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State of Valuation: 6x is ‘So Last Cycle’

There are plenty of cheap things in this market. But the apparel/footwear retail industry, in aggregate, is not one of them. In most market environments, 6.5x EBITDA starts looking pretty darn good. But the 6x EBITDA hurdle is turning out to be ‘so last cycle.’ 3-4x is looking better to me for key longs, and is my new line in the sand.

Iceland: Go Tell The Spartans

This battle was lost before it was even fought...

When the 300 Spartans stood at Thermopylae they were able to hold off the entire Persian army for days because they had their backs to a narrow mountain pass. The only way that their enemies could pass was through that narrow corridor and, as such, the few could hold off the many. In Russia Putin & co. are using the same technique to stabilize their stock markets: creating a liquidity valve that they can control –in this case by turning off the stock market. The Icelandic government’s attempt to hold the line at 131 vs. the Euro by contrast was the tactical equivalent of Custer’s debacle at the Little Big Horn, a small misguided and outnumbered force surrounded on all sides.

The line has collapsed and the Krona is rapidly losing any value. Here are some of this week’s highlights:

• Iceland's government has given up attempts to bolster Glitnir Bank. It is now in receivership.

• UK PM is threatening legal action if the 300,000 accounts of UK citizens in Icesave, an online subsidiary of a failed Icelandic institution (lots of UK residents opened online accounts with Icelandic banks to get the super high interest rates -whoops) were not granted in the same manner as domestic deposits.

Conflicting reports regarding the proposed Russian Government in the media suggest that it is a far from done deal.

Andrew Barber
Director

State of the Industry: Beware the Sucker Punch

Step 1 was ‘State of the Consumer.’ Step 2 is ‘State of the Industry,’ which is outlined herein. Step 3 is nailing who wins, and flushing out my list of who goes bankrupt. That one is growing.

From an industry standpoint, the conclusion is that looking forward, the year/year trajectory in sales and margins might start to look like an intriguing ‘Trade,’ but tread lightly as the ‘Trend’ is headed lower, and does not synch with the consensus 40bp improvement in margins next year. Let’s look at the key profitability components…

Revenue: In aggregating the top line the industry is still humming at about +5% vs. last year – despite a sharp sequential deceleration. Comp store sales are running down low-single digits, but yy compares don’t start to get easier until December, and then more meaningfully so in June. That might be good under most circumstances, but go back and read my ‘State of the Consumer’ postings. This is precisely the point when the yy delta in spending for the consumer in aggregate will intensify. My point? Don’t get suckered into the ‘comps are getting easier’ argument.

EBIT Margin: Margins troughed in 1Q, and while still off -175bp vs. last year, they are clearly ‘less bad’. That’s good at face value given that margins drive stocks in this group. But there are two factors we cannot ignore. 1) Working capital in this industry is at its lowest level in 8-years. There’s not enough working capital to drive operating profit growth even if the consumer did rebound. Historically, higher margins on top of normal working capital levels resulted in a meaningful pop in growth. It’s very difficult to get the math to make that work today. 2) Margins are still sitting at 8-9% overall – right in line with where they were before margins raced higher in ’04-’07. No reason why they can’t go lower. In fact, they will.

Lastly, the SIGMA chart below ties it all together (triangulating sales growth and inventory growth on the vertical axis, with the change in gross margin on the horizontal). The picture this paints is one that has been healthy over the past 1.5 years – especially the last 3 quarters. My sense is that we’ll see this trajectory head down and to the left. Never a good event, and one that clearly does not synch with the consensus expectation for margins to head higher by 40bp.


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 80.28%
  • SHORT SIGNALS 78.51%

MACAU VS OTHER GAMING MARKETS

Actually, Beijing’s interference is a major driver of the sharp sequential downturn in gaming revenues in Macau. While underlying casino demand declines across the globe, it is accelerating in Macau. However, Beijing controls the spigot. If you believe Beijing favors long term sustained growth for Macau, as I do, then Macau now appears to be a much better relative value than other gaming markets. Government interference in the US economy will do nothing to stem the negative trend in gaming revenues. Las Vegas faces a fundamental demand issue as consumers tighten, savings rates escalate, travel becomes more difficult and expensive, and the Strip pays the price for raising prices so much over the past few years.

Macau’s issues are short term and will likely get better next year at the latest. The Strip’s problems are structural and cyclical. Where would you rather invest?

THEN AND NOW PART II

In a prior post, I examined the poor stock price performance of gaming stocks in the late 1990s. Similar to now, same store sales declined dramatically but unlike now, total market revenue continued to expand. Another difference between then and now is leverage. Leverage ratios remain at all time highs (see chart #1) and certainly are contributing to all-time low valuations.
  • With a global credit and liquidity crisis, it’s no surprise that one of the most leveraged sectors has grossly underperformed. Strangely, the valuation variance across the gaming sector is low. BYD and PENN own the liquidity in the industry, yet trade roughly in-line with the group. PENN runs at least 3 turns below the average gaming leverage ratio and BYD, while at average leverage, should be able to de-lever faster than the rest.
  • The opportunity is glaring. The companies that risk managed their liquidity and balance sheets smartly (BYD and PENN) are lumped in with the rest because they are gaming stocks. As can be seen in the second chart, PENN barely outperformed the group this year and BYD underperformed. Strange that the factor that has caused gaming to underperform the market so sharply wouldn’t also drive relative value. That’s not sustainable.
Gaming leverage ratios remain at all-time highs
Despite higher liquidity, BYD and PENN lumped in with the rest of the sector

US Market Performance: Week Ended 10/10/08...


Index Performance:

Week Ended 10/10/08:
DowJones (18.2%), SP500 (18.2%), Nasdaq (15.3%), Russell2000 (15.7%)…

October/Q408’ To Date:
DowJones (22.1%), SP500 (22.9%), Nasdaq (21.2%), Russell2000 (23.1%)…

2008 Year To Date:
DowJones (36.3%), SP500 (38.8%), Nasdaq (37.8%), Russell2000 (31.8%)…

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