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PENN: THE ROE ROCKET SHIP

It’s all about liquidity and capital deployment. The gaming industry had too much of the former and failed miserably with the latter. As a result, the gaming operators are grounded in the silos of high leverage, escalating borrowing costs, and declining return metrics. And there is no one on the horizon to push the launch button. All one can hope for is cash flow stability as deleveraging becomes the main goal. Almost a microcosm of the US consumer, no?

Deleveraging is not exactly a compelling investment theme. A terrific balance sheet, excess liquidity, growing acquisition opportunities, and a return focused management team; now there’s an investment thesis. I’m referring to PENN, of course. I’ve made some calculations assuming PENN deploys its excess liquidity into gaming assets and/or companies at 7x EBITDA. The two scenarios assume capital expended to reach leverage ratios of 4x and 4.5x, respectively, both below the industry average at 5x for public gaming operators. PENN’s target leverage is 4.5x so that is the more realistic ratio. In this scenario, ROIC remains constant with EBITDA acquisitions at 7x, although lower multiple opportunities might become available if the company is patient. ROE, however, explodes as PENN adds leverage, up to almost 18% at 4.5x. It might be time to get in now before those missiles are deployed.

Unlike the industry, PENN can actually leverage up ROE

SIGNS OF LIFE IN THE REGIONAL GAMING MARKETS?

Iowa is usually the first gaming jurisdiction to report monthly gaming revenues. While not a hugely important state (unless you are an investor in ISLE or ASCA), gaming revenues were up a surprisingly strong 5.4% in August. The calendar was favorable with an extra Saturday which probably added 2-3% to the month, but still solid growth especially relative to recent trends (see chart).

More importantly, however, Iowa has been somewhat of a bellwether for the other, larger markets. The hawkeye state’s gaming revenues correlate strongly at 0.73 with the rest of the regional markets. Anecdotally, we have heard August was stronger in the heartland. Could lower gas prices be having an impact? Possibly. It may be too early to call but any positive inflection point could give these cheap stocks a lift. We would focus on PENN and PNK.


Riverboat trends are in need of rescusitation

TSN – Look before you buy

According to the National Agricultural Statistics Service, the total number of chickens currently slaughtered on average in the United States equals approximately one million birds an hour –that’s one million every hour, day and night, every day of the year.
  • The first chart is US chicken production as a percentage of the total estimated US population since the depression. The industry is losing millions every day and there has been no real change in capacity. This can’t continue!
  • The second chart is the per capita estimates that the National Agricultural Statistics Service team prepared. Do you think we eat enough chicken? Also, per capita consumption is clearly on the decline. The theory of trading down to chicken in a slow economic environment looks to be a myth.
  • The excess capacity of broiler production in this country is staggering. It’s going to take a massive cut back in capacity to fix the supply issues. The question is who will blink first? The answer lies in the balance sheets….

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Trend vs Trade

The trendline for inventory sales over a longer duration is definitely positive for retail in aggregate (see this afternoon’s post). But let’s not forget where we are in the current sales/inventory and margin cycle. 2H08 looks good. Period. We’re seeing sales growth 4-6% in excess of inventory growth (better yet, we’re seeing inventories erode 4-6% less than sales), which is a good margin event. But this spread can’t remain positive forever – in fact it’s never been positive for more than 5 quarters in a row in the history of modern apparel retail. Consensus estimates are calling for a 35bp improvement in ’09 – a year I think we’ll see another 50bp hit to margins.

My point here is that retail is trading at 7.3x EBITDA. Yes, that seems cheap at face value if we look back 5 years. But taking a historical view I can easily argue anything between 4-6x.

This remains a stock-picker’s space. I like RL, FL, LIZ, TBL, KSWS, PSS and ZK. I don’t like GES, WRC, SKX, GIL, DKS, PVH, and VFC.

These Charts Fascinate Me

I am absolutely fascinated by these charts. The first one isolates the clothing and shoes category, and compares at government-reported retail sales versus the inventory-to-sales ratio. From 1993 through 1Q2007, the inverse correlation was like clockwork. Sales go up while inventory/sales go down and vice versa (i.e. little respect for inventory management). But starting in 2007, the two became one. For the past year and a half, the inventory/sales ratio fell while sales were falling. That’s a first for US retail.
  • We can’t even blame this on the fact that it is government data, which has historically been mediocre. The second chart maps the inventory/sales trend for public companies versus the US retail universe as defined by the government. Pretty close.
  • Yes retail is more mature now than it was 15 years ago. Yes there are better inventory management systems in place today versus the 1990s. But neither of these hit critical mass in 1Q07. What did happen in ’07 is that much of the margin benefit from sourcing and quotas went away. Then several quarters later the consumer turned down. We saw inventory cuts, and we saw them big time.
  • Then we had rising input costs. Now we’re faced with a strengthening dollar. Both of these last through ’09 at least in my opinion. In fact regardless of the consumer, I think we see this sourcing pressure (due to supply/demand imbalance out of Asia) through at least 2010.
  • We’ve all heard management teams say “we’re managing our business conservatively in this tough retail climate.” In other words “we don’t have a clue what sales will be like, so we’ll err on having less tied up in our supply chain.” A defensive strategy, but not one that promotes growth.
  • I still think that the bifurcation between winners and losers in this space will be massive heading into ’09.
Huge decoupling in 1Q07
Inventory/Sales for companies reporting comps vs government retail stats.

Putin, Cheney and Chicken

Recently, Putin accused the US of backing Georgia, and as a result he put the squeeze on the US chicken processors by banning exports from 19 US plants.

According to the FT, Dick Cheney, the US vice president, pledged on Thursday that Washington would stand behind Georgia, helping rebuild the country’s economy and promoting Georgian efforts to join NATO to protect against Russian aggression. If I’m a CEO of one of the major chicken processors in the US, I could not be happy with the Bush Administration. If Putin is punishing the US chicken processors because of our stance on Georgia, the future of that export market can’t be good.

Today in NYC, the CEO of SAFM said the loss of Russia as an export would be devastating to the industry. We also learned today that TSN is increasing its liquidity position by selling equity. Why would TSN be increasing it liquidity position as this point in the cycle? Interesting timing on the part of TSN!

  • I’m taking the cynical view of this move….


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