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Old Slate

This note was originally published at 8am on August 01, 2011. INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK (published by 8am every trading day) and PORTFOLIO IDEAS in real-time.

“We’re not just going to start with a clean slate, we’re going to throw the old slate away.”

-Vince Lombardi (1959)


That was one of the first iconic leadership quotes to come out of Vince Lombardi’s mouth when he moved his family to Green Bay, Wisconsin in 1959 (page 207 of “When Pride Still Mattered”, by David Maraniss).


As all great leaders across history have proven, results matter more than rhetoric. But, when you can combine both, you have the holy grail of life’s opportunities – to “be the change you want to see in this world” (Gandhi).


Barack Obama and Johnny Boehner are not Gandhi. Neither are they Lombardi. These two gentlemen would have a tough time leading me to the men’s room at a Yale Hockey game without forming a committee. And, sadly, after we get this morning’s stock market rally out of the way, we’re all going to be stuck with their same Old Slate.


This isn’t to say that this gong show of a Debt Ceiling Debate isn’t going to help America start with a clean slate. First though, we need to throw away the old one! That will take time. Change is a process; not a point.


Back to the Global Macro Grind


With the most anticipated headline since ‘sun rising in the East’ behind us, the question for Risk Managers now isn’t about the mechanics of the debt “deal” (it will be back end loaded and will not move the dial until all of these politicians are gone) – it’s about Global Growth and Earnings Expectations – both are still too high.


Here’s how the globally interconnected market is reacting to the “news” that Washington does career risk management:

  1. STOCKS – Asia rallied across the board to lower-highs and remains the best looking region of the 3 majors (Asia/Europe/USA); European Equities are up marginally on low volume and basically still look awful; US Equities have immediate-term downside support at 1286, but a wall of intermediate-term TREND resistance up at 1319 on the SP500.
  2. TREASURY BONDS – We’ve been on the other side of the PIMCO “credit risk” trade (El-Erian) and focused more on the two things that have really provided a bid for bonds since April – US Growth Slowing and Inflation Expectations coming down. We saw new highs in 10 and 30-year UST bonds on Friday into the “news.” Now Treasuries are immediate-term TRADE overbought.
  3. EUR/USD – This is the one strike price that should continue to whip around in the next 48 hours as we finally put this debt deal dog to bed. Watch $1.43 as your TREND line that inflates/deflates everything else (across asset classes). The global market’s Correlation Risk moves off that.

From the Eurocrats to the Fiat Fools of the Keynesian Kingdom in America, do any of these people realize the causal relationship between debt and growth?


Republicans and Democrats, Reid my Boehner on this:




That’s it. So keep it simple stupid. The only thing that you are really doing to global markets and economies are:

  1. Shortening economic cycles
  2. Amplifying market volatility

How short was the last “bullish” economic cycle? You tell me (if you are a Washington/Wall Street person you will have a different answer to this question than Main Street, fyi). The only thing worse than Friday’s Q2 US GDP report of 1.3% is the thought that the government’s made-up number could be off by 81%! (Q1’s was restated at 0.36% versus 1.92% prior!!!)


I think that’s the first time I have used 3 exclamation points in an Early Look. Re-read that fact about reported US GDP. Maybe I should have used six!!!!!!


Either these Republicans and/or Democrats figure out how to throw out this Old Slate of failed economic policy, or The People are going to throw all of them out. That’s the change I can believe in.


My immediate-term support and resistance ranges for Gold (sold ours last week), Oil (no position), and the SP500 (no position) are now $1609-1633, $95.96-100.49, and 1286-1316, respectively.


Best of luck out there today,



Keith R. McCullough
Chief Executive Officer


Old Slate - Chart of the Day


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Old Men

“By 1918 everyone under the age of forty was in a bad temper with his elder…there was among the young, a curious hatred of “old men”.  The dominance of “old men” was held to be responsible for every evil known to humanity”

-George Orwell


The easiest path for an individual to take when faced with a suboptimal set of circumstances is to shift the blame, or burden, to another party.  For anyone that has been part of a team, be it a sports team or any group of people striving towards an individual goal, what sets a good team apart from a bad team is that the individuals therein do not shirk from responsibility or duty – they seek it and thrive as a result. 


Lately Keith has been constantly highlighting the (wit and) wisdom one of the great American winners of recent times – Vince Lombardi.  During a time of political and economic turmoil, the philosophies of leaders like Lombardi are far more likely to lead us out of the situation we face than those currently holding court in Washington D.C. 


“Old men” being hated in 1918 sounds quite similar to “old men” being hated in 2011.  The hatred of 2011, in my imagination, is not aimed solely at men of a certain age – I hope to become an old man one day – rather, it is aimed at men, typically old, that are stuck in old methodologies that have failed time and again. 


Rather than stopping, rethinking, reworking, and evolving, “old men” in 2011 simply press replay all the while expecting a new outcome.  Political and economic dogma is what is drawing ire among voters and market participants. 


Yesterday rumors that the most recent of the “old men” to head up the Federal Reserve in this country, Ben Bernanke, will start a fresh round of stimulus may have prevented the longest slump in performance of the Dow average since 1978; the Dow had fallen for eight consecutive days on the back of growing concern that the U.S. economy may slow further and that the $1.07 trillion in lost market value from American equities over the eight-day slump could begin to negatively impact consumer spending. 


History shows that “Old Men” in the financial industry have generally been put out to pasture by fresher, more original and adaptive players.   It is Hedgeye’s view that dogma and opacity will be exposed, real-time, in the finance world of tomorrow.  Whether it is via Twitter or another medium, the hatred of “Old Men”, and the conventions of their era, is driving the debate into the open.  In the research world, that is where Hedgeye is positioning itself.


The hedge fund industry is also changing.  It always has.  The book “More Money Than God”, by Sebastian Mallaby chronicles the history of a small group of people that shaped the hedge fund industry.  From the creator of “hedged” funds, Alfred Winslow Jones, to George Soros, the professional longevity of each character was largely defined by his ability to stop and rethink.  Jones did not adapt and so his protégés abandoned his firm upon realizing that the fund’s successes were down to them and not Jones. 


Soros, having studied the philosophy of Karl Popper at LSE in the middle of the twentieth century, held firm the belief that humans simply cannot know the truth.  He then developed this own idea of how markets work, building off the thoughts of Popper, called the Theory of Reflexivity.  The development of this theory enabled Soros to retire as a hedge fund manager with his abilities as an investor almost never questioned, nor deemed out of date, by his peers.  In terms of managing money, specifically, Soros may now be a man of a certain age but he never allowed himself to be one of the “Old Men”.


What’s clear at this point is that the bad team of “Old Men” in Washington is spending the majority of its time apportioning blame and jostling for media limelight.  The signs of Americans’ hatred for these “Old Men” are everywhere to see: consumer confidence, the stock market, 45.75 million people on food stamps (no double-dip for these folks, just one long downturn).  The number of people receiving food stamps increased 12%, year-over-year, in May 2011.  Alabama is the state that saw the largest increase at 120%.


Our troubles are causing the “Old Men” abroad to respond because it is starting to hurt other economies too.  Japan is following Switzerland in intervening in the currency markets as the currencies’ “safe haven” status could hurt their respective economies.   Europe is constantly on edge, fearful of contagion, and ready at a moment’s notice to extend further bailouts to periphery nations.


Blaming “Old Men” won’t fix any problems in the financial system, nor will it fix any problems in Washington D.C.  Leaders stepping forward to enact change for the better have to have the courage to do so. 


That is what Hedgeye is attempting to do in our small part of the world and our clients, critics, and supporters help us sustain our efforts.  Globally, governments are being overrun by dogmatic “Old Men” eager to get, and stay, in office. 


Irrespective of the performance of the S&P 500, the fortunes of Main Street America have not been improved over the past two years; some new ideas are needed.


Function in disaster; finish in style


Howard Penney

Managing Director


Old Men - foodstamps may 2011


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Pardon the length of this note, but we think BYI could be the next big thing.  The story isn’t this past quarter or next quarter but we will give you the preview on both.





We’re not expecting much this quarter from BYI, nor are we expecting terrific guidance for FY2012.  In fact, guidance will likely be heavily back end loaded with a range big enough to drive a truck through.  The Street may be closer to the high end of guidance than the low end.  How will investors react?  Hard to say but this isn’t a call on the events of August 9th.


We believe BYI is a calendar 2012 story, which is to say we buy the back end loaded earnings outlook – before management even articulates it.  Replacement demand is a big part of the long-term thesis but not over the intermediate term.  Rather, BYI’s systems business should provide a huge boost to the bottom line beginning, in earnest, in FQ3.  While we are below the Street for FQ1, we are well ahead for the back half.  The stock trades at 14x our forward estimates while we expect EPS growth to accelerate, potentially at a 20% annual clip for 3-5 years.  




Our projection is that BYI’s FYE quarter will come in-line with consensus estimates of $203MM of revenues and $0.55 cents.  As long as there are no big surprises in the quarter, we expect much of the call will be focused on the year and the opportunities ahead.  Clearly, there is a fair amount of skepticism over the company meeting over consensus expectations, and part of the issue is the backend loaded nature of BYI’s opportunities.  We’re below the street for F1Q12 but ahead for the back half of FY2012 given:

  • Lack of new openings and expansions in NA in the September quarter
  • Italy and Canada not hitting until the December or March quarter
  • Full benefit of Acqueduct opening not until the December/ March quarter
  • Full library of 50 Alpha 2 titles not available until calendar year end 


Systems driving the intermediate growth

On the systems’ side we have identified over $230MM of announced systems new install contracts – over 75% of which we believe will be realized between December 2011 and June 2013.   This amounts to an average of over $25MM per quarter. BYI’s current system’s run rate of $50MM/Q consists of over 70% upgrade sales to existing customers and recurring revenue.  If BYI can maintain its current run rate of upgrade and recurring revenue, we believe that they should be able to achieve a $60MM run rate and even have some $70MM quarters.  




Other growth drivers

In addition to new systems installation opportunities, iVIEW DM can potentially provide a new layer of growth for BYI.  On June 14th, BYI announced that it reached an enterprise wide deal with CZR to install iVIEW DM across a number of properties.  The first installation will occur at Horseshoe Hammond, which has 3,160 slot machines – of which roughly 50% (video slots) should be eligible for an iVIEW DM install.  If BYI can deliver a compelling value proposition on the initial installs, they will have the potential to install iVIEW DMs across CZR’s portfolio of over 60,000 slot machines - of which roughly 50% could support an iVIEW DM without upgrading machines.


BYI’s gaming operations is also set to show compelling growth over the next two years.  Their Italian units should start coming online late this year (in the December quarter).  According to Lottomatica, there were roughly 23,000 VLTs in operation at the end of June in Italy – the vast majority of which were produced by Speilo and Novamatica.  By the end of the year, they expect that 75% of the allotted VLTs to come online.  LTO’s VLTs are generating approximately $260/day while the market as a whole is generating a daily win of roughly $245/day –both of which augur well for BYI’s 4,500 or so units which get installed as daily fee games.  We estimate that once all the units are installed, they will generate about $40MM/year in revenue. 


The slots at Acqueduct are also slated to open in two phases by the end of 2011/early 2012.  BYI will get 50% share of the 4,500+ slots that are coming online, which we estimate will add roughly $14MM of annual revenue to BYI’s gaming operations business.  This is before we take into account the success of Cash Spin and iDeck.


Lastly, BYI is poised to gain market in the game sales market as more Alpha 2 content comes online.  By the end of the year, BYI expects to have 50 Alpha 2 titles available.  The June quarter will be the first quarter of shipments to Australia, and if their games perform well, BYI should be able to ship at least a 1,000 units a year into that market.  Even excluding Canada, we estimate that new openings and expansions should grow by 40% YoY in 2012.  We also estimate that replacements should increase by at least 15% YoY. All of this bodes well for BYI’s product sale opportunities.


When you add this all up, BYI should be able to hit the $3 annual earnings bogey over the next 18 months. 



FQ4 estimate detail 


We expect BYI to report $203MM of revenue and $0.55 of earnings.


Gaming equipment sales of $68MM at a 45% gross margin             

  • 3,900 new unit sales at an ASP of $15.5k
    • 2,700 NA machine sales (primarily replacement sales) and 1,200 international unit sales
    • “I think we would expect to see some seasonal increase in the number of replacements going into Q4.” Replacements last quarter were ~2,220
  • $7.2MM of parts, conversion and other sales
    • “I think we’re certainly focusing on used game markets these days. It’s something that, from an international perspective, we haven’t really focused on over the last couple years, so I would see some increases in used games going forward.”
  • Last quarter game sale margins were negatively impacted by 300bps of “write-offs related to the warranty of older technology platforms”. Adjusted for the write downs, margins would have been 45% - 46%
    • Margin guidance from the last call: “I think they’ll be in the mid-40 neighborhood. You have to remember we did just release… the Pro Curve, and the V32 is now out in the Pro series, which will put a little bit more pressure on our margins in the upcoming quarters… Longer-term, we expect to bring margins back to the low to mid-50s”

Systems revenue of $53MM at a 73% gross margin

  • BYI should be able to recognize the Galaxy Macau contract which we estimate was worth about $8MM in revenues
  • “iVIEW DM, and the Elite Bonusing Suite continue to generate strong customer interest… combined with our strong pipeline and industry leadership position, should result in increased systems revenues in the coming quarters.”

Gaming operations revenue of $82MM at 70% margins

  • Over the last 4 years, there has been an average 11% sequential increase in gaming operations revenues from 3Q to 4Q
  • “Cash Spin continues to perform well. Deployment of Vegas Hits has now gone past 550 units, and is currently our best-performing premium game. We recently released Cash Wizard, our first Pro Series ALPHA 2 premium game. The total orders for Cash Wizard, including those already installed, has now crossed the 700 mark.”
  • “We are very well-positioned to continue our solid growth in the WAP and Premium market segments.” 

JCP: Retirement Plan a Drop in the Bucket


Two days into Johnson’s tenure on JCP’s Board, the company initiated JCP an early retirement program, which is a nice move for Johnson at face value. He is effectively throwing his feelers out to see which senior members of the organization are interested in taking the offer helping shed overhead. Here are a few thoughts on the news:

  1. There are few details regarding the scope and size of the voluntary-retirement program. We have run a few numbers on what this could mean, but in doing so, assume this plan is intended only for those at corporate.
  2. With roughly 150,000 employees and using the general rule of thumb for a big box retailer that corporate accounts for ~2% of employees, we are talking 3,000-4,000 eligible heads. Of that number, there are likely 20% that have 20-years under their belt, which further narrows the pool of eligible employees down to 600-800 potential takers, or 0.5% of JCP’s entire workforce.
  3. On a dollar basis, this equates to roughly $140mm or 10% of JCP’s total salary expense, and ~2% of SG&A according to our math (see below).
  4. This implies an opportunity to shave 80bps off SG&A if every single employee took the offer and the company doesn’t back-fill vacated posts with new talent, which is highly unlikely. More realistically, we’re talking maybe 10%-20% of those eligible “cash out” early, which equates to 7-15bps margin opportunity.
  5. In fact, given that the company will have to payout severance expense associated with early retirements that most likely include at least 3-years of salary, we’re looking at ~50bps hit to margin before the company starts to realize its 15bps benefit.

The bottom-line here is that we agree that this is step in the right direction for the company over the longer-term as it looks to reduce fixed overhead costs.  It’s also a great way to get rid of ‘C’ and ‘D’ players.


But in the grand scheme of what needs to be fixed at this company, it is only a drop in the bucket. We still think that this will prove to be an extremely ugly CEO transition, and that earnings will go much much lower before they go higher. Johnson’s duration of 7-years is much greater than the average investor.


See our recently released JCP Black Book for more detail on this and other factors that have us squarely in the bear camp on JC Penney. If you are interested in receiving a copy, please contact .


JCP: Retirement Plan a Drop in the Bucket - JCP Emply 3 8 11


JCP: Retirement Plan a Drop in the Bucket - JCP Emply 2  8 11


JCP: Retirement Plan a Drop in the Bucket - JCP Emply 8 11



Casey Flavin


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