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DELEVERAGING THROUGH BOND BUYBACK

ASCA, BYD, LVS, MGM, and PNK all have potential debt covenant issues in 2009. BYD and MGM are in the unique position of having the combination of sufficiently lenient credit facility covenants and significantly discounted subordinated debt. Both companies can de-lever by borrowing off their credit facilities to buy back discounted sub debt and retiring it. Both can also sell assets and use the proceeds to retire sub debt subject to certain conditions.

By way of example, MGM borrows $100 million from its credit facility and buys $154 million par value debt trading at 65. The company would have to pay taxes on the gain of $54 million at the ordinary rate, say 35%. Thus, on a net basis, MGM would be deleveraging at $35 million ($54 million less taxes of $19 million) for every $100 million in bank borrowing used to repurchase sub debt. Nobody likes to pay taxes but the penalties of a covenant breach are much more severe.


MACAU VISAS: NO MAJOR CHANGES

Galaxy and SJM, the Hong Kong listed Macau stocks, have been ripping as of late with the US listed Macau stocks doing quite well in their own right. Rumors of Beijing loosening visa restrictions have been the main catalyst. Unfortunately, those rumors are probably unfounded. We still believe visa restrictions will ultimately be loosened, but not until mid to late 2009 when the new Macau Chief Executive takes the wheel.

There is potentially a touch of good news on the visa front. Beijing appears to be allowing higher frequency visitation to high net worth players identified by the casinos. This should certainly help the direct credit business but is not the visa panacea sought by investors.

BANNING GRAVITY: EURO STYLE

Today French, Belgian and German market regulators extended bans on the short selling of financial equities - on the heels of Switzerland’s Thursday announcement on the same ban for the Swiss stock exchange (SWX). At least 13 European countries followed the lead of the US and UK in September in adopting a ban on short selling. UK, Italian, Dutch, and Austrian bans will expire in the next six weeks; Belgium and Germany said they will extend their bans till late March.

Both the US and China let their temporary ban on short selling expire. We view these as positive capitalist decisions that will benefit the marketplace. In 2009 we’re looking to be long capitalist nations that proactively manage their economies. The EU’s consensus on short selling confirms our bearish views on the region.


Matthew Hedrick
Analyst

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DRI – POSTMORTEM

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

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