The Economic Data calendar for the week of the 18th of July through the 22nd is full of critical releases and events. Attached below is a snapshot of some (though far from all) of the headline numbers that we will be focused on.
HEDGEYE MACRO 3Q11 THEMES: Policy Pong, Risk Ranger & Chinese Cowboys
REPLAY PODCAST & SLIDES
July 15, 2011
Hedgeye's Macro Team, led by CEO Keith McCullough and DOR Daryl G. Jones, recently hosted their quarterly themes conference call. The key topics included:
Materials: "MACRO Q3 THEMES PRESENTATION"
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The Hedgeye Macro Team
Not surprisingly, the University of Michigan consumer sentiment index plunged in July.
It’s not a great time to be an American consumer as confidence in Washington’s ability to run the country effectively wanes. No doubt the current debt ceiling debate is doing little to boost consumers’ perception of their representatives.
Today it was reported that confidence fell 7.7 points sequentially to 63.8 in June, the biggest decline since March and the lowest level since March 2009. The expectations component led the decline, dropping 9 points to 55.8 (lowest level since March 2009) and the assessments of current conditions dropped 5.7 points to 76.3 (lowest level since November 2009). This is not a shock to anyone paying attention to the data; the economic drivers of confidence remain very weak.
The remedies required to address the serious fiscal issues facing the U.S., “eating peas” at the President calls it, are likely to impact growth negatively – at least initially. At the same time, politicians’ inability to address the nation’s debt is a serious concern for consumers’ confidence.
The decline in confidence comes on the same day that the New York Empire State Manufacturing Survey's weaker than anticipated. This survey is the first look at factory conditions during the month of July. Within the survey, the employment indicators weakened significantly; the employment index barely stayed in expansionary territory, falling from 10.2 to 1.1 in July. The average employee workweek (hours) index fell sharply from -2 to -15.6.
Looking at the overall set up, confidence and manufacturing data are decidedly bearish. This bearishness is being compounded by a volatile political climate. The uncertainty is hurting business confidence, which is discouraging hiring and impairing income growth. While I would like to strike a more positive tone this Friday afternoon, the preponderance of the evidence suggests that confidence will remain in the doldrums for, at least, the immediate term.
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Not much to worry about here other than the timing of a replacement demand recovery. Didn’t need accounting specialists to tell us that.
On June 29th, Gradient initiated on BYI with “D” – basically a sell rating. The crux of Gradient’s opinion rest’s on BYI’s exposure to the weak replacement cycle coupled with concerns over declining deferred revenues and rising inventory and accounts receivable balances. The ‘flags’ that Gradient raises are not new. CFRA has been blowing the same horn for at least a year now. While we won’t deny that BYI has some issues, we’re not concerned about the ones raised by Gradient and CRFA.
Point 1: Negative fundamental trends
“The domestic replacement cycle seems to have been prolonged as casino operators take longer to make purchasing decisions. As a result of a decline in international sales, the company now sources 81.3% of its revenue from the United States and Canada—raising our level of concern as BYI’s exposure to the slow domestic replacement has increased at an inopportune time”
HE Response: The replacement cycle is at a trough. Current levels are unsustainable and this is exactly why we like the slot manufacturers. We’ve written extensively on this topic (see UNDERSTANDING THE REPLACEMENT MARKET published on 8/17/2010) so we won’t rehash our entire thesis but in a nutshell, an 18 year replacement cycle is not sustainable since even poker machines die and yes, get replaced after 12-15 years. Mechanical spinning reels last about 8-12 years while video slots become obsolete after about 8 years. While we don’t know exactly when the replacement cycle will make its big upswing we do think that the new markets coming online over the next few years will help spur at least defensive investment by casino operators.
Point 2: Divergence between earnings and cash flow
“In recent periods, both earnings and cash flow have declined. However, cash flows have experienced much larger declines”
HE Response: This is a fair point, but the correct comparison would add back the investment that BYI makes in their gaming operations business to Cash Flow from Operations. The balance of the divergence are explained by growth in A/R and Inventory.
Point 3: Increase in accounts receivable
“Throughout FY2011, accounts receivable have increased disproportionally faster than sales have increased. The rise in total receivables is driven by a large increase in long-term receivables. According to the company’s most recent 10Q, BYI has extended payment terms for select customers. This may indicate that the company has (1) potentially pulled forward demand from future quarters, and/or (2) taken on
a greater level of collection risk.”
HE Response: $26MM of the increase in accounts receivable since 2010 is due to loans that BYI made to the Italian concessionaires to help them finance the VLT licenses (Euro 15k/device). The loans will be paid back in 5-9 years. Floor financing for customers is more typical in international deals since they tend to be longer in nature. As Bally expands more internationally, we will likely see a continuance of this trend.
Point 4: Increase in inventory
“The largest driver behind the increase in accruals was the change in BYI’s inventory level. Inventories consumed $89.8 million in CFOA for the 12 months ended 03/31/11. In our opinion, the increase in inventory is likely related to the introduction of the company’s Pro Series cabinets”
HE Response: The vast majority of the increase in inventory is Italy. Bally has contracts to place 5,000 VLTs in the Italian market over the next year and to provide systems for those units. Most of the units will be in gaming operations and so far BYI has not started collecting revenue on those units. Gaming operations expenditures sit on the balance sheet of the supplier and get depreciated over the life of the machine. A small part of the inventory increase is due to BYI stocking up on parts for the new Pro Series cabinet – particularly the Alpha 2 processor.
Point 5: Decline in deferred revenue
“Revenue sustainability may be at risk as the company’s deferred-revenue balance has declined significantly in recent periods. Growth in deferred revenue has trailed revenue growth for 11 consecutive quarters. As a result, deferred revenue is now at a level not seen since FY2007. While a portion of the decline relates to a change in the company’s revenue-recognition policy, at a minimum the decline in deferred revenue suggests less balance-sheet support for future revenue growth.”
HE Response: As Gradient points out, in 2009, there was a change in account policy that allows BYI to book non-software revenue at the time of delivery. Previously, BYI often had to defer revenue from contracts that ‘bundled’ systems and unit sales. The best example is what happened with the 2,300 unit sale to Oregon in 2008 which BYI had to recognize over 7 years (the life of the systems contract with the state). The change in accounting policy affects all industry participants, not just BYI, and allows GAAP to more accurately reflect cash revenue.
Food at home inflation is heading straight up. Restaurants seem to be holding firm.
As inflation has ramped up from the trough in 2009, Food at Home CPI has outstripped Food Away From Home CPI. Restaurants may be seeing a benefit from this as grocers have moved first in raising prices to protect margins in the face of food inflation. This could be aiding traffic trends in the restaurant industry, which, have generally been robust over recent quarters. Additionally, the price action in the space – on a relative basis – has been particularly strong of late.
The question of “when might the supermarkets’ aggressive stance with regard to pricing backfire?” remains important. To the degree that price increases begin to drive traffic away from grocers, restaurants would be the primary beneficiaries.
HEDGEYE MACRO: Q3 THEMES: Policy Pong, Risk Ranger & Chinese Cowboys
DIAL IN & MATERIALS
Today, July 15, 2011.
5-10 minutes prior to the 11 AM EDT start time please dial:
(Toll Free) or (Direct)
Conference Code: 639275#
Materials: "MACRO Q3 THEMES PRESENTATION"
"MACRO Q3 THEMES PRESENTATION"
Topics will include:
The Hedgeye Macro Team