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CAT: Not All Clear? (2Q Preview)

Summary

 

The market responded favorably to CAT’s 1Q 2014, with dealer inventory build supporting record margins in Construction Industries (CI) and an easy comp helping Energy & Transportation (E&T).  From what we can see, many investors have likely mistaken 1Q 2014 results as an ‘all clear’ signal.  As shown by CAT’s strong YTD performance, sentiment is far more positive going in to 2Q results.  We instead expect CAT’s challenges to take somewhat longer to resolve, with 2Q 2014 and 2H 2014 estimates above what the company is likely to generate.

 

For 2Q 2014, however, the comps get tougher and the environment less pretty.  Construction equipment sales appear weaker, particularly in Asia, as shown by Volvo and other early reporting construction equipment companies.  We do not expect a repeat of CI’s record 1Q margin.  Copper, iron ore, and coal prices have been weak, likely keeping Resource Industries (RI) under pressure.  Weaker CI and RI sales may reduce engine volumes at Energy & Transportation, with dealer stats showing slowing in other key E&T markets.  As for guidance, we are still amazed that anyone cares about a $0.25 2014 raise at a company that has seen 2014 estimates fall over the last ~18 months by >$7.00.  Nonetheless, for 2Q 2014, we get a likely range between $1.44 and $1.50, below current consensus of $1.52, with sales in-line to slightly below current consensus.

 

 

Segment Expectations

  

Construction Industries

 

While a performance outlier in 1Q 2014, we expect CAT’s Construction Industries segment results to weaken sequentially.  A significant build in dealer inventory last quarter helped drive a record margin and above industry revenue growth (see CAT: Dirty Paws or Easy Comp).  Volvo CE and CAT CI sales are reasonably correlated, and more tightly correlated if we back out our estimates of CAT dealer inventory changes.  As shown in the chart below, Volvo CE revenues were down ~9% in 2Q 2014.  

 

CAT:  Not All Clear? (2Q Preview) - klk

 

 

Adjusted operating income at Volvo CE was nearly cut in half YoY.  While it might be tempting to assume China will not matter for CAT, it was a factor in 4Q 2012/1Q 2013 amid a previous inventory glut.  We will look for commentary on Asia construction equipment inventory and expected factory utilization.

 

Looking at Volvo CE results, there were largely negative signs outside of a robust North America.

 

CAT:  Not All Clear? (2Q Preview) - klk2

Source: Volvo

 

 

CAT seemed to lower expectations for Construction Industries in the 1Q guidance, with the goal of maintaining double digit margins and 10% 2014 revenue growth.  Dealer inventory build likely pulled forward sales, with guidance implying to a ~7% revenue growth rate for the remainder of the year.  Margins at CI are usually fairly volatile.  We have ~11% penciled in for 2Q 2014, with a lot of potential error imbedded in that estimate.

 

 

Resource Industries

 

CAT lowered RI 2014 top line guidance last quarter from -10% 2014 to -20%; we expect to see them do so again – perhaps this quarter.  Dealer inventory changes were not identified as a factor last quarter and the environment appears to have weakened YTD.  While the comps get easier on sales, weak pricing is likely to continue to pressure margins.  As discussed in our recent call on Mining Equipment pricing, the time lag between order pricing and revenue recognition is significant.  While we have a mid-single digit margin modeled for 2Q, we do see the potential for negative RI segment margins as the downcycle in mining capital spending drags on.

 

 

Energy & Transportation

 

As we have written previously, we believe CI and RI engine demand is an important source of volume across certain E&T’s engine platforms.  CAT's dealer stats point to weak results for Power Generation and sequential slowing in Industrial and Transportation markets through May.  Oil & Gas should prove a bit more robust, although product prices have generally weakened into 3Q, notably US natural gas.  We have assumed topline growth similar to 1Q and slight margin pressure YoY amid what we expect to be weaker volume for certain engine platforms and ongoing spending to produce an emissions compliant locomotive.

 

 

Potential Upside?

 

Should dealers again add significant construction equipment or other inventory, we would expect a more in-line to better report from CAT.  CAT may also have some flexibility to further reduce backlogged orders to keep capacity utilization high, potentially reporting better results.  Of course, this tends to be the case each quarter.  We suspect that large dealer inventory increases or backlog decreases might not prove as relevant to the market given the more positive current sentiment.  To really move the needle from current levels, CAT may need to beat without results driven by a backlog drain or dealer inventory build.

 

 

What Could Get Us To Change Our View?

 

We can always be wrong and will change our views as needed.  Specifically, we will be watching CAT’s cost programs closely.  While we expect much more dramatic actions than the current restructuring to prove necessary, particularly in Resource Industries, CAT may be successful at executing significant change more gradually.  We think it is unlikely, with hope for a rebound at Resource Industries likely to preclude the necessary rationalizations. 

 

We will also track order rates.  While we believe pricing is quite likely to continue lower in Resource Industries for at least the next year, margins may bottom somewhat earlier or somewhat later.  We would expect orders for RI equipment to remain weak until a (likely muted) replacement cycle starts in the second half of this decade.  Finally, we expect more significant negative feedback from weakness at RI and CI on E&T engine volumes.  If that does not prove accurate or Oil & Gas capital spending accelerates, we would revise our longer-term E&T expectations.

 

 

Upshot

 

While 1Q 2014 benefited from inventory build at dealers and an easy comp, the set-up for CAT’s 2Q and 2H 2014 is more challenging.  At the same time, 1Q results appear to have left many investors with the impression that CAT is on the mend.  We think that is still a couple of years away.  We expect the challenges facing CAT to take far more time to resolve, with YTD outperformance analogous to CAT’s outperformance in late-2012/early-2013 – a bounce higher in a longer-term downtrend.  Assuming a cessation of inventory builds in CI, we see current consensus expectations for 2Q as too high, but calling quarters tends not to be our strategy.  The current set-up is more fragile in our view: a miss in 2Q, or later in 2H, may shatter the narrative that CAT’s troubles are over.

 


MO – Price Taking Negates Steep Volume Declines

Altria grew Q2 adjusted diluted EPS +4.8% Y/Y, but missed consensus estimates by 1 penny in a quarter that showed a mix of strong cigarette pricing to offset significant volume declines.  The company took up the lower end of its 2014 FY EPS guidance by 2 cents (now $2.54 to $2.59) and announced a new share repurchase program of $1B to be completed by the end of 2015.

 

All in, we expect MO to grind higher over the medium term, however we’re less constructive on the name than we’ve been on its peers in the year-to-date. Clearly the tobacco market is now focused squarely around RAI acquiring LO, and the implications around Imperial becoming the 3rd largest U.S. tobacco company. (Note: we removed out Best Ideas long position in LO on 7/15/14).

 

We expect MO to grind higher in the back half of the year should the company maintain and grow its Marlboro share, turn around the value perception of Skoal and maintain strong performance from Copenhagen smokeless. The company has an attractive dividend yield of 4.6% and an easier tax comp in the back half of the year (35%  vs 37% Y/Y). As we show below, it is trading above our intermediate term TREND line of support – a bullish signal in our model.

MO – Price Taking Negates Steep Volume Declines - zzz. mo

 

In the quarter MO continued to show strength in brand Marlboro (rose 0.3 points to 44%) which we expect to persist in 2H.  Cigarette revenue declined -1.2%, with volume down -5% (below the industry’s 2014 estimated volume decline of -4.5%), partially offset by pricing  of ~ +5.6%.

 

In Smokeless, strong performance came from Copenhagen (volume +7.8%) that offset weakness in Skoal (volume down -6.1% and share down -1.1 points in the quarter).  Combined (Copenhagen + Skoal) saw share jumped 0.4 share points to 51.1% in the quarter, the highest combined share since the acquisition of UST in 2009.

 

Like the rest of its Big Tobacco brethren, MO is rolling out its own e-cigarette under the MarkTen brand. The company reported MarkTen’s rolling launch started in June in 20 states in the western part of the U.S..  Now in 60,000 retail locations, the company plans to head eastward in the summer and into the fall.  Additionally, in the quarter it completed the acquisition of e-vapor business Green Smoke, which it plans to integrate alongside MarkTen.  Like LO’s blu and RAI’s VUSE, we expect marketing, advertising, and promotion costs (to win share and adoption) to eat into profitability over at least the next 2-4 quarters.  

 

The wine business showed strength, with revenue rising 6.6% in the quarter, and margin jumped 1 point to 19.9%, with volume increases from Chateau Ste. Michelle and 14 Hands offsetting declines in Columbia Crest.

 

Call with questions.

 

Howard Penney

Managing Director

 

Matt Hedrick

Associate

 

Fred Masotta

Analyst


DFRG: INFLATED MULTIPLE DEFLATING

We added DFRG to the Hedgeye Best Ideas list as a short on 06/12/14 at $27.27/share.  Since then, FY14 EPS estimates have been revised down $0.05 and the stock has acted accordingly (down ~21%), led by today's post earnings sell-off.  DFRG remains on the Hedgeye Best Ideas list as a short with potential downside to $18/share.  As it stands, we continue to believe 2014 and 2015 EPS estimates of $1.17 and $1.43 remain aggressive.

 

DFRG: INFLATED MULTIPLE DEFLATING - 1

 

Comps: DFRG delivered +2.3% system-wide comp growth in the quarter, tracking in-line with estimates.  Del Frisco's Double Eagle same-store sales increased +5.2%, beating estimates of +3.6%, driven by a +3.3% increase in average check and a +1.9% increase in traffic.  Sullivan's same-store sales increased +0.9% in the quarter, beating estimates of +0.1%.  This comp growth, however, was solely due to a +5.9% increase in average check.  Traffic continued to deteriorate, down -5.0%.  Management does not release same-store sales data for the Grille concept.  System-wide revenues of $67.386 million (+12% YoY growth) missed consensus estimates of $69.100 million by -2.48%.

 

Margins: The quarter was generally in-line with expectations surrounding margin management in the quarter.  Cost of sales increased 11 bps YoY to 30.11% of revenues, driven primarily by significant beef inflation though partially mitigated by 1.8% pricing, menu engineering and the natural hedge of the Grille rollout.  Other restaurant expenses declined -19 bps YoY to 46.63% and led to a +8 bps YoY improvement in restaurant level margins to 23.26%.  Operating margins, however, declined 123 bps YoY to 10.27%.  We maintain our positioning that the company is growing at lower margins.

 

DFRG: INFLATED MULTIPLE DEFLATING - 2

 

Earnings: Adjusted EPS of $0.20 (0% YoY growth) missed expectations of $0.21 by 4.19%.  Earnings were hurt, to an extent, by common growing pains including less operating weeks than previously anticipated due to later than expected new unit openings.  We reiterate our view that growing pains should be considered part of the bear case.

 

Brief Analysis: DFRG reported disappointing results this morning BMO, missing top line and bottom line estimates as well as guiding down FY14 EPS estimates from $0.94-0.98 to $0.90-0.94.  This release, and the stock's subsequent reaction, comes as no surprise to us.

 

As expected, the Del Frisco's concept was strong (+5.2%), although management noted lower than expected sales at its Chicago restaurant.  All told, the Del Frisco's concept has posted positive same-store sales for 18 consecutive quarters.  Sullivan's, in our view, continues to be a disaster.  Same-store sales increased +0.9% led by a +5.9% increase in average check and a -5.0% decrease in traffic.  To be fair, management attributed 80% of the decline in guest counts to the removal of an entrée item from its menu, though we're hesitant to attribute the vast majority of the traffic decline to this.  We continue to question the existence of Sullivan's as a viable concept.  We also question the viability of Grille as a growth concept.  Though we believe it has promise, the lack of clarity surrounding same-store sales, traffic and unit economics is concerning.  Management didn't seem too confident regarding same-store sales or AUV trends.  The new unit development pipeline was also pushed back toward the end of 2H14, which will result in a loss of operating weeks.

 

There is far too much uncertainty to be a supporter of this stock, which is partially why we assumed our bearish stance in the first place.  In our view, Sullivan's is still a broken concept and the Grille is far from being considered a viable growth concept.  DFRG posted $0.94 in adjusted EPS in 2012 and will only post $0.92 (or less) in adjusted EPS in 2014.  These are not numbers that anyone should associate with a growth concept and they certainly don't justify the inflated multiples the Street awarded the stock when we initially added it as a Best Idea short. 

 

As it stands, we continue to believe 2014 and 2015 EPS estimates of $1.17 and $1.43 remain aggressive.

 

What We Liked:

  • System-wide same-store sales increased +2.3%
  • Del Frisco's (+5.2% SSS) has grown same-store sales for 18 consecutive quarters
  • Del Frisco's traffic increased +1.9%
  • Sullivan's two-year same-store sales improved 340 bps sequentially to -0.9%
  • Management has food costs under control (menu engineering; natural hedge of Grille)

 

What We Didn't Like:

  • Top and bottom line miss
  • Non-existent earnings growth
  • Operating margins declined 123 bps YoY to 10.27%
  • Management guided down FY14 EPS from $0.94-0.98 to $0.90-0.94
  • Management tightened the low-end of its FY14 cost of sales guidance to 30.1-30.4%
  • Management lowered its FY14 restaurant level EBITDA guidance from 22.9-23.4% to 22.6-23.1%
  • Management raised its FY14 effective tax rate guidance to 31-32.5%
  • Full-year beef inflation is expected to be in the 8-9% range
  • Management expects fewer operating weeks in 2014 as several openings have been delayed
  • Lower FY14 sales expectations for Del Frisco's in Chicago and Grille in Palm Beach
  • Traffic declined -5.0% at Sullivan's
  • Sullivan's continues to be a lousy concept, despite initiatives to save it
  • Grille continues to be an unproven growth concept
  • Continued lack of transparency surrounding the Grille concept
  • 2013 class of Grille restaurants performing below the level of the 2011 and 2012 classes
  • Management wouldn't share development plans for 2015

 

Research Recap:

DFRG: New Best Idea Short

DFRG: A Castle-in-the-Air

DFRG: Thoughts into the Print (07/21/14)

 

DFRG: INFLATED MULTIPLE DEFLATING - 3

 

Call with questions.

 

Howard Penney

Managing Director

 

Fred Masotta

Analyst


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Cartoon of the Day: What Inflation?

Takeaway: Rising inflation? Well, maybe. But only if you include food, rent, gasoline and basically anything that costs money.

Cartoon of the Day: What Inflation? - Inflation cartoon 07.22.2014


SALES RISE, AS EXPECTED, WHILE PRICES DECELERATE FURTHER

Takeaway: June Existing Home Sales in-line with where PHS would have predicted. Absolute inventory grows, though months supply cools off a bit.

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. 

 

SALES RISE, AS EXPECTED, WHILE PRICES DECELERATE FURTHER - Compendium 072214

 

Today's Focus: Existing Home Sales & FHFA HPI

 

FHFA HPI

The FHFA HPI for May showed home prices decelerated a further -70bps sequentially to +5.5% YoY.  With Corelogic and Case-Shiller data for June and April, respectively, reflecting a similar slope of improvement, the three primary HPI measures continue to tell a cohesive story of discrete price deceleration.   

 

SALES RISE, AS EXPECTED, WHILE PRICES DECELERATE FURTHER - FHF NSA YoY   TTM

 

 

Existing Home Sales 

The National Association of Realtors (NAR) released its monthly Existing Home Sales report for June earlier this morning. 

 

As we've stated here before, there's limited usefulness in the EHS report on the sales side since the data is well-telegraphed by the Pending Home Sales report. We show this in the chart below, where we've offset the EHS data by one month to show its correlation to PHS on a 1-month lag. That being said, there is value in the data on inventory and the composition of sales (first-time buyers, cash buyers, investor share). 

 

SALES RISE, AS EXPECTED, WHILE PRICES DECELERATE FURTHER - PHS VS EHS

 

 

EHS Quick Take:

Total Existing Home Sales increased +2.6% MoM against upwardly revised May figures.  The year-over-year rate of change remained negative but improved to -2.3% vs -4.7% prior.  As highlighted above, the sequential improvement in Existing Home sales was not particularly surprising given the strong +6.1% MoM gain in Pending Home sales reported in May. From a growth perspective, comps peak next month (July 2013 was +17.2% YoY) before getting progressively easier through the balance of 2H.   

 

Regional:  All regions showed sequential improvement in the rate of change in YoY growth on a seasonally adjusted basis.  Growth in the Northeast/Midwest/West held negative while the South saw +1.0% growth in sales Y/Y – the first month of positive growth since January.

 

Inventory:  On a unit basis, existing home inventory increases 2.2% MoM and +6.48% YoY, marking the fourth consecutive month of accelerating YoY growth in supply.  On a months supply basis, inventory declined -0.4% MoM and rose +9.0% YoY as the gain in sales more than offset the inventory increase. Months supply currently stand at 5.5, down from 5.6 last month.

 

Home Prices:  Median home prices continued to increase in the mid-single digits across the South, Midwest and West.  Notably, the median home prices in the Northeast registered its 3rd straight month of negative growth.

 

Other:  Distressed sales declined to 11% of the market, Cash sales held at 32% of the market, 1st time homebuyers remained depressed at 28% of the market, and median time on the market improved for a 6th straight month to 44 days (vs 47 prior).

 

 

SALES RISE, AS EXPECTED, WHILE PRICES DECELERATE FURTHER - EHS LT 

 

SALES RISE, AS EXPECTED, WHILE PRICES DECELERATE FURTHER - EHS Regional 5Y 

 

SALES RISE, AS EXPECTED, WHILE PRICES DECELERATE FURTHER - EHS Regional June 

 

SALES RISE, AS EXPECTED, WHILE PRICES DECELERATE FURTHER - EHS Inventory Units 

 

SALES RISE, AS EXPECTED, WHILE PRICES DECELERATE FURTHER - EHS Inventory Months Supply

 

 

 

About Existing Home Sales:

The National Association of Realtors’ Existing Home Sales index measures the number of closed resales of homes, townhomes, condominiums, and co-ops. Existing home sales do not take into account the sale of newly constructed homes. Existing home sales account for 85-95% of all home sales (new home sales account for the remainder). Therefore, increases in existing home sales tend to signify increasing consumer confidence in the market. Additionally, Existing Home Sales is a lagging series, as it measures the closing of homes that were pending home sales between 1 and 2 months earlier.

 

Frequency:

The NAR’s Existing Home Sales index is published between the 20th and the 22nd of each month. The index covers data from the prior month.

 

Joshua Steiner, CFA

 

Christian B. Drake


FLASHBACK: A Castle-in-the-Air (Or Why You Should Short Del Frisco's $DFRG)

This prescient note was originally published July 02, 2014 at 08:11 in Morning Newsletter. As of this posting, shares of Del Frisco's (DFRG) are down over 17%. Click here for information on how you can subscribe to Morning Newsletter. 

“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

The big picture

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.  

 

FLASHBACK: A Castle-in-the-Air (Or Why You Should Short Del Frisco's $DFRG) - castle

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 sales@hedgeye.com 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.

  • CASH: 16
  • US EQUITIES: 6
  • INTL EQUITIES: 15
  • COMMODITIES: 22
  • FIXED INCOME: 26
  • INTL CURRENCIES: 15

Our levels

Our immediate-term Global Macro Risk Ranges are now:

 

UST 10yr Yield 2.50-2.59%

SPX 1949-1976

RUT 1169-1208

VIX 10.61-12.74

Brent Oil 111.51-115.43

Gold 1310-1330 

 

Stay grounded,

 

Fred Masotta

Analyst

 

FLASHBACK: A Castle-in-the-Air (Or Why You Should Short Del Frisco's $DFRG) - new


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