• run with the bulls

    get your first month

    of hedgeye free


Options Market: VIX Breaking Down?

Although this week the VIX fell to its lowest level since October, calm is not yet restored.

Volatility levels in the options market declined this holiday week with volume slowing to a trickle by Wednesday. Put/call ratios declined for the month of November in the aggregate with the index-option ratio remaining higher by an average margin of 27% --significantly lower that historical averages but still suggesting that investors with broad market exposure are continuing to hedge at these lower price levels.

Some of the major indications of declining volatility for the week were:

•On Wednesday the VIX closed at the lowest level since October 21, declining below its 50 day moving average.

•On Friday, realized 30 day volatility for the cash SPX declined below 71.5 for the first time since Oct. 17th.

•On Friday the VIX traded over 4% lower than its 50 day moving average while second month series VIX futures contracts (January 09) traded 13% lower --the lowest that the contract has trailed the VIX 50DMA since being introduced over four years ago. Other series traded at similar discounts. Clearly the futures market is pricing in declining volatility as we head into year end.

Despite all of this, volatility remains outside any historical corollaries and the options markets retain treacherous liquidity holes that leave plenty of room for short squeezes --this is not a time for amateurs to start selling naked volatility. Conversely, any volatility buyers need to be cognizant of the impact that suspended or decreased dividends will have on long-dated put contracts, while also remembering that the impact of time decay will be massively pronounced on short term contracts at these high vol. levels.

As we said last week, there are still phenomenal opportunities in this options markets for investors with the correct duration and fundamental conviction –it’s just important that they understand all the moving parts before wading in. Feel free to contact me with any question about derivative strategies at

Andrew Barber

The ‘Other Side’ Of The FX Trade

Yes, companies are starting to show their negative exposure to currency fluctuations. This was inevitable. But a theme in ’09 will be those companies that have proactively managed around this.

One theme I think is consistently misunderstood is ‘Imported Cost Inflation’ from China. Is it a big deal? You betcha. But to really understand the dynamics, we need to understand that FX changes and the shift in China from an export economy to a consumption-based economy impacts two parts of the P&L. Some companies are better positioned than others.

The ‘no brainer’ here is that as China’s currency continues to appreciate on both a cyclical and secular basis, it puts pressure on the COGS line for companies who overwhelmingly depend on Chinese labor. Unfortunately for the footwear industry, almost 88% of US footwear consumption comes from China. Yes, that’s bad.

But where’s the offset? It comes from the few that have though ahead and proactively planned for such an imbalance. No, this is not a 1-year investment. These are the companies that saw this coming 3-4 years ago (and in some instances 10+). Nike, Ralph Lauren, Adidas, and dare I say 3nd class citizens like CROX and Skechers. These are companies that have built-up sales organizations in anticipation of hitting a time when the revenue opportunity would eclipse sourcing cost challenges.

What’s the math? Let’s look at two examples…

Company A (Nike) has 32% of COGS sourced in China, or about 16% of sales (given that COGS is about half of revs for Nike). The company also has about 8-9% of revenue based in China. That’s only an 8-9% spread between the two, and given that incremental top line growth is coming from China while incremental sourcing costs are coming from elsewhere in Southeast Asia, this gap will continue to narrow.

Company B (K Swiss) has better than 90% of COGS sourced out of China, and less than 3% of revenue. I probably don’t even need to go through the math to show that the challenge here is very meaningful.

The companies that look best in this regard are Nike, Adidas, Timberland, Coach and Ralph Lauren. On the flip side, Brown Shoe, Payless, K Swiss, Foot Locker, Dick’s and many small footwear and apparel brands are at a meaningful disadvantage.

I don’t think that this analysis gives us much of a feel as to who the near-term longs and shorts might be, but for those that can invest with a duration of a year or more, this is an incredibly relevant issue to consider.
Here's a sampling of companies that disclose exposure to China (including some that do not, but should).

Eye On Leadership: "Keeping Perspective"

“Kind words can be short and easy to speak, but their echoes are truly endless. “
-Mother Theresa

Thanksgiving is an opportunity to spend a day with your friends and family, to enjoy a bountiful meal, some stimulating conversation, and likely a great football game, or, at least, some tryptophan induced sleep.

The origin of Thanksgiving supposedly dates back to 1621, the year after the Pilgrims landed at Plymouth. One of the earlier native friends of the Pilgrims was a man named Squanto.

Squanto taught the Pilgrims how to successfully farm in the New World. As a result, the Pilgrims first harvest in October of 1621 was very successful. As the story goes, William Bradford, the Governor of the Pilgrims, declared a day of thanksgiving to celebrate the bountiful harvest. A day of feasting ensued for the Pilgrims and Governor Bradford invited Squanto and his tribe to the party as well, to pay them thanks.

Aside from giving thanks to our friends and family, Thanksgiving is also a great day to sit back and put things in perspective. It is a day on which we should realize that the world that we live in is just not that bad. I was reminded of this earlier this week after reading a column about the treatment of women in Pakistan; I was especially intrigued about a woman who was referenced, Mukhataran Bibi. I spent the next few hours researching her and it is a story that is worth sharing.

Mukhtaran is a Pakistani woman from a small tribal village in rural Pakistan. In 2002, Mukhataran’s young brother committed an infraction against some men from the Matsoi tribe, a neighboring and more powerful tribe, and was harshly punished. When the young boy threatened to report the incident, the Matsoi men called the tribal council and claimed that the boy raped a Matsoi girl. At the conclusion of the meeting, the tribal council stated that the boy would be forgiven if his sister, Mukhataran, came to the council to plead for his clemency.

Mukhataran arrived at the tribal council to purportedly plead on behalf of her brother. She was then taken to a nearby stable where she was brutally gang raped for hours, an action that was decreed by the tribal council. Following this ordeal, Mukhataran, a Muslim woman, was forced to march almost naked in front of a jeering crowd of hundreds back to her family’s home. She was then expected to commit suicide to absolve her of this shame as is tradition for women in her culture in these situations.

After such an ordeal, one would easily expect Mukhataran to lose all faith in humanity. Instead, her response was nothing short of heroic. Rather than committing suicide, and with the help of a local religious leader, she testified against her six attackers. She eventually won the case and was awarded compensation money.

Mukhtaran’s use of the compensation money was even more noteworthy. Her fundamental belief was the most appropriate way to overcome future abuses was through education. Thus, she used her compensation money to start a school for girls and a school for boys in her village. To show that she bore no grudges after the ordeal, Mukhtaran went out of her way to enroll the children of her and her brother’s attackers in the school.

Mukhtaran has since become a lightning rod for feminist rights in the region. The creation of two schools has led to the creation of countless others. The purpose served by many of these schools is much broader than education. Many of the schools serve to protect woman that have had atrocities committed against them and to enable these woman to reenter society with confidence and independence.

I’m not trying to suggest that we should be shameful that we live in a civilized world. Nor suggesting that we need to undergo an ordeal of epic proportions to enable us to give back, but rather that we should be thankful. We should be thankful for the opportunities that we have to live in a civilized society with a rule of law that enables us to pursue our dreams and interests. And as part of being thankful, we should give back.

Giving back can mean many things. Warren Buffett and Bill Gates long ago could have forsaken their capitalistic instincts and joined the good work of a philanthropic organization. Ultimately, though, the world is better off that they did pursue their naturally given gifts and that they existed in a society that enabled them to do so. The combination of Buffet and Gates’ philanthropic monetary contributions are now the most substantial in the world.

I started with a quote from Mother Teresa as I have a great deal of admiration for her accomplishments, but as a friend of mine who is a Medical Doctor and has worked in one of Mother Theresa’s hospitals in India reminded me this weekend, she is also a woman that is surrounded with some controversy. Many of her detractors believe that her primary cause was to promote her religion. A support that sometimes came at the expense of modern medicine and, ultimately, the poor and underprivileged that she was serving.

While Mother Teresa may have been a woman of religion first, the facts don’t lie. This small, impoverished woman from a poor Macedonian family who left home at 18, never to see her family again, to become a nun and ultimately serve the world’s most needy left quite an impact. Although she passed away in 1997, the organization she founded, The Sisters of the Missionaries of Charity, is serving 697 communities in 131 countries around the world. An organization of such scale that it rivals the accomplishment of any modern capitalist.

In 1979, Mother Teresa received the Nobel peace prize. In her acceptance speech she retold the story of a group of college professors from the United States coming to visit her in Calcutta. She recounted one exchange in particular, which is outlined briefly below:

“Say, Mother, please tell us something that we will remember, and I said to them: Smile at each other, make time for each other in your family.”

Her advice was simple really. All charity and charitable acts do indeed start at home and with people that we know the best. While we should hold up people like Mother Teresa and Mukhataran Bibi and admire them for their actions, an act of kindness, as Mother Teresa states, can be, and often is, as simple as smiling and showing that you care to those around you.

Daryl G. Jones
Managing Director

Attention Students...

Get The Macro Show and the Early Look now for only $29.95/month – a savings of 57% – with the Hedgeye Student Discount! In addition to those daily macro insights, you'll receive exclusive content tailor-made to augment what you learn in the classroom. Must be a current college or university student to qualify.

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

investing ideas

Risk Managed Long Term Investing for Pros

Hedgeye CEO Keith McCullough handpicks the “best of the best” long and short ideas delivered to him by our team of over 30 research analysts across myriad sectors.