The two Cotai powers colluding to control runaway commission expenses sounds good on the surface.  Cotai versus the peninsula is a battle that started with the opening of City of Dreams on June 1st.  It does make sense for Venetian and CoD to continue to work together and commissions are an obvious place to start.  After looking at the June data and July so far, Cotai is clearly winning the battle.

One issue with self-regulating commission rates is that the other players probably won't follow the cut.  Is Jack Lam going to reduce his commission at the Mandarin from a very lucrative 1.40-1.45%?  I doubt it.  Given the competitiveness in the VIP segment, pricing is a key variable.  Junkets can easily bring their customers to the higher commission casinos.  The second problem is the lack of transparency in junket commission rates.  It's good PR to announce a commission reduction, but will CoD know that Venetian is cheating and vice versa?  Will Venetian know if CoD is making other concessions to the junkets that don't show up in the official junket rate?

Even a government enacted commission cap would be difficult to enforce.  The operators have been expecting government action since late last year and still nothing has been enacted.  We are skeptical of any government action until at least late 2009 when the new Chief Executive takes over.

We continue to believe there is upside in both MPEL and LVS for different reasons, none of which involve commission caps.  For MPEL, the incremental news flow should be positive as CoD continues to ramp.  For LVS, Macau margins could look much better than expected as drastic headcount reductions and numerous one-time expenses will improve "ongoing" margins.


Research Edge Portfolio Position: Long CAF

The staggering 28.4 % year over year increase in June M2 data released by the PBOC today took a back seat  in the media to the news that foreign currency reserves have topped $2 trillion (see charts below).  For the US, this data means that China will continue to buy treasuries. For China this data may mean that more speculative money is flowing into already extended markets.

HOT MONEY - barb1

HOT MONEY - barb2

By all measures the liquidity sloshing through the system is having a pronounced effect, and concerns over the negative impact of these easy money policies are beginning to loom ever larger. With no clear indication that regulators are moving rapidly enough to fully reign in speculative asset bubbles or that any capital injections are being planned for AMCs in order to handle fresh "special mention" loans there is real concern among observers on the ground that there is not enough being done by authorities to prepare for the pain in the pipeline.

From our perspective, the issue is fundamental: China's stimulus program was and is an attempt to buy growth -and growth is always very expensive to purchase. If data shows that internal demand is broadening -in other words that that consumers are buying more than just replacement trucks and vans with government tax rebates and factories are turning out more than just girders and beams for state infrastructure projects, then these measures will likely prove worthwhile despite the negative impact of the inevitable defaults and popping bubbles.

Bullish for the economy in the longer term, but underscoring the risk of correction in the equity and real estate markets in the near term, today's data leaves us with many unanswered questions. In the coming days we will receive Q2 GDP and Industrial Output data that will provide us with more solid answers.

Andrew Barber


Early Look

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When looking at Europe we've cautioned against reading too much into aggregate EU/Eurozone data as we believe markets there are often uncorrelated and influenced by varied underlying fundamentals.  Today's report from EuroStat estimated that June inflation in the Eurozone fell 0.1% from a year earlier will give investors a general metric of guidance for Europe, yet the averaged number misses the mark for further understanding the divergence between economies.

One important take-away from today's report is that, as with the US, energy was a major driver -down by 11.8% Y/Y in this latest reading. The deflationary pull from energy should come as no great surprise based on last year's spiking oil price. Core inflation, which excludes energy and food prices, slipped to 1.4% on an annual basis, from 1.5% in May. Conversely, total CPI rose on a monthly basis 0.2%.

This year we've held the position that countries with economic leverage will outperform those with financial leverage. Sticking to inflation, we're seeing countries with financial leverage (think loan leverage combined with a real estate bust in Ireland and Spain) see measured deflationary pressure on an annual basis (Ireland -2.2% and Spain -1.0), whereas Germany, a country we've been bullish on due in part to its fiscal conservatism, posted annual inflation at 0.0%, a level we believe is healthy on a relative basis as the country works through the constraints of reduced export demand.  In contrast we see disinflationary pressure in the UK (outside the Eurozone) on an annual basis, with CPI at 1.8%, from 2.2% in May.

In an environment in which output and wages have decline greatly, with soaring unemployment rates and credit tightening, we're likely to see deflationary pressure continue in the immediate term through much of the Eurozone. June's retail sales number declined for the 13th consecutive month; it's clear that retailers are lowering price to move inventory while consumers have tightened spending and are anticipating lower prices going forward. 

We'll continue to monitor the patient on an individual country basis, while recognizing the importance of the collective health of the EU for individual countries.

Matthew Hedrick



June CPI was released today, with the index registering at an increase of 0.7% for the month versus 0.1% in May with a 17% increase in gasoline costs as the primary driver of the broad sequential increase.  Make no mistake; this is having an impact on the consumer: gas prices and interest rates are up, confidence is down and that is the reality of our current situation.

Regardless of reality, year-over-year numbers are where we need to remain focused because that is where it becomes a "political" football and will ultimately impact the market.  The CPI was reported down 1.4% Y/Y today -a modest sequential rise from last month when we saw the worst number since 1955. Reality vs. politics:  what would be an increasing inflationary measure on an absolute or monthly basis becomes a deflationary figure when measured year-over-year basis and that means that rates will stay at zero for the foreseeable future as Bernanke & Co. keep the free money train rolling. 

We have been making the call that the CPI numbers will go positive in Q4, and that that will represent a return of true inflation which it looks increasingly likely that the Fed will not be prepared for. Right now we are experiencing REFLATION which is just taking us from one point to the next.  As I look at my screen right now the REFLATION trade is alive and well; the Dollar is down and the best performing sectors are Financials (XLF), Energy (XLE) and Materials (XLB). 

We are still looking at a "politicized" short end of the yield curve.  The FED right now has no choice but to be the "deflation fighter."  Next week, when Chairman Bernanke is in front of the politicians, he can't very well tell them that he sees inflation coming in Q4.  

What does all of this mean?

  • (1) We will have an inspirational yield curve - the FED will keep rates at ZERO longer!
  • (2) Rates are not going to stay there forever!

Howard Penney

Managing Director


YUM - Not Making Any Real Changes, Despite Slower Sales

Earlier today, I highlighted the fact that YUM was trading down despite it having beat 2Q EPS expectations and how this marked a change in pattern to how the restaurant names have been trading following quarterly earnings. For the most part, restaurant companies have been posting better than expected bottom line numbers by cutting costs to offset soft revenue trends, and their stocks have been rewarded. I think a couple of things are at play here:

1.) Investors have become accustomed to revenue misses from the casual dining operators and other restaurants in this more challenging environment, but this was the first significant same-store sales miss for YUM's China and YRI businesses, forcing YUM to take down FY comparable sales guidance.

2.) Financial engineering helped YUM to offset its weaker than expected top-line results (a lower tax rate and lower share count).

Relative to how other restaurant names have traded, I think the second point is the more important one as we have seen a lot of companies offset soft sales trends with significant cost cutting. These reduced cost structures, however, have created more operating leverage and stemmed from increased labor efficiencies and G&A savings. These companies have made real changes to how they operate their businesses and the benefit of the savings will continue to be realized going forward. A significant portion of the cost reductions have resulted from slowing new unit growth.

YUM, on the other hand, is maintaining its full-year 10% EPS growth guidance despite lowering its same-store targets as a result of a lower tax rate, a less negative foreign currency impact and improved restaurant margins in China and the U.S., largely as a result of more commodity deflation than initially anticipated. None of these earnings drivers is sustainable. YUM is not offsetting its top-line weakness by making significant changes to its operating model.

YUM is targeting $60 million in G&A savings in the U.S. but even with these cost savings, YUM had to take down its U.S. operating profit growth target to up high single digits from about 15%. In the U.S., YUM is taking real costs out of the business, primarily as a result of its refranchising strategy, but these cost reductions are not enough to offset the same-store sales shortfall. This is a big difference relative to what we have been hearing from other restaurant companies.

I have been saying for a couple of quarters now that YUM is growing too fast, particularly in China and YRI. This rapid growth will make it difficult for YUM to reduce costs and could prove a challenge to margins should sales deteriorate further.

YUM's CEO David Novak closed the call by saying that he is fixated on 3 shareholder value drivers: first, driving new unit growth; second, improving same-store sales and third, being the industry leader in return on invested capital. He highlighted the fact that the company has the most work to do around growing same-store sales. I would argue that YUM's sustainability and returns would improve dramatically if the company focused on fixing same-store sales first and growing new units second.

YUM - Not Making Any Real Changes, Despite Slower Sales - YUM 2Q09 EBIT

YUM - Not Making Any Real Changes, Despite Slower Sales - YUM 2Q09 CFFO



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