This note was originally published at 8am on August 21, 2013 for Hedgeye subscribers.
“Before I went to jail, I was active in politics as a member of South Africa’s leading organization – and I was generally busy from 7 A.M. to midnight. I never had time to sit and think.”
Former South African Prime Minister Nelson Mandela had more time to sit and think then most of us will ever get. He served 27 years in prison, first on Robben Island, and later in Pollsmoor Prison and Victor Verster Prison after being convicted of sabotage and conspiracy to overthrow the South African government.
I’ve recently been reading Mandela’s biography and after reading about how he spent his nights in a damp concrete cell of 8 feet by 7 feet and his days breaking rocks into gravel, I’m not sure I would wish this type of “thinking time” on my worst enemy. But, thinking time is important for all us, and I will be taking some thinking time myself as my first two week vacation of the last decade looms in the next couple of weeks.
In a book we have cited many times, “Thinking, Fast and Slow”, Nobel laureate Daniel Kahneman describes two modes of thought. The first is System 1, which is fast, instinctive, and emotional. The second is System 2 and is slower, more deliberative, and more logical. The main purpose of his book is to describe the dichotomy between these two kinds of thought.
To illustrate how the two different systems work, answer this before you go on:
A hockey stick and puck cost $1.10 together.
If the stick costs $1.00 more than the puck, what does the puck cost?
If you are like most people, even the highly numerical, it is likely that the price of $0.10 popped into your head. The correct answer of course is that stick cost $1.05 and the puck cost $0.05, so thus the stick cost $1.00 more than the puck.
In a day and age when we are inundated with more stimuli and decision making opportunities than ever before, it is becoming even more critical to take some Thinking Time to maintain the deep logic of System 2. The fact of the matter is, the self-induced dopamine loops of constant texting, tweeting, googling and emailing diminish our performance. (Well, at least that’s how I’m justifying my vacation to my colleagues :) )
Back to the global macro grind . . .
I’m going to take this concept of short term versus long term thinking and apply it to the current battleground stock of the day, J.C. Penney (JCP). Recently Pershing Square’s Bill Ackman all but admitted defeated in his attempt to turn around the retailer as he resigned from the board of JCP and received permission for Pershing Square to sell the more than 15% of the stock it owns. This is short term capitulation.
At the same time, a number of other hedge funds have been taking sizeable positions at the stock has declined, including Kyle Bass, Soros Fund Management and Perry Capital. Bass, as reported by Bloomberg is actually buying the debt. These are long term investment positions.
Before I dig into the stock a little more, I wanted to let you know that our Retail Sectorhead Brian McGough will be doing a deep dive on the stock on August 27th at 1pm. (Ping firstname.lastname@example.org for details.) As many of you know, Brian was in early in recommending investors short and/or sell the stock when Ackman got involved. He then tried to call the turn around and added the stock to our Best Ideas list, but ultimately removed the name at about the current price level on March 14th as there was little evidence of a turnaround and his view was that JCP was dead money (which it was).
The Chart of the Day today is a chart of JCP credit default swaps that shows that while a bankruptcy isn’t a foregone conclusion, there is certainly risk as investors are willing to pay a meaningful premium to insure JCP debt. Interestingly, while JCP debt has declined versus its peer group over the last couple years, it is not yet at extreme levels.
As examples, per Bloomberg and Forbes, the J.C. Penney 5.65% notes due 2020, yesterday traded up two points, at 73.5. While the long-tenor 6.375% bonds due 2036 traded up half a point, at 69.5, for a net gain of 3.5 points week over week. In the loan market, J.C. Penney’s covenant-lite term loan due 2018 (L+500, 1% LIBOR floor) were slightly firmer, recently quoted at 96.5/97. As a reference, the $2.25 billion loan was issued at 99.5 in May.
As McGough noted yesterday, “the fact that JCP hit the liquidity levels it guided toward at quarter-end is notable. Add on the fact that capex next year is guided to be down as far as $300mm, and the liquidity picture looks less pressured. We’d argue that these two factors are the sole reasons why the stock was up today. Why?
Let’s stress test the model. We quarter-ized our model for the next three years using the following assumptions a) JCP reaches 2012 sales per square foot levels in 2015, with a gradual comp lift throughout, b) the company generates 37% gross margins – a level we think there is no structural reason it can’t hit again relatively quickly (we know we'll get pushback on that -- but will happily entertain the debate), EBIT margins don’t turn positive until 2016, c) capex increases by $50mm each year, d) working capital patterns are similar to what we saw before 2012.
In tracking the cumulative liquidity for the next three years, there are two periods where it definitely gets dicey for JCP (the worst is 3Q15 -- in two years) – close enough such that it will likely need to find some asset sales that are not already tied to the GS secured debt offering. But even without assuming a miraculous turn at the company, we don’t get to a big liquidity event.”
So, if there is no major liquidity event for the next three years, there is decent runway for the company to turnaround and the shorter term debt, at the very least, looks reasonably safe. But what do you think?
Next Thursday at 1pm, we’ll introduce some new information and dig into more of our thoughts. If the turnaround actually happens, based on historical margin levels, JCP equity is a really cheap option at these levels.
Our immediate-term Risk Ranges are now:
Keep your head up and stick on the ice,
Daryl G. Jones
“Money is one of the shatteringly simplifying ideas of all time; it creates its own revolution.”
That’s the opening quote to an important book I started reading this week, The History of Money, by Jack Weatherford. The book’s first paragraph goes on to ring the Gold bull bell with “The Dollar is dying; so too are the Yen, the mark and the other national currencies…”
When it was published in 1997, Charles Schwab called this “the book to read.” And I agree, you should read every economic history book you can get your paws on – your hard earned money is too important to leave to the people opining on it from Washington.
The shatteringly simple observation about money is context. Its history is at least 3,000 years old. And when debating it, consensus tends to cram its craw into the moment in which it lives. The Dollar isn’t dead this year; it’s breaking out from a 40 year low. The Yen didn’t die after 1997 either (it ended up hitting a 40 year high by 2011). Everything, including the value of your moneys, is relative.
Back to the Global Macro Grind…
After another shatteringly strong string of US economic data points (starting last Thursday with US roiling jobless claims hitting another YTD low and culminating with a blockbuster New Orders component of yesterday’s ISM report for August), yesterday’s US stock market ripped a +1% morning move to the upside and Treasury bonds continued to collapse.
Up for the 4th consecutive week, another #StrongDollar move was nipping on the heels of #RatesRising too. Consensus isn’t positioned for that, so I loved it. Then, all of a sudden, the most bearish catalyst of all hit the tape – a US politician’s opinion.
In the last year, there have been very few market risks that have scared me more than US central planners intervening during critical periods of market entropy. Going back to November of 2012 (when bond yields bottomed), Boehner’s voice was as market bearish as any you could find. He was the bearish factor yesterday too – the whole thing is just plain sad to watch.
Back to the economic gravity part…
To be clear, there’s a big difference between consensus being bearish and Mr. Market’s bullish opinion. While yesterday’s intraday gains in the SP500 were cut in half, the decliners were led by the slow-growth sectors (gainers were once again all about growth):
In other words, if you are bummed out about Kimberly Clark (KMB) or Kinder Morgan (KMP) not getting you paid on the principal appreciation side of the equation, that’s just too bad. This Bernanke Yield Chaser style factor was as much a bubble as Gold was.
#RatesRising for the right reasons (growth expectations rising), is public enemy #1 for overvalued, slow-growth, securities. Whether it feels right or not, money chases positive returns. It flows away from draw-down risks.
Since I’m already out of everything Commodities, Fixed Income, and Emerging Markets (0% asset allocations), I have had relatively low stress on the draw-down risk side of big macro asset class moves in 2013 (Gold bounced, but is still -17% YTD and bonds are getting smoked), but that doesn’t mean I can afford to give up a lead for the sake of being beholden to this great growth data.
There are 3 big Macro things that would get me out of being long growth equities:
Johnny one-time Boehner’s intraday comments mattered because they kept the #1 risk to what’s been strong US consumption growth in play. It’s called an Oil tax at the pump. And Putin likes it.
The best way for Obama to pulverize Putin in St. Petersburg this week would be to stick a weapon of mass currency appreciation in his grill. If I was advising the President, I’d have him bring that #StrongDollar ace to the table – and maybe say something like this:
“Vlad, if you don’t tone this down, I am going to taper, then tighten – and if you don’t think I can get Summers to do it, try me – your little Petro-Dollar Putin power problem will look like Fukushima, and fast.”
But that’s just me – I’m a doer type of a guy who likes to make decisions without asking the bureaucracy of the world for its opinion. I’d like to see a US President build a #StrongDollar, Strong America revolution on the back of your hard earned currency.
Our immediate-term Macro Risk Ranges are now:
UST 10yr Yield 2.73-2.93%
Best of luck out there today,
Keith R. McCullough
Chief Executive Officer
THE MACAU METRO MONITOR, SEPTEMBER 4, 2013
AMBROSE SO SAYS BAN ON CASINO SMOKING IS IMMINENT Macau Daily Times
Ambrose So, SJM's CEO said a total ban on smoking is imminent and that the gambling giant is not worried about the potential fall of its market share, as it is not "a key index". So said that SJM is trialing smoking rooms in the smoking areas in its casinos, and the government encourages this practice. However, he acknowledged that it is not easy for all SJM casinos to reach the government’s standard of air quality. The CEO pointed out that some older casinos have lower ceilings, and that it is harder for those to pass the air quality test. He urged the government to make special considerations and, if possible, exempt those gambling venues from air quality-related fines.
Moreover, So said that it would actually be more financially beneficial if the government simply declared a ban on smoking in casinos, so that operators do not need to buy extra equipment to cope with the interim period.
As for the issues surrounding the location of some slot machine venues, So said some venues would be removed in accordance with the government’s timetable. SJM is now looking for new locations for these venues. However, if the group cannot secure new sites, they will temporarily close the venues. So is not worried about the revenue, as slot machines only account for a very small proportion of SJM’s profits.
SANDS CHINA EXEC DAVID SISK RESIGNS AMID SHAKE-UP WSJ
Sisk, formerly Sands China's COO, was asked to resign, said people familiar with the matter. From the beginning, there was a power struggle between current CEO Ed Tracy and Sisk, who both aspired to become Sands China's new CEO, said one of the people familiar with the matter. Tracy won the CEO appointment in July 2011.
Sisk's departure follows the resignation Friday of Hugh Fraser, who served as vice president of casino operations across Sands China's four Macau properties. Fraser is moving to Australia to become the general manager of gambling operations at The Star in Sydney. In June, Andrew Billany, formerly senior vice president of Sands China's high-end Plaza Casino and Paiza operations, left the company to become Senior Vice President of Operations for SJM Cotai. LVS CFO, Ken Kay, stepped down on July 31.
We like KKD on the LONG side, as the company fits our strategy of looking for small cap growth companies with strong business models and growth prospects. Over the past three years, the company has transformed itself into a strong regional brand and asset-light business with unique global growth potential.
Our KKD LONG thesis consists of three key tenants:
International Growth Potential
Since opening the first international store 11 years ago, international stores have grown to 532 and most recently, since 2007, have grown from only representing 31% of KKD’s total store count to approximately 69% today. International revenues now account for nearly 43% of system wide sales. In aggregate, Krispy Kreme stores are present in 21 countries outside of the United States and we believe this international presence and growth potential puts the company in a rare position within the restaurant segment. The company plans to increase the number of international shops to 900 by January 2017. This, alone, implies an increase in system wide sales of approximately +28% by January 2017. As of the end of 2Q14, total franchise commitment for international development stands at 350.
Over the past three years, the majority of the international development efforts have been in Asia and the Middle East. In FY13, new international franchise agreements have already been signed with franchisees in Moscow, India and Singapore. We will see further expansion and expect to hear about franchise efforts on new markets, including Europe and South and Central America, in the coming months.
Accelerating U.S. Growth Unit
The success of the international growth model is helping to jumpstart domestic unit growth. Over the past three years, the KKD international franchisees have pioneered the initial development of smaller, satellite shop formats and this success has been translated to the U.S. growth model.
In January, KKD opened up five of these smaller format shops in the U.S. and the results did not disappoint, as the company reported strong sales and operating performance from the shops. The company plans to move forward with these smaller unit formats and plans to open five more during the remainder of FY14. Importantly, we believe these new formats will sit well with the franchisee community and give them the confidence to incorporate these new stores into their expansion plans. In July, KKD signed a 15-store development agreement for the Dallas market, which included the sale of its three existing stores in the market. We expect to see many more arrangement similar to this, which should significantly increase the pace of U.S. store expansion.
Perhaps most impressive, the company is reporting that the 5 new, free-standing small factory shops currently in operation are seeing sales levels settling in around $30,000 a week. With an initial investment of about $590,000 per store, this indicates a sales to investment ratio of 2.6 to 1, making it one of the best in the restaurant space today.
Over the past two years, KKD has generated $66 million in free cash flow and is estimated to earn an additional $31 million in FY14. Furthermore, at the end of 2Q14, the company had over $60 million in cash and practically zero debt. Combine this with the recent announcement of a $50 million stock buyback authorization and it appears as though the financial prospects of KKD are very promising.
U.S. Same-Store Sales
One of the issues we suspect will be a point of contention with some investors is the difficult same-store sales comparisons KKD will be facing.
In our view, the greatest opportunity for KKD has always been to sell more of the higher margin beverages. Over the past couple of quarters, KKD has been seeing a significant lift in transactions and a shift in the beverage mix toward coffee products. Though work is needed in order to drive more beverage sales, it appears as though the company’s strategy of connecting with the consumers through social media outlets is helping to drive sales and traffic through innovative LTOs.
Difficult sales comparisons are not new and are a known known by the investment community. That being said, we believe KKD can weather the difficult comps without hurting its strong sales momentum. 2Q14 company sales trends were strong: +12.4% in May, +9.5% in June and +8.5% in July (despite being down for a couple of weeks, as the company lapped its 75th anniversary the previous year). And, trends early in 3Q14 suggest the current momentum is continuing as same-store sales in the first week of August were up +5%, same-store sales in the second week of August were up +12% and same-store sales in third week of August were flat. We believe that 3Q14 same-stores sales growth of +4-6% is a reasonable target.
Returns Headed Higher
Currently, KKD generates some of the best returns on incremental capital in the restaurant space. The company’s current structure, coupled with the capital-light model and accelerating franchise unit development, should allow for high returns to continue well into the foreseeable future.
On the surface, the sentiment setup on KKD looks rather positive as 70% of the analysts covering the stock have a “Buy” rating on it and short interest only comprises 3.7% of the float. However, we would take the sentiment setup with a grain of salt, as the coverage of KKD is very limited. Only 10 analysts are currently covering the stock as opposed to 25-30 analysts covering some of the other names in the restaurant space.
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