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GS: California Conflict?

Allegedly, a Goldman report advised betting against CA’s credit…

The LA Times reported this morning on a confidential Goldman Sachs research report issued in September that advised institutional investors to hedge exposure to (or establish a short on) California debt. It is no surprise that investors would receive this advice - California has been hit hard by the current financial turmoil and Governor Schwarzenegger has issued numerous dire warnings about a potential budget crisis as the credit markets began freezing up over the summer. What IS surprising, perhaps infuriating, is the source. As an underwriter and advisor, Goldman has received millions in banking fees from California bond issues and it has significant advisory and asset management relationships with pools of public capital throughout the golden state.

This conflict will likely come as a shock to California’s lawmakers who could be forgiven for assuming that, as a reputable investment bank, Goldman’s first loyalty would be to its customers and that it would avoid conflicts of interest by helping one customer profit from another’s misfortune. In this case GS apparently event tried to broker both sides of the transaction –according to the LA Times piece Goldman “regularly urged” California to trade CDS contracts on its own credit itself.

A Goldman “spokesman” was quoted saying the firm was no longer providing that advice without elaborating…

The bankers and traders that built Goldman Sachs over the first half of the last century recognized that the trust of their customers, over the long term, was worth more than any opportunity to extract a quick profit. In those days, of course, GS was still a partnership and the long term interests of the firm and those of its customers were closely aligned.

The fact that the firm’s share price is up almost 3% today on the news that they have alienated the largest municipal borrower in the nation may be an indication that the days of that kind of long term thinking is a thing of the past.

Andrew Barber
Director

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.
KM

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.
KM

Daily Trading Ranges

20 Proprietary Risk Ranges

Daily Trading Ranges is designed to help you understand where you’re buying and selling within the risk range and help you make better sales at the top end of the range and purchases at the low end.

SBUX – MANAGEMENT CAN PUT ON A GOOD SHOW

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.

'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

LIKE PEANUT BUTTER AND CHOCOLATE

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

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