Eye on Credit: Signs of a November Thaw?

A few weeks back, wily ole’ George W. Bush commented on the credit markets by explaining “you see… they’re frozen… an ya know, what we need to do here… is, gettem’ unstuck.” We math and physics students knew what he was trying to get at – thawing. The Fed’s commercial paper program begins today. This is the most positive macro signal that we currently see across our global risk factor matrix.

In an interview this morning Bill Gross said that he anticipates a credit “loosening”, resulting from the launch of the Treasury Department’s commercial paper program today, that should start to be felt in the credit markets before the week is out. Gross (the man of the hour as of late), while continuing to express discomfort over Paulson & Co.’s policy decisions, said that he anticipates that the new window will have its desired effect in the near term.

Thawing or “loosening” in the commercial paper market is crucial for Paulson’s “jumper cable” strategy. It is hoped that cheap short term money will act like a bloody mary for hung-over borrowers and that they will return to more normal drinking patterns soon.

As outlined below, we are already starting to seeing to see spreads narrow - this action in the CP market should only facilitate a further narrowing.

Keith McCullough & Andrew Barber
Research Edge LLC


Cash from Fortress of $775 million could be received as soon as Friday, pending regulatory approval from the Missouri Gaming Commission. PENN expects the approval sometime this week. PENN has already received a nonrefundable deposit of $475 million for the preferred security. The remaining $775m is currently in escrow.
I personally own shares of PENN

Wal-Mart versus QSR

WMT is attempting to steal breakfast market share from QSR operators.

Nation’s Restaurant News reported that Wal-Mart is focusing a considerable amount of marketing dollars to steal breakfast sales. The company is now airing a commercial that asserts families can save $900 per year by having breakfast at home once a week rather than buying a fast food breakfast, which the commercial states can cost up to $5 per person. Wal-Mart is going after breakfast share at the same time most QSR operators have targeted breakfast as a new source of incremental sales.

Please refer to the link below to view WMT’s commercial pushing breakfast sales.

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Capitalists Starting To Emerge

I read two interesting reports this weekend. One that talked about normalized earnings by sector, and the other that looked at the earnings revisions needed next year to justify current valuation. Both very well-done – that is, if Wall Street operated out of a University lecture hall. As for me, I’ve just about had it with focus on current earnings and revisions. There are bigger questions to be answered here. Who will exist in a year? Who will go away? Who is making the right investments today and will double market share? There’s tremendous value out there folks… (yes, that is McGough sounding bullish), but there are just as many value traps and potential zeros. Starting later today, you will see regular postings from our team that tears apart each company in the space and drills down each company’s asset value.

Those who have started to let their inner Capitalist shine?
1) Diddy/LIZ: P Diddy (Sean Combs) stepped up last week with a financial partner to buy Enyce from Liz Claiborne. The deal is for $20mm, which is a rather sad statement for LIZ given that it bought the brand for $114mm just 4 years ago.

2) PSUN/Adrenalina: Also last week, Andrenalina (AENA) which is a 2-store retailer/media outlet, bid on Pacific Sunwear, which has about 950 stores. Here’s a $20mm EV company bidding for a $300mm EV company. Conventional wisdom might not like this, but are there any rules against David buying Goliath? We’ll be seeing more of this.

3) Gap/Athleta: Though this was earlier in the month, Gap buying Athleta was one of the few truly smart moves I’ve seen from Gap in a while. All that cash needs to go somewhere.


PENN had already pre-announced Q3 so those details are mostly trivial. The major takeaways from the release are 1) less than toxic Q4 guidance, and 2) final regulatory approvals for the Fortress Preferred security are only days/weeks away, and 3) PENN looks like it serious about acquisitions.
I would characterize Q4 EBITDA and EPS guidance $145 million and $0.28, respectively, as pretty much right in-line with current consensus estimates. The official Reuters estimates are $146 million and $0.29 but they include dated numbers and typically slow moving outliers. Practically, given the recent deterioration in the economy and consumer confidence, the guidance looks pretty good actually.

Regarding the regulatory approvals related to the Preferred deal, management indicated a late October/early November closing. The cash has already been deposited with an escrow agent. This deal looks like it will close and that is good news.

Finally, in an interesting preview of how the company may deploy its excess liquidity, management is setting up an unrestricted subsidiary to invest in its own debt/equity or the debt/equity of other gaming companies. We believe the latter/latter is most likely. I wrote about an interesting transaction structure PENN might pursue in my 7/25/08 post “PENN: BASSET SWAPS AND VALUE CREATION”. As discussed, PENN could buy up another gaming company’s bonds on the cheap and trade them to the company in exchange for a coveted asset.

Economic headwinds remain and the November referendums could bring additional competition. However, PENN’s industry leading liquidity and balance sheet should lead to relative outperformance over the long-term, particularly considering the external credit crisis. Free cash flow is accelerating and should turn positive by Q2 2009. Likely due to the referendum overhang, the stock trades in-line with the peer group.
I personally own shares of PENN

China’s Mix Shift Becoming More Ominous

A new policy in China’s Guangdong province, which builds 75% of footwear consumed in the US, makes clear the government’s intent to shift capacity to a higher value mix of goods.
China’s Guangdong province announced it will invest more than 50 billion yuan ($7.32 billion) in the next five years to implement a new labor and industry strategy, known as "Double Transfer," which aims to transfer labor-intensive industries from the Pearl River Delta (PRD) to less developed regions of the province. The end goal is to accelerate the PRD from a traditional manufacturing industry base to a center of service-oriented, advanced manufacturing systems. In other words….not footwear or apparel. As a sidenote, I estimate that close to 75% of US footwear consumption originates in the PRD.

So far, many small and medium-sized enterprises in the PRD have closed or suspended operation, with a third of footwear capacity closing over the past year alone. So many on Wall Street hit me with the ‘it’s cyclical argument’ in that once capacity becomes tighter in China, then pricing goes up and more plant space will be built. My view is that it is all about duration. If you’re talking 5+ years, then I agree. Anything less then the argument holds no water.

The Chinese government simply does not want the developed cities to be manufacturing low value goods. Semi chips? Yes. Cotton Ts? No. Proof positive of this is when the government instituted mandatory vacation back pay to apparel/footwear factories earlier this year. If you were a small factory on the brink of making money, you had to dole out cash too all employees at your factory for unused vacation over multi-years. Yes, the easier route in the decision tree is to close the factory doors.

The benefits of this ‘Double Transfer’ initiative to less developed parts of the PRD will help, but we’re talking about building up highways and infrastructure. This is more of a ‘next decade thing’ than a ‘next year thing’. Before costs start to come down due to more capacity, I think they’ll double at a minimum. The worst is yet to come, and those costs will flow through to marginal US brands and retailers.

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