This note was originally published at 8am on December 05, 2014 for Hedgeye subscribers.
“When your enemy is making mistakes, don’t interrupt him.” – Billy Beane
This week I had the pleasure of presenting the state of Hedgeye’s Research engine to nearly 60 of my colleagues throughout our Firm. There were about a dozen key conclusions, followed by a spirited dialogue (which is part of our DNA). But there was one key component of our discussion that I believe is relevant to not only our own team internally, but also to our customers, without whom Hedgeye would not have had such a banner year in 2014. That component is how our business model is structurally different, and how it allows us to think, act, and produce money-making ideas in ways that are dramatically different from the #OldWall.
The Model: WallStreet2.0
Before understanding how we generate ideas, it is important to understand the structure that allows us to do what we do – on a repeatable basis. Consider the table below. I compared an OldWall model against Hedgeye on some key operating metrics. The #OldWall could be your typical bulge bracket ibank, a regional research firm, or pretty much anyone else who is in the business of selling research. Let’s compare and contrast…
1) Stocks Covered: A typical #OldWall analyst will have a fixed coverage universe between 12 and 18 stocks. It takes an average of one month per company to ‘initiate coverage’ on a new name (been there, done that). If you ask that person about a name on the fringe of their coverage, they’ll likely answer “sorry, I don’t cover that”. They’re not allowed to have an opinion without an ‘official’ rating. Note: if an analyst at a Hedge Fund told his/her PM that “I don’t cover that”, they’d soon be out of a job. At Hedgeye, the typical Sector Head has about 100 names under coverage. In Retail, the sector I have the privilege of covering, there’s about 130 names I track regularly. No one at Hedgeye will ever utter the words ‘I don’t cover that’. They might say something like “I’m not familiar with it right now – can I get back to you in a day?” But “I don’t cover it” is not in our vernacular.
Does that mean that I have a ‘call’ on 130 names? Absolutely not. But I have a tremendous playing field from which to source big ideas. I hold myself responsible – as do the other Sector Heads at Hedgeye – to have a repeatable process in place to consistently fish where the fish are. By the time a company works its way through our vetting process, we’ve checked enough risk management boxes such that it’s like a batter stepping up to the plate with a 3 and 0 count. Chances are grossly in favor of that player getting to first base – at a minimum.
2) Big Calls: The way I see it, if I can’t find at least three big longs and three big shorts at any given time out of a group of 130 stocks, then I don’t deserve my seat. Plain and simple. If I were to look at those 130 charts (which I do every weekend) I can assure you that there’s a heck of a lot more than three names that doubled last year, and three that got cut in half.
Let’s add another dimension to the concept of a Big Call. Actually, let’s add two more. Now I’m talking Keith’s language -- TRADE, TREND and TAIL. We’re asked so often why we don’t have ratings. The answer is that the concept of a ‘rating system’ is broken. What if there is a name that we think will double in 18 months, but is going to miss the upcoming quarter by 20%? It might be a short for a more nimble investor, or a long for someone with a 3-year duration that looks through quarterly earnings oscillations (admittedly not many of those people exist, but you get the point). It’s our job to help customers navigate the duration curve.
3) Percent Short: Roughly half of our calls are short. And I’m not just talking about TRADE positions. Each of our Sector Heads has about half of their respective calls on the short side. Heck, our Energy and Internet Analysts have nothing BUT shorts – and they have an enviable track record (check out Kaiser’s call on LINE). The reason why I note in the table above that 0% of Sell-Side calls are Short is that I have yet to see an #OldWall report that actually uses the word ‘short’. About 10% of ratings in an informal check were either Sell or Underweight. But none made an outright short call, and the average price decline was only 5% (which is hardly shortable in today's liquidity environment).
4) Expected Return: The average expected upside for Buy ratings on the Sell side is about 12% for Retailers. If I’m investing real money, I’m probably not going to get too excited about something that gives me a 12% return, unless there is zero potential for downside (which is impossible). In my little world, I’d point out Restoration Hardware, which is a name we’ve liked since $32 (it’s $84 today), and we still think it’s a winner. For those that like it on the sell side, the debate seems to be whether it will be a $90 stock or a $100 stock. From where I sit, the bigger question is whether it is a $200 vs $300 stock. Will it get there tomorrow? No. But by 2018 I think RH will earn $11/share. The consensus is at about $6. It looks expensive today if you believe the Street. But it’s extremely cheap if I’m right. I can guarantee you that if I were at my former (sell side) employer, I literally would not have been allowed to go out with estimates and a resulting equity value that was so far outside of the mean.
One of the inherent challenges to having such a broad coverage approach is that we’ll miss some big moves. With a list of 130 stocks, I can guarantee I’ll miss some big longs and shorts in 2015. I’m not happy about that one bit, but as long as I’m right on the names I pick and help our customers make money, then that’s a win from where I sit. As long as we stick to our process and keep stepping up to the plate with a 3-0 count, I’m downright excited about what 2015 has in store.
Our immediate-term Global Macro Risk Ranges are now:
UST 10yr Yield 2.16-2.30%
WTI Oil 62.99-70.64
Get on base,
Managing Director and Retail Sector Head
Takeaway: Some quick Macro Eye-Candy to close out a Dramamine Thursday.
The U.S. has been the relative outperformer on the global Macro fundamental front and we highlighted the ongoing strength in the high frequency labor data this morning (HERE) but no month/quarter/year-end markup for domestic manufacturing as the data continued to slow into December.
The Markit Composite PMI slowed in December alongside sequential slowing in both the manufacturing and services components. While holding above the expansion demarcation line of 50 for a 14th month, New Orders in December dropped to the lowest reading since October 2012 while the headline reading retreated for a 6th consecutive month, slipping to the lowest level since October of last year.
Alongside a reversal in here-to favorable seasonals and a deceleration in domestic mfg and export demand, we expect the reported ISM/IP data to follow the Markit reading lower in the coming months.
Looking globally – and despite the whipsaw action in markets – the trend towards disinflation and decelerating growth remains predominate as the negative growth and inflation estimate revisions continue to roll-in.
Oversold market bounce but with cross-asset class volatility ramping, the VVIX (VIX of the VIX) in breakout mode and the currency war race-to-the-bottom in full re-crescendo, being long of Dramamine futures…or its more liquid little brother, the long-bong (TLT)…remains our favored macro position into year-end.
Have a good night,
Christian B. Drake
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Takeaway: SBUX continues to be a Best Idea short.
Today, DNKN announced that it expects Dunkin’ Donuts U.S. full-year same-store sales growth to be approximately +1.4% in 2014, below the current +1.8% consensus estimate. This guidance implies that 4Q same-store sales are running in the +0.5-0.8% range, well below the current +2.2% consensus estimate. In 2015, the company expects to deliver full-year same-store sales growth of +1-3% in the U.S and adjusted EPS of $1.88-1.91 (current consensus estimate is $2.02).
Management broadly alluded to a couple of headwinds its business is facing: “Dunkin' Donuts' 2014 U.S. comparable store sales and transactions remained positive, although not as positive as we hoped because of continued pressure on the consumer and decelerating sales of packaged coffee in our restaurants. We expect these trends to continue into next year.”
Is Starbucks Immune?
The obvious question that arises from this press release and aforementioned guidance is whether or not Starbucks is seeing similar pressure. Many people will roll their eyes at this notion as “the brands have different consumer bases,” but the fact of the matter is, the correlation between Dunkin’ Donuts and Starbucks same-store sales is a respectable 0.75 since the beginning of calendar 2011. Call us crazy, but it isn’t clear that Starbucks is immune to some of the softness Dunkin’ is facing.
What’s Really Wrong with Dunkin’?
DNKN sales trends have been decelerating for quite some time now. In fact, two-year trends would suggest comps have been steadily decelerating for the past three years. It is now abundantly clear that 2014 has been a real pain for the company and management constantly cites a difficult macro environment as the reason for the slowdown. Intense competition in the QSR segment could be partially to blame, but it certainly doesn’t tell the whole story. This rationale has also been extremely inconsistent with the improving jobs outlook, consumer confidence, and declining gasoline prices.
Menu Proliferation Can’t Be Helping
Pulling back the curtain on the menu complexity at Dunkin’ reveals a much bigger problem for the company than the current competitive environment. Similar to MCD and (dare we say) SBUX, DNKN’s sales trends have decelerated as menu proliferation has accelerated. As we outlined in our Starbucks deck back in September, concepts that see a significant increase in menu items tend to see a coincident deceleration in comps (and vice versa). Ask McDonald’s how well menu expansion has gone for them!
Needless to say, today’s DNKN news certainly makes us feel more comfortable with our SBUX short. Expectations are elevated after the recent Starbucks analyst meeting that the concept will see an acceleration in traffic trends during the holiday period. At 26x forward P/E and 14x forward EV/EBITDA, this isn’t something were willing to bank on and, so far, the news flow around the holiday season has favored the short side of the trade.
Yesterday we erroneously published a comment as part of our Leisure Letter, that read in part “MGM may have difficulty fulfilling its debt obligations and staying compliant with its covenants in 2016.” This is a misstatement of our position. In fact, we believe that MGM should not have difficulty fulfilling its debt obligations, and that it should be able to remain compliant with its covenants in 2016. We regret any confusion this may have caused. Please feel free to contact us for further clarification.
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