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Mexican Short Thesis: Oil Production

We re-shorted the Mexican etf (EWW) yesterday in the Hedgeye portfolio. While Keith has been trading around the EWW versus some of our long positions, there are a number of key long term trends that make us negative on Mexico. A primary trend is that of Mexican oil production.

Mexico is the sixth largest producer of oil in the world and the tenth largest in terms of net export as of 2007. On March 18, 1938, citing article 27 of the 1917 constitution, President Cardenas embarked on state-expropriation of all oil resources and facilities, nationalizing the U.S. and Anglo-Dutch operating companies, creating Petróleos Mexicanos, or PEMEX.

To this day, PEMEX owns and operates all of Mexican oil production and is meaningful contributor to the Mexican economy. In 2007, Mexican oil exports contributed 10% of Mexican export revenue. PEMEX pays out over 60% of its revenue to the Mexican state in the way of royalties and taxes. In aggregate, PEMEX contributes almost 40% of the federal government’s budget. Despite record oil prices over the last few years, the Company has a substantial debt balance estimated at over $42.5BN as the vast majority of profits have gone to the government rather than to pay down debt, let alone investing in the business.

The Mexican government’s dependence on revenue from Pemex is a major issue for two reasons. First, oil is a commodity and as we have seen over the last five months the price of any commodity can change quickly. While the inherent long term value of Pemex’s reserve base does not change, the royalties and taxies paid to the government can be very volatile. Second, and more importantly, is that Pemex crude oil production has been in decline since 2004 and is down 10% ytd.

The issue of Pemex’s production issues first gained international notice in 2005 when an unknown PEMEX employee suggested on an oil news website that both the country and company were at Hubbert’s peak (a term named after M. King Hubbert and used to signal a peak in a region’s oil production). According to Hubbert, the oil under the ground in any region is finite and the rate of discovery which initially increases will eventually reach a maximum and decline. While we don’t have concrete evidence that Mexico has reached a peak, the chart of Mexican production outlined below points to a trend that is worrisome as production has decreased consistently for the last 5 years.

On October 22nd 2008, the Mexican Senate approved legislation that would free Pemex from many government controls and allow the company more flexibility in the way it signs contracts. The idea is that this legislation will make Pemex more agile in its pursuit of new reserves. Many experts suggest that Pemex’s best opportunities are in the deep water Gulf of Mexico. To date, Pemex has not had the technology to adequately explore these opportunities. The new bill would allow Pemex to pay cash incentives to contractors for finding oil or using a new technology. Critics of the bill suggest that cash incentives are not enough and that future partners need to be offered a percentage of reserves.

If this new legislation does not stimulate investment and if this investment does not stimulate increased production, the Mexican state budget is likely facing a major shortfall in the coming years particularly if oil stays at relatively depressed prices.

Daryl G. Jones
Managing Director

RRGB – Setting Up For Disappointment

RRGB can join the list of companies that have added significant leverage to their balance sheets at exactly the wrong time. In 2Q08, the company’s total debt increased nearly $70 million on a sequential basis from the first quarter to about $222 million. RRGB increased its borrowings in the second quarter to fund both franchise acquisitions and a $50 million share repurchase program. As I have said many times before, I don’t understand the capital allocation decision to borrow money in order to repurchase shares. RRGB spent $50 million to buy back about 1.5 million shares at an average purchase prices of $33.76. The stock is trading closer to $13 today…How has that generated shareholder returns? In August 2008, RRGB’s board authorized an additional repurchase of up to $50 million so the borrowing to buy more may not yet be over.
  • Through the third quarter, RRGB has generated $66.9 million in cash from operations relative to its $65 million of capital spending needs so outside of its franchise acquisitions, the company did not need to increase its borrowings in order to maintain its FY08 unit growth targets, which highlights the financial irresponsibility of increasing debt levels to buy back shares in today’s environment. RRGB has increased its financial leverage at the same time same-store sales are falling off a cliff and margins are declining significantly (EBIT margins are down 420 bps from 2005 levels and down 250 bps YOY in 3Q alone). Additionally, RRGB is still targeting 7% company-operated unit growth in FY09. Although the 20 units targeted in 2009 represents a slowdown from the 31 openings expected in 2008, RRGB’s new unit targets seem aggressive relative to the current environment. And yet, when the company was questioned about its debt covenant levels, management appeared to dismiss the concerns:
  • Analyst
    Got you. And then, Katie, you mentioned your covenants - 2.5 times coverage is the--I guess is what you need to achieve. What will you be at for the year based on your new guidance?
    Katie Scherping - Red Robin - CFO
    It should be just over two or two and a smidge.
    So you're just over two times the EBITDA coverage versus the 2.5 times that you need?
    Katie Scherping - Red Robin - CFO
    And what happens if you went above--what if you broke the covenant? What is the remedy?
    Katie Scherping - Red Robin - CFO
    We don't plan to.
    But there is cure in the debt covenant probably?
    Katie Scherping - Red Robin - CFO
    We'd probably have to go and ask for a waiver.
    Okay, which would imply a higher interest rate probably?
    Katie Scherping - Red Robin - CFO
    That's purely speculation at this point. That's pretty far out, so I--.
    Denny Mullen - Red Robin - Chairman, CEO
    --We've got a lot of room in that 2.5 covenant. And if we projected forward, if there was any issues moving towards it, we would take other courses of action.

  • Given the lack of visibility around same-store sales trends, the direction margins are heading and the company’s current level of debt, this line of questioning was warranted and should not have been taken so lightly by the company.

  • RRGB reported yesterday that its October same-store sales deteriorated from 3Q levels and were down 8%. However, 4Q guidance assumes a slight improvement in trends for the balance of the quarter with same-store sales down 5% to 7%. Of the five casual dining companies that have reported October comparable sales trends over the last couple of days, RRGB is the only company that is basing its 4Q guidance on an acceleration of same-store sales trends from October levels. The company attributed its optimism to easier comparisons in November and December, but easier comparisons are no longer too meaningful in today’s consumer environment. Making matters worse, RRGB is facing its most difficult operating margin comparison from 2007 in the fourth quarter.

Unemployment: Why Was This Chart So Hard To Proactively Predict?

I guess the answer must be that the conclusions wouldn’t support the economic incentives associated with Wall Street's storytelling. Facts are stubborn little critters in the non-fiction world aren’t they!

We were in print as far back 6 months ago with an unemployment rate forecast of 6-7% by year end – it’s November. Today's October report was another new ytd high at 6.5%. Of course Goldman's analyst savants are all over Bloomberg today having “expected” these numbers to be horrible… Where were they 6-12 months ago? Counting their money, I guess!

Is this a positive fundamental data point? Of course not... but stock market's are discounting mechanisms of future events, not historical ones. The US stock market has been hammered for a -42% down move from this time last year. Now the news that's on the tape is telling you why this has occurred.

What’s our forecast from here? That’s an easy one – that proactively managing risk will crush reactive management in the game's to come.

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S&P500 Levels: Refreshed for the 11AM Math...

This market's range is tightening, quickly. This, on the margin, is bullish. So is the reaction to a worse than expected US employment report…So is Europe closing on it's highs (failing to register its 3rd consecutive down day).

Our new levels in the S&P500 support our view, that in the immediate term, we will see the stock market bounce from a higher low (see chart):

BUY "Trade" line = 892
SELL "Trade" line = 958


Show Me The Shippers Money, Part Deux

Yesterday's Research Edge Network insight of the day came from one of our contacts in Asia... today's comes from my homeland, eh...

The upshot is more of the same. Global counterparty trade risk is not purely reflected in the TED Spread! It is global this time, indeed... if you are liquid long cash, you are going to crush the levered. This is what we call "The New Reality". Our RE Network comments from Canada are below:

Dear KM/DJ,

All of my lentil/bean/pea aka. food commodity shippers/traders in Saskatchewan are buzzing about the rumored 2000+ Hapag-Lloyd Canada containers sitting uncollected at the port in Turkey. Their interest is domestic, as uncollected cargo generally means abandoned contracts, and in size, could result in the business failure of their competitors. Both an opportunity and a strong warning about doing business where you don't know your buyer. A few months ago, commodity prices for these food items were soaring, today some of these food staple prices are as much as 40% lower so buyers are abandoning their contracts (why pay 90 day old contracted prices when current price is deep discounted?)...there will be many buyers out there where reputation is not worth as much to them as saving 40% in product costs....just like on the street...memories are short and eventually someone will do business with them for the trade and they'll be buying again.

-Your Research Network Edge Contributor

Swissy Bulls?

As the latest data rolls into our macro models, Switzerland looks more and more attractive on a relative basis to other European economies…

This week’s economic data was bullish, on the margin. Unemployment increased by a paltry 1,200 job seekers in October according to SECO data released today, leaving the total national rate barely changed at 2.6%. On an absolute basis, that’s amongst the best unemployment levels in the world. On a more significantly negative note, state data indicates manufacturing contracted in October for the second consecutive month while exports declined for the first time in 4 years. On the GDP front, this is not a surprise. This is just one more piece of the new reality – a global slowdown.

Following the lead of central bankers around the globe, SNB yesterday made a surprise rate cut, lower their target by 50 basis points to 2%. Easy money will prove to be stimulative, in the end.

Although Swiss GDP is heavily dependent on financial services (the % driven by banks, brokers and insures at north of 25%), this concentration factor provides risk as well as potential reward. The preeminent institutions like UBS and CS face the prospect of continued write-downs as toxic assets work their way through the system, but the steepening yield curve should offset that as the gnomes of Zurich start to deploy the massive deposits at their disposal. Within the framework of our “New Reality” Investment Theme for 2009, the players best poised to win are those who have access to capital.

We are long Swiss equities via the EWL ETF and will continue to be until the relative math changes.

Keith McCullough & Andrew Barber

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