A steady diet of market share losses has IGT looking more like a chimp than the 500 pound Gorilla it once was. Have sentiment and market share both reach a trough?



We’re pretty sure IGT’s market share is close to bottoming.  With the latest downgrade, we think sentiment may be as well.  Sure there are still some buy ratings out there but no one seems to be pounding the table on the stock.  Why?  A perceived lack of catalysts, a perceived lack of earnings visibility, and a perceived 25% market share in perpetuity.  Well, in this case, perception is not reality.


The Elusive Replacement Market

The biggest catalyst out there is the normalization of replacement demand.  It will happen, only the timing is uncertain.  If we knew when, IGT would be a $25 stock.  We don’t but we’re not going to rely on the sell side consensus that replacements will stay under pressure for the next 18 months.  We think an analysis of the major potential drivers yields an acceleration sooner than that and potentially V-shaped in magnitude.  Here are the major drivers:

  1. Accelerated depreciation initiatives working through Congress.  President Obama proposed 100% expensing of capital equipment purchases.
  2. Floors are not old yet but they will be soon – end of TITO was 6 years ago
  3. IGT’s footprint is older than average
  4. Operator balance sheets are in much better shape
  5. More certainty in the casino business – revenues are stagnant but at least the world isn’t ending
  6. More competition from new markets

While accelerated replacement demand would benefit all suppliers, IGT’s stock could have the most upside to that catalyst.  Given the liquidity of the stock, name recognition, and its reliance on box sale, investors would likely flock to IGT.


Again, the problem is timing.  However, near term earnings visibility may be a little better than what the bears are chirping.  Despite the recent downturn in sentiment, we don’t believe anything has really changed since IGT last gave guidance in July.  Our $0.18 estimate looks safe and while we are a little below the Street for FY2011, we have not modeled significant replacement growth (yet), share buyback, or the convertible takeout. 


25% Ship Share Not Sustainable

IGT has rung up two consecutive quarters of mid 20s ship share.  The share deterioration is nothing short of stunning.  After all, IGT was at 50% as recent as Q3 2006 and at 40% in Q2 2008.  However, we think IGT’s recent share is unsustainably low.  The dearth of new casino openings has not helped since IGT usually garners a bigger share of slot orders from new and expanding casinos.  Second, IGT’s existing footprint is older than the average North American slot machine.  IGT’s content has undergone a significant upgrade as resources have moved from systems to development to game development.  Finally, server based gaming is finally gaining some traction.  Ship share in the 35% range is probably a good run rate and while we don’t see a lot of improvement occurring in the next few quarters, calendar 2011 should show gradual improvement throughout the year.  Ship share gains off the current bottom should be a catalyst.


Core Earnings

Given the trough level of replacement demand and the dearth of new markets, we believe earnings are also at a trough.  Starting at a baseline of $0.90, we get to $1.20 in core earnings just from normalizing industry wide replacement demand at 76,000 (adds $0.17), adding $0.08 from taking out the convertible, and $0.05 from using free cash flow to buy back stock.  Beyond the $1.20, IGT should be able to grow earnings 20%+ annually over the next 3-5 years with the addition of new markets (MD, OH, IL, Italy, etc.) and continued share repurchases. 


With cash earnings tracking very close to EPS, it seems reasonable to assume at least an 18x multiple for that kind of growth and cash flow generation.  So if IGT is worth at least $21-22 per the analysis, what will it take to get there?  It probably starts with making the FQ4 which we think IGT will do.  Market share stabilization and improvement will certainly help but the real catalyst will be replacement demand.  While we wait for the inevitable, downside appears limited, owing to awful sentiment.


The Macau Metro Monitor, September 21th 2010

LAND PREMIUM CALCULATION TO BE REVISED Macau Daily Times, Intelligence Macau

Director of the Land, Public Works and Transport Bureau (DSSOPT), Jaime Carion, said the calculation method of land premium will be revised “shortly” and that the fine for land concessionaires in cases of idle land will link with the land premium.  Moreover, he disclosed that the draft law proposes that all land parcels will be put up in open auctions “except those that involve public interest”, and bidders will be required to submit an economic feasibility analysis report to prove the company’s financial capability when applying for land concession.


Carion stressed that the Government will be “tough” on the land concessionaire who wants to renew the contract but hasn’t developed the land before the deadline.  IM believes this comment is directed at the holder of Lot 3, which is having trouble finding tables given the 5,500 ceiling established by the Government.



According to China Business News, China may announce property tax measures as early as the October National Day holidays.  The new tax, which will be extended to include residential property, is more likely to be implemented at the start of next year 



Managing director of L'Arc Macau, Johnny Chan, said, "We are continuously upgrading our existing facilities and later in the year, we will offer more choices of entertainment facilities to our customers.  The hotel has recorded an average occupancy rate of 90 percent over the past year."  Chan added that the casino operations in L'Arc have had a "good performance."



Composite CPI rose 2.55% YoY.  The price index of Recreation & Culture rose by 1.39%, attributable to higher charges for outbound package tours during the summer holidays.

Walk The Line

“Because your mine, I walk the line.”

-Johnny Cash


Since we introduced it at the beginning of July as our intermediate term TREND line of bearish resistance for Q3, it’s no secret that the 1144 line on the SP500 has been our line. Now that the SP500 has rallied sharply (+9.8%) from what we called immediate term TRADE support (1040), it’s time for me to walk the line.


Will I be bullish? Will I be bearish? Or will I be neither? I don’t have to make a call; I make calls when the probability in my math tells me to. I already made my selling moves yesterday and I will be accountable to them.


It’s NFL season. This is a great time of year in America because it allows us to remind ourselves how real winners in this country behave. Professional athletes and their coaches like making calls too – unlike professional politicians of the Fiat Republic, they thrive on accountability.


Before the Monday Night Football game between the San Francisco 49ers and the New Orleans Saints, 49er head coach, Mike Singletary, made the call that “we will not try to stop Drew Brees – we will stop Drew Brees.”


After the game Brees said, “we won the game and that’s all that counts.”


Ultimately, this business is a lot like professional sports in that being right or wrong is really all that counts. This isn’t a charity. This isn’t a philanthropic venture. This is meat and potatoes bids versus asks. Take your position, and walk the line.


No matter where I go this morning, here I am. Here are the moves I made yesterday:


1.  09/20/2010 02:45 PM SHORTING XLY $33.34

We covered this short position on August 24th and now we'll put it back on as we are bearish on US Consumer Spending for the intermediate term TREND, from this price. Timing matters.


2.  09/20/2010 10:42 AM SELLING CAF $28.24

Chinese stocks have closed down for 4 consecutive days and have broken their immediate term TRADE line. Could Chinese growth slow in SEP vs AUG?


3.  09/20/2010 10:34 AM SELLING GLD $125.22

I said I was going to do it in this morning's Early Look, so I'm doing it - booking a gain here in gold as it is immediate term TRADE overbought.


4.  09/20/2010 10:28 AM COVERING HCBK $12.14

US Housing data this week won't be as much of a bomb (relative to expectations) as the AUG24th report was. We'll cover here and re-short later.


5.  09/20/2010 10:22 AM SELLING ASPS $27.48

Steiner remains bullish on ASPS for the intermediate term TREND, but it is finally overbought here from an immediate term TRADE perspective. Selling high.


6.  09/20/2010 10:16 AM SHORTING HOT $53.23

Jordan and I remain bearish on the market's intermediate term expectations for revpar growth. Shorting green.


In summary, one of the first takeaways you’ll have from these 6 position changes is how mixed the research reasoning is. That, Dear Fundamentalist Sir, is the hallmark of both chaos theory and how you apply it to a modern day risk management model. Managing risk has nothing to do with the certainty of your “valuation model” or your latest super-duper “one-on-one” with a company. It has everything to do with accepting uncertainty.


When I make a call, I immediately start trying to prove myself wrong. Each position in the Hedgeye Portfolio has to undergo a disciplined and repeatable line of examination every morning, afternoon, and night. If you want to have a position playing on my team, your research is mine.


Sounds hard core, because it is. We’re not here to sell our clients some broken Greek bond promise, CNBC advertising, or an investment banking fee. We’re here to win – and the best way to ensure that is to keep moving as the game does.


My immediate term and intermediate term lines of resistance (TRADE and TREND) are the same line this morning, 1144. It’s time to walk the line.


Best of luck out there today,



Keith R. McCullough
Chief Executive Officer


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EARLY LOOK: Trojan Protection





“The best lightning rod for your protection is your own spine.”

-Ralph Waldo Emerson



EARLY LOOK: Trojan Protection - chart2






On Friday President Obama introduced Elizabeth Warren as the new head of the US Consumer Protection Agency. Sounds serious. We hope that she’ll be working vigilantly to protect us from more policy making ideas coming out of Larry Summers and Timmy Geithner.



EARLY LOOK: Trojan Protection - chart1



Hope, of course, is not an investment process. So the best we can do for your protection this morning is recommend you take your financial security into your own hands – in the face of government sponsored volatility, sell high - buy low.


If you thought last week was a big week for Government (Congress was back in session), this week is going to be a barn burner:  



1.   Monday - kicks things off with an “exclusive CNBC” town-hall meeting with none other than the President of the United States as 12PM EST today (I couldn’t make that up if I tried).


2.   Tuesday - Heli-Ben is going to save us all from the road that is US monetary policy perdition at the FOMC meeting that will be brought to you by Trojan’s NEW “Fire & Ice Quantitative Easing”, twice the turn on!


3.   Wednesday – both the Senate Banking Committee and weekend at Barney’s House Financial Service committee will be back in action.

Some people take the alleged Trojan horse protection Ben Bernanke provides us very seriously – if you think about it in terms of the world’s poor who are watching food prices rip higher again this morning, it’s very serious indeed.



EARLY LOOK: Trojan Protection - chart4



Bernanke’s “Warped Twenty Ten Tour” (Trojan) has been a battle. He started the year talking about US GDP growth accelerating into the back half of the year on the order of 3.5-4%. Now that US GDP growth is barely 2%, you can fully expect him to downgrade his growth estimates tomorrow. In modern day risk management speak, we call this chasing your own tail.


Protecting their own tail is what people in Washington do. This isn’t new, and you don’t need CNBC to provide the sponsor’s messaging to understand this either. Today is just another day in the Fiat Republic. Prices are a lot higher than where they were only a month ago, so now is not the time to be buying those inflated prices.


On a sequential basis versus August, inflation in September has re-reared its ugly head. Expect Ben Bernanke to mention none of this tomorrow. If he didn’t see inflation in 2008, he’s certainly not going to see it now. These things are very hard to see from a helicopter.


Interestingly, but not ironically, Bernanke’s counterpart at the Reserve Bank of Australia, Glenn Stevens, pre-empted Heli-Ben’s political pandering by saying the following in Victoria this morning: “If downside possibilities do not materialize, the task ahead is likely to be one of managing a fairly robust upswing. Part of that task will, clearly, fall to monetary policy.”


Now if you are part of the perma-Deflationista camp, you probably don’t like these trivial things like prices going up being mentioned as inflation. Heck, how should we expect one of the next alleged great leaders of the Fiat Republic like Republican Senate candidate, Christine O’Donnell, ever see anything but deflation in US home prices since she stopped paying her mortgage in 2007?



EARLY LOOK: Trojan Protection - chart5



Never mind 15 year highs in cotton prices this morning or all-time highs in the nominal price of gold – the deflation story-telling is entrenched – and Elizabeth Warren is going to protect all consumers from those evil-doer gold commercials anyway.


Last week saw further deflation in the US Dollar Index’s price. The US Dollar continued to look like the credibility of the government that backs it, losing another -1.6% of its debauched value week-over-week and closing down for the 13th week out of the last sixteen.


In response to the Dollar DOWN trade that Ben Bernanke has been hired to perpetuate, most asset prices inflated week-over-week, including short-term US Treasury bonds. As we look at 2-year yields dropping to generational lows this morning of 0.47%, Americans with hard earned savings accounts in this country must be wondering whether Elizabeth is going to protect us from Japanese style fixed income rates too…


As Emerson dares me to have the spine to sell my 6% asset allocation to Gold (GLD) this morning, I think I might just do it. That’s right - I have my own protection strategy against Government.


My immediate term support and resistance levels for the SP500 are now 1113 and 1137, respectively. On Friday, I sold 3% of our 15% position in the Chinese Yuan (CYB), taking our asset allocation to Cash up from 46% to 49%. Unlike prior bear market rallies, we have plenty more to sell into this one.


Best of luck out there today,



Keith R. McCullough
Chief Executive Officer




This note was originally published at 8am this morning, September 20, 2010. INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK (published by 8am every trading day) and PORTFOLIO IDEAS in real-time.


After feeding at the trough of cheap commodities during 2009, restaurant operators are facing an increasingly difficult cost environment as food prices head higher.  Of all commodity cost inputs, corn speaks to this fact most lucidly.


Since the most recent low in prices (6/29, $3.25/bushel), corn prices have move sharply higher.  There are several reasons for the move; some are more transient than others.  Corn prices provide a highly accurate reflection of the cost environment facing restaurant companies since the commodity is used in soft drinks (high fructose corn syrup), bread, as feed for livestock and in the production of ethanol.  There is no restaurant company that I’m aware of that is immune to a sustained move higher in corn prices; it’s really a question of how exposed each company is. 


The United States produces more than twice as much corn as its closest corn producing competitor, China, according to USDA data.  Any factors impacting corn production on the United States have a strong impact on the direction of prices and, therefore, restaurant company margins. 


Regulatory risk is the most pertinent factor in domestic corn markets today.  In 2007, with the passing of the Energy Independence and Security Act, the U.S. government adopted an active role in the price of the grain.  The Renewable Fuel Standard (RFS) portion of the EISA pertains to bio-diesel and ethanol.  The RFS mandates that “applicable volumes of renewable fuel” must be produced with the majority of that renewable fuel to be ethanol to be blended in with gasoline.  The result has been gasoline E10: 10% ethanol mixed with 90% gasoline. 


As you can see in the chart below, as passage of this legislation became more certain, corn responded appropriately by gaining sharply over the next few months.  Recent agitation on the part of the Environmental Protection Agency to increase the ethanol blend to E15 (15% of the blend) has added further support to corn prices.  In conversation with our Energy sector head, Lou Gagliardi, he has made it clear that he expects this momentum to continue and for lobbyists in D.C. to seek higher and higher levels of ethanol in gasoline.  A recent study, touted by the EPA, “confirming” the safety of E15 for older vehicles (as well as new models) was just released late last week and is available on the Renewable Fuels Association website. 




Recent USDA reports have highlighted some interesting supply and demand dynamics in the corn market.  Firstly, the USDA revised its 2010/2011 U.S. corn yield forecast lower to 162.5 bushels per acre in the September World Agricultural Supply and Demand Estimates from 165 bushels per acre prior.  The higher 2009/10 use of corn for ethanol was incorporated in to this forecast.  Another pertinent factor is the excessive rain in corn-growing regions earlier in the summer coupled with high temperatures in August.   Weather has impacted grains heavily this summer with China and Russia experiencing shocks to their grain supply chains.  Irregular weather patterns can cause significant price fluctuations in corn – especially if top corn supplying countries are affected: The United States, China, Brazil, Mexico, Argentina, and India are currently the top six.  Investors seem to believe that national corn balances will tighten further, as is suggested by the chart below of net long contracts for corn.   If anything, the high level of net long speculative positions could impede further gains in corn prices if a significant portion of the positions are unwound.




Of course, since corn prices are denominated in dollars, it is important to consider the impact of foreign exchange on spot prices.  Our view on the U.S. dollar continues to be bearish in light of sharp down moves in recent weeks in response to rhetoric from Capitol Hill.  As long as the dollar continues to decline, it will continue to be bullish for corn price and negative for restaurant margins.


NO MORE ROOM AT THE TROUGH - us dollar corn


Howard Penney

Managing Director

Where Is the Inflation? Just Like Politics, It’s Local

A number of our subscribers have rightfully pointed out the apparent contradiction in our call for slowing economic growth in the United States combined with a pick-up in inflation.   Not unlike politics, inflation is local.  In many local markets, we continue to see a pick-up in inflation, despite the increased likelihood of sequentially declining growth in the United States.


China is probably the best example of accelerating inflation globally.  Directly below we’ve posted the chart of Chinese CPI going back two years.  While we are not back to the year-over-year increases in CPI that we witnessed in late 2008, which neared 5%, CPI in China is accelerating.   From July 2009 of last year to the most recent data point for August, CPI growth year-over-year has increased steadily to 3.5%, which is a 22-month high.


Where Is the Inflation? Just Like Politics, It’s Local - 1


Another global inflationary signal relates to major food inputs.  Immediately below we’ve posted the CRB Foodstuff Index.  This index incorporates the following food inputs: butter, cocoa, corn, hogs, lard, soybean, steers, sugar, and wheat.  This index has accelerated dramatically off of its June lows and is up almost 35% on a year-over-year basis.  If a year-over-year price increase of the 35% doesn’t imply some form of inflation, then shame on us. 


Where Is the Inflation? Just Like Politics, It’s Local - 2


Our Retail team lead by Brian McGough and Retail COO Zach “The Hammer” Brown also highlighted another key inflation data point recently in a post on cotton titled, “Apparel: We Just Got More Bearish.”  As Zach wrote in the note:


“While we’re talking 3-Standard Deviation moves, look at the recent move in cotton. Yes, the recent spike puts it into the ‘statistical aberration’ bucket. Anomalies or not, it is an economic reality, and a 50% boost in the industry’s biggest cost input must be dealt with.”


Cotton is, obviously, one of the key inputs in making apparel; ultimately, inflation in cotton prices will be felt throughout the apparel supply chain. Either consumers will have to pay higher prices or retailers, apparel makers, and/or vendors will have to eat margin. In the U.S., this could not come at a worse time, as Consumer Confidence recently hit a 13-month low and unemployment continues to hover above 9%.


Where Is the Inflation? Just Like Politics, It’s Local - 3 


Currently, the primary driver of inflation is the continued debasement of the U.S. dollar.  As the U.S. dollar declines, the cost of goods and materials priced in U.S. dollars should increase. In our opinion, the main reason we are seeing all-time highs in gold is that investors and sovereign wealth funds globally are looking to protect their wealth from the debasement of fiat currencies. 


Even if we aren’t currently seeing inflation on a reported basis in the U.S., the rapid increase over the past few months in food costs, apparel costs, and reported CPI from China suggest anything but deflation to the team at Hedgeye.


Daryl G. Jones

Managing Director

Early Look

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