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YUM - THE CASH FLOW STORY IS CHANGING.

I have always wondered why the street is enamored with a company that can only grow EPS 10-12%, when they are reducing shares outstanding by 8% (company FY08 guidance). This raises so many red flags!

I recently ran my sustainability analysis on YUM, only to conclude that there is shift in how the company is going to allocate is cash flow over the coming years. Quietly, YUM’s has been allocating more cash toward capital spending - this increases the risk profile of YUM (relative to the past) and drives lower incremental returns for shareholders.

Here are some of the facts regarding YUM's uses of cash over the past 12-months:
Dividends paid declined by 3% (partly due to a lower share count).
Yum has burned thru $1.4 billion in cash (Cash from ops - Cap Ex. - Share repo - Dividends)
Interest expense increased 8% (due to higher debt levels to fund the cash burn)
Shares outstanding declined by 2% (despite spending $1.9B on buying back stock)
Capital spending has increased 13%

First, YUM’s capital spending needs are growing and that will come at the expense of the share repurchase program. Second, if interest expense in up 8% (due to higher debt levels to buy back stock) and the share count has only declined by 2%, how is that accretive to shareholders?

This dogs hunting day are over.

Charting the Chinese Yuan vs. USD and Euro

Chinese Industrial Production growth slowed again in July, moving down to +14.7% year over year growth versus +16% in June. The Chinese currency continues to be better for sale as of late, and this is a new path.

Given that consensus is that the Chinese slowdown is driven by the timing of the Olympics, the simple question to ask here is whether this new data point is an immediate "Trade" or a developing intermediate "Trend"?

Andrew Barber put together both short term and intermediate term charts of the Yuan versus the US Dollar and the Euro below.

KM

European GDP Growth Rates Continue Their Decline

Below we have attached both the French and German GDP growth rate charts. The Euro Zone reported trailing news this morning, that Q2 GDP growth contracted. I think Q3 and Q4 will look worse.
KM

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Things

One of my favorite investment process quotes comes from Warren Buffett, where he likens investing to playing bridge, “the approach and strategies are very similar in that you gather all the information you can and then keep adding to that base of information as things develop.”

Depending on your investment style, these “things” that Buffett alludes to, can most certainly vary. While it is sad that some still use a whisper of “Blue Horseshoe” as their dominant sourcing mechanism for information, there are plenty of investors out there who are well equipped with process oriented picks and shovels that combine global macro with bottoms up stock picking.

This morning is a great example of how we use both here at Research Edge. Yesterday, in our “Hedgeye Portfolio” you’ll see that we repurchased our Wal-Mart (WMT) position, ahead of their quarterly report today. This has been a fundamental bottoms up call that we have been bullish on since November of 2007. Yes, we have disclosed when we have sold strength into Street euphoria a few times, but we have also consistently bought weakness because my teammates, who are some of the best global consumer sector analysts in the world, like it. Buy Low, Sell High.

At the same time, we’re short Japan, which closed down another -51 basis points overnight. We’re also long a bag full of waterproof US Dollar denominated cash that has appreciated +6% in the last month. I outlined a proactive plan of moving to 85% cash ahead of what I thought was going to be a volatile 2 weeks of trading into a negative unemployment report and out of what should be a positive inflation report this morning. Once this CPI number is printed today, the “things” I care about will have indeed “developed”, and I can start considering the redeployment of capital.

With US Earnings Reporting season out of the way, we are going to get back to “macro” time. Obama will be back from his vacation in Hawaii, the Russians will be trying to explain why they are behaving like its 1968 all over again (when they invaded Czechoslovakia and took the capital), and John Thain at Merrill will contemplate whether or not to cut his dividend. So, what do we do next?

My first plan is always to wait. As a friend of mine likes to say, “the plan is … that plans will change”. I am data dependent, and that’s just the way that it is. On the global trading front, there are a few interesting developments to consider. One is re-shorting India. I have been out of this position for a month, and the BSE Sensex Index has rallied +17% during the same period that the S&P 500 put in that “bottom” that so many of the hopeful bulls are starting to call it from July 14th. India’s industrial production growth numbers are decelerating faster than a Chinese synchronized diver slicing into the Olympic pool – now you see it, then you don’t!

At -2.8% for August to date, the Singapore Dollar is chasing the Japanese Yen lower for worst Asian currency performer of the month. The world has slowed and Asian trading, across asset classes, is a leading indicator informing us that “things are developing” at a deteriorating pace!

Europe doesn’t look any better, so don’t expect me to be buying anything there anytime soon. The Euro is only a decade old don’t forget, and the newly formed Team “Euro Zone” is entering its first significant recession of consequence. Do you expect the Europeans to hold hands during times of adversity or point fingers? Russia’s answer is neither – they’d rather just start a war and get on with it.

Fundamentally, the US market still has some interesting pockets of security specific opportunity. I like liquidity; I like Wal-Mart; I like Hershey (HSY); and Tom Tobin and I still like Big Cap Pharma (Johnson & Johnson (JNJ), in particular). For the rest of our solidly positive year to date portfolio, you’d have to be a client to get a look at the “things” we like.

Best of luck out there today,
KM



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.


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