US gaming revenues still haven’t reached a definitive recovery phase and investors are worried. That worry spreads to suppliers and their gaming ops segments. BYI looks the most protected.
Which supplier should you own given the current casino environment? Well, that depends on your outlook. If you are looking for a V-shaped recovery in gaming spend, then WMS or IGT is your best bet. Close to 100% of WMS gaming operations revenue is on a variable revenue share basis, while for IGT it is 75%. However, IGT generates approximately 57% of its revenue from gaming operations and WMS only 40%. Thus, on a net basis, IGT has a higher exposure to casino variability at 43% versus 38%.
If you think casino revenue growth will stay sluggish/negative and potentially take a turn for the worse, then you short the operators and stay away from the suppliers. If you must own a supplier stock, then BYI is for you. BYI generates approximately 50% of its gaming operations revenue from fixed daily fee structures and 50% variable. Moreover, only 36% of its total revenues is derived from gaming operations so net exposure to casino revenue variability is only 18%.
Of course, should US gaming revenues take the plunge, the recent acceleration in replacement demand will be short-lived and operators will cut back. That will not benefit any equipment supplier. BYI would be relatively better off in that scenario and is probably the lower risk slot play.
“Everything we hear is an opinion, not a fact. Everything we see is a perspective, not the truth.”
Austerity is the new buzz word in Europe; from newly elected UK Prime Minister David Cameron in the north to Italian PM Silvio Berlusconi in the south, the issuance of austerity measures from European governments to combat bloated fiscal imbalances seems like a near daily occurrence.
The word austerity comes from the Latin austerus meaning “dry, harsh, sour, tart” and was originally used to describe fruit and wine, however in economics refers to a government’s reduction in spending and/or increases in taxes to reduce a budget deficit. Over the last weeks, European austerity packages have included such provisions as civil servant wage freezes, extensions on the age of retirement, and levies on alcohol and tobacco to an additional tax on the price of an airplane ticket. In short, governments are trimming obvious “fat” and creating revenue streams to rein in over-extended budgets.
Here’s a quick recap of budget deficits (as a percentage of GDP) and the notable austerity packages issued in Europe over the last months:
Greece – (13.6%); plans to cut €30 Billion in spending over the next three years
UK – (11.5%); £6.2 Billion (or €7 Billion) in spending cuts this year
Spain – (11.2%); €15 Billion in spending cuts and 5% reduction in public worker wage this year
Portugal – (9.4%); plans to issue measures to save €2 billion this year
Italy – (5.3%); €25 Billion in cuts over two years (*strike planned for June 25th)
Germany – (3.3%); €11.2 Billion in spending cuts for next year, or ~€85 Billion by 2014.
The most obvious question to ask is will these measures be enough to reduce deficits and return “health” to Europe?
In both the immediate and longer term the answer to this question appears to be No and a qualified No. In the near term, Europeans are taking to the streets, with strikes over austerity measures already held in Greece and Spain. While the estimated 2.5MM strikers in Spain appeared mostly harmless (a colleague likened the visual displays on TV to a pre-game World Cup party), strikes in Greece had a very ugly undertone with the death of 3 protestors. As Keith has noted recently, austerity will equate to civil unrest: the confluence of a government’s need to tax its people versus the public’s cry that they aren’t responsible for the government’s fiscal mismanagement, and therefore refusal to bear the brunt of the measures. We believe that deficit reduction alone won’t solve Europe’s fiscal problems.
In the longer term there are numerous structural and fundamental concerns related to the Eurozone. We’ve pointed out in our quarterly theme work that the investment risk related to sovereign debt default or restructuring is not limited to Greece, but will spread to Spain, France, and Italy, much larger economies than Greece with debt exposure to European banks far greater than Greece’s obligations by a factor of 4-5 times. The outcome could cause further (and greater) downward pressure on markets.
Importantly, it’s worth noting that the European and IMF-led €750 trillion “loan” facility to buy up toxic debt from European countries “in need” (and return investor confidence) has failed to buoy European markets largely because ECB President Jean-Claude Trichet has not outlined just how the facility works! As a result, we’ve tracked increases in government bond yields, sovereign CDS, and equity underperformance, along with the Euro-USD that broke through our immediate term support line of $1.20-1.21 earlier this week to a low of $1.1876 on 6/7 and is down 15% YTD.
Further, what we have seen since the facility was announced on May 10th is strong headline risk (think comments from a Hungarian official last week of a Greece-like debt crisis in his country that sent markets plunging) and continued day-to-day volatility. Also, the separate European/IMF funded €110 Billion aid package to Greece hasn’t made a dent in performance or sentiment: the Athex is down 33% YTD and the worst performing major index in the world.
Could it be that the experiment of uniting disparate economies is a losing effort?
As we see it, there are two main threads of questions that still need to be worked through to determine the path of the Eurozone:
Clearly these are big questions, all of which we don’t have the answer for. What we can count on is the continued lack of political solidarity from European leaders to proactively address the region’s ails, which is risk we’re focused on managing around. Statements yesterday from EU President Herman Van Rompuy are case in point: “And if the plan [€750 Billion loan facility] were to prove insufficient, my answer is simple: in this case, we’ll do more.” This is not leadership!
If austerity is the first start to something better, we caution that weaker growth prospects are ahead for much of Europe. In the longer term, it just may be that despite the Eurozone’s intention for the whole to be stronger than the individual parts, disparate parts may remain just that, or conversely, and to quote a line from William Butler Yeats’ poem “The Second Coming”: Things fall apart; the center cannot hold.
We’re currently short France in our virtual portfolio via the etf EWQ and have been short Spain (EWP) this year as a way to play the weakness we see in Europe.
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On 5/19 we published a note titled, “WEN - Undervalued Yes, Where is the Opportunity?” that discussed WEN’s stock and provided a sum-of-the-parts analysis that suggested that the company’s stock was trading below its intrinsic value.
I said at the time, “Over the years, Trian Partners has been extremely successful at creating value from mispriced securities. In the almost two years since creating the Wendy’s/Arby’s Group, it has now created one of those mispriced equities. Can Trian and senior management fix WEN again?”
After the close yesterday, Train said in a 13D/A filing that it recently received an oral inquiry from a third party expressing interest on a preliminary basis in a potential acquisition involving WEN. Our sum of the parts analysis from 5/19 values the WEN at $7.70. We value the Wendy’s business at $6.30 per share and the Arby’s business at $1.40 per share. Send me an email if you would like additional details.
Thus far WEN is the third company to announce some sort of value enhancing initiative. Fist it was CKE, then CPKI and now WEN. If you are looking for the next possible candidate I would bet on EAT...
Despite Keith’s selling of EAT in the firm’s virtual portfolio, we remain confident in the long-term opportunities for Brinker shares.
By now, many of our subscribers are aware of our unique process at Hedgeye that marries Keith’s macro and quantitative views with our company-focused fundamental perspective. While Keith’s move here is primarily predicated on his broader view of the market, we want to reiterate that our fundamental, long-term view on Brinker shares and the company’s turnaround efforts at Chili’s remain unchanged.
Specifically, Keith provided the following perspective on his move to sell EAT in the portfolio, “I'm going to take the loss here and sell the stock on an up day. Penney remains bullish for the long term here but is becoming increasingly negative on competitor balance sheets like DIN.”
I would agree with Keith that the MACRO environment will remain challenging in the near-term and overleveraged balance sheets will only magnify those challenges for certain restaurant companies, like DIN, but I would actually point to DIN’s balance sheet issues as a positive for Brinker. As I outlined in my EAT Black Book, Brinker has a strong balance sheet and one primary reason I think the company will outperform in these challenging times, in the more challenging Bar and Grill segment, is that its largest competitor (DIN’s Applebee’s) does not have the financial capability to compete. And, as I said earlier this week, I continue to believe it will be important to focus on those companies that are being proactive and creating leaner, more efficient cost structures as they will be better positioned to mitigate margin erosion in a tough sales environment. To that end, EAT is one name that is pursuing a proactive strategy and remains a core focus name.
To be clear, when I became more vocal on the reasons to own EAT, I stated that sales trends through the end of fiscal 2010 would be choppy as Chili’s attempts to decrease its reliance on aggressive discounting (and move away from “3 Courses for $20) and as customers adjust to the significant menu changes at the concept. That being said, management’s efforts to revitalize the brand from both the retail and manufacturing sides puts the company on track to post significant margin growth at about the same time top-line trends should begin to recover, beginning in FY11; though I think the margin story will materialize even without a significant tick up in trends.
There seems to be a lot of confusion among investors about the timing of implementation for POS, KDS and kitchen retrofits and the subsequent 500 bp margin benefit (net 400 bps after depreciation) forecast to materialize by the end fiscal 2013, but management said very specifically at an investor conference this week, “So we do think more than half of the 500 basis points of margin improvement will be in place by the end of fiscal 2011.” I do not think most investors were forecasting this level of growth in FY11 and management’s comment only strengthens my conviction that the street’s FY11 EPS estimate is too low.
Management seems confident about its potential earnings growth in the next two years. EAT’s 5-year target to double EPS by FY15, off of the $1.40-$1.44 base, with 10%-12% EPS growth in FY13-FY15 implies 40% to 50% EPS growth from FY10 to FY12. This two-year target assumes 1% to 2% same-store sales growth, which seems achievable; though it does it rely on sequentially better 2-year trends going forward.
I am comfortable saying again what I wrote on April 20th, following Brinker’s fiscal 3Q10 earnings call, “I know things don’t happen in a straight line and there will be bumps in the road, but I want to be a little early on this one. Once it gets going, it’s gone…”
“China is teeing themselves up to take over the financial world.”
-Keith McCullough, June 10th, 2010
Conclusion: China is starting to look interesting on the long side, as the stock market has priced in slowing economic growth.
Bottoms are processes, not points. With the Shanghai Composite down just over 21% YTD, it’s obvious that investors have been discounting what we are starting to see evidence of: slowing growth. At a point, however, that all gets baked into the market and bottomed-out, downward growth expectations begin to shift on the margin towards upward growth forecasts. Combined with the prospects of a simple intermediate-term mean reversion trade (China has underperformed all major equity indices YTD except Greece, Spain, and Slovakia), it’s easy to see why we’re starting to warm up to China on the long side – of course not at every price. We’ll wait for more confirmation of the Shanghai Composite’s higher-low to begin looking for an entry point.
For now, allow the charts below to tell the story on China and what the forward growth outlook is from here.
No surprise here: Chinese equity markets and Chinese demand for copper (as measured by our proprietary Hedgeye China Market Index) have been a leading indicator for growth. As our index would suggest, GDP growth peaked in 1Q10.
The YTD look at the Hedgeye China Market Index suggests that Chinese GDP growth will decline sequentially from its 11.9% peak in 1Q10. The markets have been pricing this in. At a point, what has been priced in will begin surprise to the upside.
Chinese real estate prices were up 12.4% Y/Y in May – the first sequential deceleration in a year. It appears the peak has been established, which has been priced into the Chinese equity market for quite some time. With peak property price growth perhaps in the rear view, the next question logical question will be where will the current cycle bottom out?
To a large extent, the answer to that question will be to watch the Chinese equity markets and the price of copper. With a positive 0.78 correlation (0.61 r-squared) to property price growth for the last three years, our Hedgeye China Market Index should prove to be a reasonably reliable concurrent indicator for the growth of one of China’s main industries. If Chinese property price growth continues to sequentially decline, we expect those declines to bottom out alongside, or shortly after we’ve put in a bottom in Chinese stocks.
Much to-do has been made about the Chinese trade numbers released overnight (Trade surplus – $19.5B in May vs. $1.7B in April; Exports up sequentially – 48.5% Y/Y in May vs. 30.5% Y/Y in April; Imports down sequentially – 48.3% Y/Y in May vs. 49.7% Y/Y in April). Members of the Manic Media appear puzzled that May could produce such large gains in exports – especially with a significantly weaker Euro. Analysis shows, however, that the May 2009’s export growth compare (-26.4% Y/Y) was the easiest “comp” on record. It appears basic math and probability analysis trumps even European sovereign debt scares, or the analytical skills of the Manic Media.
Lastly, a sequential deceleration in import growth is just what the Chinese wanted to see. With what is widely considered an “undervalued” currency, the Chinese are prone to importing inflation. To gauge real-time, we’ve created rolled out our Hedgeye China Growth Commodities Index, which indexes the price of copper, crude oil, and aluminum to the start of the year. The chart below suggests that China indeed imported deflationary commodity prices in May and is continuing to do so in June. No surprise that China’s copper and aluminum imports were down Y/Y in May (-6.1% and -71.5% respectively).
So what does this all mean? You have a government that put the screws to its economy in order to cool growth and it appears the peaks have been established, making it less likely we’ll see more tightening in the near term and likely that perhaps equities have already discounted future slowing growth.
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