Here are some thoughts on the PENN deal to acquire the Harrah’s property in St. Louis



We are moderately positive on the transaction:

  • Accretive:  With goodwill accounting and low borrowing rates, EPS accretion ain’t what it used to be.  However, we calculate about $0.20 in annual EPS accretion from the deal.
  • Deferred Capex:  This situation could be worse considering it is a Caesar’s property.  We think they will need to spend about $50MM over the first few quarters on new slots, renovating the casino, rebranding, and a new IT system.  Rooms and restaurants are in pretty good shape.
  • Multiple looks ok:  The EBITDA multiple looks to be 7.4x – not a steal but not bad.
  • Is it better than buying stock? – Not right away since PENN’s multiple is lower (after Ohio opens) but probably over the long term.  PENN still needs to add a Strip property to get the cross marketing benefits of a big regional property like this.  Given the cash accretion, either option is a positive relative to status quo.
  • Total Rewards:  This is a big wildcard.  It is unclear how much the most effective loyalty program out there has contributed to EBITDA and how much goes away without it.  History is on the side of a huge impact but there are a few mitigating factors:  the closest CZR property is 120 miles away, there are marketing restrictions put in place, and the St. Louis market is well-established.  An additional negative:  would existing St. Louis customers prefer to cash in rewards benefits at Wynn (from PNK), MGM’s Strip properties (from ASCA), or PENN (M Resort)?
  • Cost Savings?  Not really a lot here although we would expect to see less promotional activity.  With rational competitors ASCA and PNK in the market, there could be some savings.




Stock vs. Asset acquisition

  • The acquisition is structured as a purchase of all the stock in the Harrah's St. Louis subsidiary.  Contrary to an asset acquisition, this allows them to step into their shoes on day one.  However, since both parties agreed, the IRS allows Penn to treat the acquisition as an asset sale, which means that they can depreciate roughly $428MM of the purchase price over 15 years, which results in a $10MM/ annual tax shield.  Penn estimates that the present value of this tax shield is worth $79MM.


  • In terms of slots, the 300 slots that are leased at the property will be replaced immediately since those are costly and then roughly 200 more will get replaced in short order
  • Penn will also reduce the number of games on participation
  • After replacing 500 slots off the bat, PENN will likely replace about 1/7th of the slots annually on a go-forward basis, which is in-line with their normal replacement cycle of 7-8 years


  • The Maryland Heights property’s margins are in the 29% range.  PENN believes that there is an opportunity to improve margins by a few hundred basis points over the course of a few years by removing costly slot leases,  lowering the participation percentage, hiring cheaper on-site property management in the fields of accounting, marketing, etc where Harrah’s used a centralized system and then allocated costs to the property, and optimizing marketing spend. 
  • Margin improvement will take some time to materialize since they need to get their new systems, marketing tools, and people in place.  PENN pointed to ASCA’s 37% property margin as an example of being able to achieve better than 29% margins.  However, comparisons to ASCA’s 37% are not apples to apples, since ASCA allocates less overhead to the property level than most companies.

Deal Closing

  • PENN hasn’t even gotten in front of the regulators yet.  They are already licensed in the state so that should make it faster.  Late 3Q/early 4Q is probably doable.  


In preparation for MPEL's FQ1 2012 earnings release Wednesday morning, we’ve put together the recent pertinent forward looking company commentary.




  • "We are optimistic regarding GGR growth for 2012, particularly in relation to the highly profitable mass market segment, which continues to be strong, as evident in the increased visitations and strong mass table growth rate."
  • "Total deprecation and amortization expense is expected to be approximately $90 million to $95 million, corporate expense is expected to come in at $18 million to $20 million and net interest expense is expected to be approximately $25 million to $30 million."
  • "In the future, couple of months, we have put in place a program to improving, expand our VIP gaming facilities in COD, and we should be able to add another three junket operators in next three months time."
  • "As a policy, and it has served us very well over the last few years, we do not intend to compete on price or credit in the rolling chip segment."
  • "I think our hypothesis for a 15%, 20% growth in the gross gaming revenue overall in the market for this year is based on around 8% GDP growth. So we are pretty comfortable with the budget that we had set last year and with the current trading rate in Macau."
  • "We have to really yield up our table productivity.  We allocate quite a lot of tables in Altira because of the history of Altira. Per table productivity, compared to COD or Cotai standard, it's a little bit low."
  • "We're hopeful and optimistic that we can stick by the schedule that we had previously guided and so the next official announcement from us regarding Studio City as the designs are all done now would be a restart of construction."
  • "Based on our current cash balances and future expected cash flow, we do not envisage a requirement to raise equity capital for Studio City."
  • "I think you will start to see mass represent a larger and larger part of our mix of EBITDA."

LIZ: Top Long

LIZ remains one of our top longs for 2012. As such, with Trade support broken, we view this morning’s drawdown as a buying opportunity as the stock nears its intermediate term TREND support of $11.58 based on Keith’s quantitative levels.


As a reminder, while LIZ’s 1Q12 earnings came in light, top line strength exceeded expectations with April-to-date comps suggesting an acceleration in underlying demand at Kate Spade and Lucky. In addition, with FOSL results out this morning suggesting accelerated weakness in European jewelry sales, we remind investors that while LIZ has nearly 20% of sales generated in international markets, less than half of that is derived in Europe. No change to our thesis here- LIZ remains on track to double in 2012.


See our 4/26 note "LIZ: On Track to Double Again" for additional detail on our thesis and thoughts headed out of the quarter. 


LIZ: Top Long - LIZ TTT

Oversold, but Bearish: SP500 Levels, Refreshed

POSITIONS: Long Healthcare (XLV), Short Industrials (XLI)


Our call for Growth Slowing is finally morphing its way into consensus expectations. Not clear why it took so long (Global Growth Slowing has been plainly obvious in the Global Macro data since March), but most things in life aren’t crystal clear until we see them in the rear-view.


The other big thing going on out there is that the US Dollar is having its 5th consecutive up day. That drives The Correlation Risk which, in turn, drives a stiff Deflating of The Inflation (Gold, Oil, Copper, etc). When Growth Slows AND Commodities Deflate, “cheap” mining and energy stocks get cheaper, fast.


All of this is obviously good, in the end, for the 71% of America that matters to GDP – Consumption. So my long-term TAIL of 1281 in the SP500 should hold, provided that we keep Bernanke’s iQe4 upgrade of oil prices out of the way.


In terms of the lines, across risk management durations, that matter most: 

  1. Immediate-term TRADE resistance = 1388
  2. Intermediate-term TREND resistance = 1365
  3. Long-term TAIL support = 1281 

In other words, once we snapped my 1388 and 1365 TRADE and TREND lines, the market snapped. Don’t freak-out down here though. Let people who didn’t prepare for this do that. Unless we crash, there’s an immediate-term TRADE line of support at 1349 that should hold today and the mean reversion bounce back up toward 1364 could happen very quickly.


Trade this aggressively from a net exposure perspective. Keep your gross exposures low.



Keith R. McCullough
Chief Executive Officer


Oversold, but Bearish: SP500 Levels, Refreshed - SPX


McDonald’s reported a global comparable sales rise of 3.3% in April, which represented a slowdown from March on a two-year average basis.  Four weeks ago, management told us that it expected global comps to come in at 4%.  The 3.3% print suggests that the last ten days of the month fell below management expectations.


MCD SALES SLOWING - mcd global1


This was a disappointing number for McDonald’s.  The Hedgeye Macro Team’s “Global Growth Slowing” theme is being confirmed by this April number as the U.S. and APMEA missed expectations.  This disappointment is driving the stock lower.  Given the significant calendar adjustment, the underlying trends may not be quite as significant as the headline numbers suggest but clearly these numbers are calling for a resetting of investor expectations; McDonald’s is unlikely to astound the investment community with its same-store sales numbers this summer.  We still see McDonald’s as the QSR leader in the U.S. but, even in that position of power, the company is having difficulty maintaining its traffic trends.


With inflation pressuring margins, particularly in the United States, and 3% of price flowing through the P&L, sales trends are taking on a higher degree of importance for investors.  We are looking for management to offer some more definite guidance on how it will comp the comps this summer. 



United States


U.S. comparable sales rose 3.3% in April versus +4.8% consensus as the company had its first full month of the Extra Value Menu.  With price running at 3%, traffic trends are weak in McDonald’s domestic business.  The calendar impact (one less Friday and one less Saturday than April 2011) seems to have dressed down the headline numbers but we remain concerned about whether the company can comp the comps this summer.  As we wrote on 4/23: “The evidence suggests that beverages are increasingly becoming a less important part of the vocabulary from McDonald’s’ management team.  With that in mind, foremost in our thoughts is what the company’s strategy will be to maintain top-line momentum over the next few months.”







Europe exceeded analyst expectations in April, coming in at 3.5% versus +3.2% consensus.  Macro continues to be the most important factor in Europe.  Europe represents 40% of total revenues and 39% of total operating profit for McDonald’s.   While the print exceeded expectations, the two-year average did decline and continuing turmoil in Europe remains a business risk for the company.







Positive results in China were offset by negative comps in Japan as APMEA reported 1.1% same-store sales versus 1.9% consensus.  Much of McDonald’s long-term growth hinges on its APMEA division but, in the near-term, we expect the company’s fortunes in U.S. and Europe to dictate the stock’s performance.


MCD SALES SLOWING - mcd apmea 1



Howard Penney

Managing Director


Rory Green




McDonald’s continues to be the de facto safety trade of the restaurant space.  Our opinion at this point is that there are some subtle changes taking place as the new Chief Executive Office takes over that are worth noting.


On Friday we took the opportunity to ask Don Thompson what he thinks his legacy will be when he finds himself – hopefully long from now – closing in on retirement as Jim Skinner currently is.  His response was, in our view, interesting in that he mentioned the “Plan to Win” but also spoke of the importance of growing organically and building new restaurants coincidentally.  Specifically, Thompson stated that “we are much smarter now” and that McDonald’s “can walk and chew gum at the same time” [organic unit growth].  We do not view this as a negative for the company but it does represent a lower return growth profile for the company than we have seen over the past five years.


Thompson’s three “global priorities” are:

  1. Optimizing the menu [transitioning from dollar menu]
  2. Modernizing the customer experience [remodel/reimage program]
  3. Broadening accessibility to Brand McDonald’s [unit growth]

Unfortunately, the McDonald’s conference call was littered with headwinds facing the company that are, on a relative basis, greater than those facing competitors such as Yum Brands.  McDonald’s highlighted three major hurdles facing the company in 2012.  Firstly, the economic climate remains challenging, particularly in Europe.  Secondly, consumer confidence remains varied across markets.  Finally, the company highlighted “economic pressures and inflationary costs”.  Beef has been a key driver of these cost pressures.


Simply comparing McDonald’s to Yum Brands under the specter of these three factors paints McDonald’s in an unfavorable light relative to its rival. Yum has shrugged off concerns related to China’s rate of growth but McDonald’s’ exposure to Europe seems to be causing some concern among management personnel and investors alike. 





Changes on the margin are all-important and we see the decrease in emphasis on beverages as a strategy going forward as being important.  While management said that “the U.S. also continues to strengthen its position as a as a beverage destination”, total beverage units were only up 6% versus up 20% in 4Q11, 16% in 3Q11, and 29% in 2Q11.  In fact, the word “beverage” was only mentioned twice on the 1Q12 call.  The 4Q11, 3Q11, and 2Q11 calls included 4, 8, and 18 mentions of the word “beverage”, respectively.  The word “McCafé” was mentioned twice on the 1Q12 call.  The 4Q11, 3Q11, and 2Q11 calls included zero, 7, and 11 mentions of the word “McCafé”, respectively. 


The evidence suggests that beverages are increasingly becoming a less important part of the vocabulary from McDonald’s’ management team.  With that in mind, foremost in our thoughts is what the company’s strategy will be to maintain top-line momentum over the next few months.


MCD: WHERE TO FROM HERE? - mentions mcd




The beverage initiative last year clearly helped McDonald’s take share from competitors.  Don Thompson did provide an interesting take on the industry when he said, “around the world we continue to gain market share in an industry with minimal-to-negative growth”.  For a frame of reference, the Justice Holdings presentation touting the upcoming Burger King presentation cited an industry growth number of +6%!


For McDonald’s, one of the core initiatives in the U.S. this year is an attempt to evolve the company’s value proposition with the new Extra Value Menu and, in doing so, turn away from the existing dollar menu.  Beginning in April, McDonald’s is focusing the menu on four tiers (excluding combo meals):

  1. Premium ($4.50-5.50)
  2. Core ($3.50-4.50)
  3. The new Extra Value Menu ($1.20-3.50)
  4. The Dollar Menu

Given that the company is guiding to 4.5-5.5% inflation in the U.S. in 2012, we believe that management is attempting to manage check and margin by forcing customers to trade up to the Extra Value Menu from the Dollar Menu.  This belief is supported by the fact that one of the biggest changes that the company is undertaking is the addition of fresh baked cookies and ice cream cones to the Dollar Menu in place of small drinks and small fries. 


Our view remains that this is a big risk for McDonald’s.  If this change goes against consumer preference, there is a

possibility that satisfaction scores will be negatively impacted.  When we spoke to the company in March when the menu changes were first announced, we learned that a “mini-combo meal” offering may bundle the fries, burger, and drink but a decision has not been made on that yet.  Still, ordering the $1 items individually is no longer an option. 







Turning to Europe, McDonald’s has been significantly impacted by the macroeconomic environment there, more so than any other multi-national restaurant company due to its relatively larger exposure to the region.  Europe represents 40% of total revenues for McDonald’s and 39% of operating profit.  As Don Thompson said, Europe is a region that “continues to experience unprecedented economic challenges from widespread austerity measures, concerns over the sovereign debt crisis and unemployment levels averaging about 10%”.


The company has long been focused on upgrading the customer experience; 80% of the system’s interiors have been refreshed as well as 50% of the exteriors.  Roughly 150 McCafés will be added to the Europe system in 2012.







In APMEA, McDonald’s called out the challenging economic conditions in China (8.5% same-store sales), ongoing “tightening” in Australia, and uneven results in Japan.  Again, the company is looking to value as a strategy with the recent launch of the Loose Change Menu in Australia last month.


We think that APMEA is an important component of the long-term strategy for McDonald’s but, given that it only comprises 18% of EBIT, the near term story will be dictated far more by business in the US and Europe, which account for 43% and 38% of EBIT, respectively.


MCD: WHERE TO FROM HERE? - mcd apmea





McDonald’s trends are not disastrous but going forward, we see plenty to be concerned about.  Specifically, lapping the outsized performance of the U.S. business last summer, which was driven by impressive beverage sales, and maintaining momentum in Europe are two key issues.  As we wrote earlier, beverage unit growth is sequentially slowing so we believe that catalyst is no longer a major factor. 


Given the pending IPO of Burger King and our view that the brand is “too big to fix”, it struck a chord when McDonald’s management emphasized that it is “willing and able to invest for continued growth and to widen our competitive advantages”.  In reimaging 2,400 restaurants globally (800 U.S., 900 Europe, and 475 APMEA) and rebuilding 200 U.S. locations, the company is clearly in a position of strength versus its closest rivals.  The longer-term outlook for McDonald’s is positive, with competitors like Wendy’s and Burger King floundering, but growth in that segment of quick service pales in comparison to fast casual/specialty.  We would look elsewhere for top long QSR ideas at this price.  Jack in the Box is one company that we believe has upside potential from here.


Globally, the price factor flowing through the company’s income statement is roughly 3%.  With inflation pressuring margins, particularly in the U.S., sales trends will take on an increased importance.  Given the difficult top-line compares and uncertainty around the transition from Dollar Menu to Extra Value Menu, our conviction on the top-line continuing to meet consensus is tenuous at best.


MCD: WHERE TO FROM HERE? - mcd quadrant



Howard Penney

Managing Director



Rory Green



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