“Many men go fishing all of their lives without knowing that it is not fish they are after.”
-Henry David Thoreau
The thing with fishing trips is they end more often with stories of massive fish that were on the hook, rather than actual proof of the whopper. The best evidence of catching a trophy fish is of course taking a picture of it. My colleague Keith McCullough and I went fishing off of Long Island more than a decade ago with some buds, back when we were hedge fund pups, and caught a whopper. Being the accountable market operators we are, we actually took a picture of it and it is featured in today’s Chart of the Day.
Managing money is a little like fishing. You can tell tall tales of your performance, but at the end of the day you need to be able to show the results. In that sense, I’m pretty certain 2012 it is going to be a year of great tales but few whoppers reeled into the boat. Simply, this has not been a year in which navigating the global macro waters has been easy.
All year we’ve been spinning the tale of both slowing growth and declining corporate earnings, but for much of the year the market shrugged off these concerns. Now, of course, these concerns are front and center again. As always, the most dangerous markets of all are those that go up in the face of declining fundamentals because ultimately those markets will have further to fall.
In the global macro waters this morning, there are a number of key points to consider:
1. Chinese leadership – After much speculation, the final names of the seven gentlemen (down from nine) that will run China was announced. The conclusion is that they are more “conservative”. The key takeaways are that we are likely to see fewer human rights reforms and likely a more tepid pursuit of economic growth. Under the outgoing leaders, China experienced a decade of 10% growth and passed both Japan and Germany to become the second largest economy in the world. At the very least, that growth rate will decelerate.
2. Japanese easing – The Japanese equity markets are up almost 2% this morning, but don’t confuse that move with economic growth. The LDP is widely expected to win in the December 16th election and LDP President Abe put his cards on the table and is calling for “unlimited easing” to achieve a 2 – 3% inflation target. Ironically, or not, one of our top ideas yesterday was shorting the Yen. Email if you’d like to get our Senior Asia Analyst Darius Dale on the phone to discuss this thesis.
3. American political dysfunction – Today, President Obama is set to meet with key Congressional leaders as formal negotiations on the fiscal cliff begins. Obama unofficially began the negotiations on Wednesday when he said in a press conference that he expects tax increases for wealthy Americans to be part of any deal. This is a much more aggressive stance than the House Republicans were willing to accept in the prior negotiations, so it is unlikely to be accepted this time either.
Of the three macro points highlighted above, the most pressing concern from a current and future growth perspective is clearly the fiscal cliff, or as we call it The Keynesian Cliff. Unfortunately, the election did not solve much in the way of giving either party a mandate to solve this issue. At the table today, we have exactly the same cast of characters: President Obama, Senator Harry Reid, Senator Mitch McConnell, Congresswoman Nancy Pelosi, and Congressman John Boehner. As Yogi Berra would say:
“It’s déjà vu all over again.”
To the extent that the participants get away from a grand plan, it may actually be a positive for the markets. Simply, there is an immediate term catalyst. In six weeks, dramatic spending cuts and tax increases go into effect, to the tune of some $500 billion annualized. If this short term catalyst can be taken off the table it is likely to at least calm equity markets. This would of course imply rational action from Washington, D.C.
Since it is unlikely, based on recent history, that the elected officials in Washington act rationally, perhaps they will act in a more bi-partisan spirit. Senator McConnell’s opening statement seems to suggest that, too, is unlikely. As the Senator stated:
“I was glad to hear the President’s focus on jobs and growth and his call for consensus. But there is no consensus on raising tax rates, which would undermine the jobs and growth we all believe are important to our economy. While I appreciate and share the President’s desire to put the election behind us, the fact is we still have yet to hear an actual plan from the President for addressing the great economic challenges we face. What’s needed now is a realistic and specific proposal from the President that can actually pass the Congress.”
It’s pretty clear, so far, that tax hikes on the rich won’t pass Congress, so President Obama’s opening gambit may ultimately be a sign that we are in for a very volatile next six weeks.
Our immediate-term risk ranges for Gold, Oil (Brent), Copper, US Dollar, EUR/USD, UST 10yr Yield, and the SP500 are now $1, $108.19-111.10, $3.41-3.47, $80.58-81.33, $1.26-1.28, 1.53-1.68%, and 1, respectively.
Enjoy the weekends with your families and all the best to Yale Football up in Cambridge!
Keep your head up and stick on the ice,
Daryl G. Jones
Director of Research
The REIT/OPCO split certainly adds value and should create a new valuation paradigm for regional gaming operators. ASCA – yes; MGM, CZR, LVS, WYNN – no.
In the making for a year, PENN’s blockbuster announcement last night should be a boon to regional gaming stocks, especially PENN. When the transaction consummates in 9 to 12 months we currently project total value at $44-62. The news is likely to propel all gaming stocks higher but we believe this structure is only possible for companies with lower leverage and high free cash flow. Folks, it’s not happening with MGM and CZR and unlikely for WYNN and LVS so we would fade any strength today in those names. Instead, we would focus on the regional gaming operators – specifically ASCA. While we caution it would take 2 years for ASCA to pull something off like this, it’s a no-brainer for them.
The details of PENN’s transaction are complicated, the premise is quite simple. REITs are much more tax efficient so instant value is created. Moreover, the split capitalizes on the arbitrage card between how REIT investors value companies vs. how gaming investors value companies. REIT investors value companies based on how much cash they throw off and hence how much they can return to shareholders via a dividend. Gaming investors use an EBITDA multiple which gets adjusted based on the quality of a management team, growth prospects, and stability of underlying assets. Using one methodology can get you a premium of 50% over the other, and hence the arbitrage.
So what is this deal essentially doing?
- PENN is putting roughly 50% of its EBITDA and guaranteeing it as fixed rent with annual escalators into a new REIT entity.
- The new entity will be structured as a triple net REIT, meaning that PNG (the operating company) in addition to paying fixed rent to the REIT would also be responsible for real estate taxes, insurance, some maintenance and utility expenses (basically most of the operating expenses).
- By setting the fixed rental payments at roughly 50% of the assets existing EBITDA, PENN’s REIT will have 2x coverage. This means that EBITDA would have to drop by approximately 50% before the rental payments are endangered.
- Under PENN’s guidance, the REIT should be able to pay a dividend of $2.36/share in 2013. Most triple net REITs are currently trading on a dividend yield of 7% or less.
- Create an operating entity that will manage all of PENN’s wholly owned properties and own/manage PENN’s JV interests. Given the high fixed rental payments due to the PROPCO REIT, the operating company will have a more volatile cash flow stream – akin to a highly leveraged gaming company (MGM/CZR) - and should trade at a lower multiple than PENN currently trades.
- Regulatory risk (changes in tax rate, gaming legalization of neighboring markets), impact of new competition, and economic risk
- Maintain the upside of the Ohio VLT facilities
We haven’t had time to go through all the numbers, but based on management’s guidance, we believe the new structure should create a value package of between $44-$62/share at closing. Below are some of the key variables:
- PROPCO REIT
- 1x special dividend of $1.4BN or $15.40/share ($487 million is cash)
- 2013 base case dividend of $2.36/share that we think should be valued at a 6-8% yield or a 12.5x implied 2013 EV/EBITDA multiple ($30-$39/share). Yes, we realize this is a discount to where most REITs trade, but this is justified given:
- Unique asset class (i.e. of its own)
- Single tenant risk
- Regulatory and competitive risks
- Less asset diversification than many truly “National” REITs
- Lower value of underlying Real Estate assets compared to other asset classes
- PNG OPCO
- Based on today’s closing price, PENN trades at roughly 7x 2013E EBITDA
- We believe that PNG OPCO should trade at a material discount of 5.0-6.5x ($10-$17/share).
- When factoring in the rental payments and the 3x leverage, PNG OPCO will in-effect be a highly leveraged entity that bears the following risks:
- New competition
- When factoring in the rental payments and the 3x leverage, PNG OPCO will in-effect be a highly leveraged entity that bears the following risks:
- Offset by some growth opportunities and still a fairly healthy FCF yield
So what are the implications for the other gaming operators and why wouldn’t other operators look at this structure if PENN’s stock reacts favorably to the spinoff?
- The second question is actually easier to answer. In order to pursue this kind of structure successfully, gaming operators need to have:
- Low leverage is key and the largest barrier
- Healthy REITs need to have good dividend coverage ratios – usually at least 1.75x. So not only will a gaming REIT have to convince investors that its rental base is stable (“bond-like”) but leverage also needs to be reasonable in order to be able to pay a generous dividend yield. The operating company will also have to have low leverage, given that they will already have a large fixed rental obligation that rating agencies take into consideration.
- Low leverage is key and the largest barrier
- Diversified and stable cash flow stream
- Given the regulatory and competitive risks inherent in the gaming business, coupled with the discretionary nature of the product, cash flow diversification is key to getting a good multiple/yield
- Low cash needs
- Since REITs pay hefty dividends, companies that need to save their cash for a development pipeline or that have heavy capex needs are not good candidates for this type of structure
- At the very least, gaming investors should be forced to pay more attention to FCF yields vs. just slapping a multiple on to EBITDA
PENN maintained the lowest leverage of any gaming operator so it was the classic fit. Given its high free cash flow, stable markets, and low capital needs following the opening of Lake Charles in two years, we think ASCA is the most likely pursuer of the PENN strategy.
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This note was originally published at 8am on November 02, 2012 for Hedgeye subscribers.
“I will have naught to do with a man who can blow hot and cold with the same breath.”
This is the coldest morning the East Coast has had to deal with since Sandy. My prayers go out to the children, sick, and elderly who have to go through this with no power or heat.
Back to the Global Macro Grind…
Get’em while they are h-h-ot! That’s what the perma-bull marketers said yesterday as US stocks were having their 1st legitimate up day in the last 7 trading sessions. It’s been a long 1.5 month drought. Literally everything that didn’t work in October went straight up. All the pundits nailed it. Welcome to November.
In other “recovery rally” news – the headlines from the manic media changed, suddenly, this morning:
- “Anger As Fuel Shortage Hampers Recovery” –BBC World News
- “Scope of Sandy’s Devastation Widens, Death Toll Spirals” –Reuters
- “Power Restoration May Take Longer Than Expected” –New York Times
But don’t worry – there a plenty of Keynesians who still believe in Broken-Window Economics who will be out peddling stories this morning about how America is seeing a jobs and hurricane recovery.
We have no idea what this morning’s US Employment Report will bring. Only a moron would have a “forecast” for a number that the government makes up. China gets that – so they are going to start making up their numbers a little faster too.
China Daily noted that the National Bureau of Statistics said China will “revise its GDP accounting methods” in line with international standards. Perfect. So the China recovery is going to get really h-h-ot now!
As our hawk-eyed Asia analyst Darius Dale wrote to our Institutional Clients yesterday, this is the “most bullish data point emanating from China today – inclusive of the sequential acceleration in Manufacturing PMI and the PBOC’s record $6B injection into Chinese money markets this week.”
“From what we’ve noticed, international standards for GDP accounting = shoot first; ask questions later (i.e. report the most positive headline figure you can and subsequently revise it down 1-3 times in the coming months/years). This bodes well for a sequential uptick in China’s YoY GDP growth in 4Q12E!”
In other economic “recovery” news out of Europe:
- Spain printed a PMI reading of 43.5 for OCT vs 44.6 in SEP
- Germany’s slowdown stayed the same in OCT with a PMI reading of 46.0
- Italy’s PMI remained well below the “50 recovery” line at 45.5 OCT vs 45.7 SEP
No worries there. Markets in Europe were relatively hot this week (other than in Greece). These poor Greek guys are having a heck of a time reconciling the media’s “recovery” rumors with economic reality. Greek stocks dropped -15% from October 22nd’s YTD high to yesterday’s close, leaving this -11% down week as the worst week for the Athex Index in 4 years.
Across asset classes, as always, there are plenty of Hot & Cold risk management signals to consider this morning:
- SP500 climbed back above its 1419 TREND line of support; but remains below its TRADE line of 1432 resistance
- US Equity Volatility (VIX) closing at 16.69 remains in a Bullish Formation; could go to 20 if this jobs report is bad
- US Dollar Index continues higher this morning, +0.35% to $80.32; bullish on both our TRADE and TAIL durations
- EUR/USD trades down to the low-end of our immediate-term $1.28-1.30 risk range (bearish TAIL remains)
- Hang Seng +1.24% last night makes it the 1st major index in Asia to make higher-highs
- KOSPI, Nikkei, Sensex were all up > 1% too, but are all making lower-highs, not confirming the Hang Seng
- Germany’s DAX and France’s CAC making lower-highs versus September, again
- Russia’s RTSI Index remains under crash-test assault, -0.3% this morning (-18% from #GrowthSlowing’s to in MAR)
- CRB Commodities Index remains in a Bearish Formation at 296 (Bernanke’s Bubble)
- Copper, down -0.5% this morning to $3.47/lb remains in a Bearish Formation as well
- US Treasury 10yr Bond Yield of 1.73% remains bearish TRADE and TAIL w/ resistance at 1.75% and 1.91% respectively
And, finally, US Equity Fund outflows (ex-ETFs) continued last week with another -$1.4B yanked. So, was yesterday’s 1-day move a head-fake? Are you feeling hot or cold?
I’ll let the market answer the 1st question for me today. If we confirm 1419 in the SP500 and the VIX snaps 15.54, that would be bullish. On the second question, my arthritic hockey knuckles are officially numb as I sign off from a chilly Westport, CT.
Out immediate-term Risk Ranges for Gold, Oil (Brent), US Dollar, EUR/USD, UST 10yr Yield, and the SP500 are now $1691-1728, $107.49-109.96, $79.68-80.47, $1.28-1.30, 1.70-1.75%, and 1391-1432, respectively.
Best of luck out there today,
Keith R. McCullough
Chief Executive Officer
Takeaway: Fundamentals and the challenges inherent in the Union of uneven states suggest our $1.31 EUR/USD resistance level will hold.
Positions in Europe: Short EUR/USD (FXE); Short Spain (EWP)
Keith added FXE to our Real-Time Positions at $127.06. FXE’s TRADE range is $126 – 128 with a TREND resistance of $131.
With regard to the trade Keith said: “The Euro bounced right where it should have, off the low-end of our immediate-term Risk Range, but remains bearish TREND.”
Our call is that the EUR/USD will trade within our quantitative levels and reflect much of the daily headline risk (from Spain, Greece, and Italy in particular), however ECB President Mario Draghi’s September announcement that “the ECB is ready to do whatever it takes to preserve the euro” and the resolve of Eurocrats to maintain the Union will prevent levels falling anywhere near parity.
There is still great political uncertainty in Europe right now, which lends support that the EUR/USD will not cross our quantitative long term TAIL line of resistance at $1.31. Further, we believe there is a high likelihood that no significant policy action comes in the remaining weeks of 2012. As a reminder, some of the main topics that Eurocrats are wrestling with are:
- Setting up a Banking Union (with Pan-European Deposit Insurance)
- Setting up a Fiscal Union
- If and when Spain will request another bailout (and will it come from the IMF or ESM, or both?)
In terms of setting up a Banking Union and Fiscal Union, we believe the two are dependent on each other. While more attention has been given to a Banking Union recently, we believe Eurocrats reaching an agreement on a fiscal union over the near term is incredibly unlikely as countries are unwilling to part with their fiscal sovereignty. This could be one factor to put downside pressure in the cross.
On Spain, we think the sovereign asking for a bailout is a question of when and not if. The recent rumor that Spain may look to the IMF for a loan would reflect the likelihood of more favorable terms versus the European Commission and ECB’s ‘conditionality’ for aid via the ESM or OMT.
European fundamentals continue to show a down to ugly trend, looking across PMIs, confidence readings, inflation, retail sales and unemployment rates across much of the region. It’s important to note that even the perceived pocket of strength are revealing weakness, with Germany, France, and the Netherlands notable call-outs.
Manufacturing and Services PMIs for October have shown little to no improvement over the last 8-9 straight months, stuck below the 50 line indicating contraction.
Below is notable data out this week:
Eurozone CPI 2.5% in OCT Y/Y (above the 2% mandate and should remain so over the intermediate term)
Eurozone Industrial Production -2.3% SEPT Y/Y (exp. -2.2%) vs -1.3% AUG
Eurozone Industrial Production -2.5% M/M vs 0.9% AUG = biggest drop in more than three years
Eurozone ZEW Economic Sentiment -2.6 NOV vs -1.4 OCT
Preliminary Q3 GDP – while many of the core countries beat expectations, growth levels contracted versus the previous quarter and the Eurozone officially slipped into recession:
Eurozone -0.6% Y/Y (inline) vs -0.4% in Q2 [-0.1% Q/Q (inline) vs -0.2% in Q2]
Germany 0.9% Y/Y (exp. 0.8%) vs 1.0% in Q2 [0.2% Q/Q (exp. 0.1%) vs 0.3% in Q2]
France 0.2% Y/Y (exp. 0.0%) vs 0.1% in Q2 [0.2% Q/Q (exp. 0.0%) vs -0.1% in Q2]
Italy -2.4% Y/Y (exp. -2.9%) vs -2.4% in Q2 [-0.2% Q/Q (exp. -0.5%) vs -0.7% in Q2]
Netherlands -1.6% Y/Y (exp. -0.5%) vs -0.4% in Q2 [-1.1% Q/Q (exp. -0.2%) vs 0.1% in Q2]
Germany ZEW Current Situation 5.4 NOV (exp. 8) vs 10 OCT
Germany ZEW Economic Sentiment -15.7 NOV (exp. -10) vs -11.5 OCT
UK CPI 2.7% OCT Y/Y (exp. 2.4%) vs 2.2% SEPT [0.5% OCT M/M vs 0.4% SEPT] – stagflation, continued.
We think slowing growth, sticky inflation, and the structural flaws inherent in creating a Eurozone will continue to present challenges that should prevent appreciation of the EUR/USD above our TAIL line of resistance at $1.31.
LVS’s MBS should get an FX boost in Q4.
- If the current S$/US$ rate of 1.224 stands, it will result in almost a 5% favorable EBITDA impact for LVS’s MBS.
- Expectations remain low in Singapore. Q4 MBS estimates were lowered by another 3% following Q3 earnings.
- After a drop in gaming market share in Q3 mostly due to hold, MBS should see a sequential comeback in Q4. While both IRs held high in 4Q11, which will no doubt make YoY comparisons challenging, MBS has an easier hold comparison of 3.3% (4Q11) vs. RWS’s hold of 3.9%.
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