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Eye on Transparency: $17.1BN+...Missing?

As we noted in The Early Look, it was disappointing to wake up to the Bernie Madoff fraud this morning. At a time when this country desperately needs leadership from the financial services industry, the news seems to get worse every day.

Madoff started his firm in 1960 and according to various biographical sources, “the firm was one of the five broker/dealers most closely involved in developing the Nasdaq market.” In addition, he has at various times served as the Vice Chairman of the NASD, a member of its Board of Governors, President of the Security Traders Association of New York, and Board member of the Depository Trust and Clearing Group.

While Bernie Madoff likely wasn’t a household name outside of Manhattan’s moneyed circles, he was clearly a substantial player in the finance industry and a major player in the asset management world. In total his firm is reputed to have managed north of $50BN dollars, with the hedge fund business managing north of $17BN.

It is unclear exactly how much money is missing, yet the SEC press release states:
“According to regulatory filings, the Madoff firm had more than $17 billion in assets under management as of the beginning of 2008. It appears that virtually all assets of the advisory business are missing.”

In addition, in the same press release, the SEC referenced a conversation that Madoff had with an employee and in this conversation “he admitted that the firm was insolvent and had been for years, and that he estimated the losses from this fraud were at least $50 billion.”

While it will take months to determine the extent of the losses, the number appears to be between $17BN and $50BN in client assets. If these losses are anywhere near accurate, this is one of the biggest frauds in business history and certainly the largest in money management history.

The implications for this are twofold. First, increased regulatory and transparency rules will have to come into play, a trend that will already be in place under the Obama administration and a Democratic Congress. Second, withdrawals from money managers of all strategies will likely accelerate in the short term. Investors should, and will, have serious doubts in regards to whether their money managers are doing what they say they are doing from both an accounting and strategy perspective.

We are wary that the Madoff fraud is a canary in the coal mine. While we know many, many money managers who have high ethical standards and take their fiduciary responsibilities very seriously, these types of events are rarely isolated. The potential for more Madoffs, and the broader implication of increased asset redemptions, is a tail risk that should be proactively prepared for and managed around.

Daryl Jones
Managing Director
Research Edge LLC


The following charts detail the decline in slot handle versus table drop on the Las Vegas Strip and Atlantic City, the two largest gaming markets in the US. Slot play peaked in 2003 in both markets. Possible explanations for the declining percentage of slot volume are:

• Younger generations don’t play slots as much, the older generation is dying off
• Higher international visitation to Las Vegas
• The popularity of poker extended to other table games
• The opening of Borgata attracted a younger customer profile

Revenue share from slots is down as well but not as much. As we wrote about in our 7/21/08 post, “I’LL HAVE A SLOT MACHINE, HOLD THE WINNINGS” slot hold percentage has climbed steadily over the past 15 years. In other words, consumers are getting less and less paid back to them in winnings for every dollar wagered.

So pricing to the consumer is up, slot pricing to the operator is up, yet demand does not appear to be keeping up. It will be interesting to see how both levels of pricing hold up in this environment.


I’m all for cutting costs. Higher margins are generally a good thing, but not always. I believe BYD’s decision to cut half of its matching 401k contributions is short sighted. Hopefully, it doesn’t speak to a larger strategy of sacrificing long-term opportunities to gain market share only to boost near-term EPS and cash flow. Let the guys without liquidity worry about that.

We’ve been vocal about the market share opportunities available to casino operators on the right side of the liquidity trade: BYD, PENN, and WYNN. Of the three, BYD seems to be in the best spot. As we wrote about in our 12/4/08 post, “IT’S THERE FOR THE TAKING”, BYD’s main competitor, Station Casinos, completely eliminated 401k matching contributions recently to ALL employees. Unhappy employees provide bad service. Since Station is close to bankruptcy, BYD also has other opportunities to offer a better product and steal market share, including a fresher slot floor.

BYD’s actions may seem inconsequential. After all, they are leaving the union alone and only cutting non-union matching 401k contributions by half. My argument is that it seems so unnecessary. Yes business is bad but BYD doesn’t need the EPS or the cash right now like ¾ of the industry and virtually all of its competition. I just hope BYD still capitalizes on the other opportunities to steal share including offering better maintained facilities and service, newer slots, and more marketing and promotions. That would put the focus on the long-term, where it belongs.

Giant Ponzi Scheme

“One measure of leadership is the caliber of people who choose to follow you.”
~ Dennis Peer

Last night, at Carmen Anthony’s in New Haven, CT, I had the pleasure and the privilege to share a celebratory holiday dinner with a US financial services firm that is both hiring and growing – Research Edge, LLC. Taking a few steps back and some time to breathe has paid handsome dividends in 2008, and last night reminded me how thankful I am to have the opportunity to work alongside this caliber of people.

Unfortunately, every great “Trend” in this business gets interrupted by negative “Trades”, and metaphorically at least, my alarm clock going off this morning was an abrupt reminder of as much. The first thing I do every morning is go through my Asian and European research, and it was plain ugly. Our friends who call it “Chindia” woke up to the reality that India is a different place than China again (don’t you hate when that happens) – India printed its first negative year-over-year industrial production growth number in 15 years. Meanwhile the Eurozone printed a horrific industrial production growth number of -5.3% year-over-year.

You see, there is no real “growth” in Western Europe right now, and that’s a real problem. That’s primarily why I have stayed away from Europe and paired myself off by being long Germany versus our short the UK position. Sometimes people forget that the Euro is barely 10-years old (her birthday is January 1st). Most of the time, people forget that this is the first time this new EU team has been forced to face the facts of an auto-correlating regional downturn. As these European countries try to figure out what to do with one another, I am happy to do nothing – sometimes that’s the best thing an investor can do.

Apparently Bernie Madoff wasn’t doing nothing. If you haven’t heard this man’s name before, you will within the next 24 hours. Like the artist formerly known as the Governor of Illinois, ole Bernie isn’t wearing the Santa suit and integrity pants at his team’s holiday party.

Rather than mince words, or go off on one of my riffs about transparency, accountability and trust, I’ll leave it to Bernie to describe what he was doing with $50B large – he called it a “giant ponzi scheme.”

So my feet are on the floor early this morning, and after investing in the USA over the course of the last few weeks, I have to deal with these losers still having an impact on your life’s savings. There’s nowhere for me to run, and if there was, I wouldn’t anyway. The only way to fix this crisis of the US Financial system’s credibility, is to take the ball this morning, and run it right up the middle.

Whether you’re working for General Motors or Bank of America this morning, it’s all one and the same. You have a confidence problem because the said leadership of your company has given you no reason to trust them. If they are going to get paid to “wear the C” on their jerseys, they are going to be held accountable for all of their actions – that’s The New Reality, and I have signed up to face-off against their principles.

Principles matter, and so does the hard earned money you have hopefully saved. We have been in cash for the better part of this year, but now we are starting to invest in America because the opportunity to change all of this nonsense has come. The US government is going to do what they always do – they are going to cut interest rates to zero and devalue your currency. When there is no rate of return and my savings account is for sale, I am not going to sit on my hands and do nothing.

Why has the US Dollar gotten smoked this week? Re-read this morning’s headlines – we have billionaires running “giant ponzi schemes” and a futures market that trades on “bailout” expectations. It’s embarrassing, and this is what happens to currencies when people lose faith in those running the country. Ask the Russians or Zimbabweans how this has been working out for them.

Am I early in taking my asset allocation to US Equities to 24% this morning? You tell me. I get called a lot of things in this business – but one of those things is not being late. The SP500 is down -44% since I was “too bearish” to work for some of this country’s investment savants, and now I get to clean up their mess. I signed up for this, and after last night’s dinner with my new team, I am ready to face The New Reality head on.

My downside target in the SP500 is 814, I’ll be buying more, patiently, from last night’s close to that price. Buy low. That’s where American confidence deserves to be this morning. On the margin, we are going to do our best to improve that.

Have a great weekend,

Long ETFs

SPY-S&P 500 Depository Receipts – CME front month futures sank this morning, trading as low as 832.7 before 7AM on news that the auto industry bailout failed to win Senate approval.

DIA –DIAMONDS Trust Series – CBOT front month futures sank this morning, trading as low as 8,250 before 7AM on news that the auto industry bailout failed to win Senate approval.

XLV - Health Care Select Sector SPDR –Johnson & Johnson (XLV:14.83% ) announced that the Israeli Antitrust Authority has approved JNJ’s acquisition of Omrix Biopharmaceuticals, Inc.

OIL - iPath ETN Crude Oil –Font month NYMEX Light Sweet Crude contracts declined below 45 in trading before 7 AM this morning.

EWG – iShares Germany –The DAX is down this morning 193.59 points, or 4.06%, at 4573.61, led by fears that the global recession may deepen following the rejection of the $14 billion bailout package for US carmakers by the Senate. Daimler AG (EWG: 4.29%), the world’s largest truckmaker, agreed to buy 10% of Russian commercial vehicle manufacturer giant OAO KamAZ.

EWH –iShares Hong Kong –The Hang Seng closed down today at 14758.39, or 5.48%.

 FXI –iShares China – Retail sales numbers slid in China at the slowest pace in nine months. Sales slowed to 20.8% in November Y/Y after gaining 22% in October Y/Y. The CSI300 closed down today to 1960.38, or 4.20%. The central banks of China, Korea and Japan announced this week an agreement to ensure currency stability in Asia.

Short ETFs

EWU – iShares United Kingdom –The FTSE100 is trading down this morning at 4249.42., or 3.17%. HBOS Plc, the UK bank that agreed to a takeover by Lloyds TSB Group, said this year’s charge for bad loans rose to $7.5 billion.

FXY – CurrencyShares Japanese Yen Trust –The dollar slumped to 88.53 Yen, the lowest level since August 2, 1995, before trading at 90.32 as of 9am in London.

EWY– iShares South Korea – South Korea and Japan will increase existing Won-Yen arrangements to $20 billion from $3 billlion.

IFN The India Fund-India’s industrial production fell for the first time in 15 years, with output at factories, utilities and mines dropping 0.4% in October Y/Y after a 5.45% gain in September Y/Y.

CKR - Better late than never

Finally, CKE’s management team made a decision that many in the investment community can get behind. Cutting capital spending is a positive development! Unfortunately, in today’s environment the national brands are winning with their discounting strategy. CKE is one to watch.

In April of this year, I argued that CKR’s then current level of capital spending was unsustainable. In contrast to many other restaurant companies, CKR was accelerating, not slowing, new unit growth. My primary concerns stemmed from the company’s decision to increase its unit growth significantly while margins were still under severe pressure, which typically results in lower returns for the entire enterprise. I pointed out that CKR’s aggressive capital spending over the past 2 years had not led to incremental returns for shareholders and said that management needed to change its long-term unit growth strategy in order to reverse declining returns.

On May 3, I posted my concerns about the level of G&A spending at CKR, highlighting the fact that although the company’s system-wide store count had declined by 8% since 2002, G&A per store had grown nearly 40%.

CKR dismissed these concerns.

On June 17, Ramius LLC sent a letter to Andrew Puzder, CEO of CKR, in which it called for the company to 1.) Significantly reduce operating costs, and 2.) Shrink the capital spending plan to improve free cash flow. Ramius’ public criticism of the company’s industry-high G&A costs as a percentage of total revenues and need to cut capital spending apparently struck a chord with management as the company has since made changes to its capital plans. Whatever the motivation, CKR now seems to be on the right track from a sustainability standpoint.

CKR has reduced both its new unit growth and capital spending targets for FY10-FY11 two times since Ramius sent its letter in June (the first reduction coming 2 days later at CKR’s annual meeting). In June, the company lowered its new unit growth plans by 35 units and lowered it again today by another 27 units. Combined with those unit growth reductions, the company has reduced its capital spending plans by $83 million and now expects to spend $193 million in FY10-FY11 ($100M-$110 in FY10 and $80M-$90M in FY11). For reference, that compares to $133 million in FY08 and an expected $120-$130 in capital spending in FY09 (FY10-FY11 guidance represents an expected 10%-20% YOY decline in both FY10 and FY11). A majority of the capital spending reductions are coming out of CKR’s discretionary spending, or from the cut back in new company openings as the company plans to only open 6 new company-operated Hardee’s units in both FY10 and FY11 (from prior guidance of 15) and 22 Carl’s Jr. units in both years (down from 40).

Management went on to highlight that it still has room to make further reductions if need be as nearly 40% of its capital plan is tied to discretionary items which could be further reduced or eliminated. Additionally, the company said it could cut back on its remodel program (although part of the company’s non-discretionary spending plan) on short notice if the environment worsens and deems it necessary. So, if the company needed to completely eliminate both its discretionary spending and remodel plans, it has the flexibility to further reduce its FY10-FY11 capital spending plan to $53.9 million from its current $193 million. Let’s just say it did not sound like the same management team that dismissed my concerns earlier this year, which again is a good thing! CKR is focused on using its increased free cash flow to either pay down debt or build liquidity so it stands ready to accelerate its growth again if high-return sites become available.

Also, post the Ramius letter, management allocates a significant amount of time on its earnings call to going over the company’s recent G&A reductions. G&A is down 2% YTD. Although CKR’s G&A costs are moving in the right direction, its G&A per store is about $45,600, still significantly above the FY04 level of $33,100 that Ramius highlighted in its letter. Mr. Puzder has stated that G&A spending levels in FY04 could not sustain the brand. At that level, he said the company was in “survival mode” and that such spending could not be maintained without deteriorating the brand. Regardless, there is still room for G&A to come down, particularly with the company’s ongoing refranchising efforts.


Monday, 8 Sep 2008 - DineEquity, Inc. Announces Chief Financial Officer Transition
Tuesday, 7 Oct 2008 - DineEquity, Inc. Declares Quarterly Dividend
Monday, 27 Oct 2008 - DineEquity, Inc. Agrees To Sell 66 Applebee's Locations
Friday, 5 Dec 2008 - Southeastern Asset files 13D Reports in DineEquity
Thursday, 11 Dec 2008 DineEquity, Inc. Announces Suspension of Common Dividend

The company declared a dividend in October and then suspended it in early December. During the intervening time period sales for the casual dining industry slowed significantly. The dividend announcement speaks directly to the liquidity issues the company is facing.

There is no reason that DIN should be trading at a premium to any of its peers in the restaurant industry, and yet, the company is trading at 8.7x on a NTM EV/EBITDA basis relative to its casual dining peers at 5.5x.

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