Cozying up to TED!

We are going on 6 consecutive weeks of this spread narrowing. This is one of the major reasons why we are deploying our oversized position in US Cash into global equities. See the chart below - this is not that complicated.

When this spread was widening (August to October) we moved to 96% cash. Now it's narrowing, and we have moved to 59% cash. A narrowing TED spread is a measure of counterparty risk – it is not the only factor in our multi-factor global macro model that is signaling to buy stocks, but it is an important one.

Storytelling and narrative fallacies are currently running rampant on the Street. When we look back on this buying opportunity in 3 weeks, this is one of the many macro factors that the revisionist historians will cite. You can 'You Tube' me on that.

China: Another Positive Data Point

This morning's consumer price inflation report (CPI) out of China came in much better than we or the Street were expecting. At +4% inflation growth for the month of October, the Chinese are seeing inflation rates at almost 1/2 of that seen prior to the Olympics - this is good!

The October report is down from September's deflating reading of 4.6% (see chart). Alongside the $586B stimulus package, fundamental economic "Trends" in China are starting to improve, on the margin.

In our macro models, everything that matters most occurs on the margin.


I can almost guarantee that Howard Schultz did not want to report a loss this quarter – the press would have skewered him. I know that seems stupid but I can actually see him thinking that way. I know this has nothing to do with an analysis of the SBUX quarter, but what more can be said about this quarter that has not already been said. I continue to think that SBUX is one of the companies that we want to own coming out of the cycle we are in, but trying to pick the bottom of the cycle is proving treacherous.

The case for SBUX is clear; (1) A global brand, selling a habitual product, operating in multiple distribution channels, (2) $1.0+ billion in operating cash flow, and (3) a strong balance sheet.

The case against the company is also clear; (1) consumer demand for premium coffee, (2) excessive growth of the past may have hurt the brand, and (3) a new, extremely powerful competitor.

  • So it has boiled down to trying to pick the bottom and when things will become “less bad” for the company. When things stop getting worse it can get better. Right now it looks like fiscal 2Q09 will be that quarter. When the company was focused on non-stop growth it tried to broaden the appeal of the concept. Today that strategy is costing the company dearly. In a challenged economic environment there are a number of consumers who just cannot afford SBUX anymore. Starbucks, however, is not going away and at some point the company’s traffic declines will stop. The question is what percent of its customer base will go away before this group of core consumers emerges? 3%, 6%, 9% - who knows! I don’t think its 15%!

    As of fiscal 4Q08, U.S. traffic declined 5%. The company commented that this quarter may represent the bottom in that metric. The way the math works that may be true as it relates to the level of customers coming into the store, but the street’s math looks at YOY comparisons and 1Q09 marks the company’s most difficult comparison for the year so the YOY decline could look worse in 1Q09. From the street’s perspective, the company will most likely not see a YOY improvement in traffic trends until fiscal 2Q09.
  • There is no rush to run out and declare a bottom for SBUX. Management is doing what they need to do to address the issues that plague the company. Having said that, I’m sure there is still a lot of fat to cut from the corporate structure so the company can earn $0.70 or better in FY 2009 (flat YOY), despite the level of same-store sales. That should provide support for the stock in the $8-9 range. If we can prove that the company will only lose 5% of its customer base the next 3-6 months should represent the bottom in the stock.

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'The Bifurcation Trade' Emerges into ’09

The gaping hole between economic reality and Street earnings estimates is no secret to anyone. What is increasingly news to me is that the gap is beginning to narrow.

Fundamentally, not much has changed over the past three months. Organic sales are under pressure, order cancellations are up, FX benefits are going the other way, pricing power is negative, GM% eroding, and SG&A is heading higher. We’ve been pretty vocal that margin assumptions still need to come down next year by 2-3 points in aggregate. Unfortunately, we’re nowhere close yet as it relates to estimates. That’s the bad news.

But multiples as low as 2-3x EBITDA on certain names in the space (i.e. ANF) account for this to some degree. The kicker is that over the past week, we saw the greatest estimate realignment we’ve seen in this group since the recent downturn began, with EBIT margin estimates coming down a full 45bps. For an entire industry of stocks (there are 60 in our index), that’s pretty meaningful.

This is not the bottom. Far from it. But it gives me greater confidence that ‘The Bifurcation Trade’ in retail will be the big theme for ’09. Some companies will dominate (UA, RL, LULU, ANF and FINL), while others will show their real pale or dying stripes (DKS, GIL, DSW, BWS, GES).

Casey Flavin and Brian McGough


Great combinations don’t happen often. Reese’s Peanut Butter Cups were created in 1928. Also in the 1920s, a Milford, Connecticut restaurant brought lobster to the masses by sticking the meat in a hot dog roll and presto, the lobster roll was born. Nobody knows exactly when, but at some point a Frenchman decided to pair up Bordeaux and Ribeye. So good. I’ve got to stop writing these posts on an empty stomach. Maybe I’ll go grocery shopping instead.

I’m not quite ready to put a PENN/PNK combination up there with those classics, but boy if there was ever a time for PENN to ignite its dry powder, now would be it. I’m thinking bear hug, a la PENN/AGY, not that long ago. PNK management may not want to sell at $10 but who cares what they think. Those guys own an immaterial amount of stock. You live by an option based executive compensation structure, you die by one.

So why is this a good combination?

• Very accretive to free cash flow – even assuming a $10 per share bid (75% premium), the deal could be accretive to PENN Free Cash Flow by 20-30% in 2010. PENN is underleveraged, maintains significant borrowing power on the credit facility, and should preserve a cost of capital significantly below the rest of the industry and certainly lower than PNK.
• Calculated accretion does NOT include likely cost savings and debt refinancing.
• Better management – PENN are better operators, pure and simple. Look for higher EBITDA margins under PENN ownership
• Better stewards of capital – no gaming company has created a larger % increase in shareholder value over the last 5 (except Wynn), 10, and 15 years than PENN and Peter Carlino.
• Asset sales – PNK won’t sell its boardwalk land. PENN would. Boardwalk property values are going lower. Bader field and the Marina district is where the value is. Look for a quick sale even with the tax bite. AC costs PNK $1m a month and the equity markets give ascribe no value to the development opportunity nor the land value itself. Sell it.
• Development opportunities – Investors are also not ascribing any value to PNK’s potential growth projects in Lake Charles and Baton Rouge. Nor should they. PNK’s management is not as ROI focused as PENN. PENN’s management would downscale the cost of these projects and drive a much better ROI. The option value is much higher under PENN’s stewardship.
• Bigger is better – Not always, but in this case bigger is better. Significant purchasing leverage could be generated along with cross marketing benefits, particularly if PENN were also able to secure a Las Vegas property (MGM?).
• Diversify market exposure – PENN is underexposed to the stronger regional markets servicing the east Texas population.
• Big step up in Baton Rouge – Baton Rouge is a growing and attractive market but PENN’s product is weak. A PNK acquisition gives them the opportunity to develop the right product for the market and jettison its existing assets.

At $10 per share, the acquisition price would be about $1.6bn, including 2009 capex and the assumption of debt. Following the receipt of the remaining $775 million from Fortress two weeks ago, PENN maintains about $1bn in cash and is net leveraged only 2.75x. A cash buyout of PNK would raise leverage to just under 4.0x, still well below industry average, and barely putting a dent in PENN’s liquidity situation.

Investors, don’t miss this one. I’m pretty sure PENN won’t.

Financial metrics of a PNK acquisition are compelling

Remembrance Day

“Rules are not necessarily sacred, principles are”
-Franklin D. Roosevelt

Roosevelt was a lot of things to many people. To some, he was simply a regulator … to others a calmness. His “fireside chats” are often looked back on by historians not for their economic resolve, but for their tone. He had a wonderful temperament. He was a man of principle.

These, of course, are not the kinds of leadership qualities that you have been waking up to in the early mornings of 2008. I spend most of my reading time these days studying Hoover and Roosevelt, their economic policies, and the respective successes and failures associated with their decisions. There is always much to glean from history, and as Santayana said best, those who have not learned her lessons “are doomed to repeat them.”

While I have been a resident bear for some time now, I am not in the “Great Depression” camp… certainly not here and now. I continue to hold the line that 2008-2009 will be much more like the mid 1970’s than any other period – but let me be clear, no economic point in this country’s history is a carbon copy of another. Today’s unique differentiation lies in the interconnectedness of global market factors. This is not 1974. This is 2008. This is a world where global information and asset classes trade hands real time. This complex system of markets waits for no one. It is always on.

Today is Veteran’s Day in the US. Today is Remembrance Day in my homeland. Today is Independence Day in Poland. Today is a day to reflect and be thankful for the men and women of principle who have served their countries.

Michael Bloomberg is an American capitalist who is now serving his country. He built an iconoclastic American company that continues to provide the world with the faster and cheaper investment tools that quickly delineate fact from fiction. Bloomberg left Wall Street after the 1970’s meltdown and started his business with what he knew best – his principles.

Those who don’t respect duration in investment modeling probably dismiss what they usually do when endowed with an investment tool like Bloomberg – context. Bloomberg’s business didn’t even exist until 1981… and now, 27 years later, we have the weaponry at our fingertips that allows us to traverse the global plains of market data as fast as you can click and read.

This morning, a top 3 Bloomberg story headline is “Bonuses for bailed-out Wall Street Should Go To Zero” – this is sad. When America came out of the “Roaring 20’s”, President Hoover was in a compromised position of over-seeing a society that had lost its moral compass. The “Trend” was first and foremost for financial wealth. The “Trade”-off was the Great Depression. Today we don’t have that – but we do have much to fix.

Whether or not the folks at “Investment Banking Inc” pay themselves the bonus pool they have allegedly allocated to themselves or not this year is very much looking at the tree. The forest is being ‘You Tubed’ by Americans in their investment savings and portfolios. Every day that they are misled, America votes and sells these stocks lower. Chris Cox and his cronies can’t stop gravity. These over-geared financial firms have disintermediated themselves via short term compensation compromises. Now the process is in motion to replace them.

The US stock market is paying less and less attention to these horse and buggy whip “Investment Banks”, and starting to look beyond them. Goldman and Morgan Stanley can lose 5-10% of their value, daily, and people in this country are no longer surprised. Americans are a people of progress and change. They are done with the conflicts, the compromises, and the constraints of a financial system that lost its way. Old rules and said leaders of American financial institutions “are not necessarily sacred… principles are”… and if it wasn’t for that, I wouldn’t have my feet on the floor early every morning, charging our business forward.

Bottoms in markets are processes, not points. The change needed in this country will take time. That’s what investing has always been about. Take your time this morning. Read and reflect. This is not my gospel. These are the principles that great American Capitalism has always been built upon. God bless America’s families today, especially those who have lost loved ones serving our countries’ principles.

Keith R. McCullough

Long ETFs

JO – iPath Coffee –Vietnam and the Central African Republic have officially established diplomatic ties with a statement signed on Nov. 10th in Hanoi. Coffee is among the agricultural staples that is encompassed in the plan for economic cooperation.

EWL –iShares Switzerland- Julius Baer fell over 6% to a decline of 56% YTD. The largest remaining independent private Swiss bank announced a decrease in AUM due to outflows as well as investment decline.

EWA –iShares Australia- Australian business confidence reached a record low of -29 in October, down 21 points since September to the lowest recorded level.

EWG – iShares Germany – The ZEW survey of German investor confidence rose to -53.5 in November from -63 in October, an unexpectedly bullish move.

FXI – iShares China – Customs data shows exports increased 19.2% y-o-y in October, down from 21.5% in September. Imports rose just 15.6%, the lowest level since June 2007 bringing the trade surplus for the month to $35.2 billion. Industry group leaders expect tax rebates on copper and aluminum exports to be re-introduced in the near term,

VYM – Vanguard High Dividend Yield ETF – Revised AIG bailout terms spurred the Markit CDX North America Investment Grade index to decline slightly by 1 basis point to 186.5 in anticipation that carmakers may also receive capital injections.

Short ETFs

UUP – U.S. Dollar Index – The dollar rose against Latin American currencies as yields for the region declined.

EWW – iShares Mexico - Consorcio Ara SAB received authorization from regulators to proceed with its 26,000 home Citara project despite financing concerns.

EWJ – iShares Japan - The Economy Watchers index, a survey of sentiment among small business owners dropped to 22.6 for October, the lowest level since the survey began in 2001.

EWU – iShares United Kingdom – Leaders from the three primary political parties called for tax cuts to soften the recessionary blow. The pound reached 82.15 pence per EUR, an all-time low.

IFN – The India Fund – -- Stocks of state controlled refiners rose on news of a 4.6 billion infusion of government bonds to compensate them for losses created by subsidies. The Rupee fell 0.5% percent to 48.12 for the largest single day decrease in a month.

Keith R. McCullough
CEO & Chief Investment Officer

Daily Trading Ranges

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