Earlier today we hosted a conference call to discuss the key points of our high-conviction bullish thesis on Lorillard (LO).
Podcast: CLICK HERE
Presentation: CLICK HERE
Key Takeaways Of The Call
- We do not see Menthol Regulation Risk from the FDA over the medium term (1-2 years) and assign less than a 20% probability over the long term.
- We expect blu e-cigs to benefit from first mover advantage and maintain leading market share despite competitive pressures from Big Tobacco’s entry into the category. Looking out 5 years to 2018, we model blu’s earnings contributing 31% to total LO, and accelerating earnings growth in the combined company that should command a re-rating of the stock to a higher multiple.
- We expect strong and stable menthol fundamentals driven by lasting consumer and demographic trends that differ from traditional tobacco.
*A supplemental expert report on menthol by a top Washington, DC law firm involved in tobacco public policy is available by request.
Call or email me with any follow-up questions.
Takeaway: We've been here before. EHTH is ripping on another headline without considering implications. Street setting EHTH up more disappointment
EHTH stock is ripping on rumors of another delay for ACA plan compliance; implication is that there will be less attrition risk next year.
MCOs may cancel plans on their own and/or push back on commission rates next year in order to recoup profitability on 2014 plans.
Either way, EHTH will not see the upside that the street is baking into its stock today.
The White House is rumored to be extending the waiver on plans that are not compliant with the Affordable Care Act (ACA) in order to avoid cancellation letters being sent ahead of mid-term elections. EHTH is up 11% intraday on the news
The most obvious takeaway is that the waiver will mitigate EHTH's attrition risk next year. We're not arguing that point; we're debating by how much.
Two important considerations on the extended waiver:
- It's subject to state approval
- MCOs make the final decision.
We can't say what states will do next year. The bigger risk is the MCOs themselves; some of which have already cancelled existing plans regardless of the state's decision for 2014. Below we explain the rationale for doing so, and why this will only get worse next year.
CANCELLATION RISK REMAINS ELEVATED
Carrying both existing and ACA-compliant plans creates an actuarial mismatch for an MCO. Plan prices for ACA-compliant plans are considerably higher in order to offset the series of new costs facing MCOs in 2014 (e.g. Essential Health Benefits/Out-of-pocket limits).
It's important to note that ACA limits MCOs from charging older (costlier) individual any more than 3x the rate of younger cohorts, which means they could only increase rates so much on the older cohorts, and explains the barbell-shaped rate increases that we have seen for 2014 plans
The main issue is that MCO profitability comes from the younger cohorts, and they're not signing up. From what we've seen to date in terms of gov't exchange (HIX) enrollment, the population signing up for coverage is considerably older than what the industry is currently accustomed (aka Adverse Selection). In turn, MCOs are seeing a higher proportion of costlier members, and 2014 plans will be less profitable than what the industry is accustomed to (if at all).
In order for MCOs to recoup profitability in 2015, they will have to do one of three things
- Raise prices on ACA-compliant plans, or exit markets if unable to do so.
- Cancel non-compliant plans to raise collective premiums
- See below
IF NOT, COMMISSIONS GET HIT
EHTH has suggested that its 2014 commission rates will be flat to slightly up in 2014. We would have expected greater pressure on 2014 commission rates given the headwinds facing MCOs, but we believe the reason why commissions have remained stable is because the gov't exchanges (HIX) were having technical difficulties during the 2014 selling season.
That changes next year; the gov't HIX are far more functional now, and should only improve from here. That makes MCOs less reliant on the private HIX (e.g. EHTH) to distribute their plans, and more likely to push back harder on commission rates.
It's also worth noting that in order for EHTH to sell subsidized plans, its must offer all subsidy-eligible plans available on the public HIXs, regardless of whether is has a commission agreement with those MCOs. In a worst case scenario, an MCO could pull its commission agreement with EHTH and still gain new members since EHTH has to offer its plans regardless.
In short, if the MCOs are experiencing headwinds to profitability, it will be that much easier to push back on commission rates in 2015.
EHTH is essentially a distributor without a captive consumer. It operates in a crowded industry with a growing competitive threat from the public HIXs. If MCOs are feeling the pressure in 2014, they're going to push back in 2015; and there's not much EHTH can do about it.
Hesham Shaaban, CFA
Takeaway: We continue to think the growth decelerating trend extends through 1H14.
Editor's note: This research note was originally published February 28, 2014 at 10:26 in Macro. For more information on how Hedgeye can help you click here.
We’ve been vocal in our expectation for a deceleration in the slope of domestic growth over the last couple months and while this morning’s downward revision to 4Q13 wasn’t particularly surprising, it does offer some positive confirmation to that view.
With the dollar breaking down, #InflationAccelerating, earnings growth still sub-trend, wealth effect (equities/housing) momentum decelerating and little incremental upside for consumption growth via a reduction in savings, we continue to think the growth decelerating trend extends through 1H14.
GIP MODEL REFRESH: The net impact to our GIP (Growth/Inflation/Policy) model from this morning’s data is another incremental shift in trajectory towards quadrant #3 – Slowing Growth and Rising Inflation.
To the extent that the market continues to discount slowing growth and subsequent, incremental easing in policy – which ironically/unfortunately only perpetuates the move into Quad #3 – we think slow growth exposure (gold/bonds/commodities/utilities) continues to outperform pro-growth leverage.
GDP DATA SUMMARY: Below we highlight the notables in this mornings, 1st revision to the 4Q13 GDP estimate.
Real GDP: revised lower by 80bps to 2.4% from 3.2%. Decelerating 170bps QoQ to 2.4%.
Nominal GDP: decelerating 200bps QoQ from +6% in 3Q13 to +4% in 4Q14.
Inflation: Inflation estimates marked higher with the GDP Price index and Core PCE measures revised up 30bps and 20bps, respectively.
C+I+G+E Revision: Investment revised up small, everything else revised lower.
C: Consumption saw the largest downward revision from a contribution perspective at -.53% with QoQ growth revised from +3.3% to +2.6%. Durable/NonDurables/Services were all revised lower but Durables (as the latest PCE data has reflected) saw the largest decline.
Whether the emergent deceleration in durables, and luxury and higher-end durables particularly, represents a pull-back in spending across the top income quintiles as equity and home value gains slow remains to be seen. We’ll get the updated PCE detail data on Monday.
I: Investment: Private Nonresidential Investment, which was revised higher by +0.4 from a contribution perspective and +3.5% from a growth perspective, was one of the lone bright spots in the report.
Inventories were revised lower and with inventory-to-sales ratios continuing to creep higher through year end, its unlikely inventories provide another outsized boost to reported growth in the coming quarters.
G + NE: Government was revised down modestly while the revision to the trade balance was the second biggest contributor to the headline decline with export growth revised -2.0% against a +.60% revision for imports.
Real Final Sales growth (GDP less Inventory Change): decelerating 20bps QoQ to 2.3%…revised lower by 50bps
Gross Domestic Purchases (GDP less exports, including imports): Very Weak sequentially - Decelerating 250bps QoQ to +1.4%..revised lower by 40bps
Real Final Sales to Domestic Purchasers (GDP less exports less inventory change): (Perhaps) The cleanest read on aggregate domestic demand was also weak, decelerating 100bps to +1.2%, revised lower by 20bps.
Christian B. Drake
Takeaway: Make no mistake about it; Otis’ top priority is saving his job.
Starboard Value announced in a 13D filing this morning that it has retained former Brinker International CFO and EVP Charles Sonsteby to serve as an advisor in its battle against Darden Restaurants. Starboard will pay $50,000 in cash to Mr. Sonsteby who will, in turn, use the proceeds to purchase Darden stock.
We view this as another favorable development for Starboard. Adding the former Brinker CFO will help the activist bring sanity to Darden Restaurants. In his role as the CFO of Brinker, Charles helped lead one of the great success stories in the new era of casual dining. In this new era of casual dining, companies that focus on operating efficiently and doing one thing right create the greatest value for shareholders. His experience and expertise makes him another extremely valuable asset.
MANAGEMENT FIGHTS BACK
Darden held a business call update yesterday morning to run through its strategic plan and rebuttal to activist pressure.
During the presentation, it became abundantly clear to us that the plan to spinoff Red Lobster was merely a hasty reaction to shareholder pressure. Unfortunately, the activists don’t agree with this plan and are intent on stopping it. Following the call, Barington Capital stated that it has lost confidence in the ability of Otis to manage the company.
Management preannounced 3Q14 results yesterday and, as we expected, they fell far short of consensus estimates. Darden expects same-restaurant sales in the quarter to decline 5.4% at Olive Garden, decline 8.8% at Red Lobster, increase 0.3% at LongHorn and decline 0.7% at SRG. While Olive Garden and Red Lobster continue to be the mismanaged brands we’ve become accustomed to, weak results at SRG, Darden’s growth vehicle, confirm our view that the Specialty Restaurant Group isn’t so special. In order to fulfill its true potential, this group should be separated from the larger, more mature brands with divergent strategic and operational priorities.
OLIVE GARDEN’S BRAND RENAISSANCE
The only thing new that came out of yesterday’s presentation was an in-depth look into Olive Garden’s Brand Renaissance plan. Fixing Olive Garden has suddenly become management’s top priority. While we agree with this positioning, and have been calling for it for the past year, we don’t have much faith in the current operating team. This repositioning effort includes new lunch and dinner menus, nationwide remodels, a new approach to advertising and promotion, and even a new logo! While we are impartial to the new logo, critics came out in full force on Twitter yesterday.
Look, we’ll give credit where it is due. Management is, in a sense, taking an aggressive approach here no matter how reactionary it may seem. With that being said, it concerns us that outside pressure was the driving force behind these changes. A strong and capable management team would have made these changes a long time ago. After a prolonged period of underperformance, we’ve lost confidence that the current team can spearhead a successful turnaround at the ailing brand.
PUSHING FORWARD WITH THE CURRENT STRATEGIC PLAN
Management intends to push forward with its plan to spin off Red Lobster. According to them, this will remove an underperforming and volatile brand from the portfolio and separates the portfolio into two companies to allow each to focus on “separate and distinct opportunities to drive long-term shareholder value.” We’ve been pretty forthright in our disagreement with this plan. Based on management’s own numbers, and own chart, Red Lobster and Olive Garden have similar guest profiles as they both appeal to lower income consumers. LongHorn Steakhouse, on the other hand, is the clear outlier as it appeals more to upper income individuals. Management is talking out of both sides of their mouth.
Part of management’s rationale behind the Red Lobster spinoff was to allow both new companies to better serve their increasingly divergent guest targets. This is nothing more than an excuse for management to rid itself of an underperforming brand that has become irrelevant under their watch. The New Darden will still have divergent guest targets.
Management briefly discussed why other potential portfolio separation alternatives – including a spinoff of LongHorn/SRG – don’t make strategic sense. Among several reasons offered was the potential for weak cash flows at SpinCo, a large amount of existing debt at NewCo, the jeopardizing of an investment grade rating and a likely cut to the dividend. While all of these statements are legitimate, they don’t necessarily strike us as major concerns. If Darden were to spinoff SRG or LongHorn/SRG, the SpinCo would most certainly be considered a growth company. Weak cash flows and a cut to the dividend would not only be expected, but accepted as well. Further, management avoided touching upon the advantages this would create for both NewCo and SpinCo, including a more intensive focus on similar guest targets, brand priorities and shareholder needs.
Management also offered up a rebuttal to the proposed separation of Darden’s real estate into a publicly traded REIT. We don’t profess ourselves to be REIT analysts, so we’ll stay clear of this debate. All we know is that both sides have supposedly done their due diligence on the proposal and both have come to vastly different conclusions.
The key takeaway from yesterday is that management is going on the offensive and we applaud them for that. We did not, however, learn much new and are still unconvinced that the current team, under the proposed operating structure, can right the ship at Darden. We plan to offer a more detailed analysis of management’s proposed spinoff at a later date.
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