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One of my favorite investment process quotes comes from Warren Buffett, where he likens investing to playing bridge, “the approach and strategies are very similar in that you gather all the information you can and then keep adding to that base of information as things develop.”

Depending on your investment style, these “things” that Buffett alludes to, can most certainly vary. While it is sad that some still use a whisper of “Blue Horseshoe” as their dominant sourcing mechanism for information, there are plenty of investors out there who are well equipped with process oriented picks and shovels that combine global macro with bottoms up stock picking.

This morning is a great example of how we use both here at Research Edge. Yesterday, in our “Hedgeye Portfolio” you’ll see that we repurchased our Wal-Mart (WMT) position, ahead of their quarterly report today. This has been a fundamental bottoms up call that we have been bullish on since November of 2007. Yes, we have disclosed when we have sold strength into Street euphoria a few times, but we have also consistently bought weakness because my teammates, who are some of the best global consumer sector analysts in the world, like it. Buy Low, Sell High.

At the same time, we’re short Japan, which closed down another -51 basis points overnight. We’re also long a bag full of waterproof US Dollar denominated cash that has appreciated +6% in the last month. I outlined a proactive plan of moving to 85% cash ahead of what I thought was going to be a volatile 2 weeks of trading into a negative unemployment report and out of what should be a positive inflation report this morning. Once this CPI number is printed today, the “things” I care about will have indeed “developed”, and I can start considering the redeployment of capital.

With US Earnings Reporting season out of the way, we are going to get back to “macro” time. Obama will be back from his vacation in Hawaii, the Russians will be trying to explain why they are behaving like its 1968 all over again (when they invaded Czechoslovakia and took the capital), and John Thain at Merrill will contemplate whether or not to cut his dividend. So, what do we do next?

My first plan is always to wait. As a friend of mine likes to say, “the plan is … that plans will change”. I am data dependent, and that’s just the way that it is. On the global trading front, there are a few interesting developments to consider. One is re-shorting India. I have been out of this position for a month, and the BSE Sensex Index has rallied +17% during the same period that the S&P 500 put in that “bottom” that so many of the hopeful bulls are starting to call it from July 14th. India’s industrial production growth numbers are decelerating faster than a Chinese synchronized diver slicing into the Olympic pool – now you see it, then you don’t!

At -2.8% for August to date, the Singapore Dollar is chasing the Japanese Yen lower for worst Asian currency performer of the month. The world has slowed and Asian trading, across asset classes, is a leading indicator informing us that “things are developing” at a deteriorating pace!

Europe doesn’t look any better, so don’t expect me to be buying anything there anytime soon. The Euro is only a decade old don’t forget, and the newly formed Team “Euro Zone” is entering its first significant recession of consequence. Do you expect the Europeans to hold hands during times of adversity or point fingers? Russia’s answer is neither – they’d rather just start a war and get on with it.

Fundamentally, the US market still has some interesting pockets of security specific opportunity. I like liquidity; I like Wal-Mart; I like Hershey (HSY); and Tom Tobin and I still like Big Cap Pharma (Johnson & Johnson (JNJ), in particular). For the rest of our solidly positive year to date portfolio, you’d have to be a client to get a look at the “things” we like.

Best of luck out there today,


Check out the correlation between oil prices and gaming stocks on the chart below. The correlation at -0.87 over the past year is almost as high as the cruise/oil correlation at -0.89. The relationship is hugely significant statistically with a T Stat of -27 and an R Square of 0.75. Basically, changes in oil explained 75% of the moves in gaming stocks over the past year.

It is all about oil, for now. I’m not sure it should be. At some point this negative correlation will weaken and probably turn positive again. As can be seen in the chart, up until the past year, the price of oil has moved in the same statistically significant direction as gaming stocks, both indicative of strong economic growth. When this correlation regresses to its mean what will these stocks trade on? Presumably, direct fundamentals will again be the driver. I’m not sure even oil at $80 solves the fundamental issues, particularly for Las Vegas.

Big reversal in the correlation coefficent beginning last year

SKX: Deal or Not, The Damage is Done

Let me paint this little narrative for you. Imagine a company that benefits from a 4 year fashion shift, a solid consumer, extremely favorable FX, and a margin-friendly sourcing environment. Margins go from 0% to 9%. Then all at the same time the company sees fashion pull a 180, a weakening consumer, unfavorable FX, and tightening capacity in Asia putting pressure on sourcing costs. Kinda puts that peak margin into perspective, no?

We’re talking, of course, about Skechers.

I’d love to have been a fly on the wall when management collectively realized that they were nearly out of growth runway.

So what do they do?
1) Accelerate growth in its own retail stores (if retail partners don’t want our stuff, let’s try to get it consumers on our own with expensive long-lived assets).
2) Broaden distribution into marginal clearance channels (remember Goody’s?)
3) Now SKX goes ahead and bids for none other than Heelys? The brand with the distinction of having more injury-related lawsuits per-pair than just about any other street shoe brand in recent memory? The same brand that grew to $188mm from almost nothing in 2 years – but in a real market size closer to $100mm?

This is just so wrong in o many ways.

How do acquisitions create value for a company in this space? Give leverage with 1) the consumer, 2) the retailer, 3) the manufacturer in Asia making the goods, and 4) the combined cost structure. Let’s evaluate those…
1) Consumer: Will either product be any better being part of the same parent? Probably not. Skechers is all about knocking product off other brands. They don’t do any R&D. It’s all about marketing. Could HLYS use Skechers’ marketing prowess? Yes. But first it needs a better product. That’s a problem.
2) Retailer: Not meaningful overlap here with retailer customers especially with HLYS’ more technical-based retail base. It’s nice that they don’t step on each other’s toes, but this gives no added leverage whatsoever.
3) Asia: Factories are closing left and right (over 3,000 thus far in China this year alone). Capacity is tightening, and manufacturers want to be aligned with the winners. Heelys? Nah.
4) Cost structure: HLYS was already extremely lean with SG&A at 27%, which is not a ‘cut-able’ rate. EVERY acquisition I can find in this space going back 20 years where a brand with SG&A below 32% has turned out to destroy shareholder value.

Is the price right? Yes, I can see why HLYS seems cheap at $143mm in equity value and $100mm in net cash. But there’s a difference between low-priced and cheap. This thing has negative EBITDA, and not many levers to pull to get margins higher. SKX said it would consider raising the offer price after due diligence. The best margin rate I can envision is 5% -- which is 6.5% on the offer. The problem is that the market is already pricing HLYS at 8x EBITDA under the assumption that SKX’s 7% premium is not enough.

If there’s one punchline I want to make clear, it is that I could care less if this deal goes through or not. The simple fact that the offer is on the table is affirmation that the underlying strategy is misaligned with the margin challenges coming down the pike. This one remains on my ‘least favorites’ list.

Early Look

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WRC: Dodges a Massive Torpedo

Was I the only one who saw a PR nightmare brimming for Warnaco at the Olympics on Wednesday? After Michael Phelps leapt in to dolphin-kick into another gold medal in the men’s 200-meter butterfly, his Speedo goggles’ suction failed and immediately filled with water. After starting in second place, The Man took the lead and never looked back – despite the fact that his specs took on water faster than the Titanic. It’s a good thing he can swim faster than I can drive.

Could you imagine if Phelps lost? Last I checked, Speedo sells more goggles than swimsuits. That’d also be a tough way to get out of paying Phelps the $1mm bonus it offered him to match the 7 gold medals won by Mark Spitz in 1972.

If a PR nightmare actually came to fruition, maybe WRC would need to rethink that new HQ it is investing in for Speedo at the peak.


Brunswick just raised $250 million in 5 year notes to pay off its floating rate borrowings due in 2009. It was the classic rate vs. liquidity trade-off I’ve been talking about. Yes, BC is now liquid but at a cost of 5-5.5% or $12.5m to $13.8m in incremental borrowing costs. I’m not making a call on BC. Rather, this is a real world illustration of what is likely to happen to some of the gaming companies, particularly ASCA and MGM. Last I checked, analysts are generally projecting current low borrowing rates in perpetuity.

I know. Brunswick is not a gaming company and doesn’t own hard assets so its borrowing rate could be higher than casino operators. However, BC is free cash flow positive and maintains a ton of cash and low leverage, unlike virtually every gaming operator. The obvious exception, of course, is PENN which remains our favorite stock.

ASCA is of particular interest in that this company negotiated one of the most attractive credit facilities, which is contributing to the lowest cost capital structure in the gaming industry (see the chart). The problem is the credit facility matures in 2010 (the earliest among the operators) and right now comprises almost all of the company’s debt structure. You can bet ASCA will be looking for liquidity at the next open credit window. My guess is long term fixed rate debt to offset its overreliance on variable rate debt. In my “GAMERS OVEREARNING: REFIS TO KNOCK EPS DOWN, ASCA AND MGM AT RISK” post on 8/10/08 I noted that ASCA’s EPS could be cut in half with a credit facility refinancing 3-4% higher. Obviously, to the extent the company opts for the safety and liquidity of long-term fixed rate debt, the EPS impact may be greater.

ASCA has been over earning due to unsustainably low borrowing costs

Chart of the Day: Japanese GDP

Japanese GDP shrank last quarter as diminishing export levels and domestic inflation weighed on the world's second largest economy like an anchor in the arms of a swimmer treading water. This chart says it all – an economic moonshot stretching from the end of the occupation into the 80’s followed by decades of stagnation resulting from weak political leadership and easy money.

Andrew Barber, Director

*Full Disclosure: Keith remains short Japan via the EWJ etf.

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