European Risk Monitor: Pause in the Storm?

Positions in Europe: EUR-USD (FXE); Italy (EWI); UK (EWU); European Financials (EUFN)

On the day following the July 21st announcement of Greece’s second bailout package risk across the European periphery (PIIGS) nose dived according to sovereign bond yields and cds spreads (see charts below). Yet in the days since both metrics have resumed higher and flirted with key breakout levels (6% on 10YR yields and 300bps on sovereign CDS), all of which gives us pause to monitor the developments of this long term sovereign debt soap opera. Currently we’re short the EUR-USD via the etf FXE; and short Italy (EWI), the UK (EWU), and the European Financials (EUFN) in the Hedgeye Portfolio to take advantage of the headwinds we see over the immediate and intermediate terms.


European Risk Monitor: Pause in the Storm? - 1. yields


  • Please note that CDS may not be the best indicator of risk because the International Swaps and Derivatives Association (ISDA), which governs CDS pricing, has ruled that the Greek restructuring does not constitute a credit event, which means that CDS will not be triggered. 

European Risk Monitor: Pause in the Storm? - 2. cds


Here are a few points to considering regarding the EFSF as we move forward in the calendar:

  • While it’s true that the bonds issued from the EFSF are AAA rated, proposed at very favorable rates of 3.5% to borrowers, and the fiscally sober-minded Germans are posting the largest amount of collateral to back the facility, it’s apparent that at its current level of €750 Billion (€250 Billion of which is IMF contribution) the facility could not handled the default of Italy and Spain, two country that we think present significant risk in the larger puzzle of the region’s fiscal imbalances. Estimates already suggest the facility would need to be expanded 2-4x to meet the needs of Italy and Spain.
  • The new structure of the existing EFSF needs to be unanimously voted on by all EU member states, which includes the individual terms of lending (maturity extension and interest rates commanded) as well as the total size of the facility. If the original issuance of the EFSF (being used for Ireland and Portugal) and the permanent ESM facility (beg. 2013) are any indicators of sentiment, we could well see indecision on the terms, especially on its overall size as individual countries (populaces) would rather not be on the hook for the peripheral countries debt. This vote isn’t scheduled until mid September when the EU parliament returns from summer recess.
  • To this point, last week we heard from German Finance Minister Schaeuble who said the EFSF will not be given carte blanche to buy up bonds on the secondary market. This is a critical point for there’s been no indication that yields for the PIIGS are compressing. As a nod to higher yields, Italy sold €2.7 billion of 10-year government bonds late last week at an average yield of 5.77% vs 4.94% on June 28. The ECB (along with China) have unofficially/officially been critical buyers of sovereign issuance ytd. Should the EFSF be limited in any capacity to buy up sovereign issuance this could encourage yields higher (neg.) and/or require other funding solutions.
  • As we’ve highlighted in our research, Italy and Spain face significant bonds coming due into year-end and in 2012. This means that the country will have to rely even more on successful future bond auctions (ie sufficient demand at yields not significantly over previous auctions) to fund its costs = more downside risk.  Specifically, we continue to see political risk in Spain, both into and out of Prime Minister Zapatero’s announcement on Friday for early elections on November 20th. On the same day Moody’s warned that it may downgrade Spain.

European Risk Monitor: Pause in the Storm? - 3. piigs

  • Finally, there’s also the unknown on how the voluntary bank swaps of Greek debt will go off. 90% of banks say they’ll participate, but there’s plenty of uncertainty around this. It's scheduled for late Aug/early Sept.


Growth Slowing

On the road to 40? European Manufacturing PMI figures for the month of July came in today and the numbers confirm a downward trend over the last 3-4 months. With the 50 line marking expansion (above the line) and contraction (below), Europe’s stalwarts were not immune to the trend: Germany fell to 52.0 and France declined to 50.5. July showed that four of the countries that reported measured below 50 (UK, Spain, Ireland, and Russia), with nine of the twelve countries reporting falling month-over-month, two expanding (Italy and Poland), and one flat (Turkey). In the case of Italy, July’s reading just got it over the 50 hump.  With sticky stagflation in the UK, today’s data point gives us more conviction in our short EWU position. Suffice it to say, these PMI numbers don’t look good!


European Risk Monitor: Pause in the Storm? - 4. m pmi


Levels on EUR-USD

As Keith mentioned this morning, the EUR/USD is the one strike price that should continue to whip around in the next 48 hours as we finally put the US debt ceiling debate to bed; watch $1.43 as your intermediate term TREND line that inflates/deflates everything else (across asset classes). The global market’s correlation risk moves off that. Our immediate term TRADE levels are $1.42 - $1.44.


European Financials CDS Monitor 

Bank swaps in Europe were mostly wider last week.  36 of the 38 swaps were wider and 2 tightened, with Italian and Spanish spreads leading the charge higher. 


European Risk Monitor: Pause in the Storm? - 5. banks


Matthew Hedrick



Keith shorted DNKN this morning in the Hedgeye Virtual Portfolio.


Paying a higher multiple for DNKN than SBUX does not make sense to us.  We published our Black Book one week ago outlining our longer term fundamental view of the stock and our view that the coffee space is currently in a bubble.  Valuations have sky-rocketed over the past year.  As we have written and communicated to clients ad nauseam over the past week, DNKN is a domestic regional brand with a plan to grow domestically into new markets within the U.S.  We find the practicalities of that plan less-than-certain and would absolutely not support a higher valuation for DNKN versus SBUX which has more convincing growth prospects via international markets, K-Cups, and other brands like Tazo Tea.  Additionally, given the fact that broader economic growth in the U.S. is and will likely continue to be below that of international markets where Starbucks is focusing its growth, we are only further convinced that the DNKN-SBUX premium is unsustainable.  We continue to see the advertisement, below, posted on industry websites; the company needs to provide "special incentives" in select markets to attract franchisees.  If the story is that good, why the incentives?


DNKN: TRADE UPDATE - SHORTING - dnkn incentives


For a copy of our Black Book on DNKN, please email


In terms of catalysts, the company is reporting 2Q earnings on Wednesday, August the 8th before the market open.   The first question to focus on is whether or not the company can deliver on exceedingly high expectations.  Dunkin’ Donuts has had mediocre top-line growth over the past couple of years and, we believe, investors need to take quite a leap of faith, by our reckoning, to pay the multiple the stock price is currently demanding for the as yet uncertain growth plans.   



Howard Penney

Managing Director


Rory Green



Macau blew the doors out in the last week of July. 



Average daily revenue increased 19% from the prior week and was 9% above the average for the first half of the month.  In total, gross gaming revenue grew 48% YoY to HK$23.5 billion, above our estimate of HK$22.5-23.0 billion.  At this point, we don’t know how much of a factor hold played but we surmise that it was high given the huge surge in revenues the past week.


In terms of market share, MPEL and Wynn were again the standouts with market share of both equal to their pre-Galaxy Macau opening levels.  LVS and MGM continued to lag in July which we think were both related to volumes and hold.  Galaxy Macau appears to have reached its stride, jumping to 19.1% from 17.7% post the opening of its flagship property.  Similar to Q2, we think MPEL should have the most upside relative to current EBITDA expectations for Q3.



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Breakdown: SP500 Levels, Refreshed

POSITION: No position SPY


I sold all of my US Equity exposure in the Hedgeye Asset Allocation Model when I sold our Healthcare (XLV) position into opening market strength. With 7 of 9 S&P Sectors bearish TRADE and TREND, the read-through to the overall market’s risk is crystal clear.


Across my 3 core durations, here are the lines that matter: 

  1. TAIL (bearish) = 1377 resistance (remains the level we have used since Q1 when we were most bearish on US Growth)
  2. TREND (bearish) = 1319 resistance (was support) and is now asserting itself with confirming volume and volatility studies
  3. TRADE (bearish) = 1275 is immediate-term TRADE oversold, but the new range draws down now to 1 

This morning’s ISM number amplifies the point I have been trying to make for the last few days – what US Equities are selling off on are Growth and Earnings Expectations, not a debt default.



Keith R. McCullough
Chief Executive Officer


Breakdown: SP500 Levels, Refreshed - SPX


With WMS trading near its 52 week low, we don’t think it's a stretch to say that investor expectations for FQ4 (June) are pretty low. 



Last quarter’s results and 2012 guidance weren’t exactly inspiring which begged the question of what additional shoes would drop.  Speculation regarding product and production issues and concern surrounding the sustainability of WMS’s market share in the face of heightened competition have emerged.  


We were early to voice concerns over WMS’s unsustainable market share [see our notes: “4Q SLOT SHIP SHARE UPDATE” (2/25/11) and “WMS: ADDRESSING THE ISSUES” (11/3/10)] but that was when the stock was trading with a $40 handle.  Sure wish we had made an aggressive short call then.  But at today’s levels a lot of the bad news is already priced in.  In fact, we think 25% market share is sustainable and its participation share should actually increase consistently over time. 


Regarding the quarter, If WMS can meet just the low end of their guidance we think that the stock can begin to work again as shorts will likely cover and the long-term is very compelling.  That doesn’t mean you have to buy it ahead of the quarter.  That would be for the brass ball crowd.


We estimate that WMS will report $209MM of revenues and $0.53 cents/share next week – slightly below consensus on the top line but in-line with EPS.  No doubt the $8MM (or roughly 500 units) that were delayed in shipping out last quarter will help WMS make its numbers.  Fiscal year end quarters also tend to be strong as companies will often offer their customers promotions to incentivize the placement of orders [see “SLOTS: MAKING THEIR QUOTA" published on 7/20/11].




  • $132MM of product sales at a 52% margin
    • 4,100 NA units – bolstered by the units that were supposed to ship last quarter
      • “The $8 million of orders were not canceled but they shipped in early April rather than by March 31st. Our production and distribution teams were simply unable to fulfill these orders in time as they were received after our normal cut-off dates which created challenges and stresses related to logistics of an already compressed order fulfillment period.”
    • ASP’s of $16.3k
      • “I don’t think pricing really entered into our issues in Q3. Pricing comes up every now and again. It didn’t use to come up hardly at all. It comes up a little bit more frequently now but we still believe that we have pricing leverage and if our content continues to perform at the levels of the G+ Deluxe and the Real Boost product, we’re not going to continue to see pricing as an issue.”
    • 2.6k international units
    • $23MM of used machine, parts, and conversion kit revenue
  • $76MM of gaming operations revenue at a 80% gross margin
    • Over the last 5 years, the average increase from the March to June quarter in gaming operations has been a $5MM sequential lift – largely due to seasonality
    • New releases should also help the quarter as well as recent approvals
      • “Battle Stations, we got the Pirate Battle and we have Leprechaun’s Gold that have essentially moved from Q2 and Q3 in our original fiscal ‘11 planning into Q4, Q1 and Q2. So, you’re going to see the games that we launched in Q3 are going to help suffice through Q4 and the games we’re launching in Q4 are going to help build our footprints slightly and our average win per day should see a nice up tick over the next couple of quarters. So, you are going to see some accretion in the footprint and the rate over the next call it two quarters.”
  • Other stuff:
    • Until revenue growth picks up, we expect that WMS will keep a lid on costs
    • We expect R&D to remain flat sequentially at $28MM, D&A to decline to $18MM, and SG&A to tick up sequentially to $39MM but be down YoY




Notable news items, macro data points, and price action pertaining to the restaurant space.






On Friday, ISM-Chicago employment index was a big disappointment, falling from 58.7 to 51.5. The decline put the index at its lowest since December 2009 and provides further confirmation that the labor market failed to improve from June to July.  Also on Friday, despite the headline ISM-NY showing business conditions improved in July, layoffs in New York City's financial services picked up in July; conditions are still notably weaker than they were a few months ago, and the employment data show that large-scale layoffs have resumed in the city's important financial services industry.





The University Of Michigan Survey Of Consumer Confidence Index collapsed in July.  Looking at the components of the Index, it was telling that expectations came down so sharply, from 64.8 in June to 56 in July.  This is the lowest level since November 2009.  The overall Sentiment Index declined 7.8 points to 63.7 in July.  This month brought the largest decline since March and the lowest level for the Index since March 2009.   Current Attitudes declined by 6.2 points to 75.8, the lowest level since November 2009.





Full service restaurants continue to trade poorly, underperforming other food, beverage, and restaurant categories over the past month.


THE HBM: DPZ, CBRL, KONA, BWLD - subsectors fbr




  • DPZ is starting a new campaign continuing its focus on accountability and consumer feedback by posting recent direct customer feedback from its online ordering Domino’s Tracker – good and bad – on a 4,360-square-foot billboard in Times Square.



  • CBRL has named Sandra B. Cochran as President and Chief Executive Officer.  Currently she is President and Chief Operating Officer.  She will assume her new role on September 12th.  Michael Woodhouse, currently Chairman and Chief Executive Officer, will become Executive Chairman upon Cochran assuming her new role.  James Bradford has been appointed to the Board of Directors, effective immediately.  Robert Hilton and Jimmie While have informed the company that they do not intend to stand for re-election at the 2011 AGM.
  • KONA has closed a restaurant in West Palm Beach that had been underperforming.  Interim President and Chief Executive Officer Mike Nahkunst said that the company believes that the closure will ultimately improve further profitability.  As a result of the closure, KONA lowered its sales guidance by $400,000.
  • BWLD may rise to $74 as the NFL labor dispute ends and a full schedule of games begins, according the Barron’s “The Trader”, citing Deutsche Bank.

THE HBM: DPZ, CBRL, KONA, BWLD - stocks 81



Howard Penney

Managing Director


Rory Green


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