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My partner Brian McGough sent me an email noting that the sell side seems to make only group calls in the gaming sector. Interesting insight that is not lost on me. Looking at the chart it is clear that the group has been lumped together this year, with the exception of WYNN, by the buy side as well.

Year to date, the average gaming operator stock has declined 75%. WYNN is down “only” 56% on the year and ISLE, which had been absolutely demolished since late 2006, is down 66%. The remaining stocks have dropped in a fairly tight band, ranging from -74% (PENN) to -89% (LVS).

What makes sense to me is that during a credit crisis, investors hammer one of the most heavily leveraged sectors in consumer land, gaming. No doubt the credit freeze is partly, if not mostly responsible for the gaming carnage. What doesn’t make sense to me is that, except for WYNN, the liquidity haves are dumped in with the have nots. PENN and BYD should be outperforming along with WYNN. PENN is actually underleveraged and maintains huge liquidity. BYD maintains average leverage but will de-lever at a faster rate than the industry. BYD’s liquidity is outstanding with $2.4bn in availability on its credit facility, no significant cash needs, and no debt maturities until 2013.

Divergence will ultimately occur. Best to be on the right side of this liquidity trade.

PENN and BYD lumped in with the highly leveraged and illiquid


The fundamentals for the casual dining industry are horrendous. I’m not even going to rehash the issues. At some point fear trumps fundamentals and that creates opportunities. Let me say right up front that I think there is a tremendous opportunity for those with patient capital wanting to own Brinker international.
First, here is the bear case – It’s worth zero - before this market is done, any company with any debt is going to be worth zero. EAT’s FY09 EBITDA declines to $250 million - put an EV/EBITDA multiple of 3.6x on it and the EV equals $900 million. Subtract debt of $900 million and the equity is worth zero. Ok so we now know the potential downside, let’s look at something a little less gloomy.

What we do know is that the industry is headed for a major shakeout, eliminating the weaker players to the benefit of the strong. To be clear, Brinker is strong and will gain significant market share over the next three to five years. Currently we have a bankruptcy watch list that includes two of Chile’s major competitors – Ruby Tuesday’s and O'Charley’s. Beyond that, every day, I read every day about smaller players closing stores. As a restaurant analyst, we have been talking about the industry’s excessive growth and the need for a shake out for five years. We are here! It’s time to take advantage of the current fear and buy assets that are trading at a significant discount to intrinsic value.

  • EAT has significant ability to generate cash.

    To management’s credit, they have been preparing for harder times – just not fast enough. If we assume just the basic capital spending needs for the next few years EAT will generate approximately $200 million in cash each year. The equity value of the company is currently $1.1 billion. So in 5.5 years EAT will generate its current equity value in cash. More importantly, the company could pay down its $900 million in debt in 4.5 years. Lastly, assuming these basic capital spending needs, the company is trading at a free cash flow yield of 18%.

  • Buy a strong brand and distribution channel below replacement cost.

    Owning the Chili’s distribution system is a valuable asset. EAT owns the valuable real estate underneath 22% of all of its stores (including land and building). For the 282 restaurant locations EAT owns, the net book value for the land was $241.2 million as of the end of FY08 and for the buildings was $237.0 million. For the remaining 983 restaurant locations, which the company leases, the net book value of the buildings and leasehold improvements was $977.6 million. The company’s total enterprise value is $1.9 billion relative to its restaurant locations’ net book value of nearly $1.5 billion, which means the market sees very little value in the cash flow of this business right now.

    In today’s environment owning real estate may not mean much, but in three years it will. It would be impossible to rebuild the Brinker restaurant distribution system, but if you could it would cost $2.2 billion to rebuild Chili’s, $350 million for OTB and over $400 million for Maggiano’s. Again, today the enterprise value of the company is $1.9 billion.

  • Selling assets

    Over the past two years Brinker’s management team has been trying to sell off assets to become more of a franchised organization. If the world returns to a normal environment, EAT will be able to sell more assets. I calculate that EAT could sell assets worth $1.0-$1.5 billion, nearly matching the entire enterprise value of the company. Once the asset sales are completed you are still left with a more efficient store base and a very valuable royalty stream.

    I know the restaurant industry’s current environment sucks, but that is the opportunity. The Chili’s brand is one of the best in the business and will be for decades. In this environment the company is perfectly positioned to capture incremental market share as other restaurant companies can’t compete in the current environment. There is probable no better time to take advantage of buying a premier company trading at a significant discount to its intrinsic value.

Declining capital spending and Improving cash flows

SP500 Levels Into The Close: Bearish Paint Remains

Both the “Trend” (intermediate term) and “Trade” (immediate) are painted bear red on our SPX lines right now. All up moves are to be sold, until we wash out more of the excess that remains from the free bananas monkey Monday rally.

Short Stocks for the “Trade” = 988.07
Cover/Buy for the “Trade” = 866.28

These prices are using a model SPX level of 945.

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Country ETF updates: Eye On the UK and Germany

1. Short EWU – UK INFLATION & EMPLOYMENT trends remain ominous

September unemployment benefit claims levels published today in the UK came in at the highest level in two years with 31,800 additional new workers on the dole. We are short EWU -although the absolute unemployment level remains low in contrast to the miserable period stretching from the late 70’s into the 90’s (see charts, historical context is critical here). We expect the chilling impact of increased employment volatility coupled with the recent increase in consumer inflation on growth to be significant.

2. Long EWG – Germany’s INFLATION & EMPLOYMENT trends are much more benign

In contrast Germany, which we are long via EWG, released an inflation number that marked a decrease over the prior month. Germany’s CPI is only +2.9% y/y vs. the UK’s at almost double that (see chart). Unemployment remains low in the largest economy in Europe and thus far German banks have proven to be either better managed or better liars than their British counterparts.

Andrew Barber

Decent Week For Footwear Too

Yes, Wednesday is Industry data day. I noted earlier that apparel positive trends continue. Footwear has been mixed for much of this year. But appears to have picked up a bit since Finish Line noted that sales sharply decelerated into September. 2 weeks a trend does not make. But this space definitely appears to be standing out in an otherwise brutal retail climate.
Source: NPD Fashionworld

Ice Age: Positive Slope In the Yield Curve Emerging, Finally!

Over the past week the yield spread between 2 & 10 year Treasuries has expanded to the widest level seen since May of 2004. As the market vacillates between bailout euphoria and the ugly reality of recession, the yield curve’s volatility has been an obvious output, but so has been an emerging positive slope.

To be sure, falling yields on Bank issued debt, decreased LIBOR levels, and evidence of liquidity creeping back into the commercial paper market are all positive signs that the credit markets are starting to thaw, but history reminds us that the speed at which liquidity returns to normal may prove to be glacial.

In the meantime, the positive slope that is developing in the US yield curve is good for healthy banks and anyone with net cash – borrow short, lend long – remember? Those businesses requiring debt leverage are less attractive however. Cost of long term capital is rising while access to it continues to tighten (spreads widen).

Keith McCullough & Andrew Barber
Research Edge LLC