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Domestic slots: less than awful?

Price discounting on slots has been a big issue for investors recently. Discounting, concerns about casino slot capex, and lower play levels of participation games have contributed to drive IGT, BYI, and WMS down 52%, 50%, and 33%, respectively, off their highs. My man in Las Vegas has been gathering intelligence recently and had less than awful commentary to report. Contrary to the views of many in the investment community, discounting has not yet taken the form of price cuts. Rather, slot suppliers appear to be offering better financing terms to their customers. On the margin this is a positive vis-a-vis price discounting but will negatively impact the timing of cash flows. The industry has also yet to see price discounting on the revenue sharing side although it is unclear whether other terms have been extended. Finally, while replacement demand is way down, it appears to be more of a slot cycle factor rather than from cuts in the operators' slot capex budgets. Asian slot sales remain a disappointment as I wrote about in my asian slot post on 7/8/08.

Unfortunately, the positive commentary is of the "on the margin" variety so I'm not quite ready to call an inflection point. However, it should be considered as we approach IGT's earnings release on Thursday.

IGT R&D SHARE NOT SUSTAINING MARKET SHARE

As many of you know I've been a long time fan of IGT and its past and current management. With the stock plummeting, management needs to pull something out of its bag of tricks in addition to just an aggressive stock buyback. Slot cycles come and go and we are certainly in a trough now. However, there seems to be something more than just an industry slowdown. IGT's share declines are well known and can be seen on the first chart. Less discussed is the lost share in the casino participation space. Most troubling, however, is that share of industry R&D has remained high and has consistently eclipsed ship share since Q4 2005.
  • A little context may allay concerns somewhat. It wasn't that long ago that IGT's ship share fell from 75% to below 60% earlier this decade. The company then took the lead in Ticket-in, Ticket-out (TITO) and dominated the technology and the roll-out. Market share climbed all the way to 80% at the height of the cycle in 2003-2004. A similar situation occurred with the bill acceptor in the mid 1990s. History shows us that market share could improve again with the advent of the next technological cycle, Server Based Gaming presumably. That will help. IGT also overcame a huge spurt in video gaming machines when it was primarily a stepper company. A concerted R&D effort led to the market share lead in the video space after the belated start. Finally, IGT blazed a huge video poker path in the 1980s to overtake Bally as the #1, a spot it has yet to relinquish.
  • How does IGT ensure that it doesn't relinquish that spot? More R&D may not be the answer. The company is boastful of its significant R&D budget relative to the industry (see the 2nd chart). More importantly, IGT has spent wisely and efficiently, until recently. Prior to 2006, IGT's ship share and share of casino participation games exceeded its portion of industry R&D spend. Could it be that 70-80% market share is not normal for a semi-mature industry? It is reasonable to believe that the pathetic shape of the competition contributed to an artificially high market share. With a revamped WMS, Bally, and Aristocrat maybe 40-50% share should be the target. Acceptance is the first step on the path to recovery. The 2nd step may be to refocus spending. Rationalizing R&D is probably a good place to start. Industry consolidation may be another.

DPZ - Folllow The Cash

Over the past 12-months any company with a leveraged balance sheet has just been shellacked. In the case of DPZ the stock is down over 40% over the past 12-months because the company's Debt/EBITDA is slightly over 7.0x. While the stock has paid the price for excessive leverage, the fundamentals of the business model do not jeopardize the company's ability to meet the interest payment and/or pay down debt over time. In fact, I believe that this trend will begin to reverse in the next 6-12 months.

DPZ is not the only restaurant company to leverage the balance sheet at exactly the wrong time; they just took leverage to a whole new level. I guess that is what you get from a board that is controlled by a PE firm that wants to extract as much cash from the company as possible. The good thing is that the business model can support it.
  • Current t Trends Look Positive Over the past three quarters, the international business has been posting same-store sale in the MSD while the U.S. has had a difficult time. While the US business is still challenged, the Pizza category is seeing a significant change in traffic trends in 2Q08. Since 2Q07 the pizza category had seen three straight quarter of sequential decline in traffic. So far in 2Q08 traffic trends are down 1.2% vs. 4% in 1Q08.
  • Domino's is as global as you get. With global retail sales of $5.5 billion, the Domino's system operates 8,600 stores in over 55 countries around the world. The Domino's business model has three different operating units; domestic (which is comprised of about 4,600 franchise owned and operated stores and only 500 company-owned stores), International (which has over 3,500 stores in over 55 countries) and a supply chain business which is critical to the DPZ story. The supply chain business is important to Domino's business model as it provides quality and consistency of product to the stores. The supply chain aggregates the purchasing power of the 5,000 U.S. stores, and allows for passing those efficiencies onto franchise operators. Importantly, franchisees sign up for a ten-year profit-sharing agreement where they pledge their business to this entity, and in return receive on a proportionate basis 50% of the profit generation of the distribution center. This distribution business has helped mitigate some of the commodity volatility in 1Q08.
  • Commodity IssuesDPZ is in the EYE of the storm from a commodity perspective. Cheese represents approximately 40% of the cost of the pizza and has been a very difficult commodity over the past couple years. Meat, wheat, tomatoes and corrugated boxes are the other key commodities for the company. Needles to say, virtually all of these commodity costs have been at a ten-year high, and in many cases, an all-time historical high over the last 12 to 18 months.
  • Financial IssuesFinancial Issues

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UA, NASCAR and Bass

Under Armour really seems to be branching out with its' brand message. It's actually nice to see, given that it was at risk of falling under Nike's shadow with such heavy roots in just one dominant US-centric support (football). But rather than stick entirely with Nike's early playbook, UA is taking its brand message in a different direction. The top two photos below show recent sports marketing initiatives over the past two weeks.
  • The first is Carl Edwards, who UA endorsed earlier this year. UA added its' logo to the hood of Edwards' #60 Ford Fusion for the Camping World RV Sales 200 in Loudon, New Hampshire. This partnership with Roush-Fenway represents UA dipping its toe in the water with NASCAR. Edwards placed an impressive 5th out of 43.
  • On July 10, those of you who are bass fishermen might have been watching the college bass championship in Little Rock. Lead sponsor? You guessed it... Under Armour.
  • The funny thing here is that most people on Wall Street look at things like NASCAR and Bass Fishing, and think that it is a ridiculous place to spend money from a brand relevance perspective. I can't say that I have a strong view that this approach will work, but we need to keep ourselves honest and look at the possibility that marketing to Middle America might actually pay off in building longer-term brand loyalty.

Pricing Trends Lagging Inputs

I'm keenly aware that it seems like every other theme I post is related to the impending margin pressure in 2009 as the apparel/footwear supply chains get stress-tested to a greater degree than anytime since perhaps the Asian currency crisis (and I'd argue that this time will be worse). But this trend should rob the industry of at least 3 points in margin, and spark the greatest consolidation wave the group has seen since the 1990s. Worthy of a few extra posts, don't you think?

With that, I've got to highlight Friday's import statistical release from OTEXA (the government office of textiles and apparel) which shows that apparel import prices into the US for the month of May posted a 0.9% year/year increase. That might not seem so bad, but given the preceding three months were down an average of -1.8% -- this unfavorable 270bp delta is not looking good for go-forward margins.

I'm not against cost increases - as long as the consumer is funding these costs. But unfortunately the CPI for apparel is down about 1.5%. This is spot on with levels have been year-to-date. So costs are going up, but revenues are not. What does all this add up to? Margin compression.

The chart below shows the consumer price less the consumer price (a positive value means that consumer prices are going up at a faster rate than cost inflation). Unfortunately, the trends in this spread are making lower highs and lower lows. I think we'll see that trend through 2009. That's a loooong time to wait.

More quantifiable analysis to come on this.

This still makes me very wary about GIL, WRC, GES, VFC and PVH. RL and LIZ are the way to go here given company-specific growth and ROIC levers that can weather the storm.



Ron Paul, The Catholic Church Wants To Know Too: "Who's In Charge?"

According to the BBC News, the Catholic Church ended up losing $14.3M in 2007. "That was despite receiving a single anonomous donation of $14.3."

Interestingly, per the article (link below), almost 1/4 of the Catholic Church's offerings annually come from Americans.

The US Peso's decline is proving to have far reaching effects within the contruct of the many geopolitical factors contributing to economies and organizations.

KM

http://news.bbc.co.uk/2/hi/business/7501486.stm

(Picture: http://romancatholicblog.typepad.com/roman_catholic_blog/images/2007/08/30/casting_out_the_money_changers.jpg)

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