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Salvaging The Wreck

This note was originally published at 8am on December 05, 2011. INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK (published by 8am every trading day) and PORTFOLIO IDEAS in real-time.

“The world will seek the greatest possible salvage out of the wreck.”

-Irving Fisher, 1918


That’s a famous Irving Fisher quote Silvia Nasar uses to introduce Act II “Fear” in her wonderfully written economic history book – Grand Pursuit.  She starts the Act with a chapter titled “War of the Worlds” where a young John Maynard Keynes obtained a critical WWI post at the British Treasury where he became the “go to-official for inter-Allied (read American) loans.”


“The Treasury’s task was not to only achieve “maximum slaughter for minimum expense” but also to finance the war without debauching the world’s safest currency or jeopardizing Britain’s supremacy as the world’s banker.” (page 198)


This week, as Keynesian bailout politicians attempt to make history through another currency debauchery, I thought I’d use the pre and post WWI period as a reminder of how The People used to think about a currency’s credibility and purchasing power.


After the Treaty of Versaille (1919) when the Germans, Austrians, and Hungarians were saddled with reparations debt, money printing became their only option – a political Policy To Inflate (sound familiar?). The economic stagflation (then hyperinflation) that ensued throughout Europe during the 1920s may rarely be discussed by Ben Bernanke and Tim Geithner, but it will never be forgotten.


As stock market futures hope for European resolve this morning, do not forget what the Germans will never forget. Hope is not a risk management process.


Back to the Global Macro Grind


After the worst Thanksgiving week for stocks since 1932, followed by one of the best weeks for stocks in the last 3 years, this week’s “full employment and price stability” Act III by central planners should be exhilarating.


Here’s how the Global Macro calendar of catalysts looks so far:

  1. Monday: US Federal Reserve President from Chicago, Charles Evans, will speak on his short-term politicking for QE3
  2. Tuesday: my brother Ryan’s birthday
  3. Wednesday: whispers of the ECB Rate Cut decision (Thursday) should be all over the tape, weakening the Euro (again)
  4. Thursday: The Chinese report all of their economic data for November (should be weak, sequentially, across the board)
  5. Thursday/Friday: The EU Summit where central planners will struggle to explain who, precisely, is going to backstop more bailouts

To review hope/expectations: there is hope of a $100-200B bank bailout fund from the IMF that is effectively backstopped by Americans more so than it would be Germans (USA’s IMF quota is 17% and Germany’s 6%). There’s also hope that we see an Italian Job by Super Mario Draghi to backstop the EFSF bailout facility by the ECB.


Hope is not a…


Right, right, Keith. But the futures are up, so how are we supposed to chase and/or beat beta when we don’t know what these European central planners are going to do?


Good question.


As most of you know, this Globally Interconnected Game of Risk is changing. In Hedge Fund Industry 1.0 some of us could “get the call” on a big market catalyst like this, whereas today Wall Street 2.0 is struggling with a flatter playing field of who gets to know what and when.


Rather than looking for some Orange Jumpsuit Risk, I look to the currency and bond market Correlation Signals before I look to equity markets. Why? Primarily because both FX levels and bond yields have had it right for the better part of 2011.


Effectively, currencies and bond yields have been front-running stocks.

  1. FX: the EUR/USD’s TRADE and TAIL lines of resistance are $1.36 and $1.40, respectively.
  2. BONDS: the UST and European 10-year yield TRADE and TREND lines continue to confirm the same I see in the EUR/USD FX pair.

For US Treasury yields to signal that Growth Slowing is no longer going to be perpetuated by Piling-Debt-Upon-Debt, I’d need to see 10 and 30-year UST yields trade, sustainably, north of 2.12% and 3.22%, respectively.


For European Sovereign Bond yields to signal that we’re all free and clear from European bank insolvency on the order of magnitude that the likes of Lehman have never seen, I’d need to see Italian bond yields trade, sustainably south of 6%.


Salvaging The Wreck is going to take a very long-time. The greatest possible salvation we can all hope for this week is that stock markets don’t run-up too high ahead of another failed expectation on Friday.


My immediate-term support and resistance ranges for Gold, Brent Oil, France (CAC40), Italy (MIB Index), EUR/USD, and the SP500 are now $1743-1769, $109.34-111.89, 3074-3303, 14589-15769, $1.32-1.35, and 1233-1267, respectively.


Best of luck out there this week,



Keith R. McCullough
Chief Executive Officer


Salvaging The Wreck - Chart of the Day


Salvaging The Wreck - Virtual Portfolio

Incredibly Hobbled

 “I can believe anything, provided it is quite incredible.

-Oscar Wilde 


Heading into tomorrow’s highly anticipated two-day EU Summit, Wilde’s pithy quote reminds us that Eurocrats have a tall order to impress the market with policy that will revert the direction of Europe’s 19 month-old sovereign debt and banking crisis. Below we caution that tomorrow’s results will likely disappoint investors’ expectations. Why?


If we’re right that the focus of tomorrow’s resolutions are largely centered on the topic of a fiscal union, either for the EU’s 27 countries or the Eurozone’s 17, we don’t think that the creation of another (likely bureaucratic) organization to monitor and impose budget restrictions will be the “bazooka” around which markets will see a sustained rally. Over the last decade we’ve seen the utter inefficiency of a somewhat similar program in the EU’s Stability and Growth Pact—a budget agreement issued in 1997 that limited member states to public debt (as a % of GDP) to 60% and deficit to 3%— as the majority of countries (including Germany) breached its mandates. 


Further, beyond how a “hands-on” Fiscal Union 2.0 is going to make up for the shortcomings of the Stability and Growth Pact, it’s unclear how Eurocrats will address the pressing question:  if peripheral European countries can’t grow and can’t fund themselves with rising credit spreads, and therefore can’t balance their budgets no matter how much austerity is delivered; aren’t allowed to default (Greece); and can’t individually adjust monetary policy, 1.) how do weak states get out of this vortex? and 2.) what’s the benefit to weaker states to be bound in the Eurozone?


If we take the view that major Eurocrat actors (including Merkel, Sarkozy, and Draghi) strive to preserve the fabric of the Eurozone, we believe Eurocrats largely have their hands tied as they don’t have the facilities (firepower) to adequately answer the questions above.  We estimate that European banks and the sovereigns need a funding facility to the tune of $2 to 3 Trillion (or $1.25 to 1.75T to recapitalize banks and $0.75 to 1.25T to fund future sovereign deficits) to address bailout and funding assistance needs.


Key factors that will continue to challenge issuing a “bazooka”:

1.)    The ECB, unlike the Fed, cannot print money to leverage/expand the EFSF

2.)    Merkel and ECB stand against the issuance of Eurobonds

3.)    We don’t see it in China’s interest to run in with a blank check to “save” Europe

4.)    The current EFSF has a mere €250 Billion left to address sovereign and banking concerns

5.)    The IMF only has €385 Billion in lending capabilities

6.)    Fiscal Union 2.0 will require treaty changes and a united voices across at least 17 countries


Should we not get any positive discussion on points 1-3 on Friday, which we think is highly likely, we do not expect capital markets or the EUR-USD to lift into a sustained rally (see chart below of our EUR-USD levels; we’d short any rally around $1.36 and don’t see a next material line of support until the previous low of $1.19).  It’s more probable that the ECB reiterates its ardent position that its sole mandate is price stability; Merkel says she is unwilling to see German funding costs rise; and the “value” of assets on the chopping block for the Chinese is unclear.


Under such a scenario, particularly in which there’s no talk or action specific to ECB backstop involvement or the issuance of Eurobonds, we’d expect the ECB’s secondary bond purchasing program, the Securities Market Program (SMP), to take on a larger role to fill waning demand for PIIGS paper. For context, last week the SMP bought €3.7 Billion versus €8.6 Billion in the previous week to take its total since May 2010 to €207 Billion.


Ultimately, we think this leaves the region in a tenuous position. First, the SMP is intended to only be a “temporary” program. Second, it will force the SMP to take on a much larger role to meet the demand of PIIGS issuance, or put an artificial bid that alone may not drive down sovereign yields.


More Risks on the Horizon Without ECB Support

While we view the actions of ratings agencies as lagging indicators, Monday’s move by Standard & Poor’s to place the ratings of 15 Eurozone nations on CreditWatch negative and Tuesday’s announcement that the EFSF’s AAA rating is being placed on CreditWatch negative adds one more bee in the Eurocrats’ bonnet ahead of Friday.  S&P said that ratings could be cut up to one notch for Austria, Belgium, Finland, Germany, Netherlands, Luxembourg – and by up to two notches for everyone else (France, Italy, Spain, Portugal, Ireland, Slovakia, Slovenia, Estonia, and Malta.)  (Note: Greece was spared, and Cyprus remains on negative watch.)


While S&P said it would review the ratings following the Summit, the warning portends negatively for the EFSF, a facility that is built around its AAA status. Should downgrades come to Germany and France, its main contributors at 28% and 22%, respectively, we’d expect funding costs to rise, which negates the very purpose of this facility, and once again (negatively) refocuses the eye on the undercapitalized programs to fund imbalanced sovereigns and banks. 


Expect insolvent banks in this environment to struggle to raise money on the secondary market. This will elevate risk as sovereigns are now less capable to back their struggling banks, and the EFSF is far undercapitalized. Here we think French and German banks will be critical to watch. Along those lines, the European Banking Authority will publish updated stress tests at 12pm EST today to review how much capital lenders should raise to absorb losses from Eurozone bonds. We’ll reiterate that if countries truly mark their sovereign holdings to market, we think the capital raise will need to be substantially larger than the Q2 published result of €106 Billion to reach a 9% core Tier 1 capital by mid-2012.


German Chancellor Angela Merkel said to her Parliament on Dec. 2, 2011: "Resolving the sovereign debt crisis is a process, and this process will take years." If Europe’s currency union is here to stay, beware of the lofty expectation that Friday will bring quick-fixes to years of fiscal and banking imbalances and excesses, as well as cultural differences that divert priorities as Europe will once again need to find a united voice on fiscal union.


Unfortunately, should Friday’s Summit come up short of expectations, there’s nothing currently on the calendar in terms of summits or major catalysts into year-end around which markets could get behind.  


Hobble on.


Matthew Hedrick

Senior Analyst


Incredibly Hobbled - EL EUR


Incredibly Hobbled - VP 12.8

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The Macau Metro Monitor, December 8, 2011




Effective today, buyers who are not Singapore citizens or permanent residents will have to pay an additional 10% stamp duty when they buy a home, on top of the existing 1-3% in stamp duties.  Permanent residents who already own a Singapore home are now required to pay an additional stamp duty of 3% when they buy second and subsequent properties.  Citizens who purchase a third and subsequent homes will pay 3%.  "We have always had open markets and must keep them that way. However, the reality is that investment flows into our property market are now larger than before, and unlikely to recede as long as interest rates remain low," said Deputy Prime Minister and Minister of Finance Tharman Shanmugaratnam.  "The additional buyer's stamp duty should help cool investment demand, and avoid the prospect of a major, destabilising correction further down the road," he added.  







What did they learn from their entry and exit into and out of UK & Japan?

  • In Japan and UK, there was very little that could be leveraged outside that markets so that's why they decided to exit those markets.  It's really about trying to leverage what they do well and bring that into those markets.
  • What are they spending on R&D efforts internationally? It's minor and included in $200MM budget.  It's more about skinning their existing content and localizing it rather then developing content from scratch. 

Timeline from market studies to localize content to put out new content

  • They are already re-skinning existing math to local tastes

How to get to $2.5BN revenue?

  • Outsized participation from the international side, which comes at a lower margin.  Interactive contribution also has a lower margin. They will need to be more aggressive internationally to gain share.  The efficiencies will come from all the back-office support functions by consolidating all the international operating systems.  Doing more market research will get them a higher success rate on the hit games, so they put out less flops by having better inputs into the product development process.  Used to have each studio have different product development tools and they are going to globalize that process.
  • ETG expertise/ lack thereof
    • Their ETGs are performing well at Acqueduct.  Their strategy is to identify good platforms and take them globally.  They had historically built games for markets - like the Australian games - and they are looking to change that and bring those low cost boxes into other markets. 
  • Investment required to grow their market share in various markets (LATAM/Asia) will not degrade their margins
  • Operating profit in Australia has significantly improved over the last 5 years.  It used to be a B/E division and is now one of the largest international contributors.
  • SAP implementation/ disruption?
    • There will be no disruption.  Berg did it at all his other companies (did it 3 times before).  Will get the implementation done in 18 months.  SAP will allow them to see how they are doing real time - and course correct - plan discounts / etc; they don't have that expertise currently.  Rolling out these systems is complex and that's why they hired Berg.


Energizing Interactive (Gideon Bierer - EVP New Media)

  • On track with plan. Few key pillars over the next 3-5 years.
    • A fews years ago, 95% of revenue in this division came from UK
    • Produced 2x as many games this year vs. last year (online casino)
    • Mobile gaming: acquired a Million to One (small tuck in) -  more then tripled their business.  Transitioned their business from feature to smartphone business.
    • Entered sports, bingo, and poker business through the Entraction acquisition.  Have a turnkey business for clients that want to get online (white label service) quickly.
  • Markets
    • Growing in UK
    • Entered into Canada in June 2011 when online was legalized; IGT should have the highest market share in online casino in Canada
    • Denmark: Legalizes Jan 1. On track to be the #1 share for online GGR casino revenue.  All the Entraction offerings have been taken up by that market.
    • Italy is in the process of legalizing online gaming.  Expect to go live March 2012
  • Customers
    • Serve 13 of the top 20 operators; landed customers in 6 markets (signed contracts), have 37 new customers.
  • Go to market strategy
    • Most of the markets that they are targeting are either in final legalization stages or just going live.  Each market is different in terms of strategy / offerings/ etc. 
    • Most of their games are made for all 3 platforms: Mobile. online, and tablets/PCs
  • Channels
    • Working on linking their land and online offerings
    • Poker and Casino are their leading offerings and that's where most of their money is going
    • Looking to strengthen the offering in sports and bingo offering
  • IGT's unique value proposition
    • Content for online games
    • Compliance position
    • Many online only guys don't have the same compliance standpoint and have no presence in casinos so they don't offer convergence products (WMS already offers this)
  • Strategic goals
    • Drive top and bottom line growth
    • Market expansion, partnerships, product investment, gain customers
    • Achieve a strong position in regulated markets
    • Leading supplier to land based casinos (very small market now)
    • Tier 1 in all verticals (this is revenue share model)


Next Generation Platforms/IGT Cloud Transformation (Chris Satchell - CTO)

  • Why does cloud matter?
    • Operators need more yield for their floor (better analytics/ROIC from floors)
    • Makes it easier for clients to access IGT content
  • What is a cloud
    • Data center (infrastructure as a service)
    • Development in the cloud (platform as a service)
    • Software as a service (ala salesforce)
  • So their strategy is developing private clouds for their clients which allows the clients to outsource their infrastructure, centralize management, and capital expense would become operating expense.  This is particularly nice for the really small European casinos (casinos that run in the cloud vs. locally at casinos) by putting the casino content in the cloud and player experiences in the cloud.
  • Reduces the acquisition cost of systems and game content for small operators (outsources a lot of the casino operation to IGT)
  • Value proposition of Cloud?
    • Reduces TCO and Capex (technology expense of operating casino systems)
    • "Deeper connection to patrons" by linking online activity of patrons and land based activity
    • Profitable access to new technology (pay as you go model/pay as you consume  - i.e. easier and more seamless upgrades)
    • For Patrons (reward experience, targeted marketing and content push)
    • Increases their global addressable market share for IGT solutions; decreases friction for IGT content and services delivery; generate new recurring revenue streams.
  • Timeline: Showed this to 35 operators in Oct11' at G2E. Launched first infrastructure test in Nevada in Dec 11. Signed 4 casino customers to trial the product; at G2E 2012, they plan to have the first commercial service available


Q&A for cloud/interactive parts

  • How are they going to make money on this?
    • Too early to talk about pricing money.  But the plan is to pay for services on a scaled basis (depending on who is hosting the data center, how many services they are delivering).  The traditional ways to pay for this is on a transactional basis - traditionally, not a revenue but an as you use it model.  Customers like it since it doesn't require upfront investment.
  • How much does IGT need to spend on this on an R&D basis?
    • It's part of their R&D budget.  They already have cloud servers that they use.
  • Regulatory reactions?
    • Nevada has deliberately changed regulations to allow for off-site hosting.  They are very forward looking.  In theory, it gives regulators more control in auditing data.  Nevada will be a good test bed for them. 
    • A lot of the places that they are looking at though are international where the regulator and the customer is the same client
  • There is a huge market for clients that can't do sbX because their capital investment is just too large (they will announce a customer that has lots of locations with 100-200 machines) so this is much more feasible


Financials (Pat Cavanaugh - CFO)

  • Eliminated about $200MM in SG&A. Only increase will be tied to uplifts in revenues.
  • Continuing to reduce their leverage by using their excess cash towards the bank leverage calculation (part of their covenant agreement in terms of calculating leverage)
  • Continue to be ROIC focused and be good stewards of capital
  • Got out of non-profitable business and restructured other business relationships that weren't favorable in past forms
  • Will invest in growth opportunities that support core and accelerated growth
  • Have been able to improve margins in a flat revenue environment.  Believe that some growth in revenues will deliver compelling bottom line growth.
  • Almost have $2/share of cash on the balance sheet.  Expect to generate significant cash over the next 3 years ($2BN in operating cash flow) : uses: ($700MM of capex; $350MM of strategic investments, $500MM of returns to shareholders; $700MM of debt reduction)


  • $500MM of growth in revenues will come from uptick in the US economy; jurisdictional expansion (50%) and 50% will come from emerging businesses and market share expansion internationally
  • Domestic market- status quo in the domestic market - tick up in the replacement market.  If things go their way, they think that hardware will be longer lived but driven by recurring revenues.
  • Continue to take share in the domestic market (and replacement cycle).  Systems growth will be in the cloud. 
  • Redirecting their efficiencies in the new technologies.
  • December is seasonally softest for them. Q4 is the strongest for them.
  • Quebec and Alberta has made their awards; others are still in the RFP process
    • Canada VLT replacement gets replaced in a wholesale fashion - so they should fair really well
  • How much of the convert is already in the share count? None of it until their share price is just under $20/share... they also have a call spread... so there is no dilution until price gets to around $30/share


Keith shorted IGT in the Hedgeye Virtual Portfolio at $17.05.  According to his model, TRADE support was broken at $17.26 and TREND support is at $15.62.



As we mentioned in "REPLACEMENT REVERSAL" (12/2/11), IGT may have pulled forward slot demand in their previous quarter and some casino capex budgets may have already been exhausted.  We believe total North American replacement sales growth in CYQ4 will be negative and IGT will lose share sequentially.  IGT's Investor Day is ongoing; we'll update on any incremental news.



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