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This note was originally published at 8am on May 14, 2014 for Hedgeye subscribers.
“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 email@example.com 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%
“Only when we admit what we don’t know can we ever hope to learn it.”
That’s another fantastic leadership quote from a new book I introduced in yesterday’s Early Look – Creativity Inc. – Overcoming The Unseen Forces That Stand In The Way of True Inspiration.
“The best managers acknowledge and make room for what they do not know – not just because humility is a virtue but because until one adopts that mindset, the more striking breakthroughs cannot occur… They must accept risk… and engage with anything that creates fear.” –Ed Catmull
I can tell you that I wake up every morning living in fear of one simple thing – losing. I hate losing. And I refuse to allow my team to lose for extended periods of time. If and when we are wrong, we either double down or change our mind. We get paid to take a line and be held accountable to it.
Back to the Global Macro Grind…
Being long slow-growth and #YieldChasing in 2014 (i.e. being long bonds and/or anything equities that looks like a bond) has not only been the winning position YTD, but it was yesterday too.
With SP500 busting out (on no volume – US Equity Volume -29% vs the 3mth avg) to all-time-bubble highs intraday, bonds reversed from opening down to closing at their highs of the day. The 10yr UST Yield has ticked down yet again this morning to re-test a fresh 2014 low of 2.49%. Bond bears are losing.
But, but, Biotech (IBB) +2.5% yesterday was winning. Yep, nice trade. I just hope you didn’t own it the whole way down, because that “growth” sub-sector of the SP500 has been a certified train wreck this year. Most things high-multiple, high-beta have been.
“So” do we buyem because they were up?
Let’s get real here folks. I left Career Risk Management Inc. in 2007 so that on days like this I could double-down on my team’s hard work and process. If you want to beat a monthly bogey, great – chase the wabbit. If you want to win a championship in 2014, stay with the fundamental trends.
In the US, here are the big intermediate-term TRENDs that have been winning for the last 5-6 months:
1. US #InflationAcclerating
2. US #ConsumerSlowing
3. US #HousingSlowdown
Winning being defined as the score:
1. CRB Commodities Index, Food, and Oil +8-22% YTD #InflationAcclerating
2. US Consumer Discretionary Stocks (XLY) = DOWN -2.1% YTD #ConsumerSlowing
3. US Housing Stocks (ITB)= DOWN -3.0% YTD #HousingSlowdown
That’s not to say that I didn’t feel like the NY Rangers last night. However magical a playoff run they’ve had, getting lit up for 7 goals in Montreal feels like I did at yesterday’s market close. Kreider went to de penalty box in the first minute of the game. Canadiens scored. He felt shame.
“So” why shouldn’t I change our entire Macro Theme Deck (6-12 month view) and positioning this morning?
1. Why isn’t it “different this time” (i.e. bond yields going down aren’t an explicit sign of US growth slowing)?
2. Why isn’t it time to giddy up and buy stocks like Facebook, Twitter, and Yelp that blew up into the thralls of April?
3. Why isn’t it time to pretend that no-volume and an 11 VIX doesn’t matter as a risk management signal anymore?
Why Mucker? Why can’t you just change everything you and your team have done YTD and join a crowded consensus long-growth US Equity Multiple Expansion (and bearish on inflation and bonds) view that almost everyone else on the sell-side has?
What would change my mind? That’s easy. Going back to what we loved about our US #GrowthAccelerating call in 2013:
In fact the Swiss have some of that this morning. As the Swiss Franc ripped to new highs, Swiss Exports ramped +2% year-over-year and so did Switzerland’s GDP growth rate. Sound familiar, Mr. Krugman? Same thing happened this year in the UK. #StrongCurrency tax cuts for The People.
“So”, other than a lot, what else don’t we know that could be driving spooos higher with the Russell 2000 -1.9% YTD?
1. How many hedge funds came into 2014 levered long growth, got smoked, then shorted the April lows?
2. How many people have Yellen and Bernanke whispered to that if growth continues to slow, that they go Qe6?
3. How many one-legged ducks can avoid swimming in a circle?
What we do know is that with the VIX at 11.51 (testing YTD lows) and the II Bull/Bear sentiment spread at its YTD highs (58.3% Bullish, 17.3% Bearish = +4100bps wide to the Bull side) that the buy in May, chase performance, and pray thing is alive and well.
Our immediate-term risk ranges are now (12 Global Macro Ranges are in our Daily Trading Range product):
UST 10yr Yield 2.48-2.60%
WTIC Oil 102.99-105.27
Best of luck out there today,
Keith R. McCullough
Chief Executive Officer
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TODAY’S S&P 500 SET-UP – May 28, 2014
As we look at today's setup for the S&P 500, the range is 36 points or 1.25% downside to 1888 and 0.63% upside to 1924.
CREDIT/ECONOMIC MARKET LOOK:
MACRO DATA POINTS (Bloomberg Estimates):
WHAT TO WATCH:
COMMODITY/GROWTH EXPECTATION (HEADLINES FROM BLOOMBERG)
The Hedgeye Macro Team
Starboard is doing the right thing. They’ve officially taken on the task of saving the largest publicly traded casual dining company in the world. From our vantage point, there is a high probability that Jeffrey Smith and his team will gain a majority position on Darden’s Board of Directors.
It will be a long, hot summer for the folks in Orlando and we want to be clear about what we think Starboard Value’s move last week means for the shareholders and employees of Darden Restaurants. In our view, Starboard has assembled a highly qualified group of professionals that will be able to rebuild a broken company into one of the most admired, while making a lot of money for all constituents along the way.
We didn’t personally know the people at Starboard prior to their investment in DRI, but we’ve been impressed with how thoughtful they’ve been in their business endeavors. Nobody is perfect, but we don’t view them as a stereotypical activist investor out to make a quick buck. From what we’ve seen in their public presentations, it is clear that they see a significant long-term opportunity.
While Starboard has not formally put a price target on the stock, we believe there is an opportunity for them to make 2-3x their investment over the next three to five years. As we’ve said before, Darden represents a “generational opportunity” that does not come around too often in the restaurant space. In my twenty years as a restaurant analyst, I’ve only seen a similar type of opportunity three other times.
Knowing that Starboard is fully committed to getting control of the Board is critical to realizing any potential upside. If Starboard is successful, which we believe they will be, it will send a loud and clear message to Darden employees and the Greater Orlando community: the future is bright.
Unfortunately, getting to that point is not going to be easy and we suspect some serious mudslinging is about to begin. There is no doubt that Clarence Otis and his advisors will be working overtime to discredit Starboard and their slate of Board nominations. We feel fairly confident that Darden will be specifically gunning for Brad Blum, because he represents the biggest threat to Otis’ job.
After advocating for change at Darden for the past two years, we are more confident than ever that senior management and the Board must be replaced. Darden continues to mislead shareholders and the investment community by telling a demonstrably fabricated tale of shareholder support.
In fact, based on our conversations, this support nearly ceases to exist in any capacity. We estimate that Darden only has support from 5-10% of the outstanding shares. The Red Lobster fire sale has further enraged shareholders who explicitly demanded a Special Meeting to discuss the merits and motives of such an ill-advised transaction. We believe the vast majority of outstanding shares are in the hands of what we consider to be Starboard advocates.
Last week, in a letter to Darden shareholders, Starboard nominated 12 directors to stand for election at Darden’s 2014 Annual Meeting. According to the release, the slate of nominees is a culmination of “experienced restaurant operators with expertise in Darden’s major business lines, and experts in real estate, finance, turnarounds, supply chain, and, critically, effective public company governance and compensation programs.” Importantly, we believe these candidates, in aggregate, are more qualified to help orchestrate the biggest revival in the history of casual dining than the current Board.
Getting to the heart of the matter, by nominating 12 Board members, Starboard hopes to effectively gain control of the company. Given management’s blatant disregard for shareholder rights and history of destroying value, we can comfortably say they’ve brought this upon themselves.
Shortly after the news hit, Darden released a press release in which it said: “by attempting to replace all 12 members of the Board with its own preferred nominees, Starboard is seeking effective control of the Company – representation which is disproportionate to Starboard’s recently acquired approximate 6.2% stake in Darden and which does not offer Darden shareholders a control premium for such change in control.” Our initial thought was that the change of control premium would come when Starboard gets control of the company.
Two things come to mind as it relates to this. First, Starboard and its potential Board members own 2x the amount of stock that Darden’s management and current Board own, so their interests are more closely aligned with other shareholders. Second, the current management team’s track record is so poor that most shareholders are begging for a major shakeup.
The other part of the Darden rebuttal was that “Starboard’s assertions continue to be based on incorrect and unrealistic analysis, which results in misleading conclusions regarding the value associated with the sale of the Red Lobster business.” Having read Starboard’s letter several times, we’re having a difficult time seeing where Starboard is being misleading. It makes us wonder if management can objectively read what the financial community is saying about the Red Lobster sale. Did management see what happened to its stock the day they announced the Red Lobster sale?
Darden goes on to say “the recently signed agreement to sell the Red Lobster business and the actions underway to reinvigorate restaurant performance, reduce costs and ensure a sound financial foundation to support Darden’s dividend reflect the input we have received from shareholders.” That statement is misleading in its purest form. If management’s plan reflects the input from shareholders, why did they not allow shareholders to vote on the Red Lobster transaction?
Darden’s cavalier attitude toward shareholders has led to an unsustainable pattern of behavior that will result in wholesale changes at the company when the Annual Meeting comes around.
Starboard’s slate of nominees possess highly relevant and broad based expertise, including significantly greater restaurant operating experience. Several of the nominees, in particular, have considerable experience turning around restaurant companies – something the current management team has proven incapable of doing.
Aside from Darden’s potential efforts to attack Starboard’s slate of nominees, the next big event for Starboard will come when they detail specific plans to fix Olive Garden and other operational issues at Darden. We still contend that Darden should spinout LongHorn and Capital Grille into a separate steak company and explore an IPO of Yard House. Olive Garden needs to stand alone and Starboard needs to communicate to the investment community how they plan to turn around the flagship brand.
All told, Starboard’s recent actions ensure that our longer-term bullish thesis remains intact. Despite the Red Lobster sale, we continue to see tremendous value that can be unlocked through various, highly feasible initiatives. However, with the Annual Meeting four or five months away, we see downside in the stock over the immediate and intermediate-term due to the significant and abrupt loss in earnings power.
Starboard must replace the current Board in order to unlock Darden’s inherent value. Barring a change of this nature, Darden would immediately become one of the best shorts in the entire restaurant space. As always, our bear case remains Chairman and CEO Clarence Otis.
Starboard’s attempt to replace the entire Board may seem overly aggressive, but those intimately involved with the situation know that this is a legitimate, even likely, possibility. The Board’s questionable practices have become increasingly egregious and its mockery of corporate governance has reached seemingly insurmountable levels. Shareholders, collectively, must put this to an end.
Call with any questions.
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