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German ZEW Economic Sentiment Dips

Position: Bullish Bias on German Equities (EWG); Long British Pound (FXB)


It’s just one data point, but it is in line with our forecast for fundamental economic data in Europe to show a meaningful negative inflection in August and continue downward into the end of the year as austerity measures throughout the region set in and choke off growth. ZEW’s sentiment survey for Germany is but one survey we track, however its 6-month forward-looking gauge of economic sentiment fell off a cliff month-over-month, from 21.2 in July to 14 in August, with consensus expectations at 21 (see chart below).  Conversely, the current situation ramped up materially, from 14.6 to 44.3, however we’ve found the current situation to be a lagging market indicator and therefore put greater stock in marginal changes in the economic sentiment curve.


With the DAX just hovering above its TREND line of support at 6076, we’re waiting to see if it makes a confirming move before taking an investment position.


Should you need to get invested in Europe, we continue to like countries with lower deficit and debt levels, like Germany, Denmark, Sweden and the Netherlands.  Inflation in the UK, which was reported today at 3.1% in July Y/Y, and further deterioration in its housing market continue to be concerns. We’re long the British Pound in our virtual portfolio as a play versus the deterioration in the US Dollar. Our TRADE (3 weeks or less) range for the GBP-USD is $1.55-$1.61 with TREND line support (3 months or more) at $1.50; our TRADE range for the EUR-USD is $1.26-$1.29.


Matthew Hedrick



German ZEW Economic Sentiment Dips - g1


German ZEW Economic Sentiment Dips - g2


In restaurants, as with the broader equity market, yesterday was a quiet day.  Besides the low volume and flat price action, there were a few interesting news items and divergences to note.


The most noteworthy category in my space yesterday was coffee.  A surge in coffee prices yesterday raised concerns that costs are going up for coffee shops such as Green Mountain, Caribou, Peet’s, and Starbucks.  The recent price movement in softs and foodstuffs (and commodities in general) suggests that these concerns are likely well-founded.  This negative was offset by news emerging that Italian coffee maker Luigi Lavazza SpA agreed to buy a stake in GMCR.  This news caused the small cap coffee names to outperform, perhaps on the suggestion that M&A activity may escalate in the category.  SBUX bifurcated to the downside from GMCR, CBOU, and PEET.  As side note, SBUX saw it necessary this morning to reaffirm guidance following the spike in coffee prices.   The company stated, “We remain confident in our ability to manage this dynamic effectively”. 


In other news, Zagat has released its 2010 Zagat Fast-Food Survey.  In terms of stocks, RRGB received the “Best Burger” award in Full Service.  PNRA and CAKE received the “Best Salad” award in Fast Food and Full Service, respectively.  SBUX and IHOP (DINE) received the “Best Coffee” award in Fast Food and Full Service, respectively.  In terms of value, MCD and Olive Garden (DRI) got the plaudits from the survey. 


Commodities should remain front and center in investors’ models going forward.  BHP’s bid for Potash, although it was turned down, supports my conviction that inflation is being factored into these price movements.  Attention is slowly shifting from being firmly focused solely on the top line towards a more equal weighting of sales and margin trends.


TALES OF THE TAPE - stocks817




Howard Penney

Managing Director






As we look at today’s set up for the S&P 500, the range is 34 points or 1.4% (1,064) downside and 1.7% (1,098) upside.

  • ADVANCE/DECLINE LINE: 790 (+1068) Breadth turned positive on a flat day for the S&P
  • VOLUME: NYSE - 788.90 (-9.49%) - 35% below the average for the last 12 months!
  • SECTOR PERFORMANCE: Two sectors positive - XLB and XLK
  • MARKET LEADING/LOOSING STOCKS: Apollo +5.2%, Cliffs natural +3.3% and Devry -8.7% and Washington Post -8.1%


  • VIX - 26.10 0.53% - The VIX remains elevated.
  • SPX PUT/CALL RATIO - 1.55 down from 1.83 (low on 07/15/10 of 0.87)


  • TED SPREAD - 20.21 -0.969 (-4.577%)
  •  3-MONTH T-BILL YIELD .16% up from .15% yesterday
  • YIELD CURVE - 2.0802 to 2.0981


  • CRB: 269.36 -0.47%
  • Oil: 75.96 +0.96%
  • COPPER: 334.80 +1.44%
  • GOLD: 1,225 +0.13%


  • EURO: 1.2886 +0.38%
  • DOLLAR: 82.257 -0.33%


  • ASIA - Markets closed mixed; China closed up and Japan closed down.
  • EUROPE - Major indices are trading close to session highs.
  •  EASTERN EUROPE - Trading higher - Slovakia, Hungary and Romania leading the way.
  • MIDDLE EAST/AFRICA - Trading higher - Egypt and Israel up over 1%.
Howard Penney
Managing Director

THE DAILY OUTLOOK - levels and trends













Hedgeye Statistics

The total percentage of successful long and short trading signals since the inception of Real-Time Alerts in August of 2008.

  • LONG SIGNALS 80.37%
  • SHORT SIGNALS 78.32%

COMPLIANCE: All That Glitters

Matt Taibbi’s latest anti-Goldman polemic was posted on line this last week (Rolling Stone, 11 August) under the poetic title “Goldman: New Reform Law Can Kiss Our Ass.”  In it Taibbi makes the point – long obvious to readers of this Screed – that Goldman executives “don’t expect the new financial regulations to cut into their profits in any meaningful way.”



COMPLIANCE: All That Glitters - chart1



As with so much current anti-Wall Street invective, Taibbi aims his gonzo prose at a paper tiger.  For if the Goldmans of the world have nothing to fear, it is thanks to those who make the laws.
Case in point: the tempest in the backroom beer keg over death benefits for survivors of military personnel who die in action.  This story was broken by Bloomberg (29 July, “Veterans Agency To Probe Insurers On Soldier Benefits”).  (Full disclosure: our CEO, Keith McCullough, is a Bloomberg TV Contributing Editor and regular guest and co-host.)  Suddenly, everyone from the New York State Insurance Department, to the Senate Veterans Affairs Committee, to the White House is calling for “the VA’s immediate investigation into these unacceptable insurance companies’ practices.”
The “unacceptable” practice is, life insurers retaining these death benefits in their own corporate accounts, rather than sending lump-sum checks to the beneficiaries.  The company keeps the interest earned on the balance, and until the balance has been withdrawn by the survivors, pays what the Bloomberg story calls an “uncompetitive interest rate,” pocketing the spread.  The beneficiaries receive a book of drafts which they can use to withdraw all, or any part of the death benefit at any time.  Complaints about this practice have already been thrown out of court (Wall Street Journal, 6 August, “Courts Often Back Insurers’ Death-Benefit Practices”).  Not only is the practice legal, it is embedded in current insurance industry regulations.
Let’s ask a different question.  “Unacceptable” to whom?   Prudential, the company in the Bloomberg story, is the second largest insurer.  You can bet that every state regulator knows about this practice.  As well as every Senator and Member of Congress who has any dealings with the insurance industry.  The task of protecting the public, you see, is tempered by the awareness of which side of the pork-roll is larded.
Now those who make the laws and regulations that have long encouraged this practice are attacking the companies that do it.  And by the way, if this practice looks Structured Notes, it is because the insurance company, rather than segregating the death benefit in a separate account in the name of the beneficiaries, makes an accounting entry, making the death benefit an IOU of the insurance company.  But unlike the “guaranteed” structured notes, the benefit is protected by state insurance authority guarantees.  In fact, states have paid out on such guarantees when the insurers could not come up with the funds.  Guess the regulators were aware of this “unacceptable” practice all along.
Prudential, whose stock trades on the NYSE, has a market cap of over $26 billion.  Its current dividend yield of 1.2% makes it a more attractive income instrument than many money market funds – including, apparently, the rate of interest it pays to survivors.  Let’s face it, insurance companies don’t make money by paying out claims.
According to the website opensecrets.org, “in 2007 and 2008, the insurance industry contributed a record $46.7 million to federal parties and candidates…”  The industry spent $164.4 million on lobbying in 2009, and $85.9 million so far this year.  Prudential, the third-largest lobbying client, has spent almost $4.7 million year to date.
“Unacceptable”?  We think “ungrateful” is more like it.  Legislators and regulators have a fine line to tread in going after the insurers.  It is only a question of time before the industry will tire of feeding the hand that bites it.
Moshe Silver
Managing Director / Chief Compliance Officer

R3: Top-Line Deceleration


August 17, 2010


In an effort to ensure that we deliver the R3 to you, our valued subscribers, on a consistent timely basis each and every morning we are removing the Call Out section of this product. Instead, what you typically find in our Call Outs will be posted as separate stand alone posts.



This morning’s confluence of earnings events confirms broad-based top-line shortfalls, a gnarly setup in light of the headlines we expect out of the Housing Finance Conference today.





- This morning’s confluence of earnings events confirms what we wrote yesterday in our WMT: Our Tone is Changing note.  First, a light topline and little to suggest that merchandising efforts are going to move the needle in the near-term at the discounter.  Inventories also coming in at 4% growth against sales up 2.8%.  Perhaps some apparel markdowns are on the horizon?  Second and as expected, HD comes in with light sales but EPS slightly better.  Guidance goes up slightly and you again have another quarter in which HD controls its own destiny while LOW looks a little worse on a relative basis.  Finally, ANF comes in with the surprise of the morning.  Inventories up 47%, sales up 17%.  Not good.


- Lowe’s noted that extreme summer heat had both it’s positives and negatives for the quarter. On the positive side, sales were strong in appliances (primarily air conditioning), dehumidifiers, and seasonal cooling. On the negative side, consumers were hesitant to spend on nursery and related items. Yard work was one of the first items the consumer gave up on when it became too hot to be outside.


- Canada continues to benefit from limited growth opportunities in the U.S for large retailers. Today marked the opening of the first Victoria’s Secret in Canada, which had approximately three hundred customers waiting in line prior to the doors opening for the first time.


- Keep an eye on Metail, a website plugin that allows the user to enter their specific measurements and ultimately get a realistic 3D model of their body. The model is then used to show how a specific piece of apparel or outfit would look without having to try it on or go to a store. If successful, this adds yet another reason why ordering online is becoming more and more like shopping in the “real” world.




Chinese Footwear Exports Increase 27% - Despite rising labor and sourcing costs, China’s export of footwear to the U.S. continued to grow in double digits in June. Imports from China increased 27% over last year to 179 mm, according to data from the Commerce Department’s Office of Textiles and Apparel. The import value increased 26%. Vietnam, the next largest supplier, increased its footwear shipments 10% to 13.4 million pairs. Indonesia increased shipments 22% to 4.7 million pairs and  Mexico’s shipments rose 46%. <wwd.com/footwear-news>

Hedgeye Retail’s Take: While China’s continued growth isn’t surprising – Mexico’s outperformance is. Over the last decade, Mexico has lost share within the U.S. import mix both in footwear and apparel to far east competitors – this may be a byproduct of more “localized” sourcing given the advent of higher shipping costs of late.


India Under Scrutiny Over Child Labor Issues and Fearful of Potential Boycotts - Apparel manufacturers in India are increasingly anxious about a boycott because of child labor abuses. The U.S. Department of Labor’s Bureau of International Affairs last month included India’s textiles and apparel industry on a list of countries and industries that use forced or indentured child labor. With the U.S. market receiving about one-third of India’s textiles exports, which last year totaled $22.4 bn, Indian manufacturers have a right to be concerned. More than 12 mm Indian children under the age of 14 are thought to work in a wide range of jobs — from cloth weaving to cleaning up in restaurants and homes. Since India increased its use of genetically modified cotton, there have been reports that children are employed to harvest bacillus thuringiensis (or Bt) cotton because it is smaller than normal cotton and easier for small hands to pick. <wwd.com/business-news>

Hedgeye Retail’s Take: India is certainly not the only country under such scrutiny, but it might just be the largest behind only China. Swift and comprehensive action by the Indian government will be needed to ease global scrutiny.


Retailers Plan for the Road Ahead - Retailers continue to keep inventories lean and reduce buying for spring until the economic situation stabilizes. But at the same time, they need to scour the market for interesting new products and categories to lure a reluctant shopper to the cash register. Among the categories primed for growth, many stores believe, are men's woven and plaid shirts and non-denim bottoms, flat-front shorts, striped v-necks or polo shirts, military-inspired jackets and novelty swimwear. In women's, long, lean dresses; tubular knits; retro tropical prints and florals; skinny-ankle pants; head-to-toe white, and American Indian influences are expected to be key to the season for spring, according to the Doneger Group. <wwd.com/business-news>

Hedgeye Retail’s Take: Sounds like “Bill & Ted’s” meets “Austin Powers” come spring 2011…can’t wait. Anyhow, the key is that retailers remain hesitant to ramp inventories heading into the holiday season. We will be keeping an close eye on those that will inevitably “hope” to capture any potential uptick in consumer demand by building supply prematurely.


Retail Footwear Prices Rise 0.6%, But Children's Footwear Drops 4% - Retail footwear prices rose 0.2% in July and advanced 0.6% compared with a year earlier, the Labor Department said Friday in its Consumer Price Index. Women’s footwear prices rose 0.4% in July compared with June and increased 2% compared with a year earlier. Men’s footwear prices fell 0.4% month-to-month and rose 1% in 12-month comparisons. Boys’ and girls’ footwear prices fell 1% compared with a month earlier, and declined 4% year-over-year. <wwd.com/footwear-news>

Hedgeye Retail’s Take: Men’s footwear continues to lag, not a surprise given persistent economic weakness. Either way, declining ASPs are likely an indication of heightened promotional activity given lighter than expected demand.


Pakistan Floods May Drive Cotton Even Higher - The worst floods in Pakistan’s history have disrupted the lives of 20 million people, with much of the devastation in smaller towns and villages near rivers, including the standing cotton crop. The crop, at the point of being harvested, has taken a substantial hit with 10% to 30% ravaged by the floodwaters. An estimated 700,000 acres of cotton cropland is under water and from 1 to 3 million bales out of an estimated 2010 harvest of 14 million bales of cotton, has been laid waste. This includes about 5 percent of the crop in Punjab and 20 percent in the harder hit province of Sindh. Pakistan is the world’s fourth largest cotton producer after China, India and the U.S. There are mixed messages of how severe of an impact this may be, but some officials claim that since it was a bumper cotton crop to begin with, and most of the flooding occurred in the reclaimed land of riverbeds the impact shouldn't be too severe. <wwd.com/business-news>

Hedgeye Retail’s Take: As we noted yesterday, on the heels of the USDA’s crop report last Thursday, this floods continues to be one of the key drivers pushing cotton higher – stay tuned.


Data Confirms Holiday Shopping Pushed Forward Earlier - In 2009, holiday shoppers were on their marks and ready to go long before the traditional Black Friday start to the season, and some retailers were behind the curve. Evidence is coming in to suggest this year will be no different. According to a May 2010 survey by Google and OTX, 35% of US internet users have already begun their holiday shopping and research as of August. That proportion is equal to the 35% who said they planned to start in November or later.  <emarketer.com>

Hedgeye Retail’s Take: As we highlighted in yesterday’s anecdotes, retailers stand ready pushing promotional activity for holiday shopping earlier as well blurring the lines between which is the chicken and the egg.


R3: Top-Line Deceleration   - 1


Shopkick: Retailers Embrace Mobile Commerce App Used in Retail Stores - Shopkick is a mobile device that allows the shopper to enter a participating retailer equipped with a transmitter and instantly learn of deals at the store. In addition, there are opportunities to earn “kickbucks,” Shopkick’s currency, which can be redeemed for rewards or donated to charity.In a move that merges mobile commerce with retail’s brick-and-mortar, American Eagle Outfitters is launching the Shopkick application today in 52 stores in NYC, Chicago, San Francisco, and LA and the form of the rewards is a gift card. Macy’s launched the app Monday in New York, San Francisco and Los Angeles. In two weeks, it will launch in Chicago as well, bringing the total number to 157 stores in four cities for the initial test run. Best Buy has already launched the app. <wwd.com/retail-news>

Hedgeye Retail’s Take: This is only the beginning – let the period of best practice discovery begin…


R3: Top-Line Deceleration   - 2


COLM's Mountain Hardwear Launches E-commerce -  Mountain Hardwear officially launched www.MountainHardwear.com, a new e-commerce site where consumers can buy Mountain Hardwear products online directly from the company for the first time. <sportsonesource.com>

Hedgeye Retail’s Take: Buried among bigger headlines re its new OmniHeat technology and related product, dot-com will only provide an added boost to the top-line.


Simon Doonan to Design Halloween Apparel and Costumes For Target - Asking Simon Doonan to design Halloween costumes is like giving a sugarholic the keys to Dylan’s Candy Bar. Costume Couture by Simon Doonan for Target, is a more sophisticated approach to playing dress-up. Doonan approached the assignment “through the prism of fashion and popular culture. No one wants to look supergoofy. Halloween is the time for people to dabble in the more crazy aspects of popular culture that they don’t normally participate in the rest of the year. They get to be a little hedonistic.” <wwd.com/retail-news>

Hedgeye Retail’s Take: Let the battle between the homemade marvels and Target styles begin…you be the judge come October.


Charlotte Russe Seeks to Entice Twentysomethings and Teens - Charlotte Russe has generated a store prototype that is intended to simplify the shopping experience. New management has retooled the 515-store chain, opened creative offices in San Francisco, updated the logo and assembled an in-house design team. The fresh look for the stores made its debut this month in the revamped Southern California shopping center Santa Monica Place. <wwd.com/retail-news>

Hedgeye Retail’s Take: There’s a reason to chase this market – it’s HUGE, but it doesn’t happen overnight. The results will such efforts will take time to come in, but it’s a start.


The outlook for replacement demand is better than investor sentiment. We’ll tell you why.



The slow recovery of replacement slot demand is clearly frustrating investors.  The fact is, replacement demand is getting better and we can see pass this perfect storm of impediments.


The replacement market discussion has dominated the price action of the suppliers for quite some time.  On the upside, server based gaming (SBG) was supposed to spur a huge IGT-led replacement cycle in late 2006.  More recently, fears of a permanent 50k annual replacement cycle has pressured the stocks.  Well, 50k in annual replacement units would imply a 19 year cycle.  Knowing that the age of the average North American slot floor is actually not old will go a long way to understanding that the cycle duration will probably normalize close to half that.


Before we can predict better replacement demand we have to understand why it was weak in the first place.  So the slot floors aren’t that old.  What else?  First, the more permanent changes:  a) the average life of a slot machine is longer than pre-TITO (ticket in/ticket out) since there is less wear and tear on the equipment and b) the ease of converting content on existing video slots is also extending the shelf life of slots.  Second and less permanent (we hope) relates to the dynamics of the casino markets:  a) economic malaise impacting casino patrons, b) overleveraged casino operator balance sheets, and c) little new casino competition the last 2 years. 


The Current Replacement Market

The unit shipment trends we’ve been observing also suggest that replacements hit a bottom of 40k units in 2008 and crept up to 43.5k units in 2009.  For 2010, we estimate units will grow modestly to 49k.  However, the heightened competition in the slot space has masked some of this ‘modest recovery’ in replacements that’s already ongoing.  The top 4 suppliers' share of NA shipments dropped from approximately 92% in 2007 to approximately 84% in 2009.  This loss of ship-share by the public companies makes the overall market appear less healthy to the public investor who is only following the top 4.

Young Slot Floors Will Age Quickly


Over the last decade, equipment suppliers have shipped over a million new slots to North America. The total number of slot machines in North America has grown from 580,000 in 2000 to over 921,000 units at the end of 2009.  We believe that an instructive way to look at replacements is as a % of the casino floor that’s been depreciated.  Most casino operators depreciate their slots over 5 years. While the decision to replace slot machines isn’t solely based on age, operators are more likely to order a conversion kit for an underperforming ‘new’ game than replace it and lose their depreciation tax shield.


When we began this project we assumed – like most – that slot floors were old.  We were wrong.  At the end of 2009, 52% of slots in NA had been refreshed over the last 5 years and 80% had been refreshed over the last 7 years.   Despite the fact that only 10% of the depreciated slot floor base was replaced last year, the average age of the floors in North America isn’t that old currently.  However, if replacements persist at the current pace - 21 year replacement cycle or a 10 year cycle of replacing depreciated slots -, the slot floors will ‘get old’ very quickly.  Assuming a replacement pace of 50,000 per year, by 2012, almost 60% of floors will be older than 5 years old and over 37% will be over 7 years old.  This compares to over 67% of slot floors having refreshes within 5 years in 2005. We think that this scenario is highly unlikely.




The Turn

Several factors negatively impacting the slot market should turn in the next 24 months:

  • Given the low level of replacements, slot floors – while still young - are aging fast
  • The economy isn’t booming but most operators would describe the environment as “stable”
  • Many operators have recently refinanced with balance sheets and some are emerging from bankruptcy
  • New competition is about to pick up with many new markets coming online:  Illinois, Maryland, Ohio, and Kansas – so a lot of pressure building to refresh slot floors

Our Estimates Probably Exceed the “Whispers”

In our base case scenario, we assume that replacements grow to 60k in 2011 and 75k in 2012.  In this scenario, by 2012, over 55% of slot floors will be fully depreciated and the implied replacement pace of depreciated units will be 7 years - 12 years for total units.  In our bull case scenario, - 65k shipments in 2011 and 90k in 2012 - we assume that 18.5k units ship to Canada to fulfill orders of ongoing RFPs in several provinces.  Even our bull case scenario suggests a 6 year replacement cycle for fully depreciated units (10 year replacement for total units) and implies approximately a third of slots floors will comprise of units more than 7 years old.  These don’t seem aggressive to us.




We understand the investor pessimism, but we also think some are misinformed about the current age of the slot floor.  We too would be much more pessimistic if we thought that the slot floors were old AND the casinos weren’t replacing machines.  The takeaway here is that replacement demand is getting better and growth has the potential to be explosive.  Demand should normalize significantly higher than current trough-like levels which implies the slot suppliers have significant built-in growth even before we consider the bull new market thesis. 

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