“The time to buy is when there's blood in the streets."
Conclusion: Equities, commodities, and high yield bonds have seen a dramatic sell off in the last couple of weeks. While they are cheaper, recent history suggests that we are not yet at washed out / “blood in the street” valuation levels.
In the last couple of weeks, we’ve had a massive sell off in global risk assets. One of the better proxies for the sell-off in risk assets in our purview is the SP500, which closed on July 26that 1,332 and has sold off in a straight line to 1,119 (as of yesterday’s close), a decline of -16.0%.
As Keith noted this morning in the Early Look, there is no doubt the market is flashing oversold in our quantitative models. In fact, according to our most recent lines, the SP500 is three deviations oversold at 1,086 on an immediate-term TRADE basis. Therefore, the purpose of this note is not to suggest there is substantial downside from here, at least in the short term, but rather to actually frame up some key valuation metrics on various asset classes that might be a better indicator of truly “cheap”.
Stepping back, one of the key domestic catalysts for the sell-off in equities was both the release of the estimate of Q2 GDP at +1.3% and the downward revision of Q1 GDP to +0.4%, which, assuming the GDP estimate for Q2 is accurate, takes GDP growth for the first half of 2011 to sub 1% in the United States. The key value of GDP growth relating to the broader equity markets is that economic growth ultimately drives earnings growth and, therefore, valuation.
We wanted to reiterate a point we made in a note on Thursday specific to the correlation of economic growth and corporate earnings, which is as follows:
“In fact, slowing or declining GDP growth can lead to dramatically decelerating earnings. In the last decade we have seen this in spades as noted by the 21.5% decline in SP500 TTM earnings from March ‘01 through June ‘02 and 44.0% decline in S&P 500 earnings from September ‘07 to September ‘09. Going back the last thirty years, there have been five periods in which earnings for the S&P 500 broadly have declined.
On average, the decline has been a peak-to-trough decline of -25%. In a scenario analysis where we assume we are entering a period in which earnings are in decline and they decline by the average of the five declining periods over the last thirty years, the implied earnings of the S&P 500 over the next twelve months is ~$74.79. Based on the current price of the S&P 500, this is a ~16.2x earnings multiple. Not exactly cheap.”
Interestingly, since we wrote the note above, the SP500 is now even cheaper trading at closer to a 14.9x multiple on the earnings projected in the scenario above and based on yesterday’s close. As well, those equity investors that continue to support being long of the equity markets on TTM earnings or NTM earnings estimates, can also argue a more compelling valuation case as the multiples of the SP500 are 12.3x and 11.2x, respectively on these metrics. We’ve summarized these valuations in the table below:
In the table, we’ve also incorporated CAPE earnings. Recall, CAPE earnings, or Cyclically Adjusted Price-to-Earnings, are utilized by Professor Shiller of the Yale Economics department to determine the fair value of the SP500. In terms of the numerator, or price, Shiller uses the monthly average of daily closes for the SP500. To derive the earnings data, the denominator, Professor Shiller uses the quarterly earnings data from the SP500’s website and utilizes an interpolation to provide earnings data by month. He then adjusts both the numerator and denominator for inflation using CPI from the Bureau of Labor Statistics. Finally, the inflation-adjusted price is divided by an average of ten years of real monthly earnings to determine the CAPE.
When we looked at this valuation methodology in late March, the market was at a 23.6x earnings on this basis. Since then, valuation has certainly become substantially more compelling with a decline in multiple of roughly 18.2%. That said, the CAPE P/E is still above its long run average of 16.4x. The equity market has become substantially cheaper, but is still marginally pricey on a cyclically adjusted basis.
In the chart below, we’ve looked at equities based on a dividend yield basis, which is typically another metric that is given to validate the valuation call for equities. In the chart, we show the Dow Jones Industrial Index, a better proxy for high dividend companies than the SP500, going back three years. While we could have gone back much further, we purposely wanted to look at the dividend yield based on the most recent cycle. As the chart shows, the dividend yield for the Dow is currently 2.8%. In this cycle, which for purposes of this analysis we will consider the last three years, the Dow has reached a 4.0% yield. On this metric, it would seem there is potentially downside based on yield before dividend yield stocks become “cheap”.
Another asset class that has been very relevant in this most recent global sell off is gold, which has been a haven for safety and protection from runaway Keynesian doctrine. Gold was up yesterday and is up more than +20% in the year-to-date. So now, of course, the question is whether gold is expensive. With gold this is obviously a difficult question to answer since there is no truly conventional valuation metric from which to evaluate its value. Specifically, gold has no earnings power.
In the chart below, we looked at the value of gold compared to the value of oil. We imputed and charted the number of barrels of oil that an ounce of gold would buy. Interestingly, on this metric, gold doesn’t look overly expensive based on its levels over the last three years. Currently, one ounce of gold will buy roughly 22 barrels of West Texas Intermediate oil. This metric peaked at closer to 28 barrels in early 2008. Even more interesting is that if we look at gold versus Brent oil, the metric is closer to 17x. Regardless, the valuation suggests there is reasonable more upside to gold, more downside to oil, or both.
The market that looks truly expensive is the recently downgraded U.S. Treasury market. As outlined in the chart below, the 10-year U.S. Treasury note is currently yielding ~2.39%. In the most recent three year cycle, the 10-year bottomed at yield of ~2.05% on December 30th, 2008. So, we are close to that price, which is the fifty year low for 10-year Treasuries. Given, it is likely fair to say that Treasuries are expensive, but, obviously, yields have the potential to go even lower especially subject to another round of incremental easing.
As it relates to fixed income, the yield on high yield credit has ramped dramatically over the last two weeks, as high yield bonds have sold off in line with equities. In fact, on August 1st 2011 the yield on high yield credit (based on the Bloomberg High Yield Index) was 7.28% and has since ramped to ~8.20%, for an increase of +11.2%. In the same period, as highlighted in the chart above of 10-year Treasuries, the spread between government bonds and high yield has widened, which we have outlined in the table below. Interestingly, this spread remains dramatically off the spreads we saw in late 2008 and early 2009.
This is not to suggest that high yield spreads will reach the parabolic widening that they did in late 2008 and early 2009, but rather just to suggest that while high yield has become less expensive it is not extremely cheap on either a relative or absolute basis.
Tomorrow we will be doing a call to discuss our more discrete thoughts on the various key asset classes at 11am. We will be sending out presentation materials and dial in info tomorrow morning.
Daryl G. Jones
Director of Research
POSITION: we are short the Financials (XLF)
The Financials (XLF), Industrials (XLI), and Basic Materials (XLB) have crashed in 2011. The question now isn’t whether or not this is a “recession” – it’s whether or not the SP500 is going to crash.
This may come as a shocker to some, but markets don’t care what a Keynesian economist defines as “recession” or “expansion.” Markets care about last price. And in this Fiat Fool environment, last price rules.
When some strategists, economists, and journalists talk about market prices, they have a picture in their head (usually a chart). They often use 1-factor point-and-click moving averages to tell you what a market is “doing.” We don’t do that. That’s what the market already did.
I used to do that, and I got crushed. Today, I constantly tweak the durations of my model across PRICE/VOLUME/VOLATILITY studies (a composite 3-factor model) that effectively front-runs my Global Macro Model (27 factors that score relevant correlation risk, fractal signals, etc.).
Since you can’t see it, what you care about is what the model is telling me right here and now. So let’s just get to that:
- TREND line = 1314 (broken)
- TAIL line = 1257 (broken)
- TRADE line = 1153 (broken)
What you also see in this chart is a proactively predictable drawdown line to 1086 in the SP500. That’s the most immediate-term TRADE line of support that my model considers probable.
Interestingly, but maybe not surprisingly, a close at or below 1086 would also constitute another 2011 crash (-20.3%).
Vive La Bernank – he’s up next. And he needs to cut his US Growth estimates, big time.
Keith R. McCullough
Chief Executive Officer
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CZR 2Q11 CONF CALL NOTES
"Our second-quarter results clearly indicate that the organizational and strategic changes we've made to meet the challenges of the recession are improving our performance and paving the way for accelerated growth when the economy improves"
- Gary Loveman, chairman, chief executive officer and president of Caesars
HIGHLIGHTS FROM THE RELEASE
- Property EBITDA $542MM and Adjusted EBITDA of $526MM
- "Revenues increased 0.4 percent ... despite an overall decline in visitation and the temporary closures of five of our properties in the Illinois/Indiana and Louisiana/Mississippi regions due to flooding. The increase was attributable to higher spend from our most loyal customers as well as growth in hotel revenue, most notably in the Las Vegas market."
- "Operations increased in the second quarter 2011 to $252.1 million, compared with $99.7 million for the 2010 second quarter. The increase was due to reduced property operating expenses resulting from the company's cost-reduction efforts and reduced and more focused marketing expenditures. Additionally, we recorded charges during the second quarter 2010, with no comparable amounts in 2011, for $52.2 million to fully
reserve a note-receivable balance related to a venture for development of a casino project in Philadelphia, and $25.0 million relating to a previously disclosed contingency"
- Eastern Band of Cherokee Indians extended their management contract by 7 years
- "Construction progressed toward completion by December of 662 rooms in the Octavius Tower at Caesars Palace. Also in Las Vegas, we made significant progress in the planning and design of the LINQ retail, dining and entertainment experience. In Ohio, the tax and regulatory agreement with Gov. Kasich has allowed us to resume construction of the Cleveland and Cincinnati casino projects with Rock Gaming that are expected to open in the first quarter of 2012 and the second quarter of 2013, respectively. We are also working to
develop additional potential casino opportunities domestically and abroad."
- "Trips by rated players in 2011 decreased 9.2 percent for the second quarter...., while spend per rated-player trip increased 5.6 percent for the second quarter... The visitation declines were the result of temporary closures of five of our properties in the Illinois/Indiana and Louisiana/Mississippi regions during the second quarter due to flooding, as well as the impact of marketing programs on visitation frequency of certain customer segments. The visitation declines in the first half 2011 also included temporary closures of two other properties in the
mentioned regions due to severe weather conditions. Cash average daily room rates saw an increase of 5.3 percent..."
- "During the quarter and first half 2011, the Company realized cost savings of $86.2 million and $152.4 million, respectively, and has estimated cost savings yet to be realized of $161.4 million as of June 30, 2011."
- Las Vegas 2Q trends:
- Property visitation by rated players: +0.2%
- Amount spent per rated-player trip: +9.2%
- Hotel revenues: +9.5%
- Cash ADR: +6.5%
- Occupancy: +3.6%
- Atlantic City 2Q trends:
- Property visitation by rated players: -4.1%
- Amount spent per rated-player trip: -0.1%
- "Revenues continued to be affected by the ongoing difficult economic environment, competition from new casinos and the mid-2010 introduction of table games in the Pennsylvania market. As a result, 2011 second-quarter and first-half revenues were slightly lower than the prior year periods. Second-quarter and first-half 2011 income from operations increased due to reduced property operating expenses as a result of reduced and more focused marketing expenses, lower depreciation expense and reduced payroll-related and property-tax expenses."
- Everywhere else 2Q trends:
- Property visitation by rated players: -15.1%
- Amount spent per rated-player trip: +6.4%
- "Visitation declines....were due largely to flood-related closures and the impact of more focused marketing"
- "Flooding of the Ohio and Mississippi Rivers during the second quarter of 2011 caused temporary closures of Horseshoe Southern Indiana, Horseshoe Tunica, Tunica Roadhouse, Harrah's Tunica and Harrah's Metropolis. Based on their locations and other factors, some properties were closed longer than others;
however, all properties were reopened as of May 27, 2011. While the closures did contribute to the reduced revenues experienced in the affected regions, the overall financial impact on the Company's results of operations for 2011 is insignificant, after taking into account insurance coverage. Costs incurred during
the closures, as well as those in connection with restoring the affected properties to operating condition of approximately $29 million, have not been expensed, but instead have been recorded as a receivable from third-party insurance providers. The Company also expects to receive insurance recoveries for lost profits through business-interruption insurance, which will be recognized into income in the period in which settlements with insurers are finalized."
- Iowa/ Missouri:
- "Revenues in the region were relatively flat in the 2011 second quarter... due to increased competitive pressures in the region and reduced visitation, offset by an increase in customer spend per trip. Income from operations and Property EBITDA for the 2011 second quarter increased due to reduced property operating expenses as a result of continued focus on effective cost management through the
implementation of the Company's efficiency projects"
- Louisiana/ Mississippi:
- "Revenues in the region decreased for the 2011 second quarter... primarily due to the temporary closures of three properties in the region due to flooding."
- "Revenues in the region decreased for the 2011 second quarter ... primarily due to the temporary closures of two properties in the region due to flooding"
- Other Nevada Region:
- "Revenues for the region declined slightly from the 2010 periods due to lower guest visitation and lower customer spend per trip driven by increased competitive pressure"
- Managed and International:
- "Revenue increases during the second quarter 2011 were attributable to Thistledown Racetrack, which was acquired in July 2010, and increased visitation and customer spend per trip at the Company's Uruguay property, offset by declines experienced by two properties in Egypt as a result of recent political uprisings. Turmoil in the region continues to impact the Egyptian properties' income from operations and Property EBITDA."
CONF CALL NOTES
- The changes they've made in their operations are allowing results to improve despite the lack of an economic recovery
- Project Renewal: created centralized department - to accelerate adoption of best practices and leverage scale to reduce costs
- By year end they will install PRISM at 3 more properties - basically allows them to make real time offers to their customers based on their play activity at the device while the player is still on the device
- Believes momentum is building in Congress to allow US citizens to play online poker.
- Expect Cleveland opening in 1Q12, Cinniccinati is expected to open in 2Q13
- Creating 4 additional VIP salons in Las Vegas at Caesar's
- Seeing sustained growth in the LV ADRs and better forward bookings
- Saw generally positive fundamentals in their Midwest region as well
- $390-$450MM of capex for the year
- Decline in trips was due to a decline in lower rated categories
- Trends for group bookings are very strong in Las Vegas for the balance of the year.
- AC - trends are stabilizing and they are focusing on driving more trips from profitable customer segments
- non-lodger spend per trip and trips were down
- Recent trends since stock market collapse?
- No changes in trends since market degradation
- Benefits of their cost savings are expected to be seen in the 2H11 and 2012 in relation to Project renewal
- How broad based was the EBITDA growth in Las Vegas results?
- Pretty broad based. During the past few quarter PH was the primary driver of growth for them, but that's anniversied now. There was a hold improvement YoY but not material. Particular strength in Caesar Palace though
- Project Renewal targets?
- Early innings of ramping up savings
- Revenue impact of floods: $50-75MM - they added the EBITDA loss back to their Adjusted EBITDA though - so no impact there
- Not anticipating a pullback in group bookings
- In AC they are looking at every source of efficiency gains - union contracts, etc
- Flood only impacted the operating company. Recognized a $29MM insurance receivable, which was an offset to flood related costs they incurred. Also assumed a $14MM recovery of losses to profits incurred.
- Feel that poker bill will pass - its just a question of when and on the back of which bill
- In MA there is also a sense of inevitability on the passage of gaming. Thinks that something will be introduced in early September and hopefully something enacted by Halloween
- Promotional environment?
- The environment has been rational and thinks that it can remain so for some time
- 40-50% of their savings this year have been driven by savings on marketing and promotional spending
- Early cost cuts post 2008 were driven by declines in volume and right sizing the orginization to lower visitation levels. The Project Renewal cuts are due to efficiency gains and marketing improvements - so flying in high rollers more efficiently. Expect to realize all of their targeted savings by end of 2012- and the run rate will be realized by 2Q/3Q. 10-15% of this program is related to labor scheduling and staffing approach
- Have seen a general trend of higher international visitation
- Seeing nice trends in terms of rate improvement in Las Vegas and the mix is getting better more towards Casino and Group segments
- Rated play is between 75-80% as a % of total play across their portfolio and a little lower in Las Vegas
We weren’t blown away by the quarter although it was decent. Management’s bullishness was surprising, even for MGM.
There is no love for gaming exposure and no love for leverage. MGM has both. So despite a decent quarter and a very favorable outlook, MGM is selling off this morning. MGM’s not our favorite stock in gaming but if management’s forward looking commentary is close to reality, the stock will likely push forward. Here is our analysis of the quarter and the outlook.
- Despite being the high on the Street at $420MM of EBITDA, adjusted for hold and impairments at the residential division of CC, MGM beat our number by $2MM
- Las Vegas:
- RevPAR growth was a little stronger than we expected. Partly due to Q2 resort fees of $9-10 vs $6-9/day in 1Q. Occupancy was also surprisingly stronger – so rate did not come at the price of occupancy
- Despite higher RevPAR, EBITDA was lower than we estimated by $21MM. The miss versus our number was likely due to lower than normal hold which management claims cost the Strip properties $27MM
- The 3 properties that missed our EBITDA estimates by the widest margin were: MGM Grand, Mirage and Luxor by 38%, 25%, and 15%, respectively
- Mandalay and Monte Carlo beat our EBITDA estimates by 16% and 14%, respectively
- Total property level expenses increased 4% YoY
- NY NY, Mirage and Bellagio had the highest YoY increases in growth of 10%, 6% and 5% respectively
- MGM Grand had the most controlled expense growth at 2%
- All the other properties at expense growth of roughly 3.5%
- The lower end properties had the best RevPAR growth. Despite strong RevPAR growth, 2 properties still had YoY declines in EBITDA – likely due to hold comparisons
- Excalibur RevPAR increased 27% but EBITDA decreased 0.2%
- MGM Grand RevPAR increased 9% but EBITDA decreased 32%. It looks like MGM Grand had very good hold last year
- Since MGM reported positive income the $1.45BN of 4.25% converts were treated as dilutive to the share count per GAAP accounting rules - hence the increase in share count. [The converts are struck at $18.58 – you can either count them in the share count or as debt but not both. We tend to treat them as debt until they are in the money]
- City Center’s revenues were $22MM above our estimate but EBITDA was only $2MM better. Adjusting for $18MM high hold benefit, City Center continues to underwhelm us at a $33MM quarterly run rate.
- Excluding residential, the revenue beat would only have been $16MM and the EBITDA beat would have been $5MM or ($60MM of EBITDA excluding residential and $42MM on a hold adjusted basis)
- Net casino revenues were roughly flat QoQ or roughly $111MM
- Estimated slot revenue $37MM
- Estimated table revenue $80MM
- Drop $285MM, hold of 28%
- Rebate rate of 5%
- $122MM of net non-gaming revenue
- Total expenses increased $10MM QoQ to $180MM
- MGM Macau total EBITDA was $9MM above our estimate while revenue $12MM better
- Implied direct play was 8% vs. our prior estimate of 13%
- Mass hold was quiet high at 27.5%
- The slot win % was 5.6%
- We estimate that fixed operating expenses increased to $82MM from $76MM in Q1
Management went so far to say the forward trends were “very positive”. If they can achieve their projection of 10% RevPAR growth and generate gains in the casino as implied in their commentary, Q3 will be a strong quarter. Here are some of the important forward looking takeaways:
- “Our booking pace is so far up quite nicely for the summer and really throughout the fall period as well.”
- “We expect RevPAR in the third quarter here in the Las Vegas strip to be up around 10%. We’re particularly encouraged in terms of second half of the year on our convention calendar, most notably the months of September and October; they’re exceptionally strong. And in fact, the third quarter convention mix is expected to be up about 300 basis points over last year’s mix.”
- “The event calendar is also strong. The back half of this year is better than the first half”
- “…July we’ve been up and in fact we’re having a very solid time of the high end internationally.”
- “I think the slot increases, though, are a function of a few things. One, overall general improvement in the customer that’s coming to Las Vegas. We’re seeing across the board improvements in RevPOR, total revenue per occupied room; that translates well on the slot side. The mix has improved in terms of the room mix so as we’re driving more productive customers through the buildings, we’re seeing higher slot revenue”
- “In terms of looking at booking trends it had its biggest booking month in three years in the month of July. So in terms of booking new business, getting back to an earlier question, we’re seeing booking trends if anything have not fallen; certainly not in July, not here in August, but we’re seeing it accelerate in some of our properties.”
- [Convention space in 2012] “I think first four months is virtually sold out and Chuck doesn’t have any space more or less to really book any large piece of business at Mandalay
- “We actually have 68% of our rooms booked for 2012”
- “I think Aria is even pacing ahead of that in terms of 2012 this early in the game and our convention folks are pretty excited about the way ‘13 and ‘14 are actually shaping up.”
TIDBITS FROM THE 10Q
- Casino net revenue increased 1% YoY
- Table game revenue was down 5% YoY, partly due to an 85bps YoY decrease in table hold to below 19%
- Table volumes were down 4% YoY
- Slot revenues were up 5% YoY and 7% in Las Vegas
- MGM Macau:
- Gaming concession expires April 20, 2020 while the land concession is good through April 6, 2031
- Company recognized intangible assets related to gaming promoter relationships with an estimated value of $180 million which will be amortized over their estimated useful lives of four years
- MGM Grand Paradise’s tax exemption expires on Dec 31, 2011. An application for a 5 year extension is pending Macau government approval
- Silver Legacy distressed situation:
- “Has approximately $143 million of outstanding senior notes due in March 2012. Silver Legacy is exploring various alternatives for refinancing or restructuring its obligations under the notes. There can be no assurance, however, that it will be able to refinance or restructure the notes on acceptable terms, or at all. If Silver Legacy is unable to refinance or restructure its obligations with respect to the mortgage notes, the holders of the notes will be entitled to exercise the remedies provided in the indenture governing the notes, including foreclosing on the assets securing the mortgage notes.”
TTM EBITDA for Credit Facility covenant calculation purposes was $1.25BN at 2Q end vs a min required level of $1.1BN
There was $619MM funded on the CC completion guarantee and $18MM of estimated net obligation outstanding (including outstanding Perini litigation). MGM recorded a $110MM receivable which represents amounts reimbursable to MGM from CityCenter from future residential sales
HEDGEYE MACRO: IS THIS A SHORT COVERING OPPORTUNITY?
AN ANALYSIS OF RECENT MARKET ACTION AND UPDATE ON OUR KEY THEMES
CONFERENCE CALL THIS WEDNESDAY, AUGUST 10, 2011, 11am EDT
Valued Hedgeye Client:
The Hedgeye Macro Team, led by CEO Keith McCullough and Director of Research Daryl Jones, will be hosting a call this coming Wednesday August 10th at 11am EDT to discuss recent global market action and our key current risk management views.
Please note the time of the call is now 11am EDT, not 1pm, to allow our Financials Sector Head Josh Steiner to join us to provide a preview of the Bank of America call that will be occurring at 1pm.
Key topics we will be addressing:
- Does the SP500 off over 15% from its YTD highs present a short covering opportunity?
- Given our outlook for the global economy, what are the key drivers over the intermediate term?
- Sovereign debt issues and the likelihood of resolution, both in the United States and Europe.
- Update of Hedgeye's quantitative and fundamental view of key assets classes - e.g. U.S. dollar, oil, gold, treasuries and copper.
- Hedgeye's top macro and asset allocation ideas.
Please contact if you do not currently subscribe to out Macro vertical and would like to attend this conference and receive the materials. The materials and dial-in information will be automatically circulated the morning of the call to current Macro clients.
As always, we'll have a robust live Q&A session. If you'd like to submit questions in advance of or during the call, please email .
The Hedgeye Macro Team
Hedgeye Risk Management is a leading independent provider of real-time investment research. Focused exclusively on generating and delivering actionable investment ideas, the firm combines quantitative, bottom-up and macro analysis with an emphasis on timing. The Hedgeye team features some of the world's most regarded research analysts - united around a vision of independent, uncompromised real-time investment research as a service.
ABOUT KEITH MCCULLOUGH
Prior to founding Hedgeye Risk Management, Keith built a track record as a successful hedge fund manager at the Carlyle-Blue Wave Partners hedge fund, Magnetar Capital, Falconhenge Partners, and Dawson-Herman Capital Management. He got his start as an institutional equity sales analyst at Credit Suisse First Boston after earning his Bachelor of Arts in Economics from Yale University, where he captained the Yale Varsity Hockey Team to a Division I Ivy League Championship. Keith is also a Contributing Editor to CNBC TV, Fortune Magazine and author of Diary of a Hedge Fund Manager (Wiley 2010).
ABOUT DARYL JONES
Prior to joining Hedgeye Risk Management, Daryl was the Sector Head for Basic Materials at HIG Capital's hedge fund, Brightpoint Capital. Earlier, Daryl founded the public investment effort at Onex Corporation, a leading private equity firm. At Hedgeye, Daryl covers commodities, geo-politics and major asset classes outside of equities.
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