Building a case for Casual Dining in Early 2009

The casual dining stocks saw a little rally going into the Thanksgiving week. The rally is coming off a disastrous past three months, where the average casual dining stock has fallen about 25% more than the market. The decline in casual dining stocks is based in part by fundamentals, but the current valuations suggest that there are deeper issues, which we don’t believe to be case. Currently the average casual dining stock is trading at 4.4x NTM EV/EBITDA (not including SNS which is trading at 11xs). This is a tricky time of year as you have tax loss selling coupled with part of the investment community taking the rest of the year off. Some parts of the investment community don’t want to have these stocks in their portfolios or they are not placing any new bets to maintain performance for the balance of the year.
  • Stating the obvious, Americans have lost their appetite and ability to spend at the same rate as in the past. The underlying force limiting the consumer’s ability to spend is the precipitous decline in consumer credit. In addition, the decline in the stock market has reduced the value of every American’s retirement plan, and the decline in home prices has left millions of homeowners with a mortgage in excess of the value of their home. As a result, survey after survey we see shows us that the consumer is unwilling to buy a new car or new house and is going to reduce spending on eating out! Trading at 4.4x cash flow the industry is discounting most of the bad news.
  • What you are not going to read in the financial press is that it is time to be looking seriously at the carnage in the casual dining industry as an opportunity to make money in the early part of 2009. Here are the catalysts/themes that will work their way into the market in the early part of 2009:

    (1) Currently gas prices are nearly 40% below last year’s level and likely to stay there for some time. See our post (Smoldering Stimulant 11/29/08) for the chart of gas prices.

    (2) There is a broadly accepted and recognized need for massive fiscal stimulus in early 2009.

    (3) Reductions in restaurant capacity in 2009, especially in the bar and grill segment. See my post (Shrink to Grow 11/12/08).

    (4) The decline in commodity prices provides a backdrop that can help mitigate the decline in margins.

    (5) Valuation
  • Longer term the restaurant industry is a cash business, and deploying cash properly drives real incremental value for shareholders. If you think the U.S. is headed for a depression, don’t buy casual dining. In a mild recession, however, there is very little risk to the cash flows of the large national casual dining chains with strong balance sheets. In today’s environment, deploying cash to build a bunch of new stores is not going to create significant value for shareholders. Nonetheless, we are seeing more casual dining companies move into the international arena to create opportunities for growth. Importantly, this growth comes in the form of high margin, high return royalty payments.
  • As you can see from the chart, the analyst community is sufficiently bearish on the group. Except for some of the names in the “quick casual” segment, there are not many buys on the larger casual dining names. This leaves some room for some piling on as sales trends become less bad in early 2009. DRI and EAT are two names that have a national base of stores, well positioned concepts, strong balance sheets and great cash flows.


“For heavily indebted casinos faced with having to choose between spending $1 million to purchase new slot technology with tremendous potential, or spending the money to buy back bonds trading below value, Loveman said the decision will be easy. They'll buy back the debt.” – Las Vegas Review Journal

The CEO of privately held Harrah’s Entertainment just described the situation facing 90% of gaming operators, including his. The list of gaming companies that won’t be buying slot machines next year is a lot longer than the list of those that could. The environment stinks but also provides opportunity. We’ve discussed the terrific buying opportunity for gamers on the right side of the liquidity trade to pick off assets/companies on the cheap. The other opportunity is to steal market share.

Increased marketing, advertising, and promotions is one way for the haves to take share from the cannots. Another way is to offer a better product through an aggressive slot replacement program. New game content looks pretty strong as evidenced by the G2E, the gaming equipment exhibition held two weeks ago. Too bad most companies won’t be able to take advantage.

Slots matter. Consumers play hot slots. That is what makes slots hot. For those of you who do not think slot product matters consider this.

• The average slot machine is functional for 10-12 years yet they are replaced at a 5-7 year clip. Why? Because there is wide variability between the best performing and the worst performing games.
• IGT has experienced serious erosion in market share over the past few years because they lost the content war as they spent heavily on server based gaming versus new game development.
• Despite serious protesting and threats, operators still pay approximately 20% of the take on certain slots (participation games) back to the operators when economically it would be more beneficial to own the slots outright. The reason they do this? Because they have to for the hottest slots.

The payback to the operator on a new machine that can generate a 25% increase in revenue per day over the house average is around 8 months. This represents a huge return. The old economic situation dictated that an operator replaced machines just to keep up with the competition. The new economic reality is that the operators with liquidity can actually drive ROI with slot purchases.

So who are the potential winners in this scenario? There is little doubt that Wynn Resorts owns the liquidity among the big caps and is a market share gainer. Wynn Las Vegas and Encore will offer the top slot floors in Las Vegas. The only other gaming operators well positioned to capitalize on the competition’s leveraged mistakes are PENN and BYD, both securely on the right side of the liquidity trade. PENN’s leverage is below 3x and BYD is at little risk of any covenant issues, will be free cash flow positive in Q2, and doesn’t have a meaningful debt maturity until 2013.

There’s a lot of market share to be stolen out there guys. Go get it.

Who wins this match up?

Quote Of The Week: Prince Alwaleed

“Full and complete support to Citi management, led by Vikram Pandit…”
-Prince Alwaleed

We have a leadership crisis in the US Financial System. The longer it takes to see it for what it is, the more protracted this bear market is going to be. Seeing the Street go back to the old well gives me a headache.

I completely disagree with the Saudi Prince’s current view of Vikram Pandit. The “New Reality” of seeing our US Financial System recover in 2009 and beyond is going to be predicated on winning back what the old boy network of Wall Street lost – credibility. Vikram Pandit’s senior management team is simply a Morgan Stanley redo of all that is imploding today. This reactive management team is no different than that which Hank Paulson led at Goldman or Dick Fuld oversaw at Lehman. Their names are different; their process is the same.

Sound judgment, accountability, and trust are at the heart of my definition of leadership. Take those coordinates on your moral compass and add a proactive risk management approach and you have yourself a winner to “completely support.”

There is not a Great Depression in this country, but there should be in the board rooms of ‘Investment Banking Inc.’ Franklin D. Roosevelt called the actual Depression “a result of the lack of honor of men in high places.” Think about that.

To believe in the illusion of the yellow brick road that the Prince painted this week requires a serious dose of groupthink and then an injection of narrative fallacy. It’s amazing what a five day rally in the stock market can do to the mind of the financial media. Don’t invest alongside their momentum chasing. Once they are done squeezing the shorts in Citigroup’s stock, I will be considering a short sale of this ex-Morgan Stanley management team.

The Pandit “Bandit” not only plugged Citigroup shareholders with an $800M sale of his hedge fund, Old Lane, but he then proceeded to make his partner at Old Lane, John Havens, head of Citigroup’s investment banking unit! I couldn’t make this up if I tried. These two didn’t know how to manage the risk in their own hedge fund, and now Alwaleed is signing off with “full and complete support” in their leading one of the world’s largest banks? Wow… do we ever live in interesting times.

After seeing oil prices drop 64% from their peak, and Citigroup’s shares lose over 80% of their value, you don’t need a major in economics to understand how self perpetuating Alwaleed’s financial motive is here. After Pandit saw the $8.4M in stock he bought get cut in half in less than 2 weeks, you don’t need to wonder about his either.

In the immediate term, Citigroup’s stock still has upside to $10.27/share. That’s 11% higher than where Pandit and Havens bought insider stock in mid-November. Notwithstanding that they made these purchases in front of one of the largest corporate bailout’s in the history of America, investors are best served watching what these pirates do versus what they say.

Somali pirates got the better of some of the Saudi Prince’s oil. Don’t let these ‘Investment Banking Inc.’ pirates of a broken Wall Street past get the best of you.

Keith R. McCullough
CEO / Chief Investment Officer

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Chart Of The Week: "The Wreck Of The Edmund Fitzgerald"

"The legend lives on from the Chippewa on down
Of the big lake they call Gitche Gumee
The lake, it is said, never gives up her dead
When the skies of November turn gloomy."

I have a family home up on "The Lake" (Lake Superior). Gordon Lightfoot's lyrics should have been played for levered long US “Activist” Equity investors, where November did indeed "turn gloomy." That said, don’t let your broker or PM tell you “T’was the witch of November” who stole all performance. For the month, China and Gold closed +8.8% and +12.7%, respectively. Staying focused on your losers and averaging down on the homeland isn't going to differentiate returns in this increasingly interconnected global market of factors. Keep it global and keep moving!

We remain long both China and Gold via the FXI and GLD exchange traded funds. We are short the S&P500 via the SPY.


KEITH - WEN is the best looking fast food stock on the long side… however…..

HOWARD – WEN - The however is due to management proving that the merger makes sense and that the margin opportunities at the Wendy’s brand are real. In 3Q05 The Wendy’s brand posted strong same-stores sales in 3Q08 on the back of the $0.99 menu. It’s a start!

KEITH - YUM starting to shape up long... has a lot of work to do, but looks better than it has in a while

HOWARD – YUM – We need to get past the 4Q08 – the quarter is not looking good. YUM’s U.S. business is in a secular decline and China is slowing versus a very difficult comparison last year.

A smoldering stimulant!

I know there are a number of factors influencing how people spend money in today’s economic environment, but current trend in gas prices will have a positive influence on consumer sentiment. As you can see from the national gas price map, the regions of the country with the lowest gas prices are those hardest hit by the current economic environment.

Hedgeye Statistics

The total percentage of successful long and short trading signals since the inception of Real-Time Alerts in August of 2008.

  • LONG SIGNALS 80.43%
  • SHORT SIGNALS 78.34%