Cannibalization is a big risk for the MGM Strip properties. The Bellagio/Mirage history is instructive. CC may do well but it probably won’t grow the market enough to push up Strip ADR as projected by the Street.



MGM management sure is projecting an aura of positivity when it comes to 2010 in Las Vegas.  “Strip room supply growth next year is only 5%.”  “The back half of 2010 looks strong.”  "MGM room rate premium will continue to grow in 2010.”  I’m paraphrasing but these are generally the comments I’ve heard.  The problem is that none of these comments give me comfort that 1) there won’t be serious cannibalization from CityCenter next year, 2) RevPAR won’t be down, 3) the Street’s MGM projections are not too high, 4) the increase in premium room supply isn't more like 57% (see "PLENTY OF ROOM AT THE STRIP INN IN 2010" 07/17/09) and 5) the first quarter isn’t under pressure already.  Never mind that no Vegas operator ever has visibility beyond the next quarter and certainly not into the back half of the next year.


MGM should be commended for its balance sheet work this year (although they did get themselves into this mess).  However, there is still a lot more work to do given the funding gap and debt maturities over the next two years.   So anything they say must be taken with a grain of salt.  We’ve seen this rerun before.  I’d prefer to look at the data, both anecdotal and historical.


CityCenter opens on December 16th.  Yes, the property only increases Strip room supply by only 5%.  This is misleading because CityCenter will open with 5,900 rooms at “premium” pricing.  Some of those rooms may or not set the price ceiling (MGM management thinks so) but combined they will increase the Premium room supply by 30%.  See the chart below.  Who is most at risk?  MGM is, of course, with 34k Strip rooms before CityCenter even opens.



Anecdotally, we’ve been hearing Aria and Vdara average daily rates may come in below $160 for January, well below our estimate of $225.  Moreover, in direct contrast to management’s assertion that Aria is pricing above Bellagio 80% of the time, our room rate survey prices Bellagio slightly above Aria in January.  Our recent conversations with industry participants indicate that the Strip in general is under pressure in January.


So the supply/demand and market exposure pictures are not too appealing for MGM and the anecdotal suggests a tough start to 2010.  What does history show us?  We dusted off our old Mirage Resorts model and discovered that The Mirage took a big hit from the Bellagio punch.  As shown in the following chart, The Mirage experienced a 32% hit to EBITDA in the quarter that Bellagio (Q4 1998) opened.  For the four quarters following Bellagio’s opening, EBITDA at The Mirage fell less, -24% which was still severe, but included a quarter with significantly higher hold percentage.  Even Treasure Island was cannibalized as its EBITDA fell 27% in Q4 1998.  This suggests that Bellagio, Mirage, Mandalay Bay, and MGM Grand could all be under pressure from CityCenter.



Surely, the cannibalization is captured in Street estimates?  Not so fast.  The consensus 2010 EBITDA estimate for Bellagio is north of $300 million, up from 2009’s $297 million.  With history as a guide, the huge supply addition right in Bellagio’s sweet spot, and the anecdotal feedback discussed above, this seems highly unlikely.  As shown in the following chart, we are projecting Bellagio EBITDA of only $236 million, approximately 20% below our 2009 estimate.  For all of MGM’s LV properties excluding CityCenter, the EBITDA projection is $1.13 billion, UP 7% from the 2009 projection.  We fear the Street is falling into the old trap of projecting a quick recovery after a bad year.  “It can’t be worse than this year.”  Supply growth be damned. 




High-end gaming is a wild card and whether Aria can grow that segment where Bellagio failed in 1 will be key to suppressing cannibalization.  The room side is more predictable.  It looks bad for MGM.  Excluding CityCenter, every $5 move in Las Vegas ADR moves the company-wide EBITDA needle by approximately $55 million, or 4% of total projected 2010 EBITDA.  Including CityCenter, the impact from our estimate would be $60 million.

Natural Gas Storage Update: Ever Is A Long Time

We’ve been somewhat silent on natural gas in terms of the virtual portfolio this year.  On the long side, we’ve been focused on those commodities that are global and priced in U.S. dollars – copper, oil, and gold.  Natural gas is a local market and, therefore is priced based on local supply and demand dynamics.


We were reviewing the weekly reports this morning from the Energy Information Administration and wanted to highlight one point relating to storage.  There is currently more natural gas in storage in the domestic United States than there has ever been.  And ever, as they say, is a long time.  This point is highlighted in the chart below.


Technically it is not ever, but only as long as the data goes back, which is to 1994.  As of November 13th, there were 3,833 Bcf in storage, which is the largest storage number recorded since the EIA began keeping the data and, obviously, well above the five year trend.    This also represents a 10.0% YoY increase.


Obviously, what ultimately matters is the next data point and if we could make the case that storage will begin to decline, we could, on the margin, get more positive.  Unfortunately, recent data points from large producers suggests just the opposite.  Chesapeake Energy provided an operational update on October 29 and stated:


“For the 2009 third quarter, daily production averaged 2.483 billion cubic feet of natural gas equivalent (bcfe), an increase of 30 million cubic feet of natural gas equivalent (mmcfe), or 1%, over the 2.453 bcfe produced per day in the 2009 second quarter and an increase of 162 mmcfe, or 7%, over the 2.321 bcfe produced per day in the 2008 third quarter. Adjusted for the company’s voluntary production curtailments due to low natural gas prices and involuntary production curtailments due to pipeline repairs (which together averaged approximately 45 mmcfe per day during the 2009 third quarter), the company’s 2009 and third and fourth quarter 2008 volumetric production payment transactions (which combined averaged approximately 125 mmcfe per day during the 2009 third quarter) and the estimated impact from various divestitures (which would have averaged approximately 105 mmcfe per day during the 2009 third quarter), Chesapeake’s sequential and year-over-year production growth rates would have been 2% and 14%, respectively, after making similar adjustments to prior quarters.”


The company currently produces 2.286 bcf/day and operates 105 rigs.  In terms of national rig activity, Chesapeake is currently operating 14.4% of all active rigs in the United States and is estimated to be the largest domestic natural gas producer.  Clearly, the decline in rig activity we have seen year-to-date will have an impact on future production, but with storage at all time highs and the country’s largest producer, Chesapeake, forecasting 7% y-o-y production growth for Q3 (which would have been 14% if it hadn’t been for curtailments), it is difficult to be overly bullish on price with these production and storage overhangs.


Daryl G. Jones
Managing Director


Natural Gas Storage Update: Ever Is A Long Time - UNG Storage3


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Topping Off

Research Edge Position: Short UK (EWU)


We’ll let the data from the manufacturing and services Purchase Managers’ Index of the Eurozone, Germany and France speak for itself (see chart below). Suffice it to say we’ve been calling for a sequential slowing in fundamentals across the continent, which we expect to continue into 2010; November’s PMI reading, while improving across the region and for the region’s largest economies, Germany and France, is showing signs of slowing.


Matthew Hedrick



Topping Off - pmi


GPS: Reverting Back to a Simple One Factor Debate

GPS: Reverting Back to a Simple One Factor Debate


At this critical time of year for all retailers, GPS has but one factor we’re keeping an eye on.  The re-emergence of the Gap brand is key to the next leg of the story.  Can TV and better merchandising drive positive same-store sales?  We can’t be sure either way, but that’s where the debate is centered.


Over the past year or so we’ve gotten many questions about GPS and the sustainability of the company’s turnaround.  There is no doubt along the way we underestimated management’s ability to put in place a sustainable, multi-year cost cutting plan, inventory reductions, and substantial product cost savings.  Despite the profit improvements, sales have continued to decline.  Although, more recently Old Navy is certainly showing signs of positive momentum. 


GPS: Reverting Back to a Simple One Factor Debate - GPS 2 yr


All these efforts have resulted in a very consistent and respectable EBIT margin just shy of  12%.  In the absence of any real growth (square footage is pretty much flat) and with a substantial war chest of cash (no debt) on the balance sheet of $2 billion, the company is a cash generating cow.  Putting sales momentum aside, stable EBIT margins and a limited growth profile basically means GPS can produce $1.4-$1.6 billion in free cash flow annually.  And while there is still some skepticism as to how long this cash flow generation and exceptional EBIT control can continue in the absence of a topline pick up, the past three years should act as a pretty good base for which to judge the limited volatility in the company’s earnings stream.


With that said, GPS is now a critical point from a sentiment standpoint.  The turnaround is largely complete on the cost side.  The inventories have been cut dramatically along with $700 million in SG&A expenses that are now permanently removed from the P&L.  The company is moving to offense from defense.  There is simply very little “addition by subtraction” left in the model, and as such investments will need to be made to drive the next leg of the story.


This is where it gets a bit less quantitative and bit more qualitative.  The single biggest issue/topic/focus facing GPS the company and the shares is the ability of management to drive same-store sales back into positive territory.  The recent resurgence in positive momentum at Old Navy is clearly a positive first step in the process.  Merchandising, pricing, and marketing changes are all yielding positive results at a time when “value” means more to consumer than ever. The timing couldn’t be better as Old Navy regains its leadership in the world of low priced apparel/accessories sales with a fashion twist.  Product cost improvements (whether it be company or market driven benefits) are allowing Old Navy to take improved profits to the bottom line while at the same time taking unit sales up.  This is the ultimate recipe for success and sustained improvement, especially in the absence of a major consumer-led recovery.


But what about Gap, the brand?  This is where the risk/reward lies.  After years of fixing and cutting, it’s now crunch time.  The next leg of the story hinges on Gap’s effort to reemerge with relevance, which will ultimately determine whether or not those comps finally turn positive.  A lot is hinging on the company’s marketing plans for this holiday with the company’s return to TV for the first time in a few years.  The real test here is whether the marketing message and merchandise is enough to make the brand relevant (and ultimately much more profitable) again.  This is just the beginning of the process and the answer is unfortunately not known at this point.  Old Navy’s recent turn suggests that there is potential here, but the brand has been losing share for years.  On the risk side, these incremental marketing efforts are somewhat contained (y/y spend is forecast to be up an incremental $45 million this 4Q) which means there is no reason to be concerned that management has suddenly gone on a spending spree. 


However, the real concern is what if this effort doesn’t work?  Access to capital is not the problem with GPS.  It’s truly the ability of Gap brand management to reinvigorate a brand that has now produced 5 years of negative same store sales in a row.  I’d argue that even some moderate success is enough to keep investors interested.  The leverage is substantial if productivity per foot can begin to rise again.  The debate though, is now relegated to a simple one factor discussion, and unfortunately for some this debate is rooted in denim and wovens and “Holiday Cheer” and no longer in expense cutting and sourcing benefits.  This makes some investors uncomfortable.  Talking product is not what most investors like to do.  Ask McGough if Fair Isle sweaters are in this season and you’ll see what I mean.


All eyes are on the holiday for sure.  But in Gap’s case, the eyes are keenly focused on TV.  November same store sales will give a glimpse of the new marketing effort’s success, but December will be the true tell tale sign.  If results are positive, then there is likely a good reason to believe there are legs to the story.  If it’s a huge flop, then it’s back to the drawing board for management and all eyes revert back to cash flow generation and preservation.  In the near term though, there is now simply one thing to watch.


GPS: Reverting Back to a Simple One Factor Debate - GPS SIGMA



Chart of The Week: Unsustainable and Unreasonable

It is funny listening to people justify why they’d hold short term US Treasury Debt at these yields (i.e. negative real yields). Funny because any student of economic history will recall that this storytelling rhymes with what American stock and bond market investors thought heading into the waning days of 1938 (the stock market closed up +25% that year; as of today, the SP500 is up almost +22%).


In the Chart of The Week, Matt Hedrick and I show the context of free moneys. If you go all the way back to 1938, you’ll find a very representative period where an American President figured out the power of both currency devaluation and reflation, and abused it.


Yields on short term Treasuries have not been this low since the 2nd leg of the 1930’s economic Depression. Many economic historians blame the bear market in stocks from 1 on the Federal Reserve “raising rates.” I disagree. I blame it on the US Government pandering to the political wind of keeping rates unsustainably low for an unreasonable length of time.


*Note to Fed Heads who currently think Japanese on the perpetual policy front of issuing ZERO rates of return for both their creditors and citizenry alike: “exceptional and extended” is UNSUSTAINABLE and UNREASONABLE – for we, the citizenry of savers and risk takers, that is.


Yes, the math of pending equity returns works is in reverse relative to the duration that governments keep Piggy Bankers at the trough (borrowing short and lending long).


Again, in capitalism speak:

  1. Exceptional = ZERO rate of return
  2. Extended = widened duration

The longer you stay “exceptionally low for an extended period of time” (1938 or 2009), the more unreasonable it is to assume that the next move in rates (UP) is going to create a sustainable economic recovery.


If you disagree with everything I am writing, that’s fine. Most “economists” who didn’t call the 2008 stock market crash didn’t agree with me that plummeting US Dollars and Treasury yields were a leading indicator of negative equity returns to come either.


Look at this chart below again, then pull it back to 1938, and look at it again.




Unless we sign off on making the USA a glossier version of Japan, the next big move in short term rates is up. This is as low as we can go. There is a bubble in short term US Treasuries that’s getting ready to pop.



Keith R. McCullough
Chief Executive Officer


Chart of The Week: Unsustainable and Unreasonable  - 2Y


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