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Despite some embarrassing pleading on the conference call, analysts may have it wrong about IGT’s level of conservatism. Guidance looks realistic to us.



IGT missed on revenues but produced better EPS due to cost controls and some one-time items.  By our math, if you adjust out all the noise and one-time items the actual EPS result was more like $0.22, exactly in-line with our projection.  The revenue miss and unsustainably low SG&A/R&D indicates that fundamentals are a little worse than we expected.  We are particularly concerned with lower than expected yield per game in gaming operations and a market share that appears to be lower than the company indicated on the call.


On the call, one analyst was almost begging IGT to acknowledge that they should do $1 in earnings in fiscal 2010.  His logic was that FQ1 is seasonally slow and they did $0.25.  IGT wasn’t biting.  What should’ve been clear to the analysts is that:

  • slot sales to new/expanded casinos will be way down in FQ2 and FQ3
  • there were a number of one-time items – management acknowledged that the “real” number was $0.22 for FQ1
  • the low levels of SG&A and R&D in FQ1 are not sustainable
  • replacement demand was disappointing in FQ1 so no evidence yet of a v-shaped recovery as projected by some analysts
  • market share may be a concern again

Thus, IGT’s unchanged guidance of $0.77-0.87 seems reasonable.  So what else did we learn from this release?


Product sales takeaways

  • Replacements have troughed but have yet to show real signs of big improvement. 
  • Since IGT gets a higher % share of new and expansion units than replacement units, replacements units need to show some hockey stick like growth in order to get to Goldman Sach’s magic $1.00 number
  • We’re still confused on how IGT came up with over 50% share of new shipments when they only sold 2,500 new and expansion units…. Unless our math is seriously off there is no way that new unit shipments this quarter were only 5,000
  • ASP’s were actually down 6% sequentially – higher priced Multi Layer Display games (MLD) were 32% of the mix vs. 34% in FQ4, and there are two types of MLD’s and there were less of the more expensive ones that sold this quarter
  • International shipments will be up a little y-o-y and assuming anemic Japan sales, pricing should be better


Game operations

  • Game operations continues to suffer from “mix issues” so yields will likely remain depressed from last years’ levels
    • Some of the legacy “higher” yielding units are coming off and being replaced with deals that are more favorable to casinos
    • We’ve been hearing this from the operators for months now and it looks like we’re seeing the “discounting” in the yields now
    • If interest rates trend upwards IGT will continue to have a favorable impact from jackpot funding (higher the interest rate, the lower the PV of the liability)
    • If IGT can continue to manage its install base churn margins should continue to benefit from lower D&A expense, although its sounded like they are doing some refreshing over the next few quarters so this quarter’s margin is not likely to be repeated


Other stuff

  • The amazingly low SG&A and R&D numbers from this quarter are not sustainable and therefore, nor is the $0.25 EPS number at the current revenue run-rate
  • SG&A was unusually low because there was lower incentive comp due to the timing of stock issuance, higher stock forfeitures, and an related $3MM benefit
  • Tax rate will also be “normal” and higher going forward 


Bottom line… fundamentals are no better than we thought, possibly a little worse, but cost controls were commendable.  Should IGT sustain this discipline they can approach the high end of their guidance range for the year, which still implies a miss from sell-side expectations.  The question is with such a favorable long-term sector outlook, will it matter?


The deterioration in the S&P 500 that started on Wednesday accelerated to the down side on Thursday.  The S&P posted its first back-to-back decline since December 8, 2009. Volume was above average, and up 42% day-over-day.  


The VIX was up 19.2% and posted its biggest one-day spike since November 27, 2009 and finished at its highest level since December 17th. The Hedgeye Risk Management models have the following levels for VIX – buy Trade (19.76) and Sell Trade (22.51).


From a MACRO perspective, there were a number of factors weighing on stocks yesterday.  First, China tightening concerns increased after another batch of strong economic data that helped to solidify fears about a bubble.  With our “CHINESE OX IN A BOX” theme we continue to be bearish on China for the immoderate term.  Last night the Shanghai index declined 0.95% and is now down 4.5% year-to-date.  This is putting pressure on the RECOVERY trade, as the Materials (XLB) was down 4.3% on the day.  The XLB is now down 2.2% year-to-date, which makes it the worst performing sector this year. 


Second, the job picture got a little worse last week.  Initial claims jumped 36,000 to 482,000 for the week ended January 16th -- the highest level in two months. Consensus expectations were for a small decline to 440,000. How convenient that the Labor Department noted that the increase was due to "administrative issues" related to a backlog of claims from the holiday season.


Third, the regional Philadelphia Fed Index fell to 15.2 in January from 20.4 in December, below the consensus of 18.0 and snapping a five-month streak of increases.  While new orders fell to 3.2 from 8.3 and shipments slipped to 11 from 14.9, the bulk of the other components of the report, including six-month expectations, showed some signs of improvement in January.


The Hedgeye Risk Management models had six sectors breaks the TRADE line yesterday and the Financials (XLF) broke both TRADE and TREND.  The only sector that is positive on both durations is Healthcare (XLV). 


The Financials were the second worst performing sector as the there was a sharp selloff in the group following President Obama's latest financial reform proposal.  Hit the hardest were the large-cap banks and investment banks with JPM -6.6%, BAC -6.2%, C -5.5%, MS -4.2% and GS -4.1%.  The banking group outperformed for a second straight session yesterday, with the regional banks among the standouts in the group.  Signs that credit quality is improving ahead of expectations seem to provide support to the group. 


The best performing sector yesterday was Technology (XLK).  A batch of largely upbeat earnings guidance out of the Technology sector was the primary factor.  The software sector remained under pressure however, with the S&P Software Index down for a second straight session.  The semis were mostly weaker with the SOX down 0.5%. 


Earning out of the consumer space helped the Consumer Discretionary outperform by 30bps.  Yesterday, EL +9.2%, PNRA +7.3% and SBUX +1.7% all reported better that expected results. 


As we look at today’s set up the range for the S&P 500 is at 16 points or 0.53% (1,110) downside and 0.90% (1,126) upside.  At the time of writing the major market futures are trading up on the day.  


Copper prices fell to the lowest level in almost four weeks as a drop in equity markets has cooled demand expectations and the dollar’s strength.  The Hedgeye Risk Management Quant models have the following levels for COPPER – buy Trade (3.30) and Sell Trade (3.38).


In early trading today Gold is declining for the third straight day.  The Hedgeye Risk Management models have the following levels for GOLD – buy Trade (1,097) and Sell Trade (1,117).


In early trading, crude oil is trading flat after declining 2.1% yesterday.  Crude looks poised for a second weekly decline, on the back of a slowing China and increased supplies.  The Hedgeye Risk Management models have the following levels for OIL – buy Trade (75.63) and Sell Trade (77.98).


Howard Penney

Managing Director















IGT 1Q 2010 Conf Call

  • One less week in the quarter negatively impacted the quarter by $22.4MM of revenues 
  • New accounting for converts increased their share count
  • Gaming operations continued to feel the negative impact from the economy and mix shift of the install base
    • Excluding the interest benefit margins would have been 57% 
    • Average win per day of $49/day
  • Domestic Product sales
    • Product sales margins increased 200 bps due to lower material costs and mix shift to higher margin units
    • While they continue to have limited visibility on replacement units they do feel like replacements have reached a trough
    • 2,500 new units shipped and 3,000 replacement units 
    • 92% of machines shipped where AVP


  • International product sales benefited from recognition of Rosario shipments and increased European shipments
  • Expect product sales gross margins to remain in the low 50% range
  • Continue to move towards their $200MM cost reduction goal
  • SG&A declined 9%, expect quarterly run rate going forward to be $95-100MM vs. $90MM in FQ1
  • R&D expense declined 7%, expect a quarterly run rate in the low $50's MM vs $47MM in FQ1
  • Total D&A inclusive of games operations expense declined, but may increase as they refresh their install base
  • Interest on the debt component on their convert calculated using a normalized non-convert interest rate will impact them by $30MM or $0.07 for the year. Also new treatment of convert debt increased their debt balance by $145MM and that amount will be amortized going forward
  • Expect quarterly tax rate to be 37-39% vs 34% in FQ1
  • Made a lot of progress on converting working capital to cash flow
  • Capital expenditures expected to trend in the $50-75MM range, although they continue to trend at the lower end of that range
  • "Sex in the City" is outperforming their expectations with an average yield to IGT of $180/day
  • Product sales in the Dec quarter has historically been there lowest.  Remain cautiously optimistic on customer demand
  • MGM is very happy with the performance of their SB system
  • Hired a head of "new media," who will be in charge of repurposing content for new media
  • 2010 guidance remains $0.77 -$0.87, and excludes one time items and assume no dilution from convertible notes (excludes the 1 cent tax benefit this Q)


    • Other income line: Interest income = 16MM, Interest expense: $43.2MM, other is $1MM
    • How much of the decrease in yields came from mix shift vs. just normal seasonality?
      • Hard to say, probably mostly due to seasonality but definitely some mix shift
    • Know that new and expansion units will be off materially in FY2010, assume a decent increase in replacements, but visibility is fairly limited on that front
    • Server based feedback from MGM/ Interest from other operators
      • Aria is very pleased with the way the floor is playing
      • Significant interest in their T1 product which they have 
    • SG&A and R&D where very low in the quarter, why isn't that going to continue and why isn't IGT going to do over a $1 in EPS this year?
      • R&D Q1 is naturally lower since the team is pre-occupied with G2E.  R&D over time will run at a couple hundred MM. 
      • SG&A had $3MM of deferrals with new compensation plan that positively impacted the Q
      • The real answer is there are no new units shipping in the balance of the FY year, and SG&A and R&D will both be higher, so $1 is a pipe dream
    • "Still experiencing a fair amount of mix shift in game operations so there should be continued pressure on yields.  Customers are still conservative on their replacement orders"
    • Ship share in the quarter?
      • Won't know until everyone else reports, but think that they are around 40% on the replacement side, and north of 50% for new and expansion units
    • Mix of MLD was the same q-o-q. 
    • Remainder of the Aria floor should be all SB by June
    • More focus on applications vs infrastructure spending compared to prior years
    • Yield on IGT's install base (game ops) should continue to stabilize but trend lower due to mix, until they see the impact from new games like Sex in the City
    • On the replacement side their just isn't a lot of visibility in demand "shouldn't have a hockey stick increase" and need a pretty significant increase to simply offset the decline in new openings and expansions
    • They will also be more prudent in their deployment of game operations capital, and are ok with adding higher ROI but still lower "yielding" units to the install base
    • Guidance for international?
      • See improvement in Europe and Latin America, stability in South Africa/ Australia/UK. They aren't forecasting any huge improvements though for international shipments but sounds like they are forecasting some improvement
    • Timing on IL VLT shipments:
      • 2011 event before they see shipments, still need a central system and lots of things to do
    • Alabama exposure? 
      • Have 3,600 units in that market (Victoryland and Country Crossing) and have $100MM tied up in that market
    • Lower ASPs could be partially due to volume discounting and G2E promotions
    • Think that their Wheel products will continue to play well despite new competition from BYI

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    Please disregard prior version.


    Besides management commentary and top-line trends, stock price movements and volume are also confirming the divergence between Casual Dining and Quick Service Restaurants.


    QSR trends have been soft, with negative same-store sales trends and an “extremely competitive landscape” being compounded by the adverse weather in December.  Information coming from management has been insightful:

    • SONC cited the economic climate, competitive pricing, and the unpredictable weather as factors in the continued freefall in its top-line trends
    • CKR also attributed their sales results for the period ending December 28th to “poor weather conditions” and “ongoing weakness in the overall economy”
    • MCD reported that domestic comparable sales in November declined 0.6%.  This was below expectations and was the second month of reported declines.  I am expecting trends to remain negative in December (MCD is reporting December and 4Q09 results tomorrow before the market opens).
    • YUM guided to US same-store-sales growth of -8% in 4Q09, which implies about -4% for the full year.  Management guided to 2% same-store sales growth in 2010, which would imply another year of declining 2-year average trends.  Two-year trends have been declining despite lapping easy comparisons (something management has been willfully blind to)

    All restaurant chains are impacted by the economy but we believe that the effect is amplified for QSR chains.  QSR chains are heavily dependent on the 16-19 year old demographic, something highlighted by JACK management on their most recent earnings call and our 01/08/10 post, “QSR – ILL TAKE ONE JOB, HOLD THE BURGER”.


    FSR is facing easier comparisons but trends appear to be improving, on the margin, while QSR trends continue to worsen.  There has been some interesting detail provided by FSR companies regarding their marginal improvement of late. 

    • CAKE’S 4Q09 same-store-sales exceeded expectations, coming in at -0.9%.  This represented a sequential 20 bps deceleration on a two-year basis but still beat management’s guidance of -2% to -3%.  Management also stated that the sequential improvement in same-store-sales growth was “driven almost entirely by guest traffic”
    • CPKI’s management struck a positive tone in their preannouncement of fourth quarter results.  While high unemployment states continued to dampen sales growth, “comparable sales improvements in dine-in, take-out, and delivery channels were encouraging”.  Overall, comparable sales growth in the fourth quarter improved sequentially.  Nevertheless, two year trends continue to deteriorate on a sequential basis
    • BJRI’s preannouncement of comparable restaurant sales of -0.2% in the fourth quarter translated into a significant improvement in two year trends on a sequential basis.  Furthermore the company targets 13% growth in restaurant operating weeks in 2010
    • EAT’s blended same-store-sales growth of -3.1% beat the street’s expectations of -4.3%.  Two year trends for EAT’s blended same-store-sales improved about 70 bps on a sequential basis.
    • At the Cowen & Company Conference recently, PFCB co-CEO Bert Vivian was far more optimistic than last year during his presentation.  While he refrained from divulging any specifics, Mr. Vivian made it clear that while the social side of PCFB’s business is still soft, he expects business customers to continue to improve.  He anticipates modestly negative comps at the Bistro and positive comps at Pei Wei

    The tone is by no means positive in either segment but the divergence between QSR and FSR is becoming more and more apparent.  This view is certainly not consensus; for some time the dominant view has been that QSR will outperform FSR as diners remained focused on value and promotions.  A WSJ article published yesterday outlined the National Restaurant Association’s prediction for QSR chains to post a 3% rise in same-store-sales while FSR are expected to see a 1.2% rise in same-store-sales.  The prevalence of this thesis only makes our view, that FSR is outperforming QSR, all the more noteworthy.  To reiterate, unemployment seems to be impacting QSR, through its important demographic groups, more meaningfully than FSR chains and we expect QSR top-line trends to continue to lag behind until that situation improves. 


    Below is a table showing the divergence between the two segments with prices from 1/20/10 and weekly, 30 day, and 60 day price changes as well as volume and latest short interest:




    The Census Bureau reported yesterday that December housing starts fell month-to-month by 4.0% to 557,000.  The November number was revised (along with a downside revision to October) to show a 10.7% monthly gain, after initially having been reported up by 8.9%. Comparisons are easy as December 2008 starts collapsed by 15.1%, while the year-to-year change was up by 0.2% in December.  The December year-over-year number is evidence that even with the government stimulus measures the housing market has found a temporary bottom.    


    As you can see from the chart below, since December 2008, housing starts are bottoming at a very low level.  For all of 2009, housing starts averaged 551,750, again confirming that housing starts are bottoming at a very low historical rate. 


    The “bottoming process” for housing is shown in the chart below, but the return to growth is less certain and the number of “starts” is significantly below historical trends.  For all of 2009, housing starts remain 64% below the level of the past decade.  Given the current job market and the fact that the Obama Administration’s housing stimulus program will end in June 2009, a significant improvement in housing starts seems unlikely. 


    Howard Penney

    Managing Director



    Chinese Charts

    Since we are bearish on Chinese equities for the intermediate term, we called the Chinese government last night and had them doctor up the numbers again.


    Here are the reported results:


    1.       A sequential deceleration in monthly Industrial Production growth

    2.       A sequential acceleration in monthly Consumer Price Inflation growth


    If you are in the camp that these guys in Beijing are just making up the numbers, get over it and just give’m a buzz. They are looking for Americans who are not willfully blind.


    These two Chinese charts simplify a complex macro concept – growth slowing as costs (inflation) ramp. Someone is out there calling that a Chinese Ox In a Box.



    Keith R. McCullough
    Chief Executive Officer


    Chinese Charts - ch1


    Chinese Charts - ch2

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