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August 13, 2014

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IRAQ: What to Watch

Takeaway: ISIL is capitalizing on a weak regime in Baghdad, but Iraq's largest Oil fields remain secure for now.

A replay of an expert call we hosted back on June 6th with Professor Charles Hill is included in the link below. His bio and an outline of key takeaways are also included. Professor Hill’s summary of the evolution and potential threats of ISIL’s growing strength out of the Arab Spring in 2011 is a good primer for understanding the longer term dynamic behind ISIL’s advancement into Western Iraq. This topic starts 13 minutes into the hour-long call:


Foreign Policy Briefing With Professor Charles Hill




The EIA estimates that about 75% of the reserves of OPEC’s second largest oil-producing country are contained its southern region. Iraq's other major oil fields with proven reserves (“major” defined as >5Bn barrels or more in proven reserves) is held in regions that ISIL has not yet penetrated. They are currently gaining on two large fields:


1. Southeast of Baghdad

2. Northeast Kurdish Region:

  • By far the largest oil field in Iraq stretching from Kirkuk to Irbil. Neither has been breached thus far

Despite the threat, Iraq’s export capacity remains unabated:

  • Currently shipping approximately 3.2-3.5MM barrels/day into the Persian Gulf (ALL out of Basra and its surrounding regions in the south)
  • ISIL Militants were successful in seizing the Kirkuk-Ceyhan pipeline in June, but the pipeline was under serious repair and had not been operating since March 2nd.
  • From solely a resource capacity standpoint, the IEA estimates that Iraq has the ability to increase its export capacity to 45% of OPEC’s total within the next several years
  • Even without the Kirkuk pipeline, Iraq has the capacity to ship far more than its current OPEC production limit

Nevertheless ISIL took control of Mosul and halted the repairing of the pipeline which is capable of exporting 310K barrels/day into the Mediterranean….


What does ISIL control at this point?

  • Major Cities of Mosul, Fallujah, and possibly now Samara (Just North of Baghdad up the Tigris River)
  • Most of North and Western Iraq: The Iraqi/Syrian border has essentially been wiped out. ISIL has not yet penetrated the Northeast Kurdish controlled region which is likely no coincidence
  • Baghdad is more or less surrounded

IRAQ: What to Watch - Map of ISIL Advance


Over the last week, the threat has escalated on three fronts:


1.       Capturing of the Mosul Dam:

  • ISIL militants captured the Mosul Dam last week north of the city and are fighting to capture the Samarra Dam along with the city itself. Fighting in Samarra has prevented military support to the Kurds in the Northeast. Both Dams sit on the Tigris River which flows from the Mediterranean through Baghdad, and down into the Persian Gulf. They may have the ability to inflict to deliberate and inadvertent flood damage with control of the dam. 

2.       ISIL move on Irbil:

  • Northeastern city in Iraq’s Kurdish controlled region that sits on the Northern tip of Iraq’s largest oil field.

3.       Pursuit and genocide of ancient Yazidi Tribe trapped in Mt. Sinjar:

  • ISIL has stated the goal of systematically destroying the Yazidi cult. ISIL spokemen have said Yazidi tribe has the choice of converting to Islam or being killed.        

These recent developments triggered the response from Washington late last week. President Obama announced airstrikes at Mt. Sinjar and military supplies for Kurdish troops. At Mt. Sinjar, the U.S., France, and U.K. dropped food and water (enough for 8,000 people according to the Defense Department).


As part of ISIL’s pillage, they have reportedly captured U.S.-supplied weaponry and vehicles from Pesh Merga Forces defending the border into Iraq's Kurdish region.


The shift in military firepower may have been a key inflection point for U.S. involvement. Without a clear path for reinforcements from Baghdad, Kurdish forces may be outgunned at the moment as they get ready to defend the two largest cities in Iraq’s Northeastern region. This shift was not considered a real threat back in June when ISIL took the city of Mosul.


A quick look at the map below would explain the significance of the Mosul Dam and the advance on the city of Irbil. Notice that not a single of Iraq’s major oilfields has yet been threatened until now. The ISIL build-up just southwest of Baghdad is increasingly threatening with the distraction of the Iraqi elections.


IRAQ: What to Watch - Map of Oil Fields in Iraq


In his speech last Thursday night Obama threatened airstrikes to protect military personnel and the U.S. consulate IF ISIL were to advance on Irbil. Washington emphasized that the airstrikes will only provide temporary relief on hindering the ISIL advance. A unified coalition coming out of the elections was labeled the key catalyst in uniting the country.


The Obama administration put its stamp of approval on newly elected Prime Minister Haider Al-Abadi. In a speech today Kerry urged Abadi to create a legitimate coalition within thirty days that would unite all sects, a seemingly impossible feat if history is any indication. In adherence to current law, Nuri Al-Maliki will remain caretaker and Prime Minister while Abadi attempts to create an effective coalition. Not surprisingly, Maliki has refused to step aside after an eight year reign. He publicly called the election results “legally insignificant.”


Maliki's disapproval stems from his failure to maintain any semblance of Sunni support. Many Sunni-based groups have now sided with the authoritarian pursuit from ISIL because of their growing disillusionment with the current regime. At this point even Shi’ite military leaders and commanders who have been some of Maliki’s most loyal followers have signed their approval for the political change. Abadi also appears to have the blessing of both Iran and Iraq’s powerful Shi’ite clergy, which have gained significant power since the U.S. helped overthrow Saddam Hussein in 2003.


Abadi said today that he would welcome all political groups to join and unite the government. In terms of granting aid to those affected by the ISIL's radical agenda, John Kerry said that the United States would request international support IF Abadi forms a government that can demonstrate an ability govern. Until this happens, Kerry reaffirmed Obama’s message that the U.S. would not send combat troops.


Abadi’s ability to implement 1) An effective coalition capable of protecting against ISIL’s crusade; and 2) support a Kurdish defense outside of Kirkuk and Irbil will be key catalysts to monitor over the coming weeks.


Please feel free to reach out to us with any additional color or areas of concern that we may be overlooking.  


Ben Ryan


Cartoon of the Day: At the Beach

Takeaway: Is the bull in danger of getting burned?

Cartoon of the Day: At the Beach - Volume cartoon 08.12.2014

Early Look

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VIDEO | Why We're Still Bearish on European Equities and the Euro

Hedgeye macro analyst Matt Hedrick explains why we remain bearish on European equities (via EZU) and the Euro (via FXE) and tells us that today’s weak economic data from Europe remains consistent with our bearish take on the region.


Takeaway: Botched communication ≠ a broken story. This story is fundamentally on track. Could be dicey for a qtr. But the roadmap to $70 is there.

Conclusion: This story is not broken -- far from it. This selloff is a perfect storm that could have easily been avoided by the company. Say what you want about uncharacteristically sloppy investor communication. It’s justified. With a 75x multiple, they have zero room for error. But the growth story here is intact as it relates to a) retail expansion, b) same store sales growth, c) category expansion, d) geographic diversification, and e) channel growth. Are there questions about how much capital Kate Spade Saturday needs to grow? Yes, and that’s perfectly normal. But if Saturday went away entirely our model would not miss a beat. The story is still 100% on track.  People don’t seem to want to buy ahead of an ‘official’ rebasing of long-term guidance w Saturday-related costs. So it may be dicey for a quarter. We’ll pick our spots to add. But longer term, if you believe in our numbers, it’s not tough to get to a $70 stock. 



Whenever a stock collapses like KATE just did – giving away $1.7bn in market cap (or 32%) in the course of about 90 minutes – it’s usually a punch in the jaw to let the market know that something has radically changed with the fundamental story. In KATE’s case, however, that’s simply not the case. The way we see it, this stock action was overwhelmingly driven by some very poorly chosen words by management on the conference call. The stock started to give up some early gains as CEO Leavitt spoke about the quarter being promotional, but absolutely collapsed after 52 minutes of prepped remarks when COO Carrera said something that sounded like…

[We gave you long term targets at the analyst meeting last year. Based on investment in Kate Spade Saturday, we may or may not push those targets out by a year. We’ll let you know in the fall.]


Ok, let’s put this into perspective. There are few companies that can make a statement like this – a very JV error -- and not get dinged materially. Mind you, as good as Leavitt and Carrera are operationally, both have little experience speaking to/through capital markets. But a 32% hit to market cap is more than a ding. It’s a high-speed collision.  Take those comments, and now combine with a high-expectation stock that trades at 75x current-year earnings and is comping 30% -- then it gets a lot more dicey. The icing on the cake is that not only has Coach blown up,  but the mighty KORS, which has served as a halo for KATE, has also started breaking down.  Note good in combination with weaker gross margins due to clearance and investment in Kate Spade Saturday (a brand that is immaterial to the story today).  On top of all that, KATE just restated its financials into a format with better forward disclosure, but did not give 2H13 restated numbers -- making it extremely difficult for the Street to build financial models in line with new reporting structure over the next two quarters.  


Combining all these factors, it makes sense to us that the stock got hit on this conference call. Note that we did not say ‘get hit on the print’, because that was otherwise solid. This was almost all about perception instead of financial factors.  The company comped 30%, grew revenue at 49%, expanded margins by 658bps, and earned money for the first time in a 2Q since 2008. Something else to keep in mind… while the 30% comp was easy to get excited about (until management lost control of the call), the the fact of the matter is that upside to the SSS comp is finite. It won’t end next quarter, or next year. But it will ultimately moderate as KATE hits its steady-state store productivity rate, which we model at $2,000 in 2018.  But keep in mind that KATE only reported $266mm in revenue this quarter. That compares to KORS at $919mm and COH at $1,136. There’s a lot of growth here that is not comp-related.

  • Store growth should go from 245 stores today to 600 in year 5. For what it’s worth 560 of those stores are Kate Spade NY, while the remainder is Kate Spade Saturday and Jack Spade.
  • International: The fact that US revenue was up 55% and International was up 54% is no mistake. The growth by geography is extremely balanced. As it relates to Int’l store growth, we saw recent openings in Macau, Hong Kong, Mexico, Middle East/Abu Dabi, and Malaysia.
  • Wholesale vs. Retail: We like how KATE is expanding its wholesale doors. It’s not simply opening up the whole product line, like so many other brands do. But rather it is opening specific product categories at different wholesale accounts. This helps prevent channel conflict, and gives retailers content they believe to be exclusive.


When all is said and done, we’re not changing our earnings estimates. We think that KATE ramps from $0.30 in EPS this year to $1.58 in just two years. It’s next  to impossible to find a ramp like that.  Key modeling assumptions…

  • Store count goes from 245 to 600, as previously noted – with little help from Kate Spade Saturday.
  • Comps slow as the company reaches $2,000 per square foot, which we expect will happen in 5-years time.
  • EBIT margins top out at 21% at KSNY, and 18% on a consolidated basis (includes 5% in D&A).
  • Interest expense goes away entirely in 3-years as internally generated cash flow outstrips capex needs to build stores.


Valuation vs Peers

A quick point on valuation. When we look at earnings today, it’s flat-out expensive. But that’s always been the case. Here are five high-growth (actually 4 high growth + Coach) names where we look at where the stocks are trading on today’s earnings, versus 2018 (if you want to look at 2016, as some people will, the chart looks extremely similar). KATE is expensive today, but right in line with KORS on out-year numbers. The only company that looks meaningfully better is RH.




KATE: KATE’S NOT BROKEN - kate financials

LM: Removing Legg Mason from Investing Ideas

Takeaway: We are removing Legg Mason (LM) from our high-conviction stock idea list.

Jonathan Casteleyn, co-head of Financials, explains the decision below.


We are removing shares of Legg Mason (LM) from our Investing Ideas list. The combination of a change in quantitative signal as well as the lack of forward fundamental catalysts are the reason for this change. Legg Mason stock has moved from Bullish to Bearish Trend duration during the course of this week and in combination with the company having made an acquisition announcement of Martin Currie two weeks ago, the potential to roll in new assets accretively via deal making has now been discounted in the stock.


LM: Removing Legg Mason from Investing Ideas - Legg Mason


Since adding LM to our Investing Ideas newsletter on the week of March 25th, shares have appreciated by 3.0% versus the Asset Management Group return of -1.0%. Thus the combination of this excess return and also the stock starting to change quantitative signals as well as now a lack of fundamental catalysts, lead us to remove the stock from our Investing Ideas newsletter. 


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