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The Bankruptcy Cycle Continues: Two More Banks Go Under This Weekend

The bankruptcy cycle continues to pick up momentum. This morning the Wall Street Journal reported that “Federal regulators shut down two national banks, First National Bank of Nevada, based in Reno, Nev., and First Heritage Bank of Newport Beach, California.”

These banks fall under FDIC protection, but don’t forget that insurance is generally only up to the first $100,000. The FDIC is basically a mutual insurance company. The FDIC has to fund any deficits by laying higher premiums on the banks that they continue to insure (i.e. premiums are going up).

This is what we have been pounding into the summer sand as of utmost importance to the US economic systems. Access to Capital is tightening as Cost of Capital is going to continue to rise.

I’ve attached the “Bankruptcy Cycle” chart that we used for our conference call on July 16th. We’ll re-run the data driving the chart on Monday, but the math is straightforward – 7 banks have now gone belly up in 2008 and 3 of the 7 had assets exceeding $1 Billion.

This is not good.
KM

Big Chain Players Should Win at the Expense of the Little Guys

According to the NPD Group, the restaurant segments which are experiencing the most severe traffic declines in the March-May 2008 timeframe are the full-service restaurant categories and those dominated by independents. The pizza category is one such category that is dominated by independent players. Domino’s highlighted in a recent presentation that small chains and independents accounted for 54% of pizza delivery dollar share in 2007, and in line with NPD’s comment, the QSR pizza category has faced significant traffic declines with negative YOY traffic trends in the last 5 quarters and down again through May in 2Q08.
  • On DPZ’s 2Q08 conference call earlier this week, when asked about independent closures, the company’s CEO David Brandon said:
    “Our belief, and it’s more anecdotal than it is statistical, is that the pressure that’s happening out there is clearly creating closures. I mean we’re seeing a few of them and we’re stronger and we can buy cheaper and we’ve got a better brand, and a 47-year track record. We are in a position where we feel the pressure with our weaker operators. We can only conclude and we’re witnessing that same pressure translating in an even bigger way to a number of the smaller operators out there. But it will take a couple of quarters for that to show up in some of the data that we can share with you and certainly when it’s available we will be talking about it.”
  • DPZ management has stated in the past that overly aggressive pricing actions across the industry are to blame for the fall off in traffic. Although more disciplined pricing should help traffic trends (but not necessarily margins), a reduction in supply could only help as well. I don’t want to root against the small players, but if more independents are forced to close their doors as a result of their not having the scale necessary to deal with both lower consumer spending and higher commodity costs, the bigger chains should emerge as winners.

Trouble Brewing in Europe?

China’s renewed pricing power in apparel/footwear exports is showing up left and right. China imported 211,000 tons of Cotton in June –off 16% vs last year. Why the decline? It probably has something to do with the fact that 50% of the 20,000 factories in the Dongguan province in China have closed year-to-date. It does not take much to do the math there. Lower production = diminished need for inputs. This plays into my theme of China passing pricing power through to marginal US players. I should note that India, Thailand and other Asian countries are picking up the slack production, but thus far are following China’s pricing lead. I’ll be keeping a close eye on whether anyone breaks rank.

An interesting call out is the rather meaningful shift we’re seeing over the past few months in Chinese exports by destination. The growth rate in shipments to the US is slowing meaningfully, but we’re not seeing carry through into the EU. The European retail environment has been strong enough to accept price increase to a certain degree, but that’s starting to turn. I’m starting to scout out potential losers vs. winners in Europe. Stay tuned.
EU and US imports from China are diverging at the wrong time for European retailers and those with exposure to the region.

Early Look

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CURRENT TRENDS IN CASUAL DINING

The current NPD data suggest that despite the gloomy economic situation, Casual Dining posted a 1% increase in traffic this quarter (The Knapp data suggest a 3.8% decline in traffic trends). Two key factors are driving the trends at casual dining.

First, the consumer environment looks bleak (consumer confidence hit a 16-year low) and consumers have very little disposable income in their pockets. Contributing to slightly better trends in the most recent quarter was the government’s stimulus package, which supported a +4.0% increase in Real Disposable Personal Income in Q2. Second, restaurant operators increased their promotional efforts and consumers took advantage of them.

  • According to NPD, customer deal traffic rose 6% while non-deal traffic was down slightly. Looking at Casual Dining, the segment was weak during its core business segments with no growth at the important dinner daypart. Lunch traffic grew significantly with 4% more customer visits this quarter. The increase at lunch included improvement on both the weekday and the weekend time periods.
  • Importantly, discounting and Combo Meal visits accounted for half of Casual Dining growth this quarter supported by promotions from major chains and increased visits with kids. The Bar and Grill category posted the largest gains this quarter. The casual dining “varied menu” lost traffic, which suggested a trade off to Bar and Grill. When consumers decided to go out to eat, side dish items were left off, while beverages posted solid growth supported by gains in healthier beverage options. Consumers are also cutting back on consumption of alcoholic beverages.
  • Some areas to consider looking forward: 1) it’s unlikely that another stimulus package will be passed by congress to help buoy consumer spending. Fortunately, gas prices have begun to ease up a little, which may help improve consumer confidence and free up some discretionary dollars. 2) Consumers will continue to look for promotions, a trend that was evident over the past three months. It’s critical that restaurant operators engineer promotions to provide attractive offers to consumers (possibly with new offerings) while trying to preserve margins.
  • My guess is that EAT’s quarter will look better than most in the casual dining space.

PENN: “BASSET” SWAPS AND VALUE CREATION

Gaming companies have a problem. Business risk is high, balance sheets are highly leveraged, credit markets are closed, and liquidity begins to dry up in 2010. PENN has a different problem. While PENN maintains the best balance sheet and liquidity to make a value creating acquisition, gaming companies are probably unwilling to sell assets or their companies at the bottom. There may be a solution: a bond for asset (“Basset”) swap. Theoretically, PENN could buy discounted bonds in the open market and trade them back to the Issuer in exchange for an asset, presumably a casino/hotel. PENN effectively buys the property at a discount and the seller deleverages at par. It seems like a win/win situation; maybe not for the bank who holds the credit facility, but certainly for the direct counterparties.

Conceptually, swapping discounted bonds for a coveted asset makes a lot of sense. There are a couple of issues, however. First, the covenants in all indentures and credit facilities senior to the purchased bonds cannot restrict the use of proceeds from asset sales. Second, as with most casino asset sales there are always tax issues. It is unclear whether the seller would be able to make a tax free exchange but that would certainly seal the deal.

In the following table, I’ve outlined a generic analysis of how this transaction would look to the buyer and seller assuming no covenant or tax issues. Clearly, PENN benefits from buying a property worth 10x EBITDA for 7.5x. The seller sees its leverage fall 4x to 3.3x and is now in a better position to obtain new liquidity from the credit markets.

This is by no means an exhaustive study of “Basset” swaps but it does indicate that there may be options for PENN to expedite an attractive acquisition. Alternatively, the company will be patient to get what it wants at fire sale levels. Presumably, potential sellers will get more desperate as we approach the beginning of what could be a gaming liquidity crisis beginning in 2010. PENN seems to be alone in dealing with this high class problem.

Hypothetical "Basset" Sale

Missing BRIC's In The Walls: Russian and Brazilian ETF's

The Russian Stock Market lost almost -6% of its value today, and now the RSX is chasing its consensus momentum ETF friend in Brazil (EWZ) down to the bottom of the July performance barrel.

These levered plays on commodity inflation are down -21% and -22% since mid May, when we made our "Fading Fast Money" call (see chart).

It may be time to call your broker and ask them what exactly resides within these ingenious ETF instruments.

KM
Charts by Andrew Barber, Director - Research Edge, LLC

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