State of the Industry: Beware the Sucker Punch

Step 1 was ‘State of the Consumer.’ Step 2 is ‘State of the Industry,’ which is outlined herein. Step 3 is nailing who wins, and flushing out my list of who goes bankrupt. That one is growing.

From an industry standpoint, the conclusion is that looking forward, the year/year trajectory in sales and margins might start to look like an intriguing ‘Trade,’ but tread lightly as the ‘Trend’ is headed lower, and does not synch with the consensus 40bp improvement in margins next year. Let’s look at the key profitability components…

Revenue: In aggregating the top line the industry is still humming at about +5% vs. last year – despite a sharp sequential deceleration. Comp store sales are running down low-single digits, but yy compares don’t start to get easier until December, and then more meaningfully so in June. That might be good under most circumstances, but go back and read my ‘State of the Consumer’ postings. This is precisely the point when the yy delta in spending for the consumer in aggregate will intensify. My point? Don’t get suckered into the ‘comps are getting easier’ argument.

EBIT Margin: Margins troughed in 1Q, and while still off -175bp vs. last year, they are clearly ‘less bad’. That’s good at face value given that margins drive stocks in this group. But there are two factors we cannot ignore. 1) Working capital in this industry is at its lowest level in 8-years. There’s not enough working capital to drive operating profit growth even if the consumer did rebound. Historically, higher margins on top of normal working capital levels resulted in a meaningful pop in growth. It’s very difficult to get the math to make that work today. 2) Margins are still sitting at 8-9% overall – right in line with where they were before margins raced higher in ’04-’07. No reason why they can’t go lower. In fact, they will.

Lastly, the SIGMA chart below ties it all together (triangulating sales growth and inventory growth on the vertical axis, with the change in gross margin on the horizontal). The picture this paints is one that has been healthy over the past 1.5 years – especially the last 3 quarters. My sense is that we’ll see this trajectory head down and to the left. Never a good event, and one that clearly does not synch with the consensus expectation for margins to head higher by 40bp.


Actually, Beijing’s interference is a major driver of the sharp sequential downturn in gaming revenues in Macau. While underlying casino demand declines across the globe, it is accelerating in Macau. However, Beijing controls the spigot. If you believe Beijing favors long term sustained growth for Macau, as I do, then Macau now appears to be a much better relative value than other gaming markets. Government interference in the US economy will do nothing to stem the negative trend in gaming revenues. Las Vegas faces a fundamental demand issue as consumers tighten, savings rates escalate, travel becomes more difficult and expensive, and the Strip pays the price for raising prices so much over the past few years.

Macau’s issues are short term and will likely get better next year at the latest. The Strip’s problems are structural and cyclical. Where would you rather invest?


In a prior post, I examined the poor stock price performance of gaming stocks in the late 1990s. Similar to now, same store sales declined dramatically but unlike now, total market revenue continued to expand. Another difference between then and now is leverage. Leverage ratios remain at all time highs (see chart #1) and certainly are contributing to all-time low valuations.
  • With a global credit and liquidity crisis, it’s no surprise that one of the most leveraged sectors has grossly underperformed. Strangely, the valuation variance across the gaming sector is low. BYD and PENN own the liquidity in the industry, yet trade roughly in-line with the group. PENN runs at least 3 turns below the average gaming leverage ratio and BYD, while at average leverage, should be able to de-lever faster than the rest.
  • The opportunity is glaring. The companies that risk managed their liquidity and balance sheets smartly (BYD and PENN) are lumped in with the rest because they are gaming stocks. As can be seen in the second chart, PENN barely outperformed the group this year and BYD underperformed. Strange that the factor that has caused gaming to underperform the market so sharply wouldn’t also drive relative value. That’s not sustainable.
Gaming leverage ratios remain at all-time highs
Despite higher liquidity, BYD and PENN lumped in with the rest of the sector

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%
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US Market Performance: Week Ended 10/10/08...

Index Performance:

Week Ended 10/10/08:
DowJones (18.2%), SP500 (18.2%), Nasdaq (15.3%), Russell2000 (15.7%)…

October/Q408’ To Date:
DowJones (22.1%), SP500 (22.9%), Nasdaq (21.2%), Russell2000 (23.1%)…

2008 Year To Date:
DowJones (36.3%), SP500 (38.8%), Nasdaq (37.8%), Russell2000 (31.8%)…


Rational people can argue whether Edmund Ho, Ao Man Lang, public perception in the Mainland, etc. are to blame for the tighter visa restrictions. The better question, however, is what is Beijing’s long term goal? Following my meetings, I feel more confident that Beijing is not out to crush Macau. Rather, the goal is controlled and moderate growth. Beijing tweaked and tweaked to no avail until September when it became clear they tweaked too much. The only question now, in my opinion, is when, not if, do they loosen the visa reigns?

Worse case scenario, the three month visa restriction from Guandong stays in place until mid next year when preparations are made for the new Chief Executive to take over. There would be obvious incentive to get the new CE off to a strong start. Just as likely, Beijing could loosen the Guandong visa restriction very soon. This view was espoused by multiple sources, including one that appears to have a direct line to Beijing. Remember that Beijing never formally announced a three month visa restriction. It would be just as easy to not formally announce a return to the two month and even one month restriction.

I don’t hear a lot of talk about Taiwan in the US analysis of Macau. Understanding the Taiwan equation is critical to understanding Beijing’s intentions in Macau. Beijing still holds the ultimate vision of bringing Taiwan into its network of SARs. I’m not sure inflicting pain for an extended period of time in Macau would be the best way to show Taiwan the benefits of an SAR. In this regression analysis, independence is a major factor in the equation and Beijing needs to prove to Taiwan that it can be an independent variable.

With investor expectations near rock bottom, the next Macau catalyst could be a positive one.

Don't underestimate the Taiwan (Formosa) impact


This past week I met with Macau operators, intermediaries (junkets), legislators, developers, and lawyers. After 15 meetings over 4 days in Macau, I think I’ve got a pretty good handle on why Beijing is inflicting so much pain on the Macau marketplace through tighter visa restrictions. At least, I’ve narrowed it down to 9 possible explanations. While my list is not exactly narrow, the right answer is probably a combination of some or all of these. More importantly, though, most of these explanations seem to suggest a finite duration. This is reason enough to be more positive on the Macau marketplace.
Possible explanations for Beijing’s actions:

1. Parent teaching child a lesson
2. Want to control growth but tweaked too much
3. Punishment for Edmund Ho – public comments about Beijing and other issues
4. Punishment for Ao Man Lang scandal
5. Protecting mainland Chinese – public perception that Chinese are losing too much money
6. Americans are making too much money
7. Gaming companies didn’t give enough to Sichuan – Adelson and Wynn gave $5m each
8. Macau government not following through on infrastructure build out
9. Want to set the stage for a strong start with the new Chief Executive next year

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