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COST OF CAPITAL DRIVES LODGING MULTIPLES

Lodging EV/EBITDA multiples appear to inversely track cost of capital more closely than for gaming operators.  Not only is the R Square higher but there is no lag on the causal relationship.  In other words, cost of capital changes get immediately reflected in the lodging multiple.  One explanation for this might be the real estate nature of the lodging business.  As bond yields rise, high dividend stocks tend to underperform.  REIT's pay large dividends.

 

COST OF CAPITAL DRIVES LODGING MULTIPLES - lodging multipls vs yields

 

So where does that leave the multiples?  As can be seen on the chart, at the end of April trailing EV/EBITDA multiples were close to historical lows.  This seems appropriate given the sharp rise in borrowing costs.  However, industry EBITDA may be down 35% in 2009 and another 10% in 2010 which renders the trailing EV/EBITDA somewhat irrelevant.  Here we defer to our prior analysis that found forward lodging multiples to be reasonable at best, even if 2009 is trough EBITDA (we don't think it is).  HOT and MAR are trading at 10.5x and 11.5 our 2010 EV/EBITDA estimates, respectively.


KONA: Penney Nails Another One!

The stock is up over +72% today on a takeout offer. Howard Penney is having what we call a BIG year!
KM


Chart Of The Week: Consumption Candy

 

Lost in last week's noise was the context of this critical chart. Consumer Price Inflation (CPI) for the month of April hit its lowest year-over-year level since 1955. Been shopping for a house or pair of oven mitts lately?

 

Does it matter? Don't ask your local short seller of everything consensus on the US Consumer - ask the stocks - they don't lie. Inclusive of today's +3.75% short squeeze remix of the Consumer Discretionary dance (XLY), this sector is up +6.5% for 2009 to-date. Being right on this sector (not being short) has made for big years for plenty a Research Edge subscriber. We salute you!

 

So should I fear my own crash call that I used to make on this sector, or should I smile? Days like today are a stiff reminder to the consensus crowd that their ideas are just that; and quantified by nosebleed levels of short interest. The New Reality is that our bearish catalyst on Consumer stocks for most of 2007-2008 now becomes a bullish one - it's called an "easy compare."

 

The end of 64 consecutive quarters of positive US Consumer Spending is now way back in the rear view mirror and, importantly, the negative "comps" associated with that positive spending streak going negative (Q3 and Q4 of 2008) is front and center on our macro screens.

 

What could spoil a recovery in nominal consumer spending? That's easy - and anyone not sleeping under a rock right now has the answer = INFLATION.

 

When does the macro short seller of everything consumer on 1970's style inflation get paid? Mostly in 1979, and maybe in 2010... but not right here and now in 2009. I am an avid short seller, and I assure you that I will be there when I think the time is right.

 

Looking at the chart below should give one a real sense of where the deflationary numbers really are for the US consumer as opposed to the rhetorical and consensus fears. These consumer prices, to the strong and the brave who wear the red, white, and blue (sans le leverage), are what we call Consumption Candy.

KM

 

Keith R. McCullough
Chief Executive Officer

 

Chart Of The Week: Consumption Candy - fed1


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Where There’s Smoke… Notes for the Week Ending Friday, May 15, 2009

 

Citi For Conquest

 

Those who cast the votes decide nothing. Those who count the votes decide everything.

                             - Josef Stalin

 

Last week, two of Citigroup's directors won re-election to the board despite the fact that more shareholders voted against them than voted for them.

 

C. Michael Armstrong, former CEO of AT&T, and John M. Deutch, former CIA chief, were both voted down by the shareholders, yet were re-instated thanks to broker votes. In this Brave New Age of corporate governance, how could this be?

 

A little history is in order.  Most stock owned by investors is held by stock brokers in what is called "In Street Name," an antiquated holdover from the days of paper stock certificates.  Here's the SEC's definition:  "When you buy securities through a brokerage firm, most firms will automatically put your securities into 'street name.' This means your brokerage firm will hold your securities in its name or another nominee and not in your name, but your firm will keep records showing you as the real or 'beneficial owner.' You will not get a certificate, but will receive an account statement from your broker showing your holdings."

 

In the days of paper record keeping, stock certificates were held in the vaults of the brokerage houses.  Runners carted canvas bags of stocks, bonds and checks from one brokerage office to another.  The "Delivery" part of the trade cycle was literal, as actual pieces of paper changed location daily.  In 1968, NYSE trading volume picked up, creating the "Paperwork Crisis."  Member firms took on extra staff and worked round-the-clock to process trades.  

 

Throughout that year, as trading continued to surge, things spun out of control.  Over the summer, the entire NYSE shut down on Wednesdays so clerical staff could catch up with trade settlements.  Major firms teetered and were forced into distressed sales just to survive.  The system very nearly collapsed entirely.

 

In general, stock registered in Customer Name created bottlenecks.  "Street Name" shares were fungible, enabling brokers to deliver and receive any batch of certificates to complete a transaction.  When registered shares were sold, the actual certificates had to be pulled and the customer had to sign the share certificates or a Stock Power to make the certificates negotiable.

 

Brokerage houses kept lists of the beneficial owners of all shares held in street name, and periodic tallies were performed in the vault to make sure the number of shares reflected on the customer lists matched the number of shares held physically.

 

But there were also benefits.  A major broker holding millions of shares for its customers and correspondents could complete trades by making journal entries.  The cost of physically pulling and delivering certificates was a savings pocketed by the brokerage firm, not passed through to the customer.  Also, stock held in margin accounts is automatically placed in street name, which makes it available for the broker to loan for short sales - a highly profitable activity for a clearing firm.

 

In the modern age of electronic record-keeping, why do we still have this practice?

 

In a recent interview (www.metrocorpcounsel.com, 4 May, "Systemic Defects In Proxy Voting Machinery Undermine Good Corporate Governance") Cary I. Klafter , Vice President, Legal and Corporate Affairs and Corporate Secretary, Intel Corporation, discussed NYSE Rule 452, which currently permits brokers to vote unvoted customer shares on "uncontested" corporate matters. As we understand it, the definition of "uncontested" includes incumbent directors who run unopposed - even if it is known that a majority of shareholders will vote against reinstatement.

 

Klafter says "Survey data shows that many retail voters assume that the broker will vote account shares for them as customers, and as a result they believe they have no need to vote on an individual basis."  Institutions do vote, says Klafter, because professionals understand the value of their vote, and many are required to by law.  Still, this leaves quite a lot of shares up for grabs.

 

How much is "quite a lot"?

 

Citing figures from Citi's quarterly report, NY Times Chief Financial Correspondent Floyd Norris writes (http://norris.blogs.nytimes.com/, 11 May, "Democracy Citigroup Style") "A year ago, there were 1,051,171,152 broker votes. For whatever reason, fewer shareholders felt like voting this year."  This year, 1,732,444,835 broker votes trumped the 1,116,831,414 actual shareholder votes against Mr. Armstrong.  Mr. Deutch, who had 1,082,994,711 votes cast against him, also benefited from street name shares, winning a total of 2,763,632,744 votes, including those cast by brokers.

 

Crain's New York Business (11 May, "Surprisingly Big Vote for Citigroup Board") reports "the American Federation of State County & Municipal Employees... lobbied investors to vote against directors who served on Citi's risk and audit committees, including former CIA director John Deutch, Xerox Chief Executive Anne Mulcahy and Dow Chemical CEO Andrew Liveris.  The campaign also was endorsed by influential proxy-voting advisory firms, including Risk Metrics, Glass Lewis, Proxy Governance and Egan-Jones."

 

Crain's says "If only votes where shareholders made their opinion known were counted, then 54% were against Mr. Armstrong and 51% against Mr. Deutch and the directors would have had to submit their resignations under Citi's rules."

 

This is a fairly appalling result.  We are not privy to the closely-guarded Depository Trust Clearing Corporation statistics, showing who holds what, but we would dearly love to know how many Citi shares are held in street name at Citi itself.

 

Finally, in keeping with our practice of Debating the Debate, this first came to our attention in Floyd Norris' blog, dated 11 May, and  Crain's New York Business has an item of the same date.  The Financial Times dutifully reported it as front-page news the following morning.  We searched the Wall Street Journal in vain for any mention of this vote.  We will accept it as coincidence that the WSJ reported (20 March, "Remodeling Flap for Citigroup") that Citigroup might be planning a reverse stock split, a strategy that is historically a disaster for shareholders.  The WSJ not only described the plan favorably, describing the benefits that a reverse split would have for Citi shareholders, but misstated the facts of a reverse split and its attendant effect on shareholder value.  Apparently someone pointed out the howler, because three days later (23 March, "Reverse Stock Splits: Good Idea, In Theory") the Journal ran an article reporting on what really happens in such transactions.  We wonder - why would the Journal be coddling Citigroup?

 

 

Voting With Someone Else's Pocketbook

 

We in America do not have government by the majority. We have government by the majority who participate.

                             - Thomas Jefferson

 

The SEC has brought the first case under the proxy voting rules, introduced in 2003 and designed to ensure that advisers vote in their investors' best interests.  Our first observation has nothing to do with this case, but rather with the volume of publicly announced actions since Chairman Schapiro came on board.  Emulating the recent successes of our military, the SEC looks to be putting on a surge of its own.  While it is too early to tell, this supports the theory we have heard from SEC apologists, that there have been lots of good people inside the Commission, with lots of investigations teed up and ready to go, and who were being held back by the policies of Chairman Cox.  Chairman Schapiro appears to have unleashed a wave of pent-up investigations.

 

While we admit to being cynical, we recognize that many actions brought by the SEC have merit. Indeed - says the cynic in us - if even the SEC catches it, they must have done something wrong!

 

Intech Investment Management, a division of Janus Capital, has run afoul of the 2003 rule requiring investment advisers to employ proxy voting procedures designed to guard their investors' best interests.

 

The SEC did not allege specific wrongdoing, but charged that Intech adopted a third-party proxy-voting service that favored one set of investors, without disclosing this to the rest of its investors.  The Denver Business Journal - Denver being home to Janus - reports (8 May, "EC Charges Janus Unit Intech With Proxy Voting Rule Violations") "The release said Intech selected the guidelines favored by the union at the same time it was participating in the annual AFL-CIO Key Votes Survey, which ranked investment advisers' adherence to AFL-CIO recommendations on certain votes."

Sounds like a conflict of interest that even a regulator could spot.

 

Hedge funds, of course, occupy a cherished spot in the hearts of both regulators, and the public.  They have so long flown above the heads of the hoi polloi, that the polloi are now eager to see them brought low.  It is, of course, reasonable to expect that professional investors would exercise greater than average diligence, and the voting process is a key part of the interaction between the shareholder and the company.  Shareholder engagement in corporate governance is the capitalist poster child for Jefferson's dictum regarding "government by those who participate."

 

Regarding the Citi story reported above, it should be noted that there is no equivalent rule covering brokers' voting of unvoted customer shares.  Brokers vote street name shares in one of two ways: sometimes they mirror the percentage distribution of actual votes received from shareholders.  More often, they vote straight-line with management recommendations.  The logic would appear unassailable: if investors still own the stock, they must agree with what management is doing.

 

The silver lining for Wall Street is the way in which this practice feeds into the Old Boys' Club of corporate finance.  The Financial Times (11 May, "Stress Tests Unleash Fee Bonanza") reports that "financial institutions [are] set to earn more than $500m in just a few weeks for helping rivals raise equity to plug capital shortfalls and repay federal aid." 

 

On May 11, for example, US Bancorp - a TARP funds recipient - announced a $2.5 billion common stock offering.  The joint bookrunners on the deal are Goldman Sachs, and Morgan Stanley.  As observed by the FT article, the syndication of these TARP-related transactions is a big fat goose, and the supply of golden eggs will be limited only by the imagination of the participating bankers.

 

We are trying to imagine the conversation between an investment banker and a former underwriting client, in the unlikely event the banker's firm decided to vote its street name shares in the "best interests" of the shareholders.  Say, by voting against the incumbent Citigroup directors.  We encourage you to join us in this exercise.

 

The SEC has announced its intention to scrap the practice of broker voting, probably effective January 2010.  The corporate world is throwing up every roadblock it can, starting by urging the SEC to exercise restraint and asking for a comprehensive review of proxy voting issues.

 

Corporate governance issues lie at the heart of America's problems - and the world's.  We wish Chairman Schapiro luck with this one.

 

 

I, SIGTARP

Do, or do not.  There is no "try".

                             - Yoda

 

Our proposed pamphlet from the Government Printing Office would explain the acronyms used by the government.  In our hallucination, it would be aptly titled "Federally Used Citations: Knowledge of Uniform Procedures".

 

The current edition would include this Washington offering: the SIGTARP.

 

This sounds like the regent of a warlike planet, come from a distant galaxy to forge an alliance with Darth Vader and the Empire.  It is, in fact, an assistant US Attorney from New York who has been tapped to be Special Inspector General for the Troubled Asset Relief Program. 

 

His name is Neil M. Barofsky.  As acronyms go, we agree with the government's decision to give him a galactic-sounding name.  How would you pronounce "NMB"?  We can not imagine anyone being thrown into a state of panic upon receiving a phone call from the office of "the Federal Numb".

 

Those doubting the relentless creativity of capitalism should look to the SIGTARP's second quarterly report to Congress, presented last month.  With the ink barely dry on Secretary Geithner's appointment, the Office of the SIGTARP is already running no fewer than 20 criminal investigations into the misuse of TARP funds. 

 

Speaking at the American Bar Association National Institute on White Collar Crime, Barofsky said the FBI projects that it will pursue some $300 billion in TARP-related criminal schemes.  "Copycats of the same old mortgage fraud are being reinvigorated by this influx of government money," said Barofsky, and warned that TARP fraud could lead to multiple convictions, including securities fraud, mail fraud, wire fraud, tax fraud, theft of government funds, and insider trading.

 

The SIGTARP is also conducting a review of all TARP recipients' use of government funds and six large-scale audits of TARP programs including an examination into TARP recipients' compliance with executive compensation limitations.

 

Barofsky stated that all TARP recipients must be required to detail how the monies are used.  It's about time, if excessively obvious.  Yet, we have faint hopes for this key notion.  The SIGTARP does not have the authority to make disclosure a binding requirement, but must make this recommendation to Treasury Secretary Geithner. 

 

As assistant US Attorney for the Southern District in New York, Mr. Barofsky worked in the international narcotics trafficking unit.  Subsequently, he was named chief of the mortgage fraud group and also acted as lead prosecutor in the securities fraud unit.  He was brought in as SIGTARP with high expectations, having been described in the press as "a letter-day Elliot Ness."  People who worked with him in the past describe their former colleague as "determined", "hard-nosed", "scrupulously prepared", and "honest."

 

Contemplating the mountain of current and projected TARP fraud facing him, Mr. Barofsk mused, "I think we're going to be around for a long time."

 

May the Force be with him.

 

 

 

 

"Where There's Smoke" Competition

 

In a new version of an old parlor game, we offer two quotes from one of this week's major news stories.  One of them is real.  The other, we made up.  The first reader to correctly identify which is an actual quote will have the satisfaction of being the winner of this week's competition. 

 

"I never said that I didn't say that I hadn't said what I wouldn't say about torture."

  • - Speaker of the House Nancy Pelosi

 

"It is not the policy of this Agency to mislead the United States Congress."

  • - CIA spokesman George Little

 

Don't feel bad if you get it wrong.  After we looked at them for a few minutes, even we could no longer tell which was which.

 

 

Pay To Pay To Play

I may have to go back to loansharking, just to take a rest.

                             Chili Palmer, "Get Shorty"

 

What do two of the most highly-regarded financial firms in history have in common?  Besides clout, cash, and their storied pasts, both Goldman Sachs and the Carlyle Group wrote small checks this week to rid themselves of the proverbial Meddlesome Priest.

 

In Goldman's case, it was the State of Massachusetts.  The Financial Times headline (12 May, "Goldman Agrees $60 Million Subprime Deal With Massachusetts Regulator") is a bit misleading.  The Massachusetts Attorney General said Goldman "played a role in predatory lending associated with the subprime market," and was investigating Goldman for its participation in "unfair and deceptive lending practices involving subprime mortgages."

 

Goldman agreed to forego $50 million in existing loans - which meant writing off unpaid balances - and paid an additional $10 million to the State.  Unlike the resolution of securities cases we are used to, there was no formal charge from the State, and the "settlement" was a payment, plus an agreement to cooperate with the State going forward.  Since there had been no formal charge, there was no consent decree - you know, "while they neither admitted nor denied the charges..."  The State appears to have taken the path of least resistance, in the interest of a quick payoff, and Goldman certainly looks to have gotten off light.  Much of the $50 million was likely to go down the drain as uncollectible, and ten million is probably less than what Goldman's legal bills, diversion of time, and nasty press would have cost, had they been forced to litigate with the State.

 

In a philosophically related incident, the Carlyle Group has just forked over $20 million to New York AG Andrew Cuomo, who likewise took the money without having charged Carlyle with anything.  This was in connection with Carlyle's use of third-party finders to raise investment dollars for its partnerships.  The fact that one of those finders was Hank Morris - arrested in March and accused of collecting more than $15 million in fraudulent "finder's fees" for greasing the skids into New York's pension fund - apparently just got up Mr. Cuomo's nose.  Carlyle's payment - all of it real money, unlike the Goldman transaction - was accompanied by the private equity giant signing up for AG Cuomo's new Public Pension Fund Code of Conduct, a document that seeks to limit fund managers' ability to game the system.

 

We are sure there will be other shoes to drop down the road - other states will no doubt call on Goldman and Carlyle with palms outstretched.  So far, it looks like a good economic deal for the two titans of finance, even if they each face 49 additional nuisance actions.  We will wait to hear from the SEC before deciding whether they got off light.

 

Meanwhile, a note to Andrew Cuomo: It might make it harder for folks to game the system if the system were not so gameable.  Unlike other states, that have committees and approval procedures regarding pension fund investments, New York's pension money is under the sole authority of the Controller.

 

 

Lead Us Not Into Temptation

Can't anybody here play this game?

                   -  Casey Stengel

 

Note to SEC Chairman Schapiro:  As prisons are but graduate schools where future criminals refine their craft, the SEC has always been among the most sought after doors to Wall Street.  Thousands of attorneys and other staffers have done brief stints at the Commission, then gone on to earn multiples of their pay by working for the very firms they used to investigate.  This is no Dark and Dirty Secret.  It is common to see Wall Street firms announce in their hiring advertisements "regulatory experience desirable."  A former SEC Enforcement Attorney commands a premium.

 

Chairman Schapiro - may we call you "Mary"? - we call your attention, Mary, to an item from CBS news (14 May, "SEC Attorneys Probed For Insider Trading").  Two of your employees, described as "high-level attorneys", are under criminal investigation by the FBI for insider trading.

 

The story quotes Senator Charles Grassley, the ranking member of the Senate Finance Committee, as saying "We ought to be outraged if there is insider trading information that's leading to personal profit..." at the SEC. 

 

Mary, we'll tell you before Senator Grassley figures it out for himself - the truly troubling part of this is the way in which the alleged perpetrators allegedly behaved during the alleged commission of their alleged crimes.

 

The story quotes other SEC staffers as overhearing conversations in which the two shared information about SEC investigations and plotted to trade on such information.  One of the attorneys allegedly approached some of her colleagues and gave them stock tips, encouraging them to trade along with her.

 

The activities are being investigated on the basis of two years' worth of emails, combined with the attorneys' brokerage records.  The emails were sent and received by both attorneys using the SEC's own email.

 

Apparently Senator Grassley has not yet figured out that the SEC has no internal personal trading policy, nor has there been any systematic surveillance by the SEC of the personal investments of its employees.

 

On top of that, these two - allegedly senior SEC lawyers - were too stupid to be aware of the risk of discovery associated with their plotting their insider trades using their own SEC email accounts.  Or, having worked for so long at the Commission, they knew the SEC is too lazy and stupid to catch fraud right in its own front yard.

 

Which means, Mary - trust us on this one, we've  been doing this a long time - there are for sure other folks inside your establishment who are doing the same thing and getting away with it, because they are smart enough not to scam The Job, on The Job.

 

Clearly, the SEC enjoys its role as a recruiting ground for Wall Street.  How else do we explain the practice of bringing hundreds of young people in - right out of school, and with no securities industry experience - and placing before them literally thousands of cases of fraud, involving billions of dollars annually, all with no control or oversight on their own activities?

 

How else do we explain the fact that, unlike every firm it oversees, the SEC itself does not have a compliance officer?  Or an employee personal trading policy?

 

Mary, you are not new to this.  You took over a deeply conflicted and atrociously run NASD and gave it a face lift.  You are now Top Cop in the world's most important marketplace.  You can not pretend you do not know that every employee of a regulatory agency has ample Means and Opportunity for fraud.  All you need to add to that mix is Motive.  Try putting hundreds of young people in front of trillions of dollars and see whether that motivates any of them.  Oh, we forgot - that's exactly what you do...

 

Mary, if you were running a brokerage firm, a hedge fund or a registered investment adviser, you would be out of your job and facing charges of Failure to Supervise.

 

Where do we start, Mary?  With the industry?  With your predecessors in the job of Chairman?  With the Congressional committees charged with overseeing the financial markets?  With you?  Mary, there's plenty of shame to go around.

 

 

Moshe Silver

Chief Compliance Officer

 


CKR – Very Unusual Indeed

 

In the proxy that CKE filed last Thursday they disclose that they spent just over $60,000 covering CEO Andrew Puzder's medical and dental expenses last year. That's an unusually high number -- the other NEOs run between $5K and $13K.

 

In checking in with our resident expert on the subject Michelle Leder of Footnoted.org, she said the number isn't just high compared with others numbers there, but it's out of whack when compared with any other companies she has seen this year.

 

What type of expenses would the company spend on the CEO that would not be covered by ordinary health insurance? Is he seriously ill?

 

Or did the California Longevity Institute brain wash him into spending thousands on finding eternal life?

 

Over the years I have been very critical of CKE's excessive compensation and the millions spent on perks like a Cessna Citation X for a company with a market value of only $500 million. I would bet this is just another example of the shareholders getting the short end of the stick.

 

The board needs to be trying to figure out why Carl's Jr. continues to lose market share!

 

CKR – Very Unusual Indeed - ap


10X EV/EBITDA? YEAH RIGHT

The impetus for this note was the MGM secondary pitch, "if you put a 10x multiple on 2012 EBITDA and discount it back, the stock is worth at least $15".  The last time one could credibly argue that a Las Vegas operator was worth close to 10x was in 2006-2008, when a casino company could float bonds at 6.5-7%.  Those days are long gone and probably aren't coming back anytime soon, even with LIBOR at 1%.  Neither should the multiples, although history has shown that there is a delay between higher cost of capital and lower multiples.  A more appropriate comparison is probably the late 1990s when the major market operators traded at 7-8x forward EV/EBITDA.

 

The following chart details the relationship between cost of capital (bond yields) and trailing EV/EBITDA for gaming operators.  The multiples are an average of regional and major market operators so they are not meant to apply to individual stocks.  Rather, we are simply illustrating the causal relationship of cost of capital to valuation.

 

10X EV/EBITDA? YEAH RIGHT - gaming multiples vs cost of capital 

 

There are two takeaways from the analysis.  First and not surprisingly, higher cost of capital leads to lower EV/EBITDA multiples.  This can be seen in the chart and in analyzing the regressions.  Second and more illuminating, the strongest relationship occurs with a lag of 18 months, meaning rising cost of capital does not immediately get fully reflected in the valuation.  The R square on the 18 month lag was 0.62, which is very high.  This second point does not bode well for gaming stocks.  Despite very high bond yields, EV/EBITDA multiples remain above historical levels.  If history and current yields hold, current multiples may not be sustainable.


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