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PENN: THIS RUMOR MIGHT NOT BE A MIRAGE

I’ve thought the two most compelling acquisitions for PENN were buying PNK or an MGM Strip asset. The pendulum appears to be swinging west all the way to Vegas.

The deal absolutely makes sense strategically. PENN would gain a high quality, well maintained, upper mid property in the premier gaming destination in the country. The Mirage brand is powerful and would bring a destination property into PENN’s portfolio. The cross marketing benefits are potentially huge. PENN’s current properties are widely dispersed with millions of customers in its database. Many of these players are already going to Las Vegas anyway and now they can be incentivized to stay at The Mirage. Harrah’s Entertainment has been very successful with this strategy and is the only company with the geographic diversity to pursue it, until now (maybe).

While we don’t know the price, an acquisition of The Mirage probably works economically. How many gaming companies can borrow over a billion dollars at 1.25% above LIBOR right now? None. We believe PENN would pay between 7.5x and 9x forward EBITDA for The Mirage. Of course, forward EBITDA is a very depressed number so the timing is probably right. We calculate The Mirage will generate $155 million in 2009. At those multiples the deal could be accretive to EPS by 20-25% to a run rate EPS number of $1.50. More importantly, the acquisition would add over 10% to free cash flow.

The previous assumptions assume PENN borrows the full purchase price from its credit facility. There is another, potentially more value added approach PENN could take. As we wrote about in our 7/25/08 post, “PENN: ‘BASSET’ SWAPS AND VALUE CREATION”, PENN may have bought/buying MGM bonds at a steep discount in order to trade them back to MGM in exchange for The Mirage. The transaction would be a “win-win” because PENN takes ownership of the property for less than 7.5x-9x discussed above while MGM retires debt at par. In effect, PENN pays a lower price than MGM is receiving. Thanks to a very lenient credit facility that allows MGM to use proceeds from asset sales to retire subordinated debt, this transaction is feasible.

Either way, the purchase of The Mirage for 9x EBITDA or below looks attractive for PENN shareholders.

Economics likely attractive


Eye On European Bond Yields

On Wednesday German 10-year bonds failed to attract enough bids to place the full €6 Billion the German government had sought, amounting to the second worst auction on record in terms of demand. In contrast France and Spain successful sold a total of around €11.4 Billion of bonds yesterday.

French 10-year bond yields traded at about 50 basis points above Germany, while Spanish 10-year bond yield came in a level over 80 basis points higher, with higher demand. This suggests that investor appetite for higher yield outweighs concerns over relative credit risk.

In the coming weeks, global markets will continue to be flooded with bond offerings as governments around the globe raise money for their respective stimulus packages. It seem likely, therefore, that we will see yields start to inch upwards as supply swoons.

Global equities, particularly those we purchased today (USA and Brazil), should outperform bonds as this perpetually bullish Trend in the Bond market comes under fire.

Matthew Hedrick
Analyst

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Korea Cut - No One cared!

The Koreans cut interest rates to their lowest level ever today – yes, even in The New Reality, “EVER” is a long time.

Both the South Korean Won and the KOSPI (Korea’s stock market Index) reacted negatively to this news. This is an immediate term “Trade” development, but it seems that Asian countries are starting to go through the withdrawal symptoms of any addict – you can only do so much, for so long. An addiction to easy money rate cutting has unintended consequences. Remember, America had this same addiction problem from September to November… not until the USA cut to zero, rate cuts were met with anxieties rather than optimism.

The KOSPI closed down another -2.1% on the day at 1180. From a quantitative perspective this country’s chart (see below) remains broken. Qualitatively, you’ll recall that not everything Asia is China. That’s why we have our long position in China, FXI, paired off with a short position in the Korean etf, EWY.

Keith R. McCullough
CEO & Chief Investment Officer

Eye On The New Reality

A New Home On Wall Street, in…New Haven

Gregory J. Fleming, the former president and chief operating officer of Merrill Lynch & Co., was appointed Senior Research Scholar at Yale Law School, which just happens to be located on the corner of Wall St. and York St. Coincidentally, it is also about two blocks from our offices on 111 Whitney Avenue in New Haven.

Fleming joins the list of ML employees jumping ship after its merger with Bank of America. A culture clash has erupted between Bank of American and Merrill over what many former ML brokers describe as an under-appreciation by their new boss of the broker-client relationships they bring to the firm. This comes in the wake of Bank of America’s CEO Kenneth Lewis proclaiming that ML’s 16,000-strong brokerage group as the “crown jewel” on the day he unveiled the acquisition.

The departure of Fleming, who was slated to run the corporate and investment banking unit, demonstrates Wall Street’s inability to retain talent as Investment Banking Inc. rolls over in the “The New Reality”. On Jan. 5, Robert McCann, head of Merrill’s brokerage and a 26-year veteran of the firm, resigned.

Matthew Hedrick
Analyst

QSR – DISCOUNTING WILL DRIVE MARKET SHARE SHIFTS

SONC recently announced the addition of several value items to its menu. Earlier this week, on its fiscal 1Q09 earnings call the company stated that its change in strategy is in response to the fact that in the past several months, QSR growth has come primarily from value offerings. This statement is supported by the charts below, based on NPD data, which show that QSR deal traffic growth has really picked up since early 2008 and has been steadily increasing as a percent of total traffic since mid 2007. Based on this data, it suggests that SONC’s new value focus is necessary if it wants to be successful in gaining market share in today’s environment. It will, however, drive traffic at the expense of margins (please refer to my post from yesterday titled “SONC – Management Seems Disconnected from Reality” for more details). That being said, I think it is the right move in the near-term from a competitive standpoint.

As I have said many times before, the restaurant industry is a zero sum game so if SONC’s new value offerings enable the company to increase its traffic growth, this growth will be coming from somewhere…its competitors. And, SONC said that in the 10 days since it implemented its new value menu that its comparable sales growth and traffic have turned positive. WEN has also experienced success recently with its aggressive push into the value arena with the introduction of its Double Stack Cheeseburger, Jr. Bacon Cheeseburger and Crispy Chicken Sandwich, all for $0.99. Although Wendy’s 3Q company-owned same-store sales declined 0.2%, they improved sequentially throughout the quarter and were up 2.1% and 5% in September and October, respectively, following the September introduction of these three value items. Again, with this incremental growth, WEN is stealing market share from someone. I would guess that MCD, which has posted consistently strong U.S. same-store sales growth, has the most to lose should WEN and SONC continue to experience improved traffic growth.

BKC might be another potential market share loser as the company is currently pursuing a strategy that focuses more on its premium products. BKC is not abandoning its value menu, but it is increasing its focus on innovation that will give the company more pricing power. Pricing power is by no means a bad thing and if the company is able to achieve both increased pricing power and traffic growth, then BKC will come out a winner. Based on the fact that value is the current driver of industry traffic growth, however, I don’t think this will be the case. Specifically, BKC management said on its most recent earnings call, “You have to look at value in terms of price point accessibility, which is what our value menu provides but then value for the money also comes with premium products that are on par with casual dining that are available for a fraction of the price. We work the value for the money equation on both ends of our menu. We have no plans to abate our advertising levels around the value menu but we’re going to continue to drive against higher quality and innovation which are better values for the money then one can find in casual dining as well.” I think it will be difficult for BKC to gain share from the casual dining segment right now with all of the attractive price points casual dining restaurants are currently offering. Personally, I see more value in the $5.99 burger with endless fries that is now being promoted at Ruby Tuesday’s.

Like BKC, CKR could also experience some near-term market share losses as it maintains its premium offering strategy. CKR management has said numerous times that it refuses to participate in the discounting tactics of its competitors by offering what it calls “low priced margin impairing products.” CKR is probably making the right decision for the long-term because these discounting initiatives will inevitably hurt margins. MCD has maintained its same-store sales growth with the help of its Dollar Menu, but it has also seen its U.S. restaurant margins decline for the last seven quarters. So the traffic growth versus market share tradeoff debate continues…


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