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‘The Question’, and a Scary Answer

We’re kicking off a new product at Research Edge called “The Question,” whereby our analysts pick one key issue each week and take industry leaders to task. We won’t take company tag-lines at face value.

I think there are few issues more important to this industry right now than the impact of FX on the P&L – not only because the multi-year slide in the dollar has been glossed over by many in this business, but also because of the violent reversal in the US$/Euro over the past 2 weeks.

I am 100% convinced that within 2 quarters, we are going to see a meaningful bifurcation between the winners and losers in a different FX climate. The winners have invested capital in their respective models while the dollar slid – companies like Ralph Lauren, Timberland, Liz Claiborne and Nike. Others printed way too much margin – such as Warnaco, Guess, Skechers, and Adidas.

‘The Question’: We asked 13 branded apparel/footwear companies the following question. “Philosophically, please walk me through your approach to managing FX. How do you alter levels of investment to take advantage of (or offset) fluctuations in the FX environment.” We were extremely consistent with our questioning, and did not lead the witness in any situation.

‘The Answer’: Weak -- all around. I expected this from the weaker players. But what surprised me most is that most of the better companies that I think have appropriately reinvested FX benefit (instead of passing it all through in the form higher margins) were unable to articulate any real strategy around the issue.

The purpose of “The Question” is to get to the bottom of key issues of investment significance, and to call out those companies that are particular standouts (+ and -). You remember back in high school when occasionally the whole class would get a detention slip instead of just the class clown? That’s what we’ve got here. No one is getting out of detention on this one.

Plan B – Math: When the results of our discussions appeared to be coming in rather grim, we started to crank through some good ol’ fashioned math. (Note, we’d have done the math anyway). We took all 13 companies and looked at company-reported FX impact to revenue, and compared to the incremental change in EBIT. In effect, we looked at what percent of the change in FX passed through to aggregate company results. The results were startling, and are shown in aggregate for the group below.

a) From early 2006 through 3Q07, the incremental FX margin averaged 100% while the Euro went from 1.26 to 1.44. No joke.
b) Starting 4Q07, the incremental margin dropped to about 15% despite another 0.14 boost in the Euro. This is the level we SHOULD see. In a perfect world, the companies would reinvest excess FX benefit in a way that keeps margins relatively steady. When FX helps, reinvest the benefit. When FX reverses, there’s a bigger base in place to help grow, and worst case to trim costs out of.
c) Unfortunately, it is not a perfect world for these companies. The fact that incremental margins came down so much when FX dictated otherwise tells me that real margins on the base business were down far more than most people realize.
d) If currency stays where it is today, we’ll be looking at negative 5-10% FX comps one quarter out. I maintain my view that margins are still coming down 2-3 points in this business over 2-3 years. FX might make this happen sooner than later. Clear the decks!


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%)

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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

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

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