While IGT's quarter contained two surprises - international sales (bad) and margins (good) - there wasn't a big read through to WMS. We expect an in-line quarter next week.



WMS will report its FQ2 EPS on Tuesday after the close.  Replacements should be sequentially better, margins on product sales should also improve, and the install base for gaming operations should see a small sequential uptick on the back of more new releases.  For more details see below:


We expect WMS to report $202MM of revenues and EPS of $0.45.

  • $128MM of product sales revenues at a 52.5% gross margin
    • NA new shipments of 850 and 3,250 replacement shipments (roughly flat YoY)
      • New units include shipments to Perryville (29% share) and Gun Lake (23-25% share)
    • 2.3k international shipments
    • $16.2k ASP
    • $18.5MM of used machine sales and $6MM of conversion kit sales
    • Our understanding is that with the exception of Europe, the international business has been doing well
  • $74MM of gaming operations revenue at a 79% margin
    • Ending install base of 10,500 units and win per day of $73.40. We expect increases across all categories with the following title launches:
      • % coin in: Great and Power Oz, Monopoly Refresh
      • % net win: Godfather
    • $3.7MM of daily fee, royalties, and other lease revenue
  • Other stuff:
    • R&D: $29.5MM
    • SG&A: $40MM
    • D&A: $16MM
    • Reduced tax rate due to the reinstatement of the R&D tax credit

Shorting VFC: Risk/Reward Good Here

Coming out of last week's meetings w/VFC and it’s competitors, we were not inspired by the story and it’s setup for 2011.  This matches up with Keith’s timing/sizing parameters as the stock is broken on both a TRADE and TREND basis.  VFC short timestamp = $83.44.



Here’s our sense on VFC over three different durations:


Long-term:  It’s hard for anyone to call VFC a bad company. This is not management’s first rodeo. They are pretty darn good at making the right business decisions to manage their portfolio, and then managing expectations accordingly.

The fact of the matter is that over the course of 10 years, VFC has…

  • transformed from a vertically owned/operated capital intensive commodity-based apparel company (ie…underwear, denim) to an outsourced and offshored  portfolio of lifestyle brands that carry significant weight the consumer (ie The North Face, Vans). 
  • printed a growth algorithm of 3-5% sales, 5-6% EBIT, and 9-10% EPS. When you layer on the fact that almost all of the incremental growth came from less capital intensive businesses, we see that RNOA went from 9% to 16% over that same period. That’s not half bad. In fact, it’s clearly above average relative to peers.


I’d argue that we’re at the point of the ROI decision tree where the business will slow organically at the same time we’re seeing severe cost inflation -- -and that’s exactly when VFC will step on the accelerator with acquisitions. We’re already modeling stock repo in our model, so we may have to redistribute the cash to above the line if a deal happens. We also will not give the company a free pass that any deal will be a good one. The industry is at peak margins right now, and valuations do not represent that. VFC knows how to vet a deal, and even they have had their share of disasters (7 for All Mankind). Also, let's not forget that this company's long-term transformation happened when the industry had the biggest milti-year tailwind that it experienced -- ever. 



Intermediate Term

  • Ultimately, with such a diverse portfolio of brands, consumers and channels of distribution, VFC is really a double edged sword. The mix protects them from some downside, but it precludes the company from fully capturing upside in the event of a rebound.
  • In the end, it’s hard to outperform the industry meaningfully when you ARE the industry. Unfortunately, 2011 will be a dark dark year for the apparel industry in the US. VFC may well be able to steer its pricing and inventories better than most, but the biggest risk is what they can’t predict – which is the irrational behavior on the part of competitors as margin is literally sucked out of the supply chain.
  • Bottom line – numbers need to come down for 2011. The Street is at $6.80 for next year vs. $6.30 in 2010. The $6.30 is very doable this year, but this company should consider itself lucky to earn that level again in 2011. Numbers are off by $0.50.



Short Term

  • 4Q10 is the last ‘easy quarter’ revenue and margin compares – which is largely due to growth in company retail (2x the usual revenue recognition) and strength in TNF.
  • This is going to come down to earnings catalysts.
  • Will VFC ‘lower the boom’? on its conference call in a few weeks? I think that there’s a 75% chance of some official guide down, and 25% chance of a BIG one (ie calling for a flat year).
  • Is it in the stock already? With an EBITDA multiple of 8.6x, my vote is No. RL is trading at the same multiple – but the difference is that the Street is LOW by 15% on RL.


Here are some cliff notes from our meetings w VFC at last week’s conference. Some is relevant, some is not. Take it for what it’s worth.



o “We want to own your closet, the whole closet. And, maybe some drawers and shelves as well”

o More than double north face to $3 bil. ‐5 yrs

o Mid march investor day will layout 5 year plans

o International EBIT 200 bps higher than total corp op margin. Lower tax rate abroad helps EPS. Will be 40% of

total in 5 years.

o China $1 bln opportunity

o No single brand fully developed on retail. Vans largest. 67 TNF, grows to 190 globally 5 years

o GM’s will continue to expand in same manner as prior 5 years.

o Spent incremental $100 mm on sg&A in 2010 centered on marketing. Half on tnf and vans.

o 5.6% of total (mktg) was, 5% historically. Will be lower in 2011, to offset margin pressure

o Cash flow: exceed $900 mm, was $850. Acquisitions top priority.

o Focus on outdoor, action sports

o 5mm repurchase in 2010, vs. historical rate of 1‐2mm shares per year.

o May see north of 80 new stores in 2011, incremental comes from international

o Will cut incremental marketing spend from ’10 to offset cost pressures

o Not yet locked in on denim for Fall. Many denim mills still not accepting orders and holding out for more clarity.

o Bought some denim textiles in late ’10, will show up in YE inventories. Small but will help to offset costs.

o Rock and Republic (if successfully closed with courts) will be positioned away from competing with Seven. Likely

goes downstream from super premium.

o All brands taking price, but not all due to cotton.

o Feb 1st will see price increases in denim at retail, at WMT

o Low‐end denim price increase will not fully offset costs

o Expect 10‐15% more cotton to be planted, which may result in substantial price relief by year end.


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In-line bottom line but top line very soft. Despite the talk of shifting focus away from NA replacement market, international product sales missed big in the quarter.


"Our first quarter results are reflective of our focus on improving our profitability and processes.  While consistent top-line growth remains challenging, our internal cost cutting and operational improvement strategies are solidly taking hold.  Based on early customer feedback, we are confident that our recently released games are gaining momentum.  We look forward to better demonstrating our top-line focused initiatives in the second half of this year and beyond."

-Patti Hart, CEO


So much for planning "to further reduce on the North American replacement cycle by taking advantage of ... diverse global revenue sources."  At least based on our model, international product sales were the source of the largest miss.  Domestic product sales were in-line with our expectations, with slightly lower pricing offset by better non-box sales.  However, margins were much better than we expected.  Weaker gaming operations revenue was more than offset by better margins as well.  EPS benefited from the reinstatement of the R&D tax credit and gain on sale of the China LotSynergy to the tune of $0.04.


The good news is clearly gross margins and a lower cost structure.  WHEN the top line turns, there will be significant leverage.  For now, investors can hold on to basically unchanged EPS guidance for fiscal 2011.


  • "Consolidated revenues decreased primarily due to fewer international openings and expansions in the quarter versus last year"
  • Gaming Ops:
    • Revenues decreased primarily due to a reduced installed base
    • Average revenue per unit in F1Q was $50.38, a decrease of $0.48 from F4Q 2010 and $1.13 increase YoY.
    • Gross margins were 63% were positively impacted by the removal of the AL bingo games.
  • Product sales:
    • Recognized 5,000 NA units (3,100 replacements and 1,900 new)
    • Recognized 4,300 International units
  • "The company expects the tax rate to be 36% in each of the next three quarters"


  • Have seen a high level of adoption of server based gaming in high limit areas
  • Center Stage platform is performing well above floor average so far.  Sex in the City has an install base of over 1,800.
  • Continue to see stabilization in gaming operations yields and return to normal seasonal patterns. While the install base is not expected to grow meaningfully this year, they have begun to replace older, lower yielding games which should improve results.
  • Product sale margins were better due to geographic mix and higher % of non-box sales
  • Expect to see SG&A stay around 2010 levels
  • Higher inventory and jackpot payments impacted cash flow from operations.  Inventory was higher due to roll-out of new gaming ops titles.
  • Considering increasing the use of financing to help customers refresh their floors and use more capital to refresh their gaming operations install base
  • Their preference is to use their cash to enhance their market position
  • Reel Edge is in the final stage of approvals and should hit floors soon
  • On the systems side, they installed 8 SbX systems and 7 Advantage systems
  • Updated guidance to $0.79-$0.87 cents for FY2011
  • Expect to see further improvements in their efficiencies


  • "Never any awards for being too aggressive"
  • New guidance includes $0.21 for the F1 quarter 
  • Order sizes were smaller during the last 2 quarters
  • NA ASPs were lower due to them pushing the regular AVPs and not so much on the MLDs front
  • Q: Are they sandbagging on guidance? A: There is still a lot of uncertainty around replacements
  • Reel Edge was the game with the most buzz coming out of G2E
  • WAP has had yields up nicely YoY
  • IL is not in their guidance but there is a little Italy in the guidance
  • Ended Dec with only $20-30MM on their credit facility
  • Non of their other debt is pre-payable so it's expensive to do so right now - but they are looking it at. Their first choice of use of cash is growing their business though.
  • Benefited by about $4MM in interest rate movements this quarter - which was in their gaming operations margins
  • International actually had a really nice quarter according to Patti. Nothing new competition-wise internationally, however, they have deployed more resources which is benefiting them.
  • US competitive environment is fierce

Is Consensus Getting Chinese (or Global) Growth Right?

Conclusion: We think consensus is finally starting to come closer to our bearish estimates with regard to China’s intermediate-term growth outlook. They are, however, not at all bearish enough, as evidenced by the muted reaction to China’s 4Q/December economic data in US equity trading. Global equities will continue to come under increasing pressure as China helps drag down global growth alongside its own domestic moderation. It appears as if US equities will come crashing in to the party late.


Growth Outlook


By now it’s no secret that we think US consensus is wrong on China; we’ve been outwardly bearish on China’s 1H11 growth outlook since 10/21 (see post: “China Sets the World Up for a CRASH”) and the Shanghai Composite is down (-15.3%) since it peaked just over two weeks later. To contrast, over that same duration, the S&P 500 is up +4.6% aided by near-manic hope of a “strengthening US recovery”.


While the merits of that can certainly be debated, what is becoming less contentious by the day is the slope of Chinese growth in 1H11 and perhaps beyond. 4Q10 GDP came in overnight at +9.8% YoY, a +20bps acceleration from 3Q10’s run rate. Chinese officials evidently see this as an intermediate-term top, aiming for +8% GDP growth in 2011 (on top of +4% inflation and +16% money supply expansion (down from around 20% in 2010)), according to a leak from the National Development and Reform Commision.


We also think 4Q10 is an intermediate-term top for Chinese growth because of our outlook for Chinese monetary policy – it’s going to get [much] tighter from here. China’s bond market foresees a similar outcome, as China’s 7-Day Repo rate jumped +347bps since the start of the week, indicating Chinese banks are hoarding cash in anticipation of further rate hikes and reserve requirement hikes.


Is Consensus Getting Chinese (or Global) Growth Right? - 1


Inflation Outlook


China December CPI came in in-line with the whisper number leaked yesterday, slowing from +5.1% YoY to +4.6% YoY; as an aside, the Shanghai Composite closed up +1.8% yesterday on the declaration. Today’s (-2.9%) move in the face of bullish growth data, bullish industrial production data, bullish retail sales data and moderating inflation data tells us investors are still concerned about the prospect for tighter monetary policy in China’s immediate future. They should be. With commodity prices continuing to accelerate on YoY basis and Real 1Y Deposit Rates remaining in negative territory, China’s fight with inflation is far from over.


Is Consensus Getting Chinese (or Global) Growth Right? - 2


Is Consensus Getting Chinese (or Global) Growth Right? - 3


Two inflationary data points that support this outlook are:


Chinese banks are still at it: Chinese lenders have reportedly lent over 1 trillion yuan January to date, according to the 21st Century Business Herald. That would be roughly ~15% more than the trailing 5Y average for the month (871.5 billion yuan) and 200 billion more than the PBOC’s target for the full month. If that’s the case, the PBOC will likely continue increasing bank reserve requirements, now done on a bank-by-bank basis, in their next monthly review. As the chart below shows, credit expansion is crucial to the slope of Chinese growth. That’s not surprising considering that 40-50% of Chinese GDP is Gross Capital Formation.


Is Consensus Getting Chinese (or Global) Growth Right? - 4


Cash surge in 1H11: Maturing central bank bills will flood the Chinese economy with cash in 1H11, adding to liquidity-based inflationary concerns. We’ve seen estimates around 1.2 trillion yuan coming due in 1Q11 and 869 billion yuan due in 2Q11. If that’s the case, the PBOC will either have to raise rates at future bill sells or continue hiking reserve requirements to prevent this influx of cash from filtering through the economy.


Side Effects


Aside from slower growth over the intermediate term brought on by tighter monetary policy aimed at quelling burgeoning inflation, there are other side effects that will negatively impact the Chinese economy.


One key area to watch is how Chinese corporations account for the slowdown in loan-denominated funding; as a result, we expect a shift to greater bond issuance. China’s bond market is relatively illiquid ($3 trillion in size), so a flood of issuance from Chinese corporations could send yields to new heights. To that point, yields on 10Y AAA Chinese corporate bonds have backed up +103bps from last year’s low on August 20th to 5.17% - near a 1Y high; the spread over similar maturity government debt widened +38bps from a 3Y low on November 5th to 119bps. To date, Chinese corporations have issued 91 billion yuan of debt, the most YTD since at least 2005.


No matter how you slice it, the cost of capital is on the rise in China, which will weigh heavily on CapEx-heavy industries and China’s highly speculative property market. Perhaps that’s another reason why growth in Chinese Property Prices has decelerated for the eighth consecutive month in December, slowing to +6.4% YoY from +7.7% YoY in November.


Is Consensus Getting Chinese (or Global) Growth Right? - 5


Chinese equities (and to a lesser extent, many Asian and emerging market equities globally) reflect the pending slowdown in Chinese and global growth; China’s Shanghai Composite is broken from a TRADE and TREND perspective.


Is Consensus Getting Chinese (or Global) Growth Right? - 6




All told, we think consensus is finally starting to come closer to our bearish estimates with regard to China’s intermediate-term growth outlook. They are, however, not at all bearish enough, as evidenced by the muted reaction to China’s 4Q/December economic data in US equity trading. Global equities will continue to come under increasing pressure as China helps drag down global growth alongside its own domestic moderation. It appears as if US equities will come crashing in to the party late.


Darius Dale



We maintain our bearish intermediate-term stance on M and JCP, despite the US Retail hype-gods telling us what they did in early 2008. KM shorting green.



Make no mistake, fundamentally, M and JCP face monumental hurdles in 2011. But here's a near-term factor that we think is driving the stock today. Here's a recap on Levine's note.


On a day where news out of retail land is scarce, the following brief statement/filing appears to be taking the mall anchors for a ride, to the upside:


Dillard's, Inc. (the "Company" or "Dillard's") intends to form a wholly-owned

subsidiary that will seek to operate as a real estate investment trust (the

"REIT"). Dillard's believes the formation of a REIT may enhance its ability to

access debt or preferred stock and thereby enhance its liquidity. It is

intended that various Dillard's entities (the "Dillard's Parties") will

transfer to the REIT interests in certain real properties (the "Properties")

currently owned by the Dillard's Parties, who will lease the Properties back

from the REIT under "triple net" leases.


We’ve been asked a couple of times what is driving the strength in the department store space, mainly Macy’s but it’s hard to ignore the strength in Sears and JC Penney.  Yes, Macy’s was stamped with a “buy” last night from Cramer but this is likely coincidence more than anything else.  The bottom line is the group is trading up in sympathy with speculation that each of this country’s mall anchors could/should employ a similar REIT subsidiary structure.  While in theory this could be viewed as a valid reason to unleash real estate value and separate the “operations” from the “assets” we have to question whether it makes sense for each of these companies.  The key differentiating factor between DDS and the others primarily surrounds the company’s “ruling family”.  The Dilliard’s themselves are still in complete control of DDS with voting rights that comprise 99.4% of the B share super-voting stock (which in turn is entitled to electing two-thirds of the board).  It’s also no secret that the Dillard family has long held interests in real estate (i.e entire malls) that Dillard stores operate in. 


Interestingly the company notes in the filing that they believe this strategy with enhance the company’s access dept or preferred stock markets.  This is clearly financial maneuvering at its best.  To our best knowledge the company is as mature as it gets and really has little true capital (i.e growth) requirements.  In looking at JCP specifically, we know that debt reduction is a company-stated top priority- even surpassing the desire to buyback stock.  So, if access to debt capital markets is a key reason for engaging in such a structure, does this even apply to JCP or the other levered mall-anchors?  Anything is possible for sure, but we’d be surprised to see the others following suit given their unique ownership characteristics as well as wide range of differences between each of the company’s operational strategies.


Eric Levine


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