Complex Simplicities

This note was originally published at 8am on January 18, 2011. INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK (published by 8am every trading day) and PORTFOLIO IDEAS in real-time.

“I must forever make the complex the simple.”

-Martin Luther King, Jr.


Ironically enough, one of my best friends gave me “The Autobiography of Martin Luther King, Jr.” for my birthday a few weeks back. Notwithstanding that he didn’t know I’d be on my back reading for the last week, the timing of this gift was impeccable. Dr. King’s passion has forever made the complex the simple.


Complex Simplicities are what we chaos theorists wake up looking for each Global Macro market morning. One of my favorite risk management books of all time (“Deep Simplicity”, by John Gribbin) got me hooked on the basic principles of chaos and complexity theory back in 2006. Thank God for those teachings. They saved our clients and our firm a lot of money in 2008.


Investment opportunities in a globally interconnected ecosystem are omnipresent. While there may be Apple days in California and snow days in Connecticut, there is no such thing as “risk on” and “risk off” days in Global Macro markets. In fact, when I hear people say that, all I can do is smile. Accepting chaos theory in risk management means accepting uncertainty, every day.


Over the intermediate-term TREND, there is no such thing as market certainty. The only thing you can be certain of, after a +91.3% melt-up in US stocks since March of 2009, is that for the immediate-term groupthink session everyone on the Barron’s Roundtable is going to be bullish.


Being bullish or bearish on the amount of uncertainty you think there is going to be in a market price is an opinion. So is doing nothing. For now, from an asset allocation perspective, we’re doing more and more of nothing. As some market prices climb, we’re raising more cash.


This is what the Hedgeye Asset Allocation Model looks like to start off this week:

  1. US Cash: UP to 67% (versus 61% last week)
  2. International Currencies: DOWN to 18%
  3. International Equities: DOWN to 6%
  4. US Equities: UP to 6%
  5. Fixed Income: UNCHANGED week-over-week at 3%
  6. Commodities: DOWN to 0% (in the last 2 wks, I’ve sold all our Oil, Sugar, and Corn – and there are no rules saying I can’t buy them back lower)

Being in cash is a simple concept. While I do get some very complex questions about the nature of my cash position, most of the time the real complexity in the questions is born out of the problems associated with many institutions being mandated to be “fully invested.” I don’t have to be.


To be crystal clear on this, the Hedgeye Asset Allocation Model represents what I am personally doing with my investable capital. I’d be nuts to put my name on any other advice than that which I abide by myself. Again, from a transparency and accountability perspective, this is very simple.


Complex Simplicities: Did I think people who were jamming into bond and gold funds in Q4 of 2010 were nuts? Yes. Do I think people who are fully invested chasing US Equity indices up here are nuts? Yes. Do people who I think are nuts make money in this business? Yes.


But, sometimes (1998, 2000, 2001, 2002, 2008), people who get nutso invested blow up. The goal here, if you’ve made money in each of the last 3 years, is to make it a fourth -  not to implode.


Last week in Global Macro, other than in the $2.8 TRILLION US Municipal Bond Market, not a lot of things blew up. Here were the most important Global Macro market moves of the week:

  1. US Dollar Index was debauched for a -2.4% loss, taking it down for the 2nd week out of the last 3 as Republicans attempt to break spending promises
  2. Euro rallied +3% from its prior week’s lows of $1.29 (where we covered our short) as “I Have A Scheme” (Zero Hedge coined) on fiat paper goes global
  3. CRB Commodities Index closed at another weekly closing-high of 333; Dear Ber-nank, that was another +3.1% inflationary move in 19 commodities
  4. Oil prices inflated +4% week-over-week, and 71% of Americans say it’s an issue – really?
  5. Gold was down -0.6% and down for the 2nd consecutive week (we remain short of gold, GLD)
  6. US stock market Volatility (VIX) dropped another -9.5% to 15.46, testing its April 2010 lows when US growth bulls were last this horned up

There wasn’t enough pin action in credit spreads (US or Sovereign) for me to call it out and nominal US Treasury Yields didn’t do much on a week-over-week basis either (they remain in what we call a Bullish Formation – bullish on all 3 of our core investment durations: TRADE, TREND, and TAIL). That’s one of the main reasons why we love our cash so much. Global Inflation Accelerating is bad for de bonds, eh.


Complex Simplicities associated with our living in a higher-and-lower American society by the week aside, we’re looking forward to watching how this year’s Global Macro picture plays out post the beginning of the year “flows” thing. While in cash, waiting and watching for US stock-centric investors to react to something other than Apples and snow should be, at a bare minimum, worth the immediate-term absolute performance charge.


My immediate term support and resistance lines for the SP500 are now 1277 and 1299, respectively.


Best of luck out there today – it’s good to be back in the game,



Keith R. McCullough
Chief Executive Officer


Complex Simplicities - box


TODAY’S S&P 500 SET-UP - January 21, 2011

Equity futures are trading marginally below fair value following Thursday's continuation of the recent downdraft following some disappointing corporate earnings and on rumors of further tightening moves by the Chinese.  As we look at today’s set up for the S&P 500, the range is 31 points or -1.27% downside to 1264 and +1.15% upside to 1295.



  • Net export sales (cotton, corn, soy meal, soybeans, wheat)
  • 1 p.m.: Baker Hughes rig count, Jan. 21
  • 3 p.m.: Cattle feedlots, Dec.


  • Warner Music hired Goldman Sachs to solicit takeover bids, according to a person with knowledge of co. plans; says Warner was approached by KKR several weeks ago
  • LinkedIn shares are being sold in an auction by secondary exchange SharesPost for $30 apiece, valuing the co. at almost $3b, three people familiar with matter say
  • Employee bonuses at Wall Street banks may be down ~5%-10% this yr, according to compensation advisor Square Mile Services. Morgan Stanley employees are set to find out their bonuses today, while Bank of America will announce bonuses on Jan. 26, according to people familiar with plans
  • IBM is said to be giving hundreds of thousands of non- executive workers $1,000 in stock after co. 4Q beat ests.
  • Advanced Micro Devices (AMD) forecast 1Q rev. ~$1.58b-$1.65b vs est. $1.54b
  • Eli Lilly (LLY) failed to win FDA panel’s backing for Amyvid
  • Emulex (ELX) sees 3Q adj. EPS 8c-11c vs est. 11c
  • Ezcorp (EZPW) reported 1Q adj. EPS 69c vs est. 64c
  • Flextronics International (FLEX) sees 4Q adj. EPS 21c-23c vs est. 21c
  • International Game Technology (IGT) reported 1Q rev. $464.8m vs est. $490.1m
  • Intuitive Surgical (ISRG) reported 4Q EPS $3.02 vs est. $2.25
  • People’s United Financial (PBCT) agreed to buy Danvers Bancorp for $23-shr cash or 1.624 PBCT shrs for each Danvers shr
  • Polycom (PLCM) reported 4Q rev. $340m vs est. $327.8m
  • Tempur-Pedic International (TPX) forecast 2011 EPS $2.60-$2.75 vs est. $2.49


  • Schlumberger Ltd (SLB) 6 a.m., $0.78 
  • Prosperity Bancshares (PRSP) 6 a.m., $0.68 
  • BB&T (BBT) 6:05 a.m., $0.25 
  • Air Products & Chemicals (APD) 6:30 a.m., $1.34 
  • SunTrust Banks (STI) 6:30 a.m., $0.09 
  • First Horizon National (FHN) 7 a.m., $(0.01)
  • Applied Industrial Technologies (AIT) 7 a.m., $0.44 
  • Bank of America (BAC) 7 a.m., $0.21 
  • Airgas (ARG) 7:45 a.m., $0.79


The XLB is still the only sector broken on the Hedgeye TRADE duration - 8 of 9 sectors positive on TRADE and 9 of 9 sectors positive on TREND.

  • One day: Dow (0.02%), S&P (0.13%), Nasdaq (0.77%), Russell 2000 (1.12%)
  • Last Week: Dow +0.96%, S&P +1.71%, Nasdaq 1.93%, Russell +2.51%
  • Year-to-date: Dow +2.12%, S&P +1.80%, Nasdaq +1.94%, Russell (0.71%)
  • Sector Performance - (5 sectors up and 4 declined): - Materials (1.42%), Energy (0.71%), Tech (0.54%), Industrials (0.5%), Healthcare +0.25%, Consumer Disc +0.21%, Consumer Spls +0.51%, Financials +0.49%, Utilities +0.76%


  • ADVANCE/DECLINE LINE: -722 (+945)  
  • VOLUME: NYSE 1190.18 (+9.30%)
  • VIX:  17.31 +3.93% YTD PERFORMANCE: +1.35%
  • SPX PUT/CALL RATIO: 1.65 from 2.28 (-27.83%)


Treasuries were weaker with the better-than-expected economic data and supply overhang.

  • TED SPREAD: 15.30 +0.507 (3.430%)
  • 3-MONTH T-BILL YIELD: 0.16%      
  • YIELD CURVE: 2.82 from 2.77


  • CRB: 331.90 -0.46%  
  • Oil: 89.59 -2.42% - trading +0.44% in the AM
  • COPPER: 427.20 -2.24% - trading +0.01% in the AM
  • GOLD: 1,352.13 -1.37% - trading -0.60% in the AM


  • Gold Set for Worst Weekly Run Since July on China Concern, Holdings Slump
  • Copper Exports From China Triple as Record LME Price Lures Trader Sales
  • Platinum Imports by China Jump in 2010 on Car Sales; Silver Exports Drop
  • Copper May Rise as German Confidence Unexpectedly Gains, Stockpiles Shrink
  • Cotton, Wheat Surge as `Return of Agflation' Outpaces Metals: Chart of Day
  • Palm Oil Futures Advance as Argentine Soybean Crop Gets Insufficient Rain
  • China Rural Incomes Rising Most Since '84 Show Lure for Job-Seeking Obama
  • Crude Rebounds From Two-Week Low as Confidence in Economic Recovery Grows
  • Corn Futures Decline as Price Near 30-Month High Deters Buyers; Soy Falls
  • OPEC Pressured to Lift Output as Africa, Asia Oil at $100: Energy Markets
  • Taurus Quits Silver After Metal Rallies `Too Much,' Sticks With Gold Wager
  • Gold May Advance Next Week as Investors Go `Bargain Hunting,' Survey Shows
  • Deflation Diminishing in Bond Market as Food Prices Increase: Japan Credit
  • Hay Point Coal Shipments Decline 22% Following Queensland Flooding, Rain


  • EURO: 1.3470 -0.07% - trading +0.48% in the AM
  • DOLLAR: 78.823 +0.23% - trading -0.30% in the AM


  • FTSE 100: +0.73%; DAX: +0.60%; CAC 40: +1.16% (AS OF 6:00 AM EST)
  • European markets are trading higher on German business confidence
  • Banks gain on stronger economic outlook.
  • Oil & gas stocks advance on M&A, as crude recovers. Techs gain on earnings.
  • Spanish banks are higher, benefiting from reports the Spanish government is ready to restructure the Cajas by enabling them to become banks and by floating them on the market. Spanish government is also said to be ready to acquire stakes in the Cajas if the market shows little interest in investing. 
  • Royal Bank of Scotland is also higher, on hopes it may leave the government asset protection program.
  • European Macro economic data was mix; Germany January Ifo business-climate index +110.3 vs consensus 110. UK Dec Retail sales (0.8%) m/m vs consensus (0.3%) and prior revised +0.4% from +0.3


  • Nikkei (1.56%); Hang Seng (0.53%); Shanghai Composite +1.41%
  • Asian markets mostly declined today on worries of higher inflation and tightening from China, thanks to a report that an interest-rate hike may be coming within the next two weeks.
  • China, ironically, was the only major regional market to post a gain, with bargain-hunting rife after yesterday’s fall. Banks and property developers advanced, though not as much as they went down yesterday.
  • Energy stocks led Hong Kong down, despite China’s bounce.
  • Taiwan went down 0.75%
  • Energy companies fell on lower oil prices, causing Japan to reverse opening gains.
  • South Korea dropped (1.74%) and Indonesia down (2.16%).

THE HEDGEYE DAILY OUTLOOK - 1 21 2011 6 27 50 AM

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While IGT's quarter contained two surprises - international sales (bad) and margins (good) - there wasn't a big read through to WMS. We expect an in-line quarter next week.



WMS will report its FQ2 EPS on Tuesday after the close.  Replacements should be sequentially better, margins on product sales should also improve, and the install base for gaming operations should see a small sequential uptick on the back of more new releases.  For more details see below:


We expect WMS to report $202MM of revenues and EPS of $0.45.

  • $128MM of product sales revenues at a 52.5% gross margin
    • NA new shipments of 850 and 3,250 replacement shipments (roughly flat YoY)
      • New units include shipments to Perryville (29% share) and Gun Lake (23-25% share)
    • 2.3k international shipments
    • $16.2k ASP
    • $18.5MM of used machine sales and $6MM of conversion kit sales
    • Our understanding is that with the exception of Europe, the international business has been doing well
  • $74MM of gaming operations revenue at a 79% margin
    • Ending install base of 10,500 units and win per day of $73.40. We expect increases across all categories with the following title launches:
      • % coin in: Great and Power Oz, Monopoly Refresh
      • % net win: Godfather
    • $3.7MM of daily fee, royalties, and other lease revenue
  • Other stuff:
    • R&D: $29.5MM
    • SG&A: $40MM
    • D&A: $16MM
    • Reduced tax rate due to the reinstatement of the R&D tax credit

Shorting VFC: Risk/Reward Good Here

Coming out of last week's meetings w/VFC and it’s competitors, we were not inspired by the story and it’s setup for 2011.  This matches up with Keith’s timing/sizing parameters as the stock is broken on both a TRADE and TREND basis.  VFC short timestamp = $83.44.



Here’s our sense on VFC over three different durations:


Long-term:  It’s hard for anyone to call VFC a bad company. This is not management’s first rodeo. They are pretty darn good at making the right business decisions to manage their portfolio, and then managing expectations accordingly.

The fact of the matter is that over the course of 10 years, VFC has…

  • transformed from a vertically owned/operated capital intensive commodity-based apparel company (ie…underwear, denim) to an outsourced and offshored  portfolio of lifestyle brands that carry significant weight the consumer (ie The North Face, Vans). 
  • printed a growth algorithm of 3-5% sales, 5-6% EBIT, and 9-10% EPS. When you layer on the fact that almost all of the incremental growth came from less capital intensive businesses, we see that RNOA went from 9% to 16% over that same period. That’s not half bad. In fact, it’s clearly above average relative to peers.


I’d argue that we’re at the point of the ROI decision tree where the business will slow organically at the same time we’re seeing severe cost inflation -- -and that’s exactly when VFC will step on the accelerator with acquisitions. We’re already modeling stock repo in our model, so we may have to redistribute the cash to above the line if a deal happens. We also will not give the company a free pass that any deal will be a good one. The industry is at peak margins right now, and valuations do not represent that. VFC knows how to vet a deal, and even they have had their share of disasters (7 for All Mankind). Also, let's not forget that this company's long-term transformation happened when the industry had the biggest milti-year tailwind that it experienced -- ever. 



Intermediate Term

  • Ultimately, with such a diverse portfolio of brands, consumers and channels of distribution, VFC is really a double edged sword. The mix protects them from some downside, but it precludes the company from fully capturing upside in the event of a rebound.
  • In the end, it’s hard to outperform the industry meaningfully when you ARE the industry. Unfortunately, 2011 will be a dark dark year for the apparel industry in the US. VFC may well be able to steer its pricing and inventories better than most, but the biggest risk is what they can’t predict – which is the irrational behavior on the part of competitors as margin is literally sucked out of the supply chain.
  • Bottom line – numbers need to come down for 2011. The Street is at $6.80 for next year vs. $6.30 in 2010. The $6.30 is very doable this year, but this company should consider itself lucky to earn that level again in 2011. Numbers are off by $0.50.



Short Term

  • 4Q10 is the last ‘easy quarter’ revenue and margin compares – which is largely due to growth in company retail (2x the usual revenue recognition) and strength in TNF.
  • This is going to come down to earnings catalysts.
  • Will VFC ‘lower the boom’? on its conference call in a few weeks? I think that there’s a 75% chance of some official guide down, and 25% chance of a BIG one (ie calling for a flat year).
  • Is it in the stock already? With an EBITDA multiple of 8.6x, my vote is No. RL is trading at the same multiple – but the difference is that the Street is LOW by 15% on RL.


Here are some cliff notes from our meetings w VFC at last week’s conference. Some is relevant, some is not. Take it for what it’s worth.



o “We want to own your closet, the whole closet. And, maybe some drawers and shelves as well”

o More than double north face to $3 bil. ‐5 yrs

o Mid march investor day will layout 5 year plans

o International EBIT 200 bps higher than total corp op margin. Lower tax rate abroad helps EPS. Will be 40% of

total in 5 years.

o China $1 bln opportunity

o No single brand fully developed on retail. Vans largest. 67 TNF, grows to 190 globally 5 years

o GM’s will continue to expand in same manner as prior 5 years.

o Spent incremental $100 mm on sg&A in 2010 centered on marketing. Half on tnf and vans.

o 5.6% of total (mktg) was, 5% historically. Will be lower in 2011, to offset margin pressure

o Cash flow: exceed $900 mm, was $850. Acquisitions top priority.

o Focus on outdoor, action sports

o 5mm repurchase in 2010, vs. historical rate of 1‐2mm shares per year.

o May see north of 80 new stores in 2011, incremental comes from international

o Will cut incremental marketing spend from ’10 to offset cost pressures

o Not yet locked in on denim for Fall. Many denim mills still not accepting orders and holding out for more clarity.

o Bought some denim textiles in late ’10, will show up in YE inventories. Small but will help to offset costs.

o Rock and Republic (if successfully closed with courts) will be positioned away from competing with Seven. Likely

goes downstream from super premium.

o All brands taking price, but not all due to cotton.

o Feb 1st will see price increases in denim at retail, at WMT

o Low‐end denim price increase will not fully offset costs

o Expect 10‐15% more cotton to be planted, which may result in substantial price relief by year end.


In-line bottom line but top line very soft. Despite the talk of shifting focus away from NA replacement market, international product sales missed big in the quarter.


"Our first quarter results are reflective of our focus on improving our profitability and processes.  While consistent top-line growth remains challenging, our internal cost cutting and operational improvement strategies are solidly taking hold.  Based on early customer feedback, we are confident that our recently released games are gaining momentum.  We look forward to better demonstrating our top-line focused initiatives in the second half of this year and beyond."

-Patti Hart, CEO


So much for planning "to further reduce on the North American replacement cycle by taking advantage of ... diverse global revenue sources."  At least based on our model, international product sales were the source of the largest miss.  Domestic product sales were in-line with our expectations, with slightly lower pricing offset by better non-box sales.  However, margins were much better than we expected.  Weaker gaming operations revenue was more than offset by better margins as well.  EPS benefited from the reinstatement of the R&D tax credit and gain on sale of the China LotSynergy to the tune of $0.04.


The good news is clearly gross margins and a lower cost structure.  WHEN the top line turns, there will be significant leverage.  For now, investors can hold on to basically unchanged EPS guidance for fiscal 2011.


  • "Consolidated revenues decreased primarily due to fewer international openings and expansions in the quarter versus last year"
  • Gaming Ops:
    • Revenues decreased primarily due to a reduced installed base
    • Average revenue per unit in F1Q was $50.38, a decrease of $0.48 from F4Q 2010 and $1.13 increase YoY.
    • Gross margins were 63% were positively impacted by the removal of the AL bingo games.
  • Product sales:
    • Recognized 5,000 NA units (3,100 replacements and 1,900 new)
    • Recognized 4,300 International units
  • "The company expects the tax rate to be 36% in each of the next three quarters"


  • Have seen a high level of adoption of server based gaming in high limit areas
  • Center Stage platform is performing well above floor average so far.  Sex in the City has an install base of over 1,800.
  • Continue to see stabilization in gaming operations yields and return to normal seasonal patterns. While the install base is not expected to grow meaningfully this year, they have begun to replace older, lower yielding games which should improve results.
  • Product sale margins were better due to geographic mix and higher % of non-box sales
  • Expect to see SG&A stay around 2010 levels
  • Higher inventory and jackpot payments impacted cash flow from operations.  Inventory was higher due to roll-out of new gaming ops titles.
  • Considering increasing the use of financing to help customers refresh their floors and use more capital to refresh their gaming operations install base
  • Their preference is to use their cash to enhance their market position
  • Reel Edge is in the final stage of approvals and should hit floors soon
  • On the systems side, they installed 8 SbX systems and 7 Advantage systems
  • Updated guidance to $0.79-$0.87 cents for FY2011
  • Expect to see further improvements in their efficiencies


  • "Never any awards for being too aggressive"
  • New guidance includes $0.21 for the F1 quarter 
  • Order sizes were smaller during the last 2 quarters
  • NA ASPs were lower due to them pushing the regular AVPs and not so much on the MLDs front
  • Q: Are they sandbagging on guidance? A: There is still a lot of uncertainty around replacements
  • Reel Edge was the game with the most buzz coming out of G2E
  • WAP has had yields up nicely YoY
  • IL is not in their guidance but there is a little Italy in the guidance
  • Ended Dec with only $20-30MM on their credit facility
  • Non of their other debt is pre-payable so it's expensive to do so right now - but they are looking it at. Their first choice of use of cash is growing their business though.
  • Benefited by about $4MM in interest rate movements this quarter - which was in their gaming operations margins
  • International actually had a really nice quarter according to Patti. Nothing new competition-wise internationally, however, they have deployed more resources which is benefiting them.
  • US competitive environment is fierce

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