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US Market Performance: Week Ended 9/26/08...

Index Performance:

Week Ended 9/26/08:
DowJones (2.2%), SP500 (3.3%), Nasdaq (-4.0%), Russell2000 (6.5%)

September 08’ To Date:
DowJones (3.5%), SP500 (5.4%), Nasdaq (7.8%), Russell2000 (4.7%).

Q308’ To Date:
DowJones (1.9%), SP500 (5.2%), Nasdaq (4.8%), Russell2000 +2.2%

2008 Year To Date:
DowJones (16.0%), SP500 (17.4%), Nasdaq (17.7%), Russell2000 (8.0%)

UA: I’m Warming To The Armour

Yes, you heard it right. McGough, believer in the UA brand, but perennial bear on UA’s margin structure, is warming to the fundamental story. I’m buying on bad numbers. Here’s why…

First off, let me say that I still think that gross margin expectations in 2H are still too high, and I do not think that 2H numbers are doable. With 45% of the float short the stock, that may or may not matter. Nonetheless, I’m not here to game near-term sentiment. Let me hit on some fundamental factors…

This is really all about footwear. I’m increasingly of the view that UA will rival New Balance as the #2 footwear brand in the US after Nike (NB has 9% share to Nike Inc’s 42% and UA’s 1.2%). This is a $600 million delta. This is more than just a ‘the brand is hot’ call, but rather increased confidence on my part that the right financial levers are being pulled to drive growth in this space.

We all know the narrative. First establish the brand with apparel. Then come out with football cleats, then baseball – both low margin, but brand authenticators. Then step into the cross-training footwear market, and then running – both of which have mass appeal at a higher margin. Makes sense to me.

But when I heard about basketball, and that UA was beginning to endorse basketball athletes, my immediate thought was that it was entering a fight it could not win (with 1/20th the financial resources as its competition). In fact, as soon as I saw that UA endorsed High-School star Brandon Jennings – who skipped college to ‘incubate’ in Europe for two years before a planned comeback to the US. First I chuckled, but then I stepped back and analyzed the trend in UA’s athlete endorsement commitments, and was surprised with what I found. (Reference Exhibit below).

1. UA’s forward commitments to athletes is running at 8.8% of sales, compared to Nike at 20.5%. You can argue both sides of this one. Either a) UA’s cost of entry has to head meaningfully higher, or b) that it is doing more with less. Both are valid, but brand momentum leads me to put more weight on the latter.

2. UA’s endorsement payments are largely front-end loaded. For example, 99% of its contractual obligations need to be paid in the coming 4 years. In the case of Nike, 29% of endorsements are guaranteed after year 5. I have a pretty darn good feel as to how Nike strikes its sports endorsement deals, and do not think that its approach is aggressive by any means. But based on what I see at UA, I’m increasingly of the view that its approach is downright conservative. That was a shocker to me.

3. Supporting that view, 79% of what UA is contractually obligated to spend is due within 2 years. Does that mean that near-term SG&A pressure is looming? Nope. In ’06, UA’s next 1-2 year obligations stood at $18mm, but in ’07 it paid close to $15mm alone. That emphasizes the strong variable component that UA has in its endorsements. Whether we’re talking athlete endorsements, or retail operating leases – it is the long-tailed deferred arrangements that have historically gotten brands and retailers in trouble. UA seems to have a winning strategy thus far. Note to UA management – don’t veer off course!

4. Another important point as it relates to footwear is capacity procurement. Anyone reading my work over the past year knows that I think that both availability of and pricing for footwear capacity in Asia is radically shifting out of favor for the brands. We know Nike will end up winning. Adidas too. Here, size matters. But I also know that factory space previously earmarked for private label product, as well as smaller US brands (incl SKX) is converting to UA – with 2 notable capacity transfers over the past two months. Simply put, Asian manufacturers want brands that they know will be growing.

5. Lastly, in a perverse way, UA’s inability to grow aggressively outside the US gives me more confidence in the stability of its earnings power due to less FX impact relative to competitors. This is not a positive, but it is certainly a lack of a negative faced by 90%+ of apparel companies.

The bottom line with this one is that it is definitely not out of the woods yet. GM expectations are too high, and inventories still need to head lower. But the company executed flawlessly on its cross trainer launch, and I think we’ll see the same from its running initiative (despite competition from Nike, New Balance, Asics and K Swiss – which can’t be ignored). I’m gaining respect for the company’s financial approach to driving growth, and clearing out inventories and taking the GM hit would seal the deal for me.

If UA feels pressure in the weeks ahead as numbers come down, I’m likely there to support it. If the stock holds in despite weak numbers, then that’s bullish too. If I’m wrong and numbers don’t need to come down, then this thing is off to the races. Either way, I think you get my point…


MGM management has met with a lot of investors as of late in addition to trying to raise $3bn for CityCenter. The company has been pretty consistent with its commentary that Q3 is a lot like Q2 and Q4 looks better. Of course, it depends on what metrics are used for the comparison. When times get tough, gaming management teams tend to focus investors on occupancy rates to give the impression that Las Vegas is still in demand. Unlike other hotel markets, Las Vegas casino hotels cut rates to sustain occupancies so occupancy is a poor measure of the underlying demand. I believe the decline in Q4 room rates will look worse than Q2.

The other major focus is gaming revenues. July’s 15% decline in Strip revenues was horrendous. The only August data to be release thus far was the McCarran Airport passenger data which actually deteriorated from July (-9.9% vs. -8.6%). However, the comparison breakdown is completely different: The 2008 July table hold percentage came in well below 2007. August gaming revenue may only fall low to mid single digits as table drop in August 2007 was abnormally low and slot hold percentage was also low. Given the investors’ reaction to the airport data (MGM down 13% in a down market), I would expect a positive reaction to any Strip gaming revenue decline less than the airport traffic decline. These numbers should be released between October 8-10th.

The August gaming revenue release may be the last positive data point for Las Vegas for some time, however. The trend is firmly in negative territory. Room rates are likely falling at a faster rate. Table drop and slot volume trends are declining, even though the near term trade is better (but still negative). Gaming revenue comps may be where MGM is getting its Q4 optimism. Sequential Q2-Q4 comps last year were 4%, 6%, -1%, respectively. However, with less airline capacity and higher airfares, already pinched consumers, and slowing global economies, my money would be on a weaker Q4, not a stronger one. And I am a betting man. As discussed in my 8/06/08 post “MGM: SOOTHSAYERS OR HOPEFUL AGNOSTICS”, MGM management actually has about as much visibility as we do on the Q4. We’re data dependent here at Research Edge and the data is certainly not making me feel better about Q4.

Easy Aug comps could be near term catalyst but underlying metrics are in decline

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Primary Insights Efforts – BKC Discounting

Our “primary insights efforts,” which included a survey of various Burger King restaurant managers/employees, showed that 78% of the restaurants surveyed are currently offering some type of corporate promotion/incentive. According to restaurant employees, these promotions include “buy one, get one free,” the Value Menu, and various meal coupons distributed primarily through newspapers and the mail. Most respondents agreed that the incentives have helped to generate more sales. We did not ask, however, how these discounts are impacting margins. On a more positive note, a handful of the BKC employees did highlight that the corporate office has introduced new and different sandwiches which are helping to drive sales.
  • As I have said before, discounting has become more prevalent across the QSR industry as restaurant operators attempt to drive increased traffic (often at the expense of margins), so BKC is not alone. Recent NPD trends also show that BKC’s percent of visits on deal has continued to tick up. The same can be said for the entire QSR hamburger category which has seen its level of discounting climb rather significantly since mid-2007.
  • We will follow up with other primary insights efforts results, including a look at BKC’s current sales trends.

Eye On Leadership: Volcker As Bailout Czar!

As Congress works over the weekend attempting to overcome partisanship and presidential election year maneuvering to pass the financial bailout bill, we continue to question the lack of leadership in Washington D.C. According to the Associated Press this morning, the bailout bill which was three pages in length a week ago now totals 42 pages, so the bill has increased in its length and complexity by 14x. In that period, Washington Mutual has gone bankrupt, which is largest bank failure in United States history.

We have reservations about government led bailouts in general, but our analysis of global credit markets continues to indicate that credit markets are tightening and the crisis will continue without some form of intervention. So our issue is not with the concept of intervention, but rather the leadership of the intervention. We have one suggestion - Paul Volcker.

In our opinion, the 6’7, cigar chomping Princeton graduate is the best hope for leadership in this crisis and both parties should come together to name him “Bailout Czar” with the role of managing the disposition of the $700BN+ mortgage securities that the U.S. government is about to take on its balance sheet.

As we have said repeatedly, facts don’t lie, people do. And the facts in regards to Volcker’s ability to manage through a prior fiscal crisis with integrity and against popular opinion speak for themselves. Volcker is rightfully credited with ending the United States’ stagflation crisis of the 1970s. Chairman Volcker abandoned interest rate targeting and adopted policy to limit the growth of money supply. His policies led to a sharp recession and were widely unpopular, but inflation which peaked at 13.5% in 1981 was 3.2% by 1983. Volcker was decisive, unpopular, but ultimately more right than any economic leader has ever been.

The only real issue with this proposal is that Volcker is as an advisor to Presidential candidate Barak Obama; so the Republicans would likely be reluctant to approve Volcker for the position. We would just remind partisan Republicans that the Democrat Volcker was appointed by President Carter in 1979 and reappointed by Ronald Reagan in 1983, an election year. As Treasury Secretary, Donald Reagan, said at the time of Volcker’s reappointment: “He’s the right man at the right time.”

While Hank Paulson getting down on both a proverbial and actual knee to ostensibly pander for bipartisan support for the “Paulson Plan” is an interesting image; and while we have no doubt Paulson is a “good man”, we just think it is once again time for “the right man”.

Daryl Jones
Managing Director
Research Edge LLC


One would be hard pressed to find a sector that benefited more from the easy money era than gaming. Unfortunately, for investors in many of these stocks we’ve come to the end of an error. Throughout most of the decade, gamers exploited the low interest rate environment to over invest and over leverage. Wall Street loved it. Long term IRR and ROI? Who cares? Growth and EPS accretion, where do I send the check? Gaming stocks outperformed the S&P by a wide margin over the past decade. As the chart shows, the level of outperformance correlated very closely to the inverse of the US corporate bond yield. In fact, the level of interest rates explained 62% (R Square=0.62) of the spread between gaming stocks and the S&P.

It should come as no surprise that gaming stocks have been pummeled by the recent credit crisis. Gaming management teams left their companies with super high leverage and significant debt maturities in an environment where cash flows are declining. As these companies refinance over the next year or two, it will become crystal clear how much they’ve over earned the past few years.

Of course, there are exceptions. There are companies on the right side of this liquidity trade. BYD, PENN, and WYNN all maintain low relative leverage and tremendous liquidity. The rest of the gamers have had religion crammed down their throats by the credit markets. BYD recently found religion on its own and suspended Echelon. WYNN and PENN never lost it.

Gaming stocks outperformed the S&P during the easy money era

Hedgeye Statistics

The total percentage of successful long and short trading signals since the inception of Real-Time Alerts in August of 2008.

  • LONG SIGNALS 80.46%
  • SHORT SIGNALS 78.35%