Everyone seems to offering the same rhetoric about replacement demand but a closer look reveals some interesting developments 



It’s probably fair to say that the consensus at G2E and the investment community is that replacement demand is likely to stay stagnant - 18 years - for the foreseeable future.  Never mind the math that shows replacements bottomed out in 2008 or that the physical life of a machine is on average no more than 12-13 years.  Interestingly, while suppliers are outwardly espousing the same rhetoric, internally, they are all cognizant of the fact that the 2 major subsectors of the slot market –video poker and 3 reel mechanicals – are older, fully depreciated, on platforms that are no longer supported, and have waning performance.  Dare we say that, despite the conservative rhetoric to investors, a few suppliers are gearing up to replace this aging base of machines?


We touched on this topic in our note, “G2E TAKEAWAY” (10/06/11).  For the first time in a long time, IGT had new video poker products on display at G2E.  IGT has an install base of 130,000 video poker machines – 100,000 of which are on the old 8960 platform – which to our understanding is about 9 years old.  WMS was also making another foray into the video poker market with a product that should be commercial in about 12 months.  Could this be a coincidence?  We think not.  Of course, the high likelihood of IL coming online doesn’t hurt either.


3 Reel spinners are the other oldie but goodie market garnering a lot of attention (not investor attention) these days.  Mechanical spinning represent roughly 30% of the total slot market in the US with 3 reel spinners being the older product.  IGT believes that they have about 130,000 3 Reel Spinners out there today, making up the majority of their total spinner product.  Given the vast install base, we’re not sure how old their install base is but we’re pretty sure that it's over 5 years old.  IGT has a new 3 Reel, one line product out – also targeting the Australian market – 36% of which is comprised of old 3 reel product.   IGT also has some neat features on its MLD platform which it hopes will garner some of the share of 3 reels being taken out.  


BYI’s has confirmed that there are about 35-40,000 legacy S-6000 high denomination, 3 Reel Spinners that are basically approaching obscelence.  BYI is hoping to replace some of those units with its new Pro-Curve cabinet. 


Konami agrees that the 3 Reels out there are old and in need of replacements but hopes that most of the new products gets replaced with video product. After many failed attempts to penetrate the spinner market, Aristocrat is out with a new hybrid stepper that also hopes to grab a share of the maturing market.


We expect to see the incumbents offering deep discounts on very expensive ‘retail’ price tags on new cabinets – mostly in form of trade-ins in order to garner as large of a share of any replacements that occur.  New entrants should also benefit as this will offer operators a chance to diversify their existing floors.  IGT is really the only video poker player to speak of, although the roll off of their Moody patents over the next 2-3 years should spur more competition in the sub-segment of the market.  IGT, followed by BYI, are the manufacturers behind almost all of the legacy spinner product installed on casino floors today.  WMS entered the spinner market with their transmissive reels about 5 years ago and ALL has never been able to get traction in spinner segment from past attempts. 


Bottom line: while the perception is that there is only a small replacement market to speak of, there are some pretty hungry bears out there chomping at the bit.  Of course the easiest solution to aging machines is simply a refurbishment, but we’re pretty sure that if manufacturers have any say in the matter they will use this as an opportunity to force replacements. 


In the category of setting expectations too high, DB's US analyst is pushing Q3 EBITDA of $250 million. Good thing the stock is dirt cheap and consensus still too low.



We just can’t get to $250 million.  That doesn’t mean we don’t think MPEL is ridiculously cheap and Q3 consensus is way too low.  The stock should trade up into the quarter but if whisper expectations are for $250 million, the actually print could be a disappointment.  We are at $228 million in Q3 EBITDA which is still almost 20% above the Street.  With some tweaks we can certainly get higher but $250 million looks like a stretch.  The stock does trade at only 7x 2012 EV/EBITDA so really, what's a few million?   


So why is $250 million unlikely?  The only way it happens is if City of Dreams and Altira held abnormally high on the rolling chip junket programs and much lower at the revenue share junkets.  We’re pretty sure overall VIP hold percentage was around 3.08%, which is above normal but already reflected in our model.  However, only a statistical anomaly favoring the rolling chip junkets could help boost EBITDA up to $250 million.  Of course, there are more subtle areas that could contribute:  lower promotions (doubtful), better cost controls (possible), but the junket mix would have to be extremely favorable.


We’re not trying to be too cute here.  The fact is the stock looks very cheap and estimates need to go higher.  That’s usually a recipe for share appreciation.  We just want to keep expectations realistic.


Jobless claims came in this week at 404k.  Backing out the revision to last week's data, claims moved higher by 3k.  Looking at the non-seasonally-adjusted series, there was an increase of 66k claims week over week - an apparently large number but not atypical for the week following quarter-end.  


We are struck by the fact that the supposedly "technical" factors that caused the sudden decline in claims a month ago have not reversed.  Distortions around quarter-end are typical, and the decrease didn't show up as an aberration in the non-seasonally-adjusted data.  Meanwhile, the spread between claims and the S&P remains as wide as it's ever been in the last three years.  If claims move to the level implied by the S&P, that would be roughly 475k.  For reference, a 475k claims level would be consistent with 0% or lower GDP growth.


Bigger picture, monetary stimulus has had a tight correlation to improving initial claims. The lack of further easing from the Fed means that this tailwind is now gone.  With further fiscal stimulus also off the table, we expect that initial claims will reflect growing weakness.  











2-10 Spread

The 2-10 spread widened by 29 bps versus the prior week as the market rallied. 






Subsector Performance 

The table below shows the performance of financial subsectors over various durations.




Joshua Steiner, CFA


Allison Kaptur


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LIZ: Playing Out in Black Book Fashion


Liz is changing exactly what it should be changing -- EVERYTHING. Could not be more spot on with what they need, and our thesis. The valuation profile and investor base will change dramatically here.



Liz is changing exactly what it should be changing -- EVERYTHING. Could not be more spot on with what they need, and our thesis, as we outlined in our Sept. 13th Black Book (LIZ: Get In While You Can). The valuation profile and investor base will change dramatically here.


What the company looked like yesterday – a highly levered (~4x Net Debt-to-EBITDA on 2012 numbers) weak primary brand, inactive management/board, no earnings, and valued largely by hopeful EBITDA numbers and phantom breakup values; to being one that has a much more defendable portfolio that is, by and large - actually growing (or just returning to growth after years of investment) has just had its debt levels decimated to 1.7-1.9x Net Debt/EBITDA on 2012 numbers – virtually eliminating bankruptcy risk. It has one division alone with a growth profile like few others in global retail that accounts for over 50% of the company’s cash flow.


We've heard nothing but silence by most investors as we worked this name as our top idea over  the better part of this year. But now people will start to value it like a viable stand-alone company with earnings power better than a buck within reason.


Slap on a reasonable EBITDA, PE, sales, FCF, or just about any other metric you want, and the stock still looks attractive even after yesterday's 34% run.


LIZ: Playing Out in Black Book Fashion - LIZ LevRatio 10 11



Time to Fail

"The credit belongs to the man who is actually in the arena, whose face is marred by dust and sweat and blood, who strives valiantly, who errs and comes up short again and again, because there is no effort without error or shortcoming …”

-Theodore Roosevelt


I’ll admit that my peak athletic days are behind me.  At my best, I was a middling college hockey defenseman with a propensity for extended stays in the penalty box.  My worst probably came last night in a beer league hockey game in Hamden, CT.  Nonetheless, my hometown of Bassano, Alberta has invited me back to speak at the annual Sportsmen of the Year Dinner, so my athleticism is, apparently, still appreciated somewhere.


In a shift of athletic gears, this summer I joined the New Haven Lawn Club and officially began my tennis career.  Certainly I’ve played tennis before, but not on clay courts attired completely in whites.  As many of you know, tennis clubs are typically populated by people that have spent a good chunk of their lives, well, populating tennis clubs.  Needless to say, this Alberta farm boy was a little overmatched this summer.   In fact, my summer was spent failing and, often, miserably so.


Personally, I’ve never believed failure to be a bad thing.  Now sure, losing or failing doesn’t give you the warm fuzzies inside, but failing and adapting ultimately sets you up for greater success.  In a 2008 commencement address to Harvard, author J.K. Rowling, who made a billion dollars for her Harry Potter series, adroitly summed up the benefits of failing when she said:


“So why do I talk about the benefits of failure? Simply because failure meant a stripping away of the inessential. I stopped pretending to myself that I was anything other than what I was, and began to direct all my energy into finishing the only work that mattered to me.”


As it relates to Europe sovereign debt, the one solution that has not been seriously considered is failure.   Instead, the key solution from almost every Eurocrat and talking head, is to continue to support and promote a broken banking system and failed monetary union.  There are other possibilities: let Greece fail, let other sovereigns fail if they can’t get their house in order, and let heavily exposed banks fail. 


The validation of the failure strategy at least partially comes in comparing the credit default swaps of Italy, Portugal and Ireland from July 1st, 2011 to today.  Respectively, Italian swaps are up 140%, Portuguese up 38.2%, and Irish down -3.2%.  Now to be fair, Ireland hasn’t failed, but three of largest banks, Allied Irish, Irish Life & Permanent, and Bank of Ireland have experienced “credit events” and, as a result, Ireland’s credit worthiness has improved, on the margin.


A more pressing question facing stock market operators is: will this current stock market rally fail?  In the near term, the key driver of the stock market will likely be corporate earnings reports.  To sustain positive price momentum, companies will need to both hit their estimates and also maintain future guidance.  Currently, according to Bloomberg consensus estimates, 2012 consensus expectations for EPS for the SP500 is $106.15, which implies 16% year-over-year growth in earnings.


Certainly, that type of earnings growth is possible for the SP500, but it is highly contingent on underlying economic growth.  Currently, our view is the economic growth will be in the sub-1.0% range in 2012.  In the last thirty years, there have been five years of 1%, or less, GDP growth in the U.S.  On average, in those years, SP500 earnings declined -18.3% y-o-y.  Thus, unless economic activity accelerates in the U.S., it is highly unlikely that 16% y-o-y growth in earnings is met.  Assuming the Hedgeye view of economic growth is correct, there is substantial downside to current 2012 consensus earnings estimates.  History would suggest, as outlined above, that 2012 earnings could be too high by at least one-third.


Alongside earnings growth, there is of course the quality of earnings.  J.P. Morgan kicked off the earnings debate this morning with an EPS number of $1.02 that, at first blush, seems solidly above consensus of $0.92.  The questions as always, though, relates to the quality of earnings, and $0.29 of EPS was a “benefit from debit valuation adjustment (“DVA”) gains in the Investment Bank, resulting from widening of the Firm’s credit spreads.”  So, if we back out the benefit to JPM’s earnings from widening of their credit spreads, EPS declined -27% year-over-year.  Yikes !


The more pressing failure in global macro land this morning is the failure of the Chinese to maintain high exports to Europe. To be fair, in aggregate Chinese exports overall were up 17.1% in September, which is a formidable number.  Unfortunately, exports to Europe, Chinese largest trading partner, declined substantially, sequentially from 22% year-over-year in August to 9.8% in September.  As the Chart of the Day below shows, this is the second slowest year-over-year growth rate of Chinese exports to Europe in 18+ months.


Chinese economic activity is clearly slowing, but in our purview it is still too early to call for massive Chinese easing.  As my colleague Darius Dale wrote yesterday:


“All things considered, it could be a while before China pulls the trigger on the monetary easing front. Merely using 2008 as a semi-comparable reference, we saw that China waited a full six months for confirmation of flat-to-down sequential CPI growth and a -380bps reduction in YoY CPI before cutting interest rates in early September of that year.”


Certainly though, growth doesn’t slow forever and whether by monetary stimulus or organic means, the positive catalyst we will be looking for is growth accelerating, on the margin.  So far though, it is too early to bet on that. 


Keep your head up and stick on the ice,


Daryl G. Jones

Director of Research


Time to Fail - DJ time to fail


Time to Fail - VVP dj

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