Investing Ideas

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Screen Shot 2018-12-03 at 3.57.09 PMUnited Natural Foods, Inc UNFI completes SVU acquisition- lowering PO to $24 on increased risksScreen Shot 2018-12-03 at 3.57.19 PM.png



12/01/18 07:02 AM EST
INVESTING IDEAS NEWSLETTER
Takeaway: RRC, GPS, RDFN, AVLR, UNFI, SGRY, DE, FL, MCHP, GWW

Below are analyst updates on our ten current high-conviction long and short ideas. Please note that we added Redfin (RDFN) and Gap Inc (GPS) to the short side this week. We removed Tesla (TSLA).

IDEAS UPDATES

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Range Resources (RRC) remains the only long on Investing Ideas.

Front month natural gas prices closed at ~$4.50 per MMbtu this week. Inventories drew by 59 Bcf during the week ended 11/13 and now sit 19% below the 5-year average. The 2019 Henry Hub strip is currently sitting around $3.15.

We continue to like the near-term macro set up for natural gas equities and think RRC is the best way to play that view.

The equities have discounted the rise in natural gas prices, but we think eventually the macro will sync with the securities – at ~$3.15 natural gas and $50 oil we value RRC at $25 – $30/share.

At ~15/share, RRC today is pricing in $50 oil and $2.50 Henry Hub.

Screen Shot 2018-12-01 at 6.54.35 PMThe Oil Gusher #323 Accounting matters? 2019 will tellScreen Shot 2018-12-01 at 6.53.47 PM.pngScreen Shot 2018-12-01 at 6.53.57 PM.pngScreen Shot 2018-12-01 at 6.54.06 PM.png

 


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United Natural Foods (UNFI) is down 50% since we recommended it as a short in Investing Ideas on June 28th. It fell approximately 5% today.

Our analyst has no additional update this week.

 

Takeaway: We added UNFI to Investing Ideas on the short side on 6/28.

Stock Report: United Natural Foods (UNFI) - HE UNFI table 07 11 18

THE HEDGEYE EDGE

In the most recent quarter, we witnessed a complete break down of United Natural Foods (UNFI). The break down came in many places:

  1. The management team
  2. The income statement
  3. The balance sheet and cash flow statements

The break down from the management team came at the end of the earnings call when they were finally put to the test about the new guidance and the Q3 accounting change. The center of the controversy was a non-cash accounting change for the accrual for inventory purchases which benefited gross margin by 78bps and EPS by $0.27 in Q3.

The following is a truly remarkable exchange between a management team that was trying to hide a break down in the business from the Wall Street community:

Edward Kelly of Wells Fargo says: “your guidance went up by about $0.10 and you did not previously contemplate a $0.27 benefit from the accrual change, which basically suggests that the guidance went down by about $0.17…Is that the shortfall in Q3? And is that related to the underlying gross margin? Just some color there I think will be helpful for us.”

At this point of the call, UNFI CFO Michael Zechmeister, was asked numerous questions about an accounting change and was struggling to figure out how to get out of the mess, so he could only repeat what Ed stated: “I think what you suggested is $0.27 in Q3, is that what you’re asking?”

Then Edward Kelly of Wells Fargo had to ask the question again: “Well, $20.9 million in incremental EBIT wasn’t contemplated in the guidance when you gave it last quarter, right? That’s about $0.27. You’ve raised by $0.10, so it implies about a $0.17 shortfall and I’m just kind of curious as to what’s driving that?”

At this point the CFO has a complete break down when he says “Yes, I’m not sure that we see it that way. We see it more as a timing issue than it is anything else.”  And then when pushed again, Mr. Zechmeister could only repeat himself: “Well, yes. I’m not sure we look at it that way. And I think that the color that we provided in our script is the color.”

At the end of this exchange, a rational person can only conclude that management was trying to cover up a massive decline in gross margins stemming from significantly higher inbound freight costs, inefficient distribution centers and higher labor costs.  Did the management team of UNFI think shareholders and the broader Wall Street community were going to reward them by making a non-cash accounting change?

Getting past management trying to cover up a break down in the income statement, the cash flow and balance sheet are also showing signs of significant stress.

GROSS MARGIN IS DETERIORATING

Gross margin is where all the drama is, as stated above, management tried to slip in a positive $20.9M change in accounting for its revised calculation for its accrual for inventory purchases. UNFI took the benefit mostly from the first 9 months of FY18 and some from FY17 to positively impact a single quarter, and expects the street to run-rate gross margins at this new elevated level.

In reality, excluding this non-cash accounting adjustment, gross margins actually declined 84bps (management trying to pitch GM’s down just 6bps) versus consensus estimates expecting a decline of 35bps, this is a huge miss! If you wanted to be generous (we aren’t feeling generous this morning) you could spread the credit for the accounting adjustment across the first three quarters of the year it would be a $7M impact per quarter and would have brought gross margin in 3Q18 to 15.1%, down 32bps YoY.

UNFI is facing long-term structural headwinds to gross margin, headlined by the customer mix shift to lower margin customers, Whole Foods and Conventional. Whole Foods has grown 373bps YoY as a percent of sales from 33.7% of sales in 3Q17 to 37.4% of sales in 3Q18, and is headed north of 40% of sales over time. While sales to independent customers (higher margin customer) are down 182bps YoY as a percent of sales to 25.1% of total sales. Independents will continue to shrink and we believe this customer segment will struggle longer-term in an increasingly price competitive food retail environment.

This all bleeds down to their EPS guidance where this accounting change benefited them by $0.27, which actually implies a reduction in guidance of $0.17 not the growth in guidance of $0.10 that management is trying to sell to investors.

Stock Report: United Natural Foods (UNFI) - unfi gross margin

BALANCE SHEET IS FALLING APART LEADING TO CASH FLOW PROBLEMS

Total working capital for UNFI was up 18% YoY in Q3, compared to sales growth of just 11.8%, due primarily to a growth in inventories as UNFI deals with increasing customer demand and suppliers that can’t keep up. This increase in inventory is leading to a deterioration in free cash flow, which was -$34.2M.

This business is truly falling apart across the financial statements. UNFI is turning into a long term structural short in which margin upside will prove very difficult given the customer mix shift and pricing pressure headwinds.

Stock Report: United Natural Foods (UNFI) - unfi free cash flow

ONE-YEAR TRAILING CHART

 


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We see more than 50% downside in Surgery Partners (SGRY) and believe they are poised to miss street estimates in 2019 despite the recent capital raise to keep the roll-up machine running. 

Leverage is running near an all-time high at ~9x Adjusted EBITDA in the last quarter and free cash flow remains elusive despite a significant acceleration in same-unit growth to 11.4% in 3Q18, which also makes us skeptical that the same-unit number is even real.  Meanwhile, weak guidance and utilization commentary out of the major labs DGX and LH, suggest that the seasonal utilization pick-up into year-end may fall short of the lofty assumptions embedded in management’s 4Q18 guidance.

Screen Shot 2018-12-01 at 7.04.33 PMSurgery Partners, Inc Takes from the call- updating our modelScreen Shot 2018-12-01 at 7.04.42 PM.png

Takeaway: We added SGRY to Investing Ideas on the short side on 7/26.

Stock Report: Surgery Partners (SGRY) - HE SGRY table 08 13 18

THE HEDGEYE EDGE

Surgery Partners (SGRY) is a bad house in a great neighborhood. While we like the macro trend of inpatient surgeries moving to low-cost ambulatory surgical centers (ASCs), Surgery Partners is not the horse we want to bet on.

INTERMEDIATE TERM (TREND)

We question how well SGRY is positioned to benefit given current case mix, geographic exposure and limited number of joint ventures with a health system.

Consider the following:

  • 38% of SGRY’s case volume is low-margin, government pay business at 38%… this compares to only 19% across the industry.
  • Only 13% of surgical case mix is high-margin orthopedic procedures, compared to 31% and 43% for SCAI and USPI, respectively
  • There are major competitors within a 20-minute drive of 75% of its facilities.
  • Surgery Partners’ facilities are primarily located in secondary markets with just 16% of the company’s facilities located in the top 25 metropolitan statistical areas (despite the top 25 MSAs representing 67% of the U.S. population)… this compares to 27% for USPI/THC

We also believe a significant portion of case volume will be captured initially by ASCs that have a financial relationship with hospitals, making it difficult for SGRY to keep or grow their market share without having to give away additional equity. ASCs account for 54% of outpatient visit volume but only 23% of charges. In other words, a significant amount of volume is done in hospital outpatient departments (HOPD).

The easiest fix for SGRY is to buy high quality facilities and divest low quality ones. However, competition for deals continues to increase, as well as the multiples paid, and SGRY does not have the balance sheet to accelerate the pace of acquisitions after NSH. The company has a risky capital structure for equity investors with debt to equity at 319% and common equity 18% of enterprise value. Given the high debt levels the focus should be on deleveraging, however, doing so will come at the cost of growth and missed estimates.

CMS has expressed an interest in adding Total Knee Arthroplasty (TKA) to ASC covered procedure list, with a proposed change coming as soon as 2019. However, the fundamental impact to SGRY will be limited as only ~20%* of SGRY’s 125 facilities are equipped to do joint replacements, and claims data reveals that none of their facilities in Florida are currently performing partial knee.

BOTTOM LINE

SGRY’s ASC portfolio is low quality compared to peers USPI/THC and SCAI/UNH, and it does not have the balance sheet capacity to make the acquisitions necessary to improve payer and case mix. Meanwhile, we are several years from total joint procedures being a large enough percentage of total ASC case volume to have a meaningful fundamental impact, despite the favorable policy environment.

From a valuation perspective, we question how much common equity value there is given SGRY’s indebted capital structure and lack of free cash flow after minority interest obligations. The company is not earning cost of capital, has limited liquidity and looming debt obligations.

We see 50%+ downside from current levels.

ONE-YEAR TRAILING CHART

 


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“Something is amiss in the case of Avalara (AVLR),” writes Hedgeye Tech analyst Ami Joseph. “We found so much hair in this process that we couldn’t stomach being LONG a stock like this even though it typically falls right into the sweet spot of our Long idea generation.”

The chart below shows a strange annual reversal in the source of incremental revenue. In the beginning of the year, it appears that revenue from new customers dominates the mix, but by year end, revenue from existing customers dominates the full year mix.

While we think we understand the boost to ‘existing’ based on year-end pricing and year-end transaction tallies that re-state backward contracts, why would implied revenue from new customers plummet in 4Q or even maybe partially reverse?

ONE-YEAR TRAILING CHART


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Below is a note from CEO Keith McCullough on why we added Redfin Corp (RDFN) to the short side of Investing Ideas this week:

Every once in a while we get lucky and the Old Wall slaps a “buy” on something we didn’t think would bounce back…

That’s what happened this week with one of Josh Steiner’s favorite US Housing Shorts of 2018, Redfin (RDFN).

Here’s Steiner and Drake’s Institutional Research take on the recent quarter (that rightfully crushed the stock!):

  • Core top line growth has slowed considerably since the IPO and is projected to slow further in 4Q18.
  • Loss guidance for 4Q is 3x what the Street was expecting (18-20 cents vs expectations for 6 cents).
  • The Housing market weakened further just recently with bookings growth for Nov/Dec down from what was seen in Sep/Oct.
  • The company plans to quadruple ad spend in 2019, up from $12mn in 2018 to $40-60mn in 2019.

ONE-YEAR TRAILING CHART



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Below is a note from CEO Keith McCullough on why we’re adding GAP (GPS) to the short side of Investing Ideas this week:

I guess consensus concern is that the low-quality Retailers are going to “not go down again”…

After going down hard earlier in the month, our Retail Sector Head Brian McGough and his team remain in the camp that these stocks can and will go down.

On Gap Inc (GPS) in particular, he doesn’t think GPS’s Q4 numbers are doable, and they’ll be setting up for a round of store closures.


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One of our favorite shorts remains Deere (DE).

We expect total North American agricultural equipment sales to drop roughly 2/3s from peak to trough. Newer downside drivers appear likely to come from tightening credit, decreasing land values, declining farm equity, and lower crop prices.

As those factors influence equipment sales, we expect FY18 estimates to move downwards and FY19 estimates to move below FY18.

Screen Shot 2018-12-01 at 7.19.44 PMDeere & Co Plenty of aces up Deere’s sleeve heading into 2019Screen Shot 2018-12-01 at 7.20.11 PM.png

 


Takeaway: We added DE to Investing Ideas on the short side on 10/3.

Stock Report: Deere (DE) - HE II Tables DE

THE HEDGEYE EDGE

We see DE as a highly cyclical capital equipment supplier to a mature, zero growth industry. Deere’s key, high margin franchise is large, North American ag equipment. Prior to 2014 or so, that market experienced a decade long surge in equipment sales, driven by soaring crop prices, increasing land values, and comparatively easy credit.

Since the peak, these factors have begun to roll over. We expect the hangover – elevated new & used equipment inventories, excess manufacturing capacity, tightening farm credit, and declines in farmer equity – to be a prolonged affair that gradually takes equipment sales below ‘normalized’ demand.

As investors price in the reflexive unwind in this commodity-related capital equipment industry, we expect to see another ~30-40% relative downside in shares of DE.

INTERMEDIATE TERM (TREND)

Foreign crop prices surged last year helping drive Deere’s South American equipment sales and we vastly underestimated the impact of that on Deere, an omission bulls should not repeat on the way down. Corn tends to lead unit sales in Brazil by 4-5 months, so the downswing here should start to be impactful shortly.

We expect total North American agricultural equipment sales to drop roughly 2/3s from peak to trough. Newer downside drivers appear likely to come from tightening credit, decreasing land values, declining farm equity, and lower crop prices. As those factors influence equipment sales, we expect FY18 estimates to move downwards and FY19 estimates to move below FY18.

LONG TERM (TAIL)

Deere is not an acquisitive company, and this Wirtgen deal is a major strategy shift. If Ag Equipment was about to surge back, why wouldn’t DE go after a big Ag and Turf acquisition? Exiting both a core market and a supposedly winning strategy is not a great idea, especially when the deal’s valuation rationale is explained via 2022 synergies. While some saw it as a positive, accretive development, we see it as a piece of confirming evidence that DE cannot rely on its core Ag equipment market as the down-cycle continues.

ONE-YEAR TRAILING CHART



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Foot Locker (FL) has continued to trade up week-over-week, adding $3 after the positive stock reaction on the 3Q18 earnings release.

Nike and Adidas got better in the US in 3Q, so we saw FL comps improve, but EBIT was still down 13%.

The big issue here is the long term trajectory of earnings. There is still rising SG&A pressure, from a decade of under-investment as higher Nike penetration drove its traffic.

And there is gross margin pressure from rising ecommerce penetration, and flat to down Nike penetration.  That means to grow earnings in 2019, FL will likely have to comp about 5%+.  We don’t think that is a reasonable assumption given how the brands are growing around the traditional wholesale channels like FL doors.

In the coming years Nike’s DTC growth will accelerate, and FL will see more and more comp pressure which means continued downside in earnings.


Takeaway: We added FL to Investing Ideas on the short side on 3/26.

Stock Report: Foot Locker (FL) - HE FL table 04 04 18

THE HEDGEYE EDGE

Nike is sitting at an unhealthy 67% of Footlocker’s (FL) sales. The ratio is dangerously high despite having come down from 73% three years ago. The Board’s risk management process should be called into question for even allowing this to happen. Regardless, the reversal of this trend should cost FL $2 in EPS, while the Street is looking for 10%+ earnings growth.

The bull case revolves around ‘the stock being cheap.’ But the numbers are simply wrong. Yes, the stock is trading at just 11x consensus estimates…but all value traps look cheap, until they’re more expensive at a lower price.

INTERMEDIATE TERM (TREND)

The latest guide down is unlikely to be the last. Nike is recovering on its own, but not enough to allow FL to grow. FL’s rents are going up 5-6% despite a lower rent structure for retailers.

Also, the ‘brand heat’ associated with Adidas does not accrue to FL’s benefit. In other words, if you substitute a Nike shoe ($160) with an Adidas shoe ($120), then you sell the same number of units, but at a lower price point. It takes sales lower.

Nonetheless, no story is linear – this will be a two steps forward and one step back story – and Nike will dictate which direction those steps take.

LONG TERM (TAIL)

Nike decided to push product into FL a decade ago, taking the share of Nike product as a percentage of Footlocker’s overall sales from 40% to over 70%. Meanwhile, Nike used the excess cash flow to build the infrastructure to ultimately go around Foot Locker with its own Direct-to-Consumer (DTC) strategy.

During that time period, FL’s comp sales, traffic, ticket and virtually all sales metrics were up 5-10% consistently – and all of that happened in a declining mall traffic environment. This drove store productivity from $300/ft to $600/ft, and took margins from 6% to 12%. In other words, instead of using Nike-driven earnings to invest in it’s model, FL ‘flowed through’ the excess earnings to shareholders. That’s fine in part, but not to the extent that FL did.

As Nike takes the FL ratio closer to 50%, we should see sales productivity approach $500/ft, and margins deleverage by 300-400bps. This results in earnings of $2.80-$3.00 while the Street is looking for EPS over $5.00. That’s a severe problem.

ONE-YEAR TRAILING CHART


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No update this week on Microchip Technology from our Tech analyst Ami Joseph.

Takeaway: We added MCHP to Investing Ideas on the short side on 10/17.

Stock Report: Microchip Technology (MCHP) - HE MCHP table 10 31 18

THE HEDGEYE EDGE

Microchip isn’t Microchip anymore. You can’t own Microchip Technology(MCHP) for industrial HPA like performance with organic growth, singular focus on share gains in large markets, and innovation curves that continue to prove out.

The organic share gains are done, the second biggest revenue category is a creation of Analog Frankenstein that doesn’t grow much, and Microsemi Corp(MSCC), now at ~30% of revenue, will be dilutive to the growth rate of the entire entity. The long game of fixing vertical analog product inside a general purpose company is not a no-brainer fix and maybe hasn’t really been done successfully in the past. Investing, healing, and re-growing individual product lines wrapped up in the MSCC mess will take some time. In addition, capital intensity and taxes seem to remain as surprise factors.

The nose dive implied here is a shift of investors who used to own MCHP as a proxy for LLTC, knowing that cash flow would come their way in increasing ways (via dividend) and that they could confidently buy short term inventory led equity value contractions. But they can’t own MCHP for those things anymore as MCHP downshifts growth rate, mix of businesses, balance sheet, and strategy into a ‘tier 2’ type category more exemplary of ON Semiconductor Corp (ON), STMicroelectronics (STM), and NXP Semiconductors (NXP).

INTERMEDIATE TERM (TREND)

The June quarter was the first negative year-over-year volume growth print in a long time after a healthy cycle suggesting a classic post cycle peak is now in the rearview. Management is now tempering outlook expectations, which typically takes 2-3 quarters to sort through to lower EPS with gross margin compression inevitably realized last.

Furthermore, a new lawsuit was filed (see filing HERE) by the former CEO of Microsemi Corp, which Microchip Technology acquired earlier this year. Details of spurious distributor programs, channel stuffing, and a failure by MCHP execs to access major sections of information in the data room during the due diligence process creates an open invitation for lawsuits against MCHP (if true).

Essentially, the plaintiff is claiming that the surprises that MCHP have been discussing in earnings calls, were all there in plain sight, if only MCHP had actually performed normal due diligence.

BOTTOM LINE

Microsemi’s trailing 5 year revenue CAGR is in the -1% to +1% zone. However, if we read MCHP CEO Steve Sanghi’s comments right, and if we read Jimmy P’s unwitting confessions right in the defamation lawsuit, even this putrid growth rate was over-stated thanks to creative inventory programs with distributors which unnecessarily extended weeks of inventory in the channel.

Depending on which MCHP comment is most relevant, management has talked about 1.5+ to nearly 3 months of excess channel inventory, which might imply something like a half-week to one week of extra shipment per year, or a 100bp to 200bp growth adder per year…oh boy.

The defamation lawsuit is bad news for both Jimmy P/MSCC as well as Steve/MCHP. The ongoing disclosure and legal tit for tat only helps the Shorts as more disclosure, in this case, as well as allegations of securities fraud, may rise in volume in the headlines. Jimmy P’s conspiracy theory is not totally without merit. What if Steve is removed from his position? This does not end well.

We think there is still an additional -25+% downside from current levels.

 

ONE-YEAR TRAILING CHART


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If you are in the market hunting for single stock short ideas to add alongside your Industrials (XLI) short position, look no further. Hedgeye Industrials analyst Jay Van Sciver remains The Bear on Grainger (GWW)

As Van Sciver recently wrote:

“Grainger remains a remarkable example of a company whose core problem, price compression leading to margin compression, somehow became the solution.  Cutting prices to a ‘relevant’ level likely just pulls forward some of the erosion that would otherwise have set in more gradually.”

Takeaway: We added GWW to Investing Ideas on the short side on 5/10.

Stock Report: W. W. Grainger (GWW) - HE GWW table 05 24 18

THE HEDGEYE EDGE

We had been waiting for an opportunity to re-enter a short position in Industrial Supply, and the recent squeeze/rally in shares of W.W. Grainger (GWW) provided such an opportunity.

While many focus on the competitive threat posed by Amazon Business and its ilk, accelerating competitive intensity from independent suppliers and other larger distributors have principally generated headwinds in the last few years.

We believe the volume ramp at GWW has been misattributed to the company’s sales restructuring and market strategy, with the credibility of turnaround efforts likely to suffer later this year.

Distributors will be comping a strong 2H17, supported by tax reform and hurricanes, with headwinds from a decelerating economic backdrop, delayed pricing, high expectations, and cost pressures.

Stock Report: W. W. Grainger (GWW) - gww

While valuation of GWW bakes in ongoing favorable growth and performance, data continues to support views that the Industrial Distributor market is being disrupted from many different directions.

From resilient independent distributors, to pricing transparency, to competitive entrants, we doubt that the legacy distributor model will prove relevant in coming years. The traditional industry moats are drying-up as customers see an opportunity to switch to competitors. In short, structural pressures are intensifying competition from all sides, while longs cling to the myth of under-penetration.

We believe that persistent gross margin pressure will preclude equity outperformance, and that recent share price outperformance is an opportunity to enter a well-supported structural short. We expect GWW shares to give back their recent gains and resume long-term underperformance as structural pressures leave the company ‘stuck in the middle’ as margin is wrung from Industrial Supply.

We see greater than 30% downside in GWW shares. Typically, shorting squeezes is an effective strategy in names like GWW.  The shares are far from cheap, and cheap usually gets cheaper in broken industries.

Stock Report: W. W. Grainger (GWW) - gww32

ONE-YEAR TRAILING CHART

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