Water Crashes

This note was originally published at 8am on August 09, 2011. INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK (published by 8am every trading day) and PORTFOLIO IDEAS in real-time.

“Empty your mind, be formless, shapeless – like water.”

-Bruce Lee


With stock and commodity markets around the world crashing, let’s review the two things that Fiat Fools who fundamentally believe that they can arrest economic gravity do to markets:


1.       They shorten economic cycles

2.       They amplify market volatility


So, let’s fire up La Bernank this morning and do some more of that!


C’mon. Really? Europe has its own issues to deal with, but is America that dumb? Americans didn’t stand for Fed Head Arthur Burns and President Jimmy Carter perpetuating economic stagflation in the mid 1970s, and I don’t think they will now.


Wall Street/Washington is not America.


Some asset managers may very well think that’s America. Some are already begging for Bernanke’s bazooka this morning. But they should remember a very important factor in the business of money management – they are managing other people’s money.


Like it did when they were begging for “shock and awe” rate cuts in 2008, other people’s money is crashing, again. So let’s review: 


1.   EUROPE:


A)     Greece is gone – crashed (down -43.9% since FEB 2011)

B)     Italy, crashing - MIB Index down -34.6% since FEB 2011

C)     Germany, crashing – DAX down -25.6% since May 2nd(and that’s the healthiest European economy!)


2.   USA:


A)     Financials (XLF) – crashed (down 29.2% since FEB 2011)

B)     Industrials (XLI) – crashed (down -23.7% since APR 2011)

C)     Basic Materials (XLB) – crashed (down -22.2% since APR 2011)


Now what does the end of April and early May 2011 have in common with both German and most US stocks putting in lower long-term highs versus the 2007 bubble peaks?


Ah, oui, oui, mes amis – c’est La Bernank!


Let’s not forget that April 2011 was the date whereby Ben Bernanke one-upped his own record setting precedent pace, debauched the US Dollar to all-time lows (post Nixon 1971, post Gold Standard), and held the Fed’s 1stever Global Press Conference On Money Printing.


Nice Trade… until it blew everyone up who was chasing yield.


What about the long-term TAIL risk associated with the gargantuan Fiat Fool Experiment that Bernanke’s Princeton buddy Paul Krugman encouraged the Japanese to engage in before locking themselves in the Keynesian death grip of GROWTH SLOWING?


Since 1992, Japan’s average annual GDP Growth has been 0.85%. And while that’s actually better than what Bernanke produced in Q1 of 2011 (0.36% US GDP Growth), that’s still not good.


On top of its debt and deficit problems… America, now we have a GROWTH problem. And if we think we are going to solve it by printing moneys and begging for La Bernank, we deserve to keep crashing.


Back to the Global Macro Grind


Whether we are going to thank them for making up their numbers like we do in this country or just thank them for not completely imploding their economy overnight, China – Thank you.


Last night’s Chinese economic data for July was as follows:

  1. INFLATION: CPI only up 10 bps in July to 6.5% y/y (vs. 6.4% in June)
  2. GROWTH: Industrial Production growth slowed sequentially in July to 14% y/y (vs. 15.1% in June)
  3. INVESTMENT: Fixed Assets Investment YTD growth slowed marginally in July to 25.4% y/y (vs. 25.6% in June)

I put inflation at the top of this 3-factor model because that’s really what China needs to solve for in Q3/Q4 of 2011. If they do (and we think they will), Chinese inflation growth should slow towards +5% year-over-year with GDP Growth running closer to 8%.


Chinese economic growth has been slowing for 15 months as inflation accelerated. Commodity inflation in China was perpetuated by the US Federal Reserve printing money (Global Commodities trade in US Dollars). Now we are seeing what Hedgeye has called for (a Deflating The Inflation) – and that’s a very good thing for China.


Deflating The Inflation is also a very good thing for you, The Consumer. And, in the end, instead of money printing I think 95% of Americans would take a 30% off sale at the pump than another call by Goldman to buy oil at $112/barrel (where Hedgeye said short oil – not that we keep a time stamp on these things or anything).


When it comes to calling this Globally Interconnected Market, “empty your mind, be formless, shapeless – like water.” Money printing may have very well flowed from the gushers of Academia’s Keynesian Dogma for the last few years but, as Bruce Lee reminds us: “Now water can flow or it can crash.”


“Be water, my friend.”


My immediate-term support and resistance ranges for Gold, Oil, and the SP500 are now $1648-1761, $78.54-91.66, and 1070-1172, respectively. Our asset allocation in the Hedgeye Asset Allocation Model maintains a 0% position in US and European Equities and a 67% position in Cash. In the Hedgeye Portfolio, I covered shorts yesterday and will look to re-short strength today.


Best of luck out there today,



Keith R. McCullough
Chief Executive Officer


Water Crashes - Chart of the Day


Water Crashes - Virtual Portfolio


With the stock down on guidance - a major sandbag in our opinion - this stock could get interesting.




“The highlight of Bally’s fiscal 2011 was the positioning we accomplished for the future.  We grew gaming operations revenue by 11 percent and established a strong base of innovative games going forward. We also successfully commercialized two major new product lines, our ALPHA 2  gaming platform, and the iVIEW DM  floor-wide network. Further, we invested in key new customers and markets, such as Australia and Italy, which should provide good revenue and earnings growth in the current and future years.”

- Richard M. Haddrill, the Company’s Chief Executive Officer



  • $214MM of revenue and $0.56 of Adjusted EPS (adding back a $0.05 debt extinguishment charge)
  • Game sales:
    • 3,829 new gaming devices sold at an ASP of $16,719
    • International sales: 27%
    • "ASP of new gaming devices increased by 9 percent ... primarily as a result of product mix, including sales of Pro Series cabinets with ALPHA 2 technology and release of the Pro Curve."
    • "Gross margin declined ... primarily due to higher costs for the initial production runs of the Pro Series V32 and Pro Curve, which were released in the back half of fiscal 2011, as well as higher royalty expenses due to a higher royalty-based mix of new-unit game sales and conversion kit sales."
  • Game ops:
    • Linked progressives: 1,059
    • Rental & daily fee: 14,315
    • Lottery: 8,350
    • Centrally determined: 50,754
    • "We placed more than 500 Cash Wizard games, our first ALPHA 2 premium game with a spinning-wheel bonus, and we began reinvesting in our wide-area progressives in the June quarter"
    • Launched: Betty Boop's Love Meter, Money Vault, Hammerhead
    • "Gross margin increased to 72 percent... due to increases in participation and rental revenue which had little associated variable costs and lower jackpot expenses."
  • Systems:
    • $17MM of maintenance revenue
    • "Gross margin declined slightly to 73 percent .... primarily as a result of the change in mix of products sold, partially offset by an increase in maintenance revenues."
    • "Hardware sales were 42 percent of Systems revenues, and software and service sales were 29 percent, as compared to 35 percent for hardware and 37 percent for software and services in the same period last year."
  • "SG&A increased to 28 percent of total revenues... primarily due to increases in payroll, regulatory, and other expenses to support key new products and markets and an increase in bad debt expense."
  • FY2012 Update:
    • "The Company expects fiscal 2012 Diluted EPS to exceed $2.15 and, as a result of seasonal trends, expects first quarter fiscal 2012 Diluted EPS to exceed $0.40."
    • Tax rate: 36-37%
    • "Gaming equipment margin improvement over the fiscal year, and continued weakness in the replacement cycle."
    • "Assumes the Company will begin generating revenues from Canadian system procurements, the Italian VLT market, and Aqueduct in late calendar 2011, which will accelerate during calendar 2012."



  • Customers' businesses are now improving
  • Annual diluted EPS was in line with guidance given last quarter when adjusting for tender and debt extinguishment costs
  • Nearly all their units sold in NA were replacements
  • They estimate their share was 19% vs 17% last Q
  • Began shipping Pro-Curve this quarter which contributed to their high ASP in the quarter 
  • Anticipate similar growth in maintenance revenues in FY12'
  • FY tax provision were positively impacted by the IRS settlement and reinstatement of the R&D tax credit and their Indian R&D facility
  • Had $200MM of liquidity and $150MM remaining under their stock repurchase plan
  • Inventory increase is due to Italian inventory build which they expect to begin to deploy later this year
  • Replacement game sales were the best in 6 quarters for BYI
  • 77% of their domestic sales were video slots. Pro Series was 72% of their shipments this quarter
  • Playboy Hot Zone was a hot seller this quarter
  • Pro Series continues to gain traction domestically and internationally
  • High ASPs were driven by Pro Series sales
  • Majority of their games sold were royalty based titles which carry lower margins (same for their conversion kit sales)
  • Completed 10 major go-lives this quarter - 7 of which were competitive replacements.  Galaxy Macau also went live this quarter. Roughly 50% of the installments were in small casino.  They have 64% share in Macau systems share. Their table view product had over 30% share
  • This quarter was one of their biggest systems 'wins' quarter.  Due to a seasonably low number of go lives in the F1 they expect low systems revenues in the September
  • BYI is the leading US Italian slot supplier
  • Canada revenue recognition should start in 6 months
  • FY outlook:
    • Guidance impacted by higher tax rate and continued investment in initiatives which won't hit until the end of the year. First half of the year will be one of investment and back half one of harvesting



  • Canada contract still isn't signed but expect timing should still be intact
  • View on buybacks?
    • Want to leave dry powder for customer financing and Italy/Aqueduct capex
    • Other than that expect to be opportunistic in buying back their stock
    • Italy and Aqueduct capex:
      • 5,400 units in Italy at $7.5-8k
      • Aqueduct - 50% of the units at roughly the same cost ($7.5-8k)
  • $1.97 is the normalized earnings rate for FY11 as an apples to apples comparison their guidance ($0.22 cents of tender, $0.05 debt extinguishment costs, $0.12 of higher tax rate expense)
    • SG&A will grow slightly next year (4Q run rate)
  • Think that they can get 10% cost reductions on the Pro-Series. Expect margins to slowly increase over the next 4 quarters and return to normal in FY13
  • If not for the turmoil in the markets today there is no reason to assume any uptick in replacements although they are assuming for a small uptick in shipshare, small uptick in game ops due to their good game content and Aqueduct/Italy opportunity. Timing of Italy and Canada are also difficult to project
  • iVIEW DM could be a rocket ship or a slow growth driver
  • If you calendarized their FY12 4Q you'd get to a really healthy number
  • Performance of Pro-Series are very strong
  • Margins on boxes vs. other revenue?
    • Used games aren't a material contributor to their revenues
    • The largest impact in the quarter was that more of their cabinets and conversion kits were heavily weighted towards royalty themes
  • iVIEW DM margins should be north of 50% - so above most hardware margins but below their software margins. However, the iVIEWs will drive the sale of software bonusing applications which have really high margins
  • Jump in progressives is due to Betty Boop and Money Vault. Made a consious effort to reinvest in their WAP network and will showcase more exciting product during G2E
  • September quarter is a seasonally weak quarter in generally - so it's not a good time for new orders and system installations since its a busy quarter for them.  Also G2E is early this year
  • New South Wales - shipped 100 units this quarter
    • Will start selling into more markets there soon. They are excited about the market and expect to do better as the year progresses.

Risk Ranger: SP500 Levels, Refreshed

POSITION: We are short the Financials (XLF)


It’s been a volatile [insert: week/month/year]. Inclusive of today’s pullback, the VIX is up nearly +150% since the start of July.


The Bernank calls this “price stability”.


We call volatility for what it is and we are quick to point out its effect on managing risk – specifically in that it adds an extra layer of complexity for larger institutions. Big Government Intervention does two things: 

  1. Shortens economic cycles
  2. Amplifies market volatility 

We are not sure the Eurocrats over at the European Securities and Markets Authority (the agency responsible for imposing short-selling bans in Europe) understand this simple concept. Furthermore, we aren’t convinced a short-selling ban is the proper remedy to the problems associated with Europe’s banking system (pull up a chart of SocGen CDS).


When volatility blows out like it has in recent weeks, investors would do better to shorten their duration and trade the range(s) appropriately – in this instance, with a bearish bias. We call this Risk Ranger and it remains one of our current Key Macro Themes.


Some call it “trading”. We call it “managing risk”. Tuh-may-toe. Tuh-mah-toe.


The bull market in price IN-stability is having a profound effect on the output of our core three-factor quant model (PRICE/VOLUME/VOLATILITY). Specifically, our immediate-term TRADE ranges are now wide enough to fit my offensive line-sized physique through: 

  1. TREND (bearish) = 1,314
  2. TAIL (bearish) = 1,257
  3. TRADE range = 1,086-1,193 

Note, our current immediate-term downside support target is within crash territory (a peak-to-trough decline of 20% or more). Moreover, the SP500 (along with most things that tick live in the Global Macro universe) remains demonstrably broken from a TREND and TAIL perspective. Manage that risk accordingly.


Darius Dale



Risk Ranger: SP500 Levels, Refreshed - SPX

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LIZ: Another Catalyst


LIZ sold off some fragrance assets to Elizabeth Arden this morning for $58.4mm in cash marking the first of what we expect will be several asset sales in the coming months. One of the key factors is that despite market turmoil, LIZ has so many asymetric factors to generate an outsized longer-term term return for investors that can shoulder near-term liquidity risk.


As you can see in our sum-of-the-parts below, this sum is nearly double the value we attributed to this business. In fact, this deal represents less than half of the company's entire fragrance/ cosmetics assets with the ownership of the Juicy, Lucky, and Kate licenses still in-house. 


Only a few weeks ago, the company confirmed it was in talks to sell its Mexx business in addition to several other possible sales in an effort to reduce debt by nearly $200mm to less than $580mm by year-end. While the timing and likelihood of that eventuality is now under question in light of recent European credit concerns, the company has a stable of other brands that it's currently evaluating. With the turn underway at Mexx along with an aggressive plan in place to reduce its underperforming store base, it's less about which brand is sold just as long as one is. 


In addition, LIZ secured a distribution agreement with Li & Fung to ensure uninterrupted service as it shutters its Ohio distribution facility – a key element of its latest $25mm cost reduction initiative.


The bottom-line here is that this model has considerably better visibility than even a month ago and management is clearly driving change to improve liquidity. LIZ remains one of our top ideas.


LIZ: Another Catalyst - LIZ SOTP 8 11



Casey Flavin











Initial jobless claims came in at 395k versus expectations at 405k consensus for the week ended August 6th.  For the week ended July 28th, the number was revised to 402k versus 400k.


THE HBM: WEN & EAT EARNINGS, JACK, CHUX, CAKE - initial claims 811





Gasoline prices are coming down on an absolute basis and this is providing relief to consumers.  On a year-over-year basis, however, prices at the pump remain elevated (as the chart below illustrates).


THE HBM: WEN & EAT EARNINGS, JACK, CHUX, CAKE - gasoline prices time series





QSR stocks underperformed yesterday along with Food Retail.  The broader market dragged all categories lower.






  • WEN reported 2Q EPS of $0.05 versus consensus $0.05 this morning.  Comps exceeded expectations at +2.3% for company-owned restaurants versus consensus at 1.5%.  Margins were heavily impacted by commodity costs (180 basis points) and incremental advertising to support the new Wendy’s breakfast in additional markets (60 basis points).
  • JACK reported results for Q3FY11 last night.  Margins dragged down EPS to $0.25 ex-items versus $0.40 expectations.  Comps continue to trend higher (Jack company comps +4.7% versus +3.3% consensus and Qdoba system +5.1% versus consensus 5.0%) and the company raised the low end of FY11 comp guidance for Jack and Qdoba.



  • EAT reported a strong quarter this morning, beating consensus EPS by a penny with $0.48 in Q4FY11.  Comps came in at +2.8% blended versus 1% consensus and Chili’s comps were +2.6% versus 3.3% expectations.  Restaurant margins were 18.3% versus 17.1% expectations.  Tellingly, management raised FY12 EPS guidance to $1.80 to $1.95 versus current expectations of $1.76.  EAT remains one of our favorite names in the space and has been for some time.
  • CHUX reported 2Q EPS of ($0.08) versus consensus ($0.05) and O’Charley’s comps of +2.9% versus consensus 1.1%.  O’Charley’s management says that beef, dairy, and seafood costs are up during 3Q.  This is bearish for CAKE, given what we believe is the government’s overly conservative commodity guidance for 4Q.
  • CAKE raised to “Buy” from “Neutral” at Lazard Capital.






Howard Penney

Managing Director


Rory Green



JCP: Life Before Johnson


JCP’s Q2 earnings out Friday are going to come in well shy of the company’s guidance, no surprise there. The bigger issue at hand is the duration mismatch between the timing of investments needed to execute on Ron Johnson’s master plan and current earnings expectations, which are too high. We firmly believe both numbers and the stock are headed lower from here.


July same-store-sales came in up 3.3% last week capping off an unimpressive quarter in which comps are likely to come in at +1.5% compared to guidance of 3-4%. This shortfall is due in part to a materially underperforming e-commerce business, which is up only LSD and running well below full-year double-digit growth expectations. With limited room for upside in gross margins as a result of the company’s competitive pricing position and limited product differentiation, SG&A will be the key lever to manage for the balance of the year. We’re shaking out at $0.07 for the quarter vs. the Street at $0.10 and management’s initial Q2 guidance of $0.20-$0.24. Given our expectation for meaningfully lower earnings, we expect JCP to take down full-year guidance for revenue, gross margins, and EPS Friday. To be clear, our thesis goes far beyond this quarter’s results.   


As we outlined in our recent JCP Black Book, here’s the setup heading into the quarter:

  1. Over the near-term (Trade = 3-weeks or less), JC Penney is one of the most poorly positioned companies in the industry as it relates to the margin compression we see ahead. We’re at $1.82 vs. the Street at $1.94 in F11.
  2. In the intermediate term (Trend = 3-months or more), we’re looking at much of the same. Numbers as the company looks today are too high in F12. Again, we’re at $1.33 vs. the Street at $2.40. 
  3. Over what we consider long-term (Tail = 3-years or less) we’ll be seeing meaningful investment back into the model, as Ullman exits either by choice or force. Then we’ll see SG&A and CapEx both go up meaningfully. Mind you, Apple lost money in retail for the first 2+ years, and fell short of its publicly stated profit goals for 2 years because Johnson opted for the benefit of long-term shareholder value, not the inability to perform. We think that this is what will take earnings down – potentially below zero based on our analysis. In F13, we’re at $1.22.
  4. Then, and only then, can JCP rise from the ashes and emerge into whatever it is that Johnson is envisioning. Heck, it might prove to be the best stock in the S&P. But that might not be until years 5-7. Johnson’s warrants get him paid – keeping in mind that he probably doesn’t need the money to feed his family in the interim.
  5. In the interim, investors have to cope with 1) the real earnings power of this company, estimates for which are too high, while keeping the Ackman’s of the world spinning their tales of value creation.

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: Life Before Johnson - JCP S 8 11


JCP: Life Before Johnson - JCP Sent 8 11



Casey Flavin




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