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LDG, Part II: Ackman Pushing For a Higher Price?

With both the Financial Times and the Wall Street Journal running stories in the last 72 hours on Bill Ackman’s alleged behind the scenes financial maneuverings with regards to Pershing’s levered investment in Longs Drugs (LDG), I guess he wants us all to pay attention. After grinding through his 13D filings and the timing of his purchases therein (see portal posting from 8/15), I am officially all in for this show.

The FT is citing someone “close to the matter” and the WSJ a “person familiar with the situation”. This kind of super secret rumor whispering is not unlike that which investors have had to endure with both of Ackman’s latest unsuccessful attempts at pushing his own book with both Border’s Group (BGP) and Target (TGT). As reference points, charts for both TGT and BGP are below.

It would be one thing if I was a reporter, it’s entirely another in this case however because I have invested in all 3 of the aforementioned companies for multi-billion dollar hedge funds in the past. I have had multiple one on one meetings with all of the senior management teams of the these companies – I know the assets and the players who analyze them.

Interestingly, when my partner and I drove up to Long’s Drugs headquarters in California for the first time in 2004, the stock was almost -75% lower than where Ackman is allegedly suggesting is not high enough today. The stores are now older, and the economy weaker.

At, $71.99/share, Longs (LDG) is trading at a premium to the proposed CVS takeout price. Why is that? Who leaks these creative “financial maximizations of shareholder value” into the market place? Who gets paid the most if it all comes to fruition? Who invests other people’s money this way?

These are all critical questions. So is addressing the two bull cases that someone out there with a levered financial incentive wants you to consider – so let’s put the analytical pants on and take a walk down that path.

1. Walgreens (WAG) coming in with a higher bid than CVS’s

2. Blackstone (BX) signing off on Ackman’s alleged, and magically creative, real estate idea

I don’t think either are reasonable options for reasonable investors to consider in economic times like this.

On the Walgreens side of the ledger there are 3 reasons I can start you off with: 1. Valuation – the implied valuation for LDG above deal price approaches 10.5x cash flow, and WAG trades for 9x (ttm) EBITDA – no way WAG pays this price, 2. CA store overlap and antitrust approval is far too cumbersome, and 3. the core Longs Drug store formats are round holes compared to WAG’s proverbial square pegs – store conversions make no sense; they would dilute WAG’s unit level productivity and return metrics.

On the Blackstone front, we are still speaking with our contacts this weekend in order to get more insight. The bottom line however is that Ackman has retained Blackstone in the past. This is not new. This is what he does. I have seen this movie before. Be sure that he pays Blackstone plenty of money to “think” about creative ways to get him out of his buying Target (TGT) at both an economic cycle top, and leverage cycle top.

CVS shareholders better be following the bouncing ball very closely here.

Stay tuned…

KM
(charts courtesy of StockCharts.com)

Credibility

With another summer weekend behind us, it’s back to the grind here this morning. All things considered, US futures look pretty good relative to what they could look like. I think there is still some gas left in the tank here on the bullish side of the pain “Trade”, which remains higher.

With the US Dollar finding its footing and commodity driven inflation coming in hot, it has been virtually impossible for the objective mind to remain ultra bearish in the immediate term. For the intermediate term “Trend” in the S&P 500 to turn positive however, I’ll need to see a close above the 1330 line.

As US earnings season winds down, we’re moving back to macro time, and I’ll do my best to proactively highlight where the masses might be focused. The two most important macro dates on your calendar for this week will be tomorrow (housing starts and PPI for July) and Friday, when Ben Bernanke will gather his politicized Fed for a powwow in Jackson Hole.

On the inflation front, it would be hard to see a more elevated headline PPI than we saw in last week’s CPI, and it would be even harder to explain why 2 year US Treasury yields have stopped going up despite as much. The most logical conclusion that I can surmise is that Bernanke is going to pander to the bailout populous on Friday, and continue with his dovish rhetoric. This, of course, keeps the easy money Fed card in play, and leaves room for levered long investors to continue to hope that the US stock market “bottom is in”.

In the end, Bernanke not tightening the screws on cost of capital is going to continue to equate to widening credit spreads and mounting systemic risk in the US Financial system. The longer he keeps undisciplined players on life support, the more protracted the American economic downturn will be. I am certainly not the only one with this view at this point. Bernanke’s recently “retired” Fed teammate, Charles Plosser, is on the record in a Bloomberg interview this morning saying, ``there is some hard thinking that needs to be done…the Fed has a terrific reputation as a credible institution. We have to be cautious not to undertake things that put that credibility at risk…''

From Russia to Jackson hole, credibility is what this brave new ‘You Tube’ world is looking for. Credibility, transparency, and accountability – people get that, particularly when you show it to them. People aren’t as dumb as Wall Street would like to think. The power of real time information transfer is shifting. The leverage is being put back into the hands of what has long been considered the feudal system of financial wherewithal – Main Street. If you want to predict how humans behave, follow where their money is.

In Asian trading this morning we are seeing the Chinese locals follow one another’s money out the door. China got hammered for another -5.3% down move overnight, taking the Shanghai Composite Index down to 2319 – that’s a -15% drop since the Olympics began. Find me a bird’s nest to crawl into.

Stocks in Hong Kong reacted negatively to this decline, closing down another -1.1%. Since July 23rd, the Hang Seng index has lost -10% of its value in the face of the S&P 500 moving +1% over the same duration. This is a major league negative divergence. It is telling you that global growth is slowing, big time. This certainly explains why commodities have corrected over -20% in a month, and probably explains why US Treasuries are breaking out as well.

As the US market “Trade” continues upward into the tail end of its latest run-up, I’ll likely be moving up to 90% cash.

Best of luck out there this week,
KM



‘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!


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“Kobe-a”

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%)

ASCA: ROE DECLINING AT A FASTER RATE THAN ROIC

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

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