THE MACAU METRO MONITOR, JANUARY 10, 2014
BILLIONAIRE CHENG'S COMPANY TO BUY MACAU JUNKET OPERATOR Bloomberg
International Entertainment, the company controlled by the family of Asia’s fourth-richest man, Cheng Yu-tung, agreed to pay as much as HK$7.35 billion ($948 million) for a 70% stake in Sun City Gaming Promotion Co, a junket operator. Cheng owns a 10% stake in closely held Sociedade de Turismo & Diversoes de Macau SA (STDM) - the 10% stake in STDM gives him control of 293 million shares of SJM.
Sun City expects its credit facilities offers to customers will be no less than HK$12 billion during 2014 and 2015 while the rolling turnover at its VIP rooms across Macau will be no less than HK$1.68 trillion, it said in the statement.
FOREIGN CASINO OPERATORS LURED BACK TO YEONGJONGDO Korea Herald
According to multiple industry sources on Thursday, the Korean government plans to announce its new tourism strategy later this month, which, among other things, would relax financial rules for foreign bidders to earn casino licenses in the nation’s economic zones. “We are considering easing the bidding standards after receiving complaints that it is too difficult to meet the criteria of BBB credit ratings,” said a government official. “But we have yet to decide on detailed plans.” Caesars and Universal are potential bidders.
Korea’s casino operator Paradise Group, together with Japan’s Sega Sammy Holdings, has already launched an 11,190-square-meter resort project, with its construction planned to start in April for completion by 2017.
TODAY’S S&P 500 SET-UP – January 10, 2014
As we look at today's setup for the S&P 500, the range is 25 points or 0.71% downside to 1825 and 0.65% upside to 1850.
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 December 27, 2013 for Hedgeye subscribers.
“Difficulties are just things to overcome, after all.”
Even though many of us thoroughly enjoy our jobs, most work years are still typically a bit of an endurance test. Luckily, as I wrote yesterday, the U.S. stock markets had a very healthy year and returns were up and to the proverbial right. So, for stock market operators, 2013 wasn’t all that much of an endurance test.
I recently finished reading a book called, “Endurance: Shackleton’s Incredible Voyage”, which tells the story of Ernest Shackleton and his failed attempt at being the first person to cross Antarctica from sea-to-sea via the pole. Shackleton’s ship was named the Endurance and endure is exactly what he and his shipmates did.
The Endurance departed from South Georgia for the Weddell Sea on December 5th, 1914. Two months later the Endurance was frozen in an ice flow and Shackleton ordered the abandonment of the ship and her conversion into an ice station. For the next 8 months, the crew lived on the ice floe in the middle of the Antarctic Sea until the ship was finally broken in half by ice pressure.
At that point, Shackleton order his crew to another ice floe and for the next six month, until March 1916, he and his crew shifted between various floes. By April, their current flow was becoming too small and Shackleton and his crew jumped into the remaining life boats to make a five day harrowing trip to Elephant Island.
After a couple weeks on the deserted Elephant Island, Shackleton selected a crew of six to sail with him across the Drake Passage back to South Georgia Island, the nearest point of civilization more than 600 miles away.
The Drake passage is widely considered the most challenging water to sail on the planet. According to Wikipedia:
“There is no significant land anywhere around the world at the latitudes of the Drake Passage, which is important to the unimpeded flow of the Antarctic Circumpolar Current which carries a huge volume of water (about 600 times the flow of the Amazon River) through the Passage and around Antarctica.”
Shackleton and his crew sailed the Drake Passage in a 20-foot wooden sail boat in the middle of a hurricane and eventually made it to a whaling station on South Georgia Island (only after crossing the Island on foot, something no man or men had done to that point). So, after almost 20 months of being stranded in the Antarctic, Shackleton and his crew made it to civilization. And that, my friends, is endurance!
Back to the Global Macro Grind...
After a relative tame investing year in 2013, the question for all of us is: what will we have to endure in 2014 to generate outperformance? There are a few things that potentially come to mind, specifically:
1) Debt Ceiling – The debt ceiling is set to expire on February 7th, though the Treasury Department has the ability to extend this via the use of extraordinary measures for about another month. Treasury Secretary Jack Lew, and thus the Obama administration, has already sent the opening volley in a letter to Congress last week. As Lew wrote in the letter:
“The creditworthiness of the United States is an essential underpinning of our strength as a nation; it is not a bargaining chip to be used for partisan political ends.”
In part he is of course correct, the debt ceiling shouldn’t be used as a bargaining chip, but in reality 2014 is an election year and it is a very good bargaining chip for the Republicans. In particular the Tea Party, who need a win to go back to their constituents with after the recent budget compromise.
In the Chart of the Day, we show the return of the SP500 in the summer and early fall of 2011. As you may recall, while it wasn’t as difficult as sailing the Drake Passage in a wooden row boat, the last major debt ceiling debate was a difficult and volatile period for U.S. equities.
2) Interest rates – As we’ve noted, the U.S. interest rate market has basically already front run the beginning of tapering. The 10-year yield has close to doubled from the lows of May of this year to the recent high of around 3.0%. Certainly increasing rates has its positive implications, especially as it relates to supporting U.S. dollar strength, the challenge of course is controlling the speed at which rates normalize. An accelerated increase in interest rates will undoubtedly serve to stymy economic growth.
In the short run, the most significant impact that rising rates will have is on the housing market. In part, the impact on the mortgage market is already being seen. According to the Mortgage Bankers Association, mortgage applications fell 6.3% on a seasonally adjusted basis last week to their lowest level in 13-years. National home prices are unlikely to continue climbing if mortgage demand and affordability are falling.
3) Chinese growth – The Shanghai Composite is having a positive morning up more than 1.4% as Chinese Interbank rates fell for the fourth day in a row. While the spike in Chinese interbank rates has garnered headlines over the last few weeks, our Asia Analyst Darius Dale has been quick to note that much of this recent spike relates to a liquidity crunch going into year-end and is likely to be short lived. The broader question for Chine relates to economic growth.
Certainly, managing growth lower will be important for Beijing in reigning in domestic credit growth and rebalancing the economy, but what of the implications globally? A Chinese growth rate potentially slowing from 7.5% to 6-7% will definitely have implications on global economic activity. Some may be positive, such as a decline in demand, and thus price, for certain commodities. Conversely, a lower than expected Chinese growth rate may be a shock to barely recovering Western countries and companies that depend on Chinese demand.
In aggregate, the three points above may actually not provide an endurance test for stock market operators in 2014, but merely be “icebergs” that we easily sail around. Only time will tell on that front.
Our immediate-term Global Macro Risk Ranges are now:
UST 10yr Yield 2.91-3.02%
Keep your head up and stick on the ice,
Daryl G. Jones
Director of Research
Brief background: Darden is the world’s largest full service restaurant company. The company operates 2,138 restaurants in the U.S. and Canada, including 828 Olive Garden restaurants, 705 Red Lobster restaurants, 430 LongHorn Steakhouse restaurants, 49 Capital Grille restaurants, 44 Yard House restaurants, 22 Bahama Breeze restaurants, 31 Seasons 52 restaurants and 12 Eddie V’s Prime Seafood restaurants. In addition, the Company owns a significant amount of real estate including the land and building on 1,048 properties and the buildings on 802 ground leases.
Darden’s management team has been under a firestorm of criticism lately for poor performance, relative to its peers, over the past five years. Hedgeye Managing Director Howard Penney has been at the forefront of this activist movement since early 2013, when he first identified the potential for unleashing significant value creation for Darden shareholders.
Less than a year later, it looks like Penney’s plan is coming to fruition. Google “Howard Penney” and “Darden” and you will see myriad recent stories in the Wall Street Journal, Barron’s and others cataloging his efforts.
Activist investor Barington Capital Group LP disclosed a 2.8% ownership stake in the Company this past October. A couple months later, they released a full-report detailing the need for change at Darden. On December 19, in a press release prior to the Company’s 2QFY14 earnings call, Darden management announced its strategic plan to increase shareholder value. This plan (which included spinning off Red Lobster) fell short of expectations. Several days later, Starboard Value, a larger activist, disclosed a 5.6% stake in the Company as well as its intentions to push for further changes at Darden.
INTERMEDIATE TERM (TREND) (the next 3 months or more)
Darden has been hampered by the performance of its two biggest brands, Olive Garden and Red Lobster. Olive Garden is a strong brand that has lost its way. Red Lobster is a disaster and Penney argues that spinning off the flailing concept may actually end up hurting the brand more than it helps. That being said, Darden still has several issues that could continue to hamper performance over the intermediate-term. Despite any short-term inconsistencies, there is still significant shareholder value to be had. With activists at the forefront, this could happen fairly soon.
LONG-TERM (TAIL) (the next 3 years or less)
Darden is a name you want to hold over the long-term.
Penney (who clearly thinks the business is grossly mismanaged and in need of a major overhaul) believes these activists will drive material change at Darden. This would obviously be extremely bullish for shareholders. In his opinion, the greatest value creation would come from getting better senior management in place, cutting excess general and administrative spending, and turning around the company’s crown jewel, Olive Garden.
Bottom line: If Barington’s changes are implemented, that would value Darden’s stock between $71 to $80 per share. If Howard Penney’s plan to fix Olive Garden is implemented, there is even greater upside in the stock.
Replay: CLICK HERE
Materials: CLICK HERE
Tighter regulation of the railroad industry is likely not a near-term threat, but a real possibility over the next few years. Of course, valuation is not a near-term exercise, either, and models should probably not forecast ever-expanding margins. Going forward, it seems quite possible that the regulatory pendulum will start to swing back toward tighter railroad oversight. When the Staggers Act was passed, there was little hope that the industry would achieve so-called revenue adequacy (e.g. meeting cost of capital targets, as defined). As a result, the legislation does not explicitly spell out the regulatory changes that should accompany the achievement of revenue adequacy. With several railroads having achieved revenue adequacy in recent years and the others close behind, legislation or regulation may be adapted over time to reflect a balance between the now higher industry profitability with the natural monopoly aspects of the industry.
A current STB effort is directed toward improving the cost of capital definition used in the determination of revenue adequacy. The current definition has several flaws, including the use of historical cost of very long lived assets for both the capital base and depreciation expense. This is an undertaking that may take Board a year or two to complete. Another key risk is that shippers may continue to seek favorable STB rate case judgments by citing the industry’s achievement of revenue adequacy. This could hasten a reappraisal of how revenue adequate railroads are treated, but requires both time and the right case. Finally, safety regulation on tankers and positive train control (PTC) may increase costs in coming years, as recent publicized accidents have shifted such issues back into the spotlight. These issues also appear to be gradual in their impact.
Any oversight changes appear likely to occur slowly; rail re-regulation is not an investor emergency. That said, by the time these regulatory issues reach the ‘front page’, rail shares may have already started to reflect less accommodation. We are not taking a position on 2014 railroad relative performance here, but note that investor expectations for rail margin expansion in coming years may be at risk if and when regulation emerges as an issue. Over the very long-run, railroad profitability has been disproportionately impacted by regulatory and legislative activity. Slow changes in regulatory direction are a positive when the regime is favorable, but a serious negative when oversight gets too tight, as the 1970s railroad results appear to demonstrate.
Summary and Partial Transcript
There are some current regulatory issues that affect the industry now and going forward. What I want to do today is highlight key economic regulatory issues as well as touch on a couple of STB proceedings as well as some legislative initiatives in Congress. My disclaimer is of my own personal view and does not necessarily represent any of the firms or clients of the firm.
Brief Summary of Introduction (see Materials like above)
STB found 3 railroads to be revenue adequate:
Two safety issues important to the industry:
1. Implementation of positive train control (PTC). There is a deadline of 2015 for implementing positive train control. There is concern that the industry is not ready for it. The recent MTA derailment in Bronx, NY has put this issue back into the spotlight.
2. Transportation of crude oil and hazardous materials by rail. The Department of Transportation has a rule making ongoing with tank car integrity related transportation issues. Congress is considering implementing new tank cars and disallowing the old ones.
Jay Van Sciver: I was wondering if you could expand on revenue adequacy and what that means in terms of regulation of railroads’ return. Could you also expand on the cost of capital definition by the STB? I understand the STB calculates the cost of capital in the 11-12% range in recent years, which is far higher than what everyone estimates it. So how did it get there and what does it mean going forward especially for revenue adequacy?
LM: I'll start with revenue adequacy, when Congress passed the Staggers Act the focus was on the industry which was in very bad shape in achieving revenue adequacy, one of the main responsibilities of the STB. Specifically to rate regulation the view is once a determination is made that revenue adequacy has been achieved then does that mean the extra earned by the industry would be allowed. The competitive cost must come from the non-competitive base. The debate will be about how much return the industry needs to operate and put back into the privately funded infrastructure. The question for the regulators is will all the companies have to meet revenue adequacy? These questions are not answered but need to be answered at some point.
On cost of capital, this issue has been around for awhile. The customer has routinely focused on it. There had been an early proceeding exploring how equity is to be determined. It will take some time to sort the issue out in roughly two years.
JVS: What are the complexities around the cost of capital? You would think they would have purchased cost of equity market perspective for what the equity holder needs to hold shares of a railroad. There is a great deal of academic literature on this so it's not something that would take two years to do.
LM: I don't disagree with you and the board doesn't disagree with you. I think it comes down to the board having a model in place for them to implement without controversy. The decision they issued did not have a consensus record on the way to go as well as the determinations that would have to be made. They have to do everything by the weight of the record.
JVS: But doesn't the nature of regulation often make them unhappy?
LM: I think you are right. I should have said the weight of the record. When the board makes a decision is there enough evidence to go in that direction based on the record. It is more of the weight of the evidence versus a complete agreement by consensus.
JVS: If the STB lowered the cost of capital, would that push more railroads into the revenue adequate position, as the primary determiner?
LM: That is the primary determiner. Essentially that is how the board determines whether a company is revenue adequate. That is why the customers are concerned about the measurement of cost of capital because the higher the level the more opportunity for higher rates?
JVS: Has the cost of capital trended higher over the years?
LM: No, in recent years it has been hovering at 11%.
JVS: What would get the conversation moving toward rail regulatory reform in Congress to deal with GAAP and the Staggers Act dealing with revenue adequacy especially as some of the rail companies have approached or passed as relative adequate?
LM: Well, I think the first thing that would occur would to get someone's attention on the Hill. The legislation has focused on opening up the marketplace to additional access. The Congress we are in right now will take a lot to get noticed.
JVS: If the STB revisited its cost of capital rates and essentially lowered it would that change their regulatory posture and look at rail proceedings differently?
LM: That's the implication of the statute. There would be a view to revisit how the industry is being regulated. That is the elephant in the room. The specifics of what measure, rates, etc are harder to determine. The interesting point would be the infrastructure spending as it is privately funded.
JVS: Do you know the actual cost of capital calculation? If you lower the cost of capital would you also consider replacement costs instead of book costs in calculating return on investment?
LM: The replacement cost issue has been part of the cost of capital discussion. The railroad industry has submitted material supporting that approach. The board was not supportive of that approach but now they have opened up a proceeding. This tells me they want to look at it as the record may have changed.
JVS: They currently use book costs even though they are old assets?
JVS: Do you have a sense of the total calculation of it?
LM: I do not. I know the elements of it. The main element of the book value versus the replacement costs. It is a model the board uses with inputs.
JVS: Is that calculation transparent?
LM: Yes, transparent in the sense the aggregate numbers are transparent.
JVS: Can you give a sense of the regulatory reform being thrown around in Congress and any specific changes and impacts on revenue adequacy?
LM: The first is what Congress has been looking at. Two, what would be the possible discussions involving revenue adequacy. Let me take the first part first. The reform legislation, Senator Rockefeller (sp?) of WVA has been championing this (he is retiring this year) for the shippers who are concerned of too high rates. First, they are concerned with the access issue by rates or routes upon demand. Second, rate complaint specifics and process. The customers have felt for awhile that the process is too cumbersome and costly. They do not have a process to reject reasonably high rates. Third, eliminates the anti-trust exemption that the railroad industry enjoys. There are activities that the railroad industry that can get involved in: mergers, pooling of agreements, and other joint ventures that regulated by the STB but not the Department of Justice. The customers feel that if this anti-trust exemption was removed that would ensure more competition after this period of consolidation. None of these have been passed but is part of the rail package in Congress.
Turning to your second question about revenue adequacy: this is an area where Congress has not spent any time on. As someone representing the customer community we will have to keep the railroad industry from keeping excessive profits but I am not sure Congress has focused on it and the STB will have to undertake.
JVS: Who are the key players in Congress and the other side defending the rail industry? Where are these efforts directed?
LM: Sure, Chairman Shuster of the Transportation & Infrastructure Committee. He has been clear that he is not a fan of regulatory reform. He likes the law as it is. Congressmen Rahall shares a similar view. On the Senate side Rockefeller (sp?) Senator Soon (sp??) are more favorably disposed to the regulatory scheme.
JVS: Touching on the two safety issues you highlighted earlier, PTC and car integrity: what is the probability of those issues being implemented?
LM: I think PTC is going to get extended for some period. I do feel Congress understand the implementation and favor it. As for the car integrity, this seems more likely to be implemented before the PTC. However, there are some concerns such as what is actually coming out of the ground being put into the cars. If we can figure out what materials are inside the car we can measure the flammability to prevent accidents. That is more of a possibility and involving the customers as well versus replacing all the current cars.
JVS: There sounds like there is need for more investment in tank cars as well
JVS: I just wanted to make sure the key points come out. The cost of capital proceeding looks like it will take a year or two to be determined.
LM: Yes, that's my guess.
JVS: In terms of the recent revenue adequacy findings there is no determination that will impact rate decisions but whether the STB will be tougher on ones that are more revenue adequate versus not revenue adequate?
LM: There was actually a rate case filed against Norfolk Southern by the shipper, which claimed that this case should be handled differently because they are revenue adequate. That case was turned as the saying goes. If there was another case in which the railroad company is revenue adequate in which case the board would decide to look at this bigger issue.
JVS: So if the precedent is set for railroads being treated differently on the basis of revenue adequacy that could be determined anytime?
LM: That could be. I would offer that this is a huge issue of revenue adequacy, reaching it, and changing how the railroads are regulated. It is the underpinning if you will. It will not be arrived lightly. If it comes to the board they will dig into it.
JVS: You would expect it anytime?
LM: It is hard to tell. It is a question of whether you have the right case for instance. It will take time to resolve it.
JVS: Would it be a year to resolve it?
LM: No, this is a big issue. It would take a couple of years to resolve.
JVS: How would track the case if it came up targeting revenue adequacy, would we see it in the proceedings of the STB?
LM: Yes in addition to a press release either by the STB or a company.
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.