DRI: A Logical Fallacy

Darden’s board is so desperate that it wants us to believe the company is on a slippery slope, which is also known as a logical fallacy.


A slippery slope is a fallacy in which a person asserts that some event must inevitably follow another without any argument for the inevitability of the event in question.


This argument typically assumes the following form:

  • Event X might occur or has occurred
  • Therefore, Event Y will inevitably happen


In this case, Event X is Starboard getting all 12 board seats and Darden wants us to believe it will be a destabilizing event for the company.  This is simply not true.  In fact, Starboard getting control of the company might be exactly what the company needs at this point.  Look at the strength of the potential independent directors Starboard has proposed.


Yesterday’s announcement about the continued shakeup at Darden is another example of how poorly managed and desperate the company is.  As of yesterday, Starboard will be awarded four board seats and Darden will replace four other board members at its October shareholder meeting.  We’d note that we believe two of the five directors that are leaving the board (Leonard L. Berry, Victoria D. Harker, Charles A. Ledsinger, William M. Lewis and William S. Simon) would have been strong members of the new Darden board, but we can certainly understand why they are leaving.


The four remaining directors are:

  1. Michael W. Barnes – 53 years old; 2 years on the board
  2. Christopher J. Fraleigh – 50 years old; 6 years on the board
  3. Michael D. Rose – 72 years old; 20 years on the board
  4. Maria A. Sastre – 59 years old; 17 years on the board


Now shareholders are faced with backing the eight directors nominated by the company or throwing out the entire board and electing the 12 directors nominated by Starboard.  It’s come down to which group of independent directors shareholders want to oversee the company: Darden’s or Starboard’s?  We believe Starboard’s slate is better qualified.


The person directly responsible for the aforementioned logical fallacy is the ex-Lead Director and now ex-Chairman of the Board, Charles A. Ledsinger Jr., who also publically supported the Red Lobster spinoff.  According to Ledsinger, “We believe this slate avoids many of the risks and destabilization that would result from full board turnover and giving control to a single shareholder’s nominees, particularly given the positive momentum we are achieving in Darden’s operations.”  If all of Starboard’s slate is elected, why can’t the departing board members assure the transition goes smoothly?  After all, management is running the day-to-day operations, not the board!


Additionally, why should shareholders trust a board member who apparently knows he’s not going to be re-elected to the board and is effectively abandoning the company?  The WSJ even challenged the company’s and Ledsinger’s credibility with shareholders in a recent article titled “Fishy Financial Disclosure at Darden’s Red Lobster.”  Ledsinger would not be leaving the company if he didn’t fail to fulfill his fiduciary duties to shareholders.


Some sell-side analysts are even buying into Ledsinger’s logical fallacy.  According to the WSJ, a KeyBanc analyst is quoted as saying: “We expect shareholders will like this plan as it should provide the change agents that shareholders are seeking without giving Starboard complete control.”  The article also goes on to quote a Barclays analyst who called Darden’s board offering “more balanced” and a “reasonable concession, particularly along with the company’s improving results.”


Let’s be clear about a few things:

  1. Massive changes are needed at DRI.
  2. “Reasonable concessions” will not return the company to its former leadership role.
  3. Starboard must get a majority of the board to effect meaningful change.
  4. The Brand Renaissance plan at Olive Garden was developed under the watch of a soon to be ex-CEO and should be scraped because it is not the proper way forward for the brand.


On the surface, it may appear as though giving Starboard control of the company could be a destabilizing force, but an important piece of the puzzle is missing: Starboard’s plans to revitalize Darden and, more importantly, Olive Garden.  While we don’t know all the details of Starboard’s plan, we’re confident it’s a better way forward for the company.  The people that Starboard has retained to form its advisory group for the Darden investment are some of the very best players in the restaurant industry.


Let’s take a quick look at Starboard’s slate of directors.  You have a past Vice Chairman of Darden and President of Olive Garden, the former CFO of Brinker, the Founder of Friday’s and others with significant experience in the casual dining industry.


Looking at Darden’s slate, you have long-tenured Darden directors who voted for the sale of Red Lobster, someone who ran a third-tier regional brand (O’Charley’s) into the ground the same way Otis destroyed Darden and someone running a drive-thru burger joint (Checkers) who previously served in a mid-level operations role at Burger King.  Restaurant experience is important, but running a quick-service restaurant is much different than running a casual dining restaurant.


We disagree with the notion that giving control to Starboard would be a destabilizing force.  In fact, it’s exactly what the company needs at this point.  The next big event for Darden shareholders will be when Starboard reveals their plans to revitalize operations at the company.


In the meantime, try not to get sucked into Darden’s logical fallacy.


No Evidence of a Brand Renaissance at Olive Garden

DRI: A Logical Fallacy - 1


DRI: A Logical Fallacy - 2


Howard Penney

Managing Director


Fred Masotta


Coffee Continues Its Run: Just how Bad is Brazil's Crop?

On August 21st we hosted an expert call with Judith Gaines of J. Gaines Consulting featuring her fundamental, non-consensus call that the outlook for Brazil’s crop into 2015-16 is much worse than expected. Coffee has remained in a BULLISH @Hedgeye TREND set-up for all of 2014 and spot prices have increased +8% since we hosted the call less than two weeks ago (+80% YTD).   


Coffee Continues Its Run: Just how Bad is Brazil's Crop? - JO Levels VF


Spot Arabica finished +4.4% yesterday after The International Coffee Organization (ICO) reported that cash market prices have been markedly-higher in recent days by Brazilian and Colombian farmers:

  • Brazil: $1.9050/lb.
  • Columbia: $2.2150/lb.

Most importantly we will continue to watch the change in cash prices from farmers over the next several weeks for a read-through on the severity of the tree damage as an indicator for the health of next year’s crop.

Here are a few of the key catalysts- which we expect to continue playing out over the next several weeks:

  • For the first time we are looking at a two-year production deficit vs. a normalized year-on, year-off production cycle:
    • Late winter frost last year: Brazilian November-December mild frost lowered crop quality
    • Severe Drought: Drought and lack of moisture in tree root system from January-March during the vegetative period
    • Heavy Rainfall: Late timing of heavy rainfall knocked flowers off trees, reducing the available volume for harvest (CURRENT CATALYST)
    • Brazil WILL NOT produce enough volume in 2015-2016 to meet the global market demand for Arabica coffee
    • End-User Risk: Possible to hedge price risk but a shortage in coffee to cover all deliverables is an un-hedgeable risk in 2015-16
    • Aggregate demand next year is expected to be around 34 million bags. However due to a current stock deficit and severe crop damage, Brazil’s production yield will be just 27 million bags in 2015
    • Not enough capacity from other countries to cover the expected crop shortage of Arabica coffee in Brazil
    • How High Can Prices Go? $2.75-$4.00/LB. There will likely be a spike in prices for Arabica and a higher basis for other grades of coffee.
    • Outlook in Vietnam and Indonesia looks worse year-over-year with Columbia picking up part of the slack

Over the next several weeks we expect a continuation in analysts pointing to irrelevant catalysts including current weather patterns…  

One of the key differentiators for Judy’s argument vs. consensus reasoning as to why prices will increase is that the damage from poor weather has already been done. Here were some of the headlines yesterday after the ICO reported higher cash market prices:

  • “Less rainfall during the flowering period” (which is happening right now)
  • “Rains needed to aid coffee crop development seen delayed by two weeks”
  • “Weather affecting near-term Brazilian coffee outlook”

Why we will certainly be watching the change in expectations for the supply/demand outlook in the coming weeks, market activity has supported the move higher:


  • QUANT: Coffee remains BULLISH from a TREND Perspective with support at $34.08
  • QUANT: is the most bullish commodity in our TACRM model aside from the base metal complex which continues to ride the strength in China  
  • VOLATILITY: Coffee was up +7.8% last week with volatility bid near YTD averages on the move. The adjustment for implied volatilities suggests the market believes in the move:


Note:  The adjustment in upside skew (difference in implied volatility between at the money calls and out of the money upside calls) to the average relative implied volatilities despite the +7.8% move suggests the market is willing to pay the same value for the same relative upside price risk after a significant run.     


  • VOLUME: Aggregate volume last week on the move ~75% of 1/3/6-month averages which was consistent with summer-end volume trends in other commodity markets
  • VOLUME: +4.4% yesterday on healthy volumes:
    • +21% vs. 5-day avg.
    • -12% vs. 1m avg.
    • -2% vs. 3m avg.
    • -8% vs. 6m avg.
  • SENTIMENT: Forward Curve in Futures Market positioned for higher prices:
    • Sep-Dec. basis = +2.23%
    • 1-yr basis= +~6%
    • 2-yr basis=+~7%
  • SENTIMENT: CFTC data shows the market is moving to position itself behind this bull story which is the common herding mentality when a market runs. Sentiment gets more bullish on the run. We view this as contrary indicator, so it’s something we’ll watch. The data is based off of the net length of futures and options contracts:
    • +3.4% longer week-over-week
    • Market long +46K contracts or approximately 2x 6-month aggregate daily futures volume
    • Market long +1.48 standard deviations vs. trailing 12-month average contract length

Despite a market that is positioned for higher prices into next summer, Judy’s price estimate in the $2.75-$4.00/lb. range remains well above current consensus positioning. We expect more color on the potential crop devastation into October and November.

As always, please ping us with any comments or questions.


Ben Ryan



Takeaway: Our Mass Deceleration thesis is in full play and the stocks are all down. There is precedent for lower, however.

Chart of the day



The chart below displays the indexed 52 week trading range for the major stocks with Macau exposure:

  • Our Mass Deceleration thesis unfolded faster than we expected, driving the last two legs of the 6 month Macau bear market.
  • Yes the stocks are beat up but there is precedent for even lower prices – looking over the past 12 months, not all stocks are on their backs.
  • From this view, MPEL and SJM look the most beat up while WYNN, Wynn Macau, and MGM are still trading above the midpoint of their respective 52 week range.
  • We’re not there yet, but when we see fundamental stabilization or a catalyst emerge, Galaxy (0027HK) and LVS look the most interesting to us on the long side.

MACAU STOCK RANGES - stock prices

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Retail – Big Sales Datapoint Today

Takeaway: Big 4.8% ICSC number, even adjusting for easy compare. If a retailer can’t smoke numbers today, then when? Good oppty to source some shorts.


Is it any wonder why even the poorest quality retailers are putting up great numbers? The general sales environment continues to remain strong in the US, with numbers for the week 4.8% higher than last year according to ICSC (index of 80 retailers excluding restaurant and vehicles).  That's the highest weekly rate we've seen in over 3-years. Compares vs last year were easy this week, but even looking at a 2-year run-rate the index is approaching highs for the year.   To be clear, US retailers should be killing it in this kind of environment. Most are. But for companies that but up questionable quality numbers (like KSS) but get rewarded anyway, we'd simply ask what they'll look like when this strength ends?


Retail – Big Sales Datapoint Today - 9 3 ECON chart1


Retail – Big Sales Datapoint Today - 9 3 ECON chart2


By comparison, Eurozone Retail Sales were also released this morning for July, and we're looking at 0.8% growth yy, which is down from +1.9% in June. Keep in mind, however, that sales for 2013 were below 2012 levels almost every month of the year.

Retail – Big Sales Datapoint Today - 9 3 ECON chart3

Mortgage Apps - August Anemia Complete

Takeaway: Purchase demand is tracking down 6% Q/Q with August data now all in.

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


*Note - to maintain cross-metric comparability, the purchase applications index shown in the table below represents the monthly average as opposed to the most recent weekly data point


Mortgage Apps - August Anemia Complete - Compendium


Today's Focus: MBA Mortgage Applications

The Mortgage Bankers Association today released its weekly mortgage applications survey data for the week ended August 29th.


The Composite index managed a +0.2% gain as the YTD low in rates continues to support marginal refi-activity.  Purchase demand declined -1.5% sequentilly with the index holding below the 170-level for an eighth straight week as the multi-decade dearth in demand persists to close out August. 


  • Demand Anemia, Week 8:  The purchase Index fell for the 4th time in 5 weeks, declining -1.5% WoW to 165.8 on the Index. This marks the eighth consecutive week at the 160-level and the softest demand streak since April of 1995.  Purchase demand remains down -12% YoY and is currently tracking -6% QoQ. 
  • Refi & Rates:   Refinance activity increased for a 3rd straight week, rising +1.4% sequentially alongside an incremental -3bps decline in the 30Y FRM contract to 4.25%.  Rates have declined -10bps over the last month and currently sit at their lowest level YTD. Refi activity remains down -26% YoY but continues to improve as we move through the easiest 2013 comps. 


We’ve discussed the regulation-catalyzed shift towards Nonbank origination and the potential challenge to intertemporal reliability and reported demand as measured by the MBA survey.  The WSJ and Inside Mortgage Finance (Here) reported that nonbank market share of mortgage originations have increased 6% to 23% in 1H14 vs. 17% in 1H13. While the MBA survey states that it covers 75% of all US retail residential mortgage applications, it does not count applications submitted through the broker/correspondent/wholesale channels.   


Under an assumption that the full 6% shift went uncaptured by the MBA survey and allowing for a lower pull-through rate (i.e originations to applications ratio) on non-QM loans, the demand decline moderates but the broader reality of ongoing softness in the housing market remains largely unchanged.  From here, demand comps across the MBA Purchase Application and Existing & Pending Home Sales series continue to ease.


Mortgage Apps - August Anemia Complete - Purchase   Refi YoY


Mortgage Apps - August Anemia Complete - Purchase Qtrly Ave


Mortgage Apps - August Anemia Complete - Purchase LT w Summary Stats


Mortgage Apps - August Anemia Complete - Purchase Apps 8Wk Rolling Ave


Mortgage Apps - August Anemia Complete - Composite Qtrly   YoY  


Mortgage Apps - August Anemia Complete - Composite LT w Summary Stats


Mortgage Apps - August Anemia Complete - 30Y FRM



About MBA Mortgage Applications:

The Mortgage Bankers’ Association’s mortgage applications index covers more than 75% of mortgage applications originated through retail and consumer direct channels. It does not include loans delivered through wholesale broker and correspondent channels. The MBA mortgage purchase applications index is considered a leading indicator of single-family home sales and construction. Moreover, it is the only housing index that is released on a weekly basis. 



The MBA Purchase Apps index is released every Wednesday morning at 7 am EST.



Joshua Steiner, CFA


Christian B. Drake

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