“What makes the desert beautiful is that somewhere it hides a well.”
-Antoine de Saint-Exupery
Volumes are light, ideas are sparse and the Hamptons are packed. Welcome to summer on Wall Street!
The desert is the most pertinent geographical analogy to this part of the investing year. Deserts are defined in a number of different ways, but generally the classification is based on the amount of precipitation that occurs in any year. Below a certain level of precipitation, the region is considered a desert. Think of precipitation as the idea generation engine of Wall Street that slows during the summer.
Interestingly, while most of us likely perceive a desert as a vast region of sand and limited plant growth, the reality is that only 20% of deserts have sand. The largest desert in the world is actually the Antarctic Desert, which is, naturally, in Antarctica and covers more than 5.5 million square miles of ice and snow. So, no, cold desert is not an oxymoron.
One place you don’t want to go after a long night of cavorting and over indulging is the Atacama Desert, which is the driest place on Earth and virtually devoid of life. The average rainfall in parts of the Atacama is less than 1mm per year. Further, evidence suggests that the Atacama may not have had any rainfall for the four hundred year period between 1570 and 1970. Needless to say, even if you feel your portfolio is devoid of new ideas, there have been worse droughts!
In the Chart of the Day, I’ve attached our current Best Ideas list, which is comprised of the ideas that our research team recommends for three months and beyond (TREND) in our models. Independent of this list I want to highlight the three ideas that I find most compelling. They are as follows:
1. International Game Technology (IGT) – IGT makes gaming machines and is, not to mince words, a free cash flow monster. Over the course of the past three fiscal years, operating cash flow has outpaced total capital expenditures by over a $1 billion dollars in aggregate. Compared to the current market capitalization of just under $5BN, this provides IGT ample cash to return to investors via share repurchases or debt pay down.
Speaking of debt pay down and cash flow, one of the more compelling reasons to own this stock is its potential interest to private equity firms and its inherent private market value. As our Gaming, Lodging & Leisure Sector Head Todd Jordan has oft noted, four private equity firms were interested in IGT’s competitor WMS and one made it to the final round before Scientific Games ultimately won out.
2. Nationstar Mortgage Holdings (NSM) – The roll up of mortgage servicing is a trillion dollar opportunity and NSM is ideally positioned. (Translation: this is huge market.) NSM recently put up an EPS number for Q2 of $1.37, which outpaced the consensus estimate by almost 50%. We think there is continued upside in numbers through 2014. Currently based on the midpoint of NSM’s 2014 guidance, the stock is trading at less than 7x earnings with upward revisions and continued acquisition catalysts on the horizon.
3. Fed-Ex (FDX) – FDX is just shy of a 52-week high and has outperformed the SP500 over that period, so is not necessarily a contrarian stock. On a valuation basis, the stock is cheap trading at less than 6x TTM EV/EBITDA and has net cash on its balance sheet (excluding leases).
Setting aside the financials, which are bullet proof, we think a key reason for owning the stock is that investors are currently ascribing little value to FedEx Express. We think this division, once restructured, could have a similar margin to UPS or DHL’s express margin and generate an incremental $1.5BN in additional EBIT per year. Frankly, if the Germans can make DHL Express profitable, it should be achievable for FDX. If FDX can’t do it, there is no doubt an activist will consider stepping up.
Speaking of Fed-Ex, its key competitor UPS announced late yesterday that it was going to be dropping 15,000 spouses who are eligible for coverage from their own employer from its health insurance plan due to higher anticipated costs under the Affordable Care Act. UPS expects to save up to $60MM per year on this “initiative”.
We’ve long extolled the benefits of limiting governments, in large part, due to unintended consequences of policy. In the UPS instance, it may lead to less or more limited coverage for 15,000 working women. There has also been ample evidence of workers hours being reduced so employers can avoid the punitive impact of the Affordable Care Act on their bottom line.
On a more macro level, there are potentially long term impacts to the labor market. As Chicago Economist Casey Mulligan wrote in a recent blog for the New York Times:
“The Affordable Care Act’s explicit taxes on employers, subsidies for layoffs and implicit taxes on employees, together amount to five or six percentage point addition to the marginal tax rate on labor income.”
By Mulligan’s analysis, this may contract the labor pool by 3% in 2015. At the end of the day, this shouldn’t really surprise any of us for as Milton Friedman said on the topic of government management:
“If you put the federal government in charge of the Sahara Desert, in 5 years there’d be a shortage of sand.”
Our immediate-term Risk Ranges are now:
Keep your head up and stick on the ice,
Daryl G. Jones
Director of Research
Hedgeye CEO Keith McCullough handpicks the “best of the best” long and short ideas delivered to him by our team of over 30 research analysts across myriad sectors.
TODAY’S S&P 500 SET-UP – August 22, 2013
As we look at today's setup for the S&P 500, the range is 38 points or 0.72% downside to 1631 and 1.59% upside to 1669.
CREDIT/ECONOMIC MARKET LOOK:
MACRO DATA POINTS (Bloomberg Estimates):
WHAT TO WATCH:
COMMODITY/GROWTH EXPECTATION (HEADLINES FROM BLOOMBERG)
The Hedgeye Macro Team
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.”
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):
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”
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:
And that’s just about it.
Markets pay a higher multiple for companies showing what?
So why is my macro model considered so absurd? It’s the same thought, but for countries:
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%
Best of luck out there today,
Keith R. McCullough
Chief Executive Officer
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.
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’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.
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