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Fitz and Reilly

I am not going to focus on Asia or Europe this morning. We have our own mess to deal with. Why is it that the US hedge fund community loves to buy everything in life on sale, other than stocks? Why is it that the CEO of Morgan Stanley, John Mack, is pointing fingers at the US hedge fund community for the weakness in his stock price?

Since I have partnered with some of Morgan Stanley’s top horses, I know a thing or two about their business. One of those things is that Prime Brokerage is one of the most important drivers of their profit growth. For those of you who are unfamiliar with what holding a prime brokerage account means to a hedge fund, quite simply, it’s where you keep your money, short balances, etc.

When my Partner and I started our own hedge fund in 2005, I used Morgan Stanley as my Prime Broker. Why? Well, I felt (and still feel) that they are the best on the Street in this business. There are two fine gentlemen who currently work for John Mack who I will refer to as Fitzpatrick and Reilly (their last names) who are two of the most intelligent and upstanding men I have ever had the pleasure of working with in this business. They understand that this is a client business. They understand the meaning of a handshake. They, unlike Dick Fuld, who calls it a “franchise business”, are the guys rolling their sleeves up every day, who understand that this is a people business.

John Mack has done the best job out of the bulge bracket investment bankers in keeping his antiquated ship from sinking, but yesterday he threw his clients and credibility into the water. He sent a letter to his employees that I have sitting here on my desk (no, neither Fitz or Reilly sent it to me). He wrote “there is no rational basis for the movement in our stock… we’re in the midst of a market controlled by fear and rumors, and short sellers are driving our stock down…”. C’mon John – now I am confusing you with the politician, Johnny Mack. I didn’t get the memo in October of 2007 that the market was being driven by “rumors and greed.” That was 26% higher in the S&P 500, but hey, the leadership on Wall Street hasn’t paid much of a premium for economic historians as of late, so I digress…

Mack proceeded to call up his boys at Goldman’s, Lloyd Blankfein and Hank Paulson, to go after their now evil prime brokerage clients. All he needed was George Bush on the call saying “we’re gonna smokem out of their holes”! Oh, my bad, Paulson is the head of the US Treasury now… and right, right… those “holes” are client accounts held at Morgan Stanley and Goldman Sachs!

Somehow I had another up day in the Portfolio yesterday – I was being an “evil doer” being short Goldman Sachs, I guess. If I haven’t made my point yet on why I’ve been short GS, I’ll say it again – the current structure of a fully integrated global “investment bank” is being revealed as conflicted, compromised, and constrained. You cannot run these businesses together anymore. It’s impossible to always be putting the client first, across the “franchise” platform. This forces executives to take on monstrous leverage and risk.

Fitzpatrick runs a heck of a prime brokerage business. Reilly is as good as they get on the institutional brokerage side of the house. These guys put the client first, not the “franchise”. The franchise issues you more disclosures and disclaimers than they do actionable real time advice. The franchise is willing to let their employees’ life savings go to zero or sell it to the lowest bidder. Why? Because their principal, prop trading, and banking businesses have conflicting agendas with your account. C’mon John, this is why your stock is going down. This is why you’re announcing that you need to talk to Wachovia about a merger.

Others will say that your firm is levered 28x to your shareholder’s equity, and that you need Wachovia’s backstop of cash deposits (liquidity). If that isn’t partly true John, why are you talking to them? If none of it is true, why didn’t you tell your employees that you, as in you yourself, bought stock in Morgan Stanley yesterday? You’re an upstanding man of the highest reputation. The Street loves you. Fitzpatrick and Reilly have families and commitments. Stand up and tell it like it is. Pointing fingers at your clients is going to be very difficult for these two fine gentlemen to explain on the phones this morning.

On massive volume and volatility yesterday, I moved from 84% to 76% cash. It’s time to take some ownership out there in the USA. US market game time is in t-minus 2 hours. Let’s get ready to win out there. Buy low, sell high. Let everyone else worry about why they bought high and why they are now selling you their stock and excuses, low.

Best of luck today,
KM



BYD: ADD ANOTHER GAMER TO WINNING SIDE OF LIQUIDITY

I think management finally has their heads screwed on tight. Free Cash Flow, Return on Investment, and Internal Rate of Return have all reentered their vocabulary. My call is that we don’t see Echelon construction ramped up until 2010. The upshot? The dam has sprung a leak. Free cash flow is going to start pouring in. I’m talking real cash, not free cash flow before I spend billions with little associated ROI.


  • BYD should be able to generate $2.50 in net free cash flow next year. That is a 25% FCF yield. As I discussed in my 6/25/08 post, 15% is the magic number for the regional stocks where outsized returns have followed. By no means is BYD sitting on its cash flow. The dividend yield is 6% which is as high as I’ve seen for a gaming company. We’re big on dividend stocks right now at Research Edge.
  • How safe is that dividend? With Echelon on hold, BYD has tremendous liquidity. Unlike the rest of the industry, borrowing costs will not explode higher in 1 to 2 years. BYD maintains $2.4bn availability in its credit facility that doesn’t mature until 2013. The interest rate on that facility ranges from 0.625-1.625% above LIBOR. PENN is the only other liquid gaming company.
  • I’m not predicting blow out quarters but management has set the bar pretty low. Near term comps get a lot easier in the LV locals market and at Blue Chip in Indiana. They have been getting killed in both those markets. Of all the gaming markets, I think the Strip has the furthest to fall. BYD now has no exposure there. With gas prices declining, the regional markets could show some stability. With a 25% free cash flow yield, stability is all we need.
With Echelon on the back burner, cash flow pours in and BYD delevers
Comps begin to ease in Q3/Q4 2008

Morgan Stanley (MS): "Rumors and Fear"

CEO, John Mack, sent a memo to his employees today saying that their stock was being driven down by "rumors and fear". I don't disagree with that. I actually think he has done the best job out of a bad bunch in terms of leadership. That said, I wonder why Mack didnt send a memo out to his employees in October of 2007 that markets were being driven higher by "rumors and greed."
  • Breaking the $38.71 line was the tell. Look at this volume accelerate thereafter!
chart courtesy of stockcharts.com

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Now "They" Are Bearish Enough! Moving to 76% Cash...

We have three views on stocks and markets here at Research Edge: Bearish, Bullish, and Not Enough of one or the other. I have been buying and covering stocks since 11:08AM today, and have moved from an 84% portfolio position in cash to 76%.

Three simple reasons:
1. The weekly Bullish to Bearish Institutional survey has finally moved to the decidedly Bearish side
2. The Volatility Index has hit my immediate target level of 35.11 today
3. Volume and Breadth are capitulating intraday on the negative side

Buy Low. Sell High.
KM

(picture: http://www.freakingnews.com/Teddy-Bear-Pictures--1666.asp)

Eye on Trust...

"Who do YOU trust?"
By Andrew Barber, Director
Research Edge LLC

The year has seen the major Wall Street banks squander generations of work spent building the trust of investors globally. Now the contagion is spreading.

Yesterday I spoke with a friend of mine who is a successful wealth manager in Greenwich. This friend is a savvy investor who has built a successful practice. When I called him he told me that he had gone to the bank where he keeps his personal saving and checking accounts and withdrawn funds to spread around among other institutions because he was paranoid about having his liquid cash accounts frozen in case his bank failed. This is a rational and informed person that I am describing who is almost at the point where he would rather bury his savings in a jar in his backyard than keep it in a bank. This represents the total markdown of the greater US financials system’s largest intangible asset – trust. Reserve Primary, the oldest money market fund in the country, had to take a big markdown on that asset today when they broke the buck and sent more people like my friend scurrying to the bank to withdraw their life savings.

The US does not have a monopoly on trust. As we all know, doing Business in China is impossible unless you have a partnership with a local firm. We talked about the potential dangers of Chinese JVs repeatedly in the first half of this year as companies like Danone and Caterpillar wrestled with bad Chinese marriages. None of the problems they experienced compare with the complete betrayal that Fonterra is feeling today. Fonterra is a 43% owner of the Sanlu group –a company that used a dangerous chemical to make baby formula. The allegations are not that this is an accidental situation caused by a mistake at the factory –this is believed to have been a heinous, deliberate decision driven by greed that has caused at least 6,200 infants to suffer kidney damage and at least 3 to die. Imagine waking up to find out that your business partner was poisoning babies. By the way; some of the early reports that came out from the Chinese media (the government is now reportedly controlling coverage now to avoid panic) mentioned that some families of sick children were pursuing legal action. Welcome to the newest consumer trend in China: litigation. It’s global this time.

The commodity markets are not immune from this crisis of trust either. Today at 1 PM the EIA will release crude oil stock data. Everyone in that market, already on edge over the fighting in the Niger delta, will be watching closely to see how much Ike disrupted supply. The data that is reported today will be the first report drawn from surveys conducted after it was announced that the CFTC is investigating whether energy firms have been supplying false inventory data to manipulate the markets. We will have to wait until the regulators finish taking depositions from more traders to see if any charges are filed –but the shadow of doubt has already been cast. How can you trust the fundamentals if the data is corrupt?

AIG has shaken my trust in my own judgment of risk. I regarded AIG’s derivative trading subsidiary, AIG Financial Products, as one of the greatest firms to ever operate in the risk markets. I have personal friends and trusted business associates there -people who are, without doubt, some of the most intelligent and honorable people in our business, period. With a massive “double-triple A” balance sheet as a foundation and an awesome concentration of intellectual firepower, AIGFP was THE counterparty of choice for the largest institutions on earth as they sought to modify their market risk. They could do trades for bigger size, in more markets and for much, much longer duration than any other player in their markets. At some levels they WERE the market. From pensions and endowments executing index swaps to bulge bracket investment banks lying off equity volatility –the success of AIGFP’s derivatives team in winning trust hardwired them directly into the US financial system’s central nervous system. I implicitly trusted any derivative contract they guaranteed as being safe as, well, milk.

So that is the question I find myself asking today is: who is left to trust?

Andrew Barber
Director

DRI - There does not appear to be a Macro Process

My number one concern about DRI continues to stem from the company’s new unit growth targets, which I don’t think properly reflect the current environment. Management acknowledged the tough environment saying, “There's no question it has been a difficult quarter and given the difficult economic environment, it looks like it is going to be a challenging year. Our current sales and earnings outlook reflects that.” Despite these challenging times when operating profit growth declined at each of the company’s core concepts, Red Lobster comparable sales declined for the third consecutive quarter with traffic down about 5.5% in 1Q and LongHorn posted a 4.9% same-store sales decline with traffic down about 7%, DRI maintained its FY09 unit growth targets (75-80 new restaurants, or 4%-5% unit growth).
DRI management has been saying for some time now that the company’s plan to achieve sustainable growth at Red Lobster has three phases: first phase was to strengthen brand fundamentals. The second phase included refreshing the brand, broadening its appeal and building guest counts. The third phase included accelerating new unit growth. As early as 4Q07, DRI communicated that this plan included the expectation that phase 3, or new unit growth, would begin later in FY09. I would have thought phase 3 would have been contingent on phase 2 having been accomplished, but the company stated again today that it will resume meaningful unit growth in 2H09 and expects to open 10 net new restaurants. Management admitted that although operating fundamentals (phase 1) have greatly improved, that Red Lobster is still working to “broaden the appeal of their brand and recapture lapsed users,” which communicated to me that they understand that phase 2 has not been completed, but they are moving ahead with phase 3 regardless. Traffic continues to decline (again, part of phase 2), but management appears unwilling to back away from their initial forecast for growth in FY09.

Apparently, I am not the only one concerned about DRI’s growth outlook as management was questioned on its conference call this morning about its continued commitment to restaurant development at Red Lobster in 2H09 relative to the concept’s performing below expectations. CEO Clarence Otis replied by saying that from a traffic standpoint, Red Lobster has outperformed the industry in the last couple of years with a materially higher average check, which leads him to believe Red Lobster has performed strong competitively. I found this answer to be a little surprising because the industry has experienced negative traffic for the better part of the last three years so outperforming these negative metrics will not lead to enhanced returns.

Additionally, Mr. Otis said that the decision to add new Red Lobster units is more of a restaurant by restaurant and market by market type of analysis. “I don't know that we have a pace of expansion that we think makes sense versus we scour the country and look at the markets and decide market by market does this restaurant make sense from a return perspective. And so it is very much a bottom up driven expansion. Here's a market that's expanded, that is strong a trade area we think we can get X guests out of. It makes sense to open this restaurant. All that adds up to five one year, other years to ten. It is more about that, and to the extent that the guest count level that we start to make that restaurant by restaurant assumption from is lower and we scale out over 30 years, fewer trade areas will make sense. So that's a little bit of how we think about Red Lobster. I don't know that there's a master plan as opposed to a unit by unit investment decision.” I found this comment to be interesting because if the CEO does not know the master plan, who does? Given the trends in the quarter and the outlook for the balance of the year combined with the current level of unemployment, trends in macro factors would point to a different strategy.




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