A recent NY Times article expands on our “New Reality” theme as it relates to Investment Banking Inc. and broadens the theme to the auto industry, calling December’s declining sales trends the “New Normal.” The article says that the historic collapse of the new-car market raises questions about whether the auto industry will ever again see the pace of sales it did a few years ago. The easy answer is no, but Detroit will adjust and move. The “New Normal” theme goes beyond auto, however, and touches just about every industry. More importantly, the death of the consumer credit cycle will mean that there is a “New Normal” for nearly everyone.

The “New Normal” refers to the fact that the world has changed forever and those companies that are reluctant to change are doomed to fail. Those companies that do not adjust to the “New Normal” will be in purgatory for an extended period of time. Reducing capacity and capital spending are the order of the day and those that try to convince you that “we can grow” through the cycle are not in tune with the “New Normal.” Our “New Reality” is closely aligned to the debacle on Wall Street and the end of Investment Banking Inc. as we know it. The “New Normal” is closely aligned to the permanent shift in every aspect of consumer behavior. The most recent example of the “New Normal” comes from Lee Scott, the CEO of Wal-Mart, who believes that recent economic activity has caused a permanent and fundamental change in the behavior of the consumer in that the consumer will not have as aggressive a desire for consumption and debt. The question that remains unanswerable as it relates to consumer spending is what level of spending is the “New Normal?”

As far as the investment community is concerned, the “New Normal” is not levered long, and does not include concentrated, activist investing. Traditional Hedge funds and Fund of Funds are not part of the “New Normal.” Business models that provide leadership, accountability and trust will be part of the “New Normal” within the investment community. The game is changing every day and we are here to play. Welcome to the “New Normal.”

Ironically, in 2004, Roger McNamee authored a book called ‘The New Normal.’ At the time, he said The New Normal is a time of risk and uncertainty, but it also offers unprecedented rewards for the bold. He also says that back in the 40s, 50s, and 60s, it was fairly easy to plan for a secure future. People picked a career, a spouse, and a place to live, and those basic decisions put them on a predictable course for the rest of their lives, especially if they were lucky enough to land at a big corporation with great benefits and smart enough to buy stocks. In the 1990s and early 2000s, technology and global competition transformed the world, and the bull market lulled people into thinking they were in control of their lives.

Today, the new normal of the 40s, 50s and 60s is looking like a great place to be. The “New Normal” of 2009 is nothing like we have ever seen.

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.


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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


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.

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