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I believe DRI is well positioned to take advantage in a difficult environment.

Going into DRI’s 2Q09 earnings call, I thought the company’s results would be less bad than consensus numbers were suggesting. It turns out that DRI’s top-lines results, particularly at its Olive Garden and Red Lobster concepts, materially outperformed the casual dining industry as measured by Knapp Track.

Earnings preview: Street consensus EPS numbers are too low for the company…..

2Q09 results: DRI reported EPS of $0.44 versus the street’s estimate of $0.30. DRI lowered its FY09 EPS range to down 5%-10% on a continuing operations basis and excluding integration costs from flat to up 5%. Although this is a fairly significant downward revision, prior to the call, the street had not believed this guidance anyway and was forecasting an 11% YOY decline. This more cautious and believable outlook provides some upside to consensus numbers and offers DRI the opportunity to beat numbers going forward should top-line trends stabilize and improve.

Earnings preview: Same-store sales trends are better than consensus (part of the reason why EPS estimates are too low).

2Q09 results: Same-store sales growth came in better than expectations at each of the company’s concepts with both the Olive Garden and Red Lobster substantially outperforming the overall casual dining industry by 610 and 560 bps, respectively. Olive Garden’s same-store sales grew 0.8% and Red Lobster posted a 0.3% increase. Positive numbers in today’s environment represents a win for DRI. DRI’s lowered guidance assumes that same-store sales at the Olive Garden, Red Lobster and LongHorn Steakhouse will decelerate somewhat in the back half of the year to down 2%-4%. Again, this revised guidance reflects a more conservative stance on the part of management and provides the company with a cushion in this challenging environment.

As I have said before, I expect casual dining top-line trends to pick up somewhat in early 2009 from Obama’s planned fiscal stimulus program. All of DRI’s concepts would benefit from such a stimulus plan, but Olive Garden would really stand out as it has outperformed the industry all along. For reference, casual dining same-store sales growth has declined for eight of the last nine quarters while Olive Garden has managed to report consistently positive numbers.

Earnings preview: The company will have positive commentary about the cost side of the equation, especially seafood, chicken and wheat costs.

2Q09 results: DRI lowered its full-year food and beverage cost outlook and now expects these costs as a percent of sales to be up about 50 bps on a reported basis versus its prior guidance of up 70 bps. And, this is based on the company’s now lowered sales guidance. Relative to DRI’s current commodity contracts and hedging strategy, management stated that it must strike a balance between wanting to lock in more costs in order to have better cost visibility and wanting to wait to take advantage of cost favorability. That being said, management stated that it has been successful in extending hedges at more favorable prices. Specifically, the company is 100% covered on its shrimp needs for the year and expects its 2H09 and FY10 results to better reflect the current favorable trends it is seeing on the spot market.
Earnings preview: Industry same-store sales trends in November, while still bad, are less bad than October.

2Q09 results: Same-store sales improved sequentially in November from October at the Olive Garden, Red Lobster and LongHorn Steakhouse. The company’s November comparable sales numbers were helped by an estimated 250 bps due to the timing of the Thanksgiving week, which fell in 3Q this year versus 2Q last year. This timing shift helped the quarter’s results by about 70 bps and is expected to reverse in 3Q. Even when you exclude the benefit, however, same-store sales improved sequentially by about 1.5% at Olive Garden, about 3.5% at Red Lobster and about 4% at LongHorn. October was extremely bad for each of these concepts, but November did turn out to be less bad, which was a definite positive in the quarter. The company attributed the strong November results at Red Lobster to the company’s new wood-fire grill menu items, which were added in November. The wood-fire grill menu launch follows the introduction of Red Lobster’s today’s fresh fish options and continues DRI’s initiative to enhance the brand.

Slowing new unit growth…

Although I have stated before that DRI is well positioned to outperform should casual dining top-line results stabilize, I have been concerned about DRI’s high level of capital spending and aggressive new unit development targets. Today, DRI lowered its FY09 net new unit growth guidance to 70 from its initial plan of 75-80. Even with this lowered new unit growth target, DRI still plans on spending $580-$600 million in capital expenditures in FY09 (about $80M of that spending is on its new restaurant support center), up 35%-40% from FY08 levels. This is still a move in the right direction. Additionally, management stated that it is more focused now on cost management and the deployment of capital in that it is only going to pursue its highest priority sites. CEO Clarence Otis even said that if the environment got appreciably worse that it could lower its future capital spending to only include its maintenance level of spending, which is about $150-$175 million. I do not expect DRI to lower its spending down to that level, but was comforted to hear that management is at least evaluating its current spending levels and recognizes that there might be a need to further reduce its capital spending going forward.

Ukraine’s Pain Setting In

Over the weekend we highlighted Ukraine’s geopolitical weight on the global macro stage based on its relationship as an energy intermediary between Russia and the European Union. The decline and incredible volatility of the Ukranian currency, the hryvnia, has served to underscore the impact this country has on relations in the region.

Ukraine’s currency was hammered earlier this week, falling 15% in two days to a record low of 9.4625 against the USD. The currency is finally rallying this morning due to the Central Bank raising interest rates to 22% from 18% for its benchmark refinance rate. This move highlights the severity of the situation in the Ukraine and the government’s response to take necessary measures to support the hryvnia.

Here are some of the factors that have sent the hryvnia and the Ukrainian economy crashing down:

Commodities- Ukraine is heavily levered to commodities and commodity products. Specifically, steel represents 40% of exports. Ukrainian steel production has dropped some 48% in November in response to demand declining on the global market. As a result, European prices for a metric ton have fallen 47% since August. The net result of this is that Ukrainian industrial production shrank by a record 28.6% last month as steel, machine building and oil refining slumped. In addition, with the country’s deep dependence on transit fees for Russian oil and gas servicing Europe, Ukraine has been hammered by the precipitously fall in price for these commodities.

Central Bank – Ukraine’s Central Bank said it will attempt to manage the hryvnia’s decline by buying and selling foreign-exchange reserves. Buying up the hryvnia could strengthen the currency by limiting supply, but it is not clear that the Central Bank is effectively managing this function. Confidence in the Central Bank is low. So low in fact that Ukranian Prime Minister Yulia Timoshenko recently demanded that the National Bank of Ukraine Governor Volodymyr Stelmakh be dismissed.

Interest Rates- President Viktor Yushchenko has called for the Central Bank to aggressively raise interest rates, yet the outcome may be negative. For one, increasing the interest rate will limit access to capital, which will dampen lending and the ability to borrow. Ukraine desperately needs access to capital to compensate for global destruction of commodity demand and price. Ukraine’s annual inflation has been running around 7% since 2000; estimates suggest that raising the interest rate would slow this number to 2% for 2008.

Loans- The IMF provided $16.4 Billion to Ukraine to shore up its depressed economy. The unintended consequence of the devalued hryvnia means the country—should it not be able to appreciate the currency through interest rate hikes—will have a larger loans in US dollars to repay. Further, it’s estimated that nearly half of all loans from domestic lenders in Ukraine are in dollars so appreciating the currency is essential to meet parity in repayment.

Debt- A substantial debt of $2.4 billion is currently owed by Ukraine’s state-controlled Naftogaz Ukrainy to Russia’s Gazprom in the form of back payments on gas. Should this loan not be paid off, Gazprom may send a message in turning off supply. In total Ukrainian companies owe some $4.1 billion in debt in December.

Politics- Since the arrival of the Orange Revolution five years ago that brought a “democratic” coalition to power, disagreements have afflicted the main party heads, Prime Minister Timoshenko and President Yushchenko. Conflicting issues have included appropriate measures to stabilize the currency since its initial slide in October and how to handle political ties with Russia and Europe.

According to the WSJ, “new central bank data showed the country’s external debt increased by $7.4 billion in 3Q to $105.4 billion, or 60% of gross domestic product, with short-term liabilities estimated at $30 billion.” These numbers are huge and signal that the Ukraine is in a world of hurt if they can’t find support for their currency.

Oil: Risk reward favors reward

We are long Oil via the USO, the U.S. Oil Fund ETF, and are adding to the position today. From a fundamental perspective, demand remains weak and the global demand picture going into 2009 looks gloomy, but Oil is a commodity with serious long term supply constraints. In addition, with interest rates as low as they have ever been in the United States, the inflation trade we have been harping on as a theme for 2009, which we will be discussing on our best ideas call on Monday, is becoming increasingly likely.

We will be posting a longer piece on Oil in the coming days, but to be clear our view isn’t that Oil returns to the euphoric highs of June / July 2008, but more simply that the risk / reward at this level, from a quantitative price perspective, offers one of the more compelling opportunities we see in the global macro arena currently. Our range is outlined in the chart below and we see upside to $51.77 per barrel.

Daryl G. Jones
Managing Director

Early Look

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Eye On Japan: The Falling Sun

With rates effectively at zero, Japan is back at to being who they are. Politicized/Compromised bureaucrats, creating zero capitalistic incentive.

Less than one month after BOJ Governor Masaaki Shirakawa told reporters that ``an additional rate cut would have many adverse effects on the functioning of the money market'' he and his team have lowered the benchmark overnight rate to 0.10% and announced that they will follow the lead of US central bankers and begin buying commercial paper in an attempt to jump start liquidity.

Shirakawa obviously didn’t want to take these steps, he had no choice. With automotive firms guiding down massively for 2009 kick starting a new Japanese layoff cycle and the most recent Tankan manufacturing survey down by the largest period margin since 1975 -the pain trade is in motion. This is why the Nikkei traded down on the day despite the cut.

We continue to be short the Yen via the FXY ETN and will keep our eye on Japanese equities with a short bias into any strength.

Andrew Barber
Keith McCullough

Research Edge LLC

A Christmas Carol

“Darkness is cheap, and Scrooge liked it.”
-Charles Dickens

If that isn’t the metaphor for the Madoffs as they prepare for their posh weekend at Bernie’s New York apartment, I don’t know what is. Today is the anniversary of Charles Dickens publishing “A Christmas Carol” in 1843 – what an appropriate story for our industry to reflect upon as we look forward to changing what went wrong. “Darkness” has proven to be cheap, after all.

The darkest hole in global asset allocation has all of a sudden turned out to the one where the plain eye cannot measure depth. It’s as black as black gets, and it’s called oil. Since its manic July highs, the commodity has plummeted on the order of -75%. Never mind the equities that have blown up from Bolivia to the Ukraine, the biggest crash of the year was where many a prop desk built compensation structures that they are still telling investors are “repeatable” business models.

Global growth has slowed; most of us get that by now… and there is a demand component associated with evaluating a commodity. After all, that’s why they are called commodities! Ask the poor guys who are long “Intrepid Potash” this morning – management is guiding revenues to less than half of what they were last quarter! There is nothing “intrepid” about fertilizer. Any farmer could tell you that.

Somewhere between those “Fast Money” highs of less than 6 months ago and this morning, the world has come to realize the commodity bubble for what it was – the last gorging global manifestation of an addiction to levered returns.

When you lever things up (banks, hedge funds, commodity bets, etc…) you implicitly increase the volatility of the prices associated with those assets. We call it “pin action” – and it’s fascinating to watch the Street argue with one another about whether the stock market is “cheap” or not on that “pin”. The “pin” you see is KM speak for “return per share”, and a lot of market pundits focus on it completely disregarding the mathematical reality that some earnings per share have a leverage component (debt on the balance sheet).

Ignoring the math is what will expedite what this business needs most – a cleansing of the analytical talent that is out there making decisions with your hard earned money. This is a great opportunity for the best analysts on the Street to rise to the occasion and gain fiduciary responsibility.

This morning’s math in Asia is more of the same. We have two more Asian countries cutting interest rates, and the Chinese stock market providing the liquid long cash leadership that the New Reality of global finance needs most. The Japanese government, predictably, cut its interest rates to effectively ZERO (0.10% to be precise), and the Vietnamese made their most aggressive rate cutting move of the year, taking rates down by a full 150 basis points to 8.5%. In sharp contrast to the “peak oil” highs of 6 months ago, when most Asian central bankers were still RAISING rates, this has turned into a major tail wind for those who have stepped up and bought Asian equities.

We put up an interesting, yet simple, Chinese chart on our portal yesterday and atop of it I wrote, “You Tell Me” in reference to the question as to where you think the Chinese stock market’s (after dropping -70% peak to trough) next move in 2009 will be. Sometimes the most important questions to solve for are the simplest. The Shanghai stock market closed up again last night, taking its latest run of up days to 6 out of the last 7. While Japan is still the world’s 2nd largest economy, I think the simple reality is that they have nothing but global market share to give the Chinese. “Merry Christmas China – here you go; we are a Japanese socialist bureaucracy now, and we’d like you to show us the way.”

Yesterday, the Chinese government issued more of their own government bonds (with an interest rate that wasn’t ZERO), and they moved to cut fuel taxes. Alongside the biggest domestic stimulus spending plan that the world has ever seen, China cutting rates and taxes in tandem reminds us all that the holiday season can indeed bring great things, provided that capitalists can sit around their family dinner tables and be incentivized to take on measured risk in the new year.

President George Bush is actually going to leave office issuing Americans his most positive Christmas carol yet. If I told you 6, 9, or 12 months ago that Bush would provide you, the American capitalist, the economic foundations of $36/barrel oil, ZERO interest rates, and stock market prices at 50% off, wouldn’t you be smiling?

The only “Bah-Humbug” that’s left in this game of global investing is the one that’s been assigned to those who deserve it. This is America, and the future for hard-working American capitalists who didn’t lever their brains out and have liquidity has never been so bright.

I don’t consider myself an oil baron, but I bought my family some yesterday. I have an upside target of $51.77 for oil, and with the US Dollar cratering alongside the investment banks turned “bank holding” companies that are being downgraded by S&P this morning, I am happy to invest in one of this world’s most basic needs before it “Re-Flates.” That’s what investing is all about – buying low in anticipation of the light of Christmas prosperity becoming expensive again. Darkness was cheap.

Have a great holiday weekend with your families,

Long ETFs

SPY-S&P 500 Depository Receipts – CME front month S&P 500 contracts traded down this morning, with a low of 882.5 before 6:30AM.

USO - U.S. OIL FUND –NYMEX front month Light Sweet Crude contracts traded as low as 35.62 in trading this morning. Bloomberg reports Saudi Arabia’s Oil Minister Ali al-Naimi saying the price decline “threatens investment” and is “wreaking havoc”. NYMEX January contracts expire today.

DIA –DIAMONDS Trust Series – CBOT front month DJIA contracts traded down this morning, with a low of 8,650 before 6:30AM.

EWZ – iShares Brazil—Brazil’s central bank hints at future interest rate cuts due to declining commodity prices and shrinking credit. The interest rate stand currently stands at 13.75%. The next meeting is scheduled for January 20-21.

EWH –iShares Hong Kong – The Hang Seng closed down to 15127.51 or 2.39% today in trading. Hong Kong’s stocks fell for the first time in five days led by commodity shares.

FXI –iShares China – The CSI300 closed slightly up at 0.34% to 2052.11. Bank of America Corp.’s plan to sell some $2.8 billion of shares in China Construction Bank Corp. was undone by a Chinese securities law provision that would have forced it to forfeit profits from the proposed sale of 5.5 billion shares in the Chinese bank.

Short ETFs

FXY – CurrencyShares Japanese Yen Trust – The Yen is trading up on the USD at 88.885, or 0.62%.

Keith R. McCullough
CEO / Chief Investment Officer

Casual Dining – RT and the last piece of the puzzle

Reduced capital spending and shrinking capacity favor large cap casual dining names.

I’m now focused on what is the critical component to the recovery and improved health in the casual dining segment. The industry behaving rationally!

As you can see in the accompanying chart, the industry has been slashing capital spending for the past year and this trend will continue into 2009. This will allow the industry to focus more on running its existing operations better, which always leads to improved ROI. On top of this, we expect to see existing capacity of the weaker players close, benefiting the strong.

This is evident in the actions of RT last night. Last night, RT announced it will incur restructuring charges in its 2Q09 and 3Q09 related to impairment and lease charges. Importantly, these charges are associated with the closure of approximately 40 locations in 3Q09 and approximately 30 additional locations anticipated to close over the next several years, as well as a non-cash impairment charge related to approximately 35-40 surplus properties which are marketed for sale.

One of my favorite themes in the restaurant industry is “shrink to grow.” See my November 12 post titled “Shrink To Grow” that briefly explains the thought process. RT is playing into that theme perfectly. RT’s announcement, while extremely difficult for the company on a number of fronts is the right one for the company. The company has effectively improved the profitability of the company by eliminating 11% of the store base that was unprofitable. For RT, specifically, it pushes out the threat of bankruptcy by 6-12 months.

I also want to point out that EAT is a big beneficiary from the closing of the RT stores as they are direct competitors within the bar and grill segment. Importantly, RT is not alone. As we move into 2009 I would expect to see the casual dining industry shrink capacity significantly.

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