TODAY’S S&P 500 SET-UP – April 23, 2014
As we look at today's setup for the S&P 500, the range is 56 points or 2.42% downside to 1834 and 0.56% upside to 1890.
CREDIT/ECONOMIC MARKET LOOK:
- YIELD CURVE: 2.27 from 2.31
- VIX closed at 13.19 1 day percent change of -0.45%
MACRO DATA POINTS (Bloomberg Estimates):
- 7am: MBA Mortgage Applications, April 18 (prior 4.3%)
- 9:45am: Markit US Manufacturing PMI, April, est. 56.0 (pr 55.5)
- 10am: New Home Sales, March, est. 450k (prior 440k)
- 10:30am: DOE Energy Inventories
- 11am: Fed to purchase $2b-$2.5b in 2021-2024 sector
- President Obama in Japan at start of 4-nation trip to Asia
- Congressional Delegation led by House Foreign Affairs Cmte Chairman Ed Royce in Ukraine for meetings with major presidential candidates, NGOs, members of minority groups
- House, Senate not in session
- 10:30am: FCC meets on proposed rule that would make up to 150 MHz of spectrum available for wireless broadband use in 3 MHz band
- 2:30pm: Consumer Financial Protection Bureau, other regulators at public forum on mortgage closing process
WHAT TO WATCH:
- Ukraine weighs move on militants in east amid Russia warnings
- Starboard asks Darden for investor say in Red Lobster spinoff
- Dish said to target summer release for U.S. Internet-TV
- Toyota outsells GM, Volkswagen in Jan.-March quarter
- Buffett’s pay principles put to test on Coke vote: Winters
- Apple’s slowing iPhone sales threaten stock after 5% slump
- PTTEP agrees to pay Hess $1b cash for Thai assets
- Australia to buy 58 more F-35 jets, scaling back initial plan
- Charter said to be near deal for divested Comcast subscribers
- Goldman unbowed as Barclays joins bank commodities exodus
- Citigroup says has no plans to exit core businesses in Korea
- Netflix said to expand into France by yr-end amid global push
- Genworth to raise as much as $700m in Australia offer
- LG Household considering making offer to buy Elizabeth Arden
- Caesars Entertainment bids to build $750m New York casino
- China manufacturing gauge signals economic weakness persists
- Euro-area industry surveys increase as price weakness persists
- Osborne hits U.K. deficit-reduction target; economy struggles
- Air Products & Chemicals (APD) 6am, $1.35
- Amphenol (APH) 8am, $0.96
- Avery Dennison (AVY) 8:30am, $0.66
- Biogen Idec (BIIB) 6:30am, $2.56 - Preview
- Boeing (BA) 7:30am, $1.54 - Preview
- Brinker Intl (EAT) 7:45am, $0.83
- Celestica (CLS CN) 7am, $0.20
- Delta Air Lines (DAL) 7:30am, $0.29 - Preview
- Dow Chemical (DOW) 7am, $0.71
- Dr Pepper Snapple (DPS) 8am, $0.59 - Preview
- EMC (EMC) 6:52am, $0.35 - Preview
- Gannett (GCI) 8:30am, $0.46
- General Dynamics (GD) 7am, $1.64 - Preview
- Gentex (GNTX) 8am, $0.45
- Ingersoll-Rand (IR) 7am, $0.26
- Johnson Controls (JCI) 7am, $0.65
- Lincoln Electric (LECO) 7:30am, $0.90
- Manpowergroup (MAN) 7:30am, $0.68
- Norfolk Southern (NSC) 8am, $1.15 - Preview
- Northrop Grumman (NOC) 7am, $2.15 - Preview
- Omnicare (OCR) 7am, $0.90
- Owens Corning (OC) 7:28am, $0.35
- Polaris Industries (PII) 6am, $1.16
- Popular (BPOP) 8am, $0.67
- Praxair (PX) 6:01am, $1.51
- Procter & Gamble (PG) 7am, $1.02 - Preview
- Reynolds American (RAI) 6:58am, $0.74 - Preview
- Ryder System (R) 7:55am, $0.87
- SEI Investments (SEIC) 8:30am, $0.40
- Supervalu (SVU) 7am, $0.15
- TD Ameritrade (AMTD) 7:30am, $0.34
- TE Connectivity (TEL) 6am, $0.91
- Thermo Fisher Scientific (TMO) 6am, $1.40 - Preview
- Tupperware Brands (TUP) 7am, $1.16
- Align Technology (ALGN) 4pm, $0.34
- Angie’s List (ANGI) 4:05pm, $(0.06)
- Apple (AAPL) 4:30pm, $10.17 - Preview
- AvalonBay Communities (AVB) 5:26pm, $0.82
- Cheesecake Factory (CAKE) 4:15pm, $0.49
- Chicago Bridge & Iron (CBI) 4:01pm, $1.12
- Citrix Systems (CTXS) 4:05pm, $0.59
- Crown Castle Intl (CCI) 4:01pm, $0.29
- E*Trade Financial (ETFC) 4:05pm, $0.23
- Equifax (EFX) 4:10pm, $0.87
- Everest Re Group (RE) 4:05pm, $5.42
- F5 Networks (FFIV) 4:05pm, $1.25
- Facebook (FB) 4:05pm, $0.24 - Preview
- Flowserve (FLS) 4:07pm, $0.75
- FNB (FNB) 4:15pm, $0.20
- Fortinet (FTNT) 4:15pm, $0.09
- Graco (GGG) 4:10pm, $0.82
- Ingram Micro (IM) 4:05pm, $0.48
- Lam Research (LRCX) 4:05pm, $1.17
- O’Reilly Automotive (ORLY) 6:30pm, $1.58
- Oceaneering Intl (OII) 4:01pm, $0.80
- Polycom (PLCM) 4:05pm, $0.14
- Qualcomm (QCOM) 4pm, $1.22
- Raymond James Financial (RJF) 4:16pm, $0.77
- ResMed (RMD) 4:05pm, $0.64
- Robert Half Intl (RHI) 4pm, $0.44
- Safeway (SWY) 4:05pm, $0.18
- ServiceNow (NOW) 4:01pm, $(0.08)
- Stryker (SYK) 4pm, $1.09
- Susquehanna Bancshares (SUSQ) 4:30pm, $0.21
- TAL Intl Group (TAL) 5:01pm, $0.96
- Teradyne (TER) 5:01pm, $0.06
- Texas Instruments (TXN) 4:30pm, $0.41
- Tractor Supply (TSCO) 4:01pm, $0.37
- TriQuint Semiconductor (TQNT) 4:02pm, $(0.12)
- Varian Medical (VAR) 4:02pm, $1.03
- Xilinx (XLNX) 4:20pm, $0.55
- Zynga (ZNGA) 4:04pm, $(0.01)
COMMODITY/GROWTH EXPECTATION (HEADLINES FROM BLOOMBERG)
- Goldman Sachs Unbowed as Barclays Joins Commodities Exodus
- WTI Crude’s Discount to Brent Widest in Five Weeks on Supplies
- Investors Checking Out of ‘Hotel Mongolia’ in Limbo: Commodities
- Soybeans Post Longest Slump Since July as China Demand May Slow
- Copper Falls on China Factories as Nickel Touches 14-Month High
- Coffee Reaches 26-Month High as Brazil Drought Raises Volatility
- Gold Above 10-Week Low as Ukraine Weighed Against U.S. Recovery
- Rebar Advances Most in 2 Weeks on Inventory, China Reserve Ratio
- Monsoon Seen Below Normal to Normal in South Asia This Year
- LME Seeks to Lure Dinner Guests From Tables to Metal Trading
- Coal Glut Foils Price Rally With Miners Tied to Exports: Energy
- Japan May Offer Canada Head Start on Pork Duty to Sway U.S.
- China Move to ’Go Green’ May Mean Lower Copper Use
- Ukraine’s Unpaid Gas Bills Dwarf U.S. Offer Amid Shutoff Threat
The Hedgeye Macro Team
Takeaway: DDS at $155 seems ridiculous. The asset play is maybe $50 on a great day. If people value DDS like a retailer again, the stock’s in trouble.
Conclusion: DDS with a $9-handle, or even an $8-handle, was enough to land a spot on our bench of short ideas. But with the spike in the wake of comments by Marcato Capital saying that the stock ‘may be worth $155’, we simply had to weigh in with what ludicrous assumptions you need to make in order to reach that value. We think the property value is maybe $50 per share – on a great day. Let’s not forget about the underlying business, which is looking toppy. We'll take the short side of this debate any day.
The comment that sparked yesterday’s rally was grounded in what could happen to DDS stock price if the company spins out its internal REIT. We absolutely agree that there is real estate value at DDS. The company owns 245 of its 296 stores outright, or about 42mm square feet of retail anchor tenant space throughout the South. There’s another 19 stores where it has equity ownership through hybrid and ground leases.
But let’s consider a few things.
In January 2011, DDS first announced that it would spin off its real estate into a wholly owned REIT. But at the time, it failed to monetize its assets to the public. Three considerations…
- DDS had a sizable NOL that was set to expire at the end of its fiscal year (Jan 11). Proceeds from the internal REIT transaction were offset by the NOL, giving the company a $202mm tax credit in FY11. Because of the transaction assets were marked to fair value allowing the company to realize tax depreciation deductions by $5mm on annualized basis for the next 20yrs and $2mm for years 21-40. Simply put, this was a no-brainer at the time from a financial engineering standpoint. But it doesn’t mean that there’s a public market for DDS’ properties, even though the equity market thought so at the time.
- Typically one retailer would not account for more than 10% of a property owner’s income. The point here is that the pool of buyers out there is extremely limited for such a large number of stores.
- DDS’ current real estate portfolio is very heavily weighted towards B & C mall properties. These assets account for less than 20% of public mall REIT NOI despite their disproportionately high representation. The top 30% of mall properties for example account for 60% of public REIT NOI. Dillard’s presence at these premier properties is scant.
What About Value?
Let’s start with the only two assumptions that really matter here, which is a) the rent/foot for the portfolio and b) the cap rate (a de-facto discount rate – the expected rate of return based on the asset’s income profile).
a) Most anchor tenants average somewhere between $4-5 per square foot. KSS is bottom of the barrel (strip malls are cheaper) at about $4.15, JCP is about $4.95, Macy’s at $5.15, and JWN at $6.30. On the properties that Dillard’s currently leases, it is paying around $4.90 per foot. But the catch here is that those are among the best properties in its portfolio. Our sense is that the properties in question (that could be monetized) are closer to $4.25.
b) The cap rate is more theoretical, but no less structured. Usually it’s feast or famine. What we mean is that the lower rent-generating assets will command a higher cap rate (north of 10%), while the premium higher-quality properties will have a cap rate within 300bp of the risk free rate. Given the preponderance of B and C malls in Dillard’s portfolio we suspect that we’d be looking at a cap rate of about 10%.
c) Add those two assumptions together and you get a value of about $1.8bn, or about 38% of DDS’ enterprise value. That’s about $42 per share, about 55% below current levels. We’re not saying that this where the stock is going, but there’s another $3bn in Enterprise Value that needs to be supported by these things called Revenue and Margins. They sometimes get forgotten when people get overly pumped about real estate.
d) Let’s assume for a minute that we’re totally wrong in our assumptions – after all, we have not had an independent appraiser visit each of the 264 properties owned by DDS. But where the stock is now, we don’t think we have to. Let’s assume that Dillard’s rent profile is an even $6.00 per foot – which is just a hair below JWN. Now let’s assume a cap rate of 6%, which is far better than you’ve got at Macy’s, and probably nearing the ballpark of what we might expect at Wal-Mart. That gets us to a $105 per share value. That’s within 10% of where the stock is trading today. You want to get to $155 in the stock? Use $6 per foot at the same yield we’re looking at today on a 30-year treasury. Good luck with that.
And if the company does manage to pull off this public REIT, then ask yourself what it does with the proceeds. About 45% of it goes to pay off debt. So then it goes from having net debt to having net cash. That’s definitely a plus. But another thing people often forget to do when properties are sold is ask the question as to whether the company will remain a viable entity. If the answer is Yes for Dillard’s, which we suppose is the case (unlike the SHLD property debate), then we have to add back $200mm per year in rent. It has these properties now at a great rate (free), but when it sells them it has to pay to play.
The punchline for us on this one is that a $155 value is simply ridiculous. We have a hard enough time getting to $90. The asset play is maybe $50 at best – and that’s assuming there is liquidity (we’re uncomfortable assuming that one). More realistically, DDS sells off properties a few at a time, where the pool of buyers is far greater. That might help along the way, but shoots the big ‘public REIT’ call in the foot. If people start valuing this like a retailer again, the stock is in trouble.
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Declining participation installed base troubling but strong ASPs were the offset. We'll have more to say on IGT
- Cost savings in $30MM in current fiscal year and $50MM on an annualized basis
- Wheel of Fortune will be in DoubleDown at calendar year-end
- Powerbucks: expect NV and Canada to come online by end of FY
- Avatar product: performance surpassing Wheel of Fortune in 40% of locations where Wheel of Fortune and Avatar both exist; Avatar performing above mgmt expectations
- Crystal Core cabinet: 2nd Avatar game coming on new hardware platform - expectations similar to 1st Avatar game
- Class II market: next quarter, will release new titles in this market
- South Africa: 2,000 terminals will come online in the next 18 months (IGT will secure 50% share)
- International systems business: in FQ2, deployed cloud product to UK. Three casinos on our cloud product will expand to ten in the next coming quarters as well.
- Replacing Aristocrat systems in South Africa (3 casinos)
- Gaming ops yields increased sequentially in-line with seasonal trends.
- Install base declined sequentially due largely to declines in MegaJackpots
- Expect gaming ops gross margins for FY to be consistent with FY2013
- Capex decreased to $15MM
- Expect increase in 3Q/4Q capex due to upcoming launch of new Crystal Core Cabinet but total CapEx lower than FY2013
- International revenues declined 25% due to implementation restrictions in Argentina and soft demand in a few other markets
- ASPs improved due to mix shift of higher priced units
- Several of recent titles performing well in the market, including Prowling Panther, high Volatility game designed for the gambler and Jade Fortune, a new Asian-themed game.
- Launching Winners Choice in F3Q
- Expect Doubledown revenues to be up 20% for FY
- Tax rate elevated at 39.5% due to adverse impact of peso devaluation in Argentina. Expect effective tax rate to be ~35% for reminder of year
Q & A
- Working hard to protect yields; continues to expect mid-single-digit decline in yields. Optimisitic on yields for F3Q, F4Q
- Non-gaming sales high: higher than expected. Had IP settlement that timed in FQ2 rather than Q3. Half of the increase is IP. Remainder of the growth is parts and conversions.
- Normalized run rate probably average of last four quarters
- Lots of noise in margins and product sales. It's about flattish. Upward pressure seen in ASPs. Expect flat product sales margins to continue.
- Non-box margins were pretty consistent with box margins
- Cost savings come exclusively from SG&A
- SG&A: Still targeting 19-20% of revenue (excluding items); however, it can fluctuate given revenue trends
- Class II similar to poker business. Ready for an upgrade in that market. See good Class II growth in Mexico/South Africa.
- Fierceness of the competition hasn't changed much
- Competition coming from both price and product, esp MegaJackpot. Another factor is the competition for operating expense $$ from their customers that is affecting both gaming ops and product sales.
- #1 priority is to eliminate declines in installed base
- Renovations at SLS and Cromwell have resulted in lower install base
- Believe flat to down (more likely down) replacement cycle this year than last
- Feel comfortable with R&D levels
- DoubleDown is GAAP accretive now
- On DD MAU, IGT focused on converting players into payers i.e. bottom line. Not concerned about MAU decline
- Continue to outperform expectations on ARP (average revenue per DAU); ARP is industry-leading
- Need 30-60 days to quantify effect of Powerbucks
- IL units in FQ2; 1,000 (pretty normal run rate). Do not have ship share #
- We think it was 44% ship share
- South Africa is an expanding market. Expect the market to be like product sales. May have a daily fee attached but more product sales than participation business
- Making progress on the mobile product
- Wheel of Fortune mobile will be out by end of calendar year too
Takeaway: We continue to dislike MCD, but we're staying on the sidelines. Look for a stronger entry point on the short side post the 2Q catalyst.
In mid-February, we pulled MCD from our Best Ideas list as a short due primarily to easy comparisons and the likelihood of a future financial engineering event. Despite this, we believe the McDonald’s business continues to have underlying issues that, at this point in the game, are not easily addressable. This morning’s press release and subsequent earnings call validated our thoughts.
McDonald’s reported disappointing 1Q14 results this morning, missing top line and bottom line estimates by 25 bps and 222 bps, respectively. Although system-wide same-restaurant sales beat estimates by 10 bps, the global business continues to be bogged down by the most important market – the U.S. Europe and APMEA same-restaurant sales exceeded expectations, but both markets continue to have issues. Overall, the McDonald’s system generated negative traffic in the quarter, driven by its four primary markets: U.S., Germany, Japan and Australia. Until performance in these markets turn meaningfully, the system will be hard pressed to generate notable earnings growth.
System-wide same-restaurant sales were +0.5%, beating estimates of +0.4%
U.S. same-restaurant sales missed estimates by 30 bps, driven by negative traffic. Management attributed most of the miss to unfavorable weather (note: CMG just put up a +13.4% comp) and, to a lesser extent, challenging industry dynamics (note: challenging for MCD). As a result, company operating margins fell 10 bps to 17.3%. Part of the margin compression can be attributed to higher commodity basket, led by proteins, that was up +3% year-over-year. Management expects this commodity pressure to persist throughout 2Q, before easing in 2H14. Guidance for the full-year grocery basket continues to imply a 1-2% increase.
MCD has identified several opportunities (enhanced marketing, enhanced customer experience, stronger core/promotional balance) to help strengthen the U.S. business. While the opportunities are apparent, the plan to execute and capitalize on them is less clear. We expect all domestic restaurants to have new kitchen equipment installed by mid-year, but the effect of the high density prep tables is largely unknown and franchisees have reported mixed feelings. Domestic restaurants will also implement a reset in the first half of 2014, focusing on staffing and scheduling, which could benefit peak hour throughput. A new, innovative marketing message could help the brand generate some modern day relevance and the company is hoping the new CMO will be able to deliver this. Management emphasized the importance of its breakfast business and denied any claims of competitive pressures affecting the daypart in 1Q.
U.S. same-restaurants sales were -1.7%, missing estimates of -1.4%.
Europe same-restaurant sales beat estimates by 20 bps, driven by strength in the U.K., France and Russia. Company operating margins improved 30 bps to 70.3%. Despite this, negative same-restaurant sales and traffic momentum continued in MCD’s most important European market – Germany. The brand continually struggles to offer affordability and connect with customers in this country. We need to see this market turn before we become bullish on this region. In accordance with Hedgeye’s Macro view, management acknowledged that economic indicators in the region appear to be stabilizing, but cautioned that quarter-to-quarter results could remain volatile.
Europe same-restaurant sales were +1.4%, beating estimates of +1.2%
APMEA same-restaurant sales beat estimates by 30 bps, driven by strength in China, due primarily to a one-time benefit as the country lapped last year’s supply chain issue. Japan and Australia, however, weighed down the overall performance of the region. Company operating margins decreased 60 bps to 14%, as sales momentum wasn’t enough to fully mitigate cost pressures and the negative impact from new restaurant openings in China. Management continues to believe this region offers the potential for significant growth.
APMEA same-restaurant sales were +0.8%, beating estimates of +0.5%.
On the earnings call, management highlighted four opportunities for improvement in their priority markets. These initiatives, which could be applied to other markets as well, include:
- More effectively bridging consumer insights into the right plans and actions
- Delivering a stronger, more resonant marketing message
- Enhancing affordability platforms
- Better balancing focus on core menu items and LTOs
There’s nothing wrong with these initiatives. In fact, we understand the basic rationale behind all of them, but that alone doesn't give us confidence in management's plan. The issue is they are not easily achievable or measurable and will be difficult to tailor to each diverse market. McDonald’s is not nearly as nimble as it used to be. We like that management is acknowledged some of the concerns we have raised, but none of these initiatives offer game-changing solutions.
As we cautioned several months ago, the real, more immediate opportunity for value creation is in the form of a future financial engineering event. Management didn’t go into much detail, but they did reinforce that they are continually looking at ways to improve shareholder returns. As CFO Pete Bensen briefly mentioned on the call, this could include optimizing the capital structure, re-franchising activity (particular in international markets) and reallocating general and administrative expenses.
We’d rather not speculate at this point, but we assume this event will be a positive catalyst for the stock. Management plans to release more details surrounding this development prior to the closing of the second quarter. As it stands, we believe the stock remains disconnected from the fundamentals and until we see a material improvement in system-wide trends, particularly in the U.S., we continue to believe this event will provide another nice entry point on the short side. For the time being, we remain on the sidelines.
Takeaway: 70% voted YES; 30% responded NO.
Hedgeye CEO Keith McCullough wrote about the lack of recent buying conviction in today’s Morning Newsletter and has argued that volume matters because “stocks are making lower-highs versus the all-time-bubble highs; it’s extreme price versus volume divergences (from unprecedented prices).”
But we wanted your opinion in today’s poll: Does volume matter?
At the time of this post, the heavy majority went toward 70% voting YES; 30% responding NO.
As one YES voter explained, “It matters because it shows lack of participation by the broader market players. The broader market is likely positioned for a downside move and waiting for that catalyst can be painful and expensive.”
Other noteworthy YES comments included:
- “Only in the very immediate term. Having been in secular decline, volume has held a near-perfect inverse correlation to the equity market over the past 5+ years. Better said, stocks pretty much only go up when volume is falling over longer durations.”
- “Volume is only one of the many components that should be considered in gauging market up vs down days. Price action, VIX, sector rotations, bonds, currency action(s) are other major components. Albeit for this poll; Yes, volume does matter.”
- “More importantly, [Dennis] Gartman is now Long of equities in equity terms. Combine all factors and you get a major warning signal.”
Over in the NO group, however, one responder explained that volume “only matters if you’re on the wrong side of the trade,” while another believed volume “hasn't mattered for five years since the current rally began.”
Though one NO voter acknowledged that volume has been in secular decline since 2009, they specifically stated that it “will be even under more pressure with the rug being pulled out from HFT.”
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