Gaming Policy

This note was originally published at 8am on April 26, 2011. INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK (published by 8am every trading day) and PORTFOLIO IDEAS in real-time.

“Conditions never persist. They change. Bureaucrats really hate that.”

-Jeffrey Tucker


That’s a quote from a book I read on my family vacation last week, “Bourbon for Breakfast – Living Outside of the Status Quo” (and, no I’m not taking up sipping on Canadian Club by the pool with my morning coffee). Nor do I aspire to ever be a professional politician in America.


Never mind understanding how the interconnectedness of the Global Macro market works, most professional politicians in America don’t get how a market works. Most of them still call this game of Big Government Intervention a “free market.”  I call that a joke.


The good news is that a lot of people get the joke. Gaming Policy is the new hedge fund game in town – so game or be gamed. There are  higher prices being paid (read: trading commissions) for “one-on-one” access to private meetings with DC bureaucrats than ever before. Sad, but true.


You don’t need inside information if you have a multi-factor, multi-duration, risk management process that flags real-time pricing of these “data points.” Anyone who has traded real-time risk capital in markets knows that someone always knows something…


We’ve titled one of our Q2 Global Macro Themes, “Indefinitely Dovish” (see yesterday’s Early Look) primarily because we think the market is pricing in Bernanke remaining dovish into and out of tomorrow’s FOMC meeting.


When we say “the market”, we mean the globally interconnected one – not just US stocks:

  1. Currency Market – the US Dollar Index is trading down again this week (for the 14th out of the last 18 weeks) and the Euro is making new highs by the day ($1.46 last) because, for the 1st time since Fed head Arthur Burns was attempting to monetize the US Debt and devalue the dollar (1970s), US monetary policy is more left leaning and dovish than even what the ex-Finance Minister of France is delivering. Jean-Claude Trichet’s comments overnight were explicitly hawkish: “it is extremely important to continue to solidly anchoring inflation expectations in a period which is marked  by uncertainties and turbulence.”
  2. Bond Market – global bond yields continue to push higher as Asian and European central bankers continue to back their rhetoric with rate hike action. Meanwhile, US Treasury yields are breaking down through our intermediate-term TREND support lines of 0.71% and 3.46% for 2-year and 10-year UST yields, respectively. Indefinitely Dovish in America is as dovish does…
  3. Commodity Market – higher-highs on rallies and higher-lows on corrections for Gold, Silver, and Oil. This is where the US Dollar Devaluation driven monetary inflation is – not in GDP growth oriented commodity pricing (copper, sugar, etc.). With the Saudis trying to talk down oil prices at these levels (calling them “uncomfortable” overnight), WTI crude oil sold off a whopping 50 cents.

And Equities, well – we’re right back to where we were in mid-February where Asian Equities (growth markets) are starting to negatively diverge versus US Equities (the Gaming Policy market). China, India, and Indonesia are rightly worrying about The Inflation that will be perpetuated by a US Currency Crash.


Have no fear however – The Bernank and Groupthink Geithner are here. They have the world’s back on this Currency Crash thing. Having never seen an oil price (including $150/barrel oil) that they thought was inflationary, we don’t think they’re about to start calling $113/oil inflationary now. While Bernanke will acknowledge rising commodity prices tomorrow, he’ll offset that hawkish shift with an incrementally dovish one on US growth.


In the Chart of The Day (attached), Darius Dale calls out how super duper the sell-side has become in leading The Bernank and The Groupthinker’s Washington boys to believe that US GDP Growth was going to be all good and fine in Q1 of 2011 – then not so much.


The good news here is that Gaming The Sellside is still one of the oldest and most profitable games in town. They haven’t learned much since missing US GDP Growth Slowing in Q2 of 2008.


If you are looking for leadership on the Currency Crash thing, the President of the United States had this to say over the weekend on gas prices:


“There’s no silver bullet that can bring down gas prices right away…”


Really? If The Bernank raised rates at tomorrow’s FOMC meeting, oil prices would break $100/barrel in a day.


We’d like to remind all of our friends and foes who are still beer-bonging the Keynesian Kool-Aid that there are 3 things that burning your currency at the stake with generational levels of leverage (debt) does to an economy:

  1. It perpetuates The Inflation priced in US Dollars
  2. It structurally impairs the sustainability of long-term economic growth
  3. It dares institutional investors to chase “yield”

No, we’re not saying that these conditions will persist as a perpetually preferred dividend for those of us who are long of The Inflation. Neither are we saying this will end well. What we are saying is that playing the game in front of us right now is the game of Gaming Policy – and, as sad a state of a “free market” as this is, when this game changes, it will change abruptly.


The bureaucrats are going to really hate having to deal with that.


My immediate-term support and resistance lines for the SP500 are now 1320 and 1341, respectively.


Best of luck out there today,



Keith R. McCullough
Chief Executive Officer


Gaming Policy - Chart of the Day


Gaming Policy - Virtual Portfolio


Cosi announced comparable restaurant sales for the first quarter and, while not a disaster by any means, it seems that March was a soft month for a number of companies I track.


COSI released comparable restaurant sales results for the first quarter today after the close.  Company-owned comparable restaurant sales grew 3% in the quarter.  The number was comprised of 1.5% price and 1.5% average check and implied two-year average trends of -0.7% or 40 basis points below 4Q.  This is a disappointment because, as the chart below illustrates, the last three quarters had brought sharp gains in the two-year trend for company owned restaurants’ comparable sales growth. 





During the 4Q10 earnings call on March 28th, management disclosed that company comparable store sales had grown 1.6% in January and 6.2% in February.  Assuming equal weights for each of the three months would imply March comps came in at roughly 1.2%, which is a disappointing number.  However, while the market may react negatively to this print tomorrow, I think there is one important caveat to keep in mind.  March of 2010 was the first month of the year where company comparable restaurant sales growth was positive. 


Clearly March of this year had a difficult comp.  If the company can produce a one-year comp better than -3.3% for 2Q, the two-year average trend for COSI’s company comps will turn positive.  With that in mind, March 2011 comparable sales being up 1.2% versus a positive March 2010 is not quite as bad as many may initially fear.  Thus far this earnings season, a number of companies including EAT and PFCB have reported soft March comps.


I believe the sales trends in 2Q11 have accelerated from the 1Q11 level.  


Howard Penney

Managing Director

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Transitory Commodity Inflation?

This note was originally published April 28, 2011 at 15:09 in Macro


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


“We are pleased with our operational and financial positioning for the future.  While current industry conditions remain challenging, we have a number of opportunities, both domestic and international, that are attractive and exciting for the Company. Additionally, the early acceptance of our new Pro Series cabinets has been excellent, and we continue to be pleased with the strength of our gaming operations business.”

- Richard M. Haddrill, the Company’s Chief Executive Officer



  • New game sales: 3,417 ; ASP: $15,556
    • ASP increased primarily as a result of mix, including sales of the Pro Series Cabinet
    • International unit sales were 29% of total
    • Nearly all of their units were replacement, 210 for sale (MD is on a participation basis for them vs. for sale for other suppliers)
    • Gross margin decreased to 43% due to "higher costs for the initial production runs of the Pro Series cabinets as well as write-downs related to older technology platforms.
  • Repurchased over 2MM shares since the beginning of FY2011 for $76MM
  • Gaming operations had a nice increase in install base
    • Placed over 550 units of New Vegas Hits game during the quarter
    • "Gross margin increased to 74 percent from 72 percent in the same period last year primarily due to lower jackpot expenses."
  • Systems revenues declined due to "fewer large new implementations during the quarter."
    • Gross margin increased to 77% "primarily as a result of the change in mix of products sold and an increase in maintenance revenues. Specifically, hardware sales were 34 percent of Systems revenues, and software and service sales were 31 percent, as compared to 36 percent for hardware and 35 percent for software and services in the same period last year."
    • Maintenance revenues hit $16MM
  • 2011 Business update:
    • Reiterated reduced guidance of $1.82-1.95 ($1.31 from continuing operating in the first 9 months of FY11).  The guidance doesn't include the impact of the tender refinance.


  • Reason for their buyback include faith in their specific opportunities and belief in the recovery of the replacement market
  • Believe that their ship share was 18% for replacement units
    • Based on our math, it was 13% for total NA shipments
  • Operating margins have been continued to be impacted by investments in international market that will not produce revenues until 2012 and beyond
  • Higher bad debt expense due to a few international receivables
  • Effective tax rate was 36.5% - impacted by change in mix of international and domestic business. Expect their tax rate to be 35-36%.
  • Inventory increased as a result of building inventory for cabinets to be deployed to Italy once approvals are obtained
  • Premium game color:
    • Cash Wizard orders are over 700
    • Heart Spin had just started
    • Money Vault w/ USpin launched
    • Betty Boop Love Meter launched
  • 80% of domestic sales this quarter were video slots
  • Pro Curve - is the first curved LCD display - look and feel of a reel spinner in a video format is also being rolled out
  • 2/3 of the new systems installs involved the replacement of a competitor system - including the system at Grand Lisboa
  • Expect pressure on their game machines margins as they ramp up their Pro Series cabinet
  • International/ new opportunities include:
    • Italy
    • Canada
    • Australia
    • New Zealand
    • Pro-Series improvement and rollout


  • Will have 50 titles on Pro-Series by end of the calendar year
  • Had 300bps of margin impact due to obsolescence charge. Expect game sale margins to be in mid 40's range. Longer term, expect margins to be in low to mid-50's once they are mid cycle on their Pro Series life cycle
  • Process in Italy is product approval and then installation - they don't need to do a field trial. They expect to start shipping later this calendar year. Have over 4,000 commitments mostly on participation.
  • Have 11 customers signed up for iVIEW DM now and 6 customers have iVIEW DM on banks of games
  • Feel like their opportunity on game sales is more on the margin side not ASPs as much.
  • Decrease on linked progressives has to do with more of a focus on premium fee games. They did just release two new games for the progressive product so they do expect it to trend up going forward.
  • Bad debt expense was roughly 3 cents and the obsolescence charge was 2 cents in the quarter. They do expect a sequential increase in systems revenue and replacements should increase seasonally as well next quarter.
  • Regarding systems - they are reviewing their guidance methodology and that's why the guidance range for 4Q is so wide
  • They will announce the results of the tender offer on May 6th
  • Bad debt expense was about $2MM higher than what they would expect - so that impacted SG&A a bit
  • Quarter end diluted share count was 55.527MM - buyback in the quarter was $35MM
  • On the Alpha 2 platform, their new games are exceeding performance expectations
  • What's in their other equipment sales?
    • Higher conversion kits and used games, expect to see some increases in used games going forward
  • Sales environment internationally?
    • There are economic challenges in Western Europe but the good news is that Italy will be a very solid market
    • Have been making investments in Africa which haven't panned out yet
    • Just starting to ship to Australia and New Zealand
    • Compared to last year they had a large sale to Mexico and LVS opening in Singapore
  • Expect to start generating revenue from the Canada system some time at the end of the year
  • Just received approval to ship to New South Wales - and will begin to recognize revenue in the June quarter
  • During their system user conference they were able to demonstrate some exciting applications that can run across DM - believe that will allow them to drive sales
  • Alpha 2 was 50% of their shipments. Used introductory pricing to get them moving.

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


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