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The Bond Battler

This note was originally published at 8am on May 05, 2015 for Hedgeye subscribers.

“You got to be tough.”

-Hemingway

 

In classic Ernest Hemingway terms (tight and to the point), that’s what a young man by the name of Nick was told by an old street fighter after he got busted by a brakemen (thrown off a train) up near Macelona, Michigan. #BlackEyes

 

The short story is called The Battler – and it’s a beauty for those of us who have to (and love to) grind it out every day. Win, lose, or draw – there’s a lesson to be learned from every experience.

 

After being bearish on Treasury Bonds in 2013, I’ve been battling it out on the long side of these barbarous low-volatility-high-return Long Duration Bonds for going on 17 months now. Every time bond yields bounce to lower-highs, I hear it from every corner of the Twitter-sphere. You got to be tough to fight off the perma Bond Bears.

The Bond Battler - 3  yield Godot 07.27.2014

 

Back to the Global Macro Grind

 

Being deaf would probably help me too.

 

If all I did was what you should do when you are trying to handicap the probability of Long-term Bonds rising/falling (front-run the rate of change in growth/inflation), I’d concern myself less with daily moves. But some of you pay me to fight. So fight today, I will.

 

“They all bust hands on me – but they couldn’t hurt me.” –Hemingway

 

If you can take a punch (both in this game and the one I used to play on the ice), your career will last longer. Here’s what the body blows have looked like on rallies (in Long Bond Yield terms) for the last 6 months:

 

  1. December 2014, US 10yr Treasury Yield rallies to 2.28% on expectations of accelerating Q1 US growth
  2. March 2015, UST 10yr Yield rallies to 2.25% post another #LateCycle US Jobs report
  3. May 2015, UST 10yr Yield rallies to 2.14% on…

 

On what?

 

  1. Global Bond Yields having their biggest 6-day % move (off the all-time lows)?
  2. The Almighty Bond “Bubble” finally popping, for real this time, because it’s “expensive”?
  3. Expectations of a mean reversion back to #LateCycle jobs gains in the US (May 8th report)?

 

Triple Crown fans, if we’re betting on expectations, I’ll take all 3 for the trifecta. And I’ll fade #3, staying long The Battler (Long Bond) to win at Friday’s run for the roses.

 

I obviously get that all 3 of the aforementioned expectations can come to fruition. But I also get this thing called probability that I won’t fade unless I have fundamental reason to do so.

 

It’s been what, 37 years, since Affirmed won the Triple Crown? While it hasn’t been that long for Bond Bears to get paid (2013), don’t forget that the key wager then was that US growth would accelerate from 2012. And it did.

 

Put another way, until our models signal real US #GrowthAccelerating (year-over-year), we’re probably staying with our biggest asset allocation horse.

 

Since I gave the bears some air-time, don’t forget to contextualize what actually happened after those December and March Lower-Highs for 10yr yields:

 

  1. JAN-FEB 2015 = re-test of the all-time lows at 1.67% after bad US GDP data
  2. APR 2015 = two separate selloffs to 1.84% after a bad March Jobs report

 

In other words, “long-term investors” (i.e. those who understood that Global Growth and Inflation expectations were too high) who have remained bullish on Long Duration Bonds have been paid to take a few punches from the pundits.

 

But, but… according to consensus, jobless claims are “good.” C’mon now – that’s not true. They are actually fantastic! And that’s the point about the cycle. See slide 13 of our #LateCycle Macro deck – they are as good as they get.

 

In that same slide deck (slides 12-17) our Macro Research Team reviews the mean reverting #history of the labor cycle, reminding you what that economic indicator is – one of the latest and lagging indicators there are.

 

Yep. I’ll take the bi-monthly black eyes for staying long Treasuries (TLT). For the next 3-6 months we think year-over-year US growth continues to slow. Staying with the process isn’t always easy. But we’ve got to be tough.

 

Our immediate-term Global Macro Risk Ranges are now:

 

UST 10yr Yield 1.86-2.17%

SPX 2096-2126
RUT 1215-1250
VIX 11.73-14.70
EUR/USD 1.06-1.13
Oil (WTI) 54.85-60.39
Copper 2.79-2.97

 

Best of luck out there today,

KM

 

Keith R. McCullough
Chief Executive Officer

 

The Bond Battler - z 05.05.15 chart


May 19, 2015

May 19, 2015 - Slide1

 

BULLISH TRENDS

May 19, 2015 - Slide2

May 19, 2015 - Slide3

May 19, 2015 - Slide4

May 19, 2015 - Slide5

May 19, 2015 - Slide6

May 19, 2015 - Slide7

May 19, 2015 - Slide8

 

 

BEARISH TRENDS

 

May 19, 2015 - Slide9

May 19, 2015 - Slide10


THE HEDGEYE MACRO PLAYBOOK

The Hedgeye Macro Playbook is a periodic, deep-dive update to our active Macro Themes and Thematic Investment Conclusions.

 

CLICK HERE to download the associated presentation in PDF format (25 slides).

 

Key conclusions: 

 

  • We believe the counter-TREND rally in reflation has legs to ~$71 on WTI and ~90 on the DXY. From that level of consolidation we think the USD resumes its structural uptrend. We don’t think Draghi will allow a sustainably stronger EUR to weigh on capital markets activity or inflation expectations within the Eurozone and expect the ECB to react by Jackson Hole 2015. We believe investor consensus simply needs to capitulate on the expectation for a tighter Fed [in absolute terms] before it can refocus on the policy divergence between Europe and Japan [in relative terms].
  • We remain bullish on bonds and bond-like equities and we think U.S. interest rates are likely to put in yet another lower-high into or on the June 17th FOMC meeting where Yellen will have to acknowledge in her press conference the marked slowing of economic momentum – which we think continues throughout the balance of the year.
  • Neither consensus among the investment community nor policymakers at the Federal Reserve have yet to fully internalize our rate-of-change work on the intensifying demographic headwinds to consumption growth, consumer price inflation and wage inflation. Most econometric models are calibrated to historical population dynamics – if at all – and simply fail to account for these headwinds amid perpetually misguided expectations of +3% annual real GDP growth, +2% core PCE inflation and +3-4% annual wage growth.
  • In conjunction with this view, we don’t think the Fed will ever be able to justify hiking interest rates – unless it is truly a political exercise. By the time September and/or December rolls around, the current economic cycle will be noticeably slowing into a likely recession sometime in mid-to-late 2016. If you think domestic economic growth is slow now, just wait until base effects steepen throughout the balance of the year.
  • In the context of our bearish growth forecast, we believe the domestic labor cycle is likely past peak from a rate-of-change perspective.

 

CLICK HERE to download the latest refresh of our Tactical Asset Class Rotation Model (32 slides).

 

Tomorrow morning (5/19) at 8:30am EST, we will run through the playbook live in lieu of our standard Macro Show. We will also host a live Q&A session at the end of the prepared remarks. Please email your sales counterpart to the extent you require a permanent passcode to our [daily] morning call.

 

As always, feel free to ping us with any follow-up questions.

 

Enjoy the rest of your respective evenings,

 

DD

 

Darius Dale

Associate


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HAIN – THE OPERATING MARGIN STORY IS OVER (Corrected)

Takeaway: The sum of the parts analysis has been updated to reflect better math!

HAIN in on the HEDGEYE Best Ideas as a SHORT!


Being short HAIN has been the pain trade for me. 

 

That being said, the FY15 financial performance (negative earnings revisions and declining margins) over the past 12 months does not warrant a multiple expansion.  Unfortunately, over the past 12-months the NTM EV/EBITDA multiple expanded from 13.6x to 16.8x today.  At the time of our SHORT call we argued the company was overvalued because the international business (UK) was a slow growing, low margin food business that did not deserve to trade at a U.S. Organic food company multiple.

 

HAIN – THE OPERATING MARGIN STORY IS OVER (Corrected) - Hain Chart 1 

 

The exact opposite happened!

 

To that end, our thesis has not changed but has strengthened over the past six months.  The company continues to provide little evidence that they have a sustainable business model, additionally management does not disclose the basic information analysts need to understand what the real organic growth rate is.  We believe that there are structural impediments to future margin improvement, making the bull case even more suspect.  The biggest impediments to margin expansion are:  

  • Global geographic diversification put pressure on margins
  • The two most recent acquisitions are low margin protein businesses
  • The limited supply of global Organic ingredients is hurting gross margins
  • Increased trade spending will lower gross margins

According to the current sell-side models the HAIN business model will look very different in FY16 versus the past four years.  Frankly, I have no explanation for the change in the sell-side logic other than they need to be bullish on the stock due to its Natural & Organic attributes.

 

The key components to the changes are:

  • Gross margins will expand in FY16 after declining for the past four years
  • The company will not be cutting SG&A any more
  • Operating margins will expand in FY16 after declining in FY15

The following is a look at why the current models are too aggressive in FY16:


GLOBAL DIVERSIFICATION LEADS TO LOWER MARGINS

Over the course of six quarters (to establish its international business), HAIN bought four international businesses for a total of $600 million. 

  1. October 29, 2012 (2Q FY13) HAIN acquired Premier Food and Jams for $315.8 million. 
  2. On April 27, 2012 (4Q FY12) HAIN acquired Cully & Sully Ltd. for $19.8 million. 
  3. On October 25, 2011 (2Q FY12) HAIN acquired Singapore Food Industries Ltd. from SATS Ltd., for $254.5 million.
  4. On October 5, 2011 (2Q FY12) HAIN acquired Europe's Best, Inc. from The J. M. Smucker Co.

Importantly, none of these businesses are organic or all-natural.  This is in direct conflict to the U.S. business which is primarily Organic and the reason why the UK business should trade at a lower multiple. 

 

Collectively HAIN’s new international businesses are producing low single digit operating margins, while the U.S. is running at 17%.  Going forward, with the company now seeing 20% of its revenues coming from international with 1/3 of the margins and another ~12.3% from its latest protein acquisitions with mid-single digit margins it will be hard to grow overall margins.  To summarize, HAIN can’t cut G&A to offset the gravitational pull of lower margins or it will sacrifice performance in other areas of the company.   

 

GROSS MARGIN PRESSURE

For the past three years HAIN gross margins have been declining at a fairly steady rate.  Since 2Q FY11 the company’s adjusted gross margins have declined from 29.3% to 26.6%, or 270bps.  Gross margins are under significant pressure from commodity headwinds, mix shift and increased trade spending.  We don’t see these issues abating in FY16.  The current consensus sees a dramatic shift in HAIN’s gross margins in 1Q FY16.  What has changed in order for management to guide to better gross margins in FY16? 

 

HAIN – THE OPERATING MARGIN STORY IS OVER (Corrected) - Hain Chart 2 

 

MASSIVE CUTS IN G&A ARE CRITICAL AND UNSUSTAINABLE

Can any company cut G&A at the rate HAIN has and sustain critical mass?  Does outsourcing G&A functions create sustainable long term advantage?  I feel this is a big risk to the HAIN business model!

 

Prior to making the series of international acquisition in FY12 HAIN had not relied on G&A cuts to drive margin expansion.  Obviously, when they acquired lower margin business they need to cut significant amounts of G&A to prevent the overall margin structure of the company from collapsing.  Until FY15 they have achieved the intended goal.

 

Prior to 2QFY12, over the previous five quarters HAIN had only cut G&A by 9bps.  Since 2QFY12 the need to cut significant amounts of G&A has become critical to the overall story.  From 2QFY12 to 3QFY15 the company has experienced on average 132bps reduction in G&A.  Over that same time G&A has gone from 18.7% to 13.45%, or 496bps. 

 

Over the past 12 months HAIN’s G&A has run has 13.75% of sales, as compared to 20% for most of HAIN non-organic companies and 23% for the biggest organic companies.  Either HAIN has figured out a better mouse trap or this company is structurally set up to fail.    

        

Now the company is in a very difficult position, the margins internationally have stopped improving and there is incremental pressure on the margins in the U.S. business.  HAIN can’t cut G&A and be a company that is built to last. 

 

HAIN – THE OPERATING MARGIN STORY IS OVER (Corrected) - Hain Chart 3

 

OPERATING MARGINS HAVE PEAKED

Looking forward into FY16 the street consensus has HAIN returning to growth in operating margins.  The improvement is entirely coming from improved gross margins, which seem counter intuitive to what is happening in the market place.    

HAINS LTM EBIT margins have gone from 9.5% in 4QFY11 to 11.6% in FY4Q15.  In FY15 LTM EBIT margins have gone from 11.8% to 11.6%.  FY15 will represent the first time in 4 years that the company has not shown margin improvement.  Why will the trajectory change in FY16? 

 

HAIN – THE OPERATING MARGIN STORY IS OVER (Corrected) - Hain Chart 4 

 

Our bottom line for HAIN is that the margin story is over!

 

When the music stops it's going to be real ugly!

 

SUM OF THE PARTS

The following charts are a look at the top line growth rate for the HAIN’s important regions.  As you can see the two most important markets U.S. and UK are showing a significant slowdown in revenue growth.  Importantly, the UK business revenue growth is estimated to slow 1% over the balance of FY16.  What is the organic growth rate of a company with 1% revenue growth?  And why should it trade at a premium multiple?  Even the U.S. business is slowing to the mid-single digits.  Again, the company organic growth will not be in the high-single digits in FY16.  

 

HAIN – THE OPERATING MARGIN STORY IS OVER (Corrected) - Hain Chart 5 

HAIN – THE OPERATING MARGIN STORY IS OVER (Corrected) - Hain Chart 6 

HAIN – THE OPERATING MARGIN STORY IS OVER (Corrected) - Hain Chart 7 

HAIN – THE OPERATING MARGIN STORY IS OVER (Corrected) - Hain Chart 13 

HAIN – THE OPERATING MARGIN STORY IS OVER (Corrected) - Hain Chart 9 

HAIN – THE OPERATING MARGIN STORY IS OVER (Corrected) - Hain Chart 10 

 

What do you pay for a company that is seeing a significant slowdown in revenues and can only grow margins by cutting massive amounts of G&A? 

 

I understand that my bearishness on HAIN ignores the roll-up story and all the hype surrounding the growth taking place in the organic market.  At best the UK business is seeing low single digit organic growth of 1-2 and high single digit operating margins.  We believe the UK business should trade at a significantly lower multiple than the U.S. business.

 

Our sum of the parts table is below:

 

HAIN – THE OPERATING MARGIN STORY IS OVER (Corrected) - Hain Chart 14

 


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


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