Takeaway: While lies about inflation in Washington can most definitely live, they can’t live forever.
Once again rumors swirl that LO is going to get taken out. Late into yesterday’s close Reuters reported that RAI remains the interested party, caught in a 3-way with BAT that owns 42% of RAI. LO ripped +10% higher on the unconfirmed source (rumors began in March of this year), however the stock has given up some of its move intraday (down ~ -4%); we think the market is getting over its ski tips on an imminent timetable for a deal given acquisition challenges.
We maintain our Best Idea Long Call Lorillard (presented on March 4 of this year). We think investors are best served to ride out the rumor mill pushing the stock higher as we don’t expect an imminent deal, and maintain that LO is fairly valued as a stand-alone or takeout target at $80/share (more below).
We view a hypothetical deal (especially an imminent one) between RAI and LO as challenged on three main factors:
- Our main flag is that a combined RAI + LO would own ~ 67% of U.S. menthol market, which we believe should trigger anti-trust flags.
- Big tobacco is already a highly concentrated industry in the U.S. across the big three – MO has a leading ~51% of market share; a combined RAI + LO would equate to ~ 42% share.
- BAT may look to maintain or increase its ownership in RAI (for the remaining 58%), however it cannot act until July of this year when a 10-year standstill agreement between it and RAI expires.
A scenario suggests that RAI could look to divest such menthol brands as Kool, Winston and Salem (~5% total market share), which could serve to change the consideration of the FTC/DOJ, however all of this shopping would take time.
As part of the Best Idea’s thesis we did not consider a RAI + LO deal. We think the decision to replace CEO Daan Delen with Susan Cameron, who held the CEO seat for 7 years ending in 2011, is contributing fuel to the speculation that she wants to come out of the box “strong” with this deal.
Our thesis is built on the superior fundamentals of the Lorillard portfolio:
- We do not see Menthol Regulation Risk from the FDA over the medium term (1-2 years) and assign less than a 20% probability over the long term.
- We expect blu e-cigs to benefit from first mover advantage and maintain leading market share despite competitive pressures from Big Tobacco’s entry into the category. Looking out 5 years to 2018, we model blu’s earnings contributing 31% to total LO, and accelerating earnings growth in the combined company.
- We expect strong and stable menthol fundamentals driven by lasting consumer and demographic trends that differ from traditional tobacco.
Below we’ve outlined the earnings power of a combined base business plus the blu e-cigarette business and a scenario table on EPS estimates five years out, as outlined in our original presentation. A fair value $80/share target would equate to a price 30% higher than today’s, so we think it pays to hold on to LO amidst the rumor winds!
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Takeaway: Initial Claims suggest the tapering will continue. The bond and currency markets, meanwhile, are still signaling slower growth.
Headline claims rose +28K WoW to +326K while the rate of improvement in non-seasonally adjusted initial claims, our preferred read on the underlying trend in the labor market, decelerated to -5.5% YoY vs. -15.8% last week. The 4-wk rolling average in YoY NSA claims decelerated -80bps sequentially to -5.3% YoY.
In short, another week of decent (not outstanding) improvement as we continue to steadily track towards the frictional lower bound at ~300K in seasonally adjusted initial claims.
Josh Steiner, our head of financials research, characterized this morning’s claims data like this:
This morning's claims data isn't as bad as it looks, but it's not great either. The previous week was anomalous in its strength, whereas this week is more or less in line with the steady trendline rate of improvement we've been seeing for a while now. The important takeaway is this. The labor market remains strong enough for the Fed to push forward with its taper.
Source: Hedgeye Financials
The “strong enough” initial claims characterization sits as a sufficient microcosm for the broader domestic macro data as well.
Sequentially, the data is generally better but the reported March-May data certainly doesn’t reflect significant deferred 1Q (weather) demand or signal a return to the slope of growth observed over 1Q-3Q13 period last year.
Still, sequential improvement supports the wait-&-see/steady-as-she-goes policy approach promulgated by the fed again yesterday– at least over the nearer term.
With the 10Y and $USD both in bearish formation, the bond and currency markets continue to price in slowing growth. On the fundamental side, housing continues (& will continue) to slow (see today’s note: Biggest MoM Growth in Inventory...Ever) and the conflation of decelerating wage growth, a troughed savings rate and rising inflation continue to constrain any upside for “non-core” consumption growth. And from a comp perspective, growth comparisons get harder while inflation comps ease through the third quarter of this year.
More broadly, looking at growth and inflation expectations across our Global Macro dashboard (click on it for an expanded view) developed market growth estimates continue to rise while EM growth revisions remain negative. Interesting, funds continue to flow in the opposite direction of revision trends (ie. into EM markets & away from domestic/DM markets) – a phenomenon largely linked to persistent weakness in the dollar, in our view.
On the inflation side, expectations for ongoing disinflation remain the prevailing trend. Notably, the U.S. sits as one of the only developed market economies (alongside Canada) where inflation expectations have been rising.
Absent technical factors driving a material supply/demand imbalance for credit, rising inflation expectations + falling (nominal) bond yields = lower real growth expectations. We think that remains the right call for the immediate/intermediate term.
Christian B. Drake
Takeaway: It’s going to be an entirely different thing when the 80% of people in this country getting jammed by the Fed’s Policy To Inflate revolt.
US rents (34% of Americans have to rent, and like it) and the cost of living hit all-time highs this week, so alongside #RentRipping, here’s more year-to-date #InflationAcclerating data:
CRB Foodstuffs Index +21.9% YTD
CRB Commodities Index +10% YTD
Coffee +57.6% YTD
Nickel +42.1% YTD
Lean Hogs +28.3% YTD
Soybeans +19.2% YTD
Cattle +15.4% YTD
Palladium +15.4% YTD
Orange Juice +10.9% YTD
Oil +7.9% YTD
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Takeaway: Existing home sales move up modestly, but the real surprise is the crush of inventory hitting the market.
Our Hedgeye Housing Compendium table (below) aspires to present the state of the housing market in a visually-friendly format that takes about 30 seconds to consume.
Today's Focus: Existing Home Sales
The National Association of Realtors (NAR) released its monthly Existing Home Sales report for April earlier this morning. Most of the data is largely useless because it's telling you what you already knew, but on a lag. This is because it mirrors the Pending Home Sales index, which comes out a month ahead.
Remember, the Pending Home Sales index reflects contract signings while the Existing Home Sales report reflects contract closings. There's typically a 1-2 month lag between signings and closings. That being said, there is one extremely valuable piece of data in the Existing Home Sales report that most market participants tend not to focus on, and that's the inventory number. It's the only measure of total housing stock for sale published by any source and it's not a stale number. It's reflecting the number of properties (existing) for sale at the end of the period.
Taking a step back, our main call here is that we're bearish on the outlook for the rate of change in home prices in 2H14 and 1H15.
Principally, it's because demand has been in decline since mid-2013 and price changes tend to follow demand on a 12-18 month lag. The mitigating force, however, is that supply of homes for sale has remained quite low by historical standards. This morning's data is interesting principally in that there was a very large move up in inventory.
To be fair, unlike existing home sales, which are seasonally adjusted, inventory numbers are not. So one would expect to see a big month-over-month upturn in inventory in April, but the size of this year's increase is significantly larger than what we've seen in Aprils past. This increase lessens the mitigating effect of the tight inventory on prices, adding incrementally to our conviction in our call for the rate of home price appreciation to slow markedly.
Here's a summary look at the numbers:
Demand: Better month over month but still weak, soft across all geographies and not reflecting any significant deferred demand from 1Q weather distortion.
- Total sales increased 1.3% MoM….but remain down -6.8% YoY (vs. -7.5% YoY in March)
- YoY Sales growth remained negative across all geographies with the decline accelerating in the Northeast (-6.3% YoY vs. -4.8% in March) and South (-3.5% YoY vs. -3.0% in March)
Supply: Large jump in Supply. Biggest MoM increase in inventory on a units basis ever (back to 1999) at +16.8% MoM
- Inventory (MM Units) = 2.3…up from 2.0 in March = +16.84% MoM & +6.5% YoY
- Inventory (Months Supply) = 5.91…up from 5.12 in March = +15.3% MoM and +14.3% YoY
Other: All cash sales remain elevated and 1st time home buyers continue to run less than 30% as QM impacts, lower affordability, low inventory (among others) all continue to drag on young buyer demand – If you view housing as a ladder then inability for 1st time buyers to purchase = lower turnover & lower total transaction activity (although rising supply may help low end volumes)
- Distressed = 15% of April Sales down from 18% last April
- 1st time buyers = 29% of buyers in April – down from 30% in March and flat with 29% from April last year
- All-cash sales = 32% of transactions vs. 33% in March and 32% april last year
About Existing Home Sales:
The National Association of Realtors’ Existing Home Sales index measures the number of closed resales of homes, townhomes, condominiums, and co-ops. Existing home sales do not take into account the sale of newly constructed homes. Existing home sales account for 85-95% of all home sales (new home sales account for the remainder). Therefore, increases in existing home sales tend to signify increasing consumer confidence in the market. Additionally, Existing Home Sales is a lagging series, as it measures the closing of homes that were pending home sales between 1 and 2 months earlier.
The NAR’s Existing Home Sales index is published between the 20th and the 22nd of each month. The index covers data from the prior month.
Joshua Steiner, CFA
Christian B. Drake
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