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PPC – WHY SHOULD TSN AND SAFM CUT CAPACITY?

If I were a ruthless CEO of a competitor to PPC, I would make them suffer. For PPC to survive under the weight of significant losses and an over leveraged balance sheet one of two things needs to happen (1) corn prices decline by another 40% which would allow the company to return to profitability given current market prices (corn would need to fall below $4.00) or (2) the industry cuts capacity allowing chicken price to rise by more than 40%, so the company can return to profitability.

According to Agri-Stats, no matter whether you measure by bird numbers, live weight or by total tonnage produced, the U.S. broiler industry expanded production in 2007, and 2008 is on track for increased production, too. Importantly, ownership and control of production has been consolidating into fewer and fewer firms. In 2008, EMI Analytics forecasts look for U.S. output to total about 36.6 billion pounds of RTC (bone-in ready to cook) chicken. Estimates show the 4 largest firms will control roughly 57% of broiler production - Pilgrim’s Pride, Tyson Foods, Perdue Farms, and Sanderson Farms. The 8 largest companies will account for 71% of U.S. production, and the 20 largest will supply over 93%.

As I see it, the fate of PPC is in the hands of eight companies that control 71% of U.S. production. If those eight firms decide not to cut production in any meaningful way, industry pricing will remain under pressure. Going back to my point about being the CEO of one of PPC’s competitors, it would not make sense for Tyson, Sanderson Farm, or Perdue Farms to cut production as the increase in market prices would provide the most incremental benefit to PPC as it is the market share leader (holds 25% of the market). PPC’s competitors have the financial flexibility to withstand current pressures over the next 6-12 months until market prices stabilize and would most likely rather watch their biggest competitor sweat it out.

The issues around PPC’s balance sheet have been well documented. Right now the issue with PPC is not liquidity, but rather the company’s ability to maintain the fixed charge coverage ratio if the industry turmoil continues well into 2009. Depending on how you measure it, PPC has $500 to $600 million of liquidity. For the company to maintain its fixed charge coverage ratio, it must return to profitability in 2009.

Right now that looks highly unlikely.

Never Forget Rules 1 and 2

“Rule #1: Do not lose money. Rule #2: Do not lose money. Rule #3: Never forget rules 1 and 2.”
-Roy Neuberger

Roy Neuberger was born on July 21, 1903, and was orphaned by the age of 12. Mr. Neuberger came to Wall Street on his own in 1929 before the crash and Great Depression. Over the course of his storied career, he figured out a thing or two about proactively managing risk during economic downturns. Neuberger’s “Guardian” Mutual Fund was one of the first no-load funds in this great country.

Today, as Dick Fuld continues to wrestle with one of the most classic investment mistakes people make, I can’t help but be saddened by where Lehman Brothers has brought this great American Capitalist’s namesake Asset Management business. That mistake, of course, is sell what you can, not what you should.

This mistake happens quite often during times of economic crisis. In the end, after firms are forced to liquidate, they end up holding their most toxic paper, rather than their most precious. This is the tail that’s wagging the dog right now in the US stock market. As investment banks, hedge funds, and mutual funds are forced to raise cash and de-lever, everyone on their respective trading desks knows that their biggest investment mistakes remain on their books.

This is why the volume and volatility sirens are ringing again. Its ‘Macro Time’ - from Asian currencies to Brazilian oil stocks, the asset management community is selling what they can. “It’s global this time”, remember? That means that TED spreads widening, European junk bond yields rising, and Ukrainian stocks crashing are all one and the same thing. This is the start of people finally being forced to sell what they should have in the first place.

Asian stock markets continue to crash this morning with the region hitting 3 year lows. China led the way to the downside again, closing down another -3.3%, hitting new year-to-date lows and taking the cumulative loss in the Shanghai Exchange to -66% since the October 16, 2007 nosebleed peak. Japan closed down another -2% overnight, and I remain short that market in the ‘Hedgeye Portfolio’. The only thing that has changed fundamentally in Asia is that the masses are figuring out fact from fiction.

European stock markets continue to be weak after the Bank Of England’s chiefs (Blanchflower and King) outline that their domestic economic situation continues to deteriorate. At a point, this is going to equate to the BOE and ECB cutting interest rates. With commodity led inflation cooling to the tune of -24% in the CRB Commodities Index since early July, European central bankers finally have some room to breathe. The Euro’s decline will raise imported inflation, but at this point commodity prices and economic growth are dropping at a faster pace than currency losses.

In Latin America, stock markets continue to get pounded, as they should. Brazil is actually raising interest rates again here this morning to 13.75% - global cost of capital continues to rise as access to it tightens. Local inflation in Brazil is much like emerging Asia and Eastern Europe – they have a wage spiral component, don’t forget. All the while, as everything from fertilizer to oil gets sold out of asset manager portfolios, the US Dollar continues to strengthen. The greenback is +11.8% since its mid July lows. US denominated cash is indeed being crowned as King!

So what to do next? I say more of the same. I moved back to 84% cash earlier this week as I just couldn’t stand the idea of losing money. Putting my family’s hard earned capital at risk would be reckless at this stage of the economic cycle. Yes, you’ll hear the bulls tell you that “there’s so much cash on the sidelines”, and “people have to own something”… if I hear it once an hour, I hear it 100 times. Unfortunately, that’s both theoretical and consensus.

People don’t have to buy anything. Ask Roy Neuberger. At a bare minimum, never forget his rules 1 and 2.

My new downside target in the S&P 500 is 1209.79.

Good luck out there today,
KM



SHOULDN’T WE NORMALIZE SLOT HOLD % TOO?

It is true that casinos played unlucky on the tables in July which contributed to the 15% drop in Strip gaming revenues. Normalizing this year’s table hold % would’ve resulted in a decline of 10%. The bullish sellsiders are quick to point that out. However, the Strip casinos actually played lucky on the slots. This good fortune added 3% to the total so net/net the Strip would’ve been down 13% with normal slot and table percentages. My model predicted -12% (on 8/24).

Part of the higher slot hold percentage certainly relates to luck but there is another contributing factor. As can be seen in the 2nd chart Las Vegas casinos have been “tightening” their slots. Think of it as stealth price increases. I addressed the stealth pricing phenomenon in my 7/21/08 post, “I’LL HAVE A SLOT MACHINE, HOLD THE WINNINGS”. The problem is that players eventually figure it out, especially when consumers feel pinched, as they certainly do know. With this in mind, I continue to worry about slot volume trends.


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Tourist Markets: Factory Store Exposure

Removing outlets from the ‘tourist market store location analysis’ highlights some very interesting call-outs.

I posted an analysis on 9/7 that included tourist market exposure for all apparel and footwear retailers in the US – both public and private. The results definitely pointed out some outliers (check out Monday’s post). This time, we stripped out all outlet stores, and only looked at factory store exposure for each company. Perhaps not a universally fair analysis, as there are certain retailers where outlets are the most profitable formats. But by and large, tourists don’t hit the outlet circuit. Not to sound like a broken record, but my concern remains that we see pressure on translation in foreign denominated profits but people look past the crimp in US comps and margins due to weaker tourism trends.

Key takeaways…
1) ZQK looks incrementally worse. 65%? Ouch!
2) Tilly’s at 50% is not much better. It’s a good thing they did not go public last year after all.
3) ZQK and Tilly’s look even worse stacked against Zumiez at 2%.
4) Ralph Lauren’s exposure is starting to bug me vis/vis an otherwise solid margin outlook.
5) Tiffany still looks very bad, and 12% of sales coming from 1 NYC store does not help.
6) Adidas looks worse than it did before at 44%.
7) Coach still looks fairly benign at 20%.
8) Liz, Carter’s, Nike – all looking low.
9) Big difference between Dick’s at 7% and Sports Authority at 23%.
10) Foot Locker and Finish Line at sub 10% looking good.

Russian Bear Hunter

Saber rattling is keeping Russians distracted from the battered Ruble and RTSI –so far.

It was a brutal day for the Russian market today. The RTS index declined over 4% again in its second huge down day in a row after the government released a lower than expected Q2 GDP growth figure of 7.5% -down from 8.5% in Q1.

So far, the conflict in Georgia and US plans to put missiles in Poland are keeping the public from focusing solely on the economy. If the markets continue to crash, Putin will need to shoot more than just Tigers to keep his people distracted.

Andrew Barber
Director

CKR – Is someone hovering?

CKR filed an 8-K yesterday highlighting its recently approved amendments to its company Bylaws. The changes expand the rules around director nominations and providing proper notice to CKR to conduct business at a stockholder meeting. Specifically, the amendments clarify that a stockholder providing notice relative to such nominations or stockholder meeting business must be a stockholder of record both at the time the notice is given and at the time of the stockholder meeting at which the business referenced in the notice will be considered. In short, “the amendments expand the disclosures required to be provided by a stockholder pursuant to such notice.” Such disclosures would include any relationships between a shareholder and any nominee for election as a director.

I find the timing of these changes to be quite telling as the company recently (June 17th) received a letter from Ramius LLC that publicly criticized CKR’s overly aggressive operating cost and capital spending levels and outlined steps to bring about immediate change, such as consolidating its three company headquarters. It was obvious that Ramius’ comments spurred some questions and concerns by others as CEO Andrew Puzder dedicated a big portion of his presentation at CKR’s annual meeting (which took place two days after the letter was received) to addressing the issues communicated in Ramius’ letter. The fact that the company is now tightening its rules around director nominations and conducting business at its shareholder meetings signals to me that the company is facing increased shareholder pressure.


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