TODAY’S S&P 500 SET-UP – November 1, 2013
As we look at today's setup for the S&P 500, the range is 31 points or 0.94% downside to 1740 and 0.82% upside to 1771.
CREDIT/ECONOMIC MARKET LOOK:
MACRO DATA POINTS (Bloomberg Estimates):
WHAT TO WATCH:
COMMODITY/GROWTH EXPECTATION (HEADLINES FROM BLOOMBERG)
The Hedgeye Macro Team
Yesterday we hosted a conference call on electronic cigarettes with Craig Weiss, CEO of NJOY, a closely-held manufacturer and marketer of electronic cigarettes. This is part of a series of talks we’ve held with industry experts to better understand the growing e-cigarette category (click for replay podcast and presentation). We came away from the call with a number of insights on NJOY and the new and growing e-cig category, which we provide below under Presentation Highlights and Key Takeaways. Further below we’ve also reproduced what we thought was a very engaging and insightful Q&A session from Craig.
As it relates to our investment outlook, we remain very bullish on e-cigs, with category sales estimated at ~ $1.5B to $2B this year and poised to double in the coming years. While the category only represents a minor (around 1-2%) portion of the overall sales portfolio of Big Tobacco and pending FDA legislation (more below) could stand to shake up the industry, we believe the interest and “buzz” from management and investors on the category is playing into U.S. tobacco stock prices, as both parties recognize the need for the industry to replace declining traditional cigarette volumes, albeit without cannibalizing existing business.
Our preferred tobacco stock on this front remains Lorillard (LO). Unlike Altria and Reynolds, who in the quarter joined the category with their own e-cig offerings, MarkTen and Vuse, respectively – LO bought Blu in April 2012 – we prefer LO, a company that is well aware that the FDA is considering restricting menthol. We believe the company, highly levered to menthols (~85%), has less cannibalization risk pursuing e-cigs (especially should an FDA ban or some form of tighter restrictions be imposed down the road) vs MO or RAI due to its portfolio mix. We think Blu is enjoying first-to-market advantage and in Q3 results, Blu saw strong sales growth of 11% quarter-over-quarter (+350% year-over-year) to $63MM. LO CEO Murray Kessler’s e-cig strategy appears to be to forgo short-term profits for long term gains: he sold e-cigs for break-even in the quarter and was able to boost Blu’s market share to 49% versus 40% last quarter. Over time, we do think that e-cigs can be margin-enhancing to the combined cigarette category. For more see our note titled “What’s Big Tobacco Saying About E-Cigs in 3Q13?”
FDA regulation remains one large wild card for the category. The agency was expected to announce regulation this month—it’s anyone’s guess now just when that may happen. It’s our opinion that the FDA wants to protect the consumer, while not stifle e-cig innovation that can ultimately lead people away from the harmful combustible cigarettes. A few of the larger regulations expected to be addressed are online sales, flavors, and marketing, however regulations could go much further. It appears the science on e-cigs remains incomplete, which would suggest to us that the agency may err on the side of less regulation versus more regulation until the science is (more) conclusive. [As a side note, the City Council of NYC decided yesterday to raise the minimum age to purchase cigarettes (and explicitly included e-cigs in the bill), which is expected to be signed off by Mayor Bloomberg and go into effect in 6 months.]
NJOY Presentation Highlights:
Founded in 2006 and ramping up distribution in 2009, NJOY is one of a handful of private companies that we believe can be competitive with Big Tobacco in the e-cig category.
NJOY is now in some 80,000 retail stores across channels nationwide with its traditional and menthol flavored disposable e-cigs and Craig says the opportunity for e-cigs is analogous to the impact that filtered cigarettes had in changing the industry, quoting Mark Twain: “History doesn’t repeat itself, but it does rhyme”. Craig says that with its product offerings at the front counter of stores, including its countertop spinners, consumers can have closer proximity (touch and feel) to NJOY’s products versus tobacco products that by law (Master Settlement Agreement) must be relegated to the back counter.
One clear differentiating factor for NJOY versus such brands as Blu, Mistic (product of Ballantyne Brands), and Vuse, is that NJOY’s product packaging aims to make the product as close as possible to a traditional cigarette in terms of look, feel, and size. Craig says the reason for the product packaging strategy is that, while there will always be a market for someone that does not want to look like they’re smoking, he believes you need to make the bridge of familiarity between the very ingrained habit of smoking and choosing an alternative like an e-cig short enough so it’s easy to cross. This is why NJOY has made its product as familiar as possible to smokers: every smoker carries a pack and lighter, so these form factors have also been integrated into the packaging as a bridge to familiarity and to improve the product’s overall experience.
Another point of differentiation is NJOY’s conviction that the industry is trending towards disposables and away from rechargables. This goes against the discussions we’ve had with other e-cig companies such as Ballantyne Brands and a general tone from Big Tobacco, all of which are in support of the margin enhancing opportunities with the razor, razor-blade model of a rechargeable unit.
Craig comments that much of the e-cig share is determined by retail presence: LO’s Blu is in 50% more outlets than NJOY and he believes that while current consumer preference is based on availability, ultimately consumers will gravitate towards those with the best consumer experience.
The following is a complete transcript of the Q&A from Craig Weiss:
Q: Any guess how the FDA will treat online sales, flavors, and indoor vaping? How would you guess deeming regulation from the FDA will impact NJOY and the industry? Do you think the rulings from the UK and EU Parliaments on e-cigs will impact the FDA’s decision?
A: On the first question there’s a lot of speculation on what the FDA will do. I don’t know that I have any more insight than anyone else does. My guess is that electronic cigarettes will continue to be available and it’s hard for me to see any scenario whereby the FDA sends 3-4 million people back to tobacco cigarettes and back to their death. I see good manufacturing practices requirements and ingredients disclosures, age verification requirements. As for the big ones, which would be online sales, flavors and advertising, my guess is that they’ll punt those further down the road until they gather more information on the impact that e-cigs are having on the population, and I know for a fact that the FDA is engaging on that research right now to do population based studies on the impact of e-cigs, and it will take some time to gather the data.
With respect to how things are shaping up internationally, I don’t know if [the UK and EU regulation] has such an impact on the U.S. It’s a different regulatory structure here. E-cigs cannot be regulated as medicinal products per a ruling in 2010 – so the real question is how the FDA will exercise its tobacco jurisdiction over the products (but not as medicinal products). It’s clearly a struggle between the Center for Tobacco Products and the FDA because they can’t take cigarettes off the shelves, and I think they know based on the scientific data that e-cigs are better for a smoker than a cigarette. So they have to figure out how they can restrict a product while leaving unrestricted a cigarette which they know to be toxic.
So we’ll see how this shakes out. My guess is this is the beginning of a very long process. Even the publication of rules will follow a commentary period before they’re proposed rules, before they go to become final rules—there’s a very good chance there will be litigation, and then they’ll have to go through a more formal process once they have enough scientific data.
So I think you’re likely to see something in the next couple of months, certainly by the end of this year, with the FDA asserting jurisdiction and maybe laying down ground rules, but I think the longer process is going to play itself out over the course of the next several years.
Q: On the international piece, we saw LO buy SKYCIG earlier this month, do you have any plans to move internationally?
A: We have already moved internationally. We sell in the U.K. right now and are on the cusp of rolling out to market in Europe and around the rest of the world. IF you look at the LO acquisition, it doesn’t have a lot of market share – it is maybe the fourth brand there – and what they really acquired was the infrastructure. There is no Newport brand outside of the U.S., in fact there is hardly any menthol market outside of the U.S., and so they spent $50 to $100MM (depending on the terms) to buy the infrastructure of 30 people associated with the business. I have been able to build out a fairly serious infrastructure for a lot less money and I think I’m poised to expand far more rapidly. But what you’re seeing is the first indication of how costly it would be for big tobacco to buy infrastructure because they can’t pull the distribution levers they can domestically and of course tobacco companies are geographically landlocked. In the U.S. you have the big three tobacco companies that are more or less [just doing business] in the U.S. And then you have BAT, Imperial (in Europe), JTI (in Asia) – there’s a lot of isolation among the big companies. You have PMI, which is big and global, but not particular dominant in one particular area, so I think there’s a great opportunity to be a big global player in the e-cig space which his obviously something that NJOY is attempting to achieve.
Q: Can you discuss capital needs associated with growth? What growth trajectory can be maintained with internally generated cash flow? How do the different sales channels and geographies place burdens on the growth capital account?
A: We’ve raised over $100MM, we’re well capitalized for growth. Fortunately our product is selling, so that helps to generate a lot of revenue to help the brand grow, so we feel pretty good about our ability to continue to scale whenever we bring on new countries, distributers, and retailers, those relationships typically start with a purchase order, and a load-in, since the stores have to load-in inventory, so that requires a large infusion of capital every time you do that. That’s part of what explains the LO numbers– their growth has all been distribution, their same-store-sales are declining but they’ve been adding enough stores to offset that and show growth but they had three flat quarters followed by a slight uptick, but that again goes to the stores that they’re adding.
Q: What have you learned about demographic trends and consumer behavior of e-cig users? Any gender or age trends? What’s the defining aspect for conversion to e-cigs versus traditional?
A: Demographically I don’t think the numbers are too dissimilar to what you see from the general smoking population. E-cigs skew a bit more female than the general smoking population, just because women tend to be a little more health conscious than men. Because e-cigs have traditionally been a bit more expensive than traditional it also skews a little more higher income, but I see that changing as the price comes down. Four years ago an electronic cigarette could cost $150, and it was a pretty terrible product, today we’re selling an e-cig for $5.99 (based on a 5-pack selling for $29.99) for a product that is far better than what was available back then. It’s a little too early to read too much into the demographics, but it typically tends to follow the smoking population.
Q: Can you talk about NJOY’s suppliers? Do you worry about supply chain disruptions and quality control?
A: We have a pretty good network of very high suppliers, with built in redundancy in the system. We manufacture the liquid in the U.S. in GMP facilities that we have oversight over. Another aspect of doing manufacturing properly in Asia is that you get two things that are hard to replicate in an automated U.S. facility: the ability to rapidly innovate and scale rapidly. And so those two things are reasons why Apple continues to manufacture in China. No one has more money than Apple or ability to build facilities in the U.S., so why haven’t they? The reason is because those key assets, the ability to rapidly innovate and scale rapidly, you can only achieve through the manufacturing prowess that China has to offer. And so we’ve availed ourselves of that. That’s reflected in the rapid innovation cycle that you’ve seen from our products as opposed to those from our competitors which for more or less have been selling the same commoditized offerings for the last several years.
Q: From a timeline perspective, where do you think you guys are at versus where you want to be, with that ultimate throat hit and satisfying experience that the consumer is accustomed to with traditional cigarettes?
A: We have a ways to go – by this I don’t mean in terms of time as we’ve moved very quickly—but I mean in terms of the offering that’s currently in the market. No matter how you slice e-cig growth, the category is currently 1-2% of the entire tobacco category. So why are we only 1-2% of the tobacco category and I think the answer is the products aren’t good enough yet (as a massive generalization). They’ve made great progress, and are building inroads, with good momentum, but the products need to get better – the good news is they are starting to get better very rapidly. NJOY will continue to lead the way to continue these innovations. There are not many people out there that have devoted the time, energy and resources that we have from a chemistry and science perspective and hardware perspective to build a product that we think will ultimately replicate the smoking experience. We feel that the products we’re rolling out in Q4 and early next year are a quantum leap closer to achieving the holy grail – I mean how much would you pay for French fries that don’t make you fat? At the end of the day when you can deliver on something, or get somewhere that is close enough – as an example Diet Coke and Coke Zero as a category are bigger in the U.S. than Coca-Cola, so you don’t have to deliver 100% of the sugar, calories and the taste of Coca-Cola if you can offer them other things, which of course Coke Zero and Diet Coke do and which electronic cigarettes do, which is other significant benefits. And it’s not just the health concerns, you also have the odor which is a huge issue – smokers hate the smell of smoke, what it does to their hair and clothes. The cost is a big issue. As the cost come down relative to smoking and the societal pressures to be alleviated, as is the emerging scientic data with regards to health – as that data becomes more prominent smokers will start to realize more and more what the opportunity is for them when they make the switch.
Q: What’s your sales mix of disposables versus rechargables and how do you see that evolving across the industry?
A: NJOY is entirely disposable and I would say for the category it is moving almost entirely towards disposables, and I see that trend continuing. I would say from a unit perspective, even Blu’s rechargeable business is declining and disposable are increasing, so the category is overwhelmingly disposable according to Nielsen today. Blu’s disposables accounted for 81% of Blu’s unit volume, according to the latest Nielsen.
Is there are rechargable customer, absolutely. There is a value consumer willing to compromise on product experience, to go through the hassle of recharging, plugging things in and screwing things together – it’s like comparing to Soda Stream which is more cost effective than buying Coca-Cola, but I don’t think people believe that is going to be a mainstream experience in the U.S. (at least) to offset soda. There are lots of things that are better value propositions. Re-chargeable AA batteries are a better value proposition than buying AAs. But how many people do you know that are exclusively using rechargeable batteries versus disposables. We don’t do it because it’s not convenient. So at the end of the day there are people willing to sacrifice convenience for value but that is a small segment of the population. I mean 85% of smokers buy by the pack, only 15% buy by the carton, although it’s greater value –while there are other factors at play, the vast majority of the cigarette market is the premium market, a very small percentage discount market. I think roll your own is maybe the appropriate analog and it is about 1% of the market in the U.S.
Q: How are states regulating e-cigs? Which states are taxing e-cigs like a tobacco product? Is there any legislation we should be aware of?
A: Only one state has succeeded in taxing e-cigs, it’s Minnesota. MN did that early on before there was really galvanized support for e-cigs among the consumer population. Three states more recently tried to pass taxes on e-cigs, also all three of them failed – Utah, Oklahoma, and Hawaii. And so in all three cases, when the taxes were proposed, literally hundreds, in some cases thousands, of people descended on those capital to protest. I don’t see taxation as the same type of threat that I think people assume it is. Even in Italy, there some consideration of taxation and people went on a hunger strike. When is the last time you saw people go on a hunger strike, for say Coca-Cola. You didn’t see this when there was a proposed ban in NYC – people are passionate about their e-cigs.
Q: How important is the ability to market the product? Worried if marketing gets banned, will it stunt your future growth?
A: The marketing is very important, it is critical that we’re able to communicate that smokers have an alternative. We’ve made this position clear publically, we’ve made this position clear privately to the FDA. I don’t want there to be advertising restrictions. I want to tell smokers that they have an alternative and I want them to know that that alternative is my product. But even in some scenario in which there are advertising restrictions, at least for NJOY, it would likely benefit us because no one else would be able to advertise and we’re already in the vast majority of locations where tobacco is sold in the U.S., in leadership positions at retail.
Q: Both Altria (Mark ten) and Reynolds (Vuse) are likely to begin their own distribution rollout similar to Lorillard with Blu, for how long will the rapid industry sales growth be relatively profitless given the heavy investment phase?
A: Vuse and MarkTen will presumably roll out nationally sometime in 2014 although it is a much more complicated effort for them than it is for LO. Not all tobacco companies are created equally. LO has a gun to its head on menthol – if menthol goes away, their entire company goes away. So they have to diversify, they have to get behind e-cigs and push the heck out of it. Their customer base is not likely to move to e-cigs, which is mostly a menthol/Newport customer base, so they have the least risk among the tobacco companies to be pushing an e-cig. It’s much more complicated for Altria and Reynolds who would be directly cannibalizing the sale of their current products in a way that Lorillard is not. I don’t think you’ll see as aggressive a roll-out form Altria and Reynolds as we saw from Lorillard but at some point they are going to roll out and they’re going to leverage their distribution networks and will get in a couple hundred thousand stores, because that’s what they do. At the end of the day, that’s going to bring new users and smokers into the category and I believe those people will migrate to the best product, which I think will be our product. But even if LO showed that they were operating the Blu business break even, that’s because they are spending so exorbitantly on marketing and it’s not clear to me that the business has to be run in that way. It depends on you want to focus on: growth, or profitability, how you want to growth the business and what your aims are. At the end of the day there is GM and there is net income, people have to make a decision what matters to them most for each company. And each investor may make different decisions.
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Regional markets should rebound sharply from a horrible September.
Takeaway: It doesn't look like the U.S. is turning Venezuelan this week. Phew.
Trick or treat? TREND or TAIL?
The Dollar's long-term TAIL support line of $79.21 was recovered. That’s good. It means we won’t look like Venezuela this week. Phew.
But the TREND resistance remains overhead at 80.16. So, unless you’re a long-term holder of dollars, you want to wait and watch on this thing. Pimco's Bill Gross begging for higher taxes this morning? Yuck. The Dollar Devaluation and Bond Bull Lobby is coming on thick.
SBUX: FIRING ON ALL CYLINDERS
SBUX reported another all-star quarter in 4Q13 and appears to be firing on all cylinders heading into FY14. A strong commodity tailwind, international growth, the beginning of a recovery in the EMEA segment, and expansion into new segments of the global food and beverage industry are all bullish factors moving forward. The only slight negative stemming from what was, overall, a bullish conference call was management reigning in expectations for FY14, which, in our view, gives the company a better chance of surprising to the upside throughout the year.
Last night, Starbucks reported global same-store sales growth of 7%, marking the 15th consecutive quarter above 5%. Same-store sales in the Americas division grew 8% (including 5% traffic). Total revenue growth of 13% produced a 28% increase in operating profit and a 30% increase in EPS.
Channel Development Segment:
Despite reporting a great 4Q13, the bears do have several legitimate concerns:
While management did their best on the earnings call to reign in expectations for FY14, by guiding to full-year global comparable sales in the mid-single digit range, we suspect that the street is looking for more. This guidance did appear to be fairly conservative but, as CEO Howard Schultz implied, it would be foolish to guide to high single-digit or double-digit comps.
All told, SBUX remains the best-run company that we follow and the long-term TAIL continues to seem unlimited. The company’s geographical reach and size is highly impressive and management continues to find feasible, innovative ways to drive comp growth accretive to the whole SBUX system.
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