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IGT F4Q12 CONF CALL NOTES

Takeaway: IGT thesis coming into view: improving fundamentals and more shareholder friendly capital deployment

Big Q and better guidance. And how about that Interactive business?

 


"Our strong fourth quarter financial results serve to highlight a very solid fiscal year 2012 for IGT.  In the quarter, we leveraged our industry-leading content to increase revenues, ship share, margins and prices in our core North American business"

 

- Patti Hart, CEO of IGT

 

 

CONF CALL NOTES

  • Core product sales business is healthier than it has been in a long time.  Their gaming operations business is stable, and I-gaming efforts are accelerating.
  • Increased % of leased and stand alone fee games, which carry higher margins.  Profit per unit in MegaJackpot was flat despite lower yield. 
  • In 2013, they expect gaming operations revenue and install base to be flat but expect higher profit per unit
  • In 2013, they expect pricing to follow historical trends.  Revenue and unit sales should experience double digit increases but gross margin may be under pressure.
  • Remain very excited about Double Downs (DD) and still expect it to be GAAP accretive in 2014. 
  • Expect some additional costs and lower revenues and gross margins in IGTi as they execute on restructuring changes, but should lower the costs of the business in the longer term
  • Expect operating expenses as a % of revenue to remain flat in 2013
  • ABB: $13.12 would be the purchase price if the transaction closed today.  Expect the ABB to close in F1Q
  • They are pleased at the rate at which their revenues are being converted to FCF
  • They will continue to prioritize organic growth and return cash to shareholders
  • Expected weighted average share count for 2013 to be 267MM shares
  • Their guidance reflects their customers' improved sentiment regarding IGT's product
  • Usually earn 40-45% of their FY earnings in 1H of the year and F1Q usually represents less than half of that.
  • Expect to stabilize Mega Jackpot revenues and improve their product sales gross margin especially in international. 
  • In DD, they expect to grow through more international penetration and in IGTi, they expect growth through more mobile applications

 

Q&A

  • Where do they see the outsized growth in 2013 by segment?
    • Gaming operations to be flat but will have better margins
    • Product sales:  FY13 will be a fantastic year on the back on VLT demand: Ohio, IL, Canada
    • Interactive expect great growth there
  • SG&A related to the interactive business?  The vast majority of the growth in SG&A is due to Interactive.  Base SG&A has grown only single digit. Expect low single digit growth next year.
  • NA replacement sales:  Expect their NA replacement share to come in at 48%. They didn't pull forward any shipments. Shipped what they forecasted they would ship. They hit the guidance range given last quarter.
  • How much of the $1.20-$1.30 includes the add-back of intangibles?  This quarter, they increased their expected payout on DD.  The EPS forecast is adjusted for those retention payments. $40MM for amortization of intangibles is adjusted out of their guidance (amortization of intangibles). 
  • Canada mix in the quarter:  expect 40% market share in Canada. Gross margin on Canada is a bit better than IL but not markedly so.
  • The products that they have moved from the IGT library onto Double Down had a big positive impact on their ability to monetize their player activity
  • Expect margins on Interactive to go down a little bit on IGTi only, not on Double Down.  Expect Social Gaming side will continue to expand margins 
  • Felt very good coming out of G2E.  Had great customer feedback. Still cautiously optimistic on customer spending. They also continue to gain share.
  • What drove the non-machine sales?  Pick up on the intellectual property side, some of that was systems related.  Is this performance expected to be recurring?  Would look at it on an annual basis.  Some was related to the settlement with BYI.
  • Gaming operations capex in 2013?  Flat to down slightly. They are trying to carefully manage the turnover of their base (this helps their margin)
  • Flat yield expectation?  Continued pressure on yields but they are continuing to try to manage that.  Think that their new games will drive better performance. There may be more declines though, and if so, more likely in the first quarter and 1H of the year.

 

HIGHLIGHTS FROM THE RELEASE

  • 2013 Outlook: EPS: $1.20-$1.30
  • Gaming operations: 
    • Flat YoY revenues with "higher lease operations revenue offset by lower MegaJackpots revenue"
    • "Gross margin increased to 61%...partially due to favorable interest rate changes"
    • "Installed base increases were primarily driven by lease operations growth globally"
    • "Average revenue per unit per day.. up 1% sequentially and down 8%" YoY
    • Install base: 57,100; Average revenue per unit per day: $50.83
  • NA Product sales: 
    • Units recognized: 10,400 (8,500 replacement, 1,900 new)
    • ASP: $14,700
      • Increase due to lower discounts
  • International Product sales:
    • Units recognized: 4,100
    • ASP: $15,800
  • "North America gross margin increased to 58%...  primarily due to favorable costs resulting from higher production volume."
  • Interactive: 
    • $53.9MM of revenue at a 62% gross margin
    • Down Down stats: 
      • DAU (000's): 1,415
      • MAU (000's): 5,072
      • Booking per DAU: $0.28
  • "During the fiscal year, the company received 28 million shares related to the previously announced accelerated stock buyback (ASB).  The total number of shares ultimately repurchased under the ASB is based on the daily volume-weighted average share price of IGT's common stock during the repurchase period and will be determined in the first quarter of fiscal year 2013. Upon completion of the ASB, the company expects the volume-weighted average price of all the shares delivered to the company to be close to the closing price on the day the company announced the program, assuming the share price stays within recent ranges."
  • In FY12 IGT repurchased 5MM shares of its stock at an average price of $15.18 for $75MM
  • Charges and one-time items in F4Q
    • Impairment of Walker Digital Gaming patents: $15MM
    • Additional impairment on the company's Alabama notes receivable: $13MM
    • Reorganization charge at IGTi operations(closure of Entraction services and facilities): $15MM
    • Tax benefit related to Entraction closures: $45MM

Feeling The Market

 

Hedgeye CEO Keith McCullough appeared on CNBC’s Fast Money this evening to discuss the market, fiscal cliff and whether or not Apple (AAPL) will continue to head lower. The market is immediate-term TRADE oversold right now and the VIX is overbought. There's no catalyst right now for the market sell off; the bottom line is that growth and earnings continue to slow.

 

Check out Keith on Fast Money in the clip we've posted above.

 


COMMODITY CHARTBOOK

Dollar strength helped pressure some commodities over the past week.  Over the longer-term, we are expecting grain and commodity prices to remain elevated as 60% of the contiguous United States is in moderate or worse drought.  Corn, wheat, soybean, and chicken prices remain up double digits versus a year ago.  Beef prices, while not as inflated as the aforementioned commodities, are expected to move higher next year on continuing supply concerns. 

 

Summary View

 

Wheat prices have been moving higher over the past week, driven by speculation that the U.S. government will reduce its estimate of global stockpiles in its World Agricultural Supply and Demand Estimates report, due out tomorrow at 08:30 AM.  France cutting its production outlook and Russia, the world’s third-largest wheat exporter, experiencing dry weather, has also impacted prices. 

 

Chicken prices remain at elevated levels with whole breast prices climbing 50 bps week-over-week.  Elevated corn prices continue to pressure margins of chicken processors, pressuring supply and supporting prices.  This is bearish for BWLD.

 

COMMODITY CHARTBOOK - egg sets wings

 

 

Beef prices were slightly higher on the week as economic concerns offset speculation that higher feed prices are set to drive meat prices higher in 2013.  Retail prices in the United States, for beef and pork, have remained stable but some industry players are commenting that rising costs will have to be passed on to consumers sooner rather than later.  If casual dining companies such as BLMN, TXRH, DRI and others are forced to increase prices it would negatively impact traffic in an industry that has been heavily dependent on traffic for footfall .  

 

COMMODITY CHARTBOOK - commod

 

 

Gasoline Prices

 

Gasoline prices have fluctuated on competing concerns around the economic outlook and possible import delays due to Hurricane Sandy.  Despite the less-than-feared impact of Sandy on national prices, we expect continuing tight supplies in NY and NJ to push prices higher and meaningfully impact consumer behavior, at least in the short term.

 

COMMODITY CHARTBOOK - gasoline

 

 

Correlation

 

COMMODITY CHARTBOOK - correl

 

 

Charts

 

COMMODITY CHARTBOOK - crb foodstuffs

 

COMMODITY CHARTBOOK - corn

 

COMMODITY CHARTBOOK - wheat

 

COMMODITY CHARTBOOK - soybeans

 

COMMODITY CHARTBOOK - rough ride

 

COMMODITY CHARTBOOK - live cattle

 

COMMODITY CHARTBOOK - chicken whole breast

 

COMMODITY CHARTBOOK - chicken broilers

 

COMMODITY CHARTBOOK - chicken wings

 

COMMODITY CHARTBOOK - coffee

 

COMMODITY CHARTBOOK - milk

 

COMMODITY CHARTBOOK - cheese

 

 

Howard Penney

Managing Director

 

Rory Green

Analyst

 

 


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Healthcare: Pulling Teeth

We believe there will be a slowdown in dental services in the next several months. Right now, dental office employment has slowed to 0%, reflecting slower demand for services. The per capita utilization rates and an aging population result in slowing dental demand in the US, not accelerating demand as is widely believed.

 

 

Healthcare: Pulling Teeth  - dental


HU SPEAKS; IS ANYONE LISTENING?: NOTES FROM CHINA’S 18TH PARTY CONGRESS

Takeaway: The Chinese demand curve looks to continue undergoing a structural shift. We do not think long-term investors are broadly prepared for this.

SUMMARY BULLETS:

 

  • There are four major themes to the Chinese Communist Party’s (CCP) long-term objectives as outlined at the start of China’s 18th National Party Congress.
  • The first of which is an increased focus on moving away from resource and capital-intensive industries and investment as drivers of economic growth towards expanding the role of the Chinese consumer via specific income growth targets, human capital development objectives, as well as a renewed focus on expanding the social safety net.
  • Secondly, there is a noticeable undertone of expanding the role of the markets and the private sector – a area where some would argue the Hu-Wen administration failed to live up to expectations due to their heavy reliance on SOEs and financial repression to achieve GROWTH targets. Any meaningful acceleration on this front would tend to be sustainably negative for the earnings growth of publically-traded SOEs.
  • Thirdly, quashing corruption among government officials and combating socioeconomic inequality was a major focus General Secretary Hu Jintao’s remarks. His willingness to be so open and outspoken on these topics suggests the broader social agenda – specifically the maintenance of social stability – has been promoted within the hierarchy of CCP objectives.
  • Lastly, there was an overt focus on China being China – specifically in that the People’s Republic of China is not going to give in to outside pressures to transform its government to a democracy, nor will it adhere to outside wishes that it pacify its foreign policy. In fact, it appears the CCP is focused on doing exactly the opposite. Additionally, Hu implicitly told the US/UN to “back off” and let China and other countries (Iran? Syria?) pursue their own political fates without interference from other world powers.
  • Combined, these four pillars hold the keys to understanding the direction of the Chinese economy as well as any future manifestations of Chinese public policy. Gone are the days of persistent double-digit real GDP growth (+10.6% per annum during the Hu-Wen administration) driven by heavy industry and infrastructure/fixed capital investment. Sure, China will certainly continue to build stuff (factories, dwellings, railroads, highways, etc.) en masse, but we anticipate the slope of growth in Chinese demand for both raw materials and capital goods to remain flat-to-negative for a long, long time.

 

NOTES FROM THE COMMENCEMENT OF THE 18TH PARTY CONGRESS

Today officially marked the start of China’s 18th National Party Congress, where it is widely anticipated that the Politburo Standing Committee (PSC), the top decision-making body in the Chinese State, is expected to have a dramatic turnover in leadership, as well as a reduction of the current 9-seat board to its original seven-seat setup (expanded in 2002).

 

To a small degree, we speculate that the number of seats may have been trimmed to allow for greater cohesion in the decision-making process, which requires a focus on long-term planning with the board having to achieve consensus on any major decision through careful deliberation. Moreover, the recent ouster of Bo Xilai from the Politburo may have ruffled some feathers throughout the party due to his close ties to senior military officials; having less “cooks in the kitchen” should aid the Chinese Communist Party (CCP) in forging ahead with its strategic initiatives.

 

That being said, we see little-to-no evidence that the CCP is crumbling from within amid internal power struggles, as some sources would have you believe. In his prepared remarks, however, incumbent Party General Secretary Hu Jintao did stress the need for the Party to appropriately respond the #1 threat to the power and legitimacy of the CCP as a whole – social discontent. This focus becomes very clear when interpreting his outline of the reforms China will undertake over the next 5-10 years, which we detail below.

 

While the composition of the new Politburo Standing Committee will not be unveiled until the congress concludes on NOV 14, it’s a near certainty that Xi Jinping and Li Keqiang will be promoted from their #6 and #7 rankings on the PSC to the #1 and #3 rankings of their respective mentors, Hu Jintao and Wen Jiabao. Xi’s likely #1 ranking will assign him the post of Party General Secretary, giving him ownership of the some of the most important portfolios, including military and foreign affairs. Keqiang’s likely #3 ranking will assign him the post of Party Secretary of the State Council (China’ s cabinet) – effectively making him the next Premier of China.

 

In some respects, Li is more important to Xi as it relates to the Chinese economy. While the Chinese Communist Party remains the ultimate source of power and key architect behind any economic, political and social reforms, the Chinese State – via the State Council, various ministries and institutions (Including the PBOC), the National People’s Congress (and its own Standing Committee), provincial/local level governments and State-Owned Enterprises (SOEs) – is often tasked with the design and execution of said initiatives. While China’s complex dual government has been set up in various ways to allow the Party to exert its influence at the top of every State organization, it is ultimately up to these committees to implement public policy in China.

 

As it relates to what reforms and strategic initiatives Party General Secretary Hu Jintao is promising below, we’ll have to wait to the 12th National People’s Congress convenes in MAR ’13 to receive any clues as to what these objectives will look like in action. For now, take his word(s) for it. If there’s one thing we’ve learned throughout our years of covering China, it’s that Chinese officials almost always do exactly what they tell you they are going to do. We caution against reading between the lines or anchoring only on reforms that support your current positioning; rather, we think it’s best to interpret these objectives holistically, as they are likely to shape the next 10 years of Chinese POLICY:

 

General Objectives:

  • "In building socialism with Chinese characteristics, we base ourselves on the basic reality that China is in the primary stage of socialism. Our overall approach is to promote economic, political, cultural, social, and ecological progress, and our general task is to achieve socialist modernization and the great renewal of the Chinese nation."
  • “The Party must be soberly aware that China is still in the primary stage of socialism and will long remain so. This basic condition of China has not changed; nor has the principal problem in the society; nor has China's international position as the largest developing country in the world… Only by promoting sustained and sound economic development can China lay a solid material foundation for enhancing the country's prosperity and strength, improving the people's wellbeing and ensuring social harmony and stability.”
  • “The country should institute a complete, multi-tiered and sustainable system to provide basic social security for both the urban and rural population.”
  • “Keeping to the goal of improving people' s health, China should improve the medical insurance system that covers the whole population, establish a mechanism to provide insurance and aid in treating major and very serious diseases, and improve mechanisms for handling public health emergencies and for preventing and controlling major diseases.”
  • “We should keep making progress in ensuring that all the people enjoy their rights to education, employment, medical and old-age care, and housing so that they will lead a better life.”

Economic Objectives:

  • “The country should fire all types of market participants with new vigor for development, increase motivation for pursuing innovation-driven development, establish a new system for developing modern industries, and create new favorable conditions for developing the open economy.”
  • “This will make economic development driven more by domestic demand, especially consumer demand, by a modern service industry and strategic emerging industries, by scientific and technological progress, by a workforce of higher quality and innovation in management, by resource conservation and a circular economy, and by coordinated and mutually reinforcing urban-rural development and development between regions.”
  • “Deepening reform is crucial for accelerating the change of the growth model.”
  • “While unwaveringly consolidate[ing] and develop[ing] the public sector of the economy, the country must also encourage, support and guide the development of the non-public sector.”
  • “On the basis of making China's development much more balanced, coordinated and sustainable, we should double [our] 2010 GDP and per capita income for both urban and rural residents.” (NOTE: This is the first time that per capita income has been included in the economic growth target set for 2020. Previous targets set at the 16th and 17th CPC National Congress merely called for the growth of GDP, not of per capita income.)
  • “The underlying issue we face in economic structural reform is how to strike a balance between the role of the government and that of the market, and we should follow more closely the rules of the market and better play the role of the government.”
  • “We should firmly maintain the strategic focus of boosting domestic demand, speed up the establishment of a long-term mechanism for increasing consumer demand, unleash the potential of individual consumption, increase investment at a proper pace, and expand the domestic market.”
  • “We should give high priority to rural areas in developing infrastructure and social programs in the country.”
  • “ China should continue to encourage industry to support agriculture in return for agriculture's earlier contribution to its development and encourage cities to support rural areas.”
  • "We should reform the land expropriation system and increase the share of gain in land value to farmers."
  • “The country should increase job opportunities for young people, especially university graduates, the rural migrant labor force, urban residents who have difficulty finding jobs, and ex-servicepersons.”
  • “The country should also strengthen vocational skill training, improve the human resources market and employment services, strengthen supervision of labor protection and labor dispute mediation and arbitration, and build harmonious labor relations.”
  • “The country should improve the way in which income is distributed, protect lawful income, increase the income of low-income groups, adjust excessively high income, and prohibit illicit income.”
  • “Major progress should be made in building a resource-conserving and environmentally friendly society. The establishment of functional zones should be basically completed, and a system for recycling resources should begin to take shape. Energy consumption and carbon dioxide emissions per unit of GDP as well as the discharge of major pollutants should decrease sharply.”

Political Objectives:

  • “We should place high importance on systemic building, give full play to the strength of the socialist political system and draw on the political achievements of other societies. However, we will never copy a Western political system.”
  • “Combating corruption and promoting political integrity, which is a major political issue of great concern to the people, is a clear-cut and long-term political commitment of the Party. If we fail to handle this issue well, it could prove fatal to the Party, and even cause the collapse of the Party and the fall of the state.”
  • “Leading officials at all levels, especially high-ranking officials, must readily observe the code of conduct on clean governance and report all important matters. They should both exercise strict self-discipline and strengthen education and supervision over their families and their staff; and they should never seek any privilege.”

Foreign Policy Objectives:

  • “We are firm in our resolve to uphold China's sovereignty, security and development interests and will never yield to any outside pressure.”
  • “China is committed to peaceful settlement of international disputes and hotspot issues, opposes the wanton use of force or threat to use it, opposes any foreign attempt to subvert the legitimate government of any other countries, and opposes terrorism in all its manifestations.”
  • “China opposes hegemonism and power politics in all their forms and will never seek hegemony or engage in expansion.”

 

SUMMARY IMPLICATIONS

There are four major themes to Hu’s remarks (and, by proxy, the CCP’s public policy objectives). The first of which is an increased focus on moving away from resource and capital-intensive industries and investment as drivers of economic growth towards expanding the role of the Chinese consumer via specific income growth targets, human capital development objectives, as well as a renewed focus on expanding the social safety net.

 

Secondly, there is a noticeable undertone of expanding the role of the markets and the private sector – a area where some would argue the Hu-Wen administration failed to live up to expectations due to their heavy reliance on SOEs and financial repression to achieve GROWTH targets. Any meaningful acceleration on this front would tend to be sustainably negative for the earnings growth of publically-traded SOEs (which happen to dominate from a market cap perspective). Perhaps that’s what the Shanghai Composite has been signaling to us all along:

 

HU SPEAKS; IS ANYONE LISTENING?: NOTES FROM CHINA’S 18TH PARTY CONGRESS - 1

 

Thirdly, quashing corruption among government officials and combating socioeconomic inequality was a major focus Hu’s remarks. His willingness to be so open and outspoken on these topics suggests the broader social agenda – specifically the maintenance of social stability – has been promoted within the hierarchy of CCP objectives.

 

Lastly, there was an overt focus on China being China – specifically in that the People’s Republic of China is not going to give in to outside pressures to transform its government to a democracy, nor will it adhere to outside wishes that it pacify its foreign policy. In fact, it appears the CCP is focused on doing exactly the opposite. Additionally, Hu implicitly told the US/UN to “back off” and let China and other countries (Iran? Syria?) pursue their own political fates without interference from other world powers. We interpret Hu’s statement that China “opposes terrorism in all its manifestations” as a direct shot across the bow of the interventionist US foreign policy experiment.

 

Combined, these four pillars hold the keys to understanding the direction of the Chinese economy as well as any future manifestations of Chinese public policy. Gone are the days of persistent double-digit real GDP growth (+10.6% per annum during the Hu-Wen administration) driven by heavy industry and infrastructure/fixed capital investment. Sure, China will certainly continue to build stuff (factories, dwellings, railroads, highways, etc.) en masse, but we anticipate the slope of growth in Chinese demand for both raw materials and capital goods to remain flat-to-negative for a long, long time.

 

In a world where price is set on the margin and first movers lock in the best returns, we can’t stress enough that it likely won’t pay to be long the go-to plays of raw industrial commodities, basic materials and energy stocks and/or commodity currencies on the expectation that China has bottomed and is poised to reflate its economy. We continue to see Chinese GROWTH in the late stages of a bottoming process and, thus, averting the risk of a “hard landing”.

 

That said, however, our expectation for Chinese real GDP growth to average +6-8% over the long-term TAIL is far shy of the expectations of some international investors and corporations. We are comfortable with this continuation of our contrarian stance because we remain willing to take Hu’s word for it – at least for now.

 

Darius Dale

Senior Analyst


Express & Courier Services Q&A

Today we held a call for our subscribers with Industrials Sector Head Jay Van Sciver focusing on the express and courier services sub-industry that includes FedEx, UPS, DHL, etc.. The Black Book call focused on everything from cyclical drivers and long-term industry trends to industry structure and valuations.

 

We’re pleased to present audio from the question and answer portion of the call, which deals with the UPS/TNT merger, FedEx market share in Europe and other topics related to the industry. We've posted the audio below for your enjoyment.

 

 


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