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WHEN OIL IS NOT THE CATALYST

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.


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.

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BC REFINANCING: IMPLICATIONS FOR GAMERS

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.

REVISITING OUR LIST OF QUESTIONABLE RESTAURANT TRANSACTIONS!

On July 20th, I published a list of 13 restaurant transactions over the past three years asking the question; how many companies on this list will need to raise equity or file bankruptcy in the next 12-18 months? Today, the WSJ highlighted some of the companies on the list.

According to the WSJ, the parent of Uno Chicago Grill will skip a bond payment on Friday as it tries to negotiate more financial breathing room. The issues at Uno are a common theme in restaurant land – UNO is being squeezed by declining customer counts, rising food costs and an overleveraged balance sheet. Not surprisingly, Uno was acquired in a leveraged-buyout in January 2005 by Centre Partners and management. Uno Chief Financial Officer Louie Psallidas commented that "We are not in any imminent danger of filing for bankruptcy."

The article also cited Chevy’s Fresh Mex, Perkins and Marie Callender's chains are also in talks with their lenders. Additionally, Real Mex Restaurants Inc., which owns the Chevys, El Torito Grill, Acapulco Mexican restaurants and other regional chains is also struggling. Real Mex and its subsidiaries is one of the largest operators of full-service Mexican restaurants in the country with about 200 restaurants. Another positive data point for EAT?

Real Mex was acquired in August 2006 for $359 million by private-equity firm Sun Capital Partners. Perkins & Marie Callender's Inc., the parent company of the two namesake chains are owned by private-equity fund Castle Harlan.

On top of all this, Bennigan's, Steak and Ale, Vicorp Restaurants Inc.'s, Bakers Square and Village Inn chains have filed for liquidation or bankruptcy protection.
The Chart we published on July 20th

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