It wasn’t a great quarter and FQ3 revenue guidance was disappointing. However, full year rev guidance was raised and long-term positive catalysts remain in place.



WMS revenue and gross profit missed Street projections in both gaming operations and product sales.  Similar to IGT, WMS was able to drive SG&A and R&D lower in the quarter as an offset.  At $0.44 in EPS we were a penny higher than the Street and right on with the actual.  International product sales were disappointing but they tend to be even more volatile than domestic product sales.


Despite slightly missing the Street’s gaming operations revenue and gross profit projections, that segment continues to impress us.  WMS’s WAP games are playing well, make more money for operators and therefore stay on the floor longer and yield higher dividends for WMS.  Depreciation per average installed device continues to decrease as the average life their install base lengthens.  We think that this “virtuous circle” of WMS growing its WAP footprint will continue as its games continue to produce.  If the portal application and Wagenet are a success we can see continued acceleration in gaming operations.


In terms of guidance, we are not surprised that FQ3 revenue guidance fell short of Street expectations.  The Street continues to miscalculate the impact of a dearth of new/expanded casino openings.  However, we are surprised that WMS raised its FY2010 revenue guidance by $5 million even as it lowered Street expectations for the near-term.  Visibility is not great in this sector so the prudent choice may have been to leave guidance unchanged.  However, the long-term positive catalysts for the sector remain in place so a revenue miss for a quarter or two may not matter. 


In-line FQ2 EPS.  Lower SG&A and R&D offset by lower than expected revenues and gross profit margins. FQ3 revenue guidance below Street but F2010 in-line.



  • On track to achieve continued revenue growth. 
  • Believe that they have the leading ship share in replacement. 
  • Continue to generate growth in their participation business.
  • At quarter end they had less than $10MM of debt and cash of $159MM
  • Anticipate to be slightly above the high end of their operating margin guidance of 21%
  • When BlueBird xD comes out they believe that it will be very well received based on its performance in trails
  • Improved economic environment in Europe should lead to a pick up in replacement units
  • First technical testing with one concessionaire in Italy to share shortly.  Believe that the market will be levered towards lease vs for sale product, given the high upfront capital investment
  • Application for license approval in Australia on the docket now.  Expect to get approved.  Expect shipments to ramp in the June quarter and continue to ramp thereafter.
  • Italy, Australia, Mexico and Helios launch should help them grow their international presence
  • Remainder of their gaming machines at Aria should be connected to SB "shortly."  In coming quarters, Aria will introduce their portal games and Wagenet.
  • Wagenet is currently on trial at several facilities and once approved that should be another engine of growth for them along with their portal technologies.
  • Expect to continue growing their WAP installed based and growth in average daily win per day.  Expect to remain above the high end of their guidance for daily fees on participation
  • ASP on sale games also exceeded the high end of their guidance, with the launch of BlueBird xD and strong performance of BB, ASP should continue to exceed $15,000 per unit for the balance of the year.  ASP will be negatively affected by Helios & Australia launches
  • Expected WMS's new unit volumes to increase in the 3rd quarter due to Mexico, replacements, and Helios
  • For FY2010 expect total units to be a little below the low end of their guidance, but ASP's to be above the high end of high end
  • Product sales gross margins were impacted by lower conversion sales, higher used game sales (lower margin), and increased shipments into new markets
  • Expect R&D to run at 14-15% of total revenues (above original guidance)
  • Continued to use cash to finance game sales
  • Expect future cash flow to be impacted due to investment in new WAP rollouts and Italy launch
  • Opportunistic share repurchases remain an attractive use of cash for WMS
  • Think that over time fewer customers will choose extended term financing, and think they will take advantage of discounts associated with shorter payment terms
  • Inducement charge for converts was $0.4MM


  • Illinios expect to have better than their average NA share, expect shipments to kick in 2Q2011
  • Internet gaming in UK follows on the heels of what they have already been doing with network gaming and online character customization. Won't launch until 2011
  • Their share of WAPs are growing, and think that their products coming out in the 2H2010 will allow their footprint to continue to grow
  • Seen a decrease in sale financing recently as operator balance sheets improve
  • Launch of Helios, a value priced platform, so that will depress ASP's a little but GM is similar to other products
  • Australia is through a distributor, hence the margins and ASPs will be a little lower than normal, but neither Helios nor Australia will have an impact on guidance
  • Italy will be part of their game ops business? Will be recorded in other gaming operations revenues so it won't impact their average daily fee.  Expect shipping in June 2010 Q but likely no revenue recognition until Sept Q since there's still testing to do.  Australia will happen before Italy
  • Think that their replacement share is in the low 30s
  • Game operations had some unfavorable jackpot expenses and lower high margin royalties
  • Product sales margins in 2H2010? Should be in the mid 50's range as volume increases.
  • Wizard of Oz continues to hold up very well, but have seen a slight degradation in the quarter - nothing alarming and Ruby Slippers should help
  • How is their Class II expansion going?
    • Shipped a few hundred units to Washington and some to Alabama and Oklahoma. Going slower than they expected but should ramp in 2H2010 (have some nice orders)
    • Right now they are predominantly selling the Class II games
  • Lord of the Rings, timing / strategy?
    • Coming out June/July time frame. Have great expectations, focus group testing and show responses have been great.  Think it can be another Wizard of Oz
  • Big negative working capital was in the Sept quarter, due to total receiveables increasing (financing) and increase in inventories due to the advance purchase of the computer chips, also some drag from royalty agreements. Hopeful that most of the WC drag is behind them
  • Where is the sequential increase in revenues in 3Q2010 coming from? Combination of better product sales and gaming operations. Highly unlikely that the gaming install base will decrease by YE
  • Depreciation in games operations continues to decrease?
    • games are staying on the floor longer

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I can’t seem to shake the bearish mentality!


The past three months have been kind to most restaurant stocks, especially casual dining.  Clearly, I have not been bullish enough, but I keep seeing macro data points that leave me concerned that any sequential improvement in restaurant demand has been driven by easy comparisons rather than any real improvement in underlying demand.  The current unemployment picture has clearly hurt the QSR names, but spared casual dining from seeing trends get any worse on a 1-year basis. 


The charts below, however, keep me up at night.  The consumer is still retrenching.  I know everybody needs to eat, but you can eat three meals a day at MCD for less than $12.  Knowing that more than 60% of casual dining meals (probably higher) are put on a credit card, the current trends in revolving credit don’t support a sustained recovery in casual dining. 



RESTAURANTS - TRYING TO SEE SOME GOOD - knapp vs consumer credit outstanding


RESTAURANTS - TRYING TO SEE SOME GOOD - knapp vs consumer credit outstanding 2 yr


Howard Penney

Managing Director

Keeping an Eye on Yue Yuen

Keeping an Eye on Yue Yuen


As the epicenter for many brands in the global supply chain for athletic and casual footwear, there are some meaningful category, geographic, and input cost callouts from Yue Yuen’s Q.


Total sales growth for Yue Yuen improved sequentially on the 1 year and 2 year.  Order flow marked a bottom in Q4 09 (September) at -6.1% (inventories down 8%) and rebounded in December’s Q1 10 at -3.4%.  Compares for the rest of the year are easy due to the sharp drop in sales in Q2 09.  Yue Yuen expects order flow from its brand name customers to be stable going forward and believes global consumer demand for athletic and casual shoes as well as athletic apparel will be reinvigorated by the World Cup.


Athletic shoes, which represent about 68% of wholesale sales, were at their weakest levels in Q4 09 at -15%.  Only shoe components came in weaker. These numbers have proven to be a lagging indicator to US footwear sales, so we’re not surprised by the weakness. In fact, we’d be alarmed if the numbers started to tick up meaningfully, as it would suggest that sales to the wholesale channel are picking up without us having seen the order flow on the front end. That would concern us as it relates to speculative inventory.  Casual and outdoor shoes sequentially improved in Q4 and performed as the only positive wholesale category in Yue Yuen’s portfolio.  Strong growth in Chinese retail at 17.4% from 9.8% in Q3 09 helped drive company topline to a sequential improvement.


Yue Yuen is banking on steady Chinese growth in athletic apparel and footwear from the increasing interests of the Chinese consumer in athletic lifestyle apparel and footwear.  South America, Europe, and the US remain weak while China and Asia continue to grow.  Revenue distribution amongst categories and geographies has been undergoing a dramatic shift as the Chinese athletic footwear and apparel market quickly surpasses the ailing US consumers.  US revenue has fallen from over 50% of Yue Yuen’s sales in 2002 to 31% in while Asian sales (over 90% is greater China) have grown from 14% to 39% over the same time period.  The growth in China’s slice of pie has been driven by Yue Yuen’s focus on retail where the company has over 10,000 points of distribution from its joint ventures and directly operated retailers.  Yue Yuen captured the emergence of the Chinese consumer as their retail business was less than 1% of sales in 2002, and is now greater than 20%.  Yue Yuen is positioned well for growth as the global emphasis shifts away from the US. 


The company cautioned that wages, commodities, currencies, and global responsibilities continue to pressure profits.  Minimum wage increases for factory workers is occurring across all of Asia and commodity prices are threatening margins.  The potential appreciation of the Renminbi, which has been demanded by developing countries, would hurt the manufacturing side of Yue Yuen’s business as FX will become a serious headwind.  They’ve been noting this for a while now, and the tone has not changed meaningfully – so there’s not much here that is new to us as it relates to our broader thesis.


-Zach Brown



Keeping an Eye on Yue Yuen - 1


Keeping an Eye on Yue Yuen - 2


Keeping an Eye on Yue Yuen - 3


Keeping an Eye on Yue Yuen - 4






Over the past two days we have gotten some incremental data points on the US housing market, none of which leaves me convinced that a real turn in housing is near.  Regarding today’s Case-Shiller news, I’m not going to get too excited about a statistically insignificant data point.


Based on the Case-Shiller data, the worst of the housing market is over with home prices, as reflected by the 20-City Composite, rising in November for the sixth consecutive month (on a seasonally adjusted basis).  The S&P/Case-Shiller home-price index increased 0.2% from last month, after a 0.3% rise in October.  Year-over-year, the index was down 5.3% from November 2008; the smallest year-over-year decline in two years.


The fact that the worst for the housing market is in the rear view is not new news and has certainly been discounted by the 62% increase in the S&P 500 since March 9, 2009.


Our “HOUSING GONE WILD” post from yesterday discusses the decline in the December existing home sales number.  This falloff in home sales, combined with other factors, which we outline below, strengthens our conviction that job growth will be the lifeblood of any sustained “recovery” in housing.


Outside of recent demand driven by tax credits, there is clearly underlying softness in the housing market.  Though it may try, the government cannot afford to support the market in perpetuity. 






If aggregate demand is not sufficient, there could be significant excess capacity in the market.  Census data shows that household formation has been slowing meaningfully over the past number of years and we believe that 2010 will fall in line with that trend. 




In addition, there has been an increase in rental households in the United States.  Home ownership is likely to become less of an option in the future with access to capital tightening and the cost of it increasing.  The chart below illustrates the boost in rental households in the United States since 2005.  As a percentage of total households, rental properties are still not at 1999 levels (red line in chart). 


HOUSING – GOVERNMENT SUPPORT VS GRAVITY - rental units as   of total


Any change in the level of immigration into the U.S. would impact overall demand for houses and we have heard, anecdotally, from some restaurant companies that people are leaving as jobs disappear.  Specifically, in reference to regional QSR demand trends, CKR management stated, “So it's really a state-by-state issue and illegal immigrants leaving one state for another state will hurt the restaurant business in the state they leave, not because we can't employ them but, I mean, where do you think those guys eat? They are late farm laborers and construction workers and you've got severe unemployment in certain Western states which will impact June…”


Supporting CKR’s comment, the Brookings Institute recently reported that the number of arrests at the U.S.-Mexico border, which is an indication of illegal crossing activity, dropped by more than 23% in 2009 to a 34-year low point.  The article attributes the lower number to “precipitously declining economic opportunity combined with beefed-up enforcement.”




Building permits seem to be indicating a possible increase in construction going forward.  Should this come to pass, it could add further stress to an already fragile market that has been leaning on Uncle Sam’s crutch.  In addition, inventory growth in recent years will continue to burden the market (as illustrated in the second chart below).






While housing inventory growth has slowed, the tsunami of inventory that came online in the years before the crash has not been absorbed.  In addition, there is the unquantifiable SHADOW INVENTORY, which reflects those homes that are on the balance sheets of financial institutions.  Although we have seen a decline in inventory, mortgage delinquencies as a percentage of total loans continue to rise.




Consumer appetite is certainly not going to meet this supply with unemployment at 10% and credit card debt data indicating a consumer that is hunkering down (as shown below).  Complicating this fact further is our “RATE RUN-UP” theme.  We believe the Fed is behind the curve and that 30-year mortgage rates are going higher.  The simple math behind a median home price of $178,300 at a rate of 5.11% yields a monthly interest payment of $759; at 6%, the monthly payment is $892 (17% higher) and at 6.2%, the monthly payment is $921 (21% worse).


Increasing jobs is the only way to get the economy weaned off government life support.




Howard Penney

Managing Director


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