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Red Light Risk

“As investors, we can’t change the course of events, but we can attempt to protect capital in the face of foreseeable risks.”

-David Einhorn

 

Admittedly, when “bottom’s up” hedge fund manager David Einhorn proclaimed his new macro mystery of investing faith at the ‘Value Investing Congress’ on October 19, 2009, I was smiling. Our Hedgeyes call this proactively managing macro risk and I do support Mr. Einhorn’s message.

 

Einhorn and I are about the same age. We both grew up in a hedge fund bubble. For a decade, we were probably both overpaid. He still runs money and I run my mouth, so I am thinking that he’s probably worth a lot more than me. But what does that mean?

 

To some in this business, that means a lot. To others, it means nothing at all. We all wake up early every morning with a passion to play this game. David’s Greenlight Capital now has its macro views. I have mine. Game on.

 

The global macro risk manager’s job in this business is to acknowledge amber flashing lights, before they go red. It’s also being keenly aware of when one of your big “ideas” is everyone else’s too. Measuring consensus is part of any repeatable Red Light Risk Management process.

 

Embedded in our macro risk management process are 3 dominating Global Macro Themes. We change them quarterly, because the math changes daily. As a reminder, my team’s current Macro Themes for Q1 of 2010 are:

 

1.       Buck Breakout (bullish on the US Dollar; bearish on gold)

2.       Rate Run-up (bearish on government bonds)

3.       Chinese Ox In A Box (bearish on Chinese equities; bullish on Chinese currency)

 

I do not know what Einhorn thinks on Macro Themes 2 and 3 but, now that he does macro, he obviously better have a view. That said, I do know that he stands on the other side of me with regards to both the US Dollar and Gold.

 

In that same speech, Einhorn made the following conclusions about gold:

 

1.       “Of course, gold should do very well if there is a sovereign debt default or currency crisis.”

2.       “I subscribed to Warren Buffett’s old criticism that gold just sits there with no yield and viewed gold’s long term value as difficult to assess.”

3.       “Gold does well when monetary and fiscal policies are poor and does poorly when they are sensible.”

 

After being bullish on gold since 2003, and vehemently bearish on what I labeled the “Burning Buck” in early 2009, I do think I have the credibility associated with understanding the bearish dollar/bullish gold case. There are many aspects to Einhorn’s conclusions that I agree with, but not at every price and every duration.

 

Now, if you really want to manage Red Light Risk in global macro, you better manage those two things dynamically  - price and duration. I have written about this before, but it’s worth mentioning again. Duration Mismatch is one of the top 3 risks that has hurt me over the course of my risk management career. We need to monitor it systematically and measure it scientifically.

 

Back to Einhorn’s points on gold. On an immediate (TRADE) to intermediate term (TREND) duration (3 weeks to 3 months), gold has not done well in the face of sovereign debt default risks rising. Now maybe he meant a sovereign debt default crisis in the USA and, to be fair, we should give him the benefit of the doubt until he replies to this. But, so far, with CDS (credit default swaps) in Greece blowing out to 414 basis points last night, gold is still going down.

 

Gold is going down because I am right on the Buck Breakout. Yes, as Mr. Buffet pointed out to David way back when, there are many risks embedded in evaluating the gold price. But those difficulties work both ways! Today, in terms of measuring the risks of being long gold, the r-square is highest relative to up moves in the US Dollar.

 

Managing Red Light Risk is just that. You have to accept that there are many types of investors telling many different types of qualitative stories about what it is that they are bullish on. You also have to accept that Mr. Macro Market’s math will rule the day over all the storytelling.

 

This morning the US Dollar is making a 5 month-high at $78.94. Gold is trading down another -1% for the week to-date at $1083/oz. I am long the US Dollar and short Gold via the UUP and GLD etfs, respectively, and I have a zero percent allocation in our Asset Allocation Model to Commodities.

 

The long term TAIL of resistance for the US Dollar Index is up at $80.21, and I think it’s going to test that line this year. My long term TAIL line of support for the gold price is down at $997/oz. That’s another -8% of Red Light “foreseeable risk” that these Hedgeyes are calling out for you Mr. Einhorn. Welcome to the game of proactively managing macro risk. It’s a full contact sport.

 

Best of luck out there today,

KM

 

LONG ETFS

 

XLV – SPDR Healthcare — We bought back our bullish intermediate term view on Healthcare on 1/22/10.

 

EWC – iShares Canada — We remain bullish on the intermediate term TREND for Canada. With a pullback in the ETF, we bought Canada on 1/15/10 and 1/21/10.

 

XLK – SPDR Technology — We bought back Tech after a healthy 2-day pullback on 1/7/10.

 

UUP – PowerShares US Dollar Index Fund — We bought the USD Fund on 1/4/10 as an explicit way to represent our Q1 2010 Macro Theme that we have labeled Buck Breakout (we were bearish on the USD in ’09).

 

EWG - iShares Germany —Buying back the bullish intermediate term TREND thesis Matt Hedrick maintains on Germany. We are short Russia and, from a European exposure perspective, like being long the lower beta DAX against the higher beta RTSI as well.


EWZ - iShares Brazil — As Greece and Dubai were blowing up, we took our Asset Allocation on International Equities to zero.  On 12/8/09 we started buying back exposure via our favorite country, Brazil, with the etf trading down on the day. We remain bullish on Brazil's commodity complex and believe the country's management of its interest rate policy has promoted stimulus.

CYB - WisdomTree Dreyfus Chinese Yuan — The Yuan is a managed floating currency that trades inside a 0.5% band around the official PBOC mark versus a FX basket. Not quite pegged, not truly floating; the speculative interest in the Yuan/USD forward market has increased dramatically in recent years. We trade the ETN CYB to take exposure to this managed currency in a managed economy hoping to manage our risk as the stimulus led recovery in China dominates global trade.

TIP - iShares TIPS — The iShares etf, TIP, which is 90% invested in the inflation protected sector of the US Treasury Market currently offers a compelling yield. We believe that future inflation expectations are mispriced and that TIPS are a efficient way to own yield on an inflation protected basis.

 
SHORT ETFS

 

GLD – SPDR Gold SharesWe re-shorted Gold on a bounce on 1/25/10. We remain bullish on the US Dollar and bearish on the intermediate term TREND for the gold price as a result.

 

IEF – iShares 7-10 Year Treasury One of our Macro Themes for Q1 of 2010 is "Rate Run-up". Our bearish view on US Treasuries is implied.
 
RSX – Market Vectors Russia
We shorted Russia on 12/18/09 after a terrible unemployment report and an intermediate term TREND view of oil’s price that’s bearish.

 

EWJ - iShares Japan While a sweeping victory for the Democratic Party of Japan has ended over 50 years of rule by the LDP bringing some hope to voters; the new leadership  appears, if anything, to have a less developed recovery plan than their predecessors. We view Japan as something of a Ponzi Economy -with a population maintaining very high savings rate whose nest eggs allow the government to borrow at ultra low interest levels in order to execute stimulus programs designed to encourage people to save less. This cycle of internal public debt accumulation (now hovering at close to 200% of GDP) is anchored to a vicious demographic curve that leaves the Japanese economy in the long-term position of a man treading water with a bowling ball in his hands


US STRATEGY – AND THEN THERE WERE THREE

After a 5.7% correction in the S&P500 since January 19th the Hedgeye Risk Management models have zero sectors positive on TRADE and only three sectors positive on TREND - XLI, XLY and XLV.  The S&P 500 came under pressure on Thursday, closing down 1.18%, though it did finish off their worst levels on the day. 

 

Yesterday, the blame game put Greece, the tax proposals in President Obama's State of the Union address, earnings and initial jobless numbers as the reason for yesterday’s decline.

 

On the MACRO front, Initial claims fell to 470,000 in the week-ended January 23rd from 478,000 in the prior week, compared with consensus expectations for a decline to 450K. On a rolling 4-week basis, average initial claims rose 9k to 457k from 448k and are up 15k in the last two weeks. While the rolling number remains within the channel of improvement (see yesterday’s post for the chart), it is moving to the upper band of that channel quickly. Given the historical tendency for this seasonally adjusted data to trend up in mid-to-late January we will give it the benefit of the doubt for now that the longer-term trend lower remains in place, but we think the next month's worth of data will be very important. It’s definitely time to pay attention.

 

Durable goods orders rose 0.3% month-to-month vs. consensus expectations for a 2% increase. The miss was fueled by a 38.2% decline in non-defense aircraft orders.  However, there were some positives, particularly in terms of the 1.3% increase in core capital goods, which followed an upwardly revised 3.1% increase in November.

 

The Dollar was strong again yesterday, up 0.29%, on the back of the increased RISK AVERSION trade surrounding the fiscal troubles in Greece and a 2.5% increase in the VIX.  The Hedgeye Risk Management models have the following levels for DXY – buy Trade (77.81) and Sell Trade (79.26). 

 

A surprising relative outperformer was the Financials (XLF).  The Banks were a bright spot yesterday with the BKX up 0.3% on the day   Regional and money center names fared the best with C, BAC and JPM up on the day. 

 

The best performing sector yesterday was the Consumer Staples (XLP).  RISK AVERSION played a big part in the outperformance, while P&G was up after the company raised its 2010 growth rate.

 

The RECOVERY trade remained under pressure with Materials (XLB) underperforming the S&P 500 by 60bps.  In addition, earnings out of the Technology (XLK) was not met with a warm reception, especially the results out of the communications equipment and semiconductors space.  Yesterday the XLK declined 2.9%, with the SOX down 3% and the S&P Communications Equipment Index down 6.95%.  QCOM declined 14.2% and was the worst performer after the company guided March quarter EPS below the consensus and MOT declined 12.4% on lower guidance too.  

 

As we look at today’s set up, the range for the S&P 500 is 32 points or 1.7% (1,065) downside and 1.1% (1,097) upside.  At the time of writing the major market futures are trading up slightly on the day.  

 

In early trading today, Copper is up slightly, but is looking at its worst monthly loss since December 2008, because of six-year high stockpiles, a stronger dollar and concern about China’s demand.  The Hedgeye Risk Management Quant models have the following levels for COPPER – buy Trade (3.10) and Sell Trade (3.32).

 

In early trading today Gold is little changed but is headed for its second monthly decline.  The decline in gold is consistent with our “BREAK-OUT BUCK” theme.  The Hedgeye Risk Management models have the following levels for GOLD – buy Trade (1,068) and Sell Trade (1,111).

 

Crude oil is trading slightly higher in early trading, but is looking at the second straight weekly decline and first monthly decline since September 2009.  The Hedgeye Risk Management models have the following levels for OIL – buy Trade (71.98) and Sell Trade (77.04).

 

Howard Penney

Managing Director

 

US STRATEGY – AND THEN THERE WERE THREE - sp1

 

US STRATEGY – AND THEN THERE WERE THREE - usdx2

 

US STRATEGY – AND THEN THERE WERE THREE - vix3

 

US STRATEGY – AND THEN THERE WERE THREE - oil4

 

US STRATEGY – AND THEN THERE WERE THREE - gold5

 

US STRATEGY – AND THEN THERE WERE THREE - copper6

 


ARO: Revisiting a Crowded Debate

It’s rare that Keith reaches out to us and says “XYZ Ticker looks awful” (based on his multi-factor models). Well, yesterday he said just that on ARO. At last count there were 34 published sell-side ratings on Aeropostale.  Wow, that’s a crowded debate!  That puts the “coverage” smack in the middle of the 23 analysts following GE and the 40 following Google.  So what does ARO do aside from selling cheap teen apparel to deserve all this attention?  Over the past year, the company has arguably been the biggest beneficiary in specialty apparel retailing from a confluence of positive events.  Let’s look at the facts:

  • The company’s highly promotional marketing approach and value pricing resonated well with the core 14-17 year old consumer over the past year.  Same store sales are up 10% YTD on top of an 8% increase in 2008.  With an average unit retail of around $11.80, there is no question that ARO’s price-driven merchandising strategy is working as higher priced competitors American Eagle and Abercrombie continued to lose share.  It’s no coincidence that Old Navy, Rue 21, and other deep value apparel retailers also outperformed.
  • Along with the topline, came an outright breakout in the company’s profitability.  With the fiscal year essentially over, ARO’s EBIT margins expanded by 400 bps in 2009- ending the year somewhere around 17.2% (beyond peak).  That puts ARO in the upper quartile of all vertically integrated specialty retailers, eclipsing JCG, GPS, ANF, and pretty much every other mall-based retailer on the planet.  Very rarely, if ever, have we seen a high-teens margin structure exist at a company that plays the in the value arena.  COH, ANF, CROX, DECK have all been there at one point or another, but these are all brands with price points substantially higher than ARO…
  • With 950 stores, ARO is no longer a growth driven story.  In fact, the core store base is pretty close to maturity.  As a result, same store sales leverage is huge. A fixed cost infrastructure pumping more and more units (180-190 million annually) through the same number of boxes is surely going to yield outsized upside.  This is especially true if you consider that one-third of the store base is approaching 10 years old and rents are probably pretty good in those locations.  Add to that some recession-driven cost cutting, and the formula makes a ton of sense.  Customer traffic increases (helped by the economy, supported by ARO’s aggressive marketing efforts) and throughput have been key to the strength in 2009.  But can this continue? And for how long?

Now let’s look at some concerns: 

  • While still in its infancy, the company’s key growth vehicle of the future is P.S. by Aeropostale, a concept aimed at a 7-12 year old consumer.  This makes a ton of sense longer term, as it’s probably cost effective to merchandise the brand as a “takedown” of the older original.  However, any ramp on growth will be a negative based on mix alone.  It’s near impossible for a chain of 40 or so stores to approach company average margins without greater scale.  Yes, it is still early to make a call on the concept’s eventual success, but nonetheless it’s both risky and margin dilutive in the near term.
  • Management cites the company’s past history when AUR’s were closer to $14-$15 vs. $11.80 today.  This is an opportunity according to management, and it surely seems like one on the surface.  However, raising prices (even if done the right way through better quality, trims, features) seems counter to what has been driving the business over the past two years.  Given the company’s strength in driving price driven purchase decisions, it seems unlikely that taking prices higher will be well received.  Yes, adding more fashion product into the mix has been in part a reason to command a higher ticket, but this also adds inventory risk.  ARO has historically been a fashion follower, which makes it hard to believe that they can successfully transition into a fashion leader. 
  • Co-CEO’s will take the helm in 2010.  The combination of an operating executive and a merchandising executive makes sense on paper, but this combo rarely works.  Before you email us with examples of how this has worked in the past, Aeropostale is no Ralph Lauren.
  • The shares have generally stopped responding positively, to positive news.  Even with continued upward earnings revisions, driven by outsized same store sales it appears that even the most aggressive assumptions are already discounted in the stock.  Yes, the shares appear cheap at 10x this year’s earnings, but the reality of slowing comps and potential EBIT margin contraction is likely to keep a lid on the shares at a minimum.  Any hiccups along the way with management’s transition and potential inventory build and this suddenly becomes one of our favorite shorts…

ARO: Revisiting a Crowded Debate - ARO earnings adj 1 10

 

  • Finally, our latest SIGMA analysis suggests that the peak may have already occurred.  Sales are still outpacing inventory growth, but the spread is narrowing.  Margin compares begin to increase meaningfully in 1Q.   With such a heavy reliance on selling more and more units, it’s becoming harder to envision a third year in a row of outsized same-store sales without a commitment to more inventory and/or higher price points.  Both prospects would suggest higher incremental risk…

ARO: Revisiting a Crowded Debate - ARO S 1 10

 

Eric Levine

Director


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Continued Sovereign Debt Buildup

I wrote a note a few days ago that summarized some key points from, “This Time is Different”, by Carmen Reinhart and Ken Rogoff.  As they write, global financial crises initiated by sovereign debt defaults are much more typical than most investors realize.  In many instances, the debt to GDP ratio of 0.9 is a metric that signals when many less than mature economies will risk defaults.

 

In the year-to-date, we have seen a massive issuance of global debt as many nations are attempting to plug holes in their budgets.  Below we’ve outlined from press releases some of the key recent issuances and their dates:

 

1/25 – Greece is reportedly trying to sell $32.5 billion of government bonds to the Chinese in a deal brokered by Goldman Sachs.  This deal would be more than 3x the size of the National Bank of Greece.

 

1/26 - Hungary on Tuesday sold $2 billion worth of 10-year debt, mainly to U.S. investors, in a move confirming its plans to come off International Monetary Fund aid this year.  Hungary sold the debt at a discount price of 99.86, bringing a yield of 6.269 or 265 basis points over comparable U.S. Treasuries, Deutsche Bank, one of the lead managers of the deal said.

 

1/26 -Vietnam raised $1 billion from its second global bond sale, offering higher yields than lower-rated Philippines and Indonesia, amid the busiest start to a year for global borrowing by developing nations since 2005.  The central bank set a 7 percent limit on the yield, the minimum amount investors AllianceBernstein L.P. and Western Asset Management estimated would be required to attract sufficient orders.

 

1/25- Greece raised 8 billion euros of a 5-year syndicated bond at a yield of 6.2%. The bond attracted total bids of EUR 25 billion, well above the EUR 3 billion to EUR 5 billion targeted by the government.

 

1/13- Indonesia scaled back an offering of dollar bonds to $2 billion from as much as $4 billion and scrapped a 30-year portion yesterday, people familiar with the deal said. Poland by contrast raised the most ever in a single sale of zloty bonds today, receiving 5.5 billion zloty ($2 billion) after 16.2 billion zloty of orders.

 

1/11 - Mexico sold $1 billion of bonds in the country’s first international offering since its credit rating was cut by Standard & Poor’s and Fitch Ratings. The bonds yield 5.25 percent, or about 1.42 percentage points more than U.S. Treasuries, the Finance Ministry said in a statement.

 

This acceleration of global debt issuances appears to be leading to a bubble in sovereign debt.  While we are not at bubble stage yet, we will be very focused on monitoring the issuance in the coming months.

 

Former Citigroup Chairman Walter Wriston once famously said, “Countries don’t go bust.”  In that case Mr. Wriston we have some Zimbabwean 30-years for you to buy . . .

 

 

Daryl Jones

Managing Director

 


LVS TRANSCRIPT FROM INVESTOR CONFERENCE

From the presentation that just ended.

 

 

LAS VEGAS COMMENTARY

  • Current operating environment in Las Vegas?
    • Supply and demand environment that are out of balance hence putting pressure on rates
    • Still doing good volume but at materially discounted rates than 2 years ago
  • $200/night is still a reasonable but difficult rate to maintain given the competition.  However, they have reduced their expenses as well – despite the lower gross margins on rooms
  • 2010 group nights will definitely be better than 2009 – what’s on the books now is already better than 2009
    • Political rhetoric is over and Vegas is no longer a shunned location
    • Not at all worried about the group business in 2010 & 2011
  • The whole market is seeing more group activity than last year - the problem is getting that business at the rates that they used to have, and that’s not going to happen in 2010 and not in early 2011.  Although 2011 rates are up a little from 2010
  • Are there incremental opportunities to cut more costs here and in Vegas?
    • There are always opportunities, but the low hanging fruit is gone
    • Have 6500 employees in Vegas (casino/hotel level) – so think that they are pretty efficient given that they have 7,000 rooms

MACAU

  • Take on political climate in Macau
    • Government of China has been very vociferous in supporting MICE and tourism business in Macau
    • As far as Visa & financial restrictions, expect that there will be some restrictions to allow for absorption.  Already said that they want Macau’s growth will be a few points above China’s GDP (~15%)
    • Feel like they are perfectly aligned with the government’s policy
  • Have had some success at growing direct play at FS.  However, junkets often try to steal that business
  • Their real success will hinge on a good balance btw VIP and Mass

OTHER

  • Balance of VIP/Mass play in Singapore given the junket restrictions?
    • They are building their business based on the assumption that they will have no junket business.  
    • Will build their business on direct play and bussing programs (Malaysia for example)
    • Don’t think that many junkets will apply for licenses
    • Don’t know the mix right now, but Singapore is very accessible by flights
    • Piaza club (100 tables) Mass floor (600 tables) Slots (1500)
  • US entity is still very highly leveraged, what are the long term plans?
    • $5BN debt in the US restricted group, and $4.5BN of cash… they can meet covenants as long as they have > $3BN of cash in the bank
    • Once Singapore opens they can see what the cash flow/cash needs will be they can make a decision

Q&A

  • Strategy in PA?
    • Disappointed with the numbers so far.
    • They will put in the tables games (80 tables) at a cost of $16-17MM. Projecting roughly a $25MM benefit from tables that open in the fall
    • No plans to start the hotels again until they can see justification from table games.  Will be using a newly opened Hyatt nearby for table players
    • Will have improved results in Bethlehem, slot facilities take about 17 months to ramp
  • RevPAR in Vegas for 2010 & 2011?
    • Guess is that in 2010 RevPAR will be down – but depends on what people put in for their “casino rooms” but that’s a fudged number since it includes comps.  Cash rooms will have lower rates
  • Will finish Sites 5 & 6 on Cotai with $500MM more equity

SLOTS: DEEP THOUGHTS

With the Big Three already reporting, here are some observations, some of which we will expound upon in more detail in later posts.

 

 

REPLACEMENT DEMAND

NA replacements for the industry seem closer to 10,000 than our 7,500 estimate but that doesn’t mean replacement demand is necessarily spiking

  • December is usually the seasonally slowest quarter for replacements but seasonality didn’t seem to hold up this year
  • It appears that some operators, having under-ordered all year decided to go the “use it or lose it” path and spent their previously allocated budgets rather than losing them.
  • Anecdotally, almost all the manufacturers stated that they weren’t seeing a big pick up in replacement orders yet despite positive sentiment.  Seems like operators are taking a cautious approach to utilizing their budgets.

 

 

NEW/EXPANSION UNITS

New and expansion shipments in the December quarter were lower than our estimate.  We crossed checked our numbers with several suppliers and don’t yet have a great explanation as to why, since our original estimates weren’t far off of their estimates.  So what happened?  We don’t know exactly but here are some preliminary thoughts:

  • Our estimate included shipments of some participation units
    • The 1,700 units shipped to Alabama’s County Crossing almost all participation/lease
    • Generally 8% of total shipments are participation or lease
    • We estimate roughly 1,000 quarterly shipments into Washington State (replacements) & Florida (conversion to Class III) - these units may be accounted for in replacement demand by operators
    • There is always the issue of timing.  We generally assume that large openings & expansions ship one quarter in advance while smaller ones can go either way depending on timing of opening. Looking back at last quarter it does appear that close to 1,000 units that we accounted for in the 4Q09 were actually shipped in 3Q09.  It’s also likely that perhaps 1,000 units that we accounted for in this quarter won’t be recognized until next quarter
    • Not all the units that go into a new facility or expansion are actually new units, many casinos have some used machines or machines relocated from other facilities to the extent they operate more than one casino. (River City is a good example)
    • Many facilities open with less units than what they announce to name a few (Parx Casino, River City, Choctow Durant expansion)

 

CONVERSIONS

All 3 manufactures reported lower conversion kit sales, why is that?

  • One of our takeaways at G2E was that while manufacturers weren’t explicitly discounting they were throwing more in – like more themes with each title
  • Perhaps content is just better and therefore lasting longer on the floors… we did walk away thinking that all the manufacturers had stepped up their game

 

EARNINGS MANAGEMENT

All three manufacturers have learned to manage expenses to meet guidance and there’s nothing like lower tax rates to save the day.  Tax rates were low across the board.  IGT and WMS reported SG&A and R&D that was below trend and expectation.  BYI posted a very high product gross margin and also lower R&D than we thought.  Revenues were light for each of the Big Three.


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