Zoetis (ZTS)
The share price of Zoetis, the leader in the production and commercialization of animal health medicines and vaccines, is trading at a substantial premium to its standalone intrinsic value as a result of speculative optimism that a takeout of its shares might happen. Activist Bill Ackman’s near-10% stake in the 2013 spin-off of Pfizer (PFE) has investors believing a deal may be in the works, but there’s no real evidence of one. In fact, it appears investors are desperate to see something (anything?) happen: on June 25, for example, Zoetis leapt more than 10% immediately on unfounded rumors that Valeant Pharma (VRX) was putting together a bid. We don’t think a buyout of Zoetis is going to happen by Valeant or another company, at least anytime soon. On such a conservative down-to-earth view, shares of Zoetis are thus trading at nearly a 40% premium to a standalone intrinsic value estimate. We’re pretty comfortable with a fair value estimate in the low-to-mid $30s per share because Zoetis’ management has provided granular operating guidance for the next three years. In doing so, management is saying: “Look at our guidance! Don’t blame us if the stock tanks.” Investors may be sorely disappointed if a suitor doesn’t emerge; from our perspective, the risk/reward implies considerable downside.
McDonald’s (MCD)
McDonald’s is far past its prime. The executive suite is doing all that it can to salvage a positive fundamental trajectory, but the rapidity of the decline in sales is something that is hard to overlook. In the first quarter of 2015, consolidated revenue at McDonald’s fell a whopping 11%. Though revenue dropped just 1% on a constant-currency basis, the unadjusted figure is flat-out frightening for a business that is no longer resonating with its core customer. McDonald’s is in a world of hurt: Not only is its premium coffee competing with Starbucks (SBUX) on the high end and Dunkin Donuts (DNKN) everywhere else, but its lucrative breakfast operations are under attack. From Yum! Brands’ Taco Bell to Subway, almost every key player seems to be offering a breakfast option these days, with perhaps Chipotle the notable exception. But fast-casual is literally eating McDonald’s lunch! Franchisees at McDonald’s are extremely frustrated, and 17+ times current-year earnings is still too much for a company that may…dare we say…be in permanent secular decline. The best days are behind McDonald’s, and the dividend and buybacks are there to keep investor attention away from the real operating issues.
Kinder Morgan (KMI)
Kinder Morgan may go down in history as one of the biggest dividend flops ever–even bigger than SeaDrill (SDRL). For those that may not remember our call on Seadrill, it took nearly 3 years for our thesis to work out from the first public warning to its dividend cut. Of course we’re not pin-pointing a time for trouble to occur at Kinder Morgan, but rather we’re pointing out that its current situation is unsustainable—just as we did with SeaDrill a number of years ago. From our perspective, the potential for a share-price collapse following a dividend cut is significantly greater than the markets are factoring in. Our expectations of the company to achieve annual distributable cash flow (DCF) of ~$5 billion in 2015 may be greater than the $4.3 billion we expect it to shell out to shareholders in dividends for the year, but such a comparison completely ignores debt coming due and growth capital spending. “Total growth capital” spending, which includes acquisitions, is expected to be $7.3 billion for 2015 alone, and Kinder Morgan has long-term debt maturities of $715 million, $1.67 billion, $3 billion, $2.3 billion and 2.8 billion in 2015, 2016, 2017, 2018, 2019, respectively. A company with this debt and capital investment profile shouldn’t be paying a dividend at all. We think it’s just a matter of time before creditors clamp down; the debt cannot be repaid when almost every dollar generated from operations is going to shareholders in the form of dividend payments. Kinder Morgan’s debt capacity has to have a limit, and we believe the credit rating agencies have yet to fully digest the re-consolidation and the magnitude of future dividend obligations Kinder Morgan continues to promise investors. They’re astronomical.
Yum! Brands (YUM)
The owner of KFC, Pizza Hut and Taco Bell has a solid franchise, but its share price has rocketed too far too fast, perhaps on renewed speculation that it will spin off its Yum! China division into a separate entity, which may never happen. But while speculation fuels the share price advance, there are a few things we do know for certain. The fast-food environment in the US is cutthroat, and the trend toward fast-casual is a long-term secular dynamic, meaning recent progress by KFC and Taco Bell in the US market, albeit noteworthy, may not hold permanently. The firm’s KFC brand is perhaps the best restaurant growth story in China and India, and its growth ambitions may pan out as planned, but such a dynamic is certainly not unknown, and from our perspective, it has been more-than-factored into the stock price. At more than 25 times present-year earnings, Yum! Brands is certainly not connected to its fundamental dynamics. With Chinese equity markets collapsing, the implications on consumer spending in the country, the most valuable one for Yum! Brands, cannot be ignored. We don’t like the risk-reward.
Linn Energy (LINE) & Legacy Reserves (LGCY)
We’ve lumped these two together as one because the theme is similar. Linn Energy yields close to 15% at the moment, while Legacy Reserves yields close to 14%. If you think these dividend yields are sustainable at current levels, you are kidding yourself. These two may not cut their dividends tomorrow, but the odds are stacked against the resiliency of the payout. The market is simply not that inefficient, where such a dislocation in the form of these outsize yields would go unchecked. Results for both will improve (can they get worse?), but we’re not counting on the dividends to be sustained at present levels. Linn Energy lost $339 million in the first quarter of 2015, while Legacy Reserves lost $228 million in the same period, and we don’t think the recent fall in crude oil prices has yet to be factored into the models at both of these upstream MLPs. The announcement that Iran may flood the world with oil is not going to help them either.