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Government’s Marking to Model . . .

Despite the catastrophic collapse of the real estate bubble and housing prices, property tax revenue collected by states and localities is still on the rise - up 2.7% in 2009. This is a disconnect from the reality of the current state of the U.S. housing market, which is a direct result of most State and local governments marking their property tax collection schemes to model.


In the most recent economic downturn, receipts to State and local governments have largely gone south, declining (-10.9%), (-16.4%), and (-11.6%) in the last three quarters alone, according to the National Association of State Budget Officers.  As to be expected with a 9.7% unemployment rate, data from the Bureau of Economic Analysis shows that in 2009, income and sales tax receipts have posted the largest annual declines on record (-19% and -4.8%, respectively). In fact, of all the major State and local government tax categories, only receipts from corporate income and property taxes grew in 2009.


Government’s Marking to Model . . . - 1


Furthermore, BEA statistics show that property taxes have been a great source of income for struggling local governments, which collect over 96% of all property taxes. With property included, receipts to State and local governments declined  5.5% in 2009. Without property taxes, however, receipts declined 9.1% in 2009.


So with everything we know about depressed home prices, how can it be that property tax receipts are actually still on the rise?


The answer is easy - most State and local governments notoriously mark their property tax collection processes to model. That is, property taxes are often based on rather outdated appraisal values that consistently lag fair market values throughout most States. On average, as determined by Federal Reserve economist Byron Lutz, it takes three years for changes in the market value of homes to get reflected in an owner's property tax bill. So most State and local governments are raking in property tax receipts based on home values appraised in 2006 - the peak of the housing bubble.


So one would think that the consumer finally gets thrown a bone in the form a property taxes finally starting to roll over and catch up to the sunken home values across the country.


Not so fast, my friend.


In classic marked-to-model form, some State and local governments have raised property tax rates to offset declining home prices. Others have adjusted tax rates to keep property tax revenue stable, regardless of what happens to prices on the real estate market. Even more appalling, some State and local governments have actually raised property taxes to deal with budget shortfalls.  All told, the budget shortfall facing State and local governments in the next three fiscal years is $136.1 billion, according to NASBO.


In a twisted way, with property tax appeals well above historic means in most municipalities, it sounds insignificant to suggest that many State and local governments across the country have each planned to spend well over a hundred million dollars on property tax appeals in the next fiscal year. That's right - millions of Americans across the country are appealing their property taxes, citing home values well below the last State-appraised values the taxes are being based upon. Twenty to forty percent of appeals are granted. If the average holds, the lifeline that property taxes have been to flailing State and local government budgets will be eroded on the margin.


Perhaps that is why 41 states are behind their fiscal 2010 revenue projections (NASBO). Six were on target as of February 20th; a paltry three were ahead of schedule (NASBO). Moreover, NASBO studies suggest States are projecting a further decline of over 1.4% in tax collections for fiscal 2010. Thinned-out receipts have left States’ Rainy Day funds at 4.8% of expenditures - the lowest ratio since 2004 (NASBO). Back out the ultra-conservative Texas and Alaska, and that ratio is only 2.7% - the lowest since 1992 (NASBO)!


It neither sustainable for State and local governments to raise taxes based on marked-to-model housing prices, nor is it sustainable for homeowners to continue to a growing percentage of the tax burned.  Yet another reason to be concerned about the Domestic PIIGS, and the outlook for municipal bonds.


Darius Dale



PENN reports Thursday and we think the quarter could be slightly better than guidance. Expectations remain low despite a good move in the stock over the last two months.



The main tenet of our post Q4 earnings bullishness was that guidance had been cut to realistic levels.  We always liked the management team, growth prospects, and balance sheet and were encouraged to see significant earnings risk taken out of the equation.  The stock is up 29% since its February lows so it doesn’t appear to be a near-term table pounder.  However, with a $1 guidance for 2010 looking beatable and a promising long-term outlook, any stock weakness should probably be taken advantage of.


We expect PENN to beat both consensus and guidance when they report this Thursday. We estimate that PENN will print $597MM of revenues, $143MM of EBITDA and $0.25 of Adjusted EPS.  Since everyone has the state reported numbers we won’t bore you with all the details… you know where to find us if you care about them.  Below are just a few assumptions we made

  • Property level EBITDA of $161.4MM
  • Corporate expense of $18MM and stock comp of $6.8MM – in-line with guidance
  • D&A of $54MM
  • Net interest expenses of $34MM
  • 45% tax rate in line with mgmt guidance


How many restaurant companies have the potential to grow earnings 50% in the next two years?


If I were one of the multiple PE firms shopping around to buy a restaurant company, EAT would be on top of the short list.


(1)    National brand in a large category

(2)    Underutilized assets

(3)    Discount valuation

(4)    Global unit growth potential

(5)    Strong balance sheet

(6)    Stable cash flow

(7)    Strong franchise partners


My analogy to a PE company buying EAT is not totally misplaced.  First, buying a stock today with a credible (and somewhat proven) plan to double earnings in 5 years with potentially 50% of that growth coming in the first two is not a bad risk reward.


Second, the risks are well known.  Brinker and the rest of the industry are lapping severe discounting from last year’s economic turmoil.  The good news is the severe discounting is not as needed and the industry is operating in a more “normal” environment.  Yes, that makes sales comparisons difficult, but it’s a benefit to margins and cash flow.


The market reaction to earnings today was to sell off the stock.  Great, we bought it. 


If it goes down tomorrow because someone is concerned about fiscal 4Q10 same-store sales, I’ll buy it again.  We are within a six month window where all the bad news is out, and we are now looking down the barrel of potentially the best earnings growth story in the large cap casual dining space.


Judging by the dialogue on today’s call, there seems to be a lot of confusion among investors about the timing of implementation for POS, KDS and kitchen retrofits and the subsequent margin benefit.  However, management seemed confident about its potential earnings growth in the next two years.  EAT’s 5-year target to double EPS by FY15, off of the $1.40-$1.44 base, with 10%-12% EPS growth in FY13-FY15 implies 40% to 50% EPS growth from FY10 to FY12. This two-year target assumes 1% to 2% same-store sales growth, which seems achievable; though it does it rely on sequentially better 2-year trends going forward.


I know things don’t happen in a straight line and there will be bumps in the road, but I want to be a little early on this one.  Once it gets going, it’s gone…


With the typical PE firm’s 3-7 year time horizon, the odds are good on this one.


The near-term sales outlook may be choppy but, as I said earlier, negative sentiment will only offer more opportunity for those willing to look past the immediate term.








  • EPS of $0.42 before special items incl OTB
    • $0.37 on a continuing basis


Financial takeaways from Analyst Day

  • Long-term goal is to double FY2010 EPS pre special items by 2015
  • 10%-12% EPS growth for FY2013 through FY15
    • In order to double EPS, growth in the next two years must exceed 10%-12%
  • Assuming 1%-2% comps


Current FY10 Sales Guidance:

  • -1% to -2% incl 53rd week
    • 53rd week helped comps by 2%


  • For 500bps improvement:
    • 300 bps from kitchen retrofits /POS/KDS
    • 200 bps from others
    • 100 bps depreciation impact for a net 400 bps impact to margins
  • LED lighting and reimage programs also included in 100 bps impact



  • EAT will only continue to invest in incremental capital spending related to kitchen retrofits if it sees resulting margin improvement
  • FCF will be invested in business to reduce debt, pay dividends
    • Leftover cash will go to share repurchase


  • G&A cost included in discontinued operation
    • $3-6m of fees will be received for support services to acquirer to offset support costs associated with OTB (such as centralized accounting and other shared back office costs)
  • OTB sales will be $0.03 to $0.05 dilutive to EPS



  • Lower than normal expenses in 4Q09
    • Insurance, property tax, utilities, vacation
    • 110 bps favorable impact on margin


Analyst day

  • Outlined company’s “Plan to Win”
  • During quarter finished rollout of menu transformation
    • New items, improved kitchen processes, removed items, changed recipes



  • Promotional offers are attracting more guests
  • EAT’s participation in deals is among the lowest of its peers
  • Guest satisfaction has improved since the Analyst Day when it seemed to be softening as changes to the menu  were being implemented



  • During 2Q, revenues decreased by 7.8%
  • -4.2% decline in SSS, 40 fewer restaurants
    • Traffic better than comp, mix worse due to promotional activities
  • 5.3% decrease in capacity
  • COGs increased 30 bps to 28.5% vs prior year
    • 90 bps sequential improvement
  • 70bps benefit from commodities
    • Offset by margin loss from mix shifts due to promotions and changes at Maggiano’s and Chili’s
  • Restaurant operating expense was 54.7% vs 54.1% a year ago
  • Labor up due to training for new menu etc.
  • Depreciation has decreased due to fewer restaurants and more fully depreciated assets
  • G&A decreased by ~$2million per year, 10 bps as % of sales to 4.5%
    • G&A for discontinued ops are directly attributable to support costs that are identifiable to the OTB brand. Not included are accounting services and other back office costs.  EAT will collect fees that will offset these
  • Interest Expense was $1M lower YOY
  • Tax rate of 19.7% was lower than 3QFY09 due to resolution of tax positions
  • Capex was $32m
  • CFFO was $223m
  • $182m cash balance


  • Capex of $84m for fiscal year (unchg)




EAT's three businesses are Chili’s, Maggiano’s and Global business development (GBD)

  • GBD
    • Great growth potential outside the U.S.
    • Extending to 425 Chili’s outside the U.S. by 2014
  • Maggiano’s
    • Gained traction throughout the quarter
    • Comps sales +5.2% in March
      • Jan and Feb were 3.8% and 3.7% respectively
    • Margin improved 200 bps
    • KDS/POS testing in Mexico is returning great results
    • Chili’s
      • Testing initiatives aimed at driving margin
      • Rolling out LED lighting

Free Cash Flow

  • Short-term debt repayment goals are almost accomplished
  • Investment grade rating from S&P






What will the costs be for rolling out new kitchen initiatives?


The initiatives will be rolled out over time, not expecting a big hit to any one quarter, we’ll have more of an idea over the summer.



For the $0.05 dilution from OTB sale, were you referring to G&A picking up and that being the amount you have to offset with revenue?


No. Some G&A will not be recorded as OTB. There are some proceeds that will be used to buy back shares. After repurchase, net dilution will be 5cents



How do you see Chili’s navigating the competitive environment? Promotions in July last year, how do we think about promotions versus competitors that did promotions earlier in ’09?


The level of discounting and consumers that are eating on deals is staying strong. There is still a lot of discounting going on.



In some ways, will it be difficult to figure out how this summer will play out for casual dining?


Yes, it is difficult – the margin play is opportunistic for EAT and we’re balancing all that into plans as we proceed into summer and figure out strategy.



On share repurchases, will that be an open market repurchase?


Looking into all options, will discuss with the board and decide on a way forward. 



What is ticket time now?


It varies between lunch and dinner…5 minutes is a goal.  That will make us far more competitive at lunchtime in particular.



Talk about the timing of the roll-out, 5 restaurants at the start of 2011FY, by the start, how much of the systems will be POS/KDS operative?


End of this year for POS, early next year for KDS.  To finish the retro fits, however, it will take longer, possibly into 2012, 2013. 



Margin improvement timeline?


Margin equipment will come through 2011, 2012, but the full 400 bps will not be realized until 2013.



Share repurchase?


Not all OTB related, we will have excess cash that we will use for share repurchase. Didn’t receive authorization from board until late in 4Q so haven’t done that yet. 



Commodities will be down for C’10? What do you think for commodities in CY11? Also, how will health insurance legislation affect EAT?


We have gone through a lot of commodity negotiations. We have clarity on those costs out to December (still favorable in all items ex produce through December).  50-60% contracted through December. 



With current levels and outlook, do you have a sense of how they will go in C’11?


Flat from 2010 into 2011 but it’s very difficult to tell.   On health insurance, there are still more questions than answers. Most of the requirements won’t take effect until 2014, the couple of things that do (students and pre-existing conditions) are already covered by EAT health insurance.



Cash balance?





On service strategy, can you explain that?


Focused more on team service.  It’s a strategy that worked well at Maggiano’s.



Kitchen retrofit should take 2/3 years. Accelerated depreciation?


As we roll out the equipment, yes, but will be written off over five years.



What is the lead time for the marketing (fresh pairings)? Is it a couple of weeks or months?  Also, sales trends at Maggiano’s being addressed mid week? How are they looking?


We have a national marketing strategy that has media in place.  Cost structure benefit comes with that. It’s really about messaging.  We’re able to move quickly, it can be done as quick as three or four weeks.



Promotions…as you switch to fresh pairings, we saw that food costs were down but GM also declined, does this new fresh pairings have enough of an impact that it would have swung to a benefit or is there not that level of margin impact from this promotion?


Biggest issue is the introduction of the menu revolution. The promotion doesn’t have a significant impact on COGs. The difference that we see going forward is from the costs we see going forward rolling out the new menu.



First question relates to G&A, interest exp guidance. Implied 4Q guidance seems to suggest, ex OTB, that costs are increasing? Are you being conservative or what is going on?


What we might do with our credit facility at the end of the year is still in flux so the interest expense line is difficult to call conservatism.  The other two lines, perhaps can be called conservative, but profit sharing initiatives and other variables can move those lines up or down.



Do these retrofits and margin improvements happen in step or are there different investments or possible hurdles in the way? Do staff adjust quickly in your experience or will it take time for staff to ramp?


POS and KDS are already familiar to most staff.  Aloha system already in place in some restaurants.  The retro fit is where the big capital dollars come in place. $100k per restaurant. Relatively small investments with pretty quick returns in terms of guest satisfaction and margin performance – 30 to 45 days.



Advertising…you benefitted from rebalancing, media rates seem to be going up…demand may be a little softer for a while longer, do you expect to have to spend a little more on advertising going forward?


Our media costs are mostly accounted for over the next five months.



5 minute ticket time is a huge improvement…can you translate that into a comp?


When you put all of the initiatives together, no questions we see an increase in getting guests through, wait times shortened. 



EPS commentary…are we talking about $1.20, $1.24…double FY15 off that number?


Double eps is on $1.40 to $1.44



What is the comp assumption? 3%-4% longterm?


1%-2% for ’11 and ’12



How does margin expansion come then?


The initiatives will give us the margin improvements in 2011 and then in 2012 the kitchen benefit will kick in.



Given that comps came in at low end of the range, did the quarter end softly? There is an industry wide view that things are improving…did Chili’s lag?


We saw acceleration from February to March even on a weather/adjusted basis.



Maggiano’s numbers by month? March strength continuing into April?


3.8% in January, 3.7% in February, 5.4% in March.



What does this mean for the corporate spending rebound? Anything that would derail that? Is that something you see as playing out for the remainder of year?


We’re trying to grow the consumer experience? Working on a guest that doesn’t come that often.  If we can expand above the banquet/occasion business, we see a lot of growth.  Short term we see nothing that would change that.

I would say that business spending is starting to come back. Banquet bookings looking better.



Howard Penney

Managing Director

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April Flowers: SP500 Levels, Refreshed...

All they needed was a day-and-a-half of selling on well-placed Regulation Fear and the bulls are back!


I don’t know if I want to laugh or cry about some of the 2007 type behavior I am watching out here, but it is what it is. I guess we’ll know it’s a top when Ackmanism raises another $2B one-stock idea fund and calls it Yummy Targ-eh!


If there is no consensus shame in buying the SP500 up here, I certainly have no shame in reminding you where I am going to be selling it again. We issued this call on Friday and labeled our Q2 Theme April Flowers, May Showers. The overbought price level for this part of a massively bullish cycle remains 1214 (dotted red line).


Potential catalysts on the downside:


  1. AAPL earnings – oops, or is that still everyone and their brother’s catalyst on the upside?
  2. GS breaking down to $156? GOOG breaking down to $538?
  3. Producer Prices (PPI) will be another inflationary report on Thursday
  4. Dodd and his circus of clowns who live in the Bubble of US Politics performing under the Big Top (Thursday)?
  5. Gordon Brown will likely go at Goldman in the UK election debate Thursday night
  6. Home Buyer Tax Credit expires at the end of the week


The first line of immediate term support is now 1183. From today’s low volume intraday high of 1208, taking a peek at 1183 will definitely get people’s attention (a down -2% correction). Don’t forget that Friday’s down -1.6% day was the first down move of over 1% for the SP500 in 2 months. A down -2% move might be needed to remind people in this country that what goes up, can come down.


Keith R. McCullough
Chief Executive Officer


April Flowers: SP500 Levels, Refreshed...  - S P

Framing Up Volatility

Position: Closed our long position in the VIX on yesterday


We had a very astute subscriber ask about volatility and our view of risk / reward on being long volatility, specifically the VIX.  This subscriber’s point of view was that if the future of volatility was similar to the 2003 – 2007 time frame, there is potentially limited upside to being long the VIX.  In that period, broadly speaking, the VIX ranged from 10 – 20, so his point is a fair one to consider.


For starters, in our view, there are two key reasons to potentially be long volatility. 


First, volatility is potentially a hedge against the world unraveling with exponential risk / reward if the world does unravel. 

  • As a frame of reference, during the financial crisis of 2008, the VIX peaked at 79.2, which is ~360% upside from the current level of 17.3. In terms of downside, the lowest level the VIX has ever hit is 10.2, which~ 40% below current levels.  In aggregate, this is a risk / reward ratio of 9:1. In a scenario where the financial markets theoretically become unwound, like say in a spiraling sovereign debt crisis, being long volatility is very good protection.
Second, if we are expecting a market correction in the short term, which is our call, and believe that investors are getting complacently bullish, being long volatility as a way to play the correction is an effective instrument. 

  • From our perspective the Bullish / Bearish survey from the American Association of Individual Investors is a good indicator of emerging complacency, the bullish indicator hit 48.5% this week, which is the highest level since December and nine points above its historical average.  The Institutional Investor Survey that came out last week was even more extreme, with institutional bulls at 51% and institutional bears at 18.9%, which is the one of the widest divergences we’ve seen in the last decade.  In the first chart below, we’ve outlined our current trading levels on the VIX.

Longer term, the question remains whether the period from 2003 – 2007 is an accurate assessment of normalized volatility.  In fact, history actually suggests that that period may have been abnormally low versus history.  In the second chart below we’ve charted the VXO, which is the VIX normalized for a 2003 change in calculation, going back its inception in 1986, which emphasizes that there are periods of both low volatility and high volatility, with 2003 – 2007 being a low period.


At this point, we are not making a call on whether the upcoming period of volatility will be low or high, but I think we do need to keep in mind the context that the 2003 – 2007 was an abnormally low period of volatility when considering a position in volatility.


Daryl G. Jones

Managing Director


Framing Up Volatility - VIX


Framing Up Volatility - VXO

Gordon Brown's Losing Game

Position : Long Germany (EWG); Short Spain (EWP); Short Euro (FXE)


We’ve been vocal on rising inflation globally, a theme we’ve named Inflation's V-Bottom and outlined in our recent Q2 Themes call.  Certainly, today’s CPI reading out of the UK confirms as much, up +3.4% in March Y/Y, and is also a mark against Gordon Brown’s insistence that “staying the course” of Labour’s economic policy will bring prosperity.


The inflation print, which is up from an annual 3.0% rate in February, is now above the government’s soft cap limit of 3%, which itself was upwardly revised from 2%. As we noted in recent work, the UK economy continues to have its hands tied, struggling off its bottom, and we expect to see inflation continue to rise as commodity prices are up significantly over the previous year, nearing the prospect for stagflation. 


As the General Election approaches on May 6th, we continue to believe that party victory will hinge on the economic policy debate (it’s the economy, stupid!). Does Brown’s “stay the course” message have a chance?


Recent daily tracking polls show that the Liberal Democrat Clegg gained significant approval following last week’s initial political debate, one that set a historical precedent as the first political debate of its kind hosted on live television in the UK. While Clegg’s positive showing was a surprise, the recent average of most daily polls tracking the candidates shows a tight spread (YouGov for instance has a 6 point spread in conservative Cameron’s favor over Brown, or 33% to 27%, versus the Liberal Democrats at 31%), however Intrade, typically a stealth indicator in our opinion, would suggest that the favored candidate is Cameron, with a lead of over 70%.


While last Thursday’s debate focused on domestic issues, we’d expect the two subsequent Thursday night debates to cover such topics as banking issues (Goldman likely debated this Thursday) as well as the UK’s relationship to the EU, a position that especially pits Cameron’s Euro-skepticism against Clegg’s support.


Matthew Hedrick



Gordon Brown's Losing Game - 1

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