The press release associated with RUTH’s recently completed sale lease-back transaction was a difficult one to read. Basically, Wells Fargo wants its money back and forced the company to use the cash proceeds from the sale leaseback to reduce the Company's outstanding debt balance on its revolving credit facility.

In the press release, the company said “the primary corporate objectives in the current environment is to maximize free cash flow and pay down debt, so that we can ensure maximum operating flexibility as well as remove any risk related to our debt covenant compliance.”

Unfortunately, the sale leaseback accomplished the exact opposite from what the company was trying to accomplish. The only way that this transaction provides more flexibility is that it might put off the company filing bankruptcy. Owning real estate and not paying rent is a much more conservative restaurant operating model. In the end, although the company may have reduced debt balance on its revolving credit facility, the overall leverage of the company did not change much. How ironic that the banks look at leases differently than debt.

You can surmise from all of this that Wells Fargo wants its money and is happy to spread the risk to a broader audience. Given the bind the company was in, I would expect that this transaction was dilutive to EPS. The weighted average interest rate on the company’s senior credit facility is 6.074%. The CAP rate on the sale leaseback is 8.45%. Clearly, Wells Fargo is getting its money back and it’s not in the best interest of shareholders.

Apparently there is still more work to do as the company goes on to say “In addition to several ongoing cost-cutting initiatives in the areas of supply chain, G&A, and restaurant level expenses, we believe monetizing some of the assets on our balance sheet is an effective means to reduce our leverage."

Accomplishing this task is going to be a tall order. From a G&A standpoint, there does not appear to be much fat to cut. Also, other than the recently acquired Mitchell’s Fish Market, RUTH owns the real estate under two more stores and the corporate campus in Florida. Needless to say, there are few, if any, buyers of restaurant assets that are going to give them a fair price.

SONC – Sales accelerating to the Downside

Based on SONC management’s 3Q comments, we knew 4Q partner drive-in same-store sales would be bad, but we did not know they would be this bad. After partner drive-in comparable sales declined 3.9% in 3Q, management forecasted that 4Q same-store sales would be up 2%-4% with partner drive-in performance continuing to be 3%-4% below this range (implies 4Q same-store sales of -2% to +1%). SONC attributed this significantly weaker partner performance to overly aggressive price increases taken last year combined with a decline in customer service as a result of the company’s focus on margin management.

SONC preannounced its 4Q results after the close yesterday and same-store sales came in significantly lower than the already lowered expectations. The company stated 4Q partner drive-in comparable sales “continued to be significantly negative,” resulting in slightly negative system same-store sales. I did not find these results to be that alarming until I did the math and realized how bad these “significantly negative” partner numbers potentially were in 4Q. The press release went on to say that for the full year, franchise drive-in same-store sales came in slightly below the 2%-4% targeted range with partner drive-ins performing 3%-4% below that range (again implies slightly below the -2% to +1% range, but now for FY08 rather than 4Q). Based on partner drive-in performance in the prior three quarters, same-store sales could have declined as much as 9% in 4Q to end the year down 2% (much bigger potential downside relative to management’s prior guidance for 4Q of -2% to +1%). To be clear, for the partner drive-in same-store sales to finish out the year -2% to +1%, 4Q numbers could be anywhere between -9% and +3%. However, the company said numbers were significantly negative, which implies -9% to -3% is the more likely range.

Short Selling Ban, Part IV: Endangered Species...

During the past few years as the ETF menagerie was populated by increasingly unlikely and exotic creatures many investors never considered how the mechanics of the products they were purchasing would react to the kind of market stress we are facing today.

The Ultrashort Proshares Dow 30 (DXD) is a prime example. Many investors were taken aback today as they saw their leveraged short trade vehicle begin to positively correlate with the underlying index while options trading halt for the name –not realizing that they were receiving a special short term gain distribution due to the fact that DXD (as well as its ultra short siblings like SDS) are not actually holding short positions in the underlying securities, but rather are long OTC total return swaps that provide synthetic short exposure. As the system deleverages some of these winning trades held by these ETFs and others are being unwound and accrued interest is being realized creating extraordinary one time distributions.

I think that ETFS are an excellent way for investors to access the markets and I think that they will remain a popular product, but in the coming years I expect that some of the more exotic species that came to market during the boom will go the way of the dodo.

Andrew Barber

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China: Burning Both Ends of Supply Rope?

China has been gaining leverage in sourcing product – that is well known. But now we see an investment in US retail -- perhaps the first step to own both ends of the supply chain?

Here’s a scary thought. Gottschalks (troubled West Coast-based department store chain) announced yesterday that it has received a $30mm capital investment from Chinese based Everbright Development Overseas, to establish an ‘exclusive sourcing and sales partnership’.

So let me get this straight… Values on marginal US assets are justifiably falling due to inability to maintain margin in an environment characterized by weak spending and rising imported inflation. At the same time, factory dynamics in China are dramatically changing in a way that is limiting capacity and giving the large factories long-sought-after pricing power. Then we see the Chinese use this leverage plus stronger FX to invest in said US assets after the initial margin hit?

Under the terms of the deal, Everbright will be issued 5.6mm shares, 29% of the total shares outstanding, and a $20mm convertible secured note that convert at $1.80 per share. In addition, Everbright can acquire up to 60mm shares of Gottschalks common stock at $120mm in cash if shares trade above $6 for more than 60 day and performance thresholds are met. This would be another $300mm payday.

Morgan Stanley: Where are the Evil Doers today?

MS is down -7% from its intraday high and down -3% on the day to $27.11. The stock is being sold by someone, and since John Mack, Chris Cox and Lloyd Blankfein have the shorts banned from playing the game, this leaves the objective mind to wonder who these sellers might be.

From a quantitative perspective, the stock looks like it can easily trade down to $19.18 again. The scariest thing about the Street buying into this evil doer short seller narrative is what happens next.

Now we all know why Goldman Sachs was trading down prior to the short selling ban – they needed capital to survive!

As MLK said, “a lie cannot live”.

TED spread widening again today...

Below is a TED spread chart since beginning of August. This spread is widening this morning partly because Goldman Sachs is admitting that they need capital, and partly because the duration on the Paulson Plan fix is being pushed out to reality (i.e. not rubber stamped this week).

CNBC has this chart flashing on their screens more regularly now. From a sentiment perspective, this is a positive sign. The consensus fear associated with a psychological bottom is finally in motion.


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