bottom-up investing in a world turning top-down

the old days

Europe…

I started looking seriously at non-North American stock markets in 1984, after six years researching a number of sectors in the US market.  At that time, UK and continental European investors used almost exclusively a top-down style.  That is, they used macroeconomic analysis to select the countries they were interested in.  They then either bought banks, on the idea that the loan portfolios mirrored the economic structure of the countries; or they ventured into other sectors based on their economists’ view on what would be the areas of greatest economic strength.

…vs. the US

This process stood in stark contrast to what American investors did–which was to select individual stocks, mostly based on firm-specific factors, but with a little industry or sector guesswork also thrown in.  In fact, Peter Lynch of Fidelity Magellan, the most successful investor of that generation, wrote in his first book that he really didn’t pay much attention to macroeconomics.  He just picked good companies.

continental Europe?

When I began to manage a global portfolio at a small firm in 1986, I was faced with the problem of continental Europe.  I had limited resources.  There were lots of countries, all with different customs, different politics and different attitudes toward investing.  But together they only made up 10% or so of my benchmark index.   I’d spend all my time looking at just them if I adopted the European approach.  So I decided to do what Americans do, just pick stocks, on a pan-European basis and hope I didn’t get hurt too badly.

Ten years of European integration–and stellar portfolio performance along the way–later, my “accidental” approach had become the new norm.  It has stayed that way since.

…or so I thought.

macro-driven analysis

I’ve been surprised over the past couple of weeks to be seeing reports that harken back to an earlier day when analysts drew conclusions about individual stocks from general economic analysis, and nothing much else.

Two stick out.

1.  According to press reports, Goldman cut its price target on TIF a few days ago by 13%, from $77 to $67.  2013 eps were clipped by 4%, from $4.60 to $4.40.  Why?  Slowdown in the overall US economy.  That’s it.  Macroeconomic weakness will translate into lower jewelry purchases.

We’ll get some new evidence when TIF reports a little later this morning.   But judging from last night’s results from more down-market jewelry company SIG (which you’d expect to be hurt more severely than TIF if consumers were pulling in their horns),  however, there’s no sign of slowdown yet.  SIG said same store sales in the US were up 12% year on year in each month of the July quarter, and up 12% as well for the first three weeks of August.

I’m not saying GS is particularly insightful about TIF, nor that what I’ve read (I haven’t seen the actual report) is internally consistent.  What strikes me is the methodology–that there’s no apparent attempt to find a metric more subtle than that GDP growth is slowing.

2.  Deutsche Bank recently declared that the growth days for the casino gambling market in Macau are over.  Why?  Imports of German luxury cars into China, which had been growing at close to a 50% annual clip in the first half of 2011, slowed to +22% in July.  Deutsche believes this means wealthy Chinese citizens are seeing their income squeezed by global slowdown and are cutting back on spending (again, I haven’t seen the actual report, but it has been widely covered by the Asian press).

But July was a blowout month for the Macau gaming market.

According to Deutsche, that doesn’t matter.  We’re already seeing now is a reduction in high-roller participation in the market, but it’s being disguised for now by a boost in visits by less affluent Chinese gamblers.  By yearend, Deutsche thinks the Macau market will only be growing by 20%.  Growth of a mere 10% is possible for next year.  Evidence for any of this??

That’s an awful lot of inference from a one-month dropoff in sales of imported automobiles.   Who knows?  …maybe this year’s models are ugly.  …or customers have run out of garage space and will pick up the spending pace when their new garage additions are finished.

This report really struck a nerve in Hong Kong, however.  The entire gambling sector fell, with some stocks off as much as 10%.  It hasn’t recovered to date.

premises and conclusions

It’s always possible that your conclusions end up being correct even though your reasons are crazy–or non-existent. I happen to think that both reports will end up being too negative.  But that’s not my point.

In my experience, good analysts visit stores, interview/survey customers, talk with suppliers and with competitors to build a bottom-up model of a company or an industry.  They have detailed factual knowledge of a set of companies that they then integrate into an industry view.  Then maybe they knock on the door of their firm’s economist to give empirical feedback about the house macroeconomic view.

In these cases, the flow seems to have been reversed.  An economist who deals at the highest level of abstraction seems to be dictating what analysts are “supposed” to be seeing.  There’s a risk that the house macroeconomic view acts as a set of blinders that certainly make the analyst’s job easier, but makes the results less valuable at the same time.  I hope this isn’t the start of a trend.

We’ll know more about TIF later on today.  And Macau gambling numbers for August will be out in a week or so.

 

 

old soldiers fade away; what about old hotels?–how overcapacity shrinks

supply/demand imbalances…

In many cases, imbalances between supply and demand resolve themselves relatively quickly.

–Fresh produce goes bad.

–Clothing wears out, or is lost or damaged–or fashions shift–constantly creating new demand.

–Workers retrain and change careers.

–Technological change makes production equipment, as well as their output, obsolete.

…are difficult with long-lived assets like real estate

But what happens with real estate?

…where structures can be very expensive, are typically funded with borrowed money, may take years to build, generally can’t be relocated and can last for fifty years or more.  They’re also relatively low tech.

In this post, fresh from my visit to Las Vegas, I’m going to write about what happens with hotels/motels, a special case of this real estate question.

motels

These are easier to analyze than hotels, since they cost less and can be built faster.  Often, they’re designed in modular fashion so they can add extra wings of rooms at relatively low expense, if needed.  They also tend, in the US at least, to draw most of their customers from people who have business within a few miles of the motel.

Therefore, new capacity comes in lower increments and is visible to potential new entrants faster than with hotels.  So overcapacity tends to be less severe.

cost pressure points

There are two big costs for a motel operator that I don’t think are readily apparent–the price of affiliation with a national chain, and the need for periodic refurbishment of rooms.  These expenses end up being the big factors in eliminating existing capacity.

Chain affiliation, which may cost 5% or more of revenues, brings two benefits:  a brand image and access to a reservation system to direct potential guests to the motel.

Although guests don’t think about it much, hotels and motels suffer a lot of wear and tear, both in the rooms themselves and in common areas.  So they require a considerable amount of spending on maintenance.  In addition, to keep the rooms new looking in a way that justifies a higher rate, rooms have to be refurbished periodically–say every five years.

The two expense items are interconnected, since maintaining a specified standard of appearance will also be a condition for retaining affiliation with a chain.

When profits are under pressure, in my experience the first area to suffer cutbacks will be maintenance/room refurbishment.  Once these expenditures begin being postponed, it becomes progressively more difficult to catch up, since returning to the former standard is increasingly more expensive.  At the same time, less favorable online user reviews translate into less repeat business.  This compounds the financial problem.

At some point, a motel may fall below the standards necessary to maintain its affiliation with, say, the Marriott chain.  It may, however, still qualify to be a Best Western or Comfort Inn affiliate.   So it “solves” its maintenance/refurbishment problem by switching affiliations.  The motel effectively removes capacity from a higher-price market segment and introduces new capacity to another, lower-price one.

For a given motel, this journey to less expensive market segments may have several steps.  At some point, the building may be sold for alternate use as, for example, a nursing home.  If so, the capacity disappears entirely.

hotels

The same principles apply.  Three differences, however:

–hotels need to achieve a certain amount of occupancy–generally thought of as 30%–regardless of profits, so the building will feel “alive” and safe

–hotels are much larger in scale

–there are no alternate uses.

In Las Vegas, scene of immense overcapacity currently, two additional patterns are evident:

–older and new, but not as conveniently located, properties had been competing on lower price.  Given the new hotels’ need to generate occupancy to create a favorable ambiance, that advantage is diminished.  WYNN, for instance, had been planning to charge $300+/night for its new rooms.  But average room rates are currently around $200, with mid-week rates considerably below that.

–in the case of WYNN, LVS and to a lesser extent MGM,  management fees from Asian operations to the US are supplementing US cash flows, thereby enhancing the location advantage the three have.

signs of strain

You can already see signs of strain–and of capacity leaving the premium segment of the market.  The Wall Street Journal reported yesterday, for example, that Hilton is planning to end its affiliation with the Las Vegas hotel owned by private equity investor Colony Capital.

And MGM is also hoping to be able to blow up its as yet unopened Harmon hotel on the Las Vegas Strip.

walking around in Las Vegas last week

My wife and I went to San Francisco to see the Giants play two weeks ago.  Then we drove down the coast to Los Angeles to visit relatives.  And we stopped in Las Vegas for a day on the way home, just to see how the city looked compared with our last trip early in the year.

Over the years, I’ve learned that you have to be careful in drawing any firm conclusions about the hustle and bustle you see.  As I’ve already mentioned a long while ago in this blog, I once was in Caesars in Atlantic City at a time when the casino was packed to the gills.   (By the way, I’m not a big casino gambler myself.  I find it too much like work.  But the stocks are simple to analyze and usually generate huge amounts of cash flow.)

I called the company the next day and found out that their profits in Atlantic City were weaker than usual, not stronger.  A main set of doors had broken and no one could get in or out easily.  Few people were actually gambling; most were just stuck, and preventing fresh money from getting in.

Nevertheless, for what it’s worth:

–the city seemed to have far more foreign visitors than in January

–WYNN had a lot more casino patrons

–the Fashion Mall across the street was bustling

–the Bellagio seemed quieter; the visibly worn carpeting in retail areas hasn’t been replaced

–CityCenter appeared a lot quieter than in January

–I didn’t detect much difference with LVS

–every retail complex I saw had at least one vacancy, even WYNN;  CityCenter, understandably had the most empty space.

 

One of the odder aspects of my trip was the controversy that flared up last week over the yet-to-be-completed Harmon hotel in the CityCenter.  MGM is proposing to blow the structure up. (VegasInc has a comprehensive account).  It says the building is a potential hazard in an earthquake, because of construction defects.  Contractor Perini Building Co., which says MGM owes it $200 million+ for its work on the building, asserts any problems are design defects caused by MGM.   Just another day in the desert.

Macau gambling: July 2011 results; longer-term outlook

July 2011 results

For Macau, it was business as usual in July–another huge, and surprisingly strong,  year on year increase in casino win from gamblers in the SAR.  Here are the numbers from the Macau Gaming Coordination and Inspection Bureau:

* 1 HKD = 1.03MOP (Unit:MOP million )
Monthly Gross Revenue from Games of Fortune in 2011 and 2010
Monthly Gross Revenue Accumulated Gross Revenue
2011 2010 Variance 2011 2010 Variance
Jan 18,571 13,937 +33.2% 18,571 13,937 +33.2%
Feb 19,863 13,445 +47.7% 38,434 27,383 +40.4%
Mar 20,087 13,569 +48.0% 58,521 40,951 +42.9%
Apr 20,507 14,186 +44.6% 79,028 55,137 +43.3%
May 24,306 17,075 +42.4% 103,334 72,211 +43.1%
Jun 20,792 13,642 +52.4% 124,126 85,853 +44.6%
Jul 24,212 16,310 +48.4% 148,337 102,163 +45.2%

source: Macau Gaming Coordination and Inspection Bureau

To me, the interesting thing about these figures is that the year on year market gains seem to be accelerating over the past two months.  Hong Kong investors, however, continue to fret about the possibility that withdrawal, underway for a considerable time already, of the countercyclical stimulus Beijing applied during the financial crisis in the West will stunt growth in Macau.

Macau Business magazine indicates, for what it’s worth, that Galaxy Entertainment continues to gain market share, as gamblers visit its recently opened Galaxy Macau casino in Cotai.  Wynn Macau also appears to have been a relative winner.

the longer term

The most attractive aspect of the casino business for me as an investor is that it is relatively simple to analyze.  Revenue growth under normal circumstances is a function of two variables:

–the growth in the amount of floor space in the market and

–the growth of nominal GDP ( or nominal disposable income, if you prefer) in the area the casinos’ customers come from.

The very strong market growth numbers in Macau indicate that conditions there aren’t “normal.”  There’s still a substantial imbalance between the potential demand for gambling from China as a whole and the supply of casino space in Macau.  Network effects are still at work increasing the number of gamblers able to afford a trip to Macau who want to go.  Transport and border control bottlenecks still exist.  Rapid economic expansion is also swelling the ranks of those who can afford Macau.  I think we have at least several more years of this.

What happens when the imbalance is gone?  Well, the main thing is that the 40%-50% growth rates disappear as well.  From that point on, market growth becomes mostly a function of nominal GDP expansion.  For China, that probably means 8% real growth plus 4% inflation, or about 12% annual growth in revenues.  Operating leverage means that a 12% revenue increase will translate into 18% profit growth.  In addition, the market will likely split into relative winners and relative losers.  The former will grow profits at 20%, the latter at 15%.

It strikes me that the Hong Kong-listed casino companies are all currently priced as if the low end of the range will emerge as the norm almost immediately.  I think that’s highly unlikely.

 

 

Las Vegas Sands–a bounceback in 2Q11

the results

In 2Q11, LVS had unusually bad luck in its gambling operations in Singapore and in Las Vegas.  That happens occasionally.  Give a properly run casino enough time, however, and the odds even out.  2Q11 was a more normal quarter for the company from an odds point of view.  Combine that with stunning growth in Singapore, and the result was revenue for LVS during 2Q11 of $2.35 billion, up 47% year on year.  Eps of $.54 weere more than triple the net during the comparable period of 2010, and 25% ahead of the Wall Street consensus.

the details

To my mind, the biggest story is Singapore, where EBITDA (earnings before interest, taxes, depreciation and amortization–I’m not a fan of this metric, but it’s the one this industry uses) was $405.4 million, up 42% quarter on quarter (up “only” 30% if you adjust 1Q11 results up to reflect normal “luck”).  July may turn out to be the best month ever for the Marina Bay complex–which, strictly speaking, isn’t even finished.  Singapore is now by far the most valuable part of LVS.

I wasn’t floored by the Macau results, which–at EBITDA of $391.6 million–were up 27.5% year on year and about 4% quarter on quarter (market growth rates were 40%+ and 12%+, respectively, during those periods).  The issues are new capacity that opened recently right next to some of LVS’s operations, and the time it tales to recover from the actions of an inept CEO (since fired; he’s suing).  The Hong Kong stock market, however, regards the earnings report as very good news.  Sands China was up 10% in overnight in a flat market.

Las Vegas continues its slow recovery.  LVS posted EBITDA of $92 million in 2Q11 for Nevada operations. The lion’s share of the $30+ million quarter on quarter gain is a return of casino “luck” to normal.

$10 billion in debt no longer looks like such a big problem

Roughly speaking, $4 billion of that amount is borrowed against Singapore operations, $3 billion against Macau and $3 billion against the US.  LVS has just renegotiated the Macau debt to extend maturities and lower interest expense by close to $100 million yearly.  LVS will likely refinance Singapore soon, as well.

My back-of-the-envelope guess is that the LVS empire will generate $2.5 billion-$3 billion in cash flow over the coming 12 months.  Call it $2.8 billion.  Assume calls on that cash of $1 billion for capital expenditure plus $300 million for interest expense and $200 million for extra working capital.  That leaves $1.3 billion to go to debt repayment.  If LVS could manage twelve months without major capital outlays, borrowings would be more than cut in half in under three years.

Also, were LVS to sell 15% of Marina Bay in an IPO, I think it would raise enough to wipe out all its US debt.  I doubt this will happen until the property is more mature, but the possibility has to make lenders–and investors–feel more comfortable about LVS’ debt level.

And, of course, LVS has $3 billion or so in cash on its balance sheet.

the stock

A sum of the parts calculation is probably the most reasonable.

At yesterday’s closing price, LVS had a market capitalization of $33.8 billion.  The company’s share of publicly traded Sands China is worth $17 billion.  If we assume that Marina Bay would trade on the same valuation as Sands China–which could prove much too low–then that 100%-owned property is worth $24 billion.

This means Wall Street is valuing LVS’ US operations at -$7 billion.  This compares with a +$7 billion implied valuation for WYNN’s US operations and +$3.3 billion for those of heavily indebted MGM.

LVS shares (which I own–I may sell some today, though) would have to rise by about 30%, just for the implied valuation of its US properties to match those of MGM.  It would take a 20% rise just to get the value up to zero.

Why the disconnect?  I don’t know.  The former CEO of Sands China is suing, and claiming all sorts of improprieties by LVS management.  It’s also possible that some investors are uncomfortable with LVS’s debt–I know I have been–or don’t understand that the earnings disappointment in 1Q11 is just one of those things that happen in the gambling business.