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"For What It's Worth" - An Interesting Note From One Of Our Readers...

I often have very intelligent editorials sent to me. I thought this one was worth sharing...
KM

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I was up in New Hampshire this past weekend. My friend's father came up in the investment world in the 60s and 1970s and amassed a fortune selling his asset management business to one of the biggest firms on Wall Street in the early 1980s, and then investing on his own thereafter. He is actually going to introduce me to the CEO of a very successful Healthcare IT company who owns an interest in.

We were talking about the markets and the 1970s and he made a couple of interesting points. In the 70s there was no doubt about the supremacy of the US military and the dollar as the reserve currency of the world. He said that while we are still the dominant power, there's never been a period like this where so many small countries are essential flipping the bird at us.

The US Dollar's weakness speaks for itself. While the parallels to the 70s are interesting, it may actually be worse this time. Also, I listened to Bloomberg radio last night with a technical analyst Louise Yamada and her thought was that conditions today are more similar to the period from 1 than the 1970s.

For what it's worth...

-The Professor

SKX was asking for this one...

SKX capitulated by acknowledging that economic harm could be done by knocking off other brands. Now CROX - with the most recognizable innovation in this industry in 5+ years - is suing for patent infringement. Not god for SKX.

Remember a couple weeks ago (6/23) I noted the irony that Skechers - the king of knocking off other shoe brands - was suing a smaller shoe company (Aetrex) for patent infringement? (See picture below).

I don't like to render my own 'expert' opinion on legal cases like this, but my concern with this filing was that it was more of a capitulation that validated the claims by numerous brands that economic harm could, in fact, be created by knocking off footwear designs. Skechers had been in denial (publicly) about this for quite some time.

I can't imagine that it has been pleasant working in Skechers' legal department since then (in fact, I know this to be the case).

Now SKX has Crocs - the company with what is arguably the most recognizable innovation in this industry in 5+ years - suing for patent infringement. Does CROX have a case? Check out the exhibit below. You be the judge. With the massive $300mm ruling against Payless in favor of Adidas, we're seeing the financial ante heading higher. This is increasingly an issue for Skechers.


US Market Performance: Week Ended 7/11/08...

Index Performance:

Week Ended 7/11/08:
Dow Jones (1.7%); SP500 (1.9%); Nasdaq (0.30%); Russell 2000 1.4%

2008 Year To Date:
Dow Jones (16.3%), SP500 (15.6%), Nasdaq (15.6%), Russell 2000 (11.9%)

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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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