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MACRO: THE FUTURE OF THE U.S. BALANCE SHEET

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 large


BYI F3Q2010 YouTUBE

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.

DOLLAR REVPAR MORE RELEVANT THAN %

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.

 

DOLLAR REVPAR MORE RELEVANT THAN % - UU1

 

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.


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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

Director


EAT: GLANCE AT THE 4QFY10 MENU

At this point the consensus thinking is that EAT had a difficult quarter and every indication is that they did.  The sale of OTB and the extra week will add to the confusion. 

 

So far in the 2Q earnings season, with few exceptions, there have not been many restaurant companies that didn’t have a difficult quarter.  So will EAT’s quarter be much worse than consensus and how will the stock react?  As you can see for our sigma chart on EAT, the company has been operating in the “deep hole” for all of FY 2010 and this quarter will not look much better.  Here is a look at guidance and key focus points ahead of earnings on Thursday.

  • The current $0.46 consensus estimate is largely meaningless although $0.45 is a better number.
  • The 2011 outlook and commentary on current trends will be the focus of the call.
  • Progress on margin initiatives is important for restoring confidence as sales trends remain challenged.
  • The street is so bearish that the number of shares sold short doubled during the quarter.

 

SAME STORE SALES

  • To maintain or sequentially improve two-year average blended same-store sales (52 weeks vs 52 weeks), Brinker will need to post roughly flat comps or better for 4QFY10.  We have sales down 3-4% (on a 52 week vs 52 week basis) so this will be a net negative.
  • According to Factset, the Street is expecting a company same-store sales number of 0%, would seem to include the 53rd week.  The nine estimates comprising this Factset estimate are greatly varied; the highest estimate is +5.3% and the lowest is -4.3%. 

 

GUIDANCE

  • Same-restaurant sales of 1 to 2% for current fiscal year includes 53rd week.
  • Full year EPS guidance on a continuing operations basis before special items of $1.20 to $1.24 (consensus at $1.21), implying a range of $0.45 to $0.49 (consensus is at $0.46) for the fourth quarter.
  • Lower-than-normal expenses such as insurance expense, property tax, utilities, and vacation expense favorably impacted margins be approximately 110 bps in 4QFY09.
  • The long-term goal is to double fiscal 2010 consolidated EPS before special items by 2015 with 10 to 12% EPS growth is for fiscal years ’13 through ’15.
  • Minor levels of sales growth of approximately 1 to 2% same-restaurant sales.
  • 500 basis points of margin expansion at Chili’s offset by 100 basis point depreciation impact for a net 400 basis point impact to operating margins over the next three years.
  • Investment in CapEx will only continue as proof of returns warrant.
  • Free cash flow will be reinvested into the business, used to reduce debt, pay dividends and, to the extent cash remains, reinstate our share repurchase program.
  • The cash balance will be put to work and the company will likely carry levels to meet working capital needs of approximately $50 million, barring any significant event in the future that may suggest a need for higher liquidity levels.  (Cash balance at 3/31: $181.9m)
  • On The Border proceeds will be put to use…for share repurchase to quickly rebuild the EPS base
  • “We will receive approximately three to $6 million of fees for providing support services to the acquirer, Golden Gate.”
  • We will extend our portfolio to have 425 Chili’s restaurants internationally by 2014, cementing us as the dominant player.

 

OTHER INTERESTING COMMENTARY/NOTEWORTHY POINTS

  • We will fuel our growth through equity investments and franchise partnerships, taking advantage of demographic and eating trends that will only accelerate In the rest of the world over the next decade.
  • Same-restaurant sales for the quarter at our international restaurants increased nearly 1%, and we’re further encouraged by the economic stability of many of the countries that we do business in today.

 

EAT: GLANCE AT THE 4QFY10 MENU - eat sigma chart

 

 

Howard Penney

Managing Director

 

 

 


HBI: Your Long Thesis Just Blew Up

Don’t get lost in the weeds here, folks. Every analyst is likely to come out defending this HBI deal. Mathematically, it makes sense. The conference call – at face value – made sense too. But make no mistake – to stay invested here your thesis HAS TO change; and meaningfully at that.               

 

This story has changed. Period. Think about it… It used to be a story where the last standing US manufacturer of apparel was offshoring its apparel to recapture margin to become more competitive, kick-start growth, boost margin and repay a heavy debt burden.  Now, the company is out doing acquisitions when it cannot even keep up with the current boost in growth it is experiencing in its core business (remember in 2Q they had to outsource demand at zero margin). In addition, they’re getting into the licensed apparel business for college bookstores? Yeah…perhaps it makes sense given HBI’s core competency. But whatever happened to de-levering?  Debt on top of big, expensive, inflexible, wholly-owned factories that depend on maximizing capacity utilization is a very very dangerous combination, my friends.

 

Most people are going to come out defending this deal, while few will nix it. Management is following up with a roadshow to fuel the fire. But one thing is certain. The primary reason why 90%+ of the bulls I have EVER spoken with on this name (and I worked on the deal when it was spun out of Sarah Lee) has absolutely positively changed. To think that there’s not some serious ‘thesis-morph’ at play here would be flat-out disingenuous.  This thing is actually starting to smell a bit more like VFC. But keep in mind that it took VFC the better part of a decade to diversify away from its capital intensive denim and intimate apparel businesses (the latter of which it sold at a fire-sale price).  VFC had its fair share of blowups in the interim.

 

The point here? DO NOT lose sight of the core business for HBI. Lack of de-levering + high commodity costs + increasingly desperate competition + shake up in the management ranks at largest customer + unsustainable growth in second most important distribution channel (dollar stores) = risk, risk, risk.  

 

 

 

Gear For Sports, a leading seller of licensed logo apparel in collegiate bookstores

 

Financials:

(FY10 ended in June)

  • Sales ~$225mm
  • EBIT $25mm+
  • OM 11%+
  • (implied D&A of ~$5mm)
  • Expected to close in Q4 and be immediately accretive
  • ~$0.20 in 1st 12 months
  • ~$0.30 in 2nd 12 months
    • No write-offs or restructurings needed, not dilutive to 4Q or 2010 earnings guidance of $2.25-$2.35

Terms:

  • Total cost of $225mm
  • $55mm in cash
  • $~$170mm in debt
  • = ~7.5x EBITDA
  •  
  • Still project 2010 debt-to-EBITDA ratio of ~3.5x on a pro forma basis

Management Changes:

  • Very little change
  • Gear For Sports senior management will remain in place to run the business, and the administrative, operational, production and sales structure will remain intact, with management offices remaining in Lenexa, Kan.Gear For Sports President Larry Graveel intends to retire but will remain in his role for approximately six months, while Chief Financial Officer Craig Peterson and Executive Vice President of Sales Jim Malseed will remain in place and continue to lead the business.

 

Call Notes:

 

 Synergies:

  • Revenues -
  • Growing MSD over last 4-5 years
    • Graphics -
    • Great
      • Justified acq solely be the opportunties on the cost side
      • Relative to what GFS can buy their products for, HBI has a significant opportunity to provide cheaper product
      • Will start to integrate more product and access global supply chain in 2011

Brands:

  • Good/better/best structure of brands
  • Gear for Sports - opening price point
  • Champion - good price
  • Under Armour - premium offering
  • have already agreed to transfer license to HBI (5-year license) restricted to college bookstores, resorts and golf

ASPs:

  • t-shirts in the $15-$30 range
  • Sweatshirts in the $30-$60 range

Accretion:

  • Paying down debt would be $0.10 accretive next year; acquisition will provide ~$0.20, so ~$0.10 net accretive in Yr1
  • Primarily predicated on cost synergies
  • Assumes MSD growth in GFS business
  • They are paying 10%+ on their debt now

Cyclicality in recession:

  • Similar to HBI, positive momentum coming out of 2008

 

  • Has ~25% market share of the college channel
  • Growing consistently MSD
  • Opportunity to grow golf and resort business, in addition to further share
  • Mgmt sees opportunity to grow in HSD range

Brand distribution (as % of total):

GFS 20%

HBI 50%

UA 30%

  • GFS sources UA product directly so that won't change

Working cap - Gear for Sports:

  • ~$60mm last year
  • Inventory accounted for ~$50mm
  • High turns as a sourced business 

Distribution Opportunities:

  • Opportunity not to take to mass, mostly sporting goods, college books stores and mid-tier dept. stores due to price point
  • Outerwear - graphics will increase from 5-6% of business today to 20-25% post acq.

Manufacturing Facilities:

  • Graphic printing in Kansas City (Gear for Sports) - quick turn
  • Operation in Mexico - semi quick turn ~1 week
  • Outsourced printing in Central America

Capacity Implications:

  • Gear for Sport units not that great, will have capacity to handle despite tightness in most recent Q2
  • Capacity constraints due more to much tighter turnaround needs

Margins:

  • $11mm in synergies in first 12-months related to better sourcing of blanks alone
  • Re 11% margins, they've been consistently in the 10%-12% range

Dynamics of Industry:

  • GCO rolling up industry on retail side
  • Not a lot of opportunity to capture synergies

Modeling:

  • Operating margins, have been in 10%-12% range, post synergies could get to mid teens margins
  • Could add 100bps to Outerwear margins, ~10bps to consolidated HBI margins

 

 

 


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