Markets pay a higher multiple for companies showing what?

  1. Revenue Growth Accelerating
  2. Margins Expanding

So why is my macro model considered so absurd? It’s the same thought, but for countries:

  1. GDP growth going from slowing to stabilizing to accelerating = LONG
  2. GDP growth going from accelerating to slowing (on the margin) = SHORT
  3. Inflation slowing (via strong currency) + GDP Growth accelerating = REALLY LONG

That’s 2013:

  1. US employment, housing, and consumption growth went from slowing (Q412) to stabilizing, to accelerating
  2. Emerging Market growth (China, Brazil, etc) went from slowing to slowing at an accelerating pace

All the while, July’s YTD high in #StrongDollar gave local inflation to “emerging markets” like India as the Rupee started to crash. Show me GDP Growth Slowing + Inflation Accelerating (India) and I’ll show you a stock market that is down YTD.

 

I’m not sure why I went off on all of this today. Probably just a function of the absurdity of me having to come up with something in 45 minutes or so at the top of the risk management morning. Thanks for reading my rant.

 

Our immediate-term Risk Ranges are now as follows:

 

UST 10yr Yield 2.57-2.73%

SPX 1676-1714

DAX 8233-8456

VIX 11.62-13.94

Yen 96.16-98.71

Copper 3.05-3.25

 

Best of luck out there today,

KM

 

Keith R. McCullough
Chief Executive Officer

 

She's Absurd - Chart of the Day

 

She's Absurd - Virtual Portfolio


CAT: The Next Move

Summary

 

On its 2Q earnings call, CAT hinted at potential new cost actions to be specified in coming weeks.  While we do not know exactly what they might be, we discuss some expectations below.  More aggressive cost reductions may make for a good press release, but the new cost cuts are unlikely to represent a meaningful acceleration from the actions already taken.  As we see it, high costs are not the issue for CAT; rather, a deflating bubble in resources-related capital equipment, increasing price competition and overpriced/poorly-timed investments are the problems.  In addition, deep cost actions could further undermining the 2009 downturn comparison we hear so much about from CAT longs.  The shares may rally on a headline cost cut announcement, but we would look to fade that optimism.

 

 

This Is Not 2009:  CAT Out of Cost Flexibility?

 

The current downturn for CAT bears little resemblance to the one during the financial crisis.  For starters, the drop in demand is specific to CAT’s end markets, not broader economic conditions.  Mining equipment prices increased in 2009, while they have started to fall as of 2Q 2013.  CAT apparently had “trough plans” ready in the last downturn, while frequent guidance cuts suggest that CAT has been caught off guard by recent weakness.  Notably, the inventory situation was much more favorable in 2008/2009.  To quote Jim Owens, “I think our ability to do a better job on the pricing front than you might have expected goes back to inventory management and not overstocking dealer inventories with product that was in the wrong product in the wrong place…” (James W. Owens, not Doug Oberhelman, 8/3/2009)

 

To the extent upcoming actions require a costly restructuring, it would add an additional difference between the current downturn and CAT’s performance through the financial crisis.  In 2009, CAT was impressively able to rely on its flexible cost base until Chinese stimulus, among other factors, buoyed both commodity prices and CAT’s resources-related capital equipment end markets.  In the current downturn, CAT has already been flexing that flexible cost base.  We suspect that recent acquisitions and capacity additions have reduced CAT’s cost flexibility.  A deeper restructuring may suggest that CAT is running short of cost flexibility.

 

 

What to Cut:  Labor, Assets, Capital Spending?

 

 

Headcount Reductions: Been There, Done That

 

CAT has already reduced headcount, with a YoY decline of about 13,500 employees worldwide, net of divestitures and including declines in its ‘flexible’ workforce.  Full-time employment was 122,402 at the end of the second quarter and we estimate that ‘flexible’ employment adds 15,000-20,000 more. 

 

Excess headcount does not appear to be CAT’s key problem.  Revenue per full-time employee compares favorably with historical averages, especially considering that Bucyrus registered lower values than CAT prior to acquisition.  While growth in flexible labor reduces comparability with earlier periods, flexible labor should not represent a cost action challenge.  While we think headcount was implied as a cost target on the 2Q 2013 earnings call, we do not expect cuts to extend beyond a single-digit thousand number.  In so far as that is the case, the new actions could be smaller than those already taken over the past year. They may just be more expensive.  The headcount actions taken so far have not boosted CAT’s results relative to expectations, in part because they do not solve the key problem, which is declining demand for resource-related capital equipment.

 

CAT: The Next Move - hg

 

 

Assets:  Facility Rationalizations and Asset Impairments

 

As we see it, CAT overinvested in resources-related capital equipment assets.  It significantly overpaid for acquisitions and added production capacity at the peak of the cycle.  Receivables growth amid falling equipment revenue suggests that recent sales might have been even lower without the extension of credit.  A BUCY goodwill impairment would probably be greeted as good news, if for no other reason than it could stop being a question on earnings calls.  Unfortunately, that testing will likely have to wait until year-end.

 

Downscaling or closing facilities beyond the current rolling plant shutdowns and reduced schedules may prove messy and time consuming.  CAT’s facilities are frequently integrated among the different segments and serve different steps in the production process, potentially making it challenging to isolate Resource Industries and weaker areas of Power Systems.  Facilities that can be isolated have already had layoffs in some instances.  Problematically, CAT has added capacity at many mining exposed plants in the last few years, potentially leaving lightly depreciated assets on the chopping block. Challenges aside, we suspect that this is an area where CAT could use more aggressive actions.

 

CAT: The Next Move - hg2

 

 

Capital Spending

 

CAT’s guidance for capital spending in 2013 is for less than $3 billion, matching consensus at just under $3 billion.  It is odd that CAT has continued to add PP&E in Machinery and Power Systems amid a downturn.  This may be a desire to complete “in flight” capital projects, but capital spending slowed relative to depreciation and amortization in 2Q 2013.  CAT may well take capital spending down more aggressively in the back half of the year, which we would generally view as a good idea amid excess capacity in many product areas.

 

 

Charges and Guidance

 

To the extent CAT management takes charges in an announced restructuring, it could provide an opportunity to revise guidance.  CAT’s management is likely under significant pressure to meet its current $6.50 guidance mid-point, which we think is it is not likely to reach (as discussed in When 795F’s Fly).  If CAT uses charges to redefine guidance or back out operating expenses as special, it could backfire.  Investors may well be tired of having their expectations managed (see Feeling Managed?).  While it might boost the stock for a day, we think it would be a bad move for a company increasingly under short-seller scrutiny for its reporting.

 

 

How Worried Should Shorts Be?

 

While a significant cost reduction headline could squeeze short sellers (short interest has increased this summer to nearly 5% of the float), we would view that squeeze as an exit opportunity for longs stuck in the CAT value trap.  CAT does not really have a cost problem; it has an end-market demand problem, a historical capital allocation problem and an industry overcapacity problem.  CAT’s flexible cost structure has been delivering, but cost actions cannot correct those broader challenges.  To the extent that CAT management again tries to manage investor expectations, those maneuvers may meet increased investor skepticism.  Given what significant restructuring actions might imply for CAT’s market outlook and cost flexibility, CAT could even decline on such an announcement.

 

 


Europe: It's Getting Interesting

(Editor's note: Below is a brief excerpt from Hedgeye CEO Keith McCullough's conference call with investors earlier this morning. For more information on how Hedgeye can help you, please click here.)

Europe Across-The-Board

I am interested in buying Germany here. Have not done that yet. We went with the UK index instead.

 

Europe: It's Getting Interesting - hed1

 

The UK index is interesting—I had a lot of questions on that yesterday because it’s obviously not all the UK. It’s kind of a back-door way to play this broadening theme of Europe—I wouldn’t say “recovering,” I would say "not going to hell in a hand basket." That’s the most appropriate way to describe what’s going on there right now.

 

If you’re just to look at this mathematically, which is the slope of the line—you can characterize something with words however you want—but the slope of the line has stabilized in Europe. In the big places. Over in the UK, it’s actually accelerating. And that’s just the point. That’s why those markets are interesting.

 

That’s also why the bond markets are not interesting. In fact, they look like shorts. Whether you look at the the German bond market, or the UK bond market, they look like hell. They look like the US bond market does because again, rates are rising. And it’s not just in the US, because these things follow the slope of growth which at a bare minimum in Europe is not slowing anymore, which is of course bullish on the margin if you’re looking at the slope of the line. 


Daily Trading Ranges

20 Proprietary Risk Ranges

Daily Trading Ranges is designed to help you understand where you’re buying and selling within the risk range and help you make better sales at the top end of the range and purchases at the low end.

DRI: RESTRUCTURING CHARGE LOOMING?

Over the past year, DRI has underperformed the S&P 500 and the XLY by 26.9% and 39.3%, respectively.  These numbers make DRI the second worst performing casual dining company, only behind BJRI, during this period.

 

Since the end of FY12, DRI has lowered its annual guidance 3 times.  A consistent lowering of guidance indicates that management does not have a feasible plan to fix the company and, given the current industry conditions, things may be getting worse before they get any better.

 

Below we run through three signs that suggest management is struggling to fix the company and lead us to believe that they will lower guidance moving forward and could, potentially, announce a restructuring charge:

  1. Shrimp prices are up +56% YoY
  2. The company has supply chain issues
  3. July and August sales trends look to be well below industry trends

 

Shrimp Prices – Urner Barry’s White Shrimp Index has shrimp priced at around $6 a pound, up +56% YoY and approaching an all-time high.  The main culprit:  the emergence of a disease that has severely reduced shrimp output in China, Thailand and Vietnam.

 

 

Supply Chain Issues – In late June and early July, the FDA linked the outbreak of a rare parasite found in Iowa and Nebraska to a salad mix produced by Taylor Farms de Mexico.  This salad mix was served at an undetermined number of Olive Garden and Red Lobster restaurants in these two states. 

 

Since that time, nearly 500 people have been sickened in 16 states, while at least 30 more have been hospitalized.  While DRI has not been linked to all the foodborne illness incidents, its initial association with the outbreak was not good news for company.  We can only wonder whether all of the DRI cost cutting initiatives, particularly in its supply chain, led to this unfortunate incident.

 

 

Sales Trends – DRI’s discounting strategy began to move the needle on traffic in 4Q13, but it came at the expense of margins.  We believe there is a potentially disastrous situation brewing in FY1Q14, whereby DRI’s discounting efforts are not having the desired impact on traffic, causing a more severe blow to margins than expected.  This scenario, combined with significantly higher food inflation in FY14, leads us to believe DRI could be looking at significantly lower earnings in FY14.

 

 

Restructuring Charge


As we have said many times before, DRI is being mismanaged, plain and simple.  DRI’s 4Q13 earnings call underscored our argument that the company needs a shakeup in the C-Suite.  When approximately $1 billion in annual operating cash is not being put to productive use and a company’s leadership team consistently disappoints, this suggests that they do not have the ability to turn the company around. 

 

That said, we believe DRI’s performance over the past five years has been consistent with that of a mismanaged business and one that will need a massive undertaking to fix.  In the end, this may include rationalizing the assets of the business.

 

Hedgeye’s Take – The sum of the parts is greater than the whole, at Darden, and we believe there is a striking opportunity for an activist to enter the fray, unlock value and, ultimately, benefit shareholders.

 

 

DRI: RESTRUCTURING CHARGE LOOMING? - DRI COGS

 

DRI: RESTRUCTURING CHARGE LOOMING? - RL SRS

 

DRI: RESTRUCTURING CHARGE LOOMING? - OG SRS

 

DRI: RESTRUCTURING CHARGE LOOMING? - LH SRS

 

 

 

Howard Penney

Managing Director

 


Bullish on the Union Jack

This note was originally published August 16, 2013 at 09:45 in Macro

  • Bullish position on the UK (etf: EWU) and Germany (EWG) remains.
  • Eurozone fundamentals inching higher; investor sentiment improving on weak comps. On a relative basis the Eurozone is well below its historical growth average and churning only modestly higher as deep structural imbalances and the lack of credit drag on growth.
  • We underline the significance of Eurocrat and ECB resolve to lend support to the region and markets (at all costs), which, along with marginally better data, should continue to support Eurozone capital market performance.

Bullish on the Union Jack - uk7 

UK’s Island Economics


In support of our fundamental bullish call on the UK economy since our June 11th European update presentation titled “Where Does Europe Go From Here”, yesterday the UK printed a strong Retail Sales figure of 3.0% in July year-over-year (exp. 2.4%) vs 1.9% JUN.

 

The print and the down move in the FTSE100 yesterday prompted us to add the UK via the etf EWU to our real-time portfolio positions on the long side.

 

Bullish on the Union Jack - hed1

 

Bullish on the Union Jack - z. uk retail and IP

 

Our outlook on the UK is data and price dependent and hasn’t changed: we expect to see outperformance from the UK economy versus many of its European peers due to its decision to issue austerity earlier in the fiscal consolidation cycle. We are now seeing stronger signs of improved consumer sentiment, and expect PMI readings to maintain their level above the 50 line (expansion) into year-end. Beyond retail sales, industrial production and housing figures have improved year-to-date, and while wage volatility and sticky stagflation persist, we view reductions in the saving rate as another indicator of improved sentiment.  Further, we’re bullish on the changing of the guard at the BOE to Mark Carney – while it’s up for argument on just how effective tying monetary policy to the unemployment rate is, we like the Bank’s move towards a more transparent state to better manage and guide expectations.

 

Bullish on the Union Jack - z. uk cpi

 

Bullish on the Union Jack - z. uk house prices

 

Bullish on the Union Jack - z. uk savings rate

 

 

Eurozone Inching Higher

 

The big news this week was a better-than-expected first print of Q2 GDP out of the Eurozone, a follow-on to improving fundamental data out of the Eurozone in recent weeks.

 

The Eurozone’s +0.3% Q2 GDP rise marked the end of an 18 month recession (cheer!), and the figure beat our expectations for only modest improvement over Q1 (consensus was at +0.2%), especially in a quarter that was hampered by bad weather (including serious flooding throughout central Europe), continued misdirection in economic leadership from France’s Hollande (France has the second largest economy behind Germany in the Eurozone), and continued political strife in Italy, Spain, and Portugal.

 

Bullish on the Union Jack - z. eurozone gdp

 

Clearly the data is looking better.  Germany and France also beat Q2 GDP expectations. Germany reported growth of +0.7% Q/Q (+10bps above expectations) versus 0.0% in Q1 and France rose +0.5% Q/Q (+30bps above expectations) vs -0.2% in Q1. Add to this performance PMI figures that have improved across the region over the last 3-5 months (reaching over the 50 line in the last 1-2 readings) and improvement in sentiment readings across the core and periphery.

 

Bullish on the Union Jack - z. pmis

 

Risk Spreads are dropping to new lows. Also, 10YR Spanish and Italian bonds are trading at their tightest spreads over comparable German paper in more than two years at ~252bps and 235bps, respectively.

 

Bullish on the Union Jack - z. 10 spreads

 

 

Not All Is Rosy


What’s our read?  While there’s optimism to be had on improving data, GDP was still down -0.7% year-over-year in Q2 and we expect a very slow churn higher in Eurozone GDP in the balance of 2013. Certainly GDP will remain well below the pre-crisis average of 2.1% (since 2000) as the region hits the reset button on standards of spending and lending as budgets are readjusted at the government and household levels.  We maintain our call for 2013 GDP between -0.8% and -0.6% year-over-year.


Beyond struggling to reset spending and lifestyles habits, here are some significant hurdles that we expect will continue to weigh on Eurozone GDP:

  • The slim availability of credit, in particular to the small and medium sized businesses, the core drivers of growth and employment (see chart below on ECB Loans to Non-Financial Corporations and Households as proxy—at or near all-time lows)
  • Diminished credit quality of banks, especially across the periphery, as they report increasing non-performing loans
  • Further bank write-downs of non-performing assets
  • Labor market reforms slow to enact or institute at all
  • A protracted unemployment overhang, especially youth unemployment across the periphery, that will limit consumer spending and confidence
  •  Political uncertainty, in Italy, Spain, and Portugal, to weigh on budget reforms and confidence

Bullish on the Union Jack - z. ecb lending

 

To throw out a couple anecdotes from the media stories we’ve recently come across that paint a still subdued outlook, we include:

  • The WSJ reported that auto sales in Europe are so bad that less than half the factories in the region operate at the minimum 75% of capacity needed to break even. It said that those operating below that level are mostly located in Italy, France, and Spain whose economies have been hit by the crisis. The article noted that governments in Western Europe are worried about seeing more workers join the ranks of the unemployed and that unions are aggressively protecting jobs, while the courts have also been sympathetic. The paper said that because of this, auto makers are losing billions of euros a year by retaining workers and factories they no longer need.
  • A poll by ING-DiBa AG and the University of Hohenheim shows that only 17% of Germans believe that the worst of the Eurozone crisis is over, while 91% think that the crisis will still go on for a long time. Only 10% of Germans believe that politicians are being honest with citizens regarding Eurozone issues.

 

Concluding Thoughts

 

Our call remains that into Q4 we expect European PMIs to hover around the 50 line (ups and downs) but not to show a material breakout given the very weak structural issues that we do not see inflecting materially over the intermediate term, including weak credit conditions, high unemployment, alongside political uncertainty at the country level – Italy, Spain, and France in particular.  We continue to be fundamentally bullish on German and the UK equities, so should we see any outperformance from PMIs, we think it could come from these two countries.

 

As it relates to the capital markets, we think a much larger force versus marginal improvement in fundamental data is the political resolve of the Eurocrats and Draghi to lend fund if needed (back-pocket OMT ready) and prevent any country from leaving the Eurozone, which we think can continue to stabilize and push markets higher. Already we’re seeing domestic and international investors become increasingly confident in Draghi’s heavy hand and buying distressed asset, for example housing in Spain and bank debt across the periphery, as the EU banking system slowly continues to heal.      

 

Enjoy the weekend!

 

Matthew Hedrick

Senior Analyst


Morning Reads on Our Radar Screen

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

Keith McCullough – CEO

Alpha Hunter James Rickards on Gold and the U.S. Dollar (via All About Alpha)

Sales of U.S. Existing Homes Rise to Highest Since 2009 (via Bloomberg)

Indian stocks plunge 11% in a month (via CNNMoney)

Syria conflict: 'Chemical attacks' kill hundreds (via BBC)

 

Morning Reads on Our Radar Screen - bullbear

 

Daryl Jones – Macro

Abandoned Dogs Roam Detroit in Packs as Humans Dwindle (via Bloomberg)

 

Jonathan Casteleyn – Financials

Goldman’s Options Error Shows Peril Persists After Knight (JC note: A $100 MM loss has a small impact on $GS - would be just $0.71 per share on a tangible book value of $140 per share  via Bloomberg)

Bond Trading Hampered as Buyers Retreat to Crowded Exits (JC note: Bond market illiquidity is a huge risk for fixed income investors - we highlighted it in our rollout via Bloomberg)

 

Brian McGough – Retail

PetSmart 2Q profit tops Street, lifts outlook (BM note: PETM maintains its streak of being the only retailer to never comp down -- ever. 'Ever' is a long time. If you know of others, let me know. via AP)

 

Matt Hedrick – Macro

Europe Prepares for More Greek Aid as German Election Approaches (via Bloomberg)


Early Look

daily macro intelligence

Relied upon by big institutional and individual investors across the world, this granular morning newsletter distills the latest and most vital market developments and insures that you are always in the know.

next