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EYE ON THE NEW REALITY: CHINA HAS THE CASH

We remain the new China bulls. This morning's announcement by the Chinese government is a reminder to all living in "The New Reality" that he/she who is liquid long cash is king.
KM

BEIJING (AP) -- China announced a $586 billion stimulus package Sunday in its biggest move to stop the global financial crisis from hitting the world's fourth-largest economy.

CASUAL DINING DISCOUNTING – JUST WHEN YOU THOUGHT YOU HAVE SEEN IT ALL!

This is the most aggressive discounting I have seen so far!

Chart Of The Week: Asia Bottoming?

We have been the bulls in the China shop since the October lows. We understand where consensus is, since the bears are using our 9 month old thesis. Does the Street understand that these 3 Asian indices are bottoming (see chart)?

We are long China via the Chinese etf (FXI). It was +12.8% on Friday, putting it +32% from the October 27, 2008 low. Bottoms are processes, not points - and this one is in motion.
KM

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ASCA: WHAT’S CHANGED?

Below is a YouTube of management’s forward-looking commentary from the Q2 conference call. Focus points for the Q3 release will be forward looking commentary, progress on the $20m in cost reductions, and the Capex outlook.

Of particular importance will be the financing situation. ASCA is on track to bust the senior leverage covenant by Q2 2009 unless the removal of the Missouri loss limit provides a big boost to EBITDA. Hopefully, the company will provide color on their refinancing strategy. Options include re-pricing the bank facility in exchange for more flexibility on the covenants. This is unlikely given that most of the company’s debt is generated through the facility and the rate would likely increase 400-500 bps. That would result in a massive increase in interest expense. More likely would be a subordinated debt offering to provide comfort under the senior leverage covenant. The rate on a sub debt bond offering could be in the mid-teens.

The company expressed a pretty cautious tone last quarter and business probably deteriorated further, particularly in September. October should be incrementally better than September, however, but still difficult. Commentary regarding Missouri should be positive, given the much faster implementation of the loss limit removal.

To limit downside on the stock in the face of estimates coming down, ASCA needs to show progress on cost reductions, limiting Capex, and put forth a reasonable refinancing strategy.

Here's what they said last quarter

The Deflation Chart...

The red line in this chart is our "Trend" line. Provided that the CRB Commodities Index remains below it, the intermediate "Trend" for commodities as an asset class will remain negative versus equities.
KM

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

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