Keith - BKC - short with impunity anywhere close to 24

Howard – BKC - The industry is still a zero sum game - WEN new value promotion is driving incremental traffic and MCD dollar menu is winning too. BKC’s trends suggest they are losing markets share in the US.

Keith - GMCR - short with impunity anywhere north of $33

Howard – GMCR - I don’t buy into the new coffee revolution and the P&L looks fragile…..

Keith - EAT buy at 7.08

Howard – EAT - Down 27% over the past 30 days! Of the 45 names that Malcolm Knapp tracks only one concept had sales trends better than Chili’s in the month of October.

Keith - MCD - short at 58.26, the monopoly game is ending here.

Howard – MCD - My concern is more about 2009. The MCD coffee program is challenged and looks like it will not provide the lift the company needs to drive incremental traffic in 2009. The reallocation of advertising money toward coffee will slow overall trends.

Keith - SBUX - I buy at 8.48; very negative divergence today

Howard – SBUX - It will take time to repair the damage done to this stock. One of the biggest negatives facing SBUX is that senior management is out of touch with the investment community.

Keith - DIN's big resistance line is 17.34

Howard – DIN - Yesterday DIN traded in a 30% range! In the early part of the 4th quarter nearly every casual dining stock has gotten crushed, but not DIN. Over the past month DIN is up 97%, while DRI is down 10% and EAT is down 27%. Of those three names only DIN has severe balance sheet issues! This market is insane!

Pop... Pop... Bang!

“I have to believe that when things are bad I can change them.”
-Jimmy Braddock (Cinderella Man, 2005)

Since all of the Street’s new consensus savants are all “beared-up” and ranting about Great Depressions and all, what better inspirational metaphor to hit you with this morning than Ron Howard’s 2005 film, Cinderella Man.

The story of Jimmy Braddock is one that I have alluded to before. “Pop… Pop… Bang!”, remember? That’s the combo Braddock would hit you with right in the gut, right when you thought you had him down for the count. Sound familiar?

How about yesterday’s rally off the mat… right when the people who might love to see me lose felt best, at say 1PM EST on November the 13th… “Pop… Pop… Bang!”… Our market call to close at higher lows came right back with a flurry to the kidneys… “Pop… Pop… Bang!” and the short squeeze was on (“Beware Of The Squeeze”, 11/12/08)… the invincible bears were dizzied, and finally the market rang the bell for an +11% intraday market move. What a great fight!

Beaten down by a real Depression, Braddock fought with a broken hand just to feed his family. In the end, he defeated the “Investment Banking Inc.” champ of his day, Max Baer, and became the heavyweight champion of the world. One of my favorite interchanges between legacy thought (Max Baer) and Braddock was the simplest: Baer – “It’s no joke, pal… people die in fairy tales all the time.” Braddock replied – “I have to believe that when things are bad, I can change them.” Amen, Jimmy. Amen.

“Cinderella Man” is a true story, and so is ours. When we’re wrong, we take our lumps, go back to our corner and re-focus. When we are right, the hitting you feel from my keystrokes feels real, because it is. “Pop… Pop… Bang!” Do I like winning? I live for it… Do I hate losing? With a passion… I am not doing this for handouts, and I am certainly not the kind of man that will take a knee to someone who has more money than me. I am in it to win it, and I am not going away.

So let’s roll up our sleeves and get back at it this morning. Are things bad in this global economy of interconnected macro factors? You bet. The number one headline on Bloomberg this morning is “Europe falls into a recession for the first time in 15 years.” Gee, thanks. Consensus can result in both a solid right or a bloody nose – keep your head up and eyes on the opponent – this is a full contact sport. On the heels of Spain, Italy, Hungary, etc reporting recessionary GDP reports this morning, the revisionist scorekeepers are seeing European markets trade up +2-4% across the board. Stock markets are leading indicators, not fans in the cheap seats.

In Asia, China continues to strengthen its bid for the new heavy weight title of the world’s “New Reality.” Are some of the short selling savants still short China? Thank God, yes. The Chinese etf that we are long (FXI) had a +15% up day yesterday, and it literally dizzied the dudes on CNBC’s “Fast Money.” There is no better way to characterize their explanation for this week’s rally in China other than hilarious. These cats don’t have a process – that we know. But man oh man is it funny to hear these traders get all amped up and “fundamental” – they remind me of Don King.

Instead of listening to what one of the crackberry “Fast Money” dudes was telling you to use as a “China signal” (something about store checking Chinese imports at Wal-Mart?), stay in the home team’s corner here at Research Edge, and just read our daily notes. Our RE Macro clients have been getting inundated with portal postings for the last 6 weeks as we have been stepping into the ring and getting the analytical job done. We have an office in Macau don’t forget – we have edge. China is cutting taxes, spending stimulus, and seeing inflation drop in unison. “Pop… Pop…Bang!”… China’s stock market closed up another +3.1% overnight, making it 3 days in a row of gains, and ringing the bell for a +13.2% week. I said it yesterday, and I will say it again, CHINA’s STOCK MARKET IS BREAKING OUT.

Back to the ring here in the USA… the best news of this morning is that earnings season is ending. Amidst the flurry of sell side firms cutting numbers in Wal-Mart and Intel yesterday, both stocks closed the gap on intraday losses and closed up on their highs. If you sold them short on the news, shame on you. If I would have been wrong yesterday, I would have easily said shame on me.

There is no shame in fighting to feed your family. There certainly is no shame in any athlete I know celebrating victory. There is no Great Depression in this country. There is as much Irish-American pride in this country in a Jimmy Braddock as there is African-American pride in Barack Obama. Winning is what Americans love. Let that be the calling card for “The New Reality” – it has always been there. You just need someone to remind you from time to time that no matter where you go, there it is – “Pop… Pop… Bang!”

Have a great weekend,

Long ETFs

EWA –iShares Australia- Australian dollar set for a down week against USD & JPY. Babcock & Brown is in negotiations with creditors to buy time to liquidate assets, avoid bankruptcy.

EWG – iShares Germany - The Eurozone fell into its first recession in 15-years during Q3. German savings banks have agreed on a proposal to merge the state controlled Landesbanken into three new units which will now face tighter risk controls.

FXI –iShares China - The central government confirmed that it will lay out over 25% of the stimulus packages directly. This increased spending and the impact of tax cuts and higher export rebates will lead to a wider budget deficit in 2009 and more sales of government bonds.

EWH –iShares Hong Kong – Hong Kong's economy entered its first recession since 2003 with GDP down 0.5% for Q3 according to latest data, the government has lowered its full-year growth forecast.

VYM – Vanguard High Dividend Yield ETF – The largest holding in the VYM, GE, reassured investors midday yesterday that it plans to maintain its dividend through 2009.

EWL –iShares Switzerland- Data released in Switzerland yesterday saw the November ZEW expectations index improve marginally to -88.5 while October producer and import prices rose 2.9% y-o-y and were off 0.6% m-o-m.

Short ETFs

UUP – U.S. Dollar Index – In early trading this morning, the U.S. dollar is down versus the yen, but stronger versus the euro and British pound.

EWW – iShares Mexico – During a budget hearing Finance Minister Agustin Carstens announced that the government controlled Petroleos Mexicanos (PEMEX) hedged oil for 2009 at $70 per barrel to protect fiscal revenues .

EWJ – iShares Japan - Mitsui O.S.K. Lines, Japan's largest shipping line, will retire some of its fleet vessels including 7 capesize, for the first time in over two decades.

FXY – CurrencyShares Japanese Yen Trust – The yen continued its decline versus the USD, AUS and other major currencies rise on carry trade unwinds.

EWU – iShares United Kingdom – U.K. stocks rallied, led by energy producers, on bargain buying in the commodity sector.

Keith R. McCullough
CEO & Chief Investment Officer


Macau gaming revenues dropped an estimated 7% year over year in October, distorted lower by a high hold percentage last year on rolling chip (RC) play. Using the same hold % as last year, revenue would’ve fallen only 3%. Of course, MGM wasn’t open last year so the market is clearly challenged from a same store sales perspective.

Total RC volume looked to be down about 4% YoY, down from +3% growth in September. Crown’s growth rate continues to deteriorate. AMA flooded the market with credit earlier this year but has pulled back considerably as of late. YoY volume grew 50% in October, down from 140% in September. The other properties have been fairly consistent. Wynn Macau continues to generate around 50% volume growth, due in part to the expansion. LVS, Galaxy, and SJM are decidedly negative in that order.

On the high margin mass market side, revenue actually increased about 2% in October but not quite as strong as the 5% generated in September. Crown had a big step up here but still couldn’t move into positive territory. Wynn continues to drive positive growth that actually accelerated from September. Despite strong growth at The Venetian and the opening of The Four Seasons, LVS’s mass market revenue declined about 4%.

Overall, Wynn and Crown were the only two companies to generate positive growth in total Baccarat revenue. Wynn had a pretty good month, up 8% despite a lower than normal RC hold in October. LVS saw its Macau Baccarat revenues fall about 4% as a much higher hold % (but still normal) was offset by a significant decline in RC play.

Early Look

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GMCR – An Aggressive Business Model, Not Without Risk

GMCR reported 45% 4Q sales growth yesterday. Although this is an impressive number and management outlined its many “enabling moves” for future growth, there are real risks to GMCR’s business model. The first of which stems from the fact that the company’s sales growth projections rely on increased sales of the company’s Keurig At Home Single-Cup Brewers, which are sold at cost. GMCR’s sales mix has been shifting more toward this is zero gross margin product, which has resulted in lower YOY gross margins for the last five quarters (FY08 gross margins down 300 bps). Thus far, the company has been able to generate improved profitability by offsetting these huge gross margin declines with significant cuts to its SG&A line. GMCR has increasingly leveraged its SG&A expenses in the most recent quarters as gross profit margins have deteriorated further with SG&A as a percent of sales declining 280 bps, nearly 570 bps and 200 bps YOY in 2Q, 3Q and 4Q, respectively.
  • GMCR will not be able to cut SG&A forever. It is not a sustainable business strategy and does not match with the company’s future growth projections. The company expects to close on its Tully’s acquisition in early FY09 and is pursuing a national retail footprint for its Keurig brewers. Both of these initiatives will require increased investment. That being said, although GMCR did post 45% sales growth, the company’s sales trajectory is slowing on a 2 year basis. This will make it increasing more difficult for the company to leverage its SG&A expenses at a time when the company’s SG&A needs will be growing.
  • Looking out to 1Q09, these challenges will already start to play out. Management is forecasting operating margin contraction in the first quarter to 3.7%-4.4%, which represents at least an 80 bp decline from 1Q08’s reported 5.2% number. The company is expecting this YOY operating margin decline as a result of its planned sales of more at home brewers (so lower YOY gross margins) and flat selling and marketing expenses as a percent of sales. In the first quarter, GMCR will not be able to leverage its SG&A expenses, or pull the goalie as we like to say at Research Edge, and therefore, the gross profit losses will be reflected on the operating profit line. And, this is expected in 1Q09 with flat SG&A expenses YOY. I would expect SG&A as a percent of sales to grow as we trend through the year with gross margins still under pressure from increased at home brewer sales so according to my math, it will be very difficult for the company to achieve its FY09 operating margin objective of 8.5%-9.3% relative to its reported FY08 operating margin of 8.5%.
  • Other risks to the model:

    GMCR started producing K-cups at its new manufacturing plant in Tennessee at the end of the quarter. In the long-term, the company hopes this new plant’s increased capacity will provide the company with more flexibility to support its growth targets, but in the near-term, particularly in FY09, it could hurt margins as the company works through new plant inefficiencies. These plant inefficiencies will hit margins at the same time the company is working through increased SG&A expenses.
  • GMCR is trying to establish a national retail footprint for its Keurig brewers, but it does not have the support of national coffee brand. Instead, the company relies on a patchwork of regional brands: primarily Green Mountain, Newman’s Own, Caribou and Tully’s (assuming the deal gets done). GMCR does not even control two of these brands, but rather has a licensing agreement in place with Newman’s Own and only partners with Caribou, which leaves the company’s national growth strategy susceptible to risk.
  • Turning to the company’s balance sheet, GMCR reported its fourth consecutive quarter of inventory growth in excess of sales growth, which is another unsustainable business practice. In the fourth quarter alone, inventories grew 119% relative to the company’s 45% sales growth. The company said this increase in inventory was necessary to meet expected strong holiday sales of its at home brewers and K-cups. Although some inventory build is warranted prior to the holiday selling season, this seems aggressive and what was the reasoning for the outpaced inventory growth in the prior three quarters? For reference, Wal-Mart, which I would call a well-managed company, reported today that its 3Q inventory grew 3.4%, half the rate of its sales growth (also ahead of the company’s important holiday selling season).
  • GMCR is burning cash. The company’s FY08 capital spending exceeded its cash from operations (partly as a result of the significant increase in inventory) and GMCR is expecting its capital expenditures to go up in FY09…again, not sustainable.

Here little Sharky... Come And Get It!

Earlier this week, we walked through the concept of the “Shark Line”, or the line that the shorts better be very careful of getting sucked under…

A Research Edge picture often trumps my prose – this is an investment classic.


Still short Mexico: The Drug Trade Is Cyclical...

A brutal war is being fought within miles of the US border…

Late last month an ice chest was delivered to the police headquarters in Ascension - a Mexican town less than 30 miles from the US border. The chest contained four severed human heads - a message of intimidation from local drug traffickers.

The drug war in Mexico continues to escalate with atrocities that rival those occurring in the conflicts of the Middle East or Africa as revitalized law enforcement agencies are locked in a struggle with trafficking gangs that are entrenched in the economy after decades of corruption and incompetence on the part of previous officials.

In September, Finance Minister Agustin Carstens estimated that the conflict may be costing the nation as much as 1% of GDP growth annually. That estimate may be low; some Mexican academics estimate the total contribution of tourism to GDP at 8%.

With the recent slide of the Peso, Mexico’s fabulous beaches should be teeming with budget conscious tourists this winter. Instead, the violence has caused a chill for tourism has increasingly been commented on by industry observers. The latest warning issued by the US state department on October 18th contained the following message: “Mexican drug cartels are engaged in an increasingly violent fight for control of narcotics trafficking routes along the U.S. - Mexico border in an apparent response to the Government of Mexico’s initiatives to crack down on narco-trafficking organizations. In order to combat violence, the government of Mexico has deployed military troops in various parts of the country. U.S. citizens should cooperate fully with official checkpoints when traveling on Mexican highways”. This type of publicity will not help fill the beaches anytime soon.

Mexico is not alone in the fight. Last week president Calderon announced and intensified strategic partnership with Columbia in the fight against cocaine trafficking. In some ways, Columbia could provide the Mexican government with a blueprint for the way forward. President Uribe has made significant gains in recent years through relentless military action and a close partnership with the US government (under the Uribe administration over 900 drug offenders have been extradited to face trial in the US). Even if the strategy does succeed, the violence will likely get worse before it gets better as the traffickers come under more pressure and fight back harder. The criminals have the equipment to put up a fight - last week the Mexican army seized 314 heavy automatic weapons with a half million rounds of ammunition, 160 hand grenades and a rocket launcher from a single gang cell in Tamaulipas.

Mexico (EWW) is one of the few short positions that we have not covered on weakness this week.

Andrew Barber

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