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Digging deeper into the incremental R&D



The vagaries of GAAP accounting force companies to expense Research and Development expenses as incurred.  In the slot industry, some R&D is indeed maintenance but much of it benefits future periods and could be considered investment spend.  WMS fell 3% yesterday – it was actually down more than 6% at one point – due in part to guidance for higher R&D reducing EPS by $0.10-0.12 in FY2011.


Would anyone care if R&D expenses were capitalized and WMS jacked them up by $10m?  Think about it.  Applying a 20x multiple on the $0.10 FY2011 hit yields $2 in value loss versus $0.17 ($10m divided by 58m shares) in stock value if R&D was accounted for as investment spend – and that would assume zero ROI.  So the real question is whether the incremental R&D is recurring, i.e. maintenance, or is it true investment?.  We think the latter.


While management was a little stingy with details of the incremental R&D spend, we’ve got some juice:


Incremental R&D

  • $10m step up has to do with networked gaming – WageNET
  • WMS has gotten a very favorable response to the WageNET products that are a few years out.  Customers want the products sooner rather than later. 
  • Essentially accelerating the commercialization of WageNET
  • Being opaque for competitive reasons (but some of it is what they’ve talked about like cashless account-based wagering)
  • Opening India too, so they can work around the clock
  • Won’t see a revenue benefit for 12-15 months

WMS has no debt and operating cash flow is finally ramping.  The beauty of the model is that they can grow and still generate positive cash flow.  The high class problem is where to spend it.  Share buyback?  Yes - $300 million worth.  Invest in the business?  Yes - $10m incremental in R&D and $40m in incremental Capex for Italy, leased games, and growing/refreshing the participation base.  Rather than detracting from value, these expenditures will generate future ROI and should be accounted for as such.


Jobs, Jobs, Jobs .... Still No Signs of Progress

Initial claims rose by 19k last week to 479k (rising 22k net of the revision).  Rolling claims came in at 458.5k, a rise of 5.25k over the previous week. This is the largest increase in the rolling series since early April, but it still remains in the range of 450-470k that it has occupied for all of 2010. Ultimately, we are still looking for initial claims in the 375-400k range before unemployment meaningfully improves. 


Our firm is of the strong view that US economic growth is going to slow markedly in the back half of this year and into 2011. We think this will keep a lid on new hiring activity and will keep cost rationalization paramount in the minds of C-suite executives. All of this raises the risks that a prospective slowdown in GDP will precipitate an incremental slowdown in hiring/pickup in firings, which will, in turn, further pressure growth. We continue to look to claims as the best indicator for the job market, as they are real time and inflections in the series have signaled important turning points in the market in the past.






The table below shows the stock performance of each Financial subsector over four durations. 




Below we show the correlations between initial claims and each of the 30 Financial Subsectors. We have refreshed this table to reflect prices through the end of July. Using this updated measure, Credit Card and Payment Processing companies remain the most correlated to initial claims, with R-squared values of .63 and .65 over the last year, respectively. Surprisingly, some subsectors show a positive correlation coefficient to initial claims - i.e. Financials that go up as unemployment claims go up.  These names are concentrated in the Pacific Northwest Banks and Construction Banks, though these correlations are usually not very high.  


INITIAL CLAIMS RISE 19K - NO SIGNS OF PROGRESS - init. claims subsector correlation analysis as of 8.4.10


Astute investors will note that in some cases the R-squared doesn't seem to reconcile with the square of the correlation coefficient. This is a result of finding the correlation and then averaging. For example, Pacific Northwest Banks have an average correlation coefficient of .33 and an average R-squared of .52 (with CACB, CTBK, FTBK, and STSA strongly positively correlated and UMPQ strongly negatively correlated). The different directions have the effect of canceling out each other out when finding the average correlation coefficient, but do not cancel out when finding the average R-squared. 


The following table shows the most highly correlated stocks (both positively and negatively correlated) with initial claims. Note that the top 15 negatively correlated stocks have a much stronger correlation on average than the top 15 positively correlated stocks - as you would expect, given that most of the Financial space is pro-cyclical. 


INITIAL CLAIMS RISE 19K - NO SIGNS OF PROGRESS - init. claims company correlation analysis as of 8.4.10


As a reminder, May was the peak month of Census hiring, and it should now be a headwind through September as the Census continues to wind down.




Joshua Steiner, CFA


Allison Kaptur

The Cliffs of Insanity

“All truths are easy to understand once they are discovered; the point is to discover them.”
- Galileo Galilei


The penalties for non-consensus thinking were harsher 400 years ago. In 1610 Galileo published his observational studies of the moons of Jupiter as evidence in support of Copernicanism and a heliocentric model of the solar system. At the time, most astronomers still believed in a geocentric model and considered a heliocentric model outrageous. Galileo’s work was derided by many of his contemporaries and, ultimately, Galileo was brought before the Roman Inquisition for heresy, tried, found guilty and forced to spend the rest of his life under house arrest.


Fortunately in today’s world the penalties for having a non-consensus view generally aren’t as severe. That said, it can still take a long time for certain entrenched assumptions to change and evolve, which brings us to the subject of today’s Early Look. One such entrenched assumption in the investment community today is that home prices are unlikely to fall materially from here.


For those unfamiliar, our view on housing is bearish and our argument relies principally on supply and demand data, and the imbalances that exist between them. Our analysis has sought to both measure and quantify the effects of dislocations in supply and demand in housing and the lagged effects these imbalances have on home prices. Our conclusion is that based on the current supply and demand imbalance, prices will be 15-20% lower in 12-18 months on a national basis. This is an overly simplistic summary of a 100+ page presentation we’ve assembled on the subject, but below we present just a few of the facts worth considering.


Consider the following. There are currently 3.99 million homes on the market for sale as of the end of June. Existing home sales were 5.37 million (seasonally adjusted annualized rate) in June, which equates to 8.9 months of supply. This is disingenuous, however, as June existing home sales represent April contract activity. We know that post-April pending homes sales are down over 30% through May and June. As such, we would expect a comparable decline in existing home sales once the data rolls through on a lag later this month. In other words, existing home sales for July/August will be in the ~4 million range, which will be a wake-up call to the Panglossian bulls. Assuming inventory remains around 4 million this will equate to ~12 months of supply. The market is often considered in equilibrium when inventory is 5-6 months of supply. For reference, 12 months will be the highest amount of supply seen since the housing downturn began. This 12 months figure does not include shadow inventory, which likely represents an additional 4.2 to 6.0 million homes (according to estimates from the Mortgage Bankers Association, the Federal Government’s HAMP Program, and Lender Processing Services, the largest mortgage default processor in the country.)


Laurie Goodman, a Senior Managing Director with Amherst Securities, one of the leading providers of mortgage data analytics, recently published a paper in the Financial Analysts Journal entitled “Dimensioning the Housing Crisis” in which she submits that from the beginning of the crisis (YE06) through today there have been 1.5 million homes liquidated through foreclosure and short sale. During this timeframe, depending on which housing series you use, home prices have fallen 20-35% nationally. Using conservative assumptions, she concludes that a further 11-12 million homes will be liquidated in coming years. If 1.5 million liquidations coupled with broader supply/demand imbalances triggered 20-35% downside in home prices, consider what 11-12mn liquidations will do amid a more severe underlying supply/demand imbalance.


While the government has intervened over the past 18 months to try and arrest the rate of decline in home prices, we think their efforts have merely kicked the can down the road and have done little to alter the underlying nature of the problem. Ultimately, the pressure from foreclosures will outstrip the government’s ability to hold back the supply.


Touching briefly on the demand side of the equation, demand for mortgages as measured by the MBA Purchase Index has been steadily falling for the last five years.  After averaging 471 in 2005, the Purchase Index fell to 264 in 2009 (-44%).  2010 to date is down to 209 (-55%).  The month of July averaged just 170, a 64% decline from 2005.  For reference, 2010 year-to-date demand is consistent with demand last seen in 1, while July demand is consistent with levels last seen in 1995. 


It seems obvious to us that home prices are headed materially lower from here, yet many people – most in fact – don’t agree. There are a host of reasons we’ve had explained to us why home prices shouldn’t go down from here. The most oft-cited is the demographics argument, namely that there should be solid net new household formation over the next several years that will drive marginal demand for homes high enough to absorb existing supply, shadow inventory and whatever other pressures might come down the road.


It’s foolish to dismiss criticism out of hand without first thinking it through – especially when multiple investors are telling you the same thing. To that end, we’ve analyzed the core of the argument that household formation is set to take off, and what we’ve found is quite interesting. The chart at the end of this report shows data that we don’t think many people are aware exists. It represents real household formation rates through June 2010. We have the data monthly – not many people do. What is striking is that it shows that in the first half of 2010 the number of households in the US actually shrank. This is the first time this has happened since the data series began, and our data goes back to the 1950s. Moreover, negative growth in 1H10 follows anemic growth in 2008 and 2009.


Why is this? Normally, some 60% of net new household formation occurs in the 20-29 year old demographic. It’s typically at this age when a young person moves away from home and, in doing so, a new household is created. The catch is that unemployment is at 9.5% nationally, and the unemployment rate for this age cohort is well into the teens. Remember, household formation is a derivative of confidence, which itself is merely an extension of the employment environment. This lack of confidence must be having a profound effect across the country for the number of households to actually be shrinking.


Will this change? The relationship between the economy and household formation is reflexive, to borrow a philosophical concept from George Soros. That is to say, when times are good household formation drives the economy amid a virtuous cycle, but when times are bad the economy will suppress household formation, which, in turn, feeds back negatively into the economy in a vicious cycle. The latter is the dynamic that exists today.


Our firm is of the strong view that US economic growth is poised to decelerate meaningfully in the back half of the year and into 2011, which will keep a lid on hiring. This will in turn keep the lid on household formation, the one credible case for a pick-up in housing demand.


Josh Steiner
Managing Director


The Cliffs of Insanity - JSEL

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The Macau Metro Monitor, August 5th, 2010



IM sources say that we should not expect any new visa restrictions from Beijing.  The provincial and central governments may be concerned about the American influence in Macau's gaming industry but they don't want to "start choking the golden goose". Also, the rumor about multiple-entry visas for transit visitors passing through Macau is bogus.


By the way, "silly season" is when real news is harder to find than a Macanese construction worker.



Large employers in Macau have started laying off Nepali migrant workers along with other foreign workers following the government's decision to give priority to local workers.


According to the Kantipur Daily, in recent days, Landmark Hotel has fired 53 Nepali workers, Ponte 16 Hotel--23 workers, New Century--21 workers, Grand Lapa--19 workers, Guardforce--21 workers, and G4 Securities--7 Nepali workers were laid off.  The workers were fired in short notice without compensation.


Despite JACK management having set expectations low last quarter, fiscal 3Q10 was ugly.  Earnings of $0.50 per share fell short of both my expectations and the street’s estimate of $0.53 per share.  Same-store sales at Jack in the Box came in down 9.4%, also below the street’s estimate and below management’s guidance of -7% to -9%.  Management again attributed the soft results to “high unemployment in [its] major markets for [its] key customer demographics.”


We will see what management has to say tomorrow on its earnings call, but the only obvious bright spot in the quarter was the continued improvement in same-store sales trends at Qdoba (+4.6%), which improved on a one-year and two-year average basis.  Management’s 4Q10 comp guidance for Qdoba of +3% to +4%, however, points to decelerating two-year average trends.


Two-year average same-store sales trends at Jack in the Box decelerated 110 bps from the prior quarter and better trends do not appear to be coming next quarter.  Management’s fourth-quarter comp guidance of -4.5% to -5.5%, which it said was reflective of trends in the first four weeks of the quarter, imply two-year average trends that are relatively flat to down about 50 bps from the third quarter.  So at best, we are looking at stabilizing trends. 


Restaurant-level margin declined nearly 370 bps YOY, when adjusted for the increase in workers’ compensation reserves that negatively impacted payroll and employee benefits costs by $1.8 million.  The company estimates that sales deleverage negatively impacted margins by approximately 280 bps during the quarter.


As expected, commodity costs were 2% higher during the quarter, which drove food and packaging costs as a percentage of sales up 40 bps YOY.  Declining margin, combined with negative same-store sales growth, put JACK safely in the “Deep Hole” quadrant of our sigma chart (shown below) for the third consecutive quarter. 


Based on management’s outlook for continued softness in same-store sales trends and expected increased commodity pressure, JACK will likely stay in the “Deep Hole” for at least another quarter.   Management now expects commodity costs to increase 4% in the fourth quarter, up from its prior guidance of +3%.  Full-year restaurant-level margin is expected to decline about 200 bps YOY to the low 14% range (down from prior guidance of 15% to 16%).  Full-year EPS guidance was lowered to $1.65 to $1.75, from $1.85 to $2.05.  I can only imagine what management is thinking now based on these results, given that on the last earnings call CFO Jerry Rebel said, “if we hit that [$1.85 – low end of full-year guidance at the time] God forbid...”  Earnings of $1.85 per share would sure look good now.




Howard Penney

Managing Director


In preparation for Hyatt's Q2 earnings release tomorrow, we’ve put together the pertinent forward looking commentary from Hyatt’s Q1 earnings release/call and subsequent conferences.


Post Earnings Call Conference Commentary  (June 7th)

  • “Approximately 70% of our rooms are in North America with 30% in International. Internationally, we have a significant and strong presence in Asia - Pacific where 15% of our rooms are located…less than 10% of our rooms are in Europe.”
  • “We reduced approximately $170 million of costs out of comparable owned hotels during 2009 and are focused on limiting cost creep as occupancies increase.”
  • “We plan selectively and opportunistically recycle assets in order to achieve our goal of driving brand preference.”
  • “Over the last 12 to 18 months, like most of the folks in the industry, we had tides of expenses largely come in the form of staffing reductions, at the hotel level as well as the management level. For example, we did restructure our overhead structure… Last year we froze salaries, we gave no merit increases, bonuses, etc cetera. As things come back, it’s going to be tough maintaining those structures. We will have wage inflation and it is our intention that over time because we’re providing authentic hospitality and get satisfaction, we don’t comprise those standards as the business recovers. I think what you’re going to see is a tight overhead structure, both at the hotel and structured overhead – in terms of actual operating expenses in the hotel, it’ll probably attract an increase in occupancy over time.”
  • “We announced plans to renovate 5 properties this year. The 2 big ones were the Grand Hyatt New York and the Grand Hyatt San Francisco…the spend is over 2 years.”
  • “Our total CapEx program this year is anywhere between $270 and $290 million. But if you look at our portfolio, we have 102 assets, 55 of them are select assets, basically Hyatt Place and Hyatt Summerfield Suites. When we acquired Marriott Suites couple of years ago, we spent a couple of years actually recreating or creating the Hyatt Place brand. So the select portfolio is largely fresh."

1Q2010 YouTUBE

  • “In North America we saw an improvement in the volume of group bookings made during the first quarter as compared to what had been booked in the first quarter of 2009, while room rates remained under pressure.”
  • “During our year-end 2009 earnings call, we stated that transient demand has started to come back, and we are happy to say this trend continued through the first quarter across all three business segments i.e. owned and leased hotels, North American managed and franchise operations, and international managed and franchise operations. Revenues from transient customers, both corporate and leisure, were up for the first quarter of 2010, compared to the first quarter of 2009.”
  • “On the group side, while revenues were down in North America as compared to the first quarter of 2009, the number of group nights sold increased by approximately 3% compared to the first quarter last year.”
  • “Over a third of the 9% (Owned/leased RevPAR) increase was driven by our international owned hotels. Results in North America were helped by the ramp-up in the performance of two hotels that were renovated 12 to 18 months ago. Results were also helped by the Olympics that benefited our property in Vancouver.”
    • “Grand Cypress, which was under renovation last year, has opened and is ramping up. We had a Hyatt at West Hollywood that we converted to an Andaz, about a little over 12 months ago, and that has ramped up nicely during the last 12 months. And then the Olympics helped us in Vancouver.”
    • “The Andaz Hotel in West Hollywood opened in January of last year, so we had no rooms out during the course of the year there. And the rooms renovation at Grand Cypress was more in the first half of the year than in the second half of the year.”
  • “Comparable owned and leased hotel margins…benefited from the two hotels ramping up from renovations that I’ve mentioned as well as our property in Vancouver. Margin improvements at these three hotels represented almost half of the 220 basis-point decrease in the quarter.”
  • “We were able to manage expense increases to approximately 5.6% even as occupancy increased by 760 basis points. However, despite focus on operating efficiently, we expect that our costs will continue to increase, driven by inflationary pressures.”
  • [North America managed and franchised hotels] First quarter comparable RevPAR for full-service hotels declined 2.2%, driven by ADR, which declined 7.9%. The number of transient room nights sold increased approximately 9% where transient rates declined slightly over 7% in the first quarter of 2010.” 
  • "While the volume of group room nights sold increased during the quarter, overall group revenues declined in the mid-single digit percentage range due to declines in average rates. Group revenue paid for 2010, as of the end in the first quarter, was down from last year, but the rate of decline of group-paid lessened over the first quarter 2010.... Group cancellations declined materially and are at pre-downturn levels.”
  • [International management franchise business] “Few special factors helped our results in the quarter, such as a lift in business in Shanghai, due to the advanced planning for the World Expo, which opened earlier this week. Overall, international fees increased 16.7% in the first quarter of 2010, excluding the impact of currency, due to higher revenues at comparable hotels and increased fees from recently opened hotels.”
  • “We are experiencing ongoing SG&A expense growth due to higher compensation costs as we restore merit increases and incur higher travel costs as the people get back on the road.”
  • “On income taxes, we are expecting that the tax rate of our U.S. income to be approximately 38%, the blended tax rate on our international income to be approximately 20%, and certain fixed charges that could be slightly higher than 2009 levels.”
  • We expected the disruption associated with these projects to reduce rooms available for sale by an average of 400 per night from July through the end of 2010.”

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