Finding Frodo Baggins

“If you’re not confused, you’re not paying attention.”
-Tom Peters
When Tom Peters wrote “In Search Of Excellence” in 1982, this country was looking for answers - and it was looking for change. His primary focus was on leadership, and getting back to a corporate America that inspired individual capitalistic instinct as opposed to the burdensome corporate overhead culture that had dominated the times. Sound like a remedy for all that ails American leadership today? That’s a rhetorical question. Groupthink sits at the top of my league table of where this country went wrong in 2008.
How many times do we have to pick up a newspaper or listen to one of the financial media network’s interviews of the said savants of the American financial system and read or hear the following: “I’m not an economist… I don’t have a crystal ball… I don’t think anyone saw this coming…” It’s really tiring and pathetic altogether. The reality is that there were plenty of people in the room who raised their hands and/or proactively predicted that this movie wouldn’t end well – but the said leaders of our largest companies, endowments, and government regulatory institutions didn’t listen.
It’s very easy to get “confused” if you hear but don’t listen. I think my Dad told me that when I was 3 years old. While that’s close to the age of Paulson’s appointed “Director of Financial Stability” program’s business career on Wall Street, it’s also a very basic thought process. At the peak of this reactive management culture we have built, the crackberry became king. The money became the reward. Now, it’s time to listen, turn it all off, and change.
Obama is making two more very important changes to the USA’s leadership lineup this morning by appointing David Tarullo to the Federal Reserve and Mary Shapiro to be the new head of the SEC. Yesterday I was saddened while I watched the current SEC groupthink head, Chris Cox, and Bernie Madoff, chased around by the manic media. One of these said leaders oversaw the doings of the other – everyone was getting paid to “not pay attention.” We can drag Arthur Levitt and every other ex-SEC chief onto the You Tube mats this morning and next, you’re not going to get any other answer from them than a narrative fallacy. There is no accountability in that - it’s time for change.
Change is good, and at least rhetorically, “no drama” Obama is going to expedite it. Like my paying attention to the leadership at Lehman, Goldman, and Morgan Stanley over the course of the last 10 years, the Democrats have been taking pretty good notes. No matter what your politics, Obama is right on espousing the American principles of transparency, accountability, and trust – that’s why over 70% of adults polled (Republicans too) are “optimistic” about the President Elect’s opportunities. The opportunity for change has never been more obvious – not because Obama and I have been so right on our “calls” in 2008, but simply because the people we have been ‘You Tubing’ have been so glaringly wrong.
Back to making the daily “call” on global markets… this morning reflects more of the same. Asian stock markets continue to build confidence on the back of Chinese capitalistic actions, and that lonely ole dark hole of October/November USA is starting to see shimmers of a global light. My view is that the balance of power in global economic leadership continues to shift. If the leaders of this country “don’t have a crystal ball”, why not find new ones that do – we have incorporated in Hong Kong and have men on the ground in Macau – they carry crystal blue Hedgeye orbs in their pockets. They get the Chinese news before most Americans do – mostly because they are on premise… but heh, the storytellers of Wall Street can call them my “Frodos” of finance, and I’ll be cool with that.
I don’t rain down on Bloomberg like I do CNBC, primarily because that would be dumb. Bloomberg generally sticks to the facts, and is smart enough to know what they don’t know. Bloomberg TV rarely has 8 people in boxes being queued by crackberry addicts and yelling at one another. Bloomberg seems to actually listen rather than hear.
That said, this morning my Chinese “Frodos” flashed me a headline story on Bloomberg this morning titled “Zhou stokes speculation – China poised for Rate Cuts”… pardon? We broke that news 3 days ago – “C’Mon Man!”
Since we have a process that I wake up to every morning (i.e. anything that’s new news in China is sent to my inbox by 3AM EST), maybe that’s why I haven’t been “confused” in 2008. I guess I haven’t been “paying attention” to the Street’s views, or stale and manic “breaking” reports of the narrative fallacy. The reality is that if you are paying attention to the right proactive risk management process, you have not been confused in 2008.
For now, it’s better to be on the buy side of the SP500, using a buying range of 867-890, and a selling range of . The facts are changing and they aren’t confusing. Volatility continues to dampen alongside low volume down days and higher volume up ones. Breadth is expanding alongside this country’s leadership changing – that’s a trading range that I can believe in. We are all in “Search Of Excellence”, not excuses. The time for change has come.
Best of luck out there today,
Long ETFs
SPY-S&P 500 Depository Receipts – Front month CME S&P 500 contracts traded as high as 909.7 in trading this morning before 7AM.
VYM -Vanguard High Dividend Yield –The FDA gave approval for a new zero-calorie sweetener, “Truvia” developed by Coca-Cola (VYM: 2.5%) and Cargill yesterday.
DIA –DIAMONDS Trust Series – Front month CBOT DJIA contracts traded as high as 8,861 in trading this morning before 7AM.
EWZ – iShares Brazil—Carrefour SA, Europe’s biggest retailer, plans to open as many as four new stores in Brazil. Lenovo Group, China’s biggest maker of personal computers, is in talks with Brazil’s Positivo Informatica over a strategic alliance.
EWH –iShares Hong Kong – The Hang Seng closed up in trading today at 15497.81, or 0.24%, led by developers on expectations China will cut interest rates and support the real estate market.
 FXI –iShares China – CSI300 closed up 2.18% at 2045.10. China cut fuel prices for the first time in almost two years in response to slumped crude prices. Gasoline slashed 14%, diesel by 18%, and jet fuel by 32%. Expectations of an interest rate cut following Chinese central bank Governor Zhou Xiaochuan’s reiteration yesterday of China’s low inflation number for November of 2.4%.
Short ETFs
FXY – CurrencyShares Japanese Yen Trust – The Yen fell to 88.69 per USD after Japanese officials signaled they may intervene in the foreign-exchange markets for the first time in four years.
Keith R. McCullough
CEO & Chief Investment Officer


Louisiana posted a surprisingly strong November with total gaming revenues up 6%. PNK was the standout, generating a 14% increase at its Lake Charles, New Orleans, and Shreveport properties combined. A lot of the increase was due to the influx of hurricane relief workers and the favorable calendar to a lesser extent. Even absent these factors though, Louisiana still outperformed the country.

BYD also performed very well with a 12% increase at its three properties combined. LA is important to BYD, providing approximately 15% of its EBITDA, but not nearly as important a state as it is to PNK. PNK generates 75% of its EBITDA in Louisiana. The strong first two months of the quarter provides a degree of near-term earnings visibility for PNK not seen in this sector for some time.

We’d approach this optimism with some degree of caution. Even though November was strong and December looks decent thus far, unemployment levels in Texas and Louisiana have been increasing at a faster rate than much of the country, albeit off a lower base (see our 12/7/08 post “THINK LOCALLY”). Low gas prices could be the offset.

We continue to believe PNK makes an attractive acquisition target for PENN (see “LIKE PEANUT BUTTER AND CHOCOLATE”, 11/11/08). While PENN does have some Louisiana exposure through its Baton Rouge property, it remains small. We’d love to see PENN make this Louisiana Purchase.


Very ugly trajectory of earnings quality – as we expected. But on the margin, my sense is that Nike will be the poster child for a Corporate Capitalist looking to get a return on its cash that the Fed is taking away. Game-changing cash deployment is on its way…

I find it both ironic and frustrating is that if there is one company where Research Edge should dominate, it is Nike. Keith and I have made our respective careers, in part, on this name – me on the fundamentals, and him on the stock. We nailed this one (sales eroding for a multitude of company-specific and Macro factors, GM% weakening, with SG&A and non-operating items saving the day) but were both a full quarter early. It took us handing over the reins to my lieutenant, Casey Flavin, to pinpoint the timing. His analysis that the weighted average FX delta would equate to a 700bp drag on the top line (12/17: Eye on Nike FX – Rate of Change is Massive) proved to be absolutely spot-on. Note that Nike’s reported futures were down 1% -- 7% below the 6% constant currency growth rate.

I’m not going to dig into every facet of what happened in the quarter. Read someone else’s note for a news report. The only things I was genuinely surprised to see were 1) that inventories outgrew sales for the first time in over 2 years, and 2) margins in the US were down 340bp to 16.7% -- the lowest 2Q margin rate in over 10 years. Yes, US futures growth of 6% maintained the 3-4% 2-year run rate we’re been seeing from Nike, but it’s costing them.

Here’s the key issue from here. One thing that has always bugged me about Nike is its sense of competitive complacency. Perhaps that’s a bad way to phrase it given that the competitive nature and spirit of this company is fierce. But in the past when the industry and its key players faced its ups and downs, Nike would only target key competitors when threatened. This time it’s different. Now that he’s been on the job for a few years, I think that Mark Parker (CEO) has found a groove that will play out in the form of meaningful strategic action in 2009. My key industry theme of next year is that the companies with the brand strength, liquidity, and raw determination to put the nail in the coffin for smaller competitors will come out the huge winners. Nike is playing right into that theme.

I’d note that in order to really take advantage, Nike will need to deploy the capital to do so. The company has already said that it is taking down SG&A spending meaningfully – so to some extent it has drawn a line in the sand there (I would not mind elevated spending levels to make it REALLY uncomfortable for its competitors – even if painful to margins near-term). The other option is for Nike to go out and deploy its $2bn in net cash. Think of it this way – with that capital, Nike can buy Timberland, Zappos, and Lululemon – and still have cash to spare. These are game changers.

You should expect to see Nike go in different directions in ’09 (i.e. outside the traditional ‘buy new brands’ strategy). They’ll buy infrastructure on the cheap that will augment existing brands and content. (Note: they are slowing store growth now. Why? Because Nike has not cracked the retail code. The time might be approaching to buy someone who has).

Capitalists that are not beholden to liquidity constraints will have a field day in this climate. With Fed-Funds targeted at ZERO in the US, the income on Nike’s cool $2bn is getting lower and lower. The financial model is anything but complacent at Nike. Combined with the ‘crush the competition’ theme should set up ’09 to be a breakout year.

If the company’s cautious tone last night takes numbers down enough to a point where I think they are ‘slam dunk-able’ – about $3.50 – then this stock is a gift in the low $40s. If it fails to sell off on this event, then that probably just as bullish a statement as any.

Brian McGough
President and Director of Research
Nike’s position on our SIGMA chart is not enviable. Inventories growing too quickly for the first time in a while. Margin trajectory has trended well over the past 2 quarters, but will reverse course in 2H. Cash deployment next year on a game-changing acquisition or two will make this unhealthy trajectory somewhat irrelevant.

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The lesson on taxes never seems to be learned. Whether it is high corporate taxes in the US forcing business out of the country or migration away from high income tax states, taxes do matter. In this case, at least one Australian gaming operator will capitalize on the large gaming tax differential between Macau and Australia. Macau confiscates 39% of gaming revenue while Australia is somewhere in the low to mid 20s depending on the state. Our sources indicate that the operator has reached an agreement with a Macau junket operator to bring its customers over to Australia in exchange for a 1.6% VIP commission, substantially higher than the prevailing 1.3% rate in Macau. A 1.6% commission would be unprofitable in Macau.

This may be a preview for Macau when Singapore opens in 2010. Singapore will tax VIP table revenues at only a 5% rate and some junkets are already in negotiation with LVS and Genting to operate VIP rooms at those facilities.

Argghh!: Somali Pirates Spark International Community

It is nearly a month to the day that we first wrote about Somali pirates hijacking a Saudi oil ship in the Gulf of Aden.

On the day the pirates made their demands Keith wrote in The Early Look (11/18):
“This morning the Saudi market is down another -3.5% and the United Arab Emirates tape is getting tagged for another -5.1% loss. This isn’t new. This is called deleveraging. This is “The New Reality.”

Today it’s clear the international community is willing to get in the curve of “The New Reality”. The U.N. Security Council voted unanimously yesterday on the US-drafted resolution to authorize nations to “use all necessary measures that are appropriate in Somalia in pursuit of pirates, as long as they are approved by the country’s transitional federal government.” The resolution encourages states to deploy naval vessels and military aircraft to carry out the operations.

China has proactively stated that it may soon deploy warships to the Gulf of Aden and Somali coast to escort its ships and prevent the disruption of commerce along one of the world’s most active sea routes. This comes in response to today’s pirate attack off the coast of Somalia in which the crew of the China Communications Construction Co. was forced to fend of pirates for five hours until coalition helicopters chased them off.

In this year alone pirates have attacked some 120 ships in the region, seized 60 of them, and have collected more than $120 million in ransom. Currently 14 ships and 240 crew members are being held hostage by pirates. This is non-trivial to say the least.

US Secretary of State Condoleezza Rice, who pushed for the resolution’s passage and stressed the importance of intelligence sharing to coordinate naval and military operations in the region, is cognizant of the unraveling political and security situation in Somalia. This in an important point to note for the resolution expects states to first get approval by the country’s transitional federal government. This last point seems unlikely to hold up.

UN Secretary General Ban Ki-moon has warned that Somalia may descend into “chaos” by the end of the month when an Ethiopian occupation force leave the country. Rice proposed a UN peacekeeping mission to Somalia, which Ban quickly rejected it, citing his past unsuccessful attempts to mobilize a strong international force in the region and unsafe condition for peacekeepers. To place Somalia under a UN flag, Rice would need the support of the vast majority of the 192 UN members to fund the operations.

China is putting its foot down and we’re behind any nation that steps up to the pirates. A joint effort from the international community is need to suppress them. This will have to come in the form of joint international intervention and must be proactively constructed with respect to the unstable Somali state.

Matthew Hedrick


DRI is going to report FY 2Q09 EPS on Friday and we don’t think things are as bad as people think. See our DRI post titled “DRI - Estimates May Have Gone Down Too Much” from November 26.

I just want to reiterate what I think could come out of the EPS call:

(1) Street consensus EPS numbers are too low for the company….
(2) Same-store sales trends are better than consensus (part of the reason why EPS estimates are too low).
(3) The company will have positive commentary about the cost side of the equation, especially seafood, chicken and wheat costs.
(4) Industry same-store sales trends in November, while still bad, are less bad than October.
(5) FY 2Q08 was such a disaster

We know that there will likely never be another national Casual Dining chain that can compete against Red Lobster or the Olive Garden. What is that worth? I bet more than 9x EPS….

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