Russia Rising?

“What’s good about the contemporary world? You can say something around the corner from a public toilet and the whole world will hear because all the television cameras will be there.” 

-Vladimir Putin


In context, this quote is taken from comments yesterday by Russian Prime Minister Putin in which he said that dissidents would keep getting beaten if they continued to hold unauthorized rallies.


The quote struck a chord with me on two fronts: 1.) it’s representative of the “closed” world Russia’s brass intends to promote, and 2.) it flies in the face of everything that Hedgeye’s founder, Keith McCullough, believes in, namely that an investment environment governed by transparency, accountability, and trust will help to increase the flow of ideas and hold market participants (and politicians) to higher standards--both of which will ultimately lead to a more even playing field for market participants and society at large.


Sticking to the first point, I’ve had the recent pleasure of working with our new Energy sector head, Lou Gagliardi, to analyze investment positions on the often “slanted” Russian playing field. While I’ll save the company-specific calls for Lou’s sector launch on September 16th, I do want to highlight some of the macro fundamentals and TREND and TAIL themes that may play out in Russia over the intermediate to longer term.


While we’d be duration sensitive in adding Russia to our virtual portfolio (we’re currently bearish over the intermediate term on oil), which we’ve previous played via the etf RSX, and we’re generally cautious on investment risk in Russia, the fundamentals suggest that Russia could outperform should commodity prices (in particular oil and gas) remain around current levels.  Further, we see the country’s increasingly larger share of geopolitical influence as a bullish indicator for domestic and global stability and like its growth profile of ~4% in 2010 (IMF), versus 1% in the Eurozone and 3% in the US.


Fundamentals First

The first fundamental point to consider when discussing Russia is an obvious one, but one worth stating: the country is levered to the mighty Petrodollar. Russian President Dmitry Medvedev has been quick to issue decrees over the last year that the country will work to diversify its growth away from sole reliance on energy commodities, yet it’s clear to us across multiple metrics just how important the oil and gas industries have been for the country’s growth, a set-up we don’t expect to change over the next 3-5 years. 


As a point of reference, oil and gas exports accounted for roughly two-thirds of all Russian exports by value, with oil and gas revenue contributing ~1/3 of general government revenue. Further, reviewing estimates on the marginal tax rate on petroleum, the government pulls in an average of 90 cents on every dollar of exported crude selling above $25/barrel, a favorable set-up should the price of oil remain around the current level of $75/barrel. [Note: under $25 the government also receives its share, albeit a proportionally smaller one on a tiered basis].


The chart below shows the tight correlations between the price of a barrel of oil, foreign direct investment in Russia, and the RUB-USD, and an inverse relationship to GDP over the last 10 years, which helps to outline the importance of the US Dollar in determining the price of oil, and therefore Russia’s economic outlook.  The chart also implies an interesting trend in investor behavior: foreign direct investment piles in or out of Russia based on the price of crude.  [As a side note, natural gas prices (not charted) fell in 2009 while oil ramped higher, a function of both separately priced global markets and supply and demand drivers that differ from crude.]


And if we’re right on our short call on the USD due to such factors as rising deficit and debt levels in the US and the potential for further QE packages (money printing) combined with our Housing call for a 15-50% decline in US home prices, a weak dollar may help buoy crude prices, and therefore Russian growth. The r-squared for the US Dollar Index versus crude is currently at 0.86 over a three week duration or a negative correlation of -0.93.


Sifting through Russian Tail- and Headwinds, in brief


  • Gas and Oil Cards: Russia holds the largest natural gas reserves in the world and is 2nd largest global producer of crude at ~9.7 MMB/d and the 2nd largest global exporter at ~7.0 MMB/d.
  • Gas Influence: Europe relies on 1/4 of natural gas supply from Russia (40% in Germany).  Gazprom’s 51% ownership stake in the natural gas Nord stream pipeline, which runs across the Baltic Sea, will add significant supply (est. 26 Million households) when the first line comes online in 2011.
  • FX Reserves: 3rd largest in the world at $475.2 Billion.
  • Geopolitical Influence: (Europe) political dominance over Ukraine, Belarus, and Moldova, important natural gas and oil transit countries and Russia’s window to the West, and an increasingly tighter grip over Kazakhstan, an energy rich country and world’s 5th largest grain exporter. (China) strategic and expanding partnership with China. China lent Russia $25 Billion in exchange for guarantees of crude last year.
  • Consumer Demand: from QSR operators to automobile manufactures, select companies are highlighting a positive outlook on Russia.  Ford’s Russia Chief Mark Ovenden recently said that “our view of Russia is that it will certainly be the most significant growth market in Europe and a very significant growth market globally.” For reference, Russian car deliveries increased 9% in the first seven months of the year (versus +0.6% in 1H for the rest of Europe) and jumped 48% in July, spurred by the economic recovery and the government’s cash-for-clunkers program, according to the Moscow-based Association of European Businesses.


  • Demographics: the country’s demographic outlook is grim. The World Bank reported that by the end of 2009, 17.4% of the population (24.6 Million) will live beneath the subsistence level of $185 per month, about 5% more than before the global recession. The Economy Ministry said Russia’s working population will annually decrease by ~1 Million every year over the next three years, and the population has been in decline over the last 14 years, falling to 141.0 Million in 2010.
  • Inflation: The Economy Ministry raised its 2010 inflation forecast to 7-8% from the previous estimate of 6-7% after the drought is set to crimp agricultural production and push up consumer prices (negative domestically).
  • Political friction with the USA: talks with President Obama to “restart” relations have largely stalled and relations between Washington and Moscow have parted ways following the exchange of spies in July.  Ongoing Russian fears that the US will install antiballistic weapons in Poland and Czech Republic persist.

As Lou often says in our morning meetings, we want to be long energy long countries like Russia. While multiple factors play into our analysis, the root of Lou’s comment implies an investment bias towards countries that produce more oil (or natural gas) than they consume.  Brazil is another country that follows this mold.


Despite the political curtain that is often drawn in Russia, the country’s natural resources offer a compelling investment opportunity with a commensurate risk premium.  Stay tuned as we look to add Russian energy names to the Hedgeye Virtual Portfolio.  To get access to Lou’s energy launch please contact sales at .


Matthew Hedrick



Russia Rising? - Russia2


Galaxy reports record results and announces additional HK $0.8 BN investment in Galaxy Macau.



“Once again GEG outperformed the market, with excellent gaming growth and strong results from all our divisions. StarWorld continues to lead the market, delivering exceptional returns and achieving some of the highest volumes of any casino in Macau. StarWorld also boasts one of the highest hotel occupancy rates in Macau, recording a very healthy 96% in the second quarter of the year. In Cotai, we are entering the final fit-out stages, in preparation for the opening of Galaxy Macau™. In early 2011 we will be unveiling the most innovative and uniquely Asian destination resort in the world. This, the first phase in our Cotai development, represents the culmination of six years of careful and detailed planning. We are hugely excited about the opening of Galaxy Macau™ and are confident that it will transform the Macau market just as it is now transforming the Cotai skyline. As a result of our confidence, we are seizing the opportunity to increase our investment and exploit surging market demand.”


--Dr. Lui Che Woo, Chairman of Galaxy Entertainment Group




  • Slightly lower ADR at Starworld's hotel  is driven by desire to increase occupancy


  • Starworld EBITDA margin: economics of scale and cost structure contributed to higher margins; hold did not impact margins.
    • Different mix of profit-sharing rooms from Q1 to Q2 may also have played a factor in higher margins.
  • Taking advantage of limited supply coming online in Cotai to expand Galaxy Macau rooms to 1,400 from 900.
    • will open 800 rooms in the next 6 months.
  • Galaxy Macau scheduled for end of Q1 2011; 2/3 mass tables, 1/3 VIP tables--but mix may change as they move closer to opening.
  • HK$5.4 BN project capex invested YTD. Will spend much of the HK$14.9 BN capex budget in 4Q 2010.

PSS: …Or Get Off The Pot

PSS reports this Wednesday. They're gonna miss. I know it. You know it. Anyone else that's bothering to look at the retail tape this week knows it. I'd love to end this little intro with "...and Mr. Market knows it too." But that would be a JV mistake I simply won't get sucked into.


There's only one time in the many years I have tracked PSS that I have seen sentiment worse -- and that's just after PSS levered up to do a dilutive deal about a week before the credit crisis began.  Fast forward a couple of years, and the deal has proven to be the right move. The acquired business has more than doubled, debt to EBITDA is down to nearly 1x,  and the cash flow in the business today (even with the core struggling) is ample enough to buy back 15% of the stock.


So let's step back a minute and drill down on what's really wrong. I could argue all day about valuation, and that the sum-of-parts math suggests that the market is only paying 2-3x EBITDA for the base business. But the reality is that the bear case that has frustrated so many people over so many years finally has some teeth. There's finally the 'I told you so' factor. And that, of course, is that the core business can't comp, the business is overexposed to Asia from a  sourcing perspective, and at face value it is tougher to model the earnings upside that used to exist in the models of many.


Let's look at the facts…

  1)  Not only did PSS undercomp its peer set by about 500bps over the past three quarters, but in the latest quarter, the  trajectory of the comp diverged meaningfully (to the negative side).

  2)  A perplexing trend has emerged. When consumers trade up (and we see higher-end retailers do well), PSS has not benefitted in its mix or price. But as consumers trade down (and Dollar Stores and Discount Stores score) we’re not seeing Payless participate.


PSS: …Or Get Off The Pot - PSS CompTrends 8 10 1


PSS: …Or Get Off The Pot - PSS CompTrends 8 10 2



Now…there are some offsetting factors over the past year that need to be considered.

  A)  At this time last year, PSS’ back-to-school push was aggressive – big time. The company went in with a $7-$8 intro price point at the same time Wal-Mart started to get out of footwear. PSS upped its SG&A and went on full offense. Unfortunately, it didn’t work. The reality is that the consumer was in a spot where they weren’t going to show up – regardless of price. So PSS either ‘over-SG&A’d’ or under-priced.  I’d argue the latter.

  B)  As it to relates to trends, keep in mind that the PSS model differs from most peers in that its proprietary brands very rarely – if ever – catch a fashion trend when they are on the upswing. PSS will usually benefit when the trends explode into the mass market and crush ‘em on price. Last fall and winter, it was short on boots. Early this year it was late on Toning. Same thing with Sandals a couple years back. There’s a couple of sub-themes here…

      -  Expect broader distribution of boots at PSS this fall. It’s about 6%-8% of the PSS mix, and carries about 2-3x the average price point.

      -  Same for Toning. It will go from 1% of business early this year to 5-6% by 4Q at a $29.99 price point. Our sense is that this business is already above plan.

  C)  Why A Late ‘Trend-Catcher’? It’s perfectly fair to question why PSS should be late in catching trends. One reason is that the company took the percent of proprietary brands up by 3x over 5 years to almost 75%.  With in-house R&D teams instead of third-party sourcing, the lead time requirements grow, short-term flexibility declines, and the risk factor in being wrong on product goes up materially. I think that this is why PSS has been so tight with inventory (and Gross Margins have steadily been heading higher) as having increased product risk AND inventory risk layered on top of that is a risky game that no retailer in their right mind wants to play.


We can debate the facts, but one thing that’s unquestionable is that PSS is at a key point in its decision tree.  Management needs to think outside the box on this one.

  1)  Does this mean that Payless increases its outside brand exposure – in effect reversing what has been part of the bull case on margins for 3+ years?

  2)  Does it start to produce ‘take-down’ versions of Saucony and Sperry to sell at Payless stores (kind of like how Nike and Polo both design and sell certain product into Kohl’s)?

  3)  Does PSS need to step back and really ask itself if it needs 4,800 stores? If the answer is Yes, are they in the right locations?

  4)  Does the low-income consumer really care one way or another about trading up to better brands at a place like PSS?


I don’t like to say this often, but I’m not certain what the right answer is -- yet.  The only thing I am certain of is that something meaningful must change. That makes this one of those ‘trust management to do the right thing’ stories.  Everyone will have their own opinion there, but again, let’s look at some facts.  Just 3 years ago, the big question was around Saucony and Sperry. Check out the following.


  A)  At the September 2008 analyst meeting, Saucony and Sperry had combined revenue of about $250, and Matt Rubel said that they should be $500mm combined by 2010. Today, they exceed $500mm (my math is $550ish). Over this time period, the business went from 7% of revenue to 15% today.

  B)  As it relates to profitability, the leverage is clear when the revenue doubles on the fixed-cost portion of the business. Translation = Saucony and Sperry went from 5.5% of EBIT then, and is around 20.5% today (based on our math).

  C)  Recent trends have been solid, to say the least. Saucony continues to gain share aggressively, with growth coming specifically from the Specialty Running channel.  As it relates to Sperry, trade shows are showing more strength in boat shoes for Spring. But more importantly, at the recent Atlanta Shoe Market in mid-August, buyers noted frustration that the brand was only accepting ‘futures’ due to ‘overwhelming demand.’


PSS: …Or Get Off The Pot - PSS BrandTrends 8 10



I’m not highlighting this to justify that there’s another part of the business that’s doing so well and that we should ignore the other 80% of cash flow. But in what I outlined as a ‘trust me’ story, these guys rank pretty high on my ‘give them the benefit of the doubt’ list. They’ve earned it.


We’ll hear Matt Rubel give his take on this at the Analyst Meeting in October. Until then, we have a sloppy print next week, extremely poor sentiment, what’s likely to be a downward earnings revision, and pretty much nothing else for people to get excited about on this name. Furthermore, there’s no doubt in my mind that we’re about 3-4 months into a major shareholder rotation, which will probably take us through year-end.


Do I think that Saucony and Sperry alone are worth $10 per share today? Yep. That suggests that the 4,800 chain, licensing business, and potential growth if the team gets this right are all worth about $3.50 per share, or $625mm if we give all the net debt to the stub. This thing is cheap on almost valuation metric possible. But I realize that that’s not enough if you’re looking at the next month.


But I think that by year-end, we’ll have a better mix AND pricing on the base business, continued growth success in PLG, a more clear strategy that the newer shareholder base can sink its teeth into, and most importantly – a roadmap that $2.50 in EPS is a reality.



PSS: …Or Get Off The Pot - PSS CompTable 8 10




the macro show

what smart investors watch to win

Hosted by Hedgeye CEO Keith McCullough at 9:00am ET, this special online broadcast offers smart investors and traders of all stripes the sharpest insights and clearest market analysis available on Wall Street.


NV will release July revenues in 2 weeks and we expect another mid-single digit drop.



With McCarran Airport traffic declining 1.1% YoY in July - the same as June - we project Strip gaming revenue will again decline in the mid-single digits.  Helping July is an extra Saturday in July of this year and a fairly easy comparison.  Total gaming revenue declined 11% last year despite above average slot and table hold percentage.  Hurting the performance will be the month end falling on the weekend.


Slots should be the laggard this month.  Since the month ended on a Saturday, the weekend's winnings won't be factored in until August.  Thus, we are projecting Strip slot revenue to fall 12% and total gaming revenue to decline 5%.  If we assume the same high 7.4% slot hold percentage experienced last year, total revenue would be flat.  However, due to the timing of month end, we are projecting only 6.6% hold.  Normal slot hold is around 7%.


Here are the details of our projections:




We've extracted this chart from a post available to RISK MANAGER SUBSCRIBERS in its entirety and in real-time.  To access this post and other research in its entirety, sign-up for a 14-DAY FREE-TRIAL or SUBSCRIBE.




We have not published our official estimate for 3Q10 GDP growth yet, but suffice to say it will be substantially below the current 1.7% number and substantially below the 2.5% consensus for 3Q10.   
Today’s made-up numbers from the commerce department suggest that the economy is in fairly bad shape.






Dr. Copper… Leading the Way Again?

Conclusion: We believe the recent strength in copper may be a leading indicator for China easing its tightening policies. This is bullish for Chinese Equities and may serve to keep a floor under copper prices going forward.


Position: Long Chinese equities (CAF); Short Copper (JJC)


As the facts change, we do. While we’d like to help our subscribers make money on 100% of our positions, the reality is we’re wrong on about 15% of them (14.4% on longs and 16.1% on shorts to be exact). Most importantly, however, rather than stay dogmatic about our losers, we accept the fact that markets don’t always trade in the direction our research suggests. 


In the spirit of this process, we went back to the drawing board on our short on Dr. Copper. After having put out a note early last week affirming our conviction in this position in light of the disastrous setup for growth and housing in the U.S., we revaluated the risks and have come to conclude that they are starting to outweigh the reward. Those risks include: Chinese demand accelerating, accelerating dollar debasement, and supply constraints.


We know growth is slowing globally. U.S. 2Q10 GDP came in at 1.6% (10bps below our estimate) and looks to continue rolling over sequentially driven largely by a weakening consumer (we are revising down our 3Q and 4Q GDP estimates to be released soon). As it relates to China, roughly one-fifth of all Chinese exports are to the U.S. so there will be negative knock-on effects in the Chinese economy as a result of slowing growth domestically. Understandably so, the likelihood that China reverses its tightening policies or accelerates the creation of policies designed to support domestic consumption increases with every incremental negative economic data point out of the U.S. and W. Europe – of which there will be plenty of going forward.  For instance, this morning the China Times reported that China’s State Administration of Taxation is considering “large” tax cuts to small and medium-sized businesses to support their growth and development. If enacted, this is incrementally bullish for Chinese employment and consumption.


Dr. Copper… Leading the Way Again? - 1


As it relates to the potential for dollar debasement, the Fed will have plenty of opportunities to quantitatively ease going forward given the negative economic backdrop domestically. If Bernanke and Co. give in to market pressure (which it appears he will based on his commentary out of Jackson Hole), we expect the dollar to resume its decline after closing up on a weekly basis for the previous two weeks. Further dollar debasement from here is positive for copper prices (r-squared = 0.69 on a two-month basis).


Dr. Copper… Leading the Way Again? - 2


With regard to supply, copper inventories stocks on the London Metals Exchange continue to trend down and are at a nine-month low. We initially thought that those inventories would start to grow as growth slows globally, but the potential for accelerating demand out of China could serve to keep inventories in check at low levels.  While the global growth story may be in question, the domestic consumption growth story in China continues to accelerate.


Dr. Copper… Leading the Way Again? - 3 


In addition, some experts are predicting that there may be a deficit in copper next year as demand outstrips supply for the first time in four years.  The impact of a volatile few years of pricing is that there has been limited investment in mines and therefore there will be limited new supply coming on in the next few years.  According to Pan Pacific Copper, “With few new large-scale mines on the horizon and stagnation at existing facilities, in our view, price direction will be upwards given the approach of multiyear deficits.” So as demand naturally continues to grind higher, supply may actually take a few years to catch up.


In the end, Dr. Copper has a Ph.D. in being a leading indicator, particularly as it relates to China and global growth. We think the potential for policy easing and accelerated demand out of China is growing and that is a major factor we will continue to monitor as it relates to our long position in Chinese equities and short exposure to copper. As we’ve seen throughout the year, any easing of policy or rumors of easing is bullish for Chinese equities and will likely serve to keep a floor under copper in spite of the negative backdrop for real estate in the U.S.


Darius Dale


investing ideas

Risk Managed Long Term Investing for Pros

Hedgeye CEO Keith McCullough handpicks the “best of the best” long and short ideas delivered to him by our team of over 30 research analysts across myriad sectors.