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Irresponsibility In Recommendation

"In addition to trying to determine how to make money one must also try to keep from losing money. It is almost as important to know what not to do as to know what should be done."
-Jesse Livermore
 
Shorting this market because the Bears keep saying it's "overbought" does not fit within the parameters of what I would consider understanding Livermore's "WHAT NOT TO DO"... Selling your long positions into a proactively prepared plan, however, will continue to keep you from losing money. That's what risk managers do.
 
Plenty of Portfolio Managers in this game proclaim that they do not "trade"... but do they manage risk? I think a lot of people are starting to... but are they doing it within the construct of what's already happened, or what has the highest probability of happening next?
 
I am no longer a money manager. Unlike Goldman, I like the idea of my clients making money doing what it is that they do, while I do what I do. There is responsibility in recommendation.
 
Like the sun rising in the East, one can proactively predict that the perma-bears of this stock market are going to say that we're "overbought", and... at a price... we are. That's why I issue risk/reward ranges for our clients to manage risk around. On Friday, I issued an immediate term TRADE target for the SP500 at the 874 line. When we hit that line midday, I sold into it. Unlike "Level 3 Asset" accounting, my process isn't that complicated to follow.
 
My risk management plan in today's globally interconnected marketplace of colliding macro factors is quite simply that the plans are going to change. It's both un-objective and reckless to take a dogmatic view that one is either perpetually bullish or bearish.  
 
For certain, a broken clock will be right at least 2 times in a day. Alan Abelson at Barron's has made a career understanding that math. In an investment community where 97% of the ratings from the sell side's investment bankers are NOT sell, it's not that hard to sound like a contrarian when one has a weekly pamphlet to capture people's attention with on Saturday mornings.
 
Last month Abelson was all beared up on China. This morning, the facts on the tape are flashing China closing up another +2.1% overnight to a new year-to-date high of +40.4%. Sure, the Bear Bubble boys will be quick to remind us all that they "don't trust China's numbers"... and that's all good and fine, because the Chinese don't trust our American irresponsibility in investment recommendation either.
 
Alan Abelson is a fantastic writer, and I have learned a great deal from him over the years, including what not to do. The folks over at Barron's are seemingly training Mike Santoli to take over the conch once Alan retires. Santoli is just another man who has never managed an amount of money of consequence who is going to tell the world what to do with theirs - just what we need. This weekend, Santoli's take on the +28.6% REFLATION of the SP500 from the March 9th lows has been "Too Far, Too Fast" - gee, thanks for the memo, man.
 
The New Reality is this: Bear Bubbles are equally as relevant as those that we called out as liabilities for the Bulls 18 months ago. Bubbles are measurable and so are the walls of worry that are associated with them. Managing risk works both ways.
 
The manic media's latest meme is to preface all sell side analyst questions with "in your view..." (implying that the rest of the conflicted firm one works for doesn't have the same view). For the immediate term TRADE, what's my view? My view is that what it was Friday morning - as we scale towards 874 on the SP500 it was time to scale out of longs and lay out some shorts. On Friday I shorted McDonald's (MCD), Starwood (HOT), and Coke (KO); and I sold out of long positions I'd been carrying in Whole Foods (WFMI), Sherwin Williams (SHW), Dick's Sporting Goods (DKS), and the Basic Materials and Canadian ETFs (XLB and EWC).
 
Does that make me a bear? Or was being long these 5 positions as the SP500 was locking down its 6th consecutive week of gains make me a bull? I really have no idea, so maybe I'll let the savants who don't have responsibility in their recommendations label me what they may.
 
Could the US market pullback? I sure hope so because, like my beautiful wife Laura, I love buying stuff on sale. In my Asset Allocation Model (just ETFs), I've sold down my invested position in equities to a point where I have ample ammo to be buying red.
 
Squeezy The Shark is awaiting the short seller of everything Depressionista down at the SP500 depths of 846 and 819. Respectively, those chum lines are -2.6% and -5.7% below Friday's closing price. All the while, on any down day, the Bear Bubble boys can say what they're always going to say... and we men and women who take responsibility in recommendation will be thanking them for teaching us what not to do.
 
Best of luck out there this week,
KM
 

LONG ETFS

EWZ - iShares Brazil- The Bovespa is up 21.9% YTD and continues to look positive on a TREND basis. President Lula da Silva is the most economically effective of the populist Latin American leaders; on his watch policy makers have kept inflation at bay with a high rate policy and serviced debt -leading to an investment grade credit rating. Brazil has managed its interest rate to promote stimulus. The Central Bank cut 150bps to 11.25% on 3/11 and likely will cut another 100bps when it next meets on April 29th. Brazil is a major producer of commodities. We believe the country's profile matches up well with our re-flation theme: as the USD breaks down global equities and commodity prices will inflate.

XLY - SPDR Consumer Discretionary-TRADE and  TREND remain bullish for XLY.  The US economy is showing faint signs the steep plunge in economic activity that began last fall is starting to level off and things are better that toxic.  We've been saying since early January that housing will bottom in 2Q09 and that "free money" for the financial system will marginally improve the US economy in 2H09, allowing early cycle stocks to outperform.  The XLY is a great way to play the early cycle thesis.

EWA - iShares Australia-EWA has a nice dividend yield of 7.54% on the trailing 12-months.  With interest rates at 3.00% (further room to stimulate) and a $26.5BN stimulus package in place, plus a commodity based economy with proximity to China's H1 reacceleration, there are a lot of ways to win being long Australia.

XLK - SPDR Technology - Technology looks positive on a TRADE and TREND basis. Fundamentally, the sector has shown signs of stabilization over the last six+ weeks.   As the world demand environment becomes more predictable, M&A should pick up given cash rich balance sheets in this sector (despite recent doubts about an IBM/JAVA deal being done).  The other big near-term factors to watch will be 1Q09 earnings - which is typically the toughest for tech, along with 2Q09 guide.  There are also preliminary signs that technology spending could be an early beneficiary of the stimulus plan.

TIP - iShares TIPS- The iShares etf, TIP, which is 90% invested in the inflation protected sector of the US Treasury Market currently offers a compelling yield on TTM basis of 5.89%.  We believe that future inflation expectations are currently mispriced and that TIPS are a compelling way to own yield on an inflation protected basis, especially in the context of our re-flation thesis.

USO - Oil Fund-We bought oil on 3/25 for a TRADE and are positive on the commodity from a TREND perspective. With the uptick of volatility in the contango, we're buying the curve with USO rather than the front month contract.  

DJP - iPath Dow Jones-AIG Commodity -With the USD breaking down we want to be long commodity re-flation. DJP broadens our asset class allocation beyond oil and gold. 

GLD - SPDR Gold-We bought more gold on 4/02. We believe gold will re-assert its bullish TREND as the yellow metal continues to be a hedge against future inflation expectations.

DVY - Dow Jones Select Dividend -We like DVY's high dividend yield of 5.85%.


SHORT ETFS

LQD  - iShares Corporate Bonds- Corporate bonds have had a huge move off their 2008 lows and we expect with the eventual rising of interest rates in the back half of 2009 that bonds will give some of that move back. Moody's estimates US corporate bond default rates to climb to 15.1% in 2009, up from a previous 2009 estimate of 10.4%.

SHY - iShares 1-3 Year Treasury Bonds- If you pull up a three year chart of 2-Year Treasuries you'll see the massive macro Trend of interest rates starting to move in the opposite direction. We call this chart the "Queen Mary" and its new-found positive slope means that America's cost of capital will start to go up, implying that access to capital will tighten. Yield is inversely correlated to bond price, so the rising yield is bearish for Treasuries.

EWU - iShares UK - We shorted the UK on 4/08. We're bearish on the country because of a number of macro factors. From a monetary standpoint we believe the Central Bank has done "too little too late" to manage the interest rate and now it is running out of room to cut. The benchmark currently stands at 0.50% after a 50bps reduction on 3/5. While the Central Bank is printing money and buying government Treasuries to help capitalize its increasingly nationalized banks, the country has a considerable ways to go to attain its 2% inflation target. GDP declined 1.5% in Q1, unemployment  is on the rise, and housing prices continue to fall.

EWL - iShares Switzerland - We shorted Switzerland on 4/07 and believe the country offers a good opportunity to get in on the short side of Western Europe, and in particular European financials.  Switzerland has nearly run out of room to cut its interest rate and due to the country's reliance on the financial sector is in a favorable trading range. Increasingly Swiss banks are being forced by governments to reveal their customers, thereby reducing the incentive of Switzerland as a tax-free haven.

UUP - U.S. Dollar Index -We believe that the US Dollar is the leading indicator for the US stock market. In the immediate term, what is bad for the US Dollar should be good for the stock market. The Euro is down versus the USD at $1.2957. The USD is down versus the Yen at 98.7370 and up versus the Pound at $1.4571 as of 6am today.

EWJ - iShares Japan -We re-shorted the Japanese equity market rally via EWJ. This is a tactical short; we expect the market there to pull back when reality sinks in over the coming weeks. Japan has experienced major GDP contraction-it dropped 3.2% in Q4 '08 on a quarterly basis, and we see no catalyst for growth to return this year. We believe the BOJ's recent program to provide $10 Billion in loans to repair banks' capital ratios and a plan to combat rising yields by buying treasuries are at best a "band aid".

XLP - SPDR Consumer Staples- Consumer Staples broke out of the TREND line resistance. This group is low beta and won't perform like Tech and Basic Materials do on market up days. There is a lot of currency and demand risk embedded in the P&L's of some of the large consumer staple multi-nationals; particularly in Latin America, Europe, and Japan.


GAMING REGIONALS: THE FALLACY OF EV/EBITDA

I recently read a BYD valuation downgrade by a sell side analyst based on a high relative valuation.  The valuation analysis was performed using EV/EBITDA, the industry standard, and concluded that BYD's multiple of 7.6x was too high relative to the competitors at around 6.5X.  This superficial analysis fails to take into account that BYD's free cash flow yield is more than twice that of its nearest competitor, when normalized for true ongoing interest cost.

 

EV/EBITDA fails to capture the big disparity in true borrowing costs.  ASCA and PNK face refinancing risk due to maturities of credit facilities and/or bonds over the next 1-2 years.  BYD, on the other hand, has no maturities until 2013.  BYD's average interest rate should stay at 2% above LIBOR (assuming no covenant breaches) while the other companies will experience rates 2-3 times that rate.  This is a phenomenal asset that EV/EBITDA cannot capture.  ISLE is in a very similar position to BYD with no large maturities until 2013.

 

In the table below, we've calculated the implied EV/EBITDA multiple assuming a constant 15% free cash flow yield across the sector.  Additionally, we've included implied target prices at those multiples.  Our analysis considers true interest cost assuming credit facility amendments and extensions based on reasonable comps. 

 

GAMING REGIONALS: THE FALLACY OF EV/EBITDA - FCF COMPS

 

Other factors to consider:

  • BYD - This FCF yield is too attractive to pass up unless you believe the company will trip its leverage covenant this year. In that scenario, BYD's interest cost would rise and its $2bn in borrowing capacity would be sharply reduced. If BYD can get through 2009, as we think it will, the likelihood of a covenant breach diminishes greatly due to the quarterly step up (a quarter turn per quarter through the end of 2010) in the maximum leverage ratio beginning in Q1 2010. BYD has a lot of levers to pull, however, including maintenance capex cuts and deleveraging bond buybacks. Based on valuation, BYD looks like the most attractive long-term play in gaming.

 

  • ASCA - The stock looks fairly valued on FCF yield when considering the likely higher interest cost associated with refinancing its credit facility due in November 2010. ASCA is likely to hit the high yield market sometime this year and we estimate a 15% coupon. However, Q1 is likely to be a blow-out quarter and estimates should go higher. We continue to like ASCA into the Q1 earnings announcement on 4/29.

 

  • ISLE - ISLE looks very attractive on a FCF yield basis. While the company maintains the highest leverage (7.5x) among the regionals and its competitive positioning is the weakest, ISLE does not have any material maturities until 2013. Next to BYD, ISLE may be the most attractive long-term gaming stock.

 

  • PNK - PNK looks very similar to ASCA. Reasonable leverage but fairly valued on a FCF basis. PNK will likely be in the market to amend its credit facility which means interest cost will rise. This is reflected in our projection. The positive catalyst for PNK is also the Q1 earnings announcement. In addition to very strong earnings, PNK may scale back or delay development due to the rising cost of capital. This should be taken positively by investors.

 

  • PENN - PENN looks fairly valued based on FCF yield. To be fair, we are assuming PENN makes an acquisition to utilize its borrowing capacity at its current bank rate. PENN is underleveraged which penalizes its current free cash flow yield. We assume almost 20% accretion to free cash flow on a $1.25bn acquisition at 6.5x EBITDA. Under this assumption, PENN's yield rises to 13%, still below our industry target of 15%. PENN is a terrific company with a great management team. However, it is the Wall Street darling of gaming right now and the valuation looks full.

 

GAMING REGIONALS: THE FALLACY OF EV/EBITDA - STOCK APPRECIATION TO 15  YIELD


A New Secular Trend You Can’t Ignore

I think that the General Growth bankruptcy filing is only the tip of the iceberg as it relates to what is to come for retail and content distribution. With landlords under duress and acting irrationally leading up to the bankruptcy filing, and with cost of capital on the rise for those retailers and brands who would otherwise buy store locations themselves, the smart CEOs are sitting in their war rooms planning how to reach the consumer regardless of what happens in the world of real-estate. Of course, they're playing catch-up to the best management teams who proactively prepared for this years ago.


The one and only answer? Invest in content to boost relevance with the core consumer while simultaneously investing in direct/virtual distribution. Create a ‘pull model' where the consumer comes to you, and have a dot.com platform that enables conversion into dollars.


Keep in mind that this is easier said than done. Most legacy wholesale models are streamlined and efficient, but are good at processing one shipment of a thousand units, but are structurally not set-up for a thousand shipments of one unit.


Companies that have invested in this regard over the past 1-3 years include Nike though (still too early to get involved for other reasons), Ralph Lauren (check out the Ralph Lauren iPhone app), and Lululemon (launching dot.com right now).


We'd also highlight less obvious companies that have a particularly strong fulfillment platform, such as Williams-Sonoma, and Zappos. Amazon.com, of course, remains the gold standard from a fulfillment standpoint. Offerings from FedEx and UPS are increasingly helping the brands without bricks and mortar step up fulfillment operations, we prefer those that have organically built and perfected their own proprietary systems.


We think that this theme will play a massive role in the upcoming wave of industry consolidation - both in bankruptcies and M&A. We'll be going deeper and deeper into this theme in the coming weeks to ferret out t he winners vs. losers.


Here's an analysis of a collection of retailers as ranked (by us) in terms of both shopability and brand consistency.


A New Secular Trend You Can’t Ignore - .com Matrix

 

 


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HARRAH’S: A FORMERLY FORMIDABLE COMPETITOR

I have pity for the Harrah’s General Managers that must contend with old and uncompetitive slots and thinning carpets.  Unkempt casinos wear pretty quickly with the tremendous volume of visitors.  This seems to be happening at an accelerated pace at Harrah’s casinos across the country.  Casinos should spend 5-6% of their revenues (including slots) in maintenance Capex.  I estimate Harrah’s is spending 1-2%.  Compounding the problem for Harrah’s is its (formerly) stellar reputation for well maintained properties.

Harrah’s competitors should continue to steal share.  The following chart details Harrah’s major competitors and the percentage of their EBITDA derived from properties competing with Harrah’s.  ASCA is the clear winner with 74% of its property EBITDA generated at properties in direct competition with Harrah’s.  PNK, BYD, and PENN also maintain significant exposure to Harrah’s at 44%, 34%, and 33%, respectively.

HARRAH’S: A FORMERLY FORMIDABLE COMPETITOR - HARRAH S OVERLAP


Is China Advocating For The Bancor? Could Be BIG For Commodities

Keith and I spent the last few days talking Macro with some of the big boys in Boston.  Not surprisingly, and as usual, the large Boston funds are ahead of the curve and asking many of the right questions.  China was a focus, particularly as it relates to her need, or want, for commodities. Specifically, there was a good deal of discussion about copper, or Doctor Copper, as we like to call the industrial metal.

 

We noted the increased demand for copper from China this year in a note earlier this week, entitled “The Good Doctor Copper”:

 

“Coincident with this increase in copper prices are data points supporting improving fundamentals from The Client (China).  Preliminary reports out of China suggest that Chinese copper scrap supply may drop 700,000+ tons this year.  The implication of this is that copper imports will have to increase, and perhaps dramatically, to offset the decline in copper scrap.   March Chinese copper imports jumped to a record high of 374,957 tons, which could be the beginning of a longer term trend of increased imports from The Client.”

 

In the chart below, I’ve outlined the Chinese import data for the last 12-months.  In aggregate the last four months have seen a real spike in imports.

 

Is China Advocating For The Bancor? Could Be BIG For Commodities - aaadddd

 


As we were discussing the case for copper on our trip earlier this week, the key debate on the copper bull case was in trying to determine the key source of demand for copper.  Was it physical demand, financial demand, or an emerging view of how the Chinese believe, or are advocating, the world financial system be ordered in the future?  Daily we get more evidence that Chinese demand for copper, and other commodities, may be driven by motives other than intermediate term needs for the physical commodity.  Specifically, Dr Zhou Xiaochuan, who is in charge of monetary policy for China, recently wrote the following in an essay that was posted on the website of the People’s Bank of China:

 

“Though the super-sovereign reserve currency has long since been proposed, yet no substantive progress has been achieved to date. Back in the 1940s, Keynes had already proposed to introduce an international currency unit named “Bancor”, based on the value of 30 representative commodities. Unfortunately, the proposal was not accepted.” (Emphasis is Research Edge’s.)

 

The Bancor was a world currency unit proposed by John Meynard Keynes in the negotiations establishing the Bretton Woods Agreements.  The idea was that the Bancor was to be fixed to 30 commodities, of which gold was one.  Keynes’ believe was that such a currency would stimulate domestic demand and promote global trade balances.  Ultimately, Bretton Woods took a different path and used gold, solely, as the basis by which countries pegged and valued their currencies.  As we know, Bretton Woods collapsed in 1971, after the United States acted alone to terminate conversion of dollars to gold.  The result of this was that the U.S. dollar effectively became the world’s reserve currency for those countries that were signatories to Bretton Woods.

 

Obviously there was a series of events that led to the Bretton Woods agreement, most notably a global economic depression and World War 2.   Additionally, as the only true global superpower, the U.S. was able to take the lead in these negotiations and in managing global monetary affairs.  While the US still has the role as a superpower, the world is in a much lower state of duress, so a complete overhaul of the global financial system seems unlikely.  Nonetheless, the Chinese are clearly stockpiling copper well beyond their immediate term physical needs and in a world where copper, and other metals, are the basis for the valuation of world currency, financial demand for copper could continue to increased dramatically.

 


Daryl G. Jones
Managing Director


YUM – LOTS OF QUESTIONS

YUM is scheduled to report Q1 earnings next week.  This is what we know:

2009 guidance of at least 10% EPS growth relies largely on a U.S. recovery.

The company is expecting U.S. operating profit growth of about 15%, or at least 5% excluding the impact of the planned $60 million in G&A savings.

U.S. operating profit growth has been flat to down for the last six years with YUM posting its largest decline in 2008 of down 6% so YUM definitely has easier comparisons working to its benefit in 2009, but this has not helped in the past.

KFC has been the biggest drag on U.S. operating performance as Taco Bell (60% of U.S. operating profit) and Pizza Hut both grew operating profit in 2008.  In the fourth quarter, KFC same-store sales declined 3% while Taco Bell increased 9% and Pizza Hut fell 1%. 

YUM needs both its Pizza Hut and KFC brands to perform in 2009 to meet its 15% operating profit growth goal.  And, as YUM management highlighted on its Q4 earnings call, both concepts were off to a slower than expected start in January “because these brands focus on the higher-end ticket dinner occasion, which are under the most pressure due to customers  doing more cooking at home.”  Management also said that KFC January sales were extremely poor.   The company has since launched its first ever nationally advertised value menu at KFC and expects its Kentucky Grilled Chicken launch in Q2 to turn things around for KFC in 2009.  I am still not convinced that this will happen.

Pizza Hut started the year out slow and although management seems convinced that its new focus on pasta and chicken wings “will totally transform the Pizza Hut brand over time,” for now, it is still called Pizza Hut and pizza sales/traffic matter.  That being said, according to NPD data, QSR pizza trends do not look good.  QSR pizza category traffic declined in both January and February.  This is not that surprising as traffic has declined on a YOY basis every month for the last two years, but the 2-year average trend steepened its declines in both January and February. This does not bode well for Pizza Hut in Q1. 

YUM – LOTS OF QUESTIONS - QSR Pizza Traffic Feb 09

Domino’s has said in the past that irresponsible industry price increases are largely to blame for pizza traffic declines, which is made evident by the chart below that shows that QSR pizza traffic generally falls off as average check increases.  The industry has apparently not yet learned this lesson as the large average check increases in January and February coincided with the accelerated traffic declines.  YUM management did say that it was not assuming any price increases at Pizza Hut in 2009, which could help its traffic trends somewhat relative to the industry…we will have to wait and see what impact this has on margins.

YUM – LOTS OF QUESTIONS - QSR Pizza Traffic and Check Feb 09

U.S. same-store sales at Pizza Hut and KFC will most likely extend their Q4 declines into Q1.  Management did its best to set the bar low for U.S. performance in Q1, however, saying that much of its U.S. plans are back-end loaded, the majority of full-year commodity inflation is expected in Q1, G&A restructuring benefits will not be fully realized until Q2 and the Kentucky Grilled Chicken launch, which it recognizes as a big catalyst for U.S. improvement, is not until Q2. 

I don’t expect YUM to miss numbers but as always the quality of EPS will be low.  Domestically, KFC is terminal; Pizza Hut is struggling (along with the category); that leaves Taco Bell to carry the day domestically.  With the USA representing more than 40% of operating income, I’m not going to take that to the bank.  Given the commentary from MCD and BKC, the international markets have slowed significantly, which suggests that YUM international will post some very punk numbers.  That leaves YUM’s Holy Grail, China, to save the day; China looks like it will be a challenge, too (please refer to yesterday’s post titled “YUM – China, Not Without Issues” for more details ).

YUM – LOTS OF QUESTIONS - YUM EBIT Margin 4Q08


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