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Ugly Chart of the Month!

In a 'how could I not have seen this coming' moment, I realized that my '3 points in lost margin over 3 years' thesis for apparel has another nail in the coffin - a meaningful slowdown in the growth of the number of core customers.

All my clients (and then some) know my thesis on apparel - that the industry will give back 3 margin points over 3 years as the supply chain gets stress-tested to a degree not seen in over 10 years. This will be driven by 1) a reversal in a massive sourcing tailwind, 2) tightening capacity in Asia, and 3) the US consumer heading into a 'consumption depression' as the personal savings rate heads higher to offset at least a temporary pause (if not long term) in a 25 year bull market for home prices and equities.

I think that the lack of sourcing savings disarms the industry of a powerful weapon previously used to stimulate per capita unit demand (up 50% in 15 years). But shame on me for not accounting for the chart below. Demographics for this space are absolutely abysmal.

While it's easy to look at the aggregate population numbers in the US, those usually don't mean much when looking at a specific industry with unique consumers. My Jr Analyst Zac (one of the best collegiate sailors in the world) took this analysis to the next level and calculated the percentage of apparel spending by age group versus the growth in each of each of those individual age groups.

His major takeaway is that from 2001-2005, the apparel population grew at a favorable rate relative to the overall population. This rate started to roll in 2006 (around the time the industry started to show more stress) and headed lower into 2008. The bad news is that this rate accelerates further all the way through 2012. This is bad bad bad.

Not only are my previous concerns enough to take out 3 points of margin, but now the demographic picture seems like the nail in the coffin. Again, I completely realize that the future demographic trend is not a new development, but that my realization of it is. But I've been covering this industry for a long time. If it's news to me, then I'm willing to bet that its news to most others as well.

I'm not trying to be negative here folks, but these are facts I simply can't ignore.

ATLANTIC CITY: RANDOM THOUGHTS

ATLANTIC CITY
I spent a hot Tuesday in Atlantic City. This may sound strange but it was refreshing to hear doom and gloom commentary from Company and Property level management personnel. There is no false optimism here. I may be falling for the contrarian just to be contrarian perspective but the Buyside, Sellside, and even industry professionals all seem to hate Atlantic City. Unlike Las Vegas, estimates have come way down and revenues and margins have been under pressure for awhile. Don't get me wrong: June was not good and the smoking ban will hit the market hard come October 1st. However, the big Pennsylvania impact will abate soon and AC could actually benefit from the Staycation effect discussed in my last portal posting.

TRUMP BONDS
The price of the Trump bonds are clearly not reflecting that the sale of the Marina will close. The bonds currently trade at 62.25 despite a deleveraging $316 million pending sale. Richard Fields and Coastal Marina can walk away from the deal for just $15 million which doesn't sound like a lot. However, the lawsuit between Trump and Fields would be reinstated upon termination. This lawsuit has legs and is a reason to believe the deal could go through. Not making a call yet on the probability of this transaction closing but I'll have more on this one later.

THE WATER CLUB
How did Borgata manage to build The Water Club for just $400 million. This is a beautiful facility with 800 rooms, an unbelievable spa, meeting space, five pools, additional retail, and a new restaurant. In my career I've enjoyed calling out questionable capital projects in this industry. I've got to say, though, this is the first project I've seen in awhile that looks like it could actually hit the magical 15% ROI. Boyd Gaming has been an easy target for the shorts and I've been there along with them. Despite my negative view on Echelon (not the quality of the facility but the ROI potential) and continued headwinds in the Las Vegas locals business, the free cash flow yield of over 20% is hard to ignore, particularly considering the potential of The Water Club. Not sure if we are there yet on BYD but stay tuned. It's getting interesting.

EYE On Demographic Trends

According to NPD, most casual dining users can be found in two age groupings - 18-34 and 35-49. Collectively, these two groups account for approximately 50% of all casual dining visits.
  • While 18 to 34 year-olds comprise only 24% of the total U.S. population, they account for 26% of the total occasions at casual dining restaurants. The 35-49 age group accounts for 24% of casual dining visits.
  • While the number of people in this demographic is still growing year-over-year, it's at a decelerating rate. Beginning in 2009 the trends for this key demographic begin to flatten out and actually decline over the next five years.
  • The current consumption recession is putting significant pressure on an industry that has excess capacity. It appears that the demographic trends will complicate this issue.

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EYE ON - Alcohol Consumption At Restaurants

Following the release of Constellation Brand's 1Q09 earnings, a Wall Street Journal article cited comments made by a vice president of the company that as a result of tougher economic times, consumers are changing their drinking habits by drinking less in restaurants and bars and more at home. This decreased alcohol consumption at restaurants will hurt casual dining operators as alcohol is typically a high-margin menu item that raises companies' average checks.

Specifically McCormick & Schmick's said on its 1Q08 conference call that its beverage sales had fallen 4.5% YOY on a comparable basis, which they indicated was a small decrease relative to a more significant decrease in on-premise liquor consumption in the broader economy. Alcohol sales, predominantly from the company's bar, represented about 28% of MSSR's 2007 sales and contributed higher gross margins than food sales.

Morton's, which generated about 29% of its 2007 sales from alcoholic beverages, however, stated that it has not seen any discernible changes in its beverage check, which is a good sign as the company is betting on continued strong off-premise consumption with 44% of its restaurants now outfitted to include its Bar 12-21. Additionally, all new restaurants will be built with the Bar 12-21.

Liquor sales are a significant contributor to the overall profitably of most casual dining restaurants. On top of everything else, the last thing the industry needs is declining liquor sales.

STAYCATIONS : SOME GOOD NEWS FOR REGIONAL GAMERS. FINALLY

A theory is only as good as statistics can prove. The theory that people will prefer Staycations over vacations in periods of escalating travel costs can also be applied to regional gaming operations. Based on a theory that higher airfares to Las Vegas may cause gamblers to stay closer to home I've taken a look at the math.

The following chart details the results from regressing quarterly YoY change in regional gaming revenues to quarterly changes in average Las Vegas airfare for the last 10 years. Airfare proves to be a statistically significant causal variable in explaining a decent percentage of the move in gaming revenues. Because of the potential that the independent (airfares) and dependent (revs) variables are autocorrelated with economic growth, I needed to control for this. In other words, a strong economy could be the driver of both higher LV airfares and higher regional revenues rather than the original thesis. Even when including the economic proxy variable, airfares remain a statistically significant explanation of movements in regional gaming revs.

As can be seen below, the Airfare t Stat remains significant (greater than 2) even after the economic variable is introduced in the multiple regression. R Square is .3 so LV airfare (variable 1) and the economy (variable 2) together explain 30% of the variance in regional gaming revenues.

Maybe there is hope for the regional gaming stocks after all. They could use the help. The precipitous fall in these stocks has driven Free Cash Flow Yields to almost 20%.

SBUX - The Proper Medicine; Shrinking to Better Profitability

Last night SBUX announced that it was going to close approximately 600 stores in the U.S. This represents a significant increase from the 100 store target the company previously announced. These stores account for about 8% of the U.S. Company operated store base. Approximately 70% of the stores targeted to be closed were opened since the beginning of fiscal 2006 and they represent about 19% of the stores opened from 2006 to 2008. The vast majority will close in Q4 of fiscal '08 through the first half of fiscal '09. In addition, SBUX reduced the number of planned new U.S. company operated stores to fewer than 200 for 2009 (down from about 250).

I have said before that SBUX's shareholders are paying dearly for the ill-conceived capital allocation decisions over the past three years. In the coming quarters, SBUX shareholders will be richly rewarded as the company corrects the excesses of the past and makes smarter capital allocation decisions for the future.

I love the shrink to grow stories, as the benefits to the P&L are immediate. First, by closing 600 stores that are losing money, EBITDA will improve. Second, 10% of the store base should see improved sales and profits due to the excess capacity taken out of the system.

This is a significant inflection point for the company.

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