Weekly Issue: Renewed concern over trade is weighing on the market
Key points inside this issue:
- Getting the check on shares of Del Frisco’s Restaurant Group
- Rather than risk an options whipsaw in a volatile market, we’ll sit on the sidelines this week
Trump brings volatility back into the market
Volatility has returned to the market, not due to the March quarter earnings season, which in aggregate is shaping up so far to be better than expected but rather to the latest development on the US-China trade front. Over the weekend President Trump said he planned to increase tariffs on $200 billion of Chinese goods to 25% from 10% this Friday even as negotiations for a U.S.-China trade deal are set to resume on Wednesday. In addition, Trump threatened to impose 25% tariffs on an additional $325 billion of Chinese goods “shortly.”
Recall that at the start of this year Trump was poised to boost tariffs to the 25% level but opted to postpone such a move as the U.S. and China began to hold trade talks. The thing that makes this latest threat rather interesting is the reports that China and U.S. were close to a trade deal, with an agreement potentially as soon as this Friday.
As I noted several months ago, odds are Trump is using some of the tactics he laid out in his book, “The Art of the Deal.” One of those tactics is “use your leverage,” and this is the one Trump is likely employing with this weekend’s talk of tariffs following last week’s IHS Markit PMI data.
That data showed the China manufacturing economy slowing in April as its PMI reading fell to 50.2 for the month, down from 50.8 in March, and its new order component also slowed month over month. Per IHS Markit, “Data indicated that subdued sales largely stemmed from weaker foreign demand, as new export business fell for the second time in the past three months.” While the IHS Markit April PMI data for the U.S. also cooled compared to March, other indicators point to the domestic economy continuing to grow at or near 2%.
In my view, the likely scenario is Trump is “using his leverage” given the state of the Chinese economy to garner incremental concessions from China as the next round of trade talks begins later this week. We will see how this develops in the coming weeks, especially as the administration appears to be
My strong suspicion is this is all playing out like an episode of “The Apprentice” — as we near the last key segment of the show, the drama ramps up considerably ahead of the big reveal, which is pretty much what we suspected all along. In other words, I see this latest salvo by President Trump and ramping up the drama, and odds are we will see some forward progress on the US-China trade front.
Again, that is my suspicion and we don’t invest on suspicions, but rather on
The Eurozone gets another growth haircut
As if the latest act in the US-China trade war and recent economic data isn’t enough for you, yesterday the European Commission cut its growth forecast the EU in general and for Germany in particular and warned on the ballooning debt level for Italy. The EU now sees the 19-nation single currency bloc growing 1.2% this year, which is down from the already tepid level of 1.3% it called for in February.
The EU also warned that Italy’s public debt would balloon to a record of almost 134% of GDP in 2019 and grow even further in 2020 to 135% of GDP, well over commitments made to Brussels and more than double the EU’s 60% limit. Clearly, we haven’t heard the last of this, and let’s not forget with negotiations for the EU’s divorce with the UK stalled and no agreement in sight we run the risk of a no-go Brexit deal.
The moral of the investing story this week is that risks to the market’s vapid increase year to date in 2019 remain even though the March quarter earnings season is, so far, coming in ahead of expectations.
While former Intel CEO Andy Grove made “only the paranoid survives” famous, I still prefer this quote from Warren Buffett at times likes this – “Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it.”
Tematica Investing
The renewed concern over trade has weighed on the market in general and on shares of not only the Thematic Leaders but also those that reside on the Tematica Select List. As I discussed above, it’s too soon to tell if this is a real threat or something designed to prod the Chinese at the negotiating table. As usual, the herd is shooting first and asking questions later, which has rarely served long-term investors well. As we look at the majority of the Thematic Leaders and companies that have earned their place on the Select List, the thematic tailwinds continue to favor them.
Should the trade landscape change in a meaningful way – read that as Trump goes forward with the threatened tariff increase and/or China retaliates – then we will likely see expectations for economic growth and earnings be meaningfully reset. The likely knee jerk reaction will be for investors to flee multinational companies in favor of those whose businesses have greater exposure to domestic economy. Should this scenario come to pass, I’ll be focusing our thematic lens on domestic opportunities, but let’s wait a few days and see what happens. As always, the devil is in the details.
Getting the check on Del Frisco’s shares
Above I said the vast majority of Thematic Leaders are performing well thus far in 2019. One that has been under pressure of last has been Guilty Pleasure thematic leader Del Frisco’s Restaurant Group (DFRG). We’ve been patient with the company, which since December has been conducting a strategic review. However, following the company’s March quarter results that beat on the top line, but missed on EPS, we are exiting the name.
While the company saw comparable restaurant sales increase 1.3% during the quarter compared to year-ago levels, margins felt the impact of new location openings, which is slated to continue as DFRG expands its restaurant footprint in the coming quarters. Then there is the issue of the company’s strategic review. Per the earnings press release,
“… we are limited in what we can disclose or comment, but the Board is continuing to work with Piper Jaffray and Kirkland & Ellis in a diligent manner. No assurances can be made with regard to the timeline for completion of the strategic review, or whether the review will result in any particular outcome.”
Remember, this review began in December, and it’s been hinted that part of what’s been dragging the process out is multiple buyers for different pieces of Del Frisco’s. Our growing concern is that even if a partial or full M&A transaction arrives, given the margin prospects for the coming quarters any takeout premium could be modest at best.
Turning to Del Frisco’s balance sheet, the company had $4.6 million in cash at the end of the March quarter, down from $8.5 million at the end of 2018. Even after accounting for non-recurring items during the quarter, Del Frisco’s still delivered a net loss of $3.4 million for the quarter. And with new location openings expected to weigh on margins near-term, odds are the company will continue to bleed cash.
And that brings us back full circle to something that may be delaying a potential M&A transaction. A smart buyer will look to squeeze the company it wishes to buy in order to get the best possible acquisition price, which benefits not only the buying company’s shareholders but also the integration and cost savings process.
In my view, either of the above scenarios would be read as a disappointment given that inside the current DFRG share price there is likely some implied takeout valuation factor. Currently DFRG shares are trading at more than 12x enterprise value to 2019 EBITDA expectations vs. 11.2x for competitor Ruth’s Hospitality (RUTH).
To sum it up, I see the risks associated with holding DFRG shares mounting, with any resolution not likely to recoup the losses to date that we’ve endured. Better to get out now and minimize additional losses is my thinking.
- We are issuing a Sell on shares of Del Frisco’s Restaurant Group (DFRG) and removing them from the Thematic Leaders.
Tematica Options+
Last week we sat on the sidelines given the swings we saw unfolding in the market as the March quarter earnings deluge continued. This week we have more swings due to the new “wrinkle” in US-China trade talks. While I shared my suspicions as to what is likely to be happen, we don’t place trades based on hopes, fears or anything like that, but rather on homework, due diligence and thematics. Over the next few days, we run the risk once again of being stopped out rather quickly one way or the other should the drama build further.
Let’s sit on the sidelines, preserve our capital and strike when the time is right.
