Adidas: Don’t These Guys Learn?

Adidas is buying Ashworth, a maker of mid-priced golf apparel, for $72.8mm or a 10% premium to Friday’s close. The market loves the deal. I simply don’t get it. Does ROIC matter to this company?
First off, Ashworth has no EBITDA, and is burning cash every day that it remains in business. EBIT margins peaked in ’04 at 10%, but has steadily crept to -8% as it grew its moderate brands into expensive company-owned retail stores (note SG&A ratio went from 31% to 42%). That’s a component of retail 101 this company ignored (and cannot easily fix).

Cash flow valuation here is useless (bc there is no cash flow), so I think that the best thing to do is to look at book equity, which is where this deal looks cheap at 88%. My only reservation is that most of this value is finished goods, and my confidence in the quality of inventory is not high. In addition, we need to consider the forward lease obligations of $75mm (which most people fail to do).

I guess what shocked me the most is that Adidas does not do well when it buys assets that 1) it needs to fix, and 2) overlap with existing businesses (like Taylor Made). Remember Reebok? $3bn invested in another brand that went away. If Adidas had invested that in its own brand, it would not be getting crushed in the US market today.

So why did they do this? My sense is that it is to leverage the fact that Ashworth has the license to make Callaway apparel. To say that Ashworth has done a poor job there is an understatement. Can Adidas make this work and leverage its TMaG infrastructure? Probably. But as a shareholder I’d rather see the company invest half that amount in its own brand and drive higher EBIT, better brand awareness, and better ROIC.

China Exporting Capitalism?

The most positive macro economic data point of the day came out of that really big country with a lot of people, China. Remember them?

Chinese exports grew sequentially, on a month over month basis, and shot up to +21.5% y/y in their September report this morning. This acceleration from August isn’t that surprising given that the country is no longer halted due to Beijing’s Olympic lockdown.

With a trade surplus of another $29B, the Chinese have what the rest of the world needs – cash. Sitting on $1.8 Trillion in currency reserves would be a pretty safe spot for even the likes of the antiquated Hank the Tank Paulson. Unfortunately for the USA, we may have to get down on our knees and beg for China to keep buying our bonds with that cash. If they don’t… you should have scary thoughts. The biggest asset bubble yet to pop is that of US Treasuries.

Cash is king, and the Chinese wanna be capitalists are on the prowl with it. Remember, they allow short selling now!

We are China via the FXI and EWH exchange traded funds. Our levels on the Shanghai Composite Index have been reviewed and here’s where the bullish lines are in our model:

"Trade" bullish > 2166.59
"Trend" bullish > 2512.11

This longer term chart of China should tell you one thing. There is plenty of runway here!

Keith McCullough
Research Edge LLC

SP500 Levels, Refreshed: Don't Sell Too Soon!

Below we have painted the lines for the new range we see in the SP500. Buyem at 842.33, and Sellem at 1018.89.

This isn't rocket science, but it is math.

Patience pays.

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DIN – Giving away food will not solve DINs problems

IHOP is rolling out a national Halloween promotion by inviting everyone to enjoy Trick or Treat All-You-Can-Eat Pancakes any time of day or night from now through October 31. IHOP said “guests can also compliment their pancakes with a Never-Empty Pot of IHOP's International House Roast coffee, a rich blend of premium beans selected, harvested and roasted exclusively for IHOP.

DF - Returning to normalized levels of profitability.

The year 2007 was a wakeup call for DF. An ill-timed leveraged recapitalization and run away commodity inflation put the fear in management that they might lose control of the company. Therefore, a major corporate initiative became critical to the future of the company. In late 2006, senior management started to undertake a strategy to enhance the profitability of the organization. The intent is for DF to become a more focused company, improving returns on its existing asset base rather than generating returns from an industry consolidation strategy. Fiscal 2008 marks the first year where there is a new leadership team and corporate structure in place at DF. The new combination will ultimately change the direction of the company. The new DF structure should allow the company to be more efficient in the areas of distribution, purchasing and G&A. The combination of the company’s asset rationalization strategy and significantly lower input costs will lead to significantly higher levels of profitability.
  • Declining Input prices

    The primary raw material used in DF’s Dairy Group is raw milk (which contains both raw milk and butterfat). Both the federal and state governments set minimum prices for raw milk, and those prices are set on a monthly basis. In 3Q08, class I milk prices declined 11.9%. Last year in 3Q07 class I milk prices peaked at $21.91 and gross margin declined over 600 basis points.

    Complicating a difficult milk environment, DF also saw a significant increase in gas prices. Every month, DF’s dairy group purchases approximately four million gallons of diesel fuel to operate its DSD system. Also, a byproduct of higher oil prices is higher resin prices, which DF uses to make plastic bottles. As an aside, DF purchases 27 million pounds of resin and bottles per month. Significantly lower oil prices will contribute to a positive bias in margins.
  • Putting the organic milk issues behind them

    In 2006, the economic incentives for farmers to transition to organic farming dramatically increased the growth of supply in 2007. Not surprisingly, the oversupply led to significant discounting and increased distribution to stimulate demand. This led to a significant reduction in profitability from the Horizon Organic brand. The economic/consumer spending issues of the past 12-months is beginning to shift back to a more favorable supply/demand situation in 2008. In total, the Horizon Organic Brand is less than 5% of total operating profit, but the profit recovery story will add to the positive bias in profitability. DF significantly increased marketing and investment behind the brand in 3Q07, depressing profitability in the quarter. A return to a more normalized environment for organic milk in 3Q08 will help profitability and investor sentiment.
  • Summing it up

    Clearly, the decline in profitability at DF was magnified by the recapitalization done in 2007. Now In October 2008, there is clear evidence that the company’s fortunes have turned. Internally, the company is making significant changes to improve profitability. Externally, as commodity prices decline and profitability improves over the next twelve months, the company’s working capital needs also decline. The decline in working capital will allow management to accelerate its debt reduction and further enhance the equity value of the company.

The Slowest Man On Campus

“If you have an important point to make, don’t try to be subtle or clever… Use a pile driver. Hit the point once. Then come back and hit it again. Then hit it a third time – a tremendous whack.”
-Winston Churchill

For three long days did I ever feel that way. I kept investing my bloated cash position into what turned out to be the worst weekly stock market decline in forever. By the time I was able to focus on what had actually happened, I was 3 miles into a run on Saturday morning with my son in his high performance “Bob” stroller (the stroller runs me). By Friday’s close my portfolio asset allocation was 65% Cash, and 35% Equities, which is the most invested I have been in 6 months.

Getting invested last week certainly didn’t help my year to date performance. For the week, I lost -1.39%. The S&P 500 down -18.2%, Oil was down -17%, and Warren Buffett was down -17%, so it could have been worse. Reality is that for the levered long community, it was. I also prayed for them while I was on mile 4 of that morning run.

For those of you who don’t know, I am a very slow long distance runner. So slow in fact that Coach Taylor cancelled the “2 Mile Run” during my senior year with the Yale hockey team, because he didn’t want me to get embarrassed by the freshman! I think I was the slowest man on campus. Little did I know back then that slow and steady wins the investment race. I expect “Patience” to overtake “Event Driven” as the fund of fund community’s favorite stylistic investment allocation in 2009.

The Europeans have shown some patience relative to our reactive management style, and they are leading global markets higher this morning. While USA’s ‘Investment Banking Inc.’ would like to think that it’s due to their latest weekend scheming, the reality is that it’s because we didn’t have to watch them on TV all weekend long for once. ECB Chief, Jean Claude Trichet, looks to be trying to take over as the world’s leading central banker this morning. European stocks are responding with a +5-7% move across the board. I, for one, feel better about who is managing this mess today. Finally, the world is giving us a hand.

In Asian trading, it looks like we got lucky buying China and Hong Kong. We are long both the EWH and FXI etfs in our ‘Hedgeye Portfolio’. The Hang Sang Index closed up a huge +10.2%, leading most Asian equity markets out of the dark black hole of hopelessness that we were staring down into on Thursday night. China closed up +3.7% after reporting a stellar export growth number for the month of September of +21.5% year over year. That’s an acceleration from August, and it shouldn’t surprise you given that the Olympics have passed. Now the Chinese are getting back down to business.

In conjunction with their positive economic report, China reported tacking on another $29B of trade surplus. Don’t forget that amidst the world coming to realize that cash is king, the Chinese have the most of it… $1.8 Trillion in reserves to be precise. The politicized and compromised US Federal Reserve better remember who buys all of our “Heli-Ben” free money bonds. If the Chinese stop buying them, the next asset bubble to burst will be the loudest - US Treasuries.

“Ah, c’mon Keith – pick up the pace back there… that will never happen.” Really? Why not? Ask the Japanese how vibrant foreign investment became in their domestic economy in the 1990’s when they cut interest rates to zero. This isn’t rocket science folks; if you don’t give a bond holder a real rate of return, he/she will be selling those bonds and buying someone else’s.

Some of the “Fast Money” folks won’t see this Chinese investment “Trend” turn, if it ever does. They are too busy running from their own shadows right now. Don’t forget, these guys are really “Fast”… so fast, that sometimes they forget to tie up their shoes before they get in this race. Remember how fired up these fast guys used to get when China Investment Corp bought $5B worth of Morgan Stanley, or was it $3B worth of Blackstone? These guys are still sprinting with crack berry in hand, so they probably missed the sign with the math on it that says -70% - that’s about what those “sovereign investments” have lost on those “deals”…

A career in money management is a marathon, not a sprint. The art of managing other people’s money is having money to manage. Be patient. My upside squeeze target for the S&P 500 is 1,042, +16% higher from Friday’s close.

Best of luck out there this week,