China: Getting More Constructive...

With the Chinese stock market down almost 70% peak to trough, and articles beginning to appear in the consensus press discussing a slowing China, we are naturally starting to get more constructive on being long China via the iShares FTSE Xinhua China 25 ETF, FXI. Classic contrarian indicators are supported by a number of fundamental factors – capitalism, commodities, and currency.

The Chinese stock market is becoming more capitalistic as markets around the globe, including the United States, are becoming less capitalistic. Notably, as we mentioned in the “Early Look” on September 26, 2008, the Chinese government signed off on a plan to “allow margin lending and short selling” four days ago. Ironically, this Communist regime is providing investors more investing “freedom” as governments around the globe, led by the United States, have been banning short selling. Simply, we like to invest in markets where capitalism is expanding.

The CRB Commodities index, which is a compilation of 19 major commodities, reported its single largest down day since 1956 yesterday. This is deflationary. The steady decline of global commodity prices since their May / June 2008 peak has also been deflationary. Clearly, the roughly 70% decline in the Chinese market since its peak is already reflective of a slowing growth outlook, which has now morphed into consensus (see “Beijing Slowdown” in the Wall Street Journal today). We believe the second derivative of this slowing growth, commodity deflation, will serve as a positive catalyst for the Chinese market.

Finally, the Chinese Yuan appears to have put in a top in mid July 2008 versus many major currencies, in particular the US Dollar. As a country whose competitive advantage is cost to produce goods (labor) versus the rest of the world, the lower its costs are in its currency versus the currencies of its major customers, the more appealing its export outlook will become. The Chinese Yuan should only continue to decline as China has signaled a willingness to cut rates with its first easing in 6 years earlier this month. Chinese interest rates have a lot further to fall versus rates in the U.S. (Chinese benchmark rate is currently at 7.2% versus 2.0% in the United States).

Daryl Jones
Managing Director

US$: Bullish Macro Chart Of The Day

We continue to evolve as our business does. Below we have attached a chart of the US Dollar Index alongside our "Trade" and "Trend" strike prices.

This should help you put both the immediate term ("Trade") and intermediate term ("Trend") in context. As a reminder, as the facts change (i.e. the numbers in the model), our price levels change. These are point in time charts that refresh their levels every 90 minutes of trading.

If the US$ can hold this bullish "Trend", it should continue to deflate other asset classes from foreign currencies to commodities, globally. US denominated cash remains king.



It looks like Japan needs a new tourism slogan. "We hate foreigners but come anyway" just isn't cutting it. As reported in the Syney Morning Herald, Nariaki Nakayama, the new tourism minister, stated that the Japanese were "ethnically homogenous" and "definitely … do not like or desire foreigners".

The Japanese government probably needs to stay out of its economy. This is another example why.

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I’ve been hitting on the free cash flow/liquidity/balance sheet theme for quite some time. With this in mind it should be quite clear why I’ve been negative on the industry. A few companies do stand out favorably through this prism: PENN, WYNN, and now BYD. BYD recently suspended construction on Echelon, its huge development on the Las Vegas Strip. With one smart IRR decision, BYD management created huge liquidity, strong free cash flow, and put the company firmly in a position to deleverage. With its new found liquidity and cash flow BYD is in a strong position to maintain its dividend, currently yielding an industry high 6.8%. BYD should be able to generate at least $2 in free cash flow per share (after all capex), for a FCF yield of 22%.

Contrast this with MGM MIRAGE, which pays no dividend but is also building a multi-billion project on the Strip: CityCenter. MGM has been struggling to raise project financing for CityCenter at the same time it is forced to consider its options to fund huge debt maturities on its own balance sheet in 2009 and 2010.

The liquidity line has clearly been drawn.

Which one would you buy?

Restaurants – What to do –Quick Service!

From a macro stand point we are at 96% cash. From a sector stand point we suggest that cash is also king but staying with low expectation names is a must. The largest players in the QSR segment have been an island in the storm for most market participants. They are also the names with the biggest expectations; growth had been driven by the strong international markets and the weak dollar. Those that have been hiding in a China story are about to see the other side of that trade. The other big negative for the larger QSR names is valuation. YUM and MCD are trading at or near historically high multiples. One last thing, the credit crunch will hurt most of these companies, as franchisees will have a more difficult time getting capital and the cost of capital is rising.

Once again, I am ranking the names in order of yesterday’s stock price performance worst to best:

TAST – A BKC franchisee that owns two regional brands with significant exposure to Florida. TAST has a leveraged balance sheet, with rising food and labor costs. On current numbers the stock is trading at 7x NTM EPS.

WEN – Looking for more clarity as we move into 2009, but it will face some challenges getting incremental customers in 2009. Could be a good place to hide, as expectations are low and the brand is strong

CKR – A regional player with a management team more concerned about the luxuries in life, like a private plane. CKR will be fine but will never get any respect because of management.

JBX – A strong, well run company. Unfortunately, $0.40 to $0.50 of JBX’s EPS growth comes from selling stores to franchisees. Once management get off this drug it’s safe to get in.

KKD – The shrinking violet…..

DPZ – Anything with leverage will get crushed and they have got it. Top line trend appear to be improving.

BKC – The best days are behind them and the street is universally bullish. I’m not a fan. A large part of the company’s success is the resurgence in the advertising campaign and that is definitely cyclical.

YUM – Where do I begin with this one? Without China there is not much here, because the U.S. business is a disaster. Management has leveraged the balance sheet at just the wrong time!!

SBUX – It’s been beaten and beaten again. We are closer to the bottom than the top. Not much management can do to offset the macro. Definitely low expectations

MCD – I still contend that 2009 is shaping up to be a disappointment for MCD. Definitely high expectations!


My first year in the business was 1987. I started at Morgan Stanley in March 1987 on the program trading desk. It was the part of the firm that was somewhat to blame for the crash in October of that year. I will never forget that fateful day in October 1987, just like I will not forget yesterday. The worst part about days like these is trying to sleep at night while thinking about what to do next. This time I have perspective and plan to put it to use.

Following the crash, the next two to three years were very difficult and a shallow recession followed in the early 1990’s. Back then, the term depression never entered anybody’s thought process. Today, we are going to wake up knowing a recession is inevitable and people are going to be asking the question can we avoid a depression. As a consumer analyst, those terms are just a technical definition, the government will step in at some point, but how much of the damage is already done?

The end of the great consumer credit cycle has led to a consumption recession, to a magnitude of which nobody has ever seen. Ironically, the Casual Dining industry as we know it today did not really exist back in 1987-early 1990’s. Most if not all of the publically traded casual dining companies did not trade back then. Brinker International (EAT) went public in 1984, but that could be the only one. It’s not to say that the concepts did not exist back them, they were just not operated as a public company. Importantly, none of the companies have a process to think about the macro environment and operate in a silo.

Needless, to say the much needed shake out in the restaurant industry is not far off. The following is a brief assessment of the prospects for companies in the industry, starting with Casual Dining. The names are ranked in order of yesterday’s stock price performance worst to best:

CHUX – There are a core group of stores in the South East and New England that will survive. My guess is it will need to close 30%+/- of its total store base. Management is in denial at this point!

DIN – The odds are better than 50% that DIN will be the largest bankruptcy in the history of the industry.

RT – It may not file for bankruptcy, but it will be close. Like CHUX it will need to close 30% or more of its store base.

RUTH – The banks are already calling the shots. B of A will likely give them a waiver, but they shouldn’t. A very ill-timed acquisitioned earlier this year ruined the company.

CAKE – CAKE will be ok, but will need to close 10-20% of its store base. It should close the smaller stores it has been opening over the past three years as the company was pushing the envelope of growth.

LNY – Tilman tried to buy the company, it’s a good thing for him it did not happen. Tilman is a survivor, it just depends on what form the company takes. LNY also needs to shrink.

RRGB – They just recently spent $50 million buying back stock and they borrowed the money to do it! I have little confidence in the management team and the staying power of the concept.

MRT – They just announced on Friday that Wachovia upped its credit line with MRT so they could buy back stock. Are you kidding me!

CPKI – At $14 it looks like a great sale. The business model is better that most in the casual dining space and the balance sheet is strong.

CBRL – A brand that has proven the test of time. Its core consumers remain under significant stress and the fatty nature of the menu will not allow it to broaden its appeal. Balances sheet is stretched, but manageable.

PFCB – A good company, but management has been in denial for the past two years. Pei Wei needs to shrink significantly and might just close completely. The rest of the business is fine, but will take time to get traction again.

DRI – DRI will be fine and gain market share as we come out of the cycle. Unfortunately, they have been slow to adjust to the current cycle, as management continues to add significant capacity. They are starting to hedge commodity costs aggressively, an accident waiting to happen.

EAT – biding time. They have been preparing for this for the better part of two years.

SNS – Not much left here but the real estate.

BWLD – We will all be eating chicken wings and drinking beer. At this point expectations are high for BWLD.

KONA – A survivor, because they have good food and no funded debt.

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