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Lethal To Liberty

This note was originally published at 8am on February 22, 2011. INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK (published by 8am every trading day) and PORTFOLIO IDEAS in real-time.

“The natural progress of things is for liberty to yield and government to gain ground.”

-Thomas Jefferson


I went into this President’s Day weekend writing an intraday note at 3PM EST on Friday titled “Exhaustion.” I wasn’t talking about my physical state. Ex-snow shoveling, I’ve been managing with my peg leg in an air cast just fine. I was writing about the US stock market’s risk management setup.


In the most immediate-term duration (today), US stock-centric investors are going to realize that there is indeed risk to a market that’s been rallying to higher-intermediate-term highs on low-volume and negative skew. From a long-term TAIL perspective, US stocks are simply making lower-highs.


Lower-highs can be lethal to returns, particularly if confirmed by fundamentals that perpetuate lower prices. While plenty a perma-dancing-bull can tell you that the US stock market is “cheap” (if they use the wrong margin and earnings assumptions in their SP500 estimates), this type of storytelling isn’t new to your average American.


After all that we’ve been through in the last 3-years my sense is that Americans get it. Americans get leadership. Americans get liberty. Americans get transparency, accountability, and trust.


Before I take a step back recapping last week’s most important weekly moves, allow me to remind you what risks Main Street Americans see to the US economy:

  1. A 2011 US Deficit of $1,650,000,000,000
  2. A 2011 US Debt Clock.org balance of $14,173,394,779,991
  3. A 2011 US Dollar Debauchery inspiring inflation

So when the S&P Futures are down 18 points like they are this morning, there are obviously more than a few relatively large risks that the “fundamentalist” might point toward.


There is also this other little risk management critter called The Rest of The World that central planning folks in Washington, DC seem to think are simply being affected by “supply and demand” as opposed to anything that’s right here in our own back yard.


Given that 85% of all foreign exchange transactions are in US Dollars, and the US Dollar continues to be debauched, we think the following week-over-week moves in Global Macro are critical correlated risks to manage around:

  1. US Dollar Index = DOWN a full -1% last week to $77.69 and down for the 6th out of the last 8 weeks.
  2. CRB Commodities Index = UP +1.2% last week to close at a new intermediate-term weekly closing high of 341.
  3. Volatility Index (VIX) = UP +4.7% last week, despite US stocks rallying to new YTD highs.

So how could US investors bid up volatility at the same time as the institutional performance chasing community bids up the price of US stocks? Maybe it wasn’t US only investors…


Maybe, just maybe, The Rest of the World remembers that deficit spending and dollar devaluation strategies don’t work out so well in the end. Maybe some Americans themselves remember what Presidents Nixon and Carter did to the US Dollar in the 1970s. Maybe history remembers The Inflation.


In terms of other important perspectives, this is what The Economist had to say this weekend in its commentary about US Leadership:


“Neither the President nor Republican leaders have had the courage to support them. In the absence of statesmanship, the chances are that only a crisis in the bond markets will provide the necessary impetus. Economic management by fiscal heart attack is not a very prudent remedy.”


This is what a massive international pension fund manager (Gerald Smith, Deputy Chief Investment Officer of Baillie Gifford, who oversees $117 Billion in assets) had to say about American monetary policy:


“If Bernanke wants inflation he’s going to get it.”


And, finally, for all of the professional politician fans who are still left out there in America, this is what Presidential candidate, Mitch Daniels, had to say about US deficit and debt spending:


“We face an enemy lethal to liberty and even more implacable than those America has defeated before.”


It’s all out there now. You don’t need this Canadian with an American family and firm to remind you of the risks. You get it too.


In the Hedgeye Asset Allocation model, last week I invested 6% of our large Cash position in a combination of Swedish stocks and soft agricultural commodities, taking the cash position down from 61% last Monday to 55% this morning.


The current exposures in the Hedgeye Asset Allocation Model are a follows:

  1. Cash = 55%
  2. International Currencies = 24% (Chinese Yuan and Canadian Dollars – CYB and FXC)
  3. Commodities = 9% (Oil and Grains – OIL and JJG)
  4. International Equities = 6% (Sweden – EWD)
  5. US Equities = 6% (US Healthcare – XLV)
  6. Fixed Income = 0%

As you can see in the Hedgeye Portfolio (see attached), I’m short both emerging markets (EEM, IFN, EWZ) and US Treasuries (SHY), so that’s one of the main reasons why I have such a large asset allocation to Cash – I don’t own any fixed income or emerging market exposure as I realize that inflation can and will continue to be lethal to these markets.


As to whether or not the Almighty Central Planners of America are infusing interconnected Global Macro market risks into our way of life … that will be an American history that writes itself on its own time… In the meantime, deficit and debt spending will remain lethal to our liberty.


My immediate term support and resistance levels for the SP500 are now 1330 and 1346, respectively. If the SP500 breaks down and closes below 1330, I have no support to 1306.


Best of luck out there today,



Keith R. McCullough
Chief Executive Officer


Lethal To Liberty - ted1


Lethal To Liberty - ted2


A normalizing quarter



Now that all the public companies have released their earnings, we can take a look a slot ship share trends.  Total shipments into North America decreased 11% YoY to approximately 16k in 4Q10 from an estimated 18k in 4Q09.  We estimate that a total of 63k units were shipped in NA in 2010 compared to an estimated 71k units in 2009.  Replacements increased an estimated 3% YoY in 2010 to 47k units from approximately 45.5k units in 2009.

  • We estimate that new and expansion units decreased almost 40% YoY to 3.9k from 6.3k in 4Q09
  • Replacements in the quarter were about 12.4k, up 4% YoY and up from roughly 10.0k replacements shipped in 3Q10

Going forward, we think ship share for IGT and BYI will likely rise throughout the year while WMS and Konami will fall slightly.


Slot Ship Shares

  • IGT:  28% in 4Q up 1% from last quarter and down from 29% in 4Q09.  For 2010, IGT’s share dropped to 27% from 34% in 2009.
  • WMS:  24%, up 1% from 3Q share and flat with their 4Q09 ship share.  For 2010, WMS’s ship share was 25% compared to 22% in 2009.
  • BYI:  14% in 4Q2010 - flat sequentially and down 400bps YoY.  In 2010, BYI’s ship share fell 3% to 15%.
  • ALL:  2H2010 results were at 12%, flat YoY.  Based on company commentary on the earnings call last night, we believe that their 4Q2010 share was 13%, up from 3Q share of 11%.
  • Konami: 13% in 4Q, down from 16% in 3Q2010 and up 2% from their 4Q09 shipshare of 11%.  In 2010, Konami’s ship share stood at 13% compared to 10% in 2009

The chart below summarizes slot ship share trends:




I went through my initial take on JACK’s fiscal 1Q11 earnings yesterday (JACK – FIRST LOOK, posted yesterday).


As we knew going into the conference call, increasing commodity costs are putting significant pressure on the company’s margin relative to its prior guidance.  Fiscal 2011 commodity costs are now expected to be up 3-4% from its prior outlook of up 1-2%. Although management broke out its expected commodity cost increases by food item, they did not say how much of the company’s total costs are currently locked in for the remainder of the year.  To that end, there is still risk to the company’s current forecast.


Management would not comment on whether they are planning on taking price to help offset some of the inflationary pressures but said their approach to pricing would be cautious and if necessary, any price increases would be modest and targeted.  Given recent comp trends at Jack in the Box, the company is right to be cautious.  Although same-store sales turned positive during the quarter and improved 20 bps on a two-year average, Jack in the Box has underperformed its competitors and one quarter of positive trends does not give me confidence that the concept has real purchasing power in this environment.  Management is either being cautious on its full-year outlook or it is not yet convinced that trends have turned the corner at Jack in the Box because the low end of its full-year comp guidance assumes a slowdown in two-year average trends from first quarter levels. 


We know 2Q11 will be difficult from a top-line standpoint as the company guided to a flat to down 2% comp at Jack in the Box, which at the low end of the range implies a 50 bp decline in two-year average trends from the first quarter.  The company cited that unfavorable weather in many of its markets, particularly Texas where it has 27% of its Jack in the Box company restaurants, impacted results in the first four weeks of the second quarter.  I would expect comp trends to improve slightly on a two-year average basis in the back half of the year; though I am currently modeling a flat comp for the full-year (at the mid-point of management’s guidance).  Comparisons get much more difficult for Jack in the Box in the fourth quarter, however, so same-store sales growth could very likely turn negative again on a one-year basis.


So, 2Q11 is going to be bad from a top-line (severe weather impact), commodity cost (guided to a 5% increase, including a 20-25% increase in produce costs, versus their up 3-4% full-year outlook) and margin perspective.  I am currently modeling a 12.4% restaurant-level margin for 2Q11, which implies a 280 bp decline YOY.  Management stated that 2Q11 margin should be about even with the reported 1Q11 level of 12.6%.  In the back half of the year, restaurant-level margins should improve modestly largely as a result of the fact that the company is lapping a nearly 370 bp decline from 3Q10 and a 330 bp decline from 4Q10.  That being said, commodity costs are the biggest wild card as we move through the balance of the year!


JACK – 2QFY11 LOOKING ROUGH - jack sigma


Howard Penney

Managing Director

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Show-me The Comps

Target’s earnings report and conference call still leaves us comfortable with our short bias over the near-term.  In fact, it’s probably now more clear than before that the near to intermediate term topline results are integral to this show-me story.  The expected sales ramp over the course of the year, tied almost entirely to the company’s growth in P-Fresh remodels and 5% Reward penetration, is the single biggest factor in determining if TGT can control its own destiny or if macro factors will keep the topline muted.  We remain concerned that guidance for incremental comps of 200-400bps driven by such initiatives still remains aggressive. 


As always there were a few positives (mostly longer-term) and a few negatives to contemplate following today’s official 4Q report.  First the positives:

  •  TGT’s quarter was largely as expected following the company’s January pre-announcement that indicated credit card profits and a favorable tax rate would offset modest declines in retail profitability.  In reality what we got was a much better tax rate to the tune of $0.07 per share and a flat y/y EBIT performance from retail.  All in no big surprises in the P&L.
  • Management suggested that a sale of the credit card portfolio has become increasingly likely, although the timing of such a transaction could take time and drag into early 2012.  The transaction will result in a gain on sale and a future stream of “shared economics” between the new owner and Target.  This should viewed as a win, as this takes risk off of the company’s balance sheet while maximizing the NPV of the portfolio at a time when credit seems to be stabilized. 
  •  Additional clarity was given on Canada and the impending transaction to acquire 180-200 former Zeller’s locations/leases.  The process is clearly underway and will begin to impact the P&L in the form of front-loaded investment beginning in 2Q.  This investment covers IT development, increased headcount to support the Canadian expansion, and the assumption of leases as they become property of Target.  Store openings are still slated to take place in 2013 and 2014.  Bottom line here is this will be a drag for a while until the stores actually produce revenues.  For those with a multi-year time horizon, we believe Canada will be a success and has the potential to be a key top and bottom line driver beyond the next two years.

And the negatives:

  •  The P-fresh and 5% reward programs are clearly having an impact on the topline, although not as much as originally anticipated at this early part of the roll-out.  Management noted that the rewards program added about 100bps to 4Q same store sales and P-fresh added a bit as well.  Target now expects the two efforts to contribute about 350bps combined on a run-rate basis to same store sales by the end of the year.  Keep in mind that in late fall, the expectation was for these efforts to contribute an incremental  200-400bps for the ENTIRE year.  Yes this is a subtle change in tune, but one that at best makes 2011 a year of two distinct halves.  First half comps now expected to be positive low single digits, while the second half is planned higher.
  •  The investments in Canada will result in two buckets of costs over the course of 2011.  First the actual investment in people and infrastructure to support the acquisition, which amounts to $0.10 share.  Second, the funding for Canada is now expected to put share repurchase temporarily on hold to the tune of $0.05 to $0.10 per share.  All in a $0.15 to $0.20 per share hit in the near term.  We understand these are prerequisite investments that must be made and we like the Canada acquisition.  However, we suspect that this effort may also add additional SG&A volatility over the coming year as operating a new and sizable division in a completely new country with re-purposed real estate is sure to bring some surprises.
  •  Inventories came out of the quarter a bit on the high side, up 6% against a 2.8% in total sales growth.  Management says inventories are in good shape but we can’t ignore that the reported sales/inventory spread as at its widest point in a year.  
  •  The year’s greatest same store sales increases are now expected to occur in the back half of the year at the same time costs and pricing issues are going to be at their greatest year over year increases.  We respect management’s conservatism on holding off from predictions on how the consumer will react, but we can’t ignore the fact this boils down to increased uncertainty at time when management appears to be more confident in their own sales growth.  Time will tell.

Show-me The Comps - tgt


Eric Levine


Pavlov's Bell: SP500 Levels, Refreshed...

POSITION: no position in SPY


I’ve seen bulls and I’ve seen bears. I’ve seen neither survive in perpetuity.


After a 40 point 3-day drop in the SP500 from my “Exhausted” range of 1, I think the “flows” bulls have been reminded of the bearish fundamentals that are associated with Global Growth Slowing as Global Inflation Accelerates.


What was 3 days ago was then, now we have to live in the now. And right now, the SP500 is trying to make up its mind between a  -2.6% correction (1308) and a -6.9% drawdown (1251). If the SP500 closes below 1308, we’ll say a -6.9% intermediate-term peak-to-drawdown is a probable risk.


Managing your gross or net exposure is one way to manage drawdown risk. Another is to be dynamically managing your asset allocation to cash. If we’ve all learning anything from managing risk in the early part of 2008, it’s that cash can be cool – particularly if inflation remains stubborn and sticky.


In terms of an immediate-term TRADE oversold line, 1295 is now our number. If we remain below 1308 on a closing basis, there will be plenty more days like this in the coming weeks. Pavlov may very well have taught everyone to buy every dip – but that doesn’t mean everyone is still going to be a winner.


Volatility (VIX) backing off today is both bullish and bearish all at once. Anytime we see the combination of a bullish TRADE and TREND breakout in any market price, it begs the question as to where that bullish breakout stops making higher-immediate-term highs.


Currently, what was heavy overhead TREND line resistance for the VIX is now support at 18.11 and I see no immediate-term TRADE resistance to north of 23.


If the SP500 can close above 1308, a lower-high of immediate-term TRADE resistance at 1330 is still our line.



Keith R. McCullough
Chief Executive Officer


Pavlov's Bell: SP500 Levels, Refreshed... - 1


Good quarter.  Margin story playing out and numbers need to go higher.




"Throughout 2010, Pinnacle developed and adopted a broad range of strategies, focused on further enhancing the best-in-market experiences that we provide to our guests.  At the same time, we undertook initiatives to leverage our development and management skills and solid balance sheet to pursue new opportunities to generate profitable revenue growth.  Going forward, we will maintain our organization-wide focus on best practices, while further positioning Pinnacle to benefit from any lasting rebound in the economy and consumer sentiment." 

- Anthony Sanfilippo, president and chief executive officer of Pinnacle Entertainment



  • "Consolidated Adjusted EBITDA for the 2010 fourth quarter increased 125.9% to $50.4 million, inclusive of $2.8 million in severance and relocation charges."
  • "2010 fourth quarter financial results also benefited from more efficient marketing activities relative to the prior-year period, particularly at its L'Auberge du Lac Casino Resort and Boomtown New Orleans properties."
  • "Pinnacle has further opportunities in 2011 to improve utilization of our personnel and systems to grow hotel yields, optimize our gaming floor layouts and game mixes, revise our approach to marketing and promotional activities, and effect additional corporate and property expense reductions.  Each of these factors contributed to our strong 2010 fourth quarter and full-year results and these areas remain priorities for improvement in 2011."
  • "The implementation of our St. Louis Shared Services structure in late 2010 is resulting in more efficient allocation of operating costs across the two properties and creating opportunities to drive revenue growth through coordinated marketing and player development efforts.  Our goal for St. Louis Shared Services is to drive consistent operating margin improvements and simultaneous market share gains."
  • "In Louisiana, we recently revised our operating approach by creating a Louisiana Shared Services structure to accomplish a similar goal as in St. Louis.  Geno Iafrate, Senior Vice President and General Manager of L'Auberge du Lac, now also oversees Boomtown New Orleans and Boomtown Bossier City, our two other operations in Louisiana."
  • "Beginning in April, we will relaunch mychoice, our guest loyalty program.  We also recently created a national casino marketing department, which focuses on marketing the unique experiences available at Pinnacle's resort facilities to potential guests outside of our immediate markets."    
  • "We plan to have a standardized marketing approach fully deployed later in 2011, and our strategic approach to marketing and branding is expected to enhance our ability to drive profitable revenue across our portfolio."
  • Development updates:
    • In January, PNK "completed the acquisition of River Downs Racetrack in southeast Cincinnati, Ohio"  for $45MM.  "If VLTs become operational, we plan to move quickly to revitalize River Downs and create a new gaming and entertainment facility for the Cincinnati market."
    •  Announced that the opening of its $357MM Baton Rouge Casino originally scheduled December 2011 will be pushed back to 1Q2012
      • "As a result of low Mississippi River water levels, the Company has been unable to move the three completed casino hulls, which together will form the casino itself, from Bollinger Shipyards in southern Louisiana to the project site in order to continue construction on the casino facilities"
      • "As of December 31, 2010, approximately $319 million of the $357 million construction budget (excluding land and capitalized interest) remains to be invested in the planned Baton Rouge facility." 



  • Believe that the Baton Rouge area is under served.   
  • They are committed to thoughtfully growing the company and continue to look at growth opportunities
  • Changed the mix of games at L'Auberge and their marketing strategy changed dramatically, which is why margins were so much better
  • Experienced about 100bps of margin compression in St. Louis due to seasonality. Properties don't perform as well when the weather is cold.
  • Believe that corporate costs will continue to trend down in 2011
  • Cash capex was $33.6MM for the quarter. Baton Rouge was $20MM;
  • January St. Louis market share reached an all time high of 32.6%. In 4Q - shared guests were 16% of rated customers but 39% of all rated play in St. Louis.
  • Belterra - impact from new competitor is easing
  • Seeing good results in their new hotel yield management system. Testing and launch new reward and marketing campaigns


  • Any impact from tornado warnings at the St. Louis properties?
    • On Dec 31st, there was a tornado warning and they needed to move their guests to a safe location. It's good and bad because the weather was warm but gaming was disrupted. Overall, the disruption was not material.
  • Hope to see a lot of the annualization of the cost reductions in 2011. 4Q corporate is the best proxy going forward but they aren't done yet. Hope for some marginal expansion.
  • They are going to use their manager from Belterra to oversee operations at River Downs and are making some improvements to that facility.  Will have the shared services concept at those 2 properties too. 
  • The $2.8MM corporate and severance charge - $1.3MM was in corporate and the balance was at the property level
  • Topline seemed to stabilize across their portfolio. They are optimistic about revenue growth for 2011.
  • Partnership opportunities with a Vegas operator?
    • Think that that idea has merit and are looking at it.
  • 15th license in Louisiana
    • License was issued to a company with very limited resources behind it and no operating experience. Think that in the best case it will take someone 30 months to open their doors
    • By that time, they hope to be a more diversified company with better operating focus
  • Continue to think that they can do a better job in running their company from a marketing and efficiency standpoint. They are very early in the process of developing their marketing engine.
  • Optimism of slots at tracks in Ohio - why?
    • Don't know when, but they do believe that they will become legal at some point in the future
  • Texas?
    • Doesn't think that the recent poll out of TX is particularly telling.
  • Marketing goal is to reallocate their marketing spend towards their best customers so that hey can capture a larger share of their wallet
  • Higher corporate expense is often driven by legal spending
  • They are continuing to work on the dry-side construction while they wait for the MS River to rise between now and mid-April/May.  They need the MS River to rise - otherwise they will not be able to move those hulls. No indication that that won't occur.
  • Doing what they can at Reno - they have a large track of land for sale there... and would entertain appropriate offers for that property but aren't actively shopping it.
  • Atlantic City is the largest portion of discontinued operations - double digit millions for the 2011. Mostly property taxes for AC.
  • There will be a shared loyalty and cost sharing service when Baton Rouge opens
  • Discovered that they weren't using the fully allowable square footage of gaming space at L'Auberge. Found another 5,500 SQFT and are putting in a poker room.

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