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“Discovery consists in seeing what everyone else has seen and thinking what no one else has thought.”

-  Albert Szent-Gyorgyi, Hungarian Physiologist, Nobel Prize Winner


There are tipping points in time when suspicions become reality, hunches become facts, and theories become laws.  The umbrella, having being raised sufficiently, clicks.  Greek mathematician, physicist, and astronomer Archimedes was once asked, according to the Roman writer Vitruvius, to determine whether or not a crown made for King Hiero II was made entirely from gold or whether silver, or another cheaper alloy, had been furtively mixed in. 


An important caveat; the crown was not to be damaged in the process.  Soon thereafter, upon observing the rising water level in the baths as people entered the water, Archimedes realized a method by which he could measure the volume of the crown, or any irregular shape.  Knowing the volume and weight of the crown, he could easily determine the density and thereby verify the soundness of the ornament.  


Archimedes ran through the streets shouting “Eureka!”, or so the story goes.  These “Eureka” moments happen to all of us and are generally preceded by a period of reflection, or obliviousness, which makes the discovery all the more jarring. 


The stock market has certainly been jarred by the recent events in global macro.  Of course, some investors were ahead of the game.  George Soros had moved heavily to cash, for instance.  For the overall market, simply looking at a chart of the S&P 500 shows quite clearly that a sudden realization came upon investors that stocks were greatly overvalued.  For a proxy of the stress/fear levels on Wall Street upon this Eureka moment, and others in the past, simply take a glance at the chart at the bottom of this note. 


It has long been Hedgeye’s contention, and Keith’s task on a daily basis, to highlight that big government intervention shortens economic cycles and amplifies market volatility.  Uncertainty dissuades investors from allocating capital and governments tend to create uncertainty – in the long-run – via bailouts, short-selling bans, and the implementation of other interventionist policies.  The volatility in the markets these past few days is testament to that fact.


To that end, today France, Italy, Spain and Belgium plan to enact bans on short selling or on short positions, which are only temporary and will do little to pacify the investment community or solve the structural problems that are impairing confidence.  Josh Steiner weighed in this morning, writing a note to his clients titled, “BANNING SHORT SELLING HELPS FOR ABOUT 5 HOURS”.  Steiner cites the short-lived bounce that occurred in US equity market, all of which was given back over the next seven trading days, when US authorities enacted a short selling ban in September of 2008.


As steep as the roller coaster in US equities has been (down ~13% over 14 days of trading), the government’s revisions of 1Q11 GDP has also been violent enough to cause whiplash; over thirty-five days, GDP for the first quarter was revised down 81%! 


Many investors today seem to be seeking a parallel to previous periods of market volatility.  Is this 1987 again or 2008 again? But how is it different?  One similarity between today and 2008 is that a major banking system is hanging by a thread.  Slowly, it is becoming evident that platitudes and assurances from Trichet and other banking officials in Europe are losing traction with global investors as the extent of the Old World’s problems become more apparent. 


One difference is that Europe is a far less united entity than the USA.  That’s not bluster, that’s a fact.  As mentioned in previous Early Look editions, conflict – not unity – has been a defining characteristic of the continent.  If the similarities between 2011 and 2008 are bad, the differences are almost worse!


Over the last three weeks the VIX is up 44.1%, 26.7% and 36.3% (through Thursday), respectfully.  As in 2008, the XLF has led the way in this downturn.  Brian Moynihan, CEO of Bank of America, is doing his best impression of Dick Fuld circa 2008, stating – in that wooden way that only corporate CEO’s can pull off – that “everything is fine”. 


Mr. Moynihan has assured interviewers that CDS spreads will go back down and instructed listeners of the company’s conference call to “trust” the management team.  The stock price has long been underperforming the market and the bank’s 5-year CDS spreads are currently 317 bps wide.  That’s 42% higher than the 2008 peak of 226 bps on 9/18/08 and 20% below the 3/30/09 peak of 402 bps.  These metrics are certainly not echoing Mr. Moynihan’s sentiments.  As Main Street America sees it, CEO’s and politicians are part of a separate group which they do not understand, do not trust, yet the actions undertaken by that group greatly influences the fortunes of the rest of the country.


Hedgeye’s Healthcare guru and general thought leader, Tom Tobin, wrote this week in his team’s morning “Healthcaster” note, “We made the point on the Debt Ceiling compromise that we would look back fondly on a process that has been roundly criticized and routinely blamed for recent stock volatility.”  Tom’s macro view has been on point lately and, rather than buying into the trap of seeing the passing of the debt ceiling resolution as cathartic, Tom was cognizant of the repercussions of the lack of transparency in CBO and ratings agency processes and heightening public emotions.  Observing this play out, Tom wrote, is “like watching two blind umpires argue a blown call.” 


Perhaps most disturbing is that “to construct its forecasts, the CBO reviews major econometric models and information from “commercial forecasting services” and also consults with and relies on the advice of its expert panel of economic advisers”, including academics and Goldman Sachs.


That’s right; the CBO bases its forecasts on the advice of Academia and Wall Street!  You couldn’t make this stuff up if you tried.  The logic is enough to make your head spin. 


The CBO uses street forecasts to peg their GDP forecasts which lead debt and deficit projections.  The Street uses federal spending to calculate its GDP forecasts.  Congress cutting spending leads to falling GDP, which leads to the Street cutting forecasts, which increases debt and deficit forecasts and increases the pressure to cut spending.  In the middle of this whirlwind is the consumer, who bears the brunt of the spending cuts and lack of jobs. Ultimately, the consumer is the linchpin holding the economy together.  70% of US GDP is consumption.  The very nature of the negative feedback loop I describe above is impairing a massive portion of our nation’s GDP from growing.


If you believe that our current political process is “broken”, as I do, the next step in the debt ceiling  debate will be no better than a made-for-TV reality show starring partisan politicians sitting on “The Super Committee” putting together back-door deals (based on flawed data) that will take us further down a path of financial morass. 


In the short run, we may get a reprieve from some of the Washington madness as Congress is on vacation for the balance of the month and the Obama family is going on vacation from the 18-28th.  The markets, like time, wait for nobody.  Not even the President.  Given the interconnected nature of global markets, with Europe facing a 2008 style financial meltdown - who is watching the store?


Again, some of the differences between 2008 and today seem worse than the similarities: joblessness is higher, more people are reliant on food stamps for sustenance, and the financial crisis threatening to wreak havoc on our economy is not here in the USA and therefore less within our government’s control.  The similarities, given that we are comparing the present situation to 2008, are inherently negative.  Gas prices are elevated, the VIX is spiking, stocks have fallen off a cliff, and consumer confidence is depressed. 


Collective Eureka moments dictate the larger trends in the market and Hedgeye has done a better-than-bad job of being ahead of the moves we have seen since our firm’s inception.  In 2008, we moved to cash (as high as 96%); in March and early April of 2009, we made some strong calls to buy US equities (buying SBUX in April).  Both of the market moves that ensued were long, pronounced, and driven not by any change in what market participants were seeing, but rather a change in how they were perceiving those factors and what they were thinking. 


We have observed a sea-change in how investors are thinking about this market, politics, the role of government, and earnings expectations in the past couple of weeks.  The Eureka moment is here.  Big government has brought around another crisis faster than almost anyone could have thought possible. 

How time flies.


Function in disaster; finish in style,


Howard Penney




THE EUREKA MOMENT - Virtual Portfolio

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.

Early Look

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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

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



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