Risk Management in the Far East

Conclusion: While Chinese equities have recently dropped like a rock on tightening speculation, careful analysis shows those concerns are overblown. Thus, we’re buyers of this dip.


Position: Long the Chinese yuan (CYB); Long Chinese Equities (CAF).


For the fifth day in a row, China’s Shanghai Composite Index closed down. Having fallen (-4.6%) from April 18 in a straight line on rising tightening fears, we welcome further weakness in Chinese equities as a buying opportunity.


As we’ve outlined in our 2Q11 Macro theme titled, “Year of the Chinese Bull”, we think the pace and magnitude of Chinese tightening has peaked and looks to slow on both fronts in the coming months. Further, we think March’s +5.4% YoY CPI reading is at or very near the cyclical top in Chinese reported inflation over the intermediate-term TREND. For the details behind our conviction in these forecasts, refer to our April 18 report titled, “Chinese Exposition” (email us if you need a copy).


It’s comforting to see that neither China’s interbank loan market, interest rate swaps market, nor its currency market are confirming this mini equity-market freak out. Shibor (a measure of interbank liquidity) and 1Y non-deliverable yuan forwards suggest further tightening is on the way, but not at an accelerated pace or increasing magnitude. Further, China’s 1Y interest rate swaps have hardly budged, suggesting that further rate hikes are not imminent (i.e. if China does tighten further, it will likely be through yuan appreciation and higher bank reserve requirement ratios).


Risk Management in the Far East - 1


We view the recent uptick in bearish sentiment surrounding China’s property market as a classic case of Duration Mismatch and the recent spate of disappointing small-cap earnings is an opportunity for market expectations to be reset. Beat or miss, we think Chinese earnings will look a lot more attractive than US earnings over the next couple of quarters – especially when US GDP growth has a 1-handle on it. If you have to be long equities, the S&P 500 at a cyclical top looks a great deal more risky than the Shanghai Composite, given that much of the bear case is priced into Chinese equities at this juncture. That is in stark contrast to the US, where less than 20% of institutional investors will admit they're bearish.


Risk Management in the Far East - 2


The major risk we see in holding Chinese equities (or any risk asset) right now is the potential for an expedited down move in the US dollar over the next 2-3 months. A crash in the global reserve currency could potentially lead to a widespread crisis across global financial markets. The overwhelming majority of global liabilities are priced in US dollars, so haircuts on such assets have ability to drive up counterparty risk across the system. To be clear, we’re certainly not calling for the next financial crisis (yet), but the risk is not one to be ignored, given the Indefinitely Dovish direction of The Bernank’s Keynesian monetary policy.


Darius Dale


Transitory Commodity Inflation?


Yesterday in his press conference, Chairman Bernanke highlighted his belief that high commodity prices are simply transitory in nature.  He pegged the current rise in oil prices to both supply and demand.  On the supply side of the equation, he noted unrest in the Middle East as currently constraining oil production, which is fair point, especially given the sharp decline in Libyan production (normally ~1.8MM barrels per day).  On the demand side, he highlighted the continuing growth in demand from emerging markets.  Interestingly, he made no mention of monetary policy, or a weak dollar, in the role of commodity price inflation. 


In the chart below, we highlight the intraday move in oil, represented by WTI in this analysis.  At roughly 10:30 am, WTI sold off sharply based on a release from the Department of Energy that showed a much larger than expected build in crude inventories.   According to the report, inventories were up 1.7% week-over-week, which was just more than 6 million barrels.  On a year-over-year basis, the growth in inventories was roughly 1.5%.  Clearly, this negative supply data point surprised oil investors and WTI sold off accordingly.  Interestingly, two hours later, in conjunction with the release of the Federal Reserve’s statement, oil rallied and completely closed the gap on the prior sell-off related to the fundamental build in inventory.


Transitory Commodity Inflation? - wti intraday


This rally in oil following both the FOMC statement and Chairman Bernanke’s press conference is not surprising.  In the FOMC statement, the Fed noted that residential housing continues to have issues, while, in their view, “measures of underlying inflation continue to be somewhat low.”  Both of these points, allow Chairman Bernanke to remain Indefinitely Dovish.  Clearly, in the view of the Fed, tightening policy would adversely impact both the tepid recovery of the housing market and economy at large. 


In contrast to the Fed’s stance, many central bankers globally continue to either tighten or make hawkish statements.   In fact, the ECB has already raised interest rates once YTD.  Based on 2.7% inflation readings from the Eurozone in March, it is likely that the ECB again raises rates at their next meeting in July.  This is confirmed by Euribor futures and the European interbank rate, which are pricing in an increase in rates in the July / September time frame.  This continued widening in global interest rate spreads should further weaken the dollar, which will further support the price of inflationary commodities (oil, gold and silver). 


On our March 23, 2011 theme call, “What’s Next For Oil?”, we highlighted three key factors that will drive the price of oil.  A brief update on these factors is below:


  1. Geopolitical – In late March our key takeaway was that civil unrest was set to accelerate in the Middle East and it has done so.  Currently, the key hot spots are Libya, Egypt, Syria and Bahrain, with long term outcomes still difficult to determine.   Since the March call, this factor has become even more prevalent.
  2. Supply & Demand – In the United States, which consumes roughly 20% of the world’s oil production, demand is clearly starting to slow as indicated by the most recent data points from the Department of Energy, which showed a much larger than expected build in oil inventory.  Conversely, Chinese demand was up 11% year-over-year, which suggest continues strong growth of oil demand out of the world’s second largest consumer, albeit this was a (-300bps) slowdown from February.  Of our three factorss, this is the one that is marginally less positive from our long oil call on March 23rd.
  3. Monetary Policy – Based on Chairman Bernanke’s comments from yesterday, it seems unlikely that the Federal Reserve will raise rates over the intermediate term TREND.  In that period, it is likely that most other major economies raise rates at least once, if not more than once.  Thus global monetary policy will, over the course of the next few months, move even further away from U.S. monetary policy, which is negative for the U.S. dollar and positive of the inversely correlated price of oil.


In the chart below, we’ve highlighted our quantitative levels on oil, and it remains in a bullish formation.  This bullish formation was underscored by yesterday’s price action, which verified our view that the Fed’s dovish monetary policy continues to lag the world and lend support to higher oil prices.


In reality, commodity inflation is about as transitory as our Chairman Bernanke’s Keynesian economic policies. When they change, so too will the price of oil.


Daryl G. Jones

Managing Director


Transitory Commodity Inflation? - wti KM levels

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The Chase: SP500 Levels, Refreshed



I feel like I am watching a rewind of the February 2011 top, but scarier. This time, I can’t count how many people are telling me to just buy US Equities because a Crashing Currency doesn’t matter, yet…


Why are stocks up +4% in a straight line since last Monday? I think the answer to that is crystal clear – The Chase into month-end performance reporting is officially on, because The Bernank said it’s on. Nice trade. We had the call on his being Indefinitely Dovish right (long Gold, Oil, and The Inflation), but short SPY wrong.


What are my catalysts and why am I staying short SPY? Gravity, time, and price. 

  1. Gravity = my quantitative risk management model (grounded in chaos theory) that I have used since founding the firm accepts mean reversion as the highest probability risk management strategy to repeat with discipline. That doesn’t mean it always works – it just means it works a lot more than it doesn’t.
  2. Time = the macro calendar of catalysts picks up, big time, in the second week of May when Geithner is going to face a generational debate on the debt ceiling and not being able to finance the debt without legislation. If the US currency crash is going to happen in my lifetime, I’ve said it will be in Q2 of 2011. The Currency Crash may already be in motion – but it won’t end well for anyone if it looks like Q208.
  3. Price = the inverse relationship between the SP500 and the VIX has been one of the highest quality contrarian signals I’ve leaned on since 2008. It’s almost autopilot at this point to sell SPY at 15 VIX. The risk obviously is that Pavlov’s bell stops ringing here – but it hasn’t yet. 

If the SP500 can grab 1367 before it corrects, that will be a 3.3 standard deviation move in my risk management model on my immediate-term TRADE duration – doesn’t happen very often, but anything can happen.



Keith R. McCullough
Chief Executive Officer


The Chase: SP500 Levels, Refreshed - 1


In preparation for the BYI FQ3 earnings release tomorrow, we’ve put together the pertinent forward looking commentary from its pre-annoucement on April 7,  BYI’s Investor Day, FQ2 earnings call and other releases.



  • “Short-term market conditions remain difficult, with the timing of large systems implementations becoming more challenging to predict. However, we continue to be pleased with the strong performance in our gaming operations business, the initial acceptance of our new Pro Series cabinets, and our business-specific initiatives. Our systems outlook remains strong, and this month we will begin selling the first ALPHA 2™ titles Playboy Hot Zone and Ole Jalapeños.”
  • 3Q EPS (ex impact of refinancing and stock tender/repurchases): $1.82-1.95; 4Q EPS higher than 3Q EPS
  • Lower than expected systems revenue caused from the timing of decisions for large installations, and lower than expected gross margins in gaming equipment due to a higher than anticipated mix of Pro Series cabinet sales.
  • Will not achieve $205MM in systems revenue for fiscal 2011
  • Refinancing:
    • $700MM of new senior secured credit facilities comprised of a $400MM, 5-yr revolving credit facility and a $300MM, 5-year term loan (collectively, the “Credit Facilities”).
    • $50 million sublimit for the issuance of standby letters of credit, a $10 million sublimit for swingline loans and a $150 million sublimit for multicurrency borrowings in Australian Dollars, Canadian Dollars, and Euro
    • Initial pricing: LIBOR +175bps (assuming a gross leverage ratio of 2.0)
    • Will have $150MM of undrawn availability under new revolver.
    • Tender offers expires on May 6
  • Repurchased ~ 898,000 shares for a total of $35.1MM, leaving $27.3MM available under its existing share repurchase plan
    • Increased repurchase program to $550 million minus the amount repurchased in the tender offer (which is expected to be $400 million).



  • "We now expect fiscal 2011 System revenues between $205 million to $215 million. As we have been guiding, this will equate to approximately 60% of our Systems revenues occurring in the back half of fiscal 2011."
  • "Based on the expected timing of current deals, we already have signed commitments for close to two-thirds of the back-half revenue."
  • "We continue to maintain our maintenance revenue guidance of $63 million to $65 million for fiscal 2011."
  • "We now expect that our effective rate for the remainder of fiscal 2011 will be between 35% and 36%."
  • "Over the next few quarters, our working capital will be used to invest in new gaming operation assets, our expansion into Italy and Australia and to supply approximately 50% of the floor at Aqueduct, all of which we will expect
    to begin to generate returns in the second half of calendar 2011."
  • “We continue to focus on international expansion opportunities, and expect to obtain regulatory approvals to begin selling our games in Australia within the next 30 days. The Italian VLT market has been initially seeded by a few European manufacturers, and the performance numbers are exceeding expectations. This has led us to favor initial deployments of more recurring revenue units versus up-front sale revenue games.”
  • "We sense some optimism from our customers but remain cautious for replacement games for the remainder of this fiscal year."
  • [Systems revenue] “We are forecasting further increases in the upcoming quarters.”
  • “We expect DM and our recently re-engineered game monitoring unit to drive in-game hardware revenue increases during the upcoming quarters.”
  • “We currently expect fully-diluted EPS of $2.00 to $2.15 per share versus our last guidance of $2.05 to $2.30 per share.”
  • “Now, due to this anticipated stronger net win, we expect most of our Italy arrangements to be recurring revenue with very little profit in fiscal 2011. However, this bodes well for our Italy revenues for our fiscal year 2012 and beyond.”
  • “Canada’s Systems revenue should also begin in the second half of this calendar year.”
    • “Canada’s not signed, and we don’t expect signing for several more months.”
  • “So we’ve been buying back roughly $20 million a quarter, so I’ve got that currently in our EPS range for the back half of the year.”
  • “Our ALPHA 2 games are beginning to roll out. iDeck has already rolled out and is showing great performance improvement for us. We’ve just got approval now for our first new WAPs in a long time. Cash Wizard goes out starting next month (March).”
  • “And on System products, iVIEW DM we’re confident of a couple more signings of casinos for iVIEW DM here in the next 60, 90 days. And the bonusing products are beginning to hit the field. If the application’s right, View DM will obviously be sold as the casinos adopt iVIEW DM. But good strong interest for iVIEW DM, where we would expect to see revenues.”
  • for that beginning in the March quarter.
  • “Other opportunities in Canada?” “Yes.”
  • [New WAP games] “The beautiful thing about Wide-Area Progressive games is that they’re always a percentage of coin-ins because we fund the top jackpot. Hence, traditionally with all our competitors, the higher revenues from those types of games, so they’ll follow the same pricing model as that.”
  •  “No deterioration in the last three months, in visibility.”
  • [Cash Spin] “It’s still going up and around 45 degrees on our charts, which is pretty much where it started. It but that’s why we timed games like Hot Spin and things like that to replenish it.”
  • “Total CapEx for this year is actually going to be up over last year."
  • Service revenues have increased from $3MM to $6MM per quarter--upgrades/add ons, etc. As they penetrate smaller casinos - which have smaller IT departments, they require more outsourcing of services.
    • Wants Software to Services revenue ratio to be 1:1
  • Additional opportunities include:
    • If BYI can capture 30% of their domestic competitor biz, they can add 120k slots to their system, which would equate to a $420MM opportunity.
    • If BYI can capture 50% share of the new casinos, then BYI can add 70K slots, representing a $245MM opportunity.
  • All-in, they think they have a $1.8BN addressable opportunity in systems.


In-line Q1 and guidance. 



“The outlook for the rest of the year looks promising as we view the events of the past few months as not having derailed the overall global economic recovery. For example, our group and transient bookings remain robust. As such, we remain cautiously confident for 2011 and are bullish about our long-term prospects.”

- Frits van Paasschen, CEO




  • "During the quarter, the Company signed 29 hotel management and franchise contracts representing approximately 8,700 rooms and opened 21 hotels and resorts with approximately 5,200 rooms... Eleven properties (representing approximately 3,400 rooms) were removed from the system during the
    quarter.... At March 31, 2011, the Company had approximately 350 hotels in the active pipeline representing approximately 85,000 rooms."
  • "Special items in the first quarter of 2011, which totaled $33 million (pre-tax), primarily relate to a charge associated with the Company’s minority investment in a hotel in Tokyo, Japan following the earthquake in March 2011. Excluding special items, the effective income tax rate in the first quarter of 2011 was 21.0%"
  • "Revenues at Starwood branded Same-Store Owned Hotels in North America increased 6.5% while costs and expenses increased 4.6% when compared to 2010. Margins at these hotels increased approximately 150 basis points."
  • "Revenues at Starwood branded Same-Store Owned Hotels Worldwide increased 8.5% (6.9% in constant dollars) while costs and expenses increased 7.4% (6.3% in constant dollars) when compared to 2010. Margins at these hotels increased approximately 90 basis points and were negatively impacted by approximately 120 basis points due to continued increase in the gap between inflation and currency devaluation at the Company’s Latin America hotels."
  • Owned hotels: "First quarter results were negatively impacted by pre-opening costs at the new leased W London Leicester Square, the effect of the earthquake at the new leased St. Regis Osaka, one renovation
    and one asset sale."
  • "Originated contract sales of vacation ownership intervals increased 6.5% primarily due to improved sales performance on existing owner channels and increased tour flow from new buyer preview packages. The number of contracts signed increased 7.8% when compared to 2010 and the average price per vacation ownership unit sold decreased 1.4% to approximately $16,500, driven by inventory mix."
  • Capex in the Q: $40MM of maintenance and $33MM of development spending. 
    • "Net investment spending on vacation ownership interest (“VOI”) and residential inventory was $16 million, primarily related to the St. Regis Bal Harbour project."
  • "On April 6, 2011, the Company completed the sale of one wholly-owned hotel for cash proceeds of approximately $110 million. This hotel was sold subject to a long-term management contract."
  • Guidance for 2Q:
    • Adjusted EBITDA of $245-255MM (consensus of $259MM)
    • EPS: $0.42-$0.46
    • WW RevPAR SS Operated Hotels: 7-9% constant dollars (+200bps for FX)
    • WW Branded SS Owned Hotels: 8-10% in constant dollars (+400bps for FX)
    • 10-12% growth in fees and income (-200bps impact from ME & Japan)
    • VOI / residential earnings: Flat YoY
    • D&A: $79MM
    • Interest expense: $58MM
    • Income from continuing ops: $82-90MM
    • Tax rate: 24%
  • FY2011 revisions from last quarter:
    • Reflect the benefit of FX/ ie weak dollar on RevPAR
    • EPS +5 cents due to lower below EBITDA line items
    • VOI earnings +5MM
    • SG&A YoY +2%
    • D&A -5MM
    • Interest expense -5MM


  • Despite global turmoil, their view of the lodging recovery remains unchanged
  • Occupancies at their hotels are now above peak 2007 levels
  • For the first time, rate contributed as much to RevPAR as occupancy
  • Annualized delinquencies and defaults in VOI have returned to 2007 levels
  • Group pace for 2011 is on track to be up double digits and 2012 business is on track to be better than 2011.
    • NA booking from outside of NA grew 20%
  • Achieved high single digit growth in corporate negotiated rates
  • Mid week occupancies are approaching peak levels in gateway cities
  • While leisure demand is likely to be somewhat impacted by rising fuel prices, business travel is not really elastic
  • Their customers tell them that they plan to travel more in 2011 than 2010
  • NY suffered from a 7% increase in supply this year. Already for Q2 they are seeing occupancies build - but they also contributed to the supply growth.  NY also suffered from weather.
  • Their websites drive 3x as much bookings for them than 3rd party sites. 50% of their bookings come directly to them (call centers etc)
  • SPG members account for 47% of their stays. SPG guests are 50% of Aloft and Element guests
  • $5MM impact from Japan and ME in the quarter
  • Japan: Their St. Regis in Osaka will lose $7-8MM this year vs expectation of B/E results
    • $20-25MM impact on EBITDA
  • China RevPAR up over 20% - China is their second largest country concentration after the US
  • India- have 32 operating hotels with 4 more to open. Goal of 100 operating hotels by 2015
  • Asia ex Japan continues to be a major contributor to their growth
  • ME: have 24 hotels across the affected countries. Expected to earn 15MM in fees and now expect that to be cut in half, earning no incentive fees. They are seeing strong growth in sub Sahara Africa.
  • Booking pace in Europe was strong
  • Mexico has been negatively impacted by drug wars and violence.  However, they are bullish long term on Mexico
  • Owned margins declined as much as 400bps in Argentina
  • Gained 300bps of share across all their brands
  • In Q2, expect occupancies in the 90s in NY and large rate increases
  • WW RevPAR is still 10% below peak levels


  • Group business comments relate to NA - obviously, they have more hotels in NA than they had a few years ago. However, most of growth in NA has been limited service not group hotels. That helps comparisons between 2006/2007 and 2011/2012
  • Most transactions are rifle shot deals
  • As they get into the middle of the cycle, they are more likely to pursue more sales of their assets or a larger transaction.  They are in the market testing asset sales.
  • Why is their SG&A guidance higher? Impact of FX - dollar is weaker and 1/3 of their SG&A is in Euros and Asian currencies
  • Weakness in Japan and ME is offset by better results in other parts of the world. NA - despite lapping some very difficult comparisons, in 2Q their RevPAR is tracking in-line with 1Q results
  • NA RevPAR is impacted by a Canadian and Mexican currency. NA would have 9.3% ex FX affects.
  • Aside from NY, London has had 3-4% supply growth. They just opened the W in Lester Square and its been one of the strongest openings. 
  • Franchise revenue growth has to do with Aloft ramp and just new hotel openings
  • Aloft is ramping faster than they expected when they launched the brand a few years ago. 
  • What percentage of their mix is still in the discount channels?
    • Their revenue management tools are giving them more insight into demand at their properties allowing them to effect mix to their benefit
    • OTA business peaked at 6-7% was about 3% in 2007
    • Government is about 3% of their business and was about 2% at their prior peak

Hedgeye Statistics

The total percentage of successful long and short trading signals since the inception of Real-Time Alerts in August of 2008.

  • LONG SIGNALS 80.52%
  • SHORT SIGNALS 78.67%