This note was originally published
at 8am on August 22, 2013 for Hedgeye subscribers.
“What makes the desert beautiful is that somewhere it hides a well.”
-Antoine de Saint-Exupery
Volumes are light, ideas are sparse and the Hamptons are packed. Welcome to summer on Wall Street!
The desert is the most pertinent geographical analogy to this part of the investing year. Deserts are defined in a number of different ways, but generally the classification is based on the amount of precipitation that occurs in any year. Below a certain level of precipitation, the region is considered a desert. Think of precipitation as the idea generation engine of Wall Street that slows during the summer.
Interestingly, while most of us likely perceive a desert as a vast region of sand and limited plant growth, the reality is that only 20% of deserts have sand. The largest desert in the world is actually the Antarctic Desert, which is, naturally, in Antarctica and covers more than 5.5 million square miles of ice and snow. So, no, cold desert is not an oxymoron.
One place you don’t want to go after a long night of cavorting and over indulging is the Atacama Desert, which is the driest place on Earth and virtually devoid of life. The average rainfall in parts of the Atacama is less than 1mm per year. Further, evidence suggests that the Atacama may not have had any rainfall for the four hundred year period between 1570 and 1970. Needless to say, even if you feel your portfolio is devoid of new ideas, there have been worse droughts!
In the Chart of the Day, I’ve attached our current Best Ideas list, which is comprised of the ideas that our research team recommends for three months and beyond (TREND) in our models. Independent of this list I want to highlight the three ideas that I find most compelling. They are as follows:
1. International Game Technology (IGT) – IGT makes gaming machines and is, not to mince words, a free cash flow monster. Over the course of the past three fiscal years, operating cash flow has outpaced total capital expenditures by over a $1 billion dollars in aggregate. Compared to the current market capitalization of just under $5BN, this provides IGT ample cash to return to investors via share repurchases or debt pay down.
Speaking of debt pay down and cash flow, one of the more compelling reasons to own this stock is its potential interest to private equity firms and its inherent private market value. As our Gaming, Lodging & Leisure Sector Head Todd Jordan has oft noted, four private equity firms were interested in IGT’s competitor WMS and one made it to the final round before Scientific Games ultimately won out.
2. Nationstar Mortgage Holdings (NSM) – The roll up of mortgage servicing is a trillion dollar opportunity and NSM is ideally positioned. (Translation: this is huge market.) NSM recently put up an EPS number for Q2 of $1.37, which outpaced the consensus estimate by almost 50%. We think there is continued upside in numbers through 2014. Currently based on the midpoint of NSM’s 2014 guidance, the stock is trading at less than 7x earnings with upward revisions and continued acquisition catalysts on the horizon.
3. Fed-Ex (FDX) – FDX is just shy of a 52-week high and has outperformed the SP500 over that period, so is not necessarily a contrarian stock. On a valuation basis, the stock is cheap trading at less than 6x TTM EV/EBITDA and has net cash on its balance sheet (excluding leases).
Setting aside the financials, which are bullet proof, we think a key reason for owning the stock is that investors are currently ascribing little value to FedEx Express. We think this division, once restructured, could have a similar margin to UPS or DHL’s express margin and generate an incremental $1.5BN in additional EBIT per year. Frankly, if the Germans can make DHL Express profitable, it should be achievable for FDX. If FDX can’t do it, there is no doubt an activist will consider stepping up.
Speaking of Fed-Ex, its key competitor UPS announced late yesterday that it was going to be dropping 15,000 spouses who are eligible for coverage from their own employer from its health insurance plan due to higher anticipated costs under the Affordable Care Act. UPS expects to save up to $60MM per year on this “initiative”.
We’ve long extolled the benefits of limiting governments, in large part, due to unintended consequences of policy. In the UPS instance, it may lead to less or more limited coverage for 15,000 working women. There has also been ample evidence of workers hours being reduced so employers can avoid the punitive impact of the Affordable Care Act on their bottom line.
On a more macro level, there are potentially long term impacts to the labor market. As Chicago Economist Casey Mulligan wrote in a recent blog for the New York Times:
“The Affordable Care Act’s explicit taxes on employers, subsidies for layoffs and implicit taxes on employees, together amount to five or six percentage point addition to the marginal tax rate on labor income.”
By Mulligan’s analysis, this may contract the labor pool by 3% in 2015. At the end of the day, this shouldn’t really surprise any of us for as Milton Friedman said on the topic of government management:
“If you put the federal government in charge of the Sahara Desert, in 5 years there’d be a shortage of sand.”
Our immediate-term Risk Ranges are now:
Keep your head up and stick on the ice,
Daryl G. Jones
Director of Research