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CHART OF THE DAY: Positioning for Fire $LNCO

CHART OF THE DAY: Positioning for Fire $LNCO - chartofday

 

Editor's note: Below is an excerpt from today's Morning Newsletter written by Hedgeye Energy Sector Head Kevin Kaiser. 

 

I don’t spend a lot of time trying to forecast what I’m ill-equipped to forecast with a high degree of confidence.  I don’t know when lightning will strike.  But I can put forth investment ideas that are based on sound data and reasoning, and are likely to work under various assumptions and scenarios.  And when the spark is set, I am prepared and well-positioned. 

 

I’ve written about no company more than LINN Energy (LINE, LNCO) over the past two years because I thought that the system was extremely unstable.  The basic story has always been the same – the company makes no real profit, but dividends out $1 billion per year, which it pays for via serial debt and equity issuance.  As I saw it, it was highly likely to end disastrously.  The pushback was consistent, “There’s no catalyst.”  This was not a good idea, I was told, because there wasn’t a lightning storm in sight…



Positioning for Fire

“From the elevation of retrospect we can see it all coming together more clearly and sooner than those who were there and running.”  - Norman Maclean, Young Men and Fire


On August 5, 1949 fifteen young men parachuted out of a C-47 transport plane to fight a wildfire in the remote forests of central Montana. 

 

It was the dead of summer in the middle of an extreme heat wave.  On the day of the jump it was 97 degrees, then the hottest day on record in Helena, Montana.  The fire danger rating was 74 out of 100, which meant “explosive potential.”  It was so windy that the turbulence onboard the plane caused one of the men not to jump, return to the base, and immediately resign.  The men that did jump landed on a steep slope in Mann Gulch that was covered in dry, knee-high grass… 

 

Within two hours of landing all but three of the “smokejumpers” were dead. 

 

What happened in Mann Gulch that day was one of the greatest disasters in US forest-fire fighting history.  The lessons learned from the tragedy had a significant effect on how the US Forest Service fought wildfires for years to come.

 

Positioning for Fire - top pic for EL

 

I think of wildfires a lot like I do investment research, in that the identification and understanding of an unstable system is the primary goal.  A wildfire occurs because existing conditions allow it to: the forest is dry, it’s hot, it’s windy, and there hasn’t been a fire in a long time.  As conditions become more extreme, the probability of fire increases.  So, as a fundamental analyst, I try to figure out where the hot, dry forests are before everyone else does, and before they go up in flames.

 

The instantaneous cause of the wildfire – the “catalyst” – is a secondary concern, and often, unpredictable.  If the forest is dry and hot enough, any small spark can set it ablaze, at any moment.  Will it be an irresponsible campfire?  A bolt of lightning to a dead tree?  A cigarette butt thrown from a car window?  It doesn’t really matter because the result is the same, the forest burns down.

 

Didier Sornette, an expert on financial crises, summarizes the point:

 

“...a crash occurs because the market has entered an unstable phase and any small disturbance or process may have triggered the instability. The collapse is fundamentally due to the unstable position; the instantaneous cause of the collapse is secondary. Essentially, anything would work once the system is ripe… a crash has fundamentally endogenous, or internal origin.”

 

I don’t spend a lot of time trying to forecast what I’m ill-equipped to forecast with a high degree of confidence.  I don’t know when lightning will strike.  But I can put forth investment ideas that are based on sound data and reasoning, and are likely to work under various assumptions and scenarios.  And when the spark is set, I am prepared and well-positioned. 

 

I’ve written about no company more than LINN Energy (LINE, LNCO) over the past two years because I thought that the system was extremely unstable.  The basic story has always been the same – the company makes no real profit, but dividends out $1 billion per year, which it pays for via serial debt and equity issuance.  As I saw it, it was highly likely to end disastrously.  The pushback was consistent, “There’s no catalyst.”  This was not a good idea, I was told, because there wasn’t a lightning storm in sight…

 

…And then the price of crude oil tumbled from $100 to $55 per barrel, prompting more investors to doubt the sustainability of LINN’s business model, and sell.  The prices of LINN’s stocks and bonds plummeted quickly; in just three months LINE and LNCO fell 60%, and the unsecured bonds lost 25 points.  The “catalyst” is now clear, as it always is in retrospect.  It was the oil price collapse, though it easily could have been something else: a failed acquisition, an SEC enforcement action, a rise in interest rates, another leg down in the natural gas price, or something else I never even considered.…  It doesn’t matter – we were well positioned for any small disturbance to trigger the instability.

 

Our latest energy investment idea is an unstable situation of a different kind – and this one we like on the long side.  Natural gas pipeline MLP Boardwalk Pipeline Partners LP (BWP) trades at a 50% discount to its peer group because it doesn’t dividend out all of its cash flows.  Investors are still sour from the February 2014 distribution cut – which we called for in advance – and have not recognized the positive turn that BWP’s business took this year.  In our view, this is an unstable system waiting for a trigger to re-rate the stock higher...  (Ping us if you’re interested in learning more about our work on BWP.)

 

What else in the financial world is at risk of going up in flames?  Like the Mann Gulch disaster of 1949, it’s not always easy to recognize an unstable system for what it is…  Are you prepared and well positioned for the lightning strikes and errant campfires that will invariably come?

 

Our immediate-term Global Macro Risk Ranges are now:

 

UST 10yr Yield 2.03-2.23%

SPX 1

RUT 1130-1199

VIX 15.21-24.58

Yen 116.97-121.38

Oil (WTI) 52.02-58.32 

 

Kevin Kaiser

Managing Director

 

Positioning for Fire - chartofday


December 19, 2014

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BULLISH TRENDS

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BEARISH TRENDS

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The 3 and 0 Count

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 3 and 0 Count - t7

 

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.

 

The 3 and 0 Count - mcg1

 

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%

SPX 2037-2079

RUT 1148-1190

Nikkei 16,098-17,930

VIX 11.71-14.38

WTI Oil 62.99-70.64

 

Get on base,

 

Brian McGough

Managing Director and Retail Sector Head


(HEDG)EYE-CANDY | SURVEY SAYS....

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. 

 

(HEDG)EYE-CANDY | SURVEY SAYS.... - Markit US

 

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. 

 

(HEDG)EYE-CANDY | SURVEY SAYS.... - ISM vs Markit

 

(HEDG)EYE-CANDY | SURVEY SAYS.... - Eco Summary

 

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. 

 

(HEDG)EYE-CANDY | SURVEY SAYS.... - GMPL 121814

 

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.  

 

(HEDG)EYE-CANDY | SURVEY SAYS.... - VVIX2

 

Have a good night,

 

 

Christian B. Drake

@HedgeyeUSA

 


DNKN DEBACLE & PARALLELS TO SBUX

Takeaway: SBUX continues to be a Best Idea short.

Disappointing Guidance

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.

 

DNKN DEBACLE & PARALLELS TO SBUX - 1

 

DNKN DEBACLE & PARALLELS TO SBUX - 12 18 2014 1 38 06 PM

 

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!

 

DNKN DEBACLE & PARALLELS TO SBUX - 2

 

DNKN DEBACLE & PARALLELS TO SBUX - 3

 

DNKN DEBACLE & PARALLELS TO SBUX - 4

 

Upshot

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.

 

Howard Penney

Managing Director

 

Fred Masotta

Analyst


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