The Bank of Japan's Haruhiko Kuroda says he "will act" if crashing oil prices kill his Policy To Inflate. This is bound to get interesting.
Oil prices have shot up around 10% over the last month. Of course, this spike occurred following a crash of epic proportions (oil has fallen over 50% from its $107 high in June 2014 to just over $52 today). The question now is what’s next?
Here at Hedgeye, we would suggest that the next move may be lower based on the reasons outlined below.
1) U.S. Production At 32-Year High - As measured by the Energy Information Administration, U.S. energy weekly production is at an almost 32+ year high at 9.2 million barrels per day (bbl/d).
2) U.S. Weekly Production Growing Over 10% - Not only is production at a multi-decade high, it is also growing double digits year-on-year. Specifically, in the week of February 6th 2015, production was at 9.2 million bbl/d versus 8.1 in the week of February 6th 2014. That’s 13.4% y-o-y.
3) U.S. Production Is Likely To Grow Into 2016 - The EIA estimates that in 2016 U.S. oil production will eclipse 9.6 million b/d. This would result in the highest U.S. production since 1970, or more than 45 years.
4) Global Growth Is Muted (At Best) – Oil consumption is obviously closely correlated to economic growth. Globally, economic growth is faltering – it is slowing in China, negative in Japan, flattish in Europe, and likely to slow in the United States this year.
5) Saudi Arabia Can Withstand Sustained Lower Prices – The world’s largest oil producer in theory needs $90 oil to fund its budget, but has more than $726 billion in foreign reserves it can use to fund its budget during periods of sustained lower prices.
6) Field Economics May Be Lower Than Many Think – According to a recent report by Wood Mackenzie, a survey of 2,222 oil fields globally found that only 1.6% would have negative cash flow at $40 per barrel.
7) Oil Dependent Nations Have No Choice But To Produce – In major oil producing and dependent countries like Russia, the government may have no choice but to produce at lower prices. Roughly 42% of Russian government outlays are financed by oil exports. In other words, to cut production in an environment where prices have collapsed would be economic suicide for the Russian government.
8) Global Demand Outlook Continues To Fall – OPEC’s most recent forecast for demand outlook suggested that global oil demand will hit a 12-year low in in 2017. This is more than 600,000 barrels less than it forecast a year ago for 2017 demand.
9) IEA Follows OPEC- Consistent with point above, the International Energy Agency has also dropped its oil outlook consistently over the last year. The IEA has dropped its forecast four times in the last year. It now sees a surplus of approximately 400,000 barrels in 2015.
10) U.S. Storage Is At A Tipping Point – It is expected that Cushing and other U.S. repositories will be completely full by the April /May 2015 timeframe. In aggregate, U.S. storage is at an 80-year high of 417.9 million barrels, which is up 15% y-o-y.
11) OECD Storage Also Highest On Record - OECD commercial inventories totaled 2,741 million barrels at the end of 2014, which was the highest level on record and equivalent to roughly 58 days of consumption. The EIA projects these inventories to rise in 2015.
12) OPEC Spare Capacity Expected To Increase – According to the EIA, OPEC surplus crude oil production capacity, which is concentrated in Saudi Arabia, is expected to increase to an annual average of 2.3 million bbl/d in 2015 and 2.7 million bbl/d in 2016, after averaging about 2.0 million bbl/d in 2014.
So, what’s the bull case on the price of oil? Email your thesis to firstname.lastname@example.org.
We had expected CAT’s 2014 10-K to be interesting, and we were not disappointed. Our review of CAT and CAT Financial’s 10-Ks leaves us feeling as though we missed as much as we saw, with the subpoenas/investigations sticking out most clearly. CAT seems to be experiencing ‘investigation creep’ from the SEC, and a pretty unhappy IRS, too. For starters, CAT should probably impair the BUCY goodwill just to get it over with. Warranty challenges, material weakness in controls at CAT Financial, and the impact of completing distributorship divestitures also seem noteworthy.
In next year’s 10-K, we would look for Caterpillar Financial to take the stage with mining and oil & gas exposures as sources of possible losses, since, “receivables from customers in construction-related industries made up approximately one-third of [their] total portfolio.” Mining, as a category, is generally only top-tier miners, with smaller mining operations categorized in their respective regions. While we took Short CAT off of the Best Ideas list, we would look to add it back if the shares continue to bounce.
Grand Jury Subpoena on U.S./Non-U.S. Subsidiary Profits, Cash: This can’t really be a positive. There has been significant speculation by shorts in CAT on the role of advance purchase transactions, tax reduction strategies, and earnings/inventory management. We will be interested to see how it turns out. The SEC correspondences linked below provide clues, but the lack of clear disclosure seems troubling. What, exactly, is the allegation here?
“On January 8, 2015, the Company received a grand jury subpoena from the U.S. District Court for the Central District of Illinois. The subpoena requests documents and information from the Company relating to, among other things, financial information concerning U.S. and non-U.S. Caterpillar subsidiaries (including undistributed profits of non-U.S. subsidiaries and the movement of cash among U.S. and non-U.S. subsidiaries). The Company is cooperating with this investigation. The Company is unable to predict the outcome or reasonably estimate any potential loss; however, we currently believe that this matter will not have a material adverse effect on the Company’s consolidated results of operations, financial position or liquidity.”
SEC Investigations: It seems that the SEC investigation has expanded beyond BUCY goodwill, which we previously discussed in 2013 here, to include the SARL (a non-U.S. subsidiary discussed in earlier SEC correspondences, such as here: http://www.sec.gov/Archives/edgar/data/18230/000001823014000193/filename1.htm)
“On September 12, 2014, the SEC notified the Company that it was conducting an informal investigation relating to Caterpillar SARL and related structures. The SEC asked the Company to preserve relevant documents and, on a voluntary basis, the Company made a presentation to the staff of the SEC on these topics. The Company is cooperating with the SEC regarding this investigation. The Company is unable to predict the outcome or reasonably estimate any potential loss; however, we currently believe that this matter will not have a material adverse effect on the Company’s consolidated results of operations, financial position or liquidity.”
“On September 10, 2014, the SEC issued to Caterpillar a subpoena seeking information concerning the Company’s accounting for the goodwill relating to its acquisition of Bucyrus International Inc. in 2011 and related matters. The Company is cooperating with the SEC regarding this subpoena and its ongoing investigation. The Company is unable to predict the outcome or reasonably estimate any potential loss; however, we currently believe that this matter will not have a material adverse effect on the Company's consolidated results of operations, financial position or liquidity.”
IRS Tax Issue, SARL A ~$1 Billion Ask: There is new tax language in many places in the 10-K. After not much disclosure on the SARL issues in the 10-Q, the 10-K expands on prior disclosure and an earlier correspondence with the S.E.C. here: http://www.sec.gov/Archives/edgar/data/18230/000001823014000193/filename1.htm. It would also seem that there would be substantially more exposure for the period after 2009 if CAT fails in its challenge. This seems likely to linger, since these processes are typically slow.
“On January 30, 2015, we received a Revenue Agent's Report (RAR) from the Internal Revenue Service (IRS) indicating the end of the field examination of our U.S. tax returns for 2007 to 2009 including the impact of a loss carryback to 2005. The RAR proposed tax increases and penalties for these years of approximately $1 billion primarily related to two significant areas that we intend to vigorously contest through the IRS Appeals process. In the first area, the IRS has proposed to tax in the United States profits earned from certain parts transactions by one of our non-U.S. subsidiaries, Caterpillar SARL (CSARL), based on the IRS examination team’s application of the “substance-over-form” or “assignment-of-income” judicial doctrines. We believe that the relevant transactions complied with applicable tax laws and did not violate judicial doctrines. We have filed U.S. tax returns on this same basis for years after 2009. In the second area, the IRS disallowed approximately $125 million of foreign tax credits that arose as a result of certain financings unrelated to CSARL. Based on the information currently available, we do not anticipate a significant increase or decrease to our recognized tax benefits for these matters within the next 12 months. We currently believe the ultimate disposition of these matters will not have a material adverse effect on our consolidated financial position, liquidity or results of operations. We expect the IRS field examination of our U.S. tax returns for 2010 to 2012 to begin in 2015. In our major non-U.S. jurisdictions, tax years are typically subject to examination for three to eight years.”
Progress Rail: Update on that subpoena. It sounds like they are planning to pay their way out.
“On October 24, 2013, Progress Rail received a grand jury subpoena from the U.S. District Court for the Central District of California. The subpoena requests documents and information from Progress Rail, United Industries Corporation, a wholly-owned subsidiary of Progress Rail, and Caterpillar Inc. relating to allegations that Progress Rail conducted improper or unnecessary railcar inspections and repairs and improperly disposed of parts, equipment, tools and other items. In connection with this subpoena, Progress Rail was informed by the U.S. Attorney for the Central District of California that it is a target of a criminal investigation into potential violations of environmental laws and alleged improper business practices. The Company is cooperating with the authorities and is currently in discussions regarding a potential resolution of the matter. Although the Company believes a loss is probable, we currently believe that this matter will not have a material adverse effect on the Company's consolidated results of operations, financial position or liquidity.”
Pre-Existing Warranty Adjustment: Warranty reserve increased despite lower sales. It was apparently due to issues with prior period warranties, which is not usually a positive disclosure, as we see it. In such situations, prior earnings were likely too high because of artificially low accruals, and it is difficult to tell if the further adjustments will be needed.
“The increase in liability includes approximately $170 million for changes in estimates for pre-existing warranties due to higher than expected actual warranty claim experience.”
Change In Residual Value Definition? This looks like a change in definition for the calculation of residual values. The elimination of the word ‘careful’ seems odd, too. If so, it might point to possible issues at CAT Financial. For instance, have used mining equipment values deteriorated? Of course, CAT Financial has already stated that “we have also concluded that our disclosure controls and procedures were not effective as of December 31, 2013” in its revised 10-K after 3Q 2014.
CAT Financial Controls Still Not Effective: Of course, CAT Financial has already stated that “we have also concluded that our disclosure controls and procedures were not effective as of December 31, 2013” in its revised 10-K after 3Q 2014. Its only half of the balance sheet.
“…we are still in the process of implementing and testing these processes and procedures and additional time is required to complete implementation and to assess and ensure the sustainability of these procedures and we have therefore concluded that our internal controls over financial reporting and our disclosure controls and procedures were not effective as of December 31, 2014.” And: “the material weakness relating to our Allowance for credit losses still exists as of December 31, 2014”
Allowances Still Low? While they may lack effective controls, as well as some interesting counterparties in mining/oil & gas, he allowance for losses remains low by historical standards.
Other Notable Items:
Japan Dealer: “While the large majority of our worldwide dealers are independently owned and operated, we own and operate a dealership in Japan: that covers approximately 85% of the Japanese market: Nippon Caterpillar Division. We are currently operating this Japanese dealer directly and its results are reported in the All Other operating segments. There are also three independent dealers in the Southern Region of Japan.”
Odd to Delete This Language: “We build and maintain a productive, motivated workforce by striving to treat all employees fairly and equitably” appears in last year’s 10-K, but was removed for 2014.
Restructuring Costs Identification Helped Construction Industries? We wonder if some of the improved performance at CI was related to ‘aggressive’ restructuring cost identification? $227 of CI’s costs were in 1H, when the segment posted the strongest adjusted margins.
Finished with BUCY Distributorships Divestitures: The BUCY distributorship divestitures are somewhat unusual since dealers are closely tied to CAT, and CAT has often provided deal financing to dealers. Apparently, they are largely complete.
Upshot: As though CAT didn't have enough business challenges, regulatory, financial, and legal issues should provide significant additional distraction. Management has dug themselves a hole, getting paid quite well for the shoveling...
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- Executing on asset recycling program
- Sold $1.6b of assets in 2014 at 13x EBITDA
- Accelerated plan to sell almost all of limited service hotels in Q4 due to favorable conditions
- Grown market share in limited service - grown number of properties by 50% since IPO
- Owned portfolio continues to evolve to stronger, higher quality, and more strategic hotels
- Pulled 4 more hotels off the market
- Return of capital - in Q4 repurchased $215m in stock, most were class A purchased in the open market
- $69m more repurchased in Q1 through last Friday
- Q4 earnings came in below expectations due to: 1) $22m in non-recurring stock comp expense, 2) transactions - $8m negative impact for Q4 adjusted EBITDA, 3) $3m negative Fx impact, 4) some weakness in international hotels
- Stock comp should run $2-3m per year going forward
- Occupancies are at record level in United States
- Group revenue would've been up 3% if you exclude 3 problem markets - don't see the Q4 problems persisting
- Group should continue to recover in 2015 and beyond in US
- Eurozone underperforming except UK
- Middle East saw drop in inbound from Russia
- Eastern Europe not good
- Weak market conditions in HK and Seoul
- Margins in Americas higher than elsewhere: up 50bps vs down 240bps
- Excluding Seoul, margins would've been flat YoY on owned
- F&B revs were flat despite higher occupancy driven by a handful of hotels - should track RevPAR over time
- NYC - 2 Hyatt hotels in the comp base
- NYC represents 9% of adjusted EBITDA
- 9 hotels in total in NYC
- Big supply growth will continue to negatively impact those hotels
- Hyatt Centric - full service lifestyle brand. First ones will open in Chicago and Miami in Q2. Should have 15 by year end.
- 2015 - 1/3rd of business is outside of the USA. 2015 EBITDA could be impacted by $20m of Fx versus in 2014
- $70m negative EBITDA impact on 2015 due to H being a net seller in 2014 - $25m in Q1 and Q2 and $20m in Q3
- By year end, 20% of hotels will have been open less than 3 years
- Q4 timeshare is a good run rate since sale was early in Q4
- NYC is primary destination for inbound traffic from Europe - started the year weak but compare is tough (Superbowl last year)
- Centric will have 3 ownership structures - Hyatt owned, Hyatt managed, and franchised
- Will continue to use balance sheet to fund growth
- No time pressure on redeploying asset sale proceeds for 1031 purposes
- No CFO update
- Sees active transactions market continuing - Hyatt will be active on the buy and sell side
- 2015 should be as active as 2014 on the transactions front - while H was a net seller in 2014, they don't know on which side they will come out
- Will look at property purchases, management deals, and brand acquisitions
- Tax rate for 2015 mid to high 30s%
- Most of the capital for new Centric's will be more related to signage and promotions
- Owned and lease margin decline of 50bps is a comparable so asset transactions did not have an impact
- RevPAR and profits will be positive in Seoul sometime this year
- 4 deals pulled off the market - price, contract structure, capital commitments into the hotels, other development opportunity are the 4 criteria looked at
- India has been under pressure for 3 years but negative progression is slowing - new government and lower oil prices are helping
- Slowdown in development in India
- China - no real slowdown in hotel development
- NYC down 20% in RevPAR to start the year - outlook for the year is still positive though
- Franchise fees up 35% in 2015 - conversions, new franchise hotels, same store growth
Takeaway: Mgmt focused on raising Prestige synergy targets on the cost and revenue side. NCLH should outperform in 2015
- 2014: strong Europe/Alaska offset promotions in Caribbean
- Synergies: certainly will achieve cost synergies of $25m
- Investing in marketing initiatives to stimulate demand via TV in 1Q 2015.
- Broke 2M guest mark for 1st time in Norwegian history.
- Harvest Caye: serve anchor for Western Caribbean itineraries beginning in Fall 2015
- Norwegian Escape bookings in-line with expectations and well ahead of Getaway/Breakaway
- Regent: free air transportation, free shore excursions, dining, premium wine spirits, free internet.
- Oceania/Regent: target customer base: net worth of $1m, age >55
- Oceania/Regent: 44%/51% were repeat guests
- Prestige: 97% cruise experience met or exceeded expectations
- Sirena: $40m drydock in March 2016
- Prestige: Ebola impacted exotic sailings.
- Norwegian brand: increased booking activities in 2016 with Explorer had slight negative impact as it relates to 2015 bookings
- Prestige: Booking velocity negatively impacted by announcement of NCL/Prestige combo. Customers saying they will wait until booking on Prestige. But that has reversed course since Frank assumed role of President/CEO.
- Experienced $10.3m fuel derivatives loss in 2014 (5 cents/share)
- Leverage ticked up to 5x as a result of acquisition...will be below 4x in the next 18 months
- 1Q 2015: tough comps; promotional environment in Caribbean will continue
- Fuel derivative loss for Q1 and 2015: $35m or $0.15 EPS; $120m or $0.52 EPS
- 2015 capacity on a combined basis vs 2014 on a Norwegian stand-alone basis:
- Caribbean: 40.4% (47.9% in 2014); Norwegian-only brand: 45.5%
- Europe: 22.8% (20.7% in 2014)
- Bermuda/Alaska: 7.5% each (unchanged from 2014)
- Hawaii: 5.3% (6.4% in 2014)
- Asia/Africa/Pacific: 3.3%
- South America: 1.6%
- 1Q deployment:
- 67.9% Caribbean (72.1% in 1Q 2014): Norwegian only brand 74.1%
- Europe is flat YoY at 11%
- Asia/Pacific 7.4% (unchanged YoY)
- South America 1.9% (unchanged YoY)
Q & A
- Bookings volume pickup recently: across all brands. Norwegian brand saw most pronounced spike. Norwegian has a good promotion in the market (focused on delivering more value, rather than low pricing).
- Q1 2015: pressures in the Caribbean continuing
- Q2/Q3/Q4 2015: no area of concern: Europe and Alaska is shaping up
- Are there more cost synergy opportunities? Probably.
- Prestige: highest per diem in industry
- Scale opportunities are tremendous.
- Have not had a Regent newbuild since 2003
- Slightly above $5.00 for EPS 2017 target
- 2013 ROIC: 7%...will be in double digits in 2015. In 2018, will double to 14%.
- Lower commissions/other line: fundamental changes in cost of sales structure. Changing agreements in casino, port agreements and lowering air subsidies. There will continue to be ongoing improvements. Prestige costs are higher since they operate in an all-inclusive business but there is room for cost improvement.
- Commissions/other line: Norwegian running at 15% clip. Prestige in the 30%s. On a consolidated basis, should anticipate upper end of 18% range.
- Regent: could take a new ship every 5 years
- Think there are ways to keep Apollo on board
- Sourcing from other markets: Fx aside, biggest opportunity international
- If Norwegian is able to source same # of guests internationally that Prestige has done, Norwegian can generate an additional 210k passengers a year
- With Prestige acquisition, want to get back to hedging at 50%
- 2016 bookings at best levels ever at this time of year
- Seeing shipyards being less aggressive in pricing than in 2009/2010
Last week we elevated a number of troubled growth stocks to our Investment Ideas list as shorts. Among these was NDLS, a name we see approximately 35-45% downside in with a fair value of $14-16 per share.
NDLS is a small cap stock that has been the recipient of an unwarranted premium growth multiple. With only ~440 Noodles & Company restaurants system-wide, management maintains that they have a tremendous runway of growth ahead of them that calls for “at least” 2,500 restaurants nationwide. This is a lofty goal, by any measure, particularly when considering the recent surge of competitors claiming similar domestic growth profiles. We’ve already seen signs of how difficult this will be to achieve in NDLS’ infancy as a public company. As the company has accelerated unit growth and ventured into new markets, system-wide sales and margins have suffered.
While this is to be expected, the company believes it is facing a brand awareness issue and thinks it will solve this issue through increased marketing spend and its catering initiative. In our view, NDLS' brand awareness problem shouldn’t be management’s top priority. In fact, elevating brand awareness will not be the panacea most hope. Execution and site selection are the real deterrents to the business, and these can’t simply be fixed by plowing more cash into advertising.
Despite bullish consensus estimates, we believe NDLS is facing a difficult 2015 for the following reasons:
- Cost of sales inflation: management is only estimating 2% food inflation, but durum wheat prices are under pressure and food cost estimates could head higher as we move into the back half of the year
- Geographic concentration: the company has a notable number of stores in the DC metro area, which is an extremely competitive market
- Rising labor costs: 52% of company operated restaurants are in markets that are facing minimum wage increases in 2015 or 2016 (or both), the majority of which are coming this year
- The Affordable Care Act: will add about 30-50 bps of pressure on margins in 2H15
- Estimates are high: the street is looking for 27% EPS growth in 2015, after an essentially flat year in 2014
Management is currently guiding to between 20-25% EPS growth in 2015. With very little flow through from same-store sales, NDLS needs to drive 3-4% comp growth in order to keep margins flat versus last year – a task we feel will be difficult to achieve.
The biggest factor working against us on the short side is the amount of short interest in the name (~25%). The analyst community is rather divided, with a 60%/40% split on buys vs holds, respectively.
Consensus Estimates for 4Q14 Look Aggressive As Well
As a part of our process we continually monitor consensus estimates for each of the major line items on the P&L for the vast majority of companies in our space.
In regards to NDLS, we have a difficult time understanding the rationale behind the street's estimates for COGS and, subsequently, restaurant level margins in 4Q14.
Consensus expects cost of sales to decrease 41 bps on a YoY basis in the quarter, after increasing 51, 67, and 64 bps in 1Q14, 2Q14, and 3Q14, respectively. We've tried, numerous ways, to reconcile the extent of this sudden reversal - but to no avail. Predictably, this leverage is expected to flow through to restaurant level margins which consensus expects to be down 36 bps YoY, after decreasing 127, 200, and 230 bps in 1Q14, 2Q14, and 3Q14, respectively.
We think there is a material disconnect here which will become readily apparent if NDLS does not put up a well-above consensus comp.
Data: Company Filings, Consensus Metrix Estimates
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