“It is important to foster individuality, for only the individual can produce new ideas”
After the sharpest single-day US stock market decline since the 1987 crash there better be some great long ideas out there. Crisis creates opportunity; creative destruction is taking hold; and after having our 3rd consecutive up day in the ‘Hedgeye Portfolio’, we’re ready to roll here this morning at Research Edge.
If you don’t like the feeling of waking up to a counterparty that is confident in this environment, my team is definitely not for you. We don’t do well hanging out in the hallways of investor conferences asking everyone else what their best ideas are – it’s hard enough to find the time to do all of the research that is required to execute on our own ideas.
Having been there for the last decade, I think there are three basic things that the “buy side” wants: speed, accuracy, and ideas. Be first and be right; rinse and repeat. That’s called “idea” generation, and Wall Street pays a premium for it. The key to building that intellectual property is to simply have your own process and your own ideas. It is critical to “foster individuality”. If you can’t stand alone, you’re probably best served to get out of the game until the next bull market begins.
Jack Bogle at Vanguard, amongst others, has proven, that it is very rare for a money manager to outperform the market across economic cycles. Investment styles come and go, and so do the faces and the names. That’s not a contrarian point. That’s just the math. The reality is that “Joe The Plumber” has just as good a shot as over 90% of us of at being right on the market when volatility is low. I love plumbers. I’m glad that Obama and McCain do to. They gave Joe at least a dozen shout outs in the final Presidential debate last night! In fact, plumbers are in relatively low supply right now, and will probably be rightly paid more in 2008 than your run of the mill “hedgie”.
Rather than watching yesterday’s market swoon recaps on CNBC, or the battle of the “who knows less” about economics in last night’s debate, Joe and his kids were probably watching the Phillies go to the World Series last night. Rather than waking up to his portfolio manager pointing fingers at him this morning, the worst thing Joe might be waking up to is something that really smells… but hey, at least he can call it for what it is. His stress isn’t in the area code of Wall Street’s right now, and it shouldn’t be. If ‘Investment Banking Inc’ owned up to what they had in their sewage system 12 months ago, we all might have less pressure on our temples. Never mind this “Level 3 Asset” stuff – if it smells like one, it usually is one… Joe calls it a liability.
The best idea I have for you this morning is to start buying stocks again, but do so patiently. The S&P 500 closed at 907, and my downside target line has moved to 854.11 this morning. You have 6% downside from here, and you should be able to leg into our or your team’s “best ideas” at a measured pace. We have an 80% position in cash that is open to buy this morning. We are accountable for every trade that we have on our sheets. If we liked it on the long side yesterday, we better like it more today, because it’s cheaper. Our gains on the short side, as always, are meant to be taken.
Our top 3 domestic stock ideas are: BMY, HSY, and PENN. All of these stocks are cheap. All of these companies have dominant market shares in their respective businesses. All of these tickers were down yesterday. Buy low.
Our top 3 global ETF ideas are: FXI, EWH, and EWG (China, Hong Kong, and Germany). All of these ETFs were down yesterday. All of the shorts that we have against them (Japan, India, and the UK) were down more. Some might actually call that “hedged” portfolio construction. Genius, I know. Sell high, buy low.
No, this business isn’t rocket science. Yes, those who told you they were are probably having a bad week. Proactively managing risk includes shunning leverage. Waking up every morning like Joe the Plumber does includes smelling the coffee before he has to deal with the smelly stuff for what it is. The story telling is over folks. The accountability cards are on the table, and the YouTube split screen on McCain & Obama last night is a metaphor for this game’s new rules. Speed and accuracy of independent and transparent ideas will win.
Best of luck out there today,
“It is important to foster individuality, for only the individual can produce new ideas”
LIZ CLAIBORNE (LIZ)
KM: LIZ finally washed out, buy it under 10.07, patiently.
BM: The sell off in conjunction with JNY’s miss makes sense. But LIZ is cutting capex by more than people think in 2009, and SG&A cuts will follow. This will become apparent in 1Q. Maybe a bit early now, but there’s well over $1 in EPS power here.
COLUMBIA (COLM) AND TIMBERLAND (TBL)
KM: COLM looks like TBL, a buy in the washed out hole.
BM: I like TBL better from a fundamental standpoint, and still think it is more likely than not that it will be owned by another company in 12 months. COLM has structural challenges given the incremental growth it is pushing in sportswear -- a crowded and commoditized category. But COLM has been gaining share in the sporting goods channel over the past month, which is one of the first times in a while I recall COLM do anything other than lose share.
GUESS? (GES) AND WARNACO (WRC)
KM: GES looks the same as WRC, wackamole on all strength. (Note: KM noted this to me post close yesterday – before Wednesday’s downward move. He’s still bearish).
BM: I’ve been vocal on both of these names, but fundamentally view WRC as being much worse off than GES. I still can’t get over how WRC can have some of the poorest returns and brand portfolio, yet among the highest multiples in the group.
Year to date, the average gaming operator stock has declined 75%. WYNN is down “only” 56% on the year and ISLE, which had been absolutely demolished since late 2006, is down 66%. The remaining stocks have dropped in a fairly tight band, ranging from -74% (PENN) to -89% (LVS).
What makes sense to me is that during a credit crisis, investors hammer one of the most heavily leveraged sectors in consumer land, gaming. No doubt the credit freeze is partly, if not mostly responsible for the gaming carnage. What doesn’t make sense to me is that, except for WYNN, the liquidity haves are dumped in with the have nots. PENN and BYD should be outperforming along with WYNN. PENN is actually underleveraged and maintains huge liquidity. BYD maintains average leverage but will de-lever at a faster rate than the industry. BYD’s liquidity is outstanding with $2.4bn in availability on its credit facility, no significant cash needs, and no debt maturities until 2013.
Divergence will ultimately occur. Best to be on the right side of this liquidity trade.
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First, here is the bear case – It’s worth zero - before this market is done, any company with any debt is going to be worth zero. EAT’s FY09 EBITDA declines to $250 million - put an EV/EBITDA multiple of 3.6x on it and the EV equals $900 million. Subtract debt of $900 million and the equity is worth zero. Ok so we now know the potential downside, let’s look at something a little less gloomy.
What we do know is that the industry is headed for a major shakeout, eliminating the weaker players to the benefit of the strong. To be clear, Brinker is strong and will gain significant market share over the next three to five years. Currently we have a bankruptcy watch list that includes two of Chile’s major competitors – Ruby Tuesday’s and O'Charley’s. Beyond that, every day, I read every day about smaller players closing stores. As a restaurant analyst, we have been talking about the industry’s excessive growth and the need for a shake out for five years. We are here! It’s time to take advantage of the current fear and buy assets that are trading at a significant discount to intrinsic value.
- EAT has significant ability to generate cash.
To management’s credit, they have been preparing for harder times – just not fast enough. If we assume just the basic capital spending needs for the next few years EAT will generate approximately $200 million in cash each year. The equity value of the company is currently $1.1 billion. So in 5.5 years EAT will generate its current equity value in cash. More importantly, the company could pay down its $900 million in debt in 4.5 years. Lastly, assuming these basic capital spending needs, the company is trading at a free cash flow yield of 18%.
- Buy a strong brand and distribution channel below replacement cost.
Owning the Chili’s distribution system is a valuable asset. EAT owns the valuable real estate underneath 22% of all of its stores (including land and building). For the 282 restaurant locations EAT owns, the net book value for the land was $241.2 million as of the end of FY08 and for the buildings was $237.0 million. For the remaining 983 restaurant locations, which the company leases, the net book value of the buildings and leasehold improvements was $977.6 million. The company’s total enterprise value is $1.9 billion relative to its restaurant locations’ net book value of nearly $1.5 billion, which means the market sees very little value in the cash flow of this business right now.
In today’s environment owning real estate may not mean much, but in three years it will. It would be impossible to rebuild the Brinker restaurant distribution system, but if you could it would cost $2.2 billion to rebuild Chili’s, $350 million for OTB and over $400 million for Maggiano’s. Again, today the enterprise value of the company is $1.9 billion.
- Selling assets
Over the past two years Brinker’s management team has been trying to sell off assets to become more of a franchised organization. If the world returns to a normal environment, EAT will be able to sell more assets. I calculate that EAT could sell assets worth $1.0-$1.5 billion, nearly matching the entire enterprise value of the company. Once the asset sales are completed you are still left with a more efficient store base and a very valuable royalty stream.
I know the restaurant industry’s current environment sucks, but that is the opportunity. The Chili’s brand is one of the best in the business and will be for decades. In this environment the company is perfectly positioned to capture incremental market share as other restaurant companies can’t compete in the current environment. There is probable no better time to take advantage of buying a premier company trading at a significant discount to its intrinsic value.
Short Stocks for the “Trade” = 988.07
Cover/Buy for the “Trade” = 866.28
These prices are using a model SPX level of 945.
September unemployment benefit claims levels published today in the UK came in at the highest level in two years with 31,800 additional new workers on the dole. We are short EWU -although the absolute unemployment level remains low in contrast to the miserable period stretching from the late 70’s into the 90’s (see charts, historical context is critical here). We expect the chilling impact of increased employment volatility coupled with the recent increase in consumer inflation on growth to be significant.
2. Long EWG – Germany’s INFLATION & EMPLOYMENT trends are much more benign
In contrast Germany, which we are long via EWG, released an inflation number that marked a decrease over the prior month. Germany’s CPI is only +2.9% y/y vs. the UK’s at almost double that (see chart). Unemployment remains low in the largest economy in Europe and thus far German banks have proven to be either better managed or better liars than their British counterparts.