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Eye On Regulation: Where There's Smoke...

Where There’s Smoke… – Notes for the Week Ending Friday 28 November 2008

In the shadow of the steeple I saw my people.
By the Relief office, I seen my people.
As they stood there hungry, I stood there asking
Is this the land made for you & me?
 Woody Guthrie

We sat at our table this Thanksgiving surrounded by family, aged twelve to 95, and friends from as far off as Bosnia and Israel. We spoke about what makes America great – and about those who have never been part of the Thanksgiving narrative. Lincoln said this nation was “conceived in Liberty…” yet, some deformation appears to have taken place in the birth canal. This is not the place to dwell on issues of race, ethnicity, and dual national identity as part of the uniquely flawed – and yet uniquely great fabric of this nation. But we acknowledge that societies are defined by access: who Gets In, and who Doesn’t Get In, and in every society there are groups that we define as Structurally Dispossessed.

As much as anything else, the recent election is the result of self-assertion by groups who heretofore never believed themselves to be full participants in American society. One need only look at the hundreds of thousands of people who had been registered to vote for years, but who never actually pulled a lever until this year. The rules remain the same. Yet, by broadening to include as “Americans” the Structurally Dispossessed, the American narrative may change dramatically. Many are shocked by this handing of political clout to large groups of people who have never participated in the process. It is the ultimate Trickle Down. Next Thanksgiving will see a different United States of Obamerica.

With all the changes we anticipate at every level of society, what might the implications be for the world of market regulation?

We Americans are unusually prone to injecting morality into our political discourse, no less in our view of securities regulation than elsewhere. We damn short sellers as being evil. When markets get choppy, we outlaw them – despite the fact that short selling is one of the fundamental mechanisms that has made our markets superior to any other securities markets in the world. We can quibble over data sets used to analyze the effectiveness of the Uptick Rule, but the fact is that Shorts are always smarter, as a group, than Longs. Their activities force realistic pricing in the markets, and their capital sustains market liquidity. Thus, regulation trashes the very markets it attempts to salvage.

The Obama Administration promises some tough new regulation. Media reports are full of words like “broad” and “sweeping”. But what philosophy will that regulation support? Rules, as we see over and over again, are meant to hide behind. It is striking to note that the violation of securities rules is often viewed as a business decision. Owners and management assess how much they will make if they violate a rule, versus how much it is likely to cost them if they get caught. It is the nature of the current regulatory process that regulatory penalties paid out by Wall Street firms generally fall short of the profits generated by the behavior that led to regulatory action.

The new Obama administration has assembled an impressive economic team. Now they must define their Narrative. We often hear that Business is more effective than Government, because of the Profit Motive, as though this were an alchemical formula for fiscal policy. As discussed in the Wall Street Journal (“Government By Contractor is a Disgrace” – 11/26/08) paying the private sector to do government work is not only not efficient, but leads ineluctably to corruption and excess. The observation that Government has a lot to learn from the private sector is dead on, but the profit motive is not the silver bullet.

The constant seeking after profits is not what makes businesses successful. It is what makes them lose sight of their long-term objectives, and often it is what makes them corrupt. The success factor in capitalism is neatly summed up by Secretary Paulson’s testimony to Congress on why he diverted TARP funds away from their original intended purpose of buying up toxic mortgages: “When the facts change, I change my mind.” The true genius of Capitalism is its ability to reinvent itself. The key question a successful entrepreneur asks is not “How many of these can I sell?” but rather: “What business am I in today?”

In the current shouting match we have heard some regulators pushing for principles-based regulation, as opposed to the standard rules-based regime, which is inherently prone to abuse. Perhaps government can do no greater service to the people and the markets by guiding the discussion about What Country Are We In? This is by its nature a fluid conversation. It is an ongoing discourse, and the principles by which we will regulate our markets in the future must emanate from that discourse. Put another way: law and regulation are an outgrowth of how the country defines itself. We now have an opportunity to make a conscious decision of what we want America to look like, to be, to do. The Obama narrative rests largely on increased Access for more Americans. If this is to succeed, it will have to very visibly undo Business As Usual, and push creative reinvention. The new administration must lead the national dialogue in asking over and over again, What Country Are We In?

O Lord, won’t you buy me a Ford Pinto?

Are we the only ones who found it odd that the UAW came to Washington together with the CEOs of the No-Longer-So-Very-Big Three? This looks like an ex-spouse looking over one’s shoulder and checking the numbers on a lottery ticket. As curious as it was to see the UAW and the Soon-To-Be-Downsized Three waltzing in arm-in-arm-in-arm-in-arm, it is shocking to us that Congress even debated their proposal. But then, this is the same Congress that approved $700 billion for Fannie and Freddie, but did not summarily fire their bosses. The auto industry conversation, in a nutshell, is: “Our business model doesn’t work. Please give us $25 billion to sustain our unsustainable business, until we can convince you to give enough of your other $700 billion to enough people to force them to buy our trash.” As we all know, What’s good for General Motors…

We note with interest that the President of the atoll nation of the Maldives is actively looking about for a new homeland – and willing to pay for it. The 350,000-odd inhabitants of this island nation feel all too keenly the imminent risk of being swallowed up by a rising sea level. One modest proposal might be to have them move to the interior of China. Half of China’s population now lives in the cities, and more are fleeing daily. The 750 million or so people still living inland are largely older – their children went to Beijing, they stayed behind. They are also largely dependent, in traditional Chinese society, on their children taking care of them as they age, a phenomenon that looks just about to go by the boards. Would they not welcome a new family into their midst, if they came bearing cash? The 350,000 people fleeing the Maldives would be a tiny blip on the radar of a nation whose population is one-fifth of all humanity. “When the facts change, I change my mind.” President Mohamed Nasheed could teach Detroit a thing or two.

Twenty-five billion dollars is a fair chunk of cash. If it is handed to the Big Three it will likely vanish in a puff of smoke. On the other hand, it is approximately $40,000 each for the 620,000 or so members of the UAW. Instead of buoying a sinking ship, we could set up a combination home mortgage guaranty and professional retraining program for auto workers. We could sock $25 billion into an artificially high-paying interest bearing account – say ten percent – and require the auto manufacturers to match the revenues. They should have no trouble doing so. As they have not tired of telling us, if they get rid of their losing US business, their profitable overseas operations will restabilize their finances. With $250 million a year from Government, matched by an equal amount from each of the Three, we have an ongoing stream of $1 billion a year to dole out to UAW members while they redeploy.

Black, Black Friday

This weekend marked the beginning of the holiday shopping season. Preliminary figures appear to indicate that reports of the death of the American consumer have been somewhat exaggerated. Bloomberg quotes the market research firm ShopperTrak RCT as saying sales were up 3% over last year. This would be the smallest increase ever recorded – but an increase, nonetheless. Retailers are on tenterhooks and will be counting every penny of revenues, hoping to pull out a profitable year.

The Bloomberg story reports that retailers advertised “doorbuster” sales nationwide. At least one location proved true to this name, as shoppers at a Wal-Mart in Valley Stream, Long Island, literally not only tore the doors off the building, but trampled a worker to death as they surged into the store. Fellow workers who tried to break up the flow of stampeding shoppers and rescue their colleague were met with angry shouts of “We’ve been waiting all night!” This gives new meaning to the concept of Pent-Up Demand, and shows the folly of the current Washington plan. If consumer spending represents 70% of American GDP, then the $700 billion should not be given to the banks, but to those who will spend it. Washington should hold a contest, with consumers being asked to describe their ideal family shopping spree. We could sponsor the ultimate reality TV show – Shopper For A Day – and Washington, as the producer, could sell advertising time, thus generating additional revenues for the consumer bail-out. Why not offer this opportunity to the UAW? The $700 billion package works out to over one million dollars per Union member. Let’s give them a shopping spree. The money will be handed out on the sole condition that it all be spent within no more than thirty days, and all within the borders of the United States.

Instead of appointing Henry Paulson to fix this mess, we should have appointed Sam Walton. He knew how to stimulate spending!

Moshe Silver
Director of Compliance

* Dedicated to the memory of Jdimytai Damour *

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).

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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

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.

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