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FLASHBACK | WAB: Adding Short Wabtec To Best Ideas List

Takeaway: Wabtec (WAB) has fallen over 30% since Jay Van Sciver made it a Best Idea Short.

Editor's Note: Our Industrials analyst Jay Van Sciver added Wabtec (WAB) as a Best Idea Short on February 20, 2015. Shares are down over 30% since he laid out his bear case. Here's an excerpt from his original note. For information on how you can subscribe to our institutional research email sales@hedgeye.com.

FLASHBACK | WAB: Adding Short Wabtec To Best Ideas List - z 3

 

Summary

While we might be a bit early, we believe that a short WAB position offers excellent exposure to the downcycle in resources-related capital spending.  Stating the obvious, railroads provide transport for bulk commodities.  The rapid growth in output for iron ore, shale oil, and many other commodities drove a boom in capital investment in rail transport infrastructure.  The gradual stagnation in bulk commodity output growth amid lower prices should drive global rail investment back toward long-run norms.  This one may not be quick, but the return opportunity appears significant, as we currently see a normalized valuation range for WAB between $40 and $60 per share.

 

We believe the valuation of WAB shares reflect a premium ‘growth industrial’ story, which we see as analogous to the mining equipment companies (JOY, CAT) in early 2012.  Back then, similar rationalizations based on population growth and aftermarket opportunities were employed to justify overvalued equity.  We view both rail capital equipment and mining capital equipment as GDP-ish growth deep cyclicals, not industries experiencing secular growth. 

 

FLASHBACK | WAB: Adding Short Wabtec To Best Ideas List - z wab 1

 

Risks

There are several risks to our view including a huge commodity price rebound, S&P index addition, and the potential for WAB to be acquired.  We would look to be long a cheaper industry player, or hedge appropriately, as discussed in last week's note.

 

For more information on how you can subscribe to our institutional research email sales@hedgeye.com.


About Everything | Warning: Earnings Smaller Than They Appear

Should we be worried about the rise of pro forma? 

 

Editor's Note: In this complimentary edition of About Everything, Hedgeye Demography Sector Head Neil Howe discusses the growing use of "pro forma" accounting and explains the broader implications for investors.

 

About Everything | Warning: Earnings Smaller Than They Appear - caution tape

WHAT’S HAPPENING?

There’s been a lot of hoopla so far this year about corporate America’s growing use of “pro forma” accounting—or its growing aversion to U.S. generally accepted accounting principles (GAAP), depending on how you think of it.

 

Sure, all public companies still have to comply with GAAP, the New Deal-era accounting playbook that ensures consistent tracking and reporting of vital financials. But firms are free to supplement their GAAP numbers with figures that aren’t required by SEC regulators.

 

These customized earnings reports go by many names—“pro forma,” “adjusted,” or simply “non-GAAP.”

 

Whatever nomenclature you prefer, these terms are a catch-all for the myriad ways companies may present a different picture than the one portrayed by their GAAP statements. Maybe a company wants to exclude taxes or regulatory fees that are not likely to reoccur again soon. Maybe they want to eliminate the effects of a currency shift. Perhaps they want to draw attention to an alternative metric not required under GAAP—such as operating earnings, EBITDA, or cash flow.

 

Undeniably, over the past two decades, more and more companies have flocked toward pro forma reporting. Back in 1996, nearly half (42%) of current S&P 500 constituents handed in only GAAP numbers. By 2006, that share had dwindled to just a quarter, and by last year, just 6% of S&P companies used GAAP exclusively.

 

About Everything | Warning: Earnings Smaller Than They Appear - neil1

 

Certain types of companies have long been in love with pro forma—especially young high-growth companies that have just gone public or financial companies with unusual valuation issues. That pattern still shows up today. According to one comprehensive sample of listed companies, tech companies continue to show the most pro forma adjustments by number (an average of eight per company in 2015) and financial companies show the most by dollar amount (roughly $40 billion in 2015).

WHAT PRO FORMA CRITICS SAY

What’s the problem with this shift toward pro forma accounting? Critics have no shortage of complaints.

 

Companies use pro forma to artificially boost earnings. Bloomberg analysis finds that 80 percent of S&P 500 tech firms used pro forma figures in order to revise their earnings higher in the most recent fiscal year. It’s not just Silicon Valley: More than half of the Dow Industrials did the same.

 

Herein lies the problem: Research has found that pro forma inflates net income by an average of 44% among profitable firms—and by a whopping 70% among companies reporting net losses. Funny how a more “accurate” non-GAAP view so often looks so much better than a GAAP view. Many analysts refer to pro forma earnings as “EBBS,” or “earnings before the bad stuff.”

 

Firms are “leaving out” more and more types of costs. When pro forma first became popular, most companies only removed costs that were clearly extraneous to the basic business proposition—because they were either a one-time hit (like a licensing fee) or a well-understood “external” item (like taxes). Today, virtually any charge—from restructuring costs to depreciation charges to pension expenses—can be removed as long as the CFO can make a plausible case for it. Accounting firm Sanford C. Bernstein finds that the average dollar amount of recurring charges held out of pro forma statements has never been higher.

 

Inevitably, the practice is spreading even among those who don’t care for it. If your hi-tech competitor sweeps stock options and IP amortization off the table when computing earnings, can you afford not to show a similar perspective to your own investors?

 

About Everything | Warning: Earnings Smaller Than They Appear - callout1

 

Adjusted earnings undermine the purpose of GAAP. Generally accepted accounting principles were adopted to ensure consistency; a manufacturing company would use the same measures and standards as a telecom provider, a trucking company, and everyone else. But pro forma earnings reports, by their very design, are inconsistent across companies and industries.

WHAT PRO FORMA SUPPORTERS SAY

Pro forma is not all bad. Plenty of analysts and executives feel that non-GAAP reports serve a vital purpose for investors and companies.

 

All information is good information. Remember: Pro forma isn’t replacing GAAP figures, but merely supplementing them. These adjusted reports add a layer of context to traditional earnings statements, giving investors a picture stripped of expenses (and earnings, mind you) that obscure the underlying business outlook.

 

Pro forma is a boon to young businesses. Start-ups routinely use “pro forma” assumptions to demonstrate their ability to generate a profit.  Even after these firms go public, their valuations are so weighted on future profitability that current GAAP earnings say little or nothing about how investors should value them.

 

 

Any GAAP alternative is fine by me. The strongest support for pro forma accounting comes from those who believe that GAAP is an archaic, outdated tool that needs replacing. Authors Baruch Lev and Feng Gu fall in this camp. They contend that GAAP prioritizes backward-looking indicators and all but ignores future growth potential.

 

Just think of a company like Amazon, which regularly falls short of earnings estimates and openly eschews profitability yet sees its share price skyrocket. Are all of those investors wrong, or does Amazon’s true value lie outside of what GAAP measures?

 

About Everything | Warning: Earnings Smaller Than They Appear - callout2

 

The pro forma camp holds that GAAP is rooted fundamentally in a 1930s materials-oriented economy that is passing away. GAAP was an appropriate way to assess company value back when goods producers like U.S. Steel were the tentpoles of American industry. But today? What’s the use of an accounting method that hinges so heavily on inventory and COGS (cost of goods sold) when a growing share of today’s star performers—from Facebook to Google—don’t sell goods at all?

BROADER IMPLICATIONS

Remember that the “earnings gap” widens during economic downturns. The gap between pro forma and GAAP earnings reached 23% in 2015, a yearly figure not seen since the Great Recession. In the first two quarters of 2016, however, this gap has started to close again.

 

About Everything | Warning: Earnings Smaller Than They Appear - neil2

 

About Everything | Warning: Earnings Smaller Than They Appear - neil3

 

In hindsight, it looks like select troubled sectors sent the gap soaring last year: S&P 500 energy companies had an estimated GAAP loss of $48 billion in 2015—but a gain of $45 billion in pro forma terms. Health care companies boosted their earnings by more than $50 billion using pro forma.

 

One interesting pattern we can observe since 1999 is that the gap seems to widen very late in the boom cycle and grow to maximum size during the following bust. In 2001 the gap peaked at just over 1.9 x GAAP earnings. And in 2008 it peaked at 5.6 x GAAP earnings. Explanation?  Late in a cycle, firms are tempted to downplay the earnings deceleration. And in a recession, they will do anything to stop the appearance of bleeding—including writing off their losses as a one-time catastrophe.

 

Late in 2015, the gap seemed to point to an impending repeat bust. The closing of the gap in 2016 may be taking us a step back from the brink. The next two quarters are worth careful watching.

 

Expect regulators to turn up the heat on pro forma abusers. The SEC is making accounting consistency one of its top priorities. In May, the SEC issued interpretive “guidance” on Regulation G (which allows publicizing pro forma numbers) warning firms against a variety of possibly noncompliant practices.

 

The guidelines are very explicit about what companies can and cannot do regarding pro forma presentation. Whether in press releases, earnings calls, or official SEC documents, GAAP figures must always be listed before any comparable pro forma figures. A company cannot refer to pro forma figures without disclosing that they are not GAAP numbers—for example, listing pro forma EPS as simply “EPS.” Pro forma metrics cannot even be listed in a more prominent font (larger, bolder) than GAAP numbers.

 

Nevertheless, there are companies that stretch these rules—and the SEC is going after them. Regulators have questioned at least 80 companies in recent months (with growing frequency of late) about their pro forma usage. Tighter oversight may be contributing to the closing of the pro forma earnings gap in 2016.

 

Get ready for growing support for a move to international accounting standards. The U.S. Financial Accounting Standards Board and the International Accounting Standards Board have been working since 2002 to find a way to merge U.S. GAAP with International Financial Reporting Standards (IFRS).

 

While the United States currently has no plans to switch over, such a move would enable companies to better convey underlying growth than GAAP allows. (IFRS is a principles-based system that gives firms more flexibility to include or exclude items than does the rules-based GAAP.)

 

To be sure, IFRS seems a tough sell for SEC regulators who want explicit rules in place for every contingency. But it’s an attractive and flexible alternative to the unstandardized world of pro forma accounting.

TAKEAWAYS

  • More and more companies are issuing adjusted earnings reports that have been proven to inflate income. While critics say that companies are using pro forma to paint a falsely positive picture, supporters believe that anything would be better than our outdated GAAP system.
  • There is growing tension between the SEC and listed firms over how earnings may be defined and publicized. The apparent impossibility of pushing earnings back into the GAAP bottle means that some non-punitive solution—whether it’s a loosening of pro forma rules or a move to international accounting standards—will eventually be needed.

3 Charts: Don't Buy Equity Market All-Time Highs

Takeaway: As consensus macro piles into the S&P 500, total equity market volume is crashing and the VIX hits a disquieting level.

3 Charts: Don't Buy Equity Market All-Time Highs - consensus cartoon 06.21.2016

 

Sell low, cover high, baby!

 

That's the latest expressed by consensus macro positioning as the S&P 500 hit a new all-time high last week.

 

"The S&P 500 (index + E-mini) net LONG position ramped another +94,526 contracts last week to +154,009 futures & options contracts. To put that in context, that’s a +2.37x move on a 1-year Z-score (at the lows in February, it was a net SHORT position of -280,000 contracts)," Hedgeye CEO Keith McCullough writes this morning.

 

3 Charts: Don't Buy Equity Market All-Time Highs - positioning

 

On a related note, a no confidence vote for the all-time high came by way of total equity market volume which crashed -23% versus its 1-year average on Friday:

 

3 Charts: Don't Buy Equity Market All-Time Highs - volume 7 25

 

Volatility?

 

The VIX is registering a foreboding level. As Hedgeye U.S. Macro analyst Christian Drake pointed out in Friday's Early Look:

 

"In the Chart of the Day below we simply show VIX vs S&P500 (S&P500 is inverted on right axis). What you’ll simply notice is how simply effective it is to take down gross exposure and tighten net exposure when VIX goes <13."

 

#Simple

 

3 Charts: Don't Buy Equity Market All-Time Highs - 7 22 16 CoD2

 

None of this bodes well for the bulls blindly buying the all-time high. 


Hedgeye Statistics

The total percentage of successful long and short trading signals since the inception of Real-Time Alerts in August of 2008.

  • LONG SIGNALS 80.65%
  • SHORT SIGNALS 78.63%

Daily Market Data Dump: Monday

Takeaway: A closer look at global macro market developments.

Editor's Note: Below are complimentary charts highlighting global equity market developments, S&P 500 sector performance, volume on U.S. stock exchanges, rates and bond spreads, key currency crosses, and commodities. It's on the house. For more information on how Hedgeye can help you better understand the markets and economy (and stay ahead of consensus) check out our array of investing products

 

CLICK TO ENLARGE

 

Daily Market Data Dump: Monday - equity markets 7 25

 

Daily Market Data Dump: Monday - sector performance 7 25

 

Daily Market Data Dump: Monday - volume 7 25 16

 

Daily Market Data Dump: Monday - rates and spreads 7 25

 

Daily Market Data Dump: Monday - currencies 7 25

 

Daily Market Data Dump: Monday - commodities 7 25


CHART OF THE DAY: The Beta Chase Is On!

Editor's Note: Below is a brief excerpt and chart from today's Early Look written by Hedgeye CEO Keith McCullough. Click here to learn more.

 

"... Looking at last week’s futures & options (CFTC) positioning, the Beta Chase is not an exaggeration: 

  1. SP500 (Index + E-mini) net LONG position increased by +94,526 contracts to +154,099 contracts
  2. The 6-month and 1-year average net positions are net SHORT averages of -54,383 and -100,426 contracts
  3. The current net LONG position registers a z-score of +2.37x (that’s the biggest in all of Global Macro)"

 

CHART OF THE DAY: The Beta Chase Is On! - 07.25.16 chart


REPLAY! This Week On HedgeyeTV

Our deep bench of analysts take to HedgeyeTV every weekday to update subscribers on Hedgeye's high conviction stock ideas and evolving macro trends. Whether it's on The Macro ShowReal-Time Alerts Live or other exclusive live events, HedgeyeTV is always chock full of insight.

 

Below is a taste of the most recent week in HedgeyeTV. (Like what you see? Click here to subscribe for free to our YouTube channel.)

 

Enjoy!   

 

1. Why I Remain An Unrepentant Bear (7/23/2016)

 

 

This is an excerpt from a special presentation Mike O’Rourke, Chief Market Strategist at Jones Trading gave to Hedgeye’s 2016 summer intern class. In this clip, O’Rourke discusses current market and economic conditions, and why he believes myriad market risks are conspiring against a continued bull market run.

 

2. 4 Stocks Hurt By The Retail Slowdown (7/22/2016)

 

 

In this excerpt from The Macro Show, Hedgeye Retail analyst Alec Richards and Macro analyst Ben Ryan discuss the companies most vulnerable to the ongoing retail slowdown.

 

3. About Everything: The Decline of the Film Industry & Its Investing Implications (7/21/2016)

 

 

In this complimentary edition of About Everything, Hedgeye Demography Sector Head Neil Howe discusses why the movie industry is in decline and breaks down the broader implications for investors.

 

Click here to read the associated About Everything writeup.

 

4. Macro Meets Micro: Behind The Bursting Biotech Bubble (7/21/2016)

 

 

In this excerpt from The Macro Show earlier today, Hedgeye CEO Keith McCullough and Healthcare analyst Andrew Freedman discuss the macro and micro fundamentals behind the bursting biotech bubble.

 

5. REPLAY | Q&A with Tom Tobin - What to Expect in Healthcare (7/18/16) 

 

CLICK HERE TO ACCESS THE ASSOCIATED SLIDES.

 

**Johnson & Johnson (JNJ) reported this morning and set the quarter's tone for the rest of Healthcare.

 

Hedgeye Healthcare Sector Head Tom Tobin and analyst Andrew Freedman were the studio today to discuss specific implications for ATHN, AHS, MDRX, ILMN, ZBH, HOLXand MD. Tom and Andrew recapped last week's Themes Presentation, which included a comprehensive overview of our #ACATaper and Healthcare Deflation themes with new datasets and analysis.

 

6. McCullough: Buy The All-Time High? (7/18/2016)

 

 

In this excerpt from The Macro Show this morning, Hedgeye CEO Keith McCullough cautions subscribers and advises what investors should consider as U.S. equities hit an all-time high.


Early Look

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