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LDG, Part IV: Levering Up To Buy An Asset Headed Into A Secularl Slowdown?

Pharmacy revenue growth appears to be in the grip of a secular slowdown that has no end in sight. While the "The Aging Baby Boomers" are a source of comfort to many investors, a closer look at the individual components that drive pharmacy revenues, suggest just the opposite, a slowing demand curve.

New drug approvals, unit inflation, and insurance coverage together point to tougher times for the pharmacy supply chain. Sum of the parts calculations place the low end of pharmacy revenue growth at 1% while putting an upper limit on growth at 3.5%, under the most favorable conditions.

Using the most recent data available from the National Health Expenditures Survey of 2004, which details per capita spending on pharmaceuticals, together with the population forecast from the US Census Bureau, total prescription dollar growth will remain at the moribund rate of 1.5% or lower for the foreseeable future.

New products from the Pharmaceutical Industry have not kept pace according the FDA. Whether this is a tougher, more risk-averse FDA, or bad decisions by R&D executives, the pace of innovation has been declining for over a decade.

Prescription inflation is slowing according to the CPI (bls.gov) While generic introductions affect the shape of the curve, it appears the Pharmaceutical Industry has entered a new phase of lower pricing power. Lower unit inflation for prescriptions directly affects same store comps, but also slows the rate of change in the spread between wholesale acquisition costs and reimbursement for the pharmacy.

According to the Kaiser Family Foundation, a 1% change in the unemployment rate creates 1.1M uninsured individuals and increases Medicaid rolls by 1.0M, by law the lowest priced pharmaceutical buyer. Through 2006, the ranks of the uninsured were already climbing. With 154.6M in the civilian workforce, further increases in unemployment could represent a 50 to 100bps drag on pharmacy alone.

Tom Tobin
Managing Director
Healthcare

A REVEALING IGT/WMS/BYI “QUADRANT” ANALYSIS

Not sure it’s embezzlement but I’m stealing some intellectual property from my partner Brian McGough. Brian has developed a very useful tool for analyzing apparel companies. In a continuous effort to take a fresh approach, I’ve incorporated his quadrant tool to analyze the gaming equipment sector. The quadrant analysis is just one of many unique tools I plan to roll out.

  • WMS sits comfortably in Quadrant 1: The Sweet Spot. In fact, the company has not wavered from this comfort zone during the last 2 years. Despite selling into a trough domestic replacement environment, sales are growing faster than inventory and gross margins are improving. Essentially, this is a tribute to management. The company grew sales faster than inventory without sacrificing gross margins for 8 straight quarters. WMS is not discounting to keep inventory low and drive sales. This is very healthy, particularly considering the challenging environment.

  • The IGT chart is very different, especially recently. Calendar 2008 has not been kind to IGT’s fundamentals or its stock price. The quadrant analysis is revealing. Trough replacement demand and market share declines have double teamed IGT’s revenue picture. Unfortunately, inventories continue to build. Q2 improved from Q1 in that gross margins actually ticked up a bit. The next few quarters will be very interesting. I’m not sure IGT can do much about the near-term revenue outlook but the story looks better if they can get inventories under control and continue the sequential margin growth. As I’ve written about, IGT is a potential long-term margin story. Headcount reductions and other SG&A cuts are the low hanging fruit and the company is making progress there. Continued gross margin improvement may come from more overseas manufacturing. More to come on these topics.

  • I have not included a BYI chart but suffice it to say that margins continue to expand and sales are outpacing inventory. Aesthetically, the chart line whips around so much it is not useful. The turnaround efforts over the past few years have yielded some drastic improvement in revenue growth and margin expansion. BYI reports tomorrow and we may have more to say on this one.

WMS firmly entrenched in the Sweet Spot
IGT needs to improve its inventory situation and maintain CY Q2 margin expansion

German Inflation +8.9% Year Over Year; Highest Since 1981

Germany's monthly inflation report wasn't as high as that reported here in the US, but it was pretty darn close. Germany's PPI report came in at +8.9% year over year.

This was the highest number they have printed since 1981. Coincidentally, June of the same year is when US inflation (PPI) was last reported as high as today's report suggested.

The top 3 economies in the world (US, Japan, and Germany) are effectively telling you that they are experiencing economic stagflation. This is not good. Lehman , Goldman, and Merrill have plenty more to be worried about other than a credit crisis now.

It is global this time, indeed.

KM

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It's not all about commodities - inflation hits +9.8% y/y!

This morning's PPI report for the month of July was 2x higher than the Street's expected number. This caught some of the "deflation" bulls offside. Reported inflation is not a straight line to the rate of change in the CRB Commodities Index. Pharmaceuticals and Autos inflated materially.

The attached chart shows the inflation that continues to mount within the cost structures of US producers. Irrespective of the fact that this report is a lagging economic indicator, be sure that this will be a "Main Street" political football that Obama shows no shame in throwing down field.

Stagflation remains economic reality in the USA, regardless.
KM

Space Dogs

Oh how quickly the facts can change in this increasingly interconnected global market place of trading. Nine different analysts have cut “estimates” for Goldman Sachs (GS) in the last week, and every other reporter is being tipped off that Lehman is going to take another multi-billion dollar write-down here in Q3. So much for policing insider trading.

Q3 is only halfway done, you see - it’s been whippy out there, to say the least. Asian growth has slowed, commodities have tanked, the US Dollar has soared, Musharraf has been ousted, and the Russians started a war. What does any of this have to do with tricky Dick Fuld at Lehman? A lot actually. On the ‘About Us’ tab of the Lehman Brothers website, the entrée into their business description is that they are “an innovator in global finance”. With all of the aforementioned cross currents associated with a global slowdown, Fuld is undoubtedly waking up to new risks that he didn’t prepare for, daily.

Not all “innovation” creates positive long term P&L. Ask the Russians, who on this day in 1960 launched Belka and Strelka into orbit. At least Sputnik carried 40 mice and 2 rats along for the dogs joy ride. Maybe Fuld should have tested some of his financial “innovations” with animals first!

Now that the “BRIC” (Brazil, Russia, India, and China) stock markets are all in free fall, our friends up here on science hill at Yale are calling us on the super secret whisper line suggesting that Wall Street investment banking structures are being struck by a breaking new discovery – gravity.

Russian space dogs succumbed to the same phenomena as Sputnik came back to Earth’s reality. It was as fascinating then as it is today. Like a space ship bracing for its landing, the Russian stock market is trading down -3.4% so far this morning, taking the RTS Index down to 1717, which marks a -31% decline since it’s May 19th, 2008 peak. On the bold red-army-colored cover of ‘The Economist’ this week, the page is titled “Russia Resurgent”. This looks more like “Russia Revealed” to me.

In Asia, gravitational forces continue to pull down everything that had expectations for moon shot flight patterns. We’ve been focusing on the horrendous economic data points out of Japan, Singapore, and Hong Kong over the course of the last few weeks, and their stock markets were down another -2.3%, -1.8%, and -2.1%, respectively overnight, testing new year to date lows. There is a Chinese company that’s listed on the Nasdaq, China TechFaith Wireless (CNTF), that is looking down -19% pre-open. “TechFaith”? – how innovative!

The Bank of Japan decided to keep its socialist regime intact, leaving interest rates at 0.50%, and issued newfound concerns that gravity may very well indeed continue to affect them more severely. They have no idea on the duration of this economic downturn, but they are certain that they will keep the easy money bailout monetary policy that has not worked for almost two decades.

European trading is quite weak, on the heels of the highest reported inflation number that the Germans have had to read since 1981. At +8.9% year over year growth, the German PPI confirmed what the leaders of the Bundesbank tried to warn Wall Street of yesterday – a deflating Euro imports inflation! Alongside Putin’s stock market getting crushed, European indices are trading down -1.5% to -2% across the board. From a quantitative perspective, the momentum factor implied in the FTSE in London actually looks a lot like that in the S&P 500. A break down and close through the 5387 line turns immediate term momentum to negative. For the S&P, my critical support line is 1267.

The US Dollar has been working now that everything that went up is coming down. Gravitational force, like cash, is king. At 77.23 this morning, the US$ has had one of its sharpest short term rallies on record (+7.6% in a month!). What is good for the US$ may not be so good for everything else, particularly if all assets classes start to auto correlate to the downside.

If your broker has any “innovative” space puppy products in your portfolio, sellem’ while you can.

KM



US HOTEL REVPAR “LINKED” TO THE DOLLAR

A weak dollar and strong worldwide economies have masked what would otherwise be a pretty bleak RevPAR picture in the US. All year, US “international” cities have outperformed the rest of the country in terms of RevPAR growth. The following chart highlights the positive correlation between growth in international visitation and RevPAR by city. A weak dollar combined with solid economic growth overseas was a big contributor to RevPAR growth. Despite strong international visitation during the first half of 2008, the rate of change in RevPAR growth slowed from 2007. The weak link: domestic business and leisure travel. While domestic travel remains sluggish in the back half of 2008, the other 2 trends have reversed. The dollar has strengthened and overseas economic growth is slowing. Looks like one weak link has turned into three.

Weak $ contributed to international & RevPAR growth. What happens now that $ is strenghening?

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