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"Heli-Ben" Flies Again!

Bernanke just cut the funds rate to the level that the crowds were crying for. He is polarized and politicized – sad, but true.

Now that we have an effective Greenspan free money 1% Fed Funds rate, I think we’ll see enough cash deployed in November to keep this short term "Trade" rally alive. Consensus is on the other side of that idea. The bulls have guns, and the bear shorts are on the run. This is all good for stocks.

Bernanke has acknowledged that the economy has slowed "markedly" and that "risks to growth remain"… gee, thanks. Since he has been looking for inflation to slow for well over 2 years, I don’t think what he thinks on inflation matters.

At 1% interest rates, I don't get paid to be in cash. Every asset class has time and a price. Look for us to continue to decrease our position in US Cash, and increase our exposure elsewhere. The US Dollar is getting whacked again today. We remain short it via the UUP etf.

Our immediate "Trade" target for the S&P500 remains 1016.
KM

EYE ON CHINESE GROWTH

The Bank of China cut rates today for the third time in two months. With five consecutive quarters of slowing growth and a downturn in industrial exports sparked by the deteriorating global markets, central bankers in China are taking their cues from the US and lowering rates to soften the landing.

If you have been reading our work you know our thesis: despite the leveling trajectory a maturing economy, China’s private sector will increasingly focus on growing internal demand, and that in turn will feed a growth pattern that will continue to greatly outpace the US and EU on a relative basis. This rate cut should bolster internal domestic consumption in China help prove us right.

Andrew Barber
Director

REFRESHING OUR S&P LEVELS

Our models refresh every 90 minutes of trading. Here are our new S&P Levels 10:45 AM


Buy aggressively = 842
Buy =921
Sell the "Trade" = 1016

Andrew Barber for KM

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A SHORT SQUEEZE COMETH

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.

DIN – MASKING THE TRUTH

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.

DIN – ACCOUNTING SHENANIGANS

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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