Takeaway: With the subdued threat of a U.S. drought affecting the harvest, volatility and bullish sentiment have collapsed from the April highs.
Volatility can turn quickly with high-frequency data, and currently equities aren’t the only asset class with a relatively complacent outlook on market catalysts into the summer months.
With commodities being the biggest outperformer through the first half of 2014, the CRB Index (+8.50% YTD) is experiencing its largest YTD increase since 2009 (+13.20%). What started off as some of the most volatile markets across all asset classes on the speculation of a drought in the U.S., investors in the grain markets remain skeptical of a forward-looking catalyst for price action into the harvest.
- Basis on 1st and 2nd month corn futures is trading at a year-to-date high (Jul-Sep. spread)
- Spot implied volatility has trended back to historical averages from April highs
Arguably the most important grain number of the year into the heat of harvesting season, the USDA reported Q2 stockpiles. The report shuddered any pre-season threat of a drought-fueled rally into harvest season. The USDA estimates Corn and Soybean Stocks may reach record levels. Bullish sentiment as measured by the CFTC’s weekly reporting of the net length of aggregate futures and options positions in the market peaked with prices at the end of April and has since declined significantly:
- Corn: After rallying to +22% on the year through the end of April, corn is now trading in negative territory after the print showed higher than expected stockpiles for Q2. The USDA now estimates the largest stock ever for the 2014 harvest:
- Q2 Stocks: 3.85Bn vs. 3.72Bn estimate
- 2014 USDA estimate: 13.94Bn Bushels (all-time high)
- Soybeans: After reaching +17% YTD at the end-of-April highs, soybeans have since retreated -10% to +7% through Q2. The USDA report this week also exceeded expectations with record acreage expected to be planted
- Q2 Stocks: 405MM vs. 382MM estimate
- Wheat: Reached a may 6th YTD high of +21% and has since plunged to -7% through Q2 (-4.5% week-to-date)
- Q2 Stocks: 590MM vs. 597MM estimate
The consumption of commodities is paid for in real, inflation-adjusted U.S. Dollars. With the driving force of high-frequency macro data points changing forward-looking expectations for the dollar and rates on a daily basis, the outlook for those who consume in U.S. dollars moves in tandem. We observe a noticeable relationship between these marginal changes and commodity prices and believe this will continue to be a potentially catalyst inducing volatility in commodity markets, weather aside.
Despite Monday’s Reuter’s headline “ISLE is in advanced talks to sell itself to GLPI” - we are skeptical as we see hurdles to such a combination despite modest value creation.
CALL TO ACTION
While the Reuter’s headline read ”ISLE is in advanced talks to sell itself to GLPI, noting that discussions were renewed in recent months after a sales process earlier this year fell apart”...frankly speaking, we found the timing of the headline unusual as well as disingenuous. Could someone simply have been “talking up their book” on the last day of the month as well as the quarter? Regardless of the headline, we are skeptical as we see several hurdles to a potential transaction between ISLE and GLPI and we outline the reasons below.
Recall on Tuesday, March 18th we held a thought-leader call with REIT Attorney Ed Glazer regarding gaming companies converting or selling assets to a REIT. During that call, Mr. Glazer outlined all the compelling reasons for why current gaming operators would not be able to either convert to or conduct a tax-free spin-off a REIT. At that time, our position was the outlying and divergent opinion. Here we are more than 90 days later and no gaming operator has announced its intent to spin-off a REIT via a tax-free or a taxable process. However, we have renewed headlines regarding a gaming operator (ISLE) in discussions with Gaming & Leisure Properties (GLPI), the PENN sponsored, gaming-focused REIT spin-off.
WHAT WE THINK WE KNOW
First, Isle of Capri owns three commercial casinos in Iowa – Isle Bettendorf (Bettendorf), Isle Waterloo (Waterloo) and Isle Lady Luck (Marquette). During 2013, the properties generated the following GGR: Bettendorf $72.3 million, Waterloo $85.7 million and Lady Luck $28.8 million while on a last twelve month basis through May 2014 GGR was: Bettendorf $70.5 million, Waterloo $85.5 million, and Lady Luck $27 million. Approximately 20% of ISLE's net revenues come from Iowa.
As background, Iowa currently has 18 commercial casinos and recently approved a 19th casino license for the development of Wild Rose Entertainment Jefferson casino with more than 500 slots and up to 15 table games. Beyond cannibalization from additional Iowa casinos, Iowa GGR is adversely impacted from the addition of VGTs in Illinois. During 2013, Illinois VGTs generated more than $51 million in GGR from Western Illinois counties viewed as feeder markets to the casinos located along Eastern Iowa on the Mississippi River. The ultimate death knell to Iowa will be when Nebraska approves commercial gaming.
Second, on Tuesday April 29th, GLPI’s Senior Vice President, Corporate Development, Steven Snyder, while speaking at a Goodwin Proctor-sponsored REIT discussion regarding “Competing in the New York Resort Casino Market” said “GLPI is very concerned about the Iowa Superior Court interpretation and ruling (in the IRGC vs. Argosy dispute) and as a result GLPI would NOT pursue any additional gaming acquisitions in Iowa.” As background, the Iowa Superior Court ruled that, in Iowa, a gaming license is held by the non-profit business partner and not the gaming operator – in a ruling between the Iowa Racing & Gaming Commission and Argosy Sioux City.
Third, at the end of 1Q 2014, GLPI had $48 million of cash on its balance sheet and $550 million remained available under the Credit Facility. At March 31, 2014, GLPI had $150 million drawn in its $700 million revolving credit facility and a fully drawn $300 million Term Loan A facility. GLPI has limited cash on hand but could draw down on its corporate credit facility.
Fourth, GLPI announced its intent to acquire The Meadows for $465 million, with a targeted closing date during 1Q15. The acquisition will likely involve an equity issuance as well as debt assumption. The May 14th GLPI press release reads "The purchase price, which the Company (GLPI) intends to fund with a combination of equity and debt". Enter the equity overhang!
Next, we believe any transaction (despite a low probability because of the Iowa issue) would involve a sale/lease back by ISLE and not the acquisition/sale of the entire ISLE entity.
In the event GLPI were to buy the entire ISLE entity, GLPI would need to complete a second transaction which is the sale of the OpCo - given the rules that govern Taxable REIT Subsidiaries. Given the negative feedback GLPI management received following the announced Meadows acquisition - and required second step of selling The Meadows OpCo, we view any transaction involving a second step as less desirable and a lower probability event.
This said, in the event GLPI were to consummate a sale/lease back with ISLE, such a transaction would likely require a sizable GLPI equity issuance - about 10.8 million shares (enter a larger equity overhang!) at today's GLPI share price as well as the assumption of approximately $612 million in debt.
Consequently, we model a theoretical sale/lease back along the lines of the PENN/GLPI spin-off where PENN pays GLPI 16.5% of Net GGR in the form of rent, which approximately translates into a 75% EBITDA margin. However, given the size of ISLE we assume a slightly lower 70% EBITDA margin on the GGR.
Finally, in our opinion, Mr. Carlino moved from PENN to GLPI as a means to "preserve" his personal and family wealth - not put the family fortunes more at risk in an industry experiencing both cannibalization as well as contraction. That said, why would Mr. Carlino "go all in" both in terms of acquisition strategy as well as increase the pressure on GLPI stock from a massive equity overhang?
While a sale or sale/lease back transaction involving ISLE would create incremental shareholder value for current ISLE shareholders, we view such a transaction with GLPI as a lower probability event - primarily since GLPI publicly said it would not pursue further gaming acquisitions in Iowa (a declining market) and a transaction with ISLE would require both a large assumption of debt as well as a sizable equity issuance, in addition to the equity issuance required to complete the acquisition of The Meadows for $465 million. This said, maybe GLPI pursues a strategy to sale/lease back a single ISLE asset such as Pompano.
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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.
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.”
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.
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
- 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.
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.
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.
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.
Q2 2014 EARNINGS CALENDAR
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).
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.
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.
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
- 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
- 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
- Continues to be a growth engine for the company with 7 of the top 10 smoking countries across the globe located in Asia
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
Happy 4th of July!
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