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Could China prove to be a massive 2nd chance for Kobe (and Nike)? 300 million fans don’t know/care about his legal/moral/ethical taint in the US. They simply see the best player in the world.

I posted a little comment on Aug 10 highlighting the disconnect between Nike’s 90%+ footwear basketball shoe share in the US and the fact that only 4 of the top 10 NBA jersey’s sold in China were for Nike athletes. This, of course, raised the question as to whether Nike is overinvesting in its most mature market to maintain dominance while exposing itself to steeper competition in the most meaningful incremental growth driver for the next decade – China.

Well, that was before I saw China’s ‘Kobe-Mania.’ (They scream ‘Kobe-a’ when they see him, and then at times start crying or faint). The simple fact that Kobe got as much thunderous applause in the USA/China game as Yao Ming (Reebok) is pretty amazing. Out of the 11 players on the USA team, Kobe is the only one who the Chinese military has demanded he stay indoors unless absolutely necessary, and if outside he is escorted by several soldiers to control the crowds.

I don’t think Jordan was ever that big in China, which actually raises an interesting question. Kobe is an amazing player. It’s tough to dispute that. But my own view is that regardless of his level of play, Kobe will never win any popularity contests in the US due to his highly-publicized legal troubles several years back. Most of the 300million Chinese basketball fans (yes, that number is correct) don’t know about the legal mess and moral/ethical taint Kobe has in the US. If they know, they probably don’t care. If Nike plays its cards right, they could help turn Kobe into a franchise in China that is several times the size of what could ever be in the US.

US Market Performance: Week Ended 8/15/08...

Index Performance:

Week Ended 8/15/08:
Dow Jones (0.6%), SP500 +0.2%, Nasdaq +1.6%, Russell2000 +2.6%

2008 Year To Date:
Dow Jones (12.1%), SP500 (11.6%), Nasdaq (7.5%), Russell2000 (1.7%)


The Return on Equity (ROE) and Return on Invested Capital (ROIC) trends shown in the chart below are scary enough. Throw in the fact that ROE is actually declining at a faster rate than ROIC and the situation is downright frightening. We estimate ASCA’s cost of borrowing will go up by 2% in 2009 as the company either refinances its entire credit facility, raises subordinated debt to shore up its senior leverage ratio, or negotiates a higher leverage restriction in exchange for a higher rate. A borrowing cost increase of 2% is probably a best case scenario for ASCA, especially considering a likely covenant bust by Q2 2009 (see my 8/14/08 post, “ASCA: TOEING THE COVENANT LINE”).

I’ve also been generous with my calculations as it relates to “non-recurring” items. All have been excluded resulting in higher ROE and ROIC than the standard measures.

This simple analysis hits on several themes I’ve been focused on: liquidity, escalating costs of capital (although you wouldn’t pick this up from the analysts’ models), over earning, and lower ROI’s. ASCA’s liquidity issues will force the company into a higher borrowing cost capital structure. Risk premiums are escalating, also forcing up interest rates. Finally, on the return side ASCA is not helping itself. The company made one of the worst acquisitions ever in gaming, buying Resorts East Chicago at the top (11x a declining EBITDA figure), ahead of a huge expansion, renovation, and rebrand at nearby Harrah’s. This poor decision is a major driver of declining returns.

Most gaming operators have been over earning (see 8/10/08 post) due to unsustainably low interest rates on credit facilities. No situation has been more egregious than ASCA. All good things must come to an end and so has the era of cheap money.

ROE declining at a faster rate than ROIC

Hedgeye Statistics

The total percentage of successful long and short trading signals since the inception of Real-Time Alerts in August of 2008.

  • LONG SIGNALS 80.51%
  • SHORT SIGNALS 78.32%

Canada Wins!

I promised our Canadian readers that I would dedicate a post to their 1st medal, when it happened. Over the span of 46 minutes at today's Olympics, they won 3 - gold, silver, and bronze!

LDG, Part I: An Eye On Pershing Square

Bill Ackman’s remarkably well timed purchase of Longs Drug Stores has already been called the “trade of the year” by at least one publication. We always love to read about a great “Trade”, but even before the news of the CVS acquisition broke we had already begun looking at the filings made by Pershing Square for different reasons.

As you recall we followed the CSX/Chris Hohn court proceedings intently as they related to the use of total return swaps by activist shareholders. As such, the filings made by Ackman had some interesting language that caught our ‘HedgEye’.

A total return swap, for those that are not familiar, is a contract which gives the purchaser a synthetic economic interest identical to an outright long or short position, typically on a significantly leveraged basis.

Even if the economic interest exceeds the equivalent of 5% of shares outstanding, most funds do not file their position with the SEC since the swaps do not confer voting rights. One of the arguments made by attorneys for CSX during their suit against TCI was that, as the fund had arranged to have the banks providing them with exposure to CSX via swaps to vote their shares according to instruction, TCI by extension had filing requirements.

In his ruling, Judge Lewis Kaplan seemed to agree with CSX’s argument that using swaps as an end run around filing requirements violated the spirit of the law, if not the letter of it in his conclusion that “Some people deliberately go close to the line dividing legal from illegal if they see a sufficient opportunity for profit in doing so. A few cross that line and, if caught, seek to justify their actions on the basis of formalistic arguments even when it is apparent that they have defeated the purpose of the law”.

We are not lawyers but, when Pershing Square filed a 13D for the famously well timed LDG purchase, a sentence in the discussion of the swap transactions they had executed caught our eye: “These Swaps do not give the Reporting Persons direct or indirect voting, investment, or dispositive control over any securities of the Issuer and do not require the counterparty thereto to acquire, hold, vote or dispose of any securities of the Issuer.”

We don’t know if Ackman’s attorneys at Proskaur Rose had already been including that language in their boilerplate before the CSX/TCI dust up but it seemed to put one possible issue to rest, if only they had disclaimer language that could answer some of the other head scratchers raised by the timelines for these trades.

Attached are some charts which map out the series of events laid out in the 13D filings made by Pershing Square in recent weeks. We will be exploring several different aspects of this situation in the coming week –stay tuned.

Andrew Barber

Keith McCullough
Chief Investment Officer

MCD – Coffee conversion math!

Here are is what we know so far:
4Q07 – No comment from the company when asked on the conference call about the number of stores selling specialty coffee, but they did not expect to see critical mass until later in 2009.
1Q08 – “We are currently in about 1300 restaurants and expect the rollout to accelerate and pick up pace later in the year.”
2Q08 – “Specialty coffees is just one element of the combined beverage business and it’s currently in more than 1600 restaurants.”
3Q08E - ???

If we assume the company accelerates the conversion process in 2H08 and converts 1,200 stores, the total number of McDonald’s stores with the ability to sell specialty coffee in the US would be 2,800. This represents only 25% of the McDonald’s system! McDonald’s senior management has set expectations for a national launch for the specialty coffee program in mid-2009. If it has not started already, the 2009 budgeting process needs to incorporate the national launch of the specialty coffee program. If only 25% of the store base has the ability to sell specialty coffee, how can the company justify spending the marketing dollars in 2009? More importantly, will the franchise system embrace the move?

Right or wrong management is committed to the specialty coffee program, I believe they need to reset expectations.

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