DPZ – Cash is King

I wrote a post about DPZ titled “Follow the Cash” back in July and despite the company’s disappointing 3Q results reported today (particularly from a top-line perspective), DPZ’s business continues to yield ample free cash flow. Year-to-date, DPZ has generated $25.8 million in free cash flow, and that number would be closer to $44 million, excluding two non-recurring expenses.

Although the company’s balance sheet is significantly leveraged (debt/LTM EBITDA over 7x), DPZ’s business model will allow it to meet its interest payments and/or pay down debt over time. I am even more confident in DPZ’s ability to pay down debt following management’s comments today on its earnings call about its plans to build cash reserves. “We are going to pile up more cash than we would think about piling up until the situation sorts itself out and once we know where the credit markets are, where our revolver is as we see more trends develop in terms of what's happening with the health and vitality of our franchise system, we would make a better decision as it relates to stock repurchase at some point in the future. So right now we are going to carry a larger cash balance and see how this all sorts out.”

In argued back in July that DPZ should not buy back stock, so needled to say I would agree with management that buying back stock might not be the most prudent use of cash right now.
  • Management voiced a lot of concern about the credit markets and the impact tightened credit markets are having on its franchisees, particularly as franchisees experience lower EBITDA margins (management expects 2008 franchisee EBITDA margins to be worse than the already low margins in 2007). The current credit conditions are making it increasingly more difficult for financially stable franchisees to acquire underperforming stores or for underperforming stores to get the short-term financial support they need to turn around their businesses.

  • DPZ currently working with banks and other lending institutions to get deals done, but they went on to say they will provide financial support if need be. “It will never be my preference to provide financing to our franchisees. We would rather keep our relationship with them being the franchisor rather than their bank. However we are weighing through unchartered waters and we are not going to let our A and B franchises fail if there are ways we can be helpful with some short term financial support and solution.”
  • The company said that one way it could offer financial support is by providing some deferral of costs and/or royalty payments. One primary benefit of the franchisor/franchisee business model is that it allows a franchisor to grow without bearing as much financial risk. By providing short-term financing to its franchisees, DPZ will be increasing its financial risk and heading down a potentially slippery slope.

From The "Bond Guy"...

Our chief correspondent in bond land continues to provide us proactive insights when it matters most... Here's what he had to say today:

"mortgages are now wider than they were pre-GSE taking over by governement...
remember they wanted to make mortgages "affordable and available" to home owners? 6.55 30yr mortgage rate right now. And that's for <80 ltv, >720 fico guys, full doc."

Access to capital continues to tighten, as cost of capital continues to rise, globally.


We shorted EWU this morning

Today’s CPI number for the UK came in at an unexpected increase of 5.25% over the same month last year –a decade high. Despite the commodity sell off British consumers are still feeling the pain of the Pound’s decline in their wallets.

This increase in CPI has left the Bank of England caught in a in a tug of war between near term inflationary concerns and the capital markets liquidity draught. Last week’s 50 basis point rate cut has not yet created the desired market stability; meanwhile the UK public pension system is pegged to the inflation index, meaning that the government faces billions in additional state payments if inflation rises. In theory the potential exists for a vicious cycle -rising inflation levels contribute to increasing public liabilities, potentially further weakening the Pound against the Euro, Dollar and Yen and contributing to more inflation. This worst case scenario seems unlikely. In fact, most economists are counting on decreasing food and fuel costs to get inflation levels back below the government’s target rate of 2% rapidly, but the prospect of any further weakness for the Pound is still sobering.

Even if inflation does recede quickly, national debt is still on the rise. The first bank bailout linked bond issuance, 30 Billion Gilts and 7 Billion in Treasury bills, has been announced with an additional 70 billion+ expected to come to market over the next several quarters.

We sold EWU into this morning’s knee jerk rally in response the US bank bailout announcements. This is a significantly damaged economy that will take time and pain to right itself, making the decision to sell into near-term wishful thinking a lot easier.

Andrew Barber

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What Would We Do Without Charlie?

From our friends at Street Account late in the day here: "Goldman Sachs and Morgan Stanley "drawing up plans" to buy banks; notes CNBC's Gasparino"...

This reporting of what doesn't look to be public information is all just part of what was a mania. It's sad.


A trip to Macau changed my mind on the prospect of a junket commission cap. I now believe the Macau government will formally institute a 1.25% cap in the coming months. Don’t think for a second that I was swayed by talking to just the operators. For obvious reasons, most of the operators favor a cap while the junkets would like the current “free market” system sustained. Opinions of these “interested” parties must be discounted. However, other, more independent sources are positive on the prospects for a formal cap.

  • As WYNN displayed with yesterday’s pre-announcement, Q3 is not likely to be a pretty one for the Macau operators. EBITDA margin for Wynn Macau declined 900 basis points sequentially. And they didn’t raise commission rates! As shown in the first chart, market wide EBITDA margin bumped up with the opening of The Venetian late in Q3 and stayed relatively stable through Q2. However, the escalation in junket rates began in Q3. Moreover, the visa tightening constricted demand in a fixed cost business.
  • Clearly, a junket commission cap would be positive for the industry. Who would benefit the most? When you take pricing out of the equation, product wins. That is why Wynn Macau would probably gain the most from a junket commission cap. Wynn Macau’s commission rate lags the market by a wide margin. He hasn’t played the pricing game. As a result, his VIP turnover market share declined 160 bps and contributed to a sequential 18% decline. We believe at least 4 operators are currently offering rates above the proposed 1.25% cap including LVS, Galaxy, SJM, and MGM. I think Starworld (Galaxy) may be offering as high as 1.5%. A return to 1.25% will surely allow Wynn Macau to recapture lost market share.

SP500 Levels Into the Close: We Trust You Sold With Us...

Thankfully, we sold our long SPY position this morning (see Hedgeye Portfolio for time stamp). No one cares about that now however. The "Question" is, what do we do from here? This is not a market to be owned. It is to be rented and traded. Here are our new levels in the SP500:

Sell "Trade" line = 1004.41
Buy "Trade" line = 862.86

Yes, you can drive a truck through the spread of this line. Hopefully your Portfolio Manager has their license. Don't forget that "Hedge Fund Inc." is going to be testifying in front of government on October 16th. We're hearing some of these gentlemen may not be enthused by Paulson's preferential treatment of "Investment Banking Inc." No, this is not a bullish macro calendar catalyst.

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