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US STRATEGY – KEEPING THE DREAM ALIVE

On Monday the market was higher across the board on DEAD volume.  The S&P 500 rose 1.4% (in line with the NASDAQ), while the higher beta Russell 2000 rose 1.7%.  Overall, this was the first up day of the last four as a 0.75% decline in the Dollar Index provided a tailwind for the equity market.

 

The MACRO calendar put the housing RECOVERY theme back in play.  After a series of disappointing headlines last week, existing home sales jumped 10.1% month-over-month in October to an annualized 6.1M units.  This represents the highest level since February of 2007. In addition, month's supply fell to 7 in October from 8 in September, with total inventory down 3.7% from September's levels.   From an equity perspective, with the exception of DRH, there was no follow through as most of the homebuilders finished lower yesterday; the extension of the homebuyer tax credit is only a temporary band aid to the issues facing the housing market.

 

Today’s MACRO calendar is full with a GDP revision at 8:30am (consensus is looking for 2.8%), followed by Case-Shiller at 9:00am (consensus is looking for -9.1%) and consumer confidence at 10:00am (consensus is looking for 47.5). 

 

On Monday, the VIX declined 4.6% and has now declined 7.6% over the past week.  Yesterday we bought the VXX.  Now that the market is hitting its YTD high it is as good a time as we have seen all year to buy some volatility. Our oversold line for the VIX is 21.03.

 

Every sector was up on Monday, but only three sectors outperformed the S&P 500 – Industrials (XLI), Technology (XLK) and Financials (XLF).  The best performing sector was the XLI, up 1.8%.   GE led the XLI higher by 2.8% yesterday.  Within the XLF, the banking group was one of the best performing subsectors.  The regional names were among the best performers as ZION rose +12.5%, STI up 5% and RF up 4.4%. 

 

The worst performing sectors were Healthcare (XLV), Consumer Discretionary (XLY) and Consumer Staples (XLP).  While the XLV underperformed the S&P 500 by 0.5%, managed care was a bright spot as JPMorgan upgraded CI and WLP.  The difficulties of Healthcare reform remain as the Democrats face an uphill battle gathering sufficient support to approve the legislation in its current form.

 

From a risk management standpoint, the ranges for the S&P 500, the Dollar Index and the VIX are seen in the charts below.  The range for the S&P 500 is 33 points or 1% upside and 2% downside.  At the time of writing the major market futures are basically flat on the day.

 

Crude oil is trading basically unchanged around $77.00 in early trading today.  The U.S. Energy Department will report tomorrow that stockpiles grew by 1.5 million barrels for the week ended Nov. 20, according to a Bloomberg survey.  The Research Edge Quant models have the following levels for OIL – buy Trade (76.21) and Sell Trade (79.09).

 

The lead story in the WSJ today – “HSBC Holdings Plc asked retail customers to remove their gold from its vaults on Fifth Avenue in New York to make room for institutional investors.”  Gold rose to a record $1,170.25 an ounce in the morning “fixing” in London.  The Research Edge Quant models have the following levels for GOLD – buy Trade (1,139) and Sell Trade (1,177).

 

Copper fell from a 14-month high (first down day in the past three) in London as the dollar strengthened; the U.S. Dollar Index traded as high a 75.44 in early trading today.  Copper for March delivery lost 0.4% percent to $3.14 a pound.  The Research Edge Quant models have the following levels for COPPER – buy Trade (3.01) and Sell Trade (3.21). 

 

Howard Penney

Managing Director

 

US STRATEGY – KEEPING THE DREAM ALIVE - sp1

 

US STRATEGY – KEEPING THE DREAM ALIVE - usd2

 

US STRATEGY – KEEPING THE DREAM ALIVE - vix3

 

US STRATEGY – KEEPING THE DREAM ALIVE - oil44

 

US STRATEGY – KEEPING THE DREAM ALIVE - gold5

 

US STRATEGY – KEEPING THE DREAM ALIVE - copper6

 



CITYCENTER: A GROWTH OR DONNER PARTY FOR MGM?

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.

 

CITYCENTER: A GROWTH OR DONNER PARTY FOR MGM? - Vegas Room Inventory Increase


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.

 

CITYCENTER: A GROWTH OR DONNER PARTY FOR MGM? - post bellagio decline 1


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. 

 

 CITYCENTER: A GROWTH OR DONNER PARTY FOR MGM? - re vs street 1

 

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.


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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

 


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

Analyst

 

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

 

 


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