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DFRG: A Castle-in-the-Air

The Hedgeye Macro Team gave us the honor of penning this morning’s Early Look.  We decided to write on our most recent best idea, short Del Frisco’s Restaurant Group (DFRG), in a note we believe is appropriately titled “A Castle-in-the-Air.”

 

EARLY LOOK: A Castle-in-the-Air

“Dreams of castles in the air, of getting rich quick, do play a role – at times a dominant one – in determining actual stock prices.”

-Burton G. Malkiel

 

For the past several days, I’ve been reading a gem of a book recommended by my colleague, Howard Penney.  Malkiel’s A Random Walk Down Wall Street is a timeless, thought provoking piece that most curious investors would enjoy reading poolside on a beautiful summer day.  I certainly did.  After all, restaurant research isn’t limited to cheeseburgers and fries.  In fact, a large part of our job pertains to understanding both human and market psychology.  The castle-in-the-air theory, which concentrates on the psychic values of investors, serves as a constant reminder of this fact. 

 

For those unfamiliar with its origin, the castle-in-the-air theory was popularized by John Maynard Keynes in 1936.  While we tend to disagree with Keynes’ and his disciples on a number of economic issues, the notion that stocks trade off of mass psychology is widely appealing.  Accordingly, some investors attempt to front run this onslaught of groupthink, not by identifying mispriced stocks, but rather by identifying stocks that are likely to become Wall Street’s next darling.  All told, this can be a profitable strategy – until it’s not.

 

DFRG: A Castle-in-the-Air - chart1

 

Back to the Global Macro Grind...

 

We believe we’ve identified one of Wall Street’s current darlings and recently added it to the Hedgeye Best Ideas list as a short.  Del Frisco’s Restaurant Group (DFRG) owns and operates three distinctly different high-end steak chains.  After coming public in July 2012, the stock has gained over 114%; quite impressive, by any measure.  More importantly, however, we believe cheerleading analysts and the subsequent madness of the crowd have propelled the stock during this time.  Is it reasonable to call a company whose adjusted EPS declined 7% in 2013 one of the greatest growth stories in the restaurant industry?  We think not. 

 

As Malkiel goes on to say:

 

“Beware of very high multiple stocks in which future growth is already discounted, if growth doesn’t materialize, losses are doubly heavy – both the earnings and the multiples drop.”

 

Beware indeed.

 

The truth is, the company currently screens as one of the most expensive stocks on both a Price-to-Sales and EV-to-EBITDA basis in the casual dining industry.  While we’re not insinuating DFRG is the beneficiary of a “get-rich quick speculative binge,” we are confident the stock is severely dislocated from its intrinsic value.

 

Part of the hype has been driven by the company’s positioning within the restaurant industry.  Del Frisco’s caters to the high-end consumer; a cohort that the stock market would suggest is doing quite well.  While this may be true, we believe the high-end consumer has been slowing on the margin as inflation in the things that matter (food, energy, rent, etc.) continues to accelerate.  Contrary to popular belief, high-end consumers can feel the pinch too and two-year trends at the company’s hallmark concept, Del Frisco’s Double Eagle Steakhouse, would suggest the same. 

 

Admittedly, the Double Eagle Steakhouse, though slowing, is a healthy concept.  But it’s only 25% of the overall portfolio.  The other 75% consists of a fundamentally broken concept (Sullivan’s) and an unproven growth concept (Grille).  Naturally, the Street is discounting an immediate turnaround at Sullivan’s and a flawless rollout of the Grille, neither of which we see materializing.  In fact, we continue to expect restaurant level and operating margin deterioration throughout 2014.  This has less to do with all-time high beef prices (32.8% of Del Frisco’s 2013 cost of sales) and the recent wave of minimum wage increases (25% of Del Frisco’s restaurants have exposure), than it does with the fact that the company is systematically growing at lower margins and, consequently, returns.

 

More broadly, there are a number of red flags that the Street is unwilling to acknowledge right now including decelerating same-store sales and traffic trends, declining margins, declining returns, increasing cost pressures, expensive operating leases, peak valuation, positive sentiment and high expectations.  We simply refuse to give the company credit for what it has not proven and while we can’t hit on all the minutiae of our thesis in this note, we do have a 67-page slide deck that does precisely that (email for more info).  In short, our sum-of-the-parts analysis suggests significant downside.

 

You can delay gravity, but you can’t deny it.  Needless to say, we don’t expect this particular castle-in-the-air to stay there much longer.

 

DFRG: A Castle-in-the-Air - chart2

 

Howard Penney

Managing Director

 

Fred Masotta

Analyst


Today 2pm EST: E-Cig Speaker Series - Are Vaporizers Taking Share from Big Tobacco's E-Cigs?

Today at 2pm EST we look forward to continuing our Speaker Series on electronic cigarettes with Jan Andries Verleur, CEO of VMR Products. VMR is a leading private online e-cigarette and vaporizer manufacturer with such brands as V2 Cigs and Vapor Couture.

 

Is the consumer switching to an alternative vaping product? Mr. Verleur will offer his latest insights and expertise to Hedgeye's ongoing research on the electronic cigarette category.

 

 

KEY CALL TOPICS WILL INCLUDE

  • Industry developments and trends
  • How the FDA's proposed regulations stands to impact the industry
  • VMR's product offering versus Big Tobacco's
  • What does future technology look like

 

CALL DETAILS

  • Toll Free Number:
  • Direct Dial Number:
  • Conference Code: 685512#
  • Materials:CLICK HERE (slides will download approximately one hour prior to the start of the call)

                                                                                                                                                     

ABOUT JAN ANDRIES VERLEUR, CEO & CO-FOUNDER OF VMR PRODUCTS

Verleur co-founded VMR with Dan Recio in 2009. During 2012/13 Verleur served as President of the Smoke Free Alternative Trade Association (SFATA), and is currently serving as its treasurer. Prior to VMR, Verleur spent the past fifteen years running business-to-consumer (B2C) companies across the Americas, Europe, and Europe that deliver products and services over the internet. He majored in marketing at Penn State University. 

  

ABOUT VMR

Incorporated in April 2010 and headquartered in Miami, VMR is a leading online retailer of electronic cigarette products, with 3,000 online orders daily across 30 countries. In the U.S. VMR products can be found across gas and convenience stations and food channels, including Walmart. The company has 225 employees worldwide.


Tobacco Trends – PM Shorter Term Struggles Persist; LO Bulls

As we begin Q3 it’s worth digesting the status of Big Tobacco and where we think it is heading. What’s the outlook on pricing and volume trends, is the industry ripe for consolidation, and what did PM say at its Investor Day that may impact the stock and the group?   July also kicks off earnings season for the group.

INVESTMENT IDEAS

The table below lists our current investment ideas as well as a list of potential ideas we are in the process of evaluating (watch list).  We intend to update this table regularly and will provide detail on any material changes.

Tobacco Trends – PM Shorter Term Struggles Persist; LO Bulls - zz tob names

Q2 2014 EARNINGS CALENDAR

7/18/14  PM

7/23/14  MO

7/24/14  RAI

7/25/14  LO

HEDGEYE TOBACCO INDUSTRY EVENTS

TODAY, July 2 - VMR Products – E-cig/E-vapor call with CEO Jan Verleur at 2pm EST

July 16 - Ballantyne Brands – E-cig/E-vapor call with CEO John Wiesehan Jr. at 11am EST

 

Sky-high Valuation. As the charts below show, the subsector is heavily overvalue on a historic basis (P/E at 16.5x versus a 5YR average of 13.1x) with all of Big Tobacco just off their max P/E’s over the period.   Valuation is certainly “rich”, however we have a favorite (Long Lorillard) and believe the group will continue to rise alongside consolidation rumors (likely RAI+LO).

Tobacco Trends – PM Shorter Term Struggles Persist; LO Bulls - z2

Tobacco Trends – PM Shorter Term Struggles Persist; LO Bulls - z. 33333

 

Cigarette Volume & Pricing.  As we look to the balance of the year, Big Tobacco forecasts U.S. volumes to fall 3-4% this year, similar to 2013, and an anomaly compared to a more recent historical trend of ~ -1 to -2% declines. PM stated that it sees volume (ex-China) falling -2 to -3% this year. We expect Big Tobacco to continue to push through pricing, here again our favorite is LO.  

 

E-Cig Volume Trends. U.S. e-cigarette sales fell -6.1%Y/Y in the four weeks ended June 15th, according to IRI. The latest figure marks the second consecutive Y/Y drop (following -2.9% for 5/18/14), and reflects a 5.2% drop in units and 1% lower prices.  We view the recent performance as a reflection of a number of factors including increased product and brand offerings, price competitiveness, increased sales of lower margin rechargable kits, and a consumer shift toward e-vapor consumption.

 

July marks the beginning of national rollout campaigns for Altria’s e-cig brand MarkTen and Reynolds’ VUSE, which is flooding shelves already occupied by Lorillard’s blu and a handful of strong private national manufacturers (including LOGIC, NJOY, Ballantyne Brands). MO and RAI are offering deep discounts and promotion to get their products in the hands of consumers and, along with LO’s blu, are selling kits at lower price/cartomizer. Finally, we’re seeing signs of consumers shift consumption toward e-vapor products (such as tanks, pens, mods), or a form that’s unlike Big Tobacco’s more cig-alike e-cig offerings.  This cohort is not included in measured channels, most often purchased in vape shops, and consumer preference seems driven on e-vapor’s better experience (drag and flavor offerings) and cheaper price versus more traditional e-cigs.   We’re conducting survey work on these issues and will be interested to present our findings.

 

Despite an increasing competitive environment, we expect advances in Big Tobacco’s e-cig technology with the roll-out of new kits will help propel the industry in the back half and ease recent sales declines.  

 

 

LONG LO.  Our long positioning on Lorillard hasn’t changed since we added it as a Best Idea on 2/26/14. What has changed since then is the addition of a rumor mill that RAI may buy the company – we’re riding LO stock alongside these rumor winds. The most recent news that Imperial Tobacco may be shopping RAI’s menthol portfolio is yet another piece of news that should fill LO’s sails. (our note).

 

What are the main anti-trust hurdles in an RAI-LO deal getting done?

  • A combined RAI + LO would own ~ 67% of U.S. menthol market.
  • A combined deal would rank as the biggest-ever tobacco merger. 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.   

We suspect RAI may be looking to sell its menthol brands like Kool, Winston and Salem, which equates to around ~5% total market share, however we do not think LO will be imminently purchased and are staying long of the stock until an announcement of an agreement or its long-term fair value of $80/share, whatever comes first.  

 

 In the box directly below we break out our 5 year EPS estimates for the base business and blu. As we show, the combined business, gets a substantial lift in earnings power from blu (currently the e-cig market share leader at 39.2%), boosting overall CAGR to 20%. In the sensitivity analysis box we offer that even under a punitive scenario in which a 10% discount rate is applied on 5yr forward earnings of $7.50, the stock is north of $80.  Given yesterday’s closing price of $61.11, that’s 31% upside in the stock from here.  

Tobacco Trends – PM Shorter Term Struggles Persist; LO Bulls - z4

 

Below we take a look at the top 10 global tobacco companies by revenue, as a reference for the industry’s biggest players as rumors of further consolidation pang the industry. 

Tobacco Trends – PM Shorter Term Struggles Persist; LO Bulls - z.5

 

 

PM Investor Day Highlights:


Intermediate Term Struggles Persist; Non-Combustible Investment Significant & Bullish. We are getting constructive on PM over the longer term, especially given its recent move (-8% off its year-to-date high on 6/19). More to follow.


We’re very encouraged by PM’s longer term outlook based on its strong international brand equity, increased R&D spend towards future growth in Reduced Risk Products (RRPs), ability to take price (which it expects to remain in-line with its historical average of $1.8B per year), and easier comps after two years of excessive (above historical norm) excise tax hikes in key geographies (like Australia, Philippines, Japan, Russia, Spain, Italy, France that’s encouraging illicit trade), unique competitive challenges (Philippines and Australia), and macroeconomic weakness, all of which has led to extraordinary volume declines of -3% to -4% per year.

 

The company did lower its EPS target for 2014 (to $4.87-$4.97 versus previous guidance in May of $5.09-$5.19) to better reflect these intermediate term challenges, however we’re encouraged by its R&D spend (some $2 billion and hiring 300+ scientists since its spin) and focus to lead the RRP category, which we see as a natural progression to declining global cigarette trends:  RRP can offset combustible cigarette declines and grow new product demand, a winning long-term strategy in our view.  

 

The company also announced the acquisition of Nicocigs Limited (“Nicocigs”), a U.K.-based e-vapor company whose principal brand is Nicolites. The terms of the deal were not disclosed, but Nicolites has a 27% share of the U.K. e-vapor market, and the acquisition gives PM instant sales presence and a 40 person sales team on the ground (the current U.K. retail e-vapor market is estimated at approximately $350MM, the second largest behind the U.S.).  We believe PM’s global inroads and partnership with MO will aid in quickly accelerating brand share and ultimately loyalty, a key component given the early stage of e-vapor product development and increased competitiveness now that all of Big Tobacco has e-cig/e-vapor products on the market. 

 

Finally, we’re bullish over the longer-term on Marlboro 2.0, the company’s architecture to modernize the brand, and with it expand into new population and smoker segments, catering towards trends of consumers seeking smoother tastes, even within the full-flavor category.  We’re positive on the company’s push to trade up consumers to the premium and above premium categories that enjoy higher margins. This we believe PM can carry out its strategy over the longer term, leveraging strong marketing and sales teams across the globe, and leverage the growth in aspirational consumers seeking the strong brand identities of the PM portfolio.

 

 

Below are key bullets from the PM Presentations last week (Thursday and Friday):


On Reduced Risk Products

  • PM calls the segment the “greatest growth opportunity” to address range of adult smoker preferences
  • Invested significantly in R&D behind RRPs (some $2 billion and hired 300+ scientists since its spin)
  • Has portfolio of over 500 patents worldwide and 1,000 patents pending

Tobacco Trends – PM Shorter Term Struggles Persist; LO Bulls - z6

  • Platform 1 on track for launch (iQOS and Marlboro HeatSticks) in test cities in Japan and Italy in Q4 2014 with national launch schedule for 2015
  • Factory being built in Bologna, Italy is expected to produce 30B units by 2016
  • iQOS consists of “precisely controlled electrically-heated tobacco system” that maintains a tobacco temperate below combustion, designed to use with a custom “HeatStick” tobacco stick that is to be Marlboro branded
  • iQOS expected to be rolled out across its C-store network
  • Platform 2 (heat-not-burn combustible cigarette with cigarette-like look) expect to launch in 2016
  • Platform 3 & 4: Nicotine containing e-cigarettes/e-vapor products scheduled to launch in 2H 2016
  • According to PM the RRP are expect to negatively impact profits in 2014-2016 (hence the update to its guidance) and tip positively beginning in 2017
  • Announced the acquisition of Nicocigs Limited (“Nicocigs”), a U.K.-based e-vapor company whose principal brand is Nicolites, which has a 27% share of the U.K. e-vapor market. The terms of the deal were not disclosed

Regional Commentary

EU:

  • Arresting the volume decline:  now forecasts volume down 5-6% in 2014 vs previous guidance of -6 to -7%.  Expects volume down 5-6% in 2015 and down 4-5% thereafter.
  • Marlboro continues to take share, up 38.9% in 1Q 2014 vs 38.5% in 2013, with 84% of the company EU volume concentrated in four brands: Marlboro, L&M, Chesterfield, and Philip Morris
  • Strategy to drive growth in premium and above premium segment and take price to offset volume declines 
  • Expects excise tax should remain rational, and within bounds of recent years range of 3% - 6%
  • Reduced Risk Products: great opportunity with test launch of Platform 1 in Q4 2014 in Italy and national expansion in 2015
  • Tailwinds: UK untapped market. PM has market share of 38.5% in the EU, but only 7.3% in the UK.
  • Headwinds: Losing share in Spain, Italy and France on hike in excise tax and uptick in illicit trade
  • says 1 in 10 cigs sold in the EU was illicit last year... working to tackle this problem

 

Asia:

  • Continues to be a growth engine for the company with 7 of the top 10 smoking countries across the globe located in Asia

Tobacco Trends – PM Shorter Term Struggles Persist; LO Bulls - z7

 

Near term headwinds

Japan, Philippines, Australia, Indonesia, and Russia offer particular challenges, citing the existing unfavorable excise tax and illicit trade headwinds

  • Japan – excise hike from 5% to 8% in April 2014, and another VAT hike expected in October 2015 in the 8-10% range (final word expected near year-end)
  • Philippines – the co. struggles with a major competitor in the Mighty Corporation. In 2013, the company only declared half of revenues for tax purposes, and continues to create an uneven playing field
  • Australia – after a 12.5% excise tax hike in December 2013, there’s another 12.5% hike scheduled for September 2014. Seeing sharp growth of illicit trade (up to 13.9% after years of decline) alongside hit from plain packaging and competitive price discounting
  • Indonesia – PM is the largest player in hand rolled cigarettes, how consumer trends against hand rolled is working against them
  • Russia – challenged volumes on higher excise (most recently in January 2014 of 8 Rubles/pack) and smoking ban in bars and restaurants effective June 2014

Longer term Tailwinds

  • Philippines – government likely to side with PM with tax stamps expect in July 2014 to better even the playing field (vs Mighty) and drive share gains. 
  • Indonesia – significant growth opportunity with increased purchasing power and middle class expansion.

LatinAm & Canada

  • In LatAm the compnay has a huge opportunity through its strong brand equity to gain share of more people moving into the middle class, GDP picking up, and by addressing illicit trade with governments throughout the region
  • Highlights include better price management in Brazil and Argentina; the co.has a great opportunity to growth the Brazilian market (as the chart below shows, Marlboro has only a 8.7% share in the country), and must work to limit downtrading in Mexico

Tobacco Trends – PM Shorter Term Struggles Persist; LO Bulls - z8

Tobacco Trends – PM Shorter Term Struggles Persist; LO Bulls - z9

 

Happy 4th of July!

 

Howard Penney

Managing Director

 

Matt Hedrick

Associate

 

Fred Masotta

Analyst


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THE JUNE SWOON ENDS WITH INCREMENTAL SWOON

Takeaway: Mortgage purchase applications decline for the third week in a row and now point to a sharp and widening divergence vs pending home sales.

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.

 

*Note - to maintain cross-metric comparability, the purchase applications index shown in the table below represents the monthly average as opposed to the most recent weekly data point.

 

THE JUNE SWOON ENDS WITH INCREMENTAL SWOON - Compendium

 

Today's Focus: MBA Mortgage Applications

The Mortgage Bankers Association today released its weekly mortgage applications survey data for the week ended June 27. 

 

We wrote on Monday that the strong Pending Home Sales number for May seemed at odds with the weak June mortgage applications data. We acknowledged, however, that there was still one week left in June that, if very strong, could explain away the difference.

 

This morning we got that number and it was quite weak. As such, we continue to expect the June Pending Home Sales number to be weak sequentially and likely to be accompanied by a downward revision to the May number. We illustrate the growing divergence between the two series in the first chart below.

 

Here's a summary look at the data: 

* Composite Index:  -0.2% sequentially and lower for a 3rd straight week 

 

* Purchase Apps:  Down -0.7% sequentially and also down for a 3rd straight week.   Ends June -15.9% YoY and +3.0% on a QoQ basis

 

* Refi:  Up +0.10% WoW with the YoY improving to -48.5% from -56.5% prior. 

 

* 30Y Rates:  The rate on the 30Y FRM contract returned to the lowest levels YTD at 4.28%, down from 4.33% the prior week.  Rates have now been negative on a YoY basis for 2 consecutive weeks and, on a monthly average basis, June marked the lowest cost of conventional home financing since April of last year.   

 

 

THE JUNE SWOON ENDS WITH INCREMENTAL SWOON - Pending HS vs Purchase Apps updated 

 

THE JUNE SWOON ENDS WITH INCREMENTAL SWOON - Purchase Apps   Refi YoY   

 

THE JUNE SWOON ENDS WITH INCREMENTAL SWOON - Purchase Apps LT w Summary Stats 

 

THE JUNE SWOON ENDS WITH INCREMENTAL SWOON - Purchase Apps Qtrly 

 

THE JUNE SWOON ENDS WITH INCREMENTAL SWOON - Composite Index Qtrly 

 

THE JUNE SWOON ENDS WITH INCREMENTAL SWOON - Composite Index LT w Summary Stats

 

THE JUNE SWOON ENDS WITH INCREMENTAL SWOON - 30Y FRM

 

  

About MBA Mortgage Applications:

The Mortgage Bankers’ Association’s mortgage applications index covers more than 75% of mortgage applications originated through retail and consumer direct channels. It does not include loans delivered through wholesale broker and correspondent channels. The MBA mortgage purchase applications index is considered a leading indicator of single-family home sales and construction. Moreover, it is the only housing index that is released on a weekly basis. 

 

Frequency:

The MBA Purchase Apps index is released every Wednesday morning at 7 am EST.

 

Joshua Steiner, CFA

 

Christian B. Drake


Daily Trading Ranges [Unlocked]

This note was originally published July 02, 2014 at 07:42 in Daily Trading Ranges

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