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EARLY LOOK: Discounting The Obvious

“Markets are constantly in a state of uncertainty and flux and money is made by discounting the obvious and betting on the unexpected.”
-George Soros
Before I went to bed last night, China reported another sequential deceleration in its manufacturing PMI Index for the month of July. I thought to myself – wow, that explains absolutely nothing in terms of how both oil and copper have been trading for the last 3 weeks (UP). However, it explains everything in terms of why Chinese stocks have underperformed global equities for the last 7 months (DOWN). China has slowed.
In Q1 we called this the Chinese Ox In A Box. In our Q1 slide presentation we even had a fancy looking Hedgeye Macro Theme chart that outlined the forecast that PMI readings in the high 50’s were unsustainable given that the Chinese were going to tighten.
So China tightened… and now the PMI reading has dropped -12% over the course of 6 months into the low 50’s (July’s reading was 51.2% versus 52.1% in June)… and next to Slovakia and Greece, the Chinese stock market is the worst performing in the world for the year-to-date.
That, however, doesn’t mean that in the face of a monster 2-month rally in European equities (i.e. the other worst performing stock markets for the YTD – Greece, Spain, etc.) that Chinese stocks don’t have every opportunity to A) mean-revert to the upside alongside global equities or B) show you that they have already Discounted The Obvious.
On the heels of this “bearish” economic data last night, China closed up another +1.3% to 2672 on the Shanghai Composite Exchange, taking its rally from its YTD low established on July 5, 2010 to +13.5%. Chinese equities are up basically in a straight line – closing up on 9 out of its last 11 trading days.
So what do you do with that? Inclusive of this rally, the Shanghai Composite Index is still -18.5% YTD. Economic growth is still slowing, but everything that slows finds a time and a price where it gets baked into the Mr. Macro’s cake. Should you chase it here? Should you short it? Should you do nothing?
Whenever I miss a big move like this, I tend to try my best to do nothing. Particularly if the math in my TRADE versus TREND model isn’t yet clarifying the risk management decision for me. Here are our TRADE, TREND, and TAIL lines for the Shanghai Composite Exchange:
1.      TRADE = bullish, with 2491 support

2.      TREND = bearish, with 2693, resistance

3.      TAIL = bearish, with 2988, resistance

Since the Shanghai Composite closed at 2672 last night, you’ll notice that it’s game time now for the intermediate term TREND in Chinese equities. We’re either at an inflection point where price momentum is making the turn from bearish to bullish, or we’re right where the long term bearish case for Chinese stocks fortifies itself.
Since I don’t have a long or short position in China right now other than long the Chinese Yuan (CYB), I don’t feel compelled to make a “call” on which way this is going to go. I’m much more comfortable letting the macro math tell me what to do. Chinese growth has every opportunity to re-accelerate from here, but it could just as easily continue to slow. The big money on the short side has already been made.
Looking at a multi-factor global macro model for the answer is also going to be critical here. Let’s consider some critical signals relative to the summer of 2008:
1.      Dr. Copper

2.      US Dollar

3.      Gold

Both the prices of copper and gold are all of a sudden doing what they did at the end of July and early August of 2008. Much like it is doing now, the US Dollar was getting creamed (down for the 8th consecutive week last week, taking the USD down -8% since early June) and all of a sudden the “reflation” trade in gold decoupled from that in copper (DOLLAR DOWN equaled copper up, but gold down and a lot of people couldn’t figure out why).
Chinese equities also based and rallied in July of 2008, but that was a sucker’s rally in as much as it was in Copper. Gold and the US Dollar were actually leading indicators for almost everything else going down back then. I don’t see that same setup right here and now, but “betting on the unexpected” can pay the bills. Food for thought on a Monday while we’re all Discounting The Obvious of the China slowdown that’s in our rear-view.
My immediate term support and resistance levels for the SP500 are now 1076 and 1118, respectively. The SP500 hasn’t had an up day in the last 4, so we took midday weakness in US equity trading on Friday as a buying opportunity, moving our allocation to US Equities from zero up to 3%.
Best of luck out there today,


EARLY LOOK: Discounting The Obvious - cHH


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.






Joshua Steiner

Managing Director, Financials


***As a reminder, May was the peak month of Census hiring, and it will remain a headwind through the September data as the Census continues to wind down.




Tomorrow at 11 a.m. eastern we will be hosting our August Theme call, titled: “Should U.S. Government Debt Be Rated Junk Status?”  The intention of the title is not to suggest literally that U.S. government debt should be rated junk status, but rather to raise a serious red flag as to the emerging deficit and debt problem in the United States and the investment implications therein.  If you would like to join the call, please email sales@hedgeye.com.
In the chart below, which is sourced from the Congressional Budget Office, the fiscal future of the United States is portrayed based on longer term budget projections.  The CBO provides two scenarios for budget projections.  In either scenario, the balance sheet of the United States sees a continued build-up of debt for the ensuing two decades.  In the more negative scenario, debt as a percentage of GDP accelerates dramatically over the coming decades, eventually approaching near 200%.
As we will discuss in greater detail tomorrow, the primary implication of a build-up in debt on the federal balance sheet is a dramatically different future as it relates to underlying growth.  If the last 200 years of data has shown us anything, it is simply that those nations with high debt balances either default or grow well below mean rates as long as debt ratios remain high.
We, of course, aren’t suggesting that the U.S. is bound to default anytime soon, but there are implications of an accelerating U.S. debt balance that we need to keep front and center.  One longer term consideration is simply that investors, both domestically and abroad, begin to lose confidence in U.S. government debt particularly at the current all-time low interest rates.  An increase in interest rates has meaningful implications for the U.S. budget.  According to a paper from the CBO today titled, “Federal Debt and the Risk of a Fiscal Crisis”, a 4-percentage across the board increase in interest rates would raise interest rate payments by more than $100 billion on an annualized basis.
A conclusion of our analysis tomorrow will be that the future will look much different than the most recent past in terms of the economic outlook of the United States over the coming years.  And the reality is, as debt grows and confidence wanes, the likelihood of a fiscal crisis of some magnitude grows.  In that scenario, as the CBO also wrote today, there are three primary prescriptions for the United States:
“restructuring its debt (that is, seeking to modify the contractual terms of existing obligations); pursuing inflationary monetary policy (that is, increasing the supply of money); and adopting an austerity program of spending cuts and tax increases.”
Is a fiscal crisis in the United States imminent? Perhaps not, but the future of the U.S. government balance sheet is bleak based any reasonable federal government budgetary assumptions.  We hope you can join us for the discussion tomorrow at 11 a.m. eastern.
Daryl G. Jones
Managing Director


MACRO: THE FUTURE OF THE U.S. BALANCE SHEET - future of us balance

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In preparation for BYI's F4Q earnings release on August 12th, we’ve put together the pertinent forward looking commentary from BYI's F3Q earnings release/call and subsequent conferences.



Post Earnings Conference Commentary


General Comments

  • “If you go out and count up all the machines in North America today, you will count about 13% of those are Bally machines and yet, over the last year and a half or so, we’ve been shipping and getting around the 20% range in casino openings and in ship share.”
  • “Last quarter, our ship share was at a low for the last couple of years at about 15%. Part of that is, if not all of that is due to our announced launch of our ALPHA II platforms and our Pro Series cabinets; [we are] starting a few shipments of the Pro Series in June and then in the September quarter.”
  • “Several of our competitors have more aggressively discounted over the last 2 or 3 quarters and more aggressively financed customer purchases on term sales. It’s our belief that discounting and too aggressive financing do get you short-term need, but because of return on investment is so strong on the products, it will bite you in future quarters. “
  • [Gaming operations] ”Over half of our games that are out there bring us daily revenue on fixed daily fees…typical participation units out where a customer can return it on 90 days notice - most of the daily fee arrangements we have or at least many of them have a longer required notice period or an initial term that’s longer that protects our capital.”

Forward Looking

  • “Cash Spin product that’s being very well received just launched about 45 days ago… 1,000 orders right out of the blocks and the performance numbers and the early placements have been very, very strong and we look to do more of that interactive style gaming. We showed in iDeck instead of a button deck. We will be launching that before the end of this year.”
  • “So we would expect our ship share to be bouncing around not in our low 20s maybe for the next quarter or two, but then building from there and our guidance reflects that.” 
  • “Gross margins …in our game sales sector have been increasing over the last couple of years and now is in the sort of low 50s% range. We think that could stay there and grow over the next year or two as we sell more conversion kits, as we get a bigger footprint of video games.  But obviously, with the new cabinet launch, we’re not going to have new supply chain gains until we get 6 or 9 months into that new launch. So we’re comfortable with a 50% margin range, but then growing say 12 months out from now to the low mid 50s.”
  • “Excited that this summer, we will launch the iVIEW DM product.”
  • “We would expect to generate revenue from Italy before the end of this calendar year  and we’ve announced 3,600 units in that 57,000 unit market, of which we are estimating right now about two-thirds of the recurring revenue over a long period of time. So don’t expect it to be as profitable as our U.S. units but expect the capital to be depreciative over the long period of time and about a third of the Italy units we expect to be sales; that’s our best guess right now.”
  • “We think still 20 to 50% are not spoken for, because most of the operators we know are only going to put out about half of their devices to start, because of capital constraints, facilities on building et cetera. So even within the 57,000, I would be disappointed within the next 6 months that we don’t get another chunk of machines out of that 57,000.”
  • “So we’re on track for hopefully getting our first shipments in Australia early in ‘11; beyond this initial batch, much of the technical work is done; we think this will be a nice market for us.”


YouTUBE from FQ3

  • “We now expect an effective tax rate for the year of between 34 and 36% due to higher income levels and lower tax jurisdictions”
  • “We expect to close the Rainbow sale around the end of June, which will add approximately $60 to 65 million in cash to our balance sheet after income taxes and transaction costs.”
  • “Entering into this calendar year, we were optimistic that our customers would be buying replacement games at a higher rate than they had spent to-date.  We remain optimistic that such an uptick will happen in the not too distant future and believe we are well positioned to take advantage of increased spending levels.”
  • “Dual Vision is on trial, and initial results are so strong that we will launch the product to our sales force next week.”
  • Systems Business: “Delayed decisions continue to be a challenge as well.”
  • “We anticipate wide deployment of iVIEW Display Managers during the remainder of the calendar year, including one international casino going live with DM across about 80% of their slot floors this June. We expect to release multiple new software applications that will add value to products like the iVIEW DM and the Elite Bonusing Suite during the coming months.”
  • “Now, our current guidance for fiscal 2010 remains at $2.15 to $2.25 per fully diluted share, which includes Rainbow operations for the full fiscal year, but excludes the Alabama impairment and any gain on the sale of Rainbow, should it close by June 30 as is currently planned.”
  • “Alabama has represented between $0.02 and $0.03 per quarter to us in the third and fourth quarter, about 1,750 games and you saw the impact of the impairment which we decided to take in light of the legislature in Alabama not acting before the session closed on a referendum for the fall.  We thought it was prudent to take the asset write off at this time, even though there is still hope for Alabama gaming to not only resurface as strong as it was, but possibly even stronger.  A few venues remain open and we’ll continue to record that revenue on a cash basis.”
  • Q: “So you didn’t really lose any games relative to last quarter in that category. They were just not generating the revenue they did?”
    • A: Correct. That is correct.


Anything less than 14% Upper Upscale RevPAR growth in August should be seen as a disappointment.



Can higher sequential YoY growth actually represent sequential slowing?  You betcha.  Given the immense volatility in RevPAR over the last few years, we believe it is more rigorous to analyze sequential RevPAR trends in terms of absolutes rather than percent change – after adjusting for seasonality, of course.


Historically, July and August are very close to each other in absolute RevPAR for the Upper Upscale (UU) segment.  July UU RevPAR should come in around $100.  Assuming stable trends, August should also be around $100, which would indicate 14% RevPAR growth over August of 2009.  The first week of August appears to be falling short, up 8.7%.


July was up 7.8%, so analysts will cheerlead an August accelerating sequential growth story.  We won't.  The slowdown will be apparent in October, December, and most of 2011, when at that level of seasonally, adjusted RevPAR YoY growth will slow to low single digits and even go negative in some months of 2011.  The problem won’t be 2010 estimates which look reasonable, but 2011 projections.  The Street consensus is currently estimating over 6% RevPAR growth in 2011.  Implicit in that estimation is that June/July is the new normal and RevPAR will grow off that base at a rate faster than GDP.


Our theory is that May/June/July represented a period of pent up demand and that the new normal is more like March/April.  Cleverly, we will call this the Pent-Up Demand Theory.  Using March/April as the new base, we think RevPAR will grow at just under 4% in 2011.  For the rest of 2010, we are at the high end of HOT/MAR guidance of 5-7%.  Here are our monthly RevPAR projections based on historical seasonal factors, GDP growth of 3%, and a recovery UU RevPAR multiple of 1.33x to GDP.




If anything, our 4% RevPAR projection could prove aggressive.  As we showed in our 03/22/10 post, “HOTEL DEMAND: IT’S NOT ALL ABOUT GDP, ” unemployment may be a big hindrance to a RevPAR snapback.  Moreover, our Hedgeye Macro team is more negative than consensus on GDP going forward - 1.7% versus the consensus 2.9% we are using in our model.  The sensitivity to our forecast is about 1.1% for every 1.0% change in GDP. 


While 2010 may not disappoint, we fear that sequential trends in seasonally adjusted RevPAR (dollars) over the coming months could signal that the Street is indeed too high in its 2011 RevPAR projections.

E-commerce Pendulum Shifting

We recently published a (mini) Black Book on the topic of e-commerce.  We explored two primary areas which we believe are most relevant to today’s retail landscape.  Growth in multi-channel retailing and the implications for an internet sales tax.  In both cases, we believe the pendulum is swinging in favor of traditional bricks & mortar retailers.   We explore the following areas in detail:


Growth in multi-channel retailing is increasing at its fastest pace in years, driven by a culmination of factors:

  • Convenience
  • Selection
  • Content/Editorial
  • Conspicuous Consumption


The internet sales tax debate is as hot as ever, with the recent introduction of the Main Street Fairness Act. We answer the following questions:

  • Why isn’t there a tax on e-commerce sales for “online only” entities to begin with?
  • What exactly is the Main Street Fairness Act?
  • What is the Streamlined Sales and Use Tax Agreement (SSUTA)?
  • What are the tax revenue implications from a tax?
  • Who’s in favor of the legislation? Who isn’t?


In the absence of meaningful physical store growth, e-commerce has emerged as the single biggest source of incremental revenue and market share gains for traditional retailers.  Interestingly, neither the Street nor the companies themselves spend much time on the topic.  Yes, there are a few exceptions including Williams-Sonoma and J Crew that have embraced the internet as a full-on profit and growth center, but there are many more that are just beginning to make meaningful inroads online. 


If you’d like a copy of the report or would like to discuss this topic in further detail please let us know.  In the near-term we expect this will become a more meaningful area to watch within the incumbent retail landscape.  In the near, near-term keep an eye on the Main Street Fairness Act.  State budgets are in turmoil and a quick fix lies within leveling the playing field between those with a tax advantage (i.e Amazon) and those without.



Eric Levine