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Spiking Skew

This note was originally published at 8am on December 04, 2013 for Hedgeye subscribers.

“My reading of history convinces me that most bad government results from too much government.” -Thomas Jefferson

 

Over the Thanksgiving break, I started reading “Thomas Jefferson: The Art of Power” by Jon Meacham.   For many of you Americans (like Keith I’m Canadian), undoubtedly studying the founding fathers is old hat, but for me the book has a number of revealing insights.

 

The key insight relates to the quote at the outset.  Specifically, this idea that too much government may, in fact, be too much government.  No doubt there are some pensioners in Detroit who are thinking just that as they are beginning to realize that the “government guarantee” of their pension is not as solid as they believed it to be.

 

Like most great men, Jefferson had his faults.  Regardless, the author of the Declaration of Independence was a stalwart protector of individual liberty, especially in the face of the threat of government.  Compared to the Jeffersonian era, the individual American certainly has much broader freedoms than he, and especially she, would have had in the early 1800s.

 

The one caveat to this of course is in the area of economic freedom, specifically taxation.  From the Jeffersonian period to the early 20th century, the government was both a small percentage of the economy and direct taxation was originally very limited.  On the last point, as recently as 1895 the Supreme Court of the United States actually ruled that federal income tax was unconstitutional.

 

Today as we “gladly” hand over 1/3+ of our incomes to the federal government and the government comprises 20%+ of the economy, it certainly begs the question of whether we have the personal economic freedoms that our Founding Fathers envisioned.

 

Back to the global macro grind . . .

 

Related to the topic above, one sneaky macro positive that has been emerging domestically is a shrinking of the federal budget deficit.  Over the past four years, the federal budget deficit has been cut in half from the peak level of $1.4 trillion.  Certainly, a $700-ish billion budget deficit is still too large, but in this regard the trend is definitely our friend, especially as it relates to U.S. dollar tailwinds.

 

Sadly, none of today’s current politicians have the political acumen of Thomas Jefferson, so the primary method to halt federal government spending growth has been for the Tea Party to effectively hijack the government, which most recently led to a government shutdown.

 

In 2014, we may have déjà vu all over again.  Consider the federal government catalysts we have in front of us in the next three months:

  • December 13th – The bipartisan budget committee is supposed to report back on budget / compromise progress;
  • January 15th – The Current Continuing Resolution runs out;  and
  • February 7th – The next debt ceiling deadline. . .

The threat of more negative government catalysts is actually coming at a really complacent and inopportune time for the U.S. equity markets. Specifically, the VIX’s monthly average price was just under 13 in November and at the lowest level we’ve seen in over two years.  As many of you well know, there is an inverse correlation between the VIX, a measure of volatility, and the price of the SP500.  Suffice it to say, the equity volatility ball is sufficiently under water . . .

 

In the Chart of the Day, we highlight the SKEW Index compared to the VIX index.  As the chart shows, SKEW is spiking and historically SKEW has been a decent leading indicator of volatility.  Intuitively this makes sense as investors are becoming more compelled to hedge exposure given the highs in the market and the fact that year-end is fast approaching. 

A potential spike in volatility and decline in equities also makes sense given a number of other signs of a near term top.

 

Consider a couple of headlines from the Wall Street Journal and Reuters from yesterday:

  • “More Hedge Funds Turn to Long-only Strategies”
  • “Short Sellers Trying to Cope”

No doubt, this has been a challenging year for short sellers as stocks with high short interest have outperformed meaningfully, but when more than half of hedge funds launch or plan to launch long only strategies it does reek of capitulation.  (And no, the Hedgeye Long Only ETF won’t be launching anytime soon!)

 

Before signing off, I also wanted to remind you of Hedgeye’s Energy Best Idea call on Boardwalk Partners (BWP) this Thursday at 11am.  BWP is a $6.4 billion market cap MLP primarily engaged in the transportation and storage of natural gas in the south/central US.  The diversified holding company Loews Corp. (L) owns the 2% GP interest in BWP, all IDRs (currently in the 50/50 split), and 52% of the BWP’s outstanding common units.

 

BWP is a high-conviction short idea given the Company’s deteriorating base business, aggressive accounting, high leverage, unsustainable distribution, valuation.  If this thesis sounds a little like our calls on Kinder Morgan (KMP) and Linn Energy (LINE), it should.  We think the valuation of the MLP sector is grossly overstating the intrinsic value of the underlying businesses held in these structures.  If you’d like to get access to the call, email sales@hedgeye.com.

 

Keep your head up and stick on the ice,

 

Daryl G. Jones

Director of Research

 

Spiking Skew - SKEW

 

Spiking Skew - 12 4 2013 8 07 41 AM


[video] $KMP: Kaiser/Gasparino Part Deux (Beware of Kinder Morgan?)



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CRUISE PRICING SURVEY FLASH CALL TODAY: PRE-CCL 2014 GUIDANCE

Please join us for our Cruise Pricing Survey Flash Call today, December 17th at 2:30pm EST

We will discuss the results of their latest Cruise Pricing Survey timed just before CCL's earnings release on Thursday.  CCL should provide fiscal 2014 guidance in their release and the Street expects the company to provide guidance below current estimates.  Listen in and see what our survey suggests for CCL's guidance as well as potential pivots in the trends for both RCL and NCLH.

 

Participant Dialing Instructions

  • Toll Free Number:
  • Direct Dial Number:
  • Conference Code: 297289#
  • Materials: CLICK HERE

 


Best Idea Update: $DRI

Takeaway: We suspect 2QF14 will be ugly, but we are bullish on the long term prospects of Darden.

Editor's note: Hedgeye Managing Director and Restaurants analyst Howard Penney added Darden (DRI) to our Best Ideas list as a long on 10/10/13.  That being said, he expects the company’s 2QF14 earnings release on Thursday to be a disaster as its two largest brands, Olive Garden and Red Lobster, continue to struggle. Here's an excerpt from a note he wrote earlier today.

BEST IDEA UPDATE: LONG DRI

Our bull case is centered on the inherent value of Darden.  As we’ve been saying for the majority of the year, we believe the business is grossly mismanaged and in need of a major overhaul.  Barington Capital entered the fray as an activist back in October, but has been relatively quiet since then. That changed this morning, when the company released an 84 page report detailing its recommendations to improve long-term shareholder value at Darden.  

 

If these changes are implemented, Barington values Darden’s stock between $71 and $80 per share.  If our plan to fix Olive Garden is implemented, we see even more upside in the stock.

 

Best Idea Update: $DRI - how2

 

The full report, featuring several of our own quotes, can be accessed HERE.  Barington intends to promptly share these recommendations with Darden Chairman and CEO, Clarence Otis.

 

Best Idea Update: $DRI - dar5

 

If Barington, or another activist, is successful in forcing change, we would expect significant shareholder value creation.  In our opinion, the most value will be created from cutting excessive G&A spending and turning around the company's crown jewel, Olive Garden.  You can read more about the activist situation and our thoughts on the matter in a recent article published by Barron’s: Darden Shares Could Jump 40% On Hedge Fund Plan.

 

Click here to watch Penney's video "Darden: Major Upside Coming?"

 

 

*   *   *   *   *   *   *   *   *

 

Interested in joining the Hedgeye Revolution? Click here.


BEST IDEA UPDATE: LONG DRI

Takeaway: We suspect 2QF14 will be ugly, but we are bullish on the long term prospects of Darden.

LONG DARDEN

We added Darden to the Best Ideas list as a long on 10/10/13.  That being said, we expect the company’s 2QF14 earnings release on Thursday to be a disaster as its two largest brands, Olive Garden and Red Lobster, continue to struggle. 

 

Our bull case is centered on the inherent value of Darden.  As we’ve been saying for the majority of the year, we believe the business is grossly mismanaged and in need of a major overhaul.  Barington Capital entered the fray as an activist back in October, but has been relatively quiet since then. That changed this morning, when the company released an 84 page report detailing its recommendations to improve long-term shareholder value at Darden.  If these changes are implemented, Barington values Darden’s stock between $71 and $80 per share.  If our plan to fix Olive Garden is implemented, we see even more upside in the stock.

 

The full report, featuring several of our own quotes, can be accessed HERE.  Barington intends to promptly share these recommendations with Darden Chairman and CEO, Clarence Otis.

 

If Barington, or another activist, is successful in forcing change, we would expect significant shareholder value creation.  In our opinion, the most value will be created from cutting excessive G&A spending and turning around the company's crown jewel, Olive Garden.  You can read more about the activist situation and our thoughts on the matter in a recent article published by Barron’s: Darden Shares Could Jump 40% On Hedge Fund Plan.

 

 

2QF14 EARNINGS

Moving back to 2QF14 earnings, we believe the release and subsequent call will be the most important of CEO Clarence Otis’ career.  His commentary will be closely scrutinized and could shed light on the timing of future events.  The current consensus EPS estimate for the quarter is $0.22, significantly above the $0.15 that we are currently modeling.  We expect to see sales deleverage in the quarter and believe food costs, labor costs, and other expenses will pressure margins more than the street anticipates.  Following the call, we would be buyers of any sell-off.  We believe Darden is currently the best positioned big cap casual dining company heading into 2014.

 

SAME-RESTAURANT SALES

Same-restaurant sales trends at Olive Garden and Red Lobster have been horrible lately, due primarily to declining traffic.  Current consensus estimates are for same-restaurant sales to increase +0.1% at Olive Garden and decrease -1.8% at Red Lobster.  Both of these estimates are, in our opinion, aggressive.  If we are right and comps are worse than expected, this would have a negative effect on the majority of line items.

 

BEST IDEA UPDATE: LONG DRI - OG

 

BEST IDEA UPDATE: LONG DRI - RL

 

 

COST OF SALES

Current consensus estimates are for cost of sales to increase +30 bps y/y in 2QF14 to 31.28% of sales.  We believe shrimp prices will pressure margins more than the street expects, particularly given Red Lobster featured Endless Shrimp Tuesday during the quarter.  We expect cost of sales to come in above consensus.

 

BEST IDEA UPDATE: LONG DRI - chart1

 

 

LABOR COSTS

Current consensus estimates are for labor costs to increase +35 bps y/y in 2QF14 to 32.78% of sales, after increasing over +100 bps y/y in each of the last three quarters.  In 1QF14, restaurant labor expenses were +110 bps higher due to lower average wage inflation, reduced productivity and sales deleverage at Olive Garden and Red Lobster.  Given the current sales trends, we do not see how the labor costs will improve that materially from 1QF14.  We expect labor costs to come in slightly above the street.

 

BEST IDEA UPDATE: LONG DRI - chart2

 

 

OTHER EXPENSES

Other restaurant expenses have been up significantly (+100 bps on average) for the past four quarters, due to the acquisition of Yard House among other reasons.  Currently, street estimates are for other expenses to increase +17 bps to 16.78% of sales.  Street estimates have come up recently, however, they are still conservative and do not account for a large enough impact from sales deleveraging at Olive Garden and Red lobster.  We expect other expenses to come in above consensus.

 

BEST IDEA UPDATE: LONG DRI - chart3

 

 

GENERAL & ADMINISTRATIVE

In an effort to cut some fat from the company cost structure, we are expecting to see an approximate $7 million (net) expense associated with G&A cuts in 2QF14.

 

BEST IDEA UPDATE: LONG DRI - Chart4

 

 

Recent Notes

12/11/13 – Restaurant Impossible: Fixing Olive Garden

10/30/13 – DRI: Pending FY2Q14 Disaster?

10/18/13 – Dismantling Darden: Hedgeye vs. Barington

10/15/13 – DRI: A Generational Opportunity

 9/12/13 – Dismantling Darden

 8/21/13 – DRI: Restructuring Charge Looming?

 6/26/13 – DRI: Beware of False Narratives

 6/21/13 – DRI Comps Flatter to Deceive

 6/17/13 – DRI Remains a Win-Win

 5/23/13 – DRI’s Jamie Question

 

 

Let us know if you have any questions or would like to discuss any of our current ideas in more detail.

 

 

Howard Penney

Managing Director


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