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Resolution & Trust?

“I’ll study and get ready, and then…the chance will come”
-Abraham Lincoln

Those who have proactively prepared for this global financial tsunami are going to be rewarded in the coming months. Repeatable success in business and in life is a function of seizing opportunity when others are preoccupied reacting to what you already prepared for. From US politicians to Japanese bureaucrats to Russian oligarchs – reacting to a global financial crisis will now be their cross to bear.

No, this isn’t an “I told you so” note – it’s a “pay attention to the facts” one. This is not a time to get cute with rhetoric. Global access to capital continues to tighten in the face of slowing global economic growth. We didn’t need Bill Gross to tell us that – this storm’s been pounding the global beach heads consistently for the last 9 months.

In Europe, Jean Claude Trichet continues to tighten capital requirements because he understands that lending bailout money to investment bankers who do not have a risk management process is going to amplify the financial crisis, not ease it. In Japan, the government is talking about issuing another 500B Yen in debt this morning, because they still don’t get it – anytime they see storms, they lever up the boat, and hand one another the bailout pails. In Russia, Putin had to have the government intervene in the currency market yesterday selling down at least $4 Billion in reserves to support the Ruble. The Russian stock market is getting hammered by the geopolitical hurricane vote again this morning, trading down another -4.8%, taking its cumulative losses since we issued our “Fading Fast Money” call on 5/19/08 to -42%!

As ridiculous as the financial market entertainers sound is what it is here in the U.S.A. Our children will look back on CNBC’s most popular shows, “Mad Money” and “Fast Money”, like I do when I read about tulip manias. From China to fertilizer stocks to Brazil, this was the loudest global stock market mania in world history. If you think that’s alarmist, don’t blame me – blame the revisionist historians who will start to reflect on as much with hindsight.

My most recent ‘Hedgeye Portfolio’ positioning (which goes “live” on our Portal this morning at www.researchedgellc.com) has been that cash is king. With yesterday’s -3% US market down move, I took the opportunity to move from 85% to 81% cash. I can assure you that I have taken on my fair share of criticism for suggesting that Wall Street still isn’t “Bearish Enough”, but that’s ok – I’m always up early and ready for a faceoff with the financial gurus of this game. Goldman is downgrading Merrill this morning – gee, thanks. The US Dollar has now moved +10% since its July 14th low. That’s not partisan politics, that’s a financial reality.

“So what do I do now Mr. Mucker”? “What overly confident genius can you offer me this morning from your soap box in New Haven”? I’ll save some of my critics the keystrokes and front run this morning’s predictable run of inbound emails. My answer will remain the same as it has been. Drop the crack berries and the latest “Fast Money” butterfly wing nut technical strategy, and find a repeatable process. Prepare proactively for the next leg of this storm. Warren Buffett will offer similar simple advice – read, and do your own work. If you’re more of an artist with your portfolio, I’ll submit Michelangelo’s view, “genius is eternal patience.”

Speaking of genius, on everyone’s required reading list in this business is “When Genius Failed”, the rise and fall of Long Term Capital Management. Remember that LTCM was born out of the last financial leverage cycle. They had all of the “smart” people that a hedge fund could assemble on one P&L. Bear in mind that a lot of hedge funds are compensation structures, not well run businesses. LTCM blew up, and had to be bailed out by Wall Street. This time around, who is going to bailout the geniuses that created this mess? Hedge funds are blowing up, but so are private equity firms, and sovereign governments. As everything commodities melts down, the cash in the “Sovereigns” coffers is deflating. Who is going to have the liquidity, the understanding, and the patience?

Father Free Money, Alan Greenspan, is on the tape this morning with a predictable answer to these questions – the US Government! Greenspan is on the record saying that it’s time to empower US Congress ala “Resolution Trust Corp” ghost of Christmas past…

Resolution and Trust – powerful concepts, indeed. Maybe people are figuring out that this global market has neither, yet…



It’s all about liquidity and capital deployment. The gaming industry had too much of the former and failed miserably with the latter. As a result, the gaming operators are grounded in the silos of high leverage, escalating borrowing costs, and declining return metrics. And there is no one on the horizon to push the launch button. All one can hope for is cash flow stability as deleveraging becomes the main goal. Almost a microcosm of the US consumer, no?

Deleveraging is not exactly a compelling investment theme. A terrific balance sheet, excess liquidity, growing acquisition opportunities, and a return focused management team; now there’s an investment thesis. I’m referring to PENN, of course. I’ve made some calculations assuming PENN deploys its excess liquidity into gaming assets and/or companies at 7x EBITDA. The two scenarios assume capital expended to reach leverage ratios of 4x and 4.5x, respectively, both below the industry average at 5x for public gaming operators. PENN’s target leverage is 4.5x so that is the more realistic ratio. In this scenario, ROIC remains constant with EBITDA acquisitions at 7x, although lower multiple opportunities might become available if the company is patient. ROE, however, explodes as PENN adds leverage, up to almost 18% at 4.5x. It might be time to get in now before those missiles are deployed.

Unlike the industry, PENN can actually leverage up ROE


Iowa is usually the first gaming jurisdiction to report monthly gaming revenues. While not a hugely important state (unless you are an investor in ISLE or ASCA), gaming revenues were up a surprisingly strong 5.4% in August. The calendar was favorable with an extra Saturday which probably added 2-3% to the month, but still solid growth especially relative to recent trends (see chart).

More importantly, however, Iowa has been somewhat of a bellwether for the other, larger markets. The hawkeye state’s gaming revenues correlate strongly at 0.73 with the rest of the regional markets. Anecdotally, we have heard August was stronger in the heartland. Could lower gas prices be having an impact? Possibly. It may be too early to call but any positive inflection point could give these cheap stocks a lift. We would focus on PENN and PNK.

Riverboat trends are in need of rescusitation

TSN – Look before you buy

According to the National Agricultural Statistics Service, the total number of chickens currently slaughtered on average in the United States equals approximately one million birds an hour –that’s one million every hour, day and night, every day of the year.
  • The first chart is US chicken production as a percentage of the total estimated US population since the depression. The industry is losing millions every day and there has been no real change in capacity. This can’t continue!
  • The second chart is the per capita estimates that the National Agricultural Statistics Service team prepared. Do you think we eat enough chicken? Also, per capita consumption is clearly on the decline. The theory of trading down to chicken in a slow economic environment looks to be a myth.
  • The excess capacity of broiler production in this country is staggering. It’s going to take a massive cut back in capacity to fix the supply issues. The question is who will blink first? The answer lies in the balance sheets….

Trend vs Trade

The trendline for inventory sales over a longer duration is definitely positive for retail in aggregate (see this afternoon’s post). But let’s not forget where we are in the current sales/inventory and margin cycle. 2H08 looks good. Period. We’re seeing sales growth 4-6% in excess of inventory growth (better yet, we’re seeing inventories erode 4-6% less than sales), which is a good margin event. But this spread can’t remain positive forever – in fact it’s never been positive for more than 5 quarters in a row in the history of modern apparel retail. Consensus estimates are calling for a 35bp improvement in ’09 – a year I think we’ll see another 50bp hit to margins.

My point here is that retail is trading at 7.3x EBITDA. Yes, that seems cheap at face value if we look back 5 years. But taking a historical view I can easily argue anything between 4-6x.

This remains a stock-picker’s space. I like RL, FL, LIZ, TBL, KSWS, PSS and ZK. I don’t like GES, WRC, SKX, GIL, DKS, PVH, and VFC.

These Charts Fascinate Me

I am absolutely fascinated by these charts. The first one isolates the clothing and shoes category, and compares at government-reported retail sales versus the inventory-to-sales ratio. From 1993 through 1Q2007, the inverse correlation was like clockwork. Sales go up while inventory/sales go down and vice versa (i.e. little respect for inventory management). But starting in 2007, the two became one. For the past year and a half, the inventory/sales ratio fell while sales were falling. That’s a first for US retail.
  • We can’t even blame this on the fact that it is government data, which has historically been mediocre. The second chart maps the inventory/sales trend for public companies versus the US retail universe as defined by the government. Pretty close.
  • Yes retail is more mature now than it was 15 years ago. Yes there are better inventory management systems in place today versus the 1990s. But neither of these hit critical mass in 1Q07. What did happen in ’07 is that much of the margin benefit from sourcing and quotas went away. Then several quarters later the consumer turned down. We saw inventory cuts, and we saw them big time.
  • Then we had rising input costs. Now we’re faced with a strengthening dollar. Both of these last through ’09 at least in my opinion. In fact regardless of the consumer, I think we see this sourcing pressure (due to supply/demand imbalance out of Asia) through at least 2010.
  • We’ve all heard management teams say “we’re managing our business conservatively in this tough retail climate.” In other words “we don’t have a clue what sales will be like, so we’ll err on having less tied up in our supply chain.” A defensive strategy, but not one that promotes growth.
  • I still think that the bifurcation between winners and losers in this space will be massive heading into ’09.
Huge decoupling in 1Q07
Inventory/Sales for companies reporting comps vs government retail stats.

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