Beat and raise should drive the stock higher
"Our third quarter results further demonstrate the positive momentum generated by our new games, platforms and internal process improvements. We are expanding our business in new and existing markets around the world in a capital-efficient manner driven by our customer-first philosophy. The investments we are making today are expected to position the company to deliver continued revenue and earnings growth."
- Patti Hart, CEO of IGT
HIGHLIGHTS FROM THE RELEASE
- Adjusted EPS of $0.26 excluding a $0.04 discrete tax benefit and revenue of $489MM
- Gaming operations revenue of $267MM and average revenue per unit per day of $55.55 up $1.47 YoY "on performance improvements in our MegaJackpots brands globally, and down $0.83 from the immediately preceding quarter due to a higher mix of lower-yielding international units."
- 62% gross margins "impacted positively by improved game performance and lower jackpot expenses."
- "IGT's gaming operations installed base totaled 53,300 units, an increase of 800 units from the immediately preceding quarter primarily due to additions in international lease operations."
- Product sales revenue of $222MM
- 8,900 unit sales, up 7% YoY "primarily due to increases in domestic replacement and Latin America sales and down 2% sequentially, primarily due to fewer new openings domestically"
- "Domestic average selling prices increased 2% compared to last year's third quarter due to a higher percentage of new cabinets, specifically, the Universal Slant and G23 MLD products. International average selling prices increased 16% compared to last year's third quarter primarily due to favorable geographical and product mix, particularly in Europe and Australia, and favorable foreign exchange rates."
- 56% gross margins: "The increase in gross margin was driven by increased higher-margin international machine sales."
- SGA "flat compared to last year's third quarter, as lower bad debt provisions offset higher variable compensation expenses."
- Cash: $401MM; Debt: $1.65BN
- "During the quarter, the Company repurchased 1.5 million shares of common stock at an average price of $16.25 per share for a total cost of $25 million."
- "During the quarter, the company closed on the previously announced tender offer to acquire Entraction Holding AB"
- Barcrest sale is expected to close in F4Q11
- Outlook: $0.89 to $0.93
- "This range excludes the favorable impact of $0.08 per share from certain items detailed in the supplemental reconciliation at the end of this release."
CONF CALL NOTES
- Operating margin was their best in over 3 years. Their business now has the potential to deliver steady growth and returns.
- Entraction acquisition is an example of their plan to responsibly grow their business. Expect nice growth in their interactive division.
- Coin-in per machine per day was up 13% in their WAP units, but international mix of more leased machines negatively impacted yields.
- International product sales - favorable shifts in product mix and FX rates (Barcrest and Japan were lower priced units and are now excluded)
- $185MM of operating cash flow was generated in the quarter
- Gaming operations: Over 1,000 Center Stage units installed, which are performing well.
- Shipping universal slant with large portfolio of games. Improving their game development process.
- International continues to break records - achieved their highest ASPs. Early returns on their 6 Asian games are encouraging.
- Interactive grew revenues 20% YoY. Significant increase in total wagers and average bet.
- Hosted systems user conference in June - demonstrated new applications on their SbX system which they expect to continue to roll out over the next year. They had significant international wins this quarter.
- Released Hot Roll Series with their first on-screen interactive bonus.
- Universal Slant Top box has been well received. Already received orders for 2,300 units. They can swap out titles in an hour on these machines. Advanced design of this machine reduces its manufacturing time by as much as 50%.
- Reduced time to bring games from idea to market by 33%
- The low hanging fruit has been picked; now it's really pruning and that takes more arms and legs and that's why they have added Eric Berg to their team
- How are they thinking about the i-gaming opportunity? They are very bullish on the idea of convergence of content. Their igaming strategy is an 100% international strategy.
- Product gross sales margins - where could they go when units improve? 59% GM that they enjoyed this quarter was a product of mix and cost reductions. Mix will move around Q to Q. Mix will determine if they can get to 60+% margins.
- SbX PNL potential? They believe that customer adoption is increasing.
- What kind of market share do they expect in new markets? 50%+ is viewed as a successful allocation.
- Trends in their domestic install base? Stabilization in their WAP segment where they have suffered a lot of degradation. Return to more normal seasonal trends. Some of that is due to better games and some is due to a more stable / healthy consumer. This was their second consecutive quarter where their WAP business saw improvements across install base, yields and coin in.
- Did they sell any of their games ops games this quarter? Their sale of gaming ops games has been very selective for mature games or ones that weren't easily upgradable. There were maybe a few hundred sales in the quarter of games that were at the end of their life cycle.
- How much of the price increase was due to FX? Regional mix, product line mix was 50% and FX was the other 50%
- Center Stage - they are still deploying the hardware (backlog) and are also layering on conversions
- How many Universal Slant shipments this quarter? Not a huge number this quarter - most of the 2300 is in their backlog. Interest is really high. They have not yet put forth a real effort on creating a poker refresh.
- MLD was just south of 50% of their shipments this quarter
- When will their interactive division revenue become material?
- Will likely not get to 10% of their business. But it's not unrealistic that by 2013/2014 the business could become material enough to break out.
- 82% of their gaming operations units were variable. The mix is pretty consistent across domestic and international units.
- Growth rate on international gaming operations going forward are better than what they are in the US given the relative maturity of their business. Internationally, they have almost 13,000 units internationally. They should be able to continue to grow their international unit install base (albeit the international units have lower yields). They are focused on Asia and Latin American more so than Europe and Australia.
Impressive Singapore results drove an estimate-beating quarter
"We set quarterly records for both net revenue and adjusted property EBITDA during the quarter. Strong revenue growth and margin expansion in Macau, together with the continuing ramp of growth in all areas at Marina Bay Sands in Singapore contributed to excellent financial performance overall."
HIGHLIGHTS FROM THE RELEASE
- Adjusted Property EBITDA $901.6MM and Net Revenue of $2.35BN
- MBS: Adjusted Property EBITDA of $405.4MM and margin of 55%
- "Record VIP, mass gaming and slot volumes coupled with steady growth in non-gaming revenue streams.. reflect the broad appeal of the property to Singapore's visitors from across the Asian region. Looking ahead, as the property continues to mature, we are confident that Marina Bay Sands will generate significant increases in business and leisure visitation to Singapore"
- Macau: Adjusted Property EBITDA $391.6MM and a 33% margin
- "The growth of our higher margin mass table and slot businesses, together with the contribution from the important non-gaming components of our integrated resort business model, continue to drive significant margin improvement at Sands China"
- Las Vegas: Adjusted Property EBITDA of $92.9MM
- "Quarterly results clearly reflect the implementation of our strategy to focus on cash-paying corporate group, convention and FIT customers, and to optimize our promotional activity for gaming customers as the Las Vegas market continues to recover. Table games drop was up modestly during the quarter, while slot handle naturally reflected the contraction expected with the decreased promotional activity. Cash revenues from occupied rooms increased by more than 18% compared to the same quarter last year. In addition, 97% of our occupied rooms during the quarter were sold to cash paying customers, compared to just 70% in the second quarter of 2010."
- "Corporate expense ....increase was primarily driven by higher incentive compensation expenses attributable to the company's improved financial and operating performance, as well as increased legal fees."
CONF CALL NOTES
- Ramp process is still ongoing at MBS. Demand is starting to outpace supply.
- Opening of Galaxy Macau has severed as an additional feeder to the Cotai market
- The Plaza casino is primarily designed to cater to the VIP segment of the market
- Embarking on a $100MM investment (ahead of Chinese New Year end in 2012) to enhance junket relations
- Retail sales at the Venetian Grand Canal shops were up 50% and 70% at the shops at Four Seasons.
- Lots 5 & 6: They have finalized franchise agreements with two brands on lot 5 and the property is still on target to open 1Q2012. Lot 6A (Sheraton rooms) will open in 3Q2012 with a casino and 2,000rooms. Lot 6B in 2013 will feature 2,000 additional rooms and suites (opening early 2013). The addition of 6,000 rooms will serve as a catalyst to grow their MICE business.
- Ed Tracy will be promoted to CEO of Sands China
- Is the summer in Singapore seasonally the strongest?
- Based on July, it seems like it will be the best quarter of the year and it does seem that summer is the peak but they are still ramping so it's too early to tell. LVMH is still opening as are two night clubs.
- Struggling more VIP growth at Sands. They are disappointed that they didn't do better at Four Seasons but they will. They're working on improving their junket relationships which should help grow their junket business
- More development on Cotai is helping support the market growth there by creating critical mass
- S'pore trends: higher spend per win; more repeat customers
- S'pore credit terms unchanged
- Macau Junket/direct play %: 4 to 1
- Macau $125MM capital campaign target for completion by Chinese New Year 2012
- S'pore refinancing talks: not started yet
- Venetian mass market: Galaxy Macau opening is having a positive effect but hasn't been material
- S'pore junket process: still thinking it will be done by end of 2011. If RWS gets approval for junkets, then MBS will too.
- Junkets at Venetian Macau: in 12-18 months, may return to better (low-teens) VIP share. May not see impact of new junket relationships until 1Q 2012.
- Good convention calendar for rest of year allows good management of cash & comps.
- Vegas room demand in July: pretty good, about what they expected.
- S'pore ETG:
- No room for additional capacity
- $650-675 slot win/day (weekday); $1,000-1,100 slot win/day (weekend)
- S'pore keeps ramping, particularly mass and slot business
- Q2 S'pore expenses are a good run rate for the rest of year
- Sites 5&6 estimates: 200 tables per casino; 110 in Plaza; 400-500 tables in total; 120-130 ETGs; no limitation on ETG but table limitation of 50 seats equal one table game
- Promotional spending: more pressure in Macau
- Sites 5 & 6: have enough workers to be on target
- S'pore market far from being saturated
- No evidence of VIP slowdown in Macau, very frothy environment
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Conclusion: Our-once long list of fundamental concerns appears to be priced in from a quantitative perspective and the go-forward outlook augers well for mean-reversion to the upside over the intermediate-term TREND.
Position: Long Indian Equities (INP).
Earlier this morning, we added a long position in Indian equities to our Virtual Portfolio. After having been the bears on this market since early November ’10, we have been explicitly warming up to India (and other bombed-out emerging markets) of late.
As we wrote in our 6/24 piece titled, “Emerging vs. Developed Markets: Aggressively Framing Up the Debate”, our Deflating the Inflation thesis is explicitly bullish for equity markets like India which have underperformed due to their central bankers hiking rates to quash inflationary pressures. Though the US Dollar Index is flirting with a TREND line breakdown, it appears to be registering a higher-low on an intermediate-term basis. Further, the CRB Index remains broken from a TREND perspective – alongside a variety of other key commodities including crude oil. It appears that neither Obama nor Boehner can help extend the Inflation Trade indefinitely.
Turning back to India specifically, we like what we saw out of the Reserve Bank of India overnight, hiking their benchmark interest rates +50bps to 8% (repo) and 7% (reverse repo). This marks their 11thrate hike since last March and takes India to being as close to positive from a real interest rate perspective since 4Q09. On the margin, this hawkishness should continue to perpetuate lower-highs in Indian credit and money supply growth over the intermediate-term TREND.
This is bearish for Indian growth on the margin and we remain 70-100bps below the Street on India’s real GDP growth in 2H11. That said however, this certainly isn’t new news (the SENSEX Index is down -10% YTD; -14% since we turned bearish) and our quantitative models continue to suggest that this is nearly priced in. Additionally, our models point to a bottoming of Indian economic growth in 3Q and an eventual rebound in 4Q11. Recall that Indian GDP growth has been decelerating since 2Q10, so this inflection in growth may prove rather bullish for Indian equities over the intermediate-term TREND.
When we last published on India, we had four major concerns which we would’ve liked to see addressed prior to going long this market. They are as follows:
- Accelerating inflation driven by rising domestic crop and energy prices;
- A highly likely miss in the government’s deficit reduction target;
- A capitulation by consensus on Indian economic growth; and
- A near-term winding down of the Sovereign Debt Dichotomy.
With the borderline exception of issue #4, we’ve seen some bullish developments in these regards.
First, both the RBI and Finance Minister Pranab Mukherjee have publicly acknowledged that recent food (rice, soybeans, and peanuts) and energy price (diesel, kerosene, and cooking gas) hikes will take some time to filter through the economy and could provide incremental upward pressure to India’s WPI reading. Additionally, a revision to the base year of the WPI calculation caused June’s +8.7% YoY reading to be revised up to +9.4%. Both give us confidence in our model’s forecasts that inflation in India will not be in the area code of the RBI’s +6% target by March ’12. Still, we do expect it to peak in August and see limited scope for additional rate increases over the intermediate-term TREND and long-term TAIL.
The interest rate swaps market agrees with our longer-term view that the magnitude of interest rate hikes in India has more than likely peaked, with the reverse repo yield above historic averages and the repo yield a mere 100bps away from its 2008 high. We suspect it will also conform to our shorter-term view as Deflating the Inflation continues to play out across certain key segments of commodity complex.
Secondly, our once-contrarian view that the Indian government will miss its deficit reduction target and cause interest rates to incrementally back up is becoming more and more consensus. Recall that in a 2/28 research note titled, “India: Missing Where It Matters Most”, we aggressively ripped apart the assumptions embedded in Mukherjee’s FY12 budget and suggested that India was likely to miss the target by a considerable margin as a result of lower than expected growth (less tax receipts) and higher than expected commodity prices (more subsidy expenditures). Now, as recently as a couple of weeks ago, even the prime minister’s chief economic adviser C. Rangarajan admitted that the target of 4.6% of GDP is “difficult to achieve.” Another top economic planning official, R. Goplan, recently launched a public defense of the target and associated borrowing requirements. We view this as the first step toward official capitulation and recent lower-lows across India’s sovereign yield curve support our view that the market has already come to this realization.
Thirdly, we recently received an important data point regarding how consensus views Indian economic growth. Earlier this week, Fitch revised down their estimate for India’s FY12 real GDP growth to +7.7% vs. a prior forecast of +8.3%. We’ve been vocal about our bearish bias on both the timing and accuracy of ratings agency and sell-side economic forecasts, and we welcome Fitch’s capitulation as a sign that growth in India is indeed bottoming from an intermediate-term perspective. We expect further capitation from sell-side forecasts in the coming weeks, as economists scramble to adjust their Keynesian models to account for today’s +50bps rate hike – a move that was correctly predicted by none of the 22 Bloomberg survey participants.
Lastly, we continue to remain bearish on the EU’s sovereign debt woes and continue to strongly believe that we are in the earlier stages of a 3-5 year sovereign debt default cycle. Understanding the research behind this backdrop grants us the conviction needed to manage the headline risk associated with Europe’s current and pending issues on both sides of the trade. Given, we are likely to remain Risk Rangers in Indian equities with a bullish bias over the intermediate-term TREND.
The fact that the stock is trading down on a beat and guide-up shows exactly why we don’t like the stock now. UA guided down gross margins materially. They’re making up for it in SG&A – which is puzzling given that they are an investment cycle. While we love UA on a TAIL (3-year) duration, the fact is that first it has to get past the TREND (3 month) and TRADE (3 weeks). We like it lower. Overall, no change to our negative thesis (see yesterday’s note – reprinted at the end of this note).
What we liked:
- UA posted solid top-line growth driven primarily by apparel revenues up +36% on top of 34% growth last year. The addition of charged cotton (we estimate between $20-$25mm, or 9-12% of growth) was a key driver in the quarter and one of several launches the company has planned in the coming quarters. Next in line for Q3 is Storm Fleece in September along with the latest basketball footwear for BTS. UA’s product pipeline is loaded and likely to keep top-line growth rates well above 30% near-term.
- Direct-to-Consumer growth was up 80% accounting for 27% of sales in the quarter up from 23% in 2010. With gross margins in excess of 10pts higher than the company’s core, DTC will be a key offset to escalating margin pressures.
- UA took up guidance by more than the Q2 beat – again. In fact, the incremental raise was greater than in Q1. The company beat top-line expectations by ~$20mm in each of the last two quarters. In Q1 it raised full-year guidance by $40mm, for Q2 the company increased guidance by another $50mm reflecting greater confidence in the 2H revenue numbers.
What we didn’t like:
- Inventories remain an overhang near-term up +75% on +42% revenue growth. Yes, the company communicated that Q2 would mark peak inventory growth due to bringing its hats and accessories business in-house and planned build ahead of BTS, but you can’t ignore the underlying trend turning negative here. If we strip out these two factors in each of the last two quarters, the sales/inventory spread over the last four quarters would were down -7%, -10%, -9%, and then down -15% here in Q2 (see SIGMA below). The yy changes in both Receivables and Payables remain negative as well.
- This is the second quarter in a row where the company beat on revenue, missed on gross margin, and then made up for it in SG&A. In fact, the company lowered its gross margin expectations for the year by an incremental 50-80bps from down -100bps to -150bps-to-180bps. As an offset, it also reduced the outlook for marketing expenses by 50-80bps. You can’t knock the company for leveraging expenses, but the outlook implies a reduction in the absolute dollar spend – something you don’t want to see for a company growing revenues at 30%+.
- Embedded in lighter than expected Q2 gross margin results was the impact of increased sales allowances. While the company has an active product pipeline for the 2H, more aggressive sales allowances with inventories at peak heightens concern over the company’s ability to maintain margin levels in the 2H. With half of the adjustment to gross margin outlook from pricing and the other half sales allowances at the same time we’re entering a period where price variability remains high, so too does the possibility for further adjustments again next quarter.
With the changes to working capital still negative and margin risk and uncertainty increasing as we head into the 2H, we remain bearish on the name over the Intermediate-term TREND (3-months or more).
07/25/11 02:39PM EDT
UA: WE’RE STILL NEGATIVE
We don’t like UA around tomorrow’s print – either into it or out of it. Let me be crystal clear on duration…
TAIL (3 years): Luv you long time, UA. These guys are pulling one right out of Nike’s playbook. The growth profile is unquestionable to us. Though they have yet to get any ancilarry categories right – such as Women, Footwear, and International – they will. Of that, I am near certain. But that is also one of the reasons why the team and I don’t like this name on a TREND (3-month) duration.
TREND: The fact of the matter is that even through all the ebbs and flows of revenue, UA has been printing an operating margin of 10-11%. It could have easily been printing something in the mid-high teens. But no, instead it opted to plow the capital into the model to stimulate top line growth. I like that. But’s a double edged sword…
- On one hand , I am extremely confident in the top line trajectory. When Plank stands up there and says that the company will double in sales over 3-years, I believe him (and I’m a natural cynic).
- But the reality is that there have been several initiatives that simply have not panned out yet. Footwear has been a zero. Granted, the original structure of the company was insufficient for anything but failure in this category), and the current team will tread slowly (no pun intended). They probably won’t mess it up, but we’re very very close to the point where people won’t simply give the Gene McCarthy organization the benefit of the doubt. If footwear does not work, this company won’t double.
- Charged cotton was a good launch. Definitely better than footwear. But it was a shadow of its core performance product. This is not a savior for UA.
- UA is spending like a drunken sailor. That’s probably a bit dramatic. But with growth in retail stores accelerating, endorsing Michael Phelps, Lindsay Vonn, Kemba Walker, Derrick Williams (#2 NBA draft – ahead of Kemba at #9) and some dude named Tom Brady, the reality is that UA is in investment mode. They’ll play this like Nike in that they will make it work – but will spend more along the way to ensure their success.
If you have a 3-year+investment time horizon, then you have nothing to worry about. They’re doing the right thing.
But we’re paid to point out the potential landmines along the way.
With the stock at $78, 40x+ earnings, 16x+ EBITDA and very little controversy on the name, we’re simply wary – if not flat-out negative given that cash flow is headed the wrong way.
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