I like Dale Black’s answer to The Question we posed to gaming companies a few weeks ago. As a reminder The Question was (and still is):

Cost of capital is rising across the globe and returns on investment in the gaming sector appear to be falling. How does this impact your long term view of the industry? If this is the new paradigm what are your long term options for capital allocation?

  • Rather than dismiss the current difficult environment, Mr. Black acknowledges higher cost of capital is here to stay. Future projects will be judged assuming a higher borrowing cost than those prevailing during last few years of easy money. ISLE’s recent goals have included improving financial flexibility and matching future expenditures with the flexibility afforded the company in the new credit facility. The focus will be on improving operations of existing properties while reducing the leverage ratio one to two turns over the next 18 months. Mr. Black’s assertions are borne out in the numbers in the first chart. I calculate ISLE could reduce leverage to 5x in 2 years.
  • This sounds a lot like the Argosy plan from the late 1990s. For the younger folks, ISLE’s current management team successfully turned around Argosy Gaming at that time. They are off to a solid start with ISLE, despite the difficult environment. Mr. Black has to be one of the most underrated CFOs in gaming as he restructured the balance sheet to effectively provide liquidity until fiscal 2013. Despite the very high leverage, ISLE has no significant debt maturities until that time. Leverage should consistently decline as capex is curtailed. See chart #2. Operationally, ISLE just reported its FQ1 ended July 31st which was the first decent quarter in some time. Margins were clearly a focus and it showed.
  • Management seems to be saying and doing the right things. Moreover, there actually could be some upside to the EPS estimates due to continued margin improvement. I see only downside EPS possibilities for most of the other gaming operators. While the ISLE story certainly has some potential, I’m not sure the stock does over the near term. Forward EV/EBITDA is around 7.5x which, while not expensive, historical precedent shows could go as low as 5x. At that multiple, I could buy PENN which maintains an underleveraged balance sheet at 2.5x versus ISLE at 7x.
ISLE's goal is to deleverage by 1-2 turns in 18 months. This looks attainable
CapEx story looks promising

Quantifying the Margin Cycle

Excess capital in the apparel supply chain freed up about 18% of the industry’s EBIT for EACH of the past 8 years. Let’s look at some unit margin math…

I think that the biggest issue facing the industry today is what I’ll call the ‘Margin Grab,’ or the sheer amount of capital that is being either consumed by, or freed up by the apparel supply chain. It sounds theoretical, but I believe that it is absolutely quantifiable.

I love when I hear someone tell me something like “that analysis can’t be done,” or “there’s no way to arrive at that number.” To no surprise, this usually refers to something where a management team, third part data firm or lobbying organization has not done the work and made it available to the free world. I’ve had several people argue that the apparel retail industry’s margin structure cannot be quantified. It might not be ‘easy’ to get, but the answer exists.

Let’s pull out our calculators for a minute and do some good ‘ol fashioned math. We know the following. a) apparel CPI, b) the change in import prices and raw material costs, c) import ratio, d) US manufacturing cost premium, and e) the delta in units sold by month. We also know the pricing algorithm for a garment – i.e. the percent of each dollar that goes towards factors such as raw materials, shipping, factory costs, selling, obsolescence, mark-up, shrink and promotions.

When I net it all out, I get the net consumer price change per garment, and then the cost input change per garment. Net those two against one another, and viola! That’s the margin. A mere $0.14 in added net margin per garment might not sound like a lot. But multiply that by 19 billion units per year and it’s a different story. In fact, the average trailing 12 month net change in capital freed up by the supply chain over the past 8 years in this industry was $2.8 billion (see chart below). For a $200bn industry with 8% margins, this equates to about 18% of annual operating profit. Yeah… Not good.

Here goes McGough the broken record again…but even if macro factors improve, there are still big issues here. Over this time period the industry went from a 72% offshore model to 99% (which it hit last year). At a 5 to 1 cost differential that will not recur, this is a massive consideration. Also, it is before the added raw material costs we’ll see next year, and the lack of any benefit from a weak dollar (and potentially FX going the other way).

Be careful what you buy here… Numbers are still largely too high.

With that, have a great weekend…

An average of $2.8bn annually over 8 years was pumped into the industry's supply chain. There's structurally no more ammo left in the tank.

EAT – Some changes in the Proxy

Brinker International is a very conservative company and is managed that way. This point is driven home by reading the company’s proxy. That being said, there are a couple of small changes to this year’s proxy.

(1) Relative to change in control provisions, the company will only accelerate ‘in the money’ stock options.
(2) In the Perquisites sections, the company added an airline club membership to the list.
(3) Management made a point to highlight that they do not own or lease an aircraft.

I don’t know what to make of the latter two changes, but found them interesting regardless. A company’s proxy is like a living organism, it’s a reflection of management and how they are thinking about the business. So why is senior management thinking about a change in control in fiscal 2009?

I have taken the following statement from the proxy filed yesterday. “We do not have any change in control agreements in place with any of our officers. However, our stock programs and Profit Sharing Plan do contain change in control provisions. Under our stock option program, in the event of a change in control, the unvested options are accelerated and the optionee has the full remaining term to exercise.”

This is the good part:
“We have made a change to this provision which will take effect in fiscal 2009. We will only accelerate ‘in the money’ stock options.”

It goes on to say; “Vesting on all unvested restricted shares is also accelerated as of the date of change in control. Under our Performance Share Plan, the participant becomes 100% vested and the relative ranking is established as of the date of the change control thus ending the measurement period. In no event will less than 100% of the target award be distributed to the participant. As for our Profit Sharing Plan, if a change in control should occur prior to the end of the fiscal year, the participant will be eligible to receive a payment equal to the greater of the payout as calculated under the Plan provisions or his/her annual target award.”

The company’s amendments to its change in control provisions most likely don’t foreshadow anything significant in fiscal 2009, but I found them to be worth noting nonetheless.

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Euro Junk

European junk bonds are now trading at higher yield levels than equivalent US credits and, according to Bloomberg, more than 30% of European high-yields are trading at distressed levels – that's the most since 2003.

The easy money story of 2005-2007 was global indeed – and so is the aftermath. As European economies cool down and interest rates climb, bond buyers will continue to demand higher risk premiums.

Andrew Barber


Thank goodness for refundable deposits. Rather than invest in a low return project in Kansas near the Oklahoma border, PENN walked away and got its deposit back. It’s not a question of funding. PENN could have easily developed and paid for the $265 million project. However, the demographics, local economy, and competition from Oklahoma justified an investment of roughly half that amount. The project works at $125 million. Kansas required more. Stay tuned, I’m not entirely sure this is over.

It’s good to see that the $1.5bn in excess liquidity is not burning a hole in their pocket. This is yet another example of PENN management being good stewards of shareholder capital.
Cherokee county borders Oklahoma

Chinese Retail Sales Topping?

Tops are processes, not points. Below we have attached a 10 year chart of Chinese Retail Sales. Since this morning's report incorporated the Olympic lift, it behooves us not to ask 'The Question' - is +23% annualized growth as good as it gets? We think it is.

On an absolute dollar basis, food inputs are a huge component of these figures. Keep in mind that this data is drawn from the immediate build up to the Olympic Games and, according to Bloomberg, NBC retail data includes “commodities sold to government agencies, institutions, social organizations, and military and armed police units”. With an army of police and military security on hand for the games in Beijing as well as 1.7 million “Citizen Volunteers” that all needed to be fed , that number may have seen a significant uptick in July due to bulk purchasing.

Keith McCullough & Andrew Barber
Research Edge LLC

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