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Where There’s Smoke… Notes for the Week Ending Friday, May 29, 2009


Demonic Possession


          Oh yuckola!

                             - Nancy McGinley


Insider trading has long been the hottest of hot buttons at the SEC.  US law defines Insider Trading as trading on the basis of material non-public information.  This means that if you know something that you shouldn't, and you trade on that knowledge, you have broken the law.  People go to jail for this - often over ridiculously small amounts of money.


In practice, the SEC staff take the position that trading while in possession of non-public information is grounds for action.  This means that if the person sitting next to you is secretly in possession of inside information - and scrupulously does not tell anyone - you could go to jail if you innocently trade the securities in question, without any knowledge of your neighbor's information.


This has led firms to erect Chinese Walls, and to create Restricted Lists and Walled-Off Business Units, and to prohibit firm employees or units from trading in the securities of an issuer if any other unit of the firm may be in possession of non-public information.


Firms generally seek to prohibit trading in securities of an issuer if they are aware of an unannounced pending transaction.  This ballooned in the 1990's, when the market in PIPEs heated up and the abuses started piling on thick and fast.  From criminals dumping worthless paper into the markets, to the bankers and brokers who sold the offerings, to the money managers and traders who manipulated the stocks, the scumbag factor in this corner of the market ran quite high. 


Traders who were shown a deal would immediately short it.  Many would then call their friends to short it as well.  Often, the shares were not available for borrow - but the shares would never have to be delivered if the company was driven out of business.  And with the stocks under pressure, the issuers did not have the clout to force the major clearing and prime brokerage firms to call stock for delivery.


Fund managers would blithely call one another and discuss deals, stepping aside to let each other bid on deals, or combining to short the stock in an effort to drive companies out of the marketplace entirely.


One outcome of the PIPEs market was increased employee personal trading surveillance procedures within the industry.  As with every new regulatory requirement, this also spawned an industry of vendors whose products are designed to make the surveillance foolproof. 


Now the SEC has a material non-public information issue of its own, and the personal trading of two of its senior attorneys is under review.  The ongoing investigation is highly confidential.  So much so that the SEC will not release the names of the two staffers involved - but their initials are Glenn Gentry and Nancy McGinley (WSJ 23-24 May, "SEC Slaps Trade Ban On Staff").


We won't opine on a case where we have nothing but the speculation and sensationalism of the news media to go on.  Indeed, it is of little consequence whether Ms. McGinley and Mr. Gentry are exonerated or convicted.  We believe the slipshod SEC will be hard pressed to find a smoking gun.  Even though there appear to be many circumstantially damning emails, the SEC has been abysmally asleep at the switch.  In the absence of clear standards for oversight of employee trading, we would not be surprised to see the individuals exonerated.  The SEC did have a few rules - and the Journal article implies that the lawyers in question followed most of the rules, most of the time.  Mr. Gentry emailed his colleague that he could not do a particular trade because the stock in question had just been restricted for SEC employees.  To his compliant, her response was "Oh yuckola!" 


We suspect even Harry Markopolous would not consider such a communication to be a Smoking Gun.


If these two are indicted on insider trading charges, what should happen to their supervisors at the SEC?  If this were a hedge fund, the partners would be under investigation along with their employees.  An indictment of the traders involved would bring an indictment of those higher up as well, likely leading to a large fine, a consent decree, and possibly a bar.


Meanwhile, the SEC has outlined the steps it will take in the wake of Yuckola-gate.


"The measures the agency is taking include:

  • First, the staff has drafted a set of new internal rules governing securities transactions for all SEC employees that will require preclearance of all trades. It also will, for the first time, prohibit staff trading in the securities of companies under SEC investigation regardless of whether the employee has personal knowledge of the investigation. The rules have been submitted to the federal government's Office of Government Ethics, which approves agency ethics rules.
  • Second, the SEC is contracting with an outside firm to develop a computer compliance system to track, audit and oversee employee securities transactions and financial disclosure in real time.
  • Third, Chairman Schapiro has signed an order consolidating responsibility for oversight of employee securities transactions and financial disclosure reporting within the Ethics Office. And, she has authorized the hiring of a new chief compliance officer."



The requirements of pre-clearance, and the prohibition against trading in the securities of issuers under review by the Commission sound like effective procedures.  All the more so since the SEC is engaging an outside firm to create a computerized surveillance system.


We have seen firms attempt to create their own internal computerized system to track all employee transactions in real time.  There are also vendors whose off-the-shelf packages can be tailored to the firm's use.


All these programs require the electronic input of the daily data feeds from the brokerage firms where the employee accounts are held.  This means a different set up for each broker, which is time consuming.  The bidding process will take some time, and each broker set-up will require scheduling on both the broker end, and at the SEC.  It will likely take six months at least from the time a decision is made to the time the SEC is receiving daily reviewable reports.  Also, the brokers charge for the data feeds, so our taxpayer dollars will be spent to pay E*Trade, Schwab and Merrill to send daily electronic reports to the SEC.


An additional catch at every firm is the Favored Employee.  There are always a small group of employees who are so important to the operation of the enterprise that "we can't tell those guys where to house their personal accounts."  This results in a small number of accounts being held, almost invariably at small brokerage offices that are not even set up for electronic reporting.  And since these are always the most important employees, they are naturally the ones a compliance officer is most interested in.


While this may not be widespread at the SEC, we wonder about individuals in temporary high-level assignments.  The Commission is already contemplating bringing in Wall Street professionals for two-year stints.  Will they be given special treatment?


These electronic surveillance set ups yield the compliance department a daily stream of electronic data about several hundred IRA accounts with an average balance of $12,000.  But Compliance has to check the mailroom every day to see whether a trade confirm has been delivered for the firm's top-producing manager, banker or salesman, who has a seven million dollar account at a three-man shop where this account has been held for the last ten years.


The SEC receives a fair number of items in the mail each day, so it could be the work of several hours to identify the envelope in question, and it is equally likely that it would be overlooked and not found until weeks after the trade.  Prudent compliance officers ask only for monthly statements, precisely to avoid being held responsible for not knowing about trades on T+2, or 3, or 5, or however long it took the mail to be delivered.  Meanwhile, it only takes the Commission making a handful of exceptions for the entire project to collapse.


Is this any way to run a federal agency?  Alas, we already know the answer.


There is one way, and one way only, to make a real-time surveillance program effective, and that is to place all employee accounts at the same broker-dealer and obtain real-time reporting from the broker.  This still leaves it to the employees to actually make the disclosures, but it is the only way to guarantee that you will actually see everything that is disclosed, and see it on time. 


We advise Chairman Shapiro not to employ a methodology that will only work 80% of the time at best - and that, only after it has been installed, retooled, tested and retested.  If we had to guess, it will probably take the SEC two years to see a standardized result, in a reliably repeatable process.  Think of all the damage that can be done in the meantime.  And all that will accomplish is to capture trades in accounts actually disclosed by SEC employees.  It will not prevent abuses.


The SEC never required firms to go beyond accepting the employees' own representations of the existence and nature of outside investments.  We wonder whether a more rigorous standard will be applied to the SEC itself.


The SEC's new compliance officer will need to implement practices the SEC itself has rejected for firms under its oversight.  The Commission will need to run checks on employee Social Security numbers, to identify undisclosed accounts.  The Commission will need to obtain information about each employee's friends and relations.  Compliance officers should know if an employee's college roommate - with whom the employee regularly socializes - is the CFO of a public company whose shares that employee trades actively. 


You might be surprised to learn that most financial firms do not know who their own employees' spouses, parents or siblings are employed by.  Do you know which of your traders or portfolio managers are married to senior executives of public companies?  What you don't know can destroy you. 


We urge Chairman Shapiro to take this to its logical conclusion.  How many stockbrokers were permitted to resign without incident, who then went on to devastate another firm, and another?  This practice resulted in innumerable fraudulent referrals - giving an employee a clean U-5 termination is equivalent to saying there were no problems - all because the managements refused to get involved in the regulatory process.  Is it too much to ask the SEC's Compliance Officer to perform follow-up reviews of former SEC employees, to see what their current involvement is with the industry they were once charged with overseeing?


Clearly, failure to supervise was endemic at the SEC.  There was no system in place for systematically reviewing employee trades - a staggering institutional failure at the federal agency charged with overseeing the investment markets.  To us, the fact that employees were permitted to trade individual equities at all betrays a lack of common sense on the part of the Commission - not to mention a tin ear with respect to public opinion.


Chairman Shapiro had the good fortune to have this come to light so early in her tenure, she will not be touched by the fallout.  Chairman Cox is another matter.  It appears that much of the activity in question happened on his watch.  Still, the details from the WSJ article support the idea that Gentry and McGinley followed the SEC's rules.  The few exceptions appear to have been explainable lapses.  McGinley is reported to have executed over 200 trades in a two-year period.  Add to that the hours she and Gentry allegedly spent in telephone and email communication - and their regular "stock lunches" - they must have spent half their time at the SEC's offices looking for, discussing and executing trades.  It is reasonable to expect that, in their haste to get back to their regulatory work, they might overlook a routine filing or two.


No one at the SEC thought it was important to put in place a system to oversee trading by staffers.  You can't punish someone for breaking a rule that never existed.


No oversight of personal trading by SEC staffers?  Whose idea was that?  Will Chairman Cox be charged with Failure to Supervise? 





On Whose Watch?


Tactics without strategy is the noise before defeat.

              - Sun Tzu


Like the Single Bullet Theory, the Finger of Blame can strike multiple victims in rapid succession, its power undiminished as it ricochets down the corporate hierarchy.  Indeed, it gains momentum in its downward cascade, striking those at the bottom of the heap with greater force than those at the pinnacle.


Such would seem to be the case at Morgan Stanley (Financial Times, 19 May, "Morgan Stanley 'Approved' Citic Trades By Accused Banker").  Morgan banker Du Jun "is at the centre of Hong Kong's highest profile insider trading trial," reports FT.   The well-connected Mr. Du worked in Morgan's fixed income department.  He testified that he was contacted by Morgan investment bankers who wanted to "leverage my relationship" with Citic Resources, a division of China's largest investment conglomerate.  Morgan's hush-hush assignment: to advise Citic on a $1 billion bond offering - and its attendant hedges - to finance the purchase of an oil field in Kazakhstan.  The FT reports that this was "a verbal mandate", which sounds like a way of saying the Chinese government wanted the deal cloaked in plausible deniability.


Well, it's not deniable any longer.  Hong Kong authorities charged Du with acquiring some $11 million worth of Citic Resources shares during a three-month period in 2007 while in the thick of the deal.  Now Hong Kong's highest-visibility securities fraud trial is in full throttle.  Morgan Stanley is on one side and the client - China - while not implicated, can not be feeling the love in this relationship.  One of the world's most important banks is facing one of the world's most important governments.  Yuckola!


As compliance folks, we point out the following procedural matters raised in the FT story.


The Chief Operating Officer of Morgan's fixed income department routinely referred Du's personal trade requests to compliance.  She claims this was because Compliance had access to the watch list, while she did not.  Meaning that she did not personally oversee her senior employee's trades, but kicked responsibility over to administrators outside of her department.


The Compliance Manager who signed off on Du's request thought she was approving his purchase of Citic Pacific, a sister company of Citic Resources.  "That's the only Citic stock I know from my memory," she testified.  Meaning that she never bothered to verify what he was actually buying, or to check with Du's supervisors as to whether this was a permissible trade.


The compliance manager was not aware of Morgan's verbal deal with Citic Resources.  Meaning that the deal was very likely kept hushed up internally, for fear of the Chinese company's plans being leaked.   Meaning it may never have been formally placed on Morgan's restricted list.


And finally, of course, there's the fact that Du Jun even thought of the trade in the first place.


When the compliance manager asked Du directly whether he was "working on anything in particular on this company," he reportedly answered, "it's not my daily job."  Meaning that no one bothered to dig any deeper.


This is a daisy chain of key points where an additional question was not asked, a second-step check was not performed, an assumption was not verified, a supervisor or banker was not contacted.  Nor, apparently, did anyone dig deeper when the size of Du's position started to balloon.  Eleven million dollars is a sizeable investment.  We wonder what Morgan's policy states with respect to large employee positions.


Can it possibly be that the banker did not know he was breaking the law?  Trading in one's personal account in violation of one's duty to the client, and in clear violation of the securities laws, is so blatantly stupid, we wonder what Du could have been thinking.  We suggest getting him together with the senior SEC attorneys who allegedly sent endless streams of emails from their Government computers at the SEC's offices while engaging in high-volume trading on inside information. 


Beyond this, we are open-mouthed at the blind reliance on representation, recollection, and lazy assumption surrounding extremely large trades in the personal account of a senor banker in a sensitive market, and at a firm of the size and visibility of Morgan Stanley.  To say nothing of the effect on their client - China - at making a very public mess over a deal they apparently wanted to pursue in the shadows.


This reminds us of Johnny Carson.  In his opening monologue, he always asked how many in the audience were from out of town.  "Anyone here from Duluth?" he would call out, and there would be a chorus of raucous cheers from five or six folks.  "Did you remember to shut off the gas?" he asked.


Lat note - a cultural aside.  Two years ago our CEO, Keith McCullough, and I attended a meeting with a Chinese trade delegation.  Some twenty regional and central government representatives had come to New York seeking financial partners for an industrial zone in the Chinese interior.  Our General Counsel, speaking fluent Mandarin, explained our investment constraints under US law.  Everything was clear to them, until he came to the concept of information barriers in banking transactions.  Our visitors were baffled by the concept of the Chinese Wall.



Mostly Harmless

Does it worry you that you don't talk any kind of sense?

                   - Hitchhiker's Guide To The Galaxy


Far out in the uncharted backwaters of the unfashionable end of the western spiral arm of the Galaxy lies a small unregarded yellow sun.  Orbiting that sun - although he believes the sun orbits around him - is a bald-headed man with a hyperactive personality and a sense of self-importance so radiant it has attracted the attention of life forms on a gas giant orbiting a binary sun a hundred light years beyond Betelgeuse who, even as you read this, are motoring through the galactic soup in their quest for a reliable way to beat the market. 


When, in Douglas Adams' enduring classic Hitchhiker's Guide To The Galaxy, earthling Arthur Dent reads the entry in the Guide that describes his home planet as "Mostly Harmless", he is devastated that his companion, Ford Prefect, could think of nothing more to say.  It originally said only "harmless," replies his friend.  The word "mostly" was added after further research.


We wonder whether Jim Cramer is having a similar moment as he contemplates the latest academic study of stock picking performance: his stock picking.


Paul J. Bolster and Emery A. Trahan, professors of finance at the Northeastern University College of Business Administration in Boston, ran a hypothetical Cramer portfolio spanning the period from July 2005 to December 2007.  As reported in a NPR spot (22 May, "Study Says Jim Cramer Beat The market - Sort Of") Bolster and Trahan conclude that Cramer beat the market handily during their time frame.  According to InvestmentNews (17 May, "Cramer's 'Harmless'") "  During the course of the study, Mr. Cramer's portfolio had a cumulative return of 31.75%, compared with 18.72% for the Standard and Poor's 500 stock index."


This looks a damn sight better than "harmless" to us.  We have not read the study, but we have also seen references over the past year to "studies" that show that Cramer has created nothing but losses for those who followed his advice.


Finally, posted on yourmoneywatch.com is Cramer's own analysis of his performance.  As of the morning of 28 May it was as follows:


"Jim Cramer's 'Mad Money' Buy Recommendations: Performance Scoreboard - 7/28/05 to 05/27/09 - TOTAL:  1638    WINNERS:  303    LOSERS:  1335    UNCH: 0

Total Portfolio Performance:   +3.71%

DOW  -22.47%     S&P 500  -28.19%     NASDAQ  -21.26%

Bolster and Trahan caution that, in order to attain his returns, Cramer invests in rather more risky vehicles than the average investor would seek out.  As the NPR story says, his returns "come with an asterisk".  They liken it with arriving earlier at one's destination, because one has driven at 100 miles per hour.


We are aware, by the way, of studies showing that the average driving speed in the US has increased substantially in the course of the last ten years, and average distance between cars on the road has gone down dramatically.  This lethal cocktail has been credited with a meaningful increase in traffic deaths, but the conclusion of these studies is that the increase in fatalities is societally acceptable risk.  We think this makes taking outsized shots in the stock market a no-brainer.  Call your broker on your hand-held cell phone to place hat order for the double-down S&P etf while sipping your latte and taking a curve at 90 mph. 


Cramer, of course, also cited Bolster and Trahan - though without the asterisk.  In mentioning the report on his show, Cramer said "It shows that my performance from July 25, 2005, through Dec. 31 of 2007 was... well, excellent!"  How many of Cramer's viewers do you think will bother to read the study itself?  Or even the press about the study?


"Know Your Customer", indeed!  Could it be the Crazy Eddie of Wall Street is onto something?  If nothing else, he's certainly got the Zeitgeist by the Proverbials.




Moshe Silver

Chief Compliance Officer

The Ox Continues To Push Forward


Fresh Chinese PMI data shows that manufacturing activity continues to expand...


Research Edge Portfolio Position: Long CAF


Both the FLP and CLSA Purchasing Manager Indices for May registered in positive territory, with the official measure at 53.10 for the third consecutive positive reading.  The market and media reaction has been enthusiastic since these latest readings continue to confirm that the stimulus measures are working, but the slight sequential decline in the pace of production recovery serves as a reminder to our process: the stimulus itself was a response to crises and, and despite the improving picture, there are still plenty of bumps on the road ahead as the process of jump starting domestic demand continues.  


Official announcements detailing progress on infrastructure projects last week indicate that the rural improvement measures in the central regions are now very well underway, while in recent weeks we have noted the continued signals from domestic automakers and foreign electronic goods exporters showing rising consumer demand. Data released by South Korea's  International Trade Association in recent days also confirms the bullish argument, with exports to China in April increased by 8% for the month improved sequentially on a Y/Y basis to -18.99%. Good numbers, albeit with a slightly moderating pace.  


All data in aggregate continues to suggest that Beijing's stimulus measures are succeeding as planned. There are lots of factors to worry about still, with bad loans fostered by gushing credit and speculative price-inflation pockets in commodity markets being two major ones that we are focused on, but for now the positive momentum remains in place.  


We are long Chinese equities via CAF, and continue to believe that the data arriving from both China and countries that supply it with commodities and production tools confirms strengthening recovery there. We are tactical investors however, and developments on the margin inform our process as we select points of entry and exit.


We will continue change as data and price action dictate; as the pace of the recovery inevitably moderates and the full cost of the stimulus comes to bear we will manage risk accordingly.  That is our discipline -there will never be anything that we own in our virtual portfolio that we would not sell without a moment of hesitation the moment that the facts stop supporting our thesis.      


Andrew Barber



The Ox Continues To Push Forward - cpmi

China's Arithmetic

"It will be helpful if Geithner can show us some arithmetic"
-Yu Yongding
From the lens of a global risk manager, this morning has to be one of the more fascinating that I have ever woken up to. At the same time as the US Government is setting themselves up to announce one of the largest bankruptcies in US corporate history, we have a squirrel hunting US Treasury Secretary telling the Chinese to "trust us" and America's currency. That a boy!
Providing leadership to the world's increasingly interconnected economy is by no means an easy task, and maybe that's why the world is voting against America holding the world's reserve Currency Conch any longer. Timmy Geithner's effectiveness with the Chinese translators overseas this morning is borderline laughable.
There was a time when the Wizards of Wall Street's Oz could fly overseas and make a comment like "we are committed to a strong dollar" and it would actually matter. Rather than getting on a plane and shaking hands with The Client (China) himself, President Obama opted to send the same guy that called the holder of $768B in US Debt "manipulators." Nice!
When it comes to financial market sophistication, other countries aren't as gullible as they used to be. An internet connection and You Tube screen have effectively changed all that. On the heels of Timmy's "reassuring" comments, the US Dollar is getting spanked again, trading down another -0.73% to lower-lows at $78.63. Rather than fading Geithner from my soapbox, now the world is - it's sad.
I understand that this is all doesn't matter yet because someone on CNBC is hopped-up about where the US futures ramped into Friday's close and look here on today's open. That manic behavior really helps America's reputation. At the end of the day, the US stock market could go up another 6% to 9% percent today, and it would still be amongst one of the worst performing stock markets in the world.
The Dollar moving into crisis mode matters. First, all of the REFLATION trades pay themselves out in full. Second, all of the global political capital associated with the almighty Petro-Dollar gets redistributed. And Third, well... rather than analyzing this as the said Great Depression Part Deux... how about another Third Quarter of 2008 in US Equities?
Nah, that's crazy right? Like they say in the Canadian Junior Hockey Leagues, "crazy is as crazy does"!  There are loads of unintended consequences associated with a US Dollar crashing - the only other sustainable break we've seen in the US Dollar Index below the $80 level since 1971 (when Nixon abandoned the gold standard), was that one that led us to that 2008 Third Quarter...
After locking in another +5.3% month for May, the SP500 is up a whopping +1.8% for the YTD. Unlike most global equity markets that are charging to higher-highs this morning, the SP500 is still trading below its January 6th high of 934.
On the heels of another strong, albeit not herculean PMI manufacturing report last night (it decelerated slightly month over month), China's stock market charged to higher-highs, closing up another +3.4%. The Shanghai Composite Index is now +49.5% YTD, and we, as our British philosophy competitor likes to say remain "long of it."
From Hong Kong to Russia, stock markets are up +4 to +6% this morning. Why? Because, much like the ONLY other time we saw the US Dollar break down to these levels, everything that China needs REFLATES. Oil prices and the promises of a potentially empowering Chinese handshake have the Russian Trading System Index (RTSI) up +83% for 2009 to-date. Now that and the price of oil trading up +19% in less than 2-weeks is getting someone paid - and it isn't the American Consumer!
As she trashes her currency, America will continue to lose political capital both domestically and abroad. After all, a -12% three-month swan dive in the US Dollar has hacked over $90 Billion of value from the Chinese position in US Treasuries. Creditors and citizenry hush yourselves! All the while, 17 out of 23 Chinese economists polled are calling holding those Treasuries a "great risk" this morning.
I know, I know... an economist or a billion US Dollars aint what it used to be...
At some point, China's interpretation of the arithmetic is going to really matter.
Best of luck out there this week,


CAF - Morgan Stanley China Fund- A closed-end fund providing exposure to the Shanghai A share market, we use CAF tactically to ride the wave of returning confidence among domestic Chinese investors fed by the stimulus package. To date the Chinese have shown leadership and a proactive response to the global recession, and now their number one priority is to offset contracting external demand with domestic growth.

EWD - iShares Sweden-The country issued a large stimulus package to combat its economic downturn and the central bank has effectively used interest rate cuts to manage its economy. Sweden's sovereign debt holds a strong AAA rating despite Swedish banks being primary lenders to the Baltic states. We expect Sweden to benefit from export demand as global economies heat up.

XLV - SPDR Healthcare-Healthcare looks positive from a TRADE and TREND duration. We've been on the sidelines for the last few months, but bought XLV on a down day on 5/11 to get long the safety trade.

TIP- iShares TIPS - The iShares etf, TIP, which is 90% invested in the inflation protected sector of the US Treasury Market currently offers a compelling yield on TTM basis of 5.89%.  We believe that future inflation expectations are currently mispriced and that TIPS are a compelling way to own yield on an inflation protected basis, especially in the context of our re-flation thesis.

GLD - SPDR GOLD -We bought more gold on 5/5. The inflation protection is what we're long here looking ahead 6-9 months. In the intermediate term, we like the safety trade too.

UUP - U.S. Dollar Index - We believe that the US Dollar is the leading indicator for the US stock market. In the immediate term, what is bad for the US Dollar should be good for the stock market. Longer term, the burgeoning U.S. government debt balance will be negative for the greenback. The Euro is up versus the USD at $1.4235. The USD is down versus the Yen at 94.6600 and down versus the Pound at $1.6393 as of 6am today.

XLU - SPDR Utilities - As long term bond yields breakout to the upside, Utility investments are the relative yield loser. TRADE and TREND remain bullish. We're wrong so far.

EWW - iShares Mexico- We're short Mexico due in part to the repercussions of the media's manic Swine flu fear.  The country's dependence on export revenues is decidedly bearish due to volatility of crude prices and when considering that the country's main oil producer, PEMEX, has substantial debt to pay down and its production capacity has declined since 2004. Additionally, the potential geo-political risks associated with the burgeoning power of regional drug lords signals that the country's economy is under serious duress.


Demand for Las Vegas is indeed elastic.  Drastic room rate cuts have improved visitation sequentially.  The nightlife impact has been noticeable.  In fact, anecdotal evidence suggests that the clubs are actually booming right now.  Unfortunately, that is the only part of the business that is doing well, unless you count crowded buffets.


We know room rates are down.  Lower visitation and gaming spend per visitor have driven down gaming revenues.  Despite the higher club and buffet activity, restaurant covers appear to be way down.  The best explanation I've heard is from a client following his recent visit.  He speculated that younger adults are packing in 4 people to a room and spending what little cash they have on the necessities:  buffet food (optional), club cover charges, and booze.


The following chart shows the departmental profit margin at Las Vegas casino hotels.  The huge margin expansion experienced over the last 15 years has been driven exclusively by Food & Beverage and the Hotel, coinciding with the nationwide housing boom.  Hotel pricing has been under the most pressure and given the falling demand, F&B may very well be too.  We first introduced this chart way back on 06/22/08 with our post, "MEAN MARGIN MEAN REVERSION".  The argument back then was that the most discretionary segments (hotel and F&B) were most at risk and Las Vegas margins had peaked.


FRAT BOYS AND LAS VEGAS - LV departmental profit margins 


The key then and now is housing and the wealth effect.  Housing was already falling throughout most of 2008 and with a little statistical analysis we showed that rising housing prices were the number one macro driver of the gaming boom over the last 15 years.  Housing prices are still falling and I'm not sure the housing related wealth decline has reached its full impact on consumer spending.  The 4% national savings rate is high by the standards set during the housing boom, but very low relative to the high single digit rate averaged during the pre-1995 period.


Las Vegas was a prime beneficiary of the housing bubble both in terms of pricing and margins.  Anyone who has consistently visited the city over the last decade can attest to the price inflation.  I certainly can.  Hotel rates and F&B pricing used to be "loss leaders".  They may soon be again.

TIF: Lux stinks, but TIF may have bottomed financially

In looking at Tiffany's 1st quarter results there were no big surprises.  Sales, margins, and expenses were all largely in-line with expectations.  EPS was $0.20, a penny below the Street, but that really shouldn't matter at this point.  This is a quarter to tuck away and forget about.  Domestic same-store sales declined by 34%, a combination of a 42% decline in the NY flagship and a 32% decline for the remainder of the US.   Anyone paying attention to the luxury segment and other big-ticket discretionary categories should not be surprised by such large declines.   Instead, we're focusing on a few subtle changes on the margin that came out of the quarter.


  • 73% of TIF's EBIT comes from the US and Japan and we're encouraged to see an uptick in the sales trend in these markets. It's always risky to call an exact bottom, but this certainly looks like one to us.


  • With just under 50% of Tiffany's products containing a diamond of some sort, it is worth noting that diamond pricing has reversed dramatically in the past 6 months. We are now back to pricing levels of a couple of years ago. It will take some time for inventory turns to work through higher cost raw materials, but this reversal should help gross margins at the end of 2009 and throughout 2010.


  • The recent and severe weakening of the U.S dollar should help TIF in the near-term, beyond the Street expectations. Let's be clear - the Dollar crashing does not end well for any of us, and we are not expecting tourists to return to 5th Avenue in droves, but this trend should help mitigate the fairly large FX translation impact we saw in 1Q.


  • Consolidation has been a key theme of ours and the high-end jewelry market is a great example. With few national brands, if any that compare to Tiffany, there has been an increasing wave of store closures and bankruptcies. Inherent in the jewelry business is a high cost to fund inventory and only those with strong balance sheets will survive.


  • Lastly, TIF's triangulation of sales, margins and inventories are improving on the margin. Check out the SIGMA chart below. 1Q is sitting in the lower left quadrant, and it is unlikely it will remain there for more than 1 more quarter. ANY move out of that quadrant is a positive stock move.


By no means are we out of the woods on the challenges facing the luxury retailer and consumer.  In addition, we're not particular fans of the TIF business model (low margins and high inventory carrying costs). However, there is an increasing amount of certainty surrounding Tiffany.  In our view the brand remains iconic in stature, expenses are being managed wisely and investments in the future remain in place where appropriate (store growth will be up 5-6% in '09).   Importantly, management remains true to the brand and hasn't conformed to the environment.  Has anyone seen the case of clearance engagement rings? 


Eric Levine


TIF: Lux stinks, but TIF may have bottomed financially - TIF Comp Trends


TIF: Lux stinks, but TIF may have bottomed financially - TIF commodity prices


TIF: Lux stinks, but TIF may have bottomed financially - TIF SIGMA


Jack Lam, an accomplished junket operator, opened a VIP operation earlier this year at the Mandarin Oriental hotel in Macau under the Stanley Ho umbrella.  By all accounts, Mr. Lam has been successful.  We've heard he may have done almost $1 billion in VIP turnover in April alone.  We've also heard that he could be retaining a commission of 1.4%, well above the much discussed "cap" of 1.25% and certainly even more above the rate Wynn Macau is likely paying him for his VIP room at that property.


With those respective economics, it should be pretty clear where Lam's priorities are.  As can be seen in the following chart, Wynn Macau's market share began falling in February, and more rapidly in March and April.  Some of the market share loss in April can be attributed to lower hold percentage.  However, considering Lam's success at the Mandarin, most of Wynn's VIP market share loss is probably sustainable.  Every 1% of VIP market share represents approximately $80 million annually in revenues or and $15-17 million in EBITDA.


WYNN MACAU MARKET SHARE ON THE LAM - wynn macau market share 


On the Mass Market side, Wynn Macau's market share has fluctuated but the trend is pretty flat.  However, that will likely change for the worse as well.  City of Dreams opens on Monday with a high end Mass Market target market.  This segment is Wynn's power alley.  CoD is unabashedly going after the core Wynn customer.  Wynn is the better operator but with visa restrictions in place, at least for a few more months, the Mass Market is unlikely to grow enough to offset the 17% capacity addition.  Wynn could be the prime casualty.

Hedgeye Statistics

The total percentage of successful long and short trading signals since the inception of Real-Time Alerts in August of 2008.

  • LONG SIGNALS 80.37%
  • SHORT SIGNALS 78.32%