The Return on Equity (ROE) and Return on Invested Capital (ROIC) trends shown in the chart below are scary enough. Throw in the fact that ROE is actually declining at a faster rate than ROIC and the situation is downright frightening. We estimate ASCA’s cost of borrowing will go up by 2% in 2009 as the company either refinances its entire credit facility, raises subordinated debt to shore up its senior leverage ratio, or negotiates a higher leverage restriction in exchange for a higher rate. A borrowing cost increase of 2% is probably a best case scenario for ASCA, especially considering a likely covenant bust by Q2 2009 (see my 8/14/08 post, “ASCA: TOEING THE COVENANT LINE”).

I’ve also been generous with my calculations as it relates to “non-recurring” items. All have been excluded resulting in higher ROE and ROIC than the standard measures.

This simple analysis hits on several themes I’ve been focused on: liquidity, escalating costs of capital (although you wouldn’t pick this up from the analysts’ models), over earning, and lower ROI’s. ASCA’s liquidity issues will force the company into a higher borrowing cost capital structure. Risk premiums are escalating, also forcing up interest rates. Finally, on the return side ASCA is not helping itself. The company made one of the worst acquisitions ever in gaming, buying Resorts East Chicago at the top (11x a declining EBITDA figure), ahead of a huge expansion, renovation, and rebrand at nearby Harrah’s. This poor decision is a major driver of declining returns.

Most gaming operators have been over earning (see 8/10/08 post) due to unsustainably low interest rates on credit facilities. No situation has been more egregious than ASCA. All good things must come to an end and so has the era of cheap money.

ROE declining at a faster rate than ROIC

Canada Wins!

I promised our Canadian readers that I would dedicate a post to their 1st medal, when it happened. Over the span of 46 minutes at today's Olympics, they won 3 - gold, silver, and bronze!

LDG, Part I: An Eye On Pershing Square

Bill Ackman’s remarkably well timed purchase of Longs Drug Stores has already been called the “trade of the year” by at least one publication. We always love to read about a great “Trade”, but even before the news of the CVS acquisition broke we had already begun looking at the filings made by Pershing Square for different reasons.

As you recall we followed the CSX/Chris Hohn court proceedings intently as they related to the use of total return swaps by activist shareholders. As such, the filings made by Ackman had some interesting language that caught our ‘HedgEye’.

A total return swap, for those that are not familiar, is a contract which gives the purchaser a synthetic economic interest identical to an outright long or short position, typically on a significantly leveraged basis.

Even if the economic interest exceeds the equivalent of 5% of shares outstanding, most funds do not file their position with the SEC since the swaps do not confer voting rights. One of the arguments made by attorneys for CSX during their suit against TCI was that, as the fund had arranged to have the banks providing them with exposure to CSX via swaps to vote their shares according to instruction, TCI by extension had filing requirements.

In his ruling, Judge Lewis Kaplan seemed to agree with CSX’s argument that using swaps as an end run around filing requirements violated the spirit of the law, if not the letter of it in his conclusion that “Some people deliberately go close to the line dividing legal from illegal if they see a sufficient opportunity for profit in doing so. A few cross that line and, if caught, seek to justify their actions on the basis of formalistic arguments even when it is apparent that they have defeated the purpose of the law”.

We are not lawyers but, when Pershing Square filed a 13D for the famously well timed LDG purchase, a sentence in the discussion of the swap transactions they had executed caught our eye: “These Swaps do not give the Reporting Persons direct or indirect voting, investment, or dispositive control over any securities of the Issuer and do not require the counterparty thereto to acquire, hold, vote or dispose of any securities of the Issuer.”

We don’t know if Ackman’s attorneys at Proskaur Rose had already been including that language in their boilerplate before the CSX/TCI dust up but it seemed to put one possible issue to rest, if only they had disclaimer language that could answer some of the other head scratchers raised by the timelines for these trades.

Attached are some charts which map out the series of events laid out in the 13D filings made by Pershing Square in recent weeks. We will be exploring several different aspects of this situation in the coming week –stay tuned.

Andrew Barber

Keith McCullough
Chief Investment Officer

Early Look

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MCD – Coffee conversion math!

Here are is what we know so far:
4Q07 – No comment from the company when asked on the conference call about the number of stores selling specialty coffee, but they did not expect to see critical mass until later in 2009.
1Q08 – “We are currently in about 1300 restaurants and expect the rollout to accelerate and pick up pace later in the year.”
2Q08 – “Specialty coffees is just one element of the combined beverage business and it’s currently in more than 1600 restaurants.”
3Q08E - ???

If we assume the company accelerates the conversion process in 2H08 and converts 1,200 stores, the total number of McDonald’s stores with the ability to sell specialty coffee in the US would be 2,800. This represents only 25% of the McDonald’s system! McDonald’s senior management has set expectations for a national launch for the specialty coffee program in mid-2009. If it has not started already, the 2009 budgeting process needs to incorporate the national launch of the specialty coffee program. If only 25% of the store base has the ability to sell specialty coffee, how can the company justify spending the marketing dollars in 2009? More importantly, will the franchise system embrace the move?

Right or wrong management is committed to the specialty coffee program, I believe they need to reset expectations.

The US Dollar Remains THE Factor...

The governing factor that will beget further immediate term strength in the US stock market, that is...

The US Dollar Index is defying the skeptics (including myself), continuing its rally in the face of an easy money US Federal Reserve. I am data dependent, and respecting this factor above all reasonable doubts. As the facts change, I will.

Today the US Dollar is up another 60 basis points to 77.16, taking its 1 month moon shot rally to +7.3%! This has led to a meltdown in everything commodities related, and provided the impetus for a bullish US stock market "Trade".

The "Trade" higher in the US$ is undeniably bullish, but will run out of momentum at the 77.55 level. I have attached the long term chart. All Bernanke has to do to extend this currency strength above my level, is step up to the plate and raise interest rates.

  • Next level of resistance in the US$ is 77.55
(chart courtesy of

Yes, Asia Has Slowed!

Hong Kong reported the most important economic data point of the day, with a GDP report that slowed to +4.2% for Q2 of 2008, down sharply from Q1's year over year growth rate of +7.3%.

I have attached a chart of the meltdown in the Hang Seng Index, which has dropped -33% now from its October 2007 highs.

Today the Hang Seng led Asian equity markets lower, closing down another -1.1% at 21,160. Next level of support is 20,857.

Until this picture improves, fundamentally or quantitatively, there is absolutely no reason to buy into the notion that the worst of the global growth slowdown is behind us. This remains a fluid situation that I am monitoring very closely.
  • Hang Sang's Collapse
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Chart courtesy of


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