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Takeaway: In the note below, we respond to a collection of our most thoughtful client inquiries regarding asset allocation of late.


  1. It feels like what has been working on an intermediate-term TREND basis is now starting to break down and/or underperform, while the things that haven’t been working on that duration are starting to break out and/or outperform. Is this something you guys are seeing as well? How do we take advantage of this shift?
  2. What does “Down Dollar, Down Rates” mean to the US economy? Aren’t lower interest rates good for the consumer?
  3. If the dollar and rates break down, would that make you bullish on emerging markets?
  4. So what do I do with all of this as it relates to my gross and net exposures?


It’s no secret that US monetary and fiscal policy is generating a fair amount of consternation, confusion and contempt among global financial market participants.


As one of the few non-buyside teams that possess a consistent and repeatable process for interpreting and risk-managing the never-ending stream of market signals and economic data, we have been humbled by a large number of thoughtful questions over the past couple of days. As such, we thought we’d pull together a quick synopsis of said client interactions with the intent of supplementing your respective internal debates.


Q: It feels like what has been working on an intermediate-term TREND basis is now starting to break down and/or underperform, while the things that haven’t been working on that duration are starting to break out and/or outperform. Is this something you guys are seeing as well? How do we take advantage of this shift?

Between the politically compromised FOMC and the highly politicized, dysfunctional mockery of government on Capitol Hill, it’s becoming increasingly clear to us that both market participants and economic agents are interpreting recent policy deltas as supportive of a return to the pre-2013 Global Macro playbook of being addicted to the drug that is QE. At least that’s precisely what the math suggests.


The TREND-duration directional relationship between the USD and US equities/US equity market volatility has completely reversed in recent weeks. Additionally, the positive correlation between the USD and US interest rates is picking up steam amid what appears to be the start of a #WeakDollar + #RatesFalling regime. The things that are typically inversely correlated to the USD are becoming dramatically more so as investors respond to the US dollar’s accelerated breakdown.




The US Dollar’s long-term TAIL line of support is under attack – as is the UST 10Y Yield’s intermediate-term TREND line of support. Is this a head-fake or will these new regimes hold in spite of a positive seasonal tailwind in labor market data from now through MAR? At the bare minimum, preliminary analysis of Janet Yellen’s recent contributions to the FOMC suggests that an #IndefinitelyDovish Fed is NOT a low-probability event. If you have yet to review our SEP 23 note titled, “THINKING LIKE A FED HEAD”, we strongly encourage you to do so; its conclusions are looking increasingly prescient by the minute.






After underperforming all year, higher-yielding equities are starting to outperform. While it’s too early to emphatically proclaim a reversal of the existing trend,  the developing quantitative signals highlighted above might lend some expediency to the development of a new one.




Commodities are the lone holdout from an asset class perspective, with both Gold and the CRB Index continuing to make lower-highs amid a bearish TREND and TAIL setup.






We continue to have a zero percent asset allocation to commodities (and fixed income). Make no mistake, however, we’d be buyers of Bernanke’s commodity and bond bubbles if the quantitative signals support that. Like most consistently effective asset allocators, we have no qualms about going both ways and changing our minds on a particular market when the quantitative and fundamental signals support making the switch.




As the chart above highlights, our dynamic asset allocation model is heavily invested in international equities and foreign currencies. We remain the #EuroBulls as the Germans and Brits looks to increasingly take share from the US in the global capital allocation pie chart. Remember, capital chases yield and currency appreciation – with the latter being another way to state that capital tends to flee from domestic currency debasement by seeking out inflation hedge assets, including other currencies.





Q: What does “Down Dollar, Down Rates” mean to the US economy? Aren’t lower interest rates good for the consumer?

Regarding the first part of the question, the confluence of #WeakDollar and #RatesFalling has historically been associated with economic environments that are characterized by slowing growth and accelerating inflation. Conversely, the polar opposite economic setup (growth accelerating as inflation decelerates) has historically been associated with a #StrongDollar + #RatesRising regime.




In our 4Q13 Macro Themes deck, we purposefully led off with two potential economic scenarios for the US here in the fourth quarter. As of now, it appears increasingly likely that a trip to Quad #3 (growth slowing as inflation accelerates) is in the cards. If our historical back-tests provide any insight, that setup should apply downward pressure upon the domestic equity market and upward pressure upon domestic credit spreads.




Regarding the latter part of the question, Keith had this to say in response to the client’s inquiry:


“Lower rates have been capitalized on by anyone w/ half a brain. That’s not to say you don’t get the brainless to refi this next go-round, but the pools of people affected get smaller with each higher-lows in rates, and the real upside to rates rising is in real-incomes rising alongside the savings rate.”


Q: If the dollar and rates break down, would that make you bullish on emerging markets?

Absolutely. We were wise to suspend our street-leading bearish thesis on emerging markets by covering our EEM short on SEP 9; we followed that up with an extremely detailed report on SEP 19 with how to play emerging markets across countries and asset classes from here – the conclusions of which remain relevant today.


To recap our views on emerging markets, the iShares MSCI Emerging Markets ETF declined a cumulative -2.4% from its APR 23 addition to our Best Ideas list – which came in conjunction with our 100+ slide Black Book titled, “EMERGING MARKET CRISES: IDENTIFYING, CONTEXTUALIZING AND NAVIGATING KEY RISKS IN THE NEXT CYCLE” – to our SEP 9 cover. The aforementioned delta is well shy of the +5.9% gain for the S&P 500 over that time frame and was inclusive of a maximum drawdown of -12.8% during the ~2M period from APR 23 to JUN 24. The EEM ETF is up +4.3% since we covered our short on SEP 9 and is now bullish TREND.




What’s outperforming? To a large degree, the bombed-out markets which became dramatically oversold during the prolonged EM rout which took place earlier this year.




While it would be analytically reckless for us to tell you to go out and speculate in the most risky of markets at the current juncture, we do feel confident in saying that in the absence of a clear uptrend in both the USD and US interest rates, investors should resort to trading emerging markets on idiosyncratic country fundamentals – something we highlighted earlier this week in a deep dive on India’s evolving political landscape.


Q: So what do I do with all of this as it relates to my gross and net exposures?

In a word, #GetActive. That means lower your gross exposure, tighten your net exposure and trade the ranges. Don’t make it any more complicated than that amid all of this policy uncertainty – especially if you’ve also had a good year and don’t want to give back any YTD gains.




Many thanks for your time and please keep the questions coming; we are always in the market for thought-provoking discourse.


Have a wonderful evening,


Darius Dale

Associate – Macro Team

DPS – We’re Not Trend Fighters

DPS cited on its earning call an operating environment that continues to be “extremely challenging” with “significant pressures in the CSD (carbonated soft drink) category now impacting both regular and diet products”.  While the company beat EPS estimates ($0.88 vs Consensus $0.83), it missed top line consensus ($1.54B vs $1.56B) on a mere +1% gain over the previous-year quarter.   Total volume was down -1% versus the year-ago quarter.


Despite today’s squeeze in the stock, we remain bearish on DPS over the intermediate term. 

From a quantitative perspective, we could see the stock pull back to its TRADE level (-3.2% from its current price) over the immediate term (3 days or less).


DPS – We’re Not Trend Fighters - z. dps


Our primary concern is not a new one and remains grounded in the fact that DPS’s portfolio is ~ 80% CSDs, a category that has drawn less demand in recent quarters (~ 3% annual industry volume decline) given health and wellness trends as consumer switch to both healthier carbonated and non-carbonated offerings versus traditional carbonated soda.


DPS’s answer to this trend is DP 10, its newest soda offering that should have full distribution by the end of the summer. DPS says that the 10 calorie drink with a full taste profile (note: the lack of a full taste profile is often the complaint of diet drinkers) stands to address the health and wellness market. That said, the diet category across the industry is seeing declines, and our bet is that DP 10 is more likely to cannibalize its Diet DP product rather than turn around its portfolio.  


Outside of CSDs, DPS saw some offsets in NCBs, including a +4% volume increase from Snapple, yet Hawaiian Punch declined -6% and Mott’s saw a mere 1% gain. Geographically, volumes were down -1% in the U.S. and Canada, partially offset by +6% increase in Mexico and the Caribbean.  


To quote CEO Larry Young: “This team never gives up on CSDs”. We, however, have no mandate to be invested in CSDs, nor the beverage category for that matter.   To say the least, we’re not convinced on this turn-around story based on DP 10 and will opportunistically short the stock or stay on the sidelines until further notice. 


Matthew Hedrick

Senior Analyst


PNRA remains on the Hedgeye Best Ideas list as a short.


We need to understand the following issues before we can determine the appropriate time to back off of our bearish call.  Moving forward, the true test of capitulation will be on display in the form of new unit capital spending.  Will management continue to accelerate unit growth, as they have stated they will, or will they reassess and decide to scale back this spending?


That being said, we had several questions come to mind following the 3Q13 earnings call:

  1. Do the planned “changes” represent a real solution?  Or is management putting a band aid on the problem?
  2. How long will it take to implement these “changes”?  Management was very vague in this regard.
  3. How are they addressing value and affordability?
  4. Despite strong new unit AUVs, should they really be accelerating, or even maintaining, new unit growth?
  5. Can the system handle all of these “changes” at once?

PNRA 3Q13 same-store sales of +1.7% missed consensus estimates of +2.9% and fell below the company’s guidance of +2-4%.  Even worse, traffic was down -1% during the quarter, and has now been down for four consecutive quarters.  We attribute this decline in traffic to the following:

  • Choppy consumer environment
  • Increased competition from Casual Dining companies due to aggressive discounting
  • Self-inflicted throughput bottlenecks during the lunch day part
  • The value equation is out of sync – price/mix is falling
  • Cannibalization from new stores


What we liked in 3Q13 results:

  • Management is aware of PNRAs issues
  • Repurchased $174 million worth of shares in 3Q13
  • Repurchased $69 million worth of shares to date in 4Q13 and have $317 million remaining under the authorized repurchase program
  • Easier comps in 2014
  • More achievable guidance is now in place


What we didn’t like in 3Q13 results:

  • Low quality print
  • Same-store sales growth missed consensus expectations and the guidance range
  • Two-year sales trends are decelerating
  • 3Q transaction growth was down -1%
  • Two-year transaction trend is negative
  • 4Q comp guidance revised down from +3-5% to +0-2%
  • 4Q EPS guidance revised down from $2.05-$2.11 to $1.91-$1.97
  • 4Q operating margin expected to be down 100-150 bps
  • FY13 operating margin expected to be down 0-50 bps y/y
  • FY13 comp guidance revised down from +3-5% to +2-2.75%
  • Targeting FY14 EPS growth below the low-end of its long-term target (15-20%)
  • The company has legitimate capacity and throughput issues
  • Management does not appear to have a plan in place to improve their value proposition


The Wild Card:

  • Will capacity and throughput issues inhibit the “demand drivers” PNRA has in place?


Management failed to give us the confidence to believe that they have a feasible plan in place to fix these operational issues and reverse negative traffic trends.  In our view, increased advertising, menu additions, and other initiatives could exacerbate the problems the company faces today.  Until management reveals their plan in more detail, we fear that they could be trying to do too much at one time.  








Howard Penney

Managing Director


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LO – Green Lights! Newport and Blu E-Cig Charge Forward

Lorillard confirmed our bullish outlook on the company today reporting market share and margin gains on pricing and volume improvement over the industry in its Q3 results.  


Total cigarette volume increased +3.5% compared to the prior-year quarter, versus an estimated decrease of -3.5% to -4% for the industry, and versus -4.3% for RAI, on the back of strong performance from its profit center, Newport. Net sales of its e-cig Blu increased 11% versus last quarter and its retail market share rose to 49% (vs. 40% last quarter), while the acquisition of SKYCIG at the beginning of the month offers the company a platform for distribution in the UK and potentially across the EU.


Our preferred tobacco play on the long side remains Lorillard (LO).

LO – Green Lights!  Newport and Blu E-Cig Charge Forward - Z. lo


What we liked:

  • In the quarter, net sales increased 10% over last year to $1.827 billion. EPS grew 15.3% to $0.83
  • Volume outperformance of +3.5% versus industry at -3.5% to -4%
  • Total Lorillard retail market share of cigarettes increased 0.5 share points to 14.9%
  • Newport saw volume gains of +4.9% (vs -1% last quarter)
  • Domestic retail share of the menthol market reached 40.4%, an increase of 0.8 share points versus the prior-year quarter
  • Gross Profit margins improved to 37.1% vs 36.3% on increased pricing and volume
  • Cigarette net sales increased $117 million, or 7.1%, to $1.764 billion
  • Blu e-cigs achieved net sales of $63MM (vs $14MM last year and $57MM last quarter) and over a 49% retail market share (vs 40% last quarter)
  • Roll-out of Newport non-Menthol Gold in October will compliment Red as a family of non-menthol offerings
  • Acquisition of SKYCIG in OCT 2013 to expand outside of the U.S.
  • Litigation costs down modestly Y/Y and company took the $79MM charge for Evans case (ongoing for 10 years) to resolve case entirely


On E-cigs: in what was another quarter of healthy interest from analysts on e-cig performance, it’s clear CEO Murray Kessler’s e-cig strategy is to forgo short-term profits for long term gains. The company sold its new rechargeable starter kits (they began shipping in Q2) for break-even in the quarter, which increased its retail market share to 49% vs 40% last quarter!  With $63MM of e-cig sales (vs $14MM in the year-ago quarter  and $57MM last quarter), Blu earned a gross profit of $15MM with SG&A of $15MM to net operating profit of $0.  From Kessler’s comments, it appears that this break-even strategy could be expected for at least the next two quarters as LO attempts to boost awareness, trialing, and repeat purchasing of Blu. Other takeaways include:

  • Kessler reiterated forecast for 2013 e-cig sales to be worth around $1-2B at retail; no hard estimate for online.
  • Expects e-cigs to have a 1% impact on total cigarette category in 2013.
  • Believes that the deciding factor on how big the category can be is what comes out on the regulatory environment.
  • If there is reasonable regulation that allows for marketing and advertising, it has already been proven that the e-cigs category can drive strong repeat purchasing.
  • While technology will get better over time, it is not the deciding factor.
  • If the FDA is overly strict, just like cigarettes requiring substantial equivalence, the category will grow more slowly.
  • Quarterly product mix (in dollars): Disposables 47%; Cartomizers 27%; and Kits 26%
  • In the quarter saw amount of rechargeable kits sold up dramatically compared to old format (discounted price also clearly driving purchases).
  • Blu now in 127,000 retail outlets.
  • Expects strong margins down the road for the company and retailers.
  • UK Market: estimated at $300MM with no clear leader. Could be another $1B market, but depends on regulatory market – so far so good.
  • Believes SKYCIG acquisition expands its global presence, although it will not have a roll-out or growth curve like Blu in the U.S. given the lack of retail relationships and sales force.
  • Kessler contextualized the purchase of SKYCIG acquisition as a one-off, with plans to grow organically if it were to expand its reach across the EU.
  • Optimistic that the UK Parliament endorsed e-cigs for their harm reduction and has moved it away from being regulated as a medicinal product. 
  •  In the UK, the company can advertise e-cigs on TV, until at least 2016, but advertising regulations vary across EU countries.
  • On UK and EU Rollout - no decision to roll out SKYCIGs to the rest of Europe. Has intention for Blu to become a global brand. Bullish that SKYCIG already has the same packaging as Blu (essentially they copied Blu from inception), and now is focused on increasing the sales force of SKYCIG. 


Matthew Hedrick

Senior Analyst

[video] McCullough to Bernanke: Get Out of the Way


This note was originally published October 17, 2013 at 18:49 in Industrials

Editor’s Note: Shares of Caterpillar (CAT) are getting bulldozed around 6% today after a weak earnings report. Take a look at this earning preview note from last week where Hedgeye Industrials Sector Head Jay Van Sciver predicted this. Jay’s been out front, trumpeting CAT as a top short idea since the middle of 2012 when he joined the firm. 

FLASHBACK: CAT Will Miss - cat5 



Investors do not seem very negative on the outlook for CAT’s 3Q earnings for an odd reason.  They tend to think that everyone else thinks that CAT will miss, limiting the relevance.   Investors are also looking for an announcement on structural cost actions at Resource Industries, which may cloud the 2H outlook.   Our view is that CAT has an end-market demand problem, not a cost problem.


CAT is also expected to issue preliminary sales and revenue guidance for 2014.  Many expect that it will be the Industrials guide of the quarter.  We think not – few analysts take guidance from CAT seriously anymore.  Remember “steady as she goes” for the 2013 outlook given in 3Q 2012?  Sales and revenues were supposed to be “roughly the same as 2012, in a band of about plus-or-minus 5%.”  Recall that 1Q 2013 sales and revenue were actually down 17.3%.   Following some short-term reaction, the market is likely to take a 2014 outlook with an excavator full of salt. 


We generally do not bet on quarters – it is a tough game.  A change in assumptions for warranty or accounts receivable allowances could leave even the best estimate off target.  A simultaneously announced buyback or acquisition could render the reported results old news before they are even read.  That said, there are a number of reasons why we expect weaker results this quarter.


While we will be ‘surprised’ if results do not disappoint, we are not ‘in’ CAT for this quarter’s results.  Rather we are focused on the long-term down-cycle in resources-related capital spending.  In the long run, resources-related capital spending requires rising commodity prices to remain far above maintenance-type levels.  Currently, resource-related capital spending is well above the levels needed to support long-term demand growth.  



Key Items


CAT Inventories:   CAT has guided flat company level inventories for 2H 2013, meaning that inventory levels at year end should be roughly the same as at the end of 2Q 2013, as we understand it.  However, in the third quarter “inventory could come down some as we have many of our Northern Hemisphere facilities take vacation shutdowns during the months of July and August.”  The company level inventory headwind should have continued into 3Q 2013, but consensus doesn’t seem to reflect it.  Dealer inventories are also expected to decline through 2H 2013.


Can CAT Get To $6.50?  That inventory outlook intersects poorly with the implied margin in current guidance.  Here is what we wrote on 8/9/2013 - our view is unchanged:


To hit guidance, CAT’s margins in 2H would need to improve ~30% vs. 1H with NEGATIVE MIX and NEGATIVE PRICING in Construction Industries and Resource Industries.  Sure, that might happen – and 795F Trucks might fly.   As we have written repeatedly – CAT is letting us down easy (gradually) and we have a tough time getting to $6.00 in 2013 EPS.  This is just a rough sketch of guidance - not what we expect, which we published here.


FLASHBACK: CAT Will Miss - jay1


Current consensus has margins at about 11.5% in the back half of the year, which would also represent a substantial and unlikely improvement in profitability from 1H.  Given the expectation of continued inventory reduction in 3Q, we are not sure why consensus expects margins to expand.  A guide down seems quite likely.


Not Just Resource Industries:  CAT management admonished us not to hyper focus on mining capital spending, shifting investor attention instead to Power Systems.  That may not be a great plan.  We have long expected the resource-related capital equipment portions of Power Systems to also experience meaningful pressure.  The most recent dealer statistics (below) show declining sales in Power Systems. That seems consistent with our broader definition of resource-related capital spending.  It is also not a great set-up for 2014 sales and margins.



FLASHBACK: CAT Will Miss - asd2



Construction Industries:  In a noticeable omission, CAT does not fully discuss the >500 basis point drop in Construction Industries margin in 2Q 2013 YoY.  It apparently relates to dealer inventory reductions, too, but that explanation does not fit the ‘it’s just a mining equipment demand drop’ narrative.  CAT’s construction equipment division participates in an intensively competitive business, but we are a bit surprised by the recent weakness.   As we understand it, lower capacity utilization in Resource Industries impacts the other divisions as well, given shared platforms, and that is a very hard problem to isolate or correct.



FLASHBACK: CAT Will Miss - asd3



3Q and 4Q Expectations:  Forecasting quarterly earnings for CAT is challenging, in no small part because we do not know how much revenue will come out of the backlog.  Last quarter, CAT emphasized inventory headwinds, but not the draw on backlog and the likely favorable pricing in it. 

  • We expect charges in 3Q for the structural capacity reductions at Resource Industries.  We also think a goodwill impairment charge is likely in 4Q for BUCY goodwill, as impairment testing should come at year-end. 
  • Excluding those factors, we would expect a 3Q result in the neighborhood of $1.30-$1.50 vs. consensus of $1.67.  We could be wrong for several reasons beyond backlog, including currency and cost controls, but that is what we get. Once a company gets into identifying restructuring charges, as CAT seems likely to do this quarter, lots of interesting items can be called special.  That said, we think current guidance is a long-shot and expect CAT to struggle to earn $6.00 this year.
  • Instead of a buyback, we expect a miss to be paired off with a cost reduction plan targeted at Resource Industries.  Of course, the cost impact of low volume at Resource Industries is not easily isolated, so that is where we will be interested to see some detail.  We could obviously be wrong in this expectation.
  • We expect comments about 2014 to be positive and focus on the eventual end of dealer inventory draw downs.  We note that JOY and Sandvik have seen large mining order and revenue drops without a dealer network. 


Other Indicators:  While we do not rely on these sort of tea leaves, secondary indicators for CAT are do not suggest an approaching inflection point:

  • Insiders Selling:  In the last couple of years, insiders have only bought 2,000 shares in the open market while selling hundreds of thousands.  Selling may have slowed down in recent months, but we do not see the open market purchases that might accompany an inflection for CAT.
  • Sell Side Estimate Revision Trends:  Since the first week of October there have been a number of downward revisions to estimates.  Quiet period or not, we all should have a sense of how this ‘revision’ process works.


We continue to see CAT as exposed to a significant, multi-year decline resources-related capital spending through both its Resource Industries and Power Systems segments.  Investors appear to be hoping for a cost reduction plan capable of resolving a lack of demand/cyclical downturn problem.  We continue to expect CAT shares to underperform through the down-cycle.


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