Let’s face it. Gaming stocks stink. The average gaming operator is down over 80% year-to-date and 90% in the last 12 months. Even yesterday, in an 11% market move, gaming stocks were flattish. The reasons for the underperformance are very clear in hindsight: gaming is a highly leveraged consumer sector that is overly reliant on housing (See “IT’S THE HOUSING STUPID” from 07/17/08). Certainly, not where you want to be in a credit crisis where cash is king, consumers are de-levering, and housing prices are falling off a cliff.

Having said that, gaming operator stocks are trading at all-time lows. Some, BYD, PENN, WYNN, and even PNK, have liquidity to ride out the storm. Free cash flow for BYD, PENN, and WYNN is actually accelerating. But I’ve made this point for a few months and there has been little divergence in the stocks.

When will gaming stocks start going up? There are signs that it could be soon. Not only soon, but the moves could be big. Gaming is now a heavily shorted sector in need of a catalyst. Consider the following:

• October vs September– In the regional markets, September was awful from a revenue standpoint and could mark a near-term low. Our channel checks in the regional markets indicate that October is much improved.
• High short interest – The first chart shows the heavy short interest in the space
• Getting toxic earnings and guidance out of the way – Expectations for Q3 earnings and forward guidance is appropriately low. So far, stocks have gone up following the releases.
• Gas prices – We’ve shown that gas prices are a statistically significant driver of gaming revenues in the regional markets. As the second chart shows, gas prices have come down considerably.
• Month end – Sell the losers into month end! Not many bigger losers than gaming.
• Macro November thaw call – Keith McCullough has gotten more positive on the market, due in part to credit spreads improving
• Winding down of selling by big, long-only funds
• All time low valuations – leaving plenty of upside

At the very least, it seems that staying short this sector right now could be a dangerous game. We still maintain a negative intermediate consumer call here at Research Edge as consumers de-lever and the savings rate escalates. However, the trade looks higher. The safer plays that would still offer significant upside in a short squeeze are probably those companies on the right side of the liquidity trade: BYD, PENN, and WYNN. BYD and PENN have already announced earnings.

If you believe me on the thesis, the most interesting play could be PNK. Earnings will be released next week on Thursday. I expect a less than toxic Q3. More importantly, management should be able to allay liquidity fears on the conference call. There are no covenant issues until possibly Q2 but the company has a lot of levers to pull to maintain the appropriate leverage including, cessation of construction in St. Louis, cost cutting, and a temporary cut in maintenance Capex. Secondly, we expect a fairly upbeat discussion of October trends versus September. PNK actually maintains exposure to the stronger performing markets.

There seems to be a lot of upside to a stock at $2.75 per share and with 20% of the float short if investors could be convinced that: a) business has not fallen off a cliff and b) the company is not going bankrupt.

Recipe for a short squeeze
Gas prices are a statistically significant driver of regional gaming revenues.


When DIN first announced its intention to acquire Applebee’s in July 2007, it communicated its goal to franchise the majority of Applebee’s company-operated restaurants. In November 2007, the company said it expects to franchise approximately 475 company-operated units by 2010. In February of this year, DIN issued guidance around the expected cash proceeds from these sales and said that for FY08, the company expected to generate $90-$100 million in after-tax cash proceeds from the sale of 100 units (implies an average of $900K-$1M of cash proceeds per unit).

On March 19, DIN appeared to be having some success in achieving these goals when it announced that it had entered into two separate asset purchase agreements to sell 41 restaurants in Southern California and Nevada. Although the company did not disclose the sales dollar amount, DIN did reiterate its expectation to sell 100 restaurants in FY08 for $90-$100 million in proceeds, implying that these 41 units would be sold within the $900K-$1M per unit range. About 4 months later in early July, DIN announced that it did complete the sale of its 26 units in Southern California (26 of the 41 units in which the company had entered into purchase agreements) for $27 million in after-tax cash proceeds. This transaction again signaled that DIN was on track to reach its $90-$100 million goal as these 26 units sold on average for $1.04M, slightly better than the company’s $900K-$1M guided range. Unfortunately, that was when the good news ended.

  • By the end of July, DIN reiterated its guidance to franchise about 100 units in FY08 but lowered its after-tax cash proceeds target to $70-$80 million, which implies an average of $700K-$800K per unit (about a 20% cut in proceeds per unit). Yesterday, DIN reported that it sold an additional 3 units in Delaware in 3Q and 15 units in Nevada subsequent to 3Q’s close. These 15 units in Nevada make up the remainder of the 41 restaurants for which the company had entered into a purchase agreement back in March (took about 7 months to close). Additionally, DIN announced yesterday that subsequent to 3Q’s close, it has entered into asset purchase agreements for the sale of 66 restaurants. The company did not disclose the sales dollar amounts for the 3 units in Delaware, the 15 units in Nevada or the remaining 66 units, but it did say that it expects to generate $63 million in after-tax cash proceeds from all of its already completed and pending sales, which total 110 units (including the 26 units sold in Southern California for $27 million).
  • This $63 million in proceeds implies an average of $573K per unit, a 36%-43% reduction from management’s initial implied guidance in February and an 18%-28% decline from management’s revised guidance in July. We know that 26 of those 110 units sold for $27 million, so the remaining 84 units (18 already completed, 66 pending) are expected to generate only $36 million in cash proceeds, or $429K per unit. Management made a point to say again and again on its 3Q earnings call yesterday, that the units sold/pending thus far are the lowest profit performing restaurants in the Applebee’s system as justification for the lower than expected cash proceeds. The company did not, however, lower its cash proceeds guidance which seemed to be an attempt to not even address the fact that proceeds have come in way below guidance. But remember, according to management, things will get better because these units represent Applebee’s worst performing units. Might the lower proceeds have something to do with the current credit environment and the casual dining segment’s overall performance as of late?
  • That all being said, the cash proceeds forecasts keep getting worse and will likely continue to do so. Although DIN has entered into purchase agreements for the sale of 66 units and has given its projected cash proceeds, a lot could happen before these transactions actually close. Remember the 41 units under purchase agreements announced back in March. At that time, management reiterated its initial guidance, and the 26 units in California met that guidance. The remaining 15 units in Nevada did not close until 7 months later and based on the average $427K per unit in cash proceeds received, those Nevada units fell short of the guidance issued even after purchase agreements were announced. So those 66 units could very well fall short of management’s guidance issued yesterday, which would cause that average $427K per unit to come down again.
  • Management tweaking…
    Yesterday’s press release which announced that DIN had entered into asset purchase agreements for the sale of 66 company-operated units stated that the company expects to generate $63 million in after-tax cash proceeds from the sale of these 110 completed/pending restaurant sales. It went on to say that DIN “expects to assign approximately $50 million of sale-leaseback related rental obligations related to the 110 restaurants sold to the acquiring franchisee as a part of these transactions. Between transaction proceeds and the related reduction of sale-leaseback rental obligations, refranchising activities announced to date will enable the Company to reduce consolidated funded debt and financing obligations by approximately $113 million.”

  • At first glance that $113 million in reduced debt seems right in line with management’s initial guidance to generate $90-$100 million in after-tax proceeds from the sale of 100 units in FY08, but those numbers are not comparable. Instead, DIN is definitely falling short of its initial goal and now expects to generate only $63 million in proceeds (not the $90-$100 million). In its 3Q earnings release the company did not even mention the $63 million number or the $50 million of sale-leaseback related rental obligations. It just stated that the 110 units sold/pending would enable the company to reduce its debt and financing obligations by $113 million. Based on DIN’s initial cash proceeds guidance which again was in the ballpark of that $113 million, I thought this was an interesting way to present the numbers.


In 3Q08 DIN reduced guidance for the low end of the operating cash flow range by $10 million. At the same time the company reported a 13% increase in the operating profit at the Applebee’s chain. How can this be?

For the past three quarters DIN has seen an incremental benefit from direct and occupancy costs. In 3Q08 this accounted for 170 basis points of the 220 basis point improvement in margins. In the press release, management attributes the change to “purchase price accounting.” That is nothing more than saying that they changed the depreciation schedules on the Applebee’s business after they bought the chain.

Importantly, it’s a non cash event so it does not help to improve the cash flow of the company. Any way you look at it, this is a clear example of the company struggling to make the operations look better than reality.

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The Forgotten Man

“Insanity in the individual is something rare… but in groups, parties, nations, and epochs, it is the rule.”

The math isn’t trivial this time. You had 3 different opportunities in the last 3 trading sessions to buy stocks in our buy zone. At a bare minimum, we hope you covered. The madness of the media and the crowds alike was untenable. Volatility index (VIX) was trading over 80, and stocks were selling off on LOW VOLUME. This was not a tough shot to take.

If you aren’t into these simple quantitative market factors, surely you could have found a few stocks that were “cheap”. No matter what your investment “style”, once again, we are all looking back now on what was nothing short of a fantastic sentiment-driven buying opportunity.

On the sentiment front, we posted a note to our RE Macro clients intraday yesterday titled, “They are right freaked…” (, 10/28/08). This morning you can add two more sentiment surveys to the simple thesis that freaking out alongside your boss isn’t going to differentiate your career. The Institutional Investor Bullish to Bearish survey came out this morning with a -30 delta. That locks in last week’s survey as the low print in weekly investor bearishness. This comes on the back of the worst consumer confidence report EVER (yesterday), and a weekly ABC/Washington Post consumer confidence report this morning that again bounces off last week’s Barron’s Bear taking a chainsaw to a Bull’s head front page lows…

If you want to be part of investing “clubs” or run around scared of your own shadow, find a scary costume and meet the “hedgies” at their latest and greatest conference of “one on ones” in Midtown Manhattan. Halloween is right around the corner and you can get right freaked out, paint your faces, and scream and yell – just wear your Merrill Lynch badge and no one will find your behavior out of the ordinary. If you are part of a “hedgie” group, party, nation, or epoch, you are now being ‘You Tubed’ by America.

Today is the anniversary of “Black Tuesday” (1929). When we wrote our “Beware of the stock market crashing” note on 9/19/08, we did point out that Octobers are generally bad during bear markets. I can assure you that as simple as that calendar catalyst call looks today, it mystified the “hedgies”. Eerily however, some of the same “smart money dudes” were equally up in arms with me when I printed my “Buy’em” Early Look note 48 hours ago. I don’t know who pays these black cats 2 and 20 for buying high and selling low, but man would it be entertaining for their investors to read some of the self professed genius from the archives of their emotionally charged, no spell-check, crackberries.

Now that I have painted a few victory laps into this note, allow me to make one more emphatic “call” – this is NOT a Great Depression! Allow me to point you to the latest book I have been grinding through by Amity Shleas titled “The Forgotten Man.” This, folks, may very well be a Depression in the halls of compromised “Investment Banking Inc.” but it is far from it for we capitalists who are flush with cash looking to feed our families without using leverage.

In 1883, Yale’s William Graham Sumner defined the “Forgotten Man” - “he works, he votes, generally he prays – but he always pays…” Those who don’t respect history are definitely feeling shame about that now, and they should. Patterns repeat. Times are changing and it’s time to rebuild this American capitalistic system from the bottom up, not the top down. This country is oversupplied with men and women who are transparent and accountable. It is time to empower them with our trust.

The politicized “Heli-Ben” may very well give us commoners a shot today at borrowing money for free. Someone asked me in the morning meeting the other day if I would borrow money from the Fed if I could – I did a quick calculation and said, “why yes… I would borrow $1 Trillion dollars from the Fed at zero interest rates!” That’s actually what the latest bank holding companies of America (Morgan Stanley and Goldman Sachs) should do. Then, rather than believe they are God, they very well may become the financial equivalents of one. Doesn’t that possibility make your feel confident in our system? It’s cool isn’t it? Haven’t they earned our trust? Shades of Japanese and all…

The Nikkei closed up another +7.7% overnight in Japan, so we’ll be re-shorting it. After covering all but 4 of our short positions ahead of yesterday’s +10.8% short squeeze in the S&P500, we have a long list of short sales to re-populate on our books. Timing is everything, and we respect that and math above all else. There is a chance that Japan’s new government to cuts rates for the 1st time in 7 years this Friday. Yes, there is a shot that we “Forgotten Men” can actually borrow one tree-lion ($1T) dollar-zzz for free – the only caveat is that we may have to do it in Yen. Maybe that’s why everyone wants that Asian currency all of a sudden…

Yesterday’s resistance level in the S&P500 now becomes a support level. I think the S&P can continue to get squeezed all the way up to 1026, and nothing will have changed this market’s intermediate negative “Trend”. That said, 11-17% melt-up moves in the US market are “Trades” you better be on the right side of, or in the land of black cats and “hedgies”, you too may become a “Forgotten Man”…

Best of luck out there today,

Long ETFs

VYM – Vanguard High Dividend Yield ETF – This is a fund of the U.S. largest, blue chip companies and currently pays a dividend yield of ~3.8%.

FXC – Currency Shares Canadian Dollar Trust – Blackstone CEO Steve Schwarzman called Canada an “Oasis of Stability” in the banking crisis at conference in Quebec. While we agree with the view, the source makes us wary.

EWG – iShares Germany – The German government announced that it will finance part of its 500BN Euro rescue package by issuing bonds to banks in exchange for preferred stock. Volkswagen is down ~40% as the short squeeze has ended.

FXI – iShares China – The Chinese government cut the benchmark 1-year lending rate by 27 bps this morning for the3rd time in three months,

EWH - iShares Hong Kong - Radio Television Hong Kong quoted Premier Wen Jiabao as saying that China will "help" Hong Kong through crisis while speaking in Russia. Measures mentioned include increasing communication between Hong Kong and the mainland, speeding up infrastructure projects, ensuring food supplies and expanding tourism to the city according to the report.

Short ETFs

IFN – India Fund – The Rupee advanced for its second straight day and Indian 10-year yields declined on speculation of future rate cuts.

UUP – U.S. Dollar Index – The focus in the U.S. today is the FED, where a 50 bps cut is all but priced in. The US$ has lost 1.7% of its value in the last 48 hours.

EWU – iShares United Kingdom – In follow through from the U.S. yesterday, the FTSE is up~5.0% on the back of the pound rallying versus both the Euro and the dollar. The Chancellor of the Exchequer also pledged more borrowing, to now exceed the 40% limit, to support the U.K. economy.

Keith R. McCullough
CEO & Chief Investment Officer

EWH: Ghosts of Tiananmen; Don't Be Scared!

We have been bullish on both China and Hong Kong via the FXI and EWH etfs, respectively. While we have been early on both, we are also scaling into positions after a more than ~60%+ decline in both markets from their “It’s Global This Time” highs.

Less than 48 hours ago the Hang Seng closed down -12.7% for the day, which was its worst one day decline the Tiananmen Square crackdown in May 1989. The talking heads on T.V. were very vocal in emphasizing this point and comparing the sell off between those periods, even though they have no fundamental association.

Since the pundits were comparing this decline in the Hang Seng market to the decline during Tiananmen Square, we thought we would look back at the charts. No surprise, the Tiananmen Square sell of 1989 marked a panic bottom . . . and over the next 12-months the Hang Seng was up +50%.

We wonder what the “Global Recession” sell off in Hong Kong was marking earlier this week, probably not the top. Bottoms are processes, not points – oh, and by the way, the EWH was up a nifty +17% today… how ironic.

Daryl G. Jones
Managing Director

Volkswagen: Driving out the shorts...

Just as were finishing our morning coffee at 5:46 a.m. this morning Keith fired the Macro Team a question, “What is going in Germany?”. After a few minutes of digging, the answer was fairly obvious, Volkswagen was up 93% and Volkswagen is the largest component of the DAX. These gains came on the back of Porsche’s Oct.26th announcement that is plans to increase its stake in Volkswagen to 75%.

Going into this “event”, as the butterfly wing nut “event driven” hedgies like to call such things, Volkswagen was the most heavily shorted mega cap stock on the DAX. As of October 23rd almost 12.9% of Volkswagen common stock was shorted. Porsche owned 42.6% prior to its announcement and 75% as of its announcement Sunday night, the implied short interest was more than 50% of free float as of Monday morning.

Ironically, the shorts initially focused on Volkswagen because of its relative strength. Unlike the Japanese and Korean auto manufacturers that are grappling with heavy dependence on a single slowing market (and unlike the toxic sludge that is all that’s left of the major Detroit companies), Volkswagen had a comparatively robust balance sheet and franchise. In the minds of the “event driven” club, this meant that the stock price had further to fall, so… they ingeniously all piled in together hoping to ride it down on the “macro” story.

The average European market “event driven” hedge fund that is still bothering to report to the service we subscribe to was down -16% for the year last week. This one short squeeze “event” should “drive” that number a few points lower.

Keith and I learned a lesson early in our careers, beware the short squeeze. Indeed.

Daryl G. Jones
Managing Director

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