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“Today, I want to tell you about an investment opportunity with potential high cash flow, a superior structure, a unique sharing agreement, and low risk.” – 1983 Prudential-Bache Energy Income Fund marketing video
Between 1983 and 1991 Prudential-Bache Securities raised $1.4 billion from the sale of 35 “energy income fund” limited partnerships to more than 130,000 individual investors. The yield chase was on as interest rates fell in the wake of the early ‘80s inflation scare, and Wall Street was eager to fill the demand with new products that commanded high fees and commissions. Prudential-Bache brokers touted the limited partnerships to their retail clients as high-yielding, tax-advantaged, low-risk investments…
Of course, what seems too good to be true proved to be just that. By the late ‘80s distributions began to trail false promises as hefty fees ate into the income and asset values fell. Some of the partnerships borrowed money to maintain the payouts, but it wasn’t a sustainable solution. Eventually, most of the partnerships slashed distributions and collapsed.
In the class action lawsuits that followed, the plaintiffs alleged that Prudential-Bache “misrepresented and omitted material facts concerning cash distributions to investors by creating the appearance that the partnerships were distributing monies derived from operating income when in reality the distributions were returns of capital…”
I traveled to Omaha, Nebraska two weeks ago to pitch the bear case on Master Limited Partnerships to a group of value investors. Buffett couldn’t fit me into his schedule, but I was lucky enough to meet with seasoned money managers cut from the same cloth.
These guys understood the MLP basics – tax-exempt energy companies with high current yields, etc. – but not much more. So I walked through a few of the more surreptitious aspects of the story: the enormous “incentive” fees that many MLPs pay to their General Partners; the conflicts of interest and limited fiduciary duties; the gimmicky accounting; the serial capital raising; and the valuations.
I was showing the group how, since its inception, retail-favorite LINN Energy (LINE) has lost more than $1.4 billion while paying out $3.1 billion in distributions, when a salty Australian in the back blurted out, “The whole thing seems like a big Ponzi scheme to me.” I shrugged, “My compliance officer doesn’t let me use that word.”
MLPs are essential to the build-out of energy infrastructure that’s needed to support the recent US hydrocarbon production boom – the story is real – but that doesn’t mean all will profit. The building of the American railroads in the late 19th century was ripe with self-dealing and stock schemes. James Surowiecki of “The New Yorker” called it, “one of the biggest cons the country has ever seen, with huge losses for investors and huge fortunes for the moguls. Still, we ended up with a national transportation system.”
It’s been said that there are no new eras, only new errors – most things in finance are cyclical. We look at the fees that some of the largest MLPs are paying to their GPs today and wonder if this time will be different. How long can a business that pays two-thirds of its income to its manager survive?
It’s a unique instance of information asymmetry. MLPs are mostly owned by retail investors – not surprising given the exorbitant fees that they hand over to the wealthy individuals and institutions that own their GPs. A well-informed investor is unlikely to give his money to a hedge fund manager who defines his own performance, collects a 50% performance fee, and owes limited fiduciary duties to his investors. Would you invest in that fund? I hope not. Giving your money to that hedge fund is a liability, but with the Alerian MLP Infrastructure Index currently trading at 2x the earnings multiple of the S&P 500 (see the Chart of the Day below) despite lower returns on equity (~8%) and higher leverage (~42% debt/capital), that’s still way out-of-consensus.
But we’re OK with that. It’s a lonely view but we’re not contrarian merely for the sake of it – there’s ample justification for being negative on certain MLPs, and perhaps the timing is right as we enter the later innings of the US infrastructure growth boom, and the Federal Reserve weans markets off of the morphine drip.
Over the past year, we’ve expressed this view with reasonable success with negative calls on the E&P MLPs (most notably, LINN Energy), Kinder Morgan Energy Partners (KMP), and Boardwalk Pipeline Partners (BWP), while the MLP indices marched to new all-time highs. Our most recent work delves into the numerous issues of Atlas Energy LP (ATLS) and its limited partnerships (ping to see that research). In the first conference call after we published our note, one Atlas executive declared that because his stock has not fallen, “Truth and good have prevailed!”
Of course, I’m the bad guy. Well, for now at least…
Our immediate-term Global Macro Risk Ranges are now:
UST 10yr Yield 2.56-2.65%
This note was originally published at 8am on April 30, 2014 for Hedgeye subscribers.
“It's just a job. Grass grows, birds fly, waves pound the sand. I beat people up.”
- Muhammad Ali
As a youngster growing up in southern Alberta, I was an enthusiast of Stampede Wrestling. Back in those days, before World Wrestling Entertainment began to dominate, professional wrestling was split into territories and Calgary-based promoter Stu Hart was recognized as one of the top promoters in the field. He had many colorful wrestlers in his stable, but one of the more interesting was Joe “Tweet Tweet” Tomasso.
Tomasso was a scrappy Italian from Hamilton, Ontario. He earned his nickname “Tweet Tweet” for talking about his imaginary pet bird (incidentally, he also spoke with a pirate’s accent). Tomasso had decent success in the ring and shortly before his retirement, the famed Stu Hart said, “He was an indestructible little bastard.” High compliments from the Canadian godfather of wrestling to a small undercard wrestler like Tomasso.
Speaking of imaginary tweets, Twitter (TWTR) reported earnings last night after the close. While the $250 million in quarterly revenue suggests the business model isn’t a total façade, the fundamental sell call we’ve been making on Twitter is playing out in spades with the stock down over -11% this morning to a new 52-week low.
(Our internet analyst Hesham Shabaan reiterated his thesis in this video.)
A few key takeaways from the quarter:
The best way to describe the Twitter quarter is Shakespeare’s oft used expression, “expectation is the root of all heartache.” At more than 20x this year’s market cap to revenue, Twitter’s expectations were high, indeed.
Back to the Global Macro Grind...
Staying on the stock specific side our wily veteran and head of Retail research Brian McGough is adding Target (TGT) to our Best Ideas list as a sell in a conference call today at 11 a.m. EST. According to McGough:
“The crux of our argument? Wall Street's perception of Target's financial trajectory is more upbeat than Main Street. When the stock glossed over the company's weak 4Q earnings report, it was because Steinhafel (CEO) issued guidance that he hoped the company would grow into if the Company repaired its reputation after the data breach - not guidance that he knew TGT could meet or beat. We don't think that the Street is giving TGT credit for a) a miss this year, and b) another one in 2015. The reality is that when a customer has a great experience in retail, they tell a friend. When a customer has a bad experience, they tell 20. Just ask JC Penney or Lululemon. Some of these 'fire your customer' events are worse than others, but there's one commonality - they take a very long time to recover.”
If you don’t currently subscribe to our Retail research and would like details on how to access the call, please email email@example.com.
Keith was off seeing clients in the Midwest the last couple of days and, despite getting in late last night, hit us and subscribers on the “Direct From KM” list with some key thoughts this morning...
Buy in May, and pray? Not on the US consumer, social bubbles, or housing stuff – no thank you!
On the last point of housing, D.R. Horton, one of the nation’s largest homebuilders, recently announced they will build homes in the price range of $120,000 to $150,000. This appears to be a reaction to the obvious, which is that housing demand is tepid at best, and more aptly anemic for first time buyers. In fact, in February first time home buyers account for a mere 28% of purchases, which is the lowest level since October 2008 (the veritable apex of the financial crisis).
Not that we need more confirmatory data points, but U.S. MBA mortgage applications index came out this morning and showed applications down -4.4% for the most recent week and the total market index down -5.9%. This compares to -2.6% and -3.3% respectively in the prior week and is obviously a deceleration.
As mortgage applications go so goes housing demand and ultimately home prices. As home prices continue to stagnant or decline, it will be increasingly likely that the almighty Federal Reserve continues to be one of the more globally accommodating central banks, which will be negative for the dollar but continue to drive commodity prices higher. Reflexivity anyone?
Our immediate-term Global Macro Risk Ranges are now as follows:
UST 10yr Yield 2.63-2.73%
Keep your head up and stick on the ice,
Daryl G. Jones
Director of Research
Daily Trading Ranges is designed to help you understand where you’re buying and selling within the risk range and help you make better sales at the top end of the range and purchases at the low end.
TODAY’S S&P 500 SET-UP – May 14, 2014
As we look at today's setup for the S&P 500, the range is 28 points or 1.29% downside to 1873 and 0.19% upside to 1901.
CREDIT/ECONOMIC MARKET LOOK:
MACRO DATA POINTS (Bloomberg Estimates):
WHAT TO WATCH:
COMMODITY/GROWTH EXPECTATION (HEADLINES FROM BLOOMBERG)
The Hedgeye Macro Team
Takeaway: Here's Cliffs Notes of our JCP/KSS Real Estate Call. Punchline - expect more JCP store closures. Not the good event for KSS you might think.
Today we hosted a call to discuss our short thesis on KSS, and why JCP is both the biggest opportunity and threat to the thesis. While we presented the results of our third department store consumer survey and our e-commerce analysis (both very insightful), we think that the meat of our presentation was in our analysis of the real estate and demographics for every single one of the stores for JCP and KSS. The conclusions are significant. We outlined our research in a 47-page slide deck, and can’t possibly encapsulate all of that here. But here are some of the more salient points. For the full deck and audio presentation, click the link below.
Here are a few select highlights…
1. Real Estate Approach: We think that the biggest threat to a KSS short is JCP announcing a significant number of store closures, which would presumably help KSS longer term as it relates to market share. In order to properly assess this risk, we analyzed every JCP market to see where the most likely closures are, and whether or not they overlap with KSS. For starters, we did not simply map out store locations (a feat in itself) and draw a circle around each point on the map to gauge overlap by market. We mapped out a 15-minute driving radius around every store, which as you can see by the chart below is very different for every single store location in the country. This shows Tallahassee, FL, which has two locations where JCP and KSS overlap perfectly, and another location where JCP exists without KSS as a competitor. We did this in every market in the US.
2. Productivity Analysis. This next chart shows us what the implied sales per square foot range is for JCP’s 1089 stores. What we know is that in the US, JCP has 0.47% share of wallet in apparel, home furnishings and other relevant retail goods across its portfolio in aggregate – again, we’re looking at all expenditures within a 15 minute drive of its stores. If we apply that ratio to each market, we get implied sales/square foot levels ranging from $8 to nearly $1,000 (Manhattan). We know that share is likely to vary by market, so we’re not trying to say that these are the exact productivity levels of each store. But directionally, we think we’re right. And that direction tells us that 782 stores, or nearly 72% of JCP locations, are running below the system average of $98/square foot.
3. 300 Store Closures: We think that JCP needs to close 300 locations, at a minimum. We know that the demographic profile in the surrounding area of JCP stores in aggregate is about $66k in annual household income. We also know that JCP just identified 33 stores that it is closing. We analyzed those locations, and the demographic profile is $54k annually – that’s 18% lower than the portfolio average. So we looked throughout the system of JCP stores and looked to see how many other stores fit that profile. There are 300. If these stores are closed, the average income statistic goes up for the whole portfolio by 7% to $70k. The 300 stores closed have implied sales/square foot of less than $38 annually. There are still almost 500 stores above $38 and yet still below the system average.
4. Revenue Impact of Closures. Our math suggests that these stores would only result in about $550mm-$600mm in revenue loss to JCP. Importantly, KSS only overlaps in 42% of these markets. Our research shows that KSS took about 19% of the $5.4bn in sales JCP hemorrhaged over the past three years. If we apply a 20% share gain level to this analysis for KSS, it suggests about $73mm, or less than 0.4% to KSS in comp. If you want to get more aggressive and assume that KSS takes 100% of that revenue (which WMT won’t allow) you’re looking at about 1.9% in comp to KSS. We think something far below 1% is closer to reality. Here’s the sensitivity analysis below.
5. No Growth KSS. This analysis suggests to us that KSS can only add stores in lower demographic areas. We fully recognize that there are few people running around touting KSS as a unit growth story. But this math is definitely worth sharing. The numbers on the horizontal axis refer to JCP’s entire store base. The bucket to the far left is represents the most attractive demographic locations. The bucket to the far right represents the least attractive locations. The columns show the percent overlap KSS has in each bucket of those JCP stores. The point is that in the top 600 locations, KSS has near 100% overlap with JCP. Then it begins to tail down slightly – with the only real opportunity for growth in JCP’s worst 300-400 markets.
6. KSS Has The Greatest Exposure to JCP Prior (Not Future) Share Loss. Every time we conduct a survey, we look at the dispersion of the of the lost JCP business by retailer. We had a lot of people argue with us over the past two quarters when we presented our 18-19% share stat – but this time around, it was validated yet again. The numbers suggest that KSS captured about $1bn of the $5.4bn JCP gave away. WMT is slightly higher, but as it relates to percent of each retailer’s sales, no one even comes close to KSS at 5.3% of total sales.
7. Shopping Trend Getting Better On The Margin for JCP. There’s half a dozen slides in our deck outlining results of our consumer survey. In this one we ask people if they are buying more or less vs. a year ago at each store. Now with three surveys under our belt to an identical demographic group each time, we can at least compare the retailer sentiment to prior surveys to game the incremental change. Bottom line is that JCP is showing steady improvement, while KSS is not.
Please see the link to the presentation materials above for all of our analysis on these and other topics.
The total percentage of successful long and short trading signals since the inception of Real-Time Alerts in August of 2008.