Paired Trade: Sell DineEquity, Buy Hormel

This is the 7th in a series of ideas where I contrast a cheap security with an expensive one that otherwise shares some characteristics. So far, I am 5 for 6:

		BUY	SELL
		MPR	NLC
13-Mar		7.30	11.99
8-Jul		10.17	15.45
		39.3%	28.9%	5.2%
		JNJ	AGN
17-Apr		53.05	49.49
8-Jul		57.08	46.10
		7.6%	-6.8%	7.2%
		COLM	UA
1-May		30.36	24.00
8-Jul		30.30	20.89
		-0.2%	-13.0%	6.4%
		BCR	ISRG
8-May		73.52	158.77
8-Jul		74.76	145.18
		1.7%	-8.6%	5.1%
		EZPW	AAN
5-Jun		13.09	32.85
8-Jul		10.19	28.68
		-22.2%	-12.7%	-4.7%
		SCVL	PSS
19-Jun		12.04	14.38
8-Jul		12.55	13.31
		4.2%	-7.4%	5.8%

For reference:

• 3/14: Buy Met-Pro (MPR), Sell Nalco Holding (NLC)
• 4/18: Buy Johnson & Johnson (JNJ), Sell Allergan (AGN)
• 5/3: Buy Columbia Sportswear (COLM), Sell UnderArmour (UA)
• 5/10: Buy C.R. Bard (BCR), Sell Intuitive Surgical (ISRG)
• 6/6: Buy EZCORP (EZPW), Sell Aaron's Rents (RNT)
• 6/20: Buy Shoe Carnival (SCVL), Sell Collective Brands (PSS)

  Similar to each of the trades above, my idea today is one that allows the investor to go "up in quality". I have liked Hormel (HRL) since Thanksgiving - check out my views back then. The stock is in my own portfolio and has been a "staple" in both my model portfolios, the Top 20 (up over 29% YTD) and Conservative Growth/Balanced (up almost 11% YTD). The bullish thesis is that the company is extremely well managed, has a good balance sheet (great for the industry) and has strong prospects for EPS growth despite the weak economy as input costs fade. The other side, DineEquity (DIN), is the operator of Applebee's and IHOP. I don't know the story that well, but clearly the company is extremely leveraged. I recall not liking either of the companies before and don't see how the combination makes for a better company. This trade benefits from the shift from restaurants to home-prepared meals. Check out the tape:

  	HRL	DIN
  Price 7/9/09	34.09	31.86
  Market Cap (mm)	4578	560
  Enterprise Value	4716	2715
  2009 YTD Price Return	10.0	175.6
  2008 Price Return	-23.2	-68.4
  Income Statement
  Sales (ttm)	6824	1545
  Sales growth ttm	7%	85% (post-merge)
  Sales growth mrq	0%	-15%
  EBITDA (2008)	612	259
  EBITDA Margin 2008	9.0%	16.8%
  Pre-tax Margin 2008	7	3.4
  Avg Pre-tax Margin 2005-2007	7.5	21.0
  FCF (2008)	286	166
  Balance Sheet
  Equity	2105	266
  Tangible Equity	1340	-1384
  Cash	312	98
  Cash/Equity	14.8%	36.8%
  Total Liabilities	1528	3008
  ST Debt	100	18
  LT Debt	350	2235
  Net Debt/Cap	5.4%	85.5%
  Liabilities/Current Assets	1.0	8.8
  Liabilities/EBITDA	2.5	11.6
  Liabilities/FCF	5.3	18.1
  Valuation
  PE F12M	14.1	15.0
  EV/EBITDA	7.7	10.5
  EV/Sales	0.7	1.8
  (EV/Sales)/Pre-tax Margin	9.2	8.4
  P/B	2.2	2.1
  P/TB	3.4	-0.4
  FCF/Market Cap	6.7%	35.9%
  Dividend Yield	2.22%	0.00%

  DIN could work out great if they can grow their way out of their debt, while HRL seems very reasonable without any requirements of much growth (though I expect it to grow).

  Disclosure: Long HRL

Comments

[FredMertz:]

How can you recommend shorting a stock, when you "don't know the story that well," but you "recall not liking either company"?

Do you really feel comfortable recommending a trade on a widely read website that you really seem to know very little about?

Also, this is not a pair trade. This is two separate trades of two companies that have nothing to do with each other.

Jul 10 05:51 AM

[Alan Brochs...:]

I don't believe that I recommended shorting DIN. I know the story well enough to share my idea, but I want to admit that I haven't fully researched DIN (as I have done for HRL). That allows the reader to quickly realize I may be missing something, which is always the case anyway!

I do feel comfortable pointing out valuation differences that seem extreme to me as well as highly contrasted approaches to capital allocation.

While this isn't a sell XOM buy CVX type of pair that is so obvious that even Ethel would see it, both companies are involved in the same "food chain". As I mentioned, I expect a continued move by consumers from the restaurant to the grocery store, and I can't think of too much of a better testing ground than IHOP or Applebee's, given their low-end appeal.

Jul 10 07:41 AM

[107Sid:]

Alan! Alan! At least you admit that your knowledge of DINEequity is limited and essentially you're shooting from the hip. In the past four months the stock has increased more than five-fold and you could have made the same arguement back in March when the stock was selling for less than $6 a share.

While the stock can obviously go down (as all stocks can) especially after enjoying big run, do your homework and you'll be able to figure out why it had the big pop. CEO Julia Stewart had done a marvelous job since taking over the old IHOP which she successfuly turned around and put on a new growth path. Prior to joining IHOP she had been head of operation at Applebee's and knew the company inside and out when she had IHOP acquire it on a highly levered basis, financing it via debt. Since then she has not only made progress in repositioning Applebees (which is not fully completed yet), but has been selling-off company operated units to franchisees, not only igniting important streams of franchise fee income, but generating cash from the sale of these units to reduce the debt.

Julie Stewart is a proven winner; don't sell her short.....especially when you admittedly are not that familiar with the company.

Jul 10 11:43 AM

[Crazygirl:]

Until I see a higher high on DIN I can only assume it is going down IMO.

Jul 10 12:57 PM

[Alan Brochs...:]

I appreciate your comments. I note that I have never suggested anything about DIN until now. I don't know for sure what I might have said when it was 6, but I would like to think that it was priced for bankruptcy at that time and that I wouldn't have bet on it.

Betting on a good manager is usually a pretty good bet. It sounds like her plan is one that helps deleverage the balance sheet, but can it stand up to what I expect to be negative or very low comps for an extended period? Is she harvesting the low-hanging fruit first so that the success is front-loaded and not subject to extrapolation?

In this paired trade, I searched my restaurant universe for the appropriate other side. Maybe I didn't make the best choice. I considered EAT too. The restaurants that I follow most closely (and have written about historically) are BJRI, RRGB and TXRH.

Thanks again for sharing your view.

On Jul 10 11:43 AM 107Sid wrote:

> Alan! Alan! At least you admit that your knowledge of DINEequity
> is limited and essentially you're shooting from the hip. In the past
> four months the stock has increased more than five-fold and you could
> have made the same arguement back in March when the stock was selling
> for less than $6 a share.
>
> While the stock can obviously go down (as all stocks can) especially
> after enjoying big run, do your homework and you'll be able to figure
> out why it had the big pop. CEO Julia Stewart had done a marvelous
> job since taking over the old IHOP which she successfuly turned around
> and put on a new growth path. Prior to joining IHOP she had been
> head of operation at Applebee's and knew the company inside and out
> when she had IHOP acquire it on a highly levered basis, financing
> it via debt. Since then she has not only made progress in repositioning
> Applebees (which is not fully completed yet), but has been selling-off
> company operated units to franchisees, not only igniting important
> streams of franchise fee income, but generating cash from the sale
> of these units to reduce the debt.
>
> Julie Stewart is a proven winner; don't sell her short.....especially
> when you admittedly are not that familiar with the company.

Jul 10 01:39 PM

[107Sid:]

Your headline sees sell DIN, as part of a paired trade. A paired trade implies shorting the stock which one is recommending as a sale.


On Jul 10 07:41 AM Alan Brochstein wrote:

> I don't believe that I recommended shorting DIN. I know the story
> well enough to share my idea, but I want to admit that I haven't
> fully researched DIN (as I have done for HRL). That allows the reader
> to quickly realize I may be missing something, which is always the
> case anyway!
>
> I do feel comfortable pointing out valuation differences that seem
> extreme to me as well as highly contrasted approaches to capital
> allocation.
>
> While this isn't a sell XOM buy CVX type of pair that is so obvious
> that even Ethel would see it, both companies are involved in the
> same "food chain". As I mentioned, I expect a continued move by consumers
> from the restaurant to the grocery store, and I can't think of too
> much of a better testing ground than IHOP or Applebee's, given their
> low-end appeal.

Jul 11 12:38 PM

[User 279557:]

I like this trade for reasons Alan outlines and, in particular, this company is going to be terribly difficult to delever in an operating environment with declining margins.

While 107Sid raise good points, the reality is that under performing units are, well, under performing. From a cash flow stand point, the sale of the units need to realize a PV > WACC to make sense. I don't see. If she unloads performing units, will she cannibalize future earnings stream for short-term health of the company? and, will it make it harder for the company to hit historic CF and multiple targets?

Lastly, I don't care how great of an operating manager she is; operating leverage will only be as strong as the economy even for low end / trade down restaurants.

One major (!) problem with Alan's analysis is that you can't locate the stock and a synthetic short had an implied cost of borrow of roughly 12%. OUCH.

Jul 13 01:41 PM

[User 279557:]

One other thing, the suggestion that you could get a locate on UA or ISRG is absolutely silly.

UA has been special for some time and ISRG is a somewhat recent add to the overvalued lists, but certainly since your May 8 pair trade rec.

Jul 13 01:49 PM

[Alan Brochs...:]

Thanks for your comments. While some may think that I am recommending shorting, I am not. While you may choose to extend the analysis to that conclusion, I am solely trying to identify related securities where I see large valuation differences that I believe could reverse. For instance, if someone owned UA, I would recommend that the sell it and buy COLM. If someone wants to invest in the space, I would suggest COLM instead of UA. While I don't rule out shorting, it is true that I am not checking for borrowability, etc. You do raise an excellent point.


On Jul 13 01:49 PM User 279557 wrote:

> One other thing, the suggestion that you could get a locate on UA
> or ISRG is absolutely silly.
>
> UA has been special for some time and ISRG is a somewhat recent add
> to the overvalued lists, but certainly since your May 8 pair trade
> rec.

Jul 13 05:00 PM

[WSJevons:]

Yeah, I am sorry Allan, you cannot call your column Paired Trade and not invoke pair trading. It is disingenuous.

For any newbs, a pair trade is, by definition, a market neutral strategy that shorts one stock and goes long another based on some statistical or temporal relationship.

Jul 14 08:36 AM

[Alan Brochs...:]

I refer you to my original article in this series for how I, the author, view this:

"A paired trade in its truest form allows an investor to simultaneously short a security that is expensive and go long one that is cheap without taking market risk. Here in Texas, we have an altogether different definition that allows you to double your risk (i.e short gold and short bonds). Kidding aside, the key element is to try to take out all sorts of risk by choosing appropriate candidates. They need to be in the same or similar industry and with somewhat similar market caps. Even in these cases, the securities can continue to diverge greatly from "value" due to other factors."

"In the case of my paired trades, I am not necessarily saying to short one and buy the other, but instead suggesting to perhaps buy the cheaper one instead of the other if one is looking to invest in the industry, to sell the expensive one if one has a position in both, or to swap for the cheaper one if one owns the richer one. The point is to try to reconcile valuation differences. Doing one leg of a trade can result in a "Pyrrhic victory", where the one you buy goes down less than the other one, but you lose nonetheless, so caveat emptor."


While I am not ruling out anyone shorting the negative side, shorting comes with several constraints and risks with which anyone should be familiar before engaging in it. If you don't think that I am being fair because I am recommending shorting something that is impossible to short, feel free to call me out.

Jul 14 11:47 AM

[WSJevons:]

You can call testicles Rocky Mountain Oysters, but you can't call them steak.

Jul 14 08:55 PM