Intellectual Honesty

“I think we are very good at intellectual honesty.”

-Seth Klarman


I was flying to Kansas City from Denver last night and an outstanding interview in the Financial Analysts Journal bubbled up to the top of my pile – an interview with one of the world’s most thoughtful Risk Managers, Baupost’s Seth Klarman.


“We actually hire for intellectual honesty. In an interview, we work hard to see whether people can admit mistakes. We hold our people accountable to that standard.” (Klarman, “Ahead Of Print”, 2010 CFA Institute)


Accountability. Honesty. Standards.


That works for me and, from what I can tell, it works for a lot of our clients who understand that there is a difference between running a P&L and running a business. There’s a difference between rigorous research and disciplined risk management too. The best teams in this business do both.


“We have all our own money invested in the firm, and so we are very conservative. We have picked our poison. We would rather underperform in a huge bull market than get clobbered in a really bad bear market.” (Klarman, “Ahead Of Print”, 2010 CFA Institute)


Ownership. Preservation. Conviction.


Those principles work for me too.


“We ask people, what is the biggest mistake you’ve ever made? It’s a very open-ended question because it’s not solely an investment question, although prospective hires often answer it as if it were.” (Klarman, “Ahead Of Print”, 2010 CFA Institute)




Back to the Global Macro Morning Grind


In the face of awful US Economic data yesterday:

  1. CONFIDENCE: Bloomberg Weekly Consumer Comfort Index dropped to a fresh YTD low of -49.4 vs -46.9 last week.
  2. HOUSING: US Existing Home Sales  fell -0.8% for April, dropping from 5.09 million in March (seasonally adjusted annualized) to 5.05 in April.  This is a sharp divergence from the March Pending Home Sales, which increased 5.1% month-over-month.
  3. GDP GROWTH: US Leading Indicators for April were down (0.3%) sequentially vs. +0.7% in March (the sharpest decline in well over a year)

And … with the US Dollar down on the day… the inverse relationship (The Correlation Risk) between Fiat Fool policy and stocks continued to hold (USD down = stocks up). The US stock market was able to hold a +22 basis point gain. With the SP500 closing at 1343, it’s down -1.5% from its April 2011 YTD high, and down -14.2% from its October 2007 all-time high.


You mean, on alarmingly low-volume, the mistakes we’ve all made between late 2007 (where I got bearish too early) and early 2011 (where consensus has been too bullish on US Growth) has only equated to lower immediate-term and long-term highs in US stocks? Yep. This special case of making lower-highs in stocks has been occurring in Japan since 1992. Big Government Intervention has its perks.


No matter where I go this morning, the entire risk management community can see all of my mistakes. My current mistakes are attached at the bottom of every morning’s Early Look (my biggest mistake on the long side is currently Suncor (SU) at -5.3% and, on the short side, Consumer Staples (XLP) at -2.9% against me). My longer term mistakes are all time stamped on our website and on the back of my ankle.


Transparency. Accountability. Trust.


These are principles that plenty of politicians give lip service to. In real-life, they are extremely hard to achieve. I don’t think my firm is there yet, but I do know that the people I have working with me have Intellectual Honesty – and in terms of re-thinking industry standards on independent research, I think we’re well on our way.


My immediate-term support and resistance ranges for Gold, Oil, and the SP500 are $1480-$1502, $95.16-$100.91, and 1, respectively.


Best of luck out there today,



Keith R. McCullough
Chief Executive Officer


Intellectual Honesty - Chart of the Day


Intellectual Honesty - Virtual Portfolio


Even at the high end of the stated range, MGM China looks like a good deal for investors.





We think MGM China is worth at least HK$16 per share.  This is higher than the HK$12.36-15.34 stated range in the prospectus.  Our valuation is based on 10x 2012 EV/EBITDA plus approximately HK$1 for a future Cotai property.  The all-in valuation at HK$16 would still put MGM China at more than a 25% discount to Wynn Macau and Sands China and a 12% discount to the average of the comp group.  The discount is predicated on the following:

  • A conflicted joint venture structure that while MGM is in control, is reliant on a 29% partner Pansy Ho who serves on the STDM board, the largest shareholder of competitor SJM in the Macau market.
  • MGM is not a primary concessionaire
  • While we think it is likely that MGM ultimately develops a Cotai property, Sands China with Lots 5/6 and Wynn Macau with Wynn Cotai are further along
  • The majority shareholder MGM Resorts International is in significantly worse financial shape than LVS and especially WYNN

MGM China is likely to price at a valuation higher than MPEL which is more of a reflection of investors underpricing MPEL rather than an overvaluation of MGM China.  At the high end of the range, MGM China would price at 10.2x our 2012 EBITDA estimate of HK$5.2 billion which looks very reasonable to us given the growth profile of the Macau market and the income tax advantages in that market.  Remember that casinos pay no income taxes on gambling profits so the tax adjusted EV/EBITDA multiple is even more attractive relative to the US and even Singapore EBITDA.




Since we think MGM China is worth at least the top end of the stated range, we’ve priced out the following comp table assuming MGM China at HK$15.34:




Again, MGM China looks very cheap next to Wynn and Sands.  To be fair to Sands, since their new properties won’t be fully open in 2012, we should also look out to 2013.  Even on this basis, MGM China still would trade at an 11% discount to the comp group, a 22% discount to Sands and an even bigger discount to Wynn.  Only SJM (slightly) and MPEL would be cheaper. 


On a free cash flow yield basis, the comparisons are certainly tighter.  MPEL remains the clear standout under this metric while MGM China looks reasonable, but not necessarily cheap.  However, we think as long as Macau remains as growthy as it appears, investors probably will not pay much attention to yield.

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Over the past five days JACK has been the second best performing restaurant stock that we monitor.  Commodity costs are rampant and the hikes in inflation guidance are concerning.  However, given the commentary from other management teams that have been reporting for the past few weeks, the commentary on food costs was somewhat expected and not new news.  The top-line improvement that manifested itself in the 2QFY11 results, on the other hand, is new and therefore took center stage.  From that perspective, JACK had a good quarter.  While two-year trends remain soft, the upward revision in FY11 guidance is a positive.  With the stock trading at 6x EV/NTM EBITDA, the short thesis is losing credibility.


JACK 2QFY11 EPS came in light at $0.12 ex-items versus consensus at $0.20.  EPS guidance for fiscal 2011 remains unchanged despite a significantly more positive top-line outlook.  We’ve been highlighting improving unemployment trends in the young male demographic as being positive for QSR and, it seems, JACK has seen some benefit from that.   


On the negative side, commodity costs are clearly weighing heavily on profitability. While this is not new, it will be important to monitor commodity prices closely going forward to gauge the potential risk of further margin pressure from food costs.  Below, we detail 2Q results as well as management’s outlook and earnings call commentary.



2QFY11 Results:


Jack in the box company comparable-restaurant sales increased +0.8% year-over-year in 2QFY11 versus consensus of -0.5% and guidance of flat to -2%.  Jack in the box franchise comparable-restaurant sales declined -0.3%, in line with consensus expectations.  Qdoba system comparable-restaurant sales increased +6% versus consensus of +4.2% and guidance of +3-5%.  Food and packaging costs came in at 33.4% for the quarter versus consensus at 32.7% of sales.  Commodity costs are impacting JACK’s profitability meaningfully.









3QFY11 Guidance:


Jack in the box company same-store sales are expected to increase 2-4% versus a -9.4% decline in the year-ago quarter.  Qdoba system same-store sales are expected to increase approximately 4-6% versus a 4.6% increase in the year-ago quarter.  Commodity costs are expected to increase by 6-7% and refranchising gains are expected to decline from 3QFY10.



FY2011 Guidance:


The company raised top-line guidance significantly for FY11 following the better-than-expected 2QFY11 numbers and the trend in April which, we assume, also brought robust sales growth versus prior expectations.   Company same-store sales for Jack in the box restaurants are now expected to grow by 1-3% in FY11 versus prior guidance -2% to +2%.  Qdoba system same-store sales are expected to increase by 4-6% versus prior guidance of 3-5%. 

Consolidated restaurant operating margin is now projected to come in at 12.5% to 13.5% for the fiscal year versus prior guidance of 13% to 14%.  The company raised its commodity costs growth expectations to +4.5% to 5.5% (from 3% to 4% prior) for FY11 including +6-7% for 3QFY11.  


In terms of unit growth, 30 to 35 Jack in the box stores are projected to open in FY11 (in line with prior guidance) along with 60 to 70 Qdoba restaurants (versus prior guidance for 50 to 60 openings).



Earnings Call:


Management struck a positive tone on the earnings call, underlining the importance of same-store sales for the longer-term profitability of the company.  Commodity costs pose a strong threat to profitability and will likely continue to weigh on earnings for the foreseeable future.  Below is a selection of (paraphrased) incremental comments from management regarding the quarter and the company’s future prospects:




  • 1.5% of pricing was taken last week in company stores.  Breakfast continues to be strong and the company also saw gains during the dinner day part.
  • CA and TX continue to have positive same-store sales with CA the best performing market on a two-year basis.  AZ quarterly comparable store sales were positive for the second consecutive quarter.
  • The All-American Jack Burger has successfully driven sales as a $4.99 combo meal.  However, there was a negative impact on mix from the popularity of this promotion.
  • New menu boards are being rolled out (a “before and after” will be shown at the Wells Fargo conference next week) that management expects to improve the customer experience and encourage trial and sales of higher mix items.
  • The reimaging program (70-80% of Jack in the Box system now franchised) is nearing completion is focused on producing better sales and satisfaction scores as well as more efficient operations within the four walls.
  • Qdoba is performing well with transaction growth driving performance.
  • Management is not noticing any meaningful change in the competitive discounting environment.



  • Improved margin in the back half of FY2011 includes the sale of underperforming restaurants.  That benefit remains part of margin guidance but commodity costs being as elevated as they are, overall margins are still expected to rise.
  • Food costs are expected to remain elevated.  Tellingly, while emphasizing the lack of visibility on this issue, management stated that they are seeing no sign of abatement in food costs looking past FY11.  The recent decline in food costs did not spur the company to make a bullish statement on this subject.
  • Labor costs were higher in the quarter due to higher levels of staffing designed to approve the guest experience as well as increases in unemployment taxes in several states.
  • The company expects restaurant operating margin will be above 16% at the conclusion of the refranchising strategy in a “normalized environment”. 
  • Qdoba is expected to have a positive impact on restaurant operating margins in the back half of FY11.  Qdoba now accounts for 21% of the company restaurant base versus 12% a year ago as Qdoba stores are opened and the refranchising program continues.



Unit development/Reimaging/Refranchising

  • The refranchising program is progressing ahead of schedule – 70-80% of the Jack in the Box system is now franchise-operated.
  • Reimage contribution payments to franchisees impacted EPS significantly.  Additionally, guidance for impairment and other charges of 70-80 basis points of sales in 2011 represents approximately $0.20 of EPS. 
  • Impairment costs are expected to continue to impact earnings but, while difficult to forecast, management expects this item to have a lesser impact going forward.


Howard Penney

Managing Directory

Aussie Dollar: Dancing ‘til the Music Stops

Conclusion: We expect the Aussie dollar to correct over the intermediate term as consensus expectations for an RBA rate hike(s) over the next 3-6 months are irrational due to a pending slowdown in domestic growth. Additionally, our 2Q Macro Theme of Deflating the Inflation is incrementally negative for the AUD as the Inflation Trade unwinds.


Position: Bearish on the AUD for the intermediate-term TREND; bullish for the long-term TAIL. (ETF: FXA)


If your fund is able to take positions in currencies and you’ve been long The Great Inflation Trade, chances are you have some long exposure to the Aussie dollar. We too have dabbled over the past couple of years, going long the AUD in the Virtual Portfolio as early as June ’09 – a few months after we turned bullish on global equities and the associated Reflation Trade.


While the AUD remains one of our favorite currencies on the long side over the long-term TAIL, we cannot ignore the mounting risks associated with being long at this juncture. As such, we continue to expect a measured correction in the coming months.


Below we update our bearish thesis on the Aussie dollar. For our introductory analysis, refer to our April 6 deep-dive report titled, “Aussie Dollar Getting Long in the Tooth”.


To start let’s quickly outline the bull case, which has indeed been supportive of the Aussie dollar’s +25.6% performance over the last 12 months (second best among all currencies worldwide vs. the USD over that duration):


Hawkish central bank: Since the Great Recession, the Reserve Bank of Australia has been far and away the most hawkish central bank in the developed world, raising interest rates seven times (+175bps) to the current 4.75% - a rate advantage that has contributed to widening interest rate differentials and has made the AUD among the most attractive carry trade options on the long side. Additionally, earlier this month, the RBA increased its full-year inflation expectation +25bps to +3.25% YoY, fueling speculation about further interest rate hikes over the intermediate term. For reference, the RBA has been hold since November.


Fiscal austerity: One of the primary reasons we remain bullish on the Aussie dollar over the long-term TAIL is due to the fiscal conservatism we continue to see out of the Australian parliament. Just last week, Treasurer Wayne Swan introduced a budget that calls for an end to 23 consecutive years of spending growth, which will put them on target to deliver an A$3.5B surplus in FY13. In FY12 alone, the budget reduces the current A$49.4B deficit by a whopping (-51%)!


The Inflation Trade: One of the differentiating core tenets of our Global Macro risk management model is our acute measurement and risk-weighting of cross-asset correlation. In the case of the AUDUSD currency pair, we are measuring a positive 0.93 correlation (r² = 0.86) vs. the CRB Index on a 1Y basis. Versus the S&P 500, the positive correlation remains substantially elevated at 0.92 (r² = 0.85). While it’s true that correlations are neither causal nor perpetual, we do point out the market-positioning risk associated with r² readings in or above the 0.7-0.8 range. That is to say when the math is this high, investors are generally looking to the same global macro fundamentals to dictate the prices of the two assets in question.


As we pointed out prior, we think the support for the bull case is eroding on multiple fronts, and, as such, we expect to see a decent sized correction in Aussie dollar in the coming months. The AUDUSD currency pair is already down (-2.7%) from its 30Y-high closing price established on April 29th and we think there is more weakness to be recorded.


To recap, our bearish thesis is two-fold:


1. Our models have Australian GDP growth slowing in the near term and accelerating in the back half of the year – an acceleration that is likely to come in (-75bps) to (-100bps) shy of current consensus expectations. The slowdown in growth both on an absolute and relative basis will cause Australian interest rates to drift downward, lessening the Aussie dollar’s interest rate advantage over other currencies.  Whether or not growth slows enough for the RBA to consider loosening policy over the next six months remains to be seen at this juncture. It is, however, a very contrarian risk we are flagging and we will continue to monitor it real-time.


2. Our 2Q Macro Theme of Deflating the Inflation remains a substantial risk to the Aussie dollar, as falling commodity prices are both implicitly and explicitly bearish for the AUD. Implicitly because we expect lower inflation expectations within the Aussie fixed income market to translate into lower rate hike speculation. Explicitly because commodities account for over 60% of Australia’s total exports; thus, additional weakness across the commodity complex will reduce Australia’s terms of trade (currently at a 140yr high) and create a drag on Australian GDP growth via lower Net Exports.


Regarding component #1 specifically, recent Aussie economic data has been unsupportive of market expectations of an RBA rate hike(s) over the next 3-6 months and declining consumer and business confidence is pointing to even slower growth ahead: 

  • TD Securities Unofficial CPI Index slowed in April: +3.6% YoY vs. a prior reading of +3.8%;
  • Melbourne Institute Consumer Inflation Expectation slowed in May: +3.3% YoY vs. a prior reading of +3.5%;
  • ABS House Price Index decelerated in 1Q: (-0.2%) YoY vs. a prior reading of +5% and consensus expectations of +1.6%; the QoQ decline of (-1.7%) was the steepest decline since 3Q08;
  • Retail Sales growth slowed in March: (-0.5%) MoM vs. a prior reading of +0.8% and consensus expectations of +0.5%; higher interest rates are definitely slowing Household Consumption growth (54% of GDP), as 90% of Aussie homeowners have floating-rate mortgages and the aggregate consumer debt burden is 150% of their combined gross income;
  • Home Loan growth dropped -1.5% MoM in March to the lowest absolute level in over a decade;
  • Westpac Consumer Confidence Index fell in May to the lowest reading since June ‘10: 103.9 vs. a prior reading of 105.3;
  • Employment growth slowed in April: (-22.1k) MoM vs. a prior reading of +43.3k and consensus expectations of +17k; YTD employment growth of +26.3k is the weakest Jan-Apr pace since 1999; anecdotally, mining continues to be a bright spot, while the larger retail and manufacturing sectors continue to show weakness;
  • NAB Business Confidence Index fell in April: 5 vs. a prior reading of 9; and
  • NAB Business Conditions Index fell in April: 7 vs. a prior reading of 9. 

The Australian bond market agrees with our go-forward assessment of slowing growth, with the long end of the curve declining (-33bps) since peaking on April 11th. The short end of the Aussie interest rate curve, which is more influenced by monetary policy expectations than the long end, also declined (-13bps) over that duration, compressing the 10Y-2Y spread (-20bps) to 41bps. To be frank, Aussie bond yields breaking down across the curve alongside a compression in the maturity spread is an explicit signal of slowing growth ahead and/or lower future inflation expectations – neither of which is supportive of the RBA increasing rates anytime soon.


Aussie Dollar: Dancing ‘til the Music Stops - 1


Aussie Dollar: Dancing ‘til the Music Stops - 2


Regarding the Deflating the Inflation component, the following two charts are all you really need to see. While it would be incorrectly premature to say the Great Inflation Trade is over, the quantitative setups for the CRB and US Dollar Indexes suggest we are perhaps in the early innings of the Great Unwind.


Aussie Dollar: Dancing ‘til the Music Stops - 3


Aussie Dollar: Dancing ‘til the Music Stops - 4


While QE3 remains a definite possibility in our models (US Treasury bonds continue to trade bullish TREND across the curve), we think the mounting political pressure facing The Bernank, combined with the fact that CPI is set to accelerate, will keep him from reaching further into his bag of monetary policy tricks at the expiration of QE2 – at least temporarily. US consumers don’t buy “transient” when prices at the pump are spitting distance from $4.00/gal. Additionally, our models have US Headline CPI accelerating on a YoY basis over at least the next quarter or so, meaning that market expectations for QE3 could conceivably come down on the releases. Time will tell on whether or not this scenario plays out.


All told, the music is still playing and the Aussie dollar is still dancing – above parity with the US dollar I might add. If you’re long the Aussie dollar, don’t be caught without a chair when the music stops.


Darius Dale



We expected a miss but the hold impact was much greater. With this hurdle out of the way, the catalysts are lining up positive beginning with MGM’s pricing next week.


While we remained positive on the intermediate and long term MPEL story, we had expected a bigger blip from the earnings miss.  With earnings out of the way, the catalysts are lining up positive. 

  • MGM will price its deal next week – we expect at the high end of the range and a premium to MPEL.  This should highlight how cheap MPEL is – under 10x 2012 EV/EBITDA
  • April was a great month for Macau and MPEL’s share went up significantly.  MPEL had hold issues in the first 2 weeks of May but that will normalize.  We are looking for strong, consensus beating estimates for Q2.
  • Galaxy not having much of a negative impact so far despite the market’s concern
  • There may be an announcement soon regarding Studio City which upon completion should provide MPEL with a sizable concession and management fee.

As we expected, MPEL reported strong volumes and top line, but missed consensus expectations due to low hold.  Compared to our estimates, MPEL’s 1Q11 revenues came in 2.4% above our estimate while EBITDA was 7.4% below our estimate.  Management claims that the low hold and playing especially unlucky in their rolling chip commission programs (vs the revenue share programs) impacted their EBITDA by $53MM.  Of course, investors have no way of knowing the exact magnitude of the ‘mix’ impact but we think it may have been less than what management estimated.  If we take management’s assertion of unlucky mix impacted EBITDA of $12-13MM, our math says that the actual hold impact on EBITDA was closer to $35-40MM than $53MM.  Still, absent low hold, this would’ve been a very strong quarter.



City of Dreams

  • Net revenues of $500MM were 3% above our estimate while EBITDA of $86MM was $9MM below our estimate or 9%.
  • Gross VIP win of $470MM was $7MM above our estimate
    • RC volume was $1.1BN lower than we estimated since direct play was only 13.7% in the quarter compared to 18.9% in 4Q10 and 16.4% in 2010. The decrease in the direct play mix could have also decreased EBITDA flow through since direct play has theoretical margins that are roughly 8% higher than junket VIP play.  However, this is not something that you would normalize for.
    • Hold of 2.5% was 17bps higher than we estimated, given our higher RC estimate
    • We estimate that low hold negatively impacted revenues by $66MM, however, we have a hard time getting close to the $53MM impact that company claims hold had on EBITDA.   If hold was 2.5% across both revenue share and rolling chip play, assuming 2.85% hold, and a 50/50 RevShare/RC commission mix, hold would have negatively impacted EBITDA at CoD by $25MM.  The company stated that $40MM of the EBITDA adjustment was due to just low hold, but that would be the math if you just removed gaming taxes.  Since they have 50/50 mix, higher hold also means higher commissions to the junkets on revenue share deals.
    • Mass win of $146MM was 2% higher than we estimated
      • Drop grew 35% YoY vs. our estimate of 42%.  However, hold was 1.5% higher than we estimated.   Using the 2010 average win % of 21.3%, mass win would have been $8MM lower and we estimate that EBITDA would have been $5MM lower.
    • Slot win of $32MM was $6MM lower than we estimated
      • Handle only grew by 16% YoY, materially lower than our estimate of 45% growth. However, slot hold of 6.3% was 70bps higher than slot win in 2010 and 1.1% higher than 2009.
      • We estimate that elevated slot hold % boosted revenues by $2MM and EBITDA by $1M
    • We estimate that fixed expenses were $74MM for the quarter, although some of what looks like higher expenses is likely attributed to unlikely mix in the quarter.


  • Net revenues and EBITDA missed our estimates by 1% and 8% respectively.
  • VIP gross win of $356MM came in $6MM below our estimate
    • RC volumes were in-line with our estimate but hold was 5bps lower
    • If hold was 2.85%, we estimate that gross revenues would have been $6MM higher and EBITDA would have been $3MM higher
  • Mass win of $25MM was $4MM better than we estimated
    • Table volume grew 96% YoY vs. our estimate of 65%
  • Implied fixed cost were $32MM - $10MM above our estimate, although as the company mentioned on the call there were some hold/mix issues that impacted the property which would show up in implied fixed costs in our model

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