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BLIND LEADING THE BLIND

We looked at the relationship between gaming operator and supplier stocks over the past 10 years. As one would expect, the relationship was strong. Interestingly, the strongest relationship was gaming operator stocks driving supplier stocks on a six month lag.

Intuitively, this makes sense. When business is bad, cash flows decline, liquidity is a more pressing need, and suppliers cut back on slot capex. Operators do not immediately cut back on slot capex when their business turns down, nor do they immediately communicate to the suppliers that they are cutting back. Hence, the lag.

This relationship could be tested in the coming quarters. As discussed in my post “CAPEX, COVENANTS, AND CORPORATE CONTROL”, I expect corporate managements of the operators to direct slot capex lower in the first half of 2009 due to liquidity issues. Even if gaming trends improve sequentially, I anticipate slot purchases to be pushed back into the second half of the year.

Most significantl statistical relationship is a 6 month lag

RL: This Quarter is All in the Details

There’s never been a quarter with RL where looking at the puts and takes vs. the year-ago period mattered more. Here’s a detailed margin walk to guide the way. Yes, revenue stinks. I can’t imagine anyone on Wall Street thinks otherwise. Tack on the fact that a consistent 6-8% boost in sales from acquisitions and another 2-3% from FX goes away, and the top line ain’t very pretty. But I think there’s enough juice on the cost side to serve up a pretty decent headline number. After adding up the Impact 21 and Small Leather Goods dilution from last year, FX-driven SG&A, and a meaningful step-up in both cash and stock-based comp, RL has about a 150-175bp pad built into margins for the next two quarters. My gut (and my math) gets me to a beat on the quarter, and if there is a guide down, it should not be by much. When I stress test t he model (email me for a copy) I get to a bear case number for this year above $4.00 per share. I’ll almost never pay up for a cost leverage story. But for a global power brand like RL that is coming off a period of investing in both its P&L and balance sheet while many competitors have been doing the opposite, I like its competitive positioning at 6x EBITDA.

Click on images below to enlarge.

LOVE ‘EM OR LEAVE ‘EM

I think estimates for the first half of 2009 are probably too high for all of the gaming equipment suppliers, although IGT could save its way there. Revenue estimates look too aggressive as discussed in my post “CAPEX, COVENANTS, AND CORPORATE CONTROL”.
  • IGT could probably get away with a revenue miss since sentiment is already so low. The company guided down last week, but the general feeling is that there could be more downside. The fact that 12 analysts maintain hold or sell ratings on the stock versus only 5 with buys, is not helping sentiment either. The first chart details the ratings breakdown by company.

    WMS, on the other hand, is loved by the sell side. Of the 16 analysts that cover the stock, 14 have buy ratings. I've got to believe the optimism is reflected in the earnings estimates as well. Indeed, analysts are projecting 10% revenue growth in the face of likely Capex resets in 1H 2009 by the operators. I’ve already stated my opinion on that subject.

  • It looks like the analysts have been persuasive with the buy side. As shown in the second chart, WMS trades at a 35-45% premium to IGT and a whopping 65-75% premium to BYI. Despite the potential for a 1H revenue shortfall, BYI looks cheap at under 10x earnings.

    While I worry about the whole group, revenue shortfalls on cheap stocks are likely to be less damaging than for a more expensive one with higher ratings.


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S&P500 Levels Into the Close...

The market is annoying the bears today. Every time they try to crack it, she holds, recoils, and recovers… After a +15% squeeze in less than a week, the bears who sold the bottom can’t even muster a -3% down day with some volume behind it. Sorry guys…

As we head into the close, volatility (VIX) has broken my intermediate support line of 58.61, and is trading under the 55 line (-8% on the day). The paint on our S&P500 trading lines (see chart) really hasn’t changed much. My S&P500 trading range is narrowing – that’s also a bullish signal. As we get closer to SPX 997, I make sales. Here are my refreshed levels:

BUY in size = 843
BUY more if support holds = 920
Sell the “Trade” = 997

My name is Keith McCullough, and I support this message.
KM

Turkey Shooting (TUR): Opportunities and Pitfalls...

Turkey faces both opportunities and pitfalls in the new economic reality:

In our Weekend Edge, we initiated a case to be made for Turkey to emerge as a strong developing European economy (on a relative basis).

• External debt as % of GDP has declined to just over 37% since the 2001 crisis.
• Oil prices, a primary driver of the trade deficit, have declined dramatically (Turkey currently produces less than 9% of its daily oil consumption).
• The banking system there has shown relative resilience in the face of the credit crisis so far. Regulation is something they have already proactively managed.
• Skilled labor in Turkey is inexpensive and the labor force is both young and educated. This makes the country well situated geographically to capitalize on trade opportunities with more than just the EU (currently more than 50% of the market for Turkish exports).
• Although consumer inflation remains in low double digit territory, this represents a major decline from the nosebleed levels seen from 2001 to 2003, suggesting that domestic consumption may maintain its current levels in the near term.

There are clearly a number of major issues which face Turkey that could derail the bullish case: bureaucratic and regulatory hurdles which stymie foreign investment; significant security issues on its borders with Iraq, Iran, and Georgia; and a current account deficit that remains troublingly high.

With a stock market battered by the global selloff, Turkey is beginning to look attractive on both a quantitative and a relative value basis to other emerging markets. We will be keeping our eyes on Turkey, looking for data to indicate whether or not Turkish political and corporate leaders are making the right decisions to capture opportunities and avoid pitfalls in the new reality.

Andrew Barber
Director

Coffee Update: Seasonality Remains Bullish...

We have been following Coffee closely in recent weeks as interesting supply data emerged from South America and South East Asia. The latest bullish data point to emerge is unseasonable rain in the central highlands of Vietnam which may delay and diminish yields for the current Robusta cycle there.
In earlier posts we discussed Vietnam’s recent emergence as a major global producer of Coffee, particularly the less valued Robusta variety. With heavy rainfall in the Dak Lak, Dak Nong and Lam Dong regions and more anticipated by meteorologists, contracts for both Arabica and Robusta contracts spiked sharply late in the week.

The short term bullish thesis that we have been exploring for coffee in General and Arabica is based on the assumption that consumers in China and other developing economies that have acquired a taste for premium blends, will continue to be loyal consumers for the immediate future despite signs of slowing economic growth. In short, demand resilience combined with tightening supply in both the primary and substitute markets will drive the price higher in the near term.

The seasonal inflections of the futures markets also support the bullish case here. We averaged returns for Arabica contracts from 1973 to the present. On a 35,30,20,15, 10 and 5 year average basis the near month contract has risen in November as part of a seasonal pattern that straddles the end of harvest in Brazil and the return of cold weather in the US and Europe –which traditionally increases the consumption of hot beverages (see chart below).

The long term bullish case is less clear. In the 70’s the market for premium South American beans collapsed when major US food conglomerates like Kraft decided that ,in the midst of a recession, US consumers would drink whatever was poured. It would be easy to see companies supplying Chinese consumers –who are notoriously thrifty, come to the same conclusion if Vietnamese Robusta becomes compellingly inexpensive compared to South American Arabica.

We remain long Coffee via JO, the exchange traded fund.

Andrew Barber

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