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BYE, BYE CONVERSIONS, HELLO…..?

This October will bring a very interesting dynamic to the slot machine industry. IGT will cease to install conversion kits on all of its platforms with the exception of the newest, AVP. This looks to me to be a pretty big bet on Server Based Gaming (SBG).

  • Sluggish replacement sales have masked a solid conversion environment over the past 2 years. As can be seen in the first chart, conversion activity has not followed the downward plunge in slot demand. For the casinos, conversions are a big time money saver. Slot boxes last for a long time, game appeal does not. Game conversions run in the $4-5k range versus $12k+ for a whole new slot machine. Obviously for the supplier, a full slot sale is preferable. I attribute the relative strength of conversion sales to the following:

    • Better technology
    • Operators converting ahead of IGT’s dictum (customers were notified over a year prior)
    • Casinos with cash-strapped balance sheets pursuing the lower cost conversion alternative
    • Shorter “game appeal” duration


  • The 2nd chart shows that IGT has a little over 500,000 of the 900,000 slots installed in North America. Only 30,000 of these machines are on the AVP platform, leaving a significant number of machines unconvertible. An IGT bull might say that due to competitive conditions between the operators, casinos will be forced to replace existing games with brand new machines. Alternatively, SBG provides an easy solution whereby new games can be purchased and downloaded automatically on the AVP platform. On the other hand, IGT’s conversion decision now puts almost 500k machines up for grabs. Casinos do not have to replace an IGT machine with an IGT machine. Where there’s a bull, there’s a bear.

  • That’s the IGT story. The BYI and WMS stories are altogether different. At the very least, I think IGT’s decision could spur more conversions for BYI and WMS. More likely, the move opens the door for more market share gains, at full pricing. Again, that’s almost a half of a million slot machines that will ultimately be replaced and not converted.

Slot conversion growth outpaced replacements. A lot of market share up for grabs.
IGT Bull vs Bear

The Bear Hunter Chart: Russia's RTS Index

Russian Bears are on the loose, and those shorting Putin’s RTS Index are getting paid healthy bounties. The Russian stock market got hammered again today, closing down another -4.2%, taking the Index down to 1579. The decline in august alone is almost -20%. Since our "Fading Fast Money" call on 5/21, this levered country play on commodities has lost -37% of its value. Vladimir no likey...
KM
  • This is the RTSI (USD) charted since the day that hostilities with Georgioa kicked into high gear.

    Andrew Barber
    Director

Thailand has seen this movie before...

Thailand's recent economic history is best depicted by the charts below where we have overlaid economic growth with local currency trends. Suffice to say, if history has any relevance, Thailand's near term future looks ominous. My advice would be to consider the tail risks associated with a protracted slowdown Thai GDP very seriously.
KM
  • GDP vs. Currency, since 2003
  • GDP vs. Currency, since the Baht's crash (1998)

Early Look

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COW - WE REMAIN BULLISH ON LIVESTOCK PRICES.

The Hedgeye Portfolio is a new product that is currently being beta-tested at Research Edge. One of the holdings within the portfolio is COW, as we remain bullish on Livestock prices. COW is an ETN designed to track the return of a Livestock index as measured by the Dow Jones-AIG Livestock Total Return Sub-Index (weightings are 62% Live Cattle and 38% Lean Hogs).

The USAgNet reported that U.S. pork exports set a record in the first half of 2008, while U.S. beef exports continued to climb closer to the pre-BSE levels reached earlier this decade, according to the latest figures released by the U.S. Department of Agriculture.

According to the USDA, pork and pork variety meat exports in June doubled the volume exported last year, driving year-to-date pork exports up 67% above the first six months of 2007 in terms of volume, and 58% higher in terms of value. During the first half of the year, beef and beef variety meat exports increased 30% in volumes and 39% in value.

Beef exports are exploding at a time when the herd is declining so it does not seem like prices are going lower any time soon.



  • A weak dollar has made US protein attractive in foreign markets simultaneous to the rise of “BRIC” consumers anxious to enrich and diversify their menu –clearly illustrated by these pork export charts.
  • In the case of poke specifically, even if a post Olympic/Georgia slowdown in China and Russia dampens exports somewhat, demand should remain relatively firm for the “other white meat” –aided by the Canadian Government’s effort to reduce their breeding swine population.
The good news: Price should continue to rise
The good news: Price should continue to rise

DRI – Then and Now

Darden preannounced its 1Q09 results earlier today and significantly lowered its full-year outlook. Although back in June on its 4Q08 earnings call, Darden management highlighted the challenging environment as a reason to be cautious, citing higher costs and the expectation for traffic and mix changes to be flat to slightly negative in FY09, based on the magnitude of change in the company’s full-year outlook from then to now, management was not cautious enough.

Most surprising, relative to the company’s preliminary 1Q09 results, was the 2.4% same-store sales growth at Olive Garden, down from the 5.8% number in 4Q08. Olive Garden was facing a tough comparison in 1Q09 from last year when comparable sales grew 4.8%, but the 2-year average also declined sequentially by 1.1%, proving that Olive Garden is not immune to the issues facing the casual dining segment as it had appeared for some time. The more troubling component of the same-store sales result is the drop off in traffic. If you assume price was running up about 3%-4% in 1Q09, traffic fell from up over 3.0% in 4Q08 to negative in 1Q09.

What has changed since DRI’s June 25th 4Q08 conference call?

June 25th: “We are pleased with Olive Garden's strength in this challenging consumer environment and we believe they will continue to deliver industry leading performance during this fiscal year.”

“In fiscal 2009, we expect combined same-restaurant sales growth for Red Lobster, Olive Garden, and LongHorn Steakhouse to be approximately 2%. This includes approximately 2% to 3% of pricing for fiscal 2009 and our expectation that together, traffic and mix changes will be flat to slightly negative.”

Today: "With a more challenging than anticipated economic and consumer environment this quarter, our initial expectations for our same-restaurant sales performance proved optimistic. Our revised earnings outlook for the full year reflects expected first quarter results as well as our expectation that same-restaurant sales will remain under pressure for the balance of the fiscal year." DRI announced that it now expects combined full-year U.S. same-restaurant sales growth in fiscal 2009 of approximately 0% to 1% for Red Lobster, Olive Garden and LongHorn Steakhouse.

June 25th: Excluding the impact of integration costs and adjustments for both fiscal 2008 and fiscal 2009, the company expects EPS growth of 9% to 10% on a 53-week basis and 7% to 8% on a 52-week basis.

Today: Excluding the impact of integration costs and adjustments for both fiscal 2008 and fiscal 2009, the company expects EPS growth to be between 0% and 5% on a 53-week basis and -2% and +3% on a 52-week basis.

What has remained the same?

June 25th: “Looking ahead to fiscal 2009, the strategic priority at Olive Garden remains unchanged, and that is to accelerate new restaurant growth while maintaining same-restaurant excellence. Olive Garden expects to open approximately 40 net new restaurants during fiscal 2009 and ultimately, as we have said before, we believe that the brand has the potential to operated 800 to 900 restaurants in North America.”

“Looking ahead to unit growth, new restaurant plans that Drew and Gene outlined mean that we expect a net new restaurant increase of approximately 75 to 80 restaurants or about 4% to 5%.”

Today: DRI expects to open approximately 75 to 80 net new restaurants in fiscal 2009.

As I said earlier, today’s announcement proves that DRI and the Olive Garden are not immune to the challenges facing restaurant operators today. That being said, DRI needs to re-evaluate its new unit growth targets in light of today’s environment. If the Olive Garden cannot maintain “same-restaurant excellence,” then management should not continue to accelerate new restaurant growth.
Darden’s Olive Garden experienced a significant slowdown in same-store sales trends in 1Q09.

FL: Lease Optionality

It’s common perception that leases for mall retailers have zero optionality. I agree from an asset sale vantage point. But there’s more wiggle room with accounting and margins.

The wiggle room Foot Locker has with its real estate profile over the next five years should not be underestimated. I think that this provides the company with some downside margin support to the extent that I am wrong in my view that margins will recover over the next 12-18 months due to stronger business levels over a leaner cost structure.

Specifically, FL’s operating lease commitments decline to 55% in five years. Seems intuitive given that FL is a zero square footage growth retailer and leases are coming due faster than new ones are being signed. But the reality is that there’s no shortage of retailers that have a severe (negative) mismatch between growth and rents. There’s Dick’s, DSW, Whole Foods, and CVS, to name a few. Foot Locker is at the opposite end of the spectrum.

Think of this ratio as you would a discount rate on retirement assets. A company can choose to account for them with a high expected rate of return, hence requiring lower annual accruals and setting a high hurdle going forward. Or they can do the opposite and go with an ultra-conservative rate, booking higher annual payments but depressing margins. That’s Foot Locker.

I can’t ignore the fact that minimums coming down so much outlines how many of FL’s leases expire over 5 years – which means that management will need to be smart about whether it renews, relocates, or shuts down. The company’s history is spotty at best in that regard.

But my point on this one is that if FL so chooses, it can more aggressively tackle its leases and pad its margins. It won’t be pretty, but it’s an option. Other companies don’t have that option.

I’ll take conservative lease accounting at trough margins over aggressive accounting at peak margins any day.
FL's year 1 rent payments divided by year 5 contractual minimums are far more favorable than peers.

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