Fake it 'til You Make It

"To be a great champion, you must believe you are the best.  If you’re not, pretend you are.”

- Muhammad Ali


Last night Big Alberta (aka Daryl Jones) gave me the late look that I was to write this Early Look, so this morning I get to take extra creative liberties and subject you all to thoughts on my sector, Energy.


It’s a difficult space to make money in when oil prices aren’t going straight up, a la 2009 and 2010. 


Oil and gas companies – particularly the producers (E&Ps) – are highly promotional, as they have to be, in order to raise capital for what has become an incredibly capital-intensive industry.  In 2012, capital expenditures from S&P500 companies in the Energy sector were 39% of the index’s total; in 2000, they were only 12% (see Chart below).  Someone’s got to foot that bill, as the companies can’t do it on their own – the free cash flow yield of that same group was 0.0% in 2012, and if you back out a few cash cows like ExxonMobil and Royal Dutch Shell, you’ll find that most producers are not self-funding.


Nevertheless, in general, market participants hold the energy sector near-and-dear to their hearts.  Investors tend to anchor on recent history, and energy was by far the best performing sector over the last decade (XLE +200%).  And the sell-side knows what pays the rent – capital raises – so it’s not too surprising that Energy has the highest percentage of “buy” ratings and lowest percentage of “sell” ratings of all S&P500 sectors.


But is the love deserved?  Most E&Ps cannot generate a return greater than their cost of capital (aka “create value”), even with real oil prices near multi-decade highs and interest rates at multi-decade lows.  We shudder to think what a serious back up in rates would do to the sector…bankruptcy cycle?


But all is not lost (can’t get too cynical on a Friday)!  Among all the wealth destruction so colorfully described by activist investors in recent letters to the shareholders of Chesapeake (Icahn), Sandridge (TPG), Murphy Oil (Loeb), and Hess (Elliott), there are legitimate franchises and investment opportunities in the sector.  Over our long-term TAIL duration, we believe that select companies highly-levered to US natural gas prices will generate the best risk-adjusted investment returns in the space.


As we hover around nominal natural gas prices last seen on a consistent basis in the 1990s, it is a non-consensus view, so it needs some defending…


1.  Because natural gas is a local commodity, market fundamentals (supply, demand, and inventories) in North America impact prices in North America.  It is a remarkably efficient commodity market, and one which we can fundamentally believe in.  If we have a warm winter, natural gas prices go down – we get that.  We can’t necessarily say the same about global oil markets.


2.  In a world characterized by slow growth and tail risk, we think natural gas is a relative safe-haven.  If China has a debt crisis or the EU collapses, we will still heat our homes and turn our lights on.  US demand for natural gas is inelastic – in 2009 it fell only 1% compared to a 3% drop in US real GDP.


3.  Natural gas will continue to take power generation market share away from coal.  We estimate the natural gas demand from the power sector was +20% y/y in 2012, largely due to coal-to-gas switching and the retirement of aging coal plants.  At least 10% of existing coal-fired capacity is likely to shut down between 2012 – 2015 due to impending emissions regulations.


4.  Demand from the industrial sector should grow above GDP as new petrochemical, chemical, fertilizer, and steel plants come take advantage of the energy cost advantage in North America relative to the rest of the world.  As one example, Italy’s M&G Group announced last month that it will build the world’s largest single-line PET plant in Corpus Christi, Texas.  M&G remarked, “This is the largest PET investment ever in the western world and probably one of the largest investments recently announced in the US in the private sector.”


5.  Price is below the marginal cost of dry gas production, which we consider to be $4.50 - $5.00/Mcf, or the price at which producers can generate a positive return on a Haynesville Shale gas well.  We do think that we have seen the last of Haynesville Shale production growth.


6.  Longer-term, we are optimistic about new sources of natural gas demand: LNG exports and natural gas as legitimate transportation fuel.  With the right R&D and policy measures, both are economic and feasible, in our view.

We’re not going to give away the shop here, so if you’d like to discuss ways to invest in the thesis send us an email at .  Further, on Wednesday 2/6 we’re going to host a Black Book presentation and conference call for institutional clients on Gulfport Energy Corp. (GPOR).  There we have a very non-consensus view.  For now, we’ll just say that it’s one of the more promotional companies in the space...  Email for details on that call.


Have a great weekend,


Kevin Kaiser

Senior Analyst 


Fake it 'til You Make It - EL chart


Fake it 'til You Make It - yup


The Macau Metro Monitor, February 1, 2013




Secretary Tam said the government would only approve a total of 250 new live gaming tables this year.  Of those, 200 have already been granted to Sands China.  The remaining 50 will be allocated to Galaxy, said Tam.

“When the first phase of Galaxy Macau was completed, the government allotted a total of 450 gaming tables to the company; 400 tables were approved when it was opened and 50 more gaming tables are to be approved,” he said.  Tam stressed the government would not be approving any new gaming tables to existing casinos from other gaming operators.  SJM executive director Angela Leong On Kei had said last month that the gaming operator would apply for more tables.


Meanwhile, officials are to focus now on the table allocation for the upcoming projects in Cotai, Tam said.  He reaffirmed that the investment in non-gaming facilities would be taken into account by the government.  At least six new casino resorts will be built there in the coming years, one per gaming operator.  In 2013, with the announced addition of 250 new gaming tables, the annual increase rate in the number of tables will be 4.6%. At the end of last year, Macau had 5,485 tables.



Macau Gross Gaming Revenues rose 7.3% YoY to 26.864 MOP (26.08 HKD, 3.36 USD) billion.



RWS's casino licence has been renewed for another three years.  The Casino Regulatory Authority of Singapore (CRA) said RWS's new licence will come into effect from Feb 6.


A CRA spokesman said that RWS' compliance record was one of many factors considered with assessing the licence application.  She added, "In renewing RWS' casino licence, CRA has imposed additional requirements on RWS to put in place more robust structures and processes aimed at strengthening its overall compliance of our laws and regulations." Just last month, RWS was penalised $100,000 for breaches of the casino regulations.





Daily Trading Ranges

20 Proprietary Risk Ranges

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We thought they beat on revenues but we’ll take the margin beat



BYI delivered another solid quarter on the back of better than expected margins.  While revenues missed our estimate, they were in-line with consensus and strong gross margins pushed EPS above even our Street high estimate of 79 cents.  The market clearly liked what they saw, as the stock rallied another 2% after hours on top of being up 6% intraday.  At $49, the stock trades at 15x FY2014 earnings and throws off a 10% FCF yield, not bad in our opinion, especially given the price tag that SGMS was willing to pay for WMS, which we believe is an inferior business.  We have long thought BYI’s system business was way undervalued by investors.  With more predictable revenues and consistent growth, valuation of this segment should command its due premium.


So what did we like in the quarter?

  • Gaming equipment margins:  Excluding the 200bps benefit from a customer’s election to reduce costs, margins were still north of 50%
    • Even taking into account the higher mix of conversion kit sales in “other product sale revenues,” margins on box sales were still a little north of 50%.  Given that BYI isn’t introducing a new cabinet any time soon and their content remains solid, this should be sustainable.
    • Conversion kits are a big opportunity for BYI.  The vast majority of BYI’s sales comprise of Alpha 2 cabinets.  Currently, BYI’s makes a very small amount of revenues on conversion sales. However, we see no reason why this shouldn’t be a nice area of growth for them for the next few years.  As a point of reference, WMS sold $48MM of conversion kits in FY12 and $31MM in FY11.  FY14 should see strong growth in conversion kit demand which carries over 90% margins. 
  • Systems margins and growing maintenance revenue
    • Maintenance revenues of $23MM and growing.  Need we say more?  As BYI develops more content and continues to deploy more DMs and iVIEWs, the revenue earned per unit per day hooked up to their system should continue to grow.  Needless to say, the continued addition of units hooked up to BYI’s systems also grows this pie.  In our opinion, this is the highest quality and stickiest revenue stream at the company and deserves the highest multiple.  It’s much harder for a casino to replace a system than to replace a slot machine.  Once you have a system, you are going to pay maintenance fees to make sure you get continued updates and the latest products since the incremental cost is nominal. 
    • Margins on systems have averaged 74.4% over the last 10 quarters.  Between the high margins and the visibility on this business, what’s not to like?     

What wasn’t so hot?

  • It looks like replacements in the December quarter were likely softer than we anticipated for the market as a whole.  We now think that YoY replacements, excluding Canada, may have been flat to slightly down for the full calendar year of 2012.  With the trends we’re seeing in the regional markets right now, that doesn’t leave us feeling very encouraged on our 2013 outlook.
  • International segment continues to struggles with no real light at the end of the tunnel.  We expect this 800ish run rate to continue through year end.
  • Gaming operations saw some deceleration and was a little more seasonal than we thought
    • Roughly 50% of BYI’s gaming operation units pay variable fees and approximately 60% of their revenues are comprised from variable fees games
    • Seasonality, Sandy, and weak regional results weighed on the December quarter
    • The March quarter will be better seasonally but we don’t expect much growth in the WAP install base until the June Q

Stand On Your Hands

This note was originally published at 8am on January 18, 2013 for Hedgeye subscribers.

 “When torrential water tosses boulders, it is because of its momentum”

-Sun Tzu


To invert is to change from one position, direction, or course to the opposite position, direction, or course.   Within the context of yoga, the art of inversion includes using breathing and your core mussels to control the mind and the body; inversion allows for efficient brain stimulation.


Blockages of blood flow to the brain can sometimes result in cognitive difficulties or, in extreme cases, serious health issues.  Performing daily inversions combats this by forcibly flushing old blood out of the brain and replacing it with freshly oxygenated, nutrient rich blood coming directly from the heart.  Performing the ritual of Adho Mukha Vrksasana has been empowering and beneficial for me.  The state of relaxation that follows can lead to gratifying periods of reflection. 


Listening to restaurant companies present at the ICR XChange conference is another ritual than can lead to soul searching.  “What am I doing?” “Does this matter?” “Did he really just say that customers love getting a free bucket of peanuts?” 


After many years of attending the ICR XChange conference, I decided not to attend this year.  As part of a new approach in 2013, I am trying to do things differently.  Being a restaurant analyst that is not at the ICR conference is analogous to performing an inversion; in part, it represents the avoidance of group-think that can lead to poor investment ideas.


The truth is, the #OldWall process is broken and, other than secret one-on-one meetings with management, which I have no desire to attend, little-to-no incremental insight is available from listening to restaurant company executives at ICR this week.  The ICR Exchange Conference is as #OldWallSt as it gets.  All 21 sponsors of the 15th Annual ICR XChange are the biggest investment banks on Wall Street.  Before each presentation, an industry analyst takes the podium to say a few kind words about the presenting company and its future prospects.  There are countless intelligent people to learn from at the event but, at its core, it represents the inherent conflict of interest that typifies the traditional sell-side research model from Wall Street. 


Listening from afar, I am realizing that I have made the correct decision.  Listening to endless generic presentations, getting to Chipotle’s “break out” table 30 minutes early just to get a seat, knowing in advance that commentary will be uniformly bullish whatever the underlying reality, becomes a meaningless exercise eventually.  After yesterday’s preannounced EPS miss from Chipotle, anyone could have written the script for today’s conference: “Everything is fine, we are still changing the industry, and our growth opportunity is still as great as ever.  This EPS miss was merely a blip”.  The bar scene in Miami definitely had a Wall Street influence last night.  A lot of conviction can be gathered on an idea while having a few drinks.


The “read through” and “takeaway” from a company meeting at ICR is often meaningless.  We are getting passed a lot of notes from the sell-side stating that “our meeting with management gives us confidence” in our buy rating.  If you ever receive a note from ICR saying that management meetings have bolstered confidence in a short thesis, call me collect.


That’s the problem with the #OldWall, it is very difficult to speak one’s mind about a company.  As an analyst, your incentives should line up with your clients’: produce effective research on the value of the securities in question and assist those paying clients in making their stock selections.   Unfortunately, the incentives of an analyst are too often in conflict with the clients.  Getting paid and retained is what matters; if clients happen to do well, that’s a happy coincidence.  Ask yourself how your sources, and their firms, get paid.


Coming out of events like ICR, the momentum in certain stocks can build and get a lot of people paid in the short run.  If there is one stock in the restaurant space that has embodied momentum over the past few years, it has been Chipotle. Today, management hinted at raising prices in 2H 2013 to absorb food inflation.  Yesterday, the stock reacted very favorably to that news, we think, in error.  The following is a checklist of questions that we think investors need to become comfortable with before getting behind this move in CMG:

  • If they decide to take price, do they have pricing power?
  • How much sensitivity is there?
  • Is new unit volume growth coming back?

On December 12th, we wrote that the CMG bottoming process was likely to take several quarters and that we would be more constructive on the stock at $250.  We know that over the past number of years, new unit AUV growth has led the inflection points in revenue growth, which has sequentially decelerated over the last two reported quarters.  Until new unit AUV growth bottoms, we expect top line growth to remain sluggish. 


The ICR XChange posed an opportunity for management to hint at taking price and, as usual, the congregation was more than willing in their acceptance of the myth.  Chipotle has to operate, like everyone else, in the real world.   CPI for Food Away from Home has rolled over and, with the share-of-stomach battle in casual dining heating up, there could be limited upside from here.  We see significant risk to Chipotle’s traffic, which sequentially decelerated from 3Q to 4Q, even with price coming off the menu, if price is raised meaningfully.


Standing on my hands, over 1,000 miles from Miami, those are the points that I think matter for Chipotle’s shares going forward.   The stock ripping yesterday was predictable but we would caution against chasing it unless you can get comfortable with our checklist above.  


Our immediate-term Risk Ranges for Gold, Oil (Brent), Copper, US Dollar, EUR/USD, USD/YEN, UST 10yr Yield, and the S&P500 are now $1644-1691, $109.28-110.83, $3.61-3.71, $79.19-79.98, $1.32-1.34, $88.51-90.27 (oversold), 1.84-1.93%, and 1466-1484, respectively.


Function in disaster; finish in style,


Howard Penney


Stand On Your Hands - hp1


Stand On Your Hands - hp2

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