*Long YUM Call Today @10AM

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*Long YUM Call Today @10AM - 1



  1. Vulnerable to Activism  There has been a number of events over the past two years that suggest the timing is optimal for YUM to simplify its corporate structure.  While there several different avenues of value creation, one thing is clear: YUM’s new corporate structure, multiple brands and underleveraged balance sheet almost ensure that the company is vulnerable to change.  What remains to be seen, however, is if the new CEO will be proactive and effect change or be reactive to the changing marketplace.
  2. Transformational Transaction  For the better part of the past two years, management has been asked about a potential spinoff of the China business.  In our view, this move would be the first step in a series of potential transactions that would simplify the structure and improve the operating performance of the company.  We find it likely that a group of influential shareholders begin to push the board in this direction.  It also makes sense to consider spinning off the dilutive Pizza Hut (co-owned stores) business, which would trade at a substantially higher multiple as a standalone entity.
  3. Multiple Ways to Win The new global reporting structure of the company allows for a clean split of YUM's business units into multiple asset-light business models.  We also believe there is an opportunity to increase leverage (to repurchase stock or pay a special dividend), cut excess SG&A, refranchise additional restaurants and command a premium valuation. 


Howard Penney

Managing Director


Fred Masotta


CAT: E&T As The New RI, And Retrieving Your Excavator From Botswana

“Again, we get down to low $70s, a lot of bets are going to change on a lot of things. And there's no doubt that would be impacted to some degree. I would agree with that.”

– Doug Oberhelman 3Q 2014 Earnings Call





We have long referred to CAT as exposed to ‘resources-related capital spending’, not just mining, because we have expected a decline in energy-related capital spending.  Given the decline in crude oil prices, it seems likely that CAT’s 2015 will show stress from reduced oil & gas capital spending.  CAT’s Energy & Transportation (E&T) segment was already facing 2015 challenges from Tier IV Final. 


We also expect 2015 to bring some credit challenges to CAT Financial.  With the further declines in mined commodities, as well as Mercury Air Toxics regulations, receivables backed by mining equipment collateral may be less secure than some investors expect.  Higher provisions for credit losses seem likely, as mining equipment values (and liquidity) are likely to decline just when collateral value matters most.  CAT has had some “material weaknesses” relating to its Allowance for credit losses, but the allowance magnitude looks like a pressing problem.


We view 2015 consensus as too high, with our expected range in the $4.50-$6.70 reasonable range for next year (an EPS decline) vs. a consensus $7.05, ex charges.  There is a meaningful upcoming catalyst in the initial 2015 EPS guide with CAT’s 4Q earnings report in January.


*See Sept 2012 CAT 10 minute thesis call here, slides: CAT's Deep Cycle or our March 2013 Mining & Construction Equipment presentation for a full review.  We also held a call with the former head of Finning Power Systems titled Understanding CAT Power Systems.  On excess capital investment in energy, see links here.


Oil & Gas Capital Spending


The shale boom and high energy prices significantly increased capital investment in crude oil and natural gas production.  This chart ends in 2013, but conveys the idea reasonably well.  In our view, there is significant potential downside to oil and gas capital investment.


CAT: E&T As The New RI, And Retrieving Your Excavator From Botswana - cta1



CAT sells large engines and turbines into oil & gas applications, with much of the equipment fetching high margins.  The list below is from a call with Jeff Leigh, former head of Finning Power Systems.


CAT: E&T As The New RI, And Retrieving Your Excavator From Botswana - cta2



CAT in the Last Energy Downturn


Looking at CAT’s 1983 annual report, it is interesting to note that lower oil prices caused a meaningful drop in turbine and engine shipments, among other difficulties, particularly in emerging markets.  We have often compared the current resources capital spending downturn to that of the 1980s (see Party Like Its 1979).  Truck engines, which benefited from lower oil and deregulation, will not be an offset for CAT in this cycle.


CAT: E&T As The New RI, And Retrieving Your Excavator From Botswana - cta3


CAT: E&T As The New RI, And Retrieving Your Excavator From Botswana - cta4



Large Gensets & Locomotives:  2015 Tier 4 Final


Power generation is divided between prime power and standby power.  Lucrative prime power sales are often made to off-grid users, like mine sites and shale oil plays, or in emerging markets.  We assume sophisticated purchasers of larger gensets are pre-buying ahead of Tier 4 Final in 2015.  A prebuy seems evident from CAT’s E&T results, as sales are likely increasing in a pull forward from 2015.  


CAT: E&T As The New RI, And Retrieving Your Excavator From Botswana - cta5


Locomotive sales have been more formally disclosed as a T4F pre-buy, but management suggested the post-pre-buy bust will only trim about 2% off of E&T next year.  Given our understanding that something like 70% of CATs locomotive sales are in the U.S., maybe half of that is OE, and that EMD will make up a bit over 10% of E&T sales this year, the decline will be a bit larger, we think.


Taking the guided 2% decline for locomotives and what is likely to be lower genset sales post-Tier 4 Final and lower resources spending, it is not easy for to see how E&T revenues can increase in 2015. 


Gas Compression


CAT often describes natural gas compression as the “majority” of the oil & gas exposure in the Energy & Transportation segment.  It is not entirely clear if that is of sales or installed base, but it would be very helpful if they simply provided the numbers instead of leaving investors to speculate.  We assume that if it were favorable, it would be presented more clearly. 


Still, USA Compression (USAC) is the second largest outsourced compression services provider in the US, and they appear to have been fairly aggressive in 2014.  Street capex forecasts for Exterran, the largest provider, and USAC capital spending currently project a 6% and 20% decline in 2015 capital spending, respectively.  While it is challenging to get insight into the broader compression market, it does not appear to us that gas compression will drive E&T growth in 2015.


CAT: E&T As The New RI, And Retrieving Your Excavator From Botswana - cta6



Caterpillar Financial: Investors Have Yet To Scrutinize This


Is CAT paying more attention to collateral value and equipment sales than to the creditworthiness of its counterparties?  As a manufacturer, providing favorable customer financing to sell more equipment is a common pitfall.  In addition, we see a lack of diversification in CAT Financials credit exposure, since much of it appears mining-related.  If miners start to (or rather, continue to) go bust in coal, iron ore and the like, CAT may be left with mining equipment collateral that is challenging to remarket at assumed valuations.  

Note:  “Mining” as defined in Caterpillar Financial’s filings include only large miners, not all mining exposure.



Despite lending to some really interesting characters (see below) the allowance for loan losses seems low to us, both in absolute level and relative to historical norms.  While Caterpillar Financial is not a big part of CAT’s earnings, Industrials investors usually react poorly to unexpected losses at financial subsidiaries.  They often view it as having fluffed up prior equipment sales.  Remarketed used equipment can compete with new equipment sales at the same time that credit becomes less available for new equipment sales.


CAT: E&T As The New RI, And Retrieving Your Excavator From Botswana - cta7



As we understand it, portions of the deals below typically remain on CAT’s balance sheet.  Financing is often provided in pre-production (project finance), increasing the risk, as we see it.  CAT should provide more disclosure, we think. Discovery Metals’ Boseto project, a Botswana copper mine with $2.86/lb cash costs, sounds like a tough credit to us.


CAT: E&T As The New RI, And Retrieving Your Excavator From Botswana - cta8


CAT: E&T As The New RI, And Retrieving Your Excavator From Botswana - cta9


And, financing can be greater than CAT equipment value…


CAT: E&T As The New RI, And Retrieving Your Excavator From Botswana - cta10




2015 Expectations


We do not think that E&T will generate organic sales growth or a profit gain in 2015, given an anticipated decline in oil & gas capital investment and impact of Tier 4 Final.  We could, of course, be wrong, but we take the lead-off quote on the oil price as an indication of trouble ahead.  Mined commodity prices are meaningfully lower as we head into 2015, and we expect pricing pressure to intensify in mining equipment and MATS regulations to hurt coal mining.  Construction Industries should do well, but faces very tough margin comps in 1H 2015.  CAT Financial also looks challenged amid lower mined minerals prices.


If we were to pencil out a really favorable scenario for 2015, we would suggest E&T revenue flat at a margin comparable to 2014, and the same for Resource Industries.  We could grow Construction Industries at a mid-single digit rate and repeat the 2014 record margins.  We could grow Caterpillar Financial operating income by a low single digit percentage, too.  Even in that highly optimistic scenario, which is unlikely given the set-up outlined above, we would model a 2015 EPS (with buybacks) at around $6.70, below the $7.05 consensus.  In a more base-case outlook, we wouldn’t be surprised to see CAT at <$6.00 per share.





We don’t see Caterpillar escaping the downcycle in resources capital spending, with the long-awaited decline in energy capital spending now at hand.  The outlook for mining has deteriorated, with dealers inventories unlikely to make up the difference.  Increasingly, it seems investors are recognizing that the Caterpillar dealer network receives much of the service revenue.  We also expect price declines in various mined commodities to start to pressure Caterpillar Financial.  We suspect most investors have not scrutinized that subsidiary closely, yet.  


Cartoon of the Day: A Christmas Wish...

Cartoon of the Day: A Christmas Wish... - Retail cartoon 12.01.2014


The initial data points from Black Friday weekend? Not good. 

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China: Why Did the PBoC Cut? (Will It Even Matter?)

Takeaway: The PBoC’s surprise rate cut confirms our bearish thesis on the Chinese economy, but may portend brighter days ahead.

Editor's note: This was originally published November 21, 2014 at 13:26 in Macro. To learn more about becoming an individual subscriber click here.

Chartreuse and Spoos: The Global Central Planning Spree Continues

As you can probably tell by the overnight action in the spoos, a central bank in Asia eased monetary policy. This time, it was China – i.e. the economy responsible for 16% of global GDP and 30% of global GDP growth (on a PPP basis). Yes, the same China where 2014 Real GDP growth is tracking at the slowest pace since 1990!


From a forward-looking perspective, this is a good thing only if it signals a sustained move away from the “proactive fiscal policy and prudent monetary policy” they’ve been guiding to and implementing for over two years now. Recall that amid incessant cries for Western-style monetary easing, the PBoC has refrained from cutting interest rates since July of 2012 (excluding the removal of the lending rate floor). It has not [broadly] lowered RRRs since May of 2012.


China: Why Did the PBoC Cut? (Will It Even Matter?) - DD1


In and of itself, this rate cut will hardly do anything to arrest the rate of decline in Chinese economic growth; nor will it offset the “increasing downward pressure” upon the Chinese economy over the NTM, as most recently reiterated Xu Shaoshi (head of the National Development and Reform Commission) just two days ago.


Chinese growth is effectively crashing at this point. Our model points to a continued slowdown of Real GDP to +7.1% YoY in 4Q – and that’s being polite (i.e. conceding their made-up numbers). The reality is that Chinese growth is far shy of that number, making the 2nd derivative impact much more severe for economies and businesses that rely on Chinese demand. Pull up a 2Y chart of Standard Chartered (STAN) if you want the real story on Chinese growth. 


So Why Cut Now?

There are two primary reasons why the PBoC surprised everyone by cutting rates today (-25bps on the benchmark household deposit rate; -40bps on the benchmark lending rate):


  • Economic growth – which had already been slowing precipitously, as evidenced by the sea of red in the table below – fell off a cliff in October. This is most easily confirmed by the rate of change in Total Social Financing growth and Macau’s mass business, which was down -8% YoY (from +15% in September). That was the first annual decline in mass revenues in over five years!
  • Amid increasingly large capital outflows (see: declining FX reserves and negative “hot money” flows) and trending disinflation, the real cost of 1Y capital in the Chinese banking system has actually risen to fairly high level of late, rising to roughly 1.4% from ~0% at the start of the year.


China: Why Did the PBoC Cut? (Will It Even Matter?) - CHINA High Frequency GIP Data Monitor


China: Why Did the PBoC Cut? (Will It Even Matter?) - China Iron Ore  Rebar and Coal YoY vs. GDP


China: Why Did the PBoC Cut? (Will It Even Matter?) - China Real Interest Rate


Again, the PBoC’s decision to cut rates today makes a ton of sense to us, given China’s sustained #Quad4 setup, which calls for a dovish response from fiscal and monetary policymakers. We just didn’t see it coming given their official guidance; it's worth noting that Beijing is notorious for sticking to the script.


China: Why Did the PBoC Cut? (Will It Even Matter?) - CHINA


Cyclical Outlook: Still Very Negative, But Potentially Positive

You’ll note that in that our GIP Model has China going into #Quad1 for the first quarter. That’s primarily because of seasonality (fiscal expenditures and credit growth tend to be front-end loaded) and, obviously, very easy comps. That being said, China had these things working in its favor at the start of this year, but obviously the tightening we saw in the early part of 2014 trumped that setup (to the downside).


China: Why Did the PBoC Cut? (Will It Even Matter?) - China GDP Seasonality


A continued “recovery” in the Chinese property market – which had been truly crashing – is also supportive of any positive 2nd derivative delta for the Chinese economy in 1H15.


China: Why Did the PBoC Cut? (Will It Even Matter?) - CHINA Property Market Monitor


It’ll be interesting to see if the rebound in property development (read: fixed asset investment) is actually sustainable amid home price deflation accelerating to the downside on a trending basis. For now, it’s too early to tell; what we do know is that Chinese policymakers are very concerned about this segment of the economy and have ratcheted up support for the sector in recent months.


Investment Conclusions

All told, the PBoC’s surprise rate cut confirms our bearish thesis on the Chinese economy, but may portend brighter days ahead from a cyclical perspective.


That being said, long-term investors should NOT get involved with any “China recovery” trade that may percolate from this. China’s structural economic imbalances and official rebalancing agenda imply continued slowing over the long-term TAIL.


Feel free to ping us w/ any follow-up questions. Have a great weekend,




Darius Dale

Associate: Macro Team

The Biggest Currency Crisis Since 1998

Editor's note: This is an excerpt from Hedgeye morning research. To learn more about how you can become a subscriber to America's fastest growing independent research firm click here.

*  *  *  *  *  *  *

The Russian Ruble is down -6% since Friday. It’s plunged -40% year-to-date. This is the biggest crash in currency land since 1998.


For the record, global macro market #Intereconnectedness mattered then, and it does now.


The Biggest Currency Crisis Since 1998  - 12.01.14 Chart


As Hedgeye analyst Matt Hedrick observed earlier today:


Russia remains a major area of global risk exposure...Energy still accounts for 20-25% of Russia's GDP, and energy prices have fallen ~30% in the last two months. Multiplying those two weightings would imply that Russia's economy is at risk of suffering a decline of 6-7.5%. 


Meanwhile... Russian stocks? They are down another -3.4% today to over -32% year-to-date.


#NoWorries right? Right?

Keith's Macro Notebook 12/1: Oil | Russia | Italy


Hedgeye CEO Keith McCullough shares the top three things in his macro notebook this morning.

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