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Major Changes

This note was originally published at 8am on October 26, 2012 for Hedgeye subscribers.

“An economic model conditioned on the notion that nothing major will change is a useless one.”

-Nate Silver

 

I’ll reiterate Hedgeye Risk Management’s top Global Macro Theme for Q4 of 2012 this morning: #EarningsSlowing. We are finally seeing Major Changes to buy-side expectations for revenue and earnings. The sell-side’s estimates remain in lah-lah land.

 

As Nate Silver writes on page 193 of The Signal And The Noise, “anticipating these turning points is not easy.” But I fundamentally believe that if you study history, do math, and believe in the probability of mean reversion occurring, it’s certainly less hard.

 

“So we should have some sympathy for economic forecasters. It’s hard enough to know where the economy is going. But it’s much, much harder if you don’t know where it is to begin with.” (Silver, page 194). Since March, Global #GrowthSlowing has caught most consensus economists off-sides in 2012. Now #EarningsSlowing (which happens on a lag versus revenues) has analysts off-sides too.

 

Back to the Global Macro Grind

 

Flying back from California yesterday, I was watching Amazon (AMZN) and Apple (AAPL) earnings roll across my tweet-tape, and I couldn’t help but think, ‘gee, wouldn’t it have been nice if all the bulls warned us that both companies would miss and guide down?’

 

The risk that needed to be managed in AMZN and AAPL isn’t what you’ll see when the stocks open today - we’re already 5 weeks into what’s turning into a very serious draw-down in Tech (XLK) overall.

 

From the Bernanke Top (September 2012):

  1. Technology (XLK) = down -10%
  2. Apple (AAPL) = down -14%
  3. Amazon (AMZN) = down -15%

Remember, AAPL represents 20.6% of the Tech Sector (XLK) ETF. So Tech is outperforming AAPL at this point (and the SP500 is outperforming Tech). That means that anyone who was outperforming being long AAPL until September is probably now underperforming. Typically when this kind of rotation starts to happen in your portfolio, beta starts to eat your alpha.

 

Overall, beta (the SP500) is outperforming both Tech, AMZN, and AAPL. Since the Bernanke Top, the SP500 is in what we call a correction (down -4.2%). A draw-down is different than a correction. When you have double digit losses in a position, the next question isn’t “what is the stock down on the open?; it’s will this position start to crash?”

 

We define “crash” as a peak-to-trough price decline of 20% or more. Russia is teetering on moving back into crash mode this morning (RTSI down -1.8% on the session; down -18.3% from the March global #GrowthSlowing top). We’ll give the ole Bernank some credit for that one too – Russian stocks have everything to do with Petro-Dollars – and now we have Strong Dollar, Down Oil.

 

Away from the market’s leaders missing, that’s the other Big Beta thing going on out there this morning – remember, get the Dollar right, and you get a lot of other things right. Looking at Global Equity risk, the current 60-day Correlation Risk between the USD Index and the broad indices are as follows:

  1. SP500 = -0.87
  2. EuroStoxx600 = -0.95
  3. MSCI World Index = -0.91

So, you can look at risk from a bottom’s up stock perspective and/or from a top down (SECTOR, COUNTRY, or ASSET CLASS) beta risk factoring perspective, and you’ll learn a lot more about what’s really going on out there.

 

Keynesian economists have been saying that the Fed’s Policy To Inflate has not been causal to Correlation Risk. I say that’s a crock. If Romney wins the election (on that risk factor, probabilities in your conditional Bayesian model should be rising, not falling), there is a very good chance that the most asymmetric risk in all of Global Macro (Strong Dollar) busts a big move to the upside.

 

If that happens, the aforementioned correlations are probably going to keep moving towards 1.0, and we’ll probably be really right, in the immediate-term on Hedgeye’s 2nd Global Macro Theme for Q4 of 2012: Bubble#3 (Commodities).

 

I re-shorted the Gold Miners ETF (GDX) with that causal relationship in mind yesterday. I also re-shorted the Industrials Sector ETF (XLI) on green yesterday too.

 

Jay Van Sciver’s bearish thesis was very cogent in yesterday’s Early Look. If you believe there’s a bubble in Mining Capex, you’re probably in agreement with us that the revenue and #EarningsSlowing risk to pro-cyclical Industrials like Caterpillar (CAT) and Komatsu (KMTUY) remains to the downside as well.

 

Major Changes aren’t always underway in markets, but when you can get in front of the big ones you can save yourself, family, and clients from losing a lot of money.

 

Our immediate-term risk ranges for Gold, Oil (Brent), US Dollar, EUR/USD, UST 10yr Yield, AMZN, AAPL, XLK, and the SP500 are now $1694-1728, $105.98-110.66, $79.64-80.25, $1.28-1.30, $217-228, $591-613, $28.44-29.14, and 1395-1419, respectively.

 

Best of luck out there today,

KM

 

Keith R. McCullough
Chief Executive Officer

 

Major Changes - Chart of the Day

 

Major Changes - Virtual Portfolio


TUMI: Buy It Lower

Takeaway: For those buying into this 10.1mm TUMI secondary, keep in mind that it just fell below a critical quantitative support level.

For those of you buying into this 10.1mm TUMI secondary, keep in mind that it just fell below a critical quantitative support level and has little support until the high $17s. It might be a great story, but every story has a time and a price.

TUMI: Buy It Lower - 11 9 2012 6 51 05 AM


KSS: Cheap and Built To Stay That Way

Takeaway: The setup here looks tempting over the immediate-term, but we think KSS is in for another tough year in 2013.

The setup here looks tempting over the immediate-term, but we think KSS is in for another tough year in 2013.

 

KSS may appear to be a cheap stock, but we think it’s built to stay that way. Our bias is to the upside this holiday given the abysmal performance it went up against last holiday, and the fact that it does not really begin to feel pressure from JC Penney coming back on line until 2013.  

 

We need to keep in mind that KSS is quickly becoming a zero square footage growth retailer slowing from ~3%+ in 2010 and 2011 to +1.7% in 2012 and +1% next year. More aggressive repurchase activity can and likely will be used to grow earnings, but that doesn’t warrant ‘historical multiples’ from the days when KSS was aggressively growing its footprint productivity, and efficiency. As we pointed out in yesterday’s note on Macy’s, zero growth retailers have no problem trading at 6x forward earnings. KSS has never really gotten there, but it has also never been as mature as it is today.

 

Let’s keep in mind that it’s planning for a 3-4% comp in what it already thinks will be a highly promotional holiday. We already know that Macy’s is planning for a 4% comp, and while it has the benefit of JCP which will likely comp down at least 10-15 points below last year, there’s still potentially not going to be enough for everyone to go around.

 

That said, we’re less concerned with comp on what we’ll call ‘planned-promotion’ merchandise. In reality, it is a number we cannot forecast. No one can. Retailers themselves cannot do it other. It’s not as much a function as the actual number as the level of comp they are PLANNING. Then they execute on a marketing plan, and either a) convert at planned price, b) clear at heavier than expected discounts, or c) let comps lag, but keep margins high while letting inventories grow. (Note: Those are listed in order of attractiveness for the stock.)

 

Who are we to doubt that they can get the 3-4% comp given their more aggressive and better assorted inventory position compared to last year, but we do cast doubt on gross margins. While we see risk in 4Q EPS, however, our real concern is looking out to 2013.

 

2013 is when we expect the mid-tier to become severely promotional, and the fact that KSS is off mall does not isolate it from JCP (on-mall) regaining share. Growth in e-commerce (+220bps) and new stores (+140bps) has helped offset KSS’ contracting core business this year (-150bps), but we see slowing new store contribution, further erosion in core (comps down -3.5%), and anniversarying a 53rd week leading to a 3%-4% sales deceleration next year. This is illustrated in the first chart below.

 

The best bull case is that consumer spending rebounds, and KSS’ off-mall presence proves to insulate itself from increased competition between JCP, M, and GPS. In addition, technology investments continue to drive 40%+ e-commerce growth and the new merchandise team gets the kids business back on track driving +3%-4% comp growth. With modest gross margin expansion and SG&A leverage you get $5.25 in 2013 earnings – suggesting 10x earnings and ~5.3x EBITDA. That’s cheap enough for us to get interested in KSS, presuming there was a fundamental catalyst we could identify to get it there.

 

A number between $4.00-$4.25 suggests that  the stock is closer to 12x-13x earnings. This might not be expensive, but mature department stores – with better content – have traded at half that multiple in the past. The simple fact that KSS hasn’t comped while the rest of the mid-tier has benefitted from JCP hemorrhaging nearly $3Bn in share requires a high degree of trust to assume a meaningful rebound just when JCP’s top-line reaccelerates. We don’t see enough differentiation at KSS to bet against this risk/reward setup. While not at the top of our short list, it’s a name we think will work headed into 2013 (we like Macy’s and GPS better on the short side).


KSS: Cheap and Built To Stay That Way - KSS Grwth Comp

 

KSS: Cheap and Built To Stay That Way - KSS S

 


 

 



 


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IGT F4Q12 REPORT CARD

Takeaway: Improving fundamentals and more stock buybacks leading to higher estimates going forward

In an effort to evaluate performance and as a follow up to our YouTube, we compare how the quarter measured up to previous management commentary and guidance

 

 

OVERALL:  BETTER - IGT put up a big quarter and provided guidance above the Street.  The strength of the quarter was mainly in product sales (pricing and margins) and the Interactive division - a pleasant surprise given the negative sentiment surrounding these acquisitions.  However, gaming ops also beat us and the Street so the overall quality of the quarter was quite high.

 

 

GAMING OPERATIONS MARGINS

  • LITTLE WORSE:  Game ops gross margins ex interactive was 61% while interactive gross margins was 62%.  IGT expects margins to improve in FY 2013.
  • PREVIOUSLY: For the fourth quarter, we are assuming consolidated gaming operations gross margin of approximately 62%, including our interactive businesses.

PRODUCT SALE MARGINS

  • MUCH BETTER:  Product sales gross margin came in at 56%.  IGT expects more improvement in margins especially in their international business.
  • PREVIOUSLY: For the fourth quarter, we are assuming consolidated product sales gross margin to be approximately 52%.

SHARE COUNT AND RETURN OF CASH TO SHAREHOLDERS

  • SAME:  FY 2012 diluted share count was 290.4 million.  IGT returned $550 million to shareholders in FY 2012.
  • PREVIOUSLY: "We expect our fully diluted weighted average shares outstanding to be 291 million shares for fiscal 2012. Inclusive of dividends, we anticipate returning over $0.5 billion to shareholders in fiscal 2012, a clear indication of the strength of our cash flows and confidence in our strategies."

DOUBLE DOWN OUTLOOK

  • BETTER:   Double Downs showed solid growth in revenues, gross profits, and bookings per user in F4Q. Even though the daily and monthly active users didn't change much, bookings per user came in better than expected.
  • PREVIOUSLY: "I think Double Down is the same. Double Down, we have a couple new products launching in August."

CANADA SHIPMENTS

  • BETTER:  While IGT has yet to confirm, we're pretty confident that Canadian shipments were closer to 4,000 than a couple of thousand this quarter. 
  • PREVIOUSLY: "We have a couple thousand, I think, coming in the next quarter, but it's coming into new provinces where we have to get through the compliance process, so those things are in the balance.

REPLACEMENT MARKET

  • BETTER:  IGT expects NA replacement ship share expected to be 48%. Of course this includes their Canadian shipments
  • PREVIOUSLY: "We always hear very optimistic things about the intent to purchase. I think it has been less predictable. You can see in our North American replacements there were very strong shipments this quarter. We felt very good about the replacement market, so I think that that's an indication of confidence. We'd like to see that trend continue. The things that we hear from operators would indicate they'd like to continue to put capital to work, so we just have to get a little help from the economy."

MARGIN ISSUES

  • BETTER:  Gaming ops margins were significantly higher YoY and international product sales margins was down slightly YoY.
  • PREVIOUSLY: "We're obviously handily beating last year on the revenue line, but we're having challenges on the margin associated with game ops and then some of the international product sales, and we expect that those will continue to a degree."

3Q SG&A, R&D, D&A RUN RATES

  • SAME:  SG&A and R&D increased 3% and 8% QoQ, respectively.  D&A was flat QoQ.  IGT expects to continue to invest in the interactive business but at a rate than the revenue growth in that business going forward.  For the base business they expect low single digit SG&A growth. 
  • PREVIOUSLY:  [3Q SG&A, R&D, D&A good run rates?]  "I think you're going to continue to see some level of growth there as, for example, advertising and selling continue to factor into the Double Down model. But we will continue to make those investments as long as they're accompanied by growth in revenue, which we are seeing."

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.

 


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