Eye on Activists: Ackman . . .Burned by Lack of Liquidity

We have been long critical of Billy Ackman, primarily for his thesis on Target. And more generally negative on long only levered activist funds. On 12/10/2008, we wrote:

“Back in the market mania highs of 2005/2006, these strategies worked. Unfortunately, the cheap money, private equity bubble has popped, like all bubbles inevitably do, and with it so has the long only levered activist model.”

A primary reason we are negative on activist investing is that it typically includes an inability to sell easily due to large, and thus illiquid, positions in a Company’s stock. Additionally, being a “successful” activist often means becoming an insider by way of a Board seat. The problem with this “success” is that it does not allow an investor to change their view, by way of selling stock, when the investment’s prospects change. The net result is what we call thesis drift, which occurs when your original thesis is no longer intact and you invent a new thesis to justify your investment.

We are hardly infallible when it comes to picking stocks, so we are not beating up Ackman for the fun of it, but rather want to highlight the risks involved in concentrated activist investing. The chart below of Border’s Group probably makes the argument better than we could.

Undoubtedly Ackman had a great thesis on the stock, yet the thesis proved to be wrong and due to his size he could not easily exit the position. He then lent the Company money to alleviate their liquidity concerns. Ostensibly, due to an inability to repay these funds, Ackman has installed a former lieutenant of his, thirty-two year old Richard McGuire, as Chairman of Border’s Group.

Be careful not to get burned by lack of liquidity . . .

Daryl G. Jones
Managing Director


It’s probably just a coincidence but John Ensign, Senator from Nevada, sponsored Senate Bill 33 which would provide tax relief to companies that are restructuring debt. Clearly, a primary beneficiary of this bill is the gaming industry in general, and MGM and BYD in particular (both headquartered in Las Vegas).

As we’ve written about extensively, many gaming companies are overleveraged and face the risk of breaching credit facility covenants. ISLE, MGM, and BYD all have the wherewithal to pursue a strategy of buying back their discounted debt to de-lever. The only drawback to this strategy is the tax implications, whereby the company must pay a tax on the amount of the discount at its ordinary corporate tax rate.

We are unsure of the prospects of SB33 passing but for legislators in favor of throwing companies a lifeline to avoid bankruptcy, there should be some appeal. As we wrote about in “THE GREAT WEALTH TRANSFER”, the buyback of discounted bonds creates equity value. Eliminating the tax burden on such a transaction creates even more equity value. We’ve updated the example from our previous post to provide a third, tax-free assumption. In this example, an additional $29 million on top of the original $51 million of equity value is created with the repurchasing $200 million par value of bonds. Very compelling, indeed.

MGM looks like the biggest winner here should this bill become law.

Eye on Employment: Obama’s New Deal

At Research Edge, we believe that the fear associated with unemployment trends in this country are backward looking. Importantly, there is a very high level of anxiety associated with the current trends and little belief that the trends could possibly reverse. As we have said before, the probability that there is a change on the margin and that the trends in unemployment accelerate at a lesser rate is a key component to our MEGA call for 1H09 – The E stands for Employment and a key goal communicated by President-Elect Obama concerning the American Recovery and Reinvestment Plan is that it should save or create at least 3 million jobs by the end of 2010.

It’s clear the drama of the current trends in unemployment will continue to play out in January and February, but increased confidence in the President’s process over the same time period, will positively impact consumer behavior. Contributing to the President-Elect’s process is a report issued by Christina Romer, Chair Nominee Designate, Council of Economic Advisors and Jared Bernstein, Office of the Vice President Elect, titled American Recovery and Reinvestment Plan. The report offered several key preliminary findings:

(1) A package in the range that the President-Elect has discussed is expected to create between three and four million jobs by the end of 2010.
(2) Tax cuts, especially temporary ones, and fiscal relief to the states are likely to create fewer jobs than direct increases in government purchases. However, because there is a limit on how much government investment can be carried out efficiently in a short time frame, and because tax cuts and state relief can be implemented quickly, they are crucial elements of any package aimed at easing economic distress quickly.
(3) Certain industries, such as construction and manufacturing, are likely to experience particularly strong job growth under a recovery package that includes an emphasis on infrastructure, energy, and school repair. But, the more general simulative measures, such as a middle class tax cut and fiscal relief to the states, as well as the feedback effects of greater employment in key industries, mean that jobs are likely to be created in all sectors of the economy.
(4) More than 90 percent of the jobs created are likely to be in the private sector. Many of the government jobs are likely include professionals whose jobs are saved from state and local budget cuts by state fiscal relief.
(5) A package is likely to create jobs paying a range of wages. It is also likely to move many workers from part-time to full-time work.
If the combination of lower interest rates and the American Recovery and Reinvestment Plan can, on the margin, stimulate consumer spending, the unemployment rate looks to peak around 8% in the summer of 2009. The markets, as a leading discounting mechanism, will factor the impact of these changes to the trends in unemployment in 1H09.

Howard Penney
Managing Director

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Isle of Capri announced today a tender offer to buy back up to $140 million of its bonds at 58 cents on the dollar. This transaction allows ISLE to deleverage by the amount of the discount, adjusted for taxes. In this case, ISLE spends only $140 million to retire $241 million worth of bonds. The current tax regulations force ISLE to pay tax on the differential at the company’s ordinary tax rate so the net effect is 35-40% less but still material.

Other companies that have the ability to follow this strategy include MGM and BYD. Both companies maintain ample availability on their credit facilities but face covenant issues. Clearly, buying discounted bonds should be a major deleveraging maneuver that both should pursue. Their bonds are more liquid so hopefully bond buybacks are already underway for each company. MGM appears to be willing to compound the positive impact by selling off assets and potentially using the proceeds to buy more bonds. Importantly, MGM’s credit facility does not restrict it in this area.

The following example details the math behind the strategy. Assuming a company with $200mm in EBITDA and an enterprise value of $1.4bn tenders for $200mm face value of bonds and pays 10 cents on the dollar above the market price of 50 cents, $51mm of equity value is potentially created.

Of course, a stock is a discounting mechanism so some of the potential may already be factored in. However, we don’t think many equity investors understand the power of these transactions, particularly for a company like MGM where sentiment is wildly negative surrounding covenants, liquidity, and its balance sheet. MGM equity holders probably have the most to gain with a corporate bond buyback strategy.


Bert Vivian, PFCB’s new co-CEO as of earlier this month, presented at an investor conference this morning and spoke rather generally about current trends in casual dining. While his commentary is entertaining, he did not paint a very optimistic picture. Below are some of his comments (I am paraphrasing):
Casual dining has been ugly and it is going to continue to get uglier.

The lights went out on December retail same-store sales…This is not just a retail problem.

Yesterday, RUTH reported that comparable sales declined over 18% for the fourth quarter. Don’t be surprised by these types of numbers. Whatever numbers you are expecting for the industry should most likely be ratcheted down.

During the fourth quarter, particularly in December, people had a reason to go out shopping. When people are out, they occasionally also go out to eat. We see no reason for people to go out in 1Q. It is going to be a cold 1Q in retail and restaurants. There is nothing to change people’s behaviors in the next few months.

This is a tough sales environment. 2009 for our group is going to be a throw away.

There is no need to be in a hurry with this group. There is nothing we see that makes us think business is going to take off any time soon.

The casual dining group’s decline in development in 2009 is likely going to stretch out into 2010 because once the hammers stop, it is tough to get them going again. (This might have been the most positive thing Bert said as it relates to really fixing one of the biggest fundamental problems facing the group as a whole).

Below are some of Bert’s more positive comments:

In the past, PFCB has used its free cash flow to build new restaurants. With the slowdown in development, this is not going to be true for this year and most likely for the next few years. What do we do with our free cash flow? (Bert answered his own question, saying that PFCB will most like use its cash to pay down debt and buy back shares.)

The sun will shine again on this group…We just don’t know when.

The current market cap of all of the higher-end steak players combined suggests that people are not going to eat steak anymore…I am going to continue to eat steak.

People are going to continue to eat out. The casual dining business is not going away. There are going to be casualties, but there are also going to be survivors. 2009 is going to be a tough year, but PFCB will be one of the survivors and should come out a stronger company.

Politics, Process and People

Politics, Process and People - asset allocation011309

“There’s been a breakdown between the conduct of politics and the people”
-Yoshimi Watanabe, last night…

Japanese Cabinet Minister, Watanabe, walked out on his political position last night and called for the resignation of Japan’s latest token Prime Minister, Taro Aso. Since Koizumi stepped down, Japan basically changes their said “leader” every 9 months, so it wouldn’t surprise me whatsoever if Aso eventually resigns – what does surprise me, however, is this loud and public ‘You Tubing’ of Japan’s long held (and accepted) bureaucratic order. It’s about time – well done Mr. Watanabe, well done!

Japan’s stock market is one that I have asked you to avoid like the bubonic plague for the better part of, well… since I started writing these notes – so I trust that you have. As Marty Whitman would say, “a bargain that remains a bargain… is no bargain.”

Japanese stocks got hammered last night closing the session down -4.8% on decent volume. That was the worst performing market in Asia, and it should be. Japan’s yield curve has been flat for a decade – they have inspired ZERO foreign investment as a result. When you pay out ZERO returns, that’s what you get – the American political machine better not forget that as it locks arms with the beggars of the politico and trudges along the lows of a global socialist bailout program. When there is a “breakdown between the conduct of politics and the people,” the people in America always win. Americans are taking their country back from the bankers right now. Thankfully, this long overdue process is in motion.

All three of the American indices that I called out yesterday broke down and closed below my support levels. Make no mistake, this is bearish. Now those support levels become my resistance levels – unless we can close above them, you are best served to be making sales on up days.

Do I like getting smacked around out there in the marketplace? No. The risk/reward in my macro model’s math played to the bullish side yesterday, and it still does this morning… just from a lower price. As prices change, expectations do. The Obama inauguration catalyst that I have been highlighting, bullishly, for the last month, is what it is – a month into my ranting about it. Could the US market’s +16% rally from its November lows have already discounted the positivity associated with Obama’s new leadership in The New Reality? Maybe – as the math changes, I will.

From yesterday’s close of SP500 870, I see a risk/reward in buying the SPY’s (SP500 etf) at -1% risk for +3% reward. That’s why I bought SPY into the close yesterday in our virtual Portfolio (see ). Every decision in markets has a time and price. If I allow my mind to be infiltrated with the negative thoughts of giving away a goal, I will never have the clarity needed to get back in the faceoff circle expecting to win the next puck back. That’s just how this game goes – if you let your mistakes eat you up inside, they will.

The following levels of resistance in the SP500, Nasdaq, and Russell 2000 need to be overcome for our “Obamerica” and “MEGA US Consumer Squeeze” rally to continue to make higher 3-month cycle highs and higher lows: SP500 889, Nasdaq 1554, and Russell 477.

If those levels are overcome, and the US emotional index (VIX) can keep a lid on itself under the 54.35 line, the US stock market is going to go up as fast in the next week as it has dropped in the last one. Since I asked you to make sales at 941 SP500 last week, don’t forget the math – the SP500 has effectively dropped -7.5% in a straight line, inspiring the “Great Depression” friends of my bear clawing past to re-populate their mugs all over your local manic media TV channel. Everything has a time and a price. All of the other noise that occurs in between timing and pricing is what it is – revisionist history.

Other than the Pandit Bandit compromising whatever credibility he had left yesterday, what was it that had people run for the global equity exits? I can give you a laundry list of things – surely, this too is revisionist history by virtue of it being yesterday’s news – but here’s what gets the red marker in my notebook this morning:

1.      Asian stock markets have broken short term momentum support

2.      Asian currencies (ex-Japan) are going down in concert

3.      European stock markets broke short term support

4.      Russia came back from their holidays, and devalued both the ruble and the RTSI exchange

5.      Middle Eastern conflict has passed through its apex of Israeli attacks (they need oil to go up, not down)

6.      Brazil had a -5.2% correction yesterday, after seeing a +40% move to the upside

7.      Commodities (CRB) were down -3.9% yesterday, underperforming equities

8.      Oil prices have lost -25% in 6 days

9.      The US Dollar has strengthened from its lows, weakening everything “re-flation”

I’m stopping with 9 contributing factors that I have interpreted as negative. There are plenty more that I will touch on during our daily “Macro” client call at 830AM. I don’t wake up every morning looking for data points to support my “call”. I strap on the accountability pants and call the river cards on the table as they lay. The facts don’t lie, people do… and I for one, am not going to stand up this morning and be proud of losing yesterday.

Today is a new day, and not losing your money remains the objective. Start clean and don’t start selling the lows into the market’s opening weakness. We are one day closer to the Obama catalyst. We have $36/oil, zero percent interest rates, the narrowest TED spread we have had in months, and an arguably a deserved “Bush Bottom” (see yesterday’s intraday Macro post at  for that note) as a result of “a breakdown between the conduct of” American politics…  “and the people.”

Best of luck out there today.

Politics, Process and People - etfs011309

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