prev

Gas Prices and the Economy Do Matter

On a valuation basis, regional gaming stocks appear to be in the sweet spot for investors. Buying these stocks at a free cash flow yield of over 15% has historically been profitable. However, now more than ever one must take a macro view when assessing the fundamentals. I'd like to finally put to bed the argument that casino revenues are immune to macro factors such as the economy and changes in gas prices. Through my rigorous statistical process, I've found that regional gaming revenues are indeed tied to changes in gas prices and retail sales. Moreover, that correlation has grown as the industry has matured.

Changes in gas prices and retail sales are both statistically significant variables in explaining the change in regional gaming revenues over the last 7 years and over the last 14 years. I identify regional gaming markets as those that derive the dominant majority of customers from drive-in traffic. These markets include all of the riverboat gaming markets plus New Jersey and Michigan.

T stats for each variable for each period was over 4 (T stat over 2 is generally considered significant). As the following chart shows, changes in gas and retail explained 19% and 34%, respectively, of the change in regional gaming revenues over the two periods. Clearly, the relationship has been stronger in recent years.

So what does all this mean? Since the industry is not as defensive as we once thought, any investment decisions must be accompanied by a macro view. I don't think it means you cannot own any of the regionals. Free cash flow yields are very high and probably discount a lot of the macro issues. While gas is universally high, some economies are better than others. Pinnacle Entertainment (PNK) maintains significant exposure to the oil dependent states of Texas and Louisiana which are performing well, all things considered.

BUDGET DEFICITS = CRAPS FOR CASINOS

State budgets are in crisis yet again. In addition to the usual suspects (NJ and IL) add Nevada to the list. As one of the prime beneficiaries of the housing bubble it's not surprising to see Nevada's economy implode with the housing bust. What New Jersey and Illinois have done with their tax windfalls last go around is a topic for another posting. Regardless of how they got here, the sad truth is these states need to close the gap. Spending cuts are unlikely as usual so look for tax hikes on the politically palatable such as casinos.
  • New Jersey, Illinois, and Nevada lead the way in total dollar deficits projected for 2009. In terms of per capita deficit though, Nevada looks to be in the worst shape, followed closely by New Jersey, then Illinois and surprisingly, Iowa. Considering the recent floods Iowa (and Missouri) might be in even worse shape. Indiana and Louisiana are actually projecting surpluses.
  • Throughout the history of legalized casinos, the states have raised gaming taxes nine times including three times by Illinois. No other state raised taxes more than once. A closer look at the timing of these tax hikes reveals that 7 out of the 9 increases occurred during the last state budgetary crises of 2002-2003. That piece of history doesn't bode well for the industry currently. Whether legislators wish to tackle this issue during an election year or wait until next year will be an interesting follow. In any event, we've got our eyes on this developing trend.

US Market Performance: Week Ended 6/27/08...

Index Performance:

Week Ended 6/27/08:
Dow Jones (4.2%), SP500 (3.0%), Nasdaq (3.8%), Russell 2000 (3.8%)

June 2008 To Date:
Dow Jones (10.2%), SP500 (8.7%), Nasdaq (8.2%), Russell 2000 (6.7%)

Q208' To Date:
Dow Jones (7.4%), SP500 (3.3%), Nasdaq +1.6%, Russell 2000 +1.5%

2008 Year To Date:
Dow Jones (14.4%), SP500 (12.9%), Nasdaq (12.7%), Russell 2000 (8.9%)

real-time alerts

real edge in real-time

This indispensable trading tool is based on a risk management signaling process Hedgeye CEO Keith McCullough developed during his years as a hedge fund manager and continues to refine. Nearly every trading day, you’ll receive Keith’s latest signals - buy, sell, short or cover.

NOT BEARISH ENOUGH? NOT EVEN BEARISH

The Street's lodging estimates need to come down. The only questions in my mind are when (are they going to get it) and by how much. The analysts are still projecting positive EBITDA growth and flat EBITDA margins. Shall we take a look at some of the important factors affecting the lodging industry?
  • Labor Costs - up Commodity Costs - up Energy Costs - up Airfares - up Airline Capacity - down Leisure Travel - down Domestic Economic Growth - stagnant World Economic Growth - slowing With these unhealthy trends where is the Street math? Lodging Analysts' 2009 EBITDA projections - up Lodging Analysts' 2009 EBITDA margins - flat
  • What are you, on dope? Whatever these analysts are smoking should be banned. Sorry for the Fast Times at Ridgemont High reference but it was a good movie. The analysis from my posting last week showed that peak to trough EBITDA margins fell 850 bps during the last cycle. Sure we don't have 9/11 this time but most of the factors above were in much better shape back in 2002. I'm not suggesting we'll see that kind of drop next year but even a 3% drop in margins would be devastating to EBITDA and earnings.
  • Per Reuters, consensus EBITDA projections for HOT, MAR, HST, and OEH show 2009 EBITDA and EPS growing at an average of 9% and 17%, respectively. Despite the factors listed above, these analysts are essentially projecting flat EBITDA margins. In a more likely scenario of a 3% drop in EBITDA margin, EBITDA and EPS would decline an average of 10% and 30%, respectively. These are big deltas from consensus. Look for some new Street math in the coming months.

LEAPFROG: A HOP BACK IN ITS STEP

LF is about to make the turn, and come down the home stretch of its 3 year turnaround. Timing is everything, and now we are staring at a potential horse that's right in the sweet spot of our investment model. The plan was formulated, significant progress achieved, and strong new products are in place. Management is focused but execution remains the outstanding risk. So far, per our sources and channel checks, brand strength among mothers and teachers is unmatched. New product reviews have been encouraging, and purchase orders for over 50% of expected sales volume have already been received. What's left? The big race: commercial success. However, by the time this horse comes to the finish line, big hitters such as Larry Ellison and Mike Milken (43% ownership combined) will have won the Derby - we want to be at the winners circle alongside them.
  • The PlanIn mid-2006 new CEO Jeff Katz outlined his strategy for turning around this once powerful educational toy company. Mr. Katz was founding Chairman and CEO of Orbitz which was built from scratch and in four years generated $300m in revenues. Orbitz was sold to Cendant for $1.25bn. Not bad. Mr. Katz's plan for LF involved streamlining costs and SKU's and cleaning up inventories (phase 1) then implementing a comprehensive effort to develop new platforms and products while phasing out old product lines (phase 2).
  • The ProgressManagement's phase 1 and 2 strategy and execution is quite evident from the first chart. Gross margin began its upward move by 2006 end, only 2Qs following the beginning of Mr. Katz's tenure. SGA ratio, on the contrary, continued to move higher as the LF reinvested heavily in its brand and new products. Both metrics are now moving in the right direction but still allow for significant improvement potential as the second chart displays.
  • The ProductsLF reloaded with a significant arsenal of new products within its core competency of reading solutions, educational gaming and grade school products, and learning toys. The product output is impressive and initial feedback and reviews are positive. Some of products were introduced last year and performed well. Most, however, were released in June. Purchase orders representing 50% of expected new product revenue have already been received. While purchase orders are not necessarily an exact indicator of ultimate revenue, this is clearly a good start. New products could provide half of 2008 revenues.
  • The PotentialThe Potential

Wall Street's Estimates for Asian Growth Need To Come Down!

Suffice to say, the notion that all Asian growth will be linear between 08' and 09' (implying a modest growth slowdown altogether versus the peak 2007 level) is plain silly.

Two questions on these estimates:

1. How much higher than reality will these 08' estimates look 6 months from now?
2. How much lower are the 09' numbers going to be revised as a result?

Inflation is finally consensus. Global Stagflation is not, yet...
KM

(click on table to manify)

investing ideas

Risk Managed Long Term Investing for Pros

Hedgeye CEO Keith McCullough handpicks the “best of the best” long and short ideas delivered to him by our team of over 30 research analysts across myriad sectors.

next