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LO: Removing Lorillard from Investing Ideas

Takeaway: We are removing Lorillard (LO) from Hedgeye's high-conviction stock idea list.

We are removing long Lorillard (LO) from Investing Ideas today. 


After Consumer Stables analyst Matt Hedrick added LO on 3/6/14 and months of rumors that it would be taken out, this morning Reynolds American (RAI) announced its intention to buy LO in a cash-and-stock transaction currently valued at $68.88, or a total of $27.4B (including debt). 


LO: Removing Lorillard from Investing Ideas - 79


The price is significantly below our share target of $80, and it’s worth noting that there is significant runway before the deal is expected to close in 1H 2015. That said, this has been a fantastic position for us. 


We want to underline that beyond RAI we do not see another competitive bidder for LO. Further, given that we expect a lengthy regulatory approval process on anti-trust considerations this deal is still a long way from closed and may present a further investment opportunity.


Shares are up over 15% from where we added it to Investing Ideas.


Rigorous statistical analysis suggests that Singapore’s weakening macro environment could impact casino revenues.




We’ve found several macroeconomic metrics to be correlated with Singapore gaming revenues.  Given the few number of data points – Singapore is still a young but mature gaming market – it is too early to quantify each metric’s significance.  Considering the discretionary and cyclical nature of mature gaming markets worldwide, LVS and Genting Singapore investors should be worried about Singapore's deteriorating macro environment.



The Singapore government recently released a slew of macroeconomic data for Q2 and it’s difficult to find any ray of positivity.  Q2 GDP contracted (QoQ) for the 1st time in 7 quarters.  Retail sales (ex motor vehicles) are trending -2% YoY (April-May period).  Watches/jewelry sales (seasonally adjusted) fell 8% (April-May period).  On the housing side, Singapore private residential prices fell again in Q2 following the Q1 decline.  The results are even more extreme for Singapore new private home sales which fell 68% in the month of June.  CPI also ticked up in Q2 relative to Q1.


The Singapore Dollar remains higher versus a majority of its cross currencies in Q2.  As Genting mentioned several times on its conference call, a stronger Singapore dollar is a headwind for the mass business due to a lower bet per trip.





We’ve run the regressions and the only thing we’ve definitively concluded is that there is not enough revenue data points to formulate a working model.  However, we can derive a very high R square using multiple macro variables even though the t-stats (measuring statistical significance) among individual variables are mostly fairly weak.  Again the low t-stats are more of a function of a limited dataset. 


Among the most statistically significant and positively correlated variables are private residential prices, visitation, and watch/jewelry sales.  Negatively correlated variables include CPI and currency.  Unfortunately, none of these variables are moving the right way to support casino revenue growth.  Fortunately, all of these data points, with the exception of visitation, are released on a timely basis.



We will understand the statistical impact macro has on gaming revenues as more quarters pass.  However, our view is that the deteriorating macro environment, as evidenced by variables that we believe will prove to be significant, is negatively impacting casino play at the Singapore casinos.


For LVS, we are projecting Q2 Marina Bay Sands (MBS) EBITDA of $378 million, which assumes a normal hold percentage, versus the Street at $390 million.  Given the macro weakness, we feel less certain in our Q2 and 2014 MBS EBITDA estimates.

Cartoon of the Day: Hedgeye Gold Bulls vs. Goldman Bears

Takeaway: Goldman doesn't like Gold. We do.

Cartoon of the Day: Hedgeye Gold Bulls vs. Goldman Bears - Gold cartoon 07.15.2014

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WWW - Hated, But Not For Long

Takeaway: This is one of the most hated stocks in retail. It might be sleepy and boring, but we like this name in the mid-$20s.


Conclusion: This is one of the most hated stocks in retail. We understand the bear case, but think it’s foolish to be beared-up on a name when sentiment is at its worst, valuation is bordering on cheap, and growth is on the verge of reaccelerating.



This one is a head-scratcher. WWW beat the Street’s EPS expectation by 15% – putting up a better-than-expected top line, a positive reversal in Sperry (which is a lightning rod for this stock), and gave every indication that the productivity of international distribution agreements is improving (this was critical for us – see write up below). Yes, EPS was driven in large part by lower SG&A growth, but that was known heading into the quarter. The stock was up 8% pre-market, but then once the call got underway it cratered, and is down 2%. The primary culprit is that guidance was very ‘Wolverine-ish’, meaning that the company reaffirmed the year, but lowered the upcoming quarter – so it can beat it handily in another 13 weeks. In addition, we think that people will be concerned that the company will back away from its long term revenue target. We’re really not concerned about either of these things.


One thing that never ceases to amaze us is how much people love to hate this company. We’ve all seen companies that are perennially hated, but seriously, pull up a 20 year stock chart for WWW. It does not strike us a management team and business model that’s worth betting against for anything more than brief periods of time.  Our Sentiment Monitor below, which combines Sell Side rankings with Buy Side short interest and assigns a quantitative score, shows just how hated WWW is today. When the Sentiment score gets below that dotted green line in the chart, it almost always signals a contrarian time to buy (the inverse holds true for stocks with sentiment above the red line).


WWW - Hated, But Not For Long - 7 15 2014 WWW SentMon


Here’s something to think about from a timing perspective on WWW as it relates to its PLG acquisition.

1)      Year 1: Even though the deal was consummated in 2012, it really only benefitted 2.5 months of the year. The real ‘Year 1’ was 2013. This was a breakout year for the stock as WWW blew away EPS estimates as it immediately realized revenue and cost synergies from the deal. The stock was up 66% for the year, more than double the market.  It really served as the poster child as to why you want to own a stock in the first year after a transformational acquisition.

2)      Year 2: Unfortunately, we’re in this year right now. We’re in the back half. But we’re still in it. In deal terms, we’ve anniversaried the Year 1 euphoria of synergies, and are still building the infrastructure to support organic top line growth and margin expansion. This begins in Year 3. Unfortunately, growth investors don’t want the stock at this point in its cycle, and it’s probably not cheap enough for value investors. GARP investors might look at it, but there’s not enough ‘G’ in the GARP equation here given a tough start to the year in US retail.

3)      Year 3: 2015 – this is when we actually start to see a reacceleration in growth due to the investments that were made in years 1 and 2 of the acquisition. In WWW’s case, it will be an extension of the International growth that we’re starting to see in its numbers as Keds, Sperry, Saucony, & Stride Rite grow more aggressively overseas. That plus accelerated growth in e-commerce across all of its brands. In the end, we think that we’ll be looking at growth rates 2x what we see today.



The punchline is that today’s stock move definitely takes away what little wind WWW had in its sail, which we clearly don’t like. But when we step back, the reality (as we see it) is that the stock is bombed out, sentiment is simply abysmal, it is trading at 14x earnings and 10x EBITDA when earnings and cash flow have a long-term CAGR of 20% and 25%, respectively. That might be justified if it the business was decelerating. But we think we’ll see an inflection in 2H, and then a material acceleration in 2015. That should start to be discounted in the back half of this year  -- to some degree.  It might be sleepy and boring, but we like this name in the mid-$20s.



WWW - Hated, But Not For Long - 7 15 WWW FinChart



WWW - Hated, But Not For Long - 7 15 2014 WWW Sigma







This WWW quarter to be reported tomorrow is an important event for our confidence in our Long thesis.  To be clear, we’re not too worried about the EPS number. We think that looks fine. We’re at $0.28, about a penny above the Street, which would represent a 22% growth rate in EPS compared to a 6% decline in 1Q.  The consensus view is that the revenue is weak, and that the company will make up for it with lower pension expense. That’s mostly correct, but well-telegraphed. We shouldn’t see any downward revision to guidance for the year. If anything we think WWW will beat and keep FY guidance steady, implying that 2H will be lower (that’s what it always does). Keep in mind that the company was at the FFANNY trade show in early June where it held 1-on-1s, and then presented at a broker’s Consumer Conference. Both of those happened just 1-2 weeks before the quarter closed June 14th. In other words, WWW knew its numbers, and likely would have preannounced at that time if it thought the quarter or year was at risk.   


The key thing we’re looking for, however, is a) the number of international distribution arrangements signed for Sperry, Keds, Saucony and Stride Rite, and b) the revenue generated by the deals that have already been signed. Why is this so important? The crux of the investment opportunity here is WWW scaling up the International distribution for the four PLG brands. It already has the most efficient international distribution network of any footwear company in the world, with better than 60% of its shoes sold outside the US across a network of 210 distributors over 11,000 points of distribution. All of them are on SAP, and all are exclusive to WWW. Conversely, the PLG brands generated only 5% of its sales outside of the US due to the inefficiencies of being under the umbrella of its former owner, Collective Brands (Payless). When we look at the timeline associated with this deal, organic international growth should be ramping up right now. Here’s the timeline…


PLG Acquisition Timeline

  • 2012 was the year of the PLG deal (4Q12). It was big, and painful initially – no EBIT, just interest from $1.2bn in debt.
  • 2013 was the year of integration. In 1H people moved around, brands were repositioned, and management realigned. Then in 2H the chessboard was largely set, but they had to seal the deal with an SAP implementation, which went without a hitch.
  • Then comes 2014 – which should be all about revenue growth. The global salesforce, which is the most efficient footwear distribution operation on the planet, has four new major tools (brands) in its toolbox. WWW has been lining up international distribution arrangements over the past 18 months and is now sitting on about 55. Aside from each of those arrangements getting more productive, there’s still another 150 that could be added by our estimates.



Here’s what the company has said in its last seven public appearances about its cadence in signing new deals.

  • Q2'13 CC (Jul ‘13):  almost 20 distribution agreements in key growth markets and anticipate another 15 to 20 programs will come online in the back half of 2013
  • Q3'13  CC (Oct ‘13):  We continued to make progress on this front during the quarter by signing and executing distribution agreements covering 14 key growth markets, bringing the total number of new agreements since closing to nearly 35 covering 67 countries.
  • Investor Day (Oct '13) : Since acquisition, we've signed 35 new agreements covering 67 countries, and we're very excited about certainly the most recently inked agreements with the Elan Corporation for the Sperry Top-Sider and Keds brand for the China market.
  • ICR (Jan '14):

 WWW - Hated, But Not For Long - WWW Chart1


  • Q4 '13 CC (Feb '14) : significant investments to build out the full Sperry Top-Sider lifestyle assortment. We have seven license agreements in place today for everything from swimsuits to sun glasses and our most exciting initiative, the introduction of a full range of Sperry apparel via license agreement with Li & Fung is scheduled to launch this coming fall... We've signed 15 to 20 new contracts for Sperry. We still only have Sperry in about 67 countries around the world, for example.
  • Q1'14 CC (Apr '14): During the quarter, we signed agreements covering over 25 key growth markets, bringing the total number of new agreements since closing to nearly 55, covering nearly 85 countries.
  • Baird Conference (May '12): And as we noted in our earnings call last week, since the acquisition closed, we've signed 55 new distribution agreements for the newly acquired brands covering 85 markets. And so those distribution agreements are in place.

So there are 55 agreements in place as of May, and probably close to 70 today. We’re ahead of the consensus this quarter due to revenue growth associated with these arrangements.  If we’re wrong, then we’ve got to step back and question our logic, math and thesis. But based on what we know today, we’re comfortable owning this one.



Removing Long LO from Best Ideas List

RAI Announces LO Acquisition; Surprise on Share Price and Sale of blu E-cigs!

Today we are removing long LO from our Best Ideas list.  After adding LO on 2/26/14 at $47.74 and months of rumors that it would be taken out, this morning RAI announced its intention to buy LO in a cash-and-stock transaction currently valued at $68.88, or a total of $27.4B (including debt). 


The price is significantly below our share target of $80, and it’s worth note that there is significant runway before the deal is expected to close in 1H 2015. That said, this has been a fantastic position for us.  Based on last night’s closing price the stock is up over 40% from where we added it as a Best Idea.


Before we dive into the specifics of the announcement, we want to underline that beyond RAI we do not see another competitive bidder for LO. Further, given that we expect a lengthy regulatory approval process on anti-trust considerations this deal is still a long way from closed and may present a further investment opportunity.


As the market expected, Imperial was transformative in aiding this deal.  It’s committed (pending shareholder approval) to buy RAI’s menthol brands of KOOL, Salem, and Winston, and well as LO’s Maverick and e-cig business blu for $7.1B or $4.4B after tax. This would make Imperial the third largest U.S. tobacco company. 


The menthol divestiture is seen as a key consideration for regulatory approval (FTC is the main governing body), however the willingness of RAI to part with blu caught us by surprise.  As we outlined in our Best Idea call in early March, we viewed blu as a key driver lifting the total company’s sales growth and accounting for 31% of EPS by 2018. The e-cig business therefore significantly factored into our share price estimates for an RAI acquisition.


Given blu’s leading U.S. market share in e-cigs (~ 45%), we believe that RAI is telling the market that 1) it squarely believes in its own e-vapor business (VUSE) and 2) is showing regulators that its portfolio is pro competitive (across both combustible and non-combustible).  RAI’s VUSE is still in its infancy – the company launched in initial test state markets earlier in the year, and is in the process of national distribution in its first phase to roll out in 15,000 stores.


So what are the hurdles that remain?

  • LO and RAI shareholder approval remain outstanding.  BAT appears to be a very committed partner - it agreed to maintain its 42% ownership in RAI through an investment of ~ $4.7B, agreed to vote its shares in favor of the transaction, and with RAI has agreed in principle to pursue an ongoing technology-sharing initiative for the development and commercialization of next-generation tobacco products, including heat-not-burn cigarettes and vapor products.
  • Regulatory.  the FTC will decide on anti-competitive regulatory issues, however we think RAI took appropriate steps to divest its menthol exposure, create a viable U.S. competitor in Imperial, and signals a pro-competitive stance on the e-cig/e-vapor category by selling blu.  The process by which the FTC makes a judgment may be drawn out (hence RAI targeting 1H 2015). We maintain that menthol presents a minimal regulatory risk, assigning less than a 20% over the longer term, and believe that RAI’s acquisition proves out an environment of limited risk.


RAI + LO Boost Market Share to 34%

We are bullish on the combined power of RAI + LO as the 2nd largest U.S. tobacco company to compete with #1 MO (~51% share).  RAI + LO will compete for the top spot across industry categories:

  • Newport, Camel, Pall Mall and Natural American Spirit in combustible cigarettes
  • Grizzly in smokeless tobacco
  • VUSE in the e-cigarette market

As was central to our Long LO call we continue to like menthol’s superior fundamentals to traditional tobacco. Newport Menthol is the #1 U.S. menthol brand (37.4%) and is the #2 U.S. cigarette brand, with overexposure to urban areas and the eastern U.S.  RAI expects to reap $800M in cost savings over two years and we think the strong sales and brand equity of LO’s portfolio is complemented well by the strength in RAI’s non-menthol brands like Camel, and its more western U.S. geographic exposure.  The combined company’s ability to leverage a larger sales force, attain more shelf space and compete for higher margin (premium and above premium cigarettes and smokeless) should prove very profitable.


Removing Long LO from Best Ideas List - RAI 1

Removing Long LO from Best Ideas List - RAI 2


Additional Acquisition Details

  • Under the terms of the transaction, which has been approved by the boards of directors of both companies, Lorillard shareholders will receive, for each Lorillard share, $50.50 in cash and 0.2909 of a share in RAI stock at closing, representing $68.88 per share based on RAI's closing share price yesterday. Upon closing, Lorillard shareholders will own approximately 15% of RAI.
  • Following the transaction, RAI is projected to have over $11B in revenues and approximately $5B in operating income
  • RAI expects the transaction to be accretive to earnings in the first full year, with strong double-digit accretion in the second year and beyond (on a percentage basis).
  • As part of the divestiture, Imperial will acquire certain assets owned by Lorillard including its manufacturing and R&D facilities in Greensboro, N.C., and approximately 2,900 employees, including a national sales force.
  • Once the transaction is completed, a transition period will commence during which R.J. Reynolds will contract manufacture KOOL, Salem and Winston for Imperial and Imperial will contract manufacture Newport for R.J. Reynolds.
  • The RAI/Lorillard transaction and the Imperial transaction are scheduled to close substantially at the same time, 1H 2015.
  • Lorillard will continue its existing dividend policy until the deal closes. RAI plans to maintain its current dividend policy until the transaction closes (~80%) and is targeting a dividend payout ratio of 75% going forward.
  • RAI will generate significant cash flows and expects to maintain its investment grade credit rating following the transaction.
  • RAI has secured fully-committed bridge financing and expects to issue permanent financing for the transaction.
  • Susan Cameron will remain RAI's president and CEO after completion of the acquisition while LO CEO Murray Kessler will join RAI's board after the transaction closes.


Howard Penney

Managing Director


Matt Hedrick



Fred Masotta



What is Retail Sales?


It’s a trivial, but not an insignificant question.


In casual conversations with investors, particularly those who aren’t Macro centric, I’d say a majority don’t technically know what Retail Sales encompasses.   Superficially, the term “Retail Sales” kind of connotes that it’s a broad measure of the 70% of the economy that is consumer spending – and most people take it that way.  


In fact, retail sales is an estimate of spending at department stores, food service providers, auto dealers, and gas stations.  In other words, it is largely an estimate of spending on goods


In other, other words, while it’s a timely, insightful barometer of the prevailing state of domestic consumerism, it doesn’t include spending on services, which comprises the lion’s share of consumption at ~2/3 or household spending and ~45% of GDP


The numbers are also volatile on a month-to-month basis, subject to significant revision and reported on a nominal basis – making it difficult at times to distinguish whether sales trend changes are due to prices or volumes.  





Retail sales in June rose 0.3% MoM, decelerating -30bps sequentially to +4.3% YoY.  Strong reported auto sales in June again buttressed headline growth, although the miss vs expectations suggests pricing was probably weak. 


Under the headline, the Retail Sales Control Group (Retail Sales ex Food, Auto Dealers, Building Materials & Gas Stations, which feeds GDP) accelerated modestly on a MoM, 1Y, and 2Y basis after decelerating across all three measures in May. 


General Merchandise, Personal Care, and Nonstore/Electronic Sales (the E-sales proxy) led gainers while 9 of 13 categories improved MoM.


Overall, “decent” is probably an apt descriptor for the June data, particularly in the wake of negative MoM growth in Real Consumer spending in both April and May. 




VAPID ACCELERATION:  JUNE RETAIL SALES - Retail Sales control Group June





Relatedly, Consumer Credit Growth Continues To Improve….


We previously highlighted the Fed G.19 Data from April which showed US revolving consumer credit balances rose at a month-over-month annualized rate of +12.3%, the fastest rate of growth since 2001 and a positive inflection relative to the steady, ~0-1% growth reported the last few years. 


On the back of the jump in revolving credit in April, the recently released May data showed a +2.1% MoM annualized increase, the third straight month of sequential, above-trend growth.   


So, credit growth (credit cards, autos, C&I) is showing some positive mojo of late and the ever increasing reality of our modern, consumption economy remains:  credit = spending = the marginal driver of growth.


Whether the nascent credit acceleration can support and/or catalyze a breakout in domestic growth remains to be seen. 


With #InflationAccelerating, Real Wages decelerating, and the consumption data middling-to-slowing, the early read through appears to be that consumers are tapping credit to maintain consumption levels in the face of compressing household margins. 









Christian B. Drake



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