The Cycle of Deflation

Client Talking Points

Deflation Continues

The great commodity bubble brought forth by the monetary policy of the Federal Reserve has popped. Since the "Bernanke Top" of mid-September, commodity prices have come down considerably across the board. The CRB Commodity Index, which measures 19 different commodities, hit a fresh year-to-date low yesterday and can continue that trend quite easily. The fall of oil and ag prices drastically drags down markets (Russia, Korea, etc.) highly levered to commodity prices.

Pain in Spain

Spain continues to drag the European Union down with a slew of bad economic data. No wonder investors are nervous - the country just reported an unemployment rate of 27.2%. That's more than 1 in 4 people out of work. Whether that's by choice of their own is up to the imagination. So what's next? The ECB will likely cut rates again, giving global markets a shot of adrenaline that's welcomed by everyone.

Asset Allocation


Top Long Ideas

Company Ticker Sector Duration

Decent earnings visibility, stabilized market share, and aggressive share repurchases should keep a floor on the stock.  Near-term earnings, potentially big orders from Oregon and South Dakota, and news of proliferating gaming domestically could provide near term catalysts for a stock that trades at only 11x EPS.  We believe that multiple is unsustainably low – and management likely agrees given the buyback – for a company with the balance sheet and strong cash flow as IGT.  Given private equity’s interest in WMS (they lost out to SGMS) – a company similar to IGT that unlike IGT generates little free cash – we wouldn’t rule out a privatizing transaction to realize the inherent value in this company.


With FedEx Express margins at a 30+ year low and 4-7 percentage points behind competitors, the opportunity for effective cost reductions appears significant. FedEx Ground is using its structural advantages to take market share from UPS. FDX competes in a highly consolidated industry with rational pricing. Both the Ground and Express divisions could be separately worth more than FDX’s current market value, in our view.


HOLX remains one of our favorite longer-term fundamental growth companies given growing penetration of its 3D Tomo platform and high leverage to the 2014 Insurance Expansion from the Affordable Care Act.

Three for the Road


"$LINE $LNCO probably closes up today, just because nothing about how these stocks act makes sense to me" -@HedgeyeENERGY


"I have long been of the opinion that if work were such a splendid thing the rich would have kept more of it for themselves." -Bruce Grocott


US Initial Jobless Claims fell 16,000 to 339,000 last week, the lowest level in 5 years.


Systems drove most of the beat but there were a few positive takeaways for IGT.



BYI posted a great quarter last night and expressed its confidence in the future through the announcement of a big stock buyback.  The stock should be up big this am and we continue to like the name for the long-term.  However, after BYI pops on the open, IGT may be the more interesting stock over the near-term.  Much of BYI’s beat was driven by systems which is less important for IGT.  However, some of BYI’s conference call comments gave us more confidence in IGT’s FY2013 and upcoming quarterly earnings announcement.  BYI indicated a large video poker order in the quarter – IGT dominates the video poker segment – and expressed confidence in accelerating replacement demand and improving international orders.  IGT will report FQ2 earnings tonight after the close.


Back to BYI, on the back of record results in its systems business, BYI’s reported a quarter that handily beat consensus and our expectations.  A lower tax rate in the quarter helped offset some “unusual” but unelaborated SG&A expenses as well as a few cents of FX drag. 


In addition to reporting a solid quarter, BYI raised guidance, announced an Accelerated Buyback Program (ala IGT), upsized its share buyback program, and issued an upsizing and extension of their credit facility on more favorable terms.  All-in-all, the business continued to do well and BYI’s management team put their money where their mouths are in reinforcing confidence in the business with an aggressive share repurchase program.




  • Gaming equipment sales came in below our estimate on the back of softer ASPs.  Unit sales were spot in-line with our estimate with NA being slightly better and International coming in a little softer. 
    • BYI shipped more Canadian units than we expected but replacement sales were weaker than we would have thought.  BYI mentioned that there was a large order for video poker replacements that took some capital out of the market.  This bodes well for IGT, which likely got some large video poker orders on the back of some heavy promotions they are running. 
    • Weaker replacements were offset by better market share in new and expansion units
    • We got the impression that international sales should show some signs of a pulse in coming quarters if not next quarter
  • Systems was by far biggest upside surprise in the quarter and based on the commentary on the call it sounds like next quarter will be better with higher margins
  • Gaming operations was slightly ahead of our estimates with upside coming from better WAP placements/yields and what seems to be a lift from Pawn Stars.
  • Other:
    • SG&A:  based on the BYI commentary, the quarter’s $72MM included about $3MM of unusual expenses
    • R&D was higher than we expected
    • The 31% tax rate was below the 36.5% we were modeling
    • We assume that FX losses were in the “Other” expenses
  • We have them at 98 cents for 4Q which is 2 cents above their guidance range
    • That assume growth in systems revenue and margins
    • Improvement in international sales
    • A nice sequential lift in replacement sales
    • Continued growth in WAP placements
    • 2.5MM share reduction from the Accelerated Buyback Program

the macro show

what smart investors watch to win

Hosted by Hedgeye CEO Keith McCullough at 9:00am ET, this special online broadcast offers smart investors and traders of all stripes the sharpest insights and clearest market analysis available on Wall Street.


“Winning is not a sometime thing; it’s an all time thing. You don’t win once in a while, you don’t do things right once in a while, you do them right all the time.  Winning is habit.  Unfortunately, so is losing.”

-Vince Lombardi


Last week I took a few days of vacation and had the opportunity to catch up on some reading.  One of the key books I read last week was, “Top Dog: The Science of Winning and Losing”, by Ashley Merriman and Po Bronson.  As the title suggests, the book is a deep dive into the science behind winning, losing, and competitiveness and has applications that go well beyond athletics.


Last week I was also continuing to enjoy the fact that my alma mater Yale recently won the NCAA ice hockey championships.  To be fair, a NCAA championship, while a big deal to the players, fans and alumni, is a far cry from a gold medal, Stanley Cup, or World Championships.  Nonetheless, it is an example of a team achieving its ultimately goal in a very competitive situation.


Going into the 16 team NCAA hockey tournament, Yale was seeded 15th and a 60:1 underdog according to the Vegas odds makers.  On the path to the championship, Yale also achieved a few things that no team had every done before.  First, they beat three number one seeds (each regional of four teams has a number one seed).  Second, they are the only fourth seed in the Frozen Four to ultimately win.  Clearly, this is an example of a team that overcame significant obstacles to become a champion.


So, what is it that enables some teams to win against extreme odds?  Counter to intuition, team members getting along and being traditional team players is not the key.  In fact according to Merriman and Bronson:


“In the idealized notion of a team, everyone is equal and interchangeable, and this equality drives commitments to the team effort.  But the science argues that the ideal is, if anything, a distraction. The goal is not to live up to the ideal, but to perform.  In real life, teammates are rarely true equals, and they don’t always get along. Having a hierarchy, with its clear divisions of responsibility, is most often the solution to team performance.”


To use economic terms, great teams are usually much more capitalist than socialist.


Now as Keith would say, back to the global macro grind . . .


In terms of global economic statistics, Spain’s unemployment rate is certainly one that signifies that the nation continues to lose economic share.  At a 27.2% rate of unemployment, with an even larger unemployment rate for those new to the work force, Spain is not going to see economic recovery without some help from her teammates.


The key friend to Spain is likely to be ECB President Mario Draghi, especially if he decides to cut rates as he was hired to do.  Luckily for Spain, our quantitative models are also signaling that the ECB is likely to ease again.  Specifically, every major European equity market is now in a bullish formation in our models, expect Russia.  This makes sense as Europe easing would be U.S. dollar bullish, which is negative for the price of oil and Russia is the largest exporter of oil in total barrels per day terms in the world.


Key sovereign debt markets also appear to be signaling some chance of the ECB incrementally easing.  Since the world didn’t end with Cyrpus’ bail under as many market pundits were urging would happen, peripheral yields in Europe have tightened meaningfully.  Despite the aforementioned employment issues, Spain’s 10-year yield is now at 4.38% and Italy’s 10-year yield is now at 4.06%.  As it relates to Italy, this is the lowest yield on the 10-year in more than a year.


Much of the pin action this morning in global equity markets is coming from China.  For those that tuned into our conference call on emerging markets this week, this should be no surprise.  We came into the year bullish on Chinese equities and have reversed that stance based on new data.  The China section in the emerging markets presentation given by my colleague Darius Dale was titled, “Will China Blow?”. Increasingly, this is a very fair question to ask on China.


A key risk or concern over China is whether real estate market prices are in a bubble and whether there is too much debt behind the Chinese real estate market.  In effect, is China about to go through a real estate correction comparable to what the U.S endured starting in 2007?  Some would argue that the high pace of Chinese economic growth inherently supports a rapid increase in real estate values and this is likely true, to a point.


In general, debt and real estate are very much driving Chinese equity markets.  Overnight, the Shanghai Composite closed on its lows as the property subsector once again dramatically underperformed.  This was on the back of a Minister of Taxation official warning that if property prices in second tier cities continue to rise then more property taxes will be implemented.  On one hand, you do have to hand it to Chinese officials attempting to proactively manage bubbles.  On the other hand, the history of government intervention is that governments rarely get things right.


In the Chart of the Day below we’ve highlighted a key slide from the emerging market presentation from earlier this week.  This chart shows the performance of the SP500 and MSCI Emerging Market Index in strong dollar periods and weak dollar periods, respectively.  They key takeaway is that in strong U.S. dollar periods emerging markets underperform dramatically as, among other things, capital flows out of emerging markets.  On the back of this research, we added the emerging markets ETF, EEM, as a short idea on our best ideas list.


Our immediate-term Risk Ranges for Gold, Oil (Brent), US Dollar, USD/YEN, UST 10yr Yield, VIX, and the SP500 are now $1, $97.31-103.34, $82.55-83.44, 97.45-101.36, 1.70-1.76%, 11.33-14.89, and 1, respectively.


Keep your head up, stick on the ice, and keep #winning,


Daryl G. Jones

Director of Research


#Winning - Chart of the Day


#Winning - Virtual Portfolio

Feel The Heat

This note was originally published at 8am on April 11, 2013 for Hedgeye subscribers.

“Energy itself can neither be created nor destroyed, though its many forms can change.”

-Eric Chaisson


That’s pretty much the first law of thermodynamics. The second law is that there is a price that gets paid when forms of energy change – it’s called entropy.


Entropy is also a measure of the disorder (or randomness) of a system… some of these basic thermodynamic ideas date back to 1824, when a young French army officer, Sadi Carnot, sought to understand the rudimentary elements of an ordinary steam engine… engines work because of a temperature difference…” (Cosmic Evolution, pg 17)


In market speak, you might insert words for entropy like “rip” or “meltdown” – but, to me at least, it’s all about the same thing – rates of change. And for those of us who aren’t on the Federal Reserve’s inside information leak-list, I guess that’s the best we can do. Think for ourselves and do our own work in a transparent and accountable way.


Back to the Global Macro Grind


“Literally, thermodynamics means movement of heat” (Chaisson). That’s why I call my rants on Twitter #TweetHeat. And oh were the #PTCs (Professional Top Callers) feeling it yesterday.


No matter what your market views have been for 2013, here we are – at all-time closing highs for the SP500 (+11.3% YTD at 1587). Consumption stocks continue to lead the charge (Healthcare (XLV) +18.82%, Consumer Discretionary (XLY) +13.13%) and Commodities continue to get hammered.


To review our non-consensus bull case for US Growth (and US Consumption Equities):

  1. #StrongDollar continues to make a series of higher-lows and higher-highs (vs its 40yr low in 2011)
  2. #CommodityDeflation continues to make a series of lower-highs and lower-lows (vs their 40yr high in 2011)
  3. US Consumption Growth occurs when the real purchasing power of the US currency rises

Pretty simple really. Wouldn’t it be nice if the President of the United States (either Bush or Obama) A) understood these basic concepts and/or B) had financial advisors who made these fundamentals crystal clear to them instead of focusing on leaking whispers about their spurious economic policy conclusions to the #OldWall?


Sadly, Margaret Thatcher passed away this week. She taught Ronald Reagan a lot about the real purchasing power of a currency and the real impact a political leader can have with her people (trust) by calling out all the conflicted and compromised bureaucrats. She was a patriot. God rest her soul.


We made some sales yesterday (I don’t like buying on green), but what would really get me to change my economic and market views?

  1. If Bernanke debauched the Dollar again

What would happen if Obama let that happen?

  1. Dollar Down = Commodities Up
  2. Commodities Up = Food and Gas Prices Up
  3. Food and Gas Prices Up = US Consumption Growth Down

Again, it’s not that complicated. Really.


What is complicated is comprehending A) Bernanke’s “transparency” model (leaking information selectively? #embarrassing) and B) how he has the “best inflation track record of any central banker since World War II” (that’s what he whined to Senator Bob Corker, under oath, earlier this year after Corker called him the biggest dove in modern history).


Bernanke has been wrong on this growth forecasts at least 70-80% of the time since he took over at the Fed in 2006. Remember, he got the job with his thesis of the “Great Moderation” (he was talking about volatility, after it hit generational lows). Not that he wants to talk about that anymore (his Fed has overseen the Greatest Volatility in US market history).


Maybe we should call his legacy The Great Transparency? Nah. Maybe Obama should put Bernanke on trial. Give the man his fair share already. Please have him explain (with someone who isn’t a market moron asking the questions):


A)     How leaking information selectively = #transparency

B)      How the all-time lows in the US Dollar (2011) = #trust

C)      How the all-time highs in Commodities (2011) = #accountability


To be balanced, the all-time highs for Food Prices (globally) didn’t happen until 2012 (Gold and the CRB index topped in 2011). So there’s still a fighting chance that Bernanke’s final rip to all-time bubble highs comes in either his reputation amongst people who get paid to believe him or in the US Bond market.


Q: (in this order) Housing, Commodities, Gold, Food, Treasuries, and now US Stocks (again). He Who Saw No Inflation at the all-time highs in all of those prices – what does he really see? Or like any un-elected and un-accountable central planner with a confirmation bias, does he see what he wants to see?


What he’s hiding from you is what you really don’t trust. And you shouldn’t. Fortunately, the other side of his storytelling doesn’t cease to exist. The popping of his Commodity Bubble is becoming self evident. That’s a real-time Tax Cut. That’s good. So will be the inevitable leak that you are no longer getting 0% on your hard earned savings account.


Our immediate-term Risk Ranges for Gold, Oil (Brent), Copper, US Dollar, USD/YEN, USD/EUR, UST10yr Yield, VIX and the SP500 are now $1544-1575, $102.39-107.38, $3.29-3.45, $82.24-83.34, 97.62-101.63, $1.27-1.31, 1.71-1.88%, 12.04-14.41, and 1565-1594, respectively.


Best of luck out there today,



Keith R. McCullough
Chief Executive Officer


Feel The Heat - Chart of the Day


Feel The Heat - Virtual Portfolio


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: BYI blew away consensus on the back of record systems revenue which they promise will continue to deliver.  A lower tax rate also helped overcome some one time SG&A costs and FX losses. BYI's new re-upped buyback and ABS program also showed confidence in the company's outlook




  • SAME:  Strong initial performances from recent premium and WAP product launches, including Hot Shot Progressive, Cash Wizard Tiki Magic, and Pawn Stars.  NASCAR WAP debuted last week.  WAP yield was higher in March, relative to January/February.  BYI expects a pickup in WAP sales in the coming quarters.
  • PREVIOUSLY:  With respect to games operations… NASCAR is one of the most anticipated games that should be coming out in the next few months. The Hot Shot Dual Wheel… is an internal brand. We recently introduced a WAP game with a dual wheel, a big cabinet. That has just hit the floors, very small sample size, not statistically significant, but very, very good start… Pawn Stars on the premium segment, we know the reports have been very good from casinos. So overall we feel very good about our product momentum.


  • BETTER:  BYI bought $31 million of stock in F3Q and authorized a new $300 million stock buyback program.  BYI is entering into an accelerated share buyback agreement with JP Morgan today under which it will purchase up to $150 million worth of stock under the new share repurchase program.  BYI will receive 2.5 million shares by the end of April.
  • PREVIOUSLY:  We typically in our guidance assume somewhere in the $15 million to $20 million per quarter buyback. 


  • SAME:  788 VLTs were shipped in F3Q.
  • PREVIOUSLY:  During the quarter, we announced an agreement to provide 650 VLTs to WCLC Canada and expect to begin shipping the initial tranche during the March quarter. With respect to the Atlantic Lottery… somewhere around 1,200 to 1,300 of those shipped, so the remainder of those will likely come into this fiscal year


  • SAME:   International units sales continued to suffer this quarter, but BYI was steadfast that sales should improve as some new products get launched in the coming quarters
  • PREVIOUSLY:  International Games sales have been a disappointment once again… We have multiple product development initiatives currently underway focused on these international markets… We remain confident such efforts will pay off with improved International Games sales in the future.


  • BETTER:  Systems revenue ($71MM) was a quarterly record.  2/3rds of revenue came from existing customers.  Margins will remain 'in the 70s, +/- a couple of % points.'  Systems outlook for FY2014 is even better.
  • PREVIOUSLY:  On the Systems front, we expect fiscal 2013 to be our best year ever with increasingly visible backlog strength for the quarters ahead.

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