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M&A Market Becoming "Unstuck"?

M&A activity, either private equity or strategic, is an indicator that we track broadly. Obviously, and on the margin, if M&A activity is increasing it is bullish for equities. It goes without saying that there has been very limited M&A activity in Q4 2008 and, in fact, M&A globally as of December 22nd was “down 29 percent from the full year 2007.” This week we have seen activity perk up with the IndyMac Bancorp acquisition by a private equity consortium and an announced divestiture by the New York Times.

After closing its doors in July after a $1.3 billion run on deposits over 11 days, IndyMac Bancorp is now close to being sold by the government vis-à-vis the FDIC to private equity firms J.C. Flowers & Co. and Dune Capital Management, and hedge fund Paulson & Co. The deal would be the first of its kind involving an unregulated firm buying a bank-holding company. According to various reports, the deal will include 33 branches, its reverse-mortgage unit and a $176 billion loan-servicing portfolio, with an announcement coming as soon as tomorrow.

In another deal, the New York Times, one of many beleaguered newspaper companies, is strapped for cash, faced with a poor advertising environment and tightened credit markets. With net debt at ~$1.13 billion at the end of the third quarter and a 60% drop in its stock price year-to-date, the Company is looking to raise cash to meet a reported ~$400MM debt repayment in May 2009. The deal according to Barclays Capital could be worth as much as $166.3 million. Earlier this month, the Company said a sale-leaseback of its headquarters building would raise as much as $225 million.

While these are only two deals, they are two notable announcements in a quarter which saw almost no major asset sales. The willingness of buyers to commit capital, in the case of the IndyMac deal, and sellers willing to move prize assets, in the case of the New York Times, could be an early sign that the M&A market is starting to become “unstuck”.

Daryl G. Jones
Managing Director

Matthew Hedrick

111 Whitney Avenue
New Haven, CT 06

Eye on Leadership: Compensation

Most senior management team members of large U.S. financial institutions have publically declined bonus compensation for 2008. We applaud this leadership. This action indicates to their employees that they are willing to share in the pain of both layoffs and lower compensation, but also indicates to their shareholders that they hold themselves accountable for the weak performance of their stock prices in 2008. Two notable CEOs that have yet to publically state that they will forgo bonuses this year are, Kenneth Lewis from Bank of America (BAC) and Vikram Pandit from Citigroup (C).

While U.S. Banker, an industry publication, recently noted in a headline that, “Lewis Emerges as Exemplar of Leadership in Time of Crisis”, the performance of his Company’s stock suggests otherwise. Over the last 52-weeks, BAC is down ~-67%. He may indeed be the best of an underperforming group of money center banking executives, but the reality of the poorly timed and overpaid acquisitions of Merrill Lynch and Country Wide Financial, has led to massive underperformance of BAC’s stock versus the broader market.

We have long been critical of Vikram "The Bandit" Pandit, the current CEO of Citigroup. In fact, we have been critical of almost all of Investment Banking, Inc.'s leadership. On the margin, though, we do find positive the fact that most of the CEOs and senior managers of the major Investment Banks are forgoing bonus compensation for 2008. Even John Thain, after likely pressure from his Board, has decided to forgo a bonus for 2008. As of now, the last major CEO of all the major investment banks to forgo his 2008 bonus compensation, at least publicly, is "The Pandit Bandit".

In June 2007, Citigroup acquired Old Lane, a hedge fund founded by Pandit, for reportedly more than $800MM. Pandit's take from the acquisition was more than $165MM. Less than a year later, Citigroup decided to shut down Old Lane due to "mediocre performance and the loss of top managers." Last Wednesday, Citigroup press released that the embarrassing story of Old Lane had finally ended as Citigroup press released that they will "severe ties with senior executives" of Old Lane Partners by December 31, 2008.

While Pandit cannot take back many of his questionable management decisions from 2008, we do think it is due time for him to forgo his bonus compensation for the year and return some of the $165MM that he paid less than a year and a half ago for a business, Old Lane Partners, that no longer exists. In Pandit's own words from August of 2008 as it relates to his changing the scheme of how Citi employees were paid, "people do what you pay them to do". Indeed.

Financials (XLF) continue to underperform the SP500 today.

Daryl G. Jones
Managing Director

Attention All Bubble Watchers

One of the more peculiar notions born out of the financial media’s perpetual patrol of all that is in the rear view mirror, is that bubbles, having already popped, can continue to “deflate.”

Have you ever tried to deflate a balloon that’s already popped? Try it, and let me know how that goes. That metaphor is more mathematically represented by the chart below that shows you what Commodities (measured by the CRB Commodities Index) have done, in the aggregate, since everything from fertilizer to grain elevators were given Park Avenue valuations.

The good news here is that, with the stimulus associated with a politicized US Federal Reserve creating FREE moneys from the heavens and countries from the USA to Eastern Europe devaluing their respective currencies, we have big thick patches being put on the former commodity hot air balloons that will allow for “re-flation.”

Gold trading up +4.1% week over week last week, and hitting a 2 month high again here today is the most obvious early signal of the commodity “re-flation” that is coming to a theatre near you in 2009. The revisionist CNBC bubble watchers saw this movie before, but right now they are still focused on how it ended versus how it begins.

Our “buy” zone for Commodities is shown below, from 209 to 219 in the CRB Commodities Index.

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JC Penney is incentivizing management to drive short term earnings over long-term value. I don’t like it, even though Wall Street likely will. I can’t stop that freight train, but I can hop on board the Kohl’s express, which is a safer trip.

We’re all about Accountability and Transparency at Research Edge, and we think that one of the good guys in that regard is Michelle Leder and her team at footnoted.org. Her catch on the JC Penney 8-K earlier this month is classic.

“… this 8K that has some of the most self-serving language we’ve come across recently. Penney’s board has decided to give Chairman and CEO Myron Ullman III a supplemental performance grant ‘to provide an incentive for performance during the current economic environment and to recognize Mr. Ullman’s willingness to continue his service to the Company.’ A quick skim of the agreement doesn’t seem all that offensive, though at $25 million, it’s quite an incentive to something that really should be considered doing your job.”

We couldn’t have said it better, Michelle.

From my perspective, JCP needs all the incentives it can get. Yes, I’m about to pepper you with another noisy SIGMA quadrant chart. But check out how JC Penney is performing versus arch-rival Kohl’s. Rather astounding, I think. JCP is on its 7th consecutive of inventory growth outpacing sales growth, and its 5th quarter of down margins. The margin trajectory is zig-zagging all over the place, as both SG&A and Gross Margins are managed reactively.

On the other side we have Kohl’s. Its SIGMA trajectory (the yellow line that goes from 1Q07-3Q08) is a smooth arc that shows how management proactively clears its balance sheet in an effective manner while inventories build. Yes, margins are down today, but so are inventories relative to top line trends.
I would not bet against JCP at sub 3x EBITDA – even though I could argue that margins should take a 200bp hit from here (ie, nearly cut in half – again). The reality is that management is being incentivized to make the near-term call and pull levers that shouldn’t be pulled. That probably makes Wall Street happy – except for those who pushed short interest to all-time highs (10%).

Even at a 2x EBITDA point premium and less bullish short interest ratio (5% of float, down from 8.5%), I’ll take KSS any day over JCP as an investment. The fact that SG&A and capex compares get very easy 1 quarter out offers a nice cushion as well.

Keith and I will be revisiting these two more frequently as it relates to meshing my fundamental analysis with his ‘Trend vs Trade’ models.
The first chart (JCP) is just plain ‘ol ugly. It tells a story of a very defensive management team. In this environment, reactionary is evil. KSS is polar opposite. Quality matters…
Short interest definitely looking more bullish for JCP.

Ireland Going Dry?

It seems that the Irish government may need further liquidity to maintain banks that have recently received government capital.

Since the guarantee of all deposits in Irish banks at the end of September, The ISEQ index has plunged more than 70%. Immediately following the government action, we made our skepticism clear in our “DUBLIN DOWN” post of 10/1/08. A deeper property market problem, and the degree to which large banking institutions are levered to the property market, was not likely to be meaningfully improved by the government’s gesture, however momentous.

It will be interesting to observe how the ISEQ fairs in light of the government’s latest action. In the last few days it was proposed that €5.5 billion be pumped into three major banks: Allied Irish Bank, Anglo Irish Bank, and Bank of Ireland. According to some reports, each of these institutions has lending exposure to the commercial property sector of 22%, 71%, and 18% respectively. The commercial property market is suffering heavily at the moment due to a lack of funding from banks, according to the last bi-monthly update for 2008 by property consultants CB Richard Ellis. The situation (banks and property) is somewhat self-perpetuating.

The downward spiral of the Irish economy has been in step with that of the US economy. As corruption has been exposed in the United States financial services sector, it has been exposed in the Irish finance world. Seàn Fitzpatrick, former Chairman of Anglo Irish Bank, has stepped down following the revelation that he had “borrowed” over €87 million in clandestine director’s loans. Now the Irish government, following an injection of €1.5 billion, has taken a controlling stake in that bank.

Morgan Kelly, professor of economics at University College Dublin, labeled the €1.5 billion as being motivated by purely political motives and devoid of any other logic. Anglo Irish Bank funds developers, and, Kelly states in his Irish Times article entitled “Better to Incinerate €1.5 billion Than Squander it on Anglo Irish Bank”, developers fund the main party of the ruling coalition. The losses of Anglo Irish Bank, in the face of the housing slump, could total (based on conservative estimates, according to the article) €15 billion. This, Kelly states, means that the €1.5 billion from the government will “vaporize” in little time in the face of Anglo’s mounting liabilities.

By having considerable shareholder power in major financial institutions, the Irish government may be able to encourage a freeing up of credit markets. However, if the simple arithmetic outlined by Professor Kelly is to be believed, and if the property market doesn’t turn sooner than expected, the government may have to commit more and more capital to keep institutions like Anglo Irish Bank afloat.

Rory Green
Research Edge LLC

Flattening The Curve...

For those investors looking to borrow short and lend long, this is one of the most negative 3 week charts that has developed in American Capitalism.

This morning’s narrowing between 10s and 2s has resulted in a +126 basis point spread. This is well off the higher levels that we saw in both late October and early November when I started to get more constructive on US Equities (see chart). In “The New Reality” of American Capitalism, we need to be able to see an expedited wealth transfer from the levered long to the liquid long investor. Steepening the curve is the best way to ensure that process takes hold. It’s the only way to incentivize those with real savings to lend.

It’s not only 2 month Treasury yields that increased on a week over week basis last week (from 0.74% to 0.88%), short rates like 3 month Treasuries went from 0.00 (ZERO) to +0.06%. I have long maintained the most basic of arithmetic thesis’ that once you cut to zero, the only way to move next is UP. Now, albeit slowly, that’s starting to happen… and this development should be monitored very closely on a day to day basis. This is why the XLF (Financials) continue to underperform.

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