I recently read a BYD valuation downgrade by a sell side analyst based on a high relative valuation.  The valuation analysis was performed using EV/EBITDA, the industry standard, and concluded that BYD's multiple of 7.6x was too high relative to the competitors at around 6.5X.  This superficial analysis fails to take into account that BYD's free cash flow yield is more than twice that of its nearest competitor, when normalized for true ongoing interest cost.


EV/EBITDA fails to capture the big disparity in true borrowing costs.  ASCA and PNK face refinancing risk due to maturities of credit facilities and/or bonds over the next 1-2 years.  BYD, on the other hand, has no maturities until 2013.  BYD's average interest rate should stay at 2% above LIBOR (assuming no covenant breaches) while the other companies will experience rates 2-3 times that rate.  This is a phenomenal asset that EV/EBITDA cannot capture.  ISLE is in a very similar position to BYD with no large maturities until 2013.


In the table below, we've calculated the implied EV/EBITDA multiple assuming a constant 15% free cash flow yield across the sector.  Additionally, we've included implied target prices at those multiples.  Our analysis considers true interest cost assuming credit facility amendments and extensions based on reasonable comps. 




Other factors to consider:

  • BYD - This FCF yield is too attractive to pass up unless you believe the company will trip its leverage covenant this year. In that scenario, BYD's interest cost would rise and its $2bn in borrowing capacity would be sharply reduced. If BYD can get through 2009, as we think it will, the likelihood of a covenant breach diminishes greatly due to the quarterly step up (a quarter turn per quarter through the end of 2010) in the maximum leverage ratio beginning in Q1 2010. BYD has a lot of levers to pull, however, including maintenance capex cuts and deleveraging bond buybacks. Based on valuation, BYD looks like the most attractive long-term play in gaming.


  • ASCA - The stock looks fairly valued on FCF yield when considering the likely higher interest cost associated with refinancing its credit facility due in November 2010. ASCA is likely to hit the high yield market sometime this year and we estimate a 15% coupon. However, Q1 is likely to be a blow-out quarter and estimates should go higher. We continue to like ASCA into the Q1 earnings announcement on 4/29.


  • ISLE - ISLE looks very attractive on a FCF yield basis. While the company maintains the highest leverage (7.5x) among the regionals and its competitive positioning is the weakest, ISLE does not have any material maturities until 2013. Next to BYD, ISLE may be the most attractive long-term gaming stock.


  • PNK - PNK looks very similar to ASCA. Reasonable leverage but fairly valued on a FCF basis. PNK will likely be in the market to amend its credit facility which means interest cost will rise. This is reflected in our projection. The positive catalyst for PNK is also the Q1 earnings announcement. In addition to very strong earnings, PNK may scale back or delay development due to the rising cost of capital. This should be taken positively by investors.


  • PENN - PENN looks fairly valued based on FCF yield. To be fair, we are assuming PENN makes an acquisition to utilize its borrowing capacity at its current bank rate. PENN is underleveraged which penalizes its current free cash flow yield. We assume almost 20% accretion to free cash flow on a $1.25bn acquisition at 6.5x EBITDA. Under this assumption, PENN's yield rises to 13%, still below our industry target of 15%. PENN is a terrific company with a great management team. However, it is the Wall Street darling of gaming right now and the valuation looks full.



A New Secular Trend You Can’t Ignore

I think that the General Growth bankruptcy filing is only the tip of the iceberg as it relates to what is to come for retail and content distribution. With landlords under duress and acting irrationally leading up to the bankruptcy filing, and with cost of capital on the rise for those retailers and brands who would otherwise buy store locations themselves, the smart CEOs are sitting in their war rooms planning how to reach the consumer regardless of what happens in the world of real-estate. Of course, they're playing catch-up to the best management teams who proactively prepared for this years ago.

The one and only answer? Invest in content to boost relevance with the core consumer while simultaneously investing in direct/virtual distribution. Create a ‘pull model' where the consumer comes to you, and have a platform that enables conversion into dollars.

Keep in mind that this is easier said than done. Most legacy wholesale models are streamlined and efficient, but are good at processing one shipment of a thousand units, but are structurally not set-up for a thousand shipments of one unit.

Companies that have invested in this regard over the past 1-3 years include Nike though (still too early to get involved for other reasons), Ralph Lauren (check out the Ralph Lauren iPhone app), and Lululemon (launching right now).

We'd also highlight less obvious companies that have a particularly strong fulfillment platform, such as Williams-Sonoma, and Zappos., of course, remains the gold standard from a fulfillment standpoint. Offerings from FedEx and UPS are increasingly helping the brands without bricks and mortar step up fulfillment operations, we prefer those that have organically built and perfected their own proprietary systems.

We think that this theme will play a massive role in the upcoming wave of industry consolidation - both in bankruptcies and M&A. We'll be going deeper and deeper into this theme in the coming weeks to ferret out t he winners vs. losers.

Here's an analysis of a collection of retailers as ranked (by us) in terms of both shopability and brand consistency.

A New Secular Trend You Can’t Ignore - .com Matrix




I have pity for the Harrah’s General Managers that must contend with old and uncompetitive slots and thinning carpets.  Unkempt casinos wear pretty quickly with the tremendous volume of visitors.  This seems to be happening at an accelerated pace at Harrah’s casinos across the country.  Casinos should spend 5-6% of their revenues (including slots) in maintenance Capex.  I estimate Harrah’s is spending 1-2%.  Compounding the problem for Harrah’s is its (formerly) stellar reputation for well maintained properties.

Harrah’s competitors should continue to steal share.  The following chart details Harrah’s major competitors and the percentage of their EBITDA derived from properties competing with Harrah’s.  ASCA is the clear winner with 74% of its property EBITDA generated at properties in direct competition with Harrah’s.  PNK, BYD, and PENN also maintain significant exposure to Harrah’s at 44%, 34%, and 33%, respectively.


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Is China Advocating For The Bancor? Could Be BIG For Commodities

Keith and I spent the last few days talking Macro with some of the big boys in Boston.  Not surprisingly, and as usual, the large Boston funds are ahead of the curve and asking many of the right questions.  China was a focus, particularly as it relates to her need, or want, for commodities. Specifically, there was a good deal of discussion about copper, or Doctor Copper, as we like to call the industrial metal.


We noted the increased demand for copper from China this year in a note earlier this week, entitled “The Good Doctor Copper”:


“Coincident with this increase in copper prices are data points supporting improving fundamentals from The Client (China).  Preliminary reports out of China suggest that Chinese copper scrap supply may drop 700,000+ tons this year.  The implication of this is that copper imports will have to increase, and perhaps dramatically, to offset the decline in copper scrap.   March Chinese copper imports jumped to a record high of 374,957 tons, which could be the beginning of a longer term trend of increased imports from The Client.”


In the chart below, I’ve outlined the Chinese import data for the last 12-months.  In aggregate the last four months have seen a real spike in imports.


Is China Advocating For The Bancor? Could Be BIG For Commodities - aaadddd


As we were discussing the case for copper on our trip earlier this week, the key debate on the copper bull case was in trying to determine the key source of demand for copper.  Was it physical demand, financial demand, or an emerging view of how the Chinese believe, or are advocating, the world financial system be ordered in the future?  Daily we get more evidence that Chinese demand for copper, and other commodities, may be driven by motives other than intermediate term needs for the physical commodity.  Specifically, Dr Zhou Xiaochuan, who is in charge of monetary policy for China, recently wrote the following in an essay that was posted on the website of the People’s Bank of China:


“Though the super-sovereign reserve currency has long since been proposed, yet no substantive progress has been achieved to date. Back in the 1940s, Keynes had already proposed to introduce an international currency unit named “Bancor”, based on the value of 30 representative commodities. Unfortunately, the proposal was not accepted.” (Emphasis is Research Edge’s.)


The Bancor was a world currency unit proposed by John Meynard Keynes in the negotiations establishing the Bretton Woods Agreements.  The idea was that the Bancor was to be fixed to 30 commodities, of which gold was one.  Keynes’ believe was that such a currency would stimulate domestic demand and promote global trade balances.  Ultimately, Bretton Woods took a different path and used gold, solely, as the basis by which countries pegged and valued their currencies.  As we know, Bretton Woods collapsed in 1971, after the United States acted alone to terminate conversion of dollars to gold.  The result of this was that the U.S. dollar effectively became the world’s reserve currency for those countries that were signatories to Bretton Woods.


Obviously there was a series of events that led to the Bretton Woods agreement, most notably a global economic depression and World War 2.   Additionally, as the only true global superpower, the U.S. was able to take the lead in these negotiations and in managing global monetary affairs.  While the US still has the role as a superpower, the world is in a much lower state of duress, so a complete overhaul of the global financial system seems unlikely.  Nonetheless, the Chinese are clearly stockpiling copper well beyond their immediate term physical needs and in a world where copper, and other metals, are the basis for the valuation of world currency, financial demand for copper could continue to increased dramatically.


Daryl G. Jones
Managing Director


YUM is scheduled to report Q1 earnings next week.  This is what we know:

2009 guidance of at least 10% EPS growth relies largely on a U.S. recovery.

The company is expecting U.S. operating profit growth of about 15%, or at least 5% excluding the impact of the planned $60 million in G&A savings.

U.S. operating profit growth has been flat to down for the last six years with YUM posting its largest decline in 2008 of down 6% so YUM definitely has easier comparisons working to its benefit in 2009, but this has not helped in the past.

KFC has been the biggest drag on U.S. operating performance as Taco Bell (60% of U.S. operating profit) and Pizza Hut both grew operating profit in 2008.  In the fourth quarter, KFC same-store sales declined 3% while Taco Bell increased 9% and Pizza Hut fell 1%. 

YUM needs both its Pizza Hut and KFC brands to perform in 2009 to meet its 15% operating profit growth goal.  And, as YUM management highlighted on its Q4 earnings call, both concepts were off to a slower than expected start in January “because these brands focus on the higher-end ticket dinner occasion, which are under the most pressure due to customers  doing more cooking at home.”  Management also said that KFC January sales were extremely poor.   The company has since launched its first ever nationally advertised value menu at KFC and expects its Kentucky Grilled Chicken launch in Q2 to turn things around for KFC in 2009.  I am still not convinced that this will happen.

Pizza Hut started the year out slow and although management seems convinced that its new focus on pasta and chicken wings “will totally transform the Pizza Hut brand over time,” for now, it is still called Pizza Hut and pizza sales/traffic matter.  That being said, according to NPD data, QSR pizza trends do not look good.  QSR pizza category traffic declined in both January and February.  This is not that surprising as traffic has declined on a YOY basis every month for the last two years, but the 2-year average trend steepened its declines in both January and February. This does not bode well for Pizza Hut in Q1. 

YUM – LOTS OF QUESTIONS - QSR Pizza Traffic Feb 09

Domino’s has said in the past that irresponsible industry price increases are largely to blame for pizza traffic declines, which is made evident by the chart below that shows that QSR pizza traffic generally falls off as average check increases.  The industry has apparently not yet learned this lesson as the large average check increases in January and February coincided with the accelerated traffic declines.  YUM management did say that it was not assuming any price increases at Pizza Hut in 2009, which could help its traffic trends somewhat relative to the industry…we will have to wait and see what impact this has on margins.

YUM – LOTS OF QUESTIONS - QSR Pizza Traffic and Check Feb 09

U.S. same-store sales at Pizza Hut and KFC will most likely extend their Q4 declines into Q1.  Management did its best to set the bar low for U.S. performance in Q1, however, saying that much of its U.S. plans are back-end loaded, the majority of full-year commodity inflation is expected in Q1, G&A restructuring benefits will not be fully realized until Q2 and the Kentucky Grilled Chicken launch, which it recognizes as a big catalyst for U.S. improvement, is not until Q2. 

I don’t expect YUM to miss numbers but as always the quality of EPS will be low.  Domestically, KFC is terminal; Pizza Hut is struggling (along with the category); that leaves Taco Bell to carry the day domestically.  With the USA representing more than 40% of operating income, I’m not going to take that to the bank.  Given the commentary from MCD and BKC, the international markets have slowed significantly, which suggests that YUM international will post some very punk numbers.  That leaves YUM’s Holy Grail, China, to save the day; China looks like it will be a challenge, too (please refer to yesterday’s post titled “YUM – China, Not Without Issues” for more details ).


US Consumer: Is it January or April?

Suffice to say, it would be very difficult for someone to convince me that we have not seen the low in intermediate term US Consumer confidence. A more interesting question is whether or not the final April reading will end up flashing a higher high for 2009 to-date versus the preliminary reading that we saw back in January. Clearly, the January preliminary reading was an early head-fake.


Ironically enough, this morning’s University Michigan Consumer Confidence Report (the preliminary, not final April reading) was dead in line with the preliminary January reading of 61.9 (see chart). What’s most interesting about this is that last time the intermediate short squeeze (November to January) ended, US Consumer Confidence locked in a short term peak, then fell right back down to new lows.


As the stock market goes from here, so will the direction of this chart (see below). On the asset side to the consumer’s confidence reading, two things really matter: 1. Home Prices and 2. Stock Prices.


The Depressionistas will remind you of everything that they have been saying for the last 6 weeks and that we’re “overbought.” Meanwhile the consumer analysts will tell you that virtually all of the things that matter to consumer spending from the aforementioned, to employment, to gas prices, and mortgage rates, have improved, materially, in the last 3 months.


Don’t forget that employment losses continued to sequentially accelerate into late February, early March. As of the last 2 weeks of jobless claims, that very relevant (negative) US Consumer headwind has found a positive delta.



Keith R. McCullough
Chief Executive Officer


US Consumer: Is it January or April? - senti

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