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Loving Life

“Choose a job you love, and you will never have to work a day in your life.”

-Confucius

 

On this day in 2007, my first son Jack was born. Less than a week prior to that, on November 2nd, 2007, I was fired. Having recently achieved my highest ranking “title” in the vaunted hedge fund universe, this was a rather abrupt end to what was only a 10 month old affair at Carlyle’s new hedge fund.

 

All that ends abruptly creates opportunities for new beginnings. I’d never been cut from a team or fired by a firm before (unless I fire myself, hopefully that doesn’t happen again!). However, I firmly believe that men and women have to be able to “fail” in order to ultimately succeed. It’s the only way to learn how to rethink and rework what it is that we are here to do. Evolve.

 

Thank you to Laura, my family, and firm for giving me such a tremendous opportunity to help create Hedgeye. I am Loving Life.

 

Back to the Global Macro Grind

 

With all of the October 2011 fanfare associated with the only good month stocks and commodities have had since April, last week was a reminder of what intermediate to long-term equity investors should recognize as bearish. Welcome to November.

 

If you’ve taken the lessons of the October 2007 US stock market top and embraced it as an opportunity to change your process to one that’s more diversified and Global Macro in scope, last week was a very good one for you. Both the US Dollar and US Treasuries outperformed, big time.

 

On the week, with the US Dollar Index realizing an impressive +2.5% week-over-week return, here’s how everything that’s inversely correlated to the USD moved:

  1. US Stocks (SP500) = down -2.5%
  2. Asian Stocks (MSCI Index) = down -3.6%
  3. Latin American Stocks (MSCI Index) = down -3.3%
  4. Euro/USD = down -2.1%
  5. Canadian Dollar (CAD/USD) = down -2.0%
  6. CRB Commodities Index = down -0.9%
  7. WTIC Oil = up +0.9%
  8. Gold = up +0.5%
  9. Copper = down -3.8%
  10. 10-yr US Treasury Yields = down -12.5%

Interestingly, with both Oil and Gold maintaining 0.7-0.9 inverse correlations to the US Dollar, they diverged versus just about everything else in our Global Macro Correlation model. The intermediate-term TREND between Oil and the US Dollar since May remains intact, however, with the USD Index up +5.4% and Oil down -8.7%, since.

 

Positively correlated with the US Dollar Index (this is the good news, if you’ve been long them since May) are:

  1. Long-term Treasury Bonds (TLT)
  2. US Treasury Flattener (FLAT)
  3. Corporate Bonds (LQD)

Oh, and Volatility (VIX)…

 

Volatility was up +23% last week alone and is up +101% since The Bernank offered us his first global press conference on what he calls “full employment and price stability” (end of April 2011).

 

Not.

 

With the so called “catalyst” of the G20 meetings gone, and another terrible 2011 US employment report behind us, “the gales of November came early.”

 

That line, as many locals from Thunder Bay, Ontario would recognize, comes from one of our local risk management ballads called The Wreck of the Edmund Fitzgerald:

 

“The legend lives on from the Chipewa on down

Of the big lake they called ‘Gitche Gumee’

The lake it is said, never gives up her dead

When the skies of November turn gloomy”

 

And since today is just another day for Risk Managers who have proactively prepared for the Growth Slowing storm of 2011, I’ll just end this morning’s missive here. Given the number of rants you’ve all put up with in the last 4 years of my writing these notes, I owe you all some brevity.

 

My immediate-term support and resistance ranges for Gold (bullish TRADE, TREND, and TAIL), Oil (bearish TAIL, bullish TRADE), German DAX (bearish TRADE, TREND, and TAIL), and the SP500 (bullish TREND; bearish TAIL) are now $1, $92.97-93.88, 5711-6068, and 1, respectively.

 

Happy Birthday Jack and best of luck out there today,

KM

 

Keith R. McCullough
Chief Executive Officer

 

Loving Life - Chart of the Day

 

Loving Life - Virtual Portfolio


THE HEDGEYE DAILY OUTLOOK

THE HEDGEYE DAILY OUTLOOK

 

TODAY’S S&P 500 SET-UP - November 7, 2011

 

After the biggest 1 month short squeeze ever, welcome to November where King Dollar has returned to its bullish 6 month TREND.  As we look at today’s set up for the S&P 500, the range is 58 points or -3.45% downside to 1210 and 1.18% upside to 1268. 

 

SECTOR AND GLOBAL PERFORMANCE

 

 

THE HEDGEYE DAILY OUTLOOK - hrmsv

 

THE HEDGEYE DAILY OUTLOOK - hrmsp

 

THE HEDGEYE DAILY OUTLOOK - bpgm1

 

EQUITY SENTIMENT:

  • ADVANCE/DECLINE LINE: -636 (-1939) 
  • VOLUME: NYSE 861.48 (-14.04%)
  • VIX:  30.16 -1.11% YTD PERFORMANCE: +69.92%
  • SPX PUT/CALL RATIO: 1.57 from 1.55 (+0.98%)

 

CREDIT/ECONOMIC MARKET LOOK:

 

TREASURIES – bond yields have been front-running equity investors for all of 2011 and that didn’t change in either US Treasury yields or European sovereigns during October’s stock market beta chase. UST 10 yr yields back into a Bearish Formation with TRADE line of support (2.12%) breaking last week (that’s why we bought TLT back) and now testing 2.00% so the masses will have to pay attention.

  • TED SPREAD: 44.26
  • 3-MONTH T-BILL YIELD: 0.01%
  • 10-Year: 2.06 from 2.09    
  • YIELD CURVE: 1.84 from 1.85

 

MACRO DATA POINTS (Bloomberg Estimates):

  • 8:40 a.m.: Fed’s Rosengren speaks in Boston
  • 11:30 a.m.: U.S. to sell $29b 3-mo., $27b 6-mo. bills
  • 3 p.m.: Consumer credit, est. $5.20b, prior (-9.50b)

WHAT TO WATCH:

  • Italian benchmark yields climbed to a euro-era record; pressure grew on PM Silvio Berlusconi to resign
  • Greek PM George Papandreou agreed to step down as premier to allow creation of a national unity government
  • U.S. House will probably “move” on infrastructure bill this year, Speaker John Boehner said Sunday.
  • NBA makes ultimatum to players with Nov. 9 deadline
  • Senate will begin consideration of motion to proceed to H.R.674, to amend IRS code of 1986 to repeal imposition of 3% withholding on certain payments to vendors by govt entities

COMMODITY/GROWTH EXPECTATION

 

                                                                                                             

THE HEDGEYE DAILY OUTLOOK - dcommv

 

MOST POPULAR COMMODITY HEADLINES FROM BLOOMBERG:

  • Bangkok Tourists Vanish on Floods Leaving Hotel Bars Empty
  • Papandreou to Step Down in Accord on Greek Unity Government
  • Hedge Funds Curb Wagers for First Time in a Month: Commodities
  • China PMI, Inflation Signal Rate Cut Unlikely: Chart of the Day
  • Hedge Funds Bet Against Gas as Stockpiles Surge: Energy Markets
  • Gold Climbs to Six-Week High as European Concerns Spur Demand
  • Oil Trades Near Three-Month High as Europe Tackles Debt Crisis
  • Evraz Plc Rises as Russia’s Largest Steelmaker Relocates to U.K.
  • Copper Drops on Europe Debt-Crisis Concern Before Italy Vote
  • German Gold Reserves ‘Untouchable’ for EFSF, Roesler Says
  • Norilsk’s U.S. Premium Widens as Buyback Ends: Russia Overnight
  • Freeport’s Grasberg Workers Refuse 35% Wage-Rise Offer
  • Australian Wheat Exports Seen Jumping 15% on Bumper Crop
  • Copper Falls as Economic Slowdown May Curb Demand: LME Preview
  • Oil Falls From Three-Month High in N.Y, as Euro, Equities Slide
  • Commodities May Rise 6% in Next Three Weeks: Technical Analysis
  • Viterra Bonds Erase Gains on Shareholder Rebuff: Canada Credit
  • Copper Drops for a Second Day on European Debt-Crisis Concern
  • Rubber Falls to Two-Week Low as Thai Floods Threaten Factories

 

CURRENCIES

 

THE HEDGEYE DAILY OUTLOOK - dcurrv

 

EUROPEAN MARKETS

 

EUROPE – the percentage losses don’t tell this morning’s story of risk – with bearish TREND zones intact, now the immediate-term TRADE lines for the DAX (6068) and CAC (3191) have snapped this morning. All the while Italian bond yields are making all-time highs (6.68% on 10s) - now that the G20 meetings are gone, there really is no catalyst to keep Europe afloat.

  • UK house prices (1.8%) y/y vs consensus (2.3%), prior (2.3%) -- Halifax
  • EuroZone Nov Sentix (21.2) vs consensus (20.0), prior (18.5)
  • EuroZone Sep Retail Sales (1.5%) y/yvs consensus (0.5%), prior revised (0.1%) from (1.0%)

 


THE HEDGEYE DAILY OUTLOOK - bpem1

 

ASIAN MARKETS

 

CHINA – both the Shanghai Composite and Hang Seng failed hard at TREND line resistance levels of 2562 and 20341, respectively last night; importantly, this comes ahead of October data from China which should continue to decelerate, sequentially.

  • Japan September index of coincident indicators 88.9, (1.4 pts) m/m. Index of leading indicators 91.6, (2.2 pts) m/m.

 

  

THE HEDGEYE DAILY OUTLOOK - bpam1

 

MIDDLE EAST

 

THE HEDGEYE DAILY OUTLOOK - me

 

MOST POPULAR MIDDLE EAST HEADLINES FROM BLOOMBERG

  • Syrian Forces Kill 22; Arab League Calls Emergency Meeting
  • Doha Bank Considers 2012 Acquisition in Emerging Market
  • Iran on Verge of Building Nuclear Weapon, Washington Post Says
  • Huawei Confirms MTN Irancell Sales, Denies Censorship Role
  • Russia’s Lavrov Opposed to Possible Israeli Strike Against Iran
  • IAEA Says Foreign Expertise Has Brought Iran to Threshold of Nuclea
  • Israel's Warnings on Iran Get Quiet Nods in Gulf
  • Iran on Verge of Building Nuclear Weapon, Washington Post Says
  • 'Military op vs Iran to jeopardize stability of entire region'
  • Aramco Cuts Asia Oil Differentials, Lifts U.S.: Persian Gulf Oil
  • Iran on threshold of nuclear capability: Report
  • Billionaire Facing Death Threats Says Egypt Risks Becoming Iran
  • British Firm With Links to William Hague Sells 'Protester-tracking' P
  • Iran on Verge of Building Nuclear Weapon: Washington Post Link
  • Ehud Barak Refuses to Rule Out Military Strike Against Iran
  • Al Jazeera: CIA veteran: Israel to attack Iran in fall
  • Russia: Any strike against Iran would be "very serious mistake"

 

The Hedgeye Macro Team

Howard Penney

Managing Director

 

 


WMS YOUTUBE

In preparation for WMS's FQ1 2012 earnings release Monday afternoon, we’ve put together the recent pertinent forward looking company commentary.

 

 

WMS Receives Approval from Nevada Gaming Commission for the Initial Commercial Release of WAGE-NET® Networked Gaming System

  • Nevada Gaming Commission approves WMS’s initial commercial version of WAGE-NET
  • WMS will launch the Jackpot Explosion® application, the first themed application in WMS’ Ultra Hit Progressive® (“UHP”) Portal application family in Nevada casinos. 

 

YOUTUBE from FQ4 2011 CONFERENCE CALL

  • “$11 million to $14 million or $0.12 to $0.15 per diluted share of charges in the September 2011 quarter, mostly related to the reduction in force we are now implementing. In aggregate, we will reduce our global workforce by about 10%, which we expect should generate meaningful cost savings in future quarters.”
  • “Since the beginning of the fiscal year, we improved the gross margin on the Bluebird xD cabinet by over 20% through our continuous improvement initiatives, and we expect further improvement in fiscal 2012.”
  • “Guidance for fiscal 2012 revenue growth of 3% to 5% is slightly higher than the result achieved for our fiscal 2011 and reflects recent operating trends and a general industry environment in which we expect customers’ capital spending plans around the globe to remain flat during the remainder of calendar 2011 and into calendar 2012.”
  • “We do expect revenues from new unit sales to increase slightly, with new unit shipment growth coming primarily in the second half of the fiscal year, driven by the increase in demand from a greater number of new casino openings and expansions.  We expect ASPs to generally remain flat, with any changes generally reflecting the mix between Bluebird2 and Bluebird xD cabinets. This guidance does not include any incremental revenues from the potential expansion of Illinois gaming or the opening of Illinois or Ohio VLT markets.”
  • ”Given our industry-high daily revenue of $76.13 and only modest expectations for improvement in the lackluster consumer environment, we believe that average daily revenue will remain flat.”
  • “Additionally, we anticipate that quarterly revenues in the September 2011 quarter will be slightly below the relative percentage of annual revenue achieved in fiscal 2010 and fiscal 2009. This reflects expected year-over-year lower new unit demand, as the timing of G2E was moved from the third week of November to the first week of October, and we anticipate some customers may wait until the show before placing orders. And a slightly higher percentage of revenues in the June 2012 quarter, due to an anticipated increase in new casino opening activity.”
  • “Even with re-prioritizing our R&D efforts, we expect that our annual R&D expenses in fiscal 2012 will approximate 13% of total revenues.”
  • “We expect our product sale margin to improve in fiscal 2012, as we have initiatives targeted to lower costs in both the Bluebird2 and Bluebird xD cabinets. Overall, we expect better product sales margin in the second half of the fiscal year than the first half. Gaming operations margin is expected to be generally stable within a range similar to that experienced during fiscal 2011. Including the impact of the charges I mentioned we will be recording in the September 2011 quarter, we expect to improve our operating margin, especially with the anticipated reduction in our cost structure resulting from the workforce reduction.”
  • “We expect depreciation to increase on a quarterly sequential basis over the $20.6 million expensed in the June 2011 quarter, primarily as a result of the continued transition of our participation base to Bluebird2 and Bluebird xD cabinets and an increase in operating lease units.”
  • “We expect it’ll still be another quarter or two until we return to a more normal flow of [participation] products.”
  • “We made some difficult decisions on both products and staffing, and as a result we narrowed our focus to prioritize core categories and postponed or deselected certain longer-term projects. These actions are aimed squarely at capturing near-term revenue opportunities and improving our predictability. We’re now moving forward once again, and after a brief transition period, we expect to be back to full speed ahead in the second half of fiscal ‘12.”
  • [Portal apps] “We’ve got 300 units in 14 casinos today. We would expect that number will double by the end of this calendar year. And by the end of June next year, we’ll have 100 casinos with our servers and racks in there and a wider assortment of our portal families and applications.”
  • [Product sales margins]  “Our short-term goal is to get back to the mid-50%’s, which is probably a Q3, Q4 event, and ultimately get to that 60% margin over time. We’re working through some of these used-game issues and some of these supply chain issues. But we want to build up to that mid-50%’s rage in the last half of this year. It’ll be a ramp up from Q1 and Q2.”
  • “We would now look for Italy to be a fiscal ‘13 event.”

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MACAU: ON FURTHER REVIEW

Higher hold contributed over 10% of the 42% YoY growth.  November GGR should fall significantly MoM.

 

 

As previously disclosed, October gross gaming revenues (GGR) increased 42% YoY to $3.35BN.  With the detail in hand, we can confirm that while growth was strong, the month got a boost from good hold and an easy hold comparison from last October.  Total direct play this month was 6.3% of the market, compared to 7.5% last year.  The total market held at 3.05% vs. 2.70% in October 2010.  Normalizing for hold, October would have increased 30% YoY.  High margin Mass business increased 36%, just slightly lower than the 40-41% growth we’ve seen during the last 4 months.

 

As we approach the next 3 months of the year we expect YoY growth rates to decelerate, partly due to difficult hold comparisons and trends we are seeing in our sequential monthly projections (see “MACAU: EYE ON NOVEMBER” published on 11/2/11).  Hold rates for November 2010 through January 2011 ranged between 3.05% and 3.13%.  Normal hold levels would alone shave roughly 10% off YoY growth.

 

 

Y-o-Y Table Revenue Observations

Total table revenues grew 43% YoY this month, on top of 50% growth las­t October.  October Mass revs rose 36%; VIP revs grew 45%; and Junket RC rose 30%. 

 

LVS

Table revenues grew 5% only YoY – exhibiting the slowest concessionaire growth in the market, in-line with recent trends.  We’ll be keenly watching for a turnaround in November since we’ve heard that LVS has been extending additional junket credit and 2 new junkets are coming online at the Four Seasons this month.  Over the last 5 months LVS’s table revenues have grown at 14% while the market has grown 48% - roughly 30% of the market’s pace.

  • Sands was down 6% YoY, driven by low hold. The YoY decline was driven by a 15% drop in VIP which was somewhat offset by 12% increase in Mass.
    • Junket RC was up 21%
    • Sands held poorly in October and had a difficult YoY comp.  Adjusted for 14% direct play (15% in 3Q11), hold was about 2.05%, compared with 3.00% hold in October 2010 assuming 15% direct play (in-line with 4Q10). 
  • Venetian was up 8% YoY, driven by a Mass increase of 28% offset by a 4% drop VIP
    • Junket VIP RC fell slightly, down 1%
    • Assuming 23% direct play in the quarter (just slightly below the 24% we saw in 3Q11), hold was 2.99% compared to 3.12% hold in October 2010 assuming 19% direct play (in-line with 4Q10)
  • Four Seasons grew 17%YoY, driven by an 89% increase in Mass VIP revenues and a small 3% increase in VIP revenue. 
    • Junket VIP RC increased 10% YoY
    • While we believe that the property held low, the comparison was also very easy.  Assuming 36% direct play (which is close to the 38% in 3Q11 and implies a 19% sequential increase in average monthly direct play levels), hold was 2.65% in October, compared with a hold rate of 1.82% if we assume 54% direct play in October 2010 (in-line with 4Q10)

WYNN

Wynn table revenues were up 36%, which benefited from an easy hold comparison

  • Mass was up 23% and VIP increased 40%
  • Junket RC increased 11%
  • Assuming 10% of total VIP play was direct (in-line with 3Q11), we estimate that hold was 2.9% compared to 2.3% last year (assuming 11% direct play – in-line with 4Q10)

MPEL

Table revenues grew 49% - equally driven by Mass and VIP

  • Altira revenues rose 28% with Mass growth at 18% while VIP grew 29%, helped by an easy hold comparison
    • VIP RC increased 14%
    • We estimate that hold was 2.9% vs. 2.7% last year (direct play is not material at Altira)
  • CoD table revenue was up 62%, driven by 57% growth in Mass and 64% growth in VIP – helped by high hold and an easy comparison
    • Junket VIP RC grew 37%
    • Assuming a 13% direct play level, hold was 3.4% in October compared to 2.6% last year

SJM

Revs grew 15%

  • Mass was up 17% and VIP was up 14%
  • Junket RC was up 10%

Galaxy

Table revenues continued its streak of triple-digit gains, +201%; mass soared 340%, while VIP gained 186%

  • StarWorld table revenues grew 64% - exhibiting the best growth of any mature property
    • Mass grew 56% and VIP grew 65%, helped by high hold and an easy comp
    • Junket RC grew 28%
    • Hold was high at 3.1% compared to just 2.5% hold last October
  • Galaxy Macau's total table revenues were $339MM, 41% higher than September’s
    • Mass table revenues rose 29% MoM to $59MM
    • VIP table revenue of $280MM, a 43% MoM increase, helped by luck. Hold was 3.4% this month vs. 2.8% in September.
    • RC volume of $8.3BN, up 19% MoM

MGM

Table revenue increased 50% YoY, helped by high hold in the quarter

  • Mass revenue growth was 9%, while VIP grew 60%
  • Junket RC increased 24%
  • Assuming a direct play level of 8%, we estimate that hold was 3.6% this month vs. 3.0% in October 2010, also assuming direct play of 8% 

 

Sequential Market Share (property specific details are for table share while company-wide statistics are calculated on total GGR, including slots)

 

LVS

Share increased 40bps sequentially to 14.1%. This compares to 6 month trailing market share of 15.1% and 2010 average share of 19.5%

  • Sands' share ticked up 10bps to 3.5% off of all time lows in September
    • Mass rev share fell 30 bps offset by a 50bps improvement in VIP share
  • Venetian’s share fell 40bps sequentially to 8.1% share
    • VIP share fell 1% to 5.9%, below the prior TTM average of 6.8%
    • Mass share gained 1.5% sequentially to 15.5% - above the 14% average for the trailing 6 months
    • Junket RC fell 20bps to 4.7%
  • FS share improved 80bps to 2.0%
    • VIP share increased 1% to 1.9%
    • Mass share ticked down 10bps to 2.3%
    • Junket RC improved 20bps to 1.5%

WYNN

After hitting an all-time low in September market share, WYNN was the largest share gainer in October – gaining back 1.6% to 13.1% share - although still below their 6 month trailing average share of 14.2% and 2010 average share of 15%. Wynn’s share should continue to struggle with the opening of Sands Cotai Central in March and with the introduction of new junkets at the Four Seasons this month.

  • Mass market share fell 20bps at 10.3%
  • VIP market share increased 2.2% to 13.6%
  • Junket RC share was flat MoM at 13.5%, below its 6 month trailing average of 14.7% and 2010 average of 15.2%

MPEL 

Market share fell 1.5% points to 14.7%, below than its average 6 month trailing share of 15.2% but above its 2010 share of 14.6%.

  • Altira share fell 50bps to 4.7%, compared to a 5.6% average share in 2010; Mass share fell 10bps while VIP share dropped 1%. 
  • CoD’s share dropped 80bps to 9.9% driven by share losses in VIP that were partly offset by strength in Mass
    • Mass market share increased 1.1% points to 9.1% 
    • VIP share fell 1.5% points bps to 10.1%

SJM

In a reversal from last month SJM lost the most share in October, down 3.0% to 26.0%, their lowest share since August 2009 and below its 6-month trailing average of 29.2% and 2010 average of 31.3%.

  • Mass market share dropped 2.8% to 33.9% - an all-time low
  • VIP share fell 2.8% to 24.5%
  • Junket RC share ticked down 10bps to 28.3% - their lowest share since Sept 2009

Galaxy

Gained 1.3% share to 20.9%. October share compares with an average share of 10.9% in 2010 and a 6 month trailing average of 16.0%.

  • Galaxy Macau share gained 1% to 10.5%
    • Mass and VIP market share gained 90bps to 8.2% and 11.2%, respectively
    • RC share ticked down 20bps to 10.8%
  • Starworld lost 40bps of market share to 9.2%, 10bps above its TTM share of 9.1% pre-Galaxy Macau level.

MGM

Gained 1.1% to 11.2% due to an improvement in VIP share. October share compares with an average share of 10.3% in 2010 and a 6 month trailing average of 10.4%.

  • Mass share lost 120bps to 6.9% but was more than offset by a 160bps decrease in VIP share to 12.2%
  • Junket RC gained 60bps to 10.3%, above the property’s 2010 average of 8.4% and in-line with its 6 month trailing average of 10.4%

 

Slot Revenue

 

Slot revenue grew 18% YoY and increased $2MM sequentially.

  • As expected, Galaxy slot revenues grew the most with 309% YoY to a record of $16MM
  • MGM slot revenues had the second best growth at 24% YoY to $20MM – an all-time high for the property
  • Wynn slot revenues grew 11% YoY to $25MM
  • MPEL slot revenues grew 3% YoY to $22MM
  • SJM slot revenues grew 7% YoY to $14MM – down from $17MM in September
  • LVS slot revenues fell 3% YoY to $33MM

MACAU: ON FURTHER REVIEW - table

 

MACAU: ON FURTHER REVIEW - mass

 

MACAU: ON FURTHER REVIEW - rc


The Week Ahead

The Economic Data calendar for the week of the 7th of November through the 11th is full of critical releases and events.  Attached below is a snapshot of some (though far from all) of the headline numbers that we will be focused on.

 

The Week Ahead - 1. cal

The Week Ahead - 2. cal

 


SBUX: THE QUESTION NOBODY WANTED TO ASK

I have been a SBUX bull since early 2009 and remain one today.  Yet, unfortunately, I am still not allowed to ask a question on the earnings calls.  I know there are 28 analysts that follow SBUX and there is a limited time on the call to get every question in but I was disappointed when calling in 20 minutes in advance did not yield an opportunity to ask a question.

 

The IR team did reach out to me and I look forward the conversation, but I must say I was hoping to ask my question in a public forum.  That is not to say that I doubt they would have expertly danced around the issue I planned on bringing up but I was eagerly anticipating the dialogue nonetheless.

 

Ever the optimist, I was hoping that management might look kindly upon the only sell-side analyst that has been covering the company from day one.  Then working at Morgan Stanley, I titled my initial report “Expensive and Built to Stay That Way”.  Nine months later I got cute and put a sell on the stock due to a rich valuation.  Soon after, I received a call from Howard Schultz and he told me that I did not understand the room the company had to grow.  He invited me out to Seattle to show me what he meant.  After taking him up on his offer and spending a day driving around with him, I walked away having learned a lot.  One week later I changed my rating.  So, my relationship with Starbucks has had its ups and down, but surely longevity counts for something!

 

As Schultz reminded us on the call yesterday, SBUX has come a long way since its beginnings in 1987. He said, “this week approximately 60 million customers will visit us, and that's just an unbelievable number when you consider where we have come from 1987, 11 stores, 100 employees, and today, 17,000 stores in 55 countries.”

 

I learned a very important lesson that day early in my career and it still applies today.  Howard Schultz embraced my sell rating as a challenge and, telling me “you don’t get it and let me show you why”, set about changing my mind rather than cutting me off.  I don’t think that Starbucks would cut me off for asking the question I was going to ask yesterday, but I do think that the topic it addresses will be a real concern in the coming 12 or 18 months.   

 

So, here is the thought process behind my question:

 

Starbucks has identified the single serve category as being very important to the company future growth.   While I understand the rational for going with Keurig and Green Mountain, I was surprised the company did not want to control the “last mile” into the home.  A number of people from the SEC to forensic accountants and well-known hedge fund managers have expressed serious reservations about the integrity of the company and the viability of the business model. 

 

Does Starbucks have a contingency plan in case Green Mountain cannot access the financial markets for the needed capital to execute its growth plan and deliver an adequate supply of k-cups?

 

The lack of the company ability to generate cash has been well documented and screens “UNSUSTAINABLE” in the Hedgeye Sustainability model.  The biggest red flags in the Hedgeye Sustainability model are Asset Turns and CFFO or, more importantly, the proportion of earnings yielding cash. 

 

Why would Starbucks rely on a supplier where we need to ask the question:  Is the company generating enough cash from its operating activities to continue without accessing new external sources of cash?  What if the capital markets dry up for GMCR?

 

We define CFFO as cash from operating activities less capital expenditures, less the benefits from the exercise of Employee Stock Options and adjustment for one-time gains/losses or restructuring items.  

 

Most of the companies we follow generate free-cash flow after significant investment in the growth of the core business, while other smaller, faster growing companies do not generate free-cash flow.  This is not necessarily a negative if the cash burn rate is within the limits of available resources.  To-date, the capital markets have been very generous to GMCR, but what happens when the music stops?    

 

Importantly, we are looking at the proportion of earnings yielding cash.  If GMCR reports strong revenue growth, good margins, healthy profits but those profits are accompanied by negative cash earnings yield, SBUX must be suspicious, or at least I hope they are. 

 

 

Howard Penney

Managing Director

 

Rory Green

Analyst

 

 

   


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