Takeaway: We've said it before, and we'll say it again: Risk happens slowly at first, then all at once.
Consumer Trends Work Against Portfolio. More Than Cost Savings Needed
Kellogg’s has taken so many blows to the head that it’s curious it is still standing. Despite the leg down the stock has taken today following a disaster of a Q2 report, we’re adding Kellogg’s as a Hedgeye Best Idea on the short side.
What’s clear is the company is working against some pretty powerful consumer trends that demand healthier, protein based foods for breakfast (think Greek yogurt and Eggs & bacon) and not cereal with milk. Add on a competitive landscape in snack foods and cereal bars (GIS and MDLZ), the struggles to get cereal and breakfast food adoption across global geographies, and the economically weakened consumer (in the US and abroad), and the macro headwinds on the business are quickly apparent.
In the quarter, K’s top-line missed consensus ($3.69B vs $3.71B) and diluted EPS of $0.82 decreased -15% Y/Y! The company lowered its FY 2014 internal sale growth guidance to -1% to -2% (versus previous +1%); cut internal operating profit growth to -1% to -3% (vs prior 0% to +2%); and lowered its EPS guidance to $3.91-3.99 (vs prior $3.97- 4.05). Ouch!
Our greatest worry is that Kellogg’s management believes it can turn around the cereal category and consumer trends based on a new marketing message; in CEO John Bryant’s words “we need to communicate how cereal can be a better option for them.” The cereal category is expected to be down -5% this year and K is underperforming the category – we frankly are not of the camp that cereal sees a turn around, and in fact we believe that its glory days are firmly past.
Recent quarters have shown that Project K, a four year program design to create and enhance global efficiencies across supply chains and business units has not delivered. The resulting costs savings to re-invested and grow its core Kellogg’s brand, global snack brands (in particular Pringles), and emerging market presence, is not working as planned. The revision to guidance this quarter and the broader underperformance we’re seeing across business units is confirmation that the strategy is off track.
We look forward to sharing with you why we think Kellogg’s will continue to underperform expectations in an upcoming Best Idea presentation.
Select commentary in the quarter:
- U.S. Morning Foods (includes cereal) – operating profit down -20.9%, citing the underperformance of Kashi. The company announced a renewed focus on returning the message of progressive nutrition to Kashi and name a new CEO of the brand that is expect to become an autonomous business and return to its roots in La Jolla, CA. CEO Bryant called turning around cereal a “multi-year program”.
- U.S. Snacks – operating profit down -0.4% and underperformance in the category. Co. cited the struggle with 100 calorie packs and decision to reduce SKUs, and expectation for the “segment to be challenged for the remainder of the year”. Reaffirms strong Pringles sales trends.
- N. American, Other (includes US frozen and Canada) –operating profit down -20.4%. Frozen down on difficult comparisons (the launch of flatbread sandwiches last year) and the Eggo brand is below expectations (focusing on marketing in 2H behind the business). Canada – strong Pringles sales and 2H optimism on more product activity.
- Europe –operating profit down -29.7%. Snacking strong (Pringles sales up DD) but renewed efforts on campaign called Origins, to make the connection between food and its origins.
- Latin America –operating profit 9.5% on strong results across the region. Venezuela currency issues remain a threat to FY earnings.
- Asia –operating profit -90.2% on weakness in Australia, only partially offset by growth in India after weakness earlier in the year.
Q2 Group shift (impacted f&b too) plus international (Seoul and Bishkek) drag down an otherwise good quarter – asset sales and more buybacks forthcoming. Outlook positive
Q2 Results & Outlook
- RevPAR results driven by ADR increase
- Owned & Leased: negative comp due to calendar and strong results at 5 hotels in 2013.
- Margins: Americans +100bps Outside Americas -400 bps (Seoul and Bishkek were poor)
- Q2 Group RevPAR +1.5%, impacted by Easter but H1 Group RevPAR +5.1% YoY
- Fees: No fees at four French hotels in 2Q vs YoY. Difficult Q/Q comparisons for the French hotels will continue through 2014.
- Outlook: 60% of 2015 on the books, pace up in Q2. Catering pace +10%
Growth & Trans
- 8 of 9 hotels remain on market, decided to take 1 asset off the market. The 8 hotels earned $40 million in EBITDA in 2013.
- 42 of 44 select service hotels recently listed for sale, earned $45 million of EBITDA on LTM minus management fees.
- On track to close on Hyatt Residental Group with ILG.
- Maui Property $35 million sale at cost
- ILG will pay ongoing fees per licensing agreement
- Acquisitions: actively seeking
- Gateway: Park Hyatt $375 million plus pre-opening expense, expect to open in August. In discussions to revise acquisition, may acquire 100% of the hotel at original contract value plus $10m to $15 million = $385 to $395 million. May purchase for all cash. Allow for deferral of gains on sales if purchase 100%.
- Remains unchanged. Grow business and finding opportunities to recycle capital back into the business.
- Acquisitions via dispositions (disposition proceeds used to buy acquisitions)
- Expect to return capital to shareholders via repurchases.
- Maintain investment grade credit rating - keep gross debt / adjusted EBITDA below 3x.
- Ample disposition proceeds to fund acquisitions, so expect to continue to return capital to shareholders via share repurchases.
- Group business - was Easter shift the driver of under performance?
- America's full-service segment RevPAR negative impact by 250 bps
- Group trends for rest of the year?
- Select service RevPAR is a proxy for transient demand and transient demand quite strong, Q3 more transient led, while Q4 more corporate and leisure led demand.
- Encouraging signs for association and corporate lead times into 2015 - expansion of booking curve
- Group pace for H2?
- H1 Group revenue +5%, pace 8% for 2015
- O&L RevPAR vs STR?
- O&L in 2013 +7%, exclude two hotels outside Americas then 80 bps improvement in aggregate - actual RevPAR at two assets was -10%.
- Q2 2013 margins up 230 bps, market specific Seoul and Bishkek Kyrgyzstan (-250 bps) Seoul new supply, Bishkek demand issues due to US military airbase shutdown.
- Playa Resorts
- $4 million of JV EBITDA vs. $13-$15 million for 2014, now at the low end of the range. Focused on getting assets up and running.
- Asset sales/recycling?
- Select service - too early in process to comment but likely a six month process. Could be one large portfolio or three portfolios of 32, 6, and 4 assets. Older assets. Hyatt House brand for past six years.
- Full service - expect six to nine months from listing to closing. Listed in Q1 and expect similar timing.
- Capital Allocation?
- Dynamic process weight current commitments vs. future opportunities
- Opening Pace?
- Executed contract base remains strong, contract base is seasonal - more signings toward year end. Overall level of activity in India abated pending election, now moving from concern to optimism. China remains consistent, more activity with select service brands, evolving.
- Other Income line composition in Income Statement?
- $20 million from sale of Hyatt Place in Austin - looking foward, difficult to forecast due to equity and cost methods of accounting
- Hyatt Residential Group details and sales?
- Time share 2% of total Adj EBITDA in 2013
- Going forward: licensing fees of couple million per year
- Recent Acquisition proformas?
- Hyatt Regency Orlando on track to earn $55 million San Antonio doing slightly better than expectations.
- Park Hyatt NYC proforma expectations?
- Return in high single digits, remains current expectation, will go through ramp up, encouraging partnerships
- Seoul & Bishkek issues - when do comps get easier/anniversary?
- Seoul - comps easier in Q4 2014, on going market challenges due to North Korea and travel issues for Japanese and Chinese traveler into South Korea. So market issue will not get easier anytime soon.
- Bishkek - less than $5 million in 2013 EBITDA. Difficult due to limited market and loss of US Foreign Service/Diplomatic/Military travel.
- 2015 Group Pace Commentary - below peer pace estimate for H2 2014?
- Short term bookings of IQFTQ - hopeful bookings will come through.
- Asset sales - buyer universe for limited service buyers and valuation expectations? Tax implication for portfolio sale?
- Buyer universe: know the public REITs, non-listed REITs, private equity
- Not trying to tee-up deals for tax deferral but rather manage in normal process of acquisitions and dispositions.
- Group demand duration?
- Look to be on the ascension of group demand and progression for group, demand building on its own and not recovered on rate
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Takeaway: EHTH cut guidance following a disastrous quarter. We're largely out of catalysts for 2014, but 2015 doesn't get any easier.
- 2014 RISK ALL ON THE TABLE NOW: Individual and Family Plan (IFP) net membership declined by 49K: EHTH gained 95K new members, while losing 144K existing members (18% of its members from the quarter prior). While many believed EHTH was working with a massive tailwind from the individual mandate under ACA, we estimate that EHTH saw declining IFP revenues in 2Q14 on a y/y basis. Turns out the public exchanges posed a much bigger threat than either the street or management believed they would be. The company's updated guidance range suggests that management is only expecting ~1/3 of its previous growth outlook.
- BUT NOT OUT OF THE WOODS YET: Attrition risk will remain into 2015 as pre-ACA plans expire, and MCOs cancel those plans on their own to manage the overall risk profile of their books. We have suggested that one of the bigger risks heading into 2015 is that MCOs cut commission rates next year now that the public exchanges are largely operational. Further, when (if) EHTH gets the ability to sell subsidized plans, it must offer all subsidized plans that are available on the public exchanges, regardless of whether it has a commission agreement with that MCO or not. In a worst case scenario, EHTH could sell an MCO's plan on its platform, and not receive any commission for it. Under these circumstances, is there a compelling reason to believe that commission rates won't get cut next year?
- MULLING THE SHORT: All the major risks to 2014 are on the table now, so we're largely out of catalysts on the short side for the near future. However, 2015 is around the corner, and as we highlighted above, EHTH is not out of the woods yet. Remember, EHTH is essentially a distributor without a captive consumer. It operates in a crowded industry with a growing competitive threat from the public exchanges. MCOs are likely to push back on rates in 2015; and there's not much EHTH can do about it. For now, we remain short.
Let us know if you have any questions, or would like to discuss further.
Hesham Shaaban, CFA
Hedgeye CEO Keith McCullough discusses Argentina's default, rising volatility and related market threats with Fox Business "Opening Bell" host Maria Bartiromo.
Another lodger disappoints on Q2 RevPAR and F&B growth. However, guidance and forward commentary was positive
Q2 2014 commentary:
- High occupancy driving ADR and thus RevPAR
- International hotels continue to outperform
- Transient: demand 1.6%, rate 5%, revpar 6.5%
- Group slow due to Q2 calendar shift: demand 0.8%, revenues 2%
For H1 2014 commentary:
- Group REVPAR: +3.5%, demand: +3.5%, ADR +6% best performance since last peak
- Corporate group +5% demand
- Transient demand + 0.7% rate +4.5% = +5% revenue
- Banquet revenue +6.6%. F&B +4.8%; 50% flow through
Acquisitions: active pipeline and expect acquisitions before year end but not included in forecast currently due to timing of closing
Disposition: expect to sell at least one asset ($200M) before year end
Total capex: $180m
- Slow GDP growth, employment growth, limited new supply
- Group booking pace very strong: revenues tracking 6% higher
- Group IQFTY up 14%
- 3Q booking trending better than 4Q
- Solid banquet spend and good flow through
- 2H margins expand more than 1H
Q2 Market Highlights:
- Latin America: RevPAR +40%, Rio & Mexico City +53% RevPAR, outpeform in Q3
- West Coast: RevPAR +7.1%; ADR +7%,
- SF ADR +11.2% mix shift toward transient and higher rated group.
- Seattle: Q3 stronger than portfolio
- Pheonix: rate and occ gains due to group gains, driving transient mix, 3Q in line with portfolio
- Denver: strong group business = strong Q3
- Hawaii: negative impact due to Hyatt Maui, Q3 improving performance
- Florida: RevPAR +16.5% in April, 13% in Q2. Q3 in line with portfolio
- Houston: lost 2% occupancy due to comp and attrition: Q3 and Q4 expect under performance due to renovations and lack of citywides.
- Atlanta: Q3 better
- Chicago: RevPAR down, lack of citywides. Q3 better
- NY: occupancy up, rate weaker, Q2 RevPAR 5%, F&B +8% in Q2, supply growth hampering rate gains. Q3 and Q4 in line with Q2 but supply overhang
- Wash DC: ADR declines, suffering, Q2 group room nights -9.2%, replaced group loss with lower rated transient. Q3 expect continued weakness
- Q2 slow down due to calendar shift
- Q3 stronger
- Margin: 100-130 bps better, insurance and overhead gains
- 3Q: 22% EBITDA of total FY EBITDA will be earned in 3Q
- Blended and extended revolver and term loan
- Strong outlook, large FCF, increased dividend to $0.20 - will be run rate for few quarters.
- Potential for special dividend.
- May issue additional dividend greater than 100% of taxable income if unable to find suitable uses for excess cash.
- NA RevPAR vs. STR data
- Secondary market performed better than primary markets, natural evolution of lodging cycle. Leisure sector stronger than rest of the market, better performance at lower price points. Non-comp hotels had double digit RevPAR growth.
- Acquisitions: why no assumed acquisitions in guidance?
- Nothing to announce today, mid-year
- Acquisition pricing vs. replacement cost vs. historicals?
- Difficult to compare on replacement cost, still better to be a buyer vs as a developer. Certain markets with stronger recoveries (West Coast and Miami), transaction pricing approaching replacement cost, so some new development. Not yet at the levels of 2006 and 2007 when buyers willing to pay 15% to 20% higher price than HST ability/desire.
- Acquisitions: what's in the pipeline -- US vs. International?
- Mixed, good European activity, looking in Europe. Also looking at higher end of select service in the US. Asia slow, nothing immanent.
- Acquisition - how to find appealing opportunities given interest by PE, SWF, and other REITs? Repositioning?
- Change in operator or change in brand which allows HST to satisfy their yield requirements.
- A number of assets listed for sale, expect potential closing late fall into early winter
- If sell a $200 million asset, then EBITDA down $4 million in Q4.
- Group - increasing lead time, pricing power?
- Seeing a significant increase in corporate business, especially in Q2. Pleased with booking activity in Q2, IQFTQ room nights up 9%, rest of 2014 nights up 5% translates into revenues up 14%. Bookings getting done now ADR significantly higher than YoY. Encouraged by booking pace. 2015 unclear...1H very good on rate and occupancy but 2H rate lower and not seeing booking nights pick up.
- Prior Peak EBITDA on current portfolio?
- 2007 peak $1.48B but acquired and sold various assets, so not a true comparable number.
- F&B spend in Q2 vs. Q1 for groups?
- Up strongly in Q1, flat in Q2, up in Q3 but difficult to tell for Q4, Q4 impacted by holiday party spend decisions which are close to date. Generally seeing decision to spend more closer to event.
- Upscale select service opportunity?
- Decision based on return opportunity of the asset as well as the outlook for the asset. Not see a meaningful increase in upscale hotels in portfolio.
- European JV portfolio - H1 vs H2 trends?
- Noticed similarities in Spain & UK, urban hotels under performing. Spanish resorts did very well and outperformed urban assets. Weaker in Europe in H1 due to event timing, group events in 2013, coupled with internal travel shifts. Pleased with F&B and profit flow through. H2 trends reverse, upticks in group business.
- More acquisitive with JV partner as European economies recover?
- Looking and also seeing an uptick in activity. Will be disappointed if HST does not participate in few transactions in H2 of this year.
- Occupancy trends - markets running high 70s/80ish, how to get additional occupancy gains?
- Add'l RevPAR gains will be ADR driven. Middle of the week 90% occupancy so drives rate, on weekend need to drive occupancy and ADR will follow. Trying to move groups more to weekend stays.
- Incentive management fees - trending over coming quarters?
- Expect 50%-55% of hotels to pay IMFs. Renegotiated IMF contracts with several operators. Expect historical IMF increases in 2015 and 2016, but will approach prior peak of 70% of hotels paying IMFs.
- Domestic RevPAR below MAR and HOT - why?
- Portfolio composition and YoY compares. But encouraged and mid-point of guidance today was upper end of range last quarter. If include non-comp hotels, then Q2 closer to 5% revpar growth.
- Maui timeshare - quantify expenses?
- Have expense during Q2... didn't quantify. But $11 million of EBITDA will be recognized in Q4 when the timeshare sales begin
- Redevelopment opportunities?
- Houston Marriott, San Diego ballroom, plus couple of other redevelopment opportunities, will have more commentary on 3Q call, but expect 2015 ROI capex budget to increase slightly.
- Washington DC outlook?
- Outlook better - more rooms booked for 2015 and 2016.
- Negative is what's happening with the Government politically, government sequesters, cutbacks. H2 drag more muted/modest.
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