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Yesterday was a big day – DRI rose 3.5% on 2x the average daily volume. As we’ve said before, the theme here is consistent: the stock rises on days change is in the air and falls when management publicly digs their heels in.
The title of this note derives from the French saying: “L’heure entre chien et loup.” It refers to the moments following sunset, when the sky darkens and vision becomes unclear, making it difficult to distinguish between dogs and wolves.
We’re using this expression to create a metaphor for the uncomfortable situation that is unfolding at Darden, following the news that Starboard Value has won shareholder consent to call a Special Meeting. With yesterday’s victory, the sun is beginning to set in Orlando and it’s becoming increasingly difficult for management to distinguish between dog and wolf.
From where we sit, there is enough light to see the animal in front of them is a dog. Unfortunately, management appears predisposed to a certain view. As a result, they see a wolf and, by extension, feel trapped. It didn’t have to be this way. The truth is, there is a way out of this situation that would leave all constituents feeling safe and shareholders feeling happy. For some reason, this has been so unclear to the powers that be in Orlando.
Part of the haze may be stemming from the notion that Starboard only got 55% of shareholders to consent. On the surface, this might appear like a slim margin of victory. However, the turnover since the record date, shares short and the retail component are all factors that suggest this is a convincing margin of victory. We hope Darden’s advisors will give the Board and management a straight story, so that they can see the situation more clearly. If they wait until nightfall, however, we suspect that dog could soon become a wolf.
This French saying also highlights the stark contrast between the “familiar and comfortable” and the “unknown and dangerous.” Ever since activists began pushing for change at Darden, management has retreated and found solace in the confines of Orlando, where they have lived a comfortable life for many years. Between the lifestyle they are fighting to protect and the considerable financial resources at their disposal, they have been unwilling to face the harsh reality of the situation. In its 18 years as a public company, Darden has never found itself in a similar situation. Knowing how to properly respond, therefore, can be a daunting task.
Under significant pressure, CEO Clarence Otis has been unwilling to hold himself accountable for his decisions. For example, Mr. Otis failed to stress test his plans to create shareholder value with critical Wall Street analysts, opting, instead, to conduct one-on-one meetings with shareholders. Alas, the moat he has built around his castle is not serving him well. As a result, the Board and management now find themselves in the center of a very uncomfortable situation in which they are losing control of the company.
Yesterday, Jeffrey C. Smith, Managing Member, Chief Executive Officer and Chief Investment Officer of Starboard Value LP, went on CNBC to discuss Darden’s proposed separation of Red Lobster. Reading between the lines, Mr. Smith is very clear about what needs to happen at Darden:
“There clearly have been operational issues and clearly there are strategic issues now and that all starts at the top. I mean, so as a shareholder, our power, our control is with the Board. Our power is, in theory, at some point to be able to nominate directors and potentially replace the Board if they’re not going a great job in overseeing management and how the business is being run. The biggest decision for a board is in choosing the CEO and continuing to choose the CEO and I think there are some strategic issues here and operational issues. So, is Mr. Otis in a hot seat? I think he is in a hot seat.”
The shareholders of Darden have spoken – it is time for significant change.
One wild card, and a current “unknown” to outsiders, is the financial performance of Darden to-date in 4QF14. With nearly two-thirds of the quarter in the books, management knows precisely how the period is shaping up. The leverage they might have with shareholders is to prove their recent operational initiatives are gaining traction. However, given the current data we are seeing on sales trends, we highly doubt there will be much good news to talk about when they report earnings. In fact, considering the lack of momentum in the business, we expect to hear disappointing guidance for FY15. Even after two disastrous years of -10% and approximately -25% EPS growth, it’s unlikely they will be able to hit the current consensus estimate of 12% EPS growth in FY15.
Change is in the air.
This note was originally published at 8am on April 09, 2014 for Hedgeye subscribers.
“A good rule of thumb is that if you’ve made it to thirty-five and your job still requires you to wear a name tag, you’ve made a serious vocational error.”
As many of you may have noticed, our research team has been busy so far this quarter adding new names to our Best Ideas list. In fact, later today we will be doing a conference outlining our short case on Yelp (ticker also YELP). No surprise, at more than 10x market cap / revenue the short call on YELP has garnered some interest because clearly if we are correct, there is valuation downside.
Tomorrow we will be going over our short case on Annie’s (ticker BNNY) and this one has also garnered a lot of interest. In fact, one prospect responded to our marketing email suggesting it was somewhat irrational to short a stock with 20% short interest. In part, he’s right as there is increased risk of a short squeeze, but more broadly his email begs the question: is it an appropriate rule of thumb to not short highly shorted stocks?
Interestingly, based on the market factors we track, highly shorted stocks definitely do not consistently outperform lower shorted ones. In fact, over the last six months, the lowest quartile of short interest stocks are up 14.4% and highest quartile of short interest stocks are only up 12.5%. Now to be fair, over other time frames, high short interest stocks have outperformed, although rarely meaningfully so.
There are also a number of studies highlighting that over time highly shorted stocks underperform. Specifically, a paper from a group of MIT professors titled, “Short interest, institutional ownership, and stock returns”, concludes:
“Stocks are short-sale constrained when there is a strong demand to sell short and limited supply of shares to borrow. Using data on both short interest (a proxy for demand) and institutional ownership (a proxy for supply) we find that constrained stocks underperform during the period 1988 – 2002 by significant 215 basis points per month on an equally weighted basis . . .”
So, the moral of the story is that you shouldn’t let “tough to short stocks” get in the way of a good short idea.
Back to the Global Macro Grind . . .
Yesterday, we held our quarterly themes call and touched upon our three key macro themes heading into Q2. These themes are #ConsumerSlowing, #HousingSlowdown, and #StructuralInflation. Rather than give you my complete rehash (you can actually listen to the replay here), I wanted to highlight a key slide and point from each section.
Clearly, with consumer discretionary stocks relatively underperforming in the year-to-date (-5% on the YTD versus utilities +9%), the #ConsumerSlowing is not new news. In this presentation, though, we truly tried to quantify the impact of commodity inflation on the median consumer by rebuilding their income statement. As it turns out, the average American consumer spends more than 20% of after tax income on food and utilities. When gas and motor oil are added to the mix, the combined total of direct commodity exposure of after tax expenditures is closer to 27%.
The average consumer also primarily generates 95% of his or her income from wages, self employment, and/or government income. In aggregate, less than 1.5% is currently sourced from interest and dividends. So, perversely, as interest rates are kept low, it constrains the average consumer from earning more income and also leads to dollar devaluation. This dollar devaluation then inflates commodity prices and squeezes the consumer from the cost side.
The second key theme of #Structuralnflation gets away slightly from the concept of commodity inflation via dollar debauchery and looks at the potential for a labor market that tightens quickly. A key reason this may happen is because businesses have been consistently under investing in both capital expenditures and employees.
The Chart of the Day compares the year-over-year change of capital investment by businesses, compensation of employees, and corporate profits after taxes going back to 1983, so more than thirty years. As this chart shows, over time investment in infrastructure and employees largely maps with corporate profits. The exception of this is the last five years in which corporate profit growth has CAGRed at near 20%, while capital expenditures have CAGRed at +1.3% and employee compensation at +0.9%. The point being if hiring reverts to the mean it will likely be good for economic growth, but also accelerate inflation meaningfully.
The last theme for Q2 is #HousingSlowdown. This is obviously a reversal of our view for most of 2012/2013 where we were calling for acceleration in home prices. That parabolic move off the bottom is now decidedly in the rear view mirror based on our models. The most compelling support for a decline in housing demand and commensurately home prices is mortgage applications.
From the peak in April of 2013, purchase applications are down by -20%.
Further, the combination of both purchase applications and re-fi is now trending at a growth rate of -55% versus the same month a year ago. A key culprit behind this dramatic decline is the new Qualified Mortgage (QM) rules that were implemented as of January 10th.
While on one hand, more stringent underwriting rules will prevent excesses from developing, the new QM rules are also basically taking new and young home buyers out of the market. So be forewarned, the #HousingSlowdown is no illusion!
Our immediate-term Global Macro Risk Ranges are now:
UST 10yr Yield 2.64-2.75%
Keep your head up and stick on the ice,
Daryl G. Jones
Director of Research
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"For a very long time everybody refuses and then almost without a pause, almost everybody accepts."
That’s the closing quote to David Einhorn’s quarterly letter for the 1st quarter of 2014. Fully loaded with social bubbles and burrito gas, it is vintage Greenlight Capital – self effacing and straight up:
“Our longs were modestly profitable, our shorts lost a bit more than we made on our longs, and macro lost a little. The net result was a small loss in a market where some indices were up a little and others were down a little.”
In the March-April performance period, down a lot more than a little is how I’d characterize some of these social media and biotech bubble stocks. Having spent a lot of time with hedge fund investors, I don’t think Einhorn’s view on some of these balloons losing 90% of their value is anywhere in the area code of consensus either. Make no mistake, lots of hedgies are long these things.
Back to the Global Macro Grind…
There is a lot more than a little hedge fund supply in the marketplace today. HFR (Hedge Fund Research) confirmed that in Q1 of 2014, hedge fund assets under management hit a new peak of $2.7 Trillion. Not ironically, as hedge fund assets under management peak, performance starts to underperform a little too (Q1 2014 was the worst performance quarter for the industry since Q1 2008).
This was one of the main reasons why I was bearish on the US stock market in Q1 of 2008 (when Hedge Fund AUM peaked last time). Too many mo mo funds were long of the same names with the same catalysts. Back then it was an LBO “takeout” bubble. In 2000, it was a tech bubble. Today you can tell me how many funds are long Yahoo (YHOO) for the Alibaba IPO, but that looks a little bubbly too.
To be clear, being long of bubbles can be cool (as long as they don’t start to go down more than a little). Once they start to go down a lot, there’s this thing called draw-down risk that most hedge funds aren’t allowed to let ride anymore. Having toiled as a PM at some major US hedge funds in my day, I can tell you the only long-term strategy to survival is not getting smoked when everyone else does.
Einhorn rarely gets smoked.
Technically, a hedge fund should be hedged. But the super secret reality about the 2 and 20 business (or whatever Stevie was running at 5 and 50 back in the day) is that a lot of hedge funds get smoked, not when the market goes up – but when it goes down.
Yep. I wrote that. Been there, done that too. I’ve made every mistake you can make.
So, are you a consensus hedge fund or one like Greenlight who is willing to give up a little on the short side in order to make a lot? This common quest for the almighty alpha (on the short side) is called #asymmetry. And I like it.
Enough about what I think about this profession – I’m only a battered and bruised product of it. Here are some of the favorite quotes my teammates pulled from Einhorn’s quarterly letter. In terms of both style and substance, they are timeless:
Yes, it’s my entire team’s job to read, write, and learn about how the best players in this game think. The alternative to that would be depending on what I think (which would easily be the most dangerous thing for our business over time).
So, if you run a hedge fund and you’re having a tougher time than last year out there, don’t get upset with me writing about it. Think about the why and learn/do something about it.
Accepting that little bubbles are going to start to pop bigger ones (like, say, the US stock market’s all-time high price) is a process, not a point. While I agree with David that “what is uncertain is how much further the bubble can expand, and what might pop it” I don’t think the “what” is a silver bullet that can be legally obtained.
Having survived (made $ at a hedge fund in down tapes - 2000, 2001, 2002) the Tech Bubble, The LBO and Oil Bubbles (2008), and The Gold and Bond Bubbles (2011-2012), what I have learned about risk managing these suckers is quite simple:
First, they start to make lower-highs. Then the volume on down days eclipses the volume on the bounces (up days to lower-highs)… then bearish catalysts start to pile up… then what was happening slowly starts to happen more than a little – it happens all at once.
Our immediate-term Global Macro Risk Ranges are now as follows:
Brent Oil 108.48-110.79
Natural Gas 4.62-4.79
Best of luck out there today,
Keith R. McCullough
Chief Executive Officer
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:
MACRO DATA POINTS (Bloomberg Estimates):
WHAT TO WATCH:
COMMODITY/GROWTH EXPECTATION (HEADLINES FROM BLOOMBERG)
The Hedgeye Macro Team
Hosted by Hedgeye CEO Keith McCullough at 9:00am ET, this special online broadcast offers smart investors and traders of all stripes the sharpest insights and clearest market analysis available on Wall Street.