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Volatility: Echoes of LTCM

"History Doesn't Repeat Itself, But It Rhymes"
-Mark Twain (attrib.)

The term “relative value” can at times be slippery. Distinct from directional investing and arbitrage, the term is loosely defined as an investment designed to capture a contraction or expansion between the market values of two instruments that are not directly related but which share common economic drivers.

Earlier this week we purchased the Canadian dollar (FXC), in part, because of the relative value play between it and the US dollar (i.e. Canada and the US are both stable North American democratic economies that share(d) a high degree of financial integrity by international standards). The deficit driven US economy is facing the grave consequences of exploding levels of debt and slowing personal consumption, while the smaller and surplus driven Canadian economy ‘s only major negative is slowing GDP growth spurred by declining commodity prices.

The massive spikes in volatility levels this week appeared to be driven by indiscriminate buyers willing to pay up no matter what the price. Recall that on Thursday that we speculated that some of this buying was due to a large player (or players) being forced to liquidate short volatility positions rather than investors trying to hedge risk.

Market chatter has been full of speculation that several large players (including one particularly large fund based in Chicago) have been whipsawed in a “relative value” volatility transaction. Details are sketchy but my guess, based on this frenzied buying, is that the trade in question was a play on the relative level of volatility of small caps vs. large caps. Whether making a straightforward wager on the VIX vs. the RVXK (the Russell 2000 equivalent) or a more complex dispersal transaction spanning individual names –anyone who was counting on large cap equity volatility to revert to its historical low levels relative to small caps has been in a world of pain.

This brings to mind the demise of Long Term Capital. This of course occurred only a decade ago when the masters of bond arbitrage gambled on an equity volatility mean reversion with disastrous results. Then, the LTCM traders were undone when the VIX levels held out at anomalous levels for much longer than they anticipated. This time around not only have volatility levels sustained at highs for a prolonged period, the relative spread between the VIX and the RVXK has swung wildly, providing stresses that exceed any historical comparison. As such, any model based approach is suffering for lack of context.

Simply put, I saw the wild action in the VIX this week as the capitulation of hedge funds who were betting on a mean reversion, rather than a broad market capitulation signaling a bottom.

Andrew Barber
Director

BYD: JUST A TOUCH OF CONFIDENCE PLEASE

BYD reports Q3 earnings on Tuesday morning. The stock has acted like it will be ugly. In this case, looks probably won’t be deceiving. I’ve included a chart below that details management guidance and consensus estimates. They will all be too high, but I don’t care. I care about two things: 1) free cash flow per share will be at least $1 next year and 2) BYD can get into 2009 without busting the leverage covenant.

It looks to me like the 2009 consensus EBITDA estimate is too high by 5-10%. Even if I knock it down by 20%, BYD still generates $1.35 to $1.50 per share in net free cash flow and still doesn’t violate the leverage covenant in 2009. For those of you who haven’t looked in awhile, BYD is trading at $4. That is a yield of 34-38% on very conservative numbers. Pretty ridiculous I must say.

BYD benefits from an escalator in its leverage restriction covenant to 6.5x in 2009 from 6x in 2008. There is some risk of a Q4 covenant bust but BYD would have to see its EBITDA decline 30% below the current consensus estimate of $116m. Again, I think there is probably 10% downside to that number but certainly not 30%.

Anyone expecting a near term inflection point in business fundamentals need to look elsewhere. But BYD shouldn’t be lumped with the rest of the gamers. Liquidity is very good and free cash flow has the potential to be off the charts compared to the stock price.

Guidance and estimates are too high but $1.50 in net FCF is very doable

Charting the Chinese Yuan: Bullish "Trend" Remains...

In terms of our ‘Hedgeye Asset Allocation’ model, if there is one thing that 2008 has proven, it's that cash is king. All cash in this increasingly inter connected global marketplace of factors is not created equal, however...

The US Dollar's resurgence from the thralls of forever is pretty well known at this point. The Japanese Yen tacked on another +7% this week, making it one of the more impressive cash stories of the back half of the year. But the 2008 stability MVP in the currency market remains the Chinese Yuan (see chart below).

Given China's well publicized slowdown in economic growth this year, you have to be impressed with their currency's resilience. The new world order of economics and balance of power are changing. If you refuse to acknowledge that, your headache will not abate. China has $1.9 Trillion in currency reserves. Amongst the few kings that remain, their cash (and its valuation) seems to depend on the rest of the world, the least.
KM

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Eye on Trust...

My friend, Paul Kedrosky, posted a very profound image (see below) this morning on his site in a note titled, "White Powder, Threats, and Financial Services Companies"...

This is what American leadership at "Investment Banking Inc." has brought us to. It's embarrassing, and sad, all at the same time.

Building back the trust of the people who's money Wall Street manages will be a process that will take time.
KM

WMS: YOUTUBING AHEAD OF EARNINGS

Gaming stocks have gotten blasted since WMS reported their fiscal Q4 on 8/5/08. WMS is no exception, down 37% in almost 3 months. The suppliers have actually outperformed their operating brethren, if I can take the liberty of using the term “outperform” for such a dismal performance.

The world has changed. The credit crisis has hammered the sector. WMS is in great shape financially but its customers are not. That is a problem. I fully expect management to capitalize on the opportunity to lower guidance.

I think it is instructive to keep in mind what was said in the prior quarter’s release and conference call. To make it easy to examine the sequential change in management’s tone, I’ve put together a table detailing fiscal 2009 and Q1 guidance. I’ve also YouTubed some important metrics discussed last quarter in preparation for Monday.

• Open orders for new gaming machines and platform conversion kits totaled more than 11,700, which represents 40% of expected fiscal 09 unit volume guidance and is 700 units ahead of last yr's compare
• Average selling price guidance for fiscal 09 represents a 3-8% increase over realized results in 4FQ-08.
• They expect to continue to charge for the value-add in their products, contrary to the belief that discounting runs rampant
• Typical revenue breakdown: Q1 20-21%, Q2 23-25, Q3 25-27%, Q4 28-30%

In addition to revised guidance, the open order metric will be critical to understanding underlying demand vs. last year but also to gauge the conservatism in management’s guidance. For example, open orders exceeding 40% of next 12 month expected demand could be indicative of conservative guidance. Hopefully, that will be the case.

Fiscal 2009 guidance given last quarter

ASIAN CURRENCY DIVERGENCE CONTINUES

The Yen has gained 7% against the dollar so far this week as the “borrow cheap, lend dear” game ended for arbs and the great deleveraging continues to drive depositor towards perceived safety. Japanese conglomerates will be scrambling in the coming months to adjust to a new “strong Yen” environment as they watch the currencies of their export markets and manufacturing bases swing wildly –some will be caught flat footed and lead to serious margin compression.

On the other side of the ledger, the collapse of the Rupee is further indication that the wheels are coming off the track for the “I’ in BRIC. With a greater than 20% slide against the dollar YTD and foreign currency reserves that have declined by 15% since May the risk for the government in India is a flight of any capital. This rapid decline stands to offset any positive impact that the oil correction could have on inflation in this import dependent nation. There will be no easy policy fix for PM Singh’s coalition as they face the abyss.

Andrew Barber
Director

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