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US STRATEGY – The Chinese Ox in a Box

One of our key themes for 1Q10 is – CHINESE OX IN A BOX – and it’s important to watch what the Chinese are saying.  In simple terms, they are all about QUALITY GROWTH not SPECULATIVE GROWTH.  Right now in “real time” the Chinese self imposed slowdown in lending has the Chinese market down for 3 of 4 trading days in 2010.  The Shanghai A share index declined 1.89% last night and is now down 2.58% so far in 2010.

 

In the USA, after three days of trading all nine sectors are positive on TRADE AND TREND!  There was generally a positive tone to the performance of the S&P 500 yesterday with seven of the nine sectors outperforming.  The volume is still on the light side as it seems like market participants are looking for guidance on which way to turn.  The MACRO calendar could paint a clearer picture with some direction from December same-store sales data and Friday's release of December nonfarm payrolls.

 

Yesterday’s MACRO calendar did not support the momentum provided by Monday's release of better-than-expected manufacturing data.  Yesterday, the sectors that benefit the most from the RECOVERY trade - Materials (XLB) and Energy (XLE) - extended their outperformance in 2010. 

 

Additional support to the RECOVERY trade came from the Dollar Index sliding to 77.49, down 0.16%.  The RISK trade continues to come out of the market with the VIX down (-0.98%) yesterday and has declined every day this year, but the higher beta NASDAQ and Russell underperformed yesterday. 

 

Yesterday, the ISM non-manufacturing index moved into expansionary territory last month, rising to 50.1 from 48.7 in November.  However, the reading was slightly below the consensus of 50.5 and the forward-looking new orders component fell to 52.1 from 55.1. While employment improved to 44 from 41.6, it remained firmly in contraction territory.

 

Also on the MACRO calendar, the ADP private payrolls fell by 84,000 in December, a figure that was weaker than 75,000 decline expected by economists in a Bloomberg survey.  Yesterday’s reported decline in the ADP numbers was a significant improvement from the 145,000 decline reported in November 2009.  In addition, December marked the ninth consecutive month in which the pace of job cuts slowed.

 

The Materials (XLB) was the best performing sector yesterday and extended 2010 outperformance to 320bps.  The CRB was up 1.45% yesterday as commodities and commodity equities remained underpinned by the global recovery trade.  Precious metals stocks were also a bright spot, and the fertilizer stocks put in another day of outperformance.

 

While the XLF was not one of the top three performing sectors, it did outperform.  The BKX in now up three days in a row, up 5.79% so far this year.  The laggards in the sector were names such as ICE (3.1%), MCO (2.1%) and IVX (2.1%). 

 

The notable laggard yesterday was Technology (XLK) down 1.1% on the day.  While there was no visible catalyst, telecom and software stocks were the weakest group in the XLK.  

 

The range for the S&P 500 is 14 points or 0.4% (1,141) upside and 1.0% (1,127) downside.  At the time of writing the major market futures are trading lower on the day.    

 

Copper fell 0.93% yesterday and is trading lower today on concern that demand may wane as China moves to curb growth in bank lending.  The Research Edge Quant models have the following levels for COPPER – buy Trade (3.35) and Sell Trade (3.50).

 

Gold fell the most in a week in London as a stronger dollar curbed demand for the metal as a hedge against weakness in the currency.  The Research Edge Quant models have the following levels for GOLD – buy Trade (1,086) and Sell Trade (1,137).

 

Crude oil fell in New York, snapping 10 days of positive performance.  The Energy Department said crude inventories rose 1.3 million barrels last week, the first increase in five weeks.  The Research Edge Quant models have the following levels for OIL – buy Trade (79.72) and Sell Trade (83.57).

 

Howard Penney

Managing Director

 

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Shaky Foundations

“If you establish a democracy, you must in due time reap the fruits of a democracy. You will in due season have great impatience of the public burdens, combined in due season with great increase of the public expenditure. You will in due season have wars entered into from passion and not from reason; and you will in due season submit to peace ignominiously sought and ignominiously obtained, which will diminish your authority and perhaps endanger your independence. You will in due season find your property is less valuable, and your freedom less complete.”
–Benjamin Disraeli
 
Keith has tightened up his hockey hair this morning and will be appearing on Bloomberg TV as co-anchor, as a result I’ve been handed duties as lead author of the Early Look.  I was recently in Colorado visiting some old friends and had the opportunity to stay in their beautiful home with a mountain view, located half way in between Vail and Aspen.  Everything about their home, and life for that matter, is quite picturesque, including a cute puppy named Riggs, except for one thing, their house. Due to no fault of their own, it has a less than stable foundation.  This unstable foundation is leading to premature cracks in the walls.  In many respects, I think it is the perfect analogy for the U.S. economy.
 
Any economy, or company for that matter, is only as solid as its balance sheet, which is equivalent to the foundation of a house.  As a balance sheet’s debt ratios increase, the very foundation of the economy or company begins to crack.  We’ve recently handed the responsibility of surveying sovereign debt loads to Darius Dale, a recent Yale grad who joined our team about 6-months ago.  Every morning Darius emails out, by 630a.m., Darius’ Debt Download. After reviewing these reports for the last week, there is an obvious conclusion, the economic foundation of the United States is crumbling.
 
I discussed this in some detail to our subscribers yesterday in a note, but wanted to replay the key facts again this morning.  These are facts that every investor of every asset class needs to keep front and center.  They are as follows:
 
·        Total current U.S. National Debt - ~$12.17 trillion;

·        Total current U.S. National Debt per taxpayer - ~$111,622; and

·        Debt to GDP ratio – 83.5%.

 
These numbers are subject to some debate and we have sourced them from usdebtclock.org and government data sources.  Setting aside specific debate on the precise numbers, the irrefutable point remains: the U.S. National Debt is massive and expanding.  The key components of this debt are as follows:
 
·        Medicare and Medicaid 21.9%;

·        Social Security 19.2%; and

·        Defense and Wars 19.1%.

 
U.S. National debt as a percentage of GDP has been climbing steadily since 2000, and has seen exponential growth in the last two years.  At the current ratio of ~83.5% debt to GDP, we are at a level not seen since the 1950s. In lieu of our etf portfolio this morning, we have outlined this metric in the chart below going back 90 years. By the end of 2010, this ratio is projected to be near 100% of GDP absent a dramatic shift in domestic budgetary policy.  As with any borrowing, the more a person, entity or company borrows, even the United States of America, the higher their cost of borrowing will go, all else being equal.  
 
Interestingly, the national debt of ~$12.17 trillion, actually excludes Fannie Mae and Freddie Mac debt. The U.S. government became the effective conservator of both of these entities with the Housing and Economic Recovery Act of 2008.  The estimated combined on and off balance sheet debt of Fannie and Freddie is purported to be just over ~$5 trillion. Including this additional ~$5 trillion in debt, U.S. Government debt as a percentage of GDP is actually more than 120%.  On that basis, U.S. government debt as a percentage of GDP is the highest ratio it has ever been, or at least since the numbers have been recorded, which is since 1792.  Needless to say, both ever, and since 1792, are a long time.
 
Globally, this data hasn’t been updated since 2008, but based on 2008 data, the U.S. has the fifth highest indebtedness as a percentage of GDP, just barely above Singapore and just below Jamaica, man.  The only other countries more indebted than the U.S., on this basis, are the economic stalwarts of Zimbabwe, Japan, and Lebanon  . . .
 
Keep your eyes on U.S. government debt . . . this Queen Mary is not turning any time soon and will hold investment implications related to many asset classes for years to come. We cannot increase our debt exponentially without increasing our borrowing costs.  
 
Setting aside actually investment considerations, as former British Prime Minister Benjamin Disraeli states above, there are also implications for our very freedom and prosperity. Specifically, even if she had to, America couldn’t afford to fight another large scale ground war.  The only positive from this situation is that the government may be constrained from implementing policy “from passion and not from reason”.  And that, at the end of the day, is a good thing.
 
Keep your head up and stick on the ice,
 
Daryl G. Jones
Managing Director

 

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R3: BBBY: Biggest Baddest Blowout Yet

R3: REQUIRED RETAIL READING

January 7, 2009

 

If there’s one thing we can be rightfully accused of when it comes to our positive stance on BBBY since early this Summer, it is that our above-consensus numbers were not bullish enough.

 

 

TODAY’S CALL OUT

 

We’ve taken a bit of heat over the past six months on our positive BBBY call – surprising for such a high quality name.  If there’s one thing we can be rightfully accused of when it comes to our call, it is that our above-consensus numbers were not bullish enough. On the flip side, if we had to point to the most out-of-consensus part of this call that we got right, it is our argument that the trajectory of fundamentals will trump what many argued was ‘too lofty a valuation’ as the stock ‘had already had its big run.’ . 

 

The irony is that the same bears are still likely to look at this quarter, and say that it has finally ended, the story has run its course, and valuation is too toppy. We see a name with the following attributes a) store productivity and operating margins that still have meaningful upside without accounting for any potential relief from the economic cycle; b) its largest competitor closing its doors; and c) no debt, with cash building to over $1.2bn, and increasing likelihood of significant stock repo.  We like that setup in ’10.

 

The key to this story is not the past couple of quarters of upside (Wednesday’s 3Q blowout included) but rather in understanding the 12-18 month opportunity that lies ahead.  With sales improving and a multi-year period of aggressive couponing being unwound, even the solid 3Q results are likely to be just part of a string of upside that is still in the early innings.  We’re not going to rehash all of the finer points to the story (see our notes from 1/4/10, 9/24/09, 7/14/2009, and 6/24/09 for the thesis, which remains unchanged by the way) but rather point to the actual data.  This quarter again proved that a rational competitive environment, less capacity in the marketplace (no more Linens as a start), tight inventories (up 1.9% vs. sales up 10.8%), and the beginnings of deferred maintenance spending in the home furnishings space are all key factors in driving BBBY’s 7.3% increase in same-store sales and 71% increase in EPS.  Now to be fair, 3Q was comparing against the worst sales and margin performance in company history, but the consistency and magnitude of profitable improvement is noteworthy. 

 

While we’ve been correct in identifying BBBY as one of the better earnings revisions stories in retail, we’ve been a bit off the mark with our underestimation of how truly conservative management is.  The company ended the quarter yet again with $1.2 billion in cash and equivalents on the balance sheet.  A $900 million share repurchase remains in place and management only repurchased a paltry $34 million worth of stock in the quarter.  We’ll keep waiting for an announcement on this which we’re confident is to come.  It’s just not clear when the status of the backdrop, characterized by management as “an uncertain macroeconomic environment” will be upgraded and ultimately provide a catalyst to put some cash to work.

 

In the meantime, we’ll stick to the more tangible drivers of earnings.  With square footage growth steady at 5% (powder is dry for opportunistic additions) and same-store sales now guided to 3-5% for 4Q, again we believe even management’s increased guidance is conservative.  Not to be repetitive, but gross margin expansion has now occurred for just 2 quarters in a row after 10 quarters of declines.  Sales comparisons remain easy, but share gains, 5% square footage growth, and constant store remodeling are also key drivers of the topline as the home furnishings sector continues its recovery.  And, cash is king.  Share repurchase would be even better, but for now that surprise is still yet to come. 

 

BBBY remains one of our favorite names, with the biggest risk lying in “taking the trade”.  It’s too early to bail on the momentum that is still building and it’s not too late to recognize the opportunity that still lies ahead.

 

This remains one of the best looking SIGMA charts in all of retail (if you’re confused, call us):

 

R3: BBBY: Biggest Baddest Blowout Yet - 1 

 

 

EVENT REMINDER

We are hosting a conference call on Friday,  January 8th  at 11AM (EST) to discuss our Top 10 Retail Predictable Unpredictables in 2010.  Simply put, these are 10 ideas that we assess at better than 60% chance of happening, but today's Wizards of Wall Street either: A) do not acknowledge that such ideas exist, OR B) see them as so unlikely, they do not bake them into their investment process.  Please contact or reply to this email to request dial-in information.

 

 

LEVINE’S LOW DOWN 

  • Family Dollar management noted that food stamp usage continues to increase at a steady pace. This increase is in addition to the company’s efforts to expand food stamp acceptance across the chain (with the implementation of new POS systems) . In stores that have recently begun accepting food stamps, traffic is measurably improved.
  • H&M just revealed a fashionable line of women’s apparel using only sustainable, organic, and recycled (soda bottles, textile waste) materials. The fashion forward line is priced aggressively with not item topping out above $60. Leave it to the fast fashion leader to also close the price gap on “green” products…
  • According to a BIGresearch December survey, 33.1% of adults over 18 say they shop Best Buy most often for electronics. Wal-Mart is second, with a 20.6% share. Both companies showed substantial year over year increases, with BBY adding 3.3% and WMT adding 3.7% since last December. Interestingly Amazon, Target, and Sears round out the top five, but with substantially less preference by consumers for their electronics purchases. AMZN tops out at 3.6%, while Target is 2.8%, and Sears at 2.0%. All five retailers added to their preference share, most likely due to the disappearance of Circuit City.

 

MORNING NEWS 

 

Gucci, Richemont Units Near Deal with Bank of China - Bank of China appears ready to pay $300,000 to Gucci America Inc. and Compagnie Financière Richemont brands Chloé and Alfred Dunhill to end their inquest into its handling of a counterfeiter’s financial records. Lawyers for the luxury firms and the bank submitted a proposed settlement order to U.S. District Court Judge John Koeltl in Manhattan Wednesday. According to court documents, the bank would pay the $300,000 settlement in exchange for an agreement that keeps it out of any future judgments or collection efforts stemming from a 2007 trademark suit against Kelvin Cho, a native of Malaysia who sold knockoff goods online and received payment through a Bank of China account. In March 2008, Gucci and the Richemont brands won a $4.3 million judgment against Cho. After the judgment, the firms said Cho still owed $4 million and accused Bank of China of allowing him to drain his account despite a court ordered freeze. Later that year, the state-owned bank agreed to release Cho’s records and pay $190,952, but the brands said it failed to abide by the deal. <wwd.com>

 

True Religion Names Koplin to COO Role - Koplin will oversee many of the denim firm’s day-to-day operations and will report to Jeffrey Lubell, founder, chairman and chief executive officer. Koplin was most recently president of the Tommy Bahama women’s division at Oxford Industries Inc., a position she held since July 2005. Before that, she was president and ceo of Apparel Ventures Inc. “This is an important hire for our company as we are committed to continue to invest in and build our management team in order to continue to grow our business domestically and internationally,” Lubell said. “During her tenure within the apparel industry, [Koplin] has managed all aspects of branded apparel operations and we are confident that her hands-on industry experience will prove invaluable as we look to build upon True Religion’s position as a fast-growing global apparel brand.” <wwd.com>

 

Gilt Groupe Promotes Christian Leone - Formerly vice president of marketing and communications for the company, Leone is now vice president of brand relations, a new position. He reports to founder and chief merchandising officer Alexandra Wilkis Wilson. “It’s a very creative role, brainstorming with brands and making sure the brands view us as a true strategic partner, which we’ve certainly become for hundreds of brands at this point,” said Wilkis Wilson. Leone has wide contacts in the industry, having previously handled communications at Giorgio Armani, Alberta Ferretti and Halston, she said. “Our relationship with brands has become increasingly more strategic as we partner with them and grow our business,” she continued. “We are actively seeking partnerships with our key vendors and looking at a number of ways to support their full-price business.”  <wwd.com>

 

Barneys Opens Revamped Prada Men's Shop - Right before Christmas, Barneys unveiled a completely transformed and enlarged shop for the designer brand on the second floor of its Madison Avenue flagship. The new shop is the only one of its kind in the U.S. and spans nearly 1,800 square feet. It is located next to the Giorgio Armani boutique. “There had been a discussion between Mr. Bertelli [Patrizio Bertelli, chief executive officer of Prada SpA] and Barneys about how to vastly improve the presentation of the shops both in terms of ambiance and sophistication,” said Tom Kalenderian, executive vice president and general merchandise manager of men’s wear for Barneys.  <wwd.com>

 

Jos. A. Bank to expand into tuxedo rentals - Men's apparel store Jos. A. Bank Clothiers said Wednesday that it is expanding into the tuxedo rental business. It will try the concept out in 5 percent of its stores this month and, if successful, roll it out to more than half of its stores in the spring. The company, which already sells tuxedos, was responding from demand from its customers. The rental component would "complete our formal assortment," R. Neal Black, president and CEO of the Hampstead retailer, said in a statement. The company has partnered with a national distributor who will own the inventory and deliver the tuxedos to stores, reducing the risk and investment with starting the venture, the company said <baltimoresun.com>

 

CBX expands into specialty retail, department store design - CBX, a strategic branding and retail design consulting company, has expanded its Retail Division into specialty retail and department store design.

The company has recruited a team of experienced retail designers, project managers and business development executives - including a former partner in Grid2 International, which does design work in the furniture industry - "to create solution-driven concepts for apparel and lifestyle merchants and brands," CBX said in a release.  Our expansion into specialty retail leverages the many strategic and design capabilities within the firm in order to serve retailers in the fashion apparel and lifestyle sectors," said Joseph Bona, President of CBX's Retail Division. CBX offers architecture, interior design, merchandise and store planning, identity and branding, graphics and environmental graphic design, media design, product design, master planning, construction detailing, and consumer research. It will exhibit here next week at the National Retail Federation's Annual Conference and Expo. <furnituretoday.com>

 

Seven & I Net Falls as Japan’s Lower Wages Cut Sales -  Seven & I Holdings Co., the world’s biggest convenience-store operator, said nine-month profit slumped 32 percent as lower wages sapped demand for clothes and food in Japan. Net income totaled 69.3 billion yen ($752 million) for the nine months ended November, compared with 101.7 billion yen a year earlier, the Tokyo-based owner of the 7-Eleven brand said in a statement today. Aeon Co., Japan’s second-largest retailer, had a net loss of 9.93 billion yen in the same period, it said separately today. Seven & I and Aeon are introducing instant noodles, jeans and other products under their private brands to offer lower prices and lure customers. Salaries have dropped for 18 straight months and the nation’s retail sales are down for the last 15 months as Japan emerges from its worst post-war recession.  <bloomberg.com>

 

Shoebuy.com Breaks the 1,000 Brand Mark - Shoebuy.com announced that it has launched its 1,000th brand. Brands recently made available via Shoebuy.com include: Diesel, Yellow Box, Lucky Brand, BCBG Max Azria, Vince Camuto, Reef, Jack Rogers and Converse. The cite now has over $3.5 Billion of inventory available to purchase. The website also said it was experiencing over 6,500,000 visitors a month with nearly 65% of sales from repeat buyers. <sportsonesource.com>

 

John Lewis retail director exits - John Lewis retail director Gareth Thomas has taken early retirement from the department store group after 30 years at the retailer. In a statement John Lewis said: “After 30 years at John Lewis, 10 of those as a member of the John Lewis management board, Gareth has decided that it is now time for him to have a complete change. “He intends to take a break from working full time and devote more of his life to his family and outside interests, one of which is his work for Save The Children, a charity which is close to his heart.” John Lewis managing director Andy Street said he wished Gareth “every happiness and success in the future”. He said: “We will miss his leadership and insight enormously, and value the strong legacy he leaves behind him.” <drapersonline.com>

 

Kenneth Cole Productions, Inc. Announces Upcoming Investment Conference Participation - Kenneth Cole Productions, Inc. (NYSE: KCP) announced today that it will present at the ICR XChange conference next week. Management will deliver a presentation on behalf of the Company at The 12th Annual ICR XChange Conference held at the St. Regis Monarch Beach Resort in Dana Point, CA. The Kenneth Cole Productions investor presentation will be webcast live at 1:45 p.m. Eastern Standard Time on Thursday, January 14, 2010 at: http://investor.shareholder.com/icr/2010/eventdetail.cfm?eventid=76224. <prnewswire.com>

 

Fashion's M&A Scene Heating Up - Fashion’s game of deal or no deal is heating up for 2010 and it seems almost everyone is looking to play a part. And although no one is predicting a return to the go-go days of 2006 and 2007 when buyers bid hot properties up into the stratosphere, experts said a steadier economy, easing credit markets and more realistic price tags could bring some sizzle to fashion’s mergers and acquisitions scene this year. The tenor of the market will recall the dealmaking of the earlier part of the last decade, said Pellegrini, pointing to such strategic buys as VF Corp.’s acquisitions of The North Face and then Vans and Nike Inc.’s purchase of Converse. And many of those same companies — with cash, cash equivalents and short-term investments on their balance sheets or the ability to borrow enough for a purchase — are headed back out on the hunt. Among the companies publicly scouting or said to be on the prowl with at least some capital to be put to use are Nike ($3.63 billion in cash, cash equivalents and short-term investments on hand), PPR (1.27 billion euros, or $1.83 billion at current exchange), Li & Fung Ltd. ($1 billion), VF ($379.1 million), Phillips-Van Heusen Corp. ($356.6 million), Iconix Brand Group Inc. ($233.4 million), The Warnaco Group Inc. ($229.3 million) and Jones Apparel Group Inc. ($156.9 million). <wwd.com>

 

 

Luxe Labels Raise the Bar on Quality in Men's Wear - If luxury goods were distinguished by price prior to the recession, they will be defined by quality after it is over, according to senior executives at leading European luxury goods firms who are gearing up for the new men’s wear season. The new reality is that consumers want value for their money and are turning to brands they can trust. This means an even greater attention to detail, a focus on craftsmanship and, in the short term at least, a new way of communicating that will reinforce a brand’s savoir faire credentials. “The luxury consumer has always been, by definition, a client who is attentive and demanding when it comes to buying a product,” said Cristiana Ruella, group managing director and board member of Dolce & Gabbana. “They are even more so today and, different from the past, they are much more informed and sensitive to the relationship between quality and price.” <wwd.com>

 

Mobile consumers flock to top m-commerce sites and apps, Nielsen says - Traffic to Top 500 mobile commerce web sites and through mobile apps continues to soar as more consumers become comfortable researching and shopping on mobile devices and more adopt smartphones offering rich features and high performance. Of the top 10 m-commerce merchants based on unique monthly visitors measured by The Nielsen Co., eBay Inc. remains on top: 5.03 million consumers visited its site or used its app in October 2009, up 26.7% from 3.97 million in October 2008. Amazon.com Inc. came in a strong second with 3.51 million visitors, up 42.6% from 2.46 million in the same period the previous year. And GameSpot wound up in third with 2.58 million visitors, up 33.6% from 1.93 million in October 2008. Amazon is No. 1 in the Internet Retailer Top 500 Guide (a PDF version of the company’s financial and operating profile can be ordered by clicking on its name).  <internetretailer.com>

 

Venture Capitalists Turn Positive on Investment Levels and IPOs in 2010, KPMG Study Finds - In contrast to last year, the venture capital community is signaling an uptick in overall venture capital investment in 2010, according to a recent survey by the U.S. audit, tax and advisory firm KPMG LLP. In addition, the KPMG survey found that the venture capital community expects IPO activity and valuations of venture-backed companies to trend upward next year. In polling 100 venture capitalists and entrepreneurs in the U.S., KPMG found that they are much more bullish on venture investment levels, IPO activity and valuations of venture-backed companies. In fact, the 68 percent of respondents say they expect total venture capital investment to increase in the year ahead - a completely different perspective from a year ago when 74 percent said they expected investment levels to decline. Venture capitalists also expect increases in deal volume (66 percent) and venture fundraising (53 percent). <prnewswire.com>


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.



WHAT DO WE DO WITH THESE PESKY SLOT STOCKS?

A potential short-term cross breeze (earnings reductions) but the long-term wind remains at the tail of the slot sector.

 

 

They’re cute (at least WMS is), safe (well, they should be), fun to own (when they go up), and the long-term story is as attractive as any in consumer land.  Unfortunately, they’re not cheap and analysts keep overestimating slot demand.  Ideally, we’d like to see estimates come down, particularly for the 1H CY2010, and the stocks come in.  This is a space that needs to be on the radar screen.

 

Earnings

I feel like a broken record but unit sales to new casinos and expansions will be down considerably in 2010.  We estimate almost a 50% decline.  See our 11/25/09 post “ONE IN THE HAND IS WORTH TWO IN THE BUSH”.  Replacement demand should accelerate, but will it grow more than the 50% necessary to make the Street’s slot projection?  That’s a tall order.  The first half of calendar 2010 is at risk with March being the most difficult comp of the year.  We project new/expansion units to fall 80% in the March quarter.  Yet, analysts are projecting significant revenue, EBITDA, and EPS growth in the first quarter as shown below.

 

WHAT DO WE DO WITH THESE PESKY SLOT STOCKS? - slot comps q1

 

Needless to say, we are below the Street for IGT and WMS, but in-line for BYI.

 

Valuation

They’re not cheap on a forward earnings basis.  IGT and WMS both trade at 21x consensus 2010 earnings while BYI clocks in around 17x.  Again, we think the IGT/WMS estimates are too high so the valuations may be even more inflated.  However, we think there is approximately 50% upside to the numbers from normalized replacement demand alone.  Combine “regression to the mean” replacements with a significant new market pipeline – domestically and internationally – and the gaming supply segment could generate 20%+ EPS growth over a 5+ year period.  From that perspective, 20x EPS doesn’t seem so expensive although I’d prefer mid-teens.  Maybe they’ll get there.

 

The Mexico Catalyst      

This is one market that could surprise on the upside in 2H 2010.  From what we are hearing, the transition from Class II games to Class III is showing promise.  Operators like the performance.  Class III games are also faster – 11 games per minute versus 8 for Class II.  The Class II market is anywhere from 35k machines to 50k machines so there is a lot of potential for Class III replacements.  Look for some color on the Mexico potential during the earnings conference calls.  Stay tuned for more on Mexico from us as well.

 

The Perfect Storm

We could be at the trough of a huge 5-7 year cycle for slot demand.  In a few years, we may look back on the 2008-2010 period as the perfect storm:  slot customers on the verge of bankruptcy; a dearth of new markets, new casinos, and casino expansions; and the dud that is (was) server based gaming.


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